DEPARTMENT OF ACCOUNTING AND FINANCE

COURSE CODE: BFM 414 COURSE TITLE: INTERNATIONAL FINANCE

MANUAL COMPILED BY: Mr. MBURU PETER Cell phone No.: 0723135375 Email address: mbgipe@yahoo.com

COURSE DESCRIPTION BFM 414: INTERNATIONAL FINANCE Contact hours: 42 Purpose: To provide learners with the requisite knowledge in international finance. Expected learning outcomes of the course By the end of the course unit the learners should be able to: Describe foreign exchange markets and derivatives Discuss the management of economic exposures Describe international money and capital markets Course content Introduction; significance of international finance, international financial environment, reasons why study international finance, foreign exchange markets and foreign exchange rates; functions of foreign exchange market, participants of the foreign markets, factors affecting exchange rates, foreign exchange rate regime/system, currency derivatives, balance of payments (BOPs); BOPs accounting and accounts, Sub-accounts in the BOPs, BOPs disequilibrium, correction of disequilibrium, financing of BOP deficit, international parity conditions; purchasing power parity, arbitrage profit, arbitrage profit, exchange rate equilibrium, interest rate parity, covered interest arbitrage, foreign exchange exposure ; transaction exposure, operation exposure and accounting exposure, exposure management, international investment and international financial institutions; foreign private investment, international monetary fund (IMF), World Bank, Structural Adjustment Programmes (SAPs); conditions for SAPs, criticisms of SAPs, international money and capital markets; international banking, Eurocurrency and Eurobond markets. Teaching / learning Methodologies: lectures and tutorials; group discussion; demonstration; individual assignment; case studies. Instructional materials and equipment: projector; test books; design catalogues; computer laboratory; design software; simulators Course Assessment Examination -70%

Continuous Assessment Test (CAT) -20% Assignments Total -10% 100%

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Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008), International finance, Oxford University Press

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CONTENTS
COURSE DESCRIPTION ............................................................................................................................ ii Reference.................................................................................................................................................. iii CHAPTER ONE:-INTRODUCTION TO INTERNATIONAL FINANCE ................................................. 8 1.0 Definition of international finance ...................................................................................................... 8 1.1 Significance of international finance .................................................................................................. 8 1.2 International financial environment .................................................................................................... 9 1.2.1 Reasons for studying international finance ................................................................................ 10 1.3 Chapter review questions .................................................................................................................. 12 Reference................................................................................................................................................. 12 CHPATER TWO: FOREIGN EXCHANGE MARKET ............................................................................ 13 2.0 Definition of foreign exchange market ............................................................................................. 13 2.0.1 Functions of foreign exchange market ....................................................................................... 13 2.0.2 Characteristics and participants of the foreign exchange market ............................................... 14 2.1 Determinants of demand and supply of foreign currency ................................................................. 15 2.2 Foreign exchange rate ....................................................................................................................... 16 2.2.1 Factors affecting exchange rates ................................................................................................ 17 2.2.2 Spot Exchange and Forward Exchange...................................................................................... 19 2.2.3 Nominal Exchange Rate, Real Exchange Rate and Effective Exchange Rate ........................... 22 2.3 Foreign exchange regime/systems .................................................................................................... 24 2.3.1 Fixed (stable) exchange rates ..................................................................................................... 24 2.3.2 Flexible (floating) Exchange Rate ............................................................................................. 26 2.4 Currency Derivatives (Futures, options and swaps) ......................................................................... 27 2.4.1 Reasons for rapid growth of futures and options markets .............................................................. 27 2.4.2 Currency futures and currency forwards ........................................................................................ 28 2.4.3 Currency options ........................................................................................................................ 29 2.4.4 The swaps market....................................................................................................................... 30 2.4 Chapter review questions .................................................................................................................. 31 Reference ................................................................................................................................................ 32 CHAPTER THREE: BALANCE OF PAYMENTS ................................................................................... 33 3.6 Financing of BOP deficit .................................................................................................................. 46 3.7 Chapter review questions .................................................................................................................. 46 iv

Reference ................................................................................................................................................ 46 CHAPTER FOUR: THE INTERNATIONAL PARITY CONDITIONS ................................................... 48 4.0 The law of one price (Purchasing Power Parity i.e. PPP) ................................................................. 48 4.1 Arbitrage profit ................................................................................................................................. 48 4.2 Transaction costs and the No- Arbitrage Conditions ........................................................................ 49 4.3 Exchange Rate Equilibrium .............................................................................................................. 50 4.3.1 Bilateral Exchange Rate and equilibrium and Locational Arbitrage ......................................... 51 4.3.2 Interest Rate Parity and Covered Interest Arbitrage .................................................................. 52 4.3.3 Covered Interest Arbitrage ......................................................................................................... 53 4.4 Chapter review questions ................................................................................................................. 54 Reference ................................................................................................................................................ 55 CHAPTER FIVE: FOREIGN EXCHANGE RISKS/EXPOSURES .......................................................... 56 5.0 Introduction ....................................................................................................................................... 56 5.1 Economic exposure ........................................................................................................................... 56 5.1.1 Transaction exposure ................................................................................................................. 57 5.1.2 Operating exposure .................................................................................................................... 57 5.2 Accounting exposure (transaction exposure) .................................................................................... 58 5.3 Strategies for managing exchange rate exposure/ risks ................................................................... 58 5.3 Chapter review questions .................................................................................................................. 60 Reference ................................................................................................................................................ 61 CHAPTER SIX: INTERNATIONAL INVESTMENT AND INTERNATIONAL FINANCIAL INSTITUTION ........................................................................................................................................... 62 6.0 Introduction ....................................................................................................................................... 62 6.1 Types of foreign private investment ................................................................................................. 62 6.1.1 Foreign direct investment (FDI) ................................................................................................ 63 6.1.2 Foreign Portfolio Investment (FPI) ............................................................................................ 63 6.2 Significance of foreign investment ................................................................................................... 64 6.3 Reasons for foreign investment......................................................................................................... 64 6.4 INTERNATIONAL FINANCIAL INSTITUTIONS ....................................................................... 65 6.4.1 International Monetary Fund (IMF) ........................................................................................... 65 6.4.2 World Bank ................................................................................................................................ 67 6.5 Chapter review questions .................................................................................................................. 69 v

Reference ................................................................................................................................................ 69 CHAPTER SEVEN: STRUCTURAL ANJUSTMENT PROGRAMMES (SAPs).................................... 70 7.0 Introduction ...................................................................................................................................... 70 7.1 What was structural adjustment programmes (SAPs) designed to do?............................................. 70 7.3 CONDITIONS FOR STRUCTURAL ADJUSTMENT PROGRAMMES (what measures are imposed under SAPs?) ............................................................................................................................ 71 7.4 Why the need for SAPs? ................................................................................................................... 72 7.6 Chapter review questions .................................................................................................................. 75 Reference ................................................................................................................................................ 75 CHAPTER EIGHT: INTERNATIONAL MONEY AND CAPITAL MARKET .................................. 76 8.1 International banking ........................................................................................................................ 76 8.1.1 International banks assist multinational enterprises in the following ways: .............................. 77 8.1.2 Types of international banking offices ........................................................................................... 77 8.2 Eurocurrency and Eurobond market ................................................................................................. 78 8.2.1 International capital market ........................................................................................................... 78 8.2.2 Factors to consider when choosing between Euromarkets or Domestic Markets .......................... 79 8.2.3 Participants in the Eurocurrency and Eurobond markets ........................................................... 79 8.3 Chapter review questions ................................................................................................................. 80 Reference ................................................................................................................................................ 81 SAMPLE OF UNIT REVIEW QUESTIONS ............................................................................................ 82

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CHAPTER ONE:-INTRODUCTION TO INTERNATIONAL FINANCE Objectives At the end of this chapter, the student should be able to: i. ii. iii. Define international finance and explain its significance Explain international financial environment Explain reasons for studying international finance

1.0 Definition of international finance International finance activities help organizations to engage in cross-border transactions with foreign business partners, such as customers, suppliers and lenders. Government agencies and Non-profit institutions also use international finance tools to meet operating needs. International finance is branch of economics that studies the dynamics of exchanges rates, foreign investment and how these affect international trade. International finance covers all procedures, techniques and tools that financial institutions, such as banks and insurance companies provide to clients. These tools may include financing agreements and transaction strategies on securities exchange. In other words international finance is the study of the institutions, policies, and practices that govern global financial management and/or financial aspects of global business. 1.1 Significance of international finance International finance plays a significance role in modern economies. Business transactions are not only interconnected more than ever before, but must companies engage in multinational activities through exports or import. Some of the benefits of international finance are: Access to capital markets across the world enables a country to borrow during tough times and lend during good times. It promotes domestic investment and growth through capital import. Worldwide cash flows can exert a corrective force against bad government policies. It prevents excessive domestic regulation through global financial institutions.
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International finance leads to healthy competition and, hence, a more effective banking system. It provides information on the vital areas of investments and leads to effective capital allocation.

International finance promotes the integration of economies and facilitating easy flow of capital. The free transfer of funds would eventually result in more equality among countries that are a part of the global financial system.

1.2 International financial environment The economies of the world have become increasingly interdependent trading economies. The financial services industry supports these activities by providing the means to transfer payment for goods and services purchased internationally and by acting as an intermediary between those nations with excess funds and those in need of funds. As the economies of individual nations become intertwined, the role of the financial services industry becomes more important to the world economy. Changes are taking place in the structure of financial markets as well as the structure of the industry and its participants. Communication and information technology have helped to make markets that were once local or regional in character, global. Funds travel across national boundaries with such ease that disequilibrium is offset. Globalization which is the increasing economic integration of goods, services, and financial markets, presents opportunities and challenges for governments, business firms, and individuals. Although businesses operating in countries across the globe have existed for centuries, the world has recently entered an era of unprecedented /extraordinary world-wide production and distribution.

1.2.1 Reasons for studying international finance 1. To understand a global economy Three recent changes have had a profound effect on the international finance environment. These are the end of the Cold War, The emergence of growing markets among the developing countries East Asia and Latin America, and the increasing globalization of the international economy. Understanding these changes should help one to see where the international economy is headed in the future so that you can effectively respond to these challenges, fulfill your responsibilities, and take advantage of those opportunities. (a) The end of the Cold War. In 1989 the Soviet Union relaxed its control over the Eastern Europe countries that had suffered its Domination for over 40 years. These countries immediately seized the opportunity to throw off authoritarian communist rule. Two years later the Soviet Union itself underwent a political and ideological upheaval/ disorder, which quickly led to its breaking into independent states. Most of these and other formally centrally planned economies are now engaged in a process of transition from central planning and state ownership to market forces and private ownership to market forces and private ownership. (b) Industrialization and Growth of the Developing World. The 2nd great change of recent years has been the rapid industrialization and economic growth of countries in several parts of the world. The first of these emerging markets were the four Asian tigers i.e. Hong Kong, Singapore, South Korea, and Taiwan. China and other Asian countries have followed in their footsteps. Having overcomed the debt crisis of the 1980, and undertaken economic and political reforms, some of the Latin Americans countries like Argentina, Brazil, Chile, and Venezuela have also began to experience faster and more sustained growth. (c) Increased globalization
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The 3rd major change in the international financial environment is even more sweeping than the first two. National economies are become more integrated. Technological barriers have fallen as transportation and communication costs have dropped. Government made barriers have also fallen as tariffs and non-tariffs barriers have been reduced in a series of multilateral negotiations and trading blocs since the Second World War. These falling technological and government-made barriers have caused trade and foreign direct investment to increase several times faster than world output since 1985. 2. To understand the effects of global finance on business There are many examples of the growing importance of international operations for individual companies. Companies like coca cola earn more than half of their total operating profits through international operations. Also companies like General motors, Sony, do business in more than 150 countries around the world. Philips electronics, Ford and IBM have more workers overseas than in their home countries. By the same token, global finance has also become increasingly important as it serves world trade and foreign investment. Simply stated, each nation is economically related to other nations through a complex network of international trade, foreign investment, and international loans. Companies have advantage in moving their operations forward if they understand the basic elements of international finance. Apart from career interests, persons who want to improve their knowledge of the world would be seriously handicapped if they do not understand the economic dynamics and policy issues of finance, and investment flows among nations. 3. To make intelligent personal decisions For example, when looking for a job, you may have the advantage of comparing two job offers, one from a company in home country and another from a company in foreign country. When deciding to buy a car, your choice between the latest modes offered by various companies (general motors $ volks wagen) may well depends on the exchange rate between the home currency and foreign currencies of those country where the car is coming from.

