Objectives of the Lesson:
After studying this unit you should able to:
--- Content provided by FirstRanker.com ---
Meaning of globalization
Explain the Liberalized Foreign Investment Policy
Discuss the New Global Economic War
Explain the various International Financial Institution / Development
--- Content provided by FirstRanker.com ---
Banks involved in global trade
Structure of the Lesson:
--- Content provided by FirstRanker.com ---
1.0 Introduction1.1 Liberalized Foreign Investment Policy
1.2 New Global Economic War
--- Content provided by FirstRanker.com ---
1.3 International Financial Institution / Development Banks
1.3.1 International Monetary Fund (IMF)
--- Content provided by FirstRanker.com ---
1.3.2 The International Finance Corporation (IFC)1.3.3 The World Bank
1. 3. 4 The World Bank Groups
--- Content provided by FirstRanker.com ---
1.3.5 Asian Development Bank
1.0 Introduction
--- Content provided by FirstRanker.com ---
Globalization of trade implies `universalisation of the process oftrade'. In 1990, increased openness to international trade, under such
headings as, outward orientation or trade liberalization has been
--- Content provided by FirstRanker.com ---
advocated as an engine of economic growth and a road to
development. The marginalization of Indian economy together with
--- Content provided by FirstRanker.com ---
many other factors resulted in a severe balance of payment crisis. Theforeign exchange reserves fell rapidly to less than three weeks of our
imports needs. In order to overcome this situation, and boost up
--- Content provided by FirstRanker.com ---
exports, the Government initiated steps for the dismantling ofrestrictive policy instruments through reforms m trade, tariff, and
exchange rate policies.
--- Content provided by FirstRanker.com ---
After examining the list of imports and exports, the following
--- Content provided by FirstRanker.com ---
corrections were made: gradual withdrawal of many of the quantitativerestrictions on imports and exports, shifting of a significant number of
items outside the purview of import licensing, considerable reduction
--- Content provided by FirstRanker.com ---
in the level of tariff rates, Exim scrip`s devaluation of rupee, partial
and later on full convertibility of rupee etc.
--- Content provided by FirstRanker.com ---
1.1 Liberalized Foreign Investment PolicyIn June 1991, Indian government initiated programme of macro
--- Content provided by FirstRanker.com ---
economic stabilization and structural adjustment supported by IMF
and the World Bank. As part of this programme a new industrial policy was
--- Content provided by FirstRanker.com ---
announced on July 24, 1991 in the Parliament, which has started theprocess of full-scale liberalization and intensified the process of integration
of India with the global economy.
--- Content provided by FirstRanker.com ---
A Foreign Investment Promotion Board (FIPB), authorized to
--- Content provided by FirstRanker.com ---
provide a single window clearance as been set up. The existingcompanies are allowed to raise foreign equity levels to 51 per cent for
proposed expansions in priority industries. The use of foreign brand
--- Content provided by FirstRanker.com ---
names for goods manufactured by domestic industry, which was
restricted, has also been liberalized. India became a signatory to the
--- Content provided by FirstRanker.com ---
convention of MIGA for protection of foreign investments.Companies with more than 40 per cent of foreign equity are
--- Content provided by FirstRanker.com ---
now treated on par with fully Indian owned companies. New sectors
such as mining, banking, telecommunications, high-way construction,
--- Content provided by FirstRanker.com ---
and management have been thrown Open to private, including foreignowned companies. The investment policy and the subsequent policy
amendments have liberalized the industrial policy regime in the
--- Content provided by FirstRanker.com ---
country especially, as it applies to foreign direct investment beyondrecognition.
1.2 New Global Economic War
--- Content provided by FirstRanker.com ---
After the Second War and the IMF par value system came into
--- Content provided by FirstRanker.com ---
existence, we became part of the new world system. Countries hadexchange control and various sorts of trade restrictions. It was after the
Seventies that gradually a scheme of flexible exchange rates came into
--- Content provided by FirstRanker.com ---
existence among leading developed countries. Gradually the developed
countries started freeing their exchange rates and also moved towards
--- Content provided by FirstRanker.com ---
their system off free trade.The World Trade Organization, of which we are a member, is
--- Content provided by FirstRanker.com ---
now introducing all over the world a free trade system. After the
advent of Economic Reforms from 1991-1992, we have moved over to
--- Content provided by FirstRanker.com ---
currency, convertibility on current account. The importance of theWorld Bank as financier has diminished considerably. The world is
now dependant on private capital imports. Even the role of the IMF
--- Content provided by FirstRanker.com ---
has diminished with most countries adopting currency convertibility.
Capital flows are moving on a large scale dependent on incentives.
--- Content provided by FirstRanker.com ---
Most countries have lifted trade barriers and reduced import duties.The WTO is introducing system in which domestic subsidies
--- Content provided by FirstRanker.com ---
have to be removed and uniform and low import duties have now to
become the standard. There is no place for tariff barriers and non-tariff
--- Content provided by FirstRanker.com ---
barriers are also now getting lifted. The world`s industries are noworganized largely in terms of multinational corporations whose
operations transcend many countries. International demonstration
--- Content provided by FirstRanker.com ---
effects are working powerfully in determining the living styles in all
countries.
1.3 International Financial Institution / Development Banks
--- Content provided by FirstRanker.com ---
1.3.1 International Monetary Fund (IMF)
This international monetary institution was established by 44
--- Content provided by FirstRanker.com ---
nations under his Bretton Woods Agreement of July 1944. The mainaim was to remove his economic failures of 1920s and 1930s. The
attempts of many countries to return to old gold system after world war
--- Content provided by FirstRanker.com ---
failed miserably. The world suppression of the thirties forced every
country to abandon gold standard. This led to the adoption of purely
--- Content provided by FirstRanker.com ---
nationalistic policies whereby almost every country imposed tradeRestrictions, exchange control, and resorted to exchange depreciation in
order to encourage its exports. This will lead to further spread of
--- Content provided by FirstRanker.com ---
depression. It was against this background that 44 nations assembled at the
United Nations monetary and financial conference at Breton woods,
--- Content provided by FirstRanker.com ---
New Hampshire (USA) from 1st July to 22nd July 1944. Thus the IMFwas established to promote economic and financial co-operation among
the members in order to facilitate expansion and balanced growth of
--- Content provided by FirstRanker.com ---
world trade. It started functioning from 1st march 1947.
--- Content provided by FirstRanker.com ---
The fundamental purpose and objectives of the fund had been saiddown in Article of the original Articles of agreement and they have
been upheld in the two amendments that were made in 1969 and 1978 to
--- Content provided by FirstRanker.com ---
its basic charter. They provide the framework within which the fund
functions they are as under:
--- Content provided by FirstRanker.com ---
1. To promote the international monetary cooperation through a permanentinstitution. This can provide the machinery for consultation and collaboration
in the international monetary problems.
--- Content provided by FirstRanker.com ---
2. To facilitate the expansion and balanced growth, of international
trade and to contribute promotion and maintenance of high levels of
employment and real income and to the development of the
--- Content provided by FirstRanker.com ---
productive resources of all members.
3. To promote exchange stability, to maintain orderly exchange
--- Content provided by FirstRanker.com ---
arrangements among members, and to avoid competitiveexchange, depreciation.
4. To assist in the establishment of a multilateral system of
--- Content provided by FirstRanker.com ---
payments in respect of current transactions between members and in
the elimination of foreign exchange restrictions.
--- Content provided by FirstRanker.com ---
5. To give confidence to members by making the general resources ofthe fund temporarily available to them under adequate safeguards
thus, providing them with opportunity to correct adjustment in
--- Content provided by FirstRanker.com ---
their balance of payments without resorting to measures destructive
to national or international prosperity.
--- Content provided by FirstRanker.com ---
Thus the role of IMF is mainly Two Fold: It is an organization
to monitor the proper conduct of International monetary system
--- Content provided by FirstRanker.com ---
second.
--- Content provided by FirstRanker.com ---
IMF can by way of borrowing it can supplement its own resources. Inthe year 1962 a significant achievement can be made by way of entering into
general Arrangement to borrow. Under this agreement ten industrialized
--- Content provided by FirstRanker.com ---
countries agreed to send to IMF their own currencies up to the limit agreed.
The ten countries known as group of 10 countries include Belgium, Canada,
--- Content provided by FirstRanker.com ---
France, West Germany, Italy, Japan, Netherlands, Sweden, U. K, and U. S. Itcan borrow under this arrangement only when the funds are needed for a
participant in the agreement was only four years. It was subsequently received
--- Content provided by FirstRanker.com ---
periodically and the latest reward was made in 1984 in an expanded form.
Switzerland also joined the arrangement with the group of so. The total
--- Content provided by FirstRanker.com ---
commitment by these countries increased to USD 17.65 billion.It provides temporary assistance to members to tide over the balance
--- Content provided by FirstRanker.com ---
of payments deficits. When the country requires foreign exchange, it tendersits own currency t the IMF and gets the required foreign exchange. This is
lower as Drawings from the ISSF. When the Balance of Payment position
--- Content provided by FirstRanker.com ---
improves, it should repurchase its currency from the IMF and repay the
foreign exchange.
--- Content provided by FirstRanker.com ---
Compensatory financing facility was introduced in 1963 to provide
reserves to countries that are heavily dependent on the export of primary
--- Content provided by FirstRanker.com ---
products. It main purpose is to provide the needed foreign exchange to a
country experiencing balance of payment deficit due to a temporary export
--- Content provided by FirstRanker.com ---
shortfall caused by circumstances beyond the countries control. Under thisscheme, funds equivalent to 100% of its quota can be draw by a country in
addition to those available under the franche policies. A country need not
--- Content provided by FirstRanker.com ---
exhaust its reserves franchise before making use of the compensatory
financing facility. But it most agrees to co-operate with the IMF in working
--- Content provided by FirstRanker.com ---
out appropriate solutions to its Balance of payments problems.Buffer stock financing was created in 1969 for financing commodity
--- Content provided by FirstRanker.com ---
buffer stock by member countries the facility is equivalent to 30 percent of the
Borrowing members quota. Repurchases are made in 3 1/4 to 5 years. But the
--- Content provided by FirstRanker.com ---
member is expected to co-operate with the fund in establishing commodityprices within the country
--- Content provided by FirstRanker.com ---
The extended fund facility is another specialized facility which was
created in 1974. It is based on performance criteria and drawing instilments, it
--- Content provided by FirstRanker.com ---
is availed by developing countries.The supplementary financing facility was established in 1977 to
--- Content provided by FirstRanker.com ---
provide supplementary financing under extended or stand by arrangements to
member countries to need serious balance of payments deficits that are large
--- Content provided by FirstRanker.com ---
in relation to their economics and their quotas. This facility has been extendedto low income developing member countries of the fund. To reduce the cost
of borrowing under this scheme to such countries, the fund established
--- Content provided by FirstRanker.com ---
subsidy account in 1980 through which it makes subsidy payments toborrower countries.
--- Content provided by FirstRanker.com ---
Structural adjustment facility was set up made 1986 to provide
confessional adjustment to the poorer developing countries. Loans are granted
--- Content provided by FirstRanker.com ---
to them to solve balance of payments problems and to carry out medium termmacro economic and structural adjustment programmes. Enhanced Structural
Adjustment Facility was created in 1987 with SDR 6 billion of resources for
--- Content provided by FirstRanker.com ---
the medium term financing needs of low income countries. Disbursements
under this scheme are semi annual instead of annual.
--- Content provided by FirstRanker.com ---
Compensatory and contingency financing facility was created in 1988
to provide timely help for temporary short falls or excesses in cereal import
--- Content provided by FirstRanker.com ---
cost due to facers beyond the control of members and contingency, financing
to help a member to maintain the memorandum of fund supported adjustment
--- Content provided by FirstRanker.com ---
programmes in the face of external shocks on account of factors beyond itscontrol. It replaces the compensatory financing facility for export fluctuations
of 1963 and facility for financing fluctuations in the cost of cereal imports of
--- Content provided by FirstRanker.com ---
1981. In 1990, the fund introduced an important element into CCFF for a
temporary period up to the end of 1991 to help members overcome the Gulf
--- Content provided by FirstRanker.com ---
war crisis.The most important feature of IMF system as original y conceived
--- Content provided by FirstRanker.com ---
was the exchange rate exchange rate arrangement of its member countries.
The original aim of IMF incorporate the feature of the gold exchange standard
--- Content provided by FirstRanker.com ---
basic structure of exchange rates, with flexibility built into it to a certainextent. One or two major countries remain on gold standard and their
currencies their currencies are convertible into gold. Other countries make
--- Content provided by FirstRanker.com ---
their currencies convertible in to the currency which remain on gold standard.
The same arrangement was retained in the IMF dollar taking the place of the
convertible an account of the functioning of exchange. The
--- Content provided by FirstRanker.com ---
IMF
has
--- Content provided by FirstRanker.com ---
performed well as an international monetary institution. It has been supplyingdifferent currencies to different countries for making adjustments in their
balance of payments over a long period. Both the developed and developing
--- Content provided by FirstRanker.com ---
countries have made extensive use of its resources. It has tried to solve the
problem of international liquidity by making suitable amendments to its
--- Content provided by FirstRanker.com ---
Articles of agreements. It has this proved its flexibility by moving with thechanged international economic conditions. But it can not be said that it has
been our overal success in fulfilling its objectives. Some of its criticisms are
--- Content provided by FirstRanker.com ---
discussed as under:
1. The fund has been conservative, laid down stringent conditions for lending
--- Content provided by FirstRanker.com ---
with high interest rates.2. It has developed conditionality practice over the last three decade.
3. It has been playing only a secondary role rather than the central role in
--- Content provided by FirstRanker.com ---
international monetary relations. It does not provide facilities for short term
credit arrangements.
--- Content provided by FirstRanker.com ---
4. The IMF has enough resources for the immediate future. But these are notsufficient to meet the future needs of its members.
5. The fund also failed in its objectives of promoting exchange stability and to
--- Content provided by FirstRanker.com ---
maintain orderly exchange arrangement among members.
6. One of the objectives of the fund has been to eliminate foreign exchange
--- Content provided by FirstRanker.com ---
restrictions which hamper the growth in world trade. The fund has not beensuccessful in achieving this objective. The world trade is restricted by a
variety of exchange controls and multiple exchange practice.
--- Content provided by FirstRanker.com ---
7. The fund has been criticized for its discriminatory policies against the
developing countries and in favour of the developed countries. It is therefore,
characterized as "Rich Countries' Club" it is dominated especially by United
--- Content provided by FirstRanker.com ---
States.
1.3.2 The International Finance Corporation (IFC)
--- Content provided by FirstRanker.com ---
IFC was established in 1956 with the specific purpose of extending
the finance support to private enterprises. It is an affiliate of IBRD. The
--- Content provided by FirstRanker.com ---
Articles of agreement of IFC are similar to that of the World Bank. A country
has to be a member of the World Bank in order to join the IFC. In June 1996
--- Content provided by FirstRanker.com ---
it had 181 members. The IFC can borrow from the World Bank four times itssubscribed capital and surpluses. It can also borrow from the International
money market. The purpose of the IFC is to further the economic
--- Content provided by FirstRanker.com ---
development by encouraging growth of private enterprise in member
countries, particularly in the less developed areas, thus supplementing the
--- Content provided by FirstRanker.com ---
activities of the IBRD. The IFC, therefore1. Invests in private enterprise in member countries, in association with the
private investors and without government guarantee, in cases where sufficient
--- Content provided by FirstRanker.com ---
private capital is not available on reasonable terms.
2. To bring together investment opportunities private capital of both foreign
--- Content provided by FirstRanker.com ---
and domestic origin, and experienced management and.3. Stimulates condition conducive to his flow of private capital, domestic and
foreign, into productive investment in member countries.
--- Content provided by FirstRanker.com ---
The activities were:
1. Project identification and promotion
--- Content provided by FirstRanker.com ---
2. It helps the member countries to establish, and improve privately owneddevelopment finance companies and other institutions which are themselves
engaged in grounding and financing private enterprise.
--- Content provided by FirstRanker.com ---
3. Encouraging the growth of capital markets in the developing countries.
Thus it does by a) providing support to financial institutions in developing
countries to meet their investment needs and b) by promoting his investors in
--- Content provided by FirstRanker.com ---
developed countries to participate in these capital markets.
4. Giving advice and technical counsel to developing countries in measure
--- Content provided by FirstRanker.com ---
that will create a climate conducive to growth of private investment.The IFC had a slow beginning and much of its assistance was
--- Content provided by FirstRanker.com ---
concentrated in Latin and Central American Countries. But in recent years it
has diversified its area of operations and many developing countries stand
--- Content provided by FirstRanker.com ---
benefited. India has also received substantial assistance from IFC.1.3.3 The World Bank
--- Content provided by FirstRanker.com ---
The International Bank for Reconstruction and Development (IBRD)
or the World Bank was established in 1945 under Bretton Woods Agreement
--- Content provided by FirstRanker.com ---
of 1944 to assist in bringing about a smooth transition from a War time topeace time economy. It is a sister concern of the international monetary fund.
The Functions of IBRD are:
--- Content provided by FirstRanker.com ---
1. To assist in the reconstruction and development of territories of its
--- Content provided by FirstRanker.com ---
members by facilitating the investment of capital for productive purpose, andthe encouragement of the development of productive facilities and resources
in less developed countries.
--- Content provided by FirstRanker.com ---
2. To promote private foreign investment by means of guarantees on
--- Content provided by FirstRanker.com ---
participation in loans and other investments made by private sectors, andwhen capital is not available at reasonable terms, to supplement private
investment by providing finance for productive purpose out of its own
--- Content provided by FirstRanker.com ---
resources of from borrowed funds.
--- Content provided by FirstRanker.com ---
3. Prerequisite to the long range balanced growth of internationaltrade and the maintenance of equilibrium in the Balance of Payments of
member countries by encouraging international investment for the
--- Content provided by FirstRanker.com ---
development of their productive resources. There by assisting in raising
productivity, his standard of living our conditions of workers in their
territories.
--- Content provided by FirstRanker.com ---
4. To arrange the loans made or guaranteed by it in relation to
--- Content provided by FirstRanker.com ---
international loans through other channels so that more useful and urgent.Shall and large projects are dealt with first.
The Bank can make or facilitate loans in any of the following ways.
--- Content provided by FirstRanker.com ---
1. By making or participating in direct loans out of it`s our funds.
2. By making or participating in direct loans out of funds raised in the market
--- Content provided by FirstRanker.com ---
of a member or otherwise borrowed by the Bank; and3. By guaranteeing in whole or part loans made by private investors through
the usual investment channels.
--- Content provided by FirstRanker.com ---
In short, the Bank may make loans directly to member countries or it
--- Content provided by FirstRanker.com ---
may guarantee loans granted to member countries. The Bank normally makesloans for productive purposes like agriculture and rural development, power,
industry, transport etc. The total amount of loan sanctioned by his Bank
--- Content provided by FirstRanker.com ---
should not need 100% of its total subscribed capital and surplus. The banks
adopt the following policies in respect of its loans and guarantees.
--- Content provided by FirstRanker.com ---
1. All loans are made to Governments or they must by guaranteed bygovernments.
2. Repayment is to be made within 10 to 35 years.
--- Content provided by FirstRanker.com ---
3. Loans are made only in circumstances in which other sources are not
reading available.
--- Content provided by FirstRanker.com ---
4. Investigation is made of his probability of repayment considering both thesoundness of the project and the financial responsibility of his Government.
5. Sufficient surveillance is maintained by the bank over his carrying out of
--- Content provided by FirstRanker.com ---
the project to assure that of is relatively well executed and managed.
6. Loans are sanctioned on economic and not political consideration.
7. The loan is meant to finance the foreign exchange requirements of specific
--- Content provided by FirstRanker.com ---
projects; normally the borrowing country should mobilize its domestic
resources.
--- Content provided by FirstRanker.com ---
Two aspects of lending activities of the bank deserve to be high
lighted. First since the bank has to finance high priority productive sectors of
--- Content provided by FirstRanker.com ---
economics and determine "creditworthiness" of the borrowers. The banks
comprehensive and limited pre investment surveys, which are financed by his
--- Content provided by FirstRanker.com ---
bank, have created a situation where the head quarters of the bank has becomea "monitoring" centre of the economics of the borrowing countries. Secondly
banks dependence for resources on capital markets of the world influences its
--- Content provided by FirstRanker.com ---
economic and social philosophy which is based on the doctrine of free
enterprise.
--- Content provided by FirstRanker.com ---
The activities are:1. Project identification and promotion
2. It helps the member countries to establish, and improve privately owned
--- Content provided by FirstRanker.com ---
development finance companies and other institutions which are themselves
engaged in grounding and financing private enterprise.
--- Content provided by FirstRanker.com ---
3. Encouraging the growth of capital markets in the developing countries.Thus it does by:
a) Providing support to financial institutions in developing countries to meet
--- Content provided by FirstRanker.com ---
their investment needs and
b) By promoting investors in developed countries to participate in these
--- Content provided by FirstRanker.com ---
capital markets.4. Giving advice and technical counsel to developing countries in measure
that will create a climate conducive to growth of private investment.
--- Content provided by FirstRanker.com ---
1. 3. 4 The World Bank Groups
The World Bank has at present three affiliates. The International
--- Content provided by FirstRanker.com ---
Development Association, the International Finance Corporation, and the
Multilateral Investment Guarantee Agency. These are discussed below:
--- Content provided by FirstRanker.com ---
The International Development AssociationIt is the "soft loan window" of IBRD which was established in September,
1960. It is an affiliate of World Bank. The president of the World Bank is its
--- Content provided by FirstRanker.com ---
head. The main objectives of the IDA are two fold:
1. To provide assistance for poverty alleviation to the world's poorest
--- Content provided by FirstRanker.com ---
countries.2. To provide concessional financial assistance and macro economic
management services to the poorest countries so as to raise their standard of
--- Content provided by FirstRanker.com ---
living. There relate to human resource development including population
control development of health, nutrition and education for the overall
--- Content provided by FirstRanker.com ---
objectives or removing poverty.The finance may be made available to the member governments or to
--- Content provided by FirstRanker.com ---
the private enterprise. Advances to private enterprises may be made with out
government guarantees. The credit is interest free. Only a small service charge
--- Content provided by FirstRanker.com ---
of 0.75% per annum is payable on the amount with drawn and outstanding tocover administrative expenses. Repayment period is long extending over 50
years. There is an initial moratorium for 10 years and the amount borrowed is
--- Content provided by FirstRanker.com ---
repayable in the next 40 years. IDA finances not only the foreign exchange
component but also a part of domestic cost. The credit can also be repaid in
--- Content provided by FirstRanker.com ---
the local currencies of borrowing countries. Thus, the repayment of loan doesnot burden the balance of payments of the country. IDA loans are known as
"credits" which are made to government only. Loans are given for such
--- Content provided by FirstRanker.com ---
projects for which no assistance is provided by the World Bank before
approving credit in special committee of the IDA considers three criteria.
a. Poverty criterion: A country where population pressure is high and
--- Content provided by FirstRanker.com ---
productivity is low, there by leading to a low standard of living of the people.
b. Performance criterion: It relates to past performance in terms of loans
--- Content provided by FirstRanker.com ---
received whether form IDA or the World Bank. It must have been pursuingmacro economic policies and executing projects satisfactorily.
c. Project criterion: The projects for which credits are to be utilized must
--- Content provided by FirstRanker.com ---
yield financial and economic returns to justify their.
--- Content provided by FirstRanker.com ---
On the basis of the above criteria, the IDA sanctions credit foragriculture, education, health, nutrition water: supply, sewerage etc. such
credits which are known as "soft loans". IDA has been blessing for the
--- Content provided by FirstRanker.com ---
developing countries In keeping with the objectives, most of the assistance
has gone to high development priority projects which could not get finance
--- Content provided by FirstRanker.com ---
form other sources.International Finance Corporation
--- Content provided by FirstRanker.com ---
The IFC had a slow beginning and much of its assistance was
concentrated in Latin and Central American Countries. But in recent years it
--- Content provided by FirstRanker.com ---
has diversified its area of operations and many developing countries standbenefited. India has also received substantial assistance from IFC. Right from
the president, ail the senior officers of the World Bank are its officers. Its
--- Content provided by FirstRanker.com ---
annual report forms part of the World Bank report and is submitted
simultaneously.
--- Content provided by FirstRanker.com ---
Multilateral Investment Guarantee AgencyThe IBRD has established it`s another affiliate to be known as the
--- Content provided by FirstRanker.com ---
Multilateral Investment Guarantee Agency (MIGA) carried to give
encouragement for foreign investment in developing countries by issuing
--- Content provided by FirstRanker.com ---
Guarantees against non commercial rises. MIGA provides guarantee toprivate investors against four types of non commercial rises;
i. Transfer risk of corporation
--- Content provided by FirstRanker.com ---
ii. Risk of government repudiation of contractual commitments;iii. Risk of armed conflicts and
iv. Civil unrest.
--- Content provided by FirstRanker.com ---
The very important aim of promoting his new agency is stated to the
declining trend prevailed in capital inflow to developing countries.
--- Content provided by FirstRanker.com ---
1.3.5 Asian Development BankThis was started in 1966 under the aegis of United Nations economic
--- Content provided by FirstRanker.com ---
commission for Asia and for east. Its membership consists of countries form
Asian region as well as from other regions. There are 47 members of whom
--- Content provided by FirstRanker.com ---
32 countries from Asia-Pacific region and 15 countries are from Europe andNorth America.
The functions are:
--- Content provided by FirstRanker.com ---
1. Investment promotion in the ECAFF region of public and private capital
for development purposes.
--- Content provided by FirstRanker.com ---
2. The available resources are utilized for financing the priority those regionaland sub regional and national projects and programmes which will contribute
most effectively to the harmonious economic growth of the region as a whole,
--- Content provided by FirstRanker.com ---
and having special regard to the needs of the smaller or less developed
member countries in the region.
--- Content provided by FirstRanker.com ---
3. Assist members in coordination of their development policies and planswith a view to achieving better utilization of their resources making their
economies more complimentary, and providing the orderly execution of their
--- Content provided by FirstRanker.com ---
foreign trade, in particular, intra regional trade.
4. It provides technical assistance for preparation financing and execution of
--- Content provided by FirstRanker.com ---
development projects and programmes, including the formulation of specificproposals.
5. To co-operate with the United Nations and its subsidiary bodies, including,
--- Content provided by FirstRanker.com ---
in particular ECAFE and with public international organizations and other
international institutions as well as national entities whether public or private,
and to interest such institutions and entities in now opportunities for
--- Content provided by FirstRanker.com ---
investment and assistance and undertake such other activities and to provide
such other services as may advance its purpose.
--- Content provided by FirstRanker.com ---
6. It may make to loans to or invest in the project concerned and giveguarantee to loans granted to the projects. It will finance principality specific
projects in his region and also provides programmes, sector and multi
--- Content provided by FirstRanker.com ---
project loans. Most of the loans granted are hand loans or tied loans.
However, loan from special funds set aside by the ADB up to 10% of paid up
--- Content provided by FirstRanker.com ---
capital are granted Tinder soft loans. These soft loans are granted to projectsof high development priority and requiring longer period of repayment with
lower rates of interest.
--- Content provided by FirstRanker.com ---
Asian Development Bank acts as major catalyst in promoting the
--- Content provided by FirstRanker.com ---
development of the most populous and fastest growing region in the worldtoday. The Bank is also actively expanding its financing activities; with
official as well as commercial and export credit sources. It also enters into
--- Content provided by FirstRanker.com ---
equity investment operations. India is the 2nd largest subscriber after Japan
among the regional members and third largest among all members after Japan
--- Content provided by FirstRanker.com ---
& U. S. A. but it has started to avail loan only recently.Review questions:
1. Explain the globalization of trade
--- Content provided by FirstRanker.com ---
2. Discuss the recent trends in New Global Economic War
3. Explain the various International Financial Institution /
--- Content provided by FirstRanker.com ---
Development Banks involved in global trade
References:
--- Content provided by FirstRanker.com ---
1. Maurice S "'Dlevi, 'International Financial Management., McGraw-
Hill.
--- Content provided by FirstRanker.com ---
2. C. Jeevanandham, EXCHANGE RATE ARITHMETIC, SultanChand.
3. Apte.P.G. International Financial Management, Tata McGraw Hill
--- Content provided by FirstRanker.com ---
,NewDelhi.4. Henning, C.N., W.Piggot and W.H.Scott, International Financial
Management, Mc.Graw Hill, International Edition.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Lesson - 2
Globalization and Capital Markets: An Emerging Scenario
--- Content provided by FirstRanker.com ---
Objectives of the Lesson:After studying this unit you should be able to:
Discus about Globalization of Capital Markets and Financing Mix of
--- Content provided by FirstRanker.com ---
Firms.
--- Content provided by FirstRanker.com ---
Explain the risks of financing internationally.Know about types of Bonds.
Discuss Emerging Markets for Capital Investment
Discuss the developments in Global Finance, Markets, and Institutions in
--- Content provided by FirstRanker.com ---
the Asian RegionKnow the key trends in International Capital Markets
List out important consequences due to the Prevailing Trends in
--- Content provided by FirstRanker.com ---
International Capital MarketsAppreciate role of India in the Global Scenario
Structure of the Lesson:
--- Content provided by FirstRanker.com ---
2.0 Introduction
2.1 Capital Markets Globalization and Financial Mix of Firms
2.2 The Risks involved in raising finance internationally
--- Content provided by FirstRanker.com ---
2.3 Foreign Currency Convertible Bonds (FCCBs)
2.4 Types of Bonds
--- Content provided by FirstRanker.com ---
2.5 Major Bond Markets2.6 Emerging Markets for Capital Investment
2.7 Developments in Global Finance, Markets, and Institutions in the Asian
--- Content provided by FirstRanker.com ---
Region
2.8 Key Trends in International Capital Markets
--- Content provided by FirstRanker.com ---
2.9 Important consequences due to the Prevailing Trends in InternationalCapital Markets
2.10 Implications for the Asian region
--- Content provided by FirstRanker.com ---
2. 11 Role of India in the Global Scenario
2.0 Introduction
--- Content provided by FirstRanker.com ---
Globalization of capital markets is one of the most important aspect globalbusinesses. Capital markets globalization refers to removal of all restrictions
on capital flows. One can export or import capital without restrictions. In a
--- Content provided by FirstRanker.com ---
truly global capital market banks involved in foreign exchange can convert
one currency into another without asking questions. One can maintain foreign
--- Content provided by FirstRanker.com ---
exchange account in one country or another legally. There is absolute freedomto acquire foreign assets at the official exchange rate since the barriers
between one country and the rest of the world would vanish for all economic
--- Content provided by FirstRanker.com ---
reasons. The phenomenon of global capital market is fallout of the new
emerging trend in borderless world due to the virtual abandonment of trade
--- Content provided by FirstRanker.com ---
and exchange controls in most developing countries which makes capital trulyglobal in nature. This enables global capital market flow freely to wherever it
can earn the highest reward with commensurate risk.
--- Content provided by FirstRanker.com ---
2.1 Capital Markets Globalization and Financial Mix of Firms
The Globalization of capital markets has two impacts: First a firm
--- Content provided by FirstRanker.com ---
raises its capital, fit the simplest level, access to the world's capital markets
al ows the firm to substitute money raises in foreign countries for money
--- Content provided by FirstRanker.com ---
raised in domestic capital market. There may be number of motives formaking such substitution, the most important being lower cost of foreign
capital and the lower foreign exchange risk. Next is firms that internationalize
--- Content provided by FirstRanker.com ---
their financing strategy have a greater range of opportunities for raising debt
capital. Recess to international capital markets may result into a firm altering
--- Content provided by FirstRanker.com ---
its target capital structure. When a firm gains access to a foreign capitalmarket where the cost of debt is lower than the cost of debt in the domestic
capital market it is inclined to increase the proportion of debt in its capital
--- Content provided by FirstRanker.com ---
structure.
--- Content provided by FirstRanker.com ---
The capital structure decision has become complicated with theglobalization of capital markets,. The firm must decide where to raise capital
(London, Tokyo, the United States etc,). It should decide the currency in
--- Content provided by FirstRanker.com ---
which to borrow (Pounds, yen or Dollar). It should also decide on a target
debt ratio in the capital structure. Since the decisions are interrelated there is a
--- Content provided by FirstRanker.com ---
difficulty in making these decisions. Proper decision-making procedureshould be adopted in order to arrive at a simultaneous solution to al these
problems identified.
--- Content provided by FirstRanker.com ---
2.2 The Risks involved in raising finance internationally
--- Content provided by FirstRanker.com ---
A company can do international financing by either issuing equityshares or raising debt in the international capital market. The issue of equity
shares for raising capital does not involve any exchange risk as a company is
--- Content provided by FirstRanker.com ---
not required to return the money procured through the issue of equity capital.
However the same is not true in the case of debt financing. The money raised
--- Content provided by FirstRanker.com ---
through the issue of debt has to be returned in future. Therefore debt financingposes a risk the degree of which depend upon the fluctuations in the exchange
rates. International borrowings can be broadly categorized into three classes
--- Content provided by FirstRanker.com ---
on the basis of foreign exchange risk involved.1. Financing in the currency in which cash inflows are expected.
2. Financing in a currency other than that in which cash inflows are expected,
--- Content provided by FirstRanker.com ---
but with cover in the forward or swap market.
3. Financing in currency other than in which cash inflows are expected, but
--- Content provided by FirstRanker.com ---
without forward cover or an appropriate swapFinancing by way of the first two methods avoids foreign exchange
--- Content provided by FirstRanker.com ---
risk. Financing through the third option is risky. While the interest rates and
capital repayments are fixed in foreign currency terms, the amount of home
--- Content provided by FirstRanker.com ---
currency required to serve and repay the debt is not known with certainty dueto the fluctuating exchange rates.
International borrowing is safer when:
--- Content provided by FirstRanker.com ---
(1) Stability in Exchange rates
(2) Inflows are expected in the same currency in which borrowing is effected
--- Content provided by FirstRanker.com ---
and(3) Cash inflows are expected in a currency other than the currency of
borrowings but a forward cover or an appropriate swap is available.
--- Content provided by FirstRanker.com ---
Globalization of capital markets has led to supply of cross border
--- Content provided by FirstRanker.com ---
equity from the emerging capital markets for cross listing and this in turn hasfostered intense competition in major international exchanges. Firms all over
the world now have broader investor groups and the most commonly used
--- Content provided by FirstRanker.com ---
vehicles for cross listing are American Depository Receipts (ADRs) and
Global Depository Receipts (GDRs).
--- Content provided by FirstRanker.com ---
ADRs are negotiable certificates issued by an American Bank that are
backed by ownership claims on the company`s equity, which trades in the
--- Content provided by FirstRanker.com ---
home market. These are denominated in US dollars and dividends on the
underlying shares are paid in dollars.
Similarly GDRs are traded in
--- Content provided by FirstRanker.com ---
exchanges outside US mainly in the London Stock Exchange.
--- Content provided by FirstRanker.com ---
The international listings can significantly reduce the degree ofsegmentation by providing an avenue through which firms and investors can
sidestep some of the restrictions on capital flows that contribute to the
--- Content provided by FirstRanker.com ---
segmentation of international capital markets. The increasing integration of
equity markets across the world made listing of shares on the major world
--- Content provided by FirstRanker.com ---
exchanges a natural choice for companies. Though this process is too costlybecause of very heavy legal and accounting fee coupled with the obligation of
reconciling the accounts to international standards, companies perceive great
--- Content provided by FirstRanker.com ---
strategic, financial, and operational benefits through ADR and GDR issues. A
major benefit perceived by the company is savings in the cost of capital as the
--- Content provided by FirstRanker.com ---
market risk gets diversified and is also protected against liquidity of trading inits shares. The real effect of globalization of Indian Capital markets and cross
listings started only post mid 90s. As of the middle of the year 2001 about 72
--- Content provided by FirstRanker.com ---
companies had issued ADRs and GDRs of which over 30 were cross listings,
which was between the periods 1995 to 2001.
--- Content provided by FirstRanker.com ---
2.3 Foreign Currency Convertible Bonds (FCCBs)FCCBs are a medium/long term debt instrument carrying a fixed rate
--- Content provided by FirstRanker.com ---
of interest and having an option for conversion into fixed number of shares of
the issuing company. If the issuer company desires, the issue of such bonds
--- Content provided by FirstRanker.com ---
may carry two options:(a) Cal option:
--- Content provided by FirstRanker.com ---
Where the terms of the issue of the bonds contain a provision for call
option, the issuer company has the option of calling (buying) the bonds for
--- Content provided by FirstRanker.com ---
redemption before the date of maturity of the bonds. Where the share prices ofthe issuer company have appreciated substantially, i.e. for in excess of the
redemption value of the bonds, the issuer company can exercise this option.
--- Content provided by FirstRanker.com ---
(b) Put OptionProvision of put option gives the holder of bonds a right to put (sel )
--- Content provided by FirstRanker.com ---
his bonds back to the issuer company at a predetermined price and date.
2.4 Types of Bonds
--- Content provided by FirstRanker.com ---
A number of variations of FCCBs have evolved in past few years.
They are as follows:
--- Content provided by FirstRanker.com ---
Deep Discount Convertible
--- Content provided by FirstRanker.com ---
Such bond is usually issued at a price which is 70 to 80 per cent of itsface value and the initial conversion price and the coupon rate level are lower
than that of a conventional Euro Bond, since there are no interest payments.
--- Content provided by FirstRanker.com ---
The maturity period in some cases may extend even up to 25 years.
