DRIVE FALL 2013

IB0010 & INTERNATIONAL FINANCIAL MANAGEMENT

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Q1. Explain the goals of international financial management. Give complete explanation on Gold Standard
1876-1913. List down the advantages and disadvantages of Gold Standard. (Goals of international financial
management, Introduction of Gold Standard, Advantages and disadvantages) 4, 2, 4
Answer:
Goals of International Financial management:
Effective financial management is not limited to the application of the latest business techniques or functioning more
efficiently but includes maximization of wealth meaning that it aims to offer profit to the shareholder, the owners of the
businesses and to ensure that they gain benefits from the business decisions that have been made. So, the goal of
international financial management is to increase the wealth of shareholders just like in domestic financial
management. The goals are not only limited to just the shareholders, but also to the suppliers, customers and
employees. It is also understood that any goal cannot be achieved without achieving the welfare of the shareholders.
Increasing the price of the share would mean maximizing shareholders wealth.
Though in many countries such as Canada, the United Kingdom, Australia and the United States, it has been accepted
that the primary goal of financial management is to maximize the wealth of the shareholders; in other countries it is not
as widely embraced. In countries such as Germany and France, the shareholders are generally viewed as a part of the
stakeholders along with the customers, banks, suppliers and so on. In European countries, the managers consider the
most important goal to be the overall welfare of the stakeholders of the firm. On the other hand, in Japan, many
companies come together to form a small number of business groups known as Keiretsu, including companies such as
Mitsui, Sumitomo and Mitsubishi which were formed due to consolidation of family-owned business empires. The
growth and the prosperity of their Keiretsu is the most critical goal for the Japanese managers.

Gold Standard 1876-1913:

From the ancient times, gold has been used as a medium of exchange as it is durable, portable and easily tradable.
Increase in the trade activity during the free-trade period in the 19th century led to the need for a more formalized
system for settling business transactions. This made gold desirable to be used as a standard to determine the value of
currency. The rules of the game under the gold standard were that each country would establish the rate at which its
currency could be converted to the weight of gold. Each country's government agreed to buy or sell gold at its own
fixed rate of demand. This served as a mechanism to preserve the value of each individual currency in terms of gold.
Each country had to maintain adequate reserves of gold in order to back its currency's value. There was a limit to the
rate at which any individual country could expand its supply of money. The growth in the money was limited to the
rate at which additional gold could be acquired by official authorities.

Advantages of Gold Standard:

1. Gold standard provided stable exchange rates, which were conducive for trade policy because this eliminates another
source of price instability.
2. An efficient operating gold standard exchange rate system ensures automatic adjustment of balance payment
problem through price changes.
3. This system imposes orthodoxy on fiscal policies and restricts governments from resorting to indiscriminate
spending.
Disadvantages of Gold Standard:
1. The burden of BOP adjustment shifts to domestic variables which subordinate the domestic economy to external
economic factors.
2. There is always a problem of selecting an appropriate par value which reflects the external and internal equilibria.
3. Emergence of misaligned values might have encouraged speculations of sufficient magnitude to effect exchange rate
realignment.
4. The gold standard was dependent on an adequate supply and not excess supply of new gold.

Q2. Give an introduction on capital account with its sub-categories. Discuss about capital account convertibility.
(Introduction on capital account, Sub-categories on capital account, Explanation on Capital account
convertibility) 2, 3, 5
Answer:

Capital Account:
It is an accounting measure of the total domestic currency value of financial transactions between domestic residents
and the rest of the world over a period of time. This account consists of loans, investments and other transfers of
financial assets and the creation of liabilities. It includes financial transactions associated with international trade as
well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. It
includes three categories: direct investment, Portfolio investment and other capital flow.

Sub-categories on capital account:

The detail of these three sub-categories is presented as follows:

Direct investment: It occurs when the investor acquires shares of a company acquires the entire firm or the
establishment of new subsidiaries. FDI takes place when the firms tend to take advantage of various market
imperfections. Firms also undertake FDI when the expected returns from foreign investment exceed the cost of
capital, allowing for foreign exchange and political risks.

