Assignment Code: MS-45/TMA/JULY2022

Course Code: MS-45

Assignment Name: International Financial Management

Year: 2022-2023

Verification Status: Verified by Professor

Attempt all the questions and submit this assignment to the coordinator of your study centre. Last date of submission for July 2022 session is 31st October 2022 and for January 2023 session is 30th April 2023.

Q1) Describe the different kind of international financial flows and comment on the structure of balance of payments. Explain the basic principle governing recording of these flows.

Ans) International financial flows refer to the movement of money between countries. These flows can be categorized into three main types: foreign direct investment, portfolio investment, and foreign aid.

Foreign direct investment is the most significant type of international financial flow. It refers to the investment made by a company or an individual in a foreign country. The investor may purchase shares of a foreign company or set up a subsidiary in a foreign country. FDI is usually a long-term investment that involves a significant amount of capital. FDI can contribute to the economic growth of the host country by creating jobs, transferring technology and know-how, and increasing productivity. On the other hand, FDI can also lead to the exploitation of the host country's resources and labour force if it is not properly regulated.

Portfolio investment refers to the purchase of stocks, bonds, and other financial assets of a foreign country by an investor. Unlike FDI, portfolio investment is usually short-term and does not involve the transfer of control of the company or asset. Portfolio investment can provide a source of funds for a country's economic development and help reduce the cost of borrowing. However, it can also be volatile and lead to financial instability if investors decide to withdraw their investments quickly.

Foreign aid refers to the transfer of resources from one country to another, usually by a government or an international organization. The purpose of foreign aid is to support the development of the recipient country. Aid can be in the form of grants, loans, or technical assistance. Foreign aid can be controversial as it can be perceived as a form of dependency, and there are concerns about the effectiveness of aid in promoting development.

The balance of payments is a record of a country's transactions with the rest of the world. It is divided into two main accounts: the current account and the capital account:

1. The current account records transactions in goods, services, income, and current transfers between a country and the rest of the world. Goods include physical goods such as food, clothing, and machinery. Services include non-physical items such as tourism, transportation, and consulting services. Income includes wages, salaries, and profits earned by a country's residents from investments in foreign countries. Current transfers refer to gifts or grants from one country to another, such as foreign aid.

2. The capital account records transactions in assets and liabilities between a country and the rest of the world. Capital flows can be divided into two sub-accounts: direct investment and portfolio investment. Direct investment refers to the transfer of capital in exchange for a controlling interest in a company. Portfolio investment refers to the purchase of securities such as stocks and bonds. Other capital flows include loans, debt forgiveness, and official reserves.

The basic principle governing the recording of international financial flows is the double-entry accounting system. For every transaction, there is an equal and opposite transaction. For example, if a country exports goods to another country, it will receive payment in the form of foreign currency. This transaction will be recorded as a credit in the current account, and a corresponding debit will be recorded in the capital account. If a country imports goods, it will pay for them in foreign currency, and this transaction will be recorded as a debit in the current account and a corresponding credit in the capital account.

International financial flows are essential for the development of countries, and they can take different forms such as FDI, portfolio investment, and foreign aid. The balance of payments is a record of a country's transactions with the rest of the world, and it is divided into the current account and the capital account. The basic principle governing the recording of international financial flows is the double-entry accounting system, where every transaction has an equal and opposite entry.

Q2) Describe the different kinds of exchange rate exposures and discuss the techniques used to manage these exposures.

Ans) Exchange rate exposure refers to the financial risk that arises from fluctuations in exchange rates between different currencies. There are three types of exchange rate exposures: transaction exposure, translation exposure, and economic exposure.

Transaction exposure is the risk that arises from contractual obligations denominated in a foreign currency. This exposure arises from the uncertainty of the exchange rate at the time the payment is due. Transaction exposure can be managed using techniques such as forward contracts, futures contracts, and options contracts.

Forward contracts are agreements between two parties to exchange currencies at a future date at a predetermined exchange rate. This allows companies to lock in an exchange rate and eliminate the risk of fluctuations. Futures contracts are like forward contracts, but they are traded on organized exchanges, and the terms are standardized. Options contracts give the buyer the right, but not the obligation, to exchange currencies at a predetermined exchange rate at a future date. This allows companies to protect against unfavourable exchange rate movements while retaining the flexibility to benefit from favourable movements.

Translation exposure is the risk that arises from converting the financial statements of a subsidiary or a foreign branch into the parent company's reporting currency. This exposure arises because exchange rates fluctuate over time, and these fluctuations can affect the value of assets and liabilities denominated in foreign currencies. Translation exposure can be managed using techniques such as forward contracts, currency swaps, and netting.

