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Spring 2011(Feb-July)

Master of Business Administration - MBA Semester 4

Subject Code –MF0006

Subject Name –International Financial Management

2 Credits

(Book ID: B0889)

Assignment Set- 1 (30 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Explain briefly the different exchange rate regime that are prevalent today.

Q.2 What is arbitrage? Explain with the help of suitable example a two-way and a three way arbitrage.

Q.3 You are given the following information:
Spot EUR/USD : 0.7940/0.8007 Spot USD/GBP: 1.8215/1.8240
Three months swap: 25/35
Calculate three month EUR/USD rate.


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[b]Q.3 You are given the following information:
Spot EUR/USD : 0.7940/0.8007 Spot USD/GBP: 1.8215/1.8240
Three months swap: 25/35
Calculate three month EUR/USD rate.

Solution:
Spot Rate EUR/USD: 0.7940/0.8007
Forward Outright (if Premium)
3 months swap: 25/35=0.0025/0.0035
3 months EUR/USD rate= (0.7940+0.0025)/(0.8007+0.0035)=0.7965/0.8042
Forward Outright (if Discounted)
3 months swap: -25/-35=-0.0025/-0.0035
3 months EUR/USD rate= (0.7940-0.0025)/(0.8007-0.0035)=0.7915/0.7972


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Q.1 Explain briefly the different exchange rate regime that are prevalent today.
The exchange rate is an important price in the economy and some governments like tocontrol it, manage it or influence it. Others prefer to leave the exchange rate to be determinedonly by market forces. This decision is the choice of exchange rate regime. Many alternativeregimes exist:
Floating Exchange Rate (Flexible) Regimes:
A flexible exchange rate system is one where thevalue of the currency is not officially fixed but varies according to the supply and demand for thecurrency in the foreign exchange market. In this system, currencies are allowed to:
•Appreciate – when the currency becomes more valuable relative to others.
•Depreciate– when the currency becomes less valuable relative to others.
Fixed Exchange Rate Regimes:
A Fixed exchange rate system is one where the value of thecurrency is set by official government policy. The exchange rate is determined by governmentactions designed to keep rates the same over time. The currencies are altered by the government:
•Revaluation – Government action to increase the value of domestic currency relative toothers.
•Devaluation – Government action to decrease the value of domestic currency.After the transition period of 1971-73, the major currencies started to float. Flexible exchangerates were declared acceptable to the IMF members. Gold was abandoned as an internationalreserve asset. Since 1973, most major exchange rates have been “floating” against each other.However, there are countries which have fixed exchange rate regimes.


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Q.2 What is arbitrage? Explain with the help of suitable example a two-way and a three way arbitrage.
The balance of payments(or BOP) of a country is a record of international transactions between residents of one country and the rest of the world over a specified period, usually a year.Thus, India’s balance of payments accounts record transactions between Indian residents and therest of the world. International transactions include exchanges of goods, services or assets. Theterm “residents” means businesses, individuals and government agencies and includes citizenstemporarily living abroad but excludes local subsidiaries of foreign corporations.The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exportsof goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows (sources). Transactions such as imports of goods and services that expend foreign exchange arerecorded as debit, minus, or cash outflows (uses).The Balance of Payments for a country is the sum of the Current Account, the CapitalAccount and the change in Official Reserves
.The current account is that balance of payments account in which all short-term flows of payments are listed. It is the sum of net sales from trade in goods and services, net investmentincome (interest and dividend), and net unilateral transfers (private transfer payments andgovernment transfers) from abroad. Investment income for a country is the payment made to itsresidents who are holders of foreign financial assets (includes interest on bonds and loans,dividends and other claims on profits) and payments made to its citizens who are temporaryworkers abroad. Unilateral transfers are official government grants-in-aid to foreigngovernments, charitable giving (e.g., famine relief) and migrant workers’ transfers to families intheir home countries. Net investment income and net transfers are small relative to imports andexports. Therefore a current account surplus indicates positive net exports or a trade surplusand a current account deficit indicates negative net exports or a trade deficit.The capital(or financial) account is that balance of payments account in which all cross-border transactions involving financial assets are listed. All purchases or sales of assets, including directinvestment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in thecapital account. When Indian citizens buy foreign securities or when foreigners buy Indiansecurities, they are listed here as outflows and inflows, respectively. When domestic residents purchase more financial assets in foreign economies than what foreigners purchase of domesticassets, there is a net capital outflow
. If foreigners purchase more Indian financial assets thandomestic residents spend on foreign financial assets, then there will be a net capital inflow
. A capital account surplus indicates net capital inflows or negative net foreign investment. A capital account deficit indicates net capital outflows or positive net foreign investment.
The official reserves account (ORA)records the total reserves held by the official monetaryauthorities (central banks) within the country. These reserves are normally composed of themajor currencies used in international trade and financial transactions. The reserves consist of “hard” currencies (such as US dollar, British Pound, Euro, Yen), official gold reserve and IMFSpecial Drawing Rights (SDR). The reserves are held by central banks to cushion againstinstability in international markets. The level of reserves changes because of the central bank’sintervention in the foreign exchange markets. Countries that try to control the price of their currency (set the exchange rate) have large net changes in their Official Reserve Accounts. Ingeneral, a net decrease in the Official Reserve Account indicates that a country is buying itscurrency in exchange for foreign exchange reserves, to try to keep the value of the domestic currency high with respect to foreign currencies. Countries with net increases in the OfficialReserve Account are usually attempting to keep the price of the domestic currency cheap relative to foreign currencies, by selling their currencies and buying the foreign exchange reserves. Whena central bank sells its reserves (foreign currencies) for the domestic currency in the foreignexchange market, it is a credit item in the balance of payment accounts as it makes availableforeign currencies. Similarly, when a central bank buys reserves (foreign currency), it is a debititem in the balance of payment accounts.The Balance of Payments identity states that:
Current Account + Capital Account = Changein Official Reserve Account.
If a country runs a current account deficit and it does not run downits official reserve to cover this deficit (there is no change in official reserve), then the currentaccount deficit must be balanced by a capital account surplus. Typically, in countries withfloating exchange rate system, the change in official reserves in a given year is small relative tothe Current Account and the Capital Account. Therefore, it can be approximated by zero. Thus,such a country can only consume more than it produces (or imports are greater than exports; acurrent account deficit) only if it has a capital account surplus (foreign residents are willing toinvest in the country). Even in a fixed exchange rate system, the size of the official reserveaccount is small compared to the transactions in the current and capital account. Thus theresidents of a country cannot have a current account deficit (imports exceeding exports) unlessthe foreigners are willing to invest in that country (capital account surplus).


