Question Paper

International Finance and Trade II (222) – July 2004

Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 5.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. For an Indian Company, the choice between the borrowing in home currency or foreign currency would
depend on a number of criteria. Discuss those criteria for choosing a currency of borrowing.
(10 marks) < Answer >
2. What are the reasons for the growth of Eurodollar market? Discuss the advantages; RPL can gain by
borrowing in Eurodollar market than in borrowing dollar in the US market.
(8 marks) < Answer >
3. State how the Eurocurrency interest rates are determined.
(6 marks) < Answer >
4. a. Show the cash-flows of the rupee loan and find out the effective cost of the loan if bank rates are
turned out as follows:

Period (Months) 6 – 12 12 – 18 18 – 24 24 – 30 30 – 36

Bank Rate (%) 5.50 5.00 5.00 5.50 6.00

b. Show the cash-flows of the eurodollar loan and find out the effective cost of the loan in rupee term if
the 6 month LIBOR turned out as follows:

Period (Months) 6 – 12 12 – 18 18 – 24 24 – 30 30 – 36

LIBOR (%) 2.25 2.50 2.75 2.60 2.35

c. Show the cash flows of the yen loan and find out the effective cost of the loan in rupee term.
(5 + 8 + 7 = 20 marks) < Answer >
5. Explain the types of foreign exchange exposure RPL will face if it borrows in foreign currency.
(6 marks) < Answer >
Mr. Rahul, a member of Remedy Pharmaceutical Ltd.’s (RPL) management board, recently took on
responsibility for the group’s finances. A few weeks ago, in the middle of May, the head of his Financial
Planning Group had presented a report that strongly suggested that RPL would soon reach what management
historically considered to be the upper limits of short-term sources of funds, from banks and the commercial
paper (CP) facilities in the Indian market. “Sooner or later’ we will need more term funding. And in view of
our international expansion plans, this should preferably be dollar debt, although Euro and even a Japanese
borrowing could be justified our new exposure guidelines,” said Rahul. He explained that the company had
some leeway under those guidelines because any deviation from the desired currency composition could be
adjusted by changing draw-downs of bank lines and, if absolutely necessary, via the judicious use of currency
swaps.
When the possibility of a substantial dollar denominated funding came up, Rahul’s first thought turned to the
US market. However, historical evidences reveal that the US market poses a difficult operating environment
and would requires RPL to be better known in the US financial community and beyond to get a favorable rating
at that market. Rahul quickly dismissed the idea. Immediately it stuck to his mind that the alternative market
for dollar borrowings is the Eurocurrency market. Due to various reasons Eurobanks can charge lower cost of
borrowing than the banks in US and due to less number of regulations in that market it is far more easy to get a
dollar loan in the eurocurrency market. Another market Rahul seriously considering is the Japanese yen market.
Due to incredibly low interest rate in Japanese economy and ample liquidity, it is easy to get loan at a very low
interest rate denominated in yen. Rahul has instructed his staff to begin more intensive negotiations with a
number of banks and investment banks to see what is available to the company, both in the domestic market as
well as international market. The staff of RPL after month long negotiations with various domestic and
international financial institutions has short-listed three loan proposal:
Proposal I
3 year Rs.115 crore floating rupee loan from a leading Indian nationalized bank. Interest rate payable semi-
annually at Bank Rate + 150 basis points. The principal to be repaid after 3 years with a bullet payment.
Proposal 2
3 year $25 million Eurodollar loan from a bank in London. Interest is payable at 6 month LIBOR + 200 basis
points. The principal to be repaid after 3 years with a bullet payment.
Proposal 3
3 year ¥ 2800 million from a bank in Japan Interest is payable semi-annually at fixed rate of 2.5%. The
principal is to be repaid in two equal annual installments at the end of the 30 and 36 months.
Mr. Rahul is averse of taking any foreign exchange risk, so he should cover all his foreign exchange cash flows
in the forward market. He also believes that the 6 month forward rates for dollar and yen will reflect the values
as par the purchasing power parity. Further, the loans will be availed from July 01, 2004.
Current Exchange Rates on July 01, 2004
Rs./$ 46.00
Rs./¥ 0.4120
Current Interest Rates on July 01, 2004
Bank Rate 6%
6 month LIBOR 2%
Inflation Rates
India 4%
USA 2%
Japan 0.5%

