Download MBA Finance 4th Semester International Business Finance

Download MBA Finance (Master of Business Administration) 4th Semester International Business Finance

This post was last modified on 14 March 2022

Download Document

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

UNIT ? I

--- Content provided by‌ FirstRanker.com ---

INTERNATIONAL MONETARY AND FINANCIAL SYSTEM

--- Content provided by⁠ FirstRanker.com ---

Objectives:

After studying this unit, you should be able to understand the:

--- Content provided by⁠ FirstRanker.com ---

* Concept of International Monetary and Financial System:

--- Content provided by FirstRanker.com ---

* Importance of international finance;

--- Content provided by FirstRanker.com ---

* Bretton woods conference and afterwards developments;

--- Content provided by⁠ FirstRanker.com ---

* Role of IMF and the World Bank in International business;

* Meaning and scope of European monetary system.

--- Content provided by FirstRanker.com ---

Structure:

--- Content provided by‍ FirstRanker.com ---

Introduction

--- Content provided by FirstRanker.com ---

Currency terminology
History of International Monetary System
Inter-war years and world war II
Bretton Woods and the International Monetary Fund, 1944-73.

--- Content provided by‍ FirstRanker.com ---

Exchange Rate Regime, 1973-85

1985 to date : The era of the managed float

--- Content provided by FirstRanker.com ---

Current International Financial System

International Monetary Fund (IMF)
The IMF's Exchange Rate Regime classifications
Fixed vs. Flexible Exchange Rates

--- Content provided by FirstRanker.com ---

Determination of Exchange Rate
World Bank
European Monetary System
European Bank of Investment (EBI)
European Monetary Union (EMU)

--- Content provided by FirstRanker.com ---

Foreign Exchange Markets
International Financial Markets
Summary
Further Readings

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

--- Content provided by‌ FirstRanker.com ---

International Business Finance

INTRODUCTION

--- Content provided by‌ FirstRanker.com ---

The international monetary system is the framework within which

--- Content provided by⁠ FirstRanker.com ---

countries borrow, lend, buy, sell and make payments across political frontiers.

The framework determines how balance of payments disequilibriam is resolved.

--- Content provided by FirstRanker.com ---

Numerous frameworks are possible and most have been tried in one form or

another. Today's system is a combination of several different frameworks. The

increased volatility of exchange rate is one of the main economic developments

--- Content provided by‍ FirstRanker.com ---

of the past 40 years. Under the current system of partly floating and partly fixed

undergo real and paper fluctuations as a result of changes in exchange rates.

--- Content provided by⁠ FirstRanker.com ---

Policies for forecasting and reacting to exchange rate fluctuations are still

evolving as we improve our understanding of the international monetary system,

accounting and tax rules for foreign exchange gains and losses, and the

--- Content provided by‍ FirstRanker.com ---

economic effect of exchange rate changes on future cash flows and market

values.

--- Content provided by FirstRanker.com ---

Although volatile exchange rate increase risk, they also create profit

opportunities for firms and investors, given a proper understanding of exchange

--- Content provided by FirstRanker.com ---

risk management. In order to manage foreign exchange risk, however,

management must first understand how the international monetary system

--- Content provided by FirstRanker.com ---

functions. The international monetary system is the structure within which

foreign exchange rates are determined, international trade and capital flows are

accommodated, and balance-of-payments (BoP) adjustments made. All of the

--- Content provided by FirstRanker.com ---

instruments, institutions, and agreements that link together the world's currency,

money markets, securities, real estate, and commodity markets are also

--- Content provided by FirstRanker.com ---

encompassed within that term.

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by‌ FirstRanker.com ---

CURRENCY TERMINOLOGY

--- Content provided by‌ FirstRanker.com ---

Let us begin with some terms in order to prevent confusion in reading this

--- Content provided by‌ FirstRanker.com ---

unit:

--- Content provided by FirstRanker.com ---

A foreign currency exchange rate or simply exchange rate, is the price of one

country's currency in units of another currency or commodity (typically gold or

--- Content provided by‌ FirstRanker.com ---

silver). If the government of a country- for example, Argentina- regulates the

rate at which its currency- the peso- is exchanged for other currencies, the

system or regime is classified as a fixed or managed exchange rate regime. The

--- Content provided by‌ FirstRanker.com ---

rate at which the currency is fixed, or pegged, is frequently referred to as its par

value. if the government does not interfere in the valuation of its currency in any

--- Content provided by‌ FirstRanker.com ---

way, we classify the currency as floating or flexible.

Spot exchange rate is the quoted price for foreign exchange to be delivered at

--- Content provided by FirstRanker.com ---

once, or in two days for inter-bank transactions. For example, ?114/$ is a quote

for the exchange rate between the Japanese yen and the U.S. dollar. We would

--- Content provided by‌ FirstRanker.com ---

need 114 yen to buy one U.S. dollar for immediate delivery.

Forward rate is the quoted price for foreign exchange to be delivered at a

--- Content provided by FirstRanker.com ---

specified date in future. For example, assume the 90-day forward rate for the

Japanese yen is quoted as ?112/$. No currency is exchanged today, but in 90

--- Content provided by FirstRanker.com ---

days it will take 112 yen to buy one U.S. dollar. This can be guaranteed by a

forward exchange contract.

--- Content provided by‌ FirstRanker.com ---

Forward premium or discount is the percentage difference between the spot and

forward exchange rate. To calculate this, using quotes from the previous two

--- Content provided by‍ FirstRanker.com ---

examples, one formula is:

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

--- Content provided by‌ FirstRanker.com ---

S ? F

360

?114/$ - ?112/$

--- Content provided by‌ FirstRanker.com ---

360

-------- X ------- X 100 = -------------------- X ------ X100 = 7.14%

--- Content provided by⁠ FirstRanker.com ---

F

n

?112/$

--- Content provided by FirstRanker.com ---

90

Where S is the spot exchange rate, F is the forward rate, and n is the number of

--- Content provided by‍ FirstRanker.com ---

days until the forward contract becomes due.

Devaluation of a currency refers to a drop in foreign exchange value of a

--- Content provided by⁠ FirstRanker.com ---

currency that is pegged to gold or to another currency. In other words, the par

value is reduced. The opposite of devaluation is revaluation. To calculate

--- Content provided by‍ FirstRanker.com ---

devaluation as a percentage, one formula is:

Beginning rate ? ending rate

--- Content provided by FirstRanker.com ---

Percentage change = ------------------------------------------

--- Content provided by FirstRanker.com ---

Ending rate

Weakening, deterioration, or depreciation of a currency refers to a drop in the

--- Content provided by FirstRanker.com ---

foreign exchange value of a floating currency. The opposite of weakening is

strengthening or appreciating, which refers to a gain in the exchange value of a

--- Content provided by FirstRanker.com ---

floating currency.

Soft or weak describes a currency that is expected to devalue or depreciate

--- Content provided by FirstRanker.com ---

relative to major currencies. It also refers to currencies whose values are being

artificially sustained by their governments. A currency is considered hard or

--- Content provided by FirstRanker.com ---

strong if it is expected to revalue or appreciate relative to major trading

currencies.

--- Content provided by FirstRanker.com ---

The next section presents a brief history of the international monetary system

form the days of the classical gold standard to the present time.

--- Content provided by FirstRanker.com ---

INTERNATIONAL MONETARY SYSTEM

--- Content provided by‍ FirstRanker.com ---

Over the ages, currencies have been defined in terms of gold and other

items of value, and the international monetary system has been the subject of a

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by‌ FirstRanker.com ---

International Business Finance

variety of international agreements. A review of these systems provides a useful

--- Content provided by‌ FirstRanker.com ---

perspective from which to understand today's system and to evaluate weakness

and proposed changes in the present system.

--- Content provided by⁠ FirstRanker.com ---

The Gold Standard, 1876-1913

--- Content provided by‍ FirstRanker.com ---

Since the days of the Pharaohs (about 3000 B.C.), gold has served as a

medium of exchange and a store of value. the Greeks and Romans used gold

--- Content provided by FirstRanker.com ---

coins and passed on this through the mercantile era to the nineteenth century.

The great increase in trade during the free-trade period of the late nineteenth

--- Content provided by FirstRanker.com ---

century led to a need for a more formalized system for settling international

trade balances. One country after another set a par value for its currency in terms

f gold and then tried to adhere to the so-called "rules of the game". This later

--- Content provided by FirstRanker.com ---

came to be known as the classical gold standard. The gold standard as an

international monetary system gained acceptance in Western Europe in the

--- Content provided by FirstRanker.com ---

1870s. the United States was something of a latecomer to the system, not

officially adopting the standard until 1879.

--- Content provided by‌ FirstRanker.com ---

The "rules of the game" under the gold standard were clear and

simple. Each country set the rate at which its currency unit could be converted to

--- Content provided by FirstRanker.com ---

a weight of gold. The United States, for example, declared the dollar to be

convertible to gold at a rate of $20.67 per ounce of gold (a rate in effect until the

beginning of World War I). The British pound was pegged at ?4.2474 per ounce

--- Content provided by FirstRanker.com ---

of gold. As long as both currencies were freely convertible into gold, the

dollar/pound exchange was:

--- Content provided by FirstRanker.com ---

$20.67/ounce of gold

--- Content provided by FirstRanker.com ---

-----------------------------

=

--- Content provided by‍ FirstRanker.com ---

$4.8665 / ?

?4.2474/ounce of gold

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

Because the government of each country on the gold standard agreed to

buy or sell gold on demand with anyone at its own fixed parity rate, the value of

--- Content provided by‌ FirstRanker.com ---

each individual currency in terms of gold-and therefore exchange rates between

currencies- was fixed. Maintaining adequate reserves of gold to back its

currency's value was very important for a country under this system. The system

--- Content provided by‌ FirstRanker.com ---

also had the effect of implicitly limiting the rate at which any individual country

could expand its money supply. Any growth in the amount of money was

--- Content provided by‌ FirstRanker.com ---

limited to the rate at which official authorities could acquire additional gold.

INTER-WAR YEARS AND WORLD WAR II, 1914 ? 1944

--- Content provided by‌ FirstRanker.com ---

After World War I, in twenties, the exchange rates were allowed to

--- Content provided by⁠ FirstRanker.com ---

fluctuate. This was the result of large fluctuations in currency values.

Consequently, the trade could not develop. Once a currency became weak, it

--- Content provided by⁠ FirstRanker.com ---

was further weakened because of speculative expectations. The reverse

happened with strong currencies, because of these unwarranted fluctuations in

exchange rates, the trade volumes did not grow in proportion to the growth in

--- Content provided by⁠ FirstRanker.com ---

GNP. Many attempts were made to return to gold standard. U.S. could adopt it

in 1919, U.K. in 1925 and France in 1925. U.K. fixed pre-war parity. In 1934,

--- Content provided by⁠ FirstRanker.com ---

U.S. modified the gold standard by revising the price of gold (from

$20.67/ounce to $35/ounce) at which the conversions could be effected.

--- Content provided by FirstRanker.com ---

Till World War II practically the above practice remained in force. The

gold standard to which countries returned in mid twenties was different than

--- Content provided by‍ FirstRanker.com ---

which existed prior to 1914. The major difference was that instead of two

international reserve assets, there were several currencies, which were

convertible to gold and could be termed as reserves. Apart from pound, French

--- Content provided by FirstRanker.com ---

Francs, U.S. dollar had also gained importance. Whenever French accumulated

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

pound sterling, they used to convert these into gold. The second difference was

--- Content provided by‌ FirstRanker.com ---

that Britain had returned to gold standard with a decline in relative costs and

prices.

--- Content provided by⁠ FirstRanker.com ---

In 1931 the crisis began with the failure of a branch banking

institution in Austria called Ke Kredit Anstalt. Had British, U.S. and French

--- Content provided by⁠ FirstRanker.com ---

banks did not cooperated, this could have a small impact on world exchange rate

environment, but French banks did not cooperate. Germans withdrew their

money from Austria leading to deepening of crisis led to dismemberment of

--- Content provided by‍ FirstRanker.com ---

Gold Standard.

--- Content provided by FirstRanker.com ---

BRETTON WOODS AND THE INTERNATIONAL MONETARY FUND
(IMF), 1944-1973

--- Content provided by⁠ FirstRanker.com ---

Of paramount importance to the representatives at the 1944 meeting in

Bretton Woods was the prevention of another breakdown of the international

financial order, such as the one, which followed the peace after the First World

--- Content provided by FirstRanker.com ---

War. From 1918 until well into the 1920s the world had witnessed a rise in

protectionism on a grand scale to protect jobs for those returning the war,

--- Content provided by‍ FirstRanker.com ---

competitive devaluations designed for the same effect, and massive

hyperinflation as the inability to raise conventional taxes led to use of the hidden

tax of inflation: inflation shifts buying power from the holders of money, whose

--- Content provided by⁠ FirstRanker.com ---

holdings buy less to the issuers of money, the central banks. A system was

required that would keep countries from changing exchange rates to obtain a

--- Content provided by FirstRanker.com ---

trading advantages and to limit inflationary policy. This meant that some sort of

control on rate changes was needed, as well as a reserve base for deficit

countries. The reserves were to be provided via an institution created for the

--- Content provided by‌ FirstRanker.com ---

purpose. The International Monetary Fund (IMF) was established to collect and

allocate reserves in order to implement the Articles of Agreement signed in

--- Content provided by⁠ FirstRanker.com ---

Bretton Woods.