Portfolio investment: This represents the sales and purchases of foreign financial assets such as stocks and
bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in
investments is the same for international and domestic portfolio investors. International portfolio investments
have seen a boom in the recent years as the investors have become aware about the risk diversification that can
be reduced if they invest in various financial assets globally.

Capital flows: It represents the claim with a maturity of less than one year. Such claims include bank
deposits, short-term loans, short-term securities, money market investment etc. these investments are sensitive
to both changes in relative interest rates between countries and the anticipated change in the exchange rate. Let
us understand with the help of an example. If the interest rate increases in India then it will experience a
capital inflow as investors would like to take advantage of the situation by buying bonds when prices are low,
since interest rates on bonds and inversely proportional to the bond prices.

Capital Account Convertibility

When free inflows and outflows are allowed abroad except for capital purposes like loans and investments, it is
referred to as Current Account Convertibility. This really means that residents of a country can make or receive trade
related payments, for example dollars, for exporting goods and services. They can also pay dollars for import of goods
and services to make sundry remittances, access foreign currency for studying abroad, or undergoing medical
treatments, gifts or for travel purpose. Current Account Convertibility in India was established with the acceptance of
the obligations under Article VIII of the IMFs Articles of Agreement in August 1994.
The term capital account convertibility means relaxing control on capital account transactions. For instance, it could
mean quantitative restriction on the movement of capital, a multiple exchange rate system suggesting different
exchange rates for commercial/financial transactions or explicit/implicit tax on international financial transactions for
discouraging the flow of capital. Thus, CAC gives way to an absence of quantitative taxes on capital account
transactions or the presence of a market-based exchange rate system. Capital account convertibility (CAC) permits the
local currency to be exchanged for foreign currency and no restrictions are put on the limit. Through this, the local
merchants can easily conduct transnational business without the need for foreign currency exchanges in order to carry
out small transactions. However, questions also arise whether the monetary authorities of a country should go for CAC
or not. Due to the increased competition abroad, domestic providers of financial services are required to be more
efficient. In addition to fostering efficiency in the domestic financial market, CAC also allows an economy to access
international financial market. It receives the desired amount of external funds with minimal borrowing cost. However,
it cannot function successfully in the presence of domestic distortions, such as lopsided development of the domestic
financial market.

Q3. Explain the concept of Swap. Write down its features and various types of interest rate swap. (Introduction
of Swap, Features of swap, various types of interest rate swap) 2, 4 , 4
Answer:
Swap:
Swap is an agreement between two or more parties to exchange sets of cash flows over a period in future. The parties
that agree to swap are known as counter parties. It is a combination of a purchase with a simultaneous sale for equal
amount but different dates. Swaps are used by corporate houses and banks as an innovating financing instrument that

decreases borrowing costs and increases control over other financial instruments. It is an agreement to exchange
payments of two different kinds in the future. Financial swap is a funding technique that permits a borrower to access
one market and then exchange the liability for another type of liability. The first swap contract was negotiated in 1981
between Deutsche Bank and an undisclosed counter party. The International Swap Dealers association (ISDA) was
formed in 1984 to speed up the growth in the swap market by standardizing swap documentation. In 1985, ISDA
published the standardized swap code.
Features of swap
Swaps are contracts of exchanging the cash flows and are tailored to the needs of counter parties. Swaps can meet the
specific needs of customers.
Counter parties can select amount, currencies, maturity dates etc.
Exchange trading involves loss of some privacy but in the swap market privacy exists and only the counter parties
know the transactions.
There is no regulation in swap market.
There are some limitations like

(a) Each party must find a counter party which wishes to take opposite position.
(b) Determination requires to be accepted by both parties.
(c) Since swaps are bilateral agreements the problem of potential default exists.
Various types of interest rate swap
Following are the most important types of interest rate swap:
Plain vanilla swap: This swap involves the periodic exchange of fixed rate payments for floating rate payments. It is
sometimes referred as fixed for floating swaps.
Forward swap: This involves an exchange of interest rate payments that does not begin until a specified future point
in time. It is a swap involving fixed for floating interest rates.