END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 6 - 12.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
6. Explain the role of IMF in the international monetary system.
(7 marks) < Answer >
7. Detail the various schemes through which IMF lends to its member countries?
(7 marks) < Answer >
8. What are the criticisms raised against IMF?
 (6 marks) < Answer >
India, which was a borrower from International Monetary Fund and World Bank funds for a long time, has now
been selected by IMF as a lender. According to the press release issued by the Reserve Bank of India, India has
been selected by IMF to become a member of its Financial Transaction Plan (FTP) to provide credit. With the
recent lending of $43 mn to Indonesia, India had, in the last eight months, lent hard currency of $393 mn. Out
of which, India has lent $350 mn to Brazil and another $5 mn to Burundi under FTP. The reason behind it is the
buoyant foreign exchange reserves, which crossed the $100-billion mark recently, and a worthy balance of
payments situation, which encouraged the IMF to include India as one of the 40-odd countries in its financial
transaction plan. Under the FTP, the IMF seeks volunteers from its members, to contribute to other member
countries’ needs in cash. The FTP requires countries to maintain their hard currency component in the quota at
around 25%.
The governments of 45 countries decided to develop the idea of IMF at a United Nations Conference, in the
year 1944. It was the Great Depression of the 1930s that inspired them to come up with a structure to prevent
the recurrence of such a tragic event again. Basically, the promotion of international monetary cooperation,
facilitating the expansion and balanced growth of international trade, promoting exchange stability, assisting in
the establishment of a multilateral system of payments; and making its resources available to members,
experiencing balance of payments difficulties are the core activities of the fund, in particular. Moreover, its
activities also include ensuring the stability of the international monetary and financial system, and seeking to
promote economic stability and preventing crisis.
To fulfill the above objectives it performs three main functions—surveillance, technical assistance, and
lending.
Surveillance
Under this function, the Fund conducts comprehensive evaluation of each member country’s economic
situation, normally, once a year. It then discusses with the country’s authorities, the policies that are most
favorable to stable exchange rates and a prosperous economy. The IMF also combines information from
individual sources, to assess global and regional growth and prospects. All the countries that join the IMF have
to agree to allow access of its economic and financial policies to the scrutiny of the international community.
Accordingly, the IMF keeps a watch on economic policies at the country, regional and global levels. It also
suggests the macroeconomic policies and ways to strengthen financial sectors and trade competitiveness, based
on its broad, international experience and analysis. And it considers potential national and international
consequences of domestic policies, as well as possible domestic effect of developments in other countries or
regions. The surveillance function had gained more importance from the Mexican crisis of 1994-95 and the
Asian crisis of 1997-98. These two events had triggered the watch out role of IMF and, as a result, it had
advised the member countries to incorporate more “shock absorbers” into their policies, to safeguard the
economy from such potential setbacks. Some of the shock absorbers are adequate reserve levels, efficient and
diversified financial systems, more effective social safety nets, and a fiscal policy that leaves room for higher
deficits in difficult times. And, it has introduced several specific initiatives that seek to make countries less
vulnerable to crisis.
Technical Assistance
Under this role, training is offered, mostly free of charge to help member countries strengthen their capacity to
design and implement effective policies. Technical assistance is offered in several areas, including fiscal
policy, monetary and exchange rate policies, banking and financial system supervision and regulation, and
statistics. Its areas of expertise include fiscal policy, monetary policy, and macroeconomic and financial
statistics. About three-quarters of IMF technical assistance go to low and lower-middle income countries, and
sub-Saharan Africa is, currently, the largest beneficiary of technical assistance.
Lending
It aims to help countries implement policies and reforms, in order to overcome there balance of payments crisis
and restore conditions for strong economic growth. These policies will vary, depending upon the country’s
circumstances, including the root cause of the problems. For instance, a country facing a sudden drop in the
price of a key export may simply need financial assistance to tide over until prices recover. Before a member
country can receive a loan, the country’s authorities and the IMF must agree on the appropriate program of
economic policies. The commitments made by a country to undertake actions are an integral part of IMF
lending and are meant to ensure that the funds will be used to resolve the borrower’s balance of payments
crisis. In the absence of IMF financing, the adjustment processes a country has to undergo would be quite