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All these decisions require significant knowledge of international finance to make intelligent decisions in all these cases, the important point is that you will participate not just in the domestic economy but in economies around the world. 1.3 Chapter review questions I. Define the term international finance II. III. IV. Explain significance of international finance Discuss international financial environment Clearly, discuss reasons for studying international finance.

Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008), International finance, Oxford University Press

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CHPATER TWO: FOREIGN EXCHANGE MARKET Objectives of the chapter At the end of this chapter, the student should be able to: Explain the meaning of the following terms; foreign market, foreign exchange rate, spot exchange rate, forward exchange rate, nominal exchange rate, real exchange rate, effective exchange rate, currency futures, currency swaps, currency options. Explain functions of foreign exchange market. Discuss characteristics and participants of foreign exchange market. Discuss determinants of demand and supply of foreign currency Explain factors affecting exchange rates Discuss forward exchange market and spot exchange rate. Discuss various foreign exchange regime/systems Discuss Currency derivatives, that is, futures, options and swaps. 2.0 Definition of foreign exchange market There are different interpretations of the term foreign exchange, of which the following two are most important and common:1. Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another. 2. The term foreign exchange is used to refer to foreign currencies. That is, foreign exchange is the foreign currency and includes all deposits, credits and balance payable in any foreign currency and any drafts, travelers deposits, letters of credits and bill of exchange, expressed or drawn in domestic currency, but payable in any foreign currency. 2.0.1 Functions of foreign exchange market The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought and sold against one another. A foreign exchange market performs three important functions:-

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i.

Transferring of purchasing power The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital market. Provision of credit International trade depends to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also for exporters. The Euro-dollar Market has emerged as a major international credit market. Provision of hedging facilities Foreign exchange market provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to protect themselves against losses from fluctuation in exchange rates.

ii.

iii.

2.0.2 Characteristics and participants of the foreign exchange market The foreign exchange market is a worldwide market and is made up primarily of commercial banks, foreign exchange brokers and other authorized agents trading in most of the currencies of the world. These groups are kept in close and continuous contact with one another and with developments in the market through telephone, computer terminals, telex and fax. The most heavily traded currency is the US dollar which is known as a vehicle currency because it is widely used to denominate international transactions. Oil and many other important primary products such as tin, coffee and gold all tend to be priced in dollars. The main participants in the foreign exchange market can be categorized as follows:i. Retails clients These are made up of business, international investors, multinational corporations and the like who need foreign exchange for the purposes of operating their business. Normally, they do not directly purchase or sell foreign currencies themselves; rather they operate by placing buy or sell orders with commercial banks. ii. Commercial banks the commercial banks carry out buy/sell orders from their retail clients and buy/sell currencies on their own account (known as proprietary trading) so as to alter the structure of their assets and liabilities in different currencies. The banks
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deal either directly with other banks or through foreign exchange brokers. In addition to the commercial banks other financial institutions such as merchant banks are engaged in buying and selling of currencies both for proprietary purposes and on behalf of their customers in finance-related transactions iii. Foreign exchange brokers Often banks do not trade directly with one another, rather they offer to buy and sell currencies through such brokers. Operating through such brokers is advantageous because they collect buy and sell quotations for most currencies from many banks, so that the most favorable quotation is obtained quickly and at very low cost. One disadvantageous of dealing through a broker is that a small brokerage fee is payable which is not incurred in a straight bank-to-bank deal. iv. Central Banks central banks frequently intervene to buy and sell their currencies in a bid to influence the rate at which their currency is traded. Under a fixed exchangerate system the authorities are obliged to purchase their currencies when there is excess supply and sell the currency when there is excess demand. 2.1 Determinants of demand and supply of foreign currency The demand for foreign currency is fixed by the supply and demand curve (just like any other commodity in an open market). The demand for foreign currency arises from the traders who have to make up payments for imported goods i.e. demand for a currency in the foreign exchange market is a derived demand. The supply arises from those who have exported goods and services abroad. This depends largely on how much foreigners are willing to buy goods and services from a particular country. Foreign exchange are demanded i. to buy things denominated in it (goods, services, or assets) ii. to hold interest-bearing accounts in that currency iii. greater quantity demanded at lower price/exchange rate Non-price Determinants of Demand. i. increased (decreased) demand for foreign goods and services increased (decreased) domestic income lower (higher) relative price levels for goods and services denominated in currency
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ii. Increased (decreased) relative return on assets denominated in foreign currency Supply of foreign exchange: wanting to sell a currency i. greater quantity supplied at higher price/exchange rate People wanting to sell more (less) of a currency at any given exchange rate is an increase (decrease) in supply i. change in foreign income ii. change in relative price levels iii. change in relative rate of return on domestic assets

2.2 Foreign exchange rate Exchange rate: - this is simply the price of one currency in terms of another. There are two methods of expressing exchange rate: Domestic exchange units per unit of the foreign currency. For example, taking the Kenya shilling as the domestic currency, we can have approximately Kshs. 85.6 required to purchase one US dollar (Kshs. 85.6/$1) Foreign units per unit of domestic currency. Again taking Kenya Shillings as a domestic currency, we can have approximately $0.01162/Kshs.1 required to obtain one doller. Note i. ii. The second method is a reciprocal of the first method It is necessary to be careful when talking about a rise or a fall in the exchange rate because the meaning will be very different depending upon which expression used. A rise in the Kshs per dollar exchange rate from say Kshs. 85.6/$1 to Kshs. 90.0/$1 means that more Kshs have to be give to obtain a dollar. This means that the Kshs has depreciated in value or equivalently the dollar has appreciated in value. If the second definition is employed, a rise in the exchange rate from $0.01162/Kshs.1 to $0. 01262/Kshs.1 would mean that more dollars are obtained per Kshs, so that the Kshs has appreciated or equivalently the dollar has depreciated.

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2.2.1 Factors affecting exchange rates a) Export/Imports If a country exports more goods, the importing country will have a higher demand for the currency of the exporting country so as to meet its obligation. The value of the currency of the exporting country will therefore appreciate. The opposite is the case if a country imports more goods than exports. b) Political Stability

Unsuitable political climate will make the citizens lose confidence in their currency. They would therefore wish to invest or just buy the currency of the other countries they deem to be stable. In so doing, the demand for currency of more political stable countries will appreciate as compared to those of politically unstable countries.

c)

Inflation rate differential (purchasing power parity theorem)

Parity between the purchasing powers of two currencies establishes the rate of exchange between the two currencies. When inflation rate differential between two countries changes, the

exchange rate also adjusts to correspond to the relative purchasing powers of the currencies.

The purchasing power theorem states that the: I (h) I (f) x 100 I (f) + 1

% E(f) =

Where:% E (f) = the percentage change in the direct quote I (h) = the inflation rate in the home market I (f) = the inflation rate in the foreign market. Illustration Assume that the direct quote between the $ and is 1 = $ 1.5 and that the inflation rate in UK is 10% and the inflation rate in the US is 6% Required
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Compute the % change in the direct quote and determine the new exchange rate. % E (f) = 0.06 0.1 x 100 = -3.64% 0.1+ 1 The New Direct Quote 1 = 1.5*(1 3.64%) 1 = $1.4454

d)

Interest Rate Parity (International Fisher Effect)

This theory states that differences in interest rate in different market can cause a flow of funds from markets with low interest rate to markets with high interest rates. The international fisher effect can be explained as follows: %E (f) = I (h) I (f) x 100 1+ I (f) % E (f) = is the % change in direct quote. I (h) = is the interest rate in the home market. I (f) = is the interest rate in the foreign market. Illustration Assume that the direct quote is deuchemark is DM 1 - $ 0.5 while the general interest rate in US is 6% and general interest rate in Germany is 3%. Required: Compute the percentage change in direct quote and the new exchange rate.

Solution %E (f) = 0.06 0.03 x 100 = 2.9126% 1 + 0.03

New Direct Quote DM 1 = $0.5* ( 1 2.9126%)

= $0.4854
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e)

Balance of Payment

The term balance of payment refers to a system of government accounts that catalogues the flow of economic transactions between the residents of one country and the residents of other countries. It is therefore the fund flow statement. Continuous deficit in the balance of payments is expected to depress the value of a currency because such deficit would increase the supply of that currency relative to its demand.

e)

Government Policies

A national government may through its Central Bank intervene in the foreign exchange market, buying and selling its currency as it sees fit to support its currency relative to others. In order to promote cheap export, a country may maintain a policy of undervaluing its currency.

2.2.2 Spot Exchange and Forward Exchange The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot. In practice, the settlement takes place within two days in most markets. Spot exchange rate is the quotation between two currencies for immediate delivery. In other word, the spot exchange rate is the current exchange of two currencies vis--vis each other. The market for spot exchange transaction is known as the spot market. In addition to the spot exchange rate it is possible for economic agents to agree today to exchange currencies to some specified time in the future, most commonly for 1 month, 3 month, 6 month, 9 month and 1 year. Forward transaction is an agreement between two parties, requiring the delivery at some specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contact is called the forward exchange rate and the market for forward transaction is known as the forward market.

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Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risk arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract. Note With reference to forward rate relationship with the spot rate, the forward rate may be at par, discount or premium. At par The forward exchange rate is said to be at par if the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract. At premium The forward rate for a currency, say the Kshs, is said to be at premium with respect to the spot rate when Kshs 1 buys more units of another currency say Uganda shillings, in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis. At discount the forward rate for a currency, say Kshs, is said to be at discount with respect to the spot rate when Kshs. 1 buys fewer Uganda shillings in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on per annum basis. The forward exchange rate is determined mostly by the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par. Economic agents involved in the forward exchange market are divided into three groups where classifications are distinguished by their motives for participation in the foreign exchange market. These agents are: Hedgers these are agent, usually firms, which enter the forward exchange market to protect themselves against exchange-rate fluctuations which entail exchange-rate risk. By exchange rate risk we mean the risk of loss due to daverse exchange rate movement.
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For example, consider UK importer who is due to pay for goods from the US to the value of $15,500 in one years time. Let us suppose that the spot exchange rate is $1.60/1 while the one-year forward exchange rate is $ 1.55/1. By buying dollars forward at this rate the trade can be sure that he only has to pay 10,000. If he does not buy forward today, he runs the risk that in one years time the spot exchange rate may be worse than $ 1.55/1, such as $1.30/1 which would mean him having to pay 11923 ($15,500/1.30) Arbitrageurs these are agents (usually banks) that aim to make a riskless profit out of discrepancies between interest-rate differentials and what is known as the forward discount or forward premium. A currency is said to be forward premium if the forward exchange rate quotation for that currency represents an appreciation of that currency compared to the spot quotation. A currency is said to be forward discount if the forward exchange-rate quotation for that currency represents depreciation of that currency compared to the spot quotation. The forward discount or premium is usually expressed as a percentage of the spot exchange rate, that is:Forward discount/premium = Where: F = forward exchange rate S = spot exchange rate The presence of arbitrageurs ensures that what is known as the covered interest parity condition holds continually. Formula used by banks to calculate their forward exchange quotation. F= Where:F = one-year forward exchange-rate quotation in foreign currency per unit of domestic currency S = spot exchange-rate quotation foreign currency per unit of domestic currency
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X 100

r = one-year domestic interest rate r* = one year foreign interest rate Example of the calculation of the forward exchange rate Suppose that the one-year dollar interest rate is 5 per cent, and the sterling interest rate is 8 per cent, and the spot rate of the dollar against the pound is $ 1.60/1. Then the one year forward exchange rate of the pound is:F= F= Since X 100 = =$1.5555/ X 100 = -2.78 the one-year forward rate of sterling is at an

annual forward distant of 2.78 per cent. Speculators Speculators are agents that hope to make a profit by accepting exchange-rate risk. They engage in the forward exchange market because they believe that future spot rate corresponding to the date of the quoted forward exchange rate will be different from the quoted forward rate. Consider the situation where the one year forward rate is quoted at $1.55/1, and a speculator feels that the pound will be $1.40/1 in one years time. In this instance he may sell 1000 forward at $1.55/1 so as to obtain $1550 one year hence and hope to change them back into pounds in one years time at $1.40/1, and so obtain 1107.14 making 107.14 profit. Of course the speculator maybe wrong and find that in one years time the spot exchange rate is above $1.55/1 which lead to a loss. 2.2.3 Nominal Exchange Rate, Real Exchange Rate and Effective Exchange Rate 1. Nominal Exchange rate is the exchange rate that prevails at a given date i.e. it is the amount of US dollar that will be obtained for Kshs. 1 in the foreign exchange market. The nominal exchange rate is merely the price of one currency in terms of another with no reference made to what this means in terms of purchasing power of goods or services. A depreciation or

