Q5. (b). what are the components of an option premium?

Ans. The options premium is made up of two components: intrinsic value and time value.

The intrinsic value is the difference between the strike price and the asset price for an In-the-
Money put, and the difference between the asset price and the strike price for an In-the-Money
call. The time value portion is made up of several risk factors such as volatility, days to
expiration, dividends and interest rates.

Intrinsic Value

A call option has intrinsic value if the strike price is below the current asset price. A put option
has intrinsic value if the strike price is above the current asset price. In these instances, an
options intrinsic value is the difference between the underlying asset price and the strike price of
the option. Intrinsic value can never be less than zero.

For example:

If XYZ is trading at $80 per share and you own a 90 call option:
$80 90Call = -10, intrinsic = $0.

However, if XYZ is trading at $100 per share:

$100 90Call = 10, intrinsic = $10.

If XYZ is trading at $80 per share and you own a 90 put option:
90Put $80 = 10, intrinsic = $10.
However, if XYZ is trading at $100 per share:
90Put $100 = -10, intrinsic = $0.
Time Value

Most options will trade at a price greater than their intrinsic value; this is the time-value portion
of the options premium. Time value is the amount in dollars the writer of an option is charging
the buyer to assume the price, time and volatility risk of the option.

Time (days remaining until expiration) and volatility are the two main components of time value;
interest rates and stock dividends are a much smaller factor in the pricing equations. The more
time remaining until expiration or the higher the volatility, the greater the risk to the option seller,
and therefore the greater the time-value component of the options premium.

Q7. Discuss the main function of IMF. Discuss the evolution of IMF. Critically examine the
IMF financing facilities and policies to help member to correct balance of payments
problems in a manner that promotes sustained growth.

Ans. The International Monetary Fund (IMF) is an organization of 189 countries, working to
foster global monetary cooperation, secure financial stability, facilitate international trade,
promote high employment and sustainable economic growth, and reduce poverty around the
world.

The principal function of the IMF is to supervise the international monetary system. Several
functions are derived from this. These are: granting of credit to member countries in the midst of
temporary balance of payments deficits, surveillance over the monetary and exchange rate policy
of member countries, issuing policy recommendations. It is to be noted that all these functions of
the IMF may be combined into three.

These are: regulatory, financial, and consultative functions:

Regulatory Function:

The Fund functions as the guardian of a code of rules set by its (AOA Articles of Agreement).

Financial Function:

It functions as an agency of providing resources to meet short term and medium term BOP
disequilibrium faced by the member countries.

Consultative Function:

It functions as a centre for international cooperation and a source of counsel and technical
assistance to its members.

The main function of the IMF is to provide temporary financial support to its members so that
fundamental BOP disequilibrium can be corrected. However, such granting of credit is subject
to strict conditionality. The conditionality is a direct consequence of the IMFs surveillance
function over the exchange rate policies or adjustment process of members.

Evolution of IMF:

The origin of the IMF goes back to the days of international chaos of the 1930s. During the
Second World War, plans for the construction of an international institution for the establishment
of monetary order were taken up.

At the Bretton Woods Conference held in July 1944, delegates from 44 non-communist countries
negotiated an agreement on the structure and operation of the international monetary system.

The Articles of Agreement of the IMF provided the basis of the international monetary system.
The IMF commenced financial operations on 1 March 1947, though it came into official
existence on 27 December 1945, when 29 countries signed its Articles of Agreement (its charter).
Today (May 2012), the IMF has near-global membership of 188 member countries. Virtually, the
entire world belongs to the IMF. India is one of the founder- members of the Fund.

inappropriate policies, or a combination of the two may create balance of payments difficulties in
a countrythat is, a situation where sufficient financing on affordable terms cannot be obtained
to meet international payment obligations. The causes of such difficulties are often varied and
complex. Key factors have included weak domestic financial systems; large and persistent fiscal
deficits; high levels of external and/or public debt; exchange rates fixed at inappropriate levels;
natural disasters; or armed conflicts or a sudden and strong increase in the price of key
commodities such as food and fuel. Some of these factors can directly affect a country's trade
account, reducing exports or increasing imports. Others may reduce the financing available for
international transactions;

IMF lending aims to give countries breathing room to implement adjustment policies and
reforms that will restore conditions for strong and sustainable growth, employment, and social
investment. These policies will vary depending upon the country's circumstances, including the
causes of the problems. For instance, a country facing a sudden drop in the price of a key export
may simply need financial assistance to tide it over until prices recover and to help ease the pain
of an otherwise sudden and sharp adjustment. A country suffering from capital flight needs to
address the problems that led to the loss of investor confidence: perhaps interest rates that are too
low, a large government budget deficit and debt stock that is growing too fast, or an inefficient,
poorly regulated domestic banking system.