difficult. For example, if investors do not want to buy any more of a country’s government bonds, the
government has no choice but to either reduce the amount of financing it requires—reducing its spending or
increasing its revenues—or to finance its deficit by printing money. The “belt tightening” involved in the first
case would be greater than with an IMF loan. And in the second case, the result would be inflation, which hurts
the poor most of all. IMF financing can facilitate a more gradual and carefully considered adjustment.
 Caselet 2
Read the caselet carefully and answer the following questions:
9. Discuss the various benefits and prospective troubles of holding huge reserves.
(8 marks) < Answer >
10. Discuss about the optimal level of reserves to be maintained by India.
(7 marks) < Answer >
It is ironical. The demand for foreign exchange reserves is insatiable. The more the merrier. The higher the
build up of reserves the lesser is the inclination for the central banks to use them for intervention in the forex
markets. Looking back, the foreign exchange situation, twelve years back was really scary. India had less than
one weeks requirement of imports. Industry was on short rations; every enterprise seeking release of foreign
exchange, even for essential imports, had to place a heavy rupee deposit. The tables have really turned upside
down now.
There is no denying the fact that the sizeable build-up of foreign exchange reserves has been the most
significant macroeconomic development in the country over the last decade, something that has altered the very
face of the economy and profoundly impacted monetary exchange rate and trade policy. Reserve accumulation
has, in fact, been an enduring phenomenon since the start of the 1990s and there has not been a single year,
barring 1995-96 that has not seen an accretion to India’s forex kitty. In the backdrop of the East Asian
contagion, the economic sanctions in the late 1990s, soaring world crude prices, Kargil, Kashmir, war in West
Asia etc. the burgeoning reserves phenomenon is on the more mind boggling. India’s foreign exchange reserves
have hit a record high in recent years and have maintained their upswing. Thanks to the economic reforms, the
forex reserves, which were at an all-time low in 1991, have risen continuously and crossed the $100 bn mark
recently.
Conceptually, a unique definition of forex reserves still eludes us as there have been divergent views in terms
of coverage of items, ownership of assets, liquidity aspects and need for a distinction between owned and non-
owned reserves. Nevertheless, for policy and operational purposes, most countries have adopted the definition
suggested by the International Monetary Fund. This defines reserves as external assets that are readily available
to and controlled by monetary authorities for direct financing of external payments imbalances, for indirectly
regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency
exchange rate, and/or for other purposes.
Technically, there could be three motives i.e., transaction, speculative and precautionary motives for holding
reserves. International trade gives rise to currency flows, which are assumed to be handled by private banks
driven by the transaction motive. Similarly, speculative motive is left to individuals or corporates.
Precautionary motive for holding foreign currency like the demand for money, can be positively related to
wealth and the cost of covering unplanned deficit, and negatively related to the return from alternative assets.
The rise in the amount of reserves has become a hot topic for discussion and debate among academics and
policy-makers. Some are of the opinion that while high level of reserves can prove to be effective in short-term,
their long-term implications may not be of much help to the country. On the brighter side, rising level of
reserves provides a comfort in managing external shocks, and lends confidence to the international agencies
that the country can withstand external shocks. In terms of adequacy, the existing reserves are sufficient to
finance India’s import needs for roughly 15 months as compared with the reserve cover of below two months in
March 1990 and 15 days in 1991. Recently, the International Monetary Fund (IMF), had stated that India’s
management of foreign exchange reserves was in accordance with its guidelines and comparable to global best
practices. It has also selected India as a member of its Financial Transaction Plan, keeping in view the
country’s strong balance of payments and comfortable foreign exchange reserves position.
With such high level of reserves, what can be said about the Balance of Payments (BoP) situation for India?
The high level of reserves has been a plus point for the BoP situation. It is for the first time in nearly two
decades that India has got both Capital and Current Account (CA) running in surplus. Making use of this
opportunity, India has planned to prepay $1.5 bn of its external debt. Earlier during the year, India prepaid
multilateral loans totaling $2.8 bn. The RBI is also initiating various steps on the road to current account
liberalization. It has raised the limits for remittance of foreign exchange by 3-20 times for various purposes,
ranging from education to employment abroad. The limits on remittance of foreign exchange have been raised
