Assignment Code: IBO-06/TMA/2022-23

Course Code: IBO-06

Assignment Name: International Business Finance

Year: 2022-2023

Verification Status: Verified by Professor

Attempt all the questions: (20x5)

Q1) (a) What are forward contracts? In what circumstances these contracts are used? How are they different from future contracts?

Ans) The price of the forward currency under a forward contract is the anticipated market spot rate for that maturity at that time. An outright contract could be a forward contract. An agreement to exchange currencies at a specified price and at a future date is known as an outright forward contract. The forward exchange market is an unregulated market where contract details are mostly determined by convention and subject to mutual agreement of the contracting parties. Although entering into a forward contract for any term of 3 days or more is theoretically conceivable, in reality it is challenging for maturities of more than one year. Even though the market is now expanding to longer maturities, it is still difficult to find it in India for maturities greater than six months.

Although futures are similar to forward contracts they differ in respect of the following:

Q1) (b)What are floating rate notes? Explain its features.

Ans) The Floating Rate Note is an instrument whose interest rate fluctuates with current market rates, as its name suggests. It offers a 3- or 6-month interest rate that is set above or below LIBOR, similar to Eurodollar deposits. The interest rate is updated every three or six months to a new amount depending on the current LIBOR level at the reset date, much like with foreign loans.

The phrase "Floating Rate Note" is used to describe a medium- to long-term debt security whose interest rate is frequently modified and pegged to a short-term rate or rate index. Euro bonds are used to issue Floating Rate Notes that are issued outside of the nation where the denomination's currency is legal tender. Due to this characteristic, they resemble capital-market instruments in several ways. The instrument's personality is mostly determined by the pricing structure.

Most FRNs can be characterised by the following features:

1. The Reference Rate: Interest rate the coupon payment is based on. Typically, this pricing is for a brief period. Consequently, some people think of FRN as a replacement for money-market products.

2. The Margin: The spread depicts the difference in risk between purchasing a FRN and a bank deposit that pays LIBOR at the time of issuance.

3. The Reference Rate Period: The term "reference rate period" refers to the maturity of the instrument to which the coupon is tied, such as a 3- or 6-month Eurodollar deposit.

4. Frequency Of Re-Set: The reference-rate period typically corresponds with the intervals between coupon re-set dates.

5. Coupon-Payment Frequency: This is the time between coupon payments, which typically falls during the times when the coupons are reset.

6. Maturity: The principal on the FRN will be redeemed on this day. Many FRNs have a call feature, which allows the issuer to redeem the FRN before its maturity at specific times.

Q2) (a) Discuss the working of Bretton woods system.

Ans) Initially the system worked extremely well. After the advent of the Cold War, the United States had to take over its management in 1947 to prevent a major international and political crisis when the economies of industrial countries had disintegrated after the War. The U.S. policies ensured a steady injection of dollars into the world economy to facilitate the adjustment of imbalances in international payments. it helped, in this way, to preserve the system of fixed exchange rates among industrial economies almost for two decades.

Massive U.S. assistance to other countries started with the European Recovery Programme and other official transfers in the late 1940s. The countries in Western Europe and Japan recovered economically as a result of these programmes. While official grants and loans were reduced after 1950s, the military spending and investment abroad of the U.S.A. increased. In a sense, like the United Kingdom before 1914, the United States provided other countries with its currency on a scale that facilitated the growth of world output, trade, and investment without compromising the confidence the dollar enjoyed internationally.

Under the Bretton Woods Agreement each government pledged to maintain a fixed or pegged exchange rate for its currency vis-a-vis the dollar or gold. The fixed exchange rates were maintained by official intervention in the foreign exchange markets by purchases and sales of dollars by foreign central banks against their own currencies. The IMF stood ready to provide the necessary foreign exchange to member nation defending the currencies from temporary factors.

Q2) (b) What do you understand by Balance of payment? What are its components?

Ans) The idea of a balance of payments has its roots in international trade and financial activities. Three different financial flow types are included in the balance of payments. The trade balance can be calculated by balancing the value of visible exports against the value of visible imports. Second, invisible balance can be calculated by balancing the value of unseen exports against the value of invisible imports. The costs incurred when goods exported from India are transported by foreign ships or insured by foreign underwriters are referred to as invisible imports or import of services. Thirdly, the capital account balance, often known as the balance of investment and other capital flows, makes up the balance of payments.

The current account, capital account, and finance account are the three parts of the balance of payments:

Current Account: The flow of commodities and services between nations is tracked by the current account. This account includes all of the payments and receipts related to produced items and raw materials. It also includes stock dividends, royalties from patents, and earnings from engineering, tourism, transportation, commercial services, and copyrights.