7

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

The Articles of Agreement required IMF member countries (of which there

were 178 as of March 1994) to:

--- Content provided by FirstRanker.com ---

1. Promote international monetary cooperation

--- Content provided by‍ FirstRanker.com ---

2. Facilitate the growth of trade

--- Content provided by FirstRanker.com ---

3. Establish a system of multilateral payments

--- Content provided by FirstRanker.com ---

4. Create a reserve base

--- Content provided by‌ FirstRanker.com ---

The reserves were contributed by the member countries according to a

quota system (since then many times revised) base on the national income and

importance of trade in different countries. Of the original contribution, 25

--- Content provided by‍ FirstRanker.com ---

percent was in gold- the so-called gold tranche position- and the remaining 75

percent was in the country's own currency. A country was allowed to borrow up

--- Content provided by⁠ FirstRanker.com ---

to its gold-tranche contribution without IMF approval and to borrow an

additional 100 percent of its total contribution in four steps, each with additional

stringent conditions established by the IMF. These conditions were designed to

--- Content provided by FirstRanker.com ---

ensure that corrective macroeconomic policy actions would be taken. The

lending facilities have been expanded over the years. Standby arrangements

--- Content provided by FirstRanker.com ---

were introduced in 1952, enabling a country to have funds appropriated ahead of

the need so that currencies would be less open to attack during the IMF's

deliberation of whether help would be made available. Other extensions of the

--- Content provided by⁠ FirstRanker.com ---

IMF's lending ability took the form of:

--- Content provided by⁠ FirstRanker.com ---

a. The Compensating Financing Facility, introduced in 1963 to help

countries with temporarily inadequate foreign exchange reserves as a

result of events such as crop failures.

--- Content provided by FirstRanker.com ---

b. The Extended Fund Facility of 1974, providing loans for countries with

--- Content provided by FirstRanker.com ---

structural difficulties that take longer to correct.

c. The Trust Fund from the 1976 Kingston Agreement to allow the sale

of goods, which was no longer to have a formal role in the international

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

financial system. The proceeds of gold sales are used for special

development loans.

--- Content provided by FirstRanker.com ---

d. The Supplementary Financing Facility, also known as the Witteveen

Facility after the then managing director of the IMF. This gives standby

--- Content provided by FirstRanker.com ---

credits and replaced the 1974-1976 Oil Facility, which was established

to help countries with temporary difficulties resulting from oil price

--- Content provided by‍ FirstRanker.com ---

increases.

e. The Buffer Stock Facility, which grants loans to enable countries to

--- Content provided by FirstRanker.com ---

purchase crucial inventories.

--- Content provided by FirstRanker.com ---

These facilities were supplemented by the 1980 decision allowing the

IMF to borrow in the private capital market when necessary and by the

extension of borrowing authority in the 1990 General Arrangements to

--- Content provided by FirstRanker.com ---

Borrow, Which allows the IMF to lend to nonmembers. The scope of the IMF's

power to lend was further expanded in 1993, when new facilities to assist in

--- Content provided by FirstRanker.com ---

exchange-rate stabilization were made available.

As we have seen, the most important feature of the Bretton Woods

--- Content provided by‍ FirstRanker.com ---

agreement was the decision to have the U.S. dollar freely convertible into gold

and to have the values of other currencies fixed in U.S. dollars. The exchange

--- Content provided by‌ FirstRanker.com ---

rates were to be maintained within 1 percent on either side of the official parity,

with intervention required as the support points. This required to the United

States to maintain a reserve of gold, and other countries to maintain reserve of

--- Content provided by⁠ FirstRanker.com ---

U.S. dollars. Because the initially selected exchange rates could have been

incorrect for balance-of-payments (BoP) equilibrium, each country was allowed

--- Content provided by‍ FirstRanker.com ---

a revision of up to 10 percent within a year of the initial selection of the

exchange rate. In this basic form the system survived until 1971.

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

The central place of the U.S. dollar was viewed by John Maynard Keynes

as a potential weakness. Keynes preferred an international settlement system

--- Content provided by‌ FirstRanker.com ---

based on a new currency unit, the Bancor. However, the idea was rejected, and it

was not until the 1960s that the inevitable collapse of the Bretton Woods

arrangement was recognized by a Yale economist, Robert Triffin. According to

--- Content provided by FirstRanker.com ---

the Triffin Paradox, in order for the stock of world reserves to grow along with

world trade, the provider of reserves, the United States, had to run BoP deficits.

--- Content provided by‌ FirstRanker.com ---

These deficits were the means by which other countries could accumulate dollar

reserves. Although the U.S. deficits were needed, the more they occurred, the

more the holders of dollars doubted the ability of the United States to convert

--- Content provided by FirstRanker.com ---

dollars into gold at the agreed price. This built-in paradox meant that the system

was doomed.

--- Content provided by FirstRanker.com ---

Among the more skeptical holders of dollars was France, which began

in 1962 to exchange dollars for gold despite the objection of the United States.

--- Content provided by‌ FirstRanker.com ---

Not only were the French doubtful about the future value of the dollar but they

also objected to the prominent role of the United States was political, and part

--- Content provided by FirstRanker.com ---

was base on the seigniorage gains that France believed accrued to the United

States by virtue of the U.S. role as the world's banker. Seigniorage is the profit

from "printing" money and depends on the ability to have people hold your

--- Content provided by FirstRanker.com ---

currency or other assets at a noncompetitive yield. Every government which

issues legal-tender currency can ensure that it is held by its own citizens, even if

--- Content provided by‌ FirstRanker.com ---

it offers no yield at all. For example, U.S. citizens will hold Federal Reserve

notes and give up goods or services for them, even though the paper the notes

are printed on costs very little to provide.

--- Content provided by⁠ FirstRanker.com ---

The United States was in a special position because its role as the

--- Content provided by⁠ FirstRanker.com ---

leading provider of well as U.S. citizens would hold U.S. dollars. However,

10

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‌ FirstRanker.com ---

most reserves of foreign central banks were and are kept in securities such as

treasury bills, which yield interest. If the interest that is paid on the reserve

--- Content provided by⁠ FirstRanker.com ---

assets is a competitive yield, then the seigniorage gains to the United State from

foreign holding U.S. dollar assets is small. Indeed, with sufficient competition

--- Content provided by FirstRanker.com ---

from (1) alternative reserves of different currencies and (2) alternative dollar

investments in the United States, seigniorage gains would be competed away.

Nevertheless, the French continued to convert their dollar holdings into gold.

--- Content provided by‍ FirstRanker.com ---

This led other countries to worry about whether the United States would have

sufficient gold to support the U.S. dollar the French had finished selling their

--- Content provided by FirstRanker.com ---

dollars: under a fractional reserve standard, gold reserves are only a fraction of

dollars held. By 1968, the run on gold was of such a scale that a March meeting

in Washington, D.C., a two-tier gold-pricing system was established. While the

--- Content provided by‍ FirstRanker.com ---

official U.S. price of gold was to remain at $35 per ounce, the private-market

price of gold was to be allowed to find its own level.

--- Content provided by⁠ FirstRanker.com ---

After repeated financial crises, including a devaluation of the pound

from $2.80/? to $2.40/? in 1967, some relief came in 1970 with the allocation of

--- Content provided by FirstRanker.com ---

Special Drawing Rights (SDRs). The SDRs are book entries that are credited to

the Accounts of IMF member countries according to their established quotas.

--- Content provided by FirstRanker.com ---

They can used to meet payments imbalances, and they provide a net addition to

the stock of reserves without the need for any country to run deficits or mine

gold. From 1970 to 1972, approximately $9.4 billion worth of the SDRs (or

--- Content provided by FirstRanker.com ---

paper gold) was created, and there was no further allocation until January 1,

1979, when SDR 4 billion was created. Similar amounts were created on

--- Content provided by FirstRanker.com ---

January 1, 1980, and on January 1, 1981, bringing the total to over SDR 20

billion. No allocations of SDRs have occurred since 1981. A country can draw

on its SDRs as long as it maintains an average of more than 30 percent of its

--- Content provided by⁠ FirstRanker.com ---

cumulative allocation, and a country is required to accept up to 3 times its total

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

allocation. Interest is paid to those who hold SDRs and by those who draw down

--- Content provided by‍ FirstRanker.com ---

their SDRs, with the rate based on an average of money-market interest rates in

the United States, the United Kingdom, Germany, Japan, and France.

--- Content provided by⁠ FirstRanker.com ---

The SDR was originally set equal in value to the gold content of a U.S.

dollar in 1969, which was 0.888571 grams, or 1/35 oz. The value was latter

--- Content provided by‍ FirstRanker.com ---

revised first being based on a weighted basket of 16 currencies and subsequently

being simplified to 5 currencies. The amount of each currency and the U.S.

dollar equivalents are the currency basket and the weights are revised every 5

--- Content provided by‌ FirstRanker.com ---

years according to the importance of each country in international trade. The

value of the SDR is quoted daily.

--- Content provided by‌ FirstRanker.com ---

-------------------------------------------------------------------------------------------------

--- Content provided by‍ FirstRanker.com ---

Currency

currency Amount

--- Content provided by‍ FirstRanker.com ---

U.S. $ Equivalent

--- Content provided by‍ FirstRanker.com ---

Deutschemark

--- Content provided by FirstRanker.com ---

0.4530

0.2659

French Frane

--- Content provided by‌ FirstRanker.com ---

0.0800

0.1324

--- Content provided by‍ FirstRanker.com ---

Japanese Yen

31..8000

0.3150

--- Content provided by⁠ FirstRanker.com ---

Pound Sterling

0.0812

--- Content provided by FirstRanker.com ---

0.1189

U.S. Dollar

0.5720

--- Content provided by FirstRanker.com ---

0.5720

--- Content provided by FirstRanker.com ---

Total $1.4042 = 1 SDR

--- Content provided by⁠ FirstRanker.com ---

If the SDR had arrived earlier, it might have prevented or postponed the

collapse of the Bretton Woods system, but by 1971, the fall was imminent. After

only two major revisions of exchange rates in the 1950s and 1960s- the floating

--- Content provided by⁠ FirstRanker.com ---

of the Canadian dollar during the 1950s and the devaluation of sterling in 1967-

events suddenly began to unfold rapidly. On August 15, 1971, the United States

--- Content provided by‍ FirstRanker.com ---

responded to a huge was placed on imports, and a grogram of wage and price

controls was introduced. Many of the major currencies were allowed to float

against the dollar, and by the end of 1971 most had appreciated, with the

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

German mark and the Japanese yen both up 12 percent. The dollar had begun a

decade of decline.

--- Content provided by FirstRanker.com ---

On August 15, 1971, the United States made it clear that it was no

longer content to support a system based on the U.S. dollar. The costs of being a

--- Content provided by FirstRanker.com ---

reserve currency were perceived as having begun to exceed any benefit in terms

of seigniorage. The 10 largest countries were called together for a meeting at the
Smithsonian Institution in Washington in Washington, D.C. As a result of the
Smithsonian Agreement, the United States raised the price of gold to $38 per

--- Content provided by‍ FirstRanker.com ---

ounce (that is, devalued the dollar). Each of the other countries in return
revalued its currency by an amount of up to 10 percent. The band around the

new official parity values was increased from 1 percent to 21/4 on either side,

--- Content provided by FirstRanker.com ---

but several European Community countries kept their own exchange rates within

a narrow range of each other while jointly allowing the 41/2 percent band vis-?-

vis the dollar. As we have seen, the "snake," as the European fixed-exchange-

--- Content provided by FirstRanker.com ---

rate system was called, became, with some minor revisions, the Exchange Rate
Mechanism (ERM) of the European Monetary System (EMS) in 1979.

--- Content provided by⁠ FirstRanker.com ---

The dollar devaluation was insufficient to restore stability to the system.

U.S. inflation had become a serious problem. By 1973 the dollar was under

--- Content provided by FirstRanker.com ---

heavy selling pressure even at its devalued or depreciated rates, and in February

1973, the price of gold was raised 11 percent, from $38 to $42.22 per ounce. By

the next month most major currencies were floating. This was the unsteady sate

--- Content provided by FirstRanker.com ---

of the international financial system as it approached the oil crisis of the fall of

1973.

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

--- Content provided by⁠ FirstRanker.com ---

International Business Finance

EXCHANGE RATE REGIME 1973-85

--- Content provided by‌ FirstRanker.com ---

In the wake of the collapse of the Bretton Woods exchange rate system,

--- Content provided by FirstRanker.com ---

the IMF appointed the Committee of Twenty that suggested for various options

for exchange rate arrangement. Those suggestions were approved at Jamaica

--- Content provided by FirstRanker.com ---

during February 1976 and were formally incorporated into the text of the Second

Amendment to the Articles of Agreement that came into force from April 1978.