by 20 times, from $5,000 to $100,000 for those going overseas for employment, for those emigrating and, for
the maintenance of close relatives abroad, while the limit on remittances for consultancy services procured
from outside India has been raised to $1mn per project, from $100,000. It has also allowed banks to release
foreign exchange up to $100,000 or its equivalent to resident Indians for medical treatment abroad, without
insisting on any estimate from a hospital or doctor in India or abroad. Residents have been permitted to open
Foreign Currency Deposit Accounts. The RBI has also capped the interest rates on fresh Non-Resident
(External) rupee (NRE) deposits for 1-3 years at 250 bp above the London Inter-Bank Offered Rate (LIBOR).
Caselet 3
Read the caselet carefully and answer the following questions:
11. How depreciation of dollar will affect the international trade of the countries whose currencies are pegged
to the US dollar? Explain.
(7 marks) < Answer >
12. Discuss the impact of the dollar depreciation on macroeconomic indicators of those countries whose
currencies are pegged to the US dollar. Also explain the impact on the countries following floating
exchange rate.
(8 marks) < Answer >
The US dollar has appreciated considerably since the mid 1990s. Between May 1995 and January 2002, the
dollar’s nominal effective exchange rate appreciated by 44.5 percent, and the real effective exchange rate
appreciated 34.0 percent. However, the dollar depreciated between 1 March and 19 July 2002 by 17.4 percent
against the euro, and 13.2 percent against the yen. In the same period, the dollar’s nominal effective exchange
rate depreciated by 3.9 percent, while its real effective exchange rate depreciated 4.0 percent. This has
prompted speculation that the dollar may have started a major realignment.
The depreciation came amid concerns about economic growth prospects, weak equity markets, and accounting
scandals in the US. It may, however, also reflect the US’s large current account deficit, with the annualized
deficit rising to 4.4 percent of gross domestic product (GDP) in the first quarter 2001. The current account
balance represents the difference between exports of goods and services and the income received from abroad,
and imports of goods and services and income transferred abroad. In essence, a current account deficit means
that foreign capital is financing some segments of domestic spending. Financing a current account deficit with
foreign capital is feasible in the short term, but unsustainable in the long run. Large current account deficits are
often corrected by exchange rate depreciation.
As a large current account deficit cannot be financed by foreign capital forever, there is a real possibility that
dollar depreciation may occur, although the timing is not certain. Given their level of dependence on the US
market, it is useful to consider the likely ramifications for Asian developing member countries (DMCs) should
substantial dollar depreciation take place. While exchange rate movements affect various aspects of the
economy, this brief focuses on the trade and macroeconomic policy implications.
Dollar depreciation will have different effects on economies with floating exchange rates and those with
currencies pegged to the dollar. Most DMCs maintain floating exchange rates, under which authorities
normally do not intervene in the foreign exchange market and the currency is left to react to market signals.
Currencies with floating exchange rates will appreciate in response to dollar depreciation.
A few DMCs peg their currencies to the US dollar. Hong Kong formally pegs the Hong Kong dollar to the US
dollar. The People’s Republic of China (PRC) maintains a de facto peg to the US dollar. The Malaysian
currency is also kept within a very narrow range of exchange rate with the dollar. The pegged exchange rate
arrangement requires authorities to intervene in the foreign exchange market to maintain the fixed exchange
rate. They will have to buy domestic currency when it is in excess supply and sell it when it is in excess
demand to avoid a currency depreciation or appreciation. When the dollar depreciates, currencies pegged to the
dollar will also depreciate against other currencies.
Different policy regimes mean DMC currency changes will vary relative to the dollar. The effect of a dollar
depreciation will be different for economies with floating and pegged exchange rates.
The US market takes about 20 percent of DMC exports in general and nearly 40 percent of some countries’
exports. Changes in price competitiveness due to a dollar depreciation can have an important impact on DMCs.
Macroeconomic theory has long established that export and import growth, and thus the trade balance, are
determined by changes in price competitiveness, economic growth of trading partners, and income growth in
the home country. Exchange rate changes alter both price competitiveness and income growth of countries.
Exchange rate changes have other macroeconomic impacts. One of the most important is altering aggregate
demand. When a country’s exchange rate depreciates, aggregate demand for its products can increase. This
comes about because both domestic and foreign demand for its products may increase as they become cheaper.
Such cases apply to economies whose currencies are pegged to the dollar as they depreciate in line with the
dollar.