 Callable swap: Another use of swap is through swap options (swaptions). A callable swap provides a party making
the fixed payments it the right to terminate the swap prior to its maturity. It allows a fixed rate payer to avoid
exchanging future interest rate payments if its so desired.
Putable swap: It provides the party making the floating rate payments with a right to terminate swap.
Extendable swap: It contains an extendable feature that allows fixed for floating party to extend the swap period.
Zero coupon for floating swap: In this swap, the fixed rate pair makes a bullet payment at the end and floating rate
pair makes the periodic payment throughout the swap period.
Rate capped swaps: This involves the change of fixed rate payments for floating rate payments whereby the floating
rate payments are capped. An upfront fee is paid by the floating rate party to fixed rate party for the cap.
Equity swaps: An equity swap is a financial derivative contract where a set of future cash flows are agreed to be
exchanged between two counterparties at set dates in the future.

Q4. Elaborate on measuring exchange rate movements. Explain the factors that influence exchange. (Measuring
exchange rate movement- introduction, Interest rate differentials, Focus on demand supply model, Economic
factors, Political conditions rates) 3, 2, 2, 2, 1
Answer:
Measuring Exchange Rate Movements
Exchange rates respond quickly to all sorts of events - both economic and noneconomic. The movement of exchange
rates is the result of the combined effect of a number of factors that are constantly at play. Economic factors, also
called fundamentals, are better guides as to how a currency moves in the long run. Short-term changes are affected by a
multitude of factors which may also have to be examined carefully.
In recent years, global interdependence has increased to an unprecedented degree. Changes in one nation's economy
are rapidly transmitted to that nation's trading partners. These fluctuations in economic activity are reflected almost
immediately in fluctuations of currency values.

Interest rate differentials

Foreign exchange markets and exchange rates are quite sensitive to movements in interest rates. This is because
financial markets were becoming more closely linked due to
(i) Growing interest in international investment;
(ii) Elimination or constraints on mobility of capital to a large extent;
(iii) More rapid means of communications.
Most investors would like to move their funds from a country having lower interest rates to a country having higher
interest rates. Such funds are usually termed as 'hot money'. If the interest rate in the UK is higher than the interest rate
in the USA, investors would find it profitable to invest funds in the UK and would purchase pounds and sell dollars in
the spot market, leading to an upward movement in pound sterling. In fact, the UK very often uses interest rate as a
weapon to push up the 'pound'.
Focus on the Demand-Supply Model
The demand factor
At the most primary level, a change in the price of a currency will occur because of more or less demand for it. High
demand signifies a higher price experience of the currency pair. Less demand signifies fall in the price of the currency
pair.
An increased demand for a currency suggests a strong economy, while a currency's demand can go down if the central
bank lowers the rates of interest. The movement of price is based on the demand for the currency. Actually, currencies
rally when the demand for it goes up.
Economic factors
These include the economic policy of the government which is made known through various government agencies and
the central bank of the country, and economic conditions, generally revealed through economic reports. Economic
conditions include:
Inflation levels and trends: If there is a high level of inflation in the country, or if the inflation level seems to be
rising, typically a currency will lose value because inflation brings down the purchasing power and thus the demand for
that particular currency.
Economic growth and health: The economic growth and health of a country can be known through a country's gross
domestic product (GDP), level of employment, capacity utilization, retail sales and other indicators.Generally, a
currency will perform better and there will be more demand, for it if the economy of the country is healthy and robust.
The better the economic performance, the higher will be the currency's demand.

