Monday, February 1, 2010

Answers to Theory Questions in Treasury and Forex Management

Table of Contents


1 Exam Theory Questions




1.1 Discuss the trade-off involved in determining the optimal level of current assets. What strategies are available to a firm for financing working capital requirements? [JUL2007]


ANSWER:


1.2 Explain the strategies for managing surplus funds. [JAN2006] GOOD


ANSWER:
Keith V. Smith says that financial managers can consider a series
of seven strategies for handling the excess cash balance with the
firm.



  1. Do Nothing The financial manager simply allows surplus
    liquidity to accumulate in the current account. This strategy
    enhances liquidity at the expense of profits that could be
    earned from investing surplus funds.


  2. Make Ad Hoc Investments The financial manager makes
    investments in a somewhat ad hoc manner. Such a strategy makes
    some contribution, though not the optimal contribution, to
    profitability without impairing the liquidity of the firm. It is
    followed by the firms which cannot devote enough time and
    resources to management of securities.


  3. Ride the Yield Curve This is a strategy to increase the yield
    from a portfolio of marketable securities by betting on interest
    rate changes. If the financial manager expects that interest
    rates will fall in the near future, he would buy longer-term
    securities as they appreciate more, compared to short-term
    securities. On the other hand, if the financial manager believes
    that the interest rates will rise in the near future, he would
    sell longer-term securities.


  4. Develop Guidelines A firm may develop a set of guidelines
    which may reflect the view of management towards risk and
    return. Using a set of guidelines which reflects the
    conventional wisdom often provides a 'satisfying' solution and
    not an 'optimal' solution.


  5. Utilize Control Limits There are some models of cash
    management which assume that cash inflows and outflows occur
    randomly over time. Based on this premise, these models define
    upper and lower control limits.


  6. Manage with Portfolio Perspective According to portfolio
    theory there are two key steps in portfolio selection.



    • Define the efficient frontier The efficient frontier
      represents a collection of all efficient portfolios. A
      portfolio is efficient if and only if there is no alternative
      with



      1. the same expected return and a lower standard deviation, or

      2. the same standard deviation and higher expected return, or

      3. a higher expected return and a lower standard deviation


    • Select the optimal portfolio The optimal portfolio is that
      point on the efficient frontier which enables the investor to
      achieve the highest attainable level of utility. It is found
      at the point of tangency between the efficient frontier and a
      utility reference curve.


  7. Follow a mechanical procedure The financial manager may switch
    funds between cash account and marketable securities using a
    mechanical procedure, based on models developed using set of
    rules.



1.3 Discuss the options available to a firm for investing surplus cash in the domestic market. [JAN2006]


Answer: Pg 719. Financial Management: Theory and Practice

ANSWER:
For deploying their surplus fund, the major options used by the
corporates in India are fixed deposits with banks, Treasury bills,
and debt mutual funds; the minor options used are commercial paper,
certificates of deposit, inter-corporate deposits, ready forwards,
and bill discounting.


  1. Fixed deposits in banks: 15 days to 5 years


  2. Treasury Bills: 91 day, 182, 364 days. sold at discount and
    redeemed at par value.



    • can be transacted readily as they are issued in bearer form


    • very active secondary market


    • risk-free


  3. Mutual Fund schemes: Equity; balanced; Debt


--
Short term surpluses - Debt schemes - Money Market schemes. The
corpus of the MMS is invested ininstruments such as TB, CP, CDs.

MMS are very convenient for firms that do not have in-house
expertise for managing short-term surpluses.


  • safely of principal


  • near instantaneous liquidity


  • post tax-return that is higher than what short-term bank deposits


Commercial Paper:


1.4 Discuss the approaches or methods used for credit evaluation. [JAN2007]


Answer: Pg 742. Financial Management: Theory and Practice


1.5 Discuss the important forms of working capital advance given by banks.


Answer: Pg 785. Financial Management: Theory and Practice


1.6 What are euro or offshore markets? How have they evolved? [JAN2009]


Answer:
International markets for deposits and securities denominated
in currencies other than the currency of the country where the
transaction occurs. The major offshore market center is London
and the major offshore currency is US dollars. Prior to the
advent of the euro the offshore markets were known as the
euromarkets.

Euro markets have come into existence to cater to the need of
international financing by economies in the form of short, medium
or long-term securies or credits. These markets are also called
'International Capital Markets'. These are the markets on which
Euro currencies, Euro bonds, Euro shares and Euro bills are
traded/exchanged. Over the years, there has been a phenominal
growth both in volume and types of financial instruments
transacted in these markets. Euro currency deposits are the
deposits made in a bank, situated outside the teritory of origin
of currency. For example, Euro dollar is a deposit made in US
dollars in a bank located outside the USA; likewise, Euro banks
are the banks in which Euro currencies are deposited. They have
term deposits in Euro currencies and offer credits in a currency
other than that of the country in which they are located.

While opening up of the domestic markets began only around the
end of seventies, a truly international finance market had
already been born in the mid-fifties and gradually grown in size
and scope durign sixties and seventies. This refers to Euro
currencies market where borrower (investor) from country A raise
(place) funds from (with) financial institutions in country B,
denominated in the currency of country C. During the eighties and
nineties, this market grew further in size, geographical scope
and diversity of funding instruments. It is no more a 'euro'
market but a part of the general category called "offshore
markets".

Composition of International Financial Markets:

The international financial markets consist of the credit market,
money market, bond market and equity market.
The international credit market, also called Euro credit market,
is the market that deals in medium term Euro credit or Euro
loans.