To promote sustained growth IMF:

provides a wider safety net for developing countries , effective July 2015: (i) a 50 percent
increase in access to all IMF concessional financing; and (ii) zero percent interest rate for
 IMF lending under the Rapid Credit Facility, targeted at low-income countries hit by
natural disasters or conflicts;

enhances support for developing countries in building capacity in tax policy and
administration, including on international tax issues.

provides supportthrough an infrastructure policy support initiativeto member

countries seeking to scale up public investment in infrastructure.

deepens policy advice on aspects of inclusion and environmental sustainability

Q8. Write a short note on:

(a) forward vs. future contract

Ans.

BASIS FORWARD CONTRACT FUTURE CONTRACT

Definition A forward contract is an agreement between A futures contract is a
two parties to buy or sell an asset (which can standardized contract, traded
be of any kind) at a pre-agreed future point in on a futures exchange, to buy
time at a specified price. or sell a certain underlying
instrument at a certain date
in the future, at a specified
price.
Structure & Customized to customer needs. Usually no Standardized. Initial margin
Purpose initial payment required. Usually used for payment required. Usually
hedging. used for speculation.
Transaction Negotiated directly by the buyer and seller Quoted and traded on the
method Exchange
Market Not regulated Government regulated
regulation market (the Commodity
Futures Trading Commission
or CFTC is the governing
body)
Institutiona The contracting parties Clearing House
l guarantee

Risk High counterparty risk Low counterparty risk

Guarantees No guarantee of settlement until the date of Both parties must deposit an
maturity only the forward price, based on the initial guarantee (margin).
spot price of the underlying asset is paid The value of the operation is
 marked to market rates with
daily settlement of profits
and losses.
Contract Forward contracts generally mature by Future contracts may not
Maturity delivering the commodity. necessarily mature by
delivery of commodity.
Expiry date Depending on the transaction Standardized
Method of Opposite contract with same or different Opposite contract on the
pre- counterparty. Counterparty risk remains while exchange.
termination terminating with different counterparty.
Contract Depending on the transaction and the Standardized
size requirements of the contracting parties.
Market Primary & Secondary Primary

(b) International joint venture

Ans. An international joint venture (IJV) occurs when two businesses based in two or more
countries form a partnership. A company that wants to explore international trade without
taking on the full responsibilities of cross-border business transactions has the option of
forming a joint venture with a foreign partner.

There are several reasons as to why a business may want to enter a joint venture overseas.
Things like lower manufacturing costs, favorable monetary conversion rates, and lower taxes
can all make international joint ventures beneficial. However, even though there are many
advantages to entering an international joint venture, there are considerable risks.

International joint ventures allow businesses to reduce their risk while extending their market
reach to an entirely new area. Having access to a whole new customer base is enticing for
businesses that are having trouble expanding domestically, and at the same time, their partner
will share their valuable resources, such as technology, capital, and knowledge of the local
market. Joint ventures can help a business grow accustomed to a new area, and the local
business will benefit by also having access to their partners resources.

But depending on the country and industry, international joint ventures can be risky. In some
countries, the government may have a particularly large interest in the ownership of
businesses, and they may not be so keen to allow a foreign business in their country. This risk
is particularly high for industries such as banking or defense, as opposed to cell phone
accessory manufacturers.

Another risk of an international joint venture is the possibility of naturalization. A recent

Quality Magazine article discusses international joint ventures and naturalization, and how it
can ruin joint ventures and a foreign business operations:
International ventures involve sovereign risks. Foreign governments often regulate
businesses and can confiscate assets without fair compensation (i.e., nationalization). One
should examine a nations business and political climate and history. If it has a history of
nationalization, there is a substantial risk it will happen again. Foreign companies may be
prohibited from participating in certain critical industries, such as banking or defense.