 Government budget deficits or surpluses: Widening government budget deficits lead to a negative reaction in the
market, whereas the market reacts positively in case of narrowing budget deficits. The impact of budget deficit or
budget surplus is reflected in the value of the currency of a country.
Balance of trade levels and trends: The flow of trade from a country to other parts of the world shows the demand
for goods and services of the country, which in turn indicates the demand for a country's currency for conducting trade.
The competitiveness of a country's economy is reflected by the surpluses and deficits in trade of goods and services.
Trade deficits, for example, may negatively impact the currency of a nation.
Political conditions rate
Internal, regional and international political conditions and issues can profoundly affect currency markets; for instance,
political upheaval and instability can negatively impact the economy of a nation. Similarly, the growth of a political
faction that is considered to be fiscally responsible can have a positive opposite effect on the economy. Again, cases in
one country in a region may spur positive or negative interest in a neighbouring country, and in the process, affect its
currency.

Q5. Write short notes on:

International Credit Markets
International Bond Markets
Answer:
International Credit Markets:
International credit markets are the forum where companies and governments can obtain credit (loans in various forms)
from the creditors/investors. These markets are an important part of international capital markets. International capital
market is that financial market or world financial centre where shares, bonds, debentures, currencies, mutual funds and
other long term securities are purchased and sold. These markets provide the opportunity for international companies
and investors to deal in shares and bonds of different companies from various countries. Two very important aspects of
international credit market are the syndicated loans and impact of credit crisis on the credit market, which are
explained below.

Syndicated Loans:

Syndicated loans are credits granted by a group of banks, called a syndicate to a borrower who may be a company or
the government. Interest rates can be fixed for the term of the loan or floating based on a benchmark rate such as the
London Interbank Offered Rate (LIBOR).These are hybrid instruments combining features of relationship lending and
publicly traded debt. These allow sharing of credit risk between various financial institutions without the disclosure
and marketing burden that bond issuers face. Syndicated credits are a very significant source of international
financing, these accounting for more than a third of all international financing, including bonds, commercial papers and
equity issues. Two or more banks agree jointly to make a loan to a borrower. There is a single loan agreement.

External Commercial Borrowings (ECB):

ECBs refer to loans from commercial banks, suppliers credit, buyers credit, fixed rate bonds, floating rate notes,
credit from authorized export credit agencies, and loans from institutions such as IFC (International Finance
Corporation), ADB (Asian Development Bank) and CDC (Commonwealth Development Corporation). Guidelines for
ECBs were first liberalized in India in 1997. Ever since then, corporate firms have been allowed to raise capital for
expanding existing capacity, making new investments and finance working capital. All infrastructure and Greenfield
projects are allowed to make use of ECB up to 35 per cent of total project expenses. The average maturity time of
ECBs ranges from three to five to seven years. ECBs are mostly used for:
(a) Project related cost of infrastructure projects
(b) License fee payments in the telecom sector
(c) Foreign exchange cost of capital goods and services
Those corporate firms which manage to acquire ECBs with maturity time of 10 to 20 years are able to use the capital
for general corporate purposes. However, the funds acquired through ECBs cannot be invested in stock markets or for
dabbling in real estate. How much an ECB can be mobilized depends on the relative value of current rates of interest in
India and other countries.

International Bond Markets:

Although debt financing has always been international in nature, there is still no unified international bond market. The
international bond market is divided into three bond market groups:
1. Domestic bonds: They are issued locally by a domestic borrower and are usually denominated in the local currency.