International banks and their clients comprise the Eurocurrency
market and form the core of the international money market. There
are several other money market instruments such as Euro
commericial paper (ECP) and Euro Certificate of Deposit (ECD).

Foreign bonds and Eurobonds comprise the international bond
market. There are several types of bonds such as floating rate
bonds, zero coupon bonds, deep discount bonds, etc.

International Equity market tells us how ownership in publicly
owned corporations is traded throughout the world. This comprises
of both, the rimary sale fo new common stock by corporations to
initial investors and how previously issued common stock is traded
between investors in the secondary markets.


1.7 Give a succinct overview of the organisation and functioning of the International Monetary System. [JUL2007]


Answer:


  • Motivation for formation of IMF:

The IMF, also known as the “Fund,” was conceived at a United Nations conference convened in Bretton Woods, New Hampshire, United States, in July 1944. The 45 governments represented at that conference sought to build a framework for economic cooperation that would avoid a repetition of the vicious circle of competitive devaluations that had contributed to the Great Depression of the 1930s.

+Primary Responsibility:
The IMF's primary purpose is to ensure the stability of the international monetary systemthe system of exchange rates and international payments that enables countries (and their citizens) to buy goods and services from each other. This is essential for sustainable economic growth, increasing living standards, and alleviating poverty.


  • Constitution of IMF:

The Articles of Agreement of the IMF, signed by the representatives of 44 nations, form its constitution and set out several aspects for smooth and effective functioning of the IMF. The IMF shall be guided in all its policies and decisions by the Articles of Agreement.











  • Organization:

The Board of Governors is the highest policy making body of the IMF. The board consists of one governor and one alternate governor appointed by each member of the IMF. The Board of Governors select one of the governors as chairman. The Board of Governors holds meetings as may be provided for by the Board of Governors or called by Executive Board. The Board normally meets once a year at the annual meeting. Twenty-four of the governors are on the International Monetory and Finance committee, and meet twice a year.

Day-to-day work of the IMF is conducted by the Executive Board, supported by more than 2,700 professional staff from 165 countries. The Executive Board consists of 24 members, with the Managing director as Chairman. Of the Executive Directors, five are appointed by the five members having the largest quotas, and fifteen are elected by the other members. Election of executive directors is conducted at intervals of two years. The executive board functions in continuous session at the principal office of IMF.


  • Responsibilities:


  • Surveillance of economies: To maintain stability and prevent crises in the international monetary system, the IMF reviews national, regional, and global economic and financial developments through a formal system known as surveillance. The IMF provides advice to its 186 member countries, encouraging them to adopt policies that foster economic stability, reduce their vulnerability to economic and financial crises, and raise living standards. It provides regular assessment of global prospects in its World Economic Outlook and of capital markets in its Global Financial Stability Report, as well as publishing a series of regional economic outlooks.


  • Financial Assistance: IMF financing is available to give member countries the breathing room they need to correct balance of payments problems. A policy program supported by IMF financing is designed by the national authorities in close cooperation with the IMF, and continued financial support is conditional on effective implementation of this program. To help support countries during the global economic crisis, the IMF has strengthened its lending capacity and has approved a major overhaul of how it lends money. In low-income countries, the IMF provides financial support through its concessional lending facilities. The IMF has doubled loan access limits and is boosting its lending to the world’s poorer countries, with interest rates set at zero until 2011.


  • SDRs: The IMF issues an international reserve asset known as Special Drawing Rights that can supplement the official reserves of member countries. Two allocations in August and September 2009 increased the outstanding stock of SDRs ten-fold to total about $316 billion. Members can also voluntarily exchange SDRs for currencies among themselves.


  • Technical assistance: The IMF offers technical assistance and training help member countries strengthen their capacity to design and implement effective policies. Technical assistance is offered in several areas, including tax policy and administration, expenditure management, monetary and exchange rate policies, banking and financial system supervision and regulation, legislative frameworks, and statistics.



1.8 Explain clearly the distinction between exchange rate exposure and risk? Why is it important to make distinction?


ANSWER:

In financial literature, the use of terms exchange rate exposure
and exchange rate risk are used interchangingly.

Exposure is a measure of the sensitivity of the firm's
performance against the fluctuations in the relevant risk
factor. While the risk is the extent of variability of the
performance measure attributable to the risk factor.

A firm relying excessively on exports may have high degree of
exchange rate exposure. But if the exchange rates between home and
foreign countries are stable, the risk may be negligible and
vice-versa.

It is important to make distinction as each risk needs to be
mitigated in business to reduce the impact and intensity. Each type
of exposure has a method to reduce the impact and the magnitude of
risk defines the extent to which a firm needs to engage its
resources in mitigation.


1.9 Discuss the following types of currency exposure: transactions exposure, translation exposure, and operating exposure.


Answer:
A firm may have its assets and liabilities denominated in
currencies other than that of its own. Due to the fluctuations in
the exchange rate between time from contract is written and
settlement, there will be an affect on the profits of the firm
(whether favourable or adverse), this is called Exchange
Exposure.










Types of Exchange Exposure:


  1. Transaction Exposure: (settlement - contract)
    arises due to fluctuation in exchange
    rate between the time at which the contract is concluded in
    foreign currency and the time at which settlement is
    made. Transaction exposure is short term in nature, usually for a
    period less than one year.


    Typical situations:


    1. a currency has to be converted in order to make or receive
      payment for goods or services.