Zero Coupon Convertible bonds
--- Content provided by FirstRanker.com ---
Zero coupon convertible bonds have been mainly used in U.S.
markets. These bonds are Zero Coupon securities issued at deep discounts to
--- Content provided by FirstRanker.com ---
par value. Thus, the investor's return is the accretion to par value over the life
of the instrument. The issuer escapes the periodic interest payments in
--- Content provided by FirstRanker.com ---
gestation period of the project and yet is allowed to deduct the implied interestfrom taxable income.
Bul dog Bonds
--- Content provided by FirstRanker.com ---
This is an issue in sterling in the domestic Uk market by a non-UK
--- Content provided by FirstRanker.com ---
entity.Vankee Bonds
--- Content provided by FirstRanker.com ---
Vankee Bonds are domestic US dollars issue, aimed at the US
investor made by non-US entity.
--- Content provided by FirstRanker.com ---
Samurai BondsSamurai Bonds are long term, domestic yen debt issue targeted at
--- Content provided by FirstRanker.com ---
Japanese investors and mode by a non-Japanese entity.
Bunny Bonds
--- Content provided by FirstRanker.com ---
These bonds permit the investors to reinvest their interest income into
more such bonds with the some terms and conditions. Such an open to invest
--- Content provided by FirstRanker.com ---
interest at the original yield is attractive to long term investors, pension funds,etc. and the companies find it as a cheap source of finance.
Euro Rupee Bonds
--- Content provided by FirstRanker.com ---
Although these bonds do not exist, several foreign institutions are
--- Content provided by FirstRanker.com ---
considering this instrument as a means for rising finance. Denominated inRupees, Euro Rupee Bonds can be listed in Luxembourg. Dividends will be
paid in Rupee and investors will face the risk of currency fluctuation.
--- Content provided by FirstRanker.com ---
Dragon Bond
--- Content provided by FirstRanker.com ---
Dragon Bonds come in dollars, yen, and other currencies to attract theRussian investors.
Bonds with Equity or Warrants
--- Content provided by FirstRanker.com ---
A derivative of Euro bonds is bonds with Equity Warrants, which are
--- Content provided by FirstRanker.com ---
a combination of debt, with the investor on option on the issuer`s equity. Awarrant is attached to the host bond and entitles the investor to subscribe to the
equity of the issuing company at a predetermined price. The warrant price of
--- Content provided by FirstRanker.com ---
shares is normally 10-15% above the share price at the time bond is issued
and the warrants exercisable on or between specified dates. Warrants are
--- Content provided by FirstRanker.com ---
physically separate from bonds and therefore, can be detached and traded assecurities. Therefore, an investor has the benefit of having two separately
marketable instruments. Based on risk involved yield and the expectations of
--- Content provided by FirstRanker.com ---
both issuer and the lender, there may be structural variations in these
instruments.
--- Content provided by FirstRanker.com ---
Bul -Spread WarrantsThese warrants provide an exposure to the investors to underlying
--- Content provided by FirstRanker.com ---
shares between a lower level X and on upper level 'U'. The lower level is set
to provide a return above the dividend yield on the shares. After the maturity
period (which is normally three years) if the share price is below the lower
--- Content provided by FirstRanker.com ---
level X, the investor receives the difference from level 'U' the issuer has to pay
only the amount at level U` In case, the stock is between X and 'U' on
--- Content provided by FirstRanker.com ---
maturity, the issuer has a choice of either paying the cash to the investor ordelivering shares. Such a variation is best suited to companies having low
dividend yield since the lower level is set above the dividend yield on shores.
--- Content provided by FirstRanker.com ---
Money Back Warrants (MBWs)
--- Content provided by FirstRanker.com ---
MBW entitles an investor to receive a certain predetermined sumfrom the issuer provided the investor holds the warrant till it matures and it is
not converted into shares. To the investor the cost of doing so is not only the
--- Content provided by FirstRanker.com ---
cash he loses, but also the interest foregone on that sum of money. Therefore
in order to compensate, the companies must offer a higher premium than what
--- Content provided by FirstRanker.com ---
they normally do.Reset Warrants
--- Content provided by FirstRanker.com ---
The pioneers of issuing such warrant are the Japanese companies.
Reset warrants are suitable for those stock markets where there is tremendous
--- Content provided by FirstRanker.com ---
volatility. If a share has not performed and its market price is below theexercise price after a couple of years then the exercise option is reset to level
just above the current price; typically 2.5 percent above the prevailing price.
--- Content provided by FirstRanker.com ---
However there is a downward revision, which is deeply pegged at 20 per cent.
Besides the above derivatives, there are a number of instruments in the Euro
--- Content provided by FirstRanker.com ---
bond market. Also there can be number of variations depending upon thevariations in interest rates and/or maturity redemption period.
2.5 Major Bond Markets
--- Content provided by FirstRanker.com ---
The major capital markets where a company can raise funds through
--- Content provided by FirstRanker.com ---
the issue of bonds are:(1) US capital market
(2) Euro bond market
--- Content provided by FirstRanker.com ---
(3) Japanese bond market and(4) Medium term notes market
--- Content provided by FirstRanker.com ---
1. US Capital Market
--- Content provided by FirstRanker.com ---
US Capital market is the largest and most liquid capital market in this
world. This enables companies to borrow larger amount of funds at fixed
--- Content provided by FirstRanker.com ---
interest rates with longer maturities. The U.S debt market is predominantly
comprised of large insurance companies, pension funds, fund managers, and
--- Content provided by FirstRanker.com ---
credit corporations. With the historical low interest rates in US as compared toAsian countries US institutional investors have become more receptive
towards Asian issuers/emerging market economies in order to increase their
--- Content provided by FirstRanker.com ---
yield on investment. There are three ways for an issuer company to raise
funds in US capital market.
--- Content provided by FirstRanker.com ---
(a) Private placement market(b) The rule 144-A market (Quasi Public Market) and
(c) The Vankee bond market (Public market).
--- Content provided by FirstRanker.com ---
2. Euro Bond Market
--- Content provided by FirstRanker.com ---
Euro bond market is another major source of foreign capita throughthe issue of debt instruments. Recent years have shown tremendous growth in
the Euro bond market due to low interest rates which has attracted fixed
--- Content provided by FirstRanker.com ---
income investors to look beyond traditional investment grade credit to lower
quality credit in order to enhance yield.
--- Content provided by FirstRanker.com ---
3. Japanese Bond MarketThere has been a significant growth in the Japanese Bond Market due
--- Content provided by FirstRanker.com ---
to attractive interest rates on yens. Companies may consider issue of Samurai
Bond in Japanese bond Market in order to diversify the investor`s base.
However, growth of the Samurai market is limited due to appreciation of Yen
--- Content provided by FirstRanker.com ---
as compared to other currencies.
4. Medium Term Notes Market
--- Content provided by FirstRanker.com ---
Medium Term Notes (MTNs) are debt instrument offered on a
continuous basis in a broad range of maturity primarily through lead
--- Content provided by FirstRanker.com ---
managers/managers. MTNs provide issuers with more flexibility then straight
Euro bonds by allotting them to access subject to market demand, the
--- Content provided by FirstRanker.com ---
international capital market on a continuous basis with multiple issues ofvarying face amounts and tenors.
2.6 Emerging Markets for Capital Investment
--- Content provided by FirstRanker.com ---
Of late emerging markets have become a buzzword among the
--- Content provided by FirstRanker.com ---
international investors for reaping greatest potential rewards which would beimpossible if they stayed put in their affluent hinterlands. The term emerging
markets (EMs) is a collective reference to the stock markets of the developing
--- Content provided by FirstRanker.com ---
nations. IFC (International Finance Corporation) has listed 35 countries as
emerging markets. The first place in terms of GDP/Capita is occupied by
--- Content provided by FirstRanker.com ---
Greece and India ranks poor 20th in this list of 20 countries. In terms ofcapitalization Mexico ranks first and 20th rank is secured by Zimbabwe. India
occupies fifth position in capitalization. In term of listed companies India
--- Content provided by FirstRanker.com ---
occupies the top most position. India has largest number of stock exchanges
among the emerging markets. India has a share of 46 per cent of the total
--- Content provided by FirstRanker.com ---
companies in the emerging markets and 21 per cent of the total global listedcompanies. A question, which overpowers a discerning mind, is why the
international investors are looking towards emerging markets for investing
--- Content provided by FirstRanker.com ---
their funds instead of established markets like US? Three reasons can be
given to answer this question.
--- Content provided by FirstRanker.com ---
First, the average total return of EMs has outstripped those of
developed markets. Investble total return index computed by the IFC which
--- Content provided by FirstRanker.com ---
measures the total return for each country based on those stock available toforeign investors shows that return on investment in IFC composite of EMs is
61.64 per cent higher than the return on investment in US market over the
--- Content provided by FirstRanker.com ---
years. The institutional investors like the corporate pension funds; insurance
companies and international mutual funds are looking towards investments in
--- Content provided by FirstRanker.com ---
GMs to magnify their earnings.Secondly the emerging markets provide excellent scope for
--- Content provided by FirstRanker.com ---
diversification, as their correlation with the US and other developed markets is
often exceptionally low. The EMs has low correlations not only with the
--- Content provided by FirstRanker.com ---
developed markets, but also with each other. The fact that EMs (individuallyand as a group) has low correlations with the developed markets implies that
there is an opportunity for diversification for the global investor. Thirdly as
--- Content provided by FirstRanker.com ---
the EMs are generally inefficient markets, the opportunity of finding bargain
stocks increase for the highly knowledgeable money managers.
--- Content provided by FirstRanker.com ---
It is comparatively easier to beat the markets in the EMs as compared
to developed markets. In developed markets more arcane ones with mixed
--- Content provided by FirstRanker.com ---
results have supplemented the traditional tools of fundamental and Technical
Analysis. For example, there are computer programmes called Neutral
--- Content provided by FirstRanker.com ---
Networks, which seek to identify underlying general patterns in share pricemovements to obtain clues about future prices. The evidence so for is
inconclusive. The problem may be that such tools are quickly adopted by a
--- Content provided by FirstRanker.com ---
large number of players so that they soon become history. In such a situation
the investors are attracted by what they consider to be the relatively inefficient
--- Content provided by FirstRanker.com ---
markets of developing countries. Perhaps their tools of analysis will yieldgood results there.
--- Content provided by FirstRanker.com ---
Emerging market equities had their best performing year ever in 1993
as measured by IFC benchmark indices. Even in the latter part of 1993 price a
--- Content provided by FirstRanker.com ---
gains in many EMs were on an upswing while valuation measures werehigher, Added to this fall in the real interest rotes in US coupled with a strong
growth in the developing world spurred on the demand for emerging market
--- Content provided by FirstRanker.com ---
equities which pushed market beyond their fundamental values.Considered on the risk from EMs are extremely risky when compared
--- Content provided by FirstRanker.com ---
with developed markets. Apart from the obvious threats (political instability,
insider trading and others), there are a number of possible reasons why these
--- Content provided by FirstRanker.com ---
markets are extremely volatile. First they tend to be fairly concentrated; thelarger stocks have a high proportion of the overall capitalization. As a result,
there are fewer opportunities for diversification, and returns of these stocks
--- Content provided by FirstRanker.com ---
dominate overall market return. Second, unlike the developed markets, which
tend to have forces that affect diverse sectors of the economy differently, the
--- Content provided by FirstRanker.com ---
EMs tend to have a strong market related force that affects al stocks within amarket. This widespread effect tends to accelerate volatility.
--- Content provided by FirstRanker.com ---
It is true that emerging markets are extremely risky taken
individually, but considered together EMs provide a good scope for
--- Content provided by FirstRanker.com ---
diversification as these markets have low correlations not only with eachother, but also with the developed markets. It is a general y accepted fact that
investment in unrelated markets reduces the degree of risk.
--- Content provided by FirstRanker.com ---
2.7 Developments in Global Finance, Markets, and Institutions in the
Asian Region
--- Content provided by FirstRanker.com ---
Three interrelated developments in global capital markets are:
the sustained rise in gross capital flows relative to net flows;
--- Content provided by FirstRanker.com ---
the increasing importance of securitized forms of capital flows; andthe growing concentration of financial institutions and financial markets.
--- Content provided by FirstRanker.com ---
Taken together these trends may signal what some others havereferred to as a quiet opening` of the capital account of the balance of
payments, which is resulting in the development, strengthening and growing
--- Content provided by FirstRanker.com ---
integration of domestic financial systems within the international financial
system. Finance is being rationalized across national borders, resulting in a
breakdown in many countries in the distinction between onshore and offshore
--- Content provided by FirstRanker.com ---
finance. It is particularly evident and most advanced in the wholesale side of
the financial industry, and is becoming increasingly apparent in the retail side
--- Content provided by FirstRanker.com ---
as well.Taken together these three effects have contributed to a sharp rise in
--- Content provided by FirstRanker.com ---
volatility ? in both capital flows and asset prices ? which may be
characterized as periods of turbulence interspersed with periods of relative
--- Content provided by FirstRanker.com ---
tranquility. Investor behaviour (the supply of international capital) is a criticalreason behind the rise in volatility. These broad trends have some important
implications for the ongoing development of capital markets and institutions,
--- Content provided by FirstRanker.com ---
including those in Asia.
2.8 Key Trends in International Capital Markets
--- Content provided by FirstRanker.com ---
The sharp rise in gross capital flowsThe evidence points to an acceleration of capital account opening in
--- Content provided by FirstRanker.com ---
most regions of the world since the late 1980s. The effects of opening in the
formal sense of liberalizing transaction taxes and regulatory and legal
--- Content provided by FirstRanker.com ---
restrictions on capital movements have been augmented by the liberalizationof domestic financial sectors and by technologically induced reductions in
transaction costs. This opening has resulted in a sharp rise in gross capital
--- Content provided by FirstRanker.com ---
movements relative to net capital movements.
The rise in securitised forms of capital
--- Content provided by FirstRanker.com ---
International capital flows have increasingly been in a securitised
form. At a global level, direct intermediation through bonds and equities has
--- Content provided by FirstRanker.com ---
begun to dominate more traditional forms of capital, such as syndicated bank
lending and foreign direct investment.
--- Content provided by FirstRanker.com ---
The current trend to securitisation of capital flows to emerging
markets possibly had its origins in the global debt crisis of the 1980s. At that
--- Content provided by FirstRanker.com ---
time private capital movements primarily involved syndicated bank credit.Following the extensive losses that many of the large international banks
sustained during this period, there was a marked reluctance on their part to
--- Content provided by FirstRanker.com ---
extend sovereign credit in the form of syndicated loans. Their espoused
strategy has been to focus on so-cal ed bankable business, in the form of trade
--- Content provided by FirstRanker.com ---
credit or loans for specific commercial purposes with clearly identifiable cashflows and/or suitable collateral. The debt and debt-service reduction
agreements at the end of the decade that resulted in the issuance of tradable,
--- Content provided by FirstRanker.com ---
col ateral-backed Brady bonds in exchange for outstanding loans provided the
basis on which emerging market bonds have been erected. Impetus also came
--- Content provided by FirstRanker.com ---
from the accelerating trend in mature markets toward nonbank forms offinancial intermediation.
--- Content provided by FirstRanker.com ---
In the United States and Europe, the larger internationally active
banks have sought to diversify into higher margin, fee-generating activities in
--- Content provided by FirstRanker.com ---
an attempt to raise their return on equity. It is worth noting that this trend hasbeen further stimulated recently by the rapid expansion of Euro-area securities
markets, which has accelerated the shift by European banks into wholesale
--- Content provided by FirstRanker.com ---
finance. As noted below, the expansion of Euro-securities markets has
provided new opportunities for emerging market finance. While bank lending
--- Content provided by FirstRanker.com ---
is still the dominant form of corporate finance in Europe, the direction of thetrend seems clear enough. Similarly, in Japan, it is a reasonable conjecture that
restructuring of the banking system will lead in time to a marked increase in
--- Content provided by FirstRanker.com ---
directly intermediated finance.
The consolidation of financial institutions
--- Content provided by FirstRanker.com ---
The past few years have witnessed an acceleration of consolidation
among financial institutions in mature markets and a similar trend is now
--- Content provided by FirstRanker.com ---
gathering momentum in emerging market countries. Consolidation has been
the subject of a detailed G-10 study of developments in mature markets
(including the G-10 countries, Australia and Spain). The main forces driving
--- Content provided by FirstRanker.com ---
consolidation include: attempts to reap economies of scale and scope (a search
for cost reductions driven by competitive pressures on margins and
--- Content provided by FirstRanker.com ---
shareholder pressure for performance); improvements in informationtechnology, as well as the onset of e-commerce and the spread of e-banking;
and deregulation, particularly that which is encouraging the spread of
--- Content provided by FirstRanker.com ---
universal banking. Most merger and acquisition activity during the past
decade has involved the banking sector, and has resulted in the creation of
--- Content provided by FirstRanker.com ---
large and complex financial institutions (LCFIs).Consolidation is also affecting securities exchanges. In addition to the
--- Content provided by FirstRanker.com ---
effect of technology on trading, the main causal factors are the liberalization
of commissions, reduction in barriers to foreign entry, removal of antiquated
--- Content provided by FirstRanker.com ---
trading rules and changes to governance structures. In many countries, therapid growth and consolidation of private pension funds has been a major
factor driving financial sector consolidation.
--- Content provided by FirstRanker.com ---
2.9 Important consequences due to the Prevailing Trends in
International Capital Markets
--- Content provided by FirstRanker.com ---
VolatilityOne of the main consequences of the intersection of these three trends has
been periods of extreme turbulence in international capital flows, followed by
--- Content provided by FirstRanker.com ---
periods of relative tranquility. This volatility is evident both in the flows
themselves and in the prices (or spreads) at which they are transacted.
--- Content provided by FirstRanker.com ---
Interestingly, volatility is concentrated in portfolio flows, both bond andequity, and is much less evident in more traditional forms of capital flows
such as foreign direct investment and syndicated credit; although in the case
--- Content provided by FirstRanker.com ---
of foreign direct investment, there is an important cyclical element connected
to the growth cycle in mature economies
--- Content provided by FirstRanker.com ---
The market for emerging market dollar bonds has been a particularly
unstable component of international portfolio capital flows, and has been
--- Content provided by FirstRanker.com ---
characterized by repeated periods when access by emerging market borrowershas been effectively closed, followed by periods of robust issuance. Indeed,
the on-off nature of access by emerging markets appears to have become a
--- Content provided by FirstRanker.com ---
key characteristic of international financial markets. IMF analysts have
identified 11 periods since 1993 when closure` has occurred, including
--- Content provided by FirstRanker.com ---
several episodes during 2000?01 (IMF 2001a: 19?20). From mid-August andthe most recent turbulence in Argentina (not to mention the events of
September 11 until the end of November), borrowing spreads have widened
--- Content provided by FirstRanker.com ---
for many countries and the market was effectively closed again.
--- Content provided by FirstRanker.com ---
The IMF analysis shows that these closures typically have been forrelatively short periods, the longest to date having occurred when the Russian
debt crisis and the problems at Long-Term Capital Management (LTCM)
--- Content provided by FirstRanker.com ---
coincided in August/September 1998. That closure lasted for approximately
three months. Market closures appear to coincide with periods when spreads
--- Content provided by FirstRanker.com ---
widen sharply and volatility increases. Re-opening of markets seems to takeplace only after volatility dissipates.
--- Content provided by FirstRanker.com ---
Another volatility-related feature of the market for emerging market
bonds has been the extent of contagion from one country to another, with
--- Content provided by FirstRanker.com ---
events in one country often triggering a flight from other emerging marketswithout any clear economic rationale. Contagious movements were most
notable during the Asian debt crisis in 1997. While still a concern in emerging
--- Content provided by FirstRanker.com ---
markets, contagion during the past 12 months has been less of a factor than
previously. As a final point, it is worth noting that volatility has not been
--- Content provided by FirstRanker.com ---
confined to emerging market bonds but has also, and this is of relevance to theAsian region, affected securities markets.
--- Content provided by FirstRanker.com ---
Coincident with volatility in the NASDAQ market, there has been asharp decline in issuance of shares in the technology, media, and
telecommunications (TMT) sectors, with corporations having fallen back on
--- Content provided by FirstRanker.com ---
syndicated credit as a source of finance. It is somewhat ironic that syndicated
credit now appears to be acting as a stabilizing force in international capital
--- Content provided by FirstRanker.com ---
markets, given its previous role in triggering the debt crisis of the 1980s whenit was the dominant form of private capital flow.
Emphasis on the supply of capital
--- Content provided by FirstRanker.com ---
In seeking to explain the rise in volatility, it is necessary to discuss about the
increase in gross capital flows relative to net flows. Capital flows have
--- Content provided by FirstRanker.com ---
traditionally focused on the demand side` of emerging market financing byexamining current account balances, which are equal to the net external
financing needs of countries, and then seeking to identify ways in which these
--- Content provided by FirstRanker.com ---
financing needs could be met and on what terms. However, this approach
ignores trends in capital flows into and out of the major advanced economies,
--- Content provided by FirstRanker.com ---
which are the source of most cross-border capital and the main reason whygross flows have risen so dramatically relative to net flows. These flows are
typically in a securitized form and, as such, are susceptible to trading in active
--- Content provided by FirstRanker.com ---
secondary markets. By one estimate, investors in the mature markets of
Europe, the United States and Japan have been accumulating securities issued
--- Content provided by FirstRanker.com ---
outside their own countries at the rate of about US$1 trillion a year (Smith2000). This means that international capital flows are increasingly determined
by global asset-al ocation decisions made by globally active financial
--- Content provided by FirstRanker.com ---
institutions in major industrialized countries. These institutions are becoming
increasingly concentrated as a result of the global trend toward consolidation.
--- Content provided by FirstRanker.com ---
Understanding capital movements increasingly requires an analysis andunderstanding of the underlying investor base.
--- Content provided by FirstRanker.com ---
A case in point relates to the on-off nature of the market for emergingmarket dol ar denominated bonds. The dedicated investor base for emerging
market securities has contracted in recent years, reflecting the closure of
--- Content provided by FirstRanker.com ---
several large hedge funds, the orientation of other hedge funds toward mature
market investments and reductions in the capital allocated to support the
--- Content provided by FirstRanker.com ---
activities of the proprietary trading desks of some international investmentbanks. Moreover, the current investor base is dominated by crossover`
investors; that is, investors who invest short-term and opportunistically in the
--- Content provided by FirstRanker.com ---
asset class and whose benchmark portfolio typically has a zero weight on
emerging market securities. The holdings of emerging market securities by a
--- Content provided by FirstRanker.com ---
particular crossover investor are a small share of the investor`s total portfolioand thus can be liquidated quickly without major impact on its overall value;
however, the aggregate impact in the emerging debt market of crossover
--- Content provided by FirstRanker.com ---
investors as a group reacting to a specific event, making an exogenous shift in
risk appetite or rebalancing portfolios in response to losses or gains elsewhere,
--- Content provided by FirstRanker.com ---
can be overwhelming. These developments suggest that, unless the dedicatedinvestor base expands significantly, on-off market access is likely to be a
regular feature of emerging market finance.
--- Content provided by FirstRanker.com ---
Other examples of the importance of the investor base, and the extent
--- Content provided by FirstRanker.com ---
to which developments in mature financial markets impact on the issuance ofemerging market securities, have arisen because of the creation of a pan-
European debt market since the inception of the euro, and the growth of
--- Content provided by FirstRanker.com ---
European pension funds. These events have resulted in the establishment of a
market for euro-denominated emerging market debt, at both the retail and
--- Content provided by FirstRanker.com ---
institutional level.The effect has been to mitigate to a degree the access problems
--- Content provided by FirstRanker.com ---
associated with the on-off nature of the dollar-denominated market. These
markets (along with a market for yen-denominated issuance) are
demonstrably less volatile than the dollar market, and have tended to remain
--- Content provided by FirstRanker.com ---
open when the dollar market has closed. Thus, they have become an
alternative source of funds, with a more stable investor base that appears to be
--- Content provided by FirstRanker.com ---
well worth the time and effort of emerging market countries to cultivate.--- Content provided by FirstRanker.com ---
2.10 Implications for the Asian region
--- Content provided by FirstRanker.com ---
The consolidation occurring in the banking and financial sectors is aworldwide trend that has gathered momentum in recent years. Initially largely
a banking sector phenomenon, consolidation has increasingly also affected the
--- Content provided by FirstRanker.com ---
nonbank financial sector and has resulted in the establishment of large and
complex financial institutions. In recent years, the trend has begun to gather
--- Content provided by FirstRanker.com ---
pace in emerging market financial systems, including those in Asiancountries. In addition to the main factors that are driving consolidation in
mature markets are improvements in information technology, the progressive
--- Content provided by FirstRanker.com ---
deregulation of the financial sector and competitive pressures that have come
about as a result of reduced margins in traditional banking business the need
--- Content provided by FirstRanker.com ---
to restructure banking systems in the wake of a financial crisis has been anadditional factor in emerging markets. Some Asian financial crisis countries
appear to be entering a second round of banking and financial sector
--- Content provided by FirstRanker.com ---
restructuring where further consolidation and the formation of financial
holding companies will play a major role.
--- Content provided by FirstRanker.com ---
A distinguishing feature of consolidation in emerging markets is that
it has been a cross border phenomenon that has resulted in substantial foreign
--- Content provided by FirstRanker.com ---
penetration of domestic financial systems. Indeed, col eagues in the IMF refer
to a staggering increase` in foreign ownership and control of domestic banks
--- Content provided by FirstRanker.com ---
in emerging markets, especially in Latin America and emerging Europe, butalso to a lesser degree in Asia. Note, too, that foreign penetration can be
indirect and more subtle than the ownership/control connection. The recent
--- Content provided by FirstRanker.com ---
triennial survey of foreign exchange and derivative markets coordinated bythe Bank for International Settlements (BIS), for example, revealed that
growing volumes traded in the Australian foreign exchange market have a
--- Content provided by FirstRanker.com ---
foreign-induced component, with 65 per cent of transactions now occurring
between resident dealers and overseas banks, up from 50 per cent in the
--- Content provided by FirstRanker.com ---
preceding survey (RBA 2001).As to the consequences for the Asian region, the trend to further
--- Content provided by FirstRanker.com ---
consolidation seems likely to continue for the foreseeable future. In addition
to those countries where banking systems are in need of further strengthening
--- Content provided by FirstRanker.com ---
and restructuring, there is also a case for consolidation in the Hong Kong andSingapore banking systems, which are increasingly specializing in asset
management and unit trusts/mutual funds with the aim of reaping economies
--- Content provided by FirstRanker.com ---
of scale and scope.
--- Content provided by FirstRanker.com ---
As to the mature markets in the region, both Australia and Japan wereparticipants in the G-10 study of consolidation and its conclusions presumably
apply broadly to them. With the main causal forces still operative in these
--- Content provided by FirstRanker.com ---
countries, it seems likely that further consolidation will be in order. For the
region as a whole, just how much further foreign penetration will proceed will
--- Content provided by FirstRanker.com ---
depend on whether countries are prepared to regard financial services as justanother industry` that can be allowed to find the least costly, most robust way
to provide its product. New Zealand may well be the prototype or limiting
--- Content provided by FirstRanker.com ---
case, with foreign control rising to 100 per cent of the banking system. At the
same, it is interesting to note that there are forces at play in New Zealand that
--- Content provided by FirstRanker.com ---
may result in some rollback of foreign ownership and control.The premium on liquidity
From the perspective of an investor, the appeal of securitized forms of
--- Content provided by FirstRanker.com ---
investment rests in part on the liquidity of the investment, which depends on
the possibility of continuous valuation of the security and the ability to adjust
positions quickly in secondary markets without undue impact on market
--- Content provided by FirstRanker.com ---
price. Order-driven markets, such as stock exchanges, need to concentrate
trading in order to optimize liquidity; dealer markets, which are the typical
--- Content provided by FirstRanker.com ---
form of bond markets, require well-capitalized market-makers capable ofposition-taking in size to provide the necessary liquidity and depth. From the
perspective of the issuer, deep and liquid markets are needed to optimize
--- Content provided by FirstRanker.com ---
placing power and thereby minimize issuance costs and risks. As an
increasing share of international capital movement takes a securitized form,
--- Content provided by FirstRanker.com ---
the need increases for sizeable financial institutions that are prepared todedicate a substantial capital base to the market-making function. Market-
makers in turn need access to wel -capitalized, highly liquid banks as a form
--- Content provided by FirstRanker.com ---
of support to the financial infrastructure. To provide some idea of the
importance and potential scale of needed market-making capacity, it is
--- Content provided by FirstRanker.com ---
instructive to look as a benchmark at the market for internationally tradedforeign exchange, which is probably the most liquid and deep market in the
world. There, according to the just released BIS-coordinated triennial survey,
--- Content provided by FirstRanker.com ---
fully 60 per cent of transactions are between dealers.
--- Content provided by FirstRanker.com ---
The problem for emerging markets that rely on securitised flows ofcapital, including those in the Asian region, is that the institutional capital
required to support liquid secondary markets is not always available and,
--- Content provided by FirstRanker.com ---
indeed, may be shrinking. In some instances, hedge funds have closed which,
in the past, had been active players in emerging market instruments, while
--- Content provided by FirstRanker.com ---
others have diverted their activities to mature markets. Proprietary tradingdesks in some major international investment banks have reduced the scale of
their operations. Inadequate market-making capacity inevitably contributes to
--- Content provided by FirstRanker.com ---
a further rise in volatility, which further reinforces the on-off nature of these
markets. Not only does this increase the risk to countries of a reliance on
securitized forms of capital, but it also establishes the dynamics of a vicious
--- Content provided by FirstRanker.com ---
circle by providing a motivation for existing market-makers to further reduce
their exposure to market making.
--- Content provided by FirstRanker.com ---
Intense competition between markets
--- Content provided by FirstRanker.com ---
The past decade has seen a major change in the securities trading
industry, driven partly by rapid technological innovation and the globalization
--- Content provided by FirstRanker.com ---
of finance. One effect has been a significant decline in trading costs ? whichhas reduced the costs of raising equity capital and has provided an incentive to
shift issuance and trading activity to lower-cost centres. This process has put
--- Content provided by FirstRanker.com ---
immense pressure on exchanges in emerging markets and smaller mature
markets to consolidate liberalize access and deregulate brokerage
--- Content provided by FirstRanker.com ---
commissions to maintain competitiveness. The need to concentrate tradingactivity in order to achieve the necessary depth and liquidity has only added to
the intensity of competition. In addition to providing pressure to integrate
--- Content provided by FirstRanker.com ---
exchanges within national markets, these forces also create an incentive for
cross-border alliances among exchanges and the formation of regional
--- Content provided by FirstRanker.com ---
markets. The effects of these forces have been particularly evident in Asiancountries, where stock and derivative exchanges have merged and de -
mutualised in Hong Kong, and in Singapore.
--- Content provided by FirstRanker.com ---
The change in governance structure through demutualisation has been
--- Content provided by FirstRanker.com ---
seen as critical to the ability to respond to the challenges that rapid change inthe industry entails. Plans to merge and/or demutualise have occurred or are in
train in Malaysia, Korea and the Philippines. Related to the competition
--- Content provided by FirstRanker.com ---
among exchanges, the brokerage industry in Asia faces strong pressure to
liberalize commissions. For example, Singapore liberalized commissions in
--- Content provided by FirstRanker.com ---
October 2000, and fixed commission rules have broken down in Korea.Malaysia is following a two-stage approach, to al ow the industry time to
adapt to the change, while in Hong Kong, commissions are due to be
--- Content provided by FirstRanker.com ---
liberalized this year.Another effect of the intense competition has been the tendency for
--- Content provided by FirstRanker.com ---
certain markets to specialize as a way of attracting sufficient business to
achieve the scale of operations needed to build liquidity and reap cost
--- Content provided by FirstRanker.com ---
advantages. Singapore, for example, has sought to implement a strategy offostering the development of asset management activities. Australia has seen
substantial growth in foreign exchange business in the past three years, in
--- Content provided by FirstRanker.com ---
marked contrast to the general trend recorded in the BIS-coordinated triennial
survey of a marked worldwide decline in daily turnover. The reason has been
--- Content provided by FirstRanker.com ---
that a number of global players have focused their Asian time zone businessin Australia. As a result, daily turnover in US$/third currency business has
grown to the point where it is almost equal in volume to US$/A$ turnover.
--- Content provided by FirstRanker.com ---
This growth has added substantial depth and vibrancy to the local financial
community.
--- Content provided by FirstRanker.com ---
Modernisation and convergence of regulatory frameworksConsolidation and the competition for financial business is leading to the
adoption of new legislation in national markets to establish a competitively
--- Content provided by FirstRanker.com ---
neutral` regulatory environment (e.g., the Financial Services Reform Bill,
which came into effect in Australia in March 2002). But the process is driven
--- Content provided by FirstRanker.com ---
also by the contestability of financial transactions among financial centres,which risk losing business when antiquated regulatory frameworks raise
operation costs.
--- Content provided by FirstRanker.com ---
Convergence is also evident in the development of common legal
--- Content provided by FirstRanker.com ---
forms for particular financial instruments that are traded in national markets(e.g., swaps), disclosure standards, and accounting standards. At the same
time, the potential for systemic instability and contagion across national
--- Content provided by FirstRanker.com ---
boundaries creates an incentive to adopt best practices in regulatoryframeworks.
--- Content provided by FirstRanker.com ---
The recognition of the importance of implementing best practices
underlies the Financial Sector Assessment Program (FSAP) by the IMF and
--- Content provided by FirstRanker.com ---
the World Bank, which seeks inter alia to assess countries` observance of keyregulatory standards such as the Basel Core Principles for Effective Banking
Supervision, the IOSCO (International Organisation of Securities
--- Content provided by FirstRanker.com ---
Commissions) and the IAIS (International Association of Insurance
Supervisors) principles for the securities and insurance industries, and the core
--- Content provided by FirstRanker.com ---
principles for systemically important payments systems. Foreign penetrationof domestic financial systems places a substantial premium on cooperation
among national supervisors.
--- Content provided by FirstRanker.com ---
The growing use of synthetic financial instruments
It has long been recognized that securitization has brought with it the
--- Content provided by FirstRanker.com ---
possibility to unbundled credit and market risks, price them efficiently, anddistribute them to institutions and investors most equipped to deal with them.4
Such instruments can be used also as a means for hedging the volatility risk
--- Content provided by FirstRanker.com ---
inherent in the modern international capital market. It is therefore important
that countries seek to encourage the development and appropriate use of such
--- Content provided by FirstRanker.com ---
instruments.The recent BIS-coordinated triennial survey of foreign exchange
--- Content provided by FirstRanker.com ---
turnover provides evidence on the extent to which the use of such instruments
is growing worldwide. In contrast to the world-wide decline in foreign
--- Content provided by FirstRanker.com ---
exchange market turnover, there has been a 50 per cent rise in derivativestrade in the three years since the survey was last conducted, al of this due to
the growth in interest-rate-related products. The trend seems to be well
--- Content provided by FirstRanker.com ---
established in Asia. In Australia, for example, the survey pointed to a tripling
in derivatives contracts since the last survey, suggesting rapid strides in the
maturation of local capital markets.
--- Content provided by FirstRanker.com ---
In summary, the growth of local debt and equity markets in Asia has
--- Content provided by FirstRanker.com ---
been an important step that can be further developed as a defense against highvolatility in international capital flows. Somewhat paradoxically, perhaps,
joining the trend by completing the development and integration of domestic
--- Content provided by FirstRanker.com ---
capital markets may be the best defense against the negative consequences of
the global integration of capital markets that is proceeding rapidly in other
--- Content provided by FirstRanker.com ---
parts of the world.2. 11 Role of India in the Global Scenario
--- Content provided by FirstRanker.com ---
Like other emerging markets, role of India in the global scenario has
expanded far from being a mere supplier of commodities. Now funds are
--- Content provided by FirstRanker.com ---
being brought into the country in anticipation of higher returns. This is a goodnews for the development of India because in the supply of commodities, the
nation had to produce first and then to receive payment. On the other hand in
--- Content provided by FirstRanker.com ---
the case of investment funds, the money comes in first and the returns have to
be paid later. Higher expected returns, inefficiency of capital market and
--- Content provided by FirstRanker.com ---
greater scope for diversification due to low correlations of Indian market withother emerging and developed markets, are the main reasons responsible for
attraction of Indian to the global investors. Further the attraction of India is
--- Content provided by FirstRanker.com ---
also a product of necessity. The shifting paradigm in current Indian economic
thought has transferred the main role in the economic development of the
--- Content provided by FirstRanker.com ---
nation from the Government to the private sector. Increasingly it will be themarkets rather than the Government planners who will decide on critical
issues like the allocation of capital. The virtual elimination of industrial
--- Content provided by FirstRanker.com ---
licensing, the easing of restrictive provisions of the MRTP and FERA, the
gradual dismantling of price controls on both products and equity markets
--- Content provided by FirstRanker.com ---
have all given a strong boost to business enterprises. More business impliesmore funding. Businesses are increasingly topping the capital markets to
finance their expansions, modernizations, and new projects. To meet the
--- Content provided by FirstRanker.com ---
insatisfiable thirst of business enterprises for funds Government has allowedthem to raise funds in foreign capital markets. Some established companies
have aggressively set out to tap foreign markets by issuing Foreign Currency
--- Content provided by FirstRanker.com ---
Convertible Bonds (FCCBs) and equity shares (through the depository receipt
mechanism).
--- Content provided by FirstRanker.com ---
Indian companies were first permitted to tap the Euro market in 1992.