Generally speaking, naturalization does not happen often and should not immediately deter a
business from entering an international joint venture. However, if a business is considering
entering an international joint venture, they should have a basic knowledge of the countrys
history and customs, along with a comprehensive understanding of its government and its
role in the formation of joint ventures.

(c) Theories of exchange rate determination

Purchasing power parity (PPP):

Macroeconomic analysis relies on several different metrics to compare economic

productivity and standards of living between countries and across time. One popular metric
is purchasing power parity (PPP).

Purchasing Power Parity (PPP) is an economic theory that compares different countries'
currencies through a market "basket of goods" approach. According to this concept, two
currencies are in equilibrium or at par when a market basket of goods (taking into account the
exchange rate) is priced the same in both countries.

This is how the relative version of PPP is calculated:

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1

"P2" represents the cost of good "x" in currency 2

Using PPPs is the alternative to using market exchange rates. The actual purchasing power of
any currency is the quantity of that currency needed to buy a specified unit of a good or
a basket of common goods and services. PPP is determined in each country based on its
relative cost of living and inflation rates. Purchasing power plus parity ultimately means
equalizing the purchasing power of two differing currencies by accounting for differences in
inflation rates and cost of living.
Interest rate parity:

Interest rate parity is a theory in which the interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot exchange rate.
Interest rate parity plays an essential role in foreign exchange markets, connecting interest
rates, spot exchange rates and foreign exchange rates.

If one country offers a higher risk-free rate of return in one currency than that of another, the
country that offers the higher risk-free rate of return will be exchanged at a more expensive
future price than the current spot price. In other words, the interest rate parity presents an
idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the
current exchange rate in one currency for a lower price and then purchase another currency
from a country offering a higher interest rate.

(d) Impact of recent demonetization on exchange rate of rupee

Ans. The government has pulled off arguably the most significant reform measure in its
tenure. While this expeditious move to boldly counter the black money and parallel economy
threat is likely to have significant repercussions, importantly, this effort will have a visible
impact on how the current government's policies are perceived in international circles of
economic power. Most of the macroeconomic impact will be felt in the short-term, though
there are larger implications in the medium- to long term.

We could see some appreciation of the domestic currency in the forex markets as notes in
circulation will decrease. Though the RBI will be monitoring and taking remedial action,
negative impact on international trade cannot be ruled out at this point. Counter moves by the
government are expected to ease this impact.

We are likely to see some decline in inflationary pressures as demand along with household
inflation expectations are likely to go down. This would make the RBI more comfortable on
managing inflation in the future increasing the possibility of rate cuts in the future.

Effect on parallel economy: The removal of these 500 and 1000 notes and replacement of the
same with new 500 and 2000 Rupee Notes is expected to

- remove black money from the economy as they will be blocked since the owners will not be
in a position to deposit the same in the banks,

- Temporarily stall the circulation of large volume of counterfeit currency and

- curb the funding for anti-social elements like smuggling, terrorism, espionage, etc.

Effect on Money Supply: With the older 500 and 1000 Rupees notes being scrapped, until the
new 500 and 2000 Rupees notes get widely circulated in the market, money supply is
expected to reduce in the short run. To the extent that black money (which is not counterfeit)
does not re-enter the system, reserve money and hence money supply will decrease
permanently. However gradually as the new notes get circulated in the market and the
mismatch gets corrected, money supply will pick up.

Effect on Demand: The overall demand is expected to be affected to an extent. The demand
in following areas is to be impacted particularly Consumer goods, Real Estate and Property,
Gold and luxury goods, Automobiles (only to a certain limit).

Effect on Prices: Price level is expected to be lowered due to moderation from demand side.
This demand driven fall in prices could be understood as follows:

Consumer goods: Prices are expected to fall only marginally due to moderation in
demand as use of cards and cheques would compensate for some purchases.
Real Estate and Property: Prices in this sector are largely expected to fall, especially for
sales of properties where major part of the transaction is cash based, rather than based on
banks transfer or cheque transactions. In the medium term, however the prices in this
sector could regain some levels as developers rebalance their prices (probably charging
more on cheque payment).