    2. a currency has to be converted to repay loan or make an
      interest payment.

    3. a currency has to be converted to make dividend payment,
      royalty payment, etc.



    In each of the above item the foreign currency value is fixed;
    the uncertainty pertains to the home currency value.


  2. Translation/Accounting Exposure: arises due to a company
    having foreign branches or subsidiaries, which are required to be
    consolidated with the accounts of the parent branch at the end of
    the year. These accounting statements are denominated in foreign
    currency and they have to be converted to domestic currency at the
    time of consolidation leading to exchange rate exposure. Also
    called Balance sheet exposure.


  3. Economic Exposure: arises when countries economy is
    increasingly integrated internationally, it is exposed to vagaries
    of international market. Though the firm is not involved in import
    export activities, the competitor might reduce prices due to
    decrease in cost price resulting from currency appreciation.
    ---

  4. is defined as the variance of the
    domestic currency value of assets, liabilities and operating
    incomes that is attributable to unanticipated changes in
    foreign exchange rates". By definition foreign exchange risk
    depends on exposure, as well as variability of the
    unanticipated changes in the relevant exchange rate.


    Types of Risks:


    1. Systemic Risk: is the risk occurring at one point, which
      spreads to other points because of global integration
      phenomenon, and is called a contagion. Various measures
      like capital adequacy, disclosure, effective financial
      supervision and corporate governance are used against
      Systemic risk.


    2. Market Risk: in derivative trade is due to the movement
      of price underlying, which affects the price of
      derivatives adversely.


    3. Liquidity Risk: occurs more in the case of Over the
      Counter (OTC) derivatives, which due to the non-standard
      structure makes it to have no secondary market. Hence,
      liquidity risk is there to adversely affect the parties,
      ability to get over undesirable position.


    4. Interest Rate Risk: due to rise or fall in the fixed
      interest rate risk on fixed income security as well as
      on the stock of money held.


    5. Legal Risk: is due to many instruments like Forward Rate
      agreements which in simple terms is nothing but betting
      on interest rate. It has the danger of courts in many
      countries declaring them illegal as wager. Thus, the
      OTC market tries to overcome through the procedures like
      netting, coordinating and imposing uniform regulations
      on derivatives throughout the world.


    6. Operation Risk: is due to inadequate control procedures
      like front and back office function not being separated
      or no effective internal function, no proper MIS or
      monitoring of treasury operations, no well laid out risk
      management policy by the top management and the top
      management salaries excessively linked to treasury
      operations.


    7. Counter Party Risk: due to heavy concentration of
      derivative portion with few counter parties, absence of
      information about the credit worthiness of the counter
      party, and/or derivatives being kept as off balance
      sheet items.


    8. Combined Risk: All the above risks influence
      individually or as combination.



1.10 Why should firms manage financial risk? [JUL2006][JUL2009]


Answer:
Active risk management helps,


  1. in altering the cash flows in a way beneficial to shareholders
    even after meeting the cost of hedging

  2. firm can achieve it at lower cost than what the shareholders
    would have to incur if they did it on their own.



1.11 Explain the absolute and relative versions of Purchasing Power Parity.


Answer:
Absolute PPP implies that 'a bundle of goods should cost the same
in India and the USA once you take the exchange rate into
account". Any deviations from this, the we should expect relative
prices and the exchange rate between the two countries to move
towards a level at which basket of goods have the same price in the
two countries.

Let us assume the price of standard basket of goods and services in
India as represented by price index P₁ and price index of US
represented by P₂.

The spot exchange rate between INR and USD can also be represented
as S₀ = PINR / PUS

P₁ = P₂.S₀.(USD/INR)

Absolute PPP also known as the static form of PPP is based on the
low of one price. It only holds when there are no frictions such as
transportation costs, transaction costs, quotas and tariff
barriers.

Relative PPP describes differences in the rates of inflation
between two countries. It is also called dynamic form of
PPP. Specifically, suppose the rate of inflation in India is higher
than in the US, causing the price of a basket of goods in India to
rise. Purchasing power parity requires the basket to be the same
price in each country, so this implies that Indian rupee must
depreciate vis-a-vis the U.S. dollar. The percentage change in
value of the currency should then equal the difference in the
inflation rates between the two countries.

In other words, the foreign currency depreciates when the inflation
rate in the foreign county is more than domestic inflation rate,
and the foreign currency appreciates when the domestic inflation
rate is more than the foreign country's inflation. This means
currency of a country with high rate of inflation should depreciate
relative to the currency of a country with a lower rate of
inflation.

Relative PPP even holds good in the presence of frictions.

Country X = Spot Ex Rate A = Price level P₁
Country Y = Spot Ex Rate B = Price level P₂

(Refer Pg92, Pearson book)


1.12 Discuss briefly the structural models and the pure forecasting models of exchange rate forecasting.


Answer:

An exchange rate is the relative price of one currency in terms of another. In a world of floating exchange rates, like all prices, it should be determined by forces of supply and demand. The problem is to correctly model all factors that influence the price. Some of the factors that influence price are economic events, political developments, resource discoveries, technological developments. The markets are also subject to occasional speculative bubble that defy all fundamental analysis.

Demand for foreign currency originates in:


  • Residents of the home country wanting to import foreign goods and services.

  • Residents of the home country wishing to acquire assets, both real and financial, denominated in the foreign currency. The following payment of liabilities, such as service loans or gaining dividends.

  • Central banks intervening in the foreign exchange market.