Since then a number of companies have raised capital in the Euro market
--- Content provided by FirstRanker.com ---
through the issue of FCCBs and GDRs. Companies have been drown
overseas because the volumes that can be raised are higher. The issuance costs
--- Content provided by FirstRanker.com ---
are at 2 to 3 percent being substantially lower than comparable rupee issues.Interest rates in overseas markets are lower as compared to Indian domestic
standards
--- Content provided by FirstRanker.com ---
India ranks high among the emerging markets in respect of attraction
--- Content provided by FirstRanker.com ---
for capital, as world markets are getting increasingly turbulent, India is stillfortunately free from the cascading effects of butterfly in Mexico or an
earthquake in Argentina. Also foreign investors need not be worry about over-
--- Content provided by FirstRanker.com ---
night seismic policy changes brought therein, as it happened in the case of
Mexico, devaluation of local currency, paucity of foreign exchange reserves
--- Content provided by FirstRanker.com ---
and serious trade deficit have created a flight of capital from what appears tobe the most promising emerging market of the decade. In spite of the
attractiveness of Indian capital market for foreign investment, the inflow of
--- Content provided by FirstRanker.com ---
foreign capital has not been satisfactory.
--- Content provided by FirstRanker.com ---
To fortify its chances of attracting foreign funds, both in the portfolioand the direct formats, India should make active efforts to improve the
functioning of its financial markets that is allocating capital more efficiently,
--- Content provided by FirstRanker.com ---
focus on core financial themes such as interest liberalization (which is done to
a large extent), smaller government role in credit allocation, and improvement
in the role of banks as financial intermediaries. India has to focus more
--- Content provided by FirstRanker.com ---
inwards than outwards. Problems regarding custodial services, clearances,
settlements and taxation etc engage most attention. Many Fls did not enter
--- Content provided by FirstRanker.com ---
Indian market due to custodial services. Foreign banks custodians alonecannot handle Fls business.
--- Content provided by FirstRanker.com ---
The sole and purchase of securities should be allowed in large
marketable lots to reduce the transactional load. The transfer of shares take an
--- Content provided by FirstRanker.com ---
average two months and some companies even take six months despitereminders; there is a lack of transparency in the transactions which can justify
the genuineness of the quoted prices. SEBI should be given legal power to
--- Content provided by FirstRanker.com ---
take drastic action against the erring companies.
--- Content provided by FirstRanker.com ---
Consequent upon efforts towards globalization of business and tradein the recent past capital markets of different countries are turning global.
Emerging markets consisting of developing economies have become
--- Content provided by FirstRanker.com ---
attraction among the international investors for increasing return on their
investment. This is because the developed markets have reached a level of
--- Content provided by FirstRanker.com ---
saturated growth. Hence the attractiveness of the emerging markets, sincethey offer higher return, reflect faster growth rates and show the propensity to
absorb the surplus technology and the funds of the investors of developed
--- Content provided by FirstRanker.com ---
countries.
--- Content provided by FirstRanker.com ---
To ensure that India does not lose out in the race of capital attraction,there is a need for making radical changes in the functioning of financial
markets and government regulations, Indian companies desiring to enter the
--- Content provided by FirstRanker.com ---
foreign capital markets most strengthen their information base and make-
appropriate modifications than their accounting systems. This is required to
--- Content provided by FirstRanker.com ---
fulfill the information needs of foreign investors. Those investors requireinformation about past performance and future prospects of investor
companies for making investment decisions.
--- Content provided by FirstRanker.com ---
Review questions:1. Discus about Globalization of Capital Markets and Financing Mix`
--- Content provided by FirstRanker.com ---
of Firms.
2. Explain the risks of financing internationally.
--- Content provided by FirstRanker.com ---
3. What are the types of Bonds?4. What are the major capital markets in this world? Explain.
5. Discuss in detail the developments in Global Finance, Markets, and
--- Content provided by FirstRanker.com ---
Institutions in the Asian Region
--- Content provided by FirstRanker.com ---
6. Explain the Key Trends in International Capital Markets7. Explain in detail important consequences due to the Prevailing Trends
--- Content provided by FirstRanker.com ---
in International Capital Markets
--- Content provided by FirstRanker.com ---
References:1.MauricS"'Dlevi,'International Financial Management., McGraw-Hill.
2. C. Jeevanandham, EXCHANGE RATE ARITHMETIC, Sultan
--- Content provided by FirstRanker.com ---
Chand.
3. Apte.P.G., International Financial Management, Tata Mc. Graw
--- Content provided by FirstRanker.com ---
Hill,NewDelhi.4. Henning, C.N., W.Piggot and W.H.Scott, International Financial
Management, Mc.Graw Hill, International Edition.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Lesson - 3
--- Content provided by FirstRanker.com ---
The International Economic System and Globalization
Objectives of the Lesson:
After studying this unit you should be able to:
--- Content provided by FirstRanker.com ---
Know the Different Facets of Globalization and their Manifestations
Understand the Problems and Challenges of Globalization
Explain the relationship between Investment, Transfer of Technology and
--- Content provided by FirstRanker.com ---
Global BusinessKnow the Interfacing of the National and International Orders.
Structure of the Lesson:
--- Content provided by FirstRanker.com ---
3.0 Introduction
3.1 The Different Facets of Globalization and their Manifestations
--- Content provided by FirstRanker.com ---
3.2 The Problems and Challenges of Globalization3.3 Investment, Transfer of Technology and Global Business
3.4 The Interfacing of the National and International Orders
--- Content provided by FirstRanker.com ---
3.0 Introduction
The prevailing international economic arrangements are an amalgam of facts,
--- Content provided by FirstRanker.com ---
rules, and modalities created one at a time rather than a holistic system ofcohesive design. The monetary part is a transformation of the old Bretton
Woods system, which came into actual collapse in August 1971, but was
--- Content provided by FirstRanker.com ---
rescued by successive fixes from 1972 onwards. It remains based on the US
dol ar, and centered around the IMF whose mission and philosophy have
--- Content provided by FirstRanker.com ---
evolved at a politically control ed pace. The monetary and financial systemsare covered institutionally by the IMF in monetary matters and by the World
Bank in finance matters. Moreover, the World Bank, while an important
--- Content provided by FirstRanker.com ---
source of development funds for the poor countries and an instrument for
bringing their policies under the scrutiny of the dominant members, shares its
--- Content provided by FirstRanker.com ---
role, de facto, with the private sector, which is, de jure, not a part of theofficial system and is in the business of profit making.
--- Content provided by FirstRanker.com ---
The trade part of these arrangements, issuing essential y from theGATT, was redesigned in its scope and its law by the WTO agreement.
However, it has maintained numerous features of the old GATT; it is still
--- Content provided by FirstRanker.com ---
based on the exercise of full sovereignty in granting or not granting
concessions; it remains essentially one based on liberal trade access, on non-
--- Content provided by FirstRanker.com ---
discrimination in treatment via the application of the most favoured nationclause; and it is now based on equal treatment of countries regardless of their
trading capacities. There is yet no sub system for dealing directly and
--- Content provided by FirstRanker.com ---
explicitly with investments and the transfer of technology.
3.1 The Different Facets of Globalization and their Manifestations
--- Content provided by FirstRanker.com ---
Globalization is manifested in four interrelated developments:1. The increase in the international exchange of goods and services, and
despite all the restrictions therein, the movements of human resources;
--- Content provided by FirstRanker.com ---
2. The internationalization of production and real investments;
3. The increased integration of financial markets;
--- Content provided by FirstRanker.com ---
4. The relative high degree of policy convergence among countries.The statistical evidence on these developments is truly impressive. In
the trade area, the ratio of international trade to the GDP of practically all
--- Content provided by FirstRanker.com ---
countries has more than doubled over the last two decades. Trade has
substantially outpaced the growth of the GDP in all but very few years over
--- Content provided by FirstRanker.com ---
the past twenty- five years. A major new phenomenon is the size of servicesin total trade, in particular financial services.
World trade grew at a real per annum rate of 5.5% in 1985-1994. In the
--- Content provided by FirstRanker.com ---
following decade, 1995-2004, it registered an annual real growth of 6%3. This
is well above the average growth of the GDP in the same periods. For
--- Content provided by FirstRanker.com ---
individual countries, even the large and relatively closed ones, the trend is thesame .For example, in the US; trade went from a mere 9 % of the US`GDP in
1970 to more than 23 % in 2003. In the small European countries and most of
--- Content provided by FirstRanker.com ---
the small developing countries, trade has gone up from levels in the range of40-50% percent of the GDP in 1970 to levels in the range of 80 to 90 percent
in 2003. The increased importance of trade relative to the GDP, is particularly
--- Content provided by FirstRanker.com ---
striking in the developing countries. The twenty developing countries
classified by an UNCTAD paper as the most dynamic, have increased their
--- Content provided by FirstRanker.com ---
share in total world exports from 9.5% in 1980 to 24.3 % in 1998; this is allthe more impressive in view of the large growth of exports.
In the exchange of human resources, the movement of labour across
--- Content provided by FirstRanker.com ---
international borders, legally or illegally, together with the growth of
immigration from poor to rich countries has reached such levels that
--- Content provided by FirstRanker.com ---
immigration has become an explosive political issue in al the recent politicalcampaigns of Western Europe. Even in the US, a traditional country of
immigration, the increased scale of economic immigration is beginning to be
--- Content provided by FirstRanker.com ---
a standard feature of political campaigns and is heavily exploited by
politicians in quest of electoral gains.
--- Content provided by FirstRanker.com ---
In investment cum production area, the internationalization of
production is currently manifest in the phenomenal increase of foreign Direct
--- Content provided by FirstRanker.com ---
Investment (FDI) in the US, in Europe, and in some twenty or so developing
countries, led by China. For example, China has experienced investment
--- Content provided by FirstRanker.com ---
inflows reaching 7.9 percent of the GDP in 1993 and 8.1 in 2003. This hastaken place against the backdrop of real annual growth of China`s GDP of 8-9
percent. In some smaller economies, like Malaysia, these inflows had reached
--- Content provided by FirstRanker.com ---
a high of 14.6 percent of the GDP in1993. After dipping in 1997and 1998, net
inflows bounced back, but have not resumed a steady pace of growth after
--- Content provided by FirstRanker.com ---
2001. There is also a growing subcontracting of production and a spreading ofproduction facilities by transnational firms.
In the finance arena, businesses have increased their recourse to
--- Content provided by FirstRanker.com ---
international sources as testified by the increased volume of floatation of
foreign bond; the increased issuance of international bonds in the Euro
markets, and the increased international lending in direct and indirect forms.
--- Content provided by FirstRanker.com ---
Moreover, big companies have substantially increased their stock listings on
the various public exchanges.
--- Content provided by FirstRanker.com ---
The financial institutions, led by banks, have become truly internationalnot only in doing international financing like their predecessors have done
since the nineteenth century, but in addition, by locating in various countries
--- Content provided by FirstRanker.com ---
through some times outright establishment or acquisition of local banks. On
both the assets and liability sides of their balance sheets, banking is now
--- Content provided by FirstRanker.com ---
international: loans and deposits are denominated in different currenciesoriginating from and going to different points of the globe.
Just as tel ing perhaps but more a typical, is the increased convergence
--- Content provided by FirstRanker.com ---
of economic policies of governments. This is the result of several factors: the
complete triumph of the liberal model has narrowed the scope of choice in
--- Content provided by FirstRanker.com ---
economic policies. All countries want to be seen pursuing the right policymodel. The second factor is the emulate- thy- competitor syndrome; countries
match the concessions and benefits given by their competitors to foreign
--- Content provided by FirstRanker.com ---
investors and trans- national firms in order not to suffer a comparative
disadvantage. The third reason is the relative short time the world has had to
--- Content provided by FirstRanker.com ---
fashion policies based on some variation on the orthodox liberal model. Thepolicy convergence however, is stronger among smaller economies than the
big ones, because the big economies quite frequently pursue policies dictated
--- Content provided by FirstRanker.com ---
by short term expediencies.
The spotty results of the government control ed model, already clear in
--- Content provided by FirstRanker.com ---
the 1980`s, and the collapse of the socialist economies in 1989, have broughtabout an almost universal acceptance of liberal and open market organization
and a semi consensus on economic policies. A rather extreme version
--- Content provided by FirstRanker.com ---
emerged in the so cal ed Washington Consensus. This was so called after
the meeting in Washington of economists with views concordant with those
of the IMF and the World Bank as to what model of economic policy to
--- Content provided by FirstRanker.com ---
follow. Not withstanding the challenge to this consensus by various other
economists, there is a wide convergence of views today on what are bad
--- Content provided by FirstRanker.com ---
policies and a spectrum of accord on what are good ones.3.2 The Problems and Challenges of Globalization:
--- Content provided by FirstRanker.com ---
If globalization is a non- stoppable train, as many argue, it seems to
be a rather selective one in admitting passengers aboard. Economies
--- Content provided by FirstRanker.com ---
possessive of skilled and educated manpower and endowed with welldeveloped production and marketing capacities can get on board to reap
significant benefits if they have developed financial systems and access to
--- Content provided by FirstRanker.com ---
technology. It is a system where the benefits accrue only to the capable and
prepared. Those who do not have the products and services to sel or the
--- Content provided by FirstRanker.com ---
means to market them will assuredly be left in the station. The same is alsotrue for individuals who have not invested in their human capital and in
obtaining the requisite skills for global jobs. Thus, we are faced with the
--- Content provided by FirstRanker.com ---
phenomenon of marginalization of people, of firms and of countries; the
global system confers a large rent differential upon the participants and
--- Content provided by FirstRanker.com ---
applies exclusion to the non- participants. Unless the means to spread aroundwealth and prosperity are built into globalization, it will become the domain
of the already established, of the capable and skilled. Consequently, enabling
--- Content provided by FirstRanker.com ---
capacity -building in trade technology and human- capital is an important
issue in the debate on globalization. Unlike export-orientation, globalization
--- Content provided by FirstRanker.com ---
involves the entire resource base and know-how of the economic agents.Thus, participatory capacity is an important issue.
Faced with the reality of the requirements of the global economy,
--- Content provided by FirstRanker.com ---
Nation states confront a host of problems: they have to accept the relative loss
of sovereign control and the erosion of the fiscal base if they want to keep up
with competitors who grant tax holidays and wave off social charges. At the
--- Content provided by FirstRanker.com ---
same time, they are forced to increase their expenditure on infrastructure and
education to enter into or keep their presence in the global system. To al that
--- Content provided by FirstRanker.com ---
must be added the system consequence of accepting global openness: nationalgovernments must extend safety nets for taking care of the casualties of
globalization, be it firms, banks or workers, if they are to maintain the social
--- Content provided by FirstRanker.com ---
compact and preserve domestic civil peace. These are contradictory demands
on national governments. Another problem concerns the timing and location
--- Content provided by FirstRanker.com ---
of the short run benefits and losses in the trade sector. While the countrieswith higher wages and more exigent environmental standards stand to lose
jobs as business shifts some branches of industry to cheaper locations abroad,
--- Content provided by FirstRanker.com ---
higher paying jobs have not followed the lost ones in the short run. The theory
of international trade asserts that higher value added jobs would replace the
--- Content provided by FirstRanker.com ---
lost ones. But the theory does not have a clear time- line for the working outof comparative advantage; it has always assumed that the replacement
technology is available and the costs of conversion, in particular labour
--- Content provided by FirstRanker.com ---
retraining, are insignificant. Obviously, this is not so when replacement
technologies are the private property of businesses, which no longer have
--- Content provided by FirstRanker.com ---
national allegiance and will use the technology and locate the jobs where theymake the highest profits. In today`s world, the major concern of business is
the overall global bottom line and the increase in the wealth of the stock-
--- Content provided by FirstRanker.com ---
holders. The empirical evidence on industry replacement is hardly clear- cut
in the short run. In the US, the evidence over 1992-2004 shows that the
--- Content provided by FirstRanker.com ---
number of jobs lost has been less than the number of newly created jobs10.This is true over a decade but not necessarily true for a particular year. In the
short run, job replacement seems to carry migration born for some time by the
--- Content provided by FirstRanker.com ---
displaced workers. There are also costly structural impediments to the
transition to new jobs. The risk of creating significant constituencies in
democratic countries opposed to globalization, as witnessed in Genoa and
--- Content provided by FirstRanker.com ---
Seattle, is becoming quite high. Even when international firms own or have
access to new technology; the relative cost difference between different
--- Content provided by FirstRanker.com ---
locations might tempt them to relocate some jobs abroad. There is evidenceon that in the low white- collar jobs such as soft- wear and high information
skill jobs.
--- Content provided by FirstRanker.com ---
India has invested in education and developed a large and surplus stock
of skilled manpower, have succeeded in attracting lost jobs form global
--- Content provided by FirstRanker.com ---
businesses on account of their low wages. Traditional y, wage levels andproductivity gains have moved together. However, with openness it is
possible that higher productivity might be associated with lower wages for
--- Content provided by FirstRanker.com ---
skilled unemployed workers in a different country. We have therefore a break
in the observed historical association between wages and productivity across
--- Content provided by FirstRanker.com ---
countries with different cost of living. The historical pattern of investment ineducation is now playing a large role in the working out of the law of
comparative advantage. Second, the new jobs generated in the US have an
--- Content provided by FirstRanker.com ---
average hourly pay lower than the lost ones. In fact, quite many of the new
jobs are in services with lower productivity and lower wage rates than lost
--- Content provided by FirstRanker.com ---
manufacturing jobs; for example the average hourly wage in some of thefastest growing service jobs, the food industry, is $10.64 with a median of
$8.98 per hour, as compared to $18.07 mean and $ 17.10 median hourly
--- Content provided by FirstRanker.com ---
wages for the lost jobs in production, construction and extraction occupations.
--- Content provided by FirstRanker.com ---
Finally, the asymmetric distribution of benefits across countries isbreeding theories about disguised and new forms of economic domination
under globalization. Even though such views are often not empirically
--- Content provided by FirstRanker.com ---
demonstrated, nonetheless, they are voiced by important segments in open
societies, which have become permanent and non-discriminating opponents
--- Content provided by FirstRanker.com ---
of WTO and globalization.3.3 Investment, Transfer of Technology and Global Business
--- Content provided by FirstRanker.com ---
Trans-national investment in its forms, portfolio and Foreign DirectInvestment (FDI), has become a striking feature of globalization. Net external
worldwide financing has gone up from less than $10 billion in the early
--- Content provided by FirstRanker.com ---
1970`s to a high of $243 billion in 1996. It receded in 2001 from these
historical heights, but reached an estimated $148 in 2003 and a forecast of
--- Content provided by FirstRanker.com ---
$149 billion in 2004.14 Portfolio investment, foreign direct investment, andexternal borrowing, all exhibit the same trend. These impressive figures mask
to a certain extent the scale of the growth of gross inflows in the net receiving
--- Content provided by FirstRanker.com ---
countries because the data are in aggregate net terms. Despite that, the figures
remain quite impressive. In some developing countries such as China, Tran`s
--- Content provided by FirstRanker.com ---
border investments, largely emanating from overseas Chinese investors, haveaccounted for 10 to 12 percent of fixed capital formation. Consequently, they
rendered possible the sustained high- growth of the country over the last three
--- Content provided by FirstRanker.com ---
decades. With few exceptions in closed economies, all countries developed
and developing now welcome such investments, especially in the form of
--- Content provided by FirstRanker.com ---
FDI. The competition for foreign investment is keen enough that countriesresort to competitive concessions and more and more uniformity in
macroeconomic policies to attract the investors. The potential benefits of
--- Content provided by FirstRanker.com ---
foreign investment as a supplement to domestic savings, as a source of
technology transfer in the case of FDI and as a more efficient use of savings
--- Content provided by FirstRanker.com ---
world wide, are undeniable. But, such investments raise questions for theglobal system. In the case of portfolio investment, the Asian crisis has
graphically shown how the wave can turn around, and cause panic flights of
--- Content provided by FirstRanker.com ---
capital engendering balance of payments difficulties and currency crisis in the
host countries.
--- Content provided by FirstRanker.com ---
Another asymmetry is implicit in the agreement on the TRIPS,
negotiated in the WTO package. It protects the property rights of the owners
--- Content provided by FirstRanker.com ---
but does not fully address the twin issues of the impact of the protections onthe transfer of technology, to developing countries, and the need to make
possible and feasible, the acquisition of drugs indispensable for public health.
--- Content provided by FirstRanker.com ---
Quite naturally, the incidence of R&D favours the rich countries with their
established capacity to develop and apply new technology and to use qualified
--- Content provided by FirstRanker.com ---
cadres of educated people from all over the world. Since all of the newtechnology is essentially in private business hands, the TRIPS confirm the
exclusion principle of the market place internationally. The AIDS crisis in
--- Content provided by FirstRanker.com ---
Africa and the recent disputes between governments and drug companies
protected by the certificates of intellectual property rights are examples in
--- Content provided by FirstRanker.com ---
point. There is thus an undeniable need to bring the private holders of copyright, mostly big Trans- Nationals, into some system of internationally
control ed exploitation where, as a quid pro quo for copy -right protection,
--- Content provided by FirstRanker.com ---
they adhere to an internationally agreed code of behavior.
--- Content provided by FirstRanker.com ---
Finally, the WTO system opens up the possibility of enmeshing thetrade system into the investment and other subsystems in the application of
trade law. Developing countries have long signaled their opposition to
--- Content provided by FirstRanker.com ---
applying trade sanctions in disputes involving non- trade issues. By invoking
the WTO dispute- settlement mechanisms in non- trade disputes, the strong
--- Content provided by FirstRanker.com ---
trading countries can exploit their trade dissuasion power (the trade capacityand the associated value of trade concessions) all across the issues; and that
would create unexpected problems for those who negotiated the WTO law in
--- Content provided by FirstRanker.com ---
good faith within the strict confines of the trading system.
3.4 The Interfacing of the National and International Orders
--- Content provided by FirstRanker.com ---
The establishment of the WTO revived sharply the old disputes ofwhere the demarcation between the national and international domains lies
and how they should interface. The IMF provided an early example of this
--- Content provided by FirstRanker.com ---
tension, but the WTO has escalated the debate. The rules and obligations of
the trade organization, and indeed the new international trade law, on the
reasoning that some domestic policies have international consequences, step
--- Content provided by FirstRanker.com ---
into domains of policy hereto squarely in the national domains. Prime
examples are to be found in industrial policies and agricultural subsidies, both
--- Content provided by FirstRanker.com ---
of which violate the new WTO rules. To be sure, the essential purpose ofindustrial policies is to give extra impulse to economic development, and of
agricultural policies to impart balance to the environment and to preserve
--- Content provided by FirstRanker.com ---
certain modes of living and traditions. However, both policies are found
contrary to the international order because they violate the international
--- Content provided by FirstRanker.com ---
principle of level playing field. In many countries, wide segments of societydo not accept this encroachment upon the national sphere and place greater
value on the accomplishment of the above-mentioned goals in the national
--- Content provided by FirstRanker.com ---
domains than on the rules and efficacy of the international system. Moreover,
a certain historical duplicity is assessed upon the advocates of liberal trade in
--- Content provided by FirstRanker.com ---
that many of them, e.g. Japan, the US, European countries and South Korea,to cite some examples, have in the past practiced and benefited from these
same currently forbidden policies.
--- Content provided by FirstRanker.com ---
In the case of the IMF, certain conditionality targets such as ceilings on
debt and money supply and the size of public budget are seen to be contrary to
--- Content provided by FirstRanker.com ---
the sovereign right of governance and the self- determination of domesticaffaires. Governments accept them more by the pressures of need than by any
conviction about their merits. The same is even more egregious in the IMF
--- Content provided by FirstRanker.com ---
surveillance and conditionality provisions regarding countries that need Fund
resources. For example, the recent Fund packages for Turkey and for
--- Content provided by FirstRanker.com ---
Argentina, get into budgets, pension reforms, privatizations, financialdomestic regulations and social security, areas that countries not in need for
IMF support would strictly keep under their sovereign prerogatives. It is clear
--- Content provided by FirstRanker.com ---
that there are no ready or agreed criteria as to where the demarcation lines
should be, since what might be required by international concerns is
sometimes of a predominantly domestic nature and what might be done
--- Content provided by FirstRanker.com ---
domestically could have large international implications. Nor could one make
an easy trade- off between the national interest and those of the international
--- Content provided by FirstRanker.com ---
order because the national benefits are felt directly while the international onesare often felt indirectly. This evaluation of globalization is not accepted by
every one. There are some who argue that, in some areas like agriculture, poor
--- Content provided by FirstRanker.com ---
countries would stand to reap great benefits from globalization. However, the
research on the implications of removing the European agricultural subsidies
--- Content provided by FirstRanker.com ---
CAP shows that not al poor countries stand to benefit from it. The example ofBangladesh in textile is brought up to bolster this view for industrial sectors.
Review Questions:
--- Content provided by FirstRanker.com ---
1. Discuss the different Facets of Globalization and their Manifestations
2. Explain in brief the problems and Challenges of Globalization
--- Content provided by FirstRanker.com ---
3. Explain the relationship between Investment, Transfer of Technology, andGlobal Business
References:
1.MauricS"'Dlevi,'International Financial Management., McGraw-Hill.
--- Content provided by FirstRanker.com ---
2. C. Jeevanandham, EXCHANGE RATE ARITHMETIC, Sultan
Chand.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Lesson - 4
The International Monetary and Financial Systems
--- Content provided by FirstRanker.com ---
1.0 Introduction
It can be argued that the international monetary and financial systems are the
--- Content provided by FirstRanker.com ---
main driving force of globalization. It is evident that the free movement ofcapital affecting exchange rates and in the process, unsettling financial
conditions and economic policies, leads to boom and bust conditions and
--- Content provided by FirstRanker.com ---
currency gyrations in most economies. It is also evident that in a global
economy, the variation of economic policies and financial conditions in the
--- Content provided by FirstRanker.com ---
major countries spill over into the small countries and overwhelm their smalleconomies. Yet, the prevailing international monetary system dates back
some forty years and was designed for the conditions of the world economy
--- Content provided by FirstRanker.com ---
prior to the arrival of globalization.
--- Content provided by FirstRanker.com ---
The outstanding features of the two organizations established atBretton Woods in 1944, namely, the IMF and the IBRD, and their underlying
systems, can be succinctly described.
--- Content provided by FirstRanker.com ---
The International Monetary System (IMS) was to have no resources
--- Content provided by FirstRanker.com ---
of its own, contrary to the original proposals of Keynes and the BritishTreasury. It was instead based on national quotas negotiated with members
upon entry, which constitute the key to resource contributions and to decision
--- Content provided by FirstRanker.com ---
-making as well as to access to the financial facilities. The IMF was to be
essentially concerned with the area of current account adjustment and current
--- Content provided by FirstRanker.com ---
account flows, though article IV of the Articles of Agreement, provided thatone of its main purposes was establishing a framework for capital exchange
among members. The exchange rate system was to be initially fixed, but
--- Content provided by FirstRanker.com ---
eventual y adjustable. The US dol ar was put at the centre of the international
reserve system, to be later on complemented by other key currencies.
--- Content provided by FirstRanker.com ---
The IBRD evolved from a post war reconstruction agency for post -
war Europe, as the name says, to a development funding institution called the
--- Content provided by FirstRanker.com ---
World Bank, essentially concerned with developing countries. Interestingly, itwas not endowed with much authority in the governance of the global
financial system. Once again, the quota system was enshrined at the centre of
--- Content provided by FirstRanker.com ---
its resources, its operations, and its governance.
--- Content provided by FirstRanker.com ---
In 1972-1974, a window of opportunity opened up to revamp thesystem in order to bring it up to date and render it consistent with the
evolution of capital markets, the exchange rate experience, the development
--- Content provided by FirstRanker.com ---
issues and the evolution of international trade. This however, failed again to
secure consensus agreement, with the United States and Germany objecting to
--- Content provided by FirstRanker.com ---
different sets of recommendations made by the Committee of Twenty (C.20).The reform issue was subsequently put on the back burner for more
--- Content provided by FirstRanker.com ---
than a decade. The system has had two amendments to the Articles of
Agreements: to create the SDRs as the system currency and unit of account in
--- Content provided by FirstRanker.com ---
1968 and to legalize ex post facto floating in 1978. In the wake of the LatinAmerican and the Asian crises of 1997, many authorities, and even some
states, cal ed for a new architecture of the system more suitable to the global
--- Content provided by FirstRanker.com ---
economic conditions. Many worthwhile ideas have been put forward since
1972, and particularly after 1997. However, despite al that has been said
--- Content provided by FirstRanker.com ---
about the inadequacy of the old system under the new global conditions, therehas been no official agreement on substantial reforms.
4.1 The outstanding issues in the International Monetary and Financial
--- Content provided by FirstRanker.com ---
Systems
The outstanding issues in the International Monetary and Financial Systems
--- Content provided by FirstRanker.com ---
can be listed under the following headings:A- The Governance and Regulation of the Capital and Monetary Flows:
B- The Management of Financial Crisis and the Function of the Bank of
--- Content provided by FirstRanker.com ---
Last Resort.C- The Foreign Exchange System
D- The Reform of the IMF
--- Content provided by FirstRanker.com ---
4.1.1 The Governance and Regulation of Financial Flows
--- Content provided by FirstRanker.com ---
The Breton Woods system provided no governance for internationalfinancial flows. Although Keynes was quite keen on the topic, the other
conferees did not seem in 1944 to be much concerned about it. However, the
--- Content provided by FirstRanker.com ---
achievement of capital account convertibility in the advanced countries as of
1959 ( some four years after realizing current account equilibrium) and the
--- Content provided by FirstRanker.com ---
subsequent development of capital markets in the 60`s, 70`s and 80`s,propel ed this issue to the fore. In the wake of the Asian crisis in 1997, and the
demonstrated globalization of financial markets, it could no longer be ignored.
--- Content provided by FirstRanker.com ---
The Articles of Agreements of the IMF contained disparate
--- Content provided by FirstRanker.com ---
references to financial flows in Articles IV and VI. As indicated above,Article IV made the free exchange of finance among member states a
fundamental objective of the IMF. Article VI provides permissibility of
--- Content provided by FirstRanker.com ---
capital controls as long as they do not impede or restrict payments made for
the current account transactions (the balance of trade and unilateral transfers).
--- Content provided by FirstRanker.com ---
It also disallows the use of the resources of the fund to support large capitaloutflows.
--- Content provided by FirstRanker.com ---
The concern with the growth of financial instability impel ed the G.7
(the group of seven major industrial countries) in February 1999 to establish
--- Content provided by FirstRanker.com ---
the Financial Stability Forum with the aim of promoting internationalfinancial stability through improved exchange of information, cooperation
with respect to financial supervision and surveillance, and streamlining
--- Content provided by FirstRanker.com ---
standards and norms in the various participant countries. Natural y, this work
cannot be confined to financial flows and the financial institutions, as it has
direct implications with respect to macroeconomic policies, the various
--- Content provided by FirstRanker.com ---
standards of the financial system and its judicial framework.
--- Content provided by FirstRanker.com ---
In each of the various areas, a key standard was established with alead institution responsible for developing the necessary codes, rules, norms,
and standards. Consequently, the BIS has over the last decade been the forum
--- Content provided by FirstRanker.com ---
in which officials from the participating countries and international
organizations, without the presence of private sector agents, have concluded
--- Content provided by FirstRanker.com ---
numerous agreements aiming at establishing cooperative modalities forcol ecting systematically information on capital and monetary flows and
disseminating them to members and the public. The forum has reached
--- Content provided by FirstRanker.com ---
numerous agreements on codes of behaviour such as the code of Good
Practices on Transparency in Monetary and Financial Policies, and the same
--- Content provided by FirstRanker.com ---
for transparency in fiscal policy. It reached agreements on financial regulationand supervision such as The Core Principles of Effective Banking
Supervision and those of security and insurance. It also agreed on regulation
--- Content provided by FirstRanker.com ---
standards for insolvency, for corporate governance, for auditing and
accounting and principles to deal with money -laundering. It also agreed to
--- Content provided by FirstRanker.com ---
rules and procedures for the treatment of important financial concepts such asrisk and exposure as well as setting up modalities of cooperation among
officials of member states. An important part of what was achieved is the
--- Content provided by FirstRanker.com ---
col ection of data and the establishment of a shared data- base.
--- Content provided by FirstRanker.com ---
Unfortunately, the private sector was not involved directly in devisingthe new rules and principles and not asked to share any responsibilities.
Furthermore, no modalities were agreed for securing its continuous
--- Content provided by FirstRanker.com ---
involvement in financial governance, let alone setting up a non- voluntary
code of investors` behavior.
--- Content provided by FirstRanker.com ---
All of this work, with all its due importance, amounted in effect to
organizing in the source countries the supervision of their institutions and
--- Content provided by FirstRanker.com ---
setting up financial regulations and behavior standards for their institutions.Natural y, global financial governance involves conduct in crises, obligations
on the source authorities as well as the recipient country authorities and above
--- Content provided by FirstRanker.com ---
al , setting up proper models of conduct and codes of standards for private
investors. But this was not to be, as the private sector participation remained
--- Content provided by FirstRanker.com ---
strictly voluntary.As noted earlier, the increased globalization of the world economy
--- Content provided by FirstRanker.com ---
and the evolved integration of financial markets have resulted in enormous
increase in cross border financial flows, with a concomitant increase in
--- Content provided by FirstRanker.com ---
financial instability and frequent eruptions of financial and currency crises. Nodoubt the purpose of the new codes and standards is to increase financial
stability and prevent, or at least, forewarn of impending crises.
--- Content provided by FirstRanker.com ---
In this context, several other proposals have been put forward to set
--- Content provided by FirstRanker.com ---
up a system authority to carry out and enforce financial governance since the1980`s. Some proposals suggest the creation of a world-wide supervisory and
regulatory authority, the World Financial Authority, to regulate and
--- Content provided by FirstRanker.com ---
supervise all institutions and markets. Another variant more concerned with
system issues and policies, developed proposals to establish a super agency
--- Content provided by FirstRanker.com ---
over al the relevant international organizations to be responsible for the wholesystem: its policies, regulations, supervision, and crisis management.
--- Content provided by FirstRanker.com ---
All these proposals share the aim of establishing a global authority
with a global perspective and enforceable authority to deal with the
--- Content provided by FirstRanker.com ---
application of regulations, codes of behaviour, and methods of controls andrules of functioning on radically different basis than the piece meal, patchy
approach of the present institutions. It is argued that the globalization of the
--- Content provided by FirstRanker.com ---
world economy now cal s for such an approach.
--- Content provided by FirstRanker.com ---
Another problem concerns the treatment of the private sector. Sinceprivate investors and speculators in the source countries are responsible for the
bulk of the financial flows, the voluntary character of the application of the
--- Content provided by FirstRanker.com ---
established rules and codes to them stands in stark contrast to the summons toobey with consequent sanctions addressed to the recipient and their private
concerns. A code of behavior for investors would be an enormous
--- Content provided by FirstRanker.com ---
development. However, there are several objections to such a binding code.
The first argues that it is exceedingly difficult to enforce it. The second is an
--- Content provided by FirstRanker.com ---
efficiency argument about the distortion of allocation of internationalinvestment funds in the case of involuntary controls. The third concerns the
deterrence to capital movements it might bring about, in particular, inflows to
--- Content provided by FirstRanker.com ---
the poorer countries. The fourth is the desirability of avoiding bureaucratic
decision- making and conflict of jurisdictions in case of crisis. The counter
--- Content provided by FirstRanker.com ---
arguments are familiar from the work of the BIS and the literature on capitalcontrols and the Tobin tax. Briefly, it is argued that feasibility is an open
empirical question; that the efficiency argument assumes that a code -free
--- Content provided by FirstRanker.com ---
system is optimal and is already in place and that the fear of bureaucratic
conflicts is exaggerated. On balance, a universal code applied by all and
--- Content provided by FirstRanker.com ---
enforced by an impartial international authority, such as the IMF, should befeasible.
4.1.2 The Management of Financial Crises: the Bank of Last Resort
--- Content provided by FirstRanker.com ---
Without a reserve system with a base in the Fund, any arrangement
--- Content provided by FirstRanker.com ---
will ultimately depend on the political decisions of the dominant Fundmembers in accepting or not to fulfil this function. In the event, this function is
exercised on case-by-case basis. In other words, it is not an established and
--- Content provided by FirstRanker.com ---
regular system function. And it will not be a system function until, and
perhaps unless, the IMF has the capacity, like any national monetary
--- Content provided by FirstRanker.com ---
authority, to initiate action on its own with its own resources as the custodianof the international monetary and financial systems. For this reason, the first
amendment to the Articles of Agreement in 1968, introduced the SDRs as the
--- Content provided by FirstRanker.com ---
base of the system. However, after much improvement in their characteristicsand much extension in their use within the Fund, the SDRs have remained a
mere 2% fraction of international reserves. The last time one heard of the
--- Content provided by FirstRanker.com ---
SDRs was in 1994, when M. Camdesue, the then Managing Director of the
Fund, proposed a third issue of the SDRs, destined primarily to the newly
--- Content provided by FirstRanker.com ---
joined Eastern European countries. That proposal was scuttled by thedeveloping countries who objected to the preferential treatment accorded to
the new members. Politically speaking, the issue remains on the back burner
--- Content provided by FirstRanker.com ---
and for the time being, there seems to be no advocates.
