If 1-Merged

MBA-0000
International Finance
Block
1
FUNDAMENTALS OF INTERNATIONAL
MANAGEMENT
UNIT 1
Introduction to International Finance 7
UNIT 2
Theories of International Trade 13
UNIT 3
International Trade Finance in India 21
UNIT 4
Balance of Payments 34
Expert Committee
Dr. J. Mahender Reddy Prof. P. A. Kulkarni
Vice Chancellor Vice Chancellor
IFHE (Deemed University), Hyderabad Icfai University, Dehradun
Prof. Y. K. Bhushan Dr. O. P. Gupta

Icfai University, Meghalaya Icfai University, Nagaland
Dr. Lata Chakravorty Prof. D. S. Rao

Director Director
IBS Bangalore IBS Hyderabad
Prof. P. Bala Bhaskaran Dr. Dhananjay Keskar

Director Director
IBS Ahmedabad IBS Pune
Prof. P. Ramnath
Director
IBS Chennai
Course Preparation Team
Shri T. S. Rama Krishna Rao Prof. Hilda Amalraj

Icfai University IBS Hyderabad
Ms. Anita Prof. Bratati Ray

Icfai University IBS Kolkata
Ms. C. Padmavathi Dr. Vijaya Lakshmi S

Ms. Sudha Dr. Vunyale Narender

Ms. Sunitha Suresh Prof. Arup Chowdhury

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COURSE INTRODUCTION
Of late, the liberalization of economies was predominantly witnessed than ever before
during the last decades of the twentieth century. This change led to the expansion of
inter-country businesses. With an increase in cross-border operations, companies were
to trade with other countries and in different currencies. This prominent international
trade resulted in tremendous expansion of foreign exchange markets in the world. The
role of currency markets in international trade, exchange rate determination, and
forecasting bears good amount of significance before entering an international trade.
This course provides the inputs essential for decision making using the above
information. A fair amount of understanding is essential to identify different types of
exposures a firm is exposed to due to international trade. This course provides a good
overview of managing different exposures. Besides, it helps to know the various
financial instruments available that can be utilized for investing or borrowing from
international financial markets. The applications of centralized and decentralized cash
management techniques are discussed to manage short-term finances in MNCs. A good
amount of content is dedicated to international trade covering – trade blocks, WTO,
GATT, Documentary Credits, Exim Policy, and Export and Import Finance Regulations.
After reading this course, students would be able to comprehend the following topics.
Introduction to International Finance that outlines the increasing interdependence of
economies due to cross border trade. Further, it highlights the integration of financial
markets, costs, and benefits. The evolution of various prominent international trade
theories is also discussed.
The exchange control regulations related to imports and exports in India and the modes
of financing.
Balance of Payments which systematically records the economic transactions of a
country with the rest of the world. The knowledge of the principles of BoP accounting,
factors affecting BoP, and BoP compilation would help the reader understand the
economic situation of any economy.
Exchange Rate System that determines the framework of exchange rate movements
such as fixed, floating or hybrid. Different types of exchange rate systems that have
evolved and that currently are prevailing in various countries give a manager a fair
picture before undertaking any currency hedging.
The structure and mechanics of currency dealing, types of exchange rate quotations,
computation of forward and spot rates in forex markets etc.
Need for exchange rate determination using Purchasing Power Parity, Interest Parity
and Fischer Effect. An elaborate understanding of this will impact a firm's borrowing
and investing decisions. Further, exchange rate forecasting models are also covered.
Due to cross border transactions, firms are exposed to transaction, translation and
operating exposures. Students will get an understanding of the various internal as well
as external techniques to minimize these exposures are discussed in this course.
Foreign Direct Investment which has taken the center stage in today's trade and business
environment. Students will have a clear picture of the growth of foreign direct
investment that is witnessed across the globe due to growing needs of companies.
The Adjusted Present Value (APV) approach which enables to assess the project
internationally, is discussed in detail.
International financial markets facilitate companies to borrow and invest using financial
instruments. This book gives an extensive coverage of various international instruments
available and their features. Besides, short-term financial management strategies of
MNCs – centralization and decentralization, and their advantages and disadvantages are
discussed. The course also covers international accounting and taxation.
In order to facilitate and increase regional trade, a number of trade blocks were formed.
This book will enable the students to understand the formation of trade blocks, cartels,
bilateral and multilateral trades, and their objectives. The significance of Exim Policy,
role of documentary credits, and the export import policy regulations are also covered.
The course contains five blocks.
BLOCK 1 FUNDAMENTALS OF
INTERNATIONAL MANAGEMNET
This is the introductory block to International Finance. It highlights the significance of
international trade in the wake of globalization. With the increase in cross border trade,
companies from different economies trade in various products and services with a
variety of currencies. This block outlines the significance of international trade, various
international trade theories propounded, relevance of trade barriers, financing imports
and exports, and balance of payments.
Unit 1 of this block covers the meaning and implications of globalization. This unit
briefly discusses the reasons for integration of financial markets, the benefits, the costs
involved, and its effects.
Unit 2 outlines some of the fundamental issues that need to be addressed in the context
of international trade. It also gives an outline of the evolution of various international
trade theories. Further, this unit discusses the need for trade barriers, the types of tariff
and non-tariff barriers, and their advantages and limitations.
Unit 3 discusses the role of Export-Import Bank of India in financing international trade
in India. This unit lists the various financing schemes extended to segments like
companies, foreign governments and to Indian banks.
Unit 4 deals with the basic concepts of economic transactions and principles of Balance
of Payments accounting[v1]. Besides, this unit discusses the factors that affect the
components of BoP and the significance of BoP statistics.
UNIT 1 INTRODUCTION TO
INTERNATIONAL FINANCE
Structure
1.1 Introduction
1.2 Objectives
1.3 Need to Study International Finance
1.4 Meaning and Implications of Globalization
1.5 Integration of Financial Markets
1.6 Summary
1.7 Glossary
1.8 Suggested Readings/Reference Material
1.9 Suggested Answers
1.10 Terminal Questions
1.1 INTRODUCTION
A company with global presence has to deal with complex financial management
processes. The process of financial management gets more complicated with
globalization, when the company has its operations across various countries with a
variety of currencies. International trade, involving exchange of goods and services
across international boundaries global financial activities gained a lot of significance.
This changing scenario makes it imperative for a student of finance to study
international finance. The study of exchange rates, foreign investment and their effect
on international trade is popularly known as international finance.
1.2 OBJECTIVES
After going through the unit, you should be able to:
• Understand the importance of International Finance;
• Define the meaning and implications of globalization;
• Identify the need for integration of financial markets; and,
• Recognize the benefits, costs and effects of integration of financial markets.
1.3 NEED TO STUDY INTERNATIONAL FINANCE

Financial management of a company is a complex process, involving its own methods
and procedures. It is made even more complex because of the globalization taking
place, which is making the world’s financial and commodity markets more and more
integrated. The integration is both across countries as well as markets. Not only the
markets, but even the companies are becoming international in their operations and
approach.
When a firm operates only in the domestic market, both for procuring inputs as well as
selling its output, it needs to deal only in the domestic currency. As companies try to
increase their international presence, either by undertaking international trade or by
establishing operations in foreign countries, they start dealing with people and firms in
various nations. Since different countries have different domestic currencies, the
question arises as to which currency should the trade be settled in. The settlement
currency may either be the domestic currency of one of the parties to the trade, or
may be an internationally accepted currency. This gives rise to the problem of dealing
with a number of currencies. The mechanism by which the exchange rate between
these currencies (i.e., the value of one currency in terms of another) is determined,
along with the level and the variability of the exchange rates, can have a profound
effect on the sales, costs and profits of a firm. Globalization of the financial markets
also results in increased opportunities and risks on account of the possibility of overseas
borrowing and investments by the firm. Again, the exchange rates have a great impact
on the various financial decisions and their movements can alter the profitability of
these decisions.
1.4 MEANING AND IMPLICATIONS OF GLOBALIZATION

In this increasingly globalized scenario, companies need to be globally competitive in
order to survive. Knowledge and understanding of different countries’ economies and
their markets is a must for establishing a company as a global player. This knowledge will
help the company to cater to the different needs and demands of customers in the domestic
and international markets. For instance, in the month of January, 2008, the New York
Times commented that the General Electric is doing well in developing countries by
selling air fleets and aiding their infrastructure development. By the time the market cools
overseas, i.e., in developing countries GE predicts that the domestic market i.e., the United
States will be ready to buy again.
Studying international finance helps a finance manager to understand the complexities
of the various economies. It can help him understand as to how the various events
taking place the world over are going to affect the operations of his firm. It also helps
him to identify and exploit opportunities, while preventing the harmful effects of
international events. A thorough understanding of international finance will also assist
the finance manager in anticipating international events and analyzing their possible
effects on his firm. He would thus get a chance to maximize profits from opportunities
and minimize losses from events which are likely to affect his firm’s operations
adversely.
Companies having international operations are not the only ones which need to be
aware of the complexities of international finance. Even companies operating
domestically need to understand the issues involved. Though they may be operating
domestically, some of their inputs (raw materials, machinery, technological know-how,
capital, etc.) may be imported from other countries, thus exposing them to the risks
involved in dealing with foreign currencies. Even if they do not source anything from
outside their own country, they may have foreign companies competing with them in
the domestic market. In order to understand their competitors’ strengths and
weaknesses, awareness and understanding of international events again gains
importance.
What about the companies operating only in the domestic markets, using only
domestically available inputs and neither having, nor expecting to have any foreign
competitors in the foreseeable future? Do they need to understand international finance?
The answer is in the affirmative. Globalization and deregulation have resulted in the
various markets becoming interlinked. Any event occurring in, say Japan, is likely to
8
Introduction to
affect not only the Japanese stock markets, but also the stock markets and money
markets the world over. For example, the forex and money markets in India have
become totally interlinked now. As market players try to profit from the arbitrage
opportunities arising in these markets, the events affecting one market also end up
affecting the other market indirectly. Thus, in case of occurrence of an event which has
a direct effect on the forex markets only, the above mentioned domestic firm would also
feel its indirect effects through the money markets. The same holds good for
international events, thus, the need for studying international finance.
1.5 INTEGRATION OF FINANCIAL MARKETS

Integration of financial markets to an investor means the freedom to invest or raise
funds across various markets in various financial instruments. The advent of
globalization has resulted in quick dissemination, money transfers and reduced
transaction costs. Technology has played a key role in this process. As a result of
financial integration, any factor affecting one market automatically and quickly affects
the rest of the globe. This effect is referred to as the transmission effect. Due to increase
in inflation levels of different countries, the price of various financial assets varied with
regard to change in domestic inflation rates as well as interest rates of various countries.
These developments resulted in the development of new financial instruments, namely,
interest rate swap, currency swap, future contracts, options etc. It also led to
liberalization of various regulations governing the financial markets and helped the
countries in increasing international perspective with regard to different factors which
create an impact on globalization.
Effective integration of financial markets demonstrates better transfer of resources
between surplus units and deficit units. Capital-rich countries experience lower return
on capital compared to capital-poor countries. On the other hand, integration also
involves risks such as currency risk, country risk, market risk and other various risks.
Variation in the value of investment in terms of domestic currency, denoted in other
countries’ currency is known as currency risk. It arises when the investor is unable to
disinvest at will because of a country’s sudden change in attitude towards foreign
investment or any other factor such as war. Increase in volatility is the effect of
globalization and integration of financial markets. Interest rates, exchange rates etc.,
keep changing regularly because of the changes occurring in different segments of
various financial markets in the world.
Self-Assignment Questions
a. Define international finance.
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b. Discuss various implications of globalization.
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9
1.6 SUMMARY
Happenings in and around the world in the name of globalization are becoming a never
ending process providing lots of opportunities to grow in the arena of international trade
along with various threats which need to be thwarted.
Today all the aspects of international trade can be coolly handled by having a better
understanding of it.
1.7 GLOSSARY
Country Risk is the risk perceived by a non-resident while dealing with a country in a
commercial and/or investment transaction, which arises out of political and economic factors.
Currency Swap is a contract involving exchange of interest payments on a loan in one
currency for fixed or floating interest payments on equivalent loan in a different currency.
Future Contracts is a contract which is exchange traded subjected to losses/gains
arriving out of daily changes in underlying asset such as foreign currencies or
commodities etc.
Globalization is the process of integration of the world community into a common
system – either economical or social.
Interest Rate Swap means an agreement between two or more parties to exchange
interest payments over a specific time period on agreed terms.
International Finance is the study of exchange rates, foreign investment and their
effect on international trade.
International Trade is exchange of goods and services across international boundaries.
Option is a contract in which the seller grants the buyer, the right to purchase from the
seller a designated instrument or an asset at a specific price which is agreed upon at the
time of entering into the contract.
1.8 SUGGESTED READINGS/REFERENCE MATERIAL

• Seth, A.K. International Financial Management.
• Maurice D. Levi. International Finance.
• Francis Cherunilam. International Business Environment.
1.9 SUGGESTED ANSWERS

Self-Assignment Question
a. International finance is a branch of international economics that studies the
dynamics of exchange rates, foreign investment, and how these affect
international trade. Besides, it studies international projects, international
investments and capital flows, and trade deficits. It includes the study of futures,
options and currency swaps
b. Implications of globalization: Globalization has both positive and negative effects.
It has brought new opportunities to developing countries. Greater access to
developed country markets and technology transfer hold out promise improved
productivity and higher living standard.
It has brought new challenges like growing inequality across and within nations.
Any volatility/adversity in one financial market would spread across other
countries quickly. Another negative aspect of globalisation is that a great
majority of developing countries remain away from the process.
10
Introduction to
1.10 TERMINAL QUESTIONS
A. Multiple Choices
1. Which of the following statements is true regarding international finance?
a. Companies having international operation only need to understand
international finance.
b. Foreign companies situated in domestic markets only need to understand
international finance.
c. Domestic companies having stake in foreign companies need to
understand international finance.
d. Foreign companies having stake in domestic companies need to
understand international finance.
e. All the companies need to understand international finance.
2. Which of the following is/are settlement currency between international parties
to trade?
a. Domestic currency of any one of the parties only.
b. US Dollars only.
c. Euro only.
d. Internationally accepted currency only.
e. Both (a) and (d) of the above.
3. Diversification of securities is possible only when which of the following is true?
a. Securities are negatively correlated.
b. Securities are inversely correlated.
c. Securities are perfectly correlated.
d. Securities are perfectly positively correlated.
e. Securities are proportionately correlated.
4. Which of the following implies, ‘integration of financial markets across
geographical boundaries’?
a. Liberalization.
b. Market integration.
c. Globalization.
d. Privatization.
e. None of the above.
5. Globalization led to the development of which of the following financial
instruments?
a. Currency swap.
b. Interest rate swap.
c. Euro-dollar market instruments.
d. Options.
e. All of the above.
11
B. Descriptive
1. Explain the significance of studying international finance.
2. What is integration of markets? Discuss reasons, benefits and costs associated
with integration.
These questions will help you to understand the unit better. These are for your
practice only.
12
UNIT 2 THEORIES OF
INTERNATIONAL TRADE
Structure
2.1 Introduction
2.2 Objectives
2.3 Theory of Absolute Advantage
2.4 Theory of Comparative Advantage
2.5 Heckscher-Ohlin Model
2.6 Imitation-Gap Theory
2.7 International Product Life Cycle Theory
2.8 Developments on the International Trade Front
2.9 Trade Barriers
2.10 Summary
2.11 Glossary
2.1 INTRODUCTION
A well-developed global financial system is essential for supporting increased
international trade. The international payment system, the availability of international
credit and credit guarantees (all forming a part of the international financial system),
form the backbone of international trade. Theories of international trade are significant
as they throw light on certain basic issues of international trade as:
• Why does international trade take place?

• Which countries should participate in the trade?
• Why should a country export or import from a particular country?
Some major theories of international trade are:
i. Theory of Absolute Advantage.
ii. Theory of Comparative Advantage.
iii. Heckscher-Ohlin Model.
iv. Imitation-Gap Theory.
v. International Product Life Cycle Theory.
2.2 OBJECTIVES
• Identify the significance of international trade theories;
• Understand the major theories propounded in international trade;
• Explain the developments on the international trade front; and
• Recognize various forms of trade barriers in international trade.
2.3 THEORY OF ABSOLUTE ADVANTAGE

Adam Smith proposed the Theory of Absolute Advantage was proposed by Adam
Smith in 1776. According to this theory, international trade occurs because of ‘benefit
of specialization’ between any two countries. Where each country is comfortable and
more efficient in producing a particular good than the other, there is an incentive to
trade. Both the countries can gain from specialization, which in turn enhances the
productivity. So countries trade in goods they specialize in and thus benefit paving the
way to greater productivity. Let us consider two countries, Saintland and Starsburg.
Saintland can produce a television using 15 units of labor and Starsburg can produce
bikes using 20 units of labor. Conversely, Saintland needs 30 units of labor to produce
one electronic bike and Starsburg needs 25 units of labor to produce one digital
television. In other words, Saintland enjoys an absolute advantage in producing
televisions and Starburg in producing bikes. The remaining factors are used in the same
proportion by both the countries. These specialized goods will be traded between them.
So, Saintland using 15 units will produce a television, exchange it for one bike and use
the remaining 15 units to produce a television for its own use. In this way Saintland
experiences the satisfaction of using both television and a bike. Such a trade results in
proper utilization of resources between countries leading to higher productivity.
Limitations
i. This theory elucidates causes of international trade only when the trading
countries have absolute advantage in producing at least one product.
ii. This theory works on the assumption that transportation costs involved in the trade
are not important in comparison to degree of comparative advantage.
iii. This theory believes in stability of exchange rates.
2.4 THEORY OF COMPARATIVE ADVANTAGE

David Ricardo proposed the Theory of Comparative Advantage in 1817. According to
this theory, two countries can gain in trade, when one of them has an absolute advantage
in producing at least one good. Here comparative advantage implies lesser opportunity
cost in producing a commodity. For example, let us assume that US and Japan are
efficient in producing iron and copper as shown in Table 1.
Labor-hours required
1 unit of Product A 1 unit of Product B
US 10 20
Japan 20 25
Table 1
US enjoys absolute advantage in producing Product A as well as Product B, as the
number of labor hours needed to produce one unit of each commodity is lesser than that
required by Japan. Let us further consider that 500 units of labor-hours are available.
These 500 units can be used in producing either Product A or Product B. If US uses
these units for producing only Product A, then it will be able to produce 50 (500/10)
units of Product A. But, if it produces only Product B, it can produce 25 (500/20) units
14
Theories of International Trade
of Product B. In the same way, Japan can produce 25 units of Product A and 20 units of
Product B. To produce each unit of Product A, certain number of units of Product B has
to be foregone and vice-versa. This quantity of Product B foregone to produce an
additional unit of Product A is called opportunity cost. As US can produce either 50
units of Product A or 25 units of Product B with available resources, the opportunity
cost of Product A for US would be 0.5 (25/50) and for Product B, it would be 2 (50/25).
Similarly, for Japan the opportunity cost for producing one unit of Product A would be
0.8 and for Product B, it would be 1.25. So, US has lower opportunity cost for Product
A and thus enjoys comparative advantage in producing Product A, while Japan enjoys
the same advantage in producing Product B. This theory of comparative advantage is
based on certain implicit assumptions such as perfect competition with flexible prices
and wages in both the countries, constant marginal product of labor in both the
countries, full employment in the countries, free mobility of labor between countries
and no technological innovation in any of the economies. Comparative advantage theory
is widely used across nations.
Limitations
i. This theory does not hold good when the economy suffers from recession or
malfunctions.
ii. Assumptions of perfect competition and absence of any technological innovation
are inflexible.
iii. This theory suffers from the same drawbacks as absolute advantage theory.
2.5 HECKSCHER-OHLIN MODEL

Eli Heckscher and Bertil Ohlin developed this model in the 1920s considering two types
of products, namely, labor intensive and capital intensive. According to this model, a
labor-rich country producing labor-intensive goods trades with a capital-rich country
producing capital intensive goods and can enjoy the benefits of international trade. This
theory is based on assumptions such as constant or decreasing returns to scale, same level
of technology in both the countries leading to same level of efficiency, labor and capital
are perfectly immobile for inter-country transfers and perfectly mobile for inter-sector
transfers, commodity and factor markets are perfectly competitive and there are no
obstructions to trade.
Limitations
i. This theory considers given factor endowments which can actually be innovated.
ii. The assumption of a labor-rich country producing labor-intensive products and a
capital-rich country producing capital-rich goods is not always correct due to
minimum wage laws prevalent in some countries.
2.6 IMITATION-GAP THEORY

According to this theory proposed by Posner, two countries having similar factor
endowments and consumer tastes prefer to trade. This could be due to continuous
inventions and innovations of products that replace the existing ones. The degree of this
trade depends on the variance between the demand lag and imitation lag. The time gap
between the launch of a new or improved product in the country and its demand by
consumers in another country is called demand lag. Similarly, if the difference in time is
15
because of launch of product in one country and its production in another country by the
producers of that country, it is called imitation lag. When imitation lag is shorter than
demand lag, no trade exists between the countries. When the demand lag is shorter than
the imitation lag, then the country which has brought out the innovation will start
exporting to another country as the consumers of that country come to know of their
product and consequently exports will increase. These exports increase till (close of
demand lag) all the consumers of that country become aware of the product. In case the
local producers of the importing country start producing the same product then they can
reduce imports into their country. When imitation lag comes to an end, the trade
declines and is finally eliminated.
2.7 INTERNATIONAL PRODUCT LIFE CYCLE THEORY

Vernon explained the various stages of international product life cycle in international
trade. This process considers technological innovation and market structure as two
important factors. This theory is based on the following principles:
• New products are developed as a result of technological innovations.
• Trade patterns are determined by the market structure and the phase in a new
product’s life.
According to this theory rich and developed countries concentrate on innovations. The
new product is initially produced and exported by the country which has innovated. In the
next stage the production of this new product shifts to other developed countries giving
rise to cost advantage. In the last stage the production shifts to very less developed
countries. This ultimately leads to change – the earlier exporting countries would now
prefer to import due to cost efficiency.
Self-Assignment Questions – 1
a. Explain in brief the significance of comparative advantage theory.
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b. Define ‘demand lag’ and ‘imitation lag’.
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2.8 DEVELOPMENTS ON THE INTERNATIONAL TRADE FRONT

Intra-Industry Trade
When a particular country exports and imports simultaneously the same product, it is
known as intra-industry trade. This trade is promoted by various reasons like
transportation costs involved in trade, seasonal differences and product differences.
16
Other factors effecting international trade include high re-entry costs, economies of
scale, currency value, consumer tastes and imperfect competition.
Growth of International Trade
Trade between nations requires countries to specialize in a particular product and this in
turn leads to proper allocation and utilization of world resources. Benefits to producers
and customers by way of specialization, economies of scale and wide range of products
to choose from has led to the growth of international trade.
Risks Involved in International Trade
International trade involves additional risks, namely, exchange risk and country risk.
Exchange risk arises because of uncertainty in return due to unexpected changes in
exchange rates. Similarly, country risk arises when an exporter does not receive his
payment from the importer because of country specific reasons.
2.9 TRADE BARRIERS

To discourage imports, governments put up trade barriers. Trade barriers can be tariff or
non-tariff barriers.
Tariff Barriers
When tax is levied on internationally traded goods, it is known as tariff. If it is collected

on imported goods it is called import duty and tariff on exported goods is called export
duty. Tariff can be either specific duty, ad valorem duty or a compound duty. Tariff
barriers include technical barriers, procurement policies, international price fixing,
exchange controls, direct and indirect restrictions on foreign investments, customs
valuation and transportation costs.
Non-tariff Barriers
All rules, regulations and bureaucratic delays in restricting foreign goods from entering
into domestic markets are known as non-tariff barriers. They include quotas, embargo,
voluntary export restraint, subsidies to local goods and local content requirement.
Reasons for Imposition of Trade Barriers
• It is a source of revenue to the government.
• Sometimes trade barriers are imposed by the government keeping in view the
economic welfare of the nation.
• It improves the economic condition of the country.
• It results in free trade implications.
• It protects the domestic industry that has great growth potential.
• It acts as a retaliator for other countries imposing trade barriers.
• It reduces expenditure in foreign currency by the citizen, to improve balance of

payment situation.
17
Costs of Trade Barriers
Trade barriers affect the economy in three ways:
• Increase in cost of foreign goods and shift in domestic demand towards

domestically produced goods.
• Due to higher price consumers consume less of that particular good.
• Tariff generates revenue for the government.
The first two affects involve economic cost and the third does not involve any economic
cost.
a. Elucidate in brief risks in international trade.
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b. Discuss tariff barriers vs. non-tariff barriers.
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2.10 SUMMARY
Theories of international trade help understand certain basic issues of international trade
which is developing at a rapid pace. Major theories of international trade are Theory of
Absolute Advantage, Theory of Comparative Advantage, Heckscher-Ohlin Model,
Imitation-Gap Theory, and International Product Life Cycle Theory.
Simultaneous export and import of a product by a particular country is called intra-

industry trade.
Additional risks involved in international trade are exchange risk, and country risk.
Trade barriers are of two types, namely tariff, and non-tariff barriers. When tax is levied
on goods in international trade, it is known as tariff and includes exchange controls,
customs valuation procurement policies etc. Any rules, regulations and bureaucratic
delays in restricting the flow of foreign goods into domestic markets are included under
the head, non-tariff barriers such as quotas, embargo etc.
Trade barriers are imposed on account of various reasons such as to improve economic
conditions of the country, enhance economic welfare, and to attain national goals etc.
18
2.11 GLOSSARY
Embargo is a complete ban of imports from a specific country.
Quota means a limit on the number of units to be imported or a market share to be held
by foreign producers.
Tariff is the tax levied on goods in international trade.

