Q: 1: What is international currencies moving in and currency will

monetary system? Discuss out of various types of adjust to reflect

the alternatives exchange
pegged exchange rate changes in the
rate System. International
I monetary system: relationship. price levels of
International monetary Q: 2: What is the various the two
system refers primarily to currency control countries. For
the set of policies, mechanism. example, if
institutions, practices, The various currency inflation is 5%
regulations and mechanisms control mechanism are as in the United
that determine the rate at follows: States and 1 %
which one currency is 1. Restriction or in Japan, than
exchanged for another. prohibition of certain Q: 3: Discuss the brief history of IMF the dollar value
Alternatives exchange rate remittance categories IMF (International monetary fund) of Japanese yen
system:The alternatives such as dividends or The United Nations monetary and financial must rise by 4
exchange rate systems are: royalties conference held in Briton Woods, New Hampshire, in % to equalize
1. Free float 2. Ceiling on July 1977, was called to develop a structuredthe dollar price
2. Manages float direct foreign international monetary system. As a result of this of goods in the
3. Target – Zone inve3stment outflows conference, the international monetary fund (IMF) two countries.
arrangement 3. Control on was formed. The major objectives of the IMF, as set Formally if in
4. Fixed – rate overseas portfolio by its charter, are to: and if are the
systems investment a) promote cooperation among countries onperiodic price-
5. Hybrid system 4. Import international monetary issues level change
Free float:In a free float restrictions b) promote stability in exchange rates increases (rates
system of exchange rate, the 5. Required c) provide temporary funds to memberof inflation) for
currency exchange rate is surrender of hard countries attempting to correct imbalances ofthe home
determined by the currency export receipts international payments country and the
interaction of currency to central bank d) promote free mobility of capital fundsforeign
demand and supply. The 6. Limitations on across countries country,
supply and demand prepayments for imports e) Promote free trade. respectively,
schedules, in turn, are 7. Requirements It is clear from these objectives that the IBM’s goals eO is the dollar
influenced by price level to deposit in interest free encourage increased internationalization of business. (HC) value of
exchange, interest rate accounts with central Before 1973, when exchange rates were maintainedone unit of
differentials, and economic bank, for a specific within tight boundaries, the IMF concentrated onforeign
growth. In a free float period, some percentage removing currency exchange restrictions and ensuring currency at the
exchange rate system, as the of the value of imports or currency convertibility, with the goal of encouraging beginning of
economic parameters remittances. international trade. With the inception of floating the period; and
change, the market 8. Foreign exchange rates in 1973 and the onset of the 1974-et is the spot
participants adjust their borrowings restricted to a 1975 recessions, the IMF offered financingexchange rate
current and expected future minimum or maximum arrangements to countries experiencing large balance at period t, then
currency needs. maturity of trade deficits. The value of et
Managed float: 9. Ceilings on During the international debt crisis that erupted in appearing in
Managed float refers to the granting or credit to august 1982, the IMF provided financing to many ofEquation 4.3 is
exchange rate system where foreign firms the countries experiencing debt repayment difficulties. known as the
the floating currencies, 10. Imposition of The IMF worked with each country individually to PPP rate. For
through central bank taxes and limitations on develop and implement policies that would improve example, if the
intervention, are managed to foreign owned deposits its balance of trade positions. United -States
smooth out the exchange 11. Multiple and
rate fluctuations, Such exchange rates for Switzerland are
system of managed buying and selling of running annual
exchange rate is also known currencies depending on inflation rates
as the dirty float. The entity category of goods or of 5% and 3%
of managed float are; services each transaction respectively,
A) S falls into. and the spot
moothing out daily rate is SFr 1 =
fluctuations $0.75, then
B) Le according to
aning against the wind Equation 4.3.