The options were broadly:

--- Content provided by⁠ FirstRanker.com ---

1. Floating-independence and managed

--- Content provided by⁠ FirstRanker.com ---

2. Pegging of currency

--- Content provided by FirstRanker.com ---

3. Crawling peg

--- Content provided by‍ FirstRanker.com ---

4. Target-zone arrangement

--- Content provided by FirstRanker.com ---

Floating Rate System: In a floating-rate system, it is the market forces that

determine the exchange rate between two currencies. The advocates of the

floating-rate system put forth two major arguments. One is that the exchange

--- Content provided by FirstRanker.com ---

rate varies automatically according to the changes in the macro-economic

variables. As a result, there does not appear any gap between the real exchange

--- Content provided by⁠ FirstRanker.com ---

rate and the nominal exchange rate. The country does not need any adjustment

that is often required in a fixed-rate regime and so it does not have to bear the

cost of adjustment (Friedman, 1953). The other is that this system possesses

--- Content provided by‌ FirstRanker.com ---

insulation properties meaning that the currency remains isolated of the shocks

emanating from other countries. It also means that the government can adopt an

--- Content provided by FirstRanker.com ---

independent economic policy without impinging upon the external sector

performance (Friedman, 1953).

--- Content provided by⁠ FirstRanker.com ---

However, the empirical studies do not necessarily confirm these views.

MacDonald (1988) finds that the exchange rates among the countries on floating

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

--- Content provided by‍ FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

rate system during 1973-85 were much more volatile than warranted by changes

in fundamental monetary variables. Dunn (1983) finds absence of insulation

properties. During early 1980s, when the USA was practicing tight monetary

--- Content provided by‌ FirstRanker.com ---

policy through raising interest rates, the European countries raised interest rates

so as to prevent large outflow of capital to the USA. Again, since the nominal

--- Content provided by‍ FirstRanker.com ---

exchange rate tendered to adjust more rapidly than the market price of goods,

nominal exchange rate turbulence was closely related to real exchange rate

turbulence (Frenkel and Mussa, 1980). Cushman (1983) feels that uncertainty in

--- Content provided by‍ FirstRanker.com ---

real exchange rate did affect trade among several industrialized countries. Dunn

(1983) gives an example of Canadian firms borrowing long-term funds from the

--- Content provided by⁠ FirstRanker.com ---

USA that faced heavy losses due to 14 percent real depreciation of Canadian

dollar during 1976-79. He also finds that large appreciation in the real value of

pound in late 1970s had led to insolvency of many UK firms as their products

--- Content provided by‌ FirstRanker.com ---

turned uncompetitive in world market.

--- Content provided by‍ FirstRanker.com ---

Besides, developing countries in particular do not find floating rates

suitable for them. Since their economy is not diversified and since their export is

subject to frequent changes in demand and supply, they face frequent changes in

--- Content provided by FirstRanker.com ---

exchange rates. This is more especially when foreign demand for the products is

price-inelastic. When the value of their currency depreciates, export earnings

--- Content provided by⁠ FirstRanker.com ---

usually sag in view of inelastic demand abroad. Again, greater flexibility in

exchange rates between a developed and a developing country generates greater

exchange risk in the latter. It is because of low economic profile of the

--- Content provided by‌ FirstRanker.com ---

developing countries and also because they have limited access to forward

market and to other risk-reducing mechanisms.

--- Content provided by FirstRanker.com ---

Floating rate system may be independent or managed. Theoretically

speaking, the system of managed floating involves intervention by the monetary

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

authorities of the country for the purpose of exchange rate stabilization. The

process of intervention interferes with market forces and so it is known as

--- Content provided by‌ FirstRanker.com ---

"dirty" floating as against independent floating which is known as "clean"

floating. However, in practice, intervention is global phenomenon. Keeping this

fact in mind, the IMF is of the view that while the purpose of intervention in

--- Content provided by‌ FirstRanker.com ---

case of independent floating system is to moderate the rate of change, and to

prevent undue fluctuation, in exchange rate; the purpose in managed floating

--- Content provided by FirstRanker.com ---

system is to establish a level for the exchange rate.

Intervention is direct as well indirect. When the monetary authorities

--- Content provided by FirstRanker.com ---

stabilize exchange rate through changing interest rates, it is indirect intervention.

On the other hand, in case of direct intervention, the monetary authorities

--- Content provided by FirstRanker.com ---

purchase and sell foreign currency in the domestic market. When they sell

foreign currency, its supply increases. The domestic currency appreciates against

the foreign currency. When they purchase foreign currency, its demand

--- Content provided by‍ FirstRanker.com ---

increases. The domestic currency tends to depreciate vis-?-vis the foreign

currency. The IMF permits such intervention. If intervention is adopted for

--- Content provided by‍ FirstRanker.com ---

preventing long-term changes in exchange rate away from equilibrium, it is

known as "learning-against-the-wind" intervention. Intervention helps move up

or move down the value of domestic currency also through the expectations

--- Content provided by‍ FirstRanker.com ---

channel. When the monetary authorities begin supporting the foreign currency,

speculators begin buying it forward in the expectation that it will appreciate. Its

--- Content provided by FirstRanker.com ---

demand rises and in turn its value appreciates vis-?-vis domestic currency.

Intervention may be stabilizing or destabilizing. Stabilizing

--- Content provided by⁠ FirstRanker.com ---

intervention helps move the exchange rate towards equilibrium despite
intervention. The former causes gains of foreign exchange, while the latter

causes loss of foreign exchange. Suppose rupee depreciates from 33 a dollar to

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

36 a dollar. The Reserve Bank sell US $ 1000 and rupee improves to 33. The

RBI will be able to replenish the lost reserves through buying dollar at Rs.33/US

--- Content provided by FirstRanker.com ---

$. The gain will be US $ (36000/33-1000) or US $ 91. But after intervention, if

rupee falls to 40 a dollar, the loss will be US $ (36000/40-1000) or US $ 100.

The monetary authorities do not normally go for destabilizing intervention, but it

--- Content provided by‌ FirstRanker.com ---

is very difficult to know in advance whether intervention would be really

destabilizing. The empirical studies show both the stabilizing and destabilizing

--- Content provided by⁠ FirstRanker.com ---

intervention. Longworth's study (1980 finds stabilizing intervention in case of

Canadian dollar, while Taylor (1982) finds destabilizing intervention in case of

some European countries and Japan during 1970s.

--- Content provided by‍ FirstRanker.com ---

Again, intervention may be sterilized or non-sterilized. When the

--- Content provided by‍ FirstRanker.com ---

monetary authorities purchase foreign currency through created money, the

money supply in the country increases. It leads to inflation. This is example of

non-sterilized intervention, but if simultaneously, securities are sold in the

--- Content provided by‍ FirstRanker.com ---

market to mop up the excess supply of money, intervention does not lead to

inflation. It takes the form of sterilized intervention. The study of Obstfeld

--- Content provided by FirstRanker.com ---

(1983) reveals that non-sterilized intervention is common, for sterilized

intervention is not very effective in view of the fact that it does not change very

evidently the ratio between the supply of domestic currency and that of the

--- Content provided by FirstRanker.com ---

foreign currency. However, on the whole, Loopesko (1984) confirms the effect

of the intervention on the exchange rate stabilization. Last but least, there has

--- Content provided by⁠ FirstRanker.com ---

also been a case of co-ordinated intervention. As per the Plaza Agreement of

1985, G-5 nations had intervened in the foreign exchange market in order to

bring US dollar in consistence with the prevailing economic indicators.

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

Pegging of Currency:

--- Content provided by FirstRanker.com ---

Normally, a developing country pegs its currency to a strong currency or

to a currency with which it has a very large part of its trade. Pegging involves

--- Content provided by‌ FirstRanker.com ---

fixed exchange rate with the result that the trade payments are stable. But in case

of trading with other countries, stability cannot be guaranteed. This is why

pegging to a singly currency is not advised if the country's trade is diversified.

--- Content provided by‍ FirstRanker.com ---

In such cases, pegging to a basket of currency is advised. But if the basket is

very large, multi-currency intervention may prove costly. Pegging to SDR is not

--- Content provided by FirstRanker.com ---

different insofar as the value of SDR itself is pegged to a basket of five

currencies. Ugo Sacchetti (1979) observes that many countries did not relish

pegging to SDR in view of its declining value. Sometimes pegging is a

--- Content provided by⁠ FirstRanker.com ---

legislative commitment which is often known as the currency board

arrangement. Again, it is a fact that the exchange rate is fixed in case of pegging,

--- Content provided by⁠ FirstRanker.com ---

yet it fluctuates within a narrow margin of at most + 1.0 percent around the

central rate. On the contrary, in some countries, the fluctuation band is wider

and this arrangement is known as "pegged exchange rates within horizontal

--- Content provided by FirstRanker.com ---

bands".

--- Content provided by⁠ FirstRanker.com ---

Crawling Peg:

--- Content provided by‍ FirstRanker.com ---

Again, a few countries have a system of crawling peg. Under this system,

they allow the peg to change gradually over time to catch up with the changes in

the market-determined rates. It is a hybrid of fixed-rate and flexible-rate

--- Content provided by⁠ FirstRanker.com ---

systems. So this system avoids too much of instability and too much of rigidity.

Elwards (1983) confirms this advantage in case of a sample of some developing

--- Content provided by FirstRanker.com ---

countries. In some of the countries opting for the crawling peg, crawling bands

are maintained within which the value of currency is maintained.

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

--- Content provided by⁠ FirstRanker.com ---

International Business Finance

Target-zone Arrangement:

--- Content provided by⁠ FirstRanker.com ---

In a target-zone arrangement, the intra-zone exchange rates are fixed. An

--- Content provided by FirstRanker.com ---

opposite example of such an arrangement is the European Monetary Union

(EMU) which was earlier known as the European Monetary System (EMS).

--- Content provided by‍ FirstRanker.com ---

There are cases where the member countries of a currency union do not have

their own currency, rather they have a common currency. Under this group,

come the member countries of Eastern Caribbean Currency Union, Western

--- Content provided by FirstRanker.com ---

African Economic and Monetary Union and Central African Economic and

Monetary Community. The member countries of European Monetary Union too

--- Content provided by‍ FirstRanker.com ---

will come under this group if Euro substitutes their currency by the year, 2002.

Global Scenario of Exchange Rate Arrangements:

--- Content provided by‍ FirstRanker.com ---

The firms engaged in international business must have an idea about the

--- Content provided by FirstRanker.com ---

exchange rate arrangement prevailing in different countries as this will facilitate

their financial decisions. In this context, it can be said that over a couple of

--- Content provided by‍ FirstRanker.com ---

decades, the choice of the member countries has been found shifting from one

from of exchange rate arrangement to the other, but, on the whole, the

preference for the floating-rate regime is quite evident. At present, as many as

--- Content provided by FirstRanker.com ---

50 of a total of 185 countries are having independent float, while other 27

countries are having managed floating system. The other 11 countries have

--- Content provided by FirstRanker.com ---

crawling peg, while 53 countries have the system of peg of different kinds. The

EMU countries have target-zone arrangement where they will have a common

currency, Euro by 2002. The other 20 countries of Africa and Caribbean region

--- Content provided by FirstRanker.com ---

come under some kind of economic and monetary integration scheme in which

they have a common currency. Lastly, seven countries do not have their own

--- Content provided by‍ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

currency as a legal tender. We may refer to an IMF publication (IMF, 2001) that

provides a broad list of such arrangements among 185 countries.

--- Content provided by FirstRanker.com ---

1985 TO DATE: THE ERA OF THE MANAGED FLOAT

--- Content provided by‍ FirstRanker.com ---

By March 1985 the dollar had hit its peak. The US current account

deficit was at the unheard of level of over USD 100 billion a year. Most

--- Content provided by‌ FirstRanker.com ---

economists agreed that the dollar was far above its long-term PPP equilibrium

level. The arguments of why this was so ranged from the Dornbusch sticky

--- Content provided by FirstRanker.com ---

hypothesis to fiscal irresponsibility to the reassuring argument that the high

exchange rate was a sign of confidence in the US economy. Whatever the

reason, it was decided that the dollar had to come down in order to defuse

--- Content provided by‌ FirstRanker.com ---

protectionist sentiment in the US Congress that was that was mounting with the

mounting trade deficit.

--- Content provided by FirstRanker.com ---

Intervention in the foreign exchange markets was the method to be used

to achieve this goal. In September 1985 the Group of Five- the United States,

--- Content provided by‍ FirstRanker.com ---

France, Japan, Great Britain and West Germany- came up with the Plaza

Agreement, named after the Hotel in New York where they met. This was

--- Content provided by‍ FirstRanker.com ---

essentially a coordinated program to force down the value of the dollar against

the other major currencies. The policy worked like a charm. In fact, it worked

too well. The dollar fell like a stone, losing close to 11 percent of its SDR value

--- Content provided by‌ FirstRanker.com ---

in 1985. The Group of Five reversed field and began to support the dollar in

1986, to no avail. The dollar lost another 10 percent in 1986. The Group of Five

--- Content provided by FirstRanker.com ---

plus Canada and Italy, now called the Group of Seven (G-7) countries to slow

the dollar's fall by coordinating their economic policies and supporting the

dollar on the exchange markets within some undisclosed target range.