--- Content provided by FirstRanker.com ---
From inception, the IMF was created without resources of its own.Even before Bretton Woods, the vision of Keynes of an autonomously
financed Union with flexible and discretionary resource base was abandoned
--- Content provided by FirstRanker.com ---
in view of the opposition of the US. In its place, the US concept, articulated
by Under Secretary Harry Dexter White, was to enshrine an institution based
--- Content provided by FirstRanker.com ---
on a resource pool contributed and control ed by the countries with majorityquotas. Thus, the new global conditions in financial and currency markets
have thrust the institution into areas for which it has no adequate resource base
--- Content provided by FirstRanker.com ---
independent of the political decisions of its major members.
--- Content provided by FirstRanker.com ---
In recent years, several proposals have been formulated to deal withthis lacuna, the most ambitious of which is the proposal of the Meltzer
Commission set up by the US Congress. There are a number of issues to be
--- Content provided by FirstRanker.com ---
pointed out in this context, some political, some institutional and some
technical. The lender of last resort role requires not only resources, but as well
--- Content provided by FirstRanker.com ---
enforceable control on al countries.The financial crises in both Asia and Latin America have some
--- Content provided by FirstRanker.com ---
common features and similar sequences. They were predominantly crises in
the financial system. In the majority of cases in Asia, there was no
--- Content provided by FirstRanker.com ---
macroeconomic policy mismanagement signaled by the Fund in its priorsurveillance consultations with the members. Typically, there was a mal-
functioning domestic financial system interacting with the typical behavior of
--- Content provided by FirstRanker.com ---
the open international financial system. Usually, the start is ignited by bankscarrying on their books a great deal of large assets that are non ?performing.
This leads in short order to failure of the banks to cope with servicing
--- Content provided by FirstRanker.com ---
liabilities denominated in foreign exchange. Swiftly, a currency crisis
explodes and the balance sheets of the banks and other institutions suffer
--- Content provided by FirstRanker.com ---
severe deterioration in their domestic currency net worth. The swift andsimultaneous reaction of creditors to these developments ushers in a country
balance of payments crisis and requires usually severe adjustment. The crisis
--- Content provided by FirstRanker.com ---
soon propagates into al sectors of the economy and spills over into other
countries by, inter alia, altering the risk perception of international investors.
--- Content provided by FirstRanker.com ---
The international official system then becomes involved to stem possiblesystemic risk. As a result, rescue packages would be negotiated with the
stricken countries. These seem to have some important common features.
--- Content provided by FirstRanker.com ---
Dramatic increases in interest rates, damaging to the macroeconomic
--- Content provided by FirstRanker.com ---
performance in the first place, increase greatly the interest rate risk of debt andother fixed- income securities and inflicts large capital losses on the balance
sheet of banks and other financial institutions of the debtors. The hiking of
--- Content provided by FirstRanker.com ---
interest rates inflicts a net capital loss on the asset side. The result is severe
deterioration in banks balance sheet that might wipe out their net worth.
--- Content provided by FirstRanker.com ---
This problem has recently attracted a good deal of attention. For
example, Barry Eichengreen of Berkley has just published a proposal to float
--- Content provided by FirstRanker.com ---
bonds denominated in a synthetic unit of account based on a basket of
developing country currencies for choosy investors unwilling to invest except
--- Content provided by FirstRanker.com ---
in bonds or securities denominated in key currencies. The effective exchangerate of such bonds is more stable than individual currencies. These bonds
would further entice the creditor banks to carry them for reducing their
--- Content provided by FirstRanker.com ---
exposure to country risk. He calculated that the increased premiums to be paidwould be a small fraction of the cost of the Asian crises.
4.1.3 The Foreign Exchange System
--- Content provided by FirstRanker.com ---
The foreign exchange system used to be one of two major topics of
--- Content provided by FirstRanker.com ---
discussion regarding the IMS in the 1960`s- the other was the internationalreserve system. These discussions emphasized the choice of regimes: fixed or
floating. After the break down of the old Bretton Woods system of fixed but
--- Content provided by FirstRanker.com ---
flexible rates, in August 1971, there was no official willingness to suggest
radical changes in the prevailing system The first Smithsonian agreement of
--- Content provided by FirstRanker.com ---
December 1971, amounted to tinkering with the old parities, while the secondSmithsonian in1972, was a surrender to reality, as major currencies started
floating against each other in March 1973. In 1978, the agreement embodied
--- Content provided by FirstRanker.com ---
in the second amendment to the Articles of Agreement of Jamaica, aimed ex
post facto at legalizing the status quo. The revision of article IV on
--- Content provided by FirstRanker.com ---
surveillance, laid such vague guidelines as to amount to generalities. Therewas no statement of obligations, no standards to judge misalignments and no
authority to enforce action on countries not in need for IMF resources. It was
--- Content provided by FirstRanker.com ---
left to macroeconomic policies to carry the burden of arriving at orderly
conditions.
--- Content provided by FirstRanker.com ---
The instability of real exchange rates, defined by any statistical
measure of volatility, has increased under floating, thereby spilling over into
--- Content provided by FirstRanker.com ---
developing countries, and in the event, unsettling their macroeconomic and
financial conditions. The IMF estimates that more than half of the volatility of
--- Content provided by FirstRanker.com ---
developing country exchange rates is explained by the volatility of the realexchange rates of the G.3 countries, i.e., the dollar, the yen, and the Euro. It
also holds that the greater volatility of real exchange rates has been
--- Content provided by FirstRanker.com ---
associated with greater real effective exchange rates misalignment
During the past thirty years, the major currency countries undertook
--- Content provided by FirstRanker.com ---
only two coordinated interventions following the Plaza Accord of 1985, and
the Louvre Accord of 1987. In all other instances, where volatility aroused
--- Content provided by FirstRanker.com ---
concerns, the major countries refused to intervene on the argument thatintervention does not resolve the fundamental problems and that the markets
are better at deciding the parities. This is an argument that rejects dealing with
--- Content provided by FirstRanker.com ---
the manifestations of the symptoms but says nothing about how and when it
will deal with the problem.
--- Content provided by FirstRanker.com ---
In 2003, almost half of the emerging market economies used an
intermediate peg system, i.e., one of pegged but adjustable rates. This is a
--- Content provided by FirstRanker.com ---
decline from the level of more than two thirds in 1991, according to the
former chief economist of the Fund. Simultaneously, the proportion of
--- Content provided by FirstRanker.com ---
countries using a hard peg (a fixed peg with narrow limits), or free- floatingregimes has risen to 58%. It is not difficult to see the reason for this shift: the
floating of major currencies unsettles the financial conditions of the small
--- Content provided by FirstRanker.com ---
economies; it creates boom and bust gyrations and overshooting of their
exchange rates.
--- Content provided by FirstRanker.com ---
The proposals of reform in this area are a market -basket variety of
currency bands and intervention limits around them together with guidelines
--- Content provided by FirstRanker.com ---
of misalignment, such as price movements, and quantitative triggers of action.
--- Content provided by FirstRanker.com ---
Several policy instruments can be used to track these rates. Amongsuch instruments are: sterilized intervention- where assets are not perfect
substitutes, temporary capital controls and in the longer term, interest rates,
--- Content provided by FirstRanker.com ---
and monetary policy. Naturally, an important requirement is to have an
anchor either in the form of exchange rate or another quantitative policy
--- Content provided by FirstRanker.com ---
anchor.4.1.4 The Reform of the IMF
--- Content provided by FirstRanker.com ---
There are three main issues in this area: the governance of the IMF,the surveillance and conditionality and the reserve system together with the
function of the bank of last resort. This lesson has already dealt with the last
--- Content provided by FirstRanker.com ---
topic above.
a. The Governance of the IMF
--- Content provided by FirstRanker.com ---
The Fund governance has been a contentious issue between the
developing and developed countries since the mid of 1950`s. The familiar
--- Content provided by FirstRanker.com ---
argument of the former is that the quota system is not fair as a key for
decision- making and access to resources. The response of the latter is that it is
--- Content provided by FirstRanker.com ---
only normal and fair that each country share in decision-making becommensurate with its contribution to the Fund resources.
--- Content provided by FirstRanker.com ---
The economic system is one in which states are not equal, some are
certainly more economically important than others even though they all have
--- Content provided by FirstRanker.com ---
equal political sovereignty. This holds in fact when it comes to thecontribution of member states to the system. It also holds in economic theory
in analyzing big economy influence over international adjustment. The
--- Content provided by FirstRanker.com ---
economic conditions and policies of the major countries fundamentally affect
the international economy. Similarly, the effects of global economic changes
--- Content provided by FirstRanker.com ---
are more important for the big economies. It is uncontroversial to assert that adecision by the IMF requires more the assent and active cooperation of the
large economy countries than the small ones. Economic analysis explicitly
--- Content provided by FirstRanker.com ---
distinguishes between large and small economies when it comes to the
international influence of their macroeconomic policies.
--- Content provided by FirstRanker.com ---
The developing countries have created two institutional modalities to
strengthen their influence on the IMF: the Group of Twenty Four and the
--- Content provided by FirstRanker.com ---
Development Committee. The G.24 was established more than three decades
ago by the Group of Seventy Seven, which founded UNCTAD. It has had a
--- Content provided by FirstRanker.com ---
good working program supported by UNCTAD and other internationalsecretariats as well as by the service of independent experts of distinction. It is
fair to say that it has had beneficial influence on the IMF and has, to certain
--- Content provided by FirstRanker.com ---
extent, served the interests of developing countries.b. The Surveillance Function and Conditionality
--- Content provided by FirstRanker.com ---
Conditionality was developed by the IMF in the early 1950`s to
ensure the paying back of members purchases, thereby preserving the
--- Content provided by FirstRanker.com ---
revolving character of its resources. Some time later, in the 1960`s and1970`s, a paternalistic aspect to conditionality came into evidence as the IMF
meant to guide the countries under its adjustment programs towards what it
--- Content provided by FirstRanker.com ---
regarded the correct path to equilibrium using the correct model40 In the
1980`s as the debt crisis erupted in Mexico and later on in other indebted
--- Content provided by FirstRanker.com ---
countries, conditionality expanded beyond current account problems to covermany aspects of financial accounts and to bear on disparate aspects of
domestic economic policies. The debt crisis brought domestic financial
--- Content provided by FirstRanker.com ---
systems and policies under the purview of conditionality. At the behest of the
dominant members, policy reform emerged into the forefront at the close of
--- Content provided by FirstRanker.com ---
the eighties and beginning of the nineties. The Fund acting in coordinationwith the World Bank began to lay restrictions and performance clauses on
macro and micro economic policies and the two institutions divided the
--- Content provided by FirstRanker.com ---
enforcement work among them selves. By the 1990`s, the avowed intent and
priority of conditionality was placed on policy and structural reforms and new
--- Content provided by FirstRanker.com ---
facilities were created to finance such programs.Review Questions:
1. Outline in detail the outstanding issues in the International Monetary and
--- Content provided by FirstRanker.com ---
Financial Systems
2. Explain the Governance and Regulation of Financial Flows
--- Content provided by FirstRanker.com ---
3. Discuss the Reform of the IMFReferences:
1.MauricS"'Dlevi,'International Financial Management., McGraw-Hill.
--- Content provided by FirstRanker.com ---
2. C. Jeevanandham, EXCHANGE RATE ARITHMETIC, SultanChand.
--- Content provided by FirstRanker.com ---
Lesson - 5
Global Finance: Current Trends and Difficulties
--- Content provided by FirstRanker.com ---
Objectives of the Lesson:After studying this unit you should able to:
To know the Current Trends and Difficulties faced in the Capital
--- Content provided by FirstRanker.com ---
Markets
To understand the issues relating to Liberalization Vs
--- Content provided by FirstRanker.com ---
ProtectionismExplain the Constituents of Sound Governance in the
Contemporary World
--- Content provided by FirstRanker.com ---
Structure of Lesson
5.0 Introduction
--- Content provided by FirstRanker.com ---
5.1 Current Trends and Difficulties faced in the Capital Markets5.2 Liberalization Vs Protectionism
5.3 Constituents of Sound Governance in the Contemporary World
--- Content provided by FirstRanker.com ---
5.4 The Investment Guarantee Agreement (IGA)
5.5 Trade Disputes Settlements
--- Content provided by FirstRanker.com ---
5.0 IntroductionThe explosive growth of international financial transactions and capital
flows is one of the most far-reaching economic developments of the
--- Content provided by FirstRanker.com ---
late 20th century. Net private capital flows to developing countries
tripled ? to more than US$150 billion a year during 1995 to 1997 from
--- Content provided by FirstRanker.com ---
roughly US$50 billion a year during 1987 to 1989. At the same time,the ratio of private capital flows to domestic investment in developing
countries increased to 20% in 1996 from only 3% in 1990. Hence, this
--- Content provided by FirstRanker.com ---
has affected a shift from the national economy to global economies inwhich production and consumption is internationalized and capital
flow freely and instantly across borders.
--- Content provided by FirstRanker.com ---
Powerful forces have driven the rapid growth of international
--- Content provided by FirstRanker.com ---
capital flows, including the trend in both industrial and developingcountries towards economic liberalization and the globalization of
trade. Revolutionary changes in information and communications
--- Content provided by FirstRanker.com ---
technologies have transformed the financial services industry
worldwide. Computer links enable investors to access information on
--- Content provided by FirstRanker.com ---
asset prices at minimal cost on a real time basis, while increasedcomputing power enables them to rapidly circulate correlations among
asset prices and between asset prices and other variables. At the same
--- Content provided by FirstRanker.com ---
time, new technologies make it increasingly difficult for governments
to control either inward or outward international capital flows when
--- Content provided by FirstRanker.com ---
they wish to do so.In this context, perhaps financial markets are best understood
--- Content provided by FirstRanker.com ---
as networks and global markets as networks of different markets
linked through hubs or financial centers. This means that the
--- Content provided by FirstRanker.com ---
liberalization of capital markets and with it, likely increases in thevolume and volatility of international capital flows is an ongoing, and
to some extent, irreversible process.
--- Content provided by FirstRanker.com ---
Generally, world GDP and trade growth slowed in the past
--- Content provided by FirstRanker.com ---
1997/1998 as the East Asian crisis deepened and its repercussion werefelt increasingly outside the region. Asia recorded the strongest import
and export contraction in volume and value terms of all regions of the
--- Content provided by FirstRanker.com ---
world. The dollar value of Asia`s imports registered an unprecedented
decline of 17.5%. The five Asian countries most affected by the
financial crisis that broke in mid-1997, that is, Malaysia, Indonesia,
--- Content provided by FirstRanker.com ---
Philippines, the Republic of Korea and Thailand experienced import
contraction by one-third. In the context of these powerful trends, a few
--- Content provided by FirstRanker.com ---
significant the issues relating to them are, particularly from a capitalmarket regulator`s perspective.
5.1 Current Trends and Difficulties faced in the Capital Markets
--- Content provided by FirstRanker.com ---
Developments in computer and information technology have
made dramatic changes to the way the financial services industry
--- Content provided by FirstRanker.com ---
operates. These changes are affecting and will affect every aspect ofthe financial services industry and offer the possibility of reduced costs
in raising capital, greater efficiencies in the mobilization of domestic
--- Content provided by FirstRanker.com ---
and international savings and the provision of better, cheaper
investment products more closely tailored to the needs of different
--- Content provided by FirstRanker.com ---
investor segments. The convergence of computer and communicationstechnology is promoting the development of computer mediated
networks, allowing for users to communicate and transmit data and
--- Content provided by FirstRanker.com ---
other information regardless of boundaries and distance. As
communication costs continue to fall, the potential of outsourcing
--- Content provided by FirstRanker.com ---
grows.These changes will affect ?
--- Content provided by FirstRanker.com ---
The way investment products are offered, distributed and marketed
and the way in which investors access information about the products and
--- Content provided by FirstRanker.com ---
entities involved;The activities of financial services intermediaries, especially advisers,
--- Content provided by FirstRanker.com ---
and the way they deal with investors;
--- Content provided by FirstRanker.com ---
The continued blurring of product and institutional boundaries, andeven the scope of financial services sector itself as non-traditional entities take
on some of the functions of financial intermediaries;
--- Content provided by FirstRanker.com ---
The methods of distribution and marketing of investment products
which will increasingly draw upon the techniques of mass marketed
--- Content provided by FirstRanker.com ---
consumer products; and
--- Content provided by FirstRanker.com ---
The way secondary trading in investment products takes place asgreater scope for direct investor transactions and low cost competitors to
established securities and futures markets becomes more of a reality.
--- Content provided by FirstRanker.com ---
Just as electronic commerce affects investors and providers of
--- Content provided by FirstRanker.com ---
financial products and services; it will affect the role of corporationsand capital market regulators. Just as electronic commerce facilitates
activities across jurisdictional borders; it poses in clear terms questions
--- Content provided by FirstRanker.com ---
about the practical enforceability of national laws. As well as practical
enforcement questions, electronic commerce also raises issues about
--- Content provided by FirstRanker.com ---
the role that capital market regulators should play and the effectivenessof many of the traditional regulatory approaches and mechanisms that
have been employed by them. An example might be an offering of
--- Content provided by FirstRanker.com ---
securities made without a prospectus or registration statement on the
Internet by a person in a jurisdiction with which the capital market
--- Content provided by FirstRanker.com ---
regulator has no regular contact or mutual enforcement arrangements.There are also concerns about illegal and fraudulent activity on the
Internet.
--- Content provided by FirstRanker.com ---
5.2 Liberalization Vs Protectionism
--- Content provided by FirstRanker.com ---
On the issue of liberalization vis-?-vis protectionism, there hasbeen a proliferation of multi-lateral trade agreements since the middle
of the century. Such agreements provide for a framework of rules
--- Content provided by FirstRanker.com ---
within which nations are obligated` to assure other nations signatory
to the agreement of a sovereign`s approach towards international trade.
--- Content provided by FirstRanker.com ---
The globalization of economies is intrinsically linked to theinternationalization of the services industry. It plays a fundamental
role in the growing interdependence of markets and production across
--- Content provided by FirstRanker.com ---
nations. Information technology has further expanded the scope oftradability of this industry. Access to efficient services matters not
only because it creates new potential for export but also it will be an
--- Content provided by FirstRanker.com ---
increasingly important determinant of economic productivity and
competitiveness. The main thrusts of the services revolution` are the
--- Content provided by FirstRanker.com ---
rapid expansion of the knowledge-based services such as professionaland technical services, banking and insurance, healthcare and
education. Responding to this phenomenon, regulatory barriers to
--- Content provided by FirstRanker.com ---
entry in service industries are being reduced worldwide, either through
unilateral reforms, reciprocal negotiation, or multilateral agreements.
--- Content provided by FirstRanker.com ---
Developing countries are increasingly looking at foreign directinvestment in services as an especially powerful means of transferring
technical and managerial know-how, besides attracting foreign capital
--- Content provided by FirstRanker.com ---
and investment to the country.
5.2.1 Liberalization of Capital Account
--- Content provided by FirstRanker.com ---
A most obvious impact of globalization of trade is pressures
exerted on developing nations to liberalize their financial markets and
--- Content provided by FirstRanker.com ---
capital accounts. However, it is important to recognize that domestic
and international financial liberalization heighten the risk of crises if
--- Content provided by FirstRanker.com ---
not supported by prudential supervision and regulation and appropriatemacroeconomic policies. Domestic liberalization, by intensifying
competition in the financial sector, removes a cushion protecting
--- Content provided by FirstRanker.com ---
intermediaries from the consequences of bad loan and management
practices. It can allow domestic financial institutions to expand risky
--- Content provided by FirstRanker.com ---
activities at rates that far exceed their capacity to manage them. Byallowing domestic financial institutions access to complex derivative
instruments it can make evaluating bank balance sheets more difficult
--- Content provided by FirstRanker.com ---
and stretch the capacity of regulators to monitor risks. Externalfinancial liberalization in allowing foreign entry into the domestic
financial markets may facilitate easy access to an abundant supply of
--- Content provided by FirstRanker.com ---
offshore funding and risky foreign investments. A currency crisis or
unexpected devaluation (such as in the Asian crisis) can undermine the
--- Content provided by FirstRanker.com ---
solvency of banks and corporations which may have built up largeliabilities denominated in foreign currency and are unprotected against
foreign exchange rate changes.
--- Content provided by FirstRanker.com ---
The ideal free market is one that every one should be free to
--- Content provided by FirstRanker.com ---
enter, to participate in, and to leave. However, events in the recentfinancial crises have led many of us to believe that in the freest of
markets, there is a need to ensure that free flow of capital does not
--- Content provided by FirstRanker.com ---
destabilize the market itself.
--- Content provided by FirstRanker.com ---
Indeed, calls for reform have gained increasing support andcredence within the international community with the unfolding of the
devastating effects of the crisis beginning mid-1997. There are
--- Content provided by FirstRanker.com ---
fundamental weaknesses in the existing global financial infrastructure
that have caused and exacerbated these effects. These weaknesses
--- Content provided by FirstRanker.com ---
include the inordinate power of highly leveraged institutions to movemarkets, the destabilizing force of volatile short-term capital flows and
the failure of existing credit assessment systems to adequately inform
--- Content provided by FirstRanker.com ---
market participants of increasing risk of default. One example of this
mounting consensus was the express recognition by G7 countries at a
--- Content provided by FirstRanker.com ---
meeting in Cologne of the need to strengthen the internationalfinancial architecture. There are now increasing calls for greater
transparency and regulation of hedge funds and greater awareness of
--- Content provided by FirstRanker.com ---
the dangers of volatile short-term capital flows.
5.3 Constituents of Sound Governance in the Contemporary
World
--- Content provided by FirstRanker.com ---
On the domestic front, we would have to ask ourselves this
--- Content provided by FirstRanker.com ---
question: has our Indian financial markets kept pace with change?Whilst markets have become global, applicable rules and regulations
remain predominantly parochial or local. From a regulator`s
--- Content provided by FirstRanker.com ---
perspective, the challenge for us in a global market is to design the
regulatory and structural framework which will allow the market to
--- Content provided by FirstRanker.com ---
function efficiently, competitively in a fair and level playing fieldenvironment, ensuring at the same time that the market is not subject
to highly concentrated or destabilizing forces that would disrupt its
--- Content provided by FirstRanker.com ---
functioning.
--- Content provided by FirstRanker.com ---
The recent crisis also shows up the need for a careful andsequenced approach towards liberalizing a country`s capital account.
The experiences of Thailand, Korea, and Indonesia clearly tell us that
--- Content provided by FirstRanker.com ---
there is no prescribed formula on sequencing. However, it is important
to recognize that countries vary greatly in their levels of economic and
--- Content provided by FirstRanker.com ---
financial development, in their institutional structures, in their legalsystems and business practices, and their capacity to manage change in
a host of areas relevant for financial liberalization. It is in recognition
--- Content provided by FirstRanker.com ---
of this that the IMF policy-setting committee and subsequently the
Finance Ministers and central bank governors of the G7 industrial
--- Content provided by FirstRanker.com ---
nations, in the fall of 1998, stressed that a country opening its capitalaccount must do so in an orderly, gradual, and well sequenced manner.
--- Content provided by FirstRanker.com ---
Issues of liberalisation versus protectionism would need to be
considered at great length to ensure that a country is competitive in a
--- Content provided by FirstRanker.com ---
global trading environmentGiving certainty to international financial transactions and
protection to Foreign Investments
--- Content provided by FirstRanker.com ---
International trade and finance, because of its global nature,
necessarily involves many areas which may give rise to uncertainty as
--- Content provided by FirstRanker.com ---
to the applicability of the contract under which certain trade and
financing arrangements are made. These areas range from political
--- Content provided by FirstRanker.com ---
issues and political stability to sovereign intervention of the economy,certainty of applicable laws as well as independence of the judiciary.
--- Content provided by FirstRanker.com ---
In less than half a century, the states of Asia have moved
through a whole range of stances which could be adopted towards
--- Content provided by FirstRanker.com ---
foreign investment. The immediate post-colonial period wascharacterized by a period of hostility towards foreign investment,
motivated by the belief that the ending of economic imperialism alone
--- Content provided by FirstRanker.com ---
will bring about true independence. The ensuing period was dominated
by a debate about the regulation of multinational corporations and the
--- Content provided by FirstRanker.com ---
fear that they posed a threat to state sovereignty. In this period, lawswere devised to control the entry of foreign investment and the manner
in which such foreign investment operated in the host country after
--- Content provided by FirstRanker.com ---
entry. The third and present period is a period of pragmatism where
the dominant view is that foreign investment, if properly harnessed,
--- Content provided by FirstRanker.com ---
can be an instrument which generates rapid economic development.Competition for the limited investment that is available means that
each state country which is bent on a foreign investment led growth
--- Content provided by FirstRanker.com ---
strategy must make its laws as hospitable to the foreign investor as the
other state which is also bent on a similar strategy.
--- Content provided by FirstRanker.com ---
As much as there is competition among countries to attract
foreign investment, there is competition among multinational
--- Content provided by FirstRanker.com ---
corporations to enter host countries. Whereas previously the market
was dominated by large multinationals, now, there are small and
medium enterprises which can transfer more appropriate technology
--- Content provided by FirstRanker.com ---
and bring sufficient assets for investment.
This open door policy towards foreign investment in developing
--- Content provided by FirstRanker.com ---
countries is typically achieved through careful screening of entry byadministrative agencies which have been established for the purpose
and regulation of the process of foreign investment after entry has
--- Content provided by FirstRanker.com ---
been made. After entry, there is continued surveillance of the foreign
investment to ensure that the foreign investment keeps to the
--- Content provided by FirstRanker.com ---
conditions upon which entry was permitted. In this regard, attitudes toforeign investment protection and dispute resolution will be affected
by the new strategies adopted towards foreign investment.
--- Content provided by FirstRanker.com ---
In the context of the new strategies which have been developed
--- Content provided by FirstRanker.com ---
by controlling entry and the later surveillance of operations of foreigninvestment, the foreign investment has ceased to be a contract based
matter and had become a process initiated by a contract no doubt but
--- Content provided by FirstRanker.com ---
controlled at every point through the public law machinery of the state.
The old notions of foreign investment protection which concentrated
--- Content provided by FirstRanker.com ---
on the making of the contract and the contract as the basis of all rightsof the foreign investor would inevitably become obsolete. This
transformation which has taken place is crucial to the devising of
--- Content provided by FirstRanker.com ---
effective methods of foreign investment protection. The subject matter
of the protection has also changed in that not only physical assets of
--- Content provided by FirstRanker.com ---
the foreign investor but his intangible assets which include intellectualproperty rights as well as public law rights to licences and privileges
have become the subject of protection.
--- Content provided by FirstRanker.com ---
The proposition that contractual provisions in an agreement
--- Content provided by FirstRanker.com ---
concluded with a host country offer little protection to foreigninvestment must be qualified in a situation when a bilateral investment
treaty has been entered between the state of the foreign investor and
--- Content provided by FirstRanker.com ---
the host country. The result will be different, for the contract becomeseffectively internationalized as a result of the existence of such a
treaty. It is a basic proposition of international law that any matter that
--- Content provided by FirstRanker.com ---
is essentially within the domestic jurisdiction of any state could be
internationalized if it is made the subject of an international treaty. The
--- Content provided by FirstRanker.com ---
existence of a bilateral investment treaty which covers the foreigninvestment then internationalizes the whole process of foreign
investment which would otherwise have been a process that takes
--- Content provided by FirstRanker.com ---
place entirely within the sovereign jurisdiction of the host state. But,
whether this result will follow depends on the terms of the bilateral
--- Content provided by FirstRanker.com ---
investment treaty.Bilateral investment treaties are obviously regarded as
--- Content provided by FirstRanker.com ---
important by both capital exporting and capital importing states. But,
these treaties are not uniform and they do not have the ability to create
--- Content provided by FirstRanker.com ---
any uniform law on foreign investment protection. But their existenceadds to investor confidence and creates an expectation of investor
protection. The importance of these treaties lies in the several results
--- Content provided by FirstRanker.com ---
they achieve. The first is a signaling function about the national policy
towards foreign investment.
--- Content provided by FirstRanker.com ---
Another advantage is that the foreign investment contract in the
context of bilateral investment treaties could have the effect of forming
--- Content provided by FirstRanker.com ---
assets protected by the bilateral investment treaties. This will also
include licences and other advantages obtained from the government
--- Content provided by FirstRanker.com ---
during the course of the foreign investment. Whereas without thebilateral investment treaty these licences and advantages may have
been without protection under general international law, they new
--- Content provided by FirstRanker.com ---
receive protection as a result of the wide definition of property in thebilateral investment treaty. Whether the host country did intend that its
administrative decisions be subjected to international review as a result
--- Content provided by FirstRanker.com ---
of the treaty will remain a moot point. But, it remains a possible result
if the treaty.
--- Content provided by FirstRanker.com ---
5.4 The Investment Guarantee Agreement (IGA)The Investment Guarantee Agreement protects parties involved in an
international transaction from non-commercial risks such as
--- Content provided by FirstRanker.com ---
nationalization and expropriation. The IGA will provide a foreign
investor with the following:
--- Content provided by FirstRanker.com ---
protection against nationalization and expropriation;
--- Content provided by FirstRanker.com ---
prompt and adequate compensation in the event of nationalization or
expropriation under a lawful or public purpose;
--- Content provided by FirstRanker.com ---
free remittance of currency, profits, capital or other fees on
investment;
--- Content provided by FirstRanker.com ---
settlement of investment disputes either through a process of
--- Content provided by FirstRanker.com ---
consultation through diplomatic channels or if such process fails, for referralto the International Court of Justice. Disputes in connection with investments,
under IGAs should first be resolved through local judicial facilities. In the
--- Content provided by FirstRanker.com ---
event of failure to settle, it would be referred to the Convention on the
Settlement of Investment Disputes or the International Adhoc Arbitral
--- Content provided by FirstRanker.com ---
Tribunal established under the Arbitration Rules of the United NationsCommission on International Trade Law.
5.5 Trade Disputes Settlements
--- Content provided by FirstRanker.com ---
Another aspect of international trade is the availability of
--- Content provided by FirstRanker.com ---
acceptable dispute resolution form. Globalization of trade obviouslyinvolves greater potential for generating international trade disputes.
The international business community looks for prompt, economical,
--- Content provided by FirstRanker.com ---
and fair conflict-resolution mechanisms. Negotiation, conciliation,litigation, and arbitration are well-known conflict-resolution devices.
Direct negotiations and conciliation may resolve a conflict. However,
--- Content provided by FirstRanker.com ---
when parties fail to solve the controversy through direct negotiations,
they have two choices: litigation or arbitration.
--- Content provided by FirstRanker.com ---
Within the context of the GATS, there is an express provision
for trade settlement dispute where countries have disputes in relation
--- Content provided by FirstRanker.com ---
to commitments made under the agreement. The WTO have provided
for procedures in relation to a dispute settlement process. The dispute
--- Content provided by FirstRanker.com ---
settlement procedure is considered to be the WTO's most individualcontribution to the stability of the global economy. The WTO's
procedure underscores the rule of law, and it makes the trading system
--- Content provided by FirstRanker.com ---
more secure and predictable. It is clearly structured, with flexible
timetables set for completing a case. First rulings are made by a panel,
--- Content provided by FirstRanker.com ---
appeals based on points of law are possible, and all final rulings ordecisions are made by the WTO's full membership. No single country
can block a decision. It is indeed a challenge to us all to be able to
--- Content provided by FirstRanker.com ---
grapple with some of the abovementioned issues and adopt appropriate
responses.
--- Content provided by FirstRanker.com ---
Review Questions1. Discuss the Current Trends and Difficulties faced in the Capital
Markets.
--- Content provided by FirstRanker.com ---
2. Explain in detail the issues relating to Liberalization Vs
--- Content provided by FirstRanker.com ---
Protectionism3. What do you mean by open door?
4. What is Investment Guarantee Agreement (IGA)?
--- Content provided by FirstRanker.com ---
5. Explain Trade Disputes Settlements in detail.
References
1. Wong Sau Ngan. Wong is a specialist in Legal & Regulatory Policy for
--- Content provided by FirstRanker.com ---
Securities Commission, Policy & Development Division (Malaysia)
2.MauricS"'Dlevi,'International Financial Management., McGraw-Hill.
--- Content provided by FirstRanker.com ---
3. C. Jeevanandham, EXCHANGE RATE ARITHMETIC, SultanChand.
4. Apte.P.G., International Financial Management, Tata Mc. Graw
--- Content provided by FirstRanker.com ---
Hill,NewDelhi.
5. Henning, C.N., W.Piggot and W.H.Scott, International Financial
--- Content provided by FirstRanker.com ---
Management, Mc.Graw Hill, International Edition.--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
LESSON - 1
EXCHANGE RATES DETERMINANTS
--- Content provided by FirstRanker.com ---
Objective: In this lesson, we will introduce you the meaning of exchange rates determinants.
This lesson is concept based. After you workout this lesson, you should be able to:
--- Content provided by FirstRanker.com ---
Know the meaning of exchange rate determinants.Understand the theories of exchange rate determinants.
--- Content provided by FirstRanker.com ---
EXCHANGE RATES DETERMINANTS: AN OVERVIEWForex market is the largest financial market in terms of size. This is so irrespective of the fact
that it is fully over the counter market. By far the largest market for currencies is the inter-bank
--- Content provided by FirstRanker.com ---
market, which trades spot and forward contracts. The market can be termed as efficient with
enough breadth, depth and resilience.
--- Content provided by FirstRanker.com ---
The basic theories underlying the exchange rates ?1. Law of One Price: In competitive markets free of transportation costs barriers to trade,
identical products sold in different countries must sel at the same price when the prices are
--- Content provided by FirstRanker.com ---
expressed in terms of their same currency.Purchasing power parity: As inflation forces prices higher in one country but not another
country, the exchange rate will change to reflect the change in relative purchasing power of the
--- Content provided by FirstRanker.com ---
two currencies.
2. Interest rate effects: If capital is allowed to flow freely, the exchange rates stabilize at a
--- Content provided by FirstRanker.com ---
point where equality of interest is established.The Fisher Effect: the nominal interest rate (r) in a country is determined by the real interest
rate R and the inflation rate i as follows: (1 + r) = (1 + R)(1 + i)
--- Content provided by FirstRanker.com ---
International Fisher Effect: the spot rate should change in an equal amount but in the
opposite direction to the difference in interest rates between two countries.
--- Content provided by FirstRanker.com ---
S1 - S2----------- x 100 = i2 ? i1
S2
--- Content provided by FirstRanker.com ---
Where: S1 = spot rate using indirect quotes at beginning of the period;
S2 = spot rate using indirect quotes at the end of the period;
--- Content provided by FirstRanker.com ---
i = respective nominal interest rates for country 1 and 2.Though the above principles attempt to explain the movement of exchange rates, the
assumptions behind these two theories [free flow of capital] are seldom seen and thus these
--- Content provided by FirstRanker.com ---
theories can`t be applied directly.
The dual forces of demand and supply determine exchange rates. Various factors affect these,
--- Content provided by FirstRanker.com ---
which in turn affect the exchange rates.The business environment: Positive indications (in terms of govt. policy, competitive
advantages, market size etc) increase the demand of the currency, as more and more entities
--- Content provided by FirstRanker.com ---
want to invest there. This investment is for two basic motives ?purely business motive, and for
risk diversification purposes. Foreign direct investment is for taking advantage of the
comparative advantages and the economies of scale. Portfolio investment is mainly done for
--- Content provided by FirstRanker.com ---
risk diversification purposes.
Stock market: The major stock indices also have a correlation with the currency rates. The
--- Content provided by FirstRanker.com ---
Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown astrong positive correlation with the dollar as foreign investors purchased US equities. Three
major forces affect the indices: 1) Corporate earnings, forecast and actual; 2) Interest rate
--- Content provided by FirstRanker.com ---
expectations and 3) Global considerations. Consequently, these factors channel their way
through the local currency.
--- Content provided by FirstRanker.com ---
Political Factors: All exchange rates are susceptible to political instability and anticipationsabout the new ruling party. A threat to coalition governments in France, India, Germany or
Italy will certainly affect the exchange rate. For e.g. Political or financial instability in Russia is
--- Content provided by FirstRanker.com ---
also a red flag for EUR/USD, because of the substantial amount of Germany investment
directed to Russia.
--- Content provided by FirstRanker.com ---
Economic Data: Economic data items like labor report (payrolls, unemployment rate andaverage hourly earnings), CPI, PPI, GDP, international trade, productivity, industrial
production, consumer confidence etc. also affect the exchange rate fluctuations. Confidence in
--- Content provided by FirstRanker.com ---
a currency is the greatest determinant of the exchange rates. Decisions are made keeping in
mind the future developments that may affect the currency. And any adverse sentiments have
--- Content provided by FirstRanker.com ---
a contagion effect. The observers have generally concluded that devaluations should beavoided at al costs, since the panics have almost al followed currency devaluations. Some are
of the view that is it not the devaluation, but rather the defense of the exchange rate preceding
--- Content provided by FirstRanker.com ---
the crisis that opens the door to financial panic. The devaluation, which follows the depletion
of reserves usually, alerts the market to the exhaustion of reserves, a state of affairs, which is
--- Content provided by FirstRanker.com ---
not fully apparent to many market participants before the devaluation takes place. Holdersbegin to convert their money into foreign exchange in expectation of devaluation, and suppose
that the central bank defends the exchange rate, by buying high-powered money and selling
--- Content provided by FirstRanker.com ---
dol ars. Thus, a panic can unfold simply by the belief of creditors that it will indeed occur. In
the past four years, mainly three types of events have triggered such panics:
1) The sudden discovery that reserves is less than previously believed
--- Content provided by FirstRanker.com ---
2) Unexpected devaluation (often in part for its role in signaling the depletion of reserves); and,
3) Contagion from neighboring countries, in a situation of perceived vulnerability (low
--- Content provided by FirstRanker.com ---
reserves, high short-term debt, overvalued currency).Government influence: A country's government may reduce the growth in the money
supply, raising interest rates, and encouraging demand for its currency. Or a government may
--- Content provided by FirstRanker.com ---
simply buy or sell forex to maintain stability or to support either exporters or importers.