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appreciation of the nominal exchange rate does not necessarily imply that the country has become more or less competitive on international markets. For such a measure we have to look at the real exchange rate. 2. Real Exchange Rate is the nominal exchange rate adjusted for relative prices between the countries under consideration. It is the normally expressed in index form algebraically as:Sr = Where Sr = the index of the real exchange rate S = the nominal exchange rate (foreign currency units per unit of domestic currency) in index form P = the index of the domestic prices level P* = the index of the foreign price level Table: - Construction of nominal and real exchange-rate indices Period Nominal Exchange Rate 1 2 3 4 5 $ 2.00 $ 2.00 $ 2.40 $ 1.80 $ 1.50 Nominal Exchange- UK Price US Price Real Rate Index 100 100 120 90 75 Index 100 120 120 130 150 Index 100 100 120 117 125 Exchange-

Rate Index 100 120 120 100 90

NOTE:- The real exchange-rate index is constructed by multiplying the nominal exchange-rate index by the UK price and diving this by the US price index 3. Effective Exchange Rate: - since most countries of the world do not conduct all their trade with a single foreign country, policy-maker are not so much concerned with what is happening to their exchange rate against a single foreign currency, but rather what is happening to it against a basket of foreign currencies with whom the country trades.
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Effective exchange rate is a measure of whether or not the currency is appreciating or depreciating against a weighted basket of foreign currencies. In order to illustrate how an effective exchange rate is compiled consider the hypothetical case of the UK conducting 30 per cent of its foreign of its foreign trade with the US and 70 percent of its trade with Germany. This means that a weight of 0.3 will be attached to the bilateral exchange rate index with the dollar, and 0.7 with the deutschmark. Construction of a nominal effective exchange-rate index Period Nominal exchange rate Nominal exchange Effective index of 100 93 99 83 83 exchange rate

index of $/ 1 2 3 4 5 100 100 120 90 75

rate index of DM/ 100 90 90 80 85

The effective exchange-rate index is constructed by multiplying the $/ index by 0.3 and the DM/ index by 0.7. 2.3 Foreign exchange regime/systems Broadly, there are two important exchange rate systems, namely the fixed (stable) exchange rate system and floating (flexible) exchange rate regime/system. 2.3.1 Fixed (stable) exchange rates Fixed exchange rate is a rate not determined by the forces of supply and demand but by other outside regulator. For example in Kenya this was done before 1992. Countries following a fixed exchange rate system agree to keep their currencies at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so. 2.3.1.1 Argument for fixed exchange rate system (merits) The important arguments supporting the fixed rate system are as follows:-

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i.

Exchange rate stability is necessary for ordinarily development and growth of foreign trade. If exchange rate stability is not assured, exporters will be uncertain about the amount they will have to pay. Such uncertainties and the associated risk adversely affect foreign trade. A great advantage of a the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks

ii.

Especially the developing countries, which have a persistent balance of payment deficits, should necessarily adopt the fixed exchange rate system to prevent continuous depreciation of the external value of their currencies.

iii.

Exchange rate stability is necessary to attract foreign capital investment as foreigner will not be interested to invest in a country with an unstable currency. Thus, exchange rate stability is necessary to augment/ supplement resources and foster economic growth.

iv.

Unstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflows.

v.

A stable exchange rate system eliminates speculation in the foreign exchange market and enhances discipline in the market.

vi.

A stable exchange rate system is necessary condition for the successful function of region grouping and arrangements among nations

vii.

A stable exchange rates system is necessary for growth of international money and capital markets. Due to the uncertainties associated with unstable exchange rates, individuals, firms and institutions may shy away from lending to and borrowing from the international money and capital market.

2.3.1.2 Argument against fixed exchange rate system (demerits) i. Expensive to defend a fixed rate because it require large sum of foreign exchange reserves. A foreign exchange reserves are the amount of foreign currencies held by a countrys central bank for the purpose of international payments. ii. Defending local currencies may involve raising interest rates which could be costly and damaging to domestic economy.

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2.3.2 Flexible (floating) Exchange Rate Flexible (floating) exchange rate determined by forces of supply and demand. Under the floating exchange rate system, exchange rates are freely determined in an open market primarily by private dealing and like other market prices, vary from day to day. 2.3.2.1 Cases against floating (flexible) exchange rate (demerits) A number of economist point out that certain serious problems are associated with the system of floating rates. The following are demerits of floating exchange rates. i. A flexible exchange rate presents a situation of instability, creating uncertainty and confusion. Freidman disputes this view and argues that a flexible exchange rate need not to an unstable exchange rate. If it is, it is primarily because there is underlying instability in the economic conditions governing international governing international trade. And a rigid exchange rate may, while itself remaining nominally stable, perpetuate and accentuate/heighten other elements of instability in the economy. The mare fact that a rigid official exchange rate does not change while flexible rate does is no evidence that the former means greater stability in any more fundamental sense. ii. The system of flexible exchange rates, with its associated uncertainties, makes it impossible for exporters and importers to be certain about the price they will have to pay or receive for foreign exchange. This will have a dampening effect on foreign trade. iii. The system of flexible exchange rates gives an inflationary bias to an economy. When the currency depreciates due to payments deficit, imports become costlier and thus stir up an inflationary spiral.

2.3.2.1 Cases for floating (flexible) exchange rate (merits) i. Automatic stabilization: - automatic variations in the exchange rates, in accordance with the variations in the balance of payments position, tend to automatically restore the balance of payments equilibrium. A surplus in the balance of payments increases the exchange rate i.e. currency appreciate. This makes foreign goods cheaper in terms

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of the domestic currency and domestic goods more expensive in terms of the foreign currency. This in turn, encourages imports and discourage exports, resulting in the restoration of the balance of payments equilibrium If there is a payments deficit, the exchange rates falls i.e. currency depreciate and this makes domestic goods cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. This encourages exports, discourages imports and thus helps to establish the balance of payments equilibrium. ii. Freeing internal policy:- floating allows government to pursue internal policy objectives like growth and full employment without external constraints iii. Absence of crisis i.e. with floating rates there is no pressure on the country to devalue or revalue it currency because changes occur automatically. iv. Low reserves i.e. there are less need to maintain large reserves to defend a currency instead it is used for more production elsewhere. v. Flexibility i.e. there is a lot of freedom and easy management of trade when using floating exchange rates. Changes in trade are reflected in changes in value of currency.

2.4 Currency Derivatives (Futures, options and swaps) The growth of derivatives markets The phenomenal growth of trading in these derivative instruments has been one of the most important developments in international financial markets over the last three decades. The 1980s witnessed an astonishing growth of futures and options markets and this trend has continued into the 1990s. 2.4.1 Reasons for rapid growth of futures and options markets i. The volatility of foreign exchange markets following the collapse of Bretton Wood System of fixed exchange rates, combined with greater freedom o movement of capital internationally, has created a large demand on part of companies, investors, fund manager and the like for a means to cope the greater volatility and risk of exchange rate.

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ii.

Futures and options market enables traders to take speculative position on price movements for a low initial cash payment, known as the initial margin.

iii.

Futures and options contrasts enable traders to take short positions, that is sell something they do not own with considerable ease. This means that taking a position on currency depreciation is as easy as taking position on currency appreciation.

iv.

Unlike forward contracts, where there is a degree of counterparty risk, all futures and options contracts are guaranteed by the exchange on which they traded.

2.4.2 Currency futures and currency forwards A currency futures contract is an agreement between two counterparties to exchange a specified amount of two currencies at a given date in the future at a pre determined exchange-rate. Currency futures are basically standardized forward contracts. For example, a currency futures contract may specify that 62500 per contract is being bought or sold. With forward contract, the amount to be exchange is negotiable between the two parties; For example, the two parties might agree to buy/sell, say 64272 forward. Currency futures contract specifies: the amount of currency to be exchanged, the Exchange on which on which the contract is traded the delivery and the process for delivery. One party agree to sell the currency (go short), and the other to purchase it (go long). Despite their high degree of similarity there are some practical differences between currency forward and futures contracts. The main differences are:i. a currency futures contract is a standardized notional agreement between two counterparties to exchange a specified amount of a currency at a fixed future date for a predetermined price, while in a forward contract the amount of currencies to be exchanged is determined by the mutual agreement of the two parties.

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ii.

Futures contracts are traded on an Exchange while forward contracts are over-thecounter instruments with the exchange being made directly between two parties.

iii.

Futures contracts are guaranteed by the Exchange whereas forward contracts are not, which removes the counterparty risk inherent in forward contracts. With forward contact, each of counterparty needs to carefully consider what will happen and whether the other is capable of seeing their commitment which may involve quite substantial losses. This credit risk tends to limit the forward market to only very high grade financial and commercial institutions.

iv.

Futures contracts are generally regarded as having greater liquidity than forward contracts. Their standardized nature means that they can easily be sold to other party at any time up until maturity at the prevailing futures prices; with the trader being credited with a profit or loss. Since forward contracts obligations cannot be transferred to a third party, the only way for a trader to get out of a forward contract is to take out a new offsetting forward position. For example. If a trader is committed to buying 1 million of sterling forward at $1.50, then the only way out of the forward contract is to take out another forward contract to sell 1 million sterling with another party. There are two problems with this: The trade is now exposed to two counterparties (double his counterparty risk) The maturity date of the second forward contract may not be perfectly match with that of the first forward contract. For example, if the origin forward contract is for 90 days and 20 days later the trader tries to take an offsetting position, the nearest available forward contract is 60 days leaving 10 days of open exposure.

2.4.3 Currency options A currency option is a contract that gives the purchase the right, but not the obligations to buy or sell a currency at a predetermined price sometimes in the future. The currency in which the option is granted is known as the underlying currency. The currency to be exchanged for the underlying currency is known as the counter currency. For example, if the contact specifies the

29

right to buy 31250 at $ 1.65/1, then the pound is the underlying currency and the dollar is the counter currency. An option contract involves two parties, the writer who sells the option and the holder who purchases it. If the option contract gives the holder the right to purchase the underlying currency at a predetermined price from the other party, the contract is known as a call option. If it gives the owner the right to sell the underlying currency at a predetermined exchange rate from the other party, it is known as a put option. The price at which the underlying currency can be bought or sold is known as the strike price/ exercise price and the date at which the current express is known as expiry date or maturity date. 2.4.3.1 Differences between options and future contracts Options are futures are both examples of derivatives instruments in that their price is derived in relation to the spot price, and they can also both be used for hedging and speculative purposes. However, there are some significant differences in the two contracts. The differences are:i. With an option contract the buyer of the option is not obliged to transact, whereas both parties to a futures contract are obliged to transact. ii. With a futures contracts, for every cent the future spot prices is above the futures rate on expiry of the contract the buyer makes a cent and the seller lose a cent on the contract. This is not the case with an option contract. The maximum loss of the option holder is limited to the premium paid for the option, which is the maximum possible gain for the option writer. However, there is a limited potential profit for an option holder and likewise unlimited potential loss for the writer.

