Investment Management in International Business 3

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Sub Topic - 1

Foreign Exchange Dealings

Foreign exchange Transaction

Exchange Rate Mechanism

FEMA on International Trade


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Sub Topic - 1

Foreign Exchange Dealings

It is a part of International Finance. Domestic business

agreements are concerned with the basic issues like

price, quantity and delivery date, but international

business agreements are concerned with other issues,

in addition to the issues involved in domestic trade.These issues are:

Currency to be used in the international Business

transactionsCreditworthiness of the importer

Acceptable methods of payment

Arranging Finance


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Sub Topic1 Foreign Exchange Dealings

IF: Currency to be used

Selection of currency to settle international

transactions is very important:

Exporter prefers to have his home or hard currency

while the importer prefers to pay in his home currency.

If the currency of importing country is weak theexporter prefers payment in strong currencies like

USD, UK Pound, Japanese Yen and Euro.

Hard currencies are choice of exporter fpr settlingtransactions in international business. Hence the

iporter face struggle to earn hard currencies in order to

meet their import bills


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Sub Topic1 Foreign Exchange Dealings

IF: Creditworthiness of importer

The exporter is interested to know the creditworthinessof the importer because he first arranges for the

shipment of the goods and receives the money at later

stage. There is an amount of risk involved in the

payment of money by the importer.

EXIM Bank of USA, EXIM Bank of India and such

other organization provide credit rating information to

the exporters for a fee. After evaluating thecreditworthiness of the importer, the exporter and

importer should come to an understanding regarding

the method of payment.


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Sub Topic - 1

Foreign Exchange

All currencies other than home currency are foreigncurrencies for a particular country while settling

international transactions. There foreign currencies are

known as foreign exchange.

The exchange of foreign currencies into home

currency is carried out by exchanging some units of

the home currency for some units of foreign currency.

The ratio of exchange between the two currencies isknown as the foreign exchange rate and expression of

this ratio or the rate of foreign exchange is known as

the foreign exchange quotation.


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Sub Topic - 1

Foreign Exchange

The importing country pays money to the exportingcountry in return of goods either in its domestic

currency or in hard currency. This currency which

facilitates the payment to complete the transaction is

called foreign exchange. Foreign exchange includes

foreign currency, foreign cheques, foreign drafts.

FOREX is bought and sold in foreign exchange

markets. The components of FOREX are:The buyers

The sellers and

The intermediaries


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Exchange rate Determination

Methods of Exchange rate Quotations

Foreign Exchange Rate is defined as the rate of one

currency in terms of another currency.

In yester years, these rates used to be stable as these

were controlled by government agencies now a days

these are determined by market forces (demand andSupply). So these keep on fluctuating.

Foreign exchange trading is defined as the sale or

purchase of one currency that is traded with anothercurrency.

There are three types of quotes:

Direct Quote

Indirect uotes


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Direct Quotation: This method expresses the numberof units of domestic currency required to buy one or

100 units of foreign currency: Direct quotes in India

are:1$ = Rs. 43.5125 or Rs. 43.5125 / 1US$

1 = Rs. 82 or Rs. 82 / 1

1Euro = Rs. 54 or Rs. 54 / 1Euro

To calculate Direct Quote:

Direct Quote = 1 / Indirect Quote


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Indirect Quotation: This method expresses thenumber of units of foreign currency that can be bought

with one or 100 unit of the home currency one.

Indirect quotes of above motioned examples in India

are:

Re. 1 = 0.02298 US$ or Re. 1 / 0.02298 US$

Re. 1 = 0.01219 or Re. 1 / 0.01219

Re.1= 0.01851Euro or Re.1/ 0.01851EuroTo calculate the Indirect quote:

Indirect quote = 1/Direct Quote


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International Quote or Cross Currency Quote:Exchange rates are readily available for currencies

which are frequently transacted. Exchange rates may

not be available for currencies which have only

limited transactions. In such situation, the home

currency can be converted into common currency such

as US$ or EURO and then common currency can be

converted into desired currency. This is referred to ascross rate trading. It involves three way transaction

involving three currencies:

The home Currency

E h D i i


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Methods of Exchange rate Quotations: ProblemSet: 1

Calculate how many rupees Shri Ras Bihari Ji Lid. aNew Delhi based firm, will receive or pay for its

following four currency transactions:

The firm receives dividend amounting to Euro1,12,000 from its French Associate Company.

