Question No.

1
Because of its broad global environment, a number of disciplines (geography, history, political science, etc.) are useful to help explain the conduct of International Business. Elucidate with examples. Answer: - International Finance is a distinct field of study and certain features set it apart from other fields. The important distinguishing features of international finance are discussed below: Foreign exchange risk: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterized by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers. Political risk: Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political risk is when the sovereign country changes the rules of the game and the affected parties have no alternatives open to them. Expanded opportunity sets: When firms go global, they also tend to benefit from expanded opportunities which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economies of scale when they operate on a global basis. Market imperfections: The final feature of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect. There are profound differences among nations laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio. Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities. The International Monetary System, as we have today, has evolved over the course of centuries and defines the overall financial environment in which multinational corporations operate. The International Monetary System consists of elements such as laws, rules, agreements, institutions, mechanisms and procedures which affect foreign exchange rates, balance of payments adjustments, international trade and capital flows. This system will continue to evolve in the future as the international business and political environment of the world economy continues to change. The International Monetary System plays a crucial role in the financial management of a multinational business and economic and financial policies of each country. Evolution of the International Monetary System can be analyzed in four stages as follows: The Gold standard, 1876-1913 The Inter-war Years, 1914-1944 The Breton Woods System, 1945-1973 Flexible Exchange Rate Regime since 1973

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Question No.2
What is a credit transaction and a debit transaction? Which are the broad categories of international transactions classified as credits and as debits? Answer: 1. Credit Transactions (+) are those that involve the receipt of payment from foreigners. The following are some of the important credit transactions: (a) Exports of goods or services (b) Unilateral transfers (gifts) received from foreigners (c) Capital inflows 2. Debit Transactions () are those that involve the payment of foreign exchange i.e., transactions that expend foreign exchange. The following are some of the important debit transactions: (a) Import of goods and services (b) Unilateral transfers (or gifts) made to foreigners (c) Capital outflows Capital Inflows can take either of the two forms: (a) An increase in foreign assets of the nation (b) A reduction in the nations assets abroad For example, you can better understand the debit and credit transaction from the examples given below: A US resident purchases an Indian stock. When a US resident acquires a stock in an Indian company, foreign assets in India go up. This is a capital inflow to India because it involves the receipt of a payment from a foreigner. When an Indian resident sells a foreign stock, Indian assets abroad decrease. This transaction is a capital inflow to India because it involves receipt of a payment from a foreigner. Capital Outflows can also take any of the following forms: (a) An increase in the nations assets abroad (b) A reduction in the foreign assets of the nation Both the above transactions involve a payment to foreigners and are capital outflows.

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Question No.3
What is cross rates? Explain the two methods of quotations for exchange rates with examples. Answer: Cross Rates: The exchange rate between any two non-dollar currencies is referred to as a cross rate. A relatively large number of cross rates would be required to trade every currency directly against every other currency. For example, N currencies would require N x (N-1)/2 separate cross rates. For this reason, most exchange rates are quoted in terms of dollars and by far the greatest volume of trading directly involves the dollar. This reduces the number of cross-currency quotes that dealers must keep track of and reduces the potential losses associated with mispricing currencies relative to one another (which permit Triangular Arbitrage). Exchange rates are expressed in 2 methods: Direct Quote: The most common way in which they are expressed is called a direct quote. Generally speaking, most international countries deal with the direct quote in all their transactions and the quotes that they give are in accordance with international convention. The direct quote is when the USD is the senior currency and the local currency is expressed in terms of USD. For example USD:JPY is 83.25. This means how much Yen it must cost to buy one USD. Intuitively, you go from the back to the front. Therefore it takes 83.25 Yen to buy one US Dollar. If the rate increases to 84.00 it is known as depreciation because now it takes 84 Yen (more Yen) to buy 1 US Dollar in contrast to previous 83.25. Indirect Quote: An indirect quote is usually when the main currency, USD is in the back. The USD is quoted in terms of the local currency. In the example of the AUD: USD. If the AUD is trading at 0.95, it means it will cost 1 USD to buy 0.95 AUD. If AUD appreciates to 1.10, the indirect method means that it actually cost more in terms of USD to purchase 1 unit of the AUD. In this example, it can be seen previously while the cost was 0.95 US Dollars to purchase 1 AUD, now it cost 1.10 USD to buy 1 unit of AUD.