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by‌ FirstRanker.com ---

International Business Finance

This seemed to work for a while. The United States promised to cut the

--- Content provided by FirstRanker.com ---

budget deficit and reduce the rate of growth of the money supply while Japan

and Germany promised to stimulate their economies. Although the US did

--- Content provided by⁠ FirstRanker.com ---

manage to reduce the rate of growth of the money supply, the budget cuts were

not forthcoming, and neither did Germany and Japan come through with their

promised stimulatory measures. When worldwide stock markets crashed in

--- Content provided by‌ FirstRanker.com ---

October 1987 all pretense of policy coordination collapsed. The flooded the

markets with dollars and the dollar fell nearly 10 percent against the SDR in the

--- Content provided by‍ FirstRanker.com ---

last quarter of 1987.

CURRENT INTERNATIONAL FINANCIAL SYSTEM

--- Content provided by FirstRanker.com ---

Where is the international financial system today? The answer to this

--- Content provided by‌ FirstRanker.com ---

question revolves around three facts: (a) the dollar is still the principal currency

used in international transactions but its unchallenged dominance as an

--- Content provided by FirstRanker.com ---

economic and financial force: and (c) Bretton Woods is dead but its child, the

IMF, has evolved with the times and is more important than ever as watchdog

and arbiter of balance of payments disequilibruim.

--- Content provided by FirstRanker.com ---

INTERNATIONAL MONETARY FUND (IMF)

--- Content provided by FirstRanker.com ---

One of the most important players in the current international financial

--- Content provided by FirstRanker.com ---

system, the IMF was created to administer a code of fair exchange practices and

provide compensatory financial assistance to member countries with balance of

payments difficulties. The role of the IMF was clearly spelled out in its articles

--- Content provided by‌ FirstRanker.com ---

of agreement:

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

1. To provide international monetary cooperation through a permanent

institution that provides the machinery for consultation and collaboration

--- Content provided by‌ FirstRanker.com ---

on international monetary problems.

--- Content provided by FirstRanker.com ---

2. To facilitate the expansion and balanced growth of international trade,

and to contribute thereby to the 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 as primary objectives of economic

policy.

--- Content provided by‌ FirstRanker.com ---

3. To promote exchange stability, to maintain orderly exchange

arrangements among members, and to avoid competitive exchange

--- Content provided by FirstRanker.com ---

depreciation.

--- Content provided by⁠ FirstRanker.com ---

4. To assist in the establishment of a multilateral system of payments in

respect of current transactions between members and in the elimination

of foreign exchange restrictions that hamper the growth of world trade.

--- Content provided by FirstRanker.com ---

5. To give confidence to members by making the Fund's resources

--- Content provided by⁠ FirstRanker.com ---

available to them under adequate safeguards, thus providing them with

the opportunity to correct maladjustments in the balances of payments

without resorting to measures destructive of national or international

--- Content provided by FirstRanker.com ---

balances of payments of members.

--- Content provided by‌ FirstRanker.com ---

When a member entered the IMF, it was obliged to submit a par value of

its currency in gold or in US dollars. Once that value was established it could

only vary by 1 percent either way and any changes required the permission of

--- Content provided by FirstRanker.com ---

the IMF. All transactions with other members were then exercised at that rate.

--- Content provided by FirstRanker.com ---

The resources of the IMF came from the subscriptions for member

countries. Subscriptions were determined on the basis of the member's relative

economic size, 25 percent of the quota was to be paid in gold and the rest in the

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

member's domestic currency. The size of the quota was important because it

determined the member's voting power and the amount it could borrow. In

--- Content provided by FirstRanker.com ---

practice, members could borrow up to the first 25 percent of their quota, which

was called the "gold tranche" beyond the gold tranche, the IMF imposed

conditions.

--- Content provided by FirstRanker.com ---

Although the goals and ground rules for membership are still the same,

--- Content provided by FirstRanker.com ---

the IMF has changed considerably since its creation. Its capital has been

increased several times. The gold tranche has become the "first credit tranche"

and other "upper credit tranches" have been added. In 1969 it created the first

--- Content provided by‌ FirstRanker.com ---

SDRs. The IMF has evolved with the perceived problems of the times. In 1963 it

introduced the Compensating Financing Facility to help countries with

--- Content provided by‌ FirstRanker.com ---

temporarily inadequate foreign exchange reserves resulting from events such as

crop failure. In 1974 it set up the Oil Facility to help oil importing developing

countries. It also set up the Extended Fund Facility for countries with structural

--- Content provided by⁠ FirstRanker.com ---

difficulties, created the Trust Fund of 1976 to allow the sale of gold for the

development of third world countries and in the 1980s it negotiated special

--- Content provided by‍ FirstRanker.com ---

standby facilities for countries with foreign debt problems.

THE IMF's EXCHANGE RATE REGIME CLASSIFICATIONS

--- Content provided by⁠ FirstRanker.com ---

The International Monetary Fund classifies all exchange rate regimes

--- Content provided by FirstRanker.com ---

into eight specific categories (listed here with the number of participating

countries as of October 2001). The eight categories span the spectrum of

exchange rate regimes from rigidly fixed to independently floating:

--- Content provided by‍ FirstRanker.com ---

1. Exchange Agreements with No Separate Legal Tender (39): The

--- Content provided by‍ FirstRanker.com ---

currency of another country circulates as the sole legal tender or the

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

member belongs to a monetary or currency union which the same legal

--- Content provided by FirstRanker.com ---

tender is shared by the members of the union.

2. Currency Board Arrangement (08):A monetary regime based on an

--- Content provided by FirstRanker.com ---

implicit legislative commitment to exchange domestic currency for a

specified foreign currency at a fixed exchange rate, combined with

--- Content provided by‍ FirstRanker.com ---

restrictions on the issuing authority to ensure the fulfillment of its legal

obligations.

--- Content provided by FirstRanker.com ---

3. Other Conventional Fixed Peg Arrangement (44): The country pegs

its currency (for mall or de facto) at a fixed rate to a major currency or a

--- Content provided by‍ FirstRanker.com ---

basket of currencies (a composite), where the exchange rate fluctuates

within a narrow margin or at most + 1 percent around a central rate.

4. Pegged Exchange Rates within Horizontal Bonds (6): The value of the

--- Content provided by⁠ FirstRanker.com ---

currency is maintained within margins of fluctuation around a formal or

de facto fixed peg that are wider than + 1 percent around a central rate.

--- Content provided by FirstRanker.com ---

5. Crawling Pegs (4): The currency is adjusted periodically in small

amounts at a fixed, pre-announced rate or in response to changes in

--- Content provided by‌ FirstRanker.com ---

selective quantitative indicators.

--- Content provided by‌ FirstRanker.com ---

6. Exchange Rates within Crawling Pegs (5): The currency is maintained

within certain fluctuation margins around a central rate that is adjusted

periodically at a fixed pre-announced rate or in response to change in

--- Content provided by FirstRanker.com ---

selective quantitative indicators.

--- Content provided by FirstRanker.com ---

7. Managed Floating with No Pre-Announced Path for the Exchange

Rate (33): The monetary authority influences the movements of the

exchange rate through active intervention in the foreign exchange market

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

without specifying or pre-committing to a pre-announced path for the

--- Content provided by FirstRanker.com ---

exchange rate.

--- Content provided by‍ FirstRanker.com ---

8. Independent Floating (47): The exchange rate is market-determined,

with any foreign exchange intervention aimed at moderating the rate of

change and preventing undue fluctuations in the exchange rate, rather

--- Content provided by FirstRanker.com ---

than at establishing a level for it.

--- Content provided by FirstRanker.com ---

FIXED Vs FLEXIBLE EXCHANGE RATES

A nation's choice as to which currency regime to follow reflects national

--- Content provided by⁠ FirstRanker.com ---

priorities about all factors of the economy, including inflation, unemployment,

interest rate levels, trade balances, and economic growth. The choice between

--- Content provided by FirstRanker.com ---

fixed and flexible rates may change over time as priorities change.

At the risk of over-generalizing, the following points partly explain why

countries pursue certain exchange rate regimes. They are based on the premise

--- Content provided by‌ FirstRanker.com ---

that, other things being equal, countries would prefer fixed exchanges rates.

--- Content provided by FirstRanker.com ---

? Fixed rates provide stability in international prices for the conduct of

trade. Stable prices aid in the growth of international trade lessens risks

for all businesses.

--- Content provided by‍ FirstRanker.com ---

? Fixed exchange rates are inherently anti-inflationary, requiring the

--- Content provided by FirstRanker.com ---

country to follow restrictive monetary and fiscal policies. This

restrictiveness, however, can often be a burden to a country wishing to

pursue policies that alleviate continuing internal economic problems,

--- Content provided by FirstRanker.com ---

such as high unemployment or slow economic growth.

--- Content provided by FirstRanker.com ---

? Fixed exchange rate regimes necessitate that central banks maintain large

quantities of international reserves (hard currencies and gold) for use in

the occasional defense of the fixed rate. An international currency

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

markets have grown rapidly in size and volume, increasing reserve

holdings has become a significant burden to many nations.

--- Content provided by FirstRanker.com ---

? Fixed rates, once in place, can be maintained at rates that are inconsistent

with economic fundamentals. As the structure of a nation's economy

changes and its trade relationships and balances evolve, the exchange

--- Content provided by‍ FirstRanker.com ---

rate itself should change. Flexible exchange rates allow this to happen

gradually and efficiently, but fixed rates must be changed

--- Content provided by‌ FirstRanker.com ---

administratively- usually too late, too highly publicized, and too large a

one-time cost to the nation's economic health.

--- Content provided by FirstRanker.com ---

DETERMINATION OF EXCHANGE RATE

--- Content provided by⁠ FirstRanker.com ---

The most common type of foreign transaction involves the payment and

receipt of the foreign exchange within two business days after the day the

--- Content provided by‍ FirstRanker.com ---

transaction is agreed upon. The two-day period gives adequate time for the

parties to send instructions to debit and credit the appropriate bank accounts at

home and abroad and complete requirements under the forex regulations. This

--- Content provided by‍ FirstRanker.com ---

type of transactions is called a spot transaction, and the exchange rate at which

the transaction takes place is called the spot rate. Besides spot transaction, there

--- Content provided by‌ FirstRanker.com ---

are forward transactions. A forward transaction involves an agreement today to

buy or sell a specified amount of a foreign currency at a specified future date at

a rate agreed upon today (the forward rate). The typical forward contact is for

--- Content provided by FirstRanker.com ---

one month; three months; or six months, with three months being most common.

Forward contracts for longer periods are not as common because of the great

--- Content provided by⁠ FirstRanker.com ---

uncertainties involved. However, forward contract can be renegotiated for one or

more periods when they become due.

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

The equilibrium forward rate is determined at the intersection of the

market demand and supply forces of foreign exchange for future delivery. The

--- Content provided by FirstRanker.com ---

demand for the supply of forward foreign exchange arises in the course of

hedging, from foreign exchange speculation, and from covered interest

--- Content provided by FirstRanker.com ---

arbitrage.

SPOT MARKET

--- Content provided by‍ FirstRanker.com ---

Features: In the spot market, currencies are traded for immediate delivery at a

--- Content provided by⁠ FirstRanker.com ---

rate existing on the day of transaction. For making book-keeping entries,

delivery takes two working days after the transaction is complete. If a particular

--- Content provided by‌ FirstRanker.com ---

market is closed on Saturday and Sunday and if transaction takes place on

Thursday, delivery of currency shall take place on Monday. Monday in this case

is known as the value date or settlement date. Sometimes there are short-date

--- Content provided by FirstRanker.com ---

contracts where the time zones permit the delivery of the currency even earlier.

If the currency is delivered the same day, it is known as the value-same-day

--- Content provided by FirstRanker.com ---

contract. If it is done the next day, the contract is known as the value-next-day

contract.

--- Content provided by‌ FirstRanker.com ---

In view of the huge amounts involved in the transactions, there is seldom

any actual movement of currencies. Rather, debit and credit entries are made in

--- Content provided by‍ FirstRanker.com ---

the bank accounts of the seller and the purchaser. Most of the markets do the

transfer of funds electronically thus saving time and energy. The system existing

in New York is known as the Clearing House Inter-Bank Payment System

--- Content provided by‌ FirstRanker.com ---

(CHIPS).

--- Content provided by FirstRanker.com ---

Currency Arbitrage in Spot Market With fast development in the
telecommunication system, rates are expected to be uniform in different foreign
exchange markets. Nevertheless, inconsistency exists at times. The arbitrageurs

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

MBA- H4030

--- Content provided by‌ FirstRanker.com ---

International Business Finance

take advantage of the inconsistency and garner profits by buying and selling of

--- Content provided by‍ FirstRanker.com ---

currencies. They buy a particular currency at cheaper rate in one market and sell

it at a higher rate in the other. This process is known as currency arbitrage. The

--- Content provided by FirstRanker.com ---

process influences the demand for, and supply of, the particular currency in the

two markets which leads ultimately to removal of inconsistency in the value of

currencies in two markets.