The firm pays interest amounting to 2,00,000 Yens for

its borrowings from a Japanese Bank.The firm exported goods to UISA and has just

received US$ 3,00,000.

The firm has imported goods from Singapore

amounting to Singapore Dollars (SGD) 4,00,000


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Given:

$1 = Rs. 40.00/40.05

Euro 1 = Rs. 56.00 / 56.04

SGD = Rs. 24.98 / 25.00100 Yens = Rs. 44.00 / 44.10


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Methods of Exchange rate Quotations:Problem Set: 2

Calculate how many British pounds a London based

firm will receive or pay for its following four

currency transactions:

The firm receives dividend amounting to Euro1,12,000 from its French Associate Company.

The firm pays interest amounting to 2,00,000 Yens for

its borrowings from a Japanese Bank.The firm exported goods to USA and has just received

US$ 3,00,000.

The firm has imported goods from Singapore

amountin to Sin a ore Dollars SGD 4 00 000

T f l (T i )


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Types of settlements (Transactions):

Ready of Cash: refers to transaction to be settled on

the same day i.e transaction done on 4th June to be

settled on 4th June.TOM: refers to transactions where the delivery of

foreign currency is to be done on the next day

(tomorrow) transaction done of 15th July to be settledon 16th July.

Spot: refers to a transaction where the delivery of

foreign currency is to be done on the second workingday (day after tomorrow).

Forward: refers to a transaction where the delivery of

foreign currency is to take place on a date later than

the spot date e.g. A transaction done on June 3rd to be

T f E h R t


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Types of Exchange Rate

Cover Rate and Base rate: The rate at which the

banks can cover the merchant transactions in the inter-bank market without any profit or loss is called the

Cover Rate. That is the rate at which the bank can buy

dollars to cover import transactions in USD and the

rate at which it can sell the US dollar to cover an

export transaction in Dollars.

The base rate is deduced from the cover rate after

allowing a cushion for the adverse movement of rates.In practice, there are instances in which the cover rate

and the base rate are the same.

Fixed and Floating Exchange rate


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Bid (Buying) and Offer (Selling) Rates

Foreign Exchange dealers usually quote two prices:

For buying foreign currency (Bid rate)

For selling the foreign currency (Ask or Offer Rate)

The difference between bid rate or price and offer rate

or price is termed as the bid-offer Spread.

For example: In direct method, the first rate quotedwill be buying rate and second rate will be offer rate.

The two rates for dollar rupee exchange are:

1US $=Rs. 43.35 43.66.Difference between these two rates is the spread

showing profit of Re.0.31 or 31 paisa per dollar traded.


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What is spread?

The difference between the Bid Price and the

Ask price is called a Spread. The spread

percentage is calculated using the following

formula:

[(Ask-Bid)/Ask] x 100If a foreign exchange dealer looks at the

following quote: EUR/USD = 1.3700/05, the

spread could be 0.0005 or 5 pips also knownas points. The pip is the smallest amount a

price can move in any currency quote.


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Types of Exchange Rate

Purchase and sale of one currency against other

currency may be either on spot basis or for futuredelivery. In spot transaction, the currencies are

delivered either immediately (the same day) or on the

second day from the date of transaction. The exchange

rate of the spot transaction is called SpotRate.

A future delivery transaction is one in which a contract

is made between two parties for the purchase and sale

of one currency against other at a stipulated future dateat an agreed rate. Such future delivery transactions is

called as Forward Rate.

F d P i d Di


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Forward Premium and DiscountLet us consider the following spot and forward

exchange rates:

Situation 1:Spot Rate: 1US$ = Rs.43.51

3 Month forward: 1US$ = Rs. 43.96

Forward rate differential (higher) by Re. 0.45or 45 paise. (Forward premium)

Situation 2:

Spot rate 1 = Rs. 70.453 month forward: 1 = Rs. 69.75

Forward rate differential (Lower) Re. 0.70 or

70 paise.