2.4.4 The swaps market A swap is an agreement between two parties to exchange two differing forms of payment obligations. They are basically of two kinds: Interest rate swaps this is the exchange which involves payments denominated in same currency Currency swaps the exchange involves two different currencies.
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The first well-documented currency swap involved the World-Bank and International Business Machines (IBM) in 1981, whereby the World Bank committed itself to financing some of IBMs deutschmark/ Swiss franc debt in return for a commitment by IBM to finance some of the World Banks dollar debt. Like many other financial instruments, swap agreements are used to manage risk exposure; however, one of the main reasons for the rapid growth of the swap market has been that they enable parties to raise fund more cheaply than would otherwise be the case. Swap markets are used extensively by major corporations, international financial institutions and governments and are important part of the international bond market. 2.4 Chapter review questions I. Give the meaning of the following terms; Foreign market, Foreign exchange rate, Spot exchange rate, Forward exchange rate, Nominal exchange rate, Real exchange rate, Effective exchange rate, Currency futures, Currency swaps, Currency options. II. III. IV. V. VI. VII. VIII. Briefly, explain functions of foreign exchange market. Briefly, discuss characteristics and participants of foreign exchange market. Explain determinants of demand and supply of foreign currency Discuss factors that influence exchange rates Briefly, discuss argument for, and argument against fixed exchange rate Briefly, discuss argument for, and argument against floating exchange rate Highlight difference between currency future contacts and currency forward contracts

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Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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CHAPTER THREE: BALANCE OF PAYMENTS Objectives of the chapter At the end of this chapter, the student should be able to: Define balance of payments and explain what to be included in it. Explain collection, reporting and presentation of the balance of payments statistics. Discuss balance of payments accounting and accounts Explain sub-accounts in the balance of payments Explain balance of payments surplus and deficit Discuss factors that cause disequilibrium in the balance of payments To give correction measures for the balance of payment disequilibrium Introduction Balance of payments is one of the most important economic indicators for policy-makers in an open economy. A good or bad set of figures can have an influential effect on the exchange rate and can lead policy-makers to change the content of their economic policies. Deficits may lead to the government raising interest rates or reducing public expenditures to reduce expenditures on imports. Alternatively, deficits may lead to calls for protection against foreign imports or capital controls to defend the exchange rate. 3.0 Balance of Payment BOP The Balance of Payment is a statistical record of all the economic transactions between residents of the reporting country and residents of the rest of the world during a given period. The usual reporting period for all the statistics included in the accounts is a year. Balance of Payments is one of the most important statistical statements for any country. It reveals how many goods and services the country has been exporting and importing, and whether the country has been borrowing from or lending money to the rest of the world. In addition, whether or not the central monetary authority (usually the central bank) has added to or reduces its reserves of foreign currency is also reported in Balance of Payment

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Domestic and foreign residents need to be differentiated. It is important to note that citizenship and residency is not necessarily the same thing from the viewpoint of the Balance of Payments statistics. The term resident comprises individuals, households, firms and the public authorities, and there are some problems that arise with respect to the definition of a resident. The problems are:1. Multinational corporations are by definition resident in more than one country. For the purposes of Balance of Payment reporting, the subsidiaries of a multinational are treated as being resident in the country in which they are located even if their shares are actually owned by foreign residents 2. Another problem concerns the treatment of international organizations such as the International Monetary Fund, the World Bank e.t.c. These institutions are treated as being foreign residents even though they may actually be located in the reporting country. For example, although the International Monetary Fund is located in Washington, contributions by the US government to the fund are included in the US Balance of Payment statistics because they are regarded as transactions with foreign residents. 3. Tourists are regarded as being foreign residents if they stay in the reporting country for less than a year. Note The criterion for a transaction to be included in the Balance of Payments is that it must involve dealings between a resident of the reporting country and a resident from the rest of the world. Purchases and sales between residents from the same country are excluded. 3.1 Collection, Reporting and Presentation of the Balance-of-Payment Statistics The Balance-of-Payments statistics record all of the transactions between domestics and foreign residents, be they purchases or sales of goods, services or financial assets such as bonds, equities and banking transactions. Reported figures are normally in domestic currency of the reporting country. Obviously, collecting statistics on every transaction between domestic and foreign residents is an impossible task. The authorities collect their information from the customs authorities, surveys of tourist numbers and expenditures, and data on capital inflows and outflows is obtained from banks, pension funds, multinational and investment house. Information
34

on government expenditures and receipts with foreign residents is obtained from local authorities and central government agencies. The responses from the various sources are compiled by government statistical agencies. In Kenya, this is done by the Kenya Bureau of statistics. There is no unique method governing presentation of Balance of Payments statistics and there can be considerable variations in the presentations of different national authorities. 3.2 Balance of Payments Accounting and Accounts An important point about a countrys Balance of Payments statistics is that in an accounting sense they always balance. This is because they are based upon the principle of double-entry book keeping. Each transaction between domestic and foreign resident has two sides to it, a receipt and a payment, and both these sides are recorded in the balance of payments statistics. Each receipt of currency from residents of the rest of the world is recorded as a credit item (a plus in the account) while each payment to residents of the rest of the world is recorded as a debit item (a minus in the accounts). Traditionally, the statistics are divided into two main sections i.e. the current account and the capital account, with each part being further sub-divided. The explanation for division into these two main parts is that the current account items refer to income flows, while the capital account records changes in assets and liabilities. A simplified example of the annual Balance of Payments accounts for Europa is presented in table below:The balance of payments of Euroland

35

Current Account 1) Exports of goods 2) Imports of goods 3) Trade balance 4) Exports of services 5) Imports of services 6) Interest, profits and dividends received 7) Interest, profits and dividends paid 8) Unilateral receipts 9) Unilateral payments 10) Current account balance Capital account 11) Investment Abroad 12) Short-term lending 13) Medium-term and long-term lending 14) Repayments of borrowing from ROW 15) Inward Foreign Investment 16) Short-term borrowing 17) Medium-term and long-term borrowing -30 -60 -80 -70 +170 +40 +30 +150 -200 -50 (rows 1 + 2 ) +120 -160 +20 -10 +30 -20 -70 (sum rows 3 to 9 inclusive)

18) Repayments on loan received from received from ROW +50 19) Capital account balance 20) Statistical error 21) Official statements balance 22) Change in reserve rise (-), fall (+) 23) IMF borrowing from (+) repayments to (-) 24) Official financing balance +50 (sum rows 11 to18) +5 zero minus [(10)+(19)+(24) -15 +10 +5 +15 (22)+(23) (10)+(19)+(20)

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3.3 An Overview of the Sub-Accounts in the Balance of Payments (a) The Trade Balance The trade balance is sometimes referred to as the visible balance because it represents the difference between receipts for exports of goods and expenditure on imports of goods which can be visibly seen crossing frontiers or boundaries. The receipts for exports are recorded as a credit in the Balance of Payments, while the Payment for exports is recorded as a debit. When the trade balance is in surplus this means that a country has earned more from its exports of goods that it has earned more from its exports of goods than it has paid for its imports of goods. (b) The Current Account Balance The current account balance is the sum of visible trade balance and the invisible balance. The invisible balance shows the difference between revenue received for exports of services and payments made for imports of services such as shipping, tourism, insurance and banking. In addition, receipts and payments of interests, dividends and profits are recorded in the invisible balance because they represent the rewards for investments in overseas companies, bonds, and equity; while payments reflects the rewards to foreign residents for their investment in the domestic economy. As such, they are receipts and payments for the services of capital that earn and cost the country income just as do exports and imports. Unilateral transfers are normally included in the balance. Unilateral transfers are payments or receipts for which there is no corresponding quid pro quo. Examples of such transactions are migrant workers remittance to their families back home, the payments of pensions to foreign residents, and foreign aid. Such receipts and payment represent redistribution of income between domestic and foreign residents. Unilateral payments can be viewed as a fall in domestic income due to payments to foreigners and so are recorded as a debit; while unilateral receipts can be viewed as an increase in income due to receipts from foreigners and consequently are recorded as credit. (c) The Capital Account Balance The capital account records transactions concerning the movement of financial capital into and out of the country. Capital comes into the country by borrowing, sales of overseas assets, and
37

investments in country by foreigners. These items are referred to as capital inflows and are recorded as credit items in the balance of payments. Capital inflows are in effect, a decrease in the countrys holding of foreign assets or increase in liabilities to foreigners. Capital inflows are recorded as credits in the balance of payments. The easier way to understand why they are pluses (credit) is to think of foreign borrowing as the export of IOU. Similarly investment by foreign residents is the export of equity or bonds, while sales of overseas investments is an export of those investments to foreigners. Conversely, capital leaves the country due to lending, buying of overseas assets, and purchases of domestic assets owned by foreign residents. These items represent capital outflows and are recorded as debits in the capital account. Capital outflows are in effect, an increase in the countrys holding of foreign assets or decrease in liabilities to foreigners. These items are recorded as debits as they represent the purchase of an IOU from foreigners, the purchase of foreign bonds or equity, and the purchase of investments in foreign economy. (d) Official Settlements Balance Given the huge statistical problem involved in compiling the balance of payments statistics, there will usually be discrepancy between the sums of all the items recorded in the current account, capital account and the balance of official financing which in theory should sum to zero. To ensure that the credits and debits are equal it is necessary to incorporate a statistical discrepancy for any difference between the sum of credits and debits. 3.4 Possible source of this error (statistical discrepancy) i. It is an impossible task to keep track of all the transactions between domestic and foreign residents. Many of the reported statistics are based on sampling estimates derived from separate sources, so that some error is unavoidable. ii. Desire to avoid taxes i.e. some of transactions in the capital account are underreported. Moreover some dishonest firms may deliberately under-invoice their exports and over-invoice their imports to artificially deflate their profits. iii. Another problem is that of leads and lags the balance of payments record receipts and payments for a transaction between domestic and foreign residents, but it can happen that a good is imported but the payments delayed. Since the imports is
38

recorded by the customs authorities and the payment by the banks, the time discrepancy may mean that the two side of the transaction are not recorded in the same set of figures. The summation of the current balance, capital account balance and the statistical discrepancy gives the official settlement balance. The balance on this account is important because it shows the money available for adding to the countrys official reserves or paying off the countrys official borrowing. A central bank normally holds a stock of reserves made up of foreign currency assets. Such reserves are held primarily to enable the central bank to purchase its currency should it wish to prevent it depreciating. Any official settlements deficit has to be covered by the authorities drawing on the reserves, or borrowing money from foreign central banks or the IMF (recorded as a plus in the accounts). If, on the other hand, there is an official settlements surplus then this can be reflected by the government increasing official reserves or repaying debts to the IMF or other sources overseas (a minus since money leaves the country) 3.5 Balance of payments surplus and deficit The balance of payments always balances since each credit in the account has corresponding debt elsewhere. However, this does not mean that each of the individual accounts make up the balance of payments is necessarily in balance. For instance, the current account can be in surplus while the capital account is in deficit. When talking about a balance of payments deficit or surplus, economists are really saying that subsets of items in the balance of payments are in surplus or in deficit. Autonomous or above the line items are transactions that take place independently of the balance of payments, whilst accommodating or below the line items are transaction which finance any difference between autonomous receipts or payments. A surplus in the balance of payments is defined as a excess of autonomous receipts over autonomous payments. A deficit is an excess of autonomous payments over autonomous receipts. Autonomous receipts > autonomous payments = surplus Autonomous receipts < autonomous payments = deficit
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Note There is disagreement on which items qualify as autonomous. This leads to alternative views on what constitutes a balance of payments surplus or deficits. The difficulty arises because it is not easy to identify the motive underlying a transaction. For example, if there is a short-term capital inflow in response to a higher domestic interest rate, it should be classified as autonomous item. If, however, the item is an inflow to enable the financing of imports then it should classified as an accommodating item. The difficulty of deciding which items should be classified as accommodating and autonomous has led to several concepts of balance of payments disequilibrium. 3.5.1 Balance of payments disequilibrium The balance of payment of a country is said to in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. The balance of payments is regarded as being in disequilibrium when the demand for foreign exchange exceeds its supply, and there will be a surplus when the supply of foreign exchange exceeds the demand. (a) Factors that may cause disequilibrium in the balance of payments i. Economic factors: - Various economic factors cause development disequilibrium, cyclical disequilibrium, secular disequilibrium and structural disequilibrium. Development disequilibrium large scale development expenditures usually increase the purchasing power, aggregate demand and prices, resulting in substantially large imports. Development disequilibrium is common in the case of developing countries, because the above factors and the large scale import of capital goods needed for carrying out the various development programs give rise to a deficit in their balance of payment. Cyclical disequilibrium cyclical fluctuation of general business actively is one of the prominent reasons for balance of payments disequilibrium. Depression always brings about a drastic shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itself will ordinarily experience a more rapid growth in its imports than its exports, while the opposite will be true of other countries.
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Secular disequilibrium sometimes, the balance of payments disequilibrium persists for long period due to certain secular trends in the economy. For instance, in a developed country, the disposable income is generally very high and, therefore, so is the aggregate demand. At the same time, the production costs are also very high due to the high wages. This naturally results in higher prices. These two factors (high aggregate demand and higher domestic prices) may result in the imports being much higher than the exports.

Structural disequilibrium such structural changes include development of alternative sources of supply, development of better substitutes, exhaustion of productive resources or changes in transport routes and costs.

ii.

