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Master of Business Administration- MBA Semester 4

MF0006 –International Financial Management - 2 Credits

(Book ID: B0889)

Assignment Set- 1 (30 Marks)


Note: Each Question carries 10 marks. Answer all the questions.

Q1. What is meant by BOP? How are capital account convertibility and current account convertibility different? What is the current scenario in India?

Q2. Distinguish between Eurobond and foreign bonds? What are the unique characteristics of Eurobond markets?

Q3. What is arbitrage? Explain with the help of suitable example a two-way and a three way arb


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Q1. What is meant by BOP? How are capital account convertibility and current account convertibility different? What is the current scenario in India?

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The balance of payments (BOP)

The balance of payments (BOP) is a country’s record of all transactions between its residents and the residents of all foreign countries. Inflows of funds generate credits for the country’s balance, while outflows of funds generate debits. If all transactions are recorded correctly, then the sum of all credit items necessarily equals the sum of all debit items, because the foreign exchange that is bought must also have been sold. Thus the balance of payments entries are always balanced; the entries add up to zero.

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 the rest of the world. International transactions include exchanges of goods, services or assets. The term “residents” means businesses, individuals and government agencies and includes citizens temporarily living abroad but excludes local subsidiaries of foreign corporations.

The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exports of 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 are recorded as debit, minus, or cash outflows (uses).

The Balance of Payments for a country is the sum of the Current Account, the Capital Account and the change in Official Reserves.

The Balance of Payments identity states that: Current Account + Capital Account = Change in Official Reserve Account. If a country runs a current account deficit and it does not run down its official reserve to cover this deficit (there is no change in official reserve), then the current account deficit must be balanced by a capital account surplus. Typically, in countries with floating exchange rate system, the change in official reserves in a given year is small relative to the Current Account and the Capital Account. Therefore, it can be approximated by zero.

Capital Account Convertibility and Current Account Convertibility
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 investment income (interest and dividend), and net unilateral transfers (private transfer payments and government transfers) from abroad. Investment income for a country is the payment made to its residents 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 temporary workers abroad. Unilateral transfers are official government grants-in-aid to foreign governments, charitable giving (e.g., famine relief) and migrant workers’ transfers to families in their home countries. Net investment income and net transfers are small relative to imports and exports. Therefore a current account surplus indicates positive net exports or a trade surplus and 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 direct investment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in the capital account. When Indian citizens buy foreign securities or when foreigners buy Indian securities, they are listed here as outflows and inflows, respectively. When domestic residents purchase more financial assets in foreign economies than what foreigners purchase of domestic assets, there is a net capital outflow. If foreigners purchase more Indian financial assets than domestic 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.

Current Scenario in India
No country in today’s globalized world can be fully insulated from what happens in the global economy and India is no exception to the rule. As the country is increasingly integrated into the world, it cannot remain impervious to developments abroad. The unfolding of the euro zone crisis and uncertainty surrounding the global economy have impacted the Indian economy causing drop in growth, higher current account deficit (CAD) and declining capital inflows. As in 2008, the transmission of the crisis has been mainly through the balance-of-payments (BoP) channel. Export growth has decelerated in the third quarter of fiscal 2011-12, while imports have remained high, partly because of continued high international oil prices. At the same time, foreign institutional investment flows have declined, straining the capital account and the rupee exchange rate that touched an all-time low of IRS 54.23 per US dollar on 15 December 2011.

The highlights of BoP developments during2010-11 were higher exports, imports, invisibles, trade, CAD and capital flows in absolute terms as compared to fiscal 2009-10. Both exports and imports showed substantial growth of 37.3 per cent and 26.8 per cent respectively in 2010-11 over the previous year. The trade deficit increased by 10.5 per cent in 2010-11 over 2009-10. However, as a proportion of gross domestic product (GDP), it improved to 7.8 per cent in 2010-11 (8.7 per cent in 2009-10). Net invisible balances showed improvement, registering a 5.8 per cent increase in 2010-11. The CAD widened to US$ 45.9 billion in 2010-11 from US$ 38.2 billion in 2009-10, but improved marginally as a ratio of GDP to 2.7 percent in 2010-11 vis-a-vis 2.8 per cent in 2009-10. Net capital flows at US$ 62.0 billion in 2010-11 were higher by 20.1 per cent as against US$ 51.6 billion in 2009-10, mainly due to higher inflows under ECBs, external assistance, short-term trade credit, NRI deposits, and bank capital. In 2010-11, the CAD of US$ 45.9 billion was financed by the capital account surplus of US$ 62.0 billion and it resulted in accretion to foreign exchange reserves to the tune of US$ 13.1 billion (US$ 13.4 billion in 2009-10).