(Forward discount)


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Some More Examples of Forward Rate at

premium and at DiscountSpot: = $ 1=Rs.40. 44

Six month Forward: $ 1= Rs. 42.38$ is at premium

If a currency is cheaper in future as compared

to Spot, it is said to be at discount.

Forward Premium and Discount

The forward premium or discount can beexpressed as an annualized percentage

deviation from the spot rate by using the

following formula:


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Problem set

A person has to pay $ 13750 after three

months today. Spot Rate: Re. 1 = $0.0275.

Rupee is likely to depreciate by 5% over three

months. What is likely forward rate?

F d R t Q t ti


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Forward Rate Quotations

As per forex market convention, spot rates and

forward rate differentials (premium or discount) are

quoted separately. To arrive at the forward rates thespot rate has to be adjusted for the forward points.

Forward premium points are added to the spot rate

while forward discount pointed are deducted from thespot rate to arrive at the forward rate

Forward Rate Quotations: Example:

The dollar- Rupee exchange rate is

1US dollar = Rs. 43.30 43.73

The table below gives some forward premiums for the

USD in paise per US dollar in the forward market


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Risk in Foreign Exchange

FOREX risk is defined as the possibility of adverse

movement in foreign exchange ratesIf one has to sell the foreign currency in future, the

possibility of decline in the rate / price of that currency

is foreign exchange rate risk.If one has to buy some foreign currency, the possibility

of increase in the rate / price of that currency is foreign

exchange rate risk.

To conclude: Foreign exchange rate risk refers to such

movements in foreign exchange rate which result in

loss.


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Resource Mobilization

through Portfolio, ADR and

GDR


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Foreign Institutional Investors

Foreign Institutional investors (FIIs) are foreign

institutions like pension funds, mutual funds,

investment trusts and portfolio managers.As per the regulation issues by GOI, FIIs, NRIs and

PIOs are allowed to invest in the primary and

secondary capital markets in India through theportfolio investent scheme. Under this scheme, FIIS/

NRIs can acquire shares and debentures of Indian

Companies through the stock exchanges in India.

F i I tit ti l I t


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Foreign Institutional Investors

The ceiling for overall investment for FIIs is 24% of

the paid up capital of the Indian company and 1o% for

NRIs/PIOs. The imit is 20% of paid up capital in case

of PSBs including the State Bank of India.

Regulation on FIIs were issued in November 14,

1995. According to this regulation FIIs may investonly in :

Securities in the primary and secondary markets

including shares, debentures and warrants ofcompanies listed in a recognized stock exchange in

India.

Units of schemes floated by domestic mutual funds

includin Unit Trust of India whether listed on

D it R i t


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Depository Receipts

A depository receipt (DR) is a negotiable certificate

that represents a companys publically traded equity or

debt.

It is a negotiable certificate, denominated in US$ that

represents a non US companys publically traded local

currency equity shares or dept instruments. Depositoryreceipts are created when local currency shares of

Indian company are delivered to the depository s

local custodian Bank, against which the DepositoryBank (like the Bank of America) issues DR in US$.

The depository receipts may trade freely in the

overseas markets like any other dollar denominated

securit either on a forei n stock exchan e or over the

American Depositor Receipts


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American Depository ReceiptsA negotiable certificate issued by a U.S. bank

representing a specified number of shares (or one

share) in a foreign stock that is traded on a U.S.exchange. ADRs are denominated in U.S. dollars, with

the underlying security held by a U.S. financial

institution overseas. ADRs help to reduceadministration and duty costs that would otherwise be

levied on each transaction.

This is an excellent way to buy shares in a foreigncompany while realizing any dividends and capital

gains in U.S. dollars. However, ADRs do not eliminate

the currency and economic risks for the underlying

shares in another country. For example, dividend


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Global Depository Receipts

In order to enable the Indian companies to mobilizefunds from foreign countries, the Govt. of India

allowed Indian companies satisfying certain conditions

to access foreign capital market through Euro issue ofGlobal depository Receipts (GDR) and Foreign

Currency Convertible Bonds.

The term global depository receipts indicates that the

depository receipts are marketed globally rather thanin ant specific country or market.

Documents

Investment Management in International Business 3