• Machiraju, H.R. International Financial Management.

a. The theory of comparative advantage explains - how a trade can create value for
both parties even when one can produce all goods with fewer resources than the
other. The net benefits of such an outcome are called gains from trade.
b. The degree of the trade depends on the variance between the demand lag and
imitation lag. The time gap between the launch of a new or improved product in
the country and its demand by consumers in another country is called demand
lag. Similarly, if the difference in time is because of launch of product in one
country and its production in another country by the producers of that country, it
is called imitation lag. When imitation lag is shorter than demand lag, no trade
exists between the countries. When the demand lag is shorter than the imitation
lag, then the country which has brought out the innovation will start exporting to
another country as the consumers of that country come to know of their product
and consequently exports will increase. These exports increase till (close of
demand lag) all the consumers of that country become aware of the product. In
case the local producers of the importing country start producing the same
product then they can reduce imports into their country. When imitation lag
comes to an end, the trade declines and is finally eliminated.
a. International trade involves additional risks, namely, exchange risk and country
risk. Exchange risk arises because of uncertainty in return due to unexpected
changes in exchange rates. Similarly, country risk arises when an exporter does
not receive his payment from the importer because of country specific reasons.
b. Tariff Barriers When tax is levied on internationally traded goods, it is known
as tariff. If it is collected on imported goods it is called import duty and tariff on
exported goods is called export duty. Tariff can be either specific duty, ad
valorem duty or a compound duty. Tariff barriers include technical barriers,
procurement policies, international price fixing, exchange controls, direct and
indirect restrictions on foreign investments, customs valuation and transportation
costs.
Non-tariff Barriers: All rules, regulations and bureaucratic delays in restricting
foreign goods from entering into domestic markets are known as non-tariff
barriers. They include quotas, embargo, voluntary export restraint, subsidies to
local goods and local content requirement.
19
A. Multiple Choices
1. Who amongst the following proposed the Imitation-gap theory?
a. Bertil Ohlin.
b. David Ricardo.
c. Vernon.
d. Posner.
e. Adam Smith.
2. Which of the following is not an assumption made by David Ricardo?
a. Productivity of labor.
b. Partial employment.
c. Perfect competition.
d. Mobility.
e. Technology.
3. Which of the following duties is levied on goods taken out of the country?
a. Import duty.
b. Foreign duty.
c. Export duty.
d. Specific duty.
e. Compound duty.
4. Duty drawback allowed for exported goods is an example of ____________
a. Quota
b. Tariff
c. Embargo
d. Subsidy
e. Export Restraint.
5. Which of the following theories of International Trade explains the trade
between two countries having similar factor endowments and consumer tastes?
a. Theory of absolute advantage
b. Theory of comparative advantage
c. Heckscher-Ohlin model
d. Imitation-Gap theory
e. International product life cycle theory.
B. Descriptive
1. Explain the various theories of international trade in detail.
2. What is intra-industry trade? Mention the reasons that have contributed to its
popularity.
3. What are Non-Tariff Barriers? Discuss different types of NTBs.
4. ‘Tariffs are sources of revenue to the government’. Explain.
practice only.
20
UNIT 3 INTERNATIONAL TRADE
FINANCE IN INDIA
Structure
3.1 Introduction
3.2 Objectives
3.3 The Role of Exim Bank of India in Trade Finance
3.3.1 Lending
3.3.2 Lending to Indian Companies
3.3.3 Lending to Foreign Governments and Foreign Companies
3.3.4 Lending to Indian Banks
3.4 Global Trade Finance Limited
3.5 Exchange Control Regulations Related to Merchant Transactions
3.6 Summary
3.7 Glossary
3.1 INTRODUCTION
International trade finance comprises various aspects related to international trade
finance[v1]. Export-Import Bank of India (EXIM Bank), one of the top financial
institutions in the country, was set up to promote and finance international trade.
3.2 OBJECTIVES
• Understand the role of EXIM Bank in trade finance; and
• Know the exchange control regulations related to merchant transaction.
3.3 THE ROLE OF EXIM BANK OF INDIA IN TRADE FINANCE

The Export-Import (EXIM) Bank was set up to finance and promote foreign trade. The
EXIM Bank extends finance to exporters of capital and manufactured goods, exporters
of software and consultancy services and to overseas joint ventures and
turnkey/construction projects. Term loans are also extended to projects located in export
zones.
EXIM bank financing can, if required, supplement working capital finance extended by
commercial banks at pre-shipment stage. The functions of the EXIM bank are lending,
guaranteeing, promotional services and advisory services.
3.3.1 Lending
To Indian Companies To Foreign Govt., To Indian Banks
Foreign Companies
1. Direct Assistance 1. Buyers’ Credit 1. Bill Rediscounting

2. Consultancy and 2. Lines of Credit 2. Refinance
Technology Services
3. Overseas Investment 3. Relending Facility
Finance
4. Pre-shipment Credit
5. Deemed Exports
6. 100% Export Oriented
Units and Free Trade
Zones
7. Forfaiting
3.3.2 Lending to Indian Companies

Direct Assistance
Funds are provided on deferred payment terms to Indian exporters of plant, equipment
and related services, which enable them to extend deferred credit to the overseas buyer.
Credit is provided by EXIM bank in participation with commercial banks. Banks
provide the credit and they can avail of refinance from the EXIM bank. The exporter is
expected to obtain an advance and a down payment of at least 15 percent of the contract
value.
Consultancy and Technology Services
Indian companies executing overseas contract involving consultancy and technology
services, can avail of EXIM’s financing program, to offer deferred payment terms to
their clients. The credit may be extended to the Indian company either by EXIM bank in
participation with commercial banks, or directly by commercial banks who could in turn
seek refinance from EXIM bank. The Indian company in turn would offer deferred
payment terms to their clients.
The credit normally given in Indian rupees is repayable in half-yearly installments over
a period not exceeding five years. Guarantee of foreign government or a
guarantee/irrevocable LC of an acceptable bank would need to be obtained. The Indian
company also has to obtain ECGC insurance cover and assign it in favor of the bank.
Overseas Investment Finance
The EXIM bank provides export credits to Indian promoters for their equity
contribution to overseas joint ventures. The funds are in the form of long-term credit not
exceeding ten years. EXIM bank’s finance will be made available to Indian promoters
by way of,
i. Rupee term loans for financing equity contribution.
ii. Foreign currency loans/guarantees, where the equity contribution is allowed by
the Government of India out of foreign currency loan to be raised by the Indian
promoter.
22
International Trade
Finance in India
Equity contribution by Indian promoters can be in various forms such as:
a. Capitalization of proceeds of exports in the form of plant and machinery.
b. Technical know-how.
c. Capitalization of earnings such as royalty and management fees.
d. Cash remittances.
Where cash remittances are allowed, Indian promoters are granted approvals to remit
foreign exchange from India or raise foreign currency loans for the purpose of equity
contribution.
The quantum of finance will be determined with reference to the Indian promoters’
share in the equity structure of overseas joint ventures, subject to a maximum of 80
percent of the Indian promoters’ equity contribution. Commercial banks may also opt to
take up risk participation in term loans and guarantees extended by EXIM bank.
Pre-shipment Credit
If the requirement of pre-shipment credit by exporters is for periods in excess of 180
days, EXIM bank participates in the credit.
Financing Deemed Exports
Deemed exports occur in case of specified transactions within India, which result in
foreign exchange earnings or savings as given below:
i. Supplies made in India to World Bank/IDA-aided projects against international

competitive bidding.
ii. Supplies to free-trade zones/100 percent export oriented units.
iii. Sales to foreign shipping companies.
iv. Supplies to ONGC and Oil India Ltd., for offshore and onshore drilling
operations.
Deemed exports can avail of EXIM bank’s deferred credit facility. EXIM bank may
participate with commercial banks in extending rupee loans for bridging cash flow
deficits of projects/supply contracts; EXIM bank also issues guarantees and provides
bridge finance in foreign currency.
Capital and producer goods are eligible for medium-term credits. Long-term credits up
to ten years are provided in exceptional cases. Credit is normally secured by a bank
guarantee.
Assistance to Export-Oriented Units

Free-trade zones and export-oriented units are given finance for acquisition of land,
building, plant and machinery, preliminary and pre-operative expenses and working
capital (as margin money). EXIM bank’s assistance will be in the form of direct
assistance given as rupee term loans or deferred payment guarantees or indirect
assistance as refinance to commercial banks.
The export-oriented units seeking EXIM’s finance will have to establish the technical,
economic and financial feasibility of their projects.
23
Forfaiting
Forfaiting is a common form of financing export related receivables. It is similar to Bill

Rediscounting Scheme. EXIM Bank has introduced this scheme for the Indian
exporters. Under this scheme, the exporter after finalization of the sale (or contract) with a
prospective buyer furnishes all the necessary details regarding the contract to the EXIM
Bank through which a contract of forfaiting is finalized by the exporter with the
overseas forfaiting agency. The exporters draw a series of bills of exchange on the
overseas buyers’ which will be sent along with the shipping documents to the buyer’s
bank for overseas buyers’ acceptance. Overseas buyers’ bankers will hand over to the
exporter the documents against the acceptance of the buyer and signature of ‘aval’ or the
guaranteeing bank. The exporter will submit to his bank to be forwarded to EXIM Bank
which passes the documents to the forfaiting agency. Proceeds of the bills are passed
from the overseas forfaiting agency to the exporter through the EXIM Bank. From October
1997, the authorized dealers are allowed to undertake forfaiting of medium-term export
receivables.
Figure 1: A Flow Chart of a Forfaiting Transaction

1. Commercial contract between the foreign buyer and the Indian exporter.
2. Commitment to forfait bills of exchange/promissory notes (debt instruments).
3. Delivery of goods by the Indian exporter to the foreign buyer.
4. Delivery of debt instruments.
5. Endorsement of debt instruments without recourse in favor of the forfaiter.
24
International Trade
Finance in India
6. Cash payment of discounted debt instruments.
7. Presentation of debt instruments on maturity.
8. Payment of debt instruments on maturity.
Self Assessment Questions – 1
a. What is overseas investment finance by EXIM Bank?

……….……………………………………………………………………
……….……………………………………………………………………
……….……………………………………………………………………
b. Discuss steps in a forfaiting transaction.
……….……………………………………………………………………
……….……………………………………………………………………
……….……………………………………………………………………
3.3.3 Lending to Foreign Governments and Foreign

Companies
Buyers’ Credit
Credit is given to buyers abroad to enable them to import engineering goods from India
on deferred payment terms. The loan facility is to be secured by a letter of credit or a
bank guarantee.
Lines of Credit
EXIM bank also extends lines of credit to overseas governments or agencies nominated
by them, to enable buyers in these countries to import capital/engineering goods from
India on deferred payment terms. The exporters can obtain payment from EXIM bank
against negotiation of shipping documents.
Relending
An overseas bank can enter into a credit line agreement with EXIM bank. The overseas
bank would relend the funds to importers of capital goods, consumer durables and
services from India. The borrowing bank may be a commercial bank, a central bank, an
investment/merchant bank with a good credit standing.
Figure 2: Specimen Copy of a Promissory Note

25
Figure 3: Specimen Copy of a Bill of Exchange

Loans will be denominated in US dollars and repayment will also be in the same
currency. Short-term loans extending from 180 days to one year are repayable by
quarterly/half-yearly installments. Medium-term loans are also given.
The relending facility will operate as follows:
a. The borrowing bank, upon its approval of a sub-loan to an importer, opens
irrevocable letters of credit in favor of the Indian exporter through EXIM bank or
banks designated by the latter.
b. The Indian exporter ships goods and presents shipping documents to EXIM bank
or banks designated by the latter.
c. EXIM bank pays to the Indian exporter the rupee equivalent.
d. EXIM bank or the negotiating bank in India forwards shipping documents to the
borrowing bank, together with the advice of having made disbursement to the
supplier.
3.3.4 Lending to Indian Banks
Rediscounting of Export Bills
Commercial banks that are authorized dealers can rediscount their short-term usance
export bills with EXIM bank.
Refinance for Deferred Payment Exports
Deferred payment exports arise when export proceeds are to be received after six
months from the date of shipment. EXIM bank offers hundred percent refinance facility
to banks, which enables a bank to extend deferred credit to an Indian exporter against
supplier’s credit offered by the exporter to the overseas buyer. Capital goods, consumer
durables and industrial manufactures can be considered for deferred credit.
GUARANTEES
Overseas Construction Projects
Guarantees are issued by the EXIM bank on behalf of exports of turnkey projects and
construction contracts. Such guarantees include:
i. Bid bond guarantee.
ii. Advance payment guarantee.
26
International Trade
Finance in India
iii. Performance guarantee.
iv. Retention money guarantee.
v. Guarantee for borrowing abroad.
Bid bond guarantee is issued for a maximum period of six months. For advance payment
guarantee, exporters are expected to secure mobilization advance of 10-20 percent of
contract value. Performance guarantee for 5 to 10 percent of contract is issued and is valid
up to one year after completion of the contract. Guarantee for release of retention money
enables the exporter to obtain the release of full payments.
Bridge finance may be needed at the earlier phases of the contract. Up to 10 percent of the
contract value may be raised in foreign currency from a foreign bank against the EXIM
bank’s guarantee for borrowing abroad.
Syndication of Export Credit Risks
EXIM bank and other banks participating in the funding of a loan would syndicate the
respective credit risks to other eligible commercial banks, who would assume part of the
total risk. Proposals valued at more than Rs.1 crore, entailing deferred credit exports of
engineering goods and services, are forwarded by the sponsoring bank for consideration
by an inter-institutional working group which meets at Mumbai, with EXIM bank as the
focal point. While clearing the proposal, the participation arrangement for the funding
of export credit is also determined.
Software Exports
The new policy of the government on computer software exports and development has
rationalized the system of facilities and incentives for exports. Under the new policy,
EXIM bank has been designated as an agency for facilitating speedy clearances and
meeting foreign exchange requirements towards imports for computer software export
where export obligation of 350 percent of foreign exchange used is undertaken. EXIM
bank will undertake financial and technical analysis of Software export proposals and
monitor the progress.
EXIM bank extends advisory services to exporters in several areas and undertakes
promotional activities like techno-economic surveys collecting and disseminating
market information.
EXIM bank offers an integrated package covering foreign currency and rupee term
finance for acquisition of imported and indigenous computer/computer-based systems
for export purposes. EXIM bank welcomes the association of commercial banks for
providing working capital finance for software export projects assisted by it. A rebate of
50 percent on customs duty payable on import of computer system is available to
software exporters opting for 350 percent export obligation.
Export and import transactions are governed by the EXIM policy and the RBI exchange
control regulations. While the EXIM policy regulates the movements of goods and
services by prescribing the permissible exports and imports, the RBI regulations
regulate the corresponding payments for these international transactions. While
extending credit for any such trade, the banks need to make sure that the respective
guidelines have been followed by the concerned parties.
27
3.4 GLOBAL TRADE FINANCE LIMITED
Global Trade Finance Limited (GTF) provides international factoring, import factoring,
domestic factoring, and forfaiting services in India. GTF is a member of Factors Chain
International (FCI), a global association of international factoring companies established
in 1968. FCI played a major role in bringing factoring into most countries and today it
has a membership of 216 factoring companies operating in 62 countries. GTF
commenced its operations in India in September 2001. It was established as a joint
venture promoted by EXIM Bank; West LB, Germany; and IFC, Washington (the
private sector arm of World Bank). GTF is managed by an independent ‘Board’ of 7
Directors. It has received Authorized Dealer status (to conduct Foreign Currency
operations in India) from RBI, in addition they are conducting factoring by forfaiting to
support exporters and importers. The Head Quarters of GTF is located at Mumbai and
its six regional offices are at New Delhi, Bangalore, Chennai, Hyderabad, Ahmedabad,
and Kolkata. The aim of GTF is to be the premier export and import solution provider in
India offering professional quality services on an e-commerce platform. According to
GTF, international trade on the basis of LC’s is gradually becoming extinct. “Open
Account”1 and “Extended Credit”2 is becoming a pre-requisite for increasing sales volume
in global market. Hence, GTF is helping with its export factoring product that provides
credit assessment, credit protection, financing and collection services to exporters for
regular sales on open account terms. The products and services offered by GTF can be
classified as follows:
Products
• Export
– International Factoring
– Forfaiting
• Domestic
– Domestic Factoring
– Channel Financing
• Import Factoring
• Other products
– LC Discounting (Export/Domestic)
– Reverse Factoring or Purchase Bill Discounting.
Services
• Finance
• Credit Protection
• Collection Service
• Professional Sales Ledges Management of Analysis.
1 Payment of international trade transactions can be made on an “Open Account”. The seller
ships the goods and forwards the documents directly to the buyer. The buyer clears the goods
upon arrival and arranges for payment either by bank draft or SWIFT transfer. Society for
Worldwide Interbank Financial Telecommunications is a computerized method by which
banks all over the World are corresponding in a secure and standardized way.
2 Extended credit refers to credit extended by exporters to importers (i.e., Supplier Credit) or
Medium to Long-Term (MLT) loans made by banks (or EXIM Banks), used to finance projects
and capital goods exports (i.e., buyer credit).
28
International Trade
Finance in India
3.5 EXCHANGE CONTROL REGULATIONS RELATED TO
MERCHANT TRANSACTIONS
Exchange controls were introduced in India in 1939, during the World War II, to
conserve foreign exchange, particularly the US dollar, for meeting essential defence
expenditure. The main purpose of exchange controls is to conserve foreign exchange
and ensure its effective utilization.
After the World War II, the exchange control regulations framed under the Defence of
India Rules were replaced by the Foreign Exchange Regulation Act, 1947, which was
revised and replaced by the Foreign Exchange Regulation Act, 1973. With a view to
create conducive climate for attracting foreign direct investment to increase production
and promote exports, FERA 1973, has been substantially amended by FERA
[Amendment] Act, 1993. FERA was replaced with Foreign Exchange Management Act
(FEMA), 1999 to consolidate and amend the law relating to foreign exchange with the
objective of facilitating external trade and payments and for promoting the orderly
development and maintenance of foreign exchange market in India.
Exchange controls also cover foreign capital and activities financed by it. The
administrative authority of foreign exchange regulation is vested with the Reserve Bank
of India (RBI) and the routine work of exchange control is delegated to banks
authorized to deal in foreign exchange. Exchange controls and procedures are set out in
the Exchange Control Manual published by the RBI.
Transactions Subject to Control
a. Purchase, sale, and other dealings in foreign exchange and maintenance of
balance at foreign centers.
b. Realization of export proceeds and payment for imports.
c. Payments to non-residents or to their accounts in India.
d. Transfer of securities between residents and non-residents and acquisition and
holding of foreign securities.
e. Foreign travel with foreign exchange.
f. Export and import of currency, cheques, travellers cheques, securities, etc.
g. Activities in India of foreign nationals and branches of foreign firms and
companies.
h. Foreign direct investment and portfolio investment in India including investment
by non-resident Indians, persons of Indian origin and corporate bodies
predominantly owned by such persons.
i. Appointment of non-residents and foreign nationals and foreign companies, etc.,
as agents in India.
j. Setting up of joint ventures/subsidiaries outside India by Indian companies.
k. Acquisition, holding and disposal of immovable property in India by foreign
nationals/companies.
Acquisition, holding and disposal of immovable property outside India by residents in
India.
29
Self-Assessment Questions – 2
a. What is a guarantee? Mention different guarantees issued by Exim bank.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
b. Define Exchange control.
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
3.6 SUMMARY
The Exim Bank was set-up to finance and promote foreign trade.
It extends finance to exporters of capital and manufactured goods, exporters of software
and consultancy services, and to overseas joint ventures and turn-key/construction
projects abroad.
Exim Bank precisely lends to the Indian companies, Indian banks, Foreign
governments, and Foreign companies.
Exim Bank also issues various guarantees.
GTF was set to provide international factoring, domestic factoring, and forfeiting
services under one roof in India.
Certain regulations are issued by the RBI for exporters.
The Exim Bank, wholly owned by Government of India, was established to provide
financial assistance to promote Foreign Trade.
It provides financial assistance to promote Indian exports through direct financial
assistance, overseas investment finance, term finance for export production and export
development, pre-shipping credit, buyer’s credit, lines of credit, relending facility,
export bills rediscounting, refinance to commercial banks.
Functions of Exim Bank include lending, guaranteeing, promoting and advisory
services.
3.7 GLOSSARY
Bid Bond Guarantee is a guarantee issued by the EXIM Bank for a maximum period
of 6 months.
Free Trade Zone is an area designated by the government of a country to which goods
may be imported for processing and subsequent export on duty-free basis.
Letter of Credit is an arrangement by means of which an issuing bank, acting at the
request of an applicant, undertakes to pay a third party a predetermined amount at a
given date according to agreed stipulations and against stipulated documents.
Performance Guarantee is issued by the EXIM Bank for 5 to 10 percent contract.
30
International Trade
Finance in India

a. The EXIM bank provides export credits to Indian promoters for their equity
contribution to overseas joint ventures. The funds are in the form of long-term
credit not exceeding ten years. EXIM bank’s finance will be made available to
Indian promoters by way of
i. Rupee term loans for financing equity contribution.
ii. Foreign currency loans/guarantees, where the equity contribution is
allowed by the Government of India out of foreign currency loan to be
raised by the Indian promoter.
b. Forfaiting is a common form of financing export related receivables. It is similar
to Bill Rediscounting Scheme. EXIM Bank has introduced this scheme for the
Indian exporters. The following are the steps in forfeiting:
1. Commercial contract between the foreign buyer and the Indian exporter.
2. Commitment to forfait bills of exchange/promissory notes (debt
instruments).
3. Delivery of goods by the Indian exporter to the foreign buyer.
4. Delivery of debt instruments.
5. Endorsement of debt instruments without recourse in favor of the
forfaiter.
6. Cash payment of discounted debt instruments.
7. Presentation of debt instruments on maturity.
8. Payment of debt instruments on maturity.
a. An non-cancellable indemnity bond that is backed by an guarantor in order to
guarantee investors that principal and interest payments will be made.
Guarantees are issued by the EXIM bank on behalf of exports of turnkey projects
and construction contracts. Such guarantees include:
i. Bid bond guarantee
ii. Advance payment guarantee
iii. Performance guarantee
iv. Retention money guarantee and
v. Guarantee for borrowing abroad.
b. Exchange controls were introduced in India in 1939, during the World War II, to
conserve foreign exchange, particularly the US dollar, for meeting essential
defence expenditure. The main purpose of exchange controls is to conserve
foreign exchange and ensure its effective utilization.
31
Exchange controls also cover foreign capital and activities financed by it.
The administrative authority of foreign exchange regulation is vested with
the Reserve Bank of India (RBI) and the routine work of exchange control
is delegated to banks authorized to deal in foreign exchange. Exchange
controls and procedures are set out in the Exchange Control Manual
published by the RBI.

A. Multiple Choices
1. Exim Bank provides term loans to projects located in which of the following
zones?
a. Trade zones.
b. Free trade zones.
c. Import zones.
d. Export zones.
e. Special zones.
2. Credit given to overseas buyers to import engineering goods from India on

deferred payment terms is known as ___________________.
a. Overseas credit
b. Import credit
c. Letter of credit
d. Buyer’s credit
e. Lines of credit.
3. Which of the following is not a guarantee issued by EXIM Bank?
a. Bid bond guarantee.
b. Post payment guarantee.
c. Retention money guarantee.
d. Performance guarantee.
e. Guarantee for borrowing abroad.
4. To avail EXIM bank finance Export-oriented units should establish which of the
following regarding their projects?
a. Technical Feasibility.
b. Economic Feasibility.
c. Financial Feasibility.
d. All of the above.
32
International Trade
Finance in India
5. Supplies to ONGC and Oil India Ltd are included under which of the following
exports?
a. Regular Exports.
b. Normal Exports.
c. Deemed Exports.
d. Exceptional Exports.
e. Specific Exports.
B. Descriptive
1. Explain the functions of Exim Bank in international trade finance.
2. Explain the process of forfaiting in detail.
practice only.
33
UNIT 4 BALANCE OF PAYMENTS
Structure
4.1 Introduction
4.2 Objectives
4.3 Concepts of Economic Transaction, Resident and Non-resident Entities
4.4 Principles for Valuation of Transactions
4.5 Principles of BoP Accounting
4.6 Balance of Payments
4.7 Factors Affecting the Components of BoP Account
4.8 Balance of Payments Compilation
4.9 Balance of Payments Accounts – Indian Perspective
4.10 Importance of BoP Statistics
4.11 Limitations of Balance of Payments
4.12 Relationship between BoP Variables and Other Economic Variables
4.13 Summary
4.14 Glossary
4.1 INTRODUCTION
Every country participating in international trade records its international transactions in
an account called Balance of Payments (BoP) account. International transactions
include all payments made by the country for its imports, gifts and investments abroad
and payments received for exports, gifts and investments by foreigners. Balance of
Payments account aims to maintain a systematic record of all economic transactions
between the home country and the Rest of the World (ROW) for a specific period of
time which is usually a year. Thus, BoP can be defined as ‘a systematic accounting
record of all economic transactions during a given period of time between residents of a
country and foreign countries or non-residents of a country.’
4.2 OBJECTIVES
After going through this unit, you should be able to:
• Understand the concept of economic transactions;
• Know the principles of BoP accounting;
• Recognize the balance of payments factors affecting the components of BoP
account;
• Do BoP compilation;
• Understand BoP account – The Indian perspective;
• Comprehend the importance and limitations of BoP; and
• Value the relationship between BoP variables and other economic variables.
Balance of Payments
4.3 CONCEPTS OF ECONOMIC TRANSACTION, RESIDENT AND
NON-RESIDENT ENTITIES
Economic transaction involves exchange of economic value from residents of one
country with the residents of another country. Exchange of economic value may take
place through purchase or sale of goods and services for cash, exchange of financial
items such as purchase of foreign securities through cash or cheque, a barter transaction
and a unilateral gift in kind or financial gift. For this purpose an individual, government,
non-profit organization or any enterprise whose primary residence is in the given
country is said to be a resident of that country. A company’s foreign subsidiary is
treated as a resident of that foreign economy in which it is incorporated and is carrying
on operations. International organizations such as World Bank and International
Monetary Fund (IMF) are not treated as residents by any nation. All the individuals
and entities other than those who are eligible for resident category are called
‘non-residents’.
4.4 PRINCIPLES FOR VALUATION OF TRANSACTIONS

To facilitate comparison of balance of payments accounts across countries at a given
period of time, a uniform system is required. For example, if credit and debit sides of a
transaction are not valued on the same basis, they will never be equal. Hence, certain
principles recommended by the IMF manual must be followed while preparing BoP
accounts. They are as follows:
• All the transactions must be valued at market prices.
• Exports and imports must be valued at free on board basis (Fob).
• Transactions denominated in foreign currency must be converted into domestic
currency at exchange rates prevailing in the market at the time the transaction
took place.
4.5 PRINCIPLES OF BOP ACCOUNTING

Balance of payment accounting involves double entry accounting system. Hence all the
transactions are recorded twice, once as credit (+) and then as a debit (–). The two basic
principles of BoP accounting are:
i. All transactions which lead to an immediate or perspective payment from the
Rest of the World (RoW) to the country are recorded as credit entries. The actual
or perspective payments are recorded as debit entries. Conversely, all the
transactions involving actual or perspective payments from the country to the
rest of the world are recorded as debits and the corresponding payments as
credits.
ii. Transactions which result in an increase in demand for foreign exchange, i.e.,
imports are recorded as debit entries, while transactions which result in an
increase in the supply of foreign exchange, i.e., exports are recorded as credit
entries.
Payment received from outside increases a country’s foreign assets and appears on the
debit side. On the other hand, payment made by the country to the rest of the world
decreases its foreign assets or increases its liabilities. As such it appears on the credit
35
side of the BoP account. This can be understood more clearly from the following
example:
Country P exports raw material worth $2000 to Country Q. An invoice has been
prepared for the same in Country Q and payment by Country Q will result in crediting
the bank account of Country P held in the importing country. The balance in such a
bank account is a foreign asset to the Country P and foreign liability to Country Q. This
entry in Country P’s BOP account will appear as follows:
BoP Account of Country P
Current Account Capital Account

Items Items
Credit Debit Credit Debit
Raw material Increase
Exports $2000 in foreign claims $2000
If Country Q agrees to export plastic worth $1000, then the entry will appear as follows:
Current Account Capital Account

Items Items
Credit Debit Credit Debit
Raw material Increase in
Exports $2000 foreign claims $2000
Decrease in
Plastic Import $1000 Foreign claims $1000
4.6 BALANCE OF PAYMENTS

Balance of payments covers all the visible and invisible economic transactions. It is a
wider concept than balance of trade which covers only visible transactions. Visible
transactions include services like import and export of goods while invisible
transactions include banking, insurance, and transport services and so on with rest of the
world. Balance of payments account is useful in forecasting exchange rate, disclosing
financial inflows and outflows in addition to growth indicators of a country’s economy.
Components of Balance of Payments
The Balance of Payments statement is classified into three major accounts namely
current account, capital account and reserve account.
Current Account: Current account records all international flows of monetary value
that have direct impact on the national income accounts. They are exports and imports
of merchandise, invisibles or services, inflows and outflows of investment income,
grants, remittances and other transfers. Merchandise exports are recorded as credit items
as payment is received by the country from the outside world and imports are recorded
as debit items as payment is made by the country to the outside world. Merchandise
trade is valued on free on board basis, as such any international freight and insurance
involved are not considered along with value of goods. Export and import of services is
treated in the same manner as merchandise exports/imports. Inflow of investment
income is recorded as credit item and outflow of the same is recorded as debit item.
Grants, remittances or unilateral transfers and other transfers can be treated as
36
Balance of Payments
redistribution of incomes and any outward payment is recorded as debit item and inward
payment received is recorded as credit item. For example, funds donated by India to
Pakistan towards earthquake relief are recorded as grants on debit side of BoP account.
Similarly, funds donated by US to India towards tsunami relief are recorded as a credit
item.
Current Account Credit Debit Net
1. Merchandise
a. Exports (on f.o.b. basis)
b. Imports (on c.i.f. basis)
2. Invisibles (a + b + c)
a. Services
i. Travel
ii. Transportation
iii. Insurance
iv. G.N.I.E
v. Miscellaneous
b. Transfers
vi. Official
vii. Private
c. Investment Income
Total Current Account (1 + 2)
Capital Account: Capital account records all international flows of monetary value that
are directly related to the assets of the country. They are foreign investments, loans,
banking capital, rupee debt service and other capital. Foreign investments may be either
direct investment such as GEMOTORS initiating a new venture in India or portfolio
investment like purchase of stocks in India by overseas institutional investors. Loans
procured can be categorized as concessional loans received by the government or public
sector bodies, long-term and medium-term loans from the commercial capital market,
bond issues, etc., and short-term credits. Disbursements received by Indian resident
entities are shown on credit side, while repayments and loans made by Indians are
shown on debit side. Banking capital includes any changes in foreign assets and
37
liabilities of commercial banks which belong to private sector or government and also
recognized co-operative banks dealing with foreign exchange. Rupee debt service
includes the cost of paying interest and regular contractual repayments of principal of a
loan along with administration charges in the Indian currency.
\ Capital Account Credit Debit Net
1. Foreign Investment (a + b)
a. In India
i. Direct
ii. Portfolio
b. Abroad
2. Loans (a + b + c)
a. External Assistance
i. By India
ii. To India
b. Commercial Borrowings (MT and LT)
i. By India
ii. To India
c. Short-term
To India
3. Banking Capital (a + b)
a. Commercial Banks
i. Assets
ii. Liabilities
iii. Non-Resident Deposits
b. Others
4. Rupee Debt Service
5. Other Capital
Total Capital Account (1 + 2 + 3 + 4 + 5)
ERRORS AND OMISSIONS

BoP statements though prepared in accordance with the double entry system may
sometimes show debits which are not equal to credits. This is because of collection of
date from different sources at different points of time. In such a case the difference is
shown as a separate item after capital account as ‘Errors and Omissions’. Errors and
Omissions show the net figure of imbalances thereby balancing the BoP.
38
Balance of Payments
Monetary Movements
Monetary movements include purchases and repurchases from IMF, India’s foreign
exchange reserves containing RBI holdings of gold and foreign currency assets and
finally SDRs (Special Drawing Rights).
Monetary Movements (i) + (ii) + (iii) Credit Debit Net

i. I.M.F.
ii. Foreign Exchange Reserves
(Increase – / Decrease +)
iii SDRs

a. Define BOP Account.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
b. Discuss Balance of Trade.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
Balance in the BoP Statement

The balance of payments as a whole will fully balance as it is prepared according to the
double entry system. As such the terms deficit and surplus in the BoP imply imbalance
because of certain items in the BoP statement. To find the imbalance, the complete BoP
statement is divided into a set of accounts one ‘above the line’ and another set ‘below
the line’. If there is positive net balance above the line, then it is called balance of
payments surplus. Conversely, if the same is negative, it is called balance of payments
deficit. The terms below the line are of compensatory nature and they ‘settle’ or
‘finance’ the difference above the line. The net balance below the line should be same in
magnitude and opposite in sign to the net balance above the line.
Trade Balance
The net value of merchandise exports minus merchandise imports is called trade
balance. The trade balance is shown by placing the merchandise flows alone above the
dividing line and all other items below the line. Changes in trade balance indicate
changes in the efficiency of the country in producing and exporting goods in which it
experiences comparative advantage. A surplus of exports over imports implies that
home country goods are competitive in nature and along with foreign importers,
domestic buyers also prefer these goods. Conversely a deficit implies that the home
country goods are not competitive and appropriate measures must be taken to improve
the same. The Balance of Payments accounts provide a monthly trade balance
information.
Current Account Balance
Current account balance refers to the difference between domestic savings and
domestic investments in a given period. Any deficit in this account implies that domestic
39
savings are insufficient to fund domestic investment. This results in import of savings
from overseas. Excess of domestic savings over domestic investment results in current
account surplus and this results in a favorable or surplus of BoP positions. The current
account balance indicates the country’s stock of net international assets.
Capital Account Balance
The capital account balance shows how the balance in current account is financed.
The greater the finances obtained on commercial terms, the greater will be the
vulnerability of the country to volatility in interest rates. Capital account balance can be
defined as a country’s receipts less payments for capital account transactions. When the
balance of current and capital accounts combined is negative, then the BoP has deficit
balance. This can be balanced by reducing foreign exchange and gold reserves.
The Balance of Payments account always Balances
The Balance of Payments account always balances as a whole. A country’s total
outgoings must be equal to its total receipts. The current account surplus must be
matched by a rise in external assets and a current account deficit by a fall. As all the
transaction are recorded on double entry basis, the BoP account must always balance.
But, in reality, the BoP account seldom balances because of different data sources and
imperfect nature of data collection. For this purpose, a balancing item called ‘Errors and
Omissions’ is included in the BoP account. This item indicates the values of
discrepancies resulting due to different exchange rates applied to receipts and payments.
Balance in Current Account + Balance in Capital Account
+ Change in Monetary Movements = Zero.
When no change happens in the monetary movement, then:
Surplus/deficit in current account = deficit/surplus in capital account
Principles for Timing the Recording of Transactions
The principles given by IMF in the case of timing of transactions are as follows:
a. Current Account: Merchandise trade should be recorded when the change in
ownership takes place. (This occurs when the corresponding payment is made.)
b. Capital Account: Capital account transactions are recorded when change in
ownership is assumed to have taken place through banking channels.
4.7 FACTORS AFFECTING THE COMPONENTS OF BOP