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Q.2 What is arbitrage? Explain with the help of suitable example a two-way and a three way arbitrage.
Arbitrage is the activity of exploiting imbalances between two or more markets. Foreignmoney exchangers operate their entire businesses on this principle. They find tourists who needthe convenience of a quick cash exchange. Tourists exchange cash for less than the market rateand then the money exchanger converts those foreign funds into the local currency at a higher rate. The difference between the two rates is the spread or profit.There are plenty of other instances where one can engage in the practice arbitrage. In some cases,one market does not know about or have access to the other market. Alternatively, arbitrageurscan take advantage of varying liquidities between markets. The term 'arbitrage' is usually reserved for money and other investments as opposed toimbalances in the price of goods. The presence of arbitrageurs typically causes the prices indifferent markets to converge: the prices in the more expensive market will tend to decline andthe opposite will ensue for the cheaper market. The the
efficiency of the market refers to thespeed at which the disparate prices converge.Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk is the potential for rapid fluctuations in market prices. For example, the spread between twomarkets can fluctuate during the time required for the transactions themselves. In cases where prices fluctuate rapidly, would-be arbitrageurs can actually lose money.
There are basically two types of arbitrage
. One is two-way arbitrage and the other is three-way arbitrage. The more popular of the two is the two-way forex arbitrage.In the international market the currency is expressed in the form AAA/BBB. AAA denotes the price of one unit of the currency which the trader wishes to trade and it refers the base currency.While BBB is international three-letter code 0f the counter currency. For instance, when thevalue of EUR/USD is 1.4015, it means 1 euro = 1.4015 dollar.If the speculator is shrewd and has a deeper understanding of the forex market, then he can makeuse of this opportunity to make big profits. Forex arbitrage transactions are quite easy once youunderstand the method by which the business is conducted.
For instance,the exchange rates of EUR/USD = 0.652, EUR/GBP = 1.312 and USD/GBP =2.012. You can buy around 326100 Euros with $500,000. Using the Euros you buyapproximately 248420 Pounds which is sold for approximately $500,043 and thereby earning asmall profit of $43.To make a large profit on triangular arbitrage you should be ready to invest a large amount anddeal with trustworthy brokers.Arbitrage is one of the strategies of forex trading. To make a substantial income out of thisstrategy you need to make an enormous amount of investment. Though theoretically it isconsidered to be risk free, in reality it is not the case. You should enter into this transaction onlyif you have deeper understanding of forex market. Hence, it would be wise not to devote muchtime in looking out for arbitrage opportunities. However, forex arbitrage is a rare opportunity andif it comes your way, then grab it without any hesitation.
Three Way (Triangular) Arbitrage
The three way arbitrate inefficiency now arises when we consider a case in which the EUR/JPYexchange rate is NOT equivalent to the EUR/USD/USD/JPY case so there must be somethinggoing on in the market that is causing a temporary inconsistency. If this inconsistency becomes large enough one can enter trades on the cross and the other pairs in opposite directions so thatthe discrepancy is corrected. Let us consider the following
example :
EUR/JPY=107.86EUR/USD=1.2713USD/JPY = 84.75 The exchange rate inferred from the above would be 1.2713*84.75 which would be 107.74 andthe actual rate is 107.86. What we can do now is short the EUR/JPY and go long EUR/USD andUSD/JPY until the correlation is reestablished. Sounds easy, right ? The fact is that there aremany important problems that make the exploitation of this three way arbitrage almostimpossible.


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tia


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Thanks for the solutions......

7 Entertaining blog - cheers. on 6th November 2011, 6:06 pm

This is a truly interesting blog post. I will return in future.

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