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Question No.4

 Explain covered and uncovered interest rate arbitrage. Answer: Covered Interest Arbitrage Interest arbitrage is usually covered as investors of short-term funds abroad generally want to avoid the foreign exchange risk. To do this, the investor exchanges the domestic currency for the foreign currency at the current spot rate so as to purchase the foreign treasury bills and at the same time he sells forward the amount of the foreign currency he is investing plus the interest he will earn so as to coincide with the maturity of his foreign investment. Thus, covered interest arbitrage refers to the spot purchase of the foreign currency to make the investment and offsetting the simultaneous forward sale (swap of the foreign currency) to cover the foreign exchange risk. When the treasury bills mature, the investor can then get the domestic currency equivalent of the foreign investment plus the interest earned without a foreign exchange risk. Since the currency with the higher interest rate is usually at a forward discount, the net return on the investment is roughly equal to the positive interest differential earned abroad minus the forward discount on the foreign currency. This reduction in earnings is the cost of insurance against the foreign exchange risk. Continuing with the earlier example where the interest rate on three-month treasury bills is 11 per cent per year in Germany and 15 per cent in London, let us also assume that the pound is at a three-month forward discount of 1 per cent per year. To engage in covered interest arbitrage, the German investor must exchange marks for pounds at the current exchange rate (to purchase the British treasury bills) and at the same time sell forward a quantity of pounds equal to the amount invested plus the interest he will earn at the prevailing forward rate. Since the pound is at a forward discount of 1 per cent per year, German investor loses 1 per cent on the foreign exchange transaction to cover his foreign exchange risk for the three month period. His net gain is thus the extra 1 per cent interest he earns for the three months minus th of the 1 per cent he loses on the foreign exchange transaction, or 3/4 of 1 per cent. Covered interest arbitrage and interest parity theory Figure 1 shows the relationship through Covered Interest Arbitrage (CIA) between the interest rate differentials between the two nations and the forward premium or discount on the foreign currency.

Figure 1: Interest Rate Differentials, Forward Exchange Rates and Covered Interest Arbitrage

The horizontal axis in the diagram shows the forward premium (+) or forward discount on the foreign currency expressed in percentages per year. The vertical axis measures the interest differential in favour of the foreign country in per cent per annum. The solid line in the Figure depicts interest parity. Positive values indicate that interest rates are higher abroad. Negative values indicate that interest rates are higher domestically. And when the interest differential is zero, the foreign currency is neither at a forward discount nor at a forward premium (i.e., the forward rate on the foreign currency is equal to its spot rate). For example, when the positive interest differential is 1.5 per cent per year in favour of the foreign nation, the foreign currency is at a forward discount of 1.5 per cent per year. Similarly, a negative interest differential of 2.0 per cent is associated with a forward premium of 2.0 per cent. The Figure shows that for all points above the interest parity line, there will be a net gain from an arbitrage outflow due to two reasons. First, the positive interest differential exceeds the forward discount and second, the forward premium exceeds the negative interest differential. Uncovered Interest Arbitrage The transfer of funds abroad to take advantage of higher interest rates in foreign monetary centres usually involves the conversion of the domestic currency to the foreign currency, to make the investment. At the time of maturity, the funds (plus the interest) are reconverted from the foreign currency to the domestic currency. During the period of investment, a foreign exchange risk is involved due to the possible depreciation of the foreign currency. If such a foreign exchange risk is covered, we have covered interest arbitrage; otherwise we have uncovered interest arbitrage. Suppose that the interest rate on three-month treasury bills is 11 per cent at an annual basis in Germany and 15 per cent in London. It may then pay for a German investor to exchange marks for pounds at the current spot rate and purchase British treasury bills to earn the extra 1 per cent interest for the three months. When the British treasury bills mature, the German investor may want to exchange the pounds he invested plus the interest he earned back into marks. The situation is shown in Figure 2.

Figure 2: Arbitrage Process However, by that time, the pound may have depreciated so that he gets back fewer marks per pound than he paid.

Figure 3: Pound Depreciates of 1% Figure 3 shows if the pound depreciates by of 1 per cent during the three months of the investment, the German investor nets only about of 1 per cent from his foreign investment (the extra 1 per cent interest he earns minus the of 1 per cent that he loses from the depreciation of the pound).

Figure 4 shows the situation when the pound depreciates by 1 per cent during the three months, the German investor gains nothing, while Figure 5 shows if the pound depreciates by more than 1 per cent, the German investor lose. However, if the pound appreciates, the German investor gains both from the extra interest he earns and from the appreciation of the pound.

Figure 5: Pound Appreciated by More than 1%

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Question No.5

 Explain briefly the mechanism of futures trading Answer: Mechanism of Futures Trading The mechanics of futures trading consists of two parts. {1}. Components of Futures Trade