ACCOUNT
Various factors affect the exports and imports of goods and services:
• Value of Domestic Currency: An appreciation of domestic currency makes
exports of goods uncompetitive and a depreciation would facilitate an increase in
demand. However, an appreciation of Home Currency makes imports less
expensive/cheap and depreciation would make imports costly.
• Inflation Rate: Higher inflation rate results in lower competitiveness and lower
demand for domestic goods for exports. Yet, lower demand for domestic goods
and services need not necessarily mean a lower demand for the domestic
currency. If the demand for domestic goods is relatively inelastic, then the fall in
demand may not offset the rise in price completely, resulting in an increase in the
value of exports. This would end up increasing the demand for the local
currency. In the case of imports, a domestic inflation rate that is higher than the
40
Balance of Payments
inflation rate of other economies, would result in imported goods and services
becoming relatively cheaper than domestically produced goods and services.
This would increase the demand for the former and hence, the supply of the
domestic currency.
• Trade Barriers: More number of trade barriers imposed by domestic country
leads to lower imports and exports resulting in lower supply of domestic
currency.
• Any increase in commodity price (domestic price remains the same) in the world
market results in increase in export of that good. This increases the demand for
domestic currency. Conversely, any reduction in the commodity price ultimately
leads to decrease in demand for domestic currency.
• A positive correlation exits between income of the resident of importing country
and exports. When all the other things remain constant, any increase in standard
of living of the resident of importing country will result in increase in domestic
goods leading to increase in demand for domestic currency.
Income on Investments
Payments with regard to interest, dividends, profits etc., depend on the level of past
foreign investment and prevailing domestic rates of return. Receipts depend on the level
of past domestic investments in foreign countries and the prevailing foreign rates of
return.
Transfer Payments
The following two factors affect transfer payments:
i. Number of migrants to or from a country, who may receive money from or send
money to relatives.
ii. Country’s desire to generate goodwill by providing aids to other countries or in
turn to take grants or aids to overcome certain problems.
Capital Account Transactions
The following major factors affect international capital transactions:
i. The rate of return earned on the investments compared to domestic investment

returns.
ii. Additional risk associated with the above returns.
iii. Expected movement in the exchange rates.
4.8 BALANCE OF PAYMENTS COMPILATION

BoP account is compiled using information from different sources. The major source of
information is R-Returns which is submitted by the authorized dealer to RBI every
fortnight. R-Returns provide information regarding foreign exchange transactions
entered into by the ADs, including the transactions passing through the rupee accounts
of non-resident banks. Other sources include Department of Economic Affairs under the
Ministry of Finance, Government of India and other government agencies located
overseas and various surveys conducted for BoP compilation etc. All the transactions
under different heads and sub-heads are combined and based on the net figures, a BoP
account is prepared.
41
4.9 BALANCE OF PAYMENTS ACCOUNT – THE INDIAN

PERSPECTIVE
The Indian BoP account is prepared in accordance with the principles given in the IMF
manual. All the transactions in the BoP account, excluding merchandise the trade are
recorded at actual price rather than market price and are paid through bank. Imports are
recorded at c.i.f value (cost, insurance, freight value). Transactions recorded in foreign
currency are converted into Indian rupees according to average exchange rate for that
particular month. Timings for transactions given by IMF are followed for capital
account transactions, transportation and insurance services, transfer payments and
undistributed income. Exports are recorded only after customs clearance for shipment
and imports are recorded when they are actually paid for.
The Statement
The Indian Balance of Payments Account appears as follows:
India’s BoP Account
Item Credit Debit Net
A. Current Account
i. Merchandise
ii. Invisibles (a + b + c)
a. Services
b. Transfers
c. Income
Total Current Account (i + ii)
B. Capital Account
1. Foreign Investment (a + b)
a. Foreign Direct Investment
i. In India
ii. Abroad
b. Portfolio Investment
i. In India
ii. Abroad
2. External Assistance, Net
3. Commercial Borrowings
4. Short Term to India
5. Banking Capital
6. Rupee Debt Service
7. Other Capital, Net
8. Total Capital Account (1 – 5)
C. Errors & Omissions
D. Overall Balance [A(5) + B(8) + C]
E. Monetary Movement (i + ii)
i. I.M.F
ii. Foreign Exchange Reserve (–/+)
42
Balance of Payments
4.10 IMPORTANCE OF BOP STATISTICS
The study of various factors affecting the demand and supply of a currency helps in
forecasting exchange rate based on BoP account. For example, the direction of
movement of exchange rates can be predicted. Any movement in the reserves of the
country furnishes certain indications with regard to the possible movement of exchange
of the currency. A continuous depletion of reserves indicates repeated BoP deficit and
the simultaneous pressure on the exchange rate results in selling of reserves (for the
sake of domestic currency) in order to increase the demand for domestic currency and to
maintain the exchange rate.
4.11 LIMITATIONS OF BALANCE OF PAYMENTS

BoP accounts suffer from following limitations:
i. BoP statistics are useful in predicting only general trends in exchange rates.
ii. Interpreting BoP data is little complicated and all the different balances must be
considered in addition to their actual and expected trends.
iii. BoP data of a country indicates only possible appreciation or deprecation of its
currency.
a. Explain various factors that affect the exports and imports of goods and
services.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
b. Discuss various sources of information used in compiling BoP statement.
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
4.12 RELATIONSHIP BETWEEN BOP VARIABLES AND OTHER

ECONOMIC VARIABLES
Implications of a Recurring Current Account Surplus/Deficit
The national income of a country can be shown by the following equation:
Y = C + G + I + (X – M) … Eq. (1)
Here,
Y = National Income
C = Consumption
I = Investment
X = Exports
M = Imports
G = Government Expenditure.
43
The above equation can be rewritten as:
X – M = Y – (C + G + I) … Eq. (2)
The left hand side equation indicates current account balance and the right hand side
indicates difference between income and expenditure. Thus, a current account surplus
implies that a country is not consuming as much as it is producing. In other words, it is
living below its means. This type of situation will be beneficial to a developed country
compared to a developing country. It would be beneficial to developing countries, if
they could run a current account deficit and finance it by a capital account surplus i.e.,
live beyond their means. The way the deficit is being financed and the purpose for
which it is being used are important aspects to be considered with regard to the growth
problem faced by the developing countries. If the deficit is being financed by short-term
borrowing which would need to be repaid before the corresponding investments star
generating adequate returns, the country may get into problems as it must refinance its
borrowings at increasingly higher costs. The second aspect would be more clear with
the help of an equation. The income can also be written as Sum of Consumption (C),
Taxes paid (T) and Savings (S). The equation can be written as:
Y = C+T+S … Eq. (3)
Using Eq. (3), Eq. (2) can be rewritten as:
X – M = (C + T + S) – (C + G + I)
= (S – I) + (T – G) … Eq. (4)
The second term on the right hand side of the equation indicates the budget deficit.
4.13 SUMMARY
The information provided in Balance of Payments must be interpreted with utmost care.
The Balance of Payments statement is classified into three major accounts namely
current account, capital account and reserve account.
Balance of Payments account is useful in forecasting exchange rate, disclosing financial

inflows and outflows in addition to growth indicators of a country’s economy.
As balance of payments covers all the visible and invisible economic transactions, it is a
wider concept than balance of trade which covers only visible transactions.
Balance of payments account along with other economic factors must be considered for
the purpose of predicting movement in exchange rates.
4.14 GLOSSARY
Capital Account Balance is a part of the balance-of-payments which reflects the net
inflow of public and private capital.
Cost, Insurance and Freight (CIF) is used in connection with a price quotation under
which a seller in addition to the payment of costs of goods and transportation to the
named port, must also provide insurance up to the named destination. It is the same as
C&F except that the seller also provides insurance up to the named destination.
Current Account Balance is a part of the balance-of-payments which reflects the net
inflow on account of trade in goods, services and transfer payments.
44
Balance of Payments
International Monetary Fund (IMF) is a supranational body, created to help
countries in maintaining exchange rate stability which came into existence along
with the World Bank.


a. Balance of payments covers all the visible and invisible economic transactions. It
is a wider concept than balance of trade which covers only visible transactions.
Visible transactions include services like import and export of goods while
invisible transactions include banking, insurance, and transport services and so
on with rest of the world. Balance of payments account is useful in forecasting
exchange rate, disclosing financial inflows and outflows in addition to growth
indicators of a country’s economy.
b. Balance of trade is the difference between the monetary value of exports and
imports of output in an economy over a specific period of time. It is the
relationship between a nation's imports and exports. A positive or favorable
balance of trade is referred to as a ‘trade surplus’ where exports more than
imports. A negative or unfavorable balance is referred to as a ‘trade deficit’,
where the balance of trade is sometimes divided into a goods and a services
balance.

a. Various factors affect the exports and imports of goods and services:
i. Value of Domestic Currency: An appreciation of domestic currency
makes exports of goods uncompetitive and a depreciation would facilitate
an increase in demand. However, an appreciation of Home Currency
makes imports less expensive/cheap and depreciation would make
imports costly.
ii. Inflation Rate: Higher inflation rate results in lower competitiveness and
lower demand for domestic goods for exports. Yet, lower demand for
domestic goods and services need not necessarily mean a lower demand
for the domestic currency. If the demand for domestic goods is relatively
inelastic, then the fall in demand may not offset the rise in price
completely, resulting in an increase in the value of exports. This would
end up increasing the demand for the local currency. In the case of
imports, a domestic inflation rate that is higher than the inflation rate of
other economies, would result in imported goods and services becoming
relatively cheaper than domestically produced goods and services. This
45
would increase the demand for the former and hence, the supply of the
domestic currency.
iii. Trade Barriers: More number of trade barriers imposed by domestic
country leads to lower imports and exports resulting in lower supply of
domestic currency.
b. BoP account is compiled using information from different sources. The major
source of information is R-Returns which is submitted by the authorized dealer
to RBI every fortnight. R-Returns provide information regarding foreign
exchange transactions entered into by the ADs, including the transactions
passing through the rupee accounts of non-resident banks. Other sources include
Department of Economic Affairs under the Ministry of Finance, Government of
India and other government agencies located overseas and various surveys
conducted for BoP compilation etc. All the transactions under different heads
and sub-heads are combined and based on the net figures, a BoP account is
prepared.

A. Multiple Choices
1. Which of the following is an invisible transaction?
a. Banking.
b. Insurance.
c. Transportation.
d. None of the above.
2. Which of the following statements is true?
a. Balance in Current Account + Balance in Capital Account = Zero.
b. Balance in Current Account – Balance in Capital Account = Zero.
c. Balance in Current Account + Change in Monetary movements = Zero.
d. Balance in Capital Account + Change in Monetary movements = Zero.
e. Balance in Current Account + Balance in Capital Account + Change in
Monetary movements = Zero.
3. Indian BoP account is prepared according to the provisions of the ________.
a. International Monetary Fund
b. Foreign Exchange Regulation Act
c. Reserve Bank of India
d. Both (a) and (c) of the above
e. Both (b) and (c) of the above.
4. Which of the following statements is true with regard to national income?
a. National income = Consumption + Taxes Paid.
b. National income = Consumption + Taxes Paid + Savings.
c. National income = Consumption – Taxes Paid + Savings.
d. National income = Consumption – Taxes Paid – Savings.
e. National income = Consumption + Savings.
5. Imports in Indian BoP statement are recorded on the basis of ___________.
46
Balance of Payments
a. Cost, Freight, Insurance Value
b. Cost & Freight Value
c. Freight & Insurance
d. Cost & Insurance
e. Free on Board.
B. Descriptive
1. Explain various components of Balance of Payments account.
2. Explain different factors affecting the components of BOP account.
3. Explain Balance of Payments account in the Indian context.
4. How do you compile Balance of Payments account?
practice only.
47
NOTES
48
Block Unit Unit Title

Nos.
I FUNDAMENTALS OF INTERNATIONAL
MANAGEMENT
1. Introduction to International Finance
2. Theories of International Trade
3. International Trade Finance in India
4. Balance of Payments
II FOREIGN EXCHANGE MARKET
5. International Monetary System
6. The Foreign Exchange Market
7. Exchange Rate Determination
8. Exchange Rate Forecasting
III EXCHANGE RISK MANAGEMENT
9. Introduction to Exchange Risk
10. Management of Exchange Risk

11. International Project Appraisal
IV INTERNATIONAL FINANCIAL MANAGEMENT
12. International Financial Markets and Instruments
13. International Equity Investments
14. Short-Term Financial Management
15. International Accounting and Taxation
V INTERNATIONAL TRADE
16. Trade Blocks
17. Foreign Trade Policy
18. Documentary Credits
19. Export Finance and Exchange Control

Regulations Governing Exports
20. Import Finance and Exchange Regulations
Relating to Import Finance
MBA-0000
Block
2
FOREIGN EXCHANGE MARKET
UNIT 5
International Monetary System 5
UNIT 6
The Foreign Exchange Market 15
UNIT 7
Exchange Rate Determination 32
UNIT 8
Exchange Rate Forecasting 46
Expert Committee


Director Director

Director Director
Prof. P. Ramnath
Director
IBS Chennai






While every possible care has been taken in type-setting and printing this book, The ICFAI

BLOCK 2 FOREIGN EXCHANGE MARKET
This block discusses the significance of foreign exchange markets. It outlines various
types of exchange rate me the significance of international trade in the wake of
globalization. With the increase in cross border trade, companies from different
economies trade exchanging various products and services with variety of currencies.
This block outlines the evolution of international monetary systems and discusses the
importance of foreign exchange markets, exchange rate determination and exchange
rate forecasting.
Unit 5 covers at length the exchange rate mechanisms such as fixed rate, floating rate,
and with limited flexibility. Further, this unit explores the evolution of different
monetary systems and the emergence of the European Monetary System.
Unit 6 highlights the significance of foreign exchange markets, their structure, exchange
rate quotations and different types of transactions. Besides, this unit discusses the
significance of settlement dates, how to quote merchant transactions and how to deal
with early delivery, extension and cancelation of forward contracts in India.
Unit 7 discusses the law of one price and the relationship between various variables that
determine the exchange rates across different countries. This unit explains the
relationship between goods and exchange rates using purchasing power parity, and
interest rates and exchange rates using interest rate parity.
Unit 8 deals with a plethora of factors that determine the currency forward rates. It
elaborates on the exchange rate forecasting models such as the demand and supply
approach, the monetary approach, the asset approach, and the portfolio balance
approach. The role of technical analysis in exchange rate forecasting is also dealt in this
unit.
UNIT 5 INTERNATIONAL MONETARY
SYSTEM
Structure
5.1 Introduction
5.2 Objectives
5.3 Exchange Rate Mechanisms
5.4 History of Monetary Systems
5.5 Recent Developments
5.6 Summary
5.7 Glossary
5.1 INTRODUCTION
The international monetary system includes rules, regulations, institutions, procedures,
practices and mechanisms that facilitate settlement of international payments.
A manager looking after international business should be conversant with the
international monetary system. Familiarity with a country’s exchange rate mechanisms
can help forecast the appreciation/depreciation of foreign currency against the domestic
currency based on which the investment/borrowing decision can be taken.
5.2 OBJECTIVES
• Understand the various exchange rate mechanisms;
• Record the evolution of monetary systems; and
• Comprehend the evolution of Eurozone.
5.3 EXCHANGE RATE MECHANISMS

The value of one currency in terms of another currency is termed as exchange rate. It
may be a fixed exchange rate, floating exchange rate or limited flexible exchange rate.
These exchange rates can be determined using different exchange rate systems, each
system following a method of its own.
Fixed Exchange Rate System
Under fixed exchange rate system, the value of a currency is fixed or pegged in terms of
another currency. Fixed exchange rate is determined by the government and maintained
on a daily basis through internal regulations to put a limit on exchange rate movements.
Exchange rate parities are framed in terms of a single foreign currency called single
currency peg or basket of currencies called peg to a basket. The characteristics of a
fixed exchange rate system are as follows:
• Fixed exchange rate system decreases variability of the exchange rate.
• Foreign investors find investments less risky and safe.
• Foreign exchange surplus or deficit may occur, as pegging to another currency
does not represent equilibrium price.
• Pegging involves cost as the prices in the system do not reflect their true value.
There are different methods of fixed exchange rate system namely, Currency Board
System, Target Zone Arrangement, and Monetary Union.
CURRENCY BOARD SYSTEM

Under this system, a country pegs the rate of its domestic currency in terms of foreign
currency. The exchange rate between domestic and other foreign currencies depends on
the respective rates at which each of these currencies rates against the foreign currency
(to which the domestic currency is pegged). On account of this pegging, the monetary
policies and economic variables of the foreign currency to which the domestic currency
is pegged will get reflected in the domestic currency. Consequently the country should
keep changing the exchange rate accordingly or sometimes completely abandon the peg.
To control such a situation the monetary policies of the domestic currency are kept in
line with that of the reference country by the central monetary authority known as the
Currency Board. The major advantage is that the Board provides stable exchange rates
which inturn may boost international trade and investment. The main drawback of this
system is that it leads to loss of control over interest rates.
TARGET ZONE ARRANGEMENT

When a group of countries maintain the exchange rates between their currencies within
a specific band around the fixed central exchange rates it is called target zone
arrangement. The European Monetary System is an example of target zone
arrangement.
MONETARY UNION
In this system a group of countries decide upon a common currency in place of
individual currencies. A common Central Bank is formulated, that has the sole authority
to issue the currency and frame the monetary policy of the group. The member countries
align macro economic variables such as interest rates, inflation, GDP etc., to adjust their
economies to the phase of economic cycle they are going through.
Floating Exchange Rate System
The exchange rate is determined based on demand and supply of currencies in the world
trade. In other words, unlike fixed exchange rate, floating exchange rate fluctuates in
response to market forces. Floating exchange rate may be a free float exchange rate or a
managed float exchange rate. When the exchange rate movements are determined
completely by the market, it is called free float exchange rate system or clean float. The
markets which use free float system experience much volatility. This volatility creates
increased economic uncertainty to the players of international markets. This may result
in sudden depreciation or appreciation of the domestic currency. Appreciation in the
domestic currency results in uncompetitive domestic goods and thus decreases the
exports. Similarly, depreciation of the currency increases price of goods imported and
this in turn increases the inflation rate. All these uncertainties reduce the efficiency of
the world economy. To control these inefficiencies the government or central bank
interferes in the currency market. When the exchange rate movements are controlled
with the interference of the government or central bank to minimize the currency
6
International Monetary System
fluctuations, it is called managed float. The government or central bank may interfere
regularly or occasionally or sometimes only to clear certain overnight fluctuations in the
market. Floating exchange rates provide domestic economic autonomy by removing
external constraints on the balance of payments equilibrium.
Hybrid Mechanism
Crawling Peg
A crawling peg system also known as Trotting peg or Gliding peg system is a
combination of fixed and flexible exchange rate systems. The exchange rate is pegged
to a currency, but is allowed to fluctuate around the fixed rate in response to the market
conditions. In other words, this system adjusts the peg frequently at regular periods by
small amounts instead of making any large devaluations or revaluations when there is
change in the equilibrium exchange rate. When the market determined exchange rate
exhibits a continuous declining trend over a given period of time, then the peg is revised
downwards and vice versa.
a. Explain Fixed Exchange Rate System.

…………………………………………..……………………………………….
…………………………………………..……………………………………….
…………………………………………..……………………………………….
b. Discuss Floating Exchange Rate System.
…………………………………………..……………………………………….
…………………………………………..……………………………………….
…………………………………………..……………………………………….
5.4 HISTORY OF MONETARY SYSTEMS

Different exchange rate systems such as the Gold Standard, the Gold-Exchange
Standard, Bretton Woods System, Post Bretton Woods System and the European
Monetary System were followed in the past.
The Gold Standard
The gold standard was followed during the nineteenth century (1870-1914). Except US
and UK, which adopted this system from 1821 and 1834 respectively, most of the other
countries adopted this system by 1870. Under this system, the governments provided
unconditional guarantee to convert their paper money or fiat money into gold on
demand at a pre-determined rate at any given time. The exchange rate between
currencies was determined based on the price of gold prevalent in the countries. This
exchange rate was maintained at an equilibrium level due to possible involvement of
arbitrage. Due to transportation costs and transaction costs involved in buying and
selling gold, the exchange rate fluctuated between bands on either side of the
equilibrium exchange rate. These bands were determined based on the size of costs and
subsequently, the end points of the range determined by the bands were termed as gold
points. An inbuilt mechanism of the gold standard facilitated correction of imbalance in
international receipts and payments. This process of correction is called price-specie-
flow mechanism. For this purpose, a country maintained a gold reserve equal to a fixed
7
percentage of circulating currency. The gold standard system could sustain for such a
long period because of fiscal discipline it imposed on the government, and its
predictability of exchange rate movements. The predictability of exchange rates further
reduced risks involved in international trade and investments and also facilitated
efficient allocation of world resources. From 1870 to 1913, the paper currency and bank
deposits grew rapidly and led to growth in money supply at a rate of 3 to 4 percent. In
the absence of these developments, the money supply would have depended heavily on
output of newly mined gold, resulting in deflationary pressure. Concern over scarcity of
gold led to saving the existing gold in central banks and treasuries and ultimately
economizing its use in domestic circulation. Consequently, this exchange rate system
was eliminated with the outbreak of World War I in 1914.
The Gold-Exchange Standard
During the war (World War I) period many countries including Britain borrowed
heavily from the US to meet the expenses of food and arms. Creditor nations liquidated
most of their foreign assets to finance the war and the debtor nations (mainly US)
1
became creditors, on balance. The war came to an end in 1918 but the exchange rates
were allowed to float for some more years. In 1925, Britain adopted a modified version
of gold standard at the pre-war parity, slowly followed by other countries. The need for
additional liquidity was felt in the international markets. As such under the new system
called gold-exchange standard, some countries converted their currencies into the
currency of another country on the gold standard instead of gold. Consequently, instead
of holding gold reserves, the countries started holding reserves of that currency into
which they had converted their currency. During this period there was no flexibility in
prices and costs. Though the prices remained stable in the long run, the economy
witnessed alternate periods of inflation and deflation in the short run. The deflation
resulted in increased unemployment in most of the countries. The Great Depression of
the late 1920s proved fatal to the US and other countries. It led to low earnings, low
demand and much lower employment in addition to the already existing unemployment.
Unable to meet its financial obligations, Britain abandoned this system in 1931. With
this move, the pressure was completely shifted to the dollar, the only currency
convertible to gold. This pressure led to suspending the convertibility by US in 1933.
As a result gold-exchange standard system came to an end and many countries floated
their currencies along with trade and capital controls. Even the few countries which still
followed gold-exchange standard imposed trade controls. All this led to competitive
2
devaluation in order to boost exports.
Bretton Woods System
In 1944, the representatives of 44 countries met in Bretton Woods, New Hampshire,
USA and signed an agreement to bring into force a new monetary system called the
Bretton Woods System. The main terms of agreement were as follows:
• Two new institutions, namely International Monetary Fund (IMF) and
International Bank for Reconstruction and Development (IBRD or World Bank)
were established. IMF would be considered more significant and powerful than
the World Bank. All the member countries should work according to the
guidelines and instructions provided.
1 The United States became, on balance, a creditor nation by the end of World War I, but only
for its wartime loans to the Allies. Most of these loans were never repaid.
2 Every country tries to devalue its currency more than the other countries, to increase its
exports. This is also called beggar-thy-neighbor policy.
8
• Adjustable peg system (exchange rate system) was established
• Currencies must be convertible with regard to trade related activities and other
current account transactions, inspite of governments regulations on capital flows.
• The countries could change the exchange rate upto 10% of initial rate, within one
year of the rates being determined.
• All the member countries must subscribe towards IMF’s capital.
THE INSTITUTIONS
In addition to IMF and World Bank and two more institutions namely International
Finance Corporation (IFC) and International Development Association (IDA) were also
established.
INTERNATIONAL MONETARY FUND (IMF)

IMF was established to maintain proper working of the international monetary system.
One of its main functions is to provide reserve credit to its member countries to meet
temporary problems related to balance-of-payment. IMF is managed by an executive
board consisting of 22 directors, among whom six directors are appointed by the
governments which hold largest quotas.3 The highest governing body of IMF is Board
of Governors which meets annually to make major policy decisions. IMF provides
finance to its member countries under various schemes such as Buffer Stock Financing,
Compensating Financing, Trust fund etc.
WORLD BANK
The World Bank was established to provide medium and long term loans to the
member countries in reconstructing their economies in the post world war II period and
at the same time help the developing countries to increase their economic growth.
INTERNATIONAL FINANCE CORPORATION (IFC)

IFC supplements the activities of World Bank by providing help to private enterprises
located in different countries. It provides loans, subscription to equity and also technical
assistance to private enterprises.
INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)

IDA which was established in 1960 provides finances to all such projects in the
developing countries that indirectly contribute to the positive economic growth of the
country rather than financial profits. The membership of World Bank is a prerequisite to
attain the membership of IDA. As such, it is referred to as soft loan window of the
World Bank.
Failure of Bretton Woods System
Many countries were ready to hold dollar reserves rather than convert them into gold.
As a result the total number of dollars issued by the Federal Reserve was far more than
the value of gold held by it. As conversion of all the dollars into gold was not possible,
the system purely ran on the member countries’ confidence. This resulted in a paradox
in the system known as Triffin Paradox or Triffin Dilemma after Robert Triffin, a Yale
university professor. According to him, the US had to run BoP deficit to supply the
world with required additional dollar reserves in order to increase the international
3 Every member country of IMF must contribute to a currency pool (maintained by IMF) in
accordance to its quota which is fixed on the basis of its importance in the world trade.
9
trade. When the deficit increases and the volume of dollar reserves with the other
countries also increases without any simultaneous increase in US gold reserves, the US
ability to convert dollars into gold will decrease. This situation will result in decrease of
confidence in the system and consequently its breakdown. The excess supply of dollars
in the international markets compared to the US gold holdings also led to the belief that
the dollar was overvalued and hence a correction was necessary. In 1960, the London
market in which much of the private gold trading was carried out experienced increase
in value of gold. This occurred because of the speculation that the dollar was to be
devalued by increasing the gold price. To curtail the markets from varying too much
with the official price of $35 per ounce, US made gold pool arrangement with 7
countries, according to which they sold gold in London. In the early sixties Britain also
experienced BoP deficit and it desired to devalue the pound. Due to US objection to the
same, UK maintained the same value for sometime but in 1967 it finally devalued the
pound. This was followed by Franc’s devaluation in 1969. All these problems affected
the system to a large extent. In 1968, selling of gold by the gold pool in the private
market was stopped and the dollar was made non-convertible into gold with regard to
private market players. As the system was experiencing many problems in addition to
increased pressure on the dollar, a new reserve asset was created by the IMF in 1967.
This was called Special Drawing Rights (SDRs). This international currency was given
to member countries in proportion to their quotas. But the introduction of SDRs did not
prove helpful and the situation worsened further. The reserve position of US turned
negative in 1979 and its BoP deficit increased further.
Post-Bretton Woods System (The Current System)
As most of the countries were following floating exchange rates after the Bretton woods
system, the IMF amended its articles accordingly in Jamaica in 1976 and the same
became effective from April 1, 1978. According to the amendment, every country could
choose its exchange rate system. It could either float or peg its currency. The currency
could be pegged to another currency or to a basket of currencies or SDRs. The only
constraint laid down by IMF was that the pegging should not be done with gold. At the
same time the member countries were not allowed to fix any official price for gold. They
were required to follow the principles adopted by IMF in April 1977. These principles
aimed to maintain stability in the Forex markets and also prevent occurrence of any
competitive devaluations. So, different countries adopted different exchange rate systems
suitable to their economies.
a. What is International Monetary Fund?
…………………….……………………………………………………………...
…………………….……………………………………………………………...
…………………….……………………………………………………………...
b. What do you understand by the term ‘competitive devaluations’?
…………………….……………………………………………………………...
…………………….……………………………………………………………...
…………………….……………………………………………………………...
10
The European Monetary System
The European Monetary System came into effect in 1979. A new currency called
European Currency Unit (ECU) was created and defined as a weighted average of
various European currencies. Due to its stability compared to individual currencies, it
better suited the international transactions. Each member country of European
Economic Community (EEC) had to fix the value of its currency in terms of ECU. This
monetary system was more flexible compared to the Bretton Woods System. The Treaty
of Rome, which came into effect in 1957, was revised in December 1991 to provide for
the European Monetary Union. The revisions collectively constituted the core of the
Maastricht Treaty. This treaty came into effect on November 1, 1993 and consequently
the European and Monetary Union was formed. In December 1995, at the summit held
in Madrid, a single European currency called Euro was framed and a time table for
EMU was formulated. The Dublin summit held in December 1996 provided full
autonomy to European Central Bank (ECB). It also formulated various rules and
regulations to be followed by ECB in regulating monetary policy and ensuring stability
of the exchange rate. The main functions of ECB are as follows:
• Determine the monetary policy and implement it.
• Support the member countries in implementing their economic policies, if that does
not entail going against its main aim of maintaining price stability.
• Help the member countries in managing their forex reserves and to conduct forex
operations.
• Ensure a smoothly operating interbank payments system.
On January 1, 1999, the Euro came into use and the exchange rates of currencies of the
participating nations with Euro were fixed irrevocably. Out of 25 member countries of
EMU, Belgium, Portugal, Greece, Finland etc., traded their currency in Euro.
5.5 RECENT DEVELOPMENTS

Many of the South-East Asian countries pegged their currencies to the US dollar. The
fixed exchange rates aided these countries in attracting more foreign capital than that
could be profitably deployed in these economies. This led to deployment of funds into
property markets and long term ventures. As the funds were not being utilized for any
real economic activity the investors started disinvesting out of these economies. This
action further resulted in bringing the asset markets down. Liquidation of long-term
investments to return investor’s money was also not possible. All this made daily
activities of financially good companies very difficult. The economies suffered badly
and as a result countries gave up pegging and floated their currencies.
5.6 SUMMARY
International monetary system includes rules, regulations, institutions, procedures,
practices and mechanisms that facilitate settlement of international payments.
Different exchange rate systems were used in the past as the Gold Standard, the Gold-
Exchange Standard, Bretton Woods System, Post Bretton Woods System and the
European Monetary System.
11
Each monetary system has advantages and disadvantages. No system can be a perfect
monetary system.
The value of one currency in terms of another currency is termed as exchange rate.
Exchange rate can be a fixed exchange rate, floating exchange rate or limited flexibility
exchange rate.
5.7 GLOSSARY
Arbitrage is the process of buying and selling the same product at different prices at the
same time and thereby making a profit.
Devaluation is the reduction in the value of a currency dictated by the authorities.
Euro is the new common currency for eleven European nations which came into effect
from January 1, 1999.
Fiat Money is the money which has insignificant intrinsic value, but a high face value
due to the decree or fiat that it can be used for the settlement of all the financial
obligations.

a. Fixed Exchange Rate System
Under fixed exchange rate system, the value of a currency is fixed or pegged in
terms of another currency. Fixed exchange rate is determined by the government
and maintained on a daily basis through internal regulations to put a limit on
exchange rate movements. Exchange rate parities are framed in terms of a single
foreign currency called single currency peg or basket of currencies called peg to
a basket. The characteristics of a fixed exchange rate system are as follows:
• Fixed exchange rate system decreases variability of the exchange rate.
• Foreign investors find investments less risky and safe.
• Foreign exchange surplus or deficit may occur, as pegging to another
currency does not represent equilibrium price.
• Pegging involves cost as the prices in the system do not reflect their true
value.
There are different methods of fixed exchange rate system namely, Currency
Board System, Target Zone Arrangement, and Monetary Union.
b. The exchange rate is determined based on demand and supply of currencies in
the world trade. In other words, unlike fixed exchange rate, floating exchange
rate fluctuates in response to market forces. Floating exchange rate may be a free
float exchange rate or a managed float exchange rate. When the exchange rate
movements are determined completely by the market, it is called free float
exchange rate system or clean float. The markets which use free float system
experience much volatility. This volatility creates increased economic
12
uncertainty to the players of international markets. This may result in sudden
depreciation or appreciation of the domestic currency. Appreciation in the
domestic currency results in uncompetitive domestic goods and thus decreases
the exports. Similarly, depreciation of the currency increases price of goods
imported and this in turn increases the inflation rate. All these uncertainties
reduce the efficiency of the world economy. To control these inefficiencies the
government or central bank interferes in the currency market. When the
exchange rate movements are controlled with the interference of the government
or central bank to minimize the currency fluctuations, it is called managed float.
a. IMF was established to maintain proper working of the international monetary
system. One of its main functions is to provide reserve credit to its member
countries to meet temporary problems related to balance-of-payment. IMF is
managed by an executive board consisting of 22 directors, among whom six
directors are appointed by the governments which hold largest quotas. The
highest governing body of IMF is Board of Governors which meets annually to
make major policy decisions. IMF provides finance to its member countries
under various schemes such as Buffer Stock Financing, Compensating
Financing, Trust fund etc.
b. When a country tries to devalue its currency to increase its international
competitiveness. However, this often encourages other countries to also devalue
leading to only temporary increases in the competitiveness of exports. In
competitive devaluation, a country only gains a temporary advantage until the
next country devalues as well. Devaluation can often lead to inflation which
reduces long term gains in competitiveness.