END OF SECTION E
END OF QUESTION PAPER
 Suggested Answers
International Finance and Trade II (222) – July 2004
Section D : Case Study
1. For an Indian company, the choice between the domestic and international market would depend on a
number of criteria, some of which are listed below:
i. Currency Requirements: A decision has to be taken about the currency needs of the company, keeping
in view the future expansion plans, capital imports, export earnings/potential export earnings. A
conscious view on the exchange rate also needs to be taken.
ii. Pricing: Pricing of an international issue would be a factor of interests rates and the value of the
underlying stock in the domestic market. Based on these factors, the issue price conversion (for
convertible) premium would be decided. Given the arbitrage available between interest rates in rupees
and say, US dollars, and given the strength of the rupee, as well as the resilience a company can have
in its operations against exchange fluctuation risk, due to export earnings, it is possible to take
advantage of the low interest rates that are prevailing in the international markets. The above is
possible without dilution of the value of the underlying stock. This is so, because, in the case of
international issues, open pricing/book building is possible, which has the advantage of allowing the
foreign investors to set the premium ensuring transparency and creating price tension.
iii. Investment: At present greater flexibility is available in structuring an international issue in terms of
pure equity offering, a debt instrument or a hybrid instrument like foreign currency convertible bond
(FCCB). Each company can take a view on instrument depending upon the financials of the company
and its future plans.
iv. Depth of the Market: Relatively larger issues can be floated, marketed and absorbed in international
markets more easily than in the domestic markets.
v. International Postioning: Planning for an international offering has to be a part of the long-term
perspective of a company. An international issue positions the issuing company, for a much higher
visibility and an international exposure. Besides, it opens up new avenues for further fund-raising
activities.
vi. Regulatory Aspects: For an international issue, approvals are required from the government of India
and the Reserve Bank of India, whereas for a domestic issue the requirements to be satisfied are those
of the SEBI and the stock exchanges.
vii. Disclosure Requirements: The disclosure requirements for an international issue are more stringent as
compared with a domestic issue. The requirements would, however, differ depending upon the market
addressed and the place where listing is sought.
viii. Investment Climate: The international offering would be affected by factors like the international
liquidity and the country risk, which will not have an effect in a domestic issue. With the current
country rating, companies have to depend on the strength of their balance sheets to raise funds at
competitive rates in the international markets.
< TOP >
2. Euro dollar market is mostly unregulated. This meant that Eurodollar banks could offer higher rates on
deposits and charge lower rates on loans. So the most important factor affecting the supply of and demand
for Eurodollars is the desire of dollar depositors to receive highest yield and the desire of dollar borrowers
to pay the lowest interest on loans. Because of the absence of reserve requirements, deposit-insurance
requirements and other costly regulations, the Eurobanks can offer higher yields on dollar deposits than can
US Banks. At the same time, the Eurobanks can charge lower interest on their advances. The lower interest
rates on loans are made possible by the absence of severe regulations and by the sheer size and number of
informal contacts among Eurobanks. Higher rates on deposits and lower costs to borrowers mean operating
on narrow spreads for banks. So the growth of Eurodollar market is best attributed to the ability of the
Eurobanks to operate on a narrow spread.
There are some advantages AIL can derive by borrowing Eurodollars rather than dollars in USA. There are
many regulations of Federal Reserve like reserve requirements, deposit insurance etc., which make dollar
deposits costly in the US. The controls and restrictions of Federal Reserve on borrowing funds in the US
for reinvestment abroad make dollar borrowing costly for the outsiders. Euro currency market does not face
such stiff financial regulations as the US domestic banking system. Also the flow of dollars in the
 eurocurrency market is sufficient to keep the euro dollar interest rate lower than US domestic rates. Also
credit rating criteria is much more lenient in euro currency markets than in the US. So the cost of borrowing
will also be lower in eurocurrency market than in US market.
< TOP >
3. Eurocurrency interest rates cannot differ much from rates offered on similar deposits in the currency’s
home country. As we know, the rate offered to eurodollar depositors is slightly higher than in the United
States, and the rate charged to borrowers is slightly lower. Each country’s market interest rates influence
the euro currency interest rates, and vice versa, as they are all part of the global money market. The total
supply of each currency in this global market, together with the total demand, determines the rate of
interest.
The interest rate charged to borrowers of euro currencies are based on London Interbank Offer Rates
(LIBOR) in the particular currencies. LIBOR rates are those charged in interbank transactions and are base
rates for non-bank customers. LIBOR rates are calculated as the averages of the lending rates in the
respective currencies of six leading London banks. Borrowers are charged on a ‘LIBOR-plus’ basis, with
the premium based on the credit worthiness of the borrower. With borrowing maturities of over 6 months, a
floating interest rate is charged.
Every 6 months, the loan is rolled over, and the interest rate is reset based on the current LIBOR rate. This
reduces risk to both the borrowers and the lender, as neither will be left with a long-term contract that does
not reflect the current interest costs. For example, if interest rates rise after the credit is extended, the lender
will lose the opportunity to earn more interest rate for maximum 6 months. If interest rates fall after a loan
is arranged, the borrower will lose the opportunity to borrow more cheaply for only 6 months. With the
lower interest-rate risk, credit terms frequently reach 10 years.
< TOP >
4. a.
Total
Principal
Interest rate Interest Principal repayment
Month (Rs. in
(%) payment repayment (Rs. in
Crore)
Crore)
0 115 – – – (115)
6 115 7.50 4.313 – 4.313
12 115 7.00 4.025 – 4.025
18 115 6.50 3.738 – 3.738
24 115 6.50 3.738 – 3.738
30 115 7.00 4.025 – 4.025
36 – 7.50 4.313 115 119.313
The effective interest rate is given by ‘r’ in the following equation:
115 = 4.313 PVIF (r/2, 1) + 4.025 PVIF (r/2, 2) + 3.738 PVIF (r/2, 3) + 3.738 PVIF (r/2, 4) +
4.025 PVIF (r/2, 5) + 119.313 PVIF (r/2, 6)
For r/2 = 3%, R. H. S. = 118.062
For r/2 = 4%, R. H. S. = 111.958
118.062 − 115.00
∴ r/2 = 3% + (4 – 3)% × 118.062 − 111.958
3.062
= 3 + 1 × 6.104 = 3.50
∴r = 7.00%.
b. Spot Rs./$ 46.00
0.04
1+
2
Forward 6 month Rs./$ 0.02 = 46.46
1+
46.00 × 2
12 month Rs./$ 46.46 × = 46.92
18 month Rs./$ 46.92 × = 47.38
24 month Rs./$ 47.38 × = 47.85
 30 month Rs./$ 47.85 × = 48.32
36 month Rs./$ 48.32 × = 48.80