Productivity of an economy: An increase in productivity of an economy tends to impact
--- Content provided by FirstRanker.com ---
exchange rates. It affects are more prominent if the increase is in the traded sector. A recentstudy by the federal reserve bank of New York shows that over a 30 yrs. Period [1970-1999]
productivity changes and the dollar /euro real exchange rates have moved in tandem.
--- Content provided by FirstRanker.com ---
AN ILLUSTRATION
1. The exchange rate often fluctuated quite a lot over the short term, but followed a more
--- Content provided by FirstRanker.com ---
rational path over the long term.2. That against the background of over the twenty-one month period from the beginning of
2000 to 11 September 2001 the rand maintained an almost consistent and fairly well-defined
--- Content provided by FirstRanker.com ---
declining trend against the US dol ar.
Possible reasons attributed:
--- Content provided by FirstRanker.com ---
1. The internal purchasing power of a currency and its exchange rate tend to move togetherover time. Historically, South Africa has had a faster than average inflation rate and rand has
had a declining trend against, for example, US dol ar.
--- Content provided by FirstRanker.com ---
2. A currency with above average inflation and that tends to depreciate will tend to have higher
than average inflation rates. The more than average interest rates in South Africa made rand
--- Content provided by FirstRanker.com ---
more attractive and valuable.2. Due to steady depreciation of the rand during 2000 and the first half of 2001 most market
participants came to the view that the currency was weak and it is likely that they took
--- Content provided by FirstRanker.com ---
decisions to help protect themselves against the contagion effect A perfectly legitimate large
transaction by one of the major market players might have led to the emergence of a herd
mentality resulting in the run on the rand. The steady decline was a result of economic,
--- Content provided by FirstRanker.com ---
political, policy and confidence factors and other factors that build over months.
3. The South African exchange rate is determined by forces of demand and supply. The
--- Content provided by FirstRanker.com ---
system of a managed float is by its nature unstable. Volatile movements in the exchange ratecan be expected from time to time.
4. There were a number of variables at play at the same time and certainly in our attempts to
--- Content provided by FirstRanker.com ---
try and understand what was going on, we have been unable to say what caused it was A and
not B. It was a complex set of issues not least of which is the confidence that South Africans
--- Content provided by FirstRanker.com ---
have in their own country and their own economy and so it has been difficult for us to say thatthere was one. There were lots of things happening at the same time.
--- Content provided by FirstRanker.com ---
LESSON - 2FOREIGN
EXCHANGE
--- Content provided by FirstRanker.com ---
EXPOSURE,
EXPOSURE
--- Content provided by FirstRanker.com ---
&RISK
AND
--- Content provided by FirstRanker.com ---
CLASSIFICATION, ESTIMATION & PRACTICE OF THE EXPOSURE
Objectives: In this lesson, we will introduce you to the meaning and nature of foreign
--- Content provided by FirstRanker.com ---
exchange exposure, risk and estimation of the exposure line. This lesson is concept based.After you workout this lesson, you should be able to:
Know the meaning of foreign exchange exposure, risk and classification, estimation &
--- Content provided by FirstRanker.com ---
practice of exposure.
Understand the nature of foreign exchange exposure and risk.
--- Content provided by FirstRanker.com ---
THE MEANING AND NATURE OF FOREIGN EXCHANGE EXPOSURE
The values of a firm's assets, liabilities and operating income vary continually in response to
--- Content provided by FirstRanker.com ---
changes in myriad economic and financial variables such as exchange rates, interest rates,
inflation rates, relative prices and so forth. We can label these uncertainties as macro-economic
--- Content provided by FirstRanker.com ---
environmental risks. In addition, uncertainties related to its operating business such asinterruptions in raw materials supplies, labour troubles, success or failure of a new product or
technology and so forth obviously have an impact on the firm's performance. These can be
--- Content provided by FirstRanker.com ---
grouped under the heading of core business risks.
While core business risks are specific to firm, macro-economic uncertainties affect al firms in
--- Content provided by FirstRanker.com ---
the economy. However, the extent and nature of impact of even macro-economic riskscrucially depend upon the nature of a firm's business. For instance, fluctuations of exchange
rate will affect net importers and net exporters quite differently; the impact of interest rate
--- Content provided by FirstRanker.com ---
fluctuations will be very different on a bank from that on a manufacturing firm; oil price
gyrations will affect an airline in one way and an oil producer in a quite different way.
--- Content provided by FirstRanker.com ---
The nature of macro-economic uncertainty can be illustrated by a number of commonlyencountered situations. An appreciation of the value of a foreign currency (or equivalently,
a depreciation of the domestic currency), increases the domestic currency value of a firm's
assets and liabilities denominated in the foreign currency-foreign currency receivables and
payables, bank deposits and loans, etc. It will also change domestic currency cash flows
--- Content provided by FirstRanker.com ---
from exports and imports. An increase in interest rates reduces the market value of aportfolio of fixed-rate bonds and may increase the cash outflow on account of interest
payments. Acceleration in the rate of inflation may increase the value of unsold stocks, the
revenue from future sales as well as the future costs of production. Thus the firm is
"exposed" to uncertain changes in a number of variables in its environment. These
--- Content provided by FirstRanker.com ---
variables are sometimes called Risk Factors.Uncertainties arising out of fluctuations in exchange rates, interest rates and relative prices of
key commodities such as oil, copper, etc, create strategic exposure and risk for a firm. As we
--- Content provided by FirstRanker.com ---
will see below, the long run response of the firm to these risks can involve significant changes
in the firm's strategic posture choice of product-market combinations, sourcing of inputs, and
--- Content provided by FirstRanker.com ---
choice of technology, location of manufacturing activities, strategic alliances and so forth.The primary focus of this book is on the firm's exposure to changes in exchange rates and
interest rates. However, as we will see later, exchange rates, interest rates and inflation rates
--- Content provided by FirstRanker.com ---
are intimately interrelated and, are in turn related to a whole complex of macroeconomic
variables. In many cases, it may be very difficult to isolate the effect of changes in anyone of
--- Content provided by FirstRanker.com ---
them on the firm's assets, liabilities and cash flows.It is not uncommon to find the terms exposure and risk being used interchangeably. However,
as several authors have pointed out the two are not identical. Exposure is a measure of the
--- Content provided by FirstRanker.com ---
sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the
relevant risk factor while risk is a measure of the variability of the value of the item attributable
--- Content provided by FirstRanker.com ---
to the risk factor. Let us understand this distinction clearly: from April 1993 to July 1995 theexchange rate between rupee and US dollar-was almost rock steady. Consider a firm whose
business involved both exports to and imports from the US. During this period the firm would
--- Content provided by FirstRanker.com ---
have readily agreed that its operating cash flows were very sensitive to the rupee-dollar
exchange rate i.e. it had significant exposure to this exchange rate; at the same time it would
--- Content provided by FirstRanker.com ---
have said that it did not perceive significant risk on this account because given the stability ofthe rupee exchange rate, the probability of large fluctuations in its operating cash flows on
account of rupee dollar fluctuations would have been perceived to be minimal. Thus the
--- Content provided by FirstRanker.com ---
magnitude of risk is determined by the magnitude of exposure and the degree of variability in
the relevant risk factor.
EXPOSURE AND RISK
--- Content provided by FirstRanker.com ---
Exposure of a firm to a risk factor is the sensitivity of the real value of a firm`s assets,
liabilities or operating income, expressed in its functional currency, to unanticipated
--- Content provided by FirstRanker.com ---
changes in the risk factor. The important points of risk are as follows:Values of assets, liabilities or operating income are to be denominated in the
functional currency of the firm. This is the primary currency of the firm and in which
--- Content provided by FirstRanker.com ---
its financial statements are published. For most firms it is the domestic currency of
their country.
--- Content provided by FirstRanker.com ---
Exposure is defined with respect to the real values i.e. values adjusted for inflation.While theoretically this is the correct way of assessing exposure, in practice due to the
difficulty of dealing with an uncertain inflation rate this adjustment is often ignored i.e.
--- Content provided by FirstRanker.com ---
exposure is estimated with reference to changes in nominal values.
The definition stresses that only unanticipated changes in the relevant risk factor are to
--- Content provided by FirstRanker.com ---
be considered. The reason is that markets will have already made an allowance foranticipated changes. For instance, an exporter invoicing a foreign buyer in the buyer's
currency will build an allowance for the expected depreciation of that currency into
--- Content provided by FirstRanker.com ---
the price. A lender will adjust the rate of interest charged on the loan to incorporate an
al owance for the expected depreciation. From an operational point of view, the
--- Content provided by FirstRanker.com ---
question is how do we separate a given change in exchange rate or interest rate into itsanticipated and unanticipated components since only the actual change is observable?
One possible answer is to use the relevant forward rate as the expected value of the
--- Content provided by FirstRanker.com ---
underlying risk factor. For instance, one possible estimate of what the exchange rate
will be three months from now is today three month forward rate. Suppose that the
--- Content provided by FirstRanker.com ---
price of a pound sterling in terms of rupees for immediate delivery (the so called spotrate) is Rs. 80.00 while the six month forward rate is Rs. 80.20. We can say that the
anticipated depreciation of the rupee is 20 paisa per pound in six months. If six months
--- Content provided by FirstRanker.com ---
later, the spot rate turns out to be Rs. 80.30, there has been an unanticipated
depreciation of 10 paisa per pound.
The change in exchange rate is the only risk factor affecting the value of the exposed item.
--- Content provided by FirstRanker.com ---
This will indeed be the case if the foreign currency value of the item is fixed.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Currency Exposure
--- Content provided by FirstRanker.com ---
Accounting Exposure
--- Content provided by FirstRanker.com ---
Operating Exposure
--- Content provided by FirstRanker.com ---
Translation
--- Content provided by FirstRanker.com ---
Contingent
--- Content provided by FirstRanker.com ---
Translation
--- Content provided by FirstRanker.com ---
Competition
--- Content provided by FirstRanker.com ---
ESTIMATION OF THE EXPOSURE LINE
--- Content provided by FirstRanker.com ---
The interpretation of the exposure relationship as a regression equation suggests that an
estimate of 1 can be obtained by the method of ordinary least squares. We can collect
--- Content provided by FirstRanker.com ---
historical data on V and SU and fit a straight line to the data by the least squares method. Theslope of the fitted line then is the measure of exposure.
As we have seen above, in the case of items with contractual y fixed foreign currency values,
--- Content provided by FirstRanker.com ---
there is an exact systematic relation between V and Su and all our data points will fall precisely
on the line. In the case of items whose foreign currency values can change, there will be
--- Content provided by FirstRanker.com ---
"noise" in the relationship due to the random element. The data points will not fall exactly ona straight line; we can statistically estimate the parameter 1' However, in this case, the
reliability of the estimated equation will depend upon the relative strengths of the systematic
--- Content provided by FirstRanker.com ---
and random components of equation.More pertinent however is the fact that the exposure relation may not be stable, i.e. the
underlying "true" values of the parameters 0 and 1 may be changing over time particularly if
--- Content provided by FirstRanker.com ---
the relationship is being estimated for the entire collection of a firm's assets or liabilities and
the composition of these collections changes over time. Further, in practice it may be quite
--- Content provided by FirstRanker.com ---
difficult to obtain estimates of changes in real domestic currency values of exposed items. Inpractice therefore, estimation of exposure requires that the finance manager should construct
alternative scenarios of exchange rates, interest rates and inflation rates and examine the
--- Content provided by FirstRanker.com ---
impact of each combination on the various items in the firm's balance sheet and projected
income statement.
--- Content provided by FirstRanker.com ---
The idea of foreign exchange exposure as the systematic relation between the change inreal domestic currency value of an item and the unanticipated change in exchange rate can
be extended to multiple exposures, for example when the firm has receivables in many
--- Content provided by FirstRanker.com ---
foreign currencies. The relationship can be written as
V = 0 + 1 ( Su1) + 2 ( Su2) + . . + n ( Sun) +
--- Content provided by FirstRanker.com ---
The slope coefficients 1, 2 . . n measure the exposure with respect to the corresponding
exchange rate. One can also include other risk factors in the above equation to estimate the
--- Content provided by FirstRanker.com ---
exposure to them.
Finally, it must be recognized that exchange rate changes can affect a firm even if all or most
--- Content provided by FirstRanker.com ---
of its assets, liabilities and cash flows are denominated in its home currency. This is because ofthe intimate connection between exchange rates and other macro-economic variables like
interest rates and price level. For instance, in response to an actual or incipient depreciation of
--- Content provided by FirstRanker.com ---
the home currency, the monetary authorities might resort to raising interest rates at home in
order to attract short-term foreign capital or make it difficult for domestic residents to borrow
--- Content provided by FirstRanker.com ---
home currency to buy and hold foreign currency. This in turn will adversely affect the marketvalue of a portfolio of fixed interest securities held by the firm. For a non financial firm selling
consumer durables like cars, higher interest rates may be bad news. Changes in exchange rates
--- Content provided by FirstRanker.com ---
will affect the relative competitiveness of a firm which produces an import substitute andhence will affect its future sales and cash flows. An appreciation of the home currency reduces
home currency price of imports; if a firm produces an import-competing product, such an
--- Content provided by FirstRanker.com ---
event would have a depressing effect on its sales. Thus even a "purely domestic" firm is
exposed to exchange rate changes.
--- Content provided by FirstRanker.com ---
In contrast to exposure which is a measure of the response of value to changes in the relevantrisk factor, risk is a measure of variability of the value of an item attributable to variations in
the risk factor. There are many ways to quantify this concept of variability. The one most often
--- Content provided by FirstRanker.com ---
used by statisticians is the so cal ed variance or its square-root known as standard deviation.
The variance of a random variable is a probability-weighted measure of departures from its
--- Content provided by FirstRanker.com ---
average value. Using this measure of variability, foreign exchange risk can be defined as:The variance of the real domestic currency value of assets, liabilities or operating income
attributable to unanticipated changes in exchange rates.
--- Content provided by FirstRanker.com ---
Risk as defined here depends upon the exposure as 1 appears in this relation. It also depends
upon the variance of the unanticipated changes in exchange rates.
--- Content provided by FirstRanker.com ---
Consider an example; a firm has a 90 day payable of 100,000 Swiss francs. The current spotrate is Rs 37.00/SFr. The 90 day forward rate is Rs 37.50. The spot rate 90 days hence is
assumed to have a, normal distribution with a mean of Rs 37.50 and a standard deviation of Rs
--- Content provided by FirstRanker.com ---
0.05.11 Denote the spot rate by So' and the spot rate 90 days from today by S3' The total
change in exchange rate from today to 90 days from today is (S3 - So). This can be broken
--- Content provided by FirstRanker.com ---
down intoS3 - So = [S3 - E(S3)] + [E(S3) - So] = Su + Sa
Where, E(S3) means "expected value of S3", SU is the unanticipated component of the change
--- Content provided by FirstRanker.com ---
and Sa is the anticipated component. Thus suppose the spot rate 90 days hence is 37.90. Thetotal change is Rs 0.90 (S3-So), anticipated change is 0.50 [= E(S3) - So] and unanticipated
change is 0.40 [= S3 - E(S3)]. Since S3 has a normal distribution with mean 37.50 and standard
deviation Rs 0.05, [S3 - E(S3)] will have a normal distribution with mean zero and identical
--- Content provided by FirstRanker.com ---
standard deviation of Rs 0.05. Since the unanticipated change in the rupee value of the payableis given by 100,000 ( SU), it will also have a normal distribution with mean zero and standard
deviation of Rs 5,000. Using the properties of the normal distribution, one can say with 95%
--- Content provided by FirstRanker.com ---
confidence that the unanticipated change in the value of the payable will lie between -10,000
and +10,000. Since the anticipated change is Rs 50,000 [= 0.50 x 100000] the total change will
--- Content provided by FirstRanker.com ---
be between Rs 40,000 to Rs 60,000.Thus, the measure of risk tel s us how volatile the values of the firm's assets, liabilities or
operating income are in the face of fluctuations in the underlying risk factor, in this case, the
--- Content provided by FirstRanker.com ---
exchange rate.
Instead of variance, one can estimate the possible range i.e. the difference between the highest
--- Content provided by FirstRanker.com ---
and lowest values of the item given certain assumptions about the possible range of variationin the exchange rate. In a similar vein, one can construct alternative scenarios of exchange rate
movements (or movements in any other risk factor). The "best case" and the "worst case"
--- Content provided by FirstRanker.com ---
scenarios correspond to the most favourable and the least favourable circumstances. For
instance, for a company with a payable in foreign currency, "best case" would correspond to
--- Content provided by FirstRanker.com ---
the largest depreciation (or smallest appreciation) of the foreign currency considered likely andthe "worst case" would consider the maximum appreciation.
--- Content provided by FirstRanker.com ---
CLASSIFICATION OF FOREIGN EXCHANGE EXPOSURE AND RISK
--- Content provided by FirstRanker.com ---
Since the advent of floating exchange rates in 1973, firms around the world have becomeacutely aware of the fact that fluctuations in exchange rates expose their revenues, costs,
operating cash flows and hence their market value to substantial fluctuations. Firms which
--- Content provided by FirstRanker.com ---
have cross-border transactions-exports and imports of goods and services, foreign borrowing
and lending, foreign portfolio and direct investment, etc.-are directly exposed; but even
--- Content provided by FirstRanker.com ---
"purely domestic" firms which have absolutely no cross-border transactions are also exposedbecause their customers, suppliers and competitors are exposed. Considerable effort has since
been devoted to identifying and categorizing currency exposure and developing more and
--- Content provided by FirstRanker.com ---
more sophisticated methods to quantify it.In the short-term, the firm is faced with two kinds of exposures. It has certain contractual y
fixed payments and receipts in foreign currency such as export receivables, import payables,
--- Content provided by FirstRanker.com ---
interest payable on foreign currency loans and so forth. Most of these items are expected to be
settled within the upcoming financial year.
--- Content provided by FirstRanker.com ---
An unanticipated change in the exchange rate has an impact-favorable or adverse on its cashflows. Such exposures are known as Transactions Exposures. In essence it is a measure of the
sensitivity of the home currency value of assets and liabilities which are denominated in
--- Content provided by FirstRanker.com ---
foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are
liquidated. The foreign currency values of these items are contractual y fixed i.e. do not vary
--- Content provided by FirstRanker.com ---
with exchange rate. Hence it is also known as contractual exposure.Some typical situations which give rise to transactions exposure are:
(a)
--- Content provided by FirstRanker.com ---
A currency has to be converted in order to make or receive payment for goods and
services-import payables or export receivables denominated in a foreign currency.
--- Content provided by FirstRanker.com ---
(b) A currency has to be converted to repay a loan or make an interest payment.(c)
A currency has to be converted to make a dividend payment, royalty payment, etc.
--- Content provided by FirstRanker.com ---
Note that in each case, the foreign currency value of the item is fixed; the
uncertainty pertains to the home currency value.
It is March 18, 2005. An Indian company has cleared an import shipment of specialty
--- Content provided by FirstRanker.com ---
chemicals. The invoice is for US$ 250,000 payable on September 20. The current exchangerate is Rs 43.67 per dollar. The recent history of the exchange rate depicted below shows some
volatility. During the last six months or so, dollar has shown considerable weakness against all
--- Content provided by FirstRanker.com ---
currencies including the rupee. An adverse movement in exchange rate Viz. a sharp rise in
dol ar, will reduce the firm's cash flows. There is also the problem of how to value the imports
--- Content provided by FirstRanker.com ---
for the purpose of product costing and pricing decisions.What should the firm do?
A US firm has exported some computer peripherals to a German buyer. For customer
--- Content provided by FirstRanker.com ---
relationship reasons the sale has been invoiced in buyer's currency viz. Euro. The invoice is for$1,000,000 to be settled 60 days from now. The current exchange rate is $1.3250 per Euro.
The recent history of the dollar-euro rate Sl10wn below indicates an upward trend with some
--- Content provided by FirstRanker.com ---
fluctuations. The firm's bankers are fairly bullish about the Euro despite the reversionary
conditions in the major European economies viz. Germany and France. However, US treasury
--- Content provided by FirstRanker.com ---
secretary has expressed concern about the weak dollar.What should the firm do?
Suppose a firm receives an export order, it fixes a price, manufactures the product, makes the
--- Content provided by FirstRanker.com ---
shipment and gives 90 days credit to the buyer who will pay in his currency. A company has
acquired a foreign currency receivable which will be liquidated before the next balance sheet
--- Content provided by FirstRanker.com ---
date. The company has a transaction exposure from the time it accepts the order till the timethe payment is received and converted into domestic currency. The exposure affects cash
flows during the current accounting period. If the foreign currency has appreciated between
--- Content provided by FirstRanker.com ---
the day the receivable was booked and the day the payment was received, the company makes
an exchange gain which may have tax implications. In a similar fashion, interest payments and
--- Content provided by FirstRanker.com ---
principal repayments due during the accounting period create transaction exposure.Transaction risk can be defined as a measure of variability in the value of assets and
liabilities when they are liquidated.
--- Content provided by FirstRanker.com ---
The important points to be noted here are (1) transactions exposures usually have short time
horizons and (2) operating cash flows are affected.
--- Content provided by FirstRanker.com ---
Sometimes, a transaction is being negotiated, al the terms have been more or less finalized buta contractual arrangement is yet to be entered into. In such cases the firm has an anticipated
cash flow exposure.
--- Content provided by FirstRanker.com ---
The other kind of short-term exposure is known as Translation Exposure also called
Accounting Exposure. A firm may have assets and liabilities denominated in a foreign
--- Content provided by FirstRanker.com ---
currency. These are not going to be liquidated in the foreseeable future but accountingstandards which govern the reporting and disclosure practices require that at the end of the
fiscal year the firm must translate the values of these foreign currency-denominated items into
--- Content provided by FirstRanker.com ---
its home currency and report these in its balance sheet. Translation risk is the related measureof variability.
The key difference between transaction and translation exposure is that the former has impact
--- Content provided by FirstRanker.com ---
on cash flows while the latter has no direct effect on cash flows. (This is true only if there are
no tax effects arising out of translation gains and losses.)
--- Content provided by FirstRanker.com ---
Translation exposure typically arises when a parent multinational company is required toconsolidate a foreign subsidiary's financial statements with the parent's own statements after
translating the subsidiary's statements from its functional currency into the parent's home
--- Content provided by FirstRanker.com ---
currency. Thus suppose an Indian company has a UK subsidiary. At the beginning of the
parent's financial year the subsidiary has real estate, inventories and cash valued at,
--- Content provided by FirstRanker.com ---
respectively, ?1,000,000, ?200,000 and ?150,000. The spot rate is Rs 80 per pound sterling.By the close of the financial year, these have changed to ?950,000, ?205,000 and ?160,000 re-
spectively. However, during the year, there has been a drastic depreciation of the pound to Rs
--- Content provided by FirstRanker.com ---
75. If the parent is required to translate the subsidiary's balance sheet from pound sterling into
rupees at the current exchange rate, it has "suffered" a translation loss. The translated value of
--- Content provided by FirstRanker.com ---
its assets has declined from Rs 10.80 crore to Rs 9.8625 crore. Note that no cash movement isinvolved since the subsidiary is not to be liquidated. Also note that there must have been a
translation gain on the subsidiary's liabilities e.g., debt denominated in pound sterling.
--- Content provided by FirstRanker.com ---
There is broad agreement among finance theorists that translation losses and gains are only
national accounting losses and gains. The actual numbers will differ according to the
--- Content provided by FirstRanker.com ---
accounting practices followed and, depending upon the tax laws, there mayor may not be taximplications and therefore real gains or losses. Accountants and corporate treasurers however
do not fully accept this view. They argue that even though no cash losses or gains are
--- Content provided by FirstRanker.com ---
involved, translation does affect the published financial statements and hence may affect
market valuation of the parent company's stock. Whether investors indeed suffer from
--- Content provided by FirstRanker.com ---
"translation illusion" is an empirical question. Some evidence from studies of the valuation ofAmerican multinationals seems to indicate that investors are quite aware of the notional
character of these losses and gains and discount them in valuing the stock. For Indian
--- Content provided by FirstRanker.com ---
multinationals, translation exposure is a relatively less important consideration since as ofnow; the law does not require translation and consolidation of foreign subsidiaries' financial
statements with those of the parent companies.
--- Content provided by FirstRanker.com ---
The second group of exposures, classified as long-term exposures consists of operating
exposure and strategic exposures. The principal focus here is on items which will have impact
--- Content provided by FirstRanker.com ---
on the cash flows of the firm in years to come and which may have a serious impact on thecompetitive posture of the firm forcing it to restructure its business and redefine its long-term
strategy. Horizons are long, nothing is contractual y fixed and the impact of exchange rate
--- Content provided by FirstRanker.com ---
fluctuations can have substantial, sustained implications for the firm's bottom line and whose
values are not (yet) contractual y fixed in foreign currency terms.
--- Content provided by FirstRanker.com ---
Of the two kinds of long-term exposures, operating exposures capture the impact ofunanticipated exchange rate changes on the firm's revenues, operating costs and operating net
cash flows over a medium-term horizon-say up to three years.
--- Content provided by FirstRanker.com ---
Consider a firm which is involved in producing goods for export and/or import substitutes. It
may also import a part of its raw materials, components, etc. A change in exchange rate(s)
--- Content provided by FirstRanker.com ---
gives rise to a number of concerns for such a firm:1.
What will be the effect on sales volume if prices are maintained? If prices are
--- Content provided by FirstRanker.com ---
changed? Should prices be changed? For instance, a firm exporting to a foreign
market might benefit from reducing its foreign currency price to the foreign
--- Content provided by FirstRanker.com ---
customers following an appreciation of the foreign currency; a firm whichproduces import substitutes may contemplate an increase in its domestic currency
price to its domestic customers without hurting its sales. A firm supplying inputs
--- Content provided by FirstRanker.com ---
to customers who in turn are exporters will find that the demand for its product is
sensitive to exchange rates.
--- Content provided by FirstRanker.com ---
2.Since a part of the inputs are imported, material costs will increase following a
depreciation of the home currency. Even if all inputs are locally purchased, if their
--- Content provided by FirstRanker.com ---
production requires imported inputs, the firm's material costs will be affected
following a change in exchange rate.
3.
--- Content provided by FirstRanker.com ---
Labour costs may also increase if cost of living increases and wages have to be
raised.
--- Content provided by FirstRanker.com ---
4.Interest costs on working capital may rise if in response to depreciation the
authorities resort to monetary tightening.
--- Content provided by FirstRanker.com ---
5.
Exchange rate changes are usually accompanied by; if not caused by differences
--- Content provided by FirstRanker.com ---
in inflation across countries. Domestic inflation will increase the firms` materialand labour costs quite independently of exchange rate changes. This will affect its
competitiveness in all the markets but particularly so in markets where it is
--- Content provided by FirstRanker.com ---
competing with firms from other countries.
6.
--- Content provided by FirstRanker.com ---
Real exchange rate changes also alter income distribution across countries. A realappreciation of the US dollar vis-?-vis say the Euro implies an increase in real
incomes of US residents and a fall in real incomes of Euro land. For an American
--- Content provided by FirstRanker.com ---
firm which sells both at home and exports to Europe, the net impact depends upon
the relative income elasticity in addition to any effect of relative price changes.
--- Content provided by FirstRanker.com ---
Thus, the total impact of a real exchange rate change on a firm`s sales, costs and marginsdepends upon the response of consumers, suppliers, competitors and the government to this
macro-economic shock.
--- Content provided by FirstRanker.com ---
In general, an exchange rate change will affect both future revenues as well as operating costs
and hence the operating income. As we will see later, the net effect depends upon the complex
--- Content provided by FirstRanker.com ---
interaction of exchange rate changes, relative inflation rates at home and abroad, extent ofcompetition in the product and input markets, currency composition of the firm's costs as
compared to its competitors' costs, price elasticity of export and import demand and supply,
--- Content provided by FirstRanker.com ---
and so forth.
In the long run, exchange rate effects can undermine a firm competitive advantage by raising
--- Content provided by FirstRanker.com ---
its costs above those of its competitors or affecting its ability to service its market in otherways. Such competitive exposure is often referred to as "Strategic Exposure" because it has
significant implications for some strategic business decisions. It influences the firm's choice of
--- Content provided by FirstRanker.com ---
product-market combinations, sources of inputs, location of manufacturing activity, decisions
as to whether foreign operations should be started.
A number of examples from recent and past history clearly bring out the nature of operating
--- Content provided by FirstRanker.com ---
and strategic exposure:
1.
--- Content provided by FirstRanker.com ---
In the late '70's Laker Airways started offering cut-price, trans-Atlantic air travel toBritish tourists taking vacations in the US. The dollar was weak and tourist traffic
was strong. Laker then expanded its fleet by buying aircraft financed with dollar
--- Content provided by FirstRanker.com ---
borrowing. In late 1981 the dollar started rising and continued to climb for nearly
four years. On the one hand, the transaction exposure on servicing the dollar
--- Content provided by FirstRanker.com ---
liabilities and on the other the operating exposure due to falling tourist trafficcreated a severe cash crunch for Laker. The strong dollar meant that US vacations
were an expensive proposition for British tourists. Ultimately, Laker Airways
--- Content provided by FirstRanker.com ---
went bankrupt.
2.
--- Content provided by FirstRanker.com ---
The relentless rise of the dollar during the first half of eighties eroded thecompetitive position of many American firms. Corporations like Kodak found
that most of their costs were dollar denominated while their sales were in all parts
--- Content provided by FirstRanker.com ---
of the world, denominated in a number of foreign currencies which were falling
against the dollar. They faced stiff competition from Japanese firms such as Fuji
--- Content provided by FirstRanker.com ---
both in the US market as well as third country markets. Kodak could not raise itsprices without significant loss of sales. Companies like International Harvester
found themselves in a similar position and even moved some of their
--- Content provided by FirstRanker.com ---
manufacturing operations out of US.
3.
--- Content provided by FirstRanker.com ---
Conversely, when the dollar started falling against the Yen and Deutschemarkaround mid-1985 and continued to fall for over two years, Japanese and German
car makers found their operating margins being squeezed. They responded partly
--- Content provided by FirstRanker.com ---
by starting manufacturing operations in US and partly by moving up-market into
premium-priced luxury cars where consumer sensitivity to price increases are
--- Content provided by FirstRanker.com ---
relatively less.4.
Closer home, Indian manufacturers of cars and two-wheelers with significant
--- Content provided by FirstRanker.com ---
import content denominated in Yen have found that the persistent strength of theYen has meant cost increases which they have not always been able to pass on to
the consumer because of depressed demand conditions and competitive
--- Content provided by FirstRanker.com ---
considerations.
5.
--- Content provided by FirstRanker.com ---
American pharmaceutical multinationals like Merck have found that duringperiods of strong dol ar, their cash flows denominated in dollars tend to shrink.
Bulk of their R&D expenditures is denominated in dol ars, and shortage of
--- Content provided by FirstRanker.com ---
internally generated cash tends to have adverse impact on their R&D budgets
which are a crucial factor in their long-run competitiveness.
--- Content provided by FirstRanker.com ---
In all these cases, exchange rate changes coupled with concomitant changes in relative costshave had significant impact on the firms' ability to compete effectively in particular product-
market segments, to undertake good investment projects and thus to enhance their long-run
--- Content provided by FirstRanker.com ---
growth potential. This is the essence of operating and strategic exposure.
If a firm has no direct involvement in any cross-border transactions it is not immune to
--- Content provided by FirstRanker.com ---
exchange rate exposure. This "indirect" exposure is also in the nature of operating exposurefaced by the firm. Changes in exchange rates will most likely have an impact on its customers,
suppliers and competitors which in turn will force the firm to alter its operations and strategies.
--- Content provided by FirstRanker.com ---
Thus a firm which produces an import substitute for purely domestic consumption with inputs
denominated exclusively in home currency is nonetheless exposed to competitive exposure.
--- Content provided by FirstRanker.com ---
An appreciation of the home currency puts it at a disadvantage relative to its competitors whosell the imported product. Similarly, a firm which buys its inputs from local firms who in turn
have significant import content is as surely affected by exchange rate changes as a firm which
--- Content provided by FirstRanker.com ---
directly imports some of its inputs. A firm which supplies intermediates to an exporter faces
operating exposure even though it has no direct involvement in exports or imports. Finally,
--- Content provided by FirstRanker.com ---
changes in exchange rates may trigger policy responses by the government which affects allthe firms in the economy.
An alternative but similar in spirit approach to classification of currency exposure focuses on
--- Content provided by FirstRanker.com ---
the length of the time horizon and whether or not the exposure impacts on the end-of-the-
horizon financial statements. For detailed discussions of this approach the reader should
consult Antl (1989) and Hekman (1989). In this approach the term accounting exposure is
--- Content provided by FirstRanker.com ---
used for short-term exposures which will have an impact on the financial results-income
statement and balance sheet-for the immediate upcoming financial reporting period. It includes
--- Content provided by FirstRanker.com ---
contractual transactions exposures as defined above, exposures on anticipated cash flowsdenominated in foreign currency and balance sheet exposures of foreign operations-what we
have referred to as translation exposures. Depending upon the time profile of the anticipated
--- Content provided by FirstRanker.com ---
cash flows and the changes in exchange rate, the cash flows impact would show up partly as
operating variance and partly as a translation adjustment. Operating exposure is defined as
--- Content provided by FirstRanker.com ---
above as the sensitivity of future operating profits to unanticipated changes in the exchangerate. Here the horizon is medium-term-say about 3 years-and the firm is expected to have
some operational flexibility such as varying prices, sourcing and so forth. Balance sheet
--- Content provided by FirstRanker.com ---
impact of translation gains or losses is left out of consideration. Strategic exposure refers to a
still horizon and contemplates longer-term operational flexibility such as changing product-
--- Content provided by FirstRanker.com ---
market mix, shifting location of operations and adopting new technologies. Finally, acomprehensive concept-which is very difficult to operational- is: "value-based" exposure
which focuses on the impact of currency fluctuations on market value of the firm. It must take
--- Content provided by FirstRanker.com ---
into account both short-term accounting exposures as wel as operating and strategic flexibility
in responding to currency movements.
--- Content provided by FirstRanker.com ---
THE PRACTICE OF EXPOSURE MANAGEMENTThere have been a number of investigations of corporate currency exposure management
practices. The Important ones among these are Bodnar and Gentry (1993), Bodnar, Marston
--- Content provided by FirstRanker.com ---
and Hayt (1998), Bodnar and Gebhardt (1999) and Loderer and Pichler (2000). Using
secondary data, these studies investigate the reasons why corporations do or do not manage
--- Content provided by FirstRanker.com ---
currency risk, the methods and instruments they use, whether they make any conscious effortto assess and quantify their currency risk profiles and whether they are any systematic
relationships between firm characteristics such as size and risk management practices. While
--- Content provided by FirstRanker.com ---
detailed findings vary, some broad patterns seem to be common across industries and
countries. The key findings can be summarized as follows:
1. Very few corporations undertake an accurate, quantitative assessment of how
--- Content provided by FirstRanker.com ---
unanticipated exchange rate changes impact on the value of their firm. Even firms
which are aware of the serious imp~ currency risk can have on the valuation of their
--- Content provided by FirstRanker.com ---
stock have at best a qualitative understanding currency exposure-whether adepreciation of their home currency will improve or adversely after their value.
2. Most firms find it very difficult to gauge the long-term exposure of their businesses to
--- Content provided by FirstRanker.com ---
currency fluctuations.
3. Relatively more but still a minority of the firms have some reliable quantitative
--- Content provided by FirstRanker.com ---
understanding of II exposure of their operating cash flows to currency fluctuations.4. A surprisingly large number of firms appear to think that they are not exposed to
currency risk or that the risk is trivial. Most firms do not seem to be aware that indirect
--- Content provided by FirstRanker.com ---
exposure can some times be quite significant.
5. Even among firms which engage in systematic assessment of their currency risk
--- Content provided by FirstRanker.com ---
currency risk management, the focus is almost exclusively on short-term
transactions exposures extending up to a year. Here too, firms do not appear to take an
--- Content provided by FirstRanker.com ---
aggregate view of exposures preferring to deal with them individually.
6. Long-term operating exposures are dealt with by "on balance sheet" operating
--- Content provided by FirstRanker.com ---
mechanisms. Ansuch structural defense mechanisms are:
(i)
--- Content provided by FirstRanker.com ---
Setting up plants and sourcing of inputs in different currency areas.
(i )
--- Content provided by FirstRanker.com ---
Have foreign subsidiaries borrow in local currencies(i i)
Employee wages indexed to the ex change rate
--- Content provided by FirstRanker.com ---
(iv)
Redesign or upgrade products to cater to more price inelastic market
--- Content provided by FirstRanker.com ---
segments.Firms also react to exchange rate changes after the fact by revising pricing policies. Thus the
practice of currency risk management, particularly long-term exposure, is much less precise
--- Content provided by FirstRanker.com ---
and sophisticated than what the development of the theory would suggest even among the
large firms in advanced countries.
--- Content provided by FirstRanker.com ---
LESSON - 3
EXPOSURE MANAGEMENT SYSTEM
--- Content provided by FirstRanker.com ---
Objectives: In this lesson, we will introduce you corporate exposure management policy andMIS for exposure management. After you workout this lesson, you should be able to:
Know the meaning of corporate exposure management policy, MIS for exposure
--- Content provided by FirstRanker.com ---
management and transaction exposure.