Political Factors:- certain political factors could also Produce a BOP disequilibrium. For instance, a country plagued with political instability may experience large capital outflows and inadequacy of domestic investment and production. These factors may, sometimes, cause disequilibrium in the balance of payment. Sociological factors for instance, changes in the tastes, preferences and fashion, may affect imports and thereby affect the balance of payments.

iii.

(b) Correction of disequilibrium There are a number of measures available for correcting the balance of payments disequilibrium. They fall into two broad groups, namely, automatic measures and deliberate measures. i. Automatic correction

The theory of automatic correction is that if the market forces of demand and supply are allowed to have free play, in course of time, equilibrium will be automatically restored. When there is a BOP deficit, the demand for foreign exchange exceeds it supply and this result in an increase in the exchange rate and a fall in the external value of the domestic currency. This makes the exports of the country cheaper and imports expensive than before. Consequently, the increase in exports and fall in imports restore the balance of payment equilibrium. Under the fixed exchange rate system, the automatic adjustments of the balance of payments happen via changes in the adjustment variable such as price, interest, income and capital flows.
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 Price adjustments A fall in the money supply in the deficit country and increase in money in the surplus country will result in rise in the prices in the surplus country which will encourage imports and discourage exports, and fall in prices in the deficit country which will encourage exports and discourage imports, leading to restorations of BOP equilibrium in due course. Interest rate adjustments A monetary effect of BOP surplus or deficit, is its impact on the short-term interest rates. The contraction or expansion of money supply resulting from the BOP deficit or surplus leads to a rise or fall in the interest rates. This will encourage investors in the deficit country where the interest rate has risen to withdraw then funds from abroad and invest in the home country. Because of the fall in interest rate in the foreign country with BOP surplus, foreigners will be encouraged to send money to the deficit country where the interest rate has risen. These changes will also contribute to the restoration of BOP. Income adjustments Kaynes demonstrated that under the fixed rate system, the changes in income will help restore BOP equilibrium automatically. A nation with persistent payment surplus will experience rising income causing increasing exports. The opposite will happen in the deficit nation. Capital flows Changes in the interest rates consequent to BOP disequilibrium will encourage capital flows between the deficit and surplus nations, helping restoration of the BOP.

ii.

Deliberate measures

Because of the various problems associated with the policy of automatic correction, deliberate measures are widely employed today. Deliberate measures refer to correction of disequilibrium by means of measures taken deliberately with this end in view. Deliberate measures may be broadly grouped into monetary measures, trade measures and miscellaneous measures.

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(a) Monetary Measures The important monetary measures are: i. Monetary contraction/expansion:- the level of aggregate domestic demand, domestic price level and the demand for imports and exports may be influenced by contraction or expansion of money supply so that a balance of payment disequilibrium may be corrected. For example, assume a situation of balance of payments deficit for the correction of which a contraction of money supply is required. Contraction of money supply is likely to reduce the purchasing power and thereby the aggregate demand. It also reduces domestic prices. The fall in the domestic aggregate demand and domestic prices reduces the demand for imports and encourage exports. ii. Devaluation:- Devaluation means reduction of the official rate at which the currency is exchanged for another currency. A country with fundamental disequilibrium in the balance of payments may devalue its currency in order to stimulate its exports and discourage imports to correct the disequilibrium. Devaluation makes export goods cheaper and imports dearer/expensive iii. Exchange control:- exchange control is a popular method employed to influence the balance of payments positions of a country. Under exchange control, the government or central bank assumes complete control over the foreign exchange reserves and earnings of the country. The recipients of foreign exchange, like exporter, are required to surrender foreign exchange to the government or central banks in exchange for domestic currency. By virtue of its control over the use of foreign exchange, the government can control imports.

(b) Trade measures Trade measures include export promotion measures and measures to reduce imports. These include:i. Export promotion Exports may be encouraged by reducing or abolishing export duties, providing export subsidies, encouraging export production and export

43

marketing by giving monetary, fiscal, physical and institutional incentives and facilities. ii. Import control Imports may be controlled by imposing or enhancing import duties, restricting imports through quotas, licensing and even prohibiting altogether the import of certain inessential items.

(b) Miscellaneous measures Apart from the monetary contraction/expansion and trade measures, there are a number of other measures that can help to make the balance of payments position more favorable, like obtaining foreign loans, encouraging foreign investment in the home country, development of tourism to attract foreign tourist and providing incentives to enhance inward remittances

44

Figure 3.1 Correction measures balance of payment disequilibrium CORRECTION OF BOP DISEQUILIBRIUM

Automatic correction

Deliberate measures

Monetary measures 1. Monetary contraction/ expansion 2. Devaluation/ revaluation 3. Exchange control

Trade measures

Miscellaneous measures 1. Foreign loan 2. Incentives for foreign investment 3. Tourism development 4. Incentives for foreign remittances 5. Import substitution

Export promotion 1. abolition/reduction of export duties 2. Export subsidies 3. Export incentives

Import control 1. Import duties 2. Import quotas 3. Import prohibition

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3.6 Financing of BOP deficit When a nation has a balance of payment deficit i.e. when the total external payments obligations exceed the total receipts, an external payments problem arises. The nation has to find out means for meeting the payments obligation. The common methods of financing the BOP deficit are the following:i. Using foreign exchange reserves If the nation has comfortable foreign exchange reserves, the deficit can be financed by drawing upon the reserves. The problem, however, is that only when the BOP has a continuous surplus that a country will have a comfortable foreign exchange reserves. If a country experiences persistent deficits, the reserves would dry up and it will have to resort to some other method(s) to finance deficit. ii. External assistance If a nation does not have enough foreign exchange reserves to draw upon to finance the BOP deficit, it may have to take reserve to external assistance. It very important source of assistance for countries with BOP problem is the IMF. A nation may also resort to other sources, including commercial borrowing, for financing the deficit. 3.7 Chapter review questions i. Define balance of payments and explain what to be included in it. ii. iii. iv. v. vi. Briefly, discuss balance of payments accounting and accounts Clearly, explain sub-accounts in the balance of payments What is the meaning of balance of payments surplus and balance of payments deficit Discuss factors that cause disequilibrium in the balance of payments State and explain correction measures for the balance of payment disequilibrium

Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson)

46

Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008), International finance, Oxford University Press

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CHAPTER FOUR: THE INTERNATIONAL PARITY CONDITIONS Objectives of the chapter At the end of this chapter, the student should be able to: Explain the law of one price Discuss the concept of arbitrage profit Discuss transaction costs and no-arbitrage conditions Explain interest rate parity and covered interest arbitrage. Discuss exchange rate equilibrium Explain low covered interest rate arbitrage and how to undertake covered interest arbitrage. 4.0 The law of one price (Purchasing Power Parity i.e. PPP) The Law of One Price, also known as Purchasing Power Parity or PPP, is the single most important concept in international finance and economics. The implication for multinational finance is that an asset must have the same value regardless of the currency in which value is measured. The law of one price implies that equivalent assets sell for the same price. If PPP does not hold within the bounds of transaction costs, then there is an opportunity to profit from crosscurrency difference in prices. 4.1 Arbitrage profit Although the term arbitrage or risk arbitrage is often used to refer to speculation positions, arbitrage is more strictly defined as a profitable position obtained with no net investment and no risk. Arbitrage opportunities are often exploited, and just as quickly disappear as arbitragers drive prices back toward equilibrium. Let Pd denote the price of an asset in domestic currency and Pt denote the price of the same asset or an identical asset in a foreign currency. The law of one price requires that the value of an asset be the same whether the value is measured in the foreign or in the domestic currency. This means that the spot rate of exchange ( the domestic currency. = =
48

must equate the value in the foreign currency to the value in

If this equality does not hold within the bounds, of transaction costs, then there may be an opportunity for an arbitrage profit. Example Suppose gold sells for P$=$ 400/oz (i.e $ 400 per Ounces) in New York and = 250/oz (i.e.

250 per Ounces) in London. The no-arbitrage condition requires that the value of gold in dollars must equal the value of gold in pounds, so = Or = = = 0.6250/1$ = =$ 1.6000/1

If this condition does not hold within the bound s of transaction costs, then there is an opportunity to lock in a riskless arbitrage profit in cross-currency gold transactions. Transaction costs are relatively small for actively traded financial assets, such as currencies in the interbank market. The purchasing power parity nearly always holds in these markets, because the potential for arbitrage ensures that prices are in equilibrium. PPP is less likely to hold in illiquid markets where high transaction costs or financial markets controls prevent arbitrage from enforcing the law of one price. 4.2 Transaction costs and the No- Arbitrage Conditions For there to be no-arbitrage opportunities, PPP (Purchasing Power Parity) must hold within the bounds of transactions costs for identical assets bought or sold simultaneously in two or more locations. Whether the PPP holds depends on the extent to which market frictions restrain from working magic. Some barriers to the cross-border flow of capital are generated in the normal course of business, as fees are charged for making a market, providing information, or transporting and delivering an asset. Other barriers are imposed by governmental Authorities, including trade barriers, taxes and financial market controls.

49

Buying and selling real assets usually entails higher costs than trading a financial claim on the real assets. As an example, gold is costly to transport because of its weight, but a financial asset representing ownership of gold is easily transferred from one party to another and can be as simple as a piece of paper or a credit in an account. Although a large amount of gold are a nuisance to store, currency can be conveniently store in the Eurocurrency market at a competitive interest rate. Because of this difference between financial and real assets, actively traded financial assets are more likely to conform to the law of one price than similar real assets. Example (How transaction cost influence the analysis) Suppose gold is quoted at 250.00/oz bid and 253.00/oz ask in London and $402.00/oz bid and 406.00/oz ask in New York. A forex dealer quotes pounds in the spot market as $ 1.5990/ bid and 1.6010/ ask. Translated into pounds at the $1.6000/ mid rate, the New York dealers midprice of = 252.50/oz is slightly higher than the London dealers mid-price of

251.50/oz, so the winning play should be to buy gold from the London dealer and sell gold to the New York dealer. Suppose you buy 1,000 ounces of gold for 253,000 at London dealers ask price for gold of 253/oz. The forex dealer will sell 253,000 to you for a payment of

(253,000)x($1.6010/)=$405,053 at the $1.6010/ ask price for pounds. Selling the gold in New York yields only $ 402,000 at the New York dealers bid price for gold. This leaves you with a net loss of $3,053. Even though purchasing power parity does not hold exactly, it does hold within the bounds of transaction costs in this example. Unfortunately for your dreams of wealth, the dealers bid-ask price overlap one another and an arbitrage profit is not possible. 4.3 Exchange Rate Equilibrium Spot exchange and forward currency contracts are traded in liquid interbank markets with few governmental restrictions r market frictions. The potential for arbitrage using actively traded financial contracts ensures that the following international parity conditions:

50

1.

(Y) =

(X)

=1

2.