C) Un the PPP rate for
official pegging the Swiss Franc
Target Zone in three should
Arrangement: be The one year
Under a target zone version of the
arrangement, countries PPP is
adjust their national commonly
economic policies to used. It is
maintain their exchange The
rates within a specific purchasing
margin around agreed upon, power parity is
fixed exchange rates. Such a often
system existed for major represented by
European currencies following
participating in the approximation
European monetary System Q: 4: What is arbitrage? PPP, IRP, IFE theory. of Equation
and was the precursor to the Arbitrage: Arbitrage is ordinarily defined as the4.4:The
euro.Fixed rate System: simultaneous purchase and sale of the same assets orexchange rate
Under a fixed rate system commodities on different markets to profit from price change during a
governments are committed differentials. The concepts of arbitrage is of particularperiod should
to maintain target exchanges importance in international finance because so many equal the
rates. Each central bank of the relationships between domestic andinflation
actively buys or sells its international financial markets, exchange rates,differential for
currency in the foreign interest, rates, and inflation rates depend on arbitragethe same time
exchange market whenever for their existence period. In
its exchange rate threatens Purchasing power parity theory- Explain.(PPP) effect, PPP says
to deviate from its stated par Purchasing Power Parity: In absolute version, PPPthat currencies
value by more than the states that price levels should be equal worldwide with high rates
agreed on percentage. when expressed in a common currency. In other of inflation
Current Hybrid System: words, a unit of home currency should have the equal should devalue
The current international purchasing power around the world. This theory is relative to
monetary system is a hybrid, just and application of one price law to national price currencies with
with major currencies levels rather than to individual prices. lower rates of
floating on a managed basis; The relative version of PPP: The relative version ofinflation. *4
some currencies are freely PPP is used more commonly. It states that exchange
floating, and other rate between the home currency and any foreign

*4 The Lesson of
Purchasing Power Parity:
The PPP bears an important
message: just as the price of
goods in one year cannot be
meaningfully compared with
the price of goods in another
year without adjusting for
interim inflation, so
exchange rate change
indicates the reality of
inflation rates differentials.
Real exchange rate, not the
nominal exchange rate,
should be the focus of the
real competitiveness
analysis.
If the changes in the
nominal exchange rate are
fully offset by the changes
in the relative price levels
between two countries, then
the real exchange rate
remains unchanged.
Specifically, if PPP holds,
then we can substitute the
value of e1 from equation
4.2 into equation 4.6.
Making this substitution
yields elO = eO.
Alternatively a change in the
real exchange rate is
equivalent to the deviation
from PPP.
Interest rate parity
theory? (IRP)
Interest Rate Parity (IRP):
Once market forces cause
interest rates and exchange
rates to adjust such that
covered interest arbitrage is
no longer feasible, there is
an equilibrium state referred
to as interest rate parity
theory (IRP). In equilibrium,
the forward rate differs from
the spot rate by a sufficient
amount to offset the interest
rate differential between two
currencies.
According to IRP theory,
the currency of the country
with lower interest rate
should be at a forward
premium in terms of the
currency of the country with
the higher rate. More
specifically, in an efficient
market with no transaction
costs, the interest rate
differential should be
(approximately) equal to the
forward differential. When
this condition is met, the
forward rate is said to be at
interest rate is parity, an
equilibrium prevails in the
money markets.
It can be expressed in the
following equality:
Where,
P = forward premium or
discount
F = forward rate
S = spot rate
ih = home interest rate
if = foreign interest rate.
If the forward premium is
equal to the interest rate
differential, covered interest
arbitrage is not feasible.
Exception to the IRP: The
covered interest arbitrage
will not hold under the
following circumstances:
Transaction costs: if an
investor wishes to account
for transaction costs, the
actual point reflecting the
interest rate differential and
forward rate premium must
be farther from the IRP line
to make covered interest
arbitrage worthwhile.
Political Risk: Even if
covered interest arbitrage
appears feasible after
accounting for transaction
cost, investing funds
overseas is subject to
political risk. A crisis in
foreign currency could
cause its government to
restrict any exchange of the
local currency for other
currencies. In this case,
investors would be unable to
use these funds until the
foreign government
eliminated the restriction.
Differential Tax Law:
Because tax laws vary
among countries, investors
and firms that set up
deposits in other countries
must be aware of the
existing tax laws. Covered
interest arbitrage might be
feasible when considering
before-tax returns but not
necessarily when
considering after-tax
returns. International
Fisher Effect?(IFE)
International Fisher
Effect: The International
Fisher Effect states the
relationship between the
interest rates and expected
exchange rates between two
countries. It is the
combination of PPP and
Fisher Effect. The following
equation shows this
relationship:
Where et is the expected
exchange rate in period t.
the single-period analogue
to the Equation 4.14 IS:
Forward Premium or
Discount =Forward rate -
spot rate x 360
---------------- x--------------
Spot rate Forward number of
days
According to Equation
4.15, the expected return
from investing at home, 1
+rh, should equal the
expected HC return from
investing abroad,
(1+rf)e1/eO.