A. Multiple Choices
1. International monetary fund came into existence during which of the following
monetary systems?
a. European Monetary System.
b. Bretton Woods system.
c. Gold Standard.
d. Gold-Exchange Standard.
2. Price-specie-flow mechanism is a process of correcting imbalance in _____.
a. Current account and Capital Account
b. International receipts and payments
c. International Exports and Imports
d. All of the above
e. Only (c) of the above.
13
3. Which of the following is an example to Target Zone Arrangement?
a. Gold-Exchange Standard.
b. Bretton Woods System.
c. European Monetary System.
d. Gold Standard.
e. Post-Bretton Woods System.
4. A reduction in the price of a currency in the terms of another currency is termed

as _________.
a. Appreciation in the exchange rate
b. Devaluation of currency
c. Depreciation in the exchange rate
d. Appreciation in the currency
5. Which of the following is a scheme provided by IMF to its member countries?
a. Extended Facility.
b. Oil Facility.
c. Trust Fund.
d. Standby Arrangement.
B. Descriptive
1. Explain in detail Fixed Exchange Rate System.
2. Explain in detail different Monetary Systems.
3. Discuss in detail Free Float vs Managed Float.
practice only.
14
UNIT 6 THE FOREIGN EXCHANGE
MARKET
Structure
6.1 Introduction
6.2 Objectives
6.3 Structure of Forex Market
6.4 Exchange Rate Quotations
6.5 Types of Transactions
6.6 Settlement Dates
6.7 Quotes for Various Kinds of Merchant Transactions
6.8 The Indian Forex Markets
6.9 Summary
6.10 Glossary
6.1 INTRODUCTION
The existence of a number of currencies gives rise to the need to transact in these
currencies for settling international payments. As we know, in international
transactions, at least one of the parties would be dealing in a foreign currency. For
example, if an Indian exporter sells some goods to an American resident and the price of
the goods is denominated in dollars, the exporter would be dealing in a foreign
currency. Similarly, if an Italian resident makes an investment in the German money
market, he would need to deal in the German Mark (now Euro) which would be a
foreign currency to him. Sometimes, the currency in which the transaction is
denominated may be a foreign currency to both the parties involved. For example, if a
resident of Australia buys a car from a resident of Spain and the transaction is
denominated in US dollar, both the parties will be dealing in a foreign currency. As it
happens for other commodities, it would be difficult for buyers and sellers of currencies to
find each other. This fact resulted in the development of a market which deals specifically
in currencies, called the foreign exchange market. This is an Over-The-Counter (OTC)
market, i.e., there is no physical marketplace where the deals are made. Instead, it is a
network of banks, brokers and dealers spread across the various financial centers of the
world. These players trade in different currencies through (and are linked to each other
by) telephones, faxes, computers and other electronic networks like the SWIFT system
(Society for Worldwide Interbank Financial Telecommunications). These traders
generally operate through a trading room. The deals are mostly done on an oral basis,
with written confirmations following later.
6.2 OBJECTIVES
• Understand the structure of forex market;
• Derive exchange rate quotations;
• List the types of transactions in forex markets;
• Give quotes for various kinds of merchant transactions; and
• Detail the structure of the Indian forex markets.
6.3 STRUCTURE OF FOREX MARKET

Foreign exchange market includes various large commercial banks, forex brokers, large
corporations and central banks. The commercial banks work on behalf of their clients –
either corporates or individuals and also deal with their own accounts. They function as
market makers in the forex markets. This function of commercial banks along with
speculation facilitates liquidity in the markets, especially in the case of major currencies
of the world. The foreign exchange brokers do not actually buy or sell any currency, but
bring the buyers and sellers together. They mostly deal with major currencies and
specialize in a pair of currencies. Central banks usually venture into the market to
smoothen any large exchange rate fluctuations. The market in which the commercial
banks deal with their clients is called the retail market. On the other hand, the market in
which banks deal with each other is called the whole sale or interbank market. The
worldwide forex market is a 24-hour market and is virtually open all the 24-hours of a
day in at least one of the financial markets across the globe. The following figure shows
the opening and closing times of different markets w.r.t the G.M.T.
Figure 1: Working Hours of the Various Financial Markets w.r.t. the GTM
The settlement of trades comes to an end when the deposits denominated in relevant
currencies between the parties are transferred. In the case of interbank market,
currencies are transferred electronically through Nostro account or Vostro account. A
currency is always settled in the country of its origin. The exchange rate between two
countries is determined by the overall equilibrium between their demand and supply. In
16
The Foreign Exchange Market
India, RBI regulates all the foreign exchange dealings through Foreign Exchange
Management Act, 1999 (FEMA). In accordance to FEMA, only entities authorized
either as Authorized Dealers (ADs) or as money changers can deal in foreign exchange.
Commercial banks usually act as Authorized Dealers and they form a large part of
interbank market in India. They are authorized to buy and sell foreign currency from
their customers. They can also deal with the various items classified as foreign
exchange by FEMA and at the same time are permitted to deal with various documents
related to imports and exports. Authorized Dealers functions in accordance with the
rules and regulations issued by Foreign Exchange Dealers Association of India
(FEDAI). The branches of authorized dealers are classified into the following types:
Category A: These are the offices/branches which keep independent foreign currency
accounts with overseas correspondent banks/branches in their own names.
Category B: These are the branches which do not maintain independent foreign
currency accounts but have powers to operate the accounts maintained abroad by their
head office or the branches categorized as ‘A’.
Category C: The branches which fall in neither of the above categories and yet handle
forex business through Category A or B fall under Category C.
On the other hand, money changers include either full-fledged money changers or
restricted money changers. They can only buy foreign currency from their customers.
The Indian Foreign exchange market has a three-tier structure. The first tier includes all
transactions between Authorized Dealers and RBI. The second tier includes interbank
market and third tier consists of retail segment, wherein ADs and money changers
transact with their customers.
Foreign Exchange
Foreign exchange involves all kinds of claims of residents of a country to foreign
currency payable abroad. In terms of sec. 2 of FEMA, 1999, foreign exchange is defined
as foreign currency, which includes:
i. All deposits, credits, balances payable in any foreign currency;
ii. Any drafts, travelers’ cheques, letters of credit and bills of exchange expressed or
drawn in Indian currency and payable in foreign currency; and
iii. Any instrument giving anyone the option of making it payable either partly or fully
in a foreign currency.
6.4 EXCHANGE RATE QUOTATIONS

In an exchange rate quotation, the price of a currency is stated in terms of another
currency. The following are the different quotes used by various reporting agencies.
Quotes given by
www.marketwatch.com as on 28-09-2006
Curr. USD GBP EUR JPY
USD – 0.52958 0.78687 117.36500
GBP 1.88829 – 1.48584 221.61902
EUR 1.27086 0.67302 – 149.15424
JPY 0.85204 0.45122 0.67045 –
Table 1: Key Cross Currency Rates
17
American vs. European Quote
A quote is classified as American quote when numbers of dollars are expressed per unit
of any other currency. On the other hand, in a European quote the numbers of units of
any other currency are expressed per dollar.
Bid and Ask Rate
The rate at which a bank is ready to buy a currency is different from the rate at which it
is willing to sell the currency. These rates are called bid and ask rates respectively.
The difference in these rates denotes the cost the bank is incurring in these transactions,
a smaller return on the capital employed and the compensation for the risk it
understates. This risk occurs because of unfavorable movement in the exchange rate
before the bank is able to offset the transaction. The difference between the bid rate and
ask rate is called bid-ask spread or just ‘spread’. The spread is higher in a retail market
compared to interbank market. The following are the essential conventions with regard
to quotes with reference to bid and ask rates:
• The bid rate always precedes the ask rate. As such in the quote
Rs per $: 45.45/45.50, the bid rate is Rs.45.45 and ask rate is 45.50.
• The bid and the ask rate are separated either by a slash (/) or a dash sign (–).
• The quote is always from the banker’s point of view i.e., the banker is ready to
buy dollars at Rs.45.45 per dollar and sell at Rs.45.50 per dollar.
Interbank Quote vs. Merchant Quote
Merchant quote is the quote given by a bank to its retail customers. On the other hand, a
quote given by one bank to another is called an interbank quote. It has been mentioned
that a quote is invariably the banker’s quote. The question that arises, is that since both
the parties involved in the interbank market are banks, whose quote will it be taken.
The convention is that the bank requesting the quote is the customer and the quote will
be taken as that of the bank giving the quote, i.e. the one which is acting as the market-
maker.
Market Mechanism and Conventions
When bank ‘A’ is in need of £1,000,000, its dealer consults another dealer bank ‘B’ and
requests for a quote in sterling, without mentioning whether he wants to buy or sell. So, the
bank issues a two-way quote mentioning both the bid and ask rates for sterling. In case the
ask rate for the pound is acceptable to the former B-bank, he says – “one mine”. This implies
that Bank has bought £1,000,000. The settlement of trade takes place through electronic
money transfer such as CHIPS etc.
In case a bank wants to sell the pounds it says “one yours” – implying it has sold
£1,000,000 to the market-making bank. When a two-way quote is given, a bank
maintains the bid and asks rates at such levels that, both buyers and sellers of relevant
currency find it attractive and as such the bank expects to receive both buy as well as
sell orders from the market. In case, a bank is getting only buy orders for a particular
currency, it implies that the market is getting a competitive rate for selling the currency
to the bank, but the bank’s selling rate is very high to attract buyers. It could also mean
that there are too many sellers in the market. In the above cases, the bank would reduce
its rates on both the buy and sell sides.
18
a. Who is an Authorized Dealer? List out different categories of Dealers in
India?
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..
b. Define Bid and Ask Rate; Explain bid ask spread.
…………………………………………………………………………………..
…………………………………………………………………………………..
…………………………………………………………………………………..
MARKET MECHANISM AND CONVENTIONS

Let us now see how deals are struck in the interbank market. Suppose a bank requires
£1,000,000. The dealer of the bank approaches another bank and asks for a quote in the
sterling, without mentioning whether he wants to buy or sell. The market-making bank
gives him a two-way quote (i.e., both the bid and ask rates for sterling). If the ask rate
for the pound is acceptable to the banker, he says – “One mine” – implying that he has
bought £1,000,000. The trade will enter the books of both the banks and written
confirmations of the trade would be sent later. The settlement of the trade will take
place through any of the available electronic money transfer systems (like CHIPS).
Suppose the bank wanted to sell pounds and found the quoting bank’s bid rate
acceptable, it would instead have said – “One yours” – implying that it has sold
£1,000,000 to the market making bank.
While giving a two-way quote, a bank keeps the bid and ask rates at such levels which
both buyers and sellers of the relevant currency are likely to find attractive, and hence the
bank expects to receive both buy and sell orders from the market. If the bank is getting
orders for only one side of the transaction, it would mean either of two things – either the
rates quoted by the bank are out of alignment with the rates being quoted by other players
in the market, or there is too much buying or selling pressure in the market for that
particular currency. In either of the cases, the bank would have to adjust its quote. Let us
take the scenario where the bank is ending up getting only buy orders for a particular
currency (i.e., the bank is only buying the currency), without being able to sell. It would
mean that the market is getting a competitive rate for selling the currency to the bank, but
the bank’s selling rate is too high to attract buyers. On the other hand, it could also mean
that there are too many sellers in the market. In both the cases, the bank will have to
reduce its rates on both the buy and sell side. The lower bid rate will attract a fewer
number of sellers, while the lower ask rate would encourage customers to buy from the
bank. In case the bank is getting too many orders to sell currency to customers, it would
have to increase both the bid and the ask rates, in order to attract more customers
interested in selling the currency and fewer interested in buying it.
The quotes are generally given in the market as : $/Rs: 43.4250/43.4275
It is also a practice to state the same quote as : $/Rs : 43.4250/4275
19
Since the dealers in currencies would anyway be aware of the going rate, the big figures
are not specified. In the interbank market the quote is generally further shortened to:
$/Rs: 4250/4275
The last after-decimal digit of a quote is known as a ‘pip’. There are a few currencies
which are quoted in 100s rather than 1s or 2s. The reason is that their value is too small
to be quoted otherwise. An example is the Japanese yen. Its quote generally looks like:
$/¥: 109.28/30
The quotes given by different banks for the same pair of currencies may not necessarily
be the same, but they have to be within certain limits to prevent arbitrage. Let us see an
example to understand these limits. Suppose there are two banks A and B. Their quotes
for the Euro/$ rate are:
A — Euro/$: 1.6688/1.6693
B — Euro/$: 1.6683/1.6686
As A’s bid rate is greater than B’s ask rate, there is a risk-free arbitrage opportunity
available. (Arbitrage is the process of buying and selling the same asset at the same
time, to profit from price discrepancies within a market or across different markets.
When it does not involve any commitment of capital or the taking on of risk, it is
referred to as risk-free arbitrage). Euros can be bought from B at 1.6686 and sold to A
at 1.6688, thus making a gain of $ 0.0002. Thus, any bank’s bid rate has to be lower
than other banks’ ask rate, and its ask rate greater than other banks’ bid rate.
Sometimes, banks deliberately maintain their rates out of alignment with the rest of
the market, because they require only one type of transactions to come to them. For
example a bank may have an overbought position in marks (i.e., it may have bought
more marks than it sold). In such a case, it may like to keep its ask rate lower so as to
attract customers who want to buy marks.
Note: According to FEDAI rules, exchange rates in the merchant as well as the
interbank markets are to be quoted up to 4 decimals, with the last two digits being in
multiples of 25 (for e.g., $/Rs: 45.4225/4250). The card rates of banks (the reference
rates given by the dealing room to the ‘B category’ branches at the beginning of the
day) should be either quoted in two decimals, or quoted in 4 decimals with the last two
figures being 0 (for e.g., $/Rs: 45.5000 or 45.50). Also, all merchant transactions are to
be settled after rounding off the final rupee amount to the nearest whole rupee. For this,
amounts up to 49 paise are to be ignored, and amounts from 50 to 99 paise are to be
rounded off to the next rupee. Throughout the chapter, these rules have been ignored
and the $/Rs quotes are given up to 2 decimals, only to make the computations
convenient. These quotes result in a higher spread, while in the actual market the spread
does not usually exceed 1 or 2 paise. The student should keep this digression from the
real-time market quotes in mind while going through the chapter.
Box 2: Euro and its Constituents
On January 1, 1999, the various European currencies were irrevocably locked to the
euro (and through it to each other) at the following rates:
DM/Euro : 1.95583
FF/Euro : 6.55957
S/Euro : 13.7603
BF/Euro : 40.3399
DG/Euro : 2.20371
20
FmK/Euro : 5.94573
£Ir/Euro : 0.787564
Lit/Euro : 1936.27
Lux F/Euro : 40.3399
Esc/Euro : 200.482
Ptas/Euro : 166.386
Up to July 1, 2002, these currencies coexisted with the euro, and their exchange rates
with other world currencies were calculated through the ruling euro rates. Recalling from
Chapter International Monetary System, from January 1, 1999, all interbank payments
are made in euros, there is no interbank quotes directly between the dollar and local
currencies, all new government debt are denominated in euros, the ECB conduct repo
transactions only in euros, and all stock exchange quotations for equities and trades and
settlements of government debt and equity are in euro. On the retail level, the bank
statements and the credit card bills give the euro equivalents of the national currency
figure.
Cross Rates
In the foreign exchange markets, it is a practice to quote most of the currencies against
the dollar; and to calculate the exchange rates between other currencies with the dollar
as the intermediate currency. For example the ∈/Rs. rate will be calculated through the
∈/$ quote and the $/Rs. quote. The ∈/Rs. rate thus calculated is called a cross rate or the
synthetic rate.
These rates can be generalized as:
Synthetic (A/C)bid = (A/B)bid x (B/C)bid Eq. (1)
Synthetic (A/C)ask = (A/B)ask x (B/C)ask Eq. (2)
Where,
A, B and C are three currencies.
Let us consider the following exchange rates:
∈/$ : 1.2520/22
$/Rs. : 48.85/86
Now, the cross rate will be calculated as follows:
∈/Rs.(bid) = 1.2520 x 48.85 = 61.1602
∈/Rs.(ask) = 1.2522 x 48.86 = 61.1727
Hence, ∈/Rs. spotrate (can be approximated to) = 61.1600/1725
However, cross rate between two currencies can be calculated using any other currency
as the intermediate currency. Generally, the third currency used in calculating cross
rates is USD. There rates are calculated using a process known as ‘chain rule’.
Prior to the advent of online trading, arbitration was possible due to manual quotes.
However, now the systems are programmed to calculate cross rates using the chain rule
and as such no arbitrage opportunities would be available.
21
6.5 TYPES OF TRANSACTIONS

Foreign exchange transactions are classified into spot and forward contracts. Contracts
that are settled after 2 business days from the date of contract are called spot
transactions. If the contract between the parties involves one party agreeing to buy or
sell a currency at a predetermined future date at a particular price, it is called forward
contract or outright forward. The future date is beyond 2 business days. By entering into
a forward contract, the customer is able to lock-in the exchange rate at which he will
buy or sell the currency.
Forward Quotes
Forward quotes are similar to spot quotes. They are calculated just as implied inverse
rates, synthetic cross rate etc. For example, a three-month forward rate between the £
and the ¥ will be as follows:
3-m ¥ per £: 182.70/75
Discount and Premium
When the currency is more expensive in the forward market than the spot market, then it
is said to be at premium against another currency. That is forward rate is higher than the
spot rate. This occurs when the future spot rate is expected to be higher than the current
spot rate. In case, the currency is cheaper in the forward market than in the spot market, it
is said to be at discount. Here, forward rate will be lower than the current spot rate. In case
of forward rates, the bid-ask spread increases into future, without any consideration to the
base currency whether it is at a premium or discount. This is because of the liquidity in the
market which decreases with increase in maturity of contract. The difference between the
spot rates and forward rates can be expressed in terms of swap points.
Forward Rates vs. Expected Spot Rates

When the speculators in the market are risk-neutral and where transaction costs are
involved, in such a case the forward rate should be equal to the market’s expected future
spot rate. If forward rate is lower than the expected spot rate, the speculator buys a
forward contract expecting to sell in the spot market in future at a higher price. This
results in increased demand in the forward market and simultaneously the forward rate
also increases in equal measure to the expected future spot rate. Similarly, speculators
may take/use a reverse strategy if the forward rates are higher than the expected future
spot rates. However, in reality the spot rate involves risk, which is different from the
expected spot rate and at the same time the speculators are not completely risk-neutral.
Similarly transaction costs are also involved. These factors differentiate forward rate
from the spot rate.
Broken-date Forward Contracts

A broken date contract is a forward contract with maturity less than a month and for
which a quote is not readily available. For example, if the quotes are readily available
for 2 weeks forward and 4 weeks, but a customer wants a 3 week forward, then it is a
broken-date contract. For this purpose, the rate is calculated by interpolating between
available quotes for the preceding and succeeding maturities.
22
Option Forwards
Under option forward contract or the option forward, a customer of a bank enjoys the
option in asking for the settlement of a contract anytime during a particular period, i.e.,
option period. In such case, giving a quote becomes difficult, because although the rate
at which the currencies will be exchanged is fixed, the timing of exchange is not. This
might result in a unfavorable buy or sell. To avoid loss in such situations, banks comply
with following rules while providing quotes:
i. When the bank is buying a currency, it will add on the minimum premium
possible (when the currency is at a premium) and deduct the maximum discount
possible (when the currency is at a discount) from the spot rate.
ii. When the bank is selling a currency, it will add the maximum premium possible
(when the currency is at a premium) and deduct the minimum discount possible
(when the currency is at a discount) from the spot rate.
Swaps
A transaction which involves exchange of two currencies by the parties and which is
later exchanged back is called a currency swap. In other words, swap involves
selling/buying of one currency at a point of time to purchase/sell it back later at lower or
a higher price (based on the discount or premium). Hence it includes one spot and one
forward. A swap transaction wherein the foreign currency is bought in the first leg and
sold in the second leg against the local currency is called a swap-in or buy sell swap.
Similarly a Swap transaction which involves selling a foreign currency and buying it
later is referred to as swap out or sell buy swaps. Swaps are mainly used for hedging by
entities investing or borrowing abroad. The major players of swap markets are banks.
By using swaps they hedge their positions arising from merchant transactions. The
difference in the spot and the forward leg price of a swap are represented as swap
points.
6.6 SETTLEMENT DATES

In a foreign exchange market, the settlement date or value date refers to the day on
which the transaction is settled by a transfer of deposits. Usually the second business
day from the date of transaction is considered as settlement date for a spot transaction.
Business day implies that neither of the days between the transaction date and
settlement date should be a holiday, in any of the settlement locations or in the dealing
locations of the bank, which provides the quote. The settlement locations include
countries whose currencies are involved in the transaction and countries where the
banks involved in the transaction are located. The settlement date for a forward contract
depends on the settlement date for a spot transaction entered on the same date as the
forward contract and the maturity of the forward contract in months. To determine the
settlement date for a forward contract, initially the settlement date for the corresponding
spot transaction is calculated and later the relevant number of calender months is added
to it. Usually, forward contract mature in whole months.
23
Short-Date Contracts
When the settlement date of a transaction is less than two business days after the date of
transaction, it is as short-date contract. This transaction can either be outright contract or
swaps. The following are the various swaps available in the market:
• Between today and tomorrow – cash/tom, C/T, overnight swap.
• Between today and spot day – cash/spot, C/S.
• Between tomorrow and next day – tom/next, T/N or tom/spot, T/S.
• Between spot and the next day – spot/next, S/N.
The interbank market issues swap points for the above contracts and a bank buying
currency must pay the higher of the swap points as premium. Conversely, it receives
lower of swap points as discount.
The First Quote
When a bank needs to give its first quote at the beginning of a day, the dealer considers
various factors such as previous night’s closing rate etc. that affect the exchange rate
between to currencies. This closing rate acts as a starting point and is later adjusted for
expected changes because of other factors. One such important factor is the expected
demand-supply position in the market on that particular day. This factor is in turn
affected by a number of other factors such as interest rates prevalent in the domestic
economy etc. The expected happenings in the stock market also affect the demand-
supply position. The overnight rate is adjusted in accordance with the expected demand
and supply position prevalent in the market on that day. If the supply is expected to
exceed demand, then rate is revised to be on the lower side and if the supply is expected
to be less compared to expected demand, then the rate is revised to be on the higher
side. Other factors such as the bank’s own overnight position with regard to net long
position in the foreign currency or net short position also affects the quote it issues to
the market. In addition several economic and other factors affect the day’s first quote.
6.7 QUOTES FOR VARIOUS KINDS OF MERCHANT

TRANSACTIONS
Retail market includes outward or inward remittance. The bank receives or sends a
currency either through Telegraphic Transfer (TT), demand draft, postal order or Mail
Transfer (MT). The rates offered by the banks with regard to above transactions are
called TT buying and TT selling rates. TT selling rate applies to outward remittance in
foreign currency and towards cancellation of an earlier booked forward purchase
contact. TT buying rate applies to inward remittance and cancellation of a forward sale
contract. In India, these rates are determined according to FEDAI rules and are based on
the base rate which is derived from the on-going market rate. Maximum permissible
margin is left at the discretion of authorized dealers, subject to restriction on the
maximum spreads and other provisions involved in calculating exchange rates as
specified by FEDAI. The following are the margins prescribed by FEDAI:
TT purchase 0.025% to 0.080%
TT sale 0.125% to 0.150%
24
The following are the maximum permissible spreads between the TT Buying and TT
selling rate:
US$: 1.00 percent of the mean rate (the mid-rate) Pound, Euro, Yen, French franc,
Swiss franc, Dutch Guilders and Australian dollars: 2.00 percent of the mean rate.
Other currencies: No limit at present but ADs are instructed to keep the spread to a
minimum.
To arrive at the TT rates the following procedure must be followed:
• Spot TT Buying Rate: Take the base rate and deduct the appropriate margin
from it
• Spot TT Selling Rate: Take the base rate and add the appropriate margin to it.
• Forward TT Buying Rate: Take the base rate. Add (deduct) the on-going
forward premium (discount) to (from) the base rate, depending upon the delivery
period. From this, deduct the appropriate margin.
• Forward TT Selling Rate: Take the base rate. Add (deduct) the on-going
forward premium (discount) to (from) the base rate, depending upon the delivery
period. To this, add the appropriate margin.
The authorized dealers must charge the following amounts from their customers with
regard to various transactions:
• No additional charge for inward remittances for which credit has already been
made to the nostro account of the AD.
• An additional margin of 0.125% to be charged on the TT buying rate and interest to
be recovered from the customer @15% for 10 days’ transit period, for inward
remittances (for example, DDs) where the amount has not been credited to the nostro
account of the AD and the reimbursement has to be obtained from the overseas
drawee bank (in case of a DD) or the overseas correspondent bank (in other cases).
• On inward remittances by way of customer’s personal cheque, an additional
margin of 0.15% on the TT buying rate is to be charged. In addition, interest for
transit period of 15 days is to be recovered from the customer at domestic
commercial rate of interest.
• For all foreign currency outward remittances (not being proceeds of import
bills), a minimum flat charge of Rs.100 is to be made.
• On all outward rupee remittances the charge is to be:
Up to Rs.10,000 0.25% subject to a minimum of Rs.10
Over Rs.10,000 0.125% subject to a minimum of Rs.25