=[

]t

will hold with the bounds of transaction cost in the interbank markets. 4.3.1 Bilateral Exchange Rate and equilibrium and Locational Arbitrage In the absence of market frictions, the no-arbitrage condition for trade in spot exchange rates between two banks X and Y is

(Y) =

(X)

=1

This ensures bilateral exchange rate equilibrium. If this relation does not hold within the bounds of transaction costs, then there is a locational arbitrage opportunity between the banks. An example of Locational Arbitrage Bank X is quoting A $0.5838/ bid and A $0.5841/ ask and bank Y is quoting A $ 0.5842/ bid and A $ 0.5845/ ask. If you buy 1million from X at its A $0.5841/ ask price and simultaneously sell 1million to Y at its A $ 0.5842/ bid price. You can lock in an arbitrage profit of (A$ 0.0001/) x (1,000,000) = A$ 100 with no net investment or risk. Transaction costs are built into the bid-ask spread, so this profit is free and clear. If this is a good deal with 1 million, it is even better with a billion transaction. The larger the trade, the larger is the profit. With forex volume around $ 2 trillion par day, there is no doubt that there are plenty of arbitrageurs looking for opportunities such as these. Dealers are just as vigilant in ensuring that their bid and offer quotes overlap those of other forex dealers. If a banks bid or offer quotes drift outside of the band defined by other dealers quotes, they quickly find themselves in undated with buy (sell) orders for their low-priced (high-priced) currencies.
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Even if banks quoted rates do not allow arbitrage, banks offering the lowest offer (or highest bid) prices in a currency will attract the bulk of customer purchases (sales) in that currency. The long and the short of it A long position is synonymous with ownership of an asset. A short position means the holder of the position has sold the asset with the intention of buying it back at a later date. Long positions benefit if the price of the asset goes up, whereas short positions benefits if the price of the asset goes down. For example, a bank is in a long Euro position and a short Dollar position when, on balance, it has purchased Euros and sold Dollars. Conversely, a bank is short position Euros and Long position Dollars when it has sold Euros and purchased Dollars. Currency balances must be netted out; if a bank has bought 100 million and sold 120 million in two separate transactions, then its net position is short 20 million. Banks try to minimize their net exposures, because currency dealers operating with large imbalances risk big gains or losses if new information arrives and currency value unexpectedly changes. 4.3.2 Interest Rate Parity and Covered Interest Arbitrage Let be the t-period forward exchange rate initiated at time zero (0) for exchange at time t.

is the spot exchange rate at time zero (0). Nominal interest rates in the two currencies are denoted if and id. Interest Rate Parity, or IRP, relates the currency and interest rate markets as follows

=[

]t

According to Interest Rate Parity, the forward premium (or discount) reflects the interest rate differential on the right-hand side of equation above. For major currencies, nominal interest rate contracts are actively traded in the interbank Eurocurrency markets. Likewise, there are active spot and forward markets for major currencies. Because each contract in equation above is actively traded, interest rate parity always holds within the bounds of transaction costs in these markets.
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4.3.3 Covered Interest Arbitrage Locational arbitrage takes advantage of a price discrepancy between two locations, and triangular arbitrage takes advantage of price disequilibria across three bilateral cross rates. Through a similar mechanism, covered interest arbitrage takes advantages of an interest rate differential that is not fairly reflected in the forward premium. Disequilibrium in the interest rate parity relation provides an opportunity for arbitrageurs to borrow in one currency, invest in the other currency, and cover the difference in the spot and forward currency markets. The noarbitrage condition then ensures that currency and Eurocurrency markets are in equilibrium within the bounds of transactions. Example Suppose you can trade at the following prices: =$ 1.250000/ =$ 1.200000/

i$ = 8.15000% Where; S = spot exchange rate F = forward exchange rate i$ = domestic interest rate i = foreign interest rate

i =11.5625%

Interest Rate Parity doesnt hold, because

=0.960000 < 0.969412 =

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Covered interest rate arbitrage is described below as follows 1. Borrow 1 million at the prevailing Eurocurrency interest rate of i = 11.5625 percent for one year. Your obligation will be $ 1,115,625 in one year. 2. Exchange the 1 million for $ 1.25 million at as the spot exchange rate. This leaves you with a net dollar inflow today and a pound obligation in one year. 3. Invest the $ 1.25 million at i$ = 8.15000 percent. Your pay off will be ($1,250,000)(1.0815) = $ 1,351,875 in one year. Your net position is now an inflow of $1,351,875 and outflow of 1,115,625, both at time t=1. 4. To cover your time t=1 obligation of 1,115,625, sign a 1 year forward contract in which you bag 1,115,625 and sell ($1.2/)(1,115,625) = $ 1,338,750 at the forward rate =$ 1.200000/. The net result is an arbitrage profit of $13,125. Although this example ignores bid-ask spreads, these could be included by using appropriate bid or offer price when trading each contact.

4.4 Chapter review questions

i. ii. iii. Explain what is meant by the term Purchasing Power Parity (PPP). What is arbitrage profit and when one can make arbitrage profit. Given the following information, assess whether the interest rate parity condition holds =$ 2.500000/ i$ = 16.3000% rate, i is foreign interest rate. If bank X is quoting A $1.5838/ bid and A $1.1682/ ask and bank Y is quoting A $1.1684/ bid and A $1.1690/ ask. If you buy 2million from X at its A $1.1682/ ask price and simultaneously sell 2million to Y at its A $ 1.1684/ bid price. Calculate arbitrage profit.
54

=$ 2.400000/ i =23.1250%

Where S is spot exchange rate, F is forward exchange rate, i$ is domestic interest

iv.

Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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CHAPTER FIVE: FOREIGN EXCHANGE RISKS/EXPOSURES Objectives of the chapter At the end of this chapter, the student should be able to: Give the meaning of foreign exchange exposure. Clearly, discuss various types of foreign exchange exposure Explain various strategies for managing exchange rate exposure 5.0 Introduction There are two types of foreign exchange risk or exposure. The term foreign exchange exposure refers to the degree to which a company is affected by exchange rate changes. Economic exposure Accounting exposure (translation exposure)

5.1 Economic exposure Economic exposure refers to the risks arising from economic transaction and other economic activities. The economic exposures focuses on the impact of an exchange rate change on future cash flows; that is, economic exposure is based on the extent to which the value of the firm, as measured by the present value of its expected future cash flows, will change when exchange rate change. Specifically, if PV is the present value of a firm then firm is exposed to risk if zero, where: = is the change in that firms present value associated with an exchange rate change, . is not equal to

Economic exposure may be divided into its two component parts; transaction exposure and real operating exposure.

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5.1.1 Transaction exposure Transaction exposure arise out of the various types of transactions, such as international trade, borrowing and lending in foreign currencies, and the local purchasing and sales activities of foreign subsidiaries, that requires settlement in a foreign currency. Transaction exposure measure the change in the value of outstanding nominal financial obligations incurred prior to a change in the exchange rate but not due to be settled until after exchange rate change. Example A US firm sells good to a Kenyan importer with price of $10,000, with payments due in 90 days. The current spot exchange rate is Kshs.86/$1, so the price of the sale in foreign currency is Kshs.860, 000. The transaction exposure arises because in all likelihood the foreign buyer will not probably pay Kshs 860,000 because the spot rate will differ on the settlement date. If spot exchange rate in 90 days to come is Kshs.90/$1 the Kenyan importer pays Kshs.900, 000. If spot exchange rate in 90 days to come is Kshs.80/$1 the Kenyan importer pays Kshs.800, 000. Thus, the foreign buyer faces an economic gain or loss on the purchase of the good depending on how the exchange changes. 5.1.2 Operating exposure This exposure arises because currency fluctuation can alter companys future revenues and costs, that is, its operating cash flows. Measuring a firms operating exposure requires a longer-term perspective, viewing the firm as an ongoing concern with operations whose cost and price competitiveness could be affected by exchange rate changes. Example Assume that a multinational firm has concentrated its production in one country and sells the output across the world. If the currency of this particular country appreciates considerably, the products from this country will be costly in terms of the currencies which have depreciated vis-vis that countrys currency, making its goods good costly in foreign markets.
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5.2 Accounting exposure (transaction exposure) Accounting exposure arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies involved to the home currency. Translation exposure measures the accounting derived exchange rate gains or losses that result from the need to convert foreign currency financial statements of affiliates into parent currency units. It arises from the total change in the nominal exchange rate from previous reporting period and the particular accounting basis i.e. consolidation method used. Translation effects do not result in a change in current cash flow.

5.3 Strategies for managing exchange rate exposure/ risks

The four most common ways of minimizing exchange risk are: Exchange risk avoidance Changing sourcing Exchange risk adaptation Currency diversification

i.

Exchange risk avoidance

This is the elimination of exchange risk by doing business locally. The adverse effects of a devaluation of the domestic currency can be mitigated by procuring the items domestically if devaluation has made the domestic goods cheaper than foreign goods. Devaluation often encourages imports substitution (indigenization) ii. Changing /diversify sourcing

Another strategy is to change the sources of purchasing. For example, if the US goods become costlier because of dollar appreciation, change the source of purchase from US to countries where the product is cheaper, either because of depreciation of their currencies or other reasons. iii. Currency diversification

Currency diversification is the spreading financial assets across several currencies so that exchange rate movements of different currencies may be evened out. This may be applicable to change to large multinational national enterprises that have an ongoing need for those currencies;
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however it is not feasible in respect of small firms whose international operations are not widely spread. iv. Exchange risk adaptation

Exchange risk adaptation is the use of hedging to provide protection against exchange rate fluctuation. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates. In other words, hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Hedging can protect a firm from unforeseen currency movements. One of the most common methods of hedging is the purchase of forward contract, futures and currency options. Other methods include: Money market hedge Money market hedge is a technique by which transaction exposure may be hedged by borrowing and lending in the domestic and foreign money market. A firm may borrow or lend in foreign currency to hedge currency receivables. For example, an American firm which has receivables in pounds may borrow the required amount in pounds for a period which equals the maturity of the receivables, convert them into dollars and invest them. The pound loan can be paid off when the pound receivables are realized. Hedging by lead and lag Leading and lagging the foreign currency receipts and payments is another technique for reducing the transaction exposure. To lead means to pay or collect early and to lag means to pay or collect late. A firm lead soft currency (i.e. relatively weak currency, prone to depreciation) payments and lag hard currency (strong currency which is likely to appreciate) receivables to avoid the loss from depreciation of the soft currency and to gain from the appreciation of the hard currency.

59

 Exposure netting When a firm has a portfolio of currency positions i.e. both receivables and payments in different currencies, it is unnecessary to hedge every position if the adverse effects of exchange rate movements in some cases are likely to be offset by the favourable movements in other cases. Exposure netting involves offsetting exposures in one currency which exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. This portfolio approach to hedging recognizes that the total variability or risk of a currency exposure portfolio should be less than the sum of the individual variabilities of each currency exposure considered in isolation. The assumption underlying exposure netting is that the net gain or loss on the entire currency exposure portfolio is what matter, rather than the gains or loss on any individual monetary unit. In practice, exposure netting involves one of the 3 possibilities:1. A firm can offset a long-position in a currency with a short position in that some currency. 2. If the exchange movements of two currencies are positively correlated (for example the Swiss franc and deutsch mark), then the firm can offset a longposition in one currency with a short position in the other. 3. If the currency movements are negatively correlated, then short (or long) positions can be used to offset each other. 5.3 Chapter review questions i. What do you understand is meant by the term foreign exchange exposure? ii. Define economic exposure and discuss, by give example, two component of economic exposure. iii. iv. Explain accounting (translation) exposure. Discuss any five strategies for managing exchange rate exposure

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Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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CHAPTER SIX: INTERNATIONAL INVESTMENT AND INTERNATIONAL FINANCIAL INSTITUTION Objectives of the chapter At the end of this chapter, the student should be: Explain the meaning of the term Official Development Assistance (ODA) Discuss types of foreign private investment Give significance of foreign investment Differentiate between IMF and world bank, and explain their purposes 6.0 Introduction International business has been propelled/ boosted by large cross-border flows of finance. While the private financial flows are invariably/always, commercial in nature, financial flows related to Official Development Assistance (ODA) have also implications for business. Official Development Assistance refers to grants and soft loans from official sources, with the objectives of promoting economic development and social welfare. There are two channels of aid flows:I. II. Between governments and government agencies (bilateral flows) Through multilateral institutions like the World Bank and Regional Development Banks (multilateral flows) The poor countries are not able to raise much money on commercial terms. Official Development Assistance (ODA) or Aid is very important for that, investments resulting from ODA also provide opportunities for private business besides the general economic improvements such investments may promote. 6.1 Types of foreign private investment Broadly, there are two types of foreign private investment: Foreign direct investment (FDI) Foreign portfolio investment (FPI)

62

6.1.1 Foreign direct investment (FDI) Foreign direct investment refers to investment in a foreign country where the investor retains control over the investment. It typically takes the form of starting a subsidiary, acquiring a stake in an existing firm or starting a joint venture in the foreign country. United Nations Conference on Trade and Development (UNCTED)s world invest report defines foreign direct investment (FDI) as an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate). FDI implies that the investor exerts a significant degree of influence on the management of the enterprise resident in the other country. Flows of FDI comprise capital provided (either directly or through other related enterprises) by a foreign direct investor to an FDI enterprise, or capital received from an FDI enterprise by a foreign direct investor. Foreign domestic investment (FDI) has three components: Equity capital, Reinvested earnings and Intra-company loans. FDIs are governed by long-term considerations because these investments cannot be easily liquidated. Hence factors like long term political stability, government policy, industrial and economic prospects, among other, influence FDI decision. 6.1.2 Foreign Portfolio Investment (FPI) If the investor has only a sort of property interest in investing the capital in buying equities, bonds, or other securities abroad, it is referred to as portfolio investment. That is, in the case of portfolio investments, the investor uses his capital in order to get a return on it, but has no much control on the use of the capital.