Understand the application of corporate exposure management policy and MIS for
--- Content provided by FirstRanker.com ---
exposure management.CORPORTAE EXPOSURE MANAGEMENT POLICY
--- Content provided by FirstRanker.com ---
Here we focus on the risk management process and addresses the issues involved in setting up
and implementing an exposure management system. Management of risk and exposure is an
--- Content provided by FirstRanker.com ---
extremely important task and the effectiveness with which it is performed can have seriousimplications for a company's survival. It is not just a question of using particular instruments
like forwards, futures or options to hedge individual exposures; deeper issues have to be
--- Content provided by FirstRanker.com ---
addressed. Among them are:
(a)
--- Content provided by FirstRanker.com ---
The company's strategic business posture, attitude towards risk and its risktolerance.
(b)
--- Content provided by FirstRanker.com ---
Organizational design to implement a coherent policy.
(c)
--- Content provided by FirstRanker.com ---
Monitoring and control mechanisms.(d)
Implications for managerial performance evaluation.
--- Content provided by FirstRanker.com ---
(e)
Possible conflict of interest between a parent company and its global subsidiaries.
--- Content provided by FirstRanker.com ---
Consequently, top management must get intimately involved in the process of designing thepolicy and ensure the participation of all those who have contributions to make as also those
who might be affected by it.
--- Content provided by FirstRanker.com ---
It is obvious that exposure management policy and its implementation cannot be divorced
from the particular set of circumstances which condition a firm's decision-making and
operations. Hence it would be foolhardy to attempt to provide a framework with universal
--- Content provided by FirstRanker.com ---
applicability. Our aim in this chapter is only to bring out the critical dimensions-the questions
that must be addressed in the process of evolving a risk management policy and related
--- Content provided by FirstRanker.com ---
systems. The answers to these questions must be situation specific.In the next section, we briefly outline the steps involved in the risk management process. Our
exposition here draws on Lessard (1995) who discusses these issues in a somewhat different
--- Content provided by FirstRanker.com ---
context. Fol owing this, we discuss the issues related to organizational structure, al ocation of
responsibility and performance measurement. In the last section, we briefly outline the
--- Content provided by FirstRanker.com ---
arguments for and against centralization of the exposure management function in the case of aglobal corporation.
--- Content provided by FirstRanker.com ---
INFORMATION SYSTEM FOR EXPOSURE MANAGEMENT
Effective exposure management requires a well-designed management information system
--- Content provided by FirstRanker.com ---
(MIS). Exposures above a certain minimum size must be immediately reported to theexecutive or department responsible for exposure management. The three types of exposures-
transactions, translation and operating must be clearly separated. In the case of cash flow
--- Content provided by FirstRanker.com ---
exposures, the report must state the timing and amount of foreign currency cash flows,
whether either or both are known with certainty or, if uncertain the degree of uncertainty
--- Content provided by FirstRanker.com ---
associated with timing or amount. The exposure management team must evolve a procedureof assessing the risk associated with these exposures by adopting a clearly articulated
forecasting method scenario approach. The benchmark for comparing the alternative scenarios
--- Content provided by FirstRanker.com ---
must be clearly stated. As argued above, the appropriate benchmark for short-term transactions
exposures is the relevant forward rate.
--- Content provided by FirstRanker.com ---
If a discretionary hedging posture is to be adopted, stop-loss guidelines must be clearlyarticulated. These can take the form of specified levels of forward rate or specified changes in
the spot rate which when crossed would automatically trigger appropriate hedging actions.
--- Content provided by FirstRanker.com ---
All exposed positions including their hedges if any should be monitored at frequent intervals
to estimate the mark-to-market value of the entire portfolio consisting of the underlying
exposures and their corresponding hedges.
--- Content provided by FirstRanker.com ---
When a particular exposure is extinguished, a performance assessment must be carried out by
comparing the actual all-in rate achieved with the benchmark. This should be done at regular
--- Content provided by FirstRanker.com ---
intervals with the frequency of assessment being determined by the size of exposures and theirtime profiles. Periodic reviews must be carried out to ensure that the risk scenarios being
considered are not far removed from actual developments in exchange rates due to large
--- Content provided by FirstRanker.com ---
forecasting errors.
Effective management of operating exposures requires far more information and judgmental
--- Content provided by FirstRanker.com ---
inputs from operating managers. Pricing and sourcing decisions must involve the exchangerate dimension and its likely impact on future operating cash flows. A strategic review of the
entire business model must incorporate realistic assessment of the impact of exchange rate
--- Content provided by FirstRanker.com ---
fluctuations on the firm's entire operations in the medium to long term.
--- Content provided by FirstRanker.com ---
MANAGEMENT OF TRANSACTIONS EXPOSUREHere we have defined the various types of exchange rate exposure and the associated risk that
firms are subject to as a consequence of fluctuating exchange rate. We must now address the
--- Content provided by FirstRanker.com ---
question of how to reduce or avoid this exposure. It deals with management of transactions
exposure call that transaction exposure refers to the change in the home currency value of an
--- Content provided by FirstRanker.com ---
item whose foreign currency value is contractual y fixed.The terms hedging and speculation that appear in the title of this chapter need to be clearly
defined. The former will be understood to mean a transaction undertaken specifically to offset
--- Content provided by FirstRanker.com ---
some exposure arising out of the firm's usual operations while the latter will refer to deliberate
creation of a position for the express purpose of generating a profit from exchange rate
--- Content provided by FirstRanker.com ---
fluctuations, accepting the added risk. With this definition, a decision not to hedge an exposurearising out of operations is also equivalent to speculation.
Management of transactions exposure has two significant dimensions. First, the treasurer must
--- Content provided by FirstRanker.com ---
decide whether and to what extent any exposure should be explicitly hedged. The nature of the
firm's operations may provide some natural hedges. Its market position may occasionally
permit it to entirely avoid transaction exposure. At other times, these internal hedges may be
--- Content provided by FirstRanker.com ---
quite imperfect or too costly because of their adverse effects on sales or profit margins. Having
decided to hedge whole or part of an exposure, the treasurer must evaluate alternative hedging
--- Content provided by FirstRanker.com ---
strategies.USING THE FORWARD MARKETS FOR HEDGING TRANSACTIONS EXPOSURE:
In the normal course of business, a firm will have several contractual exposures in various
--- Content provided by FirstRanker.com ---
currencies maturing at various dates. The net exposure in a given currency at a given date is
simply the difference between the total inflows and total outflows to be settled on that date.
--- Content provided by FirstRanker.com ---
Thus suppose Fantasy Jewelry Co. has the following items outstanding:Item
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
Value
Days to maturity
--- Content provided by FirstRanker.com ---
1. USD receivable
800,000
--- Content provided by FirstRanker.com ---
60--- Content provided by FirstRanker.com ---
2. EUR payable
2,000,000
--- Content provided by FirstRanker.com ---
903. USD interest payable
100,000
--- Content provided by FirstRanker.com ---
180
4. USD payable
--- Content provided by FirstRanker.com ---
200,00060
5. USD purchased forward
--- Content provided by FirstRanker.com ---
300,00
60
--- Content provided by FirstRanker.com ---
6. USD loan instalment due250,00
60
--- Content provided by FirstRanker.com ---
7. EUR purchased forward
1,000,000
--- Content provided by FirstRanker.com ---
90Its net exposure in USD at 60 days is
--- Content provided by FirstRanker.com ---
(800,000 + 300,000) - (200,000 + 250,000) = + USD 650,000
Whereas, it has a net exposure in EUR -1,000,000 at 90 days.
--- Content provided by FirstRanker.com ---
The use of forward contracts to hedge transactions exposure at a single date is quitestraightforward. A contractual net inflow of foreign currency is sold forward and a contractual
net outflow is bought forward. This removes all uncertainty regarding the domestic currency
--- Content provided by FirstRanker.com ---
value of the receivable or payable. Thus in the above example, to hedge the 60-day USD
exposure Fantasy Jewelry Co. can sell forward USD 650,(0) while for the EUR exposure it
--- Content provided by FirstRanker.com ---
can buy EUR 1,000,000 90 days forward.What about exposures at different dates? One obvious solution is to hedge each exposure
separately with a forward sale or purchase contract as the case may be. Thus in the example,
--- Content provided by FirstRanker.com ---
the firm can hedge the 60-day USD exposure with a forward sale and the 180-day USD
exposure with a forward purchase.
The Cost of a Forward Hedge
--- Content provided by FirstRanker.com ---
An important and often misunderstood concept is that of cost of forward hedging. It is a
common fallacy to claim that the cost of forward hedging is the forward discount or premium.
--- Content provided by FirstRanker.com ---
(If the foreign currency is sold at a discount, the discount is claimed to be the "cost" of thehedge; if it is bought at a premium, the premium is regarded as the cost. On this view,
premium gained on forward sale or discount obtained on forward purchase is a "negative cost"
--- Content provided by FirstRanker.com ---
or a gain).
The genesis of this fallacy is in the accounting procedure used to record transactions
--- Content provided by FirstRanker.com ---
denominated in foreign currency and for which a forward hedge is used. Suppose an Indianfirm buys equipment worth Euro 1,000,000 from a German supplier on 90-day credit. The
accounts payable is then valued at today spot rate which is say Rs 52.50. The firm covers the
--- Content provided by FirstRanker.com ---
payable with a 90-day forward purchase of Euros at 'premium of say Rs 0.20 i.e. the 90-day
forward offer rate is Rs 52.70 per Euro. The firm has to pay Rs 52,700,000 to settle the
--- Content provided by FirstRanker.com ---
payable valued at Rs 52,500,000. In recording this transaction, the following entries are made:A/C Payable
--- Content provided by FirstRanker.com ---
52,500,000
--- Content provided by FirstRanker.com ---
Forward Loss200,000
--- Content provided by FirstRanker.com ---
Bank Account
52,700,000
--- Content provided by FirstRanker.com ---
Thus the premium paid is recorded as the cost of forward cover. By the same logic, if the Eurohad been at a forward discount, cost of forward cover would have been negative. However,
this is a conceptual y erroneous way of interpreting cost of forward cover.
--- Content provided by FirstRanker.com ---
The point is, the forward hedge must be compared not with today's spot rate but the ex-ante
value of the payable if the firm does not hedge. Since the latter is unknown today, the relevant
--- Content provided by FirstRanker.com ---
comparison is between the forward rate and the expected spot rate on the day the transaction isto be settled. The expected lost of forward hedge for the above Indian firm is given by
F1/4 (EUR/INR)ask - Se1/4, (EUR/INR)ask
--- Content provided by FirstRanker.com ---
Where the notation Se1/4, denotes "spot rate expected to rule 90-days from today"'.
The former when speculators are on balance forward sel ers and the latter when they are net
forward buyers. The argument here is that speculators will demand a risk premium for
--- Content provided by FirstRanker.com ---
assuming the risk of an uncertain future spot rate.
Even in this case the expected cost of hedging is zero. This is because the hedgers are passing
--- Content provided by FirstRanker.com ---
on the risk to the speculators and the risk premium paid is the price of risk avoidance. Theforward rate is the market certainty equivalent of the uncertain future spot rate. This can be
understood as follows. Suppose me current USD/INR spot rate is 45.00 and the three month
--- Content provided by FirstRanker.com ---
forward is 45.75. If you take an uncovered bog p'1sition in the forward contract, you would
gain-the bank which sells you the forward contract would lose-if the spot three months later
--- Content provided by FirstRanker.com ---
turns out to be greater than 45.75 and you would lose-the bank would gain-if it turns out to bebelow 45.75. If the forward rate quoted by the bank is inordinately high, say Rs 60, so that the
probability of your gaining is very small, you would demand an upfront payment for liking a
--- Content provided by FirstRanker.com ---
long position; similarly if it is ridiculously low, say Rs 20, the probability of the short side
gaining is very low and the bank would demand up front compensation. The actual forward
--- Content provided by FirstRanker.com ---
rate is such that risk adjusted gains equal risk adjusted losses so that the forward contract haszero value-neither the buyer nor the seller demands any payment at the initiation of the
contract.
--- Content provided by FirstRanker.com ---
Hence presence of risk premium does not invalidate the contention that the expected cost of
forward hedging is zero. Transaction costs are a different matter. As we have seen, the bid-ask
--- Content provided by FirstRanker.com ---
spreads are generally wider in the forward segment than in the spot segment so that even ifthere is no risk premium
Ft,T (EUR/INR)ask > St,T(EUR/INR)ask
--- Content provided by FirstRanker.com ---
and
Ft,T (EUR/INR)bid < St,T (EUR/INR)bid
--- Content provided by FirstRanker.com ---
Thus the only cost of a forward hedge is the larger spread in the forward market compared tothe spot market. The extent of the difference depends on the relative depth of the two markets.
For transaction between the major convertible currencies, the short-maturity forward markets
--- Content provided by FirstRanker.com ---
are nearly as deep as the spot markets and the difference in spreads tends to be quite small.
The accounting problem mentioned above arises because the invoice amount is converted into
--- Content provided by FirstRanker.com ---
domestic currency at today's spot rate. The correct procedure is to use the forward rate for thispurpose. To elaborate this argument considers the following example:
A firm has exported textiles to a German customer for which it would like to get Rs
--- Content provided by FirstRanker.com ---
10,00,000 cash However keeping in view the competitive factors it has to give 90-daycredit. The domestic interest rate is 8% p.a. The firm should charge Rs 10,20,000
--- Content provided by FirstRanker.com ---
(= 1.02 x 10,00,000) for 90-day credit sale. How should it translate this into a EUR
denominated price? The interest rate in Eurozone is 4% p.a.
--- Content provided by FirstRanker.com ---
The spot EUR/INR exchange rate is 52.50
Obviously it is wrong to calculate the EUR price as (1,020,000/52.50) = EUR 19,428.57. To
--- Content provided by FirstRanker.com ---
see why, suppose the export bill is discounted with a German bank, the proceeds will be EUR
(19,428.57/1.01) = EUR 19,236.21 which converted into rupees will be worth Rs 10,09,901
--- Content provided by FirstRanker.com ---
(=19,236.21x 52.50) whereas the firm's target is to realise Rs 10,00,000. To realise this, thefirm should quote EUR [(10,00,000/52.5) x 1.01) = EUR 19,238.10. Thus the appropriate rate
for translating the price is (10,20,000/19,238.10) = 53.0198
--- Content provided by FirstRanker.com ---
But this is precisely the forward rate arrived at by the interest parity theorem viz.
--- Content provided by FirstRanker.com ---
(52.50)(1.02/1.01) = 53.0198Of course the example overlooks the fact that in a context like the Indian market the forward
premiums/discounts are not necessarily determined by interest rate differentials and hence the
--- Content provided by FirstRanker.com ---
actual forward rate may be quite different from the interest parity rate. However, the point we
wish w emphasize is that the appropriate rate is the interest parity forward rate and not today's
--- Content provided by FirstRanker.com ---
spot rate. The major convertible currencies departures from interest parity are well within thebounds imposed by transaction costs.
It must be emphasized that forward hedging of contractual exposures does not stabilize a firms
--- Content provided by FirstRanker.com ---
cash flows. Suppose an Indian exporter who has continuing exports to the USA invoices his
exports in US dol ars and maintains US dol ar prices so as to retain its competitive position in
--- Content provided by FirstRanker.com ---
the US market. Each m~ receivable is sold forward. The firm's rupee cash flows will thenfluctuate as the USD/INR forward the fluctuations; if it does not hedge, the fluctuations in the
cash flow will be proportional to the changes in the spot rate. Empirically, the volatility of the
--- Content provided by FirstRanker.com ---
forward rate is not significantly less than the spot rate. It could also remove its contractual
exposure by invoicing each shipment in rupees on some kind of a cost plus basis. Now, the
dol ar prices will fluctuate and so will the firm's export volume and market share. Thus
--- Content provided by FirstRanker.com ---
hedging a contractual exposure just removes the uncertainty regarding the home currency
value of that particular item; it cannot stabilize the firm's cash flows or profits.
--- Content provided by FirstRanker.com ---
Choice of Invoice CurrencyThis is also the appropriate place to dispose off the issue of the choice of invoice currency
insofar as it bears on transactions exposure. Choice of invoice currency has important
--- Content provided by FirstRanker.com ---
implications for operating exposure of the exporter/importer but the foreign exchange risk
dimension is relatively unimportant. Consider the Indian exporter of textiles to Germany in the
--- Content provided by FirstRanker.com ---
above example. After the quantity and price of exports have been negotiated, it does not matterwhether the invoice is in rupees or Euros provided both parties have access to efficient forward
markets. If the invoice is in EUR, the exporter faces exposure which can be covered in the
--- Content provided by FirstRanker.com ---
forward market as seen above; if it is in rupees, the importer can buy Rs 10,20,000 in the
forward market at a total cost of EUR 19,238.10 to be incurred three months from today.
--- Content provided by FirstRanker.com ---
Problems arise if a well functioning forward market does not exist or cannot be accessed byone of the parties. With controls on capital movements for instance, the spot-forward differen-
tial in the case of the rupee is not always very closely related to the interest rate differential.
--- Content provided by FirstRanker.com ---
Suppose the EUR/INR forward rate is 52.75. Now the Indian exporter would like to quote a
price of EUR 19,336.49 (= 10,20,000/52.75) for a 90-day credit sale or would prefer to invoice
--- Content provided by FirstRanker.com ---
in rupees. To the German buyer this would mean an annualized interest cost of 6.06%.4 Thismight make the deal unattractive to the importer. A price of EUR 19,238.10 would make the
deal unattractive to the exporter because this would imply a cost of funds
--- Content provided by FirstRanker.com ---
{[19,238.10/19047.62) ? 1.0]*4.0} or 5.92% when in fact it is 8%.
The choice of currency of invoicing is often dictated by marketing considerations and
--- Content provided by FirstRanker.com ---
exchange control factors. An exporter may wish to Invoice in the buyer's currency to gaincompetitive advantage. Invoicing in a weak currency-which may be neither the buyer's nor the
seller's currency-may be an indirect way of offering discounts which otherwise may be
--- Content provided by FirstRanker.com ---
difficult to offer. In some countries, due to exchange control, the only way a company can take
a position in a currency is by invoicing a trade transaction in that currency. As mentioned
above, if forward markets in a particular currency are thin or non-existent it is better to avoid
--- Content provided by FirstRanker.com ---
invoicing in that currency since the exposure cannot be effectively hedged. Finally, it should
be kept in mind that any gains from the choice of currency of invoicing made by one party are
--- Content provided by FirstRanker.com ---
always at the expense of the other party. Hence for invoicing intra-company transactions asbetween different subsidiaries of a parent company, overall tax considerations and minority
interests of the local shareholders will playa significant role.
--- Content provided by FirstRanker.com ---
Exposures with Uncertain Timing
Sometimes the timing of the exposure may be uncertain though the amount is known with
--- Content provided by FirstRanker.com ---
certainty. Suppose a Hong Kong firm has ordered machinery from a Swiss supplier worthCHF 5,000,000. Payment is to be made when the shipment arrives and documents are handed
over to the importer. There is some uncertainty regarding the exact time of arrival of the
--- Content provided by FirstRanker.com ---
shipment. It may arrive at any time during the fourth month after a firm order is placed.
Option forwards are generally an expensive device to deal with exposures with uncertain
--- Content provided by FirstRanker.com ---
timing. Using swaps may turn out to be cheaper. Thus suppose, on May 1 a company expectsto settle a foreign currency payment on August 1 but feels that the payment date may get
postponed by as much as three months. instead of buying a 3-6 option forward, it can buy the
--- Content provided by FirstRanker.com ---
foreign currency forward for delivery on August!; suppose by June 15, it knows with certainty
that the payment will have to be settled on September 10; It can do a forward-forward swap
--- Content provided by FirstRanker.com ---
i.e. sell the foreign currency for delivery August 1 and buy for delivery September 10. The firstleg of the swap-the sale-cancels its outstanding forward commitment to buy while the other
leg takes care of the payment due on September 10.
--- Content provided by FirstRanker.com ---
Cancellation of Forward Contracts
Cancellation of forward contracts at the customer's option is also possible. The customer may
--- Content provided by FirstRanker.com ---
cancel the entire amount-e.g. when the underlying export or import deal could not materialize-or a part as when the actual payment to be made or received is less than the amount booked in
the forward contract. For a forward sale (by the customer to the bank), cancellation on due date
--- Content provided by FirstRanker.com ---
is deemed as purchase by the bank at the contracted forward rate and a simultaneous sale at the
then ruling spot rate. If the currency has appreciated beyond the forward rate, the difference is
recovered from the customer any gain is paid to the customer. For a forward purchase, can-
--- Content provided by FirstRanker.com ---
cellation is deemed as a sale by the bank at the contract rate and a simultaneous purchase at the
spot rate. Any difference in favour of the customer is paid to the customer; any loss is
--- Content provided by FirstRanker.com ---
recovered from the customer. In both cases the bank will charge a flat fee over and above anygains/ losses.
For cancellation before the due date, an opposite forward contract is deemed to have been
--- Content provided by FirstRanker.com ---
entered into. Thus suppose a firm buys $20,000 three-month forward on September 12 at a
rate of Rs 45.50. The due date is December 12. On November 12, the firm would like to
--- Content provided by FirstRanker.com ---
cancel the entire contract. The bank would deem this as a one-month forward purchase fromthe customer and do the cancellation at the one-month forward purchase rate on November 12.
It would make a one month forward sale to the market to cover its original three month
--- Content provided by FirstRanker.com ---
forward purchase from the market (which had offset its three month sale to the firm). A
forward sale (by the customer to the bank) is cancelled at the relevant forward sale rate. Once
--- Content provided by FirstRanker.com ---
again a flat fee is charged apart from any difference paid to or recovered from the customer.LESSON - 4
OPERATING EXPOSURE
--- Content provided by FirstRanker.com ---
Objectives: In this lesson, we will introduce you operating exposure and exchange rate. After
you workout this lesson, you should be able to:
--- Content provided by FirstRanker.com ---
Know the meaning of operating exposure and exchange rate.Understand the use of operating exposure and exchange rate.
--- Content provided by FirstRanker.com ---
OPERATING EXPOSURE AND REAL EXCHANGE RATEOperating exposure arises mainly on account of changes in real exchange rates. Consider an
example to reinforce this point.
--- Content provided by FirstRanker.com ---
An Indian firm exports carpets to the UK. At the beginning of the year, the exchange
rate is Rs 75.00 per pound. Competitive considerations suggest that the exporter
--- Content provided by FirstRanker.com ---
should invoice in sterling and price the carpets at ?200. At this price it is able to sell100 carpets per month. The firm's costs are all domestic at Rs 9,000 per carpet. Thus
its operating margin is Rs 6,000 per unit. Over the year, UK prices increase by 5% and
--- Content provided by FirstRanker.com ---
Indian prices by 8%. It can raise the UK price to ?210 without affecting sales. Itsoperating costs increase to Rs 9,720. To maintain operating margin in real terms i.e.
Rs 6,480 per unit in end-of-the year prices, it must get Rs 16,200 from each unit. If the
--- Content provided by FirstRanker.com ---
exchange rate appreciates to Rs 77.1429, the firm is unaffected. But this means that
real exchange rate must remain unchanged since 77.1429 = 75.00(1.08/1.05).
--- Content provided by FirstRanker.com ---
This example makes it clear that operating exposure depends upon:Change in nominal exchange rate
Change in the selling price (output price)
Change in the quantity of output sold
--- Content provided by FirstRanker.com ---
Change in operating costs i.e. quantities and prices of inputs.Changes in real exchange rates are among the consequences of real macro-economic shocks
like for instance changes in oil prices. Consumers, firms, labour and governments react to such
--- Content provided by FirstRanker.com ---
shocks by altering their buying patterns, wage demands, input choices, technologies, taxes,
subsidies. The magnitude and speed of response depends on factors like magnitude of the
--- Content provided by FirstRanker.com ---
shock, whether it is perceived to be permanent or transitory, and possibilities of substitution inconsumption and production, bargaining power of unions, market structures and political
compulsions. Real exchange rate changes alter both the relative prices faced by consumers and
--- Content provided by FirstRanker.com ---
their incomes.
For instance, a real appreciation of the US dollar versus the Indian rupee makes American
--- Content provided by FirstRanker.com ---
imports more expensive relative to their home made substitutes (and Indian exports to UScheaper than their substitutes made in the US). However, such an appreciation also reduces
real incomes of Indian consumers (and in. creases real incomes of American consumers).
--- Content provided by FirstRanker.com ---
What will be the net impact on the sales of a firm which sells in both the markets? Obviously it
depends upon the price and income elasticity of demand for its products in the two markets
--- Content provided by FirstRanker.com ---
and the relative share of the two markets in its total sales.Real exchange rate changes may also give a relative cost advantage to some firms over their
competitors. As we will see below, the extent of this advantage is largely determined by the
--- Content provided by FirstRanker.com ---
degree of mismatch in the currency composition of recurring costs of a firm and itscompetitors. Such a cost advantages may or may not be translated into competitive price
cutting.
--- Content provided by FirstRanker.com ---
Real exchange rate changes will generally have an impact on the costs of a firm's
suppliers. Their reactions will be determined by the degree of market power they
--- Content provided by FirstRanker.com ---
enjoy and availability of substitutes.Long lasting changes in real exchange rates produce persistent trade imbalances forcing
governments to take corrective actions such as import restraints, export subsidies, controls on
--- Content provided by FirstRanker.com ---
capital flows and shifts in monetary policies. Some or al of these can affect a firm's cash
flows.
--- Content provided by FirstRanker.com ---
Finally, it must be borne in mind that changes in real exchange rates do not occur in isolation.Usually they are accompanied by changes in real interest rates. This factor may influence not
only expected future cash flows but also the discount rate used to find the PV of these cash
--- Content provided by FirstRanker.com ---
flows.
Operating exposure can be looked upon as a combination of two effects-the conversion
effect and the competitive effect. The conversion effect refers to the changes in home
--- Content provided by FirstRanker.com ---
currency value of a given foreign currency cash flow while the competitive effect refers tothe impact of exchange rate changes arising out of changes in prices and quantities. The
former is similar to transactions exposure while a meaningful analysis of the latter must
inquire into the factors which determine the price impact and the quantity impact of ex-
change rate changes. The most important consideration here is the structure of the markets
--- Content provided by FirstRanker.com ---
in which the sells its output and buys its inputs.In the example above, output price increased in proportion to foreign inflation, output quantity
remained unchanged, input costs went up in proportion to domestic inflation and the nominal
--- Content provided by FirstRanker.com ---
exchange rate depreciated in line with relative PPP. In practice, one or more of these happy
circumstances do not obtain giving, 10 operating exposure. It should also be remembered that
--- Content provided by FirstRanker.com ---
the concept of real exchange rate uses some aggregate price index to measure inflation. It ispossible that even if exchange rate movements reflect inflation differentials measured by
aggregate price indices, the prices of a firm's inputs and outputs may not move in line with
--- Content provided by FirstRanker.com ---
inflation rates. Relative price changes in response to exchange rate fluctuations can create
exposure even if real exchange rate remains constant.
The table below provides some data on the nominal and real effective exchange rate of the
--- Content provided by FirstRanker.com ---
rupee with van, base periods.
Year/ Month/Day
--- Content provided by FirstRanker.com ---
Base: 1991-92Base: 1993-94
Base: 1993-94
--- Content provided by FirstRanker.com ---
(April-March) = 100
(April-March+= 100
--- Content provided by FirstRanker.com ---
(April-March+= 100Near
Reer
--- Content provided by FirstRanker.com ---
Near
Reer
--- Content provided by FirstRanker.com ---
NearReer
1
--- Content provided by FirstRanker.com ---
2
3
--- Content provided by FirstRanker.com ---
45
6
--- Content provided by FirstRanker.com ---
7
1990-91
--- Content provided by FirstRanker.com ---
133.07121.64
175.04
--- Content provided by FirstRanker.com ---
141.69
259.84
--- Content provided by FirstRanker.com ---
141.991991-92
100.00
--- Content provided by FirstRanker.com ---
100.00
131.54
--- Content provided by FirstRanker.com ---
116.48195.26
117.75
--- Content provided by FirstRanker.com ---
1992-93
89.57
--- Content provided by FirstRanker.com ---
96.42117.81
112.31
--- Content provided by FirstRanker.com ---
174.89
112.38
--- Content provided by FirstRanker.com ---
1993-9476.02
85.85
--- Content provided by FirstRanker.com ---
100.00
100.00
--- Content provided by FirstRanker.com ---
148.45100.40
1993-94
--- Content provided by FirstRanker.com ---
76.02
85.85
--- Content provided by FirstRanker.com ---
100.00100.00
148.45
--- Content provided by FirstRanker.com ---
100.40
1994-95
--- Content provided by FirstRanker.com ---
73.0690.23
96.09
--- Content provided by FirstRanker.com ---
105.81
142.85
--- Content provided by FirstRanker.com ---
106.241995-96
66.67
--- Content provided by FirstRanker.com ---
87.23
87.69
--- Content provided by FirstRanker.com ---
102.29130.19
102.71
--- Content provided by FirstRanker.com ---
1996-97
65.67
--- Content provided by FirstRanker.com ---
88.2086.38
103.43
--- Content provided by FirstRanker.com ---
128.38
106.26
--- Content provided by FirstRanker.com ---
1997-9865.71
9.25
--- Content provided by FirstRanker.com ---
86.43
105.84
--- Content provided by FirstRanker.com ---
128.38106.26
1998-99
--- Content provided by FirstRanker.com ---
58.12
83.38
--- Content provided by FirstRanker.com ---
76.4597.79
113.49
--- Content provided by FirstRanker.com ---
98.18
1999-00
--- Content provided by FirstRanker.com ---
58.4282.49
74.22
--- Content provided by FirstRanker.com ---
96.74
110.17
--- Content provided by FirstRanker.com ---
97.132000-01
56.08
--- Content provided by FirstRanker.com ---
85.92
73.77
--- Content provided by FirstRanker.com ---
100.76109.51
10 1.18
--- Content provided by FirstRanker.com ---
2001-02
55.64
--- Content provided by FirstRanker.com ---
87.0573.18
102.09
--- Content provided by FirstRanker.com ---
108.64
102.49
--- Content provided by FirstRanker.com ---
2002-0352.29
83.46
--- Content provided by FirstRanker.com ---
68.78
97.88
--- Content provided by FirstRanker.com ---
102.1198.24
2003-04
--- Content provided by FirstRanker.com ---
51.21
84.93
--- Content provided by FirstRanker.com ---
67.3699.60
100.00
--- Content provided by FirstRanker.com ---
100.00
2004-05 (P)
--- Content provided by FirstRanker.com ---
50.2486.90
66.09
--- Content provided by FirstRanker.com ---
101.91
98.11
--- Content provided by FirstRanker.com ---
102.322002-03 September
52.25
--- Content provided by FirstRanker.com ---
83.72
68.73
--- Content provided by FirstRanker.com ---
98.18102.03
98.58
--- Content provided by FirstRanker.com ---
October
52.56
--- Content provided by FirstRanker.com ---
84.2469.14
98.79
--- Content provided by FirstRanker.com ---
102.64
99.18
--- Content provided by FirstRanker.com ---
November52.15
83.76
--- Content provided by FirstRanker.com ---
68.59
98.23
--- Content provided by FirstRanker.com ---
101.8298.61
December
--- Content provided by FirstRanker.com ---
52.00
83.10
--- Content provided by FirstRanker.com ---
68.4097.46
10 1.55
--- Content provided by FirstRanker.com ---
97.86
January
--- Content provided by FirstRanker.com ---
51.2482.11
67.40
--- Content provided by FirstRanker.com ---
96.30
100.06
--- Content provided by FirstRanker.com ---
96.68February
51.33
--- Content provided by FirstRanker.com ---
82.61
67.51
--- Content provided by FirstRanker.com ---
96.88100.21
97.27
--- Content provided by FirstRanker.com ---
March
51.48
--- Content provided by FirstRanker.com ---
83.6167.72
98.06
--- Content provided by FirstRanker.com ---
100.55
98.47
--- Content provided by FirstRanker.com ---
2003-04 April51.83
84.88
--- Content provided by FirstRanker.com ---
68.18
99.55
--- Content provided by FirstRanker.com ---
101.2099.93
May
--- Content provided by FirstRanker.com ---
50.85
83.49
--- Content provided by FirstRanker.com ---
66.8897.91
99.29
--- Content provided by FirstRanker.com ---
98.31
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
These data indicate that since 1985 there was been real appreciation of the rupee between1993-94 and 1994-95 and again a very mild appreciation between 1995-96 and 1996-97.
Otherwise the rupee has by and large depreciated in real terms. Conventional wisdom says that
--- Content provided by FirstRanker.com ---
this should have benefited exporters and producers of import-competing goods and services
and hurt importers.
--- Content provided by FirstRanker.com ---
In practice, unanticipated exchange rate changes are a part of macro-economic risks faced by afirm. A relevant question is the degree to which exchange rate changes get reflected in the
changes in prices of goods and services. This is known as "pass through". Suppose an Indian
--- Content provided by FirstRanker.com ---
firm imports tennis racquets from US. The US price is $50 and the exchange rate is Rs 44.00.
The importer sel s the racquets at a price of Rs 2,750 and earns a margin of 25%. Now
--- Content provided by FirstRanker.com ---
suppose the exchange rate depreciates to Rs 45. The rupee price would increase to[(45/44)2,750] or Rs 2,812.50 and the importer's margin would be unchanged at 25%.
However, competitive factors may prevent full pass through subjecting the importer to
--- Content provided by FirstRanker.com ---
operating exposure. Also, even in the absence of competitive pressures, decision and
implementation would generally mean that the full impact of exchange rate changes does not
--- Content provided by FirstRanker.com ---
get absorbed in price changes immediately but only after a lag, the length of which depends onmany factors. The time profile of 'pass through" is also relevant in determining the degree of
operating exposure.
--- Content provided by FirstRanker.com ---
CURRENCY OF INVOICING. QUANTITY INERTIA AND OPERATING EXPOSURE
In our analysis so far we have assumed that prices and quantities respond instantaneously to
--- Content provided by FirstRanker.com ---
changes in exchange rates. In practice, a substantial amount of trade involves contractualarrangements between the exporter and the importer wherein both the quantities supplied and
prices-in either party's currency-are fixed for sometime. In addition, even in the absence of
--- Content provided by FirstRanker.com ---
contracts, while prices respond to exchange rate changes rather quickly, quantity response to
price changes is likely to be considerably slower. .
--- Content provided by FirstRanker.com ---
Consider the case of an Indian exporter who has entered into a one-year contract to supply afixed quantity of leather jackets per month to a French importer, at a fixed rupee price per unit.
This means that on the revenue side, operating exposure has been total y eliminated. On the
--- Content provided by FirstRanker.com ---
cost side however exposure continues. When rupee depreciates in real terms, rupee revenuesremain fixed while rupee costs may rise because of imported inputs, wage increases as well as
general inflation. Such an exporter is adversely affected by a real depreciation of the rupee.6
--- Content provided by FirstRanker.com ---
By the same logic, an importer may temporarily gain from a depreciation of the home
currency. What if the price had been negotiated in French francs instead of the rupee? There is
--- Content provided by FirstRanker.com ---
transactions exposure on the revenue side. A depreciation of the rupee will increase rupeerevenues by the full extent of depreciation while costs may not go up to the same extent. In
terms of the h franc, revenue is now fixed whereas costs are not. Despite rupee depreciation,
--- Content provided by FirstRanker.com ---
costs in terms of h franc can increase e.g. suppose the French inflation is at 5%, Indian
inflation at 15% and the rupee depreciates 12% p.a. If al costs are rupee costs and they keep
--- Content provided by FirstRanker.com ---
pace with home inflation, they will increase in terms of French franc.Look at the situation from the French importer's point of view. Invoicing in rupees means there
is uncertainty both on cost and revenue side. If rupee appreciates, the importer must pay a
--- Content provided by FirstRanker.com ---
larger amount of French francs. However, unless the French firm faces stiff competition from
domestic producers, it will be to increase its selling price in proportion to the rupee
--- Content provided by FirstRanker.com ---
appreciation without any significant loss of sales. The firm faces transactions exposure on thecost side (which can be covered) and operating exposure on the revenue side. If it agrees to be
invoiced in French franc and the rupee appreciates, it will be better off but if rupee depreciates,
--- Content provided by FirstRanker.com ---
it will suffer particularly if other competitors also import from India and agreed to be invoiced
in rupees. On balance, it should prefer to be invoiced in rupees. Our analysis of Indian exporter
--- Content provided by FirstRanker.com ---
indicates that if India is prone to very high rates of domestic inflation, the exporter wouldprefer to invoice in French francs.
Choice of invoicing currency has other dimensions. If the importer does not have easy access
--- Content provided by FirstRanker.com ---
to forward markets or if bid-ask spreads in forward markets are very large, an exporter
insisting on invoicing in his currency will face a competitive disadvantage if other exporters
--- Content provided by FirstRanker.com ---
(from the same or another country) willing to accommodate the importer by invoicing in thelatter's currency. The regularities in invoicing patterns in international trade found by
Grassman Bilson (1983) provide a theoretical explanation of these patterns and their
--- Content provided by FirstRanker.com ---
implications for the relation between the current account and the exchange rate.We will conclude this section with a simple numerical example of effects of contracting and
invoicing an exporter's profits.