--- Content provided by FirstRanker.com ---

Suppose, in New York: $ 1.9800 ? 10/?; and

--- Content provided by FirstRanker.com ---

In London:

$ 1.9710 ? 10/?.

--- Content provided by‌ FirstRanker.com ---

The arbitrageurs will buy the dollar in New York and sell it in London

--- Content provided by FirstRanker.com ---

making a profit of $ 1.9800 ? 1.9710 = $ 0.009 pound sterling.

Speculation in the Spot Market: Speculation in the spot market occurs when

--- Content provided by‌ FirstRanker.com ---

the speculator anticipates a change in the value of a currency, especially an

appreciation in the value of foreign currency. Suppose the exchange rate today is

--- Content provided by‌ FirstRanker.com ---

Rs.49/US $, the speculator anticipates this rate to become Rs.50/US$ within the

coming three months. Under these circumstances, he will buy US $ 1,000 for

Rs.49,000 and hold the amount for three months, although he is not committed

--- Content provided by‌ FirstRanker.com ---

to this particular time horizon. When the target exchange rate is reached, he will

sell US $ 1,000 at the new exchange rate that is at Rs.50 per dollar and earn a

--- Content provided by FirstRanker.com ---

profit of Rs.50,000 ? 49,000 = Rs.1,000.

FORWARD MARKET

--- Content provided by‌ FirstRanker.com ---

The 1- or 2-day delivery period for spot transactions is so short that when

--- Content provided by‍ FirstRanker.com ---

comparing spot rates with forward exchange rates we can usefully think of spot

rates as exchange rates for undelayed transactions. On the other hand,

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

forward exchange rates involve an arrangement to delay the exchange of

currencies until some future date. A useful working definition is:

--- Content provided by FirstRanker.com ---

The forward exchange rate is contracted today for the exchange of

--- Content provided by FirstRanker.com ---

currencies at a specified date in the future. Forward rates are generally expressed

by indicating premium/discount on the spot rate for the forward period.

Premium on one country's currency implies discount on another country's

--- Content provided by FirstRanker.com ---

currency. For instance if a currency (say the US dollar) is at a premium vis-?-vis

another currency (say the Indian rupee), it obviously implies that the Indian

--- Content provided by‌ FirstRanker.com ---

rupee is at a discount vis-?-vis the US dollar.

The forward market is not located at any specified place. Operations take

--- Content provided by⁠ FirstRanker.com ---

place mostly by telephone/telex, etc., through brokers. Generally, participants in

the market are banks, which want to cover orders for their clients. Though a

--- Content provided by⁠ FirstRanker.com ---

trader may quote the forward rate for any future date, the normal practice is to

quote them for 30 days (1 month), 60 days (2 months), 90 days (3 months) and

180 days (6 months).

--- Content provided by‌ FirstRanker.com ---

Quotations for forward rates can be made in two ways. They can be

--- Content provided by FirstRanker.com ---

made in terms of the exact amount of local currency at which the trader quoting

the rates will buy and sell a unit of foreign currency. This is called `outright rate'

and traders in quoting to customers use it. The forward rates can also be quoted

--- Content provided by‍ FirstRanker.com ---

in terms of points of premium or discount on the spot rate, which used in inter-

bank quotations. To find the outright forward rates when premium or discount

--- Content provided by⁠ FirstRanker.com ---

on quotes of forward rates are given in terms of points, the points are add to the

spot price. If the foreign currency is trading at a forward premium; the points are

subtracted from spot price if the foreign currency is trading at a forward

--- Content provided by⁠ FirstRanker.com ---

discount.

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

The traders know well whether the quotes in points represent a premium

--- Content provided by FirstRanker.com ---

or a discount on the spot rate. This can be determined in a mechanical fashion. If

the first forward quote (the bid or buying figure) is smaller than the second

forward quote (the offer or the asking or selling figure), then there is a premium.

--- Content provided by FirstRanker.com ---

In such a situation, points are added to the spot rate. Conversely, if the first

quote is greater than the second then it is a discount. If, however, both the

--- Content provided by FirstRanker.com ---

figures are the same, then the trader has to specify whether the forward rate is at

premium or discount. This procedure ensures that the buy price is lower than the

sell price, and trader profits from the spread between the prices.

--- Content provided by⁠ FirstRanker.com ---

Example 6.1

--- Content provided by‍ FirstRanker.com ---

Spot

--- Content provided by FirstRanker.com ---

1-month

3-months

6-months

--- Content provided by FirstRanker.com ---

(FFr/US$)

5.2321/2340

--- Content provided by‌ FirstRanker.com ---

25/20

40/32

20/26

--- Content provided by⁠ FirstRanker.com ---

In outright terms, these quotes would be expressed as below:

--- Content provided by FirstRanker.com ---

Maturity

Bid/Buy

Sell/Offer/Ask

--- Content provided by FirstRanker.com ---

Spread

Spot

--- Content provided by‍ FirstRanker.com ---

FFr 5.2321 Per US$

FFr 5.2340 Per US$

0.0019

--- Content provided by FirstRanker.com ---

1-month

FFr 5.2296 Per US$

--- Content provided by⁠ FirstRanker.com ---

FFr 5.2320 Per US$

0.0024

2-month

--- Content provided by FirstRanker.com ---

FFr 5.2281 Per US$

FFr 5.2308 Per US$

--- Content provided by⁠ FirstRanker.com ---

0.0027

3-month

FFr 5.2341 Per US$

--- Content provided by‌ FirstRanker.com ---

FFr 5.2366 Per US$

0.0025

--- Content provided by⁠ FirstRanker.com ---

It may noted that in the case of forward deals of 1 month and 3 months,

--- Content provided by⁠ FirstRanker.com ---

US dollar is at discount against French Franc (FF) while 6 months forward is at

premium. The first figure is greater than second both 1 month and 3 months

forward quotes. Therefore, these quotes are at discount and accordingly these

--- Content provided by FirstRanker.com ---

points have been subtracted from the spot rates to arrive at outright rates. The

reverse is the case for 6 moths forward.

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

Example

--- Content provided by‌ FirstRanker.com ---

Let us take an example of a quotation for the US dollar against rupees, given by

--- Content provided by FirstRanker.com ---

a trader in New Delhi.

--- Content provided by‌ FirstRanker.com ---

Spot

1-month

--- Content provided by⁠ FirstRanker.com ---

3-months

6-months

Rs.32.1010-Rs.32.1100

--- Content provided by FirstRanker.com ---

225/275

300/350

--- Content provided by‌ FirstRanker.com ---

375/455

Spread 0.0090

0.0050

--- Content provided by‍ FirstRanker.com ---

0.0050

0.0080

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

The outright rates form this quotation will be as below:

Maturity

--- Content provided by⁠ FirstRanker.com ---

Bid/Buy

Sell/Offer/Ask

--- Content provided by FirstRanker.com ---

Spread

Spot

Rs.32.1010 per US$

--- Content provided by‍ FirstRanker.com ---

Rs.32.1100 per US$

0.0090

--- Content provided by‌ FirstRanker.com ---

1-month

Rs.32.1235 per US$

Rs.32.1375 per US$

--- Content provided by‌ FirstRanker.com ---

0.0140

2-month

--- Content provided by‍ FirstRanker.com ---

Rs.32.1310 per US$

Rs.32.1450 per US$

0.0140

--- Content provided by‍ FirstRanker.com ---

3-month

Rs.32.1385 per US$

--- Content provided by FirstRanker.com ---

Rs.32.1555 per US$

0.0170

--- Content provided by‌ FirstRanker.com ---

Here, we notice that the US dollar is at premium for all the three forward

periods. Also, it should be noted that the spreads in forward rates are always

--- Content provided by⁠ FirstRanker.com ---

equal to the sum of the spread of the spot rate and that of the corresponding

forward points. For Example, the spread of 1month forward is 0.0140

(=0.0090+0.0050), and, so on.

--- Content provided by⁠ FirstRanker.com ---

Major Currencies Quoted in the Forward Market

--- Content provided by FirstRanker.com ---

The major currencies quoted on the forward market are given below. They are

--- Content provided by‍ FirstRanker.com ---

generally in terms of the US dollar.

? Deutschmark

--- Content provided by FirstRanker.com ---

? Swiss franc

--- Content provided by FirstRanker.com ---

? Pound sterling

--- Content provided by FirstRanker.com ---

? Belgian franc

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

? Dutch guilder

--- Content provided by FirstRanker.com ---

? Japanese yen

--- Content provided by FirstRanker.com ---

? Peseta

--- Content provided by FirstRanker.com ---

? Canadian dollar

? Australian dollar

--- Content provided by‌ FirstRanker.com ---

Generally, currencies are quoted in terms of 1 month, 3 months and one

--- Content provided by FirstRanker.com ---

year forward. But enterprises may obtain from banks quotations for different

periods. Premium or Discount. Premium or discount of a currency in the

--- Content provided by‌ FirstRanker.com ---

forward market on the spot rate (SR) is calculated as following:

Premium or discount (per cent) = [(Fwd rate ? Spot rate)/Spot rate] x (12/n) x

100*

--- Content provided by FirstRanker.com ---

When n is the number of months forward.

--- Content provided by FirstRanker.com ---

If, FR > SR, it implies premium.

<SR, it signals discount.

--- Content provided by⁠ FirstRanker.com ---

Arbitrage in case of Forward Market (or Covered Interest Arbitrage)

--- Content provided by‍ FirstRanker.com ---

In the case of forward market, the arbitrage operates on the differential of

--- Content provided by‌ FirstRanker.com ---

interest rates and the premium or discount on exchange rates. The rule is that if

the interest rate differential is greater than the premium or discount, place the

--- Content provided by FirstRanker.com ---

money in the currency that has higher rate of interest or vice-versa. Consider the

following examples:

--- Content provided by FirstRanker.com ---

Example :

--- Content provided by‍ FirstRanker.com ---

Exchange rate:

Can $ 1.317 per US $ (spot)

--- Content provided by FirstRanker.com ---

Can $ 1.2950 per US $ (6 months forward)

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by‌ FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

6-months interest rate:

US $ 10 percent

--- Content provided by‌ FirstRanker.com ---

Can $ 6 percent

--- Content provided by‌ FirstRanker.com ---

Work out the possibilities of arbitrage gain.

--- Content provided by FirstRanker.com ---

Solution:

--- Content provided by FirstRanker.com ---

In this case, it is clear that US $ is at discount on 6-months forward

market. The rate of annualized discount is:

--- Content provided by‍ FirstRanker.com ---

[(1.2950 ? 1.317)/1.317] x (12/6) x 100 = 3.34 percent.

--- Content provided by FirstRanker.com ---

Differential in the interest rate = 10-6 =4 percent.

Here, the interest rate differential is greater than the discount. So in order to

--- Content provided by FirstRanker.com ---

derive to an arbitrage gain, money is to be placed in US$ money market since

this currency has a higher rate of interest. The following steps are involved:

--- Content provided by FirstRanker.com ---

a) Borrow Can$ 1000 at 6 percent p.a. for 6 months.

--- Content provided by FirstRanker.com ---

b) Transform this sum into US$ at the spot rate to obtain US$ 759.3

(=1000/1.317):

--- Content provided by FirstRanker.com ---

c) Place these US dollars at 10 percent p.a. for 6-months in the money

market to obtain US$ 797.23 = [=759.3 x (1+0.1 x 6/12)]

--- Content provided by FirstRanker.com ---

d) Sell US$ 797.23 in the forward market to yield, at the end of 6-months,

Canadian $ 1032.4 (=797.23 x 1.295);

--- Content provided by⁠ FirstRanker.com ---

e) At the end of 6-months, refund the debt taken in Canadian dollars plus

--- Content provided by FirstRanker.com ---

interest, i.e. Canadian $ 1030 [= 1000 x (1 + 0.06 x 6/12)]

Net gain = Canadian $ 1032.4 ? Canadian $ 1030 = Canadian $2.4.

--- Content provided by‍ FirstRanker.com ---

Thus, starting from zero one is richer by Canadian $ 2.4 at the end of 6

months period. Accordingly, on borrowings of Canadian $1 million, one will be

--- Content provided by‌ FirstRanker.com ---

richer by (100,00,000 x $2.4/1000), i.e., Canadian $ 2400.

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

Example :

--- Content provided by‌ FirstRanker.com ---

Exchange rates:

--- Content provided by⁠ FirstRanker.com ---

Can $ 0.665 per DM (Spot)

Can$0.670 per DM (3 months)

--- Content provided by FirstRanker.com ---

Interest rates: DM 7 percent p.a.

--- Content provided by‌ FirstRanker.com ---

Can$ 9 percent p.a.