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6.2 Significance of foreign investment (a) Foreign investment is playing an increasing role in economic development. Economic reforms and the far-reaching political changes have resulted in very substantial changes in the international capital flows. FDI now contributes to a significant share of the domestic investment, employment generation, exports, tax revenue e.t.c. in a number of economies. (b) The changes in the composition of the capital flows and the substantial increase in the magnitude of some of the flows like FDI, have remarkably changed the balance of payments and foreign exchange reserves position of several countries. (c) Foreign investment has assisted and is assisting the economic growth of many countries. As a World Bank report points out, for developing countries FDI has the following advantages over the Official Development Assistance (ODA): FDA shifts the burden of risk of an investment from domestic to foreign investors. Repayments are linked to profitability of the underlying investment, whereas under debt financing the borrowed funds must be serviced regardless of the project costs. Further World Bank has also observed that FDI is the only capital inflow that has been strongly associated with higher GDP growth since 1970. Note Given the limitations of domestic savings, many developing countries will have to rely on foreign investment to accelerate economic growth. 6.3 Reasons for foreign investment The decision to invest capital in a project abroad should be based upon consideration of expected return and risk just like investing locally. However, these factors are different in different countries. Some of the reasons for foreign investment are: Return considerations: - Domestically, competitive pressures may be such that only a normal rate of return can be earned. A firm may invest abroad so as to produce more efficient due to existence of cheaper factors of production.

64

 Taxation:- Tax lows are different in different countries and therefore a firm may invest abroad to minimize tax payment to the government. Risk considerations:- international diversification is often more effective than domestic diversification in reducing risk in relation to expected return. This is due to differences in economic cycles in different countries.

6.4 INTERNATIONAL FINANCIAL INSTITUTIONS There are several international organizations, funding and assisting the development of nations. These include International Monetary Fund, World Bank, Regional Development Bank e.t.c. the influence of some of them is, indeed, very profound. The economic policies and programmes of member countries which take financial assistance from these organizations may be influenced by policies and conditions of assistance of these organizations. The IMF has several schemes of financial assistance for countries with balance of payment problems. It also provides different types of technical assistance. Assistance from the World Bank and Regional Development Banks are substantial sources of public investments in a number of countries and such investments may help improve the general business conditions in those countries. Many of these public projects are implemented by private parties and it is mandatory that contracts in respect of large projects funded by these institutions shall be award by global tendering. Further some of the organizations also provide direct financial assistance to the private sector. 6.4.1 International Monetary Fund (IMF) The International Monetary Fund (IMF), which was established on December 27, 1945 with 29 countries and which began financial operation on March 1, 1947, is the result of the Bretton Woods Conference of nations held in 1944 to discuss the major international economic problems, including reconstruction of the economies ravaged by World War II, and to evolve practical solutions for them. The IMF is the central institution of the international monetary system. It aims to prevent crises in the system by encouraging countries to adopt sound economic policies. Also, as it name
65

suggests, a fund can be tapped by members needing temporary financing to address balance of payment problems. Membership in the IMF is open to every country that controls its foreign relations and is able and prepared to fulfill the obligation of membership. (a) Purpose of IMF The IMFs statutory purposes include promoting the balance expansion of world trade, the stability of exchange rates, the avoidance of competitive currency devaluations, and the orderly correction of a countys balance of payments problems. According to Article one of Agreement of the International Monetary Fund, the purposes of the IMF are: To promote international monetary cooperation through a permanent institutions which provide the machinery for consultation and collaboration on international monetary problems. 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 productive resources of all members as primary objectives of economic policy. To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. 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 which hamper the growth of world trade. To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

66

In accordance with the above, to shorten the duration and lessen the degree of disequilibria in the international balances of payments of members.

(b) Technical Assistance The IMF provides technical assistance in areas within its core mandate; these areas are macroeconomic policy, monetary and foreign exchange policy and systems, fiscal policy and management, external debt, and macroeconomic statistics. The objective of IMF technical assistance is to contribute to the development of the productive resources of member countries by enhancing the effectiveness of economic policy and financial policy. In practice, the IMF fulfills this objective by providing support to capacity building and policy design. It helps countries strengthen their human and institutional capacity, as a means to improve the quality of policy-making, and gives advice on how to design and implement effective macroeconomic and structural policies. The IMF provides technical assistance in three broad areas: Designing and implementing fiscal and monetary policies. Drafting and receiving economic and financial legislation, regulations, and procedures, thereby helping to resolve difficulties that often lie at the heart of macroeconomic imbalances Institution and capacity building, such as in central banks, treasuries, tax and customs departments, and statistical services. 6.4.2 World Bank The World Bank Group, originated as a result of the Bretton Woods Conference of 1944, is one of the Worlds largest sources of development assistance and it has extended assistance to more than 100 developing economies bringing a mix of finance and ideas to improve living standards and eliminate the worst forms of poverty. For each of its clients, the bank works with government agencies, non-governmental organizations, and the private sector to formulate assistance strategies.
67

The World Bank Group consists of five closely associated institutions playing a distinct role in the mission to fight poverty and improve living standards for people in the developing world. The term World Bank refers specifically to two of the five, that is, The International Bank for Reconstruction and Development (IBRD) and The International Development Association (IDA). The other 3 institutions are: The International Finance Corporation (IFC) The multilateral investment guarantee agency The International Centre for Settlement of Investment Disputes (ICSID)

While all five specialize in different aspects of development, they use their comparative advantages to work collaboratively towards the goal of poverty reduction. (a) The purposes of the World Bank, as laid down in its Articles of agreement, are:(a) To assist in the reconstruction and development of the territories of its members governments, by facilitating investments of capital for productive purposes, including the restoration of economies destroyed or disrupted by war and the encouragement of the development of productive facilities and resources in less developed countries. (b) To promote foreign private investment by guarantees of or through participation in loans and other investments made by private investors. (c) Where private capital is not available on reasonable terms, to make loans for productive purposes out of its own resources or out of the funds borrowed by it. (d) To promote the long term growth of international trade and the maintenance of equilibrium in balance of payments by encouraging international investment for the resources of members. The bank advance loans to member countries in the following three ways: i. ii. By making or participating in direct loans out of its own funds. Out of funds raised in the markets of a member or otherwise borrowed by the bank.
68

iii.

By guaranteeing in whole or part loans made by private investors through the investments channels.

The bank has made loans for specific development projects in the field of Agriculture, Power, Transport, Industry and Education, Railway Rehabilitation, Highway Constructions etc. 6.5 Chapter review questions I. State two channels if aid flows II. Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) III. State significance of foreign investment IV. Explain 3 reasons for foreign investment V. Highlight any four purposes of IMF VI. Highlight 3 area in which IMF provides technical assistance VII. Give the purposes of the World Bank as stipulated in its Articles of agreement. VIII. Highlight 3 ways in which the world advance loans to member countries.

Reference Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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CHAPTER SEVEN: STRUCTURAL ANJUSTMENT PROGRAMMES (SAPs) Objectives of the chapter At the end of this chapter, the student should be able to: What is meant by the term structural adjusted programme (SAPs) Explain what SAPs was designed to do Discuss conditions for structural adjustment programme Criticize structural adjusted programme 7.0 Introduction Structural adjustment programmes is the name given to a set of free market economic policy refers imposed on developing countries by the World Bank and international monetary fund [IMF] as a condition for receipt of loans. Thus structural adjustment programmers are the policies implemented by the international monetary fund (IMF) and the World Bank in developing countries. These policy changes are conditions for getting new loans from international monetary fund or World Bank, or for obtaining lower interest rates on existing loans. The conditions are implemented to ensure that the money lent will be spent in accordance with the overall goods of the loan. 7.1 What was structural adjustment programmes (SAPs) designed to do? SAPs are designed to:i. Improve a countrys foreign investment climate by eliminating trade and investment regulations. ii. To boost foreign exchange earnings by promoting exports. iii. To reduce government deficits through cuts in spend. SAPs were developed in the early 1980s as a means of gaining stronger influence over the economies of debt-strapped governments in the south. To ensure the continued inflow of funds, countries already devastated by debt obligations have little choose but to adhere to conditions
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mandated by the IMF and World Bank. The structured adjustment programmers (SAPs) are created with the goal of reducing the borrowing countrys fiscal imbalances. The SAPS are supposed to allow the economies of the developing countries to become were market oriented. This then forces them to concentrate more on trade and production so it can boost their economy. Through conditionalities, structural adjustment programmes and policy these programs include; 1. Internal changes (privatization and deregulation) 2. External changes, especially the reduction of trade barriers. Countries which fail to enact these programs may be subject to severe fiscal discipline.

7.3 CONDITIONS FOR STRUCTURAL ADJUSTMENT PROGRAMMES (what measures are imposed under SAPs?) 1. Cutting expenditures (austerity) that is, deep cuts to social programs usually in the areas of health, education and housing and massive layoffs in the civil service. 2. Shift from growing diverse food crops for domestic consumption to specializing in the production of cash crops or other commodities like rubber, cotton, coffee, copper, tin for export. 3. Abolishing food and agricultural subsidies to reduce government expenditures 4. Devaluation of currencies currency devaluation measures increase import costs while reducing the value of domestically produced goods. 5. Trade liberalization, i.e. lifting import and export restrictions and high interest rates to attract foreign investment. 6. Balancing budgets and not overspending. 7. Removing price controls and state subsidies. 8. Privatization of government held enterprises. 9. Enhancing the rights of foreign investors vis- vis national laws. 10. Improving governance and fighting corruption. 11. Increasing the stability of investments by supplemental foreign direct investment with the opening of domestic stock markets. 12. Focusing economic output on direct export and resource extraction.
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These conditions have also been sometimes labeled as the Washington consensus.

7.4 Why the need for SAPs? The World Bank and the IMF argue that SAPs are necessary to bring a developing country from crisis to economic recovery and growth. Economic growth driven by private sector foreign investment is seen as the key to development. These agencies argue that the resulting national wealth will eventually trickle down or spread throughout the economy and eventually to the poor. 7.5 Criticisms on SAPs Multiple criticisms that focus on different elements of SAPs 1. National sovereignty- critics claim that SAPs threaten the sovereignty of national economies because an outside organization is dictating a nations economic policy. Critics argue that the creation of good policy is in a sovereign nations own best interest. Thus, SAPs are unnecessary given the state is acting in its best interest. However, supporters consider that in many developing countries the government will favor political gain over national economic interests; that is, it will engage in rent-seeking practices to consolidate political power rather than address crucial practices to consolidate political power rather than address crucial economic issues. Also some critic argue that the democratic policy process of countless countries has been undermined by decisions formulated miles away by western economic bureaucrats and that the implementation of such policy has solely benefited the largest donor countries like US, UK, Canada & Japan. 2. Privatization: - A common policy in structural adjustment is the privatization of stateowned industries and resources. This policy aims to increase efficiency and investments, and decrease state spending. State-owned resources are to be sold whether they generate a fiscals profit or not. Critics argue that when resources are transferred to foreign corporation and/or national elites, the goal of public prosperity is replaced with the goal of private accumulation.
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Privatization makes essential needs such as water and health cure a commodity, and these who are poor are unable to access such basic necessities. Therefore, many scholars have argued that SAPs are not in the interest of the borrowing country, but rather caters to the elites of the eliminating and undeveloped worlds. The privatization of a previously social service such as health care is actually counterintuitive to the alleged purpose of structural adjustment. 3. Agriculture:-The agricultural, anti-land reform and food trade policies associated with SAPs have been pointed to as a major engine in the urbanization of the developing. In the irrigation sub-sector the trend has been towards disengagement of governments from irrigation development and management. There are also sources of contention for environmental activities. If large portion of SAPs policy in agriculture focuses on the increased use of fertilizers and pesticides which harm the health of local bodies of water and therefore fish populations Impact- the privatization of the agricultural sector increased the inequality of good distribution and inequality wealth in general as some farmers adapted to privatization and flourished and others fell behind. Farmers were introduced to fertilizers that left the hand nutrient barren and unusable. In theory, devolution, by lowering the relative price of farm commodities on the international market, should make a countrys agriculture exports more competitive. However, it is by no means certain that increased exports compensate for the loss of purchasing power of a cheaper currency. 4. Environment Local environments can easily become casualties of pro-trade policies. Pro-trade policy promotes an increase of industry geared toward western needs. As a result of the policy, local industries begin the focus on producing in expensive goods to sell on the international market.

