I.

Write short notes on:

a) Measuring exchange rate movements
b) Factors that influence exchange rates
a) Measuring exchange rate movements
Exchange rates respond quickly to all sorts of events- both economic and non-economic. 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. 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. These changes in exchange rates expose all those
firms having export import operations as also multinationals with integrated cross border production and
marketing operations. By a study of these factors and the trend of movements in the value of particular
currency, an experienced businessman may be able to forecast the possible future movement of that
currency. This will enable him to:
(i) Estimate his risk and
(ii) Make an informed, prudent decision as to whether it would be worthwhile for him to carry the risk or to
take some appropriate steps to reduce that risk.

b) Factors that influence exchange rates

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 currencys demand can go down if the central bank lowers the rate of interest. Currencies rally when the
demand for it goes up.

The supply side factor

A basic economic principle of supply says that a currency's value will change with the rise and fall
of the levels of supply. The value and price of a currency will diminish if there is a higher supply of a
currency. Similarly, the value and price of a currency will increase when there is a lower supply of a
currency.

Long term vs. short term

A time period of a year or more signifies a long-term supply and demand. Short-term is generally
thirty days or less than that. The currency prices in both the time periods can be affected by the same
factors. A trader should be conscious of the time factor in which a trade is placed. Long and short-term
price movements can happen in parallel. However, they can also deviate, which can lead to inconsistency
in price movements. Hence, a trader should always keep in mind the trading environment and the time
frame while doing foreign exchange trade.

II. The key component of the financial system is the money market that acts as a fulcrum of monetary
operations. Write down the important points under each category mentioned below.
a) Functions performed by money market
b) International interest rates
c) Standardized Global Market regulations.
a) Functions performed by money market
There are three broad functions that are performed by the money market.
1. For the demand and supply of short term funds, the money market provides an equilibrating
mechanism.
2. It helps the lenders and the borrowers of the short term funds in fulfilling the borrowing and
investment requirements at a competent market clearing price.
3. It offers an avenue to the central bank to intervene in influencing the cost of liquidity and the
quantum in the financial system which in turn transmits monetary policy impulses to the real
economy.

b) International interest rates

Money market rates are interest rates used by banks for operations among themselves. Money
market enables the banks to trade their surpluses and deficits. This rate is also commonly known as interbank rate. The rates for various countries vary substantially. The reason for this substantial difference in
rates is due to the interaction of supply or availability of short term funds (bank deposits) in a particular
country versus the demand by borrowers for short term funds in that country. If the supply is more than the
demand the interest rate will be low. A typical case is of Japan where the short term rates are very low for
the same reason. On the other hand, if the supply of short term funds is less, than the demand of rates will
be high as in the case of Australia. The interest rates in developing countries are higher than the other
developed countries.

c) Standardized Global Market regulations.

Regulations contribute to the development of international money markets because these impose
restrictions on local markets. Local investors and borrowers try to circumvent the restrictions in local
markets. Difference in regulations among countries puts banks in some countries to advantageous position
compared to banks in other countries. Over a period of time, international banking regulations have been
standardized, which permit competitive global banking. Three most significant regulatory events for
creating more competitive global level playing field are given below:
1. The Single European Act
2. The Basel I Accord
3. The Basel II Accord
Single European Act
This was one of the most significant events pertaining to international banking. It was introduced in
1992 throughout the European Union countries.

The Basel I Accord

In July 1988, central bank governors of 12 countries agreed on standard guidelines for banking
regulation under The Basel Accord. As per the guidelines of The Basel Accord, banks are required to
maintain capital equal to minimum of 4 per cent of their assets.

The Basel II Accord

The banking regulators those formed the Basel Accord introduced a new accord called The Basel
II Accord. The objective of this accord is to rectify some inconsistencies that still exist in the earlier
accord. For example, banks in some countries require better collateral to back the loans.

III. Thousands of years back the concept of bartering between parties was prevalent, when the concept
of money had not evolved. Explain on counter trade with examples.
Counter trade
Bartering is exchange of goods between parties as per agreed terms without the use of money.
When the concept of money had not evolved, A person could give say 100 bags of wheat and get wood or
coal, a certain quantity for cooking. These bartering contracts were between individuals or small kingdoms.
Bartering exists today also but at different level. For example, Iran may give 100 million barrels of oil to
France and get 5000 guns of certain type in exchange.
Today, most business is transacted with money as medium. Trading between countries is through
respective currencies using international exchange rate. Countertrade means all types of foreign trade in

which the sale of goods to another country is associated with parallel purchase of some other goods from
that country.