Different models of exchange rates differ in emphasis they put on the different components of demand for and supply of a currency.










a) Flow models
Simplest view of exchange rate focuses on demand for and supply of foreign exchanging arising out of imports and exports. This model does not consider capital flows.

b) Monetary model attempts to predict a proportional relationship between nominal exchange rates and relative supplies of money between nations. Economies that follow a relatively expansionary monetary policy will observe depreciation of their currencies, while those that follow a relatively restrictive monetary policy will observe appreciation of their currencies.
The monetary model suggests that the exchange rate is determined by three independent variables:


  1. relative money supply

  2. relative interest rates

  3. relative national output


There are two versions of monetary model


  • flexible-price monetary model
    assumes that PPP always holds. It assumes that changes in price level instantaneously translate into changes in exchange rates. Thus real exchange rate is constant over time.

  • sticky-price monetary model
    assumes that prices of goods are sticky in the short run, and PPP holds only in the long run. Therefore, a change in the nominal money supply causes a change in real money supply, which, in turn, results in interest rate changes and capital flows.


c) The Asset Market Model :: views foreign exchange as a financial asset, and its exchange rate is determined by the demand and supply for the stock of foreign exchange. This model is based on the assumption that asset markets are efficient and fully reflect all available information.

d) Portfolio balance model :: investors would adjust their portfolios, consisting of domestic money, foreign money, domestic bonds and foreign bonds, keeping in view their risk-return characteristics.


1.13 Describe the structure of the foreign exchange market.


Answer:

A foreign exchange transaction is a trade of one currency for
another currency. The institutional setup that facilitates the
trading of currencies is known as the Foreign Exchange Market or
the forex market or FX market. The foreign exchange market is not
located in a physical space and does not have a central
exchange. Rather, it is an electronically linked network of large
number of individual foreign exchange trading centers, in which
the market participants deal directly with each other. Thus, forex
market provides a single, cohesive, integrated, and worldwide
market by linking various individual foreign exchange trading
centers and markets spread all over the globe.


Banks and dealers, who largely constitute the foreign exchange
market, are connected by communications networks provided by the
Society for Worldwide Interbank Financial Telecommunication
(SWIFT). The Clearing House Interbank Payment System (CHIPS) links
several banks and dealers involved in dollar currency
transactions.


Market Participants:
Individuals, Businesses and Governments

To allow individuals and institutions to buy or sell foreign
currencies, certain other institutions and individuals, called
facilitators, have come to play a role. In market
terminology, these facilitators are categorized as primary dealers and brokers. Primary dealers act as a principal in
a transaction and conduct business in their own account by
committing their own funds, while brokers act as agents for
an actual buyer/seller of foreign exchange and do not commit
their own funds. Dealers on the other hand, rely on their
bid-ask spread.

Individuals and organizations that participate in a foreign
exchange market may also be classified as hedgers,
arbitrageurs and speculators.

Hedgers
are those who participate in the foreign exchange market to reduce the foreign exchange risk that they already face. They try to insure themselves against adverse foreign exchange rate movements while benefiting from favourable movements.
Arbitrageurs
attempt to make risk-less profit by entering into foreign exchange transactions simultaneously in two or more market centers.
Speculators
are those who take positions in the foreign exchange market by anticipating whether the exchange rate will go up or down. They take positions to profit from exchange rate fluctuations.

MARKET SEGMENTS

Whole sale segment
is also known as interbank market, as the exchange transactions take place between banks that are primary dealers. It consists of commercial banks, investments banks, central banks, corporations, and high-net-worth individuals.
Retail segment
of foreign exchange market consists of tourists, restaurants, hotels, shops, banks, and other bodies and individuals. Currency notes, traveller's cheques, and bank drafts are the common instruments in the retail market.


1.14 Explain the following terms: bid rate, offer rate, bid offer spread, value date, and swap transaction.



Answer:

Bid rate
is the rate at which the bank giving the quotation is ready to buy one unit of the base currency by paying the quoted currency. For example, a bank may quote USD/INR 39.5470/39.5480. The component before the solidus is the bid rate and the one after solidus is the ask rate or the offer.
Offer rate
also called as ask rate, is the rate at which the bank giving the quotation is ready to sell one unit of the base currency for the quoted currency.
bid offer spread
the difference between the bid rate and offer rate is the bid offer spread. The bid-offer spread is obtained in points or pips.
Value date
the date on which counterparts to a financial transaction agree to settle their respective obligations, i.e., exchanging payments. For spot currency transactions, the value date is normally two business days forward. Also known as maturity date.
Swap transaction
The simultaneous purchase and sale of the same amount of a given currency for two different dates, against the sale and purchase of another. A swap can be a swap against a forward. In essence, swapping is somewhat similar to borrowing one currency and lending another for the same period. However, any rate of return or cost of funds is expressed in the price differential between the two sides of the transaction.


1.15 What steps are involved in the risk management process? [JUL2007]


ANSWER:
Risk management process is a continuing process rather than a one
time project. There are key decisions to be taken on risk profile,
that would involve top management involvement. In a large corporate
with world-wide operations, currency exposures are constantly being
created by almost every decision taken by operating businesses.



  1. Selection of a target performance variable, like operating cash
    flows.


  2. Identification of environmental factors that might have
    significant impact on a firm's performance, like exchange rates,
    interest rates and commodity prices. In addition changes in
    government policies regarding taxation, foreign trade and so
    forth.