Principal Interest Principal Exchange Total repayment

Interest
Month ($ payment ($ repayment ($ rate (Rs. in crores)
rate (%)
Million) Million) Million) (Rs./$)
0 25 – – – 46.00 (115.00)
6 25 4.00 0.50 – 46.46 2.323
12 25 4.25 0.531 – 46.92 2.492
18 25 4.50 0.563 – 47.38 2.668
24 25 4.75 0.594 – 47.85 2.842
30 25 4.60 0.58 – 48.32 2.803
36 – 4.35 0.544 25 48.80 124.655
Effective cost of the loan in rupee term is given by ‘r’ in the following equation.
115 = 2.323 PVIF (r/2, 1) + 2.492 PVIF (r/2, 2) + 2.668 PVIF (r/2, 3) + 2.842 PVIF (r/2, 4) +
2.803 PVIF (r/2, 5) + 124.655 PVIF (r/2, 6)
For r/2 = 3%, R. H. S. = 116.32574
For r/2 = 4%, R. H. S. = 110.12311
r 116.32574 − 115.00 1.32574
∴ 2 = 3% + (4 – 3)% × 116.32574 − 110.12311 = 3 + 1 × 6.20263 = 3.215%
∴r = 6.43%.
c. Spot Rs./¥ 0.4120
0.04
1+
2
Forward 6 Month Rs./¥ 0.005 = 0.4192
1+
0.4120 × 2
1.02
12 Month Rs./ ¥ = 0.4265
0.4192 × 1.0025
1.02
18 Month Rs./ ¥ = 0.4339
0.4265 × 1.0025
1.02
24 Month Rs./ ¥ = 0.4415
0.4339 × 1.0025
1.02
30 Month Rs./ ¥ = 0.4492
0.4415 × 1.0025
1.02
36 Month Rs./ ¥ = 0.4570
0.4492 × 1.0025

Principal Interest Interest Principal Exchange Total repayment

Month
(¥ million) rate (%) payment repayment rate (Rs./¥) rupees in crores
0 2800 – – – 0.4120 115.360
6 2800 2.5 35 – 0.4192 1.4672
12 2800 2.5 35 – 0.4265 1.4928
18 2800 2.5 35 – 0.4339 1.5187
24 2800 2.5 35 – 0.4415 1.5453
30 1400 2.5 35 1400 0.4492 64.4602
36 – 2.5 17.5 1400 0.4570 64.7798
The effective interest rate is given by ‘r’ in the following equation.
115.36 = 1.4672 PVIF (r/2, 1) + 1.4928 PVIF (r/2, 2) + 1.5187 PVIF (r/2, 3) + 1.5453 PVIF
(r/2, 4) + 64.4602 PVIF (r/2, 5) + 64.7798 PVIF (r/2, 6)
 For r/2 = 4%, R. H. S. = 109.626
For r/2 = 3%, R. H. S. = 115.444
115.444 − 115.36
∴ r/2 = 3% + (4 – 3)% × 115.444 − 109.626
0.084
= 3 + 1 × 5.818 = 3.014%
∴ r = 6.03%.
< TOP >
5. APL will face transaction and translation exposure if it borrows in dollar.
Transaction Exposure
Transaction exposure is the exposure that arises from foreign currency denominated transactions which an
entity is committed to complete. In other words, it arises from contractual, foreign currency, future cash
flows. For example, if a firm has entered into a contract to sell computers to a foreign customer at a fixed
price denominated in a foreign currency, the firm would be exposed to exchange rate movements till it
receives the payment and converts the receipts into the domestic currency. The exposure of a company in a
particular currency is measured in net terms, i.e. after netting off potential cash inflows with outflows.
Translation Exposure
Translation exposure is the exposure that arises from the need to convert values of assets and liabilities
denominated in a foreign currency, into the domestic currency. For example, a company having a foreign
currency deposit would need to translate its value into its domestic currency for the purpose of reporting at
the time of preparation of its financial statements. Any exposure arising out of exchange rate movement
and the resultant change in the domestic-currency value of the deposit would classify as translation
exposure. It needs to be noted that this exposure is mostly notional, as there is no real gain or loss due to
exchange rate movements since the asset or liability does not stand liquidated at the time of reporting.
Hence, it is also referred to as accounting exposure. This fact makes the measurement of translation
exposure dependent on the accounting policies followed for the purpose of converting the foreign-currency
values of assets and liabilities into the domestic currency.
< TOP >