Forward contracts and currency swaps are used to manage translation exposure in the same way as they are used for transaction exposure. Netting involves offsetting payables and receivables denominated in the same currency, which reduces the need for currency conversions and mitigates the impact of exchange rate fluctuations.

Economic exposure is the risk that arises from changes in the competitive environment due to fluctuations in exchange rates. Economic exposure arises because exchange rate movements can affect a company's competitiveness in international markets, its cost structure, and its cash flows. Economic exposure can be managed using techniques such as hedging, diversification, and strategic planning.

Hedging involves using financial instruments such as forward contracts, options, and futures to protect against economic exposure. Diversification involves expanding a company's operations to reduce its exposure to a specific market or currency. Strategic planning involves analysing the impact of exchange rate fluctuations on a company's operations and adjusting its business strategy accordingly.

Exchange rate exposure can be managed using a variety of techniques, depending on the type of exposure and the company's risk tolerance. Transaction exposure can be managed using forward contracts, futures contracts, and options contracts. Translation exposure can be managed using forward contracts, currency swaps, and netting. Economic exposure can be managed using hedging, diversification, and strategic planning. Companies must carefully assess their exposure to exchange rate risk and implement a risk management strategy that is appropriate for their specific circumstances. By doing so, they can protect their bottom line and ensure the stability of their operations in the face of currency fluctuations.

Q3) What do you understand by Purchasing Power Parity (PPP) and Interest rate Parity (IRP). Discuss the reasons for their deviation.

Ans) Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are two economic concepts used to explain the behaviour of exchange rates.

Purchasing Power Parity is the theory that in the long run, exchange rates between two countries should equalize the purchasing power of their respective currencies. In other words, the same basket of goods and services should have the same price in both countries, when expressed in the same currency. PPP is based on the idea that goods should have the same price, regardless of where they are produced. The intuition behind PPP is that if the same basket of goods costs more in one country than in another, consumers would buy more of the goods in the cheaper country, leading to an increase in demand for the currency of the cheaper country, and therefore an appreciation of its exchange rate.

Interest Rate Parity (IRP) is the theory that the difference in interest rates between two countries should equalize the expected appreciation or depreciation of their respective currencies. In other words, if the interest rate in Country A is higher than the interest rate in Country B, investors would expect the currency of Country A to appreciate relative to the currency of Country B, and this expected appreciation should offset the difference in interest rates.

However, PPP and IRP do not always hold in practice. There are several reasons for the deviation from these theories:

1. Transaction Costs: In reality, there are costs associated with trading currencies, such as bid-ask spreads, brokerage fees, and taxes. These transaction costs can cause deviations from PPP and IRP.

2. Government Intervention: Central banks and governments can intervene in currency markets to influence exchange rates, which can create deviations from PPP and IRP. For example, a government may buy its own currency in the foreign exchange market to prevent its currency from appreciating too quickly.

3. Speculation: Expectations about future exchange rates can influence current exchange rates. Speculators may buy or sell a currency based on their expectation of future exchange rate movements, which can cause deviations from PPP and IRP.

4. Differences in Inflation Rates: Differences in inflation rates between countries can lead to deviations from PPP. If the inflation rate in Country A is higher than the inflation rate in Country B, the currency of Country A will depreciate relative to the currency of Country B, even if PPP holds.

5. Differences in Risk: Differences in the perceived risk of investing in different countries can lead to deviations from IRP. If investors perceive that the risk of investing in Country A is higher than the risk of investing in Country B, they may require a higher return on their investment in Country A, leading to a higher interest rate and a depreciation of its currency relative to the currency of Country B.

In conclusion, while PPP and IRP are useful economic concepts to explain exchange rate behaviour, they do not always hold in practice. Factors such as transaction costs, government intervention, speculation, differences in inflation rates, and differences in risk can cause deviations from these theories. It is important for investors and policymakers to be aware of these factors when analysing exchange rate movements and making investment decisions.

Q4) What do you understand by Standard Policies issued by ECGC? What risks are covered under these policies?

Ans) The Export Credit Guarantee Corporation is a specialized financial institution that provides export credit insurance to Indian exporters. The ECGC issues various policies that protect exporters against the risks of non-payment and other related risks. These policies are called Standard Policies and cover a range of risks that exporters may face. The Standard Policies issued by ECGC include the following:

1. Standard Policy (Exporters): This policy is designed for exporters who supply goods or services on credit terms to their buyers outside India. The policy covers the risk of non-payment due to commercial or political reasons.