--- Content provided by FirstRanker.com ---

Calculate the arbitrage possible from the above data.

--- Content provided by⁠ FirstRanker.com ---

Solution:

--- Content provided by⁠ FirstRanker.com ---

In this case, DM is at a premium against the Can$.

Premium = [(0.67 ? 0.665/0.665] x (12/3) x 100 = 3.01 percent

--- Content provided by FirstRanker.com ---

Interest rate differential = 9 ? 7 = 2 percent.

Since the interest rate differential is smaller than the premium, it will be

--- Content provided by FirstRanker.com ---

profitable to place money in Deutsch-marks the currency whose 3-months

interest is lower. The following operations are carried out:

--- Content provided by⁠ FirstRanker.com ---

a) Borrow Can$ 1000 at 9 percent for 3-months;

--- Content provided by⁠ FirstRanker.com ---

b) Change this sum into DM at the spot rate to obtain DM 1503.7

(=1000/0.665);

--- Content provided by‌ FirstRanker.com ---

c) Place DM 1503.7 in the money market for 3 months to obtain a sum of

DM 1530 [=1503.7 x (1+0.07 x 3/12)];

--- Content provided by⁠ FirstRanker.com ---

d) Sell DM at 3-months forward to obtain Can$ 1025.1 (=1530 x 0.67);

e) Refund the debt taken in Can$ with the interest due on it, i.e., Can$

--- Content provided by FirstRanker.com ---

1022.5 [ =1000 x (1+0.09 x 3/12)];

--- Content provided by FirstRanker.com ---

Net gain = 1025.1 ? 1022.5 = Can$ 2.6

SPECULATION IN THE FORWARD MARKET

--- Content provided by⁠ FirstRanker.com ---

Let us say that the US dollar is quoted as follows:

--- Content provided by FirstRanker.com ---

Spot: FFr 5.6 per US$

--- Content provided by‍ FirstRanker.com ---

6-months forward: FFr 5.65 per US$

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‌ FirstRanker.com ---

If a speculator anticipates that the US dollar is going to be FFr 5.7 in 6-

--- Content provided by FirstRanker.com ---

months, he will take a long position in that currency. He will buy US dollars at

FFr 5.65, 6 months forward. If his anticipation turns out to be true, he will sell

his US dollars at FFr 5.7 per unit and his profit will be FFr 0.05 per US$ (=FFr

--- Content provided by FirstRanker.com ---

5.7 ? FFr 5.65).

--- Content provided by‌ FirstRanker.com ---

Now, suppose that the speculator anticipates a decrease in the value of

the US dollar in next 6-months. He thinks that it will be available for FFr 5.5 per

US$. Then he will take a short position in dollars by selling them at 6-months

--- Content provided by FirstRanker.com ---

forward. If his anticipation comes true, he will make a profit of FFr 0.15 per

US$. On the other hand, if the dollar rate in 6-months actually climbs to FFr

--- Content provided by FirstRanker.com ---

5.75 per US$, he will end up incurring a loss of FFr 0.1 per US$ (=FFr 5.65 ?

FFr 5.75).

--- Content provided by‌ FirstRanker.com ---

THE WORLD BANK

--- Content provided by‌ FirstRanker.com ---

The International Bank for Reconstruction and Development (IBRD), better

known as the World Bank, was established at the same time as the International

Monetary Fund (IMF) to tackle the problem of international investment. Since

--- Content provided by FirstRanker.com ---

the IMF was designed to provide temporary assistance in correcting the balance

of payments difficulties, an institution was also needed to assist long-term

--- Content provided by FirstRanker.com ---

investment purposes. Thus, IBRD was established for promoting long-term

investment loans on reasonable terms.

--- Content provided by‌ FirstRanker.com ---

The World Bank (IBRD) is an inter-governmental institution,

corporate in form, whose capital stock is entirely owned by its member-

--- Content provided by⁠ FirstRanker.com ---

governments. Initially, only nations that were members of the IMF could be

members of the World Bank; this restriction on membership was subsequently

relaxed.

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

FUNCTIONS:

--- Content provided by‍ FirstRanker.com ---

The principal functions of the IBRD are set forth in Article 1 of the

agreement as follows:

--- Content provided by FirstRanker.com ---

1. To assist in the reconstruction and development of the territories of its

members by facilitating the investment of capital for productive

--- Content provided by‍ FirstRanker.com ---

purposes.

2. To promote private foreign investment by means of guarantee of

--- Content provided by FirstRanker.com ---

participation in loans and other investments made by private investors

and when private capital is not available on reasonable terms, to make

--- Content provided by‍ FirstRanker.com ---

loans for productive purposes out of its own resources or from funds

borrowed by it.

--- Content provided by FirstRanker.com ---

3. To promote the long-term balanced growth of international trade and the

maintenance of equilibrium in balances of payments by encouraging

--- Content provided by FirstRanker.com ---

international investment for the development of the productive resources

of members.

4. To arrange loans made or guaranteed by it in relation to international

--- Content provided by⁠ FirstRanker.com ---

loans through other channels so that more useful and urgent projects,

large and small alike, will be dealt with first. It appears that the World

--- Content provided by⁠ FirstRanker.com ---

Bank was created to promote and not to replace private foreign

investment. The Bank considers its role to be a marginal one, to

supplement and assist foreign investment in the member countries.

--- Content provided by FirstRanker.com ---

A little consideration will show that the objectives of the IMF and

--- Content provided by⁠ FirstRanker.com ---

IBRD are complementary. Both aim at increasing the level of national income

and standard of living of the member nations. Both serve as lending institutions,

the IMF for short-term and the IBRD for long-term capital. Both aim at

--- Content provided by‍ FirstRanker.com ---

promoting the balanced growth of international trade.

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

ORGANIZATION:

--- Content provided by FirstRanker.com ---

Like the Fund's the Bank's structure is organized on a three-tier basis; a

--- Content provided by⁠ FirstRanker.com ---

Board of Governors, Executive Directors and a president. The Board of

Governors is the supreme governing authority. If consists of one governor

--- Content provided by‌ FirstRanker.com ---

(usually the Finance Minister) and one alternate governor (usually the governor

of a central bank), appointed for five years by each member. The Board is

required to meet once every year. It reserves to itself the power to decide

--- Content provided by‌ FirstRanker.com ---

important matters such as new admissions, changes in the bank's stock of

capital, ways and means of distributing the net income, its ultimate liquidation,

--- Content provided by‍ FirstRanker.com ---

etc. For all technical purposes, however, the Board delegates its powers to the

Executive Directors in the day-to-day administration.

--- Content provided by FirstRanker.com ---

At present, the Executive Directors are 19 in number, of which five are

nominated by the five largest shareholders- the U.S.A., the U.K., Germany,

--- Content provided by FirstRanker.com ---

France and India. The rest are elected by the other member. The Executive

Directors elect the President who become their ex-officio Chairman holding

office during their pleasure. He is the chief of the operating staff of the Bank and

--- Content provided by FirstRanker.com ---

subject to the direction of the Executive Directors on questions of policy and is

responsible for the conduct of the ordinary business of the Bank and its

--- Content provided by‌ FirstRanker.com ---

organization.

EUROPEAN MONETARY SYSTEM

--- Content provided by⁠ FirstRanker.com ---

The Birth of a European Currency: The Euro

--- Content provided by‌ FirstRanker.com ---

The 15 members of the European Union are also members of the

--- Content provided by FirstRanker.com ---

European Monetary System (EMS). This group has tried to form an island of

fixed exchange rates among themselves in a sea of major floating currencies.

--- Content provided by‍ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

Members of the EMS rely heavily on trade with each other, so they perceive that

--- Content provided by‌ FirstRanker.com ---

the day-to-day benefits of fixed exchange rates between them are great.

Nevertheless the EMS has undergone a number of major changes since its

--- Content provided by‍ FirstRanker.com ---

inception in 1979, including major crises and reorganizations in 1992 and 1993

and conversion of 11 members to the euro on January 1, 1999 (Greece joined in

2001). In December 1991, the members of the European Union met a

--- Content provided by‌ FirstRanker.com ---

Maastricht, the Netherlands, and finalized a treaty that changed Europe's

currency future.

--- Content provided by⁠ FirstRanker.com ---

Timetable. The Maastricht treaty specified a timetable and a plan to replace all

individual ECU currencies with a single currency, call euro. Other steps were

--- Content provided by‍ FirstRanker.com ---

adopted that would lead to a full European Economic and Monetary Union

(EMU).

--- Content provided by⁠ FirstRanker.com ---

Convergence criteria. To prepare for the EMU, the Maastricht Treaty called for

the integration and coordination of the member countries' monetary and fiscal

--- Content provided by‍ FirstRanker.com ---

policies. The EMU would be implemented by a process called convergence.

Before becoming a full member of the EMU, each member country was

--- Content provided by‍ FirstRanker.com ---

originally expected to meet the following convergence criteria:

1. Nominal inflation should be no more than 1.5 percent above the average

--- Content provided by‍ FirstRanker.com ---

for the three members of the EU with the lowest inflation rates during the

previous year.

--- Content provided by FirstRanker.com ---

2. Long-term interest rates should be no more than 2 percent above the

average for the three members with the lowest inflation rates.

--- Content provided by‍ FirstRanker.com ---

3. The fiscal deficit should be no more than 3 percent of gross domestic

--- Content provided by⁠ FirstRanker.com ---

product.

4. Government debt should be no more than 60 percent of gross domestic

product.

--- 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 ---

MBA- H4030

International Business Finance

--- Content provided by‍ FirstRanker.com ---

The Currency Regime Choices for Emerging Markets

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

Emerging Market

--- Content provided by FirstRanker.com ---

Country

--- 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 ---

Free-Floating Regime

Currency Board or

--- Content provided by‍ FirstRanker.com ---

Dollarization

--- Content provided by FirstRanker.com ---

? Currency board fixes the

--- Content provided by‌ FirstRanker.com ---

? Currency value is free o

value of local currency to

--- Content provided by‍ FirstRanker.com ---

float up and down with

another currency or

--- Content provided by‍ FirstRanker.com ---

international market

basket;

--- Content provided by⁠ FirstRanker.com ---

dollarization

forces.

replaces the currency with

--- Content provided by‍ FirstRanker.com ---

? Independentmonetary policy

the U.S. dollar.

--- Content provided by⁠ FirstRanker.com ---

and free movement of

? Independent

monetary

--- Content provided by FirstRanker.com ---

capital allowed, but the

policy is lost; political

--- Content provided by⁠ FirstRanker.com ---

loss of stability.

influence on monetary

? Increased volatility may be

--- Content provided by FirstRanker.com ---

policy is eliminated.

more than what a small

--- Content provided by FirstRanker.com ---

? Seignorage, the benefits

country with a small

accruing to a government

--- Content provided by FirstRanker.com ---

financial market can

from the ability to print its

--- Content provided by FirstRanker.com ---

withstand.

own money, are lost.

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

Strong central bank. A strong central bank, called the European Central Bank

(ECB) , was established in Frankfurt, Germany, in accordance with the Treaty.

--- Content provided by‍ FirstRanker.com ---

The bank is modeled after the U.S. Federal Reserve System. This independent

--- Content provided by FirstRanker.com ---

central bank dominates the countries' central banks, which continue to regulate

--- Content provided by FirstRanker.com ---

banks resident within their borders; all financial market intervention and the

--- Content provided by FirstRanker.com ---

issuance of euros will remain the sole responsibility of the ECB. The single most

39

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

important mandate of the ECB is to promote price stability within the European

Union.

--- Content provided by FirstRanker.com ---

As part of its development of cross-boarder monetary policy, the ECB

--- Content provided by‍ FirstRanker.com ---

has formed TARGET is the mechanism by which the ECB will settle all cross-

border payments in the conduct of EU banking business and regulation. It will

the ECB to quickly and costlessly conduct monetary policy and other intra-

--- Content provided by FirstRanker.com ---

banking system capital movements.

--- Content provided by⁠ FirstRanker.com ---

MONETARY SYSTEM

--- Content provided by⁠ FirstRanker.com ---

The Treaty signed at Paris on 18 April 1951 to establish European Coal

and Steel Community (ECSC) was the first step towards the unification of

Europe. The signatories to this treaty were Belgium, France, Italy, Luxembourg,

--- Content provided by FirstRanker.com ---

the Netherlands and then Federal Republic of Germany. The same six countries

later signed the Treaty of Rome on 25 March 1957 to create the European

--- Content provided by‌ FirstRanker.com ---

Economic Community (EEC). The objective of this treaty was to establish (i) a

Custom Union, and (ii) free movement of goods, manpower and capital. In

1972, three other countries, namely, Denmark, Ireland and the UK, also joined,

--- Content provided by FirstRanker.com ---

thus taking the strength of the Community to nine. Later, Greece in 1979, and

Spain and Portugal in 1986 also joined the Community. At the moment, the

--- Content provided by FirstRanker.com ---

European Union has 15 countries as its members after the joining in of Austria,

Finland and Sweden.

