Q1 Operations in foreign exchange market are exposed to a number of risks. Explain
Answer:
Firm dealing with foreign exchange may be exposed to foreign currency exposures.
Following are the three types of exposure that a firm may face:
• FX Exposures
1. Transaction Exposure
• A firm has transaction exposure whenever it has contractual cash flows (sales/purchases) whose values are subject to unanticipated changes in exchange rate due to contract being denominated in a foreign currency.
• Ex. Change in the value of Receivables on export on exchange rate fluctuation.
2. Economic/Operating Exposure
• A firm has economic exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations.
• Ex. Shift in exchange rate will affect demand of the product. This is economic exposure
3. Translation Exposure
• A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements
• Ex. Revaluation of debtors and creditors at balance sheet date for the exchange rate fluctuations.
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Q2 Write short notes on:
a. Interest Rate Parity Theory
b. Purchasing Power Parity Theory
Answer:
A. Interest Rate Parity Theory
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage.
IRP theoretical formula
rd=Rate of interest in domestic market
rf= Rate of interest in foreign market
F = Forward rate of the foreign currency
S = Spot rate of the foreign currency
When Interest rate parity exist then high interest in one country will be offset by the depreciation in the currency of that country.
IRP theory states that the size of the forward premium (discount) should be equal to the interest rate differential between the two countries in consideration.
B. Purchasing Power Parity Theory
Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power.
PPP theoretical formula
Where,
id=Inflation rate in domestic market
if= Inflation rate in foreign market
F = Forward rate for foreign currency
S =Spot rate for foreign currency
Two forms of Purchasing Power Parity theory
1. The Absolute form: The purchasing power parity theory is based on the common sense idea. If a basket of goods cost ₹1000 in India and the same goods cost $25 in United States then the purchasing power parity between the two currencies is ₹40 / US Dollar. This form of exchange rate is called absolute PPP.
The Absolute form which is also known as Law of One price states that “prices of similar product of two different countries should be equal when measured in a common currency”
2. The Relative form: The relative purchasing power parity explains the relationship between the inflation rates and exchange rates of the two countries.
It means that if the inflation rate in one country is higher than that in another country then the effect of this high inflation is offset by the depreciation in the currency of that country.
Q3 Write short notes on Nostro, Vostro and Loro accounts.
Answer:
i) Vostro Account (Italian, English, 'yours'):a bank account held by a foreign bank with a domestic bank, is Vostro Account. Thus, if the account of Bank of America in SBI is Vostro account for SBI
ii) Nostro Account: (Italian, English, 'ours'): It is the overseas account which is held by the domestic bank in the foreign bank or with the own foreign branch of the bank. For example the account held by state bank of India with bank of America in New York is a Nostro account of the state bank of India.
iii) Loro Account (Italian, English, 'theirs'): it is used when referring to third party accounts. Ex: If State Bank of India, Mumbai has an account with Bank of America, New York denominated in US Dollars then when Bank of Baroda has to refer to this account while corresponding with Bank of America, it would refer to it as LORO Account, meaning ‘their account with you’
Q4 What is Exposure Netting? What are the advantages of Netting?
Answer
Exposure Netting refers to offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure.
The objective of the exercise is to offset the likely loss in one exposure by likely gain in another. This is a manner of hedging forex exposures though different from forward and option contracts. This method is similar to portfolio approach in handling systematic risk.
Advantages of Netting
· Reduces the number of cross border transactions between subsidiaries thereby decreasing the overall administrative costs of such cash transfers.
· Reduces the need for foreign exchange conversion and hence decreases transaction costs associated with foreign exchange conversion.
· Improves cash flow forecasting since net cash transfers are made at the end of each period.
· Gives an accurate report and settles accounts through co-ordinate efforts among all subsidiaries.
Q5 What is Leading and Lagging?
Answer:
Leading: Leading refers to prepaying import payments or receiving early payment for exports; If the importer expects the foreign currency to appreciate beyond the cost of home currency funds then he will be willing to make an early payment by borrowing the amount. On the other hand if the exporter expects that the foreign currency to depreciate more than the cost of investment then he will be willing to receive early payments for the sales made by him.
Lagging: Lagging relates to delaying import payments or receiving late payment on exports.
If the importer expects the foreign currency to depreciate more than the interest charged by the vendor for delaying the payments then he will be willing to make delayed payment. On the other hand if the exporter expects that the foreign currency to appreciate more than the cost of investment then he will be willing to receive late payments for the sales made by him.
Q6 Write short notes on ‘Arbitrage Operations’.
Answer:
✓ Arbitrage is the buying and selling of the same commodity in different markets. A number of pricing relationships exists in the foreign exchange market, whose variation would imply
the existence of arbitrage opportunities – the opportunity to make a profit without risk or investment. These transactions refer to advantage derived between two currencies at two different centers at the same time or of difference between cross rates and actual rates.
✓ For example, a customer can gain from arbitrage operation by purchase of dollars in the local market at cheaper price prevailing at a point of time and sell the same for sterling in the London market. The sterling will then be used for meeting his commitment to pay the import obligation from London.
Q7 Explain the significance of LIBOR in international financial transactions.
Answer:
✓ LIBOR stands for London Inter Bank Offered Rate.
✓ It is the base rate of exchange with respect to which most international financial transactions are priced.
✓ It is used as the base rate for a large number of financial products such as options and swaps.
✓ Banks also use the LIBOR as the base rate when setting the interest rate on loans savings and mortgages.
✓ It is monitored by a large number of professionals and private individuals worldwide.
Corporate actions.
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Private Equity-03 https://youtu.be/Wip9pwV7fZU
Derivatives https://youtu.be/iV2p9a-TUFU
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Cash Dividend https://youtu.be/F6H-wgwuDa8
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