1. Futures players: Futures trading, which represents a less than zero sum game, can be considered beneficial if it results in utility gains. This is done by the transfer of risks between the market players. These players are: Hedgers Speculators Arbitrage 2. Clearing houses: Every organised futures exchange has a clearing house that guarantees performance to all of the participants in the market. It serves this role by adopting the position of buyer to every seller and seller to every buyer. Thus, every trading party in the futures markets has obligations only to the clearing house. Since the clearing house matches its long and short positions exactly, it is perfectly hedged, i.e., its net futures position is zero. It is an independent corporation and its stockholders are its member clearing firms. All futures traders maintain an account with member clearing firms either directly or through a brokerage firm. 3. Margin requirements: Each trader is required to post a margin to insure the clearing house against credit risk. This margin varies across markets, contracts and the type of trading strategy involved. Upon completion of the futures contract, the margin is returned. 4. Daily resettlement: For most futures contracts, the initial margins are 5% or less of the underlying commodity's value. These margins are marked to the market on a daily basis and the traders are required to realise any losses in cash on the day they occur. Whenever the margin deposit falls below minimum maintenance margin, the trader is called upon to make it up to the initial margin amount. This resettlement is also called marked-to-the-market. Delivery terms. This includes: (a) Delivery date: Some contracts may be delivered on any business day of the delivery month while others permit delivery after the last trading day. (b) Manner of delivery: The possibilities are: Physical exchange of underlying asset. Cash settlement as in the case of stock index futures. (c) Reversing trade: This trade effectively makes a traders net futures position zero thus absolving him from further trading requirements. In futures markets, 99% of all futures positions are closed out via a reversing trade.

5. Types of orders: Besides placing a market order, the other types are:

(a) Limit order: It stipulates to buy or sell at a specific price or better. (b) Fill-or-kill order: It instructs the commission broker to fill an order immediately at a specified price. (c) All-or-none-order: It allows the commission broker to fill part of an order at a specified price and remainder at another price. (d) On-the-open or on-the-close order: This represents orders to trade within a few minutes of operating or closing.
(e) Stop order: Triggers a reversing trade when prices hit a prescribed limit. 6. Transaction costs: The costs incurred are: (a) Floor trading and clearing fees: These are small fees charged by the exchange and its associated clearing house. (b) Commissions: A commission broker charges a commission fees to transact a public order. (c) Bid: Ask spreads. (d) Delivery costs: Those are incurred in case of actual delivery. 7. Tax rules: The regulations include: (a) Marketing-to-the-market: The gains/losses are considered at the end of the calendar year where futures contracts are marked-to the-market. (b) Gains: The realised and unrealised gains are taxed at the ordinary personal income tax rate. (c) Losses: The realised and unrealised losses are made deductible by offsetting them against any other investment gains. (d) Commissions: Brokerage commissions are tax deductible. {2}. Execution of Futures Trade For a client who wants to assume a long position in, say, a July British pound futures contract, the following steps are undertaken: 1. Phone call to the agent. 2. The agent trades through an exchange member who may be a commission broker or a local. 3. The actual trading is conducted in a past for the particular futures contract involved. Trades are conducted through the use of sophisticated hand signals. 4. The commission broker confirms the trade with the agent who then notifies the client of the completed transaction and price. 5. The client then deposits the initial margin with a member firm of the clearing house. 6. The commission broker can transact in the pit with another commission broker representing another client or with a local.

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Question No.6

 Briefly explain the difference between functional currency and reporting currency.

Identify the factors that help in selecting an appropriate functional currency that can be used by an organization. Answer: -Functional Versus Reporting Currency Financial Accounting Standards Board Statement 52 (FASB 52) was issued in December 1981, and all US MNCs were required to adopt the statement for fiscal years beginning on or after December 15, 1982. According to FASB 52, firms must use the current rate method to translate foreign currency denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items were recognized or at an appropriate weighted average exchange rate for the period. The other important part about FASB 52 is that it requires translation gains and losses to be accumulated and shown in a separate equity account on the parents balance sheet. This account is known as the cumulative translation adjustment account. ASB 52 differentiates between a foreign affiliates functional and reporting currency. Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. Generally, this is the local currency of the country in which the entity conducts most of its business. Under certain circumstances the functional currency may be the parent firms home country currency or some third country currency. The reporting currency is the currency in which the parent firm prepares its own financial statements. This currency is normally the home country currency, i.e., the currency of the country in which the parent is located and conducts most of its business. The nature and purpose of its foreign operations must be determined by the management to decide on the appropriate functional currency. Some of the economic factors that help in selecting the appropriate functional currency are listed in Table 1. Table 1: Factors indicating the Appropriate Functional Currency

In general, if the foreign affiliates operations are relatively self-contained and integrated with a particular country, its functional currency will be the local currency of that country. Thus, for example, the German affiliates of Ford and General Motors, which do most of their manufacturing in Germany and sell most of their output for Deutschmarks, use the Deutschmark as their functional currency. If the foreign affiliates operations were an extension of the US parents operations, the functional currency could be the US dollar. If the foreign affiliates functional currency is deemed to be the parents currency, translation of the affiliates statements employs the temporal method of FAS # 8. Thus, many US multinationals continue to use the temporal method for those foreign affiliates that use the dollar as their functional currency, while using the current rate method for their other affiliates. Under FAS # 52, if the temporal method is used, translation gains or losses flow through the income statement as they did under FAS # 8; they are not charged to the CTA account.

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