A second kind of merchant rate includes bill buying and bill selling rate. These rates are
considered in case of transaction in foreign currency denominated bills of exchange and
must be calculated according to FEDAI guidelines. The following are the exchange
margins given by FEDAI:
Bill buying 0.125% to 0.150%
Bill selling (over the TT selling rate) 0.175% to 0.200%
25
Bill Buying Rate
This rate is considered when the AD gives the rate for an export transaction. The
transaction can be either in the form of realization of a collection bill or in the form of
purchase or discounting of an export bill. For the first type of transaction, the
appropriate margin is deducted from the base rate in order to arrive at the bill buying
rate. For second type of transaction, the following procedure must be adopted to arrive
at the bill buying rate:
i. Take the base rate.
ii. Add (deduct) the on-going premium (discount) to (from) the base rate, the
amount of premium (discount) depending on the nominal due date. Nominal due
date includes the remaining tenor of the bill and the normal transit period and
grace period as specified by FEDAI guidelines.
iii. From the above, deduct the appropriate margin. This will give rise to applicable
bill buying rate.
For example, let the base rate for dollar be Rs.45.42 and the premium for two months
till the notional due date be 40 paise. If the AD needs a 15% margin, the rate will be:
Base Rate 45.42
Add: Premium 0.40
45.82
Less: Margin @15% 0.0687
Bill buying rate 45.7513
Bill Selling Rate
The bill selling rate is considered when the AD is giving the quote for an import
transaction. The rate is determined by adding appropriate margin to the base rate.
The third kind of merchant transaction includes purchase and sale of foreign currency
notes and travelers cheques (TCs). The applicable rate to these transactions is arrived in
the following manner:
TC Buying Rate: Take the one month forward buying rate given by RBI as the base
rate. If the RBI rate is not available, take the on-going market rate. Deduct margin from
the base rate @1%. The resultant rate will be the TC buying rate.
TC Selling Rate: Take the TT selling rate and add a margin of 0.5% to it. This margin
is optional for the AD. On this gross amount, a commission is added (again at the option
of the AD) at a maximum rate of 1%. If the TC is issued against foreign currency
remittance, then the commission will be charged @ 0.25%. This gives the TC selling
rate.
26
a. Distinguish between currency discount and premium.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b. Discuss briefly about Bill Buying Rate and Bill Selling Rate.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
6.8 THE INDIAN FOREX MARKETS

Before 1992, the Indian forex markets were fully regulated. The value of the Indian
rupee was fixed initially in terms of pound and later US dollar. The liberalization of
forex market was initiated in 1992. In March 1992, a dual exchange rate system known
as Liberalized Exchange Rate Management System (LERMS) was established. Two
exchange rates were prevailing during this period. One of them was determined by RBI
and other by the market. This system was modified later and a Unified Exchange Rate
system came into effect from March 1, 1993. In August 18, 1994, RBI announced
further relaxations on current account transactions and delegated more powers to
Authorized Dealers. The following are some of the major regulations, and relevant
FEDAI guidelines as on January 7, 1999:
Forward Exchange Contracts
• Can be booked only for genuine transactions and where there is exposure to
exchange risk, not for speculative purposes.
• Cannot be booked for anticipated transactions, only for firm exposure.
• No ready sale or purchase should be made for a transaction for which a forward
contract has already been booked.
• Forward cover can also be taken for foreign currency loans to be raised, anytime
after the final approval for the loan arrangements has been obtained from RBI.
• For GDR issues forward cover can be obtained once the issue price has been
finalized.
• Others.
Other Regulations
• Exporters and certain other recipients of forex, at their option, can retain a
portion of the proceeds in forex in a foreign currency account opened with ADs
in India. This account is known as Exchange Earners’ Foreign Currency deposit.
• Cross currency exposures can be covered in the overseas market through ADs,
without necessarily covering the rupee/dollar leg of the transaction, etc.
27
Early Delivery/Extension/Cancellation of Forward Exchange Contracts
Many times, because of various reasons the actual date of delivery or purchase of
foreign currency varies from the date at which forward contract is booked. In such
situations, the forward contracts can be entered or cancelled or an early delivery can be
required by the customer. The customer has to bear any loss arising because of
premature/extended performance or canceling of the contract. The charges to be paid by
the customer are issued in FEDAI Rule No. 8. The rule states that,
• Customers can request for an early delivery/extension/cancelation of a forward
contract on or before the maturity date of the contract.
• The bank has to charge a minimum sum of Rs.100 for entertaining any such
request from the customer.
Early Delivery: Whenever a bank accepts or gives early delivery, in addition to flat
charge of Rs.100, the bank has to charge/pay the swap charges for the early delivery
period from/to the customer without any consideration as to bank position with regard
to swap. The swap cost/gain may be later recovered from/paid to the customer, either in
the initial swap period or at the end. Because of this swap, the bank experiences an
outlay of funds and consequently it has to charge interest from the customers for not
less than prime lending rate for the swap period. Conversely, if there is an inflow of
funds, then the bank at its own discretion pays interest to the customer at the rate
applicable to term deposits with maturity equal to period of swap.
Extension: Extension of a contract involves canceling the existing contract and
rebooking a corresponding forward contact. This cancellation is done at the relevant TT
buying or selling rate as on the date of cancellation. On the other hand, rebooking will
be done on the ongoing rate for a new forward contract. The bank has to collect/pay the
difference between the rates at which the actual contract was entered and the rate at
which it is cancelled from/to the customers.
Cancellation: A contract is cancelled at appropriate TT selling or buying rate and the
difference between the contracted rate and cancellation rate is to be collected from/paid
to the customer. The flat rate must also be collected.
6.9 SUMMARY
Foreign Exchange Market is an Over-The-Counter (OTC) market which has no physical
market place.
Foreign exchange market includes various large commercial banks, forex brokers, large
corporations and central banks.
In the interbank market, currencies are transferred electronically through Nostro account
or Vostro account.
Currency is settled always in the country of its origin.
The exchange rate quotation indicates the price of a currency in terms of another
currency.
Foreign exchange transactions are classified into spot and forward contracts.
The settlement date or value date refers to the day on which the transaction is settled by
a transfer of deposits.
28
6.10 GLOSSARY
Cross Rate is the exchange rate between two currencies calculated by using their
exchange rates with a third currency.
Hedging is a process through which an attempt is made to eliminate the risk.
Market Makers stand ready to buy or sell various currencies at specific prices at all
points of time.
Nostro Account is a bank’s account with a correspondent bank located in a foreign
country.
Vostro Account is a nostro account from the correspondent bank’s point of view.


a. An Authorized Dealer is authorized to buy and sell foreign currency from their
customers. They can also deal with the various items classified as foreign
exchange by FEMA and at the same time are permitted to deal with various
documents related to imports and exports. Authorized Dealers functions in
accordance with the rules and regulations issued by Foreign Exchange Dealers
Association of India (FEDAI). The branches of authorized dealers are classified
into the following types:
Category A: These are the offices/branches which keep independent foreign
currency accounts with overseas correspondent banks/branches in their own names.
Category B: These are the branches which do not maintain independent foreign
currency accounts but have powers to operate the accounts maintained abroad by
their head office or the branches categorized as ‘A’.
Category C: The branches which fall in neither of the above categories and yet
handle forex business through Category A or B fall under Category C.
b The rate at which a bank is ready to buy a currency is different from the rate at
which it is willing to sell the currency. These rates are called bid and ask rates
respectively. The difference in these rates denotes the cost the bank is incurring in
these transactions, a smaller return on the capital employed and the compensation
for the risk it understates. This risk occurs because of unfavorable movement in the
exchange rate before the bank is able to offset the transaction. The difference
between the bid rate and ask rate is called bid-ask spread or just ‘spread’.
a. When the currency is more expensive in the forward market than the spot
market, then it is said to be at premium against another currency. That is forward
rate is higher than the spot rate. This occurs when the future spot rate is expected
to be higher than the current spot rate. In case, the currency is cheaper in the
29
forward market than in the spot market, it is said to be at discount. Here, forward
rate will be lower than the current spot rate. In case of forward rates, the bid-ask
spread increases into future, without any consideration to the base currency
whether it is at a premium or discount.
b. Bill buying Rate
This rate is considered when the AD gives the rate for an export transaction.
The transaction can be either in the form of realization of a collection bill or in
the form of purchase or discounting of an export bill. For the first type of
transaction, the appropriate margin is deducted from the base rate in order to
arrive at the bill buying rate. For second type of transaction, the following
procedure must be adopted to arrive at the bill buying rate:
i. Take the base rate.
ii. Add (deduct) the on-going premium (discount) to (from) the base rate, the
amount of premium (discount) depending on the nominal due date.
Nominal due date includes the remaining tenor of the bill and the normal
transit period and grace period as specified by FEDAI guidelines.
iii. From the above, deduct the appropriate margin. This will give rise to
applicable bill buying rate.
Bill Selling Rate
The bill selling rate is considered when the AD is giving the quote for an import
transaction. The rate is determined by adding appropriate margin to the base rate.

A. Multiple Choices
1. The full fledged money changers in India are authorized to _____________.
a. Buy foreign currency
b. Sell foreign currency
c. Sell foreign currency in limited amounts
d. Buy and sell foreign currency
e. Buy and sell trade related documents.
2. Which of the following statements is true with regard to direct quote?
a. Exchange margin is to be added to bid rate.
b. Exchange margin is to be deducted from the ask rate.
c. Exchange margin is to be added to the ask rate.
d. Exchange margin is to be deducted from the bid rate.
e. Exchange margin is to be deducted from the bid rate and added to ask
rate.
3. Which of the following is true with regard to transaction costs?
a. Relatively less for spot transactions.
b. Relatively high for spot transactions.
c. Relatively more for spot transactions.
d. Same for spot and forward transactions.
30
4. The settlement date for a spot transaction done on 13th June, 2005, a Friday
is__________.
a. 15th June, 2005
b. 17th June, 2005
c. 14th June, 2005
d. 13th June, 2005
e. 16th June, 2005.
5. Which of the following statements is false?
a. Foreign exchange brokers buy or sell foreign currencies for their customers.
b. Foreign currency brokers act as middlemen between two market makers.
c. Authorized dealers are market makers in the foreign exchange market.
d. Banks buy and sell for their own account and carry inventory of currencies.
e. The counterparty in the foreign exchange market is another bank.
B. Descriptive
1. Explain the structure of Forex Market in detail.
2. What is an Exchange Rate Quotation? Describe various kinds of quotes.
3. Discuss different kinds of transactions. Explain about quotes for different kinds
of merchant transactions.
4. Discuss Indian forex market in detail.
C. Problems
1. Peter desires to sell a bill worth $1,000,000 to a bank. The maturity of bill can be at
anytime during the second month. Incase the bank charges a margin of 0.5%,
determine the rate at which the bank can quote. The exchange rates are as follows:
Rs./$ Spot : 45.30/45.45
One-month forward : 15/10
Two-month forward : 20/15
2. KML is a 100% export oriented company situated in Tamil Nadu. It exports shirts
to various European countries. All the exports are invoiced in Euro. In January
2005, the company dispatched a consignment to an import house based at Frankfurt.
The receivable is likely to be realized anytime in April, 2005. KML consults its
banker to sell these Euro earnings and the bank has the following details:
Rs.per $ spot : 45.30/45.45
3-m forward : 40/50
2-m forward : 25/30
Euro/$ spot : 0.7940/0.8007
2-m forward : 0.7920/0.7930
3-m forward : 0.7900/0.7915
Determine the rupee inflow for KML in April 2005, if the expected Euro one
million is sold to the banker through an option forward.
practice only.
31
UNIT 7 EXCHANGE RATE
DETERMINATION
Structure
7.1 Introduction
7.2 Objectives
7.3 Purchasing Power Parity Principle (PPP)
7.4 Empirical Evidence Regarding the Validity of PPP
7.5 Reasons for PPP not Holding Good
7.6 Interest Rate Parity (IRP)
7.7 The Relationship between PPP and IRP
7.8 Reasons for Departure from IRP
7.9 Summary
7.10 Glossary
7.1 INTRODUCTION
The theories of exchange rate determination are categorized on the basis of
Fundamental changes and Random changes. Fundamental changes have a long run
effect on the economic variables of a country, while random changes have a
temporary effect on economic variables and disappear after some time. The theories
which consider fundamental changes in determining exchange rate are called long run
theories. They are Purchasing Power Parity, Interest Rate Parity, International Fisher
Equation etc. Short run theories consider random changes and they include Demand
and Supply Theory of Exchange Rate Determination, Growth Theory of Exchange
Rate Movements etc.
7.2 OBJECTIVES
• Define law of one price;
• Explain the principle of Purchasing Power Parity Principle (PPP) in determining
exchange rate;
• Apply the principles of Interest Rate Parity (IRP) in investment and borrowing
decisions;
• Derive a relationship between PPP and IRP; and
• Recognize the reasons for departure from IRP.
Exchange Rate Determination
7.3 PURCHASING POWER PARITY (PPP)
Gustav Cassel, a Swedish Economist, proposed the theory in 1918. It propounds that the
exchange rates between different countries reflect the purchasing power of their
currencies. According to this theory, the exchange rates of different countries are
determined by the price level changes occurring in those countries. This theory equates
the purchasing power of two countries based on the ‘Law of One Price’.
The Law of One Price
The law of one price is based on certain assumptions as:
• There is no restriction on the movement of goods between countries.
• No transportation costs are involved.
• No transaction costs in buying and selling of goods.
• No Tariffs.
According to law of one price, the price of a commodity must be same all around the
world, under equilibrium conditions. Otherwise, the arbitrageurs will make the price
equal by buying in the cheaper markets and selling in the other market through a two-
way arbitrage. Prices are equalized only when the market conditions are perfect with no
transportation costs and no restrictions on the trade in any form. This is possible when
the price of commodity is denominated in international currency such as the dollar. In
case the price of a commodity is expressed in local currencies, the law of one price links
the exchange rates to prices of commodities. As such the domestic currency price of
commodities in different countries when converted into a common currency at the
ruling spot exchange rate is the same across the world. For example, Country A
converts the price of its commodity into Country B’s currency at the ruling spot
exchange rate between their two currencies as shown in the following equation:
p Ax = S(A/B) x p Bx
Where,
p Ax is the price of commodity ‘x’ in Country A.

S (A/B) is the spot exchange rate of the two countries’ currency.
p Bx is the price of commodity ‘x’ in Country B.

The law of one price gives rise to three forms of PPP. They are absolute form, relative
form and expectations form.
The Absolute form of PPP
According to absolute form of PPP the exchange rate between two countries’ currencies
is determined by their price levels. This theory describes the link between the spot
exchange rate and price levels at a particular point of time. If PA and PB are the prices
of the same basket of goods and services in countries A and B respectively, then
PA
S(A/B) =
PB
Where,
S(A/B) is the spot exchange rate of the two countries’ currencies.
33
For example, if the cost of a basket of goods and services were Rs.5,000 in India and
the same cost $100 in US, then the exchange rate between the rupee and dollar would be
5000/100 = Rs.50/$.
In addition to the assumptions made by Law of One Price, the absolute form has made
further assumptions. They are:
• No transaction costs in buying or selling a currency.
• The same basket of commodities is consumed in different countries and all the
components are used in the same proportion.
It is difficult to test this theory empirically, as the price indexes used in different
countries to measure the price level may not be comparable.
The Relative Form
The relative form of PPP describes the link between the changes in spot rates and in the price
levels over a period of time. According to this theory, changes in spot rates over a period
of time reflect the changes in the price levels over the same period in the concerned
economies. This theory relaxes certain assumptions of Law of One Price such as
absence of transaction costs, transportation costs and tariffs. In other words, the relative
form of PPP may still hold good even when these factors are present. As such the
relative form of PPP is considered superior to the absolute form of PPP. So,
(1 + P A ) = {1 + S (A/B)} x (1 + P B )
The left-hand side of the equation indicates the price level in Country A after one year.
The first term on the right-hand side of the equation indicates the spot exchange rate
between the two currencies at the end of one year, and the last term gives the price level
in country B after one year. These terms are determined by multiplying the figures at the
beginning of the year and the percentage change in the respective figures.
The Expectations form of PPP

According to expectations form of PPP, the expected percentage change in the spot rate
is equal to the difference in the expected inflation rates in the two countries. The
assumption of this theory is that the speculators are risk-neutral and markets are perfect.
If the expected percentage change in the spot rate is denoted as S*(A/B), the expected
inflation rate in Country A as PA* , and the expected inflation rate in Country B as PB* ,
then a person buying the underlying basket of commodities in Country A and holding it
for one year can expect to earn a return equal to the expected inflation rate in Country
A, i.e., PA* . But, if he desires to buy the same basket of commodities in country B, hold
it for one year, and then convert his returns in currency B into currency A at the spot
rate that is expected to rule at that time {i.e., S*(A/B)}, then his expected returns will be
equal to the expected inflation rate in country B, i.e., PB* , and the expected change in the
spot rate. If the speculators are risk-neutral, according to the assumption of the theory
these two returns should be equal, i.e.,
PA* = PB* + S*(A/B)
→ S*(A/B) = PA* – PB*

34
The above equation is called the expectations form or the efficient markets form of PPP.
a. Define Law of One Price.
………..………………………………………………………………………….
………..………………………………………………………………………….
………..………………………………………………………………………….
b. What is Absolute form of PPP?
………..………………………………………………………………………….
………..………………………………………………………………………….
………..………………………………………………………………………….
7.4 EMPIRICAL EVIDENCE REGARDING THE VALIDITY OF

PPP
Many studies have been conducted over a period of time to know whether or not the law
of one price and different forms of PPP really hold good. A study conducted by J David
Richardson reveals that the law of one price does not hold good in short-term in case of
goods having inelastic demand. But the same holds good for other goods in the long-
term. With regard to relative PPP, a number of conflicting results were obtained from
different studies conducted by different people such as Hans Genberg, J Hodgson and P
Phelps, Irving B Kravis and Richard E Lipsey etc. Inspite of conflicting results, based
on generally available information it has been revealed, that PPP does not hold good. In
other words, the movements in exchange rates will not be explained by the movements
in price levels and vice versa. This is mainly because of remaining factors which affect
the exchange rate movements in the short-term and which may dominate the effect of
inflation.
7.5 REASONS FOR PPP NOT HOLDING GOOD

PPP does not hold good because of the following reasons:
Constraints on Movement of Commodities
The constraints on movement of goods such as transportation costs and tariff cause
deviations in the price and ultimately lead to deviation from the absolute PPP. On the
other hand the quotas imposed on the goods exported or imported to a country affect
absolute PPP as well as relative PPP.
Price Index Construction
Price indexes are used to measure the movement in prices. While doing so, many times
the base of the indexes differs. In such a case these indexes prove inappropriate to verify
absolute PPP.
35
Effect of the Statistical Method Employed
The statistical method employed also affects the output of an empirical study in two
ways which are as follows:
• Incorrect measurement of any variation in the inflation rates in the two
economies.
• Ignoring the two-way link between the spot exchange rate and the inflation rates.
Both the factors affect each other. In other words, when the inflation rates affect the
exchange rates, any change in the second method affects the first method. The statistical
method that does not recognize the two-way cause-effect flow, does not give correct
results.
7.6 INTEREST RATE PARITY (IRP)

‘Interest Rate Parity’ theory also called covered interest parity condition gives the
equilibrium condition in the financial markets. Developed by Lord Keynes in 1930 the
theory is also based on law of one price. According to this theory an interest rate
differential between two countries is offset by the ‘forward premium’ or ‘forward
discount’. A forward contract cannot be used in making a gain depending on interest
rate differential. Due to the absence of transaction costs, taxes and capital controls, the
investors as well as borrowers carry on transactions in the currency which proves more
attractive to them. Further, the decision of the investor’s and borrowers’ is affected by
the prevailing interest rate on financial assets denominated in various currencies.
Investor’s Decision
An investor can invest in either securities denominated in domestic currency or in
foreign currency. If the investor invests in the latter, then his return will depend on
interest rate of those securities and any change in the value of that currency. When
foreign currency depreciates during the period of investment, the investor’s gain in the
form of interest earned will be cancelled by the loss incurred in converting that currency
to domestic currency. If the securities investment is made in currency having flexible
exchange rate, any volitility can result into loss. In order to compare the foreign
investment with domestic exchange rate risk has to be eliminated. This can be done by
entering into a forward contract. The investor can consider the forward rate, by
calculating the total returns he can earn on securities denominated in different
currencies to enable him to choose and invest in the securities which yield a maximum
return.
Borrower’s Decision
The borrower can borrow the money either in domestic currency or in foreign currency.
The borrower’s decision depends on the cost of domestic currency borrowing when
compared to the covered cost of foreign borrowing. For example, if the borrower desires
to borrow Rs.1,00,000, he may borrow either in rupees or in dollars. If he borrows in
rupees, at the end of the year he would need to pay
Rs.1,00,000 (1.10) = Rs.1,10,000.
36
On the other hand, if he borrows in dollars, he will need to borrow
1, 00, 000
$ = $2202.64
45.40
At the end of the year, he would need to pay back
$2202.64 (1.04) = $2290.75
To repay these many dollars, he would need
Rs.(2290.75 x 46.37) = Rs.106221.87
As the covered cost of borrowing in dollars is higher compared to the cost of borrowing
in rupees, the borrower would choose to borrow in rupees.
Covered Interest Arbitrage
In addition to investors and borrowers, the arbitrageurs also benefit from cost of money
which varies from one currency to another. The process of borrowing in one currency
and simultaneously investing in another, with the exchange rate hedged in the forward
market is called covered interest arbitrage. If the following equation does not hold good,
then the arbitrageur can earn riskless profits by borrowing in the cheaper currency and
investing in costlier currency, using the forward market to lock in his profits.
F(A/B)
(1 + rA ) = × (1 + rB )
S(A/B)
where,
A is domestic currency.
B is foreign currency.
rA is the return earned by investor on domestic deposits.
rB is the return earned by investor on foreign currency denominated securities.
S(A/B) is the spot rate at which conversion takes place.
F(A/B) is the relevant forward rate.
F(A/B)
If (1 + rA ) > × (1 + rB )
S(A/B)
the above condition holds good, then the arbitrageur would borrow in the foreign
currency, convert the receipts to the domestic currency at the ongoing spot rate and
invest in the domestic currency denominated securities, while covering the principal and
interest from this investment at the forward rate. Later at maturity, he will convert the
proceeds of the domestic investment at the prefixed forward rate and pay-off the foreign
liability. The difference between the receipts and payments will be his profit.
On the other hand, if
F(A/B)
(1 + rA ) < × (1 + rB )
S(A/B)
holds good, then the arbitrageur will borrow in the domestic currency, convert it into
foreign currency at the spot rate, invest the proceeds in foreign currency denominated
securities and cover the principal and interest from this investment at the forward rate.
Thus, he locks his domestic currency returns.
37
7.7 THE RELATIONSHIP BETWEEN PPP AND IRP
Uncovered Interest Parity Condition
The expected spot rate would be equal to the forward rate if the risk is not considered.
So,
S(A / B)
(1 + rA ) = × (1 + rB )
S(A / B)
Here,
S (A/B) is the expected spot rate at the end of one year.
According to the definition,
S (A/B) = S(A/B) x {1 + S* (A/B)}
Where,
S*(A/B) is the expected percentage change in the spot rate.
Hence, we can write the above equation as:
(1 + rA) = {1 + S*(A/B)} x (1 + rB)
By solving, we get,
1 + rA = 1 + S*(A/B) + rB + {S*(A/B) x rB}
(The last term on the right-hand side is likely to be very small and is ignored to get the
approximate equivalent equation.)
Hence,
rA = S*(A/B) + rB
Or
rA – rB = S*(A/B)
This equation is called the uncovered interest parity condition or the International Fisher
Effect or Inter-Relationship of Parity Conditions.
The Fisher Effect
A real increase in the investors’ wealth is not represented by nominal interest rate, as the
increase is influenced by inflation rate. The real increase is shown by the real interest
rate which the investors are more concerned with as they believe in the value of money
in terms of purchasing power. The real interest rate measures the rate at which the
current goods and services are exchanged for future goods and services. When the
nominal interest rate varies directly with the expected inflation rates, then it is known as
the Fisher Effect. According to Irving Fisher, the nominal interest rate is the
combination of real interest rate and the expected rate of inflation. So, the fisher
equation states that,
1 + r = (1 + i) x (1 + P*)
Where,
r = nominal rate.
i = real rate.
*
P = expected inflation rate.
38
By solving, we get
r = i + P* + (i x P*)
Or
r = i + P* (approximately)
The above equation implies that the nominal rate is equal to the real rate plus the
expected inflation rate.
The Relationship
According to the expectations form of the PPP,
S*(A/B) = PA* − PB*
According to the uncovered interest rate parity condition,

S*(A/B) = rA – rB
It follows that,
rA − rB = PA* − PB*
By rearranging, we get,
rA − PA* = rB − PB*
The above equation is called Fisher’s open condition, according to which the real
interest rates are equal across different countries.
a. Give reasons for departure of PPP?
………..………………………………………………………………………….
………..………………………………………………………………………….
………..………………………………………………………………………….
b. What is Fisher Effect?
………..………………………………………………………………………….
………..………………………………………………………………………….
………..………………………………………………………………………….
7.8 REASONS FOR DEPARTURE FROM IRP

Interest rates deviate from covered interest rate parity when factors like taxes, capital
controls and transaction costs are present. Covered Interest Rate Parity does not hold
good perfectly because of various reasons such as transaction costs, political risks,
taxes, liquidity preference and capital controls.
Transaction Costs
The transaction cost present in the money market transactions is the difference between
the investment and the borrowing rate. The cost involved in converting one currency to
another is called bid-ask spread. If the dealings in the money markets and currency
markets must be profitable, then any deviations from the IRP must exceed the
transaction costs.
39
Political Risk
The risk of change in the foreign country’s laws or policies that affect the return on
investments is referred to as political risk. Political risk can be in the form of any
change in the tax structure, restriction on repatriation of proceeds of the investment etc.
The additional risk of sudden confiscation of all foreign assets compels the investors to
acquire higher return on foreign investments compared to that warranted by the interest
parity. This leads to deviation from the IRP.
Taxes
Parity is affected either when taxes are withheld or through differential tax rate. Any
resident paying to a foreign resident must withhold some part of the payment in the form
of taxes and later pass it on to the tax department of his country. Foreign currency
earnings of the resident are reduced to the extent he has held payment back in the form of
tax. This allows deviation from the interest parity up to the amount of tax withheld.
Deviations from the interest parity may also occur if the earnings from the foreign
currency transactions are treated as capital gains and are taxed at differential tax rates
applicable to the interest income.
Liquidity Preference
An additional cost other than the costs involved in liquidating a foreign investment and
domestic investment is called cost of canceling the cover or canceling the forward
contract. Because of this additional cost the investor must acquire a premium over the
interest parity in order to make a foreign investment. Higher premium is required if the
expectation of liquidating the investment before maturity is high. The presence of
alternative short-term finance sources will cause reduction in the premium demanded by
the investors.
Capital Controls
Capital controls which include restrictions on investing and borrowing overseas,
restrictions on conversion of currencies etc., create large deviations from the interest
parity. Because of these controls the market forces are restricted from bringing the
interest rates and exchange rates in line with the parity.
7.9 SUMMARY
The theories which consider fundamental changes in determining exchange rate are
called long run theories and they include Purchasing Power Parity Theory, Interest rate
Parity Theory, and International Fisher Equation etc.
According to Purchasing Power Parity Theory the exchange rates of different countries
are determined by the price level changes occurring in those countries.
According to law of one price, the price of a commodity must be same all around the
world in equilibrium conditions.
Interest Rate Parity theory also called covered interest parity condition gives the
equilibrium condition in the financial markets.
When the nominal interest rate varies directly with the expected inflation rates, it is
known as the Fisher Effect.
Interest rates deviate from covered interest rate parity when factors like taxes, capital
controls and transaction costs are present.
40
7.10 GLOSSARY
Forward Discount is the difference between the spot price and the forward price of a
currency expressed in percentage terms, with the forward price being lower than the
spot price.
Forward Premium is the difference between the spot price and the forward price of a
currency expressed in percentage terms, with the forward price being higher than the
spot price.
Fundamental Changes are the changes which alter the economic performance of the
economy for all times to come.
Interest Rate Parity is the condition under which the premium on a foreign currency is
equal to the interest rate differential between the two countries.
Law of One Price states that the price of a commodity should be same across nations.
Random Changes are the changes which have a temporary effect on the economic
performance of the economy.


a. Gustav Cassel, a Swedish Economist, proposed the theory in 1918. It propounds
that the exchange rates between different countries reflect the purchasing power
of their currencies. According to this theory, the exchange rates of different
countries are determined by the price level changes occurring in those countries.
This theory equates the purchasing power of two countries based on the ‘Law of
One Price’.
The Law of One Price
The law of one price is based on certain assumptions as:
• There is no restriction on the movement of goods between countries.
• No transportation costs are involved.
• No transaction costs in buying and selling of goods.
• No Tariffs.
b. The Absolute form of PPP
According to absolute form of PPP the exchange rate between two countries’
currencies is determined by their price levels. This theory describes the link
between the spot exchange rate and price levels at a particular point of time.
41
If PA and PB are the prices of the same basket of goods and services in countries
A and B respectively, then
PA
S(A/B) =
PB
Where,
S(A/B) is the spot exchange rate of the two countries’ currencies.
For example, if the cost of a basket of goods and services were Rs.5,000 in India
and the same cost $100 in US, then the exchange rate between the rupee and
dollar would be 5000/100 = Rs.50/$.
a. PPP does not hold good because of the following reasons:
Constraints on Movement of Commodities
The constraints on movement of goods such as transportation costs and tariff
cause deviations in the price and ultimately lead to deviation from the absolute
PPP. On the other hand the quotas imposed on the goods exported or imported to
a country affect absolute PPP as well as relative PPP.
Price Index Construction
Price indexes are used to measure the movement in prices. While doing so, many
times the base of the indexes differs. In such a case these indexes prove
inappropriate to verify absolute PPP.
Effect of the Statistical Method Employed
The statistical method employed also affects the output of an empirical study in
two ways which are as follows:
• Incorrect measurement of any variation in the inflation rates in the two
economies.
• Ignoring the two-way link between the spot exchange rate and the
inflation rates.
Both the factors affect each other. In other words, when the inflation rates affect
the exchange rates, any change in the second method affects the first method.
The statistical method that does not recognize the two-way cause-effect flow,
does not give correct results.
b. A real increase in the investors’ wealth is not represented by nominal interest
rate, as the increase is influenced by inflation rate. The real increase is shown by
the real interest rate which the investors are more concerned with as they believe
in the value of money in terms of purchasing power. The real interest rate
measures the rate at which the current goods and services are exchanged for
future goods and services. When the nominal interest rate varies directly with the
expected inflation rates, then it is known as the Fisher Effect.
42
According to Irving Fisher, the nominal interest rate is the combination of real
interest rate and the expected rate of inflation. So, the fisher equation states that,
1 + r = (1 + i) x (1 + P*)
Where,
r = nominal rate.
i = real rate.
P* = expected inflation rate.
By solving, we get
r = i + P* + (i x P*)
Or
r = i + P* (approximately)
The above equation implies that the nominal rate is equal to the real rate plus the
expected inflation rate