If it is relatively small,
Equation 4.16 provides a
reasonable approximation to
international.
Q: 12: Option pricing
method.Currency option
pricing method:
Currency option pricing is
based on the following
formula:
Ct = as (t) B * (t,T) + bB
(t,T) Where,
C (t) = call option premium
at time t for an option that
expires at t + T.
T = Time to expiration of
the option expressed in
fractions of a year.
a = Amount of foreign
currency.S (t) = Spot value
of foreign currency at times
t.B* (t,T) = Price of a pure
discount foreign bond that
pays one unit of foreign
currency at t + T.
b = Amount of the domestic
currency.
B (t,T) = Price of a pure discount domestic that pays3. Co
one unit of domestic currency at t + T. mmercial
t = Time to exercise customers
Q: 5: What is balance of payment; explain its primarily
various components. Multination
Balance of payments: al
The balance of payments is an accounting statement Corporation.
that summarizes all the economic transactions 4. Go
between residents of the home country and residents vernment,
of all other countries. In other words it is the summary mainly the
of transactions between domestic and foreign central
residents for specific country over a specified period Bank.
of time. It represents an accounting of a country’s In addition to
international transactions for a period, usually a this some
quarter or a year. It accounts for transactions byspecific
businesses, individuals, and government. participant in
Currency inflows are recorded as credits, andforward
outflows are recorded as debits. Credits show up with markets are:
a plus sign, and debits have a minus sign. Balance of a) arb
payments generally follows the double entry itragers
accounting procedures. b) Tr
Components of balance of payments: aders
The various component of balance of payments are as c) He
follows: dgers
1. Current Account d) Sp
2. Capital Account eculator
3. Official Reserves Account
Current Account: Q: 13: What
The balance of current account reflects the net flow of are the various
goods, services, income, and unilateral transfers, it payment terms
includes in
a) exports and imports of merchandiseinternational
(trade balance), trade?
b) service transactions (invisibles), and The various
c) income transfers payment terms
d) unilateral transfer in international
Unilateral transfer: trade are as
It includes pensions, remittances and other transfers follows:
overseas for which no specific services are rendered. 1. Cash in
Capital Account: advance
The capital account represe3ntrs a summary of flow2. Letter of
of funds resulting from the sale of assets between one credit (L/C)
specific country and all other countries over a specific 3. Draft / bill of
period of tike. The major components of the capital exchange
account are: 4. Consignment
A) Portfolio investments 5. Open
B) Direct investments account
Portfolio investments: Q:15:
The purchases of financial assets with a maturity Discussing the
greater than one year, short term investments involve major
securities with a maturity of less than one year. techniques of
Direct investments: financing in
Direct investments represent investments in fixed International
assets in foreign countries that can be used to conductTrade?
business operations. Examples of direct foreign Techniques of
investment include a firm’s acquisition of a foreign financing
company, as construction of a new manufacturingInternational
plant, or its expansion of an existing plant in a foreign Trade:
country. 1. Ba
Official Reserve Account: nkers
It measures changes in holdings of gold and foreign acceptance
currencies – reserve asses – by official monetary (BA)
institutions. The changes in official reserves measure2. Fa
a nation’s surplus or deficit on its current and capital ctoring
account transactions by netting reserve liabilities from3. Di
reserve assets For example, a surplus will lead to an scounting
increase in official holdings of foreign currencies or4. Forfeiting
gold or both, a deficit will normally cause a reduction
in these assets.
Because double entry bookkeeping ensures that debits
equal credits, the sum of all transudation is zero. That
is the sum of the balance on the current account, the
capital account, and he official reserves account must
equal zero.
Current account balance + capital account balance +
official reserve account = Balance of payment = 0.
Q.8: What is foreign exchange market? Who are
the major participants in foreign exchange
market?
A foreign exchange market is a branch of
international financial market; it facilitates the
exchange of currencies resulting from international
trade and financial transaction. On the other hand
foreign exchange market is the mechanism that
facilitates the cross border transaction of two
currencies, International foreign exchange market
exist for international flow of goods, services and
capital.