  3. Assessing and quantifying the impact of each of the
    environmental risk factors on the target performance
    variable. Exposure identification and measurement of transaction
    exposure and operating exposure for simulation exercises.


  4. Choice of an appropriate mechanism or instrument to reduce or
    shift the risk. Some firms may have natural hedges like a
    receivable in say Euro and a payable in Swiss Francs, both
    maturing at the same time, may very well offset each other since
    these two currencies tent to be strongly correlated.


    Basic building blocks like forwards, futures, simple options,
    swaps, etc ca be combined and packaged in an almost infinite
    variety of ways to deal with a particular risk situation and the
    firm's desired risk profile. Many companies first exhaust all
    possibilities of internally hedging the exposures by means of
    netting, leading and lagging before resorting to financial
    market hedges. Risk management can also be bundled with
    financing by means of debt instruments with embedded options,
    commodity-linked bonds, etc.


  5. Execute and monitor the performance of risk reduction
    mechanism.



1.16 Explain VAR and CFAR.[JAN2008]



ANSWER:
Value at Risk (VAR) - Built around statistical ideas and
probability theories that have been around for centuries, VaR was
developed and popularized in the early 1990s by a handful of
scientists and mathematicians - "quants," they're called in
business - who went to work for JP Morgan. VaR's great appeal, and
its great selling point to people who do not happen to be quants,
is that it expresses as single number, a dollar figure.

VaR is a group of related models that share a mathematical
framework. It measures the boundaries of risk in a portfolio over
short durations, assuming a "normal" market. For instance, if you
have $50 million of weekly VaR, that means that over the course of
the next week, there is a 99 percent chance that your portfolio
won't lose more than $50 million. That portfolio could consist of
equities, bonds, derivatives or all of the above; one reason VaR
became so popular is that it is the only commonly used risk measure
that can be applied to just about any asset class. And it takes
into account a variety of variables, including diversification,
leverage and volatility, that make up the kind of market risk that
traders and firms face every day.

Another reason VaR is so appealing is that it can measure both
individual risks - the amount of risk contained in single trader's
portfolio, for instance - and firmwide risk, which it does by
combining the VaRs of a given firm's trading desks and coming up
with a net number. Top executives usually know their firm's daily
VaR within minutes of the market's close.


  • CFAR: The concept of VaR is not particularly useful for
    non-financial corporations since their portfolios consist of a
    large number of assets such as buildings, machinery, inventories,
    brand equity, etc. for which no reliable market prices can be
    obtained. For such firms, operating cash flow is a better measure
    of performance. Cash Flow at Risk attempts to link operating
    cash flow to the environmental risk factors. The attempt is to build a
    'business model' for the entire firm which links key items
    such as sales quantity, sales revenues, cost of goods
    sold, interest expenses, etc. to environmental risk
    factors like exchange rates, interest rates and commodity
    prices and also incorporates the 'decision rules' for
    discretionary variables under the control of the firm. We
    then generate a large number of 'scenarios' for the
    environmental risk factors and use the model to compute
    cash flows under each scenario.



1.17 What are the advantages and disadvantages of centralised exposure management?


ANSWER:


1.18 Discuss the aspects of market structure which influence the behaviour of prices and the resultant quantity response of various goods and services.


ANSWER:


1.19 Discuss the tools for managing transactions exposure/risk. [JUL2006][JAN2009]


ANSWER: Pg 268: International Finance: A business perspective
Section: 6.6 MANAGING TRANSACTIONS EXPOSURE

Managing transactions exposure has two significant
dimensions. First, the treasurer must decide whether and to what
extent an exposure should be explicitly hedged. Second, the nature
of the firm's operations may provide a natural hedges.


  1. Using the forward markets
    The use of forward contracts to hedge transactions exposure at a
    single date is quite forward. A contractual net outflow of
    foreign currency is sold forward and a contractual net outflow
    is bought forward. Exposures with uncertain timing can be
    covered with option forwards. Many firms follow a policy of
    'discretionary' hedging with forwards. They need to set filter
    rule and stop loss guidelines.


  2. Hedging with money market
    Firm which have access to international money markets for
    short-term borrowing as well as investment, can use the money
    market for hedging transactions exposure. From time to time
    cost-saving opportunities may arise either due to some market
    imperfections or natural market conditions which an alert
    treasurer can exploit to make sizable gains.


  3. Hedging with currency options
    Options are particularly useful hedging tool in tender bidding
    situations. When a firm bids for a foreign contract, it is not
    sure whether its bid will be successful. Foreign currency
    inflows and outflows would arise only if the bid is
    successful. Hedging such contingent exposures with forward
    contract can prove to be quite expensive in terms of opportunity
    costs. Options provide a much more flexible hedging mechanism.


    In Indian markets only cross-currency options i.e., options
    between two foreign currencies are available.


  4. Internal hedging strategies


    • Leading and lagging: if the domestic currency is expected to
      depreciate against foreign currency then payments are preponed
      but realization of the exports is postponed and vice-versa is
      true for exports. Lagging if domestic currency is expected
      to appreciate against foreign currency, payments are postponed
      while receipts are preponed.


    • Netting and offsetting: if the firm is involved in both
      imports and exports and if the imports and exports are taking
      place in the same currency, then it acts as an
      automatic/natural hedge, subject to timing difference. Netting
      is extensively used by MNCs with branches across the
      world. Offsetting is the natural hedging process of matching
      payables and receivables with closely-related currencies -
      such as GBP and EUR.