Section E: Caselets
Caselet 1
6. The various roles of IMF are as follows:
• To promote international monetary cooperation through a permanent institution, which provides the
machinery for consultation and collaboration on international monetary problems.
• To facilitate the expansion and balanced growth of international trade, and to contribute, thereby to
the promotion and maintenance of high levels of employment and real income and to the development
of the productive resources of all members, as primary objectives of economic policy.
• To promote exchange stability, to maintain orderly exchange arrangements among members, and to
avoid competitive exchange depreciation.
• To assist in the establishment of a multilateral system of payments, in respect of current transactions
between members and in the elimination of foreign exchange restrictions, which hamper the growth of
world trade.
• To give confidence to members by making the general resources of the Fund temporarily available to
them under adequate safeguards, thus, providing them with opportunity to correct maladjustments in
their balance of payments, without resorting to measures, destructive of national or international
prosperity.
• In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of the member countries.
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7. IMF lends to its member countries under various schemes. These schemes are listed below:
• • Standby arrangement: This scheme was introduced in 1952. Under this scheme, countries can
 borrow at the first indication of its possible need this would help the country in time, as it would not
have to wait for IMF’s approval for the loan when the need actually arose.
• • Compensating financing facility: This scheme was introduced in 1963 for providing financial
assistance to countries facing temporary shortfall in reserves.
• • Buffer stock financing facility: Introduced in 1969, this scheme provides for countries
receiving financial assistance from IMF in order to purchase approved primary products. This help is
extended to prevent countries from suffering due to price shocks.
• • Extended facility: This scheme was introduced in 1974. It allows countries to borrow on a
medium-term basis for overcoming balance-of-payments problems caused by structural imbalance.
• • Oil facility: It was introduced in 1974 and was terminated in 1976. Under this scheme, help
was extended to countries most affected by the oil price rise.
• • Trust Fund: As gold was demonetized in 1976, IMF set up this fund with the proceeds from
the sale of gold held by it. This fund was used for providing special development loans on
concessional terms to those 25 member-countries which has the lowest per capita income. It was
discontinued in 1981.
• • Supplementary financial facility: Under this scheme, established in 1977, financial assistance
is provided to countries facing serious BoP problems and having high external debt.
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8. IMF is successful at several points of time, but however, there is also some criticism. The most important
example is the Asian crisis which was not properly managed by the IMF. Infact, the IMF did not, and,
could not, understand the real forces driving economic development. The problem is not so much the
people as it is the focus. So deeply linked to the existing economic forces and orthodoxies, the IMF is
incapable of recognizing the emerging forces and the new realities. Another Bigger failure of IMF, was the
Russian crisis which was the largest borrower of IMF fund of around $ 20 bn. In Brazil, too, the IMF
turned out to be completely wrong in its efforts to maintain an overvalued exchange rate. The Brazilian real
collapsed in January 1999, but, only after the IMF had saddled the country with tens of billions of dollars of
added debt in a futile attempt to prop up the currency. In both the Brazilian and the Russian cases, the Fund
defended its actions, which caused great suffering and economic damage, by arguing that these countries
would face hyper-inflation, if their currencies were to fall. The projected hyper-inflation did not
materialize.
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Caselet 2
9. Undoubtedly, the accumulation of reserves reflects the apex bank’s policy of maintaining an adequate level
of foreign exchange reserves to meet import requirements, unforeseen contingencies, and liquidity risks
associated with different types of capital flows.
The benefits of holding reserves come in the form of—
• Maintaining confidence in monetary and exchange rate policies;
• Enhancing the capacity to intervene in foreign exchange markets;
• Limiting external vulnerability so as to absorb shocks during times of crisis;
• Providing confidence to the markets that external obligations can always be met;
• Adding to the comfort of the market participants, by demonstrating the backing of domestic currency
by external assets; and
• Reducing volatility in foreign exchange markets.
On the other hand holding reserves in a high proportion may not be advantageous in all instances.
Especially for developing countries like India, sharp exchange rate movements clubbed with the accreting
reserves may lead to financial crises during periods of uncertainty. Holding forex reserves involves an
opportunity cost —measured by the difference between the rate of return on the official portfolio and the
return available from alternative investments. The RBI in its recent Annual Report has claimed, “The
financial cost of additional reserve accretion in India in the recent period is quite low, and is likely to be
more than offset by the return on additional reserves.” It claims that the accretion to reserves is due to
quicker repatriation of export proceeds, high remittances by Indian workers abroad and non-debt capital
inflows. But idle reserves still involve a cost, which is foregone income from productive investments. And,
as said above, the existence of arbitrage opportunities shows that domestic interest rates are higher than
 foreign interest rates even allowing for transaction costs and country risk premium.