A. Multiple Choices
1. Which of the following is an assumption made under Law of one price?
a. No Tariffs.
b. No Transaction Costs.
c. Movement of goods between Countries.
d. No Transportation costs.
2. The absolute form of PPP describes the link between _________________.
a. Spot exchange rate and price levels over a period of time.
b. Spot exchange rate and future exchange rate over a period of time.
c. Price levels and interest rate at a particular point of time.
d. Exchange rate and interest rate over a period of time.
e. Spot exchange rate and price levels at a particular point of time.
3. Which of the following statements is true with regard to price indexes?
a. Price indexes measure the movements in interest rates.
b. Price indexes measure the movements in inflation.
c. Price indexes measure the movements in price.
d. Both (b) and (c) of the above.
4. Which of the following is true with regard to ‘bid-ask spread’?
a. Bid-ask spread is the cost involved in conversion of currencies.
b. Bid-ask spread is the cost involved in conversion of exchange rates.
c. Bid-ask spread is the cost involved in conversion of interest rates.
d. Both (a) and (b) of the above.
e. Both (a) and (c) of the above.
43
5. Interest Rate Parity theory was developed by ________________.
a. J Hodgson
b. Hans Genberg
c. Lord Keynes
d. P Phelps
e. Irving B Kravis.
B. Descriptive
1. Explain in detail Purchasing Power Parity Theory.
2. Explain the Relationship between PPP and Interest Rate Parity.
3. Explain in detail Interest Rate Parity Theory.
4. Explain the reasons why the Covered Interest Rate Parity does not hold good
perfectly.
C. Problems
1. A customer obtains the following quotes:
Spot $/Rs. : 45.00/45.10
6-month $ interest rates : 4.5% – 5%
6-month Re. interest rates : 6% – 7%

What are the likely limits for six-month forward quote?
2. A US investor chose to invest in sensex for a period of one year. The relevant
information is given below:
Size of investment ($) 2000,000

Spot rate 1 year ago ($/Rs.) 45.30/50
Spot rate now ($/Rs.) 45.80/90
Sensex 1 year ago 5333
Sensex now 6220
Inflation in US 2%
Inflation in India 4%
a. Compute the nominal return to the US investor.
b. Compute the real depreciation/appreciation of rupee.
c. What should be the exchange rate if relative purchasing power parity
holds good?
d. What will be the real return to an Indian investor in sensex?
3. Epsi Ltd. an Indian company requires Rs.10 million for six months. Epsi Ltd. has
the option of borrowing either in rupees or in US dollars. Epsi Ltd. has obtained
the following information from its banker:
$/Rs. exchange rate
Spot 43.5700/5750
3-m swap 3900/4000
6-m swap 7000/7100
44
Interest rates
Rupee
3-months 11.00%
6-months 12.00%
US dollar
3-months 6.50%
6-months 7.00%
You are required to answer the following:
a. In which currency should Epsi Ltd. borrow?
b. What should be the 3-month interest rate 3-months hence on the currency
borrowed as per your answer to part (a) so that Epsi Ltd. is indifferent
between borrowing for 6-months and borrowing for 3-months and rolling
it over for another three months?
practice only.
45
UNIT 8 EXCHANGE RATE
FORECASTING
Structure
8.1 Introduction
8.2 Objectives
8.3 Forward Rate as a Predictor
8.4 The Demand-Supply Approach
8.5 The Monetary Approach
8.6 The Asset Approach
8.7 Portfolio Balance Approach
8.8 Role of News as Determinant
8.9 Technical Analysis
8.10 Summary
8.11 Glossary
8.1 INTRODUCTION
A plethora of factors affect the levels of, and movements in exchange rates, often in a
conflicting manner. A number of theories were propounded to explain these effects.
Though a consistent prediction of the exact level of future exchange rates is impossible,
these theories help in forecasting the possible direction of the movement. Such
forecasting is very important for players in the international markets, as the exchange
rates have a great impact on their profits. Another set of players for whom correct
exchange rate forecasting is vital, are the speculators. Their forecast about the
movement in exchange rates propels them to undertake speculative activities,
especially when their expectations are against those of the market. Though
speculators are generally ill-known for the destabilizing effects of their activities
on financial markets, they are actually the liquidity providers of the markets. Also,
as their views are generally opposite to the market’s views, they stabilize the
markets by forming the other (than the market’s) side of the demand-supply forces.
The following models of exchange rate forecasting are covered in this unit:
• Forward rate as an unbiased predictor of future spot rates;
• The demand-supply approach;
• The monetary approach;
• The asset approach;
• The portfolio balance approach;
• News as the determinant of exchange rates; and
• Technical analysis.
Exchange Rate Forecasting
8.2 OBJECTIVES
• Derive the use of Forward rate as a predictor;
• Discuss various approaches in currency forecasting;
• Understand the role of news as a determinant; and
• Appreciate the role of Technical analysis in currency forecasting.
8.3 FORWARD RATE AS A PREDICTOR

When markets are competitive, forward rates act as unbiased predictors of future
exchange rates. A market is said to be competitive when the concerned currencies are
heavily traded and freely floated. Forward rate considers expected developments of
variables influencing the exchange rates and does not consider unexpected
developments, thus sometimes resulting in inaccurate forecasts. A forward rate forecast
is more accurate when the time gap is smaller.
8.4 THE DEMAND-SUPPLY APPROACH

A currency’s exchange rate can be determined by its over all demand and supply.
As such, any change in exchange rates can be forecasted by analyzing the factors that
affect the demand and supply of a currency. These factors are mentioned in the balance
of payments account and hence this approach is called as balance of payments approach.
The demand curve of a currency in accordance to this approach is derived from the
country’s supply curve of exports. An exogenous increase in exports results in the
appreciation of the domestic currency and an exogenous increase in imports results in
the depreciation of the local currency. Similarly, any change resulting in a reduction of
an inflow would depreciate a currency, while a reduction of an outflow appreciates the
domestic currency. On the other hand, an increase in the net transfers out of the country
will lead to depreciation of currency and vice versa. The economic variables also affect
exchange rate. A relatively higher inflation affects the relative prices of that country’s
exports and imports. This leads to reduction in exports and increase in imports causing
the currency to depreciate. Thus, this approach supports purchasing power parity.
Similarly, an increase in domestic interest rates attracts more foreign investment
resulting in appreciation of currency. Thus, this approach also supports IRP.
An important aspect of this theory is, that the mechanism employed to explain exchange
rate changes implies that any change in the value of a currency is only an instrument to
correct the temporary imbalance in the system. For example, if a currency depreciates
due to the country experiencing a relatively higher inflation than its trading partners, the
depreciation reduces the foreign currency price of the country’s exports and thereby
restores the competitiveness of the exports. At the same time, the imported goods are
made more expensive by the depreciation, thereby reducing imports. This improves the
current account balance. But sometimes it is observed that this does not happen. Despite
a depreciation, the current account balance continues to worsen. This results in
instability in the exchange markets as well. This phenomenon is called the J-curve
effect. According to this , when both imports and exports are price inelastic in the short
run but price elastic in the long run, volume of exports and imports do not immediately
respond to the change in relative prices of exports and imports, caused by depreciation
47
of home currency. This leads to deterioration in the Balance of Trade (and hence, BoP)
for the home country. This makes the currency depreciate further. This happens because
it takes people some time to adjust to the change in relative prices. Despite a higher
price of imports, people change-over to import substitutes only after a time lag.
Similarly, it takes time for the producers of exported goods to increase their production
of these goods, and for the foreign consumers to start consuming more of these goods.
Till such time that the exports go up and the imports come down, the trade balance
continues to worsen and the domestic currency continues to depreciate. After this time
lag, the current account balance improves and the exchange rate stabilizes. Inelasticities
of export supply and import demand curves also explain the opposite phenomenon – the
trade balance continuing to become stronger despite an appreciation of the currency.
These two conditions are shown in figure 1 and figure 2. As can be observed, the path
followed by the trade balance forms a J (an inverse J in the latter case), thus giving its
name to this phenomenon.
Figure 1: The J-Curve after Depreciation
Figure 2: The J-Curve after Appreciation

At the same time, the export supply curves of the currency become downward sloping
instead of upward sloping curve. This leads to instability in the exchange markets as
shown in the following figure:
Figure 3: Unstable Market
48
The SRs and the DRs represent the supply and demand for rupee against the dollar.
Se($/Rs) represents the equilibrium exchange rate between the dollar and the rupee.
Any small appreciation in the value of the rupee leads to demand for rupees exceeding
the supply which further appreciates the rupee. Inspite of supply curve being downward
sloping, any movement of exchange rate away from the equilibrium compels the market
forces to restore it to the equilibrium state as shown in the following figure:
Figure 4: Stable Market

An appreciation of the rupee results in higher supply compared to demand and thus
causes lower exchange rate. Conversely, depreciation causes a higher exchange rate. In
the above figure, the forex markets remain stable inspite of a flatter demand curve and
hence more elastic than the supply curve. For exchange markets to be unstable, the
demand curve for a currency has to be relatively less elastic than the supply curve, with
the supply curve being downward sloping. This occurs when the import demand curve is
inelastic and export supply curve is even more inelastic. In terms of elasticities of export
supply and demand curves, the two elasticities must together be greater than one in order
to avoid exchange market instability. This condition is termed as the Marshall-Lerner
condition.
a. Discuss in brief the J-curve effect.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
b. Explain in brief the Marshall-Lerner condition.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
8.5 THE MONETARY APPROACH

This theory is based on the assumption that PPP holds good. Whenever there is an
increase in the real GNP, it results in an increase in the real money demand. Because of
this less money is available to purchase goods, services and bonds. As there is no
change in the money supply, the price levels come down. A reduction in the demand for
bonds causes the bond prices to decrease and this leads to an increase in the nominal
interest rates. Because of this assumption, a reduction in the price level leads to
49
appreciation of currency. Thus, an increase in the real GNP results in the appreciation of
the currency. The following are the summarized predictions of the monetary theory:
• An increase in the real GNP of a country causes its currency to appreciate. Out of
two countries, the country having a higher growth in the GNP will see its
currency appreciate against the other country’s currency.
• An increase in real money demand makes the currency appreciate.
• An increase in nominal interest rates causes the currency to depreciate (as
seen in the correction mechanism). This again goes against the predictions of
the demand-supply approach.
• An increase in the money supply causes the currency to depreciate.
According to the monetary approach, the effect of inflation on the exchange rate is
immediate rather than occur after inflation.
Exchange Rate Volatility
Sometimes exchange rates change more than required by a change in an economic
variable and later come back to the new equilibrium. This phenomenon is explained by
the Dornbusch sticky-price theory. Accordingly, such phenomenon occurs due to the
stickiness of the price of some goods. When the price of traded goods changes quickly
according to the change in the money supply, the price of non-traded goods remains
sticky in the short run and takes some time to adjust. As the prices of all the goods do
not change to the level of requirement, the demand for money also does not increase
enough to become equal to the supply of money. This results in decrease in interest rates
and finally an increase in the money demand restoring equilibrium. The decrease in
interest rate also affects the exchange rates. According to interest rate parity, a decrease
in interest rate is accompanied by a corresponding decrease in the forward
premium/discount on a currency, either through the forward rate or the spot rate.
8.6 THE ASSET APPROACH

This theory is also called efficient market hypothesis approach and talks about the
effect of changes in the basic economic variables on the exchange rates. Accordingly,
any expected changes which may occur in the value of a currency in the future are
reflected in the exchange rates immediately. New information related to factors enters
the market in a random manner and is quickly absorbed by the market. The efficient
working of the market is based on the assumption that there are a large number of
participants in the market aiming to maximize their profits. So, these participants
through profit-maximizing activities ensure that all the available information is
absorbed into the market. On the other hand, central banks try not to maximize profits
from currency movements. In accordance to this theory, a fiscal deficit increases the
money supply levels in the future and an increasing fiscal deficit triggers off an
immediate depreciation of currency, even when there is no immediate increase in the
money supply.
8.7 PORTFOLIO BALANCE APPROACH

According to this approach, people can invest in assets in different countries in different
currencies. As such, any change in the exchange rates changes the wealth of the asset
holders. This forms the basis for maintaining equilibrium in money and bond markets.
50
This theory explains the link between interest rates and exchange rates as shown in the
following figure:
Note: A – Home Currency; and B – Foreign Currency.
Figure 6: Portfolio Balance Model

In the above figure, interest rates are shown on Y-axis and exchange rate on
X-axis. Curve ‘bb’ represents the combinations of interest rates and exchange rates for
which bond market is in equilibrium. Curve ‘mm’ represents combinations for which
money markets are in equilibrium. When the interest rate increases, the demand for
bonds also increases. So, when the supply of bonds remains the same, it leads to
excess demand. This resultant demand can be reduced by reducing the wealth of the
portfolio holders. This can be done by appreciating the domestic currency
accompanied by an increase in the interest rates in order to maintain equilibrium in
the bond market. This causes the curve ‘bb’ to slope downwards. When the money
supply remains constant, the increase in interest rates lowers demand for money and
results in excess supply of money. To get back to the equilibrium position in the
money markets, the demand for money is increased by increasing the real wealth of
portfolio holders by way of depreciation of domestic currency. This increase in wealth
leads to higher demand for money. Depreciation of domestic currency results in
increase in interest rates. This maintains the equilibrium in money markets and makes
the curve ‘mm’ to slope upwards. This theory assumes that any change in the money
supply is effected via open-market operation by the government and this changes the
supply of bonds. This theory also explains about the change in the value of a currency
resulting from a change in real GNP.
8.8 ROLE OF NEWS AS DETERMINANT

News contribute to a large extent towards unpredictability of exchange rates. They also
explain the reason why PPP does not always hold good. Any unexpected event
occurring is quickly absorbed by the Forex markets which change accordingly. The real
markets are slow in absorbing the news and as such there will be a divergence from PPP
until the real markets adjust.
51
a. Discuss in brief the Asset Approach.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b. Discuss in brief the role of news as a determinant.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
8.9 TECHNICAL ANALYSIS

Technical analysis involves forecasting of future exchange rates by using past exchange
rate movements by forecasters called technicians. Technicians develop their own
forecasts about future currency values and as such each technician has his individual
method. Pure technicians believe that past movements lead them to the future and they
ignore economic factors such as inflation rates, interest rates etc. On the other hand,
technicians believe that exchange rate movements are predictable by utilizing the data
on historical movements. Many methods such as statistical models, charts of past
exchange rate movements etc., are used by technicians.
Evaluation of Technical Forecasts
Technical analysts develop forecasts based on historical data and as such economists
view them as astrologers of market place inspite of their more accurate predictions
compared to economic forecasting model or highly sophisticated statistical model of
exchange rate forecasting. Economists argue that current exchange rates change with
unforeseeable events in the markets and the present rates reflect all the foreseeable
events. The unforceable events happen in a random fashion and hence exchange rate
changes also follow a random pattern.
8.10 SUMMARY
International market players need exchange rate forecasting to apprehend its effect on
their profits.
Various models of exchange rate forecasting are demand-supply approach, monetary
approach, asset approach and portfolio balance approach.
These models predict different effects in various economic variables on the exchange
rates.
News contribute to a large extent towards unpredictability of exchange rates.
Technical analysis involves forecasting of future exchange rates by using past exchange
rate movements by forecasters called technicians.
8.11 GLOSSARY
Forward Discount is the difference between the spot price and the forward price of a
currency expressed in percentage terms, with the forward price being lower than the
spot price.
Forward Premium is the difference between the spot price and the forward price of a
currency expressed in percentage terms, with the forward price being higher than the
spot price.
52
J-curve Effect is the phenomenon of a country’s trade balance worsening despite
depreciation of its currency, before it starts improving.


a. The mechanism employed to explain exchange rate changes implies that any
change in the value of a currency is only an instrument to correct the temporary
imbalance in the system. For example, if a currency depreciates due to the
country experiencing a relatively higher inflation than its trading partners, the
depreciation reduces the foreign currency price of the country’s exports and
thereby restores the competitiveness of the exports. At the same time, the
imported goods are made more expensive by the depreciation, thereby reducing
imports. This improves the current account balance. But sometimes it is observed
that this does not happen. Despite a depreciation, the current account balance
continues to worsen. This results in instability in the exchange markets as well.
This phenomenon is called the J-curve effect.
b. An appreciation of the rupee results in higher supply compared to demand and
thus causes lower exchange rate. Conversely, depreciation causes a higher
exchange rate. The forex markets remain stable in spite of a flatter demand curve
and hence more elastic than the supply curve. For exchange markets to be
unstable, the demand curve for a currency has to be relatively less elastic than
the supply curve, with the supply curve being downward sloping. This occurs
when the import demand curve is inelastic and export supply curve is even more
inelastic. In terms of elasticity of export supply and demand curves, the two
elasticity must together be greater than one in order to avoid exchange market
instability. This condition is termed as the Marshall-Lerner condition.
a. This theory is also called efficient market hypothesis approach and talks about
the effect of changes in the basic economic variables on the exchange rates.
Accordingly, any expected changes which may occur in the value of a currency
in the future are reflected in the exchange rates immediately. New information
related to factors enters the market in a random manner and is quickly absorbed
by the market. The efficient working of the market is based on the assumption
that there are a large number of participants in the market aiming to maximize
their profits. So, these participants through profit-maximizing activities ensure
that all the available information is absorbed into the market. On the other hand,
central banks try not to maximize profits from currency movements.
In accordance to this theory, a fiscal deficit increases the money supply levels in
the future and an increasing fiscal deficit triggers off an immediate depreciation
of currency, even when there is no immediate increase in the money supply.
53
b. News contribute to a large extent towards unpredictability of exchange rates.
They also explain the reason why PPP does not always hold good. Any
unexpected event occurring is quickly absorbed by the Forex markets which
change accordingly. The real markets are slow in absorbing the news and as such
there will be a divergence from PPP until the real markets adjust.

A. Multiple Choices
1. Which of the following is also known as Balance of Payment Approach?
a. Asset Approach.
b. Portfolio Balance Approach.
c. Monetary Approach.
d. Demand-Supply Approach.
2. Which of the following is/are prediction(s) of Monetary Approach?
a. An increase in money supply causes the currency to depreciate.
b. An increase in nominal interest rates causes the currency to depreciate.
c. An increase in real GNP of a country causes its currency to appreciate.
d. An increase in real money demand makes the currency appreciate.
3. Which of the following approaches assumes that the purchasing power parity
holds goods?
a. Asset Approach.
b. Monetary Approach.
c. Demand-Supply Approach.
d. Portfolio Balance Approach.
4. Which of the following statements best explains the J-curve effect?
a. Improving and subsequent improvement of trade balance after currency
appreciation.
b. Worsening and subsequent improvement of trade balance after currency
depreciation.
c. Improving and subsequent worsening of trade balance after currency
appreciation.
d. Worsening and subsequent improvement of trade balance after currency
depreciation.
54
5. Which of the following corporate function(s) does/do not require exchange rate
forecasting?
a. Earnings assessment.
b. Hedging decisions.
c. Short-term Investment decisions.
d. Capital budgeting decisions.
B. Descriptive
1. Explain in detail the Demand-Supply Approach.
2. Discuss the Monetary Approach.
3. Describe the Dornbusch Sticky-Price Theory.
4. What is a portfolio? Explain the Portfolio Balance Approach.
practice only.
55
NOTES
56

Nos.
MANAGEMENT

16. Trade Blocks

MBA-0000
Block
3
EXCHANGE RISK MANAGEMENT
UNIT 9
Introduction to Exchange Risk 5
UNIT 10
Management of Exchange Risk 15
UNIT 11
International Project Appraisal 27
Expert Committee


Director Director

Director Director
Prof. P. Ramnath
Director
IBS Chennai






While every possible care has been taken in type-setting and printing this book, the The ICFAI

BLOCK 3 EXCHANGE RISK MANAGEMENT
This block introduces the concept of exchange risk that arises out of foreign exchange
transactions. It lists and illustrates various foreign exchange exposures while carrying
out cross boarder transactions. Besides, it lists the types of exposures a firm carries and
details the different ways of managing exposures. Further, this block covers the various
reasons for foreign direct investment and its appraisal.
Unit 8 defines what an exposure is and differentiates it with risk. This unit introduces
three different types of exposures namely transaction exposure, translation exposure and
operating exposure.
Unit 9 focuses on managing transaction and translation exposures through internal

hedging techniques such as exposure netting, leading and lagging, and hedging using
various instruments. The management of economic exposure is discussed in detail by
using various strategies.
Unit 10 enumerates the reasons for FDI and discusses at length the viability of projects
using Adjusted Present Value criteria.
UNIT 9 INTRODUCTION TO
EXCHANGE RISK
Structure
9.1 Introduction
9.2 Objectives
9.3 Foreign Exchange Exposure
9.4 Foreign Exchange Risk
9.5 Types of Exposure
9.6 Summary
9.7 Glossary
9.1 INTRODUCTION
Companies operating in domestic and international markets are exposed to various
risks among which exchange rate risk is the most critical. Often profits are affected
due to adverse situations arising because of unexpected movements in exchange rates.
Variability in exchange rates results in foreign exchange exposure and foreign
exchange risk.
9.2 OBJECTIVES
• Define Foreign Exchange Exposure;
• Distinguish between Foreign Exchange Exposure and risk; and,
• Discuss and categorize different types of exposures.
9.3 FOREIGN EXCHANGE EXPOSURE

A foreign exchange exposure can be defined as the sensitivity of changes in the real
domestic currency value of assets and liabilities or operating incomes to unanticipated
changes in exchange rates.1 In other words, it is the amount of assets, liabilities and
operating income that is at risk from unanticipated changes in exchange rates. For
example, when a firm is engaged in export business, any change in the exchange rates
affects its revenue in terms of domestic currency. Sensitivity of changes is measured by
the slope of the regression equation between two variables, viz. unexpected changes in
the exchange rates and the resultant change in the domestic currency value of assets,
1 This definition is given by Michael Adler and Bernard Dumas in “Exposure to Currency Risk :
Definition and Measurement, Financial Management.”
liabilities and operating incomes. The second variable is further classified into four
categories in order to measure the exposure. They are:
• Foreign currency assets and liabilities which have fixed foreign-currency values.
• Foreign currency assets and liabilities with foreign-currency values that change
with an unexpected change in the exchange rate.
• Domestic currency assets and liabilities.
• Operating incomes.
Assessing Exposure having Fixed Foreign Currency Values
Measurement of the first category of exposure is simpler than the other categories. In
order to understand the process of measurement, let us consider that an investor is
holding a £1 million deposit. The following figure depicts the change in the rupee-value
of the deposit due to unexpected changes in Rs./£ rate.
Figure 1
In the above graph, the unexpected changes in the exchange rate [∆Su(Rs/£)] are shown
on X-axis, with a positive value denoting an appreciation in foreign currency. Similarly,
Y-axis represents the change in the rupee-value of the deposit(V). With an unexpected
appreciation of Rs.0.20 in the pound’s value, the deposit’s value increases by Rs.0.2
million while the unexpected depreciation of the pound by Rs.0.10 reduces the deposit’s
value by Rs.0.1 million. A depreciation of Rs.0.2 reduces the deposit’s value by Rs.0.2
million. This results in an upward sloping exposure line. Conversely, a foreign liability
of fixed value in terms of foreign currency will result in a downward sloping exposure
line. The combinations of the two variables may not lie exactly on a straight line.
Figure 2
6
Introduction to Exchange Risk
Whether the points fall exactly on exposure line or not, the quantum of change in the
foreign-currency value of the assets and liabilities is predictable to a high degree.
This predictability facilitates drawing a regression line and subsequently measuring
exposure.
The regression equation can be expressed as:
∆V = a x ∆Su + e
Where,
∆V = Change in the domestic value of assets and liabilities.

a = The slope of the regression line.
∆Su = Unexpected change in the exchange rate.
e = Random error, the presence of which allows for small variations in the
value of V from those given by the regression line.
In the above equation, the exposure is given by ‘a’. In the case of graph 1, the exposure
can be measured in the following way. Since all the points fall exactly on the exposure
line, the value of random error ‘e’ will be equal to zero. Hence,
∆V = a x ∆Su
∆V
⇒a =
∆Su
− Rs.1, 00, 000

=
Rs.0.10 / £
= £1,000,000.
In case the exposure line is downward sloping, then an unexpected appreciation of the
pound by Rs.0.10/£ will increase the liability by Rs.1,00,000. This makes V equal to (–)
1,00,000.
Hence, the exposure will be
∆V
a =
∆Su
− Rs.1, 00, 000

=
Rs.0.10 / £
= – £1,000,000.
From the above calculation, the following points can be deduced:
• The exposure will be equal to foreign currency value when the foreign currency
value of an asset or liability does not change with a change in exchange rate.
• The exposure appears to be negative when the slope of exposure line is negative.
An exposure with a positive sign is termed as long exposure and the exposure
with a negative sign is termed as short exposure.
7
• The unit of measurement of exposure is the foreign currency in which the asset
or liability is expressed.
• When the exposure is calculated in this method, we assume that the entire
change in the exchange rate is unexpected.
Assessing Exposure having Flexible Foreign Currency Values
A change in the exchange rate will result in a change in the foreign currency value of
an asset or liability because of common underlying factors. At the same time, it also
results in depreciation of a currency. In such a situation, the degree of exposure
depends on the response of the exchange rate and of the asset’s or liability’s value to
the change in underlying variable. When the exchange rate movements affect the
foreign currency value of the foreign asset or liability in an indirect way, the value of
an asset in the form of an interest bearing security would be reduced. Subsequently,
the degree of exposure will depend on the movement of the two variables and the
predictability of the movement in the asset’s or liability’s value. In response to these
movements, the exposure may be equal to, lower than, or higher than foreign-
currency value of the asset or liability.
Exposure on Domestic Assets and Liabilities

With regard to domestic assets and liabilities, the measurement of exposure and the
degree of exposure depends on the predictability of the change in the domestic prices.
The exposure is calculated in the same way as foreign assets and liabilities.
Operating Incomes
Measuring exposure on operating profits is a critical task. For example, let us
consider a company that uses imported raw materials. It may be selling its products in
the domestic market or the international market. When there is an appreciation in the
foreign currency, the domestic price of the imported raw material may or may not
increase depending on the response of the seller. Similarly, the international price
may or may not reduce depending on the international market conditions. The price of
raw material bought by the company depends on various factors such as availability
and the price of the same or substitute raw materials in the domestic market. The
above variables make measurement of exposure a difficult task. Sometimes,
companies which do not operate in the international markets, either as exporters or
importers are also exposed to exchange rate changes due to the presence of or the
possibility of appearance of competitors. The exchange rate changes can affect these
players by affecting the production costs and/or prices of their competitor. This may
lead to change in the domestic firm’s operating profits. Exchange rate changes can
also drive the domestic companies out of international markets by making their
foreign competitors’ operations more or less profitable or by inducing more
competitors to enter the market. All these factors, in case of companies not
functioning in international markets, also make the measurement of exposure on
operating profits impossible.
8
a. Define Foreign Exchange Exposure.
…………………………………………………………….……………………...
…………………………………………………………….……………………...
…………………………………………………………….……………………...
b. Discuss in brief exposure on domestic assets and liabilities.
…………………………………………………………….……………………...
…………………………………………………………….……………………...
…………………………………………………………….……………………...
9.4 FOREIGN EXCHANGE RISK

Foreign exchange risk can be defined as the variance of the domestic-currency value of
an asset, liability or operating income attributable to unanticipated changes in the
exchange rates. Accordingly, foreign-exchange risk results when the domestic-currency
value of assets, liabilities or operating incomes becomes variable in response to
unexpected changes in the exchange rates. As such the presence of two factors, viz.
variability of exchange rates and exposure becomes quite essential for the presence of
exchange rate risk. When exposure is measured in terms of the slope of a regression
equation between the exchange rate movements and changes in the values of assets or
liabilities, the exchange rate risk can be expressed as a function of variance of exchange
rate. Hence,
var (∆V) = var [a x ∆Su ]

or,
var (∆V) = a2 x var (∆Su )
Where,
var (∆V) = exchange rate risk.
9.5 TYPES OF EXPOSURE