1.20 Discuss the ways of coping with operating exposure. [JUL2008]


ANSWER: Pg 285: International Finance: A Business Perspective
Section 6.7: Coping with operating Exposure


1.21 Explain the merits and demerits of centralised cash management for a multinational corporation. [JUL2008]


ANSWER: Pg 310: International Finance; Section 7.4
Pg 313: INTERNATIONAL FINANCIAL MANAGEMENT; Section 11.2.6


1.22 How does the Letter of Credit (L/C) work in the case of an international transaction? Briefly describe the different kinds of L/C.


ANSWER:
A Letter of Credit (L/C) is an instrument or letter issued by
bank on behalf of the buyer/importer of the merchandise.

Pg 335: INTERNATIONAL FINANCIAL MANAGEMENT
Section 12.6.2: Banker's Letter of Credit


1.23 Summarise the various considerations that enter into the decision to choose the currency, market, and vehicle for long term borrowing. [JAN2007]





1.24 What are the crucial aspects in negotiating a syndicated bank loan? [JUL2008]


ANSWER:




1.25 Describe the features of the Eurobond market and the foreign bond market. [JUL2006]





1.26 Explain the structure of a typical GDR issue. What are the pros and cons of a GDR issue? [JAN2006]





1.27 What are the main added complications in international project appraisal? [JAN2008]



ANSWER:
A firm can acquire ''global presence'' in a variety of ways ranging from simply exporting abroad to having a wholly-owned subsidiary or a joint venture. The main added complications which distinguish a foreign project from domestic project can be summarized as follows:


  • Project Cash Flows vs. Parent Cash Flows


  • Exchange Risk and Capital Market Segmentation


  • Political or Country Risk


  • International Taxation


  • Blocked Funds



1.28 Describe the features of (a) interest rate swaps and (b) currency swaps. [JAN2006][JAN2009]


ANSWER:
Unlike the standardized options and futures contracts, swaps are
not exchange-traded instruments. Instead, swaps are customized
contracts that are traded in OTC market between private
parties. Firms and financial institutions dominate the swaps
market. Because swaps occur in OTC market, there is always the risk
of a counter-party defaulting on the swap.

Interest Rate Swap

Party A agrees to pay Party B a predetermined, fixed rate of
interest on a notional principal on specific dates for a specific
period of time. Concurrently, party B agrees to make payments based
on a floating rate of interest rate to Party A on the same notional
principal on the same specified dates for the same specific time
period. In plain vanilla swap, the two cash flows are paid in the
same currency. The specified payment dates are called settlement
dates, and the time between the payment dates are called settlement
periods. Because swaps are customized contracts, interest payments
may be made annually, quarterly, monthly or interval agreed between
parties.

Key Features:


  • The Notional Principal

  • The Fixed Rate

  • Floating Rate

  • Trade Date, Effective Date, Payment Dates


Currency Swaps
In a currency swap, the two payment streams being exchanged are
denominated in two different currencies. Usually, an exchange of
principal amounts at the beginning and a re-exchange at
termination are also a feature of a currency swap.

Types of Currency Swaps:


  1. Fixed-to-fixed currency swap

  2. Floating-to-floating currency swap

  3. Fixed-to-floating currency swap


Interest Rate Swap Example: On December 31, 2006, Company A and
Company B enter into a five-year swap with the following terms:


  • Company A pays Company B an amount equal to 6% per annum on a
    notional principal of $20 million.

  • Company B pays Company A an amount equal to one-year LIBOR + 1%
    per annum on a notional principal of $20 million.



1.29 Critically review the explanations offered for the emergence and popularity of financial swaps. [JAN2008]





1.30 What are FRAs and interest rate options? How can they be used for managing interest rate risk? [JUL2009]


ANSWER:

Forward Rate Agreement
is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e, only the differential is paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, depending on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs. Many banks and large corporations will use FRAs to hedge interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use FRAs are speculators purely looking to make bets on future directional changes in interest rates.
Interest Rates
???
How can FRAs and IRO be used for managing interest rate risk


2 Chapter End Review Questions




2.1 Chapter 1




2.1.1 What is the linkage between national financial markets and euromarkets? How do they influcence each other?


Answer:


2.1.2 What are the factors obstructing complete integration of global financial markets? What affect does taxes on short-term capital flows have on interest rate linkages between domestic and offshore markets?


Answer:


2.1.3





3 General Theory (Notes)




3.1 Gold Standard


Economics Encyclopedia: Gold Standard
International Monetory System
international monetary system rules and procedures by which
different national currencies are exchanged for each other in
world trade. Such a system is necessary to define a common
standard of value for the world's currencies.


The Gold and Gold Bullion Standards

The first modern international monetary system was the gold
standard. Operating during the late 19th and early 20th cents.,
the gold standard provided for the free circulation between
nations of gold coins of standard specification. Under the system,
gold was the only standard of value.


The advantages of the system lay in its stabilizing influence. A
nation that exported more than it imported would receive gold in
payment of the balance; such an influx of gold raised prices, and
thus lowered the value of the domestic currency. Higher prices
resulted in decreasing the demand for exports, an outflow of gold
to pay for the now relatively cheap imports, and a return to the
original price level (see balance of trade and balance of payments
).


A major defect in such a system was its inherent lack of liquidity;
the world's supply of money would necessarily be limited by the
world's supply of gold. Moreover, any unusual increase in the supply
of gold, such as the discovery of a rich lode, would cause prices to
rise abruptly. For these reasons and others, the international gold
standard broke down in 1914.