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10. In 1997 a committee under S S Tarapore, former RBI deputy governor, on capital account convertibility
suggested four alternative measures for the level of reserves to be maintained:
• Import cover of not less than six months;
• Reserves should not be less than three months of imports plus 50% of annual debt service payments
plus one month’s imports and exports;
• A ceiling of 60% in the ratio of short-term debt; and
• A portfolio stock-to-reserves and a net foreign exchange assets-to-currency ratio of not less than 40%.
But the reserve management underwent a radical change after the high level committee on Balance of
Payments led by Dr. C Rangarajan with Dr. Y V Reddy being the member secretary submitted its
recommendations in late nineties. The report highlighted that there are other perspectives too which have a
say in arriving at the desirable level of forex reserves such as meeting short-term debt obligations and the
interest payments on long- and medium-term obligations. Some other intangibles are: To achieve a
confidence level in the international financial and trading communities about the capacity of the country to
honor its obligations and maintain trade and financial flows. In addition, the seasonal factors like vagaries
of monsoon, and the speculative tendencies amongst the players also need to be factored in while
considering the level of optimal reserves.
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Caselet 3
11. An exchange rate depreciation can make a country’s exports cheaper and imports more expensive. By
depreciating in line with the dollar, products in the DMCs whose currencies are pegged to the dollar will
become more competitive against third country products. This can boost their exports, curb imports, and
improve their trade balances with countries other than the US. The opposite is likely to be true for DMCs
with floating exchange rates, as their currencies will appreciate. There are a few factors that complicate this
general relationship, however. The first is that for exchange rates to affect trade balances, export and import
demand has to be responsive to price changes, as prescribed by the Marshall-Lerner condition. The second
is that there can be substantial lags between exchange rate movements and changes in trade balances. Trade
balances can even deteriorate following deprecation as imports become more expensive. They only
improve as the quantity of exports increase, and imports decrease. This quantitative adjustment often takes
a long time, so that it can take up to two years for trade balances to improve.
Exchange rate changes also affect economic growth, which, in turn, affects trade balances. Depreciation
can lead to higher economic growth by stimulating exports. This can eventually lead to increased import
demand, and benefit the exports of its trading partners. However, increased demand for imports due to
higher income growth often comes after initial import reductions following depreciation. Trading partners
may feel the impact of reduced import demand more quickly. For this reason, depreciation of a currency
often becomes a concern for trading partners. Furthermore, due to differences in products traded, some
countries’ trade is more responsive to changes in price competitiveness, while others are more sensitive to
trading partner economic growth. Consequently, a depreciation of a currency may have variable effects on
trading partners.
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12. Those economies whose currencies are pegged to the dollar they depreciate their currencies in line with the
dollar. Currency depreciation increases competitiveness, demand for their exports may increase, while
these countries’ import demand may decrease, leading to increased aggregate demand. The monetary side
of this is that the country’s receipts from foreigners may exceed its outgoing payments, resulting in an
improved balance of payments. The flipside of an increased supply of foreign currency is that domestic
currency will be in short supply. This will place upward pressure on the domestic currency. A key feature
of the pegged exchange rate arrangement is that monetary authorities will not allow this to happen. They
will expand the money supply in order to neutralize the pressure and maintain the fixed exchange rate.
Increases in the money supply raise price levels. This, together with the fact that imports become more
expensive after depreciation, may result in higher price levels in the depreciating country. Over time, prices
are likely to increase, the exchange rate is likely to remain unchanged, and output and employment levels
are likely to rise. This naturally raises concerns about inflation. However, price pressure in the US as well
as all economies with pegged exchange rates has remained subdued. Hong Kong, China, in particular, has
been battling with deflation for nearly four years. From the usual concern about inflation there is now a
shift in focus toward deflation. The increased price pressure may even be viewed as a positive
development.
Countries following flexible exchange rates, the strengthening of their currencies relative to the US dollar
may cause exports to fall and imports to rise. This can put a strain on output growth and employment,
especially for countries that depend heavily on exports to the US. Growth in most DMCs is still subdued,
and currency appreciation may dampen economic recovery due to the synchronized nature of the recent
economic downturn. Relative prices, however, are only one factor affecting export growth.
In total, dollar depreciation may increase price pressures, improve trade balances, and facilitate output
growth for economies whose currencies depreciate in line with the dollar. For economies whose currencies
appreciate against the dollar, the appreciation may put some strain on trade balances and output growth, but
reduce inflationary pressure. Over time, dollar depreciation may boost growth in the US and the world
economy in general.
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