--- Content provided by FirstRanker.com ---
An Indian jewellery exporter has entered into an agreement with a Dutch buyer to
supply 50 neck laces per month over the next year. The Dutch party has agreed to be
--- Content provided by FirstRanker.com ---
invoiced in rupees at Rs 50,000 per necklace. At the time of initiating the agreementthe EURJINR exchange rate is 50.00. The Indian firm estimates that it will need to
import raw gemstones worth EUR 500 per necklace from Holland and other operating
--- Content provided by FirstRanker.com ---
costs would be Rs 5,000 per unit. Soon after the contract is signed, the rupee
depreciates to Rs 54.00 per Euro.
--- Content provided by FirstRanker.com ---
By invoicing in rupees, the exporter has removed exposure from the revenue side. On the costside, there is transactions exposure of EUR 25,000 per month. At the time of contracting the
expected annual profit is Rs {(50,000 x 50 x 12) - [5,000 + (500 x 50)](50 x 12)} = Rs
--- Content provided by FirstRanker.com ---
1,20,00,000
As a result of devaluation the actual profit will be
--- Content provided by FirstRanker.com ---
Rs [3,00,00,000 - 1,92,00,000] = Rs 1,08,00,000
When the first contract ends, the exporter is subject to operating exposure. He renegotiates the
--- Content provided by FirstRanker.com ---
price at Rs 53,250. In Euros this translates to EUR 986. At this price, the Dutch buyer is
willing to take 55 pieces per month.1o In the meanwhile, the euro cost of the raw stones has
--- Content provided by FirstRanker.com ---
gone up by 5% to EUR 525, and other operating costs have gone up by 10% to Rs 5,500 perunit. The exporter's profits are now expected to be Rs {(53,250 x 55 x 12) - [(525 x 54) +
5,500](55 x 12)} = Rs 1,28,04,000
--- Content provided by FirstRanker.com ---
In inflation adjusted terms, profits have declined to Rs 1,16,40,000 (=1,28,04,000/1.1) despite
a real depreciation of the rupee. You can convince yourself that if the exporter had raised the
--- Content provided by FirstRanker.com ---
price such that in guilder terms it had kept pace with Dutch inflation, the firm's rupee turnoverwould have declined, 11 but its operating profit measured in rupees would have increased in
real terms compared to the pre-devaluation situation.
--- Content provided by FirstRanker.com ---
COPING WITH OPERATING EXPOSUREA variety of external and internal devices are available to a firm to hedge its transactions
exposure. When it comes to operating exposure, none of these instruments are of much use in
--- Content provided by FirstRanker.com ---
reducing it. Forward and futures contracts, options and money market cover can protect a firm
from nominal exchange rate effects on contractual y fixed foreign currency assets, liabilities
--- Content provided by FirstRanker.com ---
and cash flows. As we have seen above, to the extent the firm can correctly identify andestimate its operating exposure to exchange rates, it can in principle use forward contracts to
hedge. The difficulty as we have seen above is in identifying and estimating the exposure
--- Content provided by FirstRanker.com ---
coefficients. Also, operating exposure covers a much longer horizon that contractual
transactions exposures; long-maturity forward contracts are not easily available even in major
--- Content provided by FirstRanker.com ---
currencies.Given these difficulties in using financial hedges, operating exposure must be managed by
altering the firm's operations-pricing, choice of markets, sourcing, location of production, etc.
--- Content provided by FirstRanker.com ---
This requires considerable flexibility in these areas. Not al businesses may permit such
flexibility in the sense that costs associated with shifting location of production facilities,
--- Content provided by FirstRanker.com ---
changing sourcing, etc. may be quite high. We briefly discuss below how each of the abovefunctional groups might contribute to reduction of operating exposure.
As we have seen above, operating exposure depends upon price elasticity of demand.
--- Content provided by FirstRanker.com ---
In the area of marketing, improved knowledge of customers' price sensitivity,
competitive response, and effect of non-price variables on sales, etc. is of great
--- Content provided by FirstRanker.com ---
importance. The firm can reduce the adverse effects of exchange rate changes on itsrevenue by moving into product lines which are fewer prices sensitive and by
countering the effect of increased prices by means of other competitive weapons such
--- Content provided by FirstRanker.com ---
as local advertising and promotion. Note that shifting product-market combinations is
a long-term strategic decision.
--- Content provided by FirstRanker.com ---
If inputs are purchased in markets where the local content in their costs is high,exchange rate changes will significantly alter the relative costs of sourcing from
alternative sources. When the input markets are global in scope e.g. crude petroleum
--- Content provided by FirstRanker.com ---
and petroleum products, sourcing decisions are relatively less important. In somecases, use of commodity options and futures may enable the firm to hedge commodity
price risk.
--- Content provided by FirstRanker.com ---
Shifting the location of production to countries whose currencies have depreciated in
real terms can reduce the adverse impact of exchange rate changes provided
--- Content provided by FirstRanker.com ---
production costs in different locations have a large local content (e.g. labour) andeconomies of scale are relatively less important.
Frequent shifts in product-market combination, sourcing and location of production
--- Content provided by FirstRanker.com ---
facilities imply changing currency composition of costs and revenues. This will call for a more
quick-footed response from the treasury in terms of short-term management of funds and
--- Content provided by FirstRanker.com ---
borrowings.A number of authors have suggested that currency matching of inputs and outputs will enable
the firm to reduce its operating exposure i.e. reduce the variance of its profits. For instance,
--- Content provided by FirstRanker.com ---
Pringle and Connolly (1993) argue that "Economic exposure results most directly in cases of
direct exposure in which there is an imbalance in revenue and cost streams with respect to
--- Content provided by FirstRanker.com ---
currency-that is when the revenue and cost 'currency footprints' do not match. There arebasically two possible ways to hedge economic exposure: operational hedges and financial
hedges. An example of an operational hedge is a change in sourcing to better match revenue
--- Content provided by FirstRanker.com ---
and cost currency footprints".
LESSON - 5
--- Content provided by FirstRanker.com ---
INTEREST RATE EXPOSUREObjectives: In this lesson, we will introduce you interest rate exposure. After you workout this
lesson, you should be able to:
--- Content provided by FirstRanker.com ---
Know the meaning of interest rate exposure.
Understand the application of interest rate exposure.
--- Content provided by FirstRanker.com ---
MANAGEMENT OF INTEREST RATE EXPOSURE
The important thing to note is that there is no exchange of principal amount. If the settlement
rate on the settlement date5 is above the contract rate, the seller compensates the buyer for the
--- Content provided by FirstRanker.com ---
difference in interest on the agreed upon principal amount for the duration of the period in the
contract. Conversely, if the settlement rate is below the contract rate, the buyer compensates
--- Content provided by FirstRanker.com ---
the seller.The compensation is paid up-front on the settlement day and therefore has to be suitably
discounted since interest payment on short-term loans is at maturity of the loan. One of the
--- Content provided by FirstRanker.com ---
following two formulas is used for calculating settlement payment from the seller to the buyer:
P = (L - R) x DF x A / [(B x 100) + (DF x L)]
--- Content provided by FirstRanker.com ---
P = (R - L) x DF x A / [(B x 100) + (DF x L)]This means that the FRA is only a hedge; the actual underlying deposit or loan is a separate
--- Content provided by FirstRanker.com ---
transaction which may not be-and most often is not-with the same bank that traded the FRA.
The settlement rate is the rate with which the contract rate is to be compared to compute the
--- Content provided by FirstRanker.com ---
settlement payment. In each market there is a clearly specified procedure to determine thesettlement rate. The fixing date is the day on which the settlement rate is determined. For US
dol ar FRAs, fixing date is the settlement date itself i.e. t=S. while for other currencies it is two
--- Content provided by FirstRanker.com ---
business days before the settlement date. In the Indian rupee market it is one day before the
settlement date. See calculation of settlement payment discussed below.
--- Content provided by FirstRanker.com ---
Here the notation isL: The settlement rate (%)
R: The contract rate (%)
--- Content provided by FirstRanker.com ---
DF: The number of days in the contract period
A: The notional principal
--- Content provided by FirstRanker.com ---
B: Day count basis (360 or 365)The first formula is used when L > R and the payment P is from the FRA seller to the FRA
buyer; the second formula is used when L < R and the payment is from the buyer to the seller.
--- Content provided by FirstRanker.com ---
In effect, if the settlement rate is higher, the FRA seller compensates the buyer for the extra
interest; if the settlement rate is lower, the buyer surrenders the interest saving to the seller.6 Let
us illustrate this with an example.
--- Content provided by FirstRanker.com ---
Consider the 6-9 FRA quotation given above:
--- Content provided by FirstRanker.com ---
USD 6/9 months: 7.20-7.30% p.a.Suppose a company which intends to take a 3-month loan starting 6 months from now wishes
to lock in its borrowing rate. It buys the FRA from the bank which is giving the above FRA
--- Content provided by FirstRanker.com ---
quotes, at the banks ask rate of 7.30% for an underlying notional principal of USD 5 million.
Suppose on the settlement date, the reference rate e.g. 3-month USD LIBOR is 8.5%. The
--- Content provided by FirstRanker.com ---
number of days in the contract period is 91 and the basis is 360 days. The bank will have topay the company
--- Content provided by FirstRanker.com ---
(L - R) x DF x A
--- Content provided by FirstRanker.com ---
[(B x 100) + (DF x L)]= USD [(8.50 - 7.30)(91)(5,000,000)]/[(36000) + (91 x 8.50)]
--- Content provided by FirstRanker.com ---
= USD 14,847.65
--- Content provided by FirstRanker.com ---
The numerator is the extra interest the company will have to pay because the actualborrowing rate is higher than the contract rate. This will be paid at the expiry of the loan.
The FRA seller pays the company the PV of this discounted at the actual rate viz. 8.5% for
--- Content provided by FirstRanker.com ---
91 days.
In the global financial markets, FRAs are traded in all convertible currencies. The minimum
--- Content provided by FirstRanker.com ---
principal amount is around 5 million units of a currency. Like the forward exchange contract,FRAs are an over the counter product and therefore not standardized.
In a forward foreign currency contract, the parties fix the rate of exchange between
--- Content provided by FirstRanker.com ---
two currencies for future delivery. In a FRA, the rate of interest on a future borrowing
or lending is locked in. Just as the forward exchange rate reflects the market's
--- Content provided by FirstRanker.com ---
expectations regarding the future spot rate, the rate fixed in an FRA reflects themarket's expectations of future interest rates.
The expectations theory of the term structure says that forward interest rates implicit in a given
--- Content provided by FirstRanker.com ---
term structure equal the expected future spot interest rates. Thus, the 3 month rate expected to
rule 6 months from today is implied by the 6 and 9 months actual rates today: where, as usual,
the superscript "e" denotes expected. In general, given the spot interest rates for a short and a
--- Content provided by FirstRanker.com ---
long maturity, the rate expected to rule for the period between the end of short maturity and the
end of long maturity is given by DS, DL and DF are as explained above. B is the day count
--- Content provided by FirstRanker.com ---
basis (360 or 365 days). Interest rates io,s iO,L stated as fractions, (not per cent) are the spotinterest rates at time t = 0 for maturities Sand L respectively. When L> R the FRA buyer
incurs extra interest cost equal to [(L - R)/100](A)(DF/B). This is discounted by a discount
--- Content provided by FirstRanker.com ---
factor equal to [1 + (L/100)(DF/B)], This gives the formula above.Note that the rate so calculated will only serve as a benchmark for a FRA quotation. The actual
quote will be influenced by demand-supply conditions in he market and the market's
--- Content provided by FirstRanker.com ---
expectations.
We will now illustrate applications of FRAs for borrowers and investors the former to lock in
--- Content provided by FirstRanker.com ---
the cost of short term borrowing and the latter to lock in the return on short-term investment.FRA for a Borrower
A firm plans to borrow ?5 million for 3 months, 6 months from now. The current 3 month
--- Content provided by FirstRanker.com ---
Euro-sterling rates are 10.50-10.75%. The firm has to pay a spread of 25 b.p. (0.25%) over
LIB OR. The treasurer is apprehensive about the possibility of rates rising over the coming six
--- Content provided by FirstRanker.com ---
months. He wishes to lock in the cost of loan. Sterling 6/9 FRA is being offered at 10.8750%.The treasurer decides to buy it. We will work out the firm's cost of borrowing under alternative
scenarios of 3month rates 6 months from today. The anticipated borrowing is for 91 days.
--- Content provided by FirstRanker.com ---
Scenario 1: Six months later, sterling settlement LIBOR is 11.50. The bank, which sold the
FRA compensates the firm by immediately paying an amount A calculated as
--- Content provided by FirstRanker.com ---
A = (0.1150 - 0.10875) x 5,000,000 x (91/365) / [1 + 0.1150(91/365)]= ?7,573.94
Notice that the upfront payment by the FRA seller equals the difference in interest on ?5
--- Content provided by FirstRanker.com ---
million, for 91 days at the actual LIBOR and the contracted rate, discounted at the actual
LIBOR. The discounting is necessary because the firm will be paying interest on its loan at
--- Content provided by FirstRanker.com ---
maturity (i.e. at the end of 91 days from the settlement date) while the bank pays the differenceon the settlement date. The firm borrows ?5 million at 11.75% including a spread of 25 b.p.
The compensation received can be invested at 11.25% (This is the LIBID). The cost of the
--- Content provided by FirstRanker.com ---
loan is Interest on 5 million at 11.75% for 91 days= (0.1175) x 5,000,000 x (91/365)
= 146,472.60
--- Content provided by FirstRanker.com ---
From this we must subtract the compounded value of the compensation received from the
FRA selling bank. This is given by
--- Content provided by FirstRanker.com ---
(7573.94) x [1 + 0.1125(91/365)]
--- Content provided by FirstRanker.com ---
= 7,786.37
So the net cost is ?1, 38,686.23 which works out to an annual rate of 11.1254%. This is the
--- Content provided by FirstRanker.com ---
rate locked in by the firm (10.8750 + 0.25 = 11.1250).Scenario 2: 6 months later the settlement rate LIBOR is 10.25%
The firm pays the bank an amount A given by
--- Content provided by FirstRanker.com ---
A = (0.10875 - 0.1025) x 5,000,000 x (91/365) = 7,596.95
--- Content provided by FirstRanker.com ---
[1+0.1025(91/365)]
The firm has to borrow this at 10.50% in addition to the loan of ?5 million. Its total cost now
--- Content provided by FirstRanker.com ---
consists of interest on 5 million plus the repayment of the loan taken to pay the compensation.
This works out to ?1 38,686.23 which is again an annual cost of 11.1254%.
--- Content provided by FirstRanker.com ---
FRA for an InvestorA fund manager is expecting to have $5 million 3 months from now to invest in a 3 month (92
days) Eurodol ar deposit. The current 3 month rates are 8.25-8.375%. The $3/6 FRA bid rate
--- Content provided by FirstRanker.com ---
is 8.1250. The manager sells a FRA for $5 million.
1. 3 months later, the settlement rate is 7.50% The bank pays the manager an amount A
--- Content provided by FirstRanker.com ---
given byA = (0.08125 - 0.0750)(5,000,000)(92/360) = $7 835 92
--- Content provided by FirstRanker.com ---
[1 + 0.075(92/360)]
--- Content provided by FirstRanker.com ---
The manager invests this along with $5 million at 7.50%. His total return is $103,819.44which is 8.125% annual return contracted in the FRA.
You can check out that if the settlement rate had instead been above the contract rate, the
--- Content provided by FirstRanker.com ---
investor would have had to pay the bank and his net return would again be 8.125%.FRAs, like forward foreign exchange contracts are a conservative way of hedging exposure. It
removes ~l uncertainty from cost of borrowing or rate of return on investment. The
--- Content provided by FirstRanker.com ---
relationship between a FRA and an interest rate futures contract is exactly~ analogous to that
between a forward foreign currency contract and a currency futures contract. Like in a
--- Content provided by FirstRanker.com ---
currency forward, FRAs imply credit risk for both parties though inaFRA the risk is limitedonly to the amount of settlement payment since there is no actual borrowing or lending
transaction involved. Also, being an OTC product, FRAs are not liquid and compared to
--- Content provided by FirstRanker.com ---
futures, the bid-offer spreads tend to be wider.
There is another product similar to a FRA for locking in borrowing cost or the return on
--- Content provided by FirstRanker.com ---
investment. This is known as a "forward-forward" contract. Here too, the two parties agree tofix an interest rate for a, lending or a borrowing transaction covering a specific period, starting
at a specified future time; however, unlike a FRA, here the lending or borrowing is not
--- Content provided by FirstRanker.com ---
notional. There is actual y a loan or deposit transaction at the contract rate.
Banks who make a market in FRAs find interest rate futures such as Eurodol ar futures a
--- Content provided by FirstRanker.com ---
convenient hedging device for hedging their FRA commitments. Technically, a bank whichsells say a 3/6 FRA or forward-forward, can borrow funds for 6 months, invest them for the
first three months and then "lend" them to the FRA buyer. Alternatively, it can hedge itself
--- Content provided by FirstRanker.com ---
against rising interest rates by selling eurodollar or similar futures. FRAs (like futures) can also
be used as a form of highly leveraged speculation on interest rate movements. Such
--- Content provided by FirstRanker.com ---
speculative use of FRAs is largely confined to market making banks.FRAs were introduced in the Indian money market in 1999. The Reserve Bank of India
circulated the guidelines applicable to FRAs in a circular dated July 7, 1999. The benchmark
--- Content provided by FirstRanker.com ---
rate may be any domestic money market rate such as T-bill yield or relevant MIBOR
(Mumbai Interbank Offered Rate) though the interbank term money market has not yet
--- Content provided by FirstRanker.com ---
developed sufficient liquidity. FRA is viewed as an exchange of interest payments on anotional principal wherein the FRA buyer agrees to pay interest at a fixed rate (the contract
rate) while the seller pays interest at the settlement rate. Settlement is done by payment of the
--- Content provided by FirstRanker.com ---
net difference by one party to the other. Here is an example:Bank A and Bank B enter into a 6 x 9 FRA. Bank A pays fixed rate at 6.50%. Bank B pays a
rate based on 91 day T -bill yield fixed the day before the settlement date.
--- Content provided by FirstRanker.com ---
Other details:
- Notional principal = Rs. 10 crore
--- Content provided by FirstRanker.com ---
- FRA start and settlement date 10/12/04, Maturity date 10/3/05- T bill yield on fixing date (say 9/12/04) = 5.50%
- Determine cash flow at settlement (assume discount rate as 7%)
--- Content provided by FirstRanker.com ---
The calculations are as follows:
(a) Interest payable by bank A = (10 crore) (0.065) (91/365) = Rs 16,20,547.9
--- Content provided by FirstRanker.com ---
(b) Interest payable by bank B = (10 crore) (0.055) (91/365) = Rs 1,371,232.8(c) Net payable by bank A on maturity date {(a) - (b)} = Rs 24,9315.1
(d) Discounting (c) to settlement date
--- Content provided by FirstRanker.com ---
= (c)/(1+ discount rate*discount period) .
--- Content provided by FirstRanker.com ---
= Rs 2,49,315.1/[1 + 0.07(91/365)] = Rs 2,45,038.67Amount payable on settlement date = Rs 2,45,038.67 payable by Bank A.
RBI guidelines state that corporate are permitted to do FRAs only to hedge underlying
--- Content provided by FirstRanker.com ---
exposures while market maker banks can take on uncovered positions within limits specified
by their boards and vetted by RBI. Capital adequacy norms are applicable and the minimum
--- Content provided by FirstRanker.com ---
required capital ratio would depend upon the underlying notional principal, the tenor of theagreement and the type of counterparty.
INTEREST RATE OPTIONS
--- Content provided by FirstRanker.com ---
A less conservative hedging device for interest rate exposure is interest rate options. A call
option on interest rate gives the holder the right to borrow funds for a specified duration at a
--- Content provided by FirstRanker.com ---
specified interest rate without an obligation to do so. A put option on interest rate gives theholder the right to invest funds for a specified duration at a specified return without an
obligation to do so. In both cases, the buyer of the option must pay the seller an upfront
--- Content provided by FirstRanker.com ---
premium stated as a fraction of the face value of the contract or the underlying notionalprincipal.
An interest rate cap consists of a series of call options on interest rate or a portfolio of calls. A
--- Content provided by FirstRanker.com ---
cap protects the borrower from increase in interest rates at each reset date in a medium-to-
Iong-term floating rate liability. Similarly, an interest rate floor is a series or portfolio of put
--- Content provided by FirstRanker.com ---
options on interest rate which protects a lender against fal in interest rate on rate rest dates of afloating rate asset. An interest rate col ar is a combination of a cap and a floor.
In the following subsection we will analyze simple interest rate options.
--- Content provided by FirstRanker.com ---
A Call Option on Interest Rate
Consider first a European call option on 6-month LIBOR. The contract specifications are as
--- Content provided by FirstRanker.com ---
follows:Time to expiry: 3 months (say 92 days)
Underlying Interest Rate: 6-month LIBOR
--- Content provided by FirstRanker.com ---
Strike Rate: 9%
Face Value: $5 million
--- Content provided by FirstRanker.com ---
Premium or Option Value: 50 b.p. (0.5% of face value) = $25,000The current three and six month LIBORS are 8.60 and 8.75% respectively. Let us work out
the pay-off to a long position in this option. Assume that the option has been purchased by a
--- Content provided by FirstRanker.com ---
firm, which needs to borrow $5 million for six months in three months time.
The pay-off to the holder depends upon the value of the 6 month LIBOR 3 months later:
--- Content provided by FirstRanker.com ---
The option is not exercised. The firm borrows in the market. The pay-off is a loss ofcompounded value of the premium paid three months ago. The present value of the loss (at the
time of option expiry) is the premium compounded for three months at the 3-month rate,
--- Content provided by FirstRanker.com ---
which prevailed at option initiation. In the above example it is
--- Content provided by FirstRanker.com ---
$25,000[1 + 0.0860(92/360)] = $25,549.44If the loss is to be reckoned at the maturity of the loan, this amount must be further
compounded for 6 months at the 6-month LIBOR at the time the option expires.
--- Content provided by FirstRanker.com ---
The option is exercised. The option writer has to pay the option buyer an amount, which
equals the difference in interest on $5 million for 6 months at today's 6 month LIBOR and the
strike rate 9%:
--- Content provided by FirstRanker.com ---
(i - 0.09) x 5,000,000 x (182/360)
--- Content provided by FirstRanker.com ---
where i is the 6-month LIBOR at option expiry.Thus suppose 6-month LIBOR at option expiry is 10%, the option writer has to pay
--- Content provided by FirstRanker.com ---
(0.10 - 0.09)(5,000,000)(182/360) = $25,277.78
This amount would be paid not at the time of exercise of the option but at the maturity of the
--- Content provided by FirstRanker.com ---
loan 6 months later. Alternatively, its discounted value using the 6-month LIBOR at optionexercise can be paid at the time of exercise.
The break-even rate is defined as that value of LIBOR at option expiry at which the borrower
--- Content provided by FirstRanker.com ---
would be indifferent between having and not having the call option i.e. the total cash outflow
at loan maturity would be identical with and without the option. Obviously, because of the
--- Content provided by FirstRanker.com ---
upfront premium, the break-even rate must be higher than the strike rate in the option. It is thevalue of i, which satisfies the following equality:
A[l + i(M/360)] = A[l + R(M/360)] + C[1 + it,T (T/360)][ 1+ i(M/360)]
--- Content provided by FirstRanker.com ---
where A is the underlying principal, R is the strike rate, it, T is the T-day LIBOR at time t
when the option is bought, C is the premium paid at time t, and, T and M are number of days
--- Content provided by FirstRanker.com ---
to option expiry and maturity of the underlying interest rate. For the example at hand, A =5,000,000, R = 0.09, it, T= 0.086, C = 25,000, T = 92 and M = 182. The breakeven rate works
out to 10.06%.9 lf the 6-month LIBOR at option expiry is above (below) the break-even rate,
--- Content provided by FirstRanker.com ---
the call buyer makes a net gain (loss).
A Put Option on Interest Rate
--- Content provided by FirstRanker.com ---
Consider an investor who expects to have surplus cash 3 months from now to be invested in a3-month Euro-deposit. The amount involved is $10 million. The current 3-month rate is
10.50%, which the investor considers to be satisfactory. A put option on LIB OR is available
--- Content provided by FirstRanker.com ---
with the following features:
Maturity
--- Content provided by FirstRanker.com ---
: 3 months (91 days)Strike Rate
: 10.50%
--- Content provided by FirstRanker.com ---
Face Value: $10 million
Underlying
--- Content provided by FirstRanker.com ---
: 3-month LIBOR.
Premium
--- Content provided by FirstRanker.com ---
: 25 b.p. (0.25% of face value) = $25,000To hedge the risk, the investor goes long in the put. Three months later, if the 3-month LIBOR
is less than 10.50% he will exercise the option or else let it lapse. Suppose the 3-month LIBOR
--- Content provided by FirstRanker.com ---
at option expiry is 9.5%. The option writer must pay the option buyer a sum equal to
(0.105 - 0.095)(10,000,000)(91/360) = $25,277.78
--- Content provided by FirstRanker.com ---
This is paid 3 months after option exercise or its discounted value atoption exercise.
The break-even rate is the value of i satisfying the following equality:
--- Content provided by FirstRanker.com ---
A[l + i(M/360)] = A[l + R(M/360)] - P[l + it,T (T/360)][1 + i(M/360)]
Where P is the put premium and other notation is same as in the case of a call option. In the
--- Content provided by FirstRanker.com ---
example, A = 10 million, R = 0.105, T = 91, M = 91, it,T= 0.105 and P = 25,000. The break-even rate works out to 9.46%. If the 3-month LIBOR 3 months later are less than this, the put
buyer makes a net gain.
--- Content provided by FirstRanker.com ---
Interest rate options are thus similar to currency options in their pay-off profiles and hedgingapplications. Valuation of these options also has many similarities with valuation of currency
options.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
A Put-call Parity RelationIt is easy to see that a long position in a call option with strike rate R and a short position in a
put with the same strike and same maturity, both on the same underlying index (such as 6-
--- Content provided by FirstRanker.com ---
month LIBOR), are equivalent to a long position in an FRA at RY to prove this we proceed as
follows. Consider the following three securities at time t:
--- Content provided by FirstRanker.com ---
1. A call option on M-day LIBOR, at strike rate R, maturing T-days from today, face value A,premium C.
2. A put option on M-day LIB OR, at strike rate R, maturing T-days from today, face
--- Content provided by FirstRanker.com ---
value A, premium P.3. An FRA, on M-day LIB OR, maturing T-days from today, face value A, contract rate R.
Thus irrespective of the outcome you gain. The discounted value of the gain at time t (today) is
--- Content provided by FirstRanker.com ---
(P - C) as it should be since the FRA is costless.
Now suppose C > P. You can verify that by selling a call, buying a put and buying an
--- Content provided by FirstRanker.com ---
FRA profit can be made irrespective of what the interest rate is at option expiry.Thus, if the strike rates in the put and the call both equal the current rate in a corresponding
FRA, the call and put must have identical premia. To put it in another manner, a long position
--- Content provided by FirstRanker.com ---
in a call and a short position in a put both with same maturity, the same strike rate and the
same underlying interest rate is equivalent to buying an FRA 'on the same interest rate at a
--- Content provided by FirstRanker.com ---
contract rate equal to the strike rate in the put and call.INTEREST RATE CAPS, FLOORS AND COLLARS
Interest rate caps and floors are portfolios respectively, simple calls and puts on interest rate.
--- Content provided by FirstRanker.com ---
We will begin by looking at examples of applications of caps and floors.
Interest Rate Caps
--- Content provided by FirstRanker.com ---
A corporation borrowing medium-term floating rate funds wishes to protect itselfagainst the risk of rising interest rates. It can do so by buying an interest rate cap for
the duration of the loan. The following example illustrates the working of this
--- Content provided by FirstRanker.com ---
instrument.
,
--- Content provided by FirstRanker.com ---
A corporation has borrowed $50 million on floating rate basis for 3 years. The interest ratereset dates are March 1 and September 1. The spread over LIBOR is 25 b.p. (0.25%). It is a
bullet loan I (i.e. repayment of the entire principal is at maturity).
--- Content provided by FirstRanker.com ---
It buys a 3 year cap on 6-month LIBOR with the following features: lf i > R, your gain from
exercising the call exactly offsets what you have to pay the buyer of the FRA leaving you with
--- Content provided by FirstRanker.com ---
the difference between the compounded values of the put premium you received and the callpremium you paid. The put you sold will lapse.
If i < R, the put will be exercised against you but the loss will be offset by your gain from the
--- Content provided by FirstRanker.com ---
FRA. Your call will lapse again leaving you with the same net gain. In the equation thatimmediately follows, the first term is the compounded value of the call option premium you
paid. The second term is the gain from exercising the call, the third term is the payment you
--- Content provided by FirstRanker.com ---
have to make to the FRA buyer and the last term is the compounded value of the put option
premium you received.
--- Content provided by FirstRanker.com ---
Term: 3 years
Underlying
--- Content provided by FirstRanker.com ---
: 6-month LIBOR
Reset Dates
--- Content provided by FirstRanker.com ---
: March 1, September 1Strike Rate
: 9%
--- Content provided by FirstRanker.com ---
Face Value
: $50 million
--- Content provided by FirstRanker.com ---
Up-Front Fee : 2% of face value or $1 millionThe cap is traded on February 27, 2000, the settlement date is March 1,2000. The current level
of 6-month LIBOR is 9%.
--- Content provided by FirstRanker.com ---
Since the rate applicable to the first 6-month period is known, there are five interest rate call
options in this cap maturing at six monthly intervals starting six months from March 1. Each
--- Content provided by FirstRanker.com ---
option has a strike rate of 9% and face value of $50 million.To determine the effective cost of borrowing with the cap we must assume an interest rate sce-
nario. Measuring time in half-years suppose the 6-month LIBOR at subsequent reset dates
--- Content provided by FirstRanker.com ---
moves as follows:
--- Content provided by FirstRanker.com ---
Reset DateLIBOR (%)
--- Content provided by FirstRanker.com ---
1/9/00
--- Content provided by FirstRanker.com ---
10.01/3/01
--- Content provided by FirstRanker.com ---
9.5
1/9/01
--- Content provided by FirstRanker.com ---
9.5
1/3/02
--- Content provided by FirstRanker.com ---
9.0
--- Content provided by FirstRanker.com ---
1/9/028.5
--- Content provided by FirstRanker.com ---
The premium cost is amortized over a 21/2 year period using a discount rate of 9%. This gives
annuity of $227,790.43 for 5 periods starting 6 months from September 1,2000. Table 15.1
--- Content provided by FirstRanker.com ---
sets out the cash flows associated with the capped loan. For simplicity of calculations we haveassumed that each half-year period consists of 1821/2 days. The first column of the table shows
semi-annual periods 0-6. The second column shows cash flows from the loan. For instance at
--- Content provided by FirstRanker.com ---
t=1, interest to be paid is 50,000,000[0.0925(182.5/360)]= 2,344,618.1A Floating Rate Loan with an Interest Rate Cap
--- Content provided by FirstRanker.com ---
Time t
Cash Flow from Loan Amortisation of Cash
--- Content provided by FirstRanker.com ---
Flow TotalPremium
from Cap
--- Content provided by FirstRanker.com ---
0
+50,000,000
--- Content provided by FirstRanker.com ---
--
+50,000,000
--- Content provided by FirstRanker.com ---
1
-2,344,618.1
--- Content provided by FirstRanker.com ---
-227,790.43-
-2,572,408.5
--- Content provided by FirstRanker.com ---
2
-2,598,090.3
--- Content provided by FirstRanker.com ---
-227,790.43+253,472.2
-2,572,408.5
--- Content provided by FirstRanker.com ---
3
-2,471,354.2
--- Content provided by FirstRanker.com ---
-227,790.43+126,736.1
-2,572,408.5
--- Content provided by FirstRanker.com ---
4
-2,471,354.2
--- Content provided by FirstRanker.com ---
-227,790.43+126,736.1
-2,572,408.5
--- Content provided by FirstRanker.com ---
5
-2,344,618.1
--- Content provided by FirstRanker.com ---
-227,790.43-
-2,572,408.5
--- Content provided by FirstRanker.com ---
6
-52,154,514
--- Content provided by FirstRanker.com ---
--
-52,154,514
--- Content provided by FirstRanker.com ---
While at t = 3 the interest outflow is
--- Content provided by FirstRanker.com ---
50,000,000[0.0975(182.5/360)]=2,471,354.2
The third column is amortization of the upfront premium. The next column shows payments
--- Content provided by FirstRanker.com ---
received from the cap seller. Thus at t=2, the borrower gets
--- Content provided by FirstRanker.com ---
50,000,000(0.10 - 0.09)(182.5/360)=253,472.2This is because LIBOR applicable for the second six-monthly period was 10%, one percent
higher than the strike rate of 9%. The last column shows the net cash flows from the capped
--- Content provided by FirstRanker.com ---
loan. The effective cost of borrowing is found by finding the IRR of this stream. It works out
to a semi-annual rate of 5.02% corresponding to an annual rate of 10.29%.
--- Content provided by FirstRanker.com ---
Interest Rate FloorsA fund manager is planning to invest $50 million in 5-year FRNs. The notes pay 6-month LIB
OR + 0.50%, the rate being reset every 6 months. The current 6-month LIBOR is 8.60%. As
--- Content provided by FirstRanker.com ---
protection against falling rates the manager decides to buy an interest rate floor with the
following features:
Term
--- Content provided by FirstRanker.com ---
: 5 years
--- Content provided by FirstRanker.com ---
Underlying Interest Rate : 6-month LIBORReset Dates
--- Content provided by FirstRanker.com ---
: June 1, December 1
Strike Rate
--- Content provided by FirstRanker.com ---
: 8%
Face Value
--- Content provided by FirstRanker.com ---
: $25 million
--- Content provided by FirstRanker.com ---
Up-front Fee: 1.5% of the face value or $375,000
--- Content provided by FirstRanker.com ---
This is a portfolio of nine simple put options on 6-month LIBOR with maturities 6, 12, 18. .54
months. As in the case of the cap above, the upfront premium is amortized in 9 equal 6
--- Content provided by FirstRanker.com ---
monthly installments discounted at today's 6 month LIB OR viz. 8.5%. The correspondingannuity is $51,126.84. Now, the effective return on investment depends upon the value of LIB
OR at al future reset dates. The cash flows in the following table are based on the following
--- Content provided by FirstRanker.com ---
scenario:
--- Content provided by FirstRanker.com ---
tLIBOR(%)
--- Content provided by FirstRanker.com ---
0
--- Content provided by FirstRanker.com ---
8.50I
--- Content provided by FirstRanker.com ---
8.75
2
--- Content provided by FirstRanker.com ---
8.75
3
--- Content provided by FirstRanker.com ---
8.00
--- Content provided by FirstRanker.com ---
47.50
--- Content provided by FirstRanker.com ---
5
--- Content provided by FirstRanker.com ---
7.506
--- Content provided by FirstRanker.com ---
7.50
7
--- Content provided by FirstRanker.com ---
7.75
8
--- Content provided by FirstRanker.com ---
8.00
--- Content provided by FirstRanker.com ---
98.00
--- Content provided by FirstRanker.com ---
An Investment with an Interest Rate Floor
--- Content provided by FirstRanker.com ---
Time t
Cash flow from Amortisation
--- Content provided by FirstRanker.com ---
Cashflow Total
investment
--- Content provided by FirstRanker.com ---
of Premium
from Floor
--- Content provided by FirstRanker.com ---
0-25,000,000
-
--- Content provided by FirstRanker.com ---
-
-25,000,000
--- Content provided by FirstRanker.com ---
11,140,625.0
-51,126.8
--- Content provided by FirstRanker.com ---
-
1,089,498.20
--- Content provided by FirstRanker.com ---
21,172,309.0
-51,126.8
--- Content provided by FirstRanker.com ---
-
1,121,182.20
--- Content provided by FirstRanker.com ---
31,172,309.0
-51,126.8
--- Content provided by FirstRanker.com ---
-
1,121,182.20
--- Content provided by FirstRanker.com ---
41,077,256.9
-51,126.8
--- Content provided by FirstRanker.com ---
-
1,026,130.10
--- Content provided by FirstRanker.com ---
51,013,888.9
-51,126.8
--- Content provided by FirstRanker.com ---
63,368
1,026,130.10
--- Content provided by FirstRanker.com ---
61,013,888.9
-51,126.8
--- Content provided by FirstRanker.com ---
63,368
1,026,130.10
--- Content provided by FirstRanker.com ---
71,013,888.9
-51,126.8
--- Content provided by FirstRanker.com ---
63,368
1,026,130.10
--- Content provided by FirstRanker.com ---
81,045,572.9
-51,126.8
--- Content provided by FirstRanker.com ---
31,684
1,026,130.10
--- Content provided by FirstRanker.com ---
91,077,256.9
-51,126.8
--- Content provided by FirstRanker.com ---
-
1,026,130.10
--- Content provided by FirstRanker.com ---
1026,077,257.0
-
--- Content provided by FirstRanker.com ---
-
26,077,257.00
--- Content provided by FirstRanker.com ---
The calculations are quite similar to the case of a cap except the buyer of the floor receives
payment 1 from the seller when LIBOR falls below the strike rate. The effective return on
--- Content provided by FirstRanker.com ---
investment is the IRR of the cash flows shown in the last column. It works out to 4.24% semi-
annual which is equivalent to 8.66% annual.