Capital Account: The capital account keeps track of all financial transactions between the nations. Capital transactions cover the buying and selling of assets like real estate and land. The flow of taxes, the acquisition and sale of fixed assets, etc., by immigrants moving out of or into another nation are also included in the capital account. Finance from the capital account is used to manage the current account's deficit or surplus, and vice versa.

Financial Account: The financial account is used to track the flow of money between foreign nations and domestic ones through various real estate investments, business endeavours, foreign direct investments, etc. This account tracks changes in both domestic and foreign ownership of assets in the United States. If the nation is selling or buying more assets, it will be easier to understand these changes after analysis.

Q3) (a) What is international fisher effect? In what situation it operates?

Ans) The key to understanding the impact of relative changes in nominal interest rates among countries on the foreign exchange value of a nation's currency is to recall the implications of purchasing power parity and the generalised Fisher effect. Purchasing power parity implies that exchange rates will move to offset changes in inflation rate differentials. It will also be associated with a rise in Indian interest rate relative to foreign interest rates. Combine these two conditions and the result is the International Fisher Effect.

Q3) (b) Explain how currency futures may be a good hedging technique with the help of an illustration.

Ans) Another method for removing the rigidity of forward contracts is to use currency futures. The concept itself is quite straightforward. A company should take a futures position such that futures provide a positive cash flow whenever an asset's value decreases if it has an asset, such as a receivable in the US dollar, that it wants to hedge. Since the company is long the underlying asset in this instance, it should sell futures contracts in US dollars to go short in futures.

For the majority of the convertible currencies, a direct hedge is available; in all other cases, a firm must select a futures contract on an underlying currency that has a strong positive correlation with the currency risk being hedged. A flawless hedge is nearly never achievable, not even when a direct hedge is available. There are two causes for this. One is that futures contracts are for standardised sums, and the exposure to be hedged will rarely equal the value of an integral number of futures.

For instance, an American company with a DM 5,50,000 receivable cannot precisely hedge this amount by selling DM futures. Five contracts for DM futures will equal DM 6,25,000, while four contracts will cover DM 5,00,000. The second and more crucial factor is that there isn't a perfect correlation between spot and futures pricing. The main challenge is that, in most cases, the change in spot price does not correspond to the change in futures price. The basis risk is what's known as this. The spot dollar/pound rate as of March 1 is 1.6750, and June futures are trading at 1.6680. The foundation is 70 ticks, or 0.0070.

Consider a scenario in which an American company hedges a 1,00,000 Pound sterling receivable with the sale of two futures contracts. Sterling's current price dropped to 1.6620 on June 1 while June futures were trading at 1.6590. As a result, the basis has decreased to 30 basis ticks. The receivable's loss is:

$100,000 (1.6750-1.6620)=$1,300

On the other hand, the gain on futures is $1,125 ($1,25,000(1.6680-1.6590)) The sterling receivable is therefore not perfectly hedged even by the two sterling futures.

Q4) What is Adjusted Present Value (APV) technique? How does it differ from other techniques of financial appraisal of the project? Why it is suitable for international project appraisal?

Ans) The Adjusted Present Value approach effectively enables for the individual cash flow components of the project to be discounted separately, giving the project the necessary flexibility to accommodate for the influence of various variables and other project elements. The APV framework gives the capital budgeting analyst the capacity to gauge the viability of the international project before taking into consideration all of its complications.

Initial Investment

The project's initial investment consists of cash, equipment, and other assets provided by the parent firm, as well as local loans for working capital. The last portion must be converted into Indian rupees at the current currency rate. if the overseas project releases the parent's locally owned monies that have been blocked. The project will be deemed to have reduced the initial investment by the face value of the blocked funds that are activated by them. It is possible to express this component as follows:

Projects Remittable Cash Flows

The cash flows for a project have a lot of parts. The main factor is the cash flows produced by sales in the host nation, which are then reduced by lost revenue on sales that were previously earned on exports made by the parents to the market in the host nation. It also includes cash flows from sales of the new project's products to markets in third countries, which are then lessened by profits from exports that were unable to reach these markets. Interest on loans made by the parent to the affiliate is also included in contractual payments to the parent. It should be stressed that only cash flows that can be legally sent to the parent are

Contribution of Subsidies and Concessions to Project

The majority of the host country's subsidies, concessions, and other perks will naturally affect cash flows. These could include giving away free land for the project's location, tax breaks, lowered import tariffs, and reduced utilities costs. When the project is able to receive a loan from a local financial institution at a low interest rate, the concessionary agreement would require a distinct approach in the APV framework.