Exposure can be classified into the following three types:
i. Transaction exposure.
ii. Translation exposure.
iii. Operating exposure.
Transaction Exposure
Transaction Exposure arises when a company is committed to complete its foreign

currency denominated transactions. For example, if company X enters into a contract to
sell DVDs to a foreign customer at a fixed price denominated in a foreign currency, then
its proceeds are exposed to exchange rate movements until it receives the payment and
converts the receipts into domestic currency. The exposure of a company in a particular
currency is measured in net terms, i.e., after netting off potential cash inflows with
outflows.
9
Translation Exposure
Translation Exposure arises when there is a need to report values of assets and
liabilities denominated in a foreign currency into domestic currency. This is a notional
exposure and there is no real gain or loss due to exchange rate movements as the asset
or liability is not liquidated at the time of reporting. Hence, this exposure is also called
accounting exposure. This necessitates measurement of translation exposure to depend
on the accounting policies used for converting the foreign currency values of assets and
liabilities into the domestic currency. At the initial stage of transaction, an asset or
liability is recorded at a particular rate as prescribed by the company policy. Later, when
there is a need to translate the value of asset or liability, it is translated either at
historical rate or some other rate in accordance with the company policy or accounting
standards or both. Assets which are translated at a historical exchange rate do not give
rise to translation exposure. Only assets which are translated at current exchange rate
contribute to translation exposure. This exposure is measured as the difference between
exposed assets and exposed liabilities for a specified time duration.
Operating Exposure
According to Alan Shapiro2 operating exposure is defined as “the extent to which the
value of a firm stands exposed to exchange rate movements, the firm’s value being
measured by the present value of its expected cash flows”. As operating exposure arises
because of economic consequences of exchange rate movements on the values of a firm,
it is also known as economic exposure. Operating exposure describes the risk of future
cash flows of a firm changing due to a change in the exchange rate. The future cash
flows of a firm depend on the exchange rate movement as well as the relative rates of
inflation prevailing in different countries. The interplay of these two factors determines
the future cash flows and their variability and subsequently the operating exposure faced
by a firm. When the real exchange rate changes, the relative prices also change resulting
in a change in the domestic firm’s cash flows. In case relative PPP holds good, even a
widely fluctuating and unpredictable exchange rate will not result in operating exposure.
The change in the real exchange rate being translated into a change in firm’s cash flow
also depends on the price flexibility enjoyed by the firm. Price flexibility is negatively
correlated to the latter and price elasticity and the latter in turn depends on various
factors, such as degree of competition, location of competitors and degree of product
differentiation.
Degree of Competition
When a firm has a large number of supplies, the consumers find it easy to change from
one product to another. This lowers the competition faced by the firm and results in
higher price flexibility.
2 Alan Shapiro is a Professor of Finance and Business Economics, Marshall School of

Business.
10
Location of Competitors
When most of the competitors are located in the same country as the exporting firm, all
of them will experience same changes in costs and pressures on profits as a result of
change in the real exchange rate. This allows the competitors to change the foreign-
currency price of their product collectively, without any effect on their competitiveness.
Degree of Product Differentiation
Every firm’s product is unique and different from that of the other firm. This helps the
firm to charge a premium on its product. So, when the product differentiation is high,
the firm enjoys more flexibility.
9.6 SUMMARY
The sensitivity of changes in the real domestic currency value of assets and liabilities or
operating incomes to unanticipated changes in exchange rates is called foreign exchange
exposure.
Foreign exchange risk is the variance of the domestic-currency value of an asset,
liability or operating income attributable to unanticipated changes in the exchange rates.
There are three types of exposures, viz., transaction exposure, translation exposure, and
operating exposure.
9.7 GLOSSARY
Operating Exposure means the extent to which the value of a firm stands exposed to
exchange rate movements and the firm’s value is measured by the present value of its
expected cash flows.[v1]
Transaction Exposure occurs when the company is committed to complete its foreign
currency denominated transactions.
Translation Exposure is the exposure which occurs when there is a need to convert
values of assets and liabilities denominated in a foreign currency into domestic
currency.


a. A foreign exchange exposure can be defined as the sensitivity of changes in the
real domestic currency value of assets and liabilities or operating incomes to
unanticipated changes in exchange rates.3 In other words, it is the amount of
assets, liabilities and operating income that is at risk from unanticipated changes
in exchange rates.
3 This definition is given by Michael Adler and Bernard Dumas in “Exposure to Currency Risk:
Definition and Measurement, Financial Management.”
11
b. i. Transaction exposure.
ii. Translation exposure.
iii. Operating exposure.
Transaction Exposure: ‘Transaction Exposure’ arises when a company is
committed to complete its foreign currency denominated transactions. For
example, if company X enters into a contract to sell DVDs to a foreign customer
at a fixed price denominated in a foreign currency, then its proceeds are exposed
to exchange rate movements until it receives the payment and converts the
receipts into domestic currency. The exposure of a company in a particular
currency is measured in net terms, i.e., after netting off potential cash inflows
with outflows.
Translation Exposure: ‘Translation Exposure’ arises when there is a need to
report values of assets and liabilities denominated in a foreign currency into
domestic currency. This is a notional exposure and there is no real gain or loss
due to exchange rate movements as the asset or liability is not liquidated at the
time of reporting. Hence, this exposure is also called accounting exposure.
This necessitates measurement of translation exposure to depend on the
accounting policies used for converting the foreign currency values of assets
and liabilities into the domestic currency. At the initial stage of transaction, an
asset or liability is recorded at a particular rate as prescribed by the company
policy. Later, when there is a need to translate the value of asset or liability, it
is translated either at historical rate or some other rate in accordance with the
company policy or accounting standards or both. Assets which are translated at
a historical exchange rate do not give rise to translation exposure. Only assets
which are translated at current exchange rate contribute to translation
exposure. This exposure is measured as the difference between exposed assets
and exposed liabilities for a specified time duration.
Operating Exposure: According to Alan Shapiro4 ‘operating exposure’ is
defined as “the extent to which the value of a firm stands exposed to exchange
rate movements, the firm’s value being measured by the present value of its
expected cash flows”. As operating exposure arises because of economic
consequences of exchange rate movements on the values of a firm, it is also
known as economic exposure. Operating exposure describes the risk of future
cash flows of a firm changing due to a change in the exchange rate. The future
cash flows of a firm depend on the exchange rate movement as well as the
relative rates of inflation prevailing in different countries. The interplay of these
two factors determines the future cash flows and their variability and
subsequently the operating exposure faced by a firm. When the real exchange
rate changes, the relative prices also change resulting in a change in the domestic
firm’s cash flows. In case relative PPP holds good, even a widely fluctuating and
unpredictable exchange rate will not result in operating exposure. The change in
the real exchange rate being translated into a change in firm’s cash flow also
4 Alan Shapiro is a Professor of Finance and Business Economics, Marshall School of

Business.
12
depends on the price flexibility enjoyed by the firm. Price flexibility is
negatively correlated to the latter and price elasticity and the latter in turn
depends on various factors, such as degree of competition, location of
competitors and degree of product differentiation.

A. Multiple Choices
1. Which of the following describe(s) the risk of future cash flows of a firm
changing due to change in the exchange rate?
a. Transaction exposure.
b. Transmission exposure.
c. Translation exposure.
d. Operating exposure.
2. When the product differentiation is high the firm experiences which of the
following?
a. Less price flexibility.
b. Moderate price flexibility.
c. More price flexibility.
d. Zero price flexibility.
3. The variability of domestic-currency value of assets, liabilities or operating

incomes in response to unexpected changes in exchange rates results in which of
the following?
a. Foreign exchange exposure.
b. Foreign exchange risk.
c. Foreign exchange interest.
d. Foreign exchange premium.
4. Which of the following is the aim of foreign exchange risk management?

a. To minimize losses.
b. To earn a minimum level of profits.
c. To maximize profits.
d. To know with certainty the quantum of future cash flows.
13
5. The firm producing and selling in domestic market may face following risk when
the economy is opened.
a. Transaction risk
b. Translation risk
c. operations risk
d. Both (a) and (b) of the above
e. Firm does not face any risk.
B. Descriptive
1. Explain in detail the exposure having fixed foreign currency values.
2. Explain in detail the exposure having flexible foreign-currency value.
3. Explain different types of exposures.
practice only.
14
UNIT 10 MANAGEMENT OF
EXCHANGE RISK
Structure
10.1 Introduction
10.2 Objectives
10.3 Management of Transaction and Translation Exposures
10.4 Management of Economic Exposure
10.5 Summary
10.6 Glossary
10.1 INTRODUCTION
Exchange risk management involves reduction or elimination of exchange rate risk
through hedging. In other words, it involves taking a position in the forex and/or money
market, which cancels the existing position. This unit looks into the various techniques
and tools employed to manage exchange risk.
10.2 OBJECTIVES
• Distinguish transaction and translation exposure;
• Understand the management of transaction and translation exposures; and
• Use various strategies to manage economic exposure.
10.3 MANAGEMENT OF TRANSACTION AND TRANSLATION

EXPOSURES
Transaction exposure should be managed on a continuous basis, because it concerns the
day-to-day activities of a firm. Translation exposure management is a periodic affair
considered at the time of preparing financial statements. Management of exposures can
be grouped under two categories – internal and external. Internal techniques or
instruments form a part of day-to-day operations of a company, while external
instruments/techniques are specifically undertaken for hedging. The following are the
various internal hedging techniques:
• Exposure netting.
• Leading and lagging.
• Hedging by choosing the currency of invoice.
• Hedging through sourcing.
Exposure Netting: ‘Exposure netting’ involves creating exposures in the normal course
of business which offset the existing exposure either in the same currency or in any
other currency. Any movement in the exchange rates that causes loss on the original
exposure should result in a gain on the new exposure by creating an opposite exposure
in the same currency or another currency. This can also be done by creating a similar
exposure in a currency which moves in the opposite direction to the currency of original
exposure.
Leading and Lagging: ‘Leading’ means making a payment before it is due and
‘lagging’ means deferred payment. A company can adopt lagging for a payable when
the home currency appreciates and adopt leading when it depreciates similarly.
Hedging by Choosing the Currency of Invoicing: Transaction and Translation
exposure can be eliminated by invoicing all receivables and payables in the domestic
currency. Thus, one party can hedge itself, while the other party remains exposed as it
deals with foreign currency. To cover its exposure the other party will build in the cost
of doing so in the price it quotes/or is willing to accept. Exports can be invoiced in a
hard currency (the currency that is widely accepted in international transactions) and
imports in a soft currency (the currency that is not widely accepted in international
transactions). Such currency need not be necessarily domestic currency for either of the
parties involved and is selected only because of its stability. The parties can also hedge
exposure by denominating international transaction partly in each of their domestic
currencies. This reduces the exposure for both the parties.
Hedging through Sourcing: A firm can buy the raw materials in the same currency in
which it sells its products. This could result in netting of exposure to some extent. But,
sometimes, this causes the company to buy costly raw material or low quality raw
material. Hence, this technique is not preferred much by the firms.
The following are the various external hedging techniques:

• Forwards.
• Futures.
• Options.
• Money markets.
Hedging through the Forward Market
The buying or selling of a currency in the forward market locks the rate at which the
foreign currency transaction occurs. To hedge its transaction exposure, a company
experiencing long position will sell the currency forward, i.e., go short in the forward
market and a company in short position will buy the currency forward, i.e., go long in
the forward market. For example, An Indian Company Z, that imports computers from
the USA would have to pay $2,00,000 for the same after 3 months to the seller in USA.
It can enter into a forward contract for 3 months to buy $2,00,000 worth of computers at
a specified rate. Say, if the 3-month forward rate is Rs.45/$, the cost to the Indian firm
will be locked at Rs.9,00,000. Thus, the firm needs to pay only the forward rate at the
end of three months, irrespective of the actual spot rate. In this way, a forward contract
completely eliminates transaction exposure. The translation exposure is automatically
hedged, when the transaction exposure is hedged. In the above example, translation
16
Management of Exchange Risk
exposure gets automatically hedged as loss/gain on the outstanding payable gets set-off
by the gain/loss on the forward contract. This may not be so always, because the
transaction exposure may not get hedged as the underlying transaction exposure has not
been hedged or because the translation exposure arises due to long-term asset or liability
held by the company. To hedge such exposure, the company must initially determine its
net exposure in a currency and then enter into an opposite forward contract. This
nullifies the exposure. But the gain/loss on the underlying exposure will remain notional
and the loss/gain on the forward contract will be real and involve cash outlay. The cost
of a forward hedge is measured as the difference between the forward rate and expected
spot rate for the required maturity.
Hedging through Futures
Hedging through futures works similar to forwards. For example, if Company Q

imports computers for $2,50,000 and has to pay the same after four months, it can buy
dollar futures for the required sum and maturity. Any gain/loss on future contracts gets
cancelled by the loss/gain on the underlying transaction and subsequently the exposure
gets almost eliminated. Only a small part of the exposure remains because of the mark-
to-market risk on future contract. The major difference between hedging through
forwards and through futures is that while in the former the whole receipt/payment takes
place at the time of contract maturity, in the case of the latter, initial payment of margin
money is required and any payments/receipts during the tenure of the contract must be
made on the basis of market movements.
Hedging through Options
Hedging through options provides a firm (importer or exporter) the right to buy or sell
the foreign currency without any obligation. A firm having a foreign currency
receivable can buy a put option on the currency, having the same maturity as the
receivable while it can buy a call option for its payable. The option contract expires
when it is not exercised by the seller or buyer. Hence, options cost more compared to
other hedging tools. Another advantage provided by options is flexibility i.e., there is
only one exchange rate at which a currency can be bought or sold under a forward or
futures contract. However, a firm depending on its outlook about future and its risk-
taking capacity can buy any suitable option contracts as options are available at
different exchange rates. An option involves strike price and premium. Price paid for an
option is called premium.
Hedging through the Money Markets

Foreign currency receivables or payables can be hedged through money markets.
This process locks the exchange rate at which a firm is required to buy dollars and at the
same time, it can also know its total cost in advance in the form of principal and interest
it has to repay in the domestic markets. For example, let us consider that a firm has a
dollar payable after three months. It can borrow in the domestic currency now, and
convert it at the spot rate into dollars and invest in the money markets. Subsequently, it
can use the proceeds to pay the dollar payable after three months.
17
a. List out Internal hedging techniques used by the companies to manage

transaction and translation exposures?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b. How can transaction exposure be hedged using Forward Contracts
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
Illustration 1
An Indian firm, ABC Ltd exports a specific type of cotton shirts to the US. It sells
30,000 pieces at $40 per piece. Its cost per piece of jeans is Rs.400. Additionally, it has
to import certain raw materials costing $20 per piece. The company incurs Rs.3,000,000
as fixed costs. The current spot rate is Rs.55.00/$. If the rupee appreciates to Rs.50/$,
how many units of sales should the company increase to maintain the same profits?
Solution
The company’s existing profits can be calculated as follows:
(in Rs.)
Sales (30,000 x 40 x 55) 66,000,000
Variable costs:
400 x 30,000 = 12,000,000
20 x 55x 30,000 = 33,000,000
45,000,000
Fixed costs 3,000,000
48,000,000
Profit 18,000,000
After the rupee appreciation, the company’s profits will be:
(in Rs.)
Sales (30,000 x 40 x 50) 60,000,000
Variable costs:
400 x 30,000 = 12,000,000
20 x 50 x 30,000 = 30,000,000
42,000,000
Fixed costs 3,000,000
45,000,000
Profit 15,000,000
18
If we assume that the company can sell unlimited quantity at the existing dollar price,
then,
18,000,000 = (50 x 40 x X) – [(400 x X) + (20 x 50 x X) + 3,000,000]
18,000,000 = 2000X – 1400X – 3,000,000
21,000,000 = 600X
X = 21,000,000/600 = 35,000 units.
Hence, the firm needs to increase its sales by 5,000 units to maintain its
pre-appreciation profits.
10.4 MANAGEMENT OF ECONOMIC EXPOSURE

Economic exposure can be managed by various marketing, production and financial
management strategies. Depending on the duration for which the exchange rate is
expected to last, an appropriate strategy can be adopted. For example, when a domestic
currency appreciation is expected not to last long then the firm need not increase the
foreign-currency price of its product if it considers the cost of regaining the lost market
share to be too high. However, if the change in exchange rate is expected to last longer,
then the cost of regaining the market share may become lower than the profit which
would be lost if the price is not increased. This may force the firm to increase the
foreign-currency price even at the cost of losing market share. If the exchange rate
change is expected to last for a very long time, the firm may even shift its production
capacities to a country whose currency has depreciated.
Illustration 2
Denim Textiles exports jeans to Germany. For the year ended March 31, 2006 the
company exported 30,000 pieces at an average price of € 30 per piece. The average cost
of producing each piece for the company is Rs.1,500. The price elasticity of demand for
the company’s product in the German market is 1.50. The rupee-euro exchange rate for
the previous year was Rs.60. In the current year, it is expected to be Rs.62.
You are required to compute:
a. The change in profit due to transaction exposure.
b. The change in profit due to economic exposure, if the company passes on the
benefit of depreciation to the buyer.
Solution
a. Current profit at exchange rate of Rs.60/€
= Rs.30,000 × (30× 60 – 1,500) = Rs.90 lakh
Profit if rupee depreciates to Rs.62/€
= Rs.30,000 × (30 × 62 – 1500) = Rs.10.80 lakh
∴ Increase in profit due to depreciation of rupee (transaction exposure)
= Rs.10.80 – 90 = Rs.79.20 lakh
b. Selling price of each garment in rupee term = Rs.30 × 60= Rs.1,800
Price in dollar terms after depreciation of rupee = 1800 = €29.0322

62
∴ Decrease in price of each piece = 3.23%
19
∴ Change in quantity demanded = –1.5 × (– 3.23)% = 4.85%
∴ Number of pieces to be sold = 30,000 × (1 + 0.0485) = 31,455
Profit = Rs.31,455 x (1800 – 1500) = Rs.94,36,500
∴ Increase in profit due to economic exposure
= Rs.(94,36,500 – 90,00,000) = Rs.4.36,500
Marketing Strategies
A marketing manager analyzes the effect of a change in the exchange rate and evaluates
the appropriate strategy required to manage the exposure. Four strategies, viz., market
selection, pricing strategy, promotional strategy and product strategy are available to the
manager.
Market Selection: This strategy can be adopted when the actual or anticipated change
in the real exchange rate is expected to last for a longer time. Market selection involves
selection of those markets in which the firm expects to market its product along with
relevant services. This may cause the firm to pullout of the markets that become
unprofitable because of currency depreciation or enter those markets that become
attractive because of currency appreciation. Decision with regard to market selection
requires adequate knowledge of market segmentation. Before pulling out of a particular
market any firm has to analyze the effect of the change in the exchange rate on its cash
flows. For example, cash flows of a firm selling a highly differentiated product to high-
income customers may not be affected by exchange rate movement. As such the firm
need not pull out of the market.
Pricing Strategy: Developing a pricing strategy involves choosing between market
share and profits, and frequency of price adjustments.
Market Share vs. Profit Margin: If the domestic currency appreciates, a firm can
reduce its domestic currency prices to maintain the foreign currency prices at the pre-
appreciation level or maintain the domestic currency prices to increase the foreign
currency price. The former results in reduced profit margins and the latter causes the
market share to decrease. This again affects the profits of the firm. However, when
domestic currency depreciates, a firm can increase the domestic currency price resulting
in increase in profit margin (price skimming) or it can maintain the domestic currency
price at the pre-depreciation level, causing a decrease in foreign currency price and
increase in market share (penetration pricing). The final decision depends on price
elasticity of demand and economies of scale experienced by the firm. When the price
elasticity is high, the incentive to adopt profit margins will be greater than adopting
market share. Similarly, larger economies of scale result in larger profit margins and the
lost profit is made up through higher volumes.
Frequency of Price Adjustments: Frequent price changes affect a firm’s sales because
of the resultant risk experienced by its consumers. The firm may also lose because of
unfavorable exchange rate movements if there is any delay in changing the price of its
product. Hence, a balance is required between these two issues which can be arrived
based on the level of uncertainty the firm’s customers are ready to face, the duration for
which the exchange rate movement is likely to remain and any loss expected to be
incurred if price remains the same without any change.
20
Promotional Strategy: Promotional strategy involves determining the amount the firm
is willing to spend in different markets to promote its products considering exchange
rate movements. Any change in the exchange rate will lead to a change in the domestic-
currency cost of overseas promotion. Exchange rate movements also affect the
promotional costs in the form of expected revenues that can be generated per unit of
expenditure on promotion. For example, domestic currency devaluation may improve
the competitive position of an exporting firm and subsequently increase the expected
revenue per unit of promotional cost. This may cause the firm to increase the
promotional expenditure in those markets.
Product Strategy: Product strategy includes timing of introduction of new products,
making product-line decisions and product innovations. The most appropriate time for a
company to introduce a new product in the market would be when it enjoys price
advantage. For example, company X involved in exporting business enjoys price
advantage when domestic currency depreciates. A firm cannot introduce the product in
domestic market or international market when the conditions are unfavorable.
A company’s need to change its products in accordance with the exchange rate
movements is known as product line decision. Depending on the market selection, a
firm can decide on high end products when the domestic currency appreciates and mass
products when the currency depreciates. In simple words, product-line decision involves
changing the product-mix. Further, a firm has to constantly make product innovations to
protect its cash flows from appreciating domestic currency and extreme competitive
conditions prevailing in the international market.
Production Strategies
Sometimes, exchange rate movements are too large and long lasting and cannot be
handled by marketing strategies. In such circumstances, the production manager
evaluates an appropriate strategy to meet the harmful effects of unfavorable exchange
rate movement. He can adopt any of the suitable strategies available such as input mix,
product sourcing, plant location and raising productivity.
Input Mix
Any pressure on the profits of an importing firm because of domestic currency
appreciation, can be countered by buying more inputs in the international markets than
in domestic markets. This results in cost reduction at the time of reducing revenues and
consequently protects the profits to a certain extent. The same objective can be achieved
by outsourcing the intermediated inputs, either from producers in the country where a firm
is selling its final product or from producers of a country whose currency is closely linked
to the country in which it markets its products. Conversely, when domestic currency
depreciates, a firm having production capacities in other countries can buy more of its
inputs from the domestic market, considering the price behavior of domestically produced
inputs. To facilitate these changes, the technology adopted by the firm for production must
be flexible and capable of adjusting to inputs sourced from different producers.
Product Sourcing
In response to the exchange rate movements, product sourcing facilitates a firm to
reallocate production among different production centers situated in more than one
country. It helps increase the quantity produced in the country whose currency has
depreciated and reduce production in countries whose currency has appreciated. This
flexibility helps MNCs experience less economic exposure compared to a company
producing only in one country. In reality, this situation also involves problems such as
21
availability of an important raw material in a particular country, protest by labor unions to
shift the production etc. Another major problem is that establishment of multiple
production facilities leads to non-utilization of economies of scale. This results in higher
unit cost, excess capacities and higher fixed costs in times of low production requirement.
Plant Location
Firms which do not have multiple production facilities are forced to establish them
overseas because of exchange rate movements, which change the relative cost
advantages. They can also establish production facilities in third-world countries for
labor-intensive products because of low labor costs. While taking such decisions, they
have to consider the duration for which such production facilities can enjoy cost
advantage. As these commitments are long-term in nature, the benefits should continue
for a substantially long period, for such investment to be justified. The underlying
economic factors of a country wherein production facilities are being set-up must be
evaluated thoroughly before taking the decision. The advantages on account of these
facilities must be weighed against factors such as loss over quality control, distance
from suppliers of crucial inputs etc.
Raising Productivity
When the domestic currency appreciates, a firm can make an effort to reduce the
domestic currency cost of its products to prevent them from becoming uncompetitive in
the international market or bear a cut in the profit margin or loose market share. This
can happen automatically when imported raw materials or intermediate inputs are being
used. Otherwise, the firm must resort to other measures such as increasing the
productivity of various factors of production. It may modernize the machinery and
technology, renegotiate wage agreement, close inefficient plants etc.
Financial Management Strategies
Financial management strategies control any damage occurring due to unfavorable
exchange rate movements while production and marketing strategies are being
implemented. The major financial management strategy involves creating a natural
hedge by way of creating liabilities in the currency to which the firm’s earnings are
exposed to a large extent. Any loss of operating profits on account of exchange rate
movements will be recovered partially by the reduction of debt-servicing costs. This
strategy can be used only for managing large exposures in currencies and it cannot
hedge exposures perfectly. At the same time, it cannot manage exposures in all
currencies. A comparative analysis of the exposures in various currencies must be made
to arrive at a final strategy.
a. What is an input mix?
………………………………………………………………………………..
………………………………………………………………………………..
………………………………………………………………………………..
b. Discuss briefly Financial Management Strategies.
……………………………………………………………………………….
…………………………………………………………………………….....
…………………………………………………………………………….....
22
10.5 SUMMARY
Transaction and translation exposure can be managed in a number of ways. Each
method has its own features, advantages and disadvantages which make it suitable for
different situations.
Exchange rate risk can be hedged using internal and external techniques.
Economic exposure cannot be measured using traditional techniques. It require various
marketing, production and financial management strategies.
Various marketing strategies include market selection, pricing strategy, promotional
strategy and product strategy.
Production strategies include input mix, product sourcing, plant location and raising
productivity.
10.6 GLOSSARY
Lagging is delaying or postponing payables or receivables.
Leading is bringing forward or advancing receivables or payables, for the purpose of
managing exchange exposure.
Market Selection is marketing the right product in the right market.
Netting means matching receivables with payables in the same currency to arrive at the
net amount.

• Machiraju, H.R. International Finance.

a. Internal techniques or instruments form a part of day-to-day operations of a
company, while external instruments/techniques are specifically undertaken for
hedging. The following are the various internal hedging techniques:
• Exposure netting.
• Leading and lagging.
• Hedging by choosing the currency of invoice.
• Hedging through sourcing.
Exposure Netting: ‘Exposure netting’ involves creating exposures in the normal
course of business which offset the existing exposure either in the same currency
or in any other currency.
Leading and Lagging: ‘Leading’ means making a payment before it is due and
‘lagging’ means deferred payment. A company can adopt lagging for a payable
when the home currency appreciates and adopt leading when it depreciates
similarly.
23
Hedging by Choosing the Currency of Invoicing: Transaction and Translation
exposure can be eliminated by invoicing all receivables and payables in the
domestic currency.
Hedging through Sourcing: A firm can buy the raw materials in the same currency
in which it sells its products. This could result in netting of exposure to some extent.
But, sometimes, this causes the company to buy costly raw material or low quality
raw material. Hence, this technique is not preferred much by the firms.
b. The buying or selling of a currency in the forward market locks the rate at which
the foreign currency transaction occurs. To hedge its transaction exposure, a
company experiencing long position will sell the currency forward, i.e., go short
in the forward market and a company in short position will buy the currency
forward, i.e., go long in the forward market. For example, An Indian Company Z,
that imports computers from the USA would have to pay $2,00,000 for the same
after 3 months to the seller in USA. It can enter into a forward contract for 3
months to buy $2,00,000 worth of computers at a specified rate. Say, if the 3-
month forward rate is Rs.45/$, the cost to the Indian firm will be locked at
Rs.9,00,000. Thus, the firm needs to pay only the forward rate at the end of three
months, irrespective of the actual spot rate. In this way, a forward contract
completely eliminates transaction exposure.
a. Any pressure on the profits of an importing firm because of domestic currency
appreciation, can be countered by buying more inputs in the international
markets than in domestic markets. This results in cost reduction at the time of
reducing revenues and consequently protects the profits to a certain extent.
The same objective can be achieved by outsourcing the intermediated inputs,
either from producers in the country where a firm is selling its final product or
from producers of a country whose currency is closely linked to the country in
which it markets its products. Conversely, when domestic currency depreciates, a
firm having production capacities in other countries can buy more of its inputs
from the domestic market, considering the price behavior of domestically
produced inputs. To facilitate these changes, the technology adopted by the firm
for production must be flexible and capable of adjusting to inputs sourced from
different producers.
b. Financial management strategies control any damage occurring due to
unfavorable exchange rate movements while production and marketing strategies
are being implemented. The major financial management strategy involves
creating a natural hedge by way of creating liabilities in the currency to which
the firm’s earnings are exposed to a large extent. Any loss of operating profits on
account of exchange rate movements will be recovered partially by the reduction
of debt-servicing costs. This strategy can be used only for managing large
exposures in currencies and it cannot hedge exposures perfectly. At the same
time, it cannot manage exposures in all currencies. A comparative analysis of the
exposures in various currencies must be made to arrive at a final strategy.