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Impact: - the focus on creating the least expensive product often leads to environment exploitative industry. As these industries are often unregulated there are no laws prohibiting this exploitation. For example, emission from factories is much less regulated in developing nations. SAPs call for increased exports to generate foreign exchange to service debt. The acceleration of resource extraction and commodity production that results as countries increase exports is not ecologically sustainable. Deforestation, land degradation, soil erosion and sanitization, biodiversity loss, increased production of green house gases, and air and water pollution are but a many the long-term environmental impacts that can be traced to the imposition of SAPs.

5. Austerity SAPS emphasized maintain a balanced budget which forces austerity programs. The casualties of balancing a budget are often social programs. The programs most often cut are education, public health, and other miscellaneous social safety nets. Commonly, those are programs that are already underfunded and desperately need monetary investment for improvement. Impact: - if government cuts education funding, universally is impaired, and therefore long-term economic growth.

6. Gendered effects Poverty is a gendered issue, that is, various differences in circumstances between males and females cause variances in the way poverty affects each. With this structural adjustment programs fail to address poverty as a gendered issue. Thus implementation of SAPs caused many problems which include: Local health, welfare and infrastructures (especially water and sanitation) are usually considered womens work and fall directly to them. Withdrawing government support directly affects the amount of work women are required to do, resulting in lessened health and well-being for women and indeed the entire family.

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 In addition, opening markets causes an upsurge of jobs in cities. As rural man leave to go to those jobs, women and children are left behind, with increased responsibility for wives and mothers to single handedly run the household. 7.6 Chapter review questions I. Define Structural Adjustment Programme (SAPs) II. III. IV. V. What was structural adjustment programme (SAPs) designed to do? Highlight 8 conditions for structural adjustment programme (SAPs) Briefly hive argument for SAPs as give by World Bank and IMF. Discuss any four criticisms on SAPs.

Reference
Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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CHAPTER EIGHT: INTERNATIONAL MONEY AND CAPITAL MARKET Objectives of the chapter At the end of this chapter, the student should be able to: Explain what is international banking and be able to differentiate between domestic banks Give ways in which international finance assist multinational enterprises Discuss various types of international banking offices Explain the concept of Eurocurrency and Eurobond market. Discuss factors to consider when choosing between Euromarkets or Domestic markets Factors which motivate capital flows between economic agents of different countries. The development of international business is highly assisted by the development of international banking and Eurocurrency market. 8.1 International banking International banks are banks which accept foreign currency deposit, finance international business and provide associated and ancillary/ supplementary services like hedging and advisory services and operate internationally. The major distinguishing features between domestic banks and international banks are the types of deposits they accept and the loans and investments they make. Large international banks both borrow and lend in the Eurocurrency market. Additionally, they are frequently members of international loan syndicates, participating with other international banks to lend large sums to multinationals corporations needing project financing and sovereign governments needing funds for economic development. Areas in which international banks typically have expertise to provide consulting services and advice to their clients are: foreign exchange hedging strategies, Interest rate and currency swap financing, and international cash management services.

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Banks that provide a majority of these services are commonly known as universal banks or full service banks. Some of the leading international banks include Bank of America, Citigroup and Industrial and commercial Bank of China (ICBC). 8.1.1 International banks assist multinational enterprises in the following ways: (a) financing of foreign trade (b) financing capital project (c) international cash management services (d) providing full local banking services in different countries (e) trading in foreign exchange and currency options (f) lending and borrowing in Eurocurrency markets (g) participating in syndicated loans facilities (h) provisions of advice and information (i) Underwriting of Eurobonds. 8.1.2 Types of international banking offices There are different types of international banking offices ranging from correspondent bank relationships, through which minimal services can be provided to a banks customers, to branch offices and subsidiaries providing a full array of services. (a) Correspondent bank:- a correspondent bank is a bank located elsewhere that provides services on behalf of other bank, besides its normal business. The correspondent banking system enables a banks foreign client to conduct business worldwide through his local bank or its contacts. The correspondent bank mode is ideal because of its low cost when the volume of business is small. The possible disadvantage is that the clients may not receive the required level of services. (b) Representative offices:- this is a small service facility staffed b the parent bank personnel that is designed to assist the foreign clients of the parent bank in dealings with a level of service greater than that provided through a correspondent relationship. (c) Foreign branches:- they provide full services, and are established when volume of business is sufficiently large and when low of the land permits it. Foreign branches facilitate better services to the clients and help the growth of business.
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(d) Subsidiaries and Affiliates:- a subsidiary bank is a locally incorporated bank that is either wholly or majority owned by a foreign parent and an affiliate bank is one that is only partially owned but not controlled by its parent. Subsidiaries and affiliates are normally meant to handle substantial volume of business. 8.2 Eurocurrency and Eurobond market Eurocurrency markets are defined as banking markets which involve short-term borrowing and lending conducted outside the legal jurisdiction of the authorities of the currency that is used. For example, Eurodollar deposits are dollar deposits held in London and Paris. The Eurocurrency market has two sides to it i.e. the receipt of deposits and the loaning out of these deposits. The most important Eurocurrency is the Eurodollar which currently accounts for approximately 65-70 per cent of all Eurocurrency activities, followed by the Euromark, Eurofrancs (Swiss), Eurosterling and Euroyen. The Eurocurrency markets are part of the international money market since it involves lending and borrowing for a period of less than a year. 8.2.1 International capital market Large companies may arrange borrowing facilities from their bank, in the form of bank loans or bank overdrafts. Instead, however, they might prefer to borrow from private investors by issuing Eurobonds. The Eurobond market is part of the international capital market and involves lending and borrowing for a period of more than a year. A Eurobond is a bond that is sold by a government, institution or company in a currency that is different from the country the bond is issued. For example, a dollar bond sold in London is a dollar Eurobond and a sterling bond sold in Germany is a sterling Eurobond. Note An investor subscribing to a bond issue will be concerned about: Security the borrower must of high quality
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 Marketability investors wish to have a ready market in which bonds can be bought and sold. The return on the investment as indicated by the coupon interest rate

8.2.2 Factors to consider when choosing between Euromarkets or Domestic Markets (a) The currency that the borrower wants to obtain Multinational companies usually want to borrow in foreign currency to reduce their foreign exchange exposure and therefore borrow in Euromarkets rather than the domestic market. (b) The cost

There is often a small difference in interest rate between Eurocurrency and domestic markets. On large borrowings, however, even a small difference in interest rate result in a large difference in the total interest charged on the loan. (c) Timing and speed

It may be possible to raise money on the Euromarkets more quickly than in the domestic markets. (d) Security

Euromarkets loans are usually unsecured, whereas, domestic market loans are more commonly secured. Large borrowers may therefore prefer Euromarkets. (e) The size of the loans

It is often easier for a large multinational to raise very large sums on the Euromarkets than in a domestic financial market. 8.2.3 Participants in the Eurocurrency and Eurobond markets The participants in the international money and capital markets include national governments, local authorities, financial institutions such as banks, multinational firms, companies and international institutions such as the World Bank, as well as private investors.

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Most industrialized countries participants act as both lenders and borrowers of funds, while many developing countries use the markets almost exclusively for borrowing purposes. The various types of capital flows between economic agents of different countries are motivated by various factors which include: Trade financing motives: - much trade is financed by borrowing on the international money and capital markets. Borrowing/lending motives:- many capital flows are simply motivated by the desire of savers to get the best possible return on their money, while borrowers are merely seeking to obtain the lowest possible interest rate. Hedging motives:- much borrowing and lending is motivated by desire to hedge positions, that is, to reduce or eliminate losses resulting from prospective interest-rate and exchange rate changes. Speculative motives:- much borrowing or lending is due to the taking of speculative positions based on profiting from prospective interest-rate and exchange-rate changes. Capital flight motives:- many movements of capital are motivated by a desire to protect investors funds from penal taxation, possible seizure by the domestic government, or to escape potential restrictions being imposed on convertibility or to avoid political risk.

8.3 Chapter review questions

I. Explain what international banking is and differentiate between domestic banks and international banks II. III. IV. V. Highlight ways in which international finance assist multinational enterprises Discuss various types of international banking offices Explain the concept of Eurocurrency and Eurobond market. Discuss factors to consider when choosing between Euromarkets or Domestic markets. VI. Factors which motivate capital flows between economic agents of different countries.

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Reference
Butler, K. C. (2008) Multinational Finance. Chichester, England: John Wilsey $ Sons Ltd, the Atrium, South Gale,. Cherunilam, F. (2007) International Business. 4TH Ed. New Delhi: Asoke K. Gitosh, PHI learning private limited Clark (2007), International Finance Management, Cengage Learning (Thompson) Morris Levis (2007), International Finance. 5th Ed. Routledge, London. Thomas J Obrien (2008),International finance, Oxford University Press

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SAMPLE REVISION QUESTIONS SECTION A 1. (a) Highlight 2 ways in which the world advance loans to member countries. (b) Define Structural Adjustment Programme (SAPs) (c) State any factors to consider when choosing between Euromarkets or Domestic markets. (2 marks) 2. (a) Highlight three ways in which international banks assist multinational enterprises (3 marks) (b) Differentiate between nominal exchange rate and real exchange rate 3. Give the meaning of the following terms; Foreign market, Foreign exchange rate, Spot exchange rate, Currency options. Nominal exchange rate, 4. Define balance of payments and explain what to be included in it. 5. What is arbitrage profit and when one can make arbitrage profit. 6. Explain significance of international finance 7. Discuss international financial environment 8. Explain what is meant by the term Purchasing Power Parity (PPP). 9. (a) What do you understand is meant by the term foreign exchange exposure? (5 marks) (5 marks) (5 marks) (5 marks) (5 marks) (1 marks) (2 marks) (5 marks) (2 marks) (1 marks)

(b) Define economic exposure and discuss, by give example, two component of economic exposure. (2 marks)

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(c) Explain accounting (translation) exposure. 10. (a) State two channels of aid flows

(2 marks) (1 mark)

(b) Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) (c) State significance of foreign investment SECTION B 11. (a) Highlight any 3 purposes of IMF (b) Highlight 3 area in which IMF provides technical assistance (3 marks) (3 marks) (2 marks) (2 marks)

(c) Give five purposes of the World Bank as stipulated in its Articles of agreement. (5 marks) (d) Highlight 8 conditions for structural adjustment programme (SAPs) (e) Briefly give argument for SAPs as give by World Bank and IMF. (8 marks) (3 marks)

12. (a) Discuss any four criticisms on SAPs. (b) Discuss four types of international banking offices

(10 marks) (10 marks)

13. (a) Explain what international banking is and differentiate between domestic banks and international banks (b) Explain the concept of Eurocurrency and Eurobond market. (c) Factors which motivate capital flows between economic agents of different countries. (8 marks) (6 marks) (6 marks)

14. Briefly, discuss argument for, and argument against floating exchange rate

(20 marks)

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15. (a) Highlight difference five between currency future contacts and currency forward contracts (b) Clearly, explain sub-accounts in the balance of payments (5 marks) (15 marks)

16. (a) What is the meaning of balance of payments surplus and balance of payments deficit. (5 marks)

17. (a) Briefly, explain functions of foreign exchange market (b) Briefly, discuss characteristics and participants of foreign exchange market.

(10 marks) (10 marks)

18. (a) Explain determinants of demand and supply of foreign currency (b) Discuss factors that influence exchange rates

(10 marks) (10 marks)

19. Briefly, discuss argument for, and argument against fixed exchange rate (b) Discuss factors that cause disequilibrium in the balance of payments (c) State and explain two correction measures for the balance of payment disequilibrium

(20 marks) (10 marks)

(5 marks)

20. (a) Given the following information, assess whether the interest rate parity condition holds =$ 1.8750/ =$ 1.800000/
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i$ = 12.2250% rate, i is foreign interest rate.

i =17.2500%

Where S is spot exchange rate, F is forward exchange rate, i$ is domestic interest (7 marks)

(b) If bank X is quoting A $1.5838/ bid and A $1.1682/ ask and bank Y is quoting A $1.1684/ bid and A $1.1690/ ask. If you buy 2million from X at its A $1.1682/ ask price and simultaneously sell 2million to Y at its A $ 1.1684/ bid price. Calculate arbitrage profit. (7 marks)

(c) State and briefly explain any three strategies for managing exchange rate exposure (6 marks)

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