--- Content provided by‌ FirstRanker.com ---

In 1978, the European Council decided to establish a European

Monetary System (EMS). With effect from 1 January 1993, the International

--- Content provided by FirstRanker.com ---

European Market has become operational. In 1989, at the Strasbourg Summit, it

was decided to convene an inter-governmental conference, whose role would be

to revise the treaties relating to the European Community in order to include

--- Content provided by‌ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by⁠ FirstRanker.com ---

therein an Economic and Monetary Union (EMU). This Conference has led to

the signing of the Maastricht Treaty on 7 February 1992 that aimed, among

--- Content provided by‍ FirstRanker.com ---

other things, at the creation of institutions permitting establishment of the EMU.

After the Maastricht Treaty, EEC has been renamed as European Union (EU).

--- Content provided by FirstRanker.com ---

Objectives of the European Monetary System

--- Content provided by FirstRanker.com ---

The primary objective of the EMS is to promote and enhance monetary

stability in the European Community. Its other objectives include working

--- Content provided by FirstRanker.com ---

towards the improvement of the general and economic situation f the countries

of the European Union in terms of growth, full employment, standard of living,

reduction of regional disparities, etc. Above all, it also aims at bringing about a

--- Content provided by‍ FirstRanker.com ---

stabilizing effect on international economic and monetary relations.

--- Content provided by⁠ FirstRanker.com ---

EMS vis-?-vis Balance of Payments (BOP)

--- Content provided by⁠ FirstRanker.com ---

The formation of EMS has the following implications for countries

having surplus balance of payment. First, the countries dealing with member

countries of the European Union may weaken the pace of appreciation of their

--- Content provided by⁠ FirstRanker.com ---

currencies. This is likely to happen as the relative stability of exchange rates

inside the EMS is expected to avoid the distortions between various currencies

--- Content provided by⁠ FirstRanker.com ---

of the European Union. Second, deceleration in the rate of appreciation of

currencies may step up exports of such countries. Increased exports, obviously,

have salutary effects on the profitability of enterprise on the one hand and higher

--- Content provided by FirstRanker.com ---

growth of their economies on the other. This assertion is based on the fact that

the surplus countries faced negative effect of continuing re-evaluation

--- Content provided by⁠ FirstRanker.com ---

(appreciation) of their currencies, vis-?-vis, and the currencies of the member

countries of the European Union (EU). In particular, the effect was more marked

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

on external trade with the EU as it constituted 40-50 percent of their total

external business.

--- Content provided by FirstRanker.com ---

In the case of the deficit BOP situation, the EMS stipulates that the

country concerned would be required to initiate appropriate economic and

--- Content provided by FirstRanker.com ---

monetary policy measures to overcome their BOP problems. The EMS has the

provision of providing assistance as well as short-term monetary support for the

purpose.

--- Content provided by‍ FirstRanker.com ---

Characteristics of the EMS

--- Content provided by FirstRanker.com ---

The following are the major characteristics of the EMS:

--- Content provided by‌ FirstRanker.com ---

1. There is a single uniform monetary unit of the European Union, namely,

the European Currency Unit (ECU);

--- Content provided by⁠ FirstRanker.com ---

2. A stable but adjustable exchange rate has emerged.

--- Content provided by⁠ FirstRanker.com ---

European Currency Unit (ECU)

--- Content provided by‍ FirstRanker.com ---

The ECU is the central element of the EMS. It is a basket composed of

different currencies of the European Union, weighted according to the economic

--- Content provided by‍ FirstRanker.com ---

strengths of each one of them.

(a) Relative weightage of each member country currency with respect to the

--- Content provided by‌ FirstRanker.com ---

ECU; the composition of the ECU is shown in the following Table.

(b) Another important premise is that central banks of parties to the EMS are

--- Content provided by FirstRanker.com ---

required to defend the fluctuations in the exchange rates of their currencies.

Initially, this range was + 2.25 percent around central parties. Some member

countries found it extremely difficult to maintain the fluctuations of their

--- Content provided by FirstRanker.com ---

currencies within this range. Therefore, in August 1993, it was raised to 15

percent.

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

--- Content provided by‌ FirstRanker.com ---

(c) There is a built-in mechanism to help one another in times of need.

Necessary finances for the purpose are to be appropriated from the assets

constituted at the level of each central bank.

--- Content provided by‍ FirstRanker.com ---

Table Composition of the ECU as on 21st September 1989

--- Content provided by FirstRanker.com ---

Currency

--- Content provided by FirstRanker.com ---

Quantity

--- Content provided by FirstRanker.com ---

Weight

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

(Percent)

--- Content provided by⁠ FirstRanker.com ---

Deutschmark

--- Content provided by‌ FirstRanker.com ---

0.6242

32.63

--- Content provided by‌ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

French Franc

1.332

--- Content provided by FirstRanker.com ---

19.89

--- Content provided by⁠ FirstRanker.com ---

Pound Sterling

--- Content provided by‍ FirstRanker.com ---

0.08784

11.45

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

Dutch Guilder

0.2198

10.23

--- Content provided by FirstRanker.com ---

Belgian Franc

3.431

--- Content provided by‍ FirstRanker.com ---

08.28

--- Content provided by FirstRanker.com ---

Spanish Peseta

--- Content provided by FirstRanker.com ---

6.885

04.50

--- Content provided by FirstRanker.com ---

Danish Kroner

0.1976

--- Content provided by FirstRanker.com ---

02.56

--- Content provided by⁠ FirstRanker.com ---

Irish Pound

--- Content provided by⁠ FirstRanker.com ---

0.008552

01.06

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

Greek Drachma

1.440

0.53

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

Portuguese Escudo

1.393

--- Content provided by‌ FirstRanker.com ---

0.71

--- Content provided by FirstRanker.com ---

Italian Lira

--- Content provided by FirstRanker.com ---

15.18

--- Content provided by FirstRanker.com ---

8.16

--- Content provided by‍ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

It is apparent form the above Table that economically strong currencies

have a very high weightage. For instance, the first three currencies

--- Content provided by FirstRanker.com ---

(Deutschmark, French Franc, and Pound) among them account for nearly two-
third of the total weightage. It may be noted that the number of countries

included in the above Table is eleven. However, with effect from 1st January

--- Content provided by⁠ FirstRanker.com ---

1996, the number of countries has gone up to fifteen. He constitution of the ECU
should obviously reflect the relative weightage of the economies of all these

countries. But, with the coming into effect of the Maastricht Treaty on 1st

--- Content provided by‌ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

--- Content provided by‌ FirstRanker.com ---

November 1993, the composition of the ECU has been frozen. It will continue at

the frozen level till the adoption of a single currency. This measure is likely to

bring about a greater stability of the ECU.

--- Content provided by FirstRanker.com ---

The ECU is a unit of payment among central banks of the European

--- Content provided by‌ FirstRanker.com ---

Union. It is also used for according financial assistance to member states which

face economic difficulties due to BOP. `Private ECU' has also found a greater

instruments (such as, long-term borrowings and inter-bank commercial paper,

--- Content provided by FirstRanker.com ---

Euro-bonds, Euro-credits, etc.), can be documented in ECU. There exist future

contracts in ECUs too. In the international capital markets, the ECU occupies an

--- Content provided by⁠ FirstRanker.com ---

important place. On a commercial plane, some enterprises have adopted it as the

currency of billing; the accounts of some multinationals are made in ECUs.

--- Content provided by FirstRanker.com ---

EUROPEAN BANK OF INVESTMENT (EBI)

--- Content provided by‍ FirstRanker.com ---

The European Bank of Investment was created in 1958 by the Treaty of

Rome with the major objective of balanced development of different regions of

--- Content provided by⁠ FirstRanker.com ---

the European Union. The text of the Maastricht has further reinforced its role to

serve the goal of economic and social cohesion. This is the European banking

institution to provide long-term financing. It is an integral part of the EU

--- Content provided by⁠ FirstRanker.com ---

structure and has its own organization of decision-making.

--- Content provided by⁠ FirstRanker.com ---

The Bard of Governors consisting of one minister of each member state

(generally the Finance Minister) gives general orientation and nominates other

members of the decision-making body. The board of governors decides about

--- Content provided by FirstRanker.com ---

lending, borrowing and interest rates on the proposal of the Managing

Committee. This committee is an executive organ of the EBI.

--- Content provided by‌ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

EUROPEAN MONETARY UNION (EMU)

--- Content provided by‍ FirstRanker.com ---

The Heads of the State and governments of the countries of the EU

decided at Maastricht on 9th and 10th December 1991 to put in place the

--- Content provided by FirstRanker.com ---

European Monetary Union (EMU). Adhering to the EMU means irrecoverable

fixed exchange rates between different currencies of the Union. The setting up

--- Content provided by‍ FirstRanker.com ---

of EMU has been a step towards the introduction of a common currency in the

member states of EU, as per the Maastricht Treaty. It has ratified by all the 12

countries, which constituted the Union at that point of time. The EMU

--- Content provided by‌ FirstRanker.com ---

completes the mechanism that started with the Customs Union of the Treaty of

Rome and the big Common Market of the Single Act.

--- Content provided by FirstRanker.com ---

FOREIGN EXCHANGE MARKETS

--- Content provided by FirstRanker.com ---

The foreign Exchange Market is the market in which currencies are

bought and sold against each other. It is the largest market in the world. In this

--- Content provided by FirstRanker.com ---

market where financial paper with a relatively short maturity is traded. However,

the financial paper traded in the foreign exchange market is not all denominated

--- Content provided by FirstRanker.com ---

in the same currency. In the foreign exchange market, paper denominated in a

given currency is always traded against paper denominated in another currency.

One justification for the existence of this market is that nations have decided to

--- Content provided by‌ FirstRanker.com ---

keep their sovereign right to have and control their own currencies. Unlike the

money market and capital markets, the foreign exchange market deals not in

--- Content provided by FirstRanker.com ---

credit but in means of payment. This brings one to a fundamental point. While

foreign exchange deals frequently take place between residents of different

countries, the money being traded never actually leaves the country of the

--- Content provided by⁠ FirstRanker.com ---

currency.

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

--- Content provided by‍ FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

Thus, when a US company exports to a foreign country of India, for

example, foreign exchange is required. The people manufacturing and

performing services in the United States must be paid in local currency, US

--- Content provided by⁠ FirstRanker.com ---

dollars. The people consuming the goods and services in India have only their

local currency, Rupees with which to pay. There are now two possibilities for

--- Content provided by‍ FirstRanker.com ---

settling the account between the United States and India. The US exporter bills

the Indian importer either in US dollars or in Rupees.

--- Content provided by‍ FirstRanker.com ---

a)

If the US exporter bills in dollars, the Indian importer must sell

--- Content provided by⁠ FirstRanker.com ---

Rupees to purchase dollars in the foreign exchange market.

b)

If the US exporter bills in Rupees, the exporter must sell rupees to

--- Content provided by FirstRanker.com ---

purchase dollars.

--- Content provided by‌ FirstRanker.com ---

As one can see, whatever the currency for invoicing is, somebody has

to go into the foreign exchange market to sell rupees and purchase dollars. In

contrast to a spot transaction, a forward foreign exchange contract calls for

--- Content provided by⁠ FirstRanker.com ---

delivery at a fixed future date of a specified amount of one currency for

specified amount of another currency. By borrowing money in one currency,

--- Content provided by FirstRanker.com ---

buying a second currency spot, placing the funds in a deposit in the foreign

currency and simultaneously selling the foreign currency forward, an arbitrageur

can profit if the domestic interest rate does not equal the foreign interest rate,

--- Content provided by FirstRanker.com ---

adjusted for the forward premium or discount. Dealing business across national

boundaries means dealing with more than one currency and therefore involves

--- Content provided by FirstRanker.com ---

exchange risk. Exchange risk is the additional systematic risk to a firm's flows

arising from exchange rate changes.

--- 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 ---

MBA- H4030

--- Content provided by⁠ FirstRanker.com ---

International Business Finance

Players in the Foreign Exchange Market

--- Content provided by‌ FirstRanker.com ---

The main participants in the foreign exchange market are commercial

--- Content provided by FirstRanker.com ---

banks. Indeed, one say that it is the commercial banks that "make a market" in

foreign exchange. Next in importance are the large Corporations with foreign

--- Content provided by‍ FirstRanker.com ---

trade activities. Finally, central banks are present in the foreign exchange

market.

--- Content provided by FirstRanker.com ---

(i) Commercial Banks

--- Content provided by‍ FirstRanker.com ---

Commercial banks are normally known as the lending players in the

foreign exchange scene, we are speaking of large commercial banks with many

--- Content provided by‍ FirstRanker.com ---

clients engaging in exports and imports which must be paid in foreign currencies

or of banks which specialize in the financing of trade. Commercial banks

participate in the foreign exchange market as an intermediary for their corporate

--- Content provided by FirstRanker.com ---

customers who wish to operate in the market and also on their own account.

Banks maintain certain inventories of foreign exchange to best service its

--- Content provided by⁠ FirstRanker.com ---

customers.