2. Standard Policy (Small Exporters): This policy is like the Standard Policy, but it is designed for small exporters who have an export turnover of up to Rs. 1 crore. The policy covers the risk of non-payment due to commercial or political reasons.

3. Standard Policy (Exporters with Turnover above Rs. 1 crore): This policy is designed for exporters who have an export turnover of more than Rs. 1 crore. The policy covers the risk of non-payment due to commercial or political reasons.

4. Standard Policy (Project Exporters): This policy is designed for project exporters who undertake turnkey projects outside India. The policy covers the risk of non-payment due to commercial or political reasons.

5. Standard Policy (Software Exporters): This policy is designed for exporters of software and related services. The policy covers the risk of non-payment due to commercial or political reasons.

The risks covered under these policies include:

1. Commercial Risks: These are risks related to the buyer's ability to pay, such as insolvency, bankruptcy, and protracted default.

2. Political Risks: These are risks related to government actions, such as war, civil unrest, nationalization, and foreign exchange restrictions.

3. Contractual Risks: These are risks related to the breach of contract by the buyer, such as non-acceptance of goods or services, rejection of goods or services, and cancellation of the contract.

4. Exchange Rate Risks: These are risks related to changes in exchange rates that may affect the value of the exporter's receivables.

5. Country Risks: These are risks related to the economic and political situation in the buyer's country, such as inflation, currency devaluation, and changes in government policies.

ECGC's Standard Policies provide exporters with comprehensive coverage against these risks, which can help them to expand their business by offering credit terms to their buyers without the fear of non-payment. The policies also provide exporters with access to finance, as banks and other financial institutions are more willing to lend to exporters who have export credit insurance.

In conclusion, the Standard Policies issued by ECGC are designed to provide exporters with protection against the risks of non-payment and related risks. The policies cover a range of risks, including commercial, political, contractual, exchange rate, and country risks. By offering export credit insurance, the ECGC helps exporters to expand their business and access finance, which can be a key driver of economic growth.

Q5) What type of risks are present in a portfolio? Which type of risk remains even after portfolio diversification? Describe some of the barriers to international portfolio diversification.

Ans) A portfolio is a collection of financial assets, such as stocks, bonds, and other securities, held by an investor. Investing in a portfolio carries different types of risks, such as market risk, credit risk, interest rate risk, liquidity risk, and geopolitical risk. These risks can be broadly classified into systematic risk and unsystematic risk.

Systematic risk is the risk that affects the entire market or the economy, and it cannot be diversified away by holding a diversified portfolio. Some examples of systematic risk include economic recessions, political instability, changes in interest rates, and natural disasters. These risks are beyond the control of individual investors and can only be managed through macroeconomic policies and regulations.

On the other hand, unsystematic risk is the risk that affects individual securities or companies, and it can be diversified away by holding a diversified portfolio. Some examples of unsystematic risk include company-specific events, such as mergers and acquisitions, regulatory changes, and product recalls. By holding a diversified portfolio, investors can reduce unsystematic risk by spreading their investments across different securities or asset classes.

However, even after diversification, investors may still face some residual risk, which is known as residual risk or idiosyncratic risk. This risk is unique to individual securities or companies and cannot be eliminated through diversification. Residual risk can arise from various factors, such as management changes, accounting scandals, and technological disruptions. Investors can manage residual risk by conducting fundamental analysis of individual securities or companies and staying up to date with industry trends.

One of the main barriers to international portfolio diversification is currency risk, which is the risk that arises from fluctuations in exchange rates. When an investor invests in securities denominated in a foreign currency, they are exposed to currency risk, which can significantly affect their returns. For example, if an Indian investor holds a US stock and the US dollar depreciates against the Indian rupee, the investor's returns will be lower in rupee terms, even if the stock price remains the same.

Another barrier to international portfolio diversification is regulatory risk, which arises from differences in regulations and laws across countries. Investing in foreign securities may involve compliance with various regulations and restrictions, such as taxes, foreign ownership limits, and disclosure requirements. These regulations can be complex and costly to navigate, especially for small investors.

Moreover, information asymmetry can also be a barrier to international portfolio diversification. Investors may not have access to accurate or timely information about foreign securities or companies, which can make it difficult to assess their risk and return potential. This can result in a higher level of risk for international investments compared to domestic investments.

Investing in a portfolio carries different types of risks, including systematic risk and unsystematic risk. Systematic risk cannot be diversified away, while unsystematic risk can be reduced through diversification. However, residual risk remains even after diversification. Barriers to international portfolio diversification include currency risk, regulatory risk, and information asymmetry. Despite these barriers, international portfolio diversification can provide investors with access to a wider range of investment opportunities, which can potentially lead to higher returns and lower risk.