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Q2. Distinguish between Eurobond and foreign bonds? What are the unique characteristics of Eurobond markets?

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Foreign Bonds

A country's foreign bond market is that market in which the bonds of issuers not domiciled in that country are sold and traded. For example, the bonds of a German company issued in the U.S. or traded on the U.S. secondary markets would be part of the U.S. foreign bond market. The definition of "foreign" refers to the nationality of the issuer in relation to the market place. For example, a US dollar bond sold in the United States by the Swedish car producer Volvo is classified as a foreign bond while one issued by General Motors is a domestic bond.

Features of the Foreign Bonds:


1. Foreign bonds are sold in the currency of the local economy.

2. Foreign bonds are subject to the regulations governing all securities traded in the national market and sometimes special regulations governing foreign borrowers (e.g., additional registration).

3. Foreign bonds provide foreign companies access to funds they often use to finance their operations in the country where they sell the bonds.

4. Foreign bonds are regulated by the domestic market authorities. The issuer must satisfy all regulations of the country in which it issues the bonds.

Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure.

Foreign bonds are known by different names in different countries. They are called Yankee bond, Samurai bonds, Matador bonds, Bulldog bonds and Rembrandt bonds in USA, Japan, Spain, UK and Netherlands respectively.


Eurobonds

A Eurobond is not a foreign bond issued within the European Union. Rather, it is a bond issued and traded within the mostly unregulated Euromarket. While that market originated within Europe – and is still largely centered there – it is a truly international market. Transactions are not subject to any particular nation's regulations.

A Eurobond is a bond issued outside the country in whose currency it is denominated. A Eurodollar bond that is denominated in U.S. dollars and issued in Japan by an Australian company would be an example of a Eurobond. The Australian company in this example could issue the Eurodollar bond in any country other than the U.S. Usually, a Eurobond is underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries. For example, to raise funds to finance its European operations, a U.S. company might sell a bond denominated in British pounds throughout Europe.

Features of the Eurobonds:


1. Currency denomination: The generic, plain vanilla Eurobond pays an annual fixed interest and has a long-term maturity. There are a number of different currencies in which Eurobonds are sold. The major currency denominations are the U.S. dollar, yen, and euro. (70 to 75 percent of Eurobonds are denominated in the U.S. dollar.) The central bank of a country can protect its currency from being used. Japan, for example, prohibited the yen from being used for Eurobond issues of its corporations until 1984.

2. Non-registered: Eurobonds are usually issued in countries in which there is little regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds. (Bearer form means that the bond is unregistered, there is no record to identify the owners, and these bonds are usually kept on deposit at depository institution). While this feature provides confidentiality, it has created some problems in countries such as the U.S., where regulations require that security owners be registered on the books of issuer.

3. Credit risk: Compared to domestic corporate bonds, Eurobonds have fewer protective covenants, making them an attractive financing instrument to corporations, but riskier to bond investors. Eurobonds differ in term of their default risk and are rated in terms of quality ratings.

4. Maturities: The maturities on Eurobonds vary. Many have intermediate terms (2 to 10 years), referred to as Euronotes, and long terms (10-30 years), and called Eurobonds. There are also short-term Europaper and Euro Medium-term notes.

5. Other features:

Like many securities issued today, Eurobonds often are sold with many innovative features. For example:
a. Dual-currency Eurobonds pay coupon interest in one currency and principal in another.

b. Option currency Eurobond offers investors a choice of currency. For instance, a sterling/Canadian dollar bond gives the holder the right to receive interest and principal in either currency.

A number of Eurobonds have special conversion features. One type of convertible Eurobond is a dual-currency bond that allows the holder to convert the bond into stock or another bond that is denominated in another currency.
A number of Eurobonds have special warrants attached to them. Some of the warrants sold with Eurobonds include those giving the holder the right to buy stock, additional bonds, currency, or gold.


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Q3. What is arbitrage? Explain with the help of suitable example a two-way and a three way arbitrage.

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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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