Different forms of counter trade

The different forms of countertrade are:
Barter
Buy-back
Counter purchase
Countertrade takes many different forms as explained below:

(i) Barter: It is exchange of goods without the use of money. Typical examples are:
(a) Oman exchange oil for air-conditions with Taiwan
(b) Sri Lanka exchange fish for mobile handsets with Germany

(ii) Buy back: In this part, the payment of the price of contract is through supply of related products.
Typical examples are:
(a) A firm in China purchases plant & technology for manufacture of high precision bearings from
Germany, and the firm in Germany agree to buy a part of bearings produced by the plant in China.
(b) An Indian aerospace firm sets up production facility for manufacture of executive jets under
technical collaboration from an American firm who in turn agrees to provide a part of worldwide
business of overhauling of executive jets to the Indian firm.

(iii) Counter purchase: In such cases, there is direct purchase of items as exchange deals. Typical
examples are:
(a) A firm in US sold soft drinks to Russian counterpart and imported vodka in exchange.
(b) Canada sold wheat to Indonesia in exchange for import of rubber.
(c) A German firm sold machine
Examples
Examples of countertrade are many and in a variety of forms. Though countertrade exists to create
win-win situation between parties involved, it has its own ills; typically following issues are existing:
1. The exporting country sells high technology items at inflated prices and the items which they
import are disposed off to other countries at a discount, using a part of high premium charged on
their exports.

2. The middlemen in the countertrade agreements are usually shrewd traders who exploit the
political and social circumstances to obtain large gains for themselves.
3. The goods that are offered in countertrade are not the required items, because the desirable items
have already been exported. For example, if Switzerland sells high precision machines to Brazil, it
may like Brazilian coffee beans in exchange, but what it may get is only leather goods.

IV. There are different techniques of exposure management. One is the Managing Transaction
Exposure and the other one is the managing operating exposure, So you have to explain on both
Managing Transaction Exposure and Managing Operating Exposure.
Managing transaction exposure
Transaction exposure is concerned with the impact of change in exchange rate on present cash
flows. Transaction exposure calculates gains or losses which occur after the current financial compulsions
according to terms of reference are resolved. Taken that the deal would lead to a future inflow or outflow
of foreign currency cash, any unprecedented alterations in rate of exchange amid the period in which
transaction is entered and the time taken for it to settle in cash would guide to a change in worth of net flow
of cash in terms of the home currency.
For example a transaction exposure of an Indian company will be the account receivable which is
associated with a sale denominated in US dollars or the compulsion of an account payable in Euro debt.
Presume an Indian firm sells goods with an open account to a German buyer for 1,800,000 payment of
which is to be done in 2 months. The current exchange rate is 50/, and the Indian seller expects to
exchange the Euros received for 90,000,000 when payment is received. If euro weakens to 45/ when
payment is received, the Indian seller will receive only 81,000,000, or some 9,000,000 less than
anticipated. Opposite will be the case should euro strengthen. Thus exposure is a chance of either gain or
loss.
Managing operating exposure
Operating exposure is alternatively known as economic exposure. It evaluates the changes that occur in
the current value of the firm. The change in the current value may be a result of the change that takes place
in predicted operating cash flows on account of fluctuations in exchange rates. Methods of managing
operating exposure are:
i)

Selecting low cost production sites: A firm may wish to diversify the location of their
production sites to mitigate the effect of exchange rate movements. The adverse repercussions
of the fluctuations in exchange rates can be avoided, if the location of the production sites is
shifted to other countries with currencies that have depreciated in real terms.

ii)

Flexible sourcing policy: It is found that if the inputs and raw materials are bought in foreign
markets where the local content in the production costs is considerably high, the fluctuations in
exchanging rates result in a corresponding change in the relative cost of sourcing from
alternative sources.

iii)

Diversification of market: This can be understood in terms of sale of products in a number of

markets in order to maximize advantage on account of diversification of the exchange rate risk.

iv)

R&D and product differentiation: This entails an effective R&D in order to facilitate the
following:

v)

Cost reduction

Increase in Productivity

Product Differentiation

Financial Hedging: Transaction exposure to currency risk is mostly short-term in nature. In

contrast operating exposure has a very long time horizon. The four most commonly employed
financial hedging policies are:

Matching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

V. Every firm is going on concern, whether domestic or MNC. Explain the techniques of capital
budgeting and the steps to determine cash flows.
Techniques of capital budgeting-NPV, IRR, PI , Payback period
There are many techniques which can be used to analyze the projects. These techniques can be
broadly classified into discounted cash flow techniques, which include net present value (NPV), internal
rate of return (IRR), profitability, index (PI) and discounted payback methods, and non-discounted cash
flow techniques which include payback and accounting rate of return (ARR) methods. The most commonly
and most widely accepted technique is NPV method.