Such a loan is a one-time contribution to the project's APV and is often given to cover all or some of the working capital needs of the overseas project. This contribution is determined by the difference between the face value of the loan in local currency and the amount of repayments, discounted to the present at the likely local borrowing rate that would have been incurred had the concessionary loan not been available.

Tax Savings and Other Transfers to Parent

This somewhat speculative element of cash flow in the APV calculation is typically not included unless the project proves to be unsatisfactory in light of remittable cash flows and the impact of subsidies and other concessions. Through the transfer pricing mechanism, international business firms are frequently able to move money from high-tax regions to low-tax places and to postpone paying taxes by moving money to tax havens.

Due to a decrease in the effective tax rate used to calculate net cash flows, tax savings realised from these operations help make the project viable. These businesses can also make transfers over and beyond the legally permissible cash flows thanks to the transfer pricing mechanism. Given the increased level of risk involved, any contributions from tax savings and additional remittable income should be evaluated at a much higher rate than contractually remittable income.

Q5) (a) What is international cash management? What are its objectives? Which of the gains from centralization of cash management are related to foreign exchange transaction costs?

Ans) Moving money between nations is made easier by the discipline of international cash management. The people in charge of setting up local currency accounts in areas of interest and moving essential funds into and out of foreign nations are known as cash managers. In order to successfully use excess cash, international cash management aims to maximise funds available at a certain level of operating expense and foreign exchange risk.

Thus, in a global setting, the following goals of successful working capital management are:

1. To distribute cash balances and short-term assets among currencies and nations in order to maximise total corporation returns.

2. To take out loans on various money markets to get the lowest rate.

The pursuit of these goals must take place while maintaining the necessary liquidity and reducing any potential dangers.

The motivation to borrow money in foreign currencies is diminished when foreign exchange transaction costs are taken into account, just like the incentive to make investments in foreign currencies. In contrast to investing, borrowing foreign currency may be discouraged by borrowing-lending spreads. This is due to the fact that lenders may charge foreign borrowers a higher rate than they do domestic borrowers when raising foreign funds abroad because they view loans to foreigners as being riskier.

The spreads for investment borrowing need not change if foreign funds may be borrowed on the domestic market. A system that integrates cash and foreign exchange management aims to either maximise total cash or reduce total borrowings across all currencies:

1. Staying away from borrowing and investing at the same time unless there are arbitrage chances

2. Reduce your exposure to foreign exchange risk and ensure exposure netting.

3. Minimise changes in the level of exposure to foreign exchange.

4. Reduce transactional expenses.

Q5) (b) Explain the different types of financing instruments and arrangements to deal with diverse risk in project export.

Ans) The different types of financing instruments and arrangements to deal with diverse risk in project export are as follows:

Bid Bond

It is a bond guarantee offered by the Bank to the buyer that offers compensation, typically on demand, in the event that a supplier declines to enter into a contract in accordance with the bid that has been made. A bid bond may only be issued for up to six months. 75 percent of the commission is refunded by the issuing bank if the contract is not granted.

Advance payment guarantee (APG)

It is a bond that the bank issues to the international buyer for the amount of the advance payment. The bond is valid until the advance payment amount is equalled by the progress made on the contract. Exporters must get a mobilisation advance equal to at least 10% of the contract value.

Performance Guarantee (PC)

It is a bond offered by a bank to the buyer that provides reimbursement in the event that the contract is not fulfilled or the items supplied do not meet the predetermined standards. It typically covers 5 to 10% of the contract's total value. Exporters must provide the format of the guarantee at least four weeks before it is actually issued to allow for discussions and approval.

Guarantee for Release of Retention Money

This assurance enables the exporter to receive complete payment release prior to receiving the client's Final Acceptance Certificate.

Guarantee for Overseas Borrowings

This guarantee may be used to secure foreign currency bridging financing from a foreign bank up to 10% of the contract value. Requests for foreign borrowings must be accompanied by currency-wise cash flows that include list any outstanding letters of credit and the date they are expected to be withdrawn. Guarantee commission is assessed at the FEDAI-specified rates. Bank for Export Performance Guarantee typically waives the margin restrictions for guaranteed issuance.

Risk Coverage

In the form of particular policies, ECOC offers protection against non-receipt of payment for commercial and political reasons. Different policies are:

1. Policy for a certain cargo (encompassing hazards).

2. Policy for a given cargo (political risks).

3. Policy on specific contracts (all-encompassing risks).

4. Political risks policy in certain contracts.

Depending on the type of risk that the bank has assumed in the form of various guarantees, ECGC also covers the risks of the bank by offering different types of guarantees. Exporters can purchase insurance to protect themselves from losses caused by changes in exchange rates.