The major participant of foreign exchange markets
are:-
1. Large commercial Bank
2. Foreign exchange brokers
 at the expiration date. There currency per US per one
are other forms of currency dollar) foreign
options are:- currency)
8. Costs of forward Futures
a) American option Transact contracts are contract
b) European option ion cost. based on bid -ask entails
American option: spread. brokerage
American option can be fees for buy
exercised at any time up to and sell
the expiration date. It is orders.
maximum 180 days. 9.Margi Margins are not Margins are
n required in the required of all
European option: forward market. participants in
European option can be he futures
exercised at only maturity market.
date. 10. The credit risk is The
There are three forms of Creddit borne by each exchanges
option based on exercise risk. party to a forward clearing
contract. Credit house
rate. limits must becomes the
a) In the money therefore be set opposite side
option for each to each
b) Out of the customer. futures
money contract,
c) At the money. thereby
reducing
In the money option: credit risk
In the money option is the substantially.
option for exercising at
below the current exchange
rate.
Out of the money:
When option is exercise
above the spot rate.
At the money:
When option is exercise
exactly at the spot rate.

Q: 9: Discussed the
various transaction types
in foreign exchange Q: 11: Currency options. Q: 10: What is the basic difference between forward and
market. What are the various types future contract.
The basic difference between forward and future contact are
The various transaction of currency option?
Title Forward contact Future
types in foreign exchange contract
market are:- Currency Option: 1.Tradin Forward Futures
1. Spot market A currency option is a form g contracts are contracts are
2. Forward transaction of foreign exchange traded by traded in a
3. Future contract derivative transaction in Telephone or competitive
4. Currency option. which the holder enjoys a telex. arena.
Spot market: right to sale or buy a
2. The forward The IMM is
Spot market is the exchange financial instrument at a set Regulati market is self regulated by
of foreign currency price. Currency options in on regulating. the
according to the prevailing foreign exchange market commodity
market exchange rate. gives the option holders a futures
Forward transaction: right but no obligation to trading
Forward transaction buy or sale a foreign commission.
3.Freque More than 90% By contracts
specifies the amount of a currency at a strike or ncy of of all forward less than 1%
particular currency which exercise price. delivery contracts are of the IMM
will be bought or sold at a Types of Currency settled by actual futures
specified future point in Option: delivery. contracts are
time and at a specify There are two types of settled by
exchange rate. currency options: delivery.
4. Size Forward Future
Future contract: 1. Call Option (Buy): A
of contracts are contracts are
Future contract specifies a call option gives the contract individually standardized
standard volume of customer the right6 to tailored and tend in terms of
particular currency to be purchase a contracted to be much larger currency
exchange on a specified currency at the expiration than the amount.
settlement date. (It is date. standardized
contracts on the
purchased on a lot) 2. Put Option (Sale): A put
futures market.
Currency option: option gives the option 5. Banks offer IMM futures
Currency option is a form of holder the right to sale a Delivery forward contracts contracts are
foreign exchange derivative contracted currencies at the date for delivery on available for
transaction in which the expiration date. There are any date. delivery on
holder enjoys a right to sell other forms of currency only a few
or buy a financial instrument option- specified
dates a year.
at a set price, currency a) American Option: The
6.Settle Forward contract Futures
option in a foreign exchange American option can be ment settlement occurs contracts
market gives the option exercised at any time up to on the date settlements
holder a right but no the expiration dates. (180 agreed on are made
obligation to buy or sell a days) between the bank daily via the
foreign currency at a strike b) European Option: The and the customer. exchanges
clearing
or exercise price. There are European option can be
house, gains
two types of currency opton. exercised at only maturity on position
a) currency call dates. values may be
option – means buy withdrawn
b) currency put There are other three and losses are
option – means sell types of options based on collected
daily. This
Call option: exercised rate:
practice is
A call option gives the a) In the Money Option known as
customers the right to b) Out of the Money Option marking to
purchases a contracted c) At the Money Option marking.
currency at the expiration 7.Quotes Forward prices Futures
date. generally are contracts are
Put option: quoted in quoted in
European terms American
A put option gives the right (units of local terms (dollars
to sell a contracted currency