(ii) Non-financial Corporations

--- Content provided by FirstRanker.com ---

The involvement of Corporations in the foreign exchange market

--- Content provided by⁠ FirstRanker.com ---

originates from two primary sources. International trade and direct investment.

International trade usually involves the home country of the corporation. In this

--- Content provided by‍ FirstRanker.com ---

regard, the concern of the corporation is not only that foreign currency be paid

or received, but also that the transaction be done at the most advantageous price

of foreign exchange possible. A business also deals with the foreign exchange

--- Content provided by‌ FirstRanker.com ---

market when it engages in foreign direct investment. Foreign direct investments

involve not only the acquisition of assets in a foreign country, but also the

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by‍ FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

generation of liabilities in a foreign currency. So, for each currency in which a

firm operates, an exposure to foreign exchange risk is likely to be generated.

That is, given that a company will have either a net asset or a net liability

--- Content provided by‌ FirstRanker.com ---

position in the operations in a given currency, any fluctuation that occurs in the

value of that currency will also occur in the value of the company's foreign

--- Content provided by‍ FirstRanker.com ---

operations.

(iii) Central Banks

--- Content provided by FirstRanker.com ---

Central Banks are not only responsible for the printing of domestic

--- Content provided by FirstRanker.com ---

currency and the management of the money supply, but, in addition, they are

often responsible for maintaining the value of the domestic currency vis-a-vis

--- Content provided by‌ FirstRanker.com ---

the foreign currencies. This is certainly true in the case of fixed exchange rates.

However, even in the systems of floating exchange rates, the central banks have

usually felt compelled to intervene in the foreign exchange market at least to

--- Content provided by‌ FirstRanker.com ---

maintain orderly markets.

--- Content provided by FirstRanker.com ---

Under the system of freely floating exchange rates, the external value of

the currency is determined like the price of any other good in a free market, by

the forces of supply and demand. If, as a result of international transactions

--- Content provided by FirstRanker.com ---

between the residents and the rest of the world, more domestic currency is

offered than is demand, that is, if more foreign currency is demanded than is

--- Content provided by FirstRanker.com ---

offered, then the value of the domestic currency in terms of the foreign

currencies will tend to decrease. In this model, the role of the central bank

should be minimal, unless it has certain preferences i.e. it wishes to protect the

--- Content provided by FirstRanker.com ---

local export industry.

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‌ FirstRanker.com ---

INTERNATIONAL FINANCIAL MARKETS

--- Content provided by FirstRanker.com ---

The financial markets of the world consist of sources of finance, and

uses for finance, in a number of different countries. Each of these is a capital

--- Content provided by‌ FirstRanker.com ---

market on its own. On the other hand, national capital markets are partially

linked and partially segmented. National capital markets are of very different

stages of development and size and depth, they have very different prices and

--- Content provided by⁠ FirstRanker.com ---

availability of capital. Hence, the international financier has great opportunities

for arbitrage ? finding the cheapest source of funds, and the highest return,

--- Content provided by FirstRanker.com ---

without adding to risk. It is because markets are imperfectly linked, the means

and channels by which foreigners enter domestic capital markets and domestic

sources or users of funds go abroad, are the essence of this aspect of

--- Content provided by‍ FirstRanker.com ---

international financial management.

--- Content provided by⁠ FirstRanker.com ---

The other aspect is the fact that domestic claims and liabilities are

denominated in national currencies. These must be exchanged for another for

capital to flow internationally; since relative values depend on supply and

--- Content provided by FirstRanker.com ---

demand, the international financier faces exchange risk. Finally, the past few

decades have seen a new phenomenon; the separation of currency of

--- Content provided by FirstRanker.com ---

denomination of assets and liabilities from country of jurisdiction.

There are three sets of markets ? home, foreign and euromarkets ? faced

--- Content provided by FirstRanker.com ---

by every investor or borrower, plus the fourth market, the foreign currency

market, which must be crossed as one enters the world of finance. Each country

--- Content provided by FirstRanker.com ---

has more or less imperfect linkages with every other country and with the euro

market, both the segment in its own currency and Euro-market segments in other

currencies. The linkages of each country with its Euromarkets segment are very

--- Content provided by FirstRanker.com ---

important, since domestic and euromarkets instrument are close substitutes and

no foreign exchange market comes between them. The links among segments of

--- Content provided by‌ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

the euromarkets are also very important, since no national controls come

between them - in other words, linkages within the euromarkets are perfect,

being differentiated only by currency of denomination. They are linked through

--- Content provided by‌ FirstRanker.com ---

the spot and forward foreign exchange markets. International finance is thus

concerned with :

--- Content provided by⁠ FirstRanker.com ---

(i) Domestic Capital Markets

--- Content provided by FirstRanker.com ---

The international role of a capital market and the regulatory climate

that prevails are closely related. Appropriate regulation can and does make

--- Content provided by FirstRanker.com ---

markets more attractive. However, the dividing line between regulatory

measures that improve markets and those that have just the opposite effect is

--- Content provided by‌ FirstRanker.com ---

very thin.

(ii) Foreign Financial Markets

--- Content provided by⁠ FirstRanker.com ---

Major chunk of the savings and investments of a country take place in that

--- Content provided by‌ FirstRanker.com ---

country's domestic financial markets. However, many financial markets have

extensive links abroad ? domestic investors purchase foreign securities and

--- Content provided by⁠ FirstRanker.com ---

invest funds in foreign financial institutions. Conversely, domestic banks can

lend to foreign residents and foreign residents can issue securities in the national

market or deposit funds with resident financial intermediaries.

--- Content provided by‌ FirstRanker.com ---

The significant aspect of traditional foreign lending and borrowing is that

--- Content provided by‍ FirstRanker.com ---

all transactions take place under the rules, usances and institutional

arrangements prevailing in the respective national markets. Most important, all

these transactions are directly subject to public policy governing foreign

--- Content provided by‌ FirstRanker.com ---

transactions in a particular market. For example, when savers, purchase

securities in a foreign market, they do so according to the rules, market practices

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

--- Content provided by‍ FirstRanker.com ---

International Business Finance

--- Content provided by FirstRanker.com ---

and regulatory percepts that govern such transactions in that particular market.

Likewise, foreign borrowers who wish to issue securities in a national market

must follow the rules and regulations of that market. Frequently, these rules are

--- Content provided by FirstRanker.com ---

discriminatory and restrictive. The same is true with respect to financial

intermediaries; the borrower who approaches a foreign financial institution for a

--- Content provided by FirstRanker.com ---

loan obtains funds at rates and conditions imposed by the financial institutions

of the foreign country and is directly affected to foreign residents.

--- Content provided by‍ FirstRanker.com ---

(iii) Euromarkets and their linkages:

--- Content provided by FirstRanker.com ---

Euro currencies ? which are neither currencies nor are they

necessarily connected with Europe ? represent the separation of currency of

--- Content provided by‍ FirstRanker.com ---

denomination from the country of jurisdiction. Banks and clients make this

separation simply by locating the market for credit denominated in a particular

currency outside the country where that currency is legal tender. For example,

--- Content provided by FirstRanker.com ---

markets for dollar denominated loans, deposits and securities in jurisdictions

other than in the United States effectively avoid US banking and securities

--- Content provided by FirstRanker.com ---

regulations. These markets are referred to as "Euro" or, more properly, as

external markets in order to indicate that they are not part of the domestic or

national financial system. As in the domestic markets, the euromarkets consist of

--- Content provided by⁠ FirstRanker.com ---

intermediated funds and direct funds. Intermediated credit in channel through

banks is called the "Euro Currency Market".

--- Content provided by‌ FirstRanker.com ---

A domestic market, usually with special and unique aspects and

institutions stemming from historical and regulatory differences. A foreign

--- Content provided by⁠ FirstRanker.com ---

segment attached to the national market, where non-residents participate as

supplier and takers of funds, frequently playing both roles simultaneously, but

--- Content provided by‍ FirstRanker.com ---

always under the specific conditions, rules and regulations established for

foreign participants in a particular national market. An external segment that is

51

--- Content provided by FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by FirstRanker.com ---

characterized by being in a different political jurisdiction, with only the currency

used to determine the financial claims being the essential link to the national

--- Content provided by‌ FirstRanker.com ---

market. As a result, the various external markets have more features in common

with each other than with the respective national markets. Therefore, they are

--- Content provided by⁠ FirstRanker.com ---

properly discussed as a common, integrated market where claims denominated

in different currencies are exchanged.

--- Content provided by⁠ FirstRanker.com ---

SUMMARY:

--- Content provided by⁠ FirstRanker.com ---

The development in the international monetary system dates back to

the commodity specie standard when metallic coins were used for international

transaction. This was followed by gold standard that provided not only domestic

--- Content provided by⁠ FirstRanker.com ---

price stability but also automatic adjustment in the exchange rate and the

balance of payments. The gold standard failed to cope with the changes in

--- Content provided by‍ FirstRanker.com ---

international economic scenario and it was finally abandoned in 1930s. Its

abandonment led to large fluctuations in exchange rates. And so a new system of

exchange rate evolved under the aegis of the "Bretton Woods" child",

--- Content provided by FirstRanker.com ---

International Monetary Fund in 1945. The system represented a fixed parity

system with adjustable pegs. The currency of the member countries was

--- Content provided by‍ FirstRanker.com ---

convertible in US dollar and the US dollar was convertible into gold. And so

when the US economy turned into distress in late 1950s, dollar failed to

command confidence. Dollar-denominated securities were converted into gold

--- Content provided by⁠ FirstRanker.com ---

depleting in turn the stock of gold with the USA. The process weakened the

dollar further and ultimately, the Bretton Woods system exchange rate crumbled

--- Content provided by FirstRanker.com ---

in early 1973. In the post-1973 or the present system, various options are given

to the member countries such as independent and managed floating rate system,

system of pegging of currency, crawling peg and target-zone arrangement. The

--- Content provided by‌ FirstRanker.com ---

--- Content provided by‍ FirstRanker.com ---

--- Content provided by⁠ FirstRanker.com ---

--- Content provided by‌ FirstRanker.com ---

MBA- H4030

International Business Finance

--- Content provided by‌ FirstRanker.com ---

different systems have no doubt merits of their own, but they suffer from one

--- Content provided by FirstRanker.com ---

limitation or the other.

The exchange rates are quoted in different forms, viz., direct and

--- Content provided by FirstRanker.com ---

indirect quote, buying and selling quote, spot and forward quote. Cross rates

between two currencies are established through a common currency. They are

--- Content provided by‌ FirstRanker.com ---

found when the rates between any two currencies are not published. During

several years (1987 to 1992) the countries belonging to the EMS had achieved,

to a marked extent, stability of real exchange rates through several adjustment

--- Content provided by‌ FirstRanker.com ---

had to be made. The crisis of September 1992, brought about by the fall of US

dollar, led to profound changes. The EMU goes largely beyond the framework

--- Content provided by FirstRanker.com ---

of internal common market since it will also have repercussions on social plane.

Once the ECU is adopted as common currency it may become a pilot currency

and other European or non-European currencies may be pegged to it.

--- Content provided by FirstRanker.com ---

KEYWORDS:

--- Content provided by FirstRanker.com ---

Balance of Payment Deficits: In a situation of worsening balance of payments, the

--- Content provided by⁠ FirstRanker.com ---

government may like to conserve foreign exchange through payment restrictions or

--- Content provided by FirstRanker.com ---

otherwise.

Euro Currency Market: Collection of banks that accept deposits and provide

--- Content provided by‌ FirstRanker.com ---

loans in large denominations and in a variety of currencies.

--- Content provided by⁠ FirstRanker.com ---

Foreign Exchange Market: Market composed primarily of banks, serving firms

and consumers who wish to buy or sell various currencies.

--- Content provided by FirstRanker.com ---

Develop Bilateralism: Exchange control may be with a view to encourage trade with a

--- Content provided by‍ FirstRanker.com ---

particular country or group of countries.

Domestic market: A domestic market, usually with special and unique aspects

--- Content provided by‍ FirstRanker.com ---

and institutions stemming from historical and regulatory differences.

--- Content provided by‌ FirstRanker.com ---

--- Content provided by FirstRanker.com ---

MBA- H4030

--- Content provided by FirstRanker.com ---

International Business Finance

Exchange Intervention: Exchange intervention or official intervention refers to the

--- Content provided by‍ FirstRanker.com ---

buying and selling of foreign exchange in the market by the government or its agency

(central bank) with a view to influencing the exchange rate.

--- Content provided by FirstRanker.com ---

External segment: An external segment that is characterized by being in a

different political jurisdiction, with only the currency used to denominate the

financial claims being the essential link to the national market.

--- Content provided by‍ FirstRanker.com ---

Foreign segment: A foreign segment attached to the national markets, where

--- Content provided by⁠ FirstRanker.com ---

non-residents participate as suppliers and takers of funds, frequently playing

both roles simultaneously, but always under the specific conditions, rules and

regulations established for foreign participants in a particular national market.

--- Content provided by‌ FirstRanker.com ---

Get the MBBS Question Bank Android App

Download MBA Finance 4th Semester International Business Finance

Share This Post:

Share This Post: