MS- 45: International Financial Management

Course Code : MS-45

Course Title : International Financial Management
Assignment Code : 45/TMA/SEM-II/2010
Coverage : All Blocks

Attempt All the Questions.

1. Explain in detail the evolution of International Financial Architecture.

Solution: In recent policy pronouncements on the future of the International Financial

Architectur in India, a dominant theme advanced by the authorities has been one of
gradual harmonization with the international best practices, in particular standardized
approach to credit risk and the basic indicator approach to operational risk under Basel II
norms. In the same vein, proposals have been canvassed for consolidation of banks so as
to create some big banks of global standards and removal of voting rights restrictions so
as to attract foreign capital into the banking industry. Thus, based on the globalization
goals and the objectives of setting global standards, the priorities and challenges facing
the banking industry are conceived in terms of upgrading risk management practices in
banks and supervisory processes “for dealing with the stress in the financial system”. It is
the same policy perspective that has been advanced in the just released Report on
Currency and Finance 2006-08 (August 2008) which is entirely devoted to the subject of
“The Banking Sector in India: Emerging Issues and Challenges”. Befitting this stance, the
Report argues that “supply-driven credit, which is being followed at present in India and
several other countries has not been effective” for agriculture and even the SME sector
(p.58); therefore, the Report resurrects the philosophy of demand-centric approach for
both the sectors - credit based on land as collaterals for agriculture and asset-based
International Financial Architecture for the SME sector in India. Such a policy
formulation is apparently the final culmination of an incessant drive towards dismantling
all aspects of social banking objectives and operations which had served the benefits of
the vast informal sectors like agriculture and micro and small non-farm enterprises at
least for a decade after the bank nationalization; studies have shown that in the 1980s,
substantial redistribution of institutional credit in favor of these sectors had conferred
many an economic and social benefit: reduction in dependence on moneylenders and
widening the demand base of the economy leading to acceleration in overall economic
growth. Now, under the dispensation of global standards, the International Financial
Architecture find it difficult to reach the asset less poor. It was in this context of the
working of the International Financial Architecture that are characterized as markedly
different from other markets, that Joseph Stieglitz came out clearly to assert that
globalization could have devastating effects on developing countries and especially the
poor within those countries Thus, in the International Financial Architecture now on the
expected role of the financial system in India, what is neglected is the imperative of
institution-building which is the fountainhead of the supply-leading approach to credit
delivery for agriculture, micro and small enterprises and for other informal sectors
adopted following bank nationalization. In fact, it is not realized that a good part of the
risk management issues also can be taken care of, if we have a fairly decentralized
institutional structure with the spread of branch network in the length and breadth of the
country, professionally well-manned, such that ‘lenders have sufficient knowledge about
borrowers’ and information asymmetry giving rise to the issues of moral hazard and
adverse selection is avoided.

2. What were the different Exchange Rate Arrangements? Explain the present
system of exchange Rate.

Solution: The currency of another country circulates as the sole legal tender or the
member belongs to a monetary or currency union in which the same legal tender is shared
by the members of the union. Adopting such regimes implies the complete surrender of
the monetary authorities' independent control over domestic monetary policy.

assets, eliminating traditional central bank functions, such as monetary control and
lender-of-last-resort, and leaving little scope for discretionary monetary policy. Some
flexibility may still be afforded, depending on how strict the banking rules of the
currency board arrangement are.

Other Conventional Fixed Peg Arrangements

The country (formally or de facto) pegs its currency at a fixed rate to another currency or
a basket of currencies, where the basket is formed from the currencies of major trading or
financial partners and weights reflect the geographical distribution of trade, services, or
capital flows. The currency composites can also be standardized, as in the case of the
SDR. There is no commitment to keep the parity irrevocably. The exchange rate may
fluctuate within narrow margins of less than ±1 percent around a central rate-or the
maximum and minimum value of the exchange rate may remain within a narrow margin
of 2 percent-for at least three months. The monetary authority stands ready to maintain
the fixed parity through direct intervention (i.e., via sale/purchase of foreign exchange in
the market) or indirect intervention (e.g., via aggressive use of interest rate policy,
imposition of foreign exchange regulations, exercise of moral suasion that constrains
foreign exchange activity, or through intervention by other public institutions). Flexibility
of monetary policy, though limited, is greater than in the case of exchange arrangements
with no separate legal tender and currency boards because traditional central banking
functions are still possible, and the monetary authority can adjust the level of the
exchange rate, although relatively infrequently

Pegged Exchange Rates within Horizontal Bands

The value of the currency is maintained within certain margins of fluctuation of at least
±1 percent around a fixed central rate or the margin between the maximum and minimum
value of the exchange rate exceeds 2 percent. It also includes arrangements of countries
in the exchange rate mechanism (ERM) of the European Monetary System (EMS) that
was replaced with the ERM II on January 1, 1999. There is a limited degree of monetary
policy discretion, depending on the band width.

Crawling Pegs
The currency is adjusted periodically in small amounts at a fixed rate or in response to
changes in selective quantitative indicators, such as past inflation differentials vis-à-vis
major trading partners, differentials between the inflation target and expected inflation in
major trading partners, and so forth. The rate of crawl can be set to generate inflation-
adjusted changes in the exchange rate (backward looking), or set at a preannounced fixed
rate and/or below the projected inflation differentials (forward looking). Maintaining a
crawling peg imposes constraints on monetary policy in a manner similar to a fixed peg
system.

Exchange Rates within Crawling Bands

The currency is maintained within certain fluctuation margins of at least ±1 percent
around a central rate-or the margin between the maximum and minimum value of the
exchange rate exceeds 2 percent-and the central rate or margins are adjusted periodically
at a fixed rate or in response to changes in selective quantitative indicators. The degree of
exchange rate flexibility is a function of the band width. Bands are either symmetric
around a crawling central parity or widen gradually with an asymmetric choice of the
crawl of upper and lower bands (in the latter case, there may be no preannounced central
rate). The commitment to maintain the exchange rate within the band imposes constraints
on monetary policy, with the degree of policy independence being a function of the band
width.

Managed Floating with No Predetermined Path for the Exchange Rate

The monetary authority attempts to influence the exchange rate without having a specific
exchange rate path or target. Indicators for managing the rate are broadly judgmental
(e.g., balance of payments position, international reserves, parallel market developments),
and adjustments may not be automatic. Intervention may be direct or indirect.

Independently Floating
The exchange rate is market-determined, with any official foreign exchange market
intervention aimed at moderating the rate of change and preventing undue fluctuations in
the exchange rate, rather than at establishing a level for it.

Monetary Policy Framework

The exchange rate regimes are presented alongside monetary policy frameworks in order
to present the role of the exchange rate in broad economic policy and help identify
potential sources of inconsistency in the monetary-exchange rate policy mix.

Exchange Rate Anchor

The monetary authority stands ready to buy/sell foreign exchange at given quoted rates to
maintain the exchange rate at its pre-announced level or range; the exchange rate serves
as the nominal anchor or intermediate target of monetary policy. This type of regime
covers exchange rate regimes with no separate legal tender; currency board
arrangements; fixed pegs with and without bands; and crawling pegs with and without
bands.

Monetary Aggregate Anchor

The monetary authority uses its instruments to achieve a target growth rate for a
monetary aggregate, such as reserve money, M1, or M2, and the targeted aggregate
becomes the nominal anchor or intermediate target of monetary policy.

Inflation Targeting Framework

This involves the public announcement of medium-term numerical targets for inflation
with an institutional commitment by the monetary authority to achieve these targets.
Additional key features include increased communication with the public and the markets
about the plans and objectives of monetary policymakers and increased accountability of
the central bank for attaining its inflation objectives. Monetary policy decisions are
guided by the deviation of forecasts of future inflation from the announced target, with
the inflation forecast acting (implicitly or explicitly) as the intermediate target of
monetary policy.

The present system of exchange Rate.

A floating exchange rate or a flexible exchange rate is a type of exchange rate regime
wherein a currency's value is allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is known as a floating currency.
The opposite of a floating exchange rate is a fixed exchange rate.

Many economists think that, in most circumstances, floating exchange rates are
preferable to fixed exchange rates. They allow the dampening of shocks and foreign
business cycles. However, in certain situations, fixed exchange rates may be preferable
for their greater stability and certainty. This may not necessarily be true, considering the
results of countries that attempt to keep the prices of their currency "strong" or "high"
relative to others, such as the UK or the Southeast Asia countries before the Asian
currency crisis.

Canada is the only country whose currency's value is determined absolutely and entirely
by the foreign exchange market; [1] in cases of extreme appreciation or depreciation, a
central bank will normally intervene to stabilize the currency. Thus, the exchange rate
regimes of floating currencies may more technically be known as a managed float. A
central bank might, for instance, allow a currency price to float freely between an upper
and lower bound, a price "ceiling" and "floor". Management by the central bank may take
the form of buying or selling large lots in order to provide price support or resistance, or,
in the case of some national currencies, there may be legal penalties for trading outside
these bounds.

3. Explain the structure of balance of payments. What are the basic principles
governing recording of the flows?
Solution: The Balance of Payments is an integrated part of the National Accounts and is
constructed as a mirror image of the institutional sector "Rest of the World" in the
National Accounts. In the Balance of Payments, transactions are seen from Norway's
point of view, while in the institutional sector accounts they will be seen from the
perspective of the rest of the world. A surplus on Norway's current account will in the
National Accounts appear as a deficit for the sector "Rest of the World".

The Balance of Payments consists of three main parts: a current account, which shows
current transactions with the rest of the world, a capital showing capital transactions, and
a financial account, which records investment transactions in the form of purchases and
sales of financial instruments. The current account comprises, first, exports and imports
of goods and services, with the balance of goods and services as a balancing item. In
addition, data are provided for compensation of employees, investment income and
expenditure as well as current transfers to and from the rest of the world. The balance for
this component is net income and current transfers. The total balance of the current
account is the sum of the balances of these two components. The capital and financial
account shows how transactions recorded in the current account result in changes in
foreign assets and liabilities, and in addition to purchases and sales of financial
instruments includes capital transfers. This entails that the balance on the current account
must be adjusted for net capital transfers in order to arrive at net lending.

The definitional relationship between the current account and the financial account is that
a current account surplus, adjusted for net capital transfers and net acquisitions of patents
and copyrights etc, increases net foreign assets (or reduces net liabilities), while a deficit
on the current account will reduce net assets (or increase net liabilities).

The financial account also includes transactions that do not have a counter entry in the
current account. One example would be a resident who uses funds in a foreign bank
account to repay a loan raised abroad. Total asset transactions less total liability
transactions result in net lending. By adjusting net lending for valuation changes and
other balance sheet changes not caused by transactions2, we arrive at changes in
Norway's net foreign assets/liabilities.

Status/Stock – these statements show the financial status of an organization at one

specified instant in time. Stock reports = a snapshot.
Flow Report – these statements show the flow of financial information over a period of
time. Flow reports = motion picture
GAAP requires the preparation of three different statements:

Balance Sheet
A Balance Sheet is a status report that shows information about the organization’s
resources at one given time. Examples of information found on a balance sheet are how
much cash is in the bank, what is owed to creditors, and the value of the company’s
assets
Income Statement
An Income Statement (also called a Statement of Earnings, Statement of Operations, or a
Profit and Loss Statement) is a report that shows the flow of revenues (amounts earned
from business activity) and expenses (amounts paid in the course of operations) over a
given period of time, typically a month, quarter, or year.

Statement of Cash Flow

As the name suggests, this is also a flow statement that details the movement of cash
through the organization over a specified period. The whole purpose of accounting is to
provide information that is useful and relevant for interested parities when making
decisions regarding the company and its operations. In order to do that effectively, a
specific language and subsequent rules have been developed for users of the information.
By learning accounting you learn these rules and can then communicate financial
information with others in a comprehensible and comparable manner.

4. Explain the Purchasing Power Parity Relationship and Interest Rate Parity
Relationship.

Solution: Purchasing power parity (PPP) is a theory of exchange rate determination and a
way to compare the average costs of goods and services between countries. The theory
assumes that the actions of importers and exporters, motivated by cross country price
differences, induces changes in the spot exchange rate. In another vein, PPP suggests that
transactions on a country's current account, affect the value of the exchange rate on the
foreign exchange market. This contrast with the interest rate parity theory which assumes
that the actions of investors, whose transactions are recorded on the capital account,
induces changes in the exchange rate.
PPP theory is based on an extension and variation of the "law of one price" as applied to
the aggregate economy. To explain the theory it is best, first, to review the idea behind
the law of one price.

The Law of One Price (LoOP)

The law of one price says that identical goods should sell for the same price in two
separate markets when there are no transportation costs and no differential taxes applied
in the two markets. Consider the following information about movie video tapes sold in
the US and Mexican markets.

Price of videos in US market (P$v) $20

Price of videos in Mexican market (Ppv) p150
Spot exchange rate (Ep/$) 10 p/$
The dollar price of videos sold in Mexico can be calculated by dividing the video price in
pesos by the spot exchange rate as shown, To see why the peso price is divided by the
exchange rate (rather than multiplied) notice the conversion of units shown in the
brackets. If the law of one price held, then the dollar price in Mexico should match the
price in the US. Since the dollar price of the video is less than the dollar price in the US,
the law of one price does not hold in this circumstance.
The next question to ask is what might happen as a result of the discrepancy in prices.
Well, as long as there are no costs incurred to transport the goods, there is a profit-
making opportunity through trade. For example, US travelers in Mexico who recognize
that identical video titles are selling there for 25% less might buy videos in Mexico and
bring them back to the US to sell. This is an example of "goods arbitrage." An arbitrage
opportunity arises whenever one can buy something at a low price in one location and
resell at a higher price and thus make a profit.
Using basic supply and demand theory, the increase in demand for videos in Mexico
would push the price of videos up. The increase supply of videos on the US market
would force the price down in the US. In the end the price of videos in Mexico may rise
to, say, 180 pesos while the price of videos in the US may fall to $18. At these new prices
the law of one price holds since,
The idea between the law of one price is that identical goods selling in an integrated
market, where there are no transportation costs or differential taxes or subsidies, should
sell at identical prices. If different prices prevailed then there would be profit-making
opportunities by buying the good in the low price market and reselling it in the high price
market. If entrepreneurs acted in this way, then the prices would converge to equality.
Of course, for many reasons the law of one price does not hold even between markets
within a country. The price of beer, gasoline and stereos will likely be different in New
York City than in Los Angeles. The price of these items will also be different in other
countries when converted at current exchange rates. The simple reason for the
discrepancies is that there are costs to transport goods between locations, there are
different taxes applied in different states and different countries, non-tradable input prices
may vary, and people do not have perfect information about the prices of goods in all
markets at all times. Thus, to refer to this as an economic "law" does seem to exaggerate
its validity.

From LoOP to PPP

The purchasing power parity theory is really just the law of one price applied in the
aggregate, but, with a slight twist added (more on the twist a bit later). If it makes sense
from the law of one price that identical goods should sell for identical prices in different
markets, then the law ought to hold for all identical goods sold in both markets.
First, let's define the variable CB$ to be the cost of a basket of goods in the US
denominated in dollars. For simplicity we could imagine using the same basket of goods
used in the construction of the US consumer price index (CPI$). The CPI uses a market
basket of goods which are purchased by an average household during a specified period.
The basket is determined by surveying the quantity of different items purchased by many
different households. One can then determine, on average, how many units of bread,
milk, cheese, rent, electricity, etc. are purchased by the typical household. You might
imagine, it's as if all products are purchased in a grocery store, with items being placed in
a basket before the purchase is made. CB$ then represents the dollar cost of purchasing
all of the items in the market basket. We shall similarly define CBp to be the cost of a
market basket of goods in Mexico denominated in pesos.
Now if the law of one price holds for each individual item in the market basket, then it
should hold for the market baskets as well.

INTEREST RATE PARITY

refers to the fundamental equation that governs the relationship between interest rates and
currency exchange rates. The basic premise of interest rate parity is that HEDGED
returns from investing in different currencies should be the same regardless of the level of
their interest rates.

There are two versions of interest rate parity:

Covered Interest Rate Parity
UNCOVERED INTEREST RATE PARITY

Covered Interest Rate Parity

According to covered interest rate parity, forward exchange rates should incorporate the
difference in interest rates between two countries; otherwise, an arbitrage opportunity
would exist.

In other words, there is no interest rate advantage if an investor borrows in a low-interest

rate currency to invest in a currency offering a higher interest rate. Typically, the investor
would take the following steps:
Borrow an amount in a currency with a lower interest rate
Convert the borrowed amount into a currency with a higher interest rate
Invest the proceeds in an interest-bearing instrument in this (higher interest rate) currency
Simultaneously hedge exchnage risk by buying a forward contract to convert the
investment proceeds into the first (lower interest rate) currency
The returns in this case would be the same as those obtained from investing in interest-
bearing instruments in the lower interest rate currency. Under the covered interest rate
parity condition, the cost of hedging exchange risk negates the higher returns that would
accrue from investing in a currency that offers a higher interest rate.

Covered Interest Rate Arbitrage

Consider the following example to illustrate covered interest rate parity. Assume that the
interest rate for borrowing funds for a one-year period in Country A is 3% per annum,
and that the one-year deposit rate in Country B is 5%. Further, assume that the currencies
of the two countries are trading at par in the spot market (i.e., Currency A = Currency B).

An investor:
Borrows in Currency A at 3% Converts the borrowed amount into Currency B at the spot
rate
Invests these proceeds in a deposit denominated in Currency B and paying 5% per annum
The investor can use the one-year forward rate to eliminate the exchange risk implicit in
this transaction, which arises because the investor is now holding Currency B, but has to
repay the funds borrowed in Currency A. Under covered interest rate parity, the one-year
forward rate should be approximately equal to 1.0194 (i.e., Currency A = 1.0194
Currency B), according to the formula discussed above.
Uncovered Interest Rate Parity
Uncovered interest rate parity (UIP) states that the difference in interest rates between
two countries equals the expected change in exchange rates between those two countries.
Theoretically, if the interest rate differential between two countries is 3%, then the
currency of the nation with the higher interest rate would be expected to depreciate 3%
against the other currency.

In reality, however, it is a different story. Since the introduction of floating exchange

rates in the early 1970s, currencies of countries with high interest rates have tended to
appreciate, rather than depreciate, as the UIP equation states.

The Interest Rate Parity Relationship Between the U.S. and Canada
Let us examine the historical relationship between interest rates and exchange rates for
the U.S. and Canada, the world's largest trading partners. The Canadian dollar has been
exceptionally volatile since the year 2000. After reaching a record low of US61.79 cents
in January 2002, it rebounded close to 80% in the following years, reaching a modern-
day high of more than US$1.10 in November 2007.

Looking at long-term cycles, the Canadian dollar depreciated against the U.S. dollar from
1980 to 1985. It appreciated against the U.S. dollar from 1986 to 1991 and commenced a
lengthy slide in 1992, culminating in its January 2002 record low. From that low, it then
appreciated steadily against the U.S. dollar for the next 5 and a half years. For the sake of
simplicity, we use prime rates to test the UIP condition between the U.S. dollar and
Canadian dollar from 1988 to 2008.

Based on prime rates, UIP held during some points of this period, but did not hold at
others, as shown in the following examples:
The Canadian prime rate was higher than the U.S. prime rate from September 1988 to
March 1993. During most of this period, the Canadian dollar appreciated against its U.S.
counterpart, which is contrary to the UIP relationship. The Canadian prime rate was
lower than the U.S. prime rate for most of the time from mid-1995 to the beginning of
2002; as a result, the Canadian dollar traded at a forward premium to the U.S. dollar for
much of this period. However, the Canadian dollar depreciated 15% against the U.S.
dollar, implying that UIP did not hold during this period as well.
The UIP condition held for most of the period from 2002, when the Canadian dollar
commenced its commodity -fueled rally, until late 2007, when it reached its peak. The
Canadian prime rate was generally below the U.S. prime rate for much of this period,
except for an 18-month span from October 2002 to March 2004.

Hedging Exchange Risk

Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a
forward contract is highly inflexible, because it is a binding contract that the buyer and
seller are obligated to execute at the agreed-upon rate.
Conclusion
Interest rate parity is fundamental knowledge for traders of foreign currencies. In order to
fully understand the two kinds of interest rate parity, however, the trader must first grasp
the basics of forward exchange rates and hedging strategies. Armed with this knowledge,
the forex trader will then be able to use interest rate differentials to his or her advantage.
The case of U.S. dollar/Canadian dollar appreciation and depreciation illustrates how
profitable these trades can be given the right circumstances, strategy and knowledge.

5. Explain the different types of Exchange Rate exposures and discuss how they are
managed.

Solution: There are three types of exchange rate risk exposure for a Financial Planner or
a Risk manager:-
Translation exposure
Transaction exposure
Economic exposure
Translation exposure is the change in accounting income and balance sheet statements
caused by changes in exchange rates. Under the rules of Financial Accounting Standards
Board, a US company must determine a functional currency for all and each of its
offshore subsidiaries. If such a subsidiary is a standalone firm with vertical or horizontal
integration with the particular country, the functional currency can be the local currency
otherwise it has to the dollar. Transaction exposure is the gain or loss that might occur
during settlement of foreign exchange transaction. Such a transaction could be the sale /
purchase of product or services lending or borrowing of money or any other transaction
involving mergers and acquisitions.
Economic exposure, the most important of the three, is the change in value of a company
that accompanies an unanticipated change in the exchange rates. There is a clear
distinction between the anticipated and the unanticipated change of exchange rates. The
anticipated change has already been factored into the valuation of the company by the
market forces. The unanticipated comes as an unforeseen risk.
The fluctuations in exchange rates subject firms operating in the international
environment to as many as three types of exposure to exchange rate risk:

1. Transaction exposure
2. Translation exposure
3. Economic exposure

The first of these, transaction exposure, is the risk of gains or losses that occurs when a
firm engages in commercial transactions in which the currency of the transaction is
foreign to the firm; i.e., it is denominated in a foreign currency. This is the type of
exchange rate risk that we have looked at the various ways of managing via futures,
forward contracts, options and money market hedges.
Currency Swap
Another means of hedging transaction exposure is through what is known as a currency
swap. With a currency swap, two companies can agree to exchanging set amounts of
currency at fixed rates of exchange. Of course, the fixed rates of exchange will be set to
reflect interest rate differentials (Interest Rate Parity). Swaps help a company faced with
possible foreign exchange restrictions and a lack of forward markets.
Exposure Netting
Exposure netting refers to the ability to use opposite exposures to reduce the amount of
risk that a firm is faced with. Just as we can create opposite risks with a futures contract
or options, it is sometimes possible to create one transaction exposure in order to offset
another. For example, if a U.S. firm has a payable to a British company in pounds (short
position), it may want to invoice a receivable in pounds (long position) in order to create
an offset. The company could then hedge only the net long (short) position and, thus,
reduce its hedging costs. Many multinationals actually have a separate subsidiary that
manages the worldwide exposure through netting, known as a reinvoice center.

Translation Exposure
A firm which has subsidiaries and assets in another country is subject to translation
exposure. Translation exposure results as a consequence of the fact that a parent company
must consolidate all of the operations of its subsidiaries into its own financial statements.
Since a foreign subsidiary’s assets are carried on its books in a foreign currency, it is
necessary to convert the foreign values into domestic currency for combining with the
parent’s assets. Fluctuating exchange rates results in gains and losses occurring during
the translation process. Since this type of exposure is related to balance sheet assets and
liabilities, it is often referred to as accounting exposure.

The primary issue related to the translation of foreign asset values has to do with whether
the proper exchange rate to use is the current rate of exchange or the historic rate of
exchange that existed at the time that an asset was acquired. In order to see the possible
gains and losses that can occur, let’s consider the following:
A U.S. company has a Mexican subsidiary that buys an asset for 12 million pesos in 20x1
when the exchange rate is 12 pesos per USD. Over the following year, inflation in
Mexico is 50% while in the U.S. it is 0%. Of course, if purchasing power parity holds,
then the exchange rate in one year should be 18 pesos per dollar.

If we use historical cost accounting, the asset will have a value of 12 million pesos on the
Mexican subsidiary’s books. Translating this at the current exchange rate of 18
pesos/USD yields a US dollar value of If we translate the historical cost of 12 million
pesos at the historical exchange rate at the time of acquisition of 12 pesos/USD we get a
US dollar value of Thus, the correct value would be to use the historical exchange rate
when the books are kept on an historical cost basis.

On the other hand, Mexico is a country that utilizes an inflation-adjusted (or current)
accounting system where assets are indexed for inflation. Thus, the Mexican subsidiary
would carry the asset on the books at 18 million pesos (12 million pesos * (1+50%) = 18
million pesos). Translating this using the current exchange rate of 18 pesos/USD yields

If the historical exchange rate were used, we would obtain the following value:
For the proper translation of value, we should either use the historic exchange rate with
historical cost accounting or the current exchange rate with current accounting practices.
For a foreign currency that has depreciated, we get the following general results (an
appreciating currency would yield the opposite results):

Accounting Valuation Method

Historic Current
(Book Value) (Market Value)

Translation Historic No Change Increased Value

Exchange
Rate Current Decreased Value No Change

In 1981, FASB 52 set the rules for U.S. GAAP accounting in which it stated that all asset
and liability accounts must be translated at the current rate of exchange. Equity accounts
are translated at historical rates of exchange. A separate account, ”Equity Adjustment
from Translation”, is used to reflect translation gains and losses. The only exception to
this is for assets in countries experiencing hyperinflation which is defined as cumulative
inflation greater than 100% over a three-year period. In that case, historical exchange
rates are allowed for non-monetary items (inventory/cost of goods sold, plant &
equipment/depreciation).
In any event, translation exposure is not a real gain or loss in terms of making or losing
money. The value of the asset is the value of the asset. The gain or loss results simply
from translating from one currency to another. In that sense, one should not really worry
about translation exposure (except to the extent that there is a perceived gain or loss from
unsophisticated users of the financial statements).

Economic Exposure
While transaction exposure is an economic exposure in the sense that a real gain or loss
can result (unlike translation exposure which is just an accounting gain or loss), the use of
the term in this context is in reference to the risk associated with revenues, costs and
demand for goods as foreign exchange rates fluctuate. Sometimes economic exposure is
called “operating exposure” since it refers to the risk to operations. An example would be
a devaluation of a foreign currency which would make your product relatively more
expensive. Thus, it would be less competitive in the foreign country (as well as
domestically), resulting in lower sales and lower profits.

How can a company hedge against economic exposure? There is no perfect hedge, but
there are actions that a company can take to help offset the risks over the longer period of
time.

Production Management –
• Product sourcing: Diversify your source of materials. If you are producing in a foreign
country that experiences a devaluation, then some of the loss of sales and profits from
your products becoming relatively more expensive is offset by the fact that some of your
costs have become less expensive since they are now bought from a country with a
weaker currency
• Shifting production: As sales drop due to a currency becoming more expensive, you can
shift production to countries where a weaker currency results in lower costs, again
protecting your profit margin even though sales will decline.

Marketing Management –
• Geographic diversification: If sales weaken in one country, they may increase in
another due to a change in currency values
• Market segmentation: High-end (luxury) segment or low-end (economy)
• Market share versus profit margin
• Product differentiation: helps make product less sensitive to price changes

Financial Management –
• Arrange financing so that a decrease in sales from a weaker currency is offset by
cheaper debt servicing costs

6. Explain the various product and services offered by export Credit Guarantee
Corporation.

Solution: Export Credit Guarantee Corporation of India Ltd. (ECGC) has announced
introduction of its non-recourse maturity export factoring. The scheme has certain unique
features and does not exactly fit into the conventional mould of maturity factoring. The
changes devised are intended to give the clients the benefits of full factoring services
through a maturity factoring scheme, thus effectively addressing the needs of exporters to
avail themselves of pre-finance (advance) on the receivables, for their working capitals
requirements.

One of the major deviations in this regard is the very important role and special benefits
envisaged for banks, under the scheme.

The services provided by ECGC under its export maturity factoring scheme are 100 per
cent credit guarantee protection against bad debts, sales register maintenance in respect of
factored transactions, and regular monitoring of outstanding credits, facilitating due
collection in the due date of recovery, at its own cost, of all recoverable bad debts.

Payments would be received by the exporter, in his account, through normal banking
channels. In the event of non-realisation of dues on factored export receivables, ECGC
will promptly make the payment in Indian currency of an equivalent amount,
immediately upon the crystallization of dues by the bank (exchange rate applicable, as on
the date of crystallization).
The Corporation would facilitate easier availability of bank finance to its factoring clients
by rendering such advances to be an attractive proposition to banks. The factoring
agreement that would be concluded by ECGC with its clients has an in-built provision
incorporating an on-demand guarantee in favour of the bank without any payment or
compliance or other requirements to be satisfied by the bank.

The following are the benefits for exporters under the scheme :

= Option to give easier credit terms to customers – better protection than an ILC,
without the need to insist on establishing one.

= More friendly delivery terms offered, like direct delivery to the customer (as against
DP/DA) without any risk.

= Reduced foreign bank handling charges on documents.

= Substantial cost savings and complete freedom in monitoring and follow up

(telephones, faxes, follow-up visits) of receivables, overdue bank interest on delayed
collections and recovery expenses relating to bad debts.

The following are the benefits for exporters under the scheme :

= Option to give easier credit terms to customers – better protection than an ILC,
without the need to insist on establishing one.

= More friendly delivery terms offered, like direct delivery to the customer (as against
DP/DA) without any risk.

= Reduced foreign bank handling charges on documents.

= Substantial cost savings and complete freedom in monitoring and follow up

(telephones, faxes, follow-up visits) of receivables, overdue bank interest on delayed
collections and recovery expenses relating to bad debts.

= Prompt and immediate payment by ECGC of the full amount outstanding on the
receivables to the bank, within three days of crystallization of the dues, in the event of
non-realisation of factored receivables on the due date, without any protracted processing
or scrutiny and without raising any queries.

= Savings on post-shipment guarantee premium to be paid to ECGC, if any.

= No pre-disbursal risk assessment or post-disbursal monitoring required of the bank.

Full risk is on ECGC, with regard to repayment of the amount due (in rupees).
 = Opportunity to build ‘zero-risk assets’, since the bank would not run any risk on the
borrower, the country or on the buyer.

= Banks could earn interest on a priority sector lending, without any of the attendant
risks or hassles.

= Opportunity to satisfy additional working capital needs of the customer by

sanctioning additional limits without enlarging the exposure risks.

Banks would be furnished with a certified copy of the factoring agreement concluded
between the client and ECGC. When a limit is established by ECGC on an overseas
customer in favour of an exporter-client, the Corporation would directly communicate to
the concerned bank branch all relevant details of the limit available to the exporter on that
specified overseas customer, and would confirm in writing its obligations to the bank in
respect of advances it may grant against such ECGC-factored export receivables.

The bank’s role lies in encouraging exporter-customers to explore the possibility of

availing of the factoring facility from ECGC. Factoring, being a high-risk premium
product, could be made available only in respect of receivables due from select
customers.

Banks may consider sanctioning of additional limits to exporters against risk-free

advances when ECGC communicates setting up of the factoring facility and the
permitting limit in respect of individual buyers.

Banks also could help ECGC to collect factoring charges on each of the factored
invoices. ECGC covers every facet of the exporter’s risks. It is the only corporation that
is committed to taking your exports higher.

EXPORT SCENARIO

Like the standard policy, this policy is based on the whole-turnover principle. An
exporter availing himself of it will be able to exercise the options that are available under
the standard policy with regard to exclusion of shipments against letters of credit and also
those to associates.

Further, in respect of policyholders who are trading houses and above, the option
available under the standard policy for exclusions of specified countries or specified
commodities or any combinations of the same will continue.

Premium

Based on the projected turnover, the amount of premium payable for the year will be
determined. The basic premium rates will be those applicable for the standard policy.
Exporters holding the standard policy will be given a turnover discount of 10 percent in
addition to the "no-claim bonus" enjoyed by them under their policy, subject to a
minimum total discount of 20 per cent.

For exporters not holding, the standard policy, a discount of 20 percent will be granted in
the premium.

The premium calculated on the projected turnover will be payable in four equal quarterly
instalments. However, payment through monthly instalments will be considered on a
case-to-case basis. The first instalment of premium is payable within 15 days from the
date the premium is called for. Subsequent instalments will have to be paid within 15
days from the beginning of the relevant period. At the end of the policy period, after the
policyholder submits the statement for the fourth quarter, the premium payable for the
actual exports effected during the year will be worked out. In case the premium payable
based on the actual turnover is less than that paid on the basis of projections, the excess
amount paid will be carried over to the next policy period and could be adjusted in the
premium for the first month/quarter for the renewed policy. If the actual premium
exceeds the projected premium by not more than 10 per cent, the excess is not required to
be paid (Thus there is a built-in incentive in the scheme for the exporters to increase their
export turnover).

If the actual premium exceeds the projected premium by more than 10 percent, the
exporter will be advised to remit the premium amount in excess of 10 per cent. In case
the exporter fails to pay the premium within 30 days from the date it is called for, cover
for any loss in respect of the policy would be limited to the turnover in respect of which
premium has been paid.

Monthly declarations of shipments will not be required to be submitted under the policy.
Instead, a statement of shipments made during the quarter in the prescribed format has to
be furnished by the policyholder within 30 days from the end of the quarter.

Declarations of payments remaining overdue for more than 30 days as at the end of the
month are to be made on or before 15th of the following month.

ECGC’s specific buyer-wise policy

Export Credit Guarantee Corporation of India Ltd. (ECGC) has been offering different
polices to exporters according to their requirement. One such new innovation is the
"specific buyer-wise policy". This is meant for those exporters who want to cover exports
made to selective buyers from whom they have regular orders.

Exporters who want to cover their shipments made to a buyer or a set of buyers can avail
of this policy. Those holding the SCR policy also can take advantage of this policy to get
the cover in respect of buyers, shipments to whom are in the excluded categories like
L/C, country, commodity, etc., as applicable. The policy is valid for one year.

Risk covered
Commercial risks covered are insolvency of the buyer/LC opening bank (as applicable);
default by the buyer/LC opening bank to make payment within four months from the due
date; and the buyer’s failure to accept the goods, subject to certain conditions/bank’s
failure to accept the bill drawn on it under the letter of credit opened by it.

Political risks covered are the imposition of restriction by the Government action which
may block or delay the transfer of payment made by the buyer; war, civil war, revolution
or civil disturbances in the buyer’s country; new import restrictions or cancellations of a
valid import licence; interruption or diversion of voyage outside India resulting in
payment of additional freight or insurance charges which cannot be recovered from the
buyer; and any other cause of loss occurring outside India, not normally insured by
general insurers and beyond the control of both the exporter and the buyer.

Premium is payable on the projected turnover for each quarter in advance. Important
obligations of the exporter are the declaration of shipments made during the quarter
within 15 days after the end of the quarter and that of payments overdue for a period of
30 days or more from the due date as at the end of the month by the 15th of the
succeeding month. The exporter should, in consultation with ECGC, take effective steps
for recovery of the debt. All amounts recovered, net of recovery expenses, shall be shared
with ECGC in the same ratio in which the loss was shared.

Turnover policy offers extra benefits The turnover policy of ECGC is a variation of the
standard policy introduced for the benefits of large exporters who contribute not less than
Rs. 10 lakhs per annum towards premium. The policy envisages projection of the export
turnover by the policyholder for a year and the initial determination of the premium
payable on that basis, subject to adjustment at the end of the year based on the actuals.

It provides additional discount in premium with an added incentive for increasing the
exports beyond the projected turnover and also offers a simplified procedure for premium
remittance and filing of shipment information.

The turnover policy can be availed of by any exporter whose anticipated export turnover
would involve payment of not less than Rs. 10 lakhs per annum towards premium. The
policy is valid for one year.

7. Describe some of the barriers to international portfolio diversification.

Solution: One of the most enduring puzzles in international macroeconomics and finance
is the tendency for investors to disproportionately weight their asset portfolios towards
domestic securities and thus to forego the gains possible through international
diversification. This tendency causes consumers to be underinsured against aggregate
shocks that otherwise could have been hedged by holding foreign assets. In the
framework of both macroeconomics and financial economics, the underlying source of
diversification arises from the relatively low correlation in asset returns across countries.
In Is the International Diversification Potential Diminishing? Foreign Equity Inside and
Outside the U.S. (NBER Working Paper No. 12697), author Karen Lewis examines the
data on foreign returns from a U.S. investor's point of view to consider the impact of
changing co-variances among international returns on the opportunities for
diversification. She first analyzes foreign markets to consider the typical argument that
domestic residents hold a less-than-optimal low portfolio allocation in foreign stock
indexes.

Lewis finds that the co-variances among country stock markets have indeed shifted over
time for a majority of countries. However, in contrast to the common perception that
markets have become more integrated over time, the co-variance between foreign
markets and the U.S. market has increased only slightly over the last twenty years.
Moreover, the standard deviation of the foreign portfolio has declined over this time.

To consider the economic significance of these changes, Lewis looks at a simple portfolio
decision model in which a U.S. investor could choose between U.S. and foreign market
portfolios. With two different assumptions about the estimates of foreign means, she
finds that the optimal allocation in foreign markets actually has increased over time. This
appears counter-intuitive, given that the higher degree of integration among countries
increases the correlation across markets. On the other hand, the falling variance of
foreign portfolios increases the allocation of assets into foreign markets.

Lewis then looks at whether foreign stocks that list in the United States can explain the
lack of foreign investment. She finds, somewhat surprisingly, that the estimates of co-
variation with the U.S. market have increased over time. Also, while the allocations in
foreign markets do not decline much over time, the allocation into U.S. listed foreign
stocks does decline, particularly in the 1990s. These results suggest that the
diversification properties of domestic-listed foreign stocks are inferior to investing
directly in foreign markets.

Using a two-asset model with cross-listed foreign stocks instead of foreign market
indexes, Lewis finds that the greatest gains in diversification improvement since 1994
have been in foreign market indexes, rather than foreign cross-listed stocks or a
combination of both groups.

Finally, she points out that her analysis is simply a way to demonstrate the effects of the
parameters. An unconstrained, efficient portfolio decision based upon the universe of
foreign stocks undoubtedly would allow a larger reduction in risk. Nevertheless, her
analysis points to some general trends in the foreign portfolio diversification potentials.
These trends could be summarized as follows: first, international equity markets have
become more highly correlated. Second, foreign stocks inside the United States have
become more correlated with the U.S. market over time. As a consequence of these
trends, the attainable diversification from participating in foreign
markets is declining, whether the investor holds foreign stocks inside or outside the
United States.