--- Content provided by FirstRanker.com ---
An interest rate col ar is a combination of a cap and a floor. A corporation wishing to limit itsborrowing cost on a floating rate liability might find the premium associated with a cap too
expensive. It can reduce this by sacrificing some of the potential gain from low interest rates. It
--- Content provided by FirstRanker.com ---
buys a cap and simultaneously sells a floor. The premium received from the sale of the floor
would partly or wholly compensate for the premium paid for the cap. In the latter case, we
--- Content provided by FirstRanker.com ---
have a zero cost col ar. Thus suppose the current 6-month LIBOR is 7.50% and the companyhas a floating rate liability with rate reset every six months indexed to 6-month LIBOR. It
might buy a cap with a strike rate of 9% and sell a floor with a strike rate of 7%. Suppose the
--- Content provided by FirstRanker.com ---
premia cancel out. Effectively, its borrowing cost will vary between 7 and 9% (plus of courseany spread over LIBOR it must pay). By sacrificing the potential gain if LIB OR falls below
7% (in which case buyer of the floor sold by the company would exercise its option), it has
--- Content provided by FirstRanker.com ---
eliminated the upfront premium payment.
VALUATION OF INTEREST RATE OPTIONS
--- Content provided by FirstRanker.com ---
The approach to valuation of interest rate options is quite similar to that for currency options.The risk neutral binomial model can be applied to simple interest rate options. Since caps and
floors are portfolios of simple options, they can be valued by simply valuing each of the
--- Content provided by FirstRanker.com ---
embedded options separately and adding together the values. While conceptually simple, this
approach is not theoretically very satisfactory particularly for options with long lives.
--- Content provided by FirstRanker.com ---
Another approach to valuation uses modifications of the Black-Scholes model. The mainmodifications required are to view options on interest rate as options on an interest bearing
instrument and take account of stochastic interest rates. We will not pursue it here. The
--- Content provided by FirstRanker.com ---
interested reader can consult the references cited in the bibliography. A theoretically rigorous
approach to valuing interest rate options has to be based on a model of the complete term
--- Content provided by FirstRanker.com ---
structure of interest rates.OPTIONS ON INTEREST RATE FUTURES
The options on interest rate futures contracts are traded on a number of financial exchanges
--- Content provided by FirstRanker.com ---
including LIFFE. The underlying asset is a futures contract such as T-bill or Eurodol arfutures. The holder of a call has the right to establish a long position in a futures contract while
a put holder has the right to establish a short position. Short-term interest rate futures prices are
--- Content provided by FirstRanker.com ---
quoted as "points of hundred" i.e. (100-the relevant interest rate in per cent). Consequently,
holder of a call option on say a Eurodol ar futures benefits from a fall in interest rate while the
--- Content provided by FirstRanker.com ---
put holder benefits from a rise in interest rate. Thus pay-offs from a long call (put) on futuresare similar to a long put (cal ) on the underlying interest rate itself. The options traded on
exchanges are American options. However, in the examples below we will assume away the
--- Content provided by FirstRanker.com ---
possibility of early exercise.
Borrower's hedge: Hedging against a rise in interest rate.
Today is March 1. A corporation is planning to issue 92-day commercial paper with face value
--- Content provided by FirstRanker.com ---
$20 million on June 1. To protect itself against a rise in interest rate, it decides to buy a put
option on 20 Eurodol ar futures contracts. The option has the following features:
--- Content provided by FirstRanker.com ---
Type: American put optionUnderlying: June Eurodol ar contracts
Expiry date: June 1 (91 days from today)
--- Content provided by FirstRanker.com ---
Strike price: 91
Face value: $1 million per contract, $20 million total
--- Content provided by FirstRanker.com ---
Premium: 0.75 b.p.The current price of June futures is 92. The current 3 month dollar LIBOR is 8.5%. 3-month
CP rate is 9%.
--- Content provided by FirstRanker.com ---
The dollar value of the premium is calculated as follows:
0.75 x (1/100) x (90/360) x $1,000,000 = $1875
--- Content provided by FirstRanker.com ---
For 20 contracts, the premium is $37,500.On June 1, the payoff from each option is
June futures price F
--- Content provided by FirstRanker.com ---
Pay-off
--- Content provided by FirstRanker.com ---
> 91Option lapses, no pay-off
--- Content provided by FirstRanker.com ---
< 91 [(91 -F)(1/100)(90/360)1,000,000]
Thus suppose the features price has fallen to 90. The total gain from exercising the option and
--- Content provided by FirstRanker.com ---
immediately liquidating the position would be(0.01)(90/360)(1,000,000)(20) = $50,000
On June 1, 3 month LIB OR has risen to 9.9% while the 3 month CP rate is lOi4%. Without
--- Content provided by FirstRanker.com ---
the option, the CP issue would have realised
$(20,000,000)/(1+ 0.104(92/360)] = $19,482,206
--- Content provided by FirstRanker.com ---
With the gain from the option it would realise $19,532,206. Of course we must deduct thecompounded cost of the premium which is
37,500[1 + 0.085(91/360)] = 38,305.73
--- Content provided by FirstRanker.com ---
The net realization is therefore $19,493,900. If the issue had been made on March 1, the firm
would have realized $(20,000,000)/[1 + 0.09(92/360)] = $19,550,342
The break-even futures price on June 1 is that value of F for which the gain from the option
--- Content provided by FirstRanker.com ---
equals the compounded value of the premium. It works out to 90.23.
Pay-off from a Put on Eurodollar Futures
--- Content provided by FirstRanker.com ---
As usual, the firm could have chosen a deeper out-of-the-money option with a smallerpremium but lower level of protection. Alternatively, the firm could have written a call option
on futures and collected an upfront premium. If interest rates had gone up as before, the call
--- Content provided by FirstRanker.com ---
would have lapsed unexercised and the premium gained would have reduced the firm's
effective borrowing cost. If the rates had fallen, the call would be exercised limiting the gain
--- Content provided by FirstRanker.com ---
from lower rates. In one of the problems at the end of this chapter you are asked to comparethis strategy with purchase of a put on futures.
We will conclude with an example in which we compare a number of alternative strategies for
--- Content provided by FirstRanker.com ---
an investor to cope with interest rate risk.
Today is March 1. An investor foresees a cash surp1us of $50 million in 3 months
--- Content provided by FirstRanker.com ---
time to be invested in 3-month Eurodol ar CDs. The current 3-month LIBOR is 8%. The following alternatives are being considered:1. Do not hedge.
2. Sell a 3/6 FRA at 8%.
--- Content provided by FirstRanker.com ---
3. Buy a 3-month put option on 3-month LIBOR.
4. Write a put on June Eurodol ar futures.
--- Content provided by FirstRanker.com ---
5. Write a 3-month call on 3-month LIBOR.6. Buy a 3-month call on June Eurodol ar futures.
--- Content provided by FirstRanker.com ---
.
--- Content provided by FirstRanker.com ---
We have already seen how (2) and (3) work. Consider (4). Writing a put on Eurodol arfutures yields an upfront premium. If rates fall, futures prices will rise and the put will not be
exercised. The premium income will lead to a higher return than remaining unheeded or an
--- Content provided by FirstRanker.com ---
FRA. If rates rise, beyond a point, the put will be exercised against the investor and gain will
be limited. Similarly, strategy (5), writing a call on LIBOR yields an upfront income but
--- Content provided by FirstRanker.com ---
limits gains from rising rates. The call will be exercised when rates rise. As to (6), if the ratesfall, there will be a gain which will partly compensate for the loss on investment while if the
rates rise, investor can gain as in buying a put on LIBOR.
--- Content provided by FirstRanker.com ---
For simplicity, we will ignore the compounding of option premia paid/received over thematurity period of the underlying rate i.e. from 6 to 9 months from the start date. Also ignore
the problem of basis in futures. The strike rates in the interest rate options are all 8% and the
--- Content provided by FirstRanker.com ---
strike prices in the futures options are 92.
SOME RECENT INNOVATIONS
--- Content provided by FirstRanker.com ---
As in the case of currency options, a number of exotic products have appeared inrecent years that permit more flexible management of interest rate risk. An interest
rate cap can be designed that provides protection contingent upon the price of some
--- Content provided by FirstRanker.com ---
commodity or asset e.g. an oil producer may want protection against high interest
rates only when oil prices are low. Average rate or Asian interest rate options have
--- Content provided by FirstRanker.com ---
pay-offs based on the average value of the underlying index (e.g. 6-month LIBOR)during a specified period m look-back options give pay-offs determined by the most
favourable value. In a cumulative option the buyer can obtain protection such that
--- Content provided by FirstRanker.com ---
cumulative interest expense over a period does not exceed a specific level
A description of some of these products can be found in Euro-money.
--- Content provided by FirstRanker.com ---
~Interest rate options have not yet been permitted in the Indian market. However, the recent
trend tow liberalization and widening of the financial derivatives market it is expected that
--- Content provided by FirstRanker.com ---
these products will 51 make their appearance in the Indian market.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
SELF?ASSESSMENT QUESTIONS (SAQs)What are the determinants of exchange rates?
Write short notes on Law of one Price and Purchasing Power
--- Content provided by FirstRanker.com ---
Parity.
Explain the International Fisher Effect.
--- Content provided by FirstRanker.com ---
Describe the nature of Exposure and Risk.Write down the objectives of Hedging Policy.
What are the roles of MIS for Exposure Management?
--- Content provided by FirstRanker.com ---
Explain Operating Exposure with suitable example.
Define Forward Rate Agreements (FRAs).
--- Content provided by FirstRanker.com ---
How you evaluate the Interest Rate Options?Write down the recent innovations on interest rate exposure.
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
REFERENCES:
--- Content provided by FirstRanker.com ---
CREDITOR PANICS: CAUSES AND REMEDIES By Jeffrey D. SachsHarvard Institute for International Development.
INTERNATIONAL FINANCIAL MANAGEMENT By Mauric S, Dlevi.
--- Content provided by FirstRanker.com ---
INTERNATIONAL FINANCIAL MANAGEMENT By Apte P. G.INTERNATIONAL FINANCIAL MANAGEMENT By Henning, C. N., W.
Piggot and W. H. Scott.
--- Content provided by FirstRanker.com ---
EXCHANGE RATE ARITHMATIC By C. Jeevanandham.
================= o ===================G===
--- Content provided by FirstRanker.com ---
Lesson 1:
--- Content provided by FirstRanker.com ---
International Capital Budgeting
Objectives:
--- Content provided by FirstRanker.com ---
After studying this lesson you should be able:
--- Content provided by FirstRanker.com ---
To know the basics of capital budgeting in international contextTo understand the complexities in long term investments in international projects
To observe the similarities and differences between capital budgeting for a foreign project
and domestic project
--- Content provided by FirstRanker.com ---
To understand the issues in foreign investment analysis
Structure
--- Content provided by FirstRanker.com ---
1.1 Introduction1.2 Basics of Capital Budgeting
1.3 Foreign Complexities
--- Content provided by FirstRanker.com ---
1.4 Issues in foreign investment analysis
1.5 Summary
--- Content provided by FirstRanker.com ---
1.6 Glossary1.7 Self Assessment Questions
1.8 Further Readings
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
1.1 Introduction:
Global corporations evaluating foreign investments find their analysis complicated by a
--- Content provided by FirstRanker.com ---
variety of problems that are rarely, if ever, faced by domestic firms. Recent times have seen amassive surge in cross-border direct investments. In the following sections we examine several
such problems, including differences between project and parent company cash flows, foreign
--- Content provided by FirstRanker.com ---
tax regulations, expropriation, blocked funds, exchange rate changes and inflation, project-
specific financing, and differences between the basic business risks of foreign and domestic
--- Content provided by FirstRanker.com ---
projects. Due to the fact that purchasing power parity does not hold, national capital marketswill continue to be segmented and exchange risk will have to be explicitly incorporated in
international investment appraisal. Thus the most important factor in appraisal of foreign
--- Content provided by FirstRanker.com ---
projects is exchange risk and how to incorporate it in the cost of capital. The lesson will also
provide a brief overview of project appraisal practices as reported in the literature for
--- Content provided by FirstRanker.com ---
international projects.Capital budgeting decisions are very crucial for the success of any organization. They are long
--- Content provided by FirstRanker.com ---
term and irreversible in nature. Firms have to invest present cash in anticipation of futurereturns. As future is always uncertain these decisions are complex in nature. These decisions in
international context assume further significance, as the very nature of foreign investment is
complex. Development of framework for international capital budgeting involves measuring,
and reducing to a common denominator, the consequences of these complex factors on the
--- Content provided by FirstRanker.com ---
desirability of the foreign investment opportunities under review. The purpose of goodframework is to maximize the use of available information while reducing arbitrary cash flow
and cost of capital adjustments. International capital budgeting techniques are used in
traditional foreign direct investment (FDI) analysis, such as for the construction of a
manufacturing plant in another country, as well as the growing field of international mergers
--- Content provided by FirstRanker.com ---
and acquisitions1.2 Basics of Capital Budgeting:
--- Content provided by FirstRanker.com ---
International capital budgeting for a foreign project uses the same theoretical framework as
domestic capital budgeting ? with a very few important differences. Multinational capital
--- Content provided by FirstRanker.com ---
budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and
outflows associated with prospective long-term investment projects. The basic steps are as
--- Content provided by FirstRanker.com ---
follows:a) Identify the initial capital invested or put at risk.
--- Content provided by FirstRanker.com ---
b) Estimate the cash flows to be derived from the project over time, including an estimate of
the terminal or salvage value of the investment.
--- Content provided by FirstRanker.com ---
c) Identify the appropriate discount rate for determining the present value of the expectedcash flows.
d) Apply traditional capital budgeting decision criteria such as net present value (NPV) and
--- Content provided by FirstRanker.com ---
internal rate of return (IRR) to determine the acceptability of or priority ranking of
potential projects.
--- Content provided by FirstRanker.com ---
Once a firm has prepared a list of prospective investments, it must then select from among them that combination of projects that maximizes the
company`s value to its shareholders. This selection requires a set of rules and decision criteria that enables managers to determine, given an
investment opportunity, whether to accept or reject it. Net present value (NPV) method considered being the most accepted method one to use since
--- Content provided by FirstRanker.com ---
its consistent with shareholders wealth maximization. We wil briefly review the standard NPV procedure used to appraise a project in the nextsection.
--- Content provided by FirstRanker.com ---
1.2.1. Net Present Value:The net present value (NPV) is defined as the present value of future cash flows discounted at an appropriate rate minus the initial net cash outlay for
the project. Projects with a positive NPV should be accepted; negative NPV projects should be rejected. If two projects are mutually exclusive, the
one with the higher NPV should be accepted. The discount rate, known as the cost of capital, is the expected rate of return on projects of similar risk.
--- Content provided by FirstRanker.com ---
In mathematical terms, the formula for net present value is--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
n
--- Content provided by FirstRanker.com ---
Xt
NPV = - I +
--- Content provided by FirstRanker.com ---
0--- Content provided by FirstRanker.com ---
(1+k)t
t=1
--- Content provided by FirstRanker.com ---
Where Io = the initial cash investmentXt = the net cash flow in period t
--- Content provided by FirstRanker.com ---
k = the project`s cost of capital
--- Content provided by FirstRanker.com ---
n = the investment horizon
The most desirable property of the NPV criterion is that it evaluates investments in the same way the company`s shareholders do; the NPV method
--- Content provided by FirstRanker.com ---
rightly focuses on cash rather than on accounting profits and emphasizes the opportunity cost of the money invested. Thus, it is consistent withshareholder wealth maximization. NPV criterion is also obeys the value additivity principle. That is, the NPV of a set of independent projects is just
the sum of the NPVs of the individual projects. This property means that managers can consider each project on its own. It also means that when a
firm undertakes several investments, its value increases by an amount equal to the sum of the NPVs of the accepted projects. However, the simplicity
of NPV method is deceptive; there are two implicit assumptions. One is that the project being appraised has the same business risk as the portfolio of
--- Content provided by FirstRanker.com ---
the firm`s current activities and the other is that the debt: equity proportion in financing the project is same as the firm`s existing debt: equity ratio. Ifeither assumption is not true, the firm`s cost of equity capital changes and the NPV formula gives no clue as to how it changes.
--- Content provided by FirstRanker.com ---
1.2.2. The Adjusted Present Value (APV) Framework:Projects with different risks are likely to possess differing debt capacities with each project, therefore, necessitating a separate financial structure.
--- Content provided by FirstRanker.com ---
Moreover, the financial package for a foreign investment often includes project-specific loans at concessionary rates or higher-cost foreign funds dueto home country exchange controls, leading to different component costs of capital. The APV framework al ows us to separate out the financing
effects and other special features of a project from the operating cash flows of the project. It is based on the wel known value additivity principle. It is
a two-step approach:
--- Content provided by FirstRanker.com ---
a)
In the first step, evaluate the project as if it is financed entirely by equity. The rate of discount is the required rate of return on equity
--- Content provided by FirstRanker.com ---
corresponding to the risk class of the project.
b)
--- Content provided by FirstRanker.com ---
In the second step, add the present values of any cash flows arising out of special financing features of the project such as external financing,special subsidies if any and so forth. The rate of discount used to find these present values should reflect the risk associated with each of the
cash flows.
--- Content provided by FirstRanker.com ---
The adjusted present value (APV) with this approach is
--- Content provided by FirstRanker.com ---
Present value ofPresent value of
Present value of interest
--- Content provided by FirstRanker.com ---
Present value of interest
APV =
--- Content provided by FirstRanker.com ---
investment o +
ut lay
--- Content provided by FirstRanker.com ---
operating ca s h +
--- Content provided by FirstRanker.com ---
f lowsta x shield
--- Content provided by FirstRanker.com ---
+
--- Content provided by FirstRanker.com ---
subsidies--- Content provided by FirstRanker.com ---
n
X
--- Content provided by FirstRanker.com ---
nT
n
--- Content provided by FirstRanker.com ---
t
S
--- Content provided by FirstRanker.com ---
t
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
t
APV = - I +
--- Content provided by FirstRanker.com ---
+
+
--- Content provided by FirstRanker.com ---
--- Content provided by FirstRanker.com ---
0
--- Content provided by FirstRanker.com ---
(1+k*)t(1+id)t
(1+id)t
--- Content provided by FirstRanker.com ---
Where T
t=1
--- Content provided by FirstRanker.com ---
t=1t=1
t = tax savings in year t due to the specific financing package.
--- Content provided by FirstRanker.com ---
St = before tax dollar value of interest subsidies (penalties) in year t due
to project ?specific financing
--- Content provided by FirstRanker.com ---
id = before-tax cost of dollar debt.It should be emphasized that the all-equity cost of capital equals the required rate of return on a specific project ? that is, the riskless rate of interest plus
an appropriate risk premium based on the project`s particular risk. Thus cost of capital varies according to the risk of the specific project.
--- Content provided by FirstRanker.com ---
According to the capital asset pricing model (CAPM), the market prices only systematic risk relative to the market rather than total corporate risk. In
other words, only interactions of project returns with overal market returns are relevant in determining project riskiness; interactions of project returns
with total corporate returns can be ignored. Thus, each project has its own required return and can be evaluated without regard to the firm`s other
--- Content provided by FirstRanker.com ---
investments. If a project-specific approach is not used, the primary advantage of the CAPM is lost ? the concept of value additivity, which al owsprojects to be considered independently.
--- Content provided by FirstRanker.com ---
1.2.3. Incremental Cash Flows:The most important and also the most difficult part of an investment analysis is to calculate the
--- Content provided by FirstRanker.com ---
cash flow associated with the project; the cost of funding the project; the cash inflow during
the life of the project; and the terminal, or ending value of the project. Shareholders are
interested in how many additional rupees they will receive in future for the rupees they lay out
--- Content provided by FirstRanker.com ---
today. Hence, what matters is not the project`s total cash flow per period, but the incremental
cash flow for a variety of reasons. They include;
--- Content provided by FirstRanker.com ---
Cannibalization: When a new product is introduced it may take away the sales of existingproducts. Cannibalization also occurs when a firm builds a plant overseas and winds up
substituting foreign production for parent company exports. In this case company may lose
--- Content provided by FirstRanker.com ---
exports because it is supplying from its overseas production center. To the extent that sales of a
new product or plant just replace other corporate sales, the new project`s estimated profits
--- Content provided by FirstRanker.com ---
must be reduced by the earnings on the lost sales. However, it is difficult to assess the truemagnitude of cannibalization because of the need to determine what would have happened to
sales in the absence of the new product or plant. The incremental effect of cannibalization ?
--- Content provided by FirstRanker.com ---
which is the relevant measure for capital budgeting purposes ? equals the lost profit on lost
sales that would not otherwise have been lost had the new project not been undertaken. Those
--- Content provided by FirstRanker.com ---
sales that would have been lost anyway should not be counted a casualty of cannibalization.Sales Creation: This is opposite of the cannibalization. For some firms, when they set up
--- Content provided by FirstRanker.com ---
manufacturing facilities abroad their overall image may goes up and sales in the domestic
market may increase. At the same time their local units may supply components to their
--- Content provided by FirstRanker.com ---
foreign units and achieve synergy. In calculating the project`s cash flows, the additional salesand associated incremental cash flows should be attributed to the project.
--- Content provided by FirstRanker.com ---
Opportunity Cost: Project costs must include the true economic cost of any resource required
for the project, regardless of whether the firm already owns the resource or has to go out and
--- Content provided by FirstRanker.com ---
acquire it. This true cost is the opportunity cost, the cash the asset could generate for the firmshould it be sold or put to some other productive use. Suppose a firm decides to builds a new
plant on some land it bought ten years ago, it must include the cost of the land in calculating
--- Content provided by FirstRanker.com ---
the value of undertaking the project. Also, this cost must be based on the current market valueof the land, not the price it paid ten years ago.
--- Content provided by FirstRanker.com ---
Transfer Pricing: Transfer prices at which goods and services are traded internally can
significantly distort the profitability of a proposed investment. Where possible, the prices used
--- Content provided by FirstRanker.com ---
to evaluate project inputs or outputs should be market prices. If no market exists for theproduct, then the firm must evaluate the project based on the cost savings or additional profits
to the corporation of going ahead with the project.
--- Content provided by FirstRanker.com ---
Fees and Royalties: Often companies will charge projects for various items such as legal
--- Content provided by FirstRanker.com ---
counsel, power, lighting, heat, rent, research and development, 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
--- Content provided by FirstRanker.com ---
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
--- Content provided by FirstRanker.com ---
should not be included when estimating project cash flows.In general, incremental cash flows associated with an investment can be found only by
--- Content provided by FirstRanker.com ---
subtracting worldwide corporate cash flows without the investment from post investment
corporate cash flows. In performing this incremental analysis, the key question that managers
--- Content provided by FirstRanker.com ---
must ask is, What will happen if we don`t make this investment?Failure to heed this question led General Motors to lose business to Japanese automakers in
--- Content provided by FirstRanker.com ---
small car segment. Small cars looked less profitable than GM`s then current mix of cars.
Eventually Japanese firms were able to expand and threaten GM`s base business. Many
--- Content provided by FirstRanker.com ---
companies that thought overseas expansion too risky today find their worldwide competitivepositions eroding. They didn`t adequately consider the consequences of not building a strong
global position. Global investments thus must be considered on their strategic importance and
--- Content provided by FirstRanker.com ---
not merely on the basis of risk return analysis in short term.1.3. Foreign Complexities:
--- Content provided by FirstRanker.com ---
David Eiteman, Arthur Stonehill and Michael Moffett have identified the following
--- Content provided by FirstRanker.com ---
complexities regarding capital budgeting decisions of foreign projects. They are;Parent cash flow must be distinguished from project cash flows. Each of these two types
of flows contributes to a different view of value.
--- Content provided by FirstRanker.com ---
Parent cash flow often depends on the form of financing. Thus, cash flows cannot be
clearly separated from financing decisions, as is done in domestic capital budgeting.
--- Content provided by FirstRanker.com ---
Additional cash flows generated by a new investment in one foreign affiliate may be in paror in whole taken away from another affiliate, with the net result that the project is
favorable from a single affiliate`s point of view but contribute nothing to world wide cash
--- Content provided by FirstRanker.com ---
flows.
Remittance of fund to the parent must be explicitly recognized because of differing tax
--- Content provided by FirstRanker.com ---
systems, legal and political constraints on the movement of funds, local business norms ,and difference in the way financial markets and institutions functions.
Cash flows from affiliates to the parent can be generated by an array of nonfinancial
--- Content provided by FirstRanker.com ---
payments, including payments of license fees and payments for imports from the parent.
Differing rate of national inflation must be anticipated because of their potential to cause
--- Content provided by FirstRanker.com ---
changes in competitive position, and thus change in cash flows over a period of time.The possibility of unanticipated foreign exchange rate changes must be kept in mind
because of possible direct effects on the value to the parent of local cash flows, as well as
--- Content provided by FirstRanker.com ---
indirect effects on the competitive position of the foreign affiliate.
Use of segmented national capital markets may create an opportunity for financing gains
--- Content provided by FirstRanker.com ---
or may lead to additional financial costsUse of host-government subsidized loan complicates both capital structure and the ability
to determine an appropriate weighted-average cost of capital for discounting purposes.
--- Content provided by FirstRanker.com ---
Political risk must be evaluated because political events can drastically reduce the value oravailability of expected cash flows.
Terminal value is more difficult to estimate because potential purchasers from the host,
--- Content provided by FirstRanker.com ---
parent, or third countries, of from the private or public sector, may have widely divergent
perspectives on the value to them of acquiring the project.
--- Content provided by FirstRanker.com ---
1.4. Issues in foreign investment analysis:
--- Content provided by FirstRanker.com ---
Since the same theoretical capital budgeting framework is used to choose
among competing foreign and domestic projects, a common standard is
--- Content provided by FirstRanker.com ---
critical. Thus, all foreign complexities must be quantified as modifications toeither expected cash flow or the rate of discount. Although in practice many
firms make such modifications arbitrarily, readily available information,
--- Content provided by FirstRanker.com ---
theoretical deduction, or just plain common sense can be used to make less
arbitrary and more reasonable choices. Some important issues in foreign
--- Content provided by FirstRanker.com ---
investment analysis are discussed below:Parent versus Project Cash Flows:
--- Content provided by FirstRanker.com ---
A substantial differences can exist between the cash flow of a project and theamount that is remitted to the parent firm because of tax regulations and
exchange controls. In addition, project expenses such as management fees
--- Content provided by FirstRanker.com ---
and royalties are returns to the parent company. Furthermore, the incremental
revenue contributed to the parent MNC by a project can differ from total
--- Content provided by FirstRanker.com ---
project revenues if, for example, the project involves substituting localproduction for parent company exports or if transfer price adjustments shift
profits elsewhere in the system. Given the differences that are likely to exist
--- Content provided by FirstRanker.com ---
between parent and project cash flows, the questions arises as to the relevantcash flows to use in project evaluation. According to economic theory, the
value of a project is determined by the net present value of future cash flows
--- Content provided by FirstRanker.com ---
back to the investor. Thus, the parent MNC should value only those cash
flows that are, or can be, repatriated net of any transfer costs such as taxes
--- Content provided by FirstRanker.com ---
because only accessible funds can be used for the payment of dividends andinterest, for amortization of the firm's debt, and for reinvestment.
--- Content provided by FirstRanker.com ---
Exchange rate Changes and Inflation:
The present value of future cash flows from a foreign project can be
--- Content provided by FirstRanker.com ---
calculated using a two-stage procedure:(1) Convert nominal foreign currency cash flows into nominal home currency
terms, and (2) discount those nominal cash flows at the nominal domestic
--- Content provided by FirstRanker.com ---
required rate of return.
--- Content provided by FirstRanker.com ---
In order to properly assess the effect of exchange rate changes on expectedcash flows from a foreign project, one must first remove the effect of offsetting
inflation and exchange rate changes. It is worthwhile to analyze each effect
--- Content provided by FirstRanker.com ---
separately because different cash flows may be differentially affected by
inflation. For example, the depreciation tax shield will not rise with inflation,
--- Content provided by FirstRanker.com ---
while revenues and variable costs are likely to rise in line with inflation. Orlocal price controls may not permit internal price adjustments. In practice,
correcting for these effects mean first adjusting the foreign currency cash
--- Content provided by FirstRanker.com ---
flows for inflation and then converting the projected cash flows back into
home currency using the forecast exchange rate.
--- Content provided by FirstRanker.com ---
Political Risk Analysis:
All else being equal, firms prefer to invest in countries with stable currencies,
--- Content provided by FirstRanker.com ---
healthy economies, and minimal political risks, such as expropriation. But allelse is usually not equal, so firms must assess the consequences of various
political and economic risks for the viability of potential investments. The
--- Content provided by FirstRanker.com ---
general approach recommended previously for incorporating political risk in
an investment analysis usually involves adjusting the cash flows of the project
--- Content provided by FirstRanker.com ---
rather than its required rate of return to reflect the impact of a particularpolitical event on the present value of the project to the parent. The extreme
form of political risk is expropriation. Expropriation is an obvious case where
--- Content provided by FirstRanker.com ---
project and parent company cash flows diverge. If all funds are expected to
be blocked in perpetuity, then the value of the project is zero.
--- Content provided by FirstRanker.com ---
1.5 Summary:
Capital budgeting for foreign projects involves many complexities that do not exist in
--- Content provided by FirstRanker.com ---
domestic projects. A foreign project should be judged on its net present value from the
viewpoint of funds that can be freely remitted to the partner. Comparison of a project`s net
--- Content provided by FirstRanker.com ---
present value to similar projects in the host country is useful for evaluating expectedperformance relative to the potential. Rates of return have to be calculated from both the
project`s viewpoint and the parent` view point. Once the most likely outcome has been
--- Content provided by FirstRanker.com ---
determined, a sensitivity analysis is normally undertaken. Foreign project returns are
particularly sensitive to change in assumptions about exchange rate developments, political
--- Content provided by FirstRanker.com ---
risk, and the way the repatriation of funds is structured.1.6 Glossary:
--- Content provided by FirstRanker.com ---
Net Present Value: The net present value (NPV) is defined as the present value of future cash
flows discounted at an appropriate rate minus the initial net cash outlay for the project.
--- Content provided by FirstRanker.com ---
Adjusted Present Value (APV): This model seeks to disentangle the effects of financing andconsiders only business risks of the project while discounting the cash flows.
Cannibalization: When a new product or project is introduced it may take away the sales of
--- Content provided by FirstRanker.com ---
existing products or projects. Cannibalizations also occur when a firm builds a plant overseasand generate sales in the foreign market and lose sales in exports.
Expropriation: Official government seizure of private property, recognized by international
--- Content provided by FirstRanker.com ---
law as the right of any sovereign state provided expropriated owners are given prompt
compensation and fair market value in convertible securities.
--- Content provided by FirstRanker.com ---
Transfer Pricing: The setting of prices to be charged by one unit such as a foreign affiliate ofa multiunit corporation to another unit such as the parent corporation for goods or services sold
between such related units.
--- Content provided by FirstRanker.com ---
Weighted average cost of capital (WACC): The sum of the proportionally weighted costs of
different sources of capital, used as the minimum acceptable target return on new returns.
--- Content provided by FirstRanker.com ---
1.7 Self Assessment Questions1. Explain briefly the basics of international capital budgeting decisions.
2. List out the complexities involved in foreign projects.
--- Content provided by FirstRanker.com ---
3. What are the major issues in foreign investment analysis?
4. How Adjusted Present Value approach is different from Net Present Value approach?
--- Content provided by FirstRanker.com ---
1.8. Further Readings:
1. Alan C Shapiro, Multinational Financial Management (2002), Prentice-Hall
--- Content provided by FirstRanker.com ---
of India, New Delhi.2. Prakash G Apte, Global Business Finance, Tata McGraw-Hill Publishing
Company Limited, New Delhi.
--- Content provided by FirstRanker.com ---
3. David K. Eiteman, Arthur I. Stonehill, Michael H Moffett, Multinational
Business Finance, Addison Wesley Longman (Singapore) Pte. Ltd, New
--- Content provided by FirstRanker.com ---
Delhi.4. Prakash G Apte, International Financial Management, Tata McGraw-Hill
Publishing Company Limited, New Delhi.
--- Content provided by FirstRanker.com ---
5. Ephraim Clark, International Financial Management, Thompson Asia Pte.Ltd, Singapore.
--- Content provided by FirstRanker.com ---
Lesson 2:
International Working Capital - An Overview
--- Content provided by FirstRanker.com ---
Objectives:After studying this lesson you should be able
To understand the basics of working capital management in international context
--- Content provided by FirstRanker.com ---
To know the objectives of international working capital managementTo observe the complexities involved in managing working capital in international
projects
--- Content provided by FirstRanker.com ---
To know the issues involved in financing the working capital requirements of amultinational corporation`s foreign affiliate
--- Content provided by FirstRanker.com ---
Structure
1.9 Introduction
--- Content provided by FirstRanker.com ---
1.10Short-term Financing Objectives
1.3. Working Capital Cycle
--- Content provided by FirstRanker.com ---
1.4 Short-term Financing Options
1.5 Investing Surplus Funds
--- Content provided by FirstRanker.com ---
1.6 Summary1.7 Glossary
1.8 Self Assessment Questions
--- Content provided by FirstRanker.com ---
1.9 Further Readings
1.3 Introduction:
--- Content provided by FirstRanker.com ---
The Working capital management is an integral part of the total financialmanagement of an enterprise that has a greater impact on Profitability,
Liquidity and Overall performance of the enterprise irrespective of its nature.
--- Content provided by FirstRanker.com ---
In fact, working capital is a circulatory money investment that takes place rightfrom the input stage to output. Management of working capital is complicated
on account of two important reasons, namely, fluctuating nature of its amount,
--- Content provided by FirstRanker.com ---
and a need to maintain a proper balance between current assets and non-
current assets in order to maximize profits. The importance of working capital
--- Content provided by FirstRanker.com ---
in an industry cannot be over stressed, as it is one of the important causes ofsuccess or failure of an industry. Whatever be the size of the business,
working capital is its life-blood. Working capital constitutes the funds needed
--- Content provided by FirstRanker.com ---
to carry on day to day operations of a business, such as purchase of raw
materials, payment of wages and other expenses. For running a business an
--- Content provided by FirstRanker.com ---
adequate amount of working capital is essential. A firm with shortage ofworking capital will be technically insolvent. The liquidity of a business is also
one of the key factors determining its propensity to success or failure. In,
--- Content provided by FirstRanker.com ---
India, paucity of working capital has become a chronic disease in the
industrial sector. This calls for a systematic and integrated approach towards
--- Content provided by FirstRanker.com ---
utilizing a company's assets with maximum efficiency.Managing working capital is a matter of balance. A department must have
--- Content provided by FirstRanker.com ---
sufficient cash on hand to meet its immediate needs while ensuring that idle
cash is invested to the organization's best possible advantage. To avoid
--- Content provided by FirstRanker.com ---
tipping the scale, it is necessary to have clear and accurate reports on eachof the components of working capital and an awareness of the potential
impact of outside influences. Working capital is the money used to make
--- Content provided by FirstRanker.com ---
goods and attract sales. The less Working capital used to attract sales, the
higher is likely to be the return on investment. Working Capital management
--- Content provided by FirstRanker.com ---
is about the commercial and financial aspects of inventory, credit, purchasing,marketing, and royalty and investment policy. The higher the profit margin,
the lower is likely to be the level of Working capital tied up in creating and
--- Content provided by FirstRanker.com ---
selling titles.Working capital management in international context involves managing cash
--- Content provided by FirstRanker.com ---
balances, account receivable, inventory, and current liabilities when faced
with political, foreign exchange, tax, and liquidity constraints. It also
--- Content provided by FirstRanker.com ---
encompasses the need to borrow short-term funds to finance current assetsfrom both in-house banks and external local and international commercial
banks. The overall goal is to reduce funds tied up in working capital. This
--- Content provided by FirstRanker.com ---
should enhance return on assets and equity. It also should improve efficiency
ratios and other evaluation of performance parameters.
--- Content provided by FirstRanker.com ---
Management of short-term assets and liabilities is an important part of the finance manager`s
job. Funds flow continually in and out of a corporation as goods are sold, receivables are
--- Content provided by FirstRanker.com ---
col ected, short-term borrowings are availed of, payables are settled and short-term
investments are made. The essence of short-term financial management can be stated as:
--- Content provided by FirstRanker.com ---
i)Minimize the working capital needs consistent with other policies for example,
granting credit to boost sales, maintain inventories to provide a desired level of
--- Content provided by FirstRanker.com ---
customer service etc.
ii)
--- Content provided by FirstRanker.com ---
Raise short-term funds at the minimum possible cost and deploy short-term cashsurpluses at the maximum possible rate of return consistent with the firm`s risk
preferences and liquidity needs.
--- Content provided by FirstRanker.com ---
In international context, the added dimensions are the multiplicity of currencies and a much
--- Content provided by FirstRanker.com ---
wider array of markets and instruments for raising and deploying funds.1.2. Working capital cycle:
--- Content provided by FirstRanker.com ---
Cash flows in a cycle into, around and out of a business. It is the business's lifeblood and everymanager's primary task is to help keep it flowing and to use the cash flow to generate profits. If
a business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't
--- Content provided by FirstRanker.com ---
generate surpluses, the business will eventually run out of cash and expire. The faster a
business expands the more cash it will need for working capital and investment. The cheapest
--- Content provided by FirstRanker.com ---
and best sources of cash exist as working capital right within business. Good management ofworking capital will generate cash will help improve profits and reduce risks. Bear in mind
that the cost of providing credit customers and holding stocks can represent a substantial
--- Content provided by FirstRanker.com ---
proportion of a firm's total profits. There are two elements in the business cycle that absorb
cash - inventory (stocks and work-in-progress) and receivables (debtor