During the 1920s the gold standard was replaced by the gold bullion
standard, under which nations no longer minted gold coins but backed
their currencies with gold bullion and agreed to buy and sell the
bullion at a fixed price. This system, too, was abandoned in the
1930s.


The Gold-Exchange System

In the decades following World War II, international trade was
conducted according to the gold-exchange standard. Under such a
system, nations fix the value of their currencies not with respect
to gold, but to some foreign currency, which is in turn fixed to
and redeemable in gold. Most nations fixed their currencies to the
U.S. dollar and retained dollar reserves in the United States,
which was known as the "key currency" country. At the Bretton
Woods international conference in 1944, a system of fixed exchange
rates was adopted, and the International Monetary Fund (IMF) was
created with the task of maintaining stable exchange rates on a
global level.


The Two-Tier System

During the 1960s, as U.S. commitments abroad drew gold reserves from
the nation, confidence in the dollar weakened, leading some
dollar-holding countries and speculators to seek exchange of their
dollars for gold. A severe drain on U.S. gold reserves developed
and, in order to correct the situation, the so-called two-tier
system was created in 1968. In the official tier, consisting of
central bank gold traders, the value of gold was set at $35 an
ounce, and gold payments to noncentral bankers were prohibited. In
the free-market tier, consisting of all nongovernmental gold
traders, gold was completely demonetized, with its price set by
supply and demand. Gold and the U.S. dollar remained the major
reserve assets for the world's central banks, although Special
Drawing Rights were created in the late 1960s as a new reserve
currency. Despite such measures, the drain on U.S. gold reserves
continued into the 1970s, and in 1971 the United States was forced
to abandon gold convertibility, leaving the world without a
single, unified international monetary system.


Floating Exchange Rates and Recent Developments

Widespread inflation after the United States abandoned gold
convertibility forced the IMF to agree (1976) on a system of
floating exchange rates, by which the gold standard became
obsolete and the values of various currencies were to be
determined by the market. In the late 20th cent., the Japanese yen
and the German Deutschmark strengthened and became increasingly
important in international financial markets, while the
U.S. dollaralthough still the most important national
currencyweakened with respect to them and diminished in
importance. The euro was introduced in financial markets in 1999
as replacement for the currencies (including the Deutschmark) of
11 countries belonging to the European Union (EU); it began
circulating in 2002 in 12 EU nations (see European Monetary
System). The euro replaced the European Currency Unit, which had
become the second most commonly used currency after the dollar in
the primary international bond market. Many large companies use
the euro rather than the dollar in bond trading, with the goal of
receiving a better exchange rate.





3.2 Chapter 1: Working Capital Policy




3.2.1 Characteristics of Current Assets



  • Short life span
    cash balances may be held idle for a week or two, accounts receivable
    may have a life span of 30 to 60 days, and inventories can be held
    for 2 to 60 days. The lifespan of current assets depends upon the
    time required in the activities of procurement, production, sales,
    and collection and degree of synchronization among them.


  • Switf transformation into another current assets
    cash is used for acquiring raw materials; raw materials are transformed
    into finished goods, generally sold on credit, are converted into
    accounts receivables (book debt); and finally accounts receivable, on
    realization, generate cash.












Implications of current asssets:


  • Decisions relatign to working capital management are repetitive and frequent.

  • Difference between profit and present value is insignificant.

  • Close interaction between components necessiates management of more than
    one component at the same time.



3.2.2 Factors influencing working capital requirements



  • Nature of business
    Examples: Precentage of current assets
    10% - 20% - Hotels and restaurants
    40% - 50% - Iron and steel, Basic Industrial Chemicals
    80% - 90% - Trading, Construction


  • Sesionality of operations
    Examples: ceiling fans (cyclic), lamps (even all through year)


  • Production policy
    Production cycle independent of sales, dependent of sales.


  • Market conditions
    Delay to serve the customer is based on how aggressive the compitition is.


  • Conditions of supply
    How fast the supplier can provide goods dictates the size of inventory to
    maintain.



3.2.3 Level of current assets


Carrying costs shortage costs


3.2.4 Current assets financing policy


Fixed assets current assets

permanant current assets temporary current assets

Strategies for financing capital requirements:

Strategy A
Long-term financing is used to meet the fixed asset requirements and peak working capital requirements. When the working capital requirement is less than peak level, the surplus amount in invested in liquid assets.
Strategy B
Long-term financing is used to meet the fixed asset requirements and permanant working capital requirements, and a portion of fluctuating working capital requirements. During seasonal upswings, short term financing is used; during seasonal down-swings, surplus is invested in liquid assets.
Strategy C
Long-term financing is used to meet the fixed asset requirements and permanent working capital requirements. Short-term financing is used to meet fluctuating working capital requirements.

The Matching Principle
The maturity of the sources of financing should match the
maturity of the assets being financed.