Net Present Value (NPV)

In this method all future cash flows occurring in different time periods are discounted to present
value using opportunity cost of capital as discount rate. Whenever there is a cash inflow, we take it with
positive sign and cash outflow, we take it as negative sign. If present value (PV) of cash inflows is greater
than present value (PV) of cash outflows the project can be accepted. The difference of PV of all future
cash flows and initial investment is known as NPV.

Internal Rate of Return (IRR)

Internal rate of return is defined as that discount rate at which NPV is equal zero. This internal rate
of return is compared with opportunity cost of capital. If IRR is greater than opportunity cost of capital the
project can be accepted; if IRR is less than opportunity cost of capital the project cannot be accepted as in
such a case, the project will not be able to generate even the opportunity cost of capital.

Profitability Index (PI)

It is defined as the ratio of present value of all cash inflows divided by the initial cash outflow. It is
similar to NPV in the sense that it also uses discounted cash flows and initial outflow but instead of
subtracting initial cash outflow from discounted cash flows, here we divide the discounted cash flows by
initial cash outflow. We accept the project if PI is greater than one, reject it if PI is less than one and may
or may not accept it if PI is equal to one.

Payback Period
This is a non-discounted cash flow technique. It finds out the time in years in which the initial
investment would be recovered. It is the easiest method as far as computation is concerned but drawback
being that it does not consider time value of money. Mathematically, it is calculated by dividing initial cash
outflow by annual constant cash inflows.

Determination of cash flow

We need to determine the incremental cash flows over the existing cash flows which will take place
by acceptance of the project under evaluation. Any expenses which are already incurred will not be
included in cash flows. Such expenses are called sunk costs.
The step of determining cash flows with accuracy is the most important step in capital budgeting
analysis as further process is dependent on it, but it is a difficult task due to the following reasons:
1. Future is uncertain, and uncertainty gives rise to risks.
2. Accounting information which is based on various assumptions is used as basis to determine cash flows
3. Economic conditions may change suddenly due to some event
In any capital investment project there will be three main cash flows:
Initial cash outflow
Cash flows during the project. It may be inflow or a mix of inflow and outflow
Final period cash flow; generally referred to as terminal cash flow

Though cash flows (not profits) are used as basis for evaluation of capital projects, both are
important. These are connected by the following equation:
Cash Flow = Profit (P) + Depreciation (D) Capital Expenditure (CAPEX)

VI. Write short note on:

a) American Depository Receipts(ADR)
b) Global Depository Receipts(GDR)
American Depository Receipts (ADR)
It represents ownership in the shares of a non-US company and trades in the American stock
markets. ADRs enable American investors to buy shares in foreign company without any issue of crossborder and cross-currency transactions. ADRs carry price in American dollar, pay dividend in the same
currency and can be traded like any other share of US-based companies. Each ADR is issued by a US
depository bank and can represent one share. The owner of ADR has the right to obtain the foreign stock it
represents, but US investors are more interested in owning ADR as they can diversify their investments
across the globe. ADR falls within the regulatory framework of the US and requires registration of the
ADRs and the underlying shares with the SEC.

Features of ADRs
The following are the features of ADR:
ADR can be listed on American Stock Exchange.
A single ADR can represent more than one share. One ADR can be two shares or any fraction also.
The holder of the ADRs can get them converted into shares.
The holders of ADR have no right to vote in the company.
Global Depository Receipts (GDR)
They are used in Global Equity offering to international investors. It can be considered as global
finance instrument that allows an investor to raise capital at the same time from two or more markets.
Depositing receipts helps in cross border trading and settlement helps to reduce transaction costs and
increases the investment base among the institutional investors. GDR is a negotiable certificate that
represents a companys publicly traded equity or debt. They are created when a broker purchases the
companys shares on domestic stock market and deliver them to the depositorys local custodian bank who
instructs the depository bank to issue GDRs. They are traded on a stock exchange where they are listed and
in OTC market.

GDRs are considered same as selling equity in the Euromarkets.

Features of GDRs:

GDRs can be listed on any American and European Stock exchange.

One GDR can represent more than one share.

The holder of GDRs can get them converted into shares.

The holder of the GDR has no right to vote in the company. However, the shareholders do
have this right. The dividend on the GDRs is quite like the dividend on shares.

GDRs are in the US dollar.