2. Foreign bonds: They are issued on a local market by a foreign borrower and are usually denominated in the local
currency. Foreign bond issues and trading are under the supervision of local market authorities.
3. Eurobonds: They are underwritten by a multinational syndicate of banks and placed mainly in countries other than
the one in whose currency the bond is denominated. These bonds are not traded on a specific national bond market.
Euro Bond Markets:
This is an international market for borrowing capital by any countries government, corporate and institutions. The
centre of activity of borrowing and lending in London and Europe is called as Euro bond market. The borrowers and
lenders can come from all over the world. A Bond market is a long term market in which the International Banks
transact. It was developed in the 1960s when there was huge surplus of US Dollars in countries other than US. Euro
bond is defined as a debt instrument underwritten by an international syndicate and offered for sale simultaneously in a
number of countries. Therefore, it is usually denominated in a currency that is foreign. There are different names for
particular segments of the foreign bond markets, for example, Yankee bonds are the bonds issued by the US companies
in US markets.
Placement of bonds:
There are two ways in which issuer can issue their bonds to the investors. They are discussed as follows:
1. Public offering: In this mode, the issue is opened to general public to invest in the issue and the issue is placed in
the market by a syndicate of international banks that make elaborate arrangements to market the issue to their clients.
Once the public offering is over, they are listed on any of the international stock exchanges.
2. Private placement: In this mode, the issue is made on a retail basis with individual investors in certain markets and
the investors who generally invest in these issues are of professional in nature. Listing arrangement is done away as the
issue is to be placed privately. The instrument is traded by leading banks on OTC market or through bank dealing
rooms.

Q6. Country risk is the risk of investing in a country, where a change in the business environment adversely
affects the profit or the value of the assets in a specific country. Explain the country risk factors and assessment
of risk factors. (Introduction of country risk factors, Explanation of assessment of risk factors) 5, 5
Answer:
Country Risk Factors:

We can define country risk as the risk of losing money due to changes that can occur in a countrys government or
regulatory environment. The most common examples are acts of war, civil wars, terrorism and military coups, etc. It
comes in various forms: for example, change in the government of a country, a new president or prime minister, some
new laws, a ruling party becoming minority, and so on. Such changes do impact a countrys economic environment.
They have a great impact on the investors perception about a countrys prospects. Political stability means the
frequency of changes in the government of a country, the level of violence in the country, etc. A country is called
politically stable if there are no frequent changes in the government and the level of violence is low or nil. For
example, Australia was considered a dream destination by Indians earlier. Now the country is being avoided due to the
instances of violence against Indians. In some countries, government can expropriate either a legal title to property or
the stream of income it generates. Such countries are said to be high political risk countries. Political risk is also said to
exist if property owners may be constrained in the way they use their property. Host government may enact laws to
prevent foreign companies from taking money out of the country or from exchanging the host countrys currency for
any other currency. This can be called financial form of country risk. It is difficult to calculate the exact value of
country risk like any economic or financial variables. The calculation of country risk scores is difficult, but there are
many important financial decisions that are based on the assessment of the country risk of a country. A company will
have to do its own calculations for taking financial decisions.

Assessment of Risk Factors:

There are risk assessment agencies that provide country risk indices which try to assess the political stability of a
country. The factors from which the political instability occurs can be classified into three categories:
1. Economic factors: These factors include inflation, unemployment, fiscal deficit, trade policies, large external debt,
etc.
2. Geographic factors: These include border disputes, natural calamities, etc.
3. Sociological factors: These include religious diversity, diversity in language, etc.
When a firm has to do business in a foreign country, it has to be doubly sure about the uncertainties that it can face. It
has to analyze all the risks that are theoretically said to exist. MNCs have to assess the country risk both qualitatively
and quantitatively.
Qualitative approach: This approach involves interpersonal contact. MNCs may know influential people in a foreign
country. They may know politicians, bureaucrats, officials, etc. who might make MNCs aware about the political

environment present in their country. They might update the MNC about the future prospects of business in their
country. The entire process is based on judgment and there is no data to support such decisions.
Quantitative models: There are specific quantitative tools for estimating country risk. One such tool is a computer
program named Primary Risk Investment Screening Matrix (PRISM) that has 200 variables and reduces them to
general ratings. It represents an index of economic viability as also an index of country stability. The variables include
the level of violence in a country, frequency of changes in government, number of armed insurrections, conflict with
other nations and economic factors such as inflation rate, external balance deficit and growth rate of the economy.

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