3.2.5 Profit criterion for working capital





3.2.6 Operating cycle and cash cycle



Investment in working capital is influenced by four key events in
the production and sales cycle of the firm:


  • Purchase of raw materials

  • Payment for raw materials

  • Sale of finished goods

  • Collection of cash for sales


Computation of

inventory period
accounts receivable period
accounts payable period

operating cycle = inventory period + accounts receivable period
cash cycle = operating cycle - accounts payable period


3.2.7 Cash requirement for working capital



How much cash is required for working capital needs:


  1. Estimate the cash cost of various current assets

  2. Deduct the spontaneous current liabilities from the cash cost
    of current assets.



3.3 Chapter 2: CASH AND LIQUIDITY MANAGEMENT


Three possible motives for holding cash:


  1. Transaction Motive: as buffer to balance the collections and
    disbursement of cash.

  2. Precautionary Motive: uncertainty about magnitude and timing

  3. Speculative Motive: tap profit making opportunities in
    commodity markets



3.3.1 Cash Budgeting or short-term cash forecasting


Helpful in:


  1. (sink) estimating cash requirements

  2. (source) planning short term financing

  3. (long-term) scheduling payments in connection with capital expenditure projects

  4. planning purchases of materials

  5. (org) developing credit policies

  6. (long-term) checking the accuracy of long-term forecasts


Cash budgeting can be quarters, months, weeks, days.


  • Receipts and Payment Method

  • Deviations from Expected cash flows

  • Evaluation of the R&P Method



3.3.2 Long Term Cash Forecasting


Adjusted Net Income Method
resembling funds flow statement, seeks to estimate the firm's need for cash at some future date and indicate weather this need can be met with internal sources or not.


3.3.3 Reports for Control


Types of cash reports


  1. Daily cash report

  2. Daily Treasury report

  3. Monthly Cash Report


3.3.4 Cash Collection and Disbursement


Float
The difference between available balance (in bank) and ledger balance (book balance) is referred to as the float.
Disbursement Float
amount deducted from book balance (like cheque issued) and still available in bank balance is called disbursement float.

x

Collection Float
opposite of Disbursement float. Cheque received from customers updated in book balance but not in bank balance.
Net float
sum of disbursement float and collection float. Or it is the difference between firms available balance and its book balance. (?? diff between net float and float?).


3.3.5 Optimal Cash Balance




3.3.6 Investment of surplus funds



  1. Investment Portfolio: Three Segments



    • Ready cash segment for unanticipated operational
      needs. highly liquid.


    • Controllable cash segment for known outflows. size and
      timing can be matched.


    • free cash segment surplus funds invested for returns.


  2. Criteria for Evaluating Investment Instruments


    • Safety

    • Liquidity

    • Yield

    • Maturity

  3. Investment Options
    Theory Q3:


    #Investment optionIssuerSafetyLiquidityYieldMaturityOther comments
    <3><15><10><8><8><10><10><30>
    1Fixed deposits with banksBanksHighLowMediumfixed (15d - 5y)
    (6 p.a.)
    2Treasury billsGovtHighHighdiscount91, 182, 364 drepresent short-term obligations of Govt. + can be transacted readily in bearer form + secondary market + risk-free
    rate
    3Mutual FundsFundTypes: equity, balanced, debt schemes
    Houses
    4Commercial paperCorporatesLow90d-180dSold at discount, redeemed at par; Do not have well developed secondary markets in India.
    5Certificates of DepositBanksHighHighUserdefinedCustom made receipt of funds deposited in banks. CDs carry explicity interest rate. Banks tailor denominations, faily liquid, risk-free, yield higher rate of interest than TB.
    6Inter-corporate depositsCorporateMediumLowcall deposits; 3-m deposits; 6-m deposits
    7Ready Forwardscommercial bank or corporateHighLowthese are securities bought by company which wants to invest surplus; later sell it back to commercial bank or corporate;
    8Bill Discountingbill is on trade transaction. seller of the goods draws bill on purchaser.



  4. Strategies for Managing Surplus Funds


3.3.7 Cash Management Models



  • Baumol Model

  • Miller and Orr Model



4 Objective Type Questions & Answers




4.1 Jan 2006



  1. In the portfolio balance approach, which one of the following,
    other things being equal, will cause an increase in
    demand for domestic bonds by home country citizen?
    ANS: A decrease in the expected rate of depreciation of the home
    currency (or a decrease in expected rate of appreciation of
    the foreign currency).

  2. Which among the following is not offered as an explanation of
    why firms hedge currency exposure:
    ANS: Firms desire to improve cash budgeting

  3. Exposure to a risk factor is:
    ANS: a measure of the sensitivity of the firm's performance
    index to unanticipated variations in the risk factor.

  4. If a firm invoices all its transactions in its home currency it
    would have no operating exposure.
    ANS: False

  5. The term 'Hedge Ratio' denotes
    ANS: The ratio of the value of futures position to cash market
    position

  6. A drop-lock provision in a syndicated loan
    ANS: Converts a floating rate loan into a fixed rate loan when
    the floating index hits a specified floor.

  7. Contango refers to situation when
    ANS: The price of a far contract is higher than that of a near
    contract.

  8. An interest rate cap is:
    ANS: a portfolio of call options on interest rate

  9. In the choice of currency to invest surplus funds for short
    horizons without incurring currency risk the treasurer should be
    guided by:
    ANS: the choice of currency does not matter

  10. In determining the total risk of a multi-currency equity
    portfolio:
    ANS: The expected values of exchange rate changes do not matter


4.2






5 Planning


TypeMarksVolumeDate/Time
Objective type1210426-Jan
Problems421226-Jan
Problems727-Jan
Mini-case16428-Jan
Theory301529-Jan
Revision30-Jan



6 Theory question in Mini-case




6.1 What is letter of credit? Name any six different types of letter of credit.




6.2 List the main differences between the features of forward contracts and futures.




6.3


Author: Janardan Revuru
<janardan@yahoo.com>
Date: 2010-02-02 08:12:50 XXX
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