24
A. Multiple Choices
1. A treasury manager normally tries to cover the forex exposure, because______.
a. It helps in reducing the cost of borrowing.
b. It helps in reducing known losses.
c. It helps in earning more profits.
d. It helps in reducing the uncertainty of cash flows.
e. Both (b) and (c) above.
2. Which of the following is not suitable to hedge economic exposure?
a. Product Mix.
b. Currency Swap.
c. Market Selection.
d. Plant Location.
e. Pricing of the product.
3. Netting helps in which of the following issues?
a. Reducing transaction costs.
b. Better control of subsidiaries.
c. Reducing Interest costs.
d. Reducing cash requirements.
4. Which of the following is not an external hedging technique?
a. Forwards.
b. Options.
c. Currency Swap.
d. Currency of Invoicing.
e. Futures.
5. If the amount and timing of a currency outflow are both uncertain, then the best
hedging technique will be _______.
a. Buy a call option
b. Buy a put option
c. Buy a forward contract
d. Sell a call option
B. Descriptive
25
1. Explain in detail various internal hedging techniques.
2. Explain different types of external hedging techniques.
3. Explain different types of marketing and production strategies employed in

managing economic exposure.
C. Problems
1. Company X, an Indian exporter has an order from America for 2000 pieces of
jeans per month at a price of $100. The company has to import Yen 6000 worth of
material per piece. Labor costs are Rs.350 per piece while other variable overheads
add up to Rs.700 per piece. The exchange rates are currently Rs.45/$ and Yen
120/$. Assuming that the order will be executed after 3 months and payment is
available immediately on shipment of goods, calculate the loss/gain due to
transaction exposure if the exchange rates change to Rs.46/$ and Yen 110/$.
2. Uday Fabrics exported silk saris to the US. For the year ended 31 march 2006, it
has exported 1,20,000 saris at an average price of $12 per sari. It incurs an
average cost of Rs.350 for producing each sari. The elasticity of demand for the
company’s product in the US market is 1.5.
The rupee-dollar exchange rate in the previous year was 43.00. In the current
year the rupee-dollar exchange rate is expected to be 44.00. Calculate (a) The
change in profit due to the transaction exposure.(b) The change in profit due to
economic exposure if the company passes on the benefit of depreciation to the
buyer.
practice only.
26
UNIT 11 INTERNATIONAL PROJECT
APPRAISAL
Structure
11.1 Introduction
11.2 Objectives
11.3 Reasons for Foreign Direct Investment
11.4 Appraisal for Foreign Direct Investment
11.5 The Adjusted Present Value Criterion
11.6 Summary
11.7 Glossary
11.1 INTRODUCTION
International project appraisal includes the expected cash flows (cash flows in foreign
currency) and their associated risk. Appraisal is done by considering certain issues such as
blocked funds, taxability of cash flows etc. This differs from the appraisal of home
country projects as it experiences a different economic, social and political environment.
11.2 OBJECTIVES
• Know the reasons for Foreign Direct Investment (FDI);
• Appraise Foreign Direct Investment (FDI); and,
• Understand the application of Adjusted Present Value (APV) criterion in capital

expenditure decision.
11.3 REASONS FOR FOREIGN DIRECT INVESTMENT (FDI)

Companies invest in physical assets of a foreign country for various reasons such as
economies of scale, vertical diversification, product life cycle, brand equity,
comparative advantage etc.
Economies of Scale: When the domestic markets get saturated, the companies target
international markets as potential sources of growth, which is very essential in
achieving economies of scale. This further facilitates the company to survive in the
competitive market.
Need to get around Trade Barriers: Trade barriers occur due to various economic,
political and social reasons. The need to cross these barriers causes the companies to
invest in foreign physical assets so that the market for their products can be expanded.
Comparative Advantage: Various countries offer lower costs, which serves as an
incentive for companies to initiate production facilities in those countries.
Vertical Diversification: Non-availability of opportunities in the domestic market
compels the companies to adopt for vertical diversification.
General Diversification Benefits: Companies invest in FDI to gain various benefits of
diversification in different markets similar to portfolio investments.
Attacking Foreign Competition: Companies that face foreign competition in the
domestic markets initiate production bases in competitor countries. For this purpose
an incentive is provided with the same cost advantage as their competitors. This
diverts the competitor’s attention as it tries to protect its own market share in the
domestic market.
Extension of Existing International Operations: Companies engaged in export
business establish foreign subsidiaries such as sales subsidiary. Later on, they slowly
obtain licensing agreements and finally overseas production capacities.
Product Life Cycle: Sometimes a product innovated in one country starts appearing in
developing countries due to the cost advantage enjoyed by the producers of developing
countries in producing the product in its maturity stage. As a result the producers of the
country in which the product was innovated shift their base to the developing countries
to withstand the competition. All this calls for foreign direct investment.
Non-transferable Knowledge: In certain situations, the knowledge possessed by a

company in manufacturing or marketing a particular product may not be transferred to
the foreign producers for a price and this compels overseas operations by the company
possessing the knowledge. Similarly, the non-transferability of knowledge may also
occur due to the reluctance of the company to share its knowledge.
Brand Equity: The popularity of certain brands acts as an incentive for producers to
expand their product reach to international markets.
Protection of Brand Equity: Companies venture into foreign markets when they fear
that they may not live up to their strict quality standards.
Following its Clients: Sometimes certain service firms expand along with their clients
when it is necessary and also when they find it attractive.
a. What is International Project Appraisal?
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
b. List out the reasons for Foreign Direct Investment.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
28
International Project Appraisal
11.4 APPRAISAL FOR FDI
Appraisal of international projects involves various issues such as blocked funds,
exchange rate movements that affect both the cash flows and discount rate.
Blocked Funds
Sometimes, a company may have funds which are blocked in another country due to
restrictions on their remittance. Such funds can be activated and invested in a new
project which reduces its initial outlay for another/new project. When the funds are
blocked completely and cannot be repatriated. The full amount of the activated funds
can be deducted from the amount of the initial investment. When a part of blocked
funds is recovered after paying withholding taxes then that part which is not recovered
will be treated as activated funds and will be deducted from the initial investment.
Effect on the Cash Flows of Other Divisions

According to basic principles of financial management, only the incremental cash flows
to the company as a whole are considered while evaluating foreign projects. Sales from
a new project lead to reduction in sales of other existing divisions located in the same
country which also caters to the same market. Such factors must also be considered
while estimating the cash flows of a new project.
Restrictions on Repatriation
If the cash flows generated by the foreign subsidiary are not available to the parent
company due to the restrictions imposed by countries in which the foreign subsidiary is
located, then only cash flows which can be repatriated to the parent company are
considered while evaluating the project worth. The legal way considered to circumvent
restrictions on profit repatriations must be accounted as they involve the way the project is
to be financed i.e., whether it involves transfer pricing, royalties, financing structure etc.
Transfer Pricing
Transfer pricing is a common method of circumventing repatriation restrictions. It
refers to the policy of invoicing purchase and sale transactions in between a parent
company and its foreign subsidiary on terms favorable to the parent company.
Royalties
A foreign subsidiary pays royalties as compensation to the parent company for using its
trademarks and copyrights.
Leading and Lagging
Depending on the expected movements of exchange rates, leading and lagging
payments are made between the parent company and subsidiary. This helps in
transferring profits from the subsidiary to the parent company.
Financing Structure
International projects are funded solely either through equity investments or through a
mixture of equity and debt. But when restrictions on repatriations of profits and
repayment of capital are involved, part of the project is funded through loans from the
parent company to the foreign subsidiary. The interest payments are tax deductable for
the subsidiary while dividend payments are not taxable. However, interest payments as
well as dividend payments are taxable for parent company.
29
Inter-Company Loans
Inter-company loan involves two companies providing parallel loans to each other’s
subsidiaries by matching amounts, timing interest payment as well as loan repayment.
The loans are completely out of the purview of exchange control regulations when the
subsidiaries are located in the same country as the parent company. But by this
method, the holding (parent) company cannot set-off the loan which it has provided
against the loan that its subsidiary has received. As part of consolidation of accounts
the loans will appear both as an asset as well as a liability on its books. Sometimes,
the parent company extends a loan to the bank or Financial Institutions (FI).
The bank/FI will inturn extend an equivalent loan to the foreign subsidiary without
any involvement by the parent company. Such loans are called back-to-back loans.
Currency of Invoicing
Choosing a currency in which intra-group trade will be invoiced is an essential
requirement for transferring profits within different companies of the same group. When
a currency is expected to depreciate inspite of controls, the export from the subsidiary
based in a country to the other group companies can be invoiced in that country’s
currency.
Reinvoicing Centers
Reinvoicing centers act as intermediate bodies in buying from one company and selling
to another company. The inbetween margin is the amount of profit transferred from the
subsidiary to the reinvoicing center. These centers are mainly used for managing
exposures and can also be used in converting non-repatriable cash flows into repatriable
cash flows, when established in countries experiencing lesser capital controls.
Counter Trade
Under counter trade the parent company and subsidiary buy from and sell to each other.
The goods transferred from the subsidiary are sold by the parent company to a third
party and the proceeds are considered as indirect transfer of the subsidiary’s profits.
Taxability of Cash Flows
The profits of a foreign subsidiary are initially taxed in the foreign country and the cash
flows considered for evaluating a project are post-tax cash flows. But when the
subsidiary repatriates its profits to the parent company, a withholding tax is levied by
the foreign country. This profit after being received by the parent company is again
taxed in the domestic country as dividends received. To avoid such problems, countries
enter into double-taxation agreements. Accordingly these taxes are paid only in one
country or partly in one country and partly in another country. The tax rate considered
while evaluating such projects is the higher of domestic and foreign rates.
Exchange Rate Movements
The initial rate of investment used in converting foreign currency is not as same as the
exchange rate prevailing at the time of repatriation of profits. The cash flows of the
subsidiary need not be converted into domestic currency of the parent company at the
expected rates that may prevail in the future.
Subsidized Loans by the Foreign Government
Sometimes, the foreign government provides concessional loans to the company which
initiates its operations in its country to encourage FDI or promote economic activity. This
helps in reducing the cost of funds required for the project. But this reduction may not get
reflected as a lower discount rate in traditional models due to the indirect concession
provided to the company’s investors.
30
11.5 THE APV CRITERIION
Adjusted Present Value (APV) approach used for evaluating projects is an extension of
the Modigliani-Miller approach. By using this approach one can overcome certain
hurdles faced in building factors for evaluation purpose. This method measures the
present value of the basic cash flows of a project using the all-equity rate of discounting.
This breaking up of evaluation facilitates analysis of indefinite number of additional
factors affecting an international project. The adjusted present value of a foreign project
is given as follows:
n
(S*t C*t + E*t )(1 − T) n
DT n
rBo T
APV = −So (Co − A o ) + ∑ (1 + k e ) t
+ ∑ (1 + kt t
+∑
(1 + k b ) t
t =1 t =1 d) t =1
… Eq. (1)
 n
Rt  n
Pt*T n
It
+ So  CLo − ∑ (1 + k )t  + ∑ (1 + k t
+ ∑ (1 + k )t
 t =1 c   t =1 p) t =1 i
Where,
APV = Adjusted Present Value.
S0 = Current exchange rate.
C0 = Initial cash outlay in foreign currency terms.
A0 = Activated funds.
S*t = Expected exchange rate at time ‘t’.
n = Life of the project.
C*t = Expected cash flow at time ‘t’, in foreign currency terms.
E*t = Expected effect on the cash flows of other divisions at time ‘t’,
expressed in domestic currency terms; can be either positive or
negative.
T = Domestic or foreign tax rate, whichever is higher.
Dt = Depreciation in home currency terms at time ‘t’.
(If the depreciation is not allowed to be set-off by the parent
company against its own profits, it needs to be defined in
foreign currency terms with its present value being converted
at S0 into domestic currency terms).
B0 = Contribution of the project to borrowing capacity of the parent
firm.
r = Domestic interest rate.
CL0 = Amount of concessional loan received in foreign currency.
Rt = Repayment of concessional loan at time ‘t’.
Pt* = Expected savings at time ‘t’ from inter-subsidiary transfer pricing.
It = Illegally repatriated cash flows at time ‘t’.

ke = All-equity discount rate, reflecting all systematic risks,
including country risk and exchange-rate risk.
kd = Discount rate for depreciation allowances.
31
kb = Discount rate for tax savings from generation of borrowing
capacity.
kc = Discount rate for savings due to concessionary loans, generally
the interest rate in the absence of concessionary loans.
kp = Discount rate for savings through transfer pricing.
ki = Discount rate for illegal transfers.
The Discount Rate
ke is the all-equity discount rate that reflects a premium for all systematic risks,
including country-risk and exchange-risk. It also reflects the risk reduction due to the
portfolio effect because of imperfect correlation between returns from the various
markets. In case the future cash flows are pre-determined or are contractual in nature,
then the nominal discounted rate should be used. On the other hand if the cash flows are
to be estimated, then the real cash flows can be estimated and discounted at the real
discount rate or the inflation estimates can be built into cash flows later followed by
discounting at nominal rates. The following are the various discount factors available:
ke : This rate should be the nominal discount rate for contractual cash
flows.
kd : Since the depreciation charge is based on the historical cost of assets
and is hence contractual, the discount rate should be the domestic
nominal rate.
kb : Since the borrowing capacity would be measured in nominal terms,
this should be the nominal rate.
kc : As the nominal foreign-currency interest rate would have had to be
paid in the absence of the concessionary loan, that rate should be
used as the discount rate for calculating the present value of the
repayments of the concessionary loan.
kp & ki : If the relevant cash flows are expressed in domestic, nominal terms,
the discount rate should be the domestic nominal rate.
The Economic Scenario
Various economic factors such as GDP growth rate, the income level in the economy,
the projected growth rate of various sectors of the economy etc., affect the profitability
of a project.
The Political Scenario
The main political factor that affects the performance of international projects is the
government’s general outlook towards FDI. An international project of a country which
is hostile in nature towards foreign capital has less chances of succeeding compared to
the project based in a country that is favorable towards foreign capital.
a. Explain Discount rate? Discuss various discounting rates applied while using
APV.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
32
b. ‘The political and economic factors affect the performance of international
projects’. Explain in brief.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
Financing Aspects: The availability of finances for international projects either from
domestic source or from foreign sources or from both must be considered before
initiating a project.
11.6 SUMMARY
International project appraisal includes expected cash flows (cash flows in foreign
currency) and their associated risk.
Corporates invest in physical assets of foreign country for reasons such as economies of
scale, vertical diversification product life cycle, brand equity, comparative advantage.
Blocked funds, exchange rate movements etc., are considered while undertaking
appraisal of international projects.
Adjusted Present Value (APV) approach used for evaluating projects is an extension of
Modigliani-Miller approach.
11.7 GLOSSARY
Leading is bringing forward or advancing receivables or payables, for the purpose of

managing exchange exposure.
Vertical Diversification involves entry by a company into new markets and channels of
distribution within the same industry(s).


a. International project appraisal includes the expected cash flows (cash flows in
foreign currency) and their associated risk. Appraisal is done by considering
certain issues such as blocked funds, taxability of cash flows etc. This differs from
the appraisal of home country projects as it experiences a different economic,
social and political environment.
33
b. Companies invest in physical assets of a foreign country for various reasons,
some of them are as follows:
• Economies of Scale
• Need to get around Trade Barriers
• Comparative Advantage
• Vertical Diversification
• General Diversification Benefits
• Attacking Foreign Competition
• Extension of Existing International Operations
• Product Life Cycle
• Non-transferable Knowledge
• Brand Equity
• Protection of Brand Equity
• Following its Clients
a. The Discount Rate
ke is the all-equity discount rate that reflects a premium for all systematic risks,
including country-risk and exchange-risk. It also reflects the risk reduction due
to the portfolio effect because of imperfect correlation between returns from the
various markets. In case the future cash flows are pre-determined or are
contractual in nature, then the nominal discounted rate should be used. On the
other hand if the cash flows are to be estimated, then the real cash flows can be
estimated and discounted at the real discount rate or the inflation estimates can
be built into cash flows later followed by discounting at nominal rates.
The following are the various discount factors available:
ke : This rate should be the nominal discount rate for contractual cash
flows.
kd : Since the depreciation charge is based on the historical cost of assets
and is hence contractual, the discount rate should be the domestic
nominal rate.
kb : Since the borrowing capacity would be measured in nominal terms,
this should be the nominal rate.
kc : As the nominal foreign-currency interest rate would have had to be
paid in the absence of the concessionary loan, that rate should be used
as the discount rate for calculating the present value of the
repayments of the concessionary loan.
kp &: If the relevant cash flows are expressed in domestic, nominal terms,
ki the discount rate should be the domestic nominal rate.
34
b. The Economic Scenario
Various economic factors such as GDP growth rate, the income level in the
economy, the projected growth rate of various sectors of the economy etc., affect
the profitability of a project.
The Political Scenario
The main political factor that affects the performance of international projects is
the government’s general outlook towards FDI. An international project of a
country which is hostile in nature towards foreign capital has less chances of
succeeding compared to the project based in a country that is favorable towards
foreign capital.

A. Multiple Choices
1. The adjusted present value approach is based on which of the following
principle(s)?
a. Net value added.
b. IRR.
c. NPV.
d. Value additively.
2. While undertaking overseas projects, a company has to consider which of the

following risks?
a. Currency Risk.
b. Inflation risk.
c. Political risk.
d. Economic risk.
3. The discount rate used in the APV method for interest shield is __________.
a. Nominal foreign currency interest rate
b. Weighted average cost of capital
c. All equity cost reflecting the project’s systematic risk
d. Nominal borrowing rate of the country where borrowing capacity is said

to augment
e. Higher of the nominal borrowing rates of the countries involved in the

project.
35
4. In the APV method, which of the following is the discount rate used for
calculating the value of concessional loans?
a. The risk-free interest rate in the host country.
b. The risk-free interest rate in the home country.
c. Competitive borrowing rate in the host country.
d. Competitive borrowing rate in the home country.
5. While taking up an overseas project, a company has to take into account.
a. Political risk
b. Sovereign risk
c. Inflation risk
d. Currency risk
B. Descriptive
1. Explain different reasons that give rise to foreign direct investment in a country.
2. Explain the procedure involved in appraising an international project based on
APV method.
C. Problems
1. Sons & Sons, a Singapore multinational company located in US evaluated its
international project. It calculated the adjusted present value to be S$15 million.
The US government provided a concessional loan of $100 million. This loan has
to be repaid in five equal installments and interest has to be paid annually on the
outstanding amount. The market rates of interest are 6% and 5% in USA and
Germany respectively. Assuming the spot rate to be S$1.80/$, determine at what
rate the MNC should negotiate the loan.
2. Company Z, an Indian company plans to invest in a project in East Asia. It
determines its borrowing capacity to be Rs.50 million. The company’s
borrowing capacity in India is 15% and the risk-free rate of interest is 6%.
Assuming that the tax rate applicable in India is 40% and the life of the project is
5 years, determine the net benefit owing to the increased borrowing capacity.
practice only.
36
NOTES
37
NOTES
38

Nos.
MANAGEMENT

16. Trade Blocks

MBA-0000
Block
4
INTERNATIONAL FINANCIAL MANAGEMENT
UNIT 12
International Financial Markets and Instruments 5
UNIT 13
International Equity Investments 22
UNIT 14
Short-Term Financial Management 32
UNIT 15
International Accounting and Taxation 40
Expert Committee


Director Director

Director Director
Prof. P. Ramnath
Director
IBS Chennai

Ms. Anitha Prof. Bratati Ray






BLOCK 4 INTERNATIONAL FINANCIAL
MANAGEMENT
This block explains the role of international financial markets and the significance of
international trade in the wake of globalization. With the increase in the cross border
trades, companies from different economies trade exchanging various products and
services with variety of currencies. This unit outlines the significance of international
trade, various international theories propounded, the relevance of various trade barriers,
financing imports and exports and balance of payments.
Unit 1 covers meaning and implications due to globalization. This unit briefly covers
the reasons for integration of financial markets, the benefits, costs and its effects.
Unit 2 outlines some of the fundamental issues that are to be addressed in international
trade and evolution of various international trade theories. Further, this unit discuss the
need for trade barriers and types of tariff and non-tariff barriers, its limitations and
advantages.
Unit 3 discusses the role of export-import bank of India in financing the international
trade in India. This unit lists out various financing schemes that are extended to
segments like – companies, foreign governments and companies and to Indian banks.
Unit 4 deals with basic concepts of economic transactions and principles of Balance of
Payments accounting. Besides, this unit discusses the factors that affect the components
of BoP and the significance of BoP statistics.
UNIT 12 INTERNATIONAL FINANCIAL
MARKETS AND
INSTRUMENTS
Structure
12.1 Introduction
12.2 Objectives
12.3 Origin of International Financial Markets
12.4 Instruments Available in the International Financial Markets
12.5 Players in the International Financial Markets
12.6 Resource Mobilization – The Decision Criteria
12.7 Equity Instruments
12.8 Debt Instruments
12.9 Euro Credit Syndication
12.10 Strategic Considerations
12.11 Summary
12.12 Glossary
12.1 INTRODUCTION
The primary role of financial markets in any country is to facilitate the transfer of
surplus funds from the savers to the deficit units through financial intermediation/
disintermediation. The gradual liberalization of the financial sector in the developing
countries initiated in early ’70s started providing multiple instruments to the savers and
the issuers bringing together the needs of suppliers of the resources with that of the
users of the resources. Further, the integration of financial markets in different countries
across the world has facilitated greater access to international markets and birth of new
financial instruments to cater to the changing needs of the international investors and
transfer of funds from prosperous countries to deficit countries.
12.2 OBJECTIVES
• Outline the origin of international financial markets;

• Identify the role of various players in the international financial markets;
• Understand the factors that affect the resource mobilization process;
• Describe various equity instruments and debt instruments;
• Know the process of Euro credit syndication; and
• Understand strategic considerations.
12.3 ORIGIN OF INTERNATIONAL FINANCIAL MARKETS
In the 1960s, the investors in order to avoid taxes in their home country and to protect
themselves against depreciating domestic currencies, wished to hold their assets outside
their home country or in currency other than domestic currency. Investment bonds were
subjected to withholding tax and registration of ownership of bonds was essential.
To overcome these issues, dollar denominated Euro-bonds were designed.
The International capital market until 1970 concentrated on debt financing and equity
finances due to the restrictions imposed on cross-border equity investments in different
countries. Investors preferred domestic equity issues rather than foreign equity issues.
During this period, exchange controls by various countries such as UK, France, and Japan
were removed which boosted financial market operations. Further, new technology
applications facilitated innovations in financial market services, institutionalization of
savings and deregulation of markets occurred, channelizing the funds from surplus units to
deficit units. This resulted in international capital markets becoming a major source of
external finance for countries with lower internal savings. Subsequently, the markets were
classified into Euro market, American market, and other foreign markets.
India’s Presence in International Markets
India, for a long time raised capital from abroad through bank borrowings, syndicated
loans, lines of credit, bonds etc. Mostly financial institutions and public sector units along
with few private companies utilized debt instruments in the international capital markets.
Presently, the scenario has changed and international markets consider India a different
nation compared to the past because of improved export performance, better forex
reserves position, healthy economic indicators etc. For the first time in March 1992, the
government permitted a few Indian companies to enter the international equity market.
12.4 INSTRUMENTS AVAILABLE IN INTERNATIONAL

FINANCIAL MARKETS
International financing can be classified into equity financing and debt financing.
The following figure shows the classification of international capital markets in
accordance with instruments used and market(s) accessed.
International Capital Markets
International Bond Market International Equity Market
Foreign Bonds Euro Bond Foreign Equity Euro

Equity
– Yankee Bonds – Euro/Dollar – ADR – GDR

– Samurai Bonds – Euro/Yen
– IDR/EDR
– Bulldog Bonds – Euro/Pounds
Figure
6
International Financial Markets
and Instruments
Debt Instruments
International bonds are broadly classified into foreign bonds; and Euro bonds.
Foreign Bonds: Bonds floated in the domestic market denominated in domestic
currency by non-resident entities are called foreign bonds. For example, Yen
denominated bonds issued in Japanese domestic market by non-Japanese companies are
called Samurai-bonds.
Euro-bonds: Bonds issued and sold outside the home country of the currency are called
Euro bonds. For example, a Yen denominated bond issued in US is called Euro (yen)
bond. Euronotes such as Commercial Paper (CP), Note Issuance Facilities (NIF), and
Medium-Term Notes (MTNs) with shorter maturities can be issued by the companies.
Euro-Commercial Paper which is unsecured has a maturity of one year and is not
underwritten. NIF is underwritten and has a maturity period of one year. MTNs are
not-underwritten and are issued for a period of more than one year. International capital
markets facilitate borrowings in the form of Euro loans from the banks to companies to
serve various long-term; and medium-term needs. Two types of syndicated credits, viz.,
club loans and syndicated loans are available in the market.
Equity Instruments
International equity markets can be accessed through an intermediate instrument called
Depository Receipt (DRs). It is a negotiable certificate issued by a depository bank
towards beneficial interest in shares issued by a company. Such shares are deposited
with a local custodian appointed by the depository and the receipts are issued by the
custodian against the deposit of shares. In accordance with the placements, DRs are
referred to as Global Depository Receipts (GDRs), American Depository Receipts
(ADRs), and International Depository Receipts (IDRs). Each of these receipts represents a
specified number of shares in the domestic markets. Countries having capital account
convertibility permit an equity holder to deposit the specified number of shares and
obtain the GDR or vice versa. A dividend based on the value of underlying shares of the
GDR is issued to the holder. Until and unless the GDRs/ADRs/IDRs are converted, the
holder cannot claim any voting right and the company is free from any foreign exchange
risk.
Quasi-Instruments
Instruments such as warrants, FCCBs etc., are treated as debt instruments for a
particular time period after which they are converted into equity either at the option of
investor or the company. Warrants are issued as a ‘sweetner’ along with a legal payment
obligation and also have a greater flexibility with conversion. A company can
incorporate a ‘call option’ at the choice of the issuer to get FCCBs before maturity
because of adverse market conditions, changes in tax laws etc. Another such instrument
issued for investment in Europe is Euro convertible bond. This is quasi-equity issue
made outside the domestic market and the holder can convert this instrument from debt
to equity.
a. Define Euro-bonds.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
7
b. What are Depository Receipts?
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
12.5 PLAYERS IN THE INTERNATIONAL FINANCIAL

MARKETS
The major players of international markets are: borrowers/issuers, lenders/investors, and
intermediaries.
Borrowers/Issuers: These include companies, banks, financial institutions, government,
quasi-government bodies and supra national organizations which borrow funds for
foreign currencies required for operation in international markets, dull/saturated
domestic market or for further expansion of operations in other countries. Supranational
organizations such as IMF, World Bank etc., mainly borrow long-term funds in order to
provide diversified financing.
Lenders/Investors: Investors include private individuals investing through Swiss banks,
the IMF and the World Bank. The other major investors are insurance companies,
professional pension fund managers etc. Institutional investors are classified into market
specific investors, time specific investors and industry specific investors. Market
specific investors specialize in specific instruments such as equity, floating rate bonds
etc. Time specific investors specialize in specific maturity bonds such as long-term,
medium-term, short-term etc. Industry specific investors specialize in industries like
chemical, steel etc. On the other hand, for Euro-loans, the lenders mainly include banks
that possess inherent confidence in the credibility of the borrowing company or any
other entity. In the case of GDRs, institutional investors subscribe to the equity of
corporates. If it is ADR, then the institutional investor or individual investor will invest
through qualified institutional buyer.
Intermediaries: Intermediaries in the international markets include lead and
co-managers, underwriters, agents and trustees etc.
Lead and Co-managers: A lead manager undertakes responsibilities such as due
diligence, preparing the offer circular, marketing the issues etc. Sometimes, the lead
manager in consultation with issuers invites a syndicate of investment banks to buy
some of the bonds/DRs and sell the remaining to other investors. In such case,
co-managers join the deal and each agrees to take up substantial portion of the issue to
sell to his investor clients.
Underwriters: The lead manager(s) and co-managers act as underwriters for the issue.
Lead manager(s) can also invite additional investment banks to act as sub-underwriters.
A third group of investment banks also joins the issue as members of the selling group
and it does not act as an underwriter. All these members together form a selling group.
Agents and Trustees: These intermediaries are concerned with the issue of
bonds/convertibles. The issuer of bonds/convertibles in consultation with the lead
manager appoints a bank as ‘paying agent’ in different financial centers and be
responsible for arrangements towards payment of interest and principal due to investors
according to the terms of issue.
8
and Instruments
Lawyers and Auditors: A prominent firm of solicitors is appointed by the lead
manager to take care of documentations concerning Bond/DRs issues. At the same time,
the issuer will appoint legal advisors in order to seek advice on matters related to
Indian/English/American laws and accordingly complete the legal requirements.
Financial information, summaries and audit report will be included in the ‘offering
circular’ by auditors or reporting accountants.
Listing Agents and Stock Exchanges: The listing agent takes care of documentation
and listing process on stock exchanges and also keeps track of annual reports, articles of
association, the depository agreement, etc., related to the issuer.
Depository Bank: The Depository Bank issues the actual DRs, disseminates
information from the issuer to the DR holders, pays dividends and also facilitates the
exchange of DRs into underlying shares when they are submitted for redemption.
Custodian: The shares underlying DRs are held by the custodian on behalf of the
Depository and he is also responsible for collecting rupee dividends on the underlying
shares. Later the custodian repatriates the collected rupee dividends to the Depository in
US dollars/foreign currency.
Printers: The printers undertake printing and delivery of the preliminary and final offer
circulars including DRs/Bond certificates.
12.6 RESOURCE MOBILIZATION – THE DECISION CRITERIA

Every management must decide upon resource mobilization at a competitive cost.
Today Indian companies due to liberalization can access both domestic and
international markets along with new instruments. For an Indian company, the selection
between domestic and international markets depends on the following issues:
Currency Requirements: A decision with regard to currency needs of a company for
future expansions, capital imports, export earnings etc must be taken.
Pricing: Pricing of an international issue includes interest rates and the value of the
underlying stock in the domestic market. In accordance with these factors, the issue
price conversion premium will be determined. A company in order to maximize the
proceeds in the international market can opt for open pricing or book building. This
enables the foreign investor to determine the premium confirming transparency and at
the same time create price tension.
Investment: Today, a greater flexibility is available in structuring international issues
in terms of pure equity offering, a debt instrument or a hybrid instrument such as
Foreign Currency Convertible Bond (FCCBs).
Depth of the Market: In the international markets, larger issues can be easily floated
when compared to domestic markets.
International Positioning: An international issue facilitates the issuing company a
higher visibility and international exposure. Further it opens many new avenues for fund
raising.
Regulatory Aspects: International issues require the approval of government of India
and RBI while the domestic issue must comply with rules and regulations of SEBI and
stock exchanges.
9
Disclosure Requirements: The disclosure norms for an international issue are more
complex compared to a domestic issue. These norms depend on the place and market
where the listing is sought.
Investment Climate: Various factors such as international liquidity, and country risk
influence international issues.
12.7 EQUITY INSTRUMENTS

Global Depository Receipts
A rapid deterioration in the foreign exchange reserves as a result of the Gulf War and oil
crisis compelled the companies to get their own foreign currencies and this led to the
emergence of GDRs. In India, these emerged because of balance of payments crisis in
the early 90s. As the foreign exchange balance was less, the governments permitted
fundamentally strong private corporates to raise funds in international capital markets
through equity or equity-related instruments. The Foreign Exchange Regulation Act
(FERA) was amended to facilitate investment by foreign investors up to 51% of the
equity-capital of the companies. Investment exceeding this limit is also being permitted
by the Government.
The Instrument
A GDR is a negotiable instrument which represents publicly traded local-currency-equity
share. At the request of the investor, GDRs can be converted into equity shares by
cancellation through the intermediation of the depository and the sale of underlying shares
in the domestic market through the local custodian. It is entitled to dividends and voting
rights from the date of issuance.
The Procedure
The following figure depicts the procedure followed in issuing a GDR:
Issuance of GDR
The various activities undertaken to issue a GDR are as follows:
a. Shareholder Approval Needed: The issuance of a GDR requires a mandate of the
shareholders of the company issuing it. All the terms and conditions will be
determined before seeking such mandate. At the same time, an authorization is
required from the Board of Directors for floating a Euro-issue and for calling a
general meeting. A committee of directors will pass approval with regard to the
offering of memorandum, fixation of issue price etc. Finally, the shareholders must
approve the issue by a special resolution passed at a general meeting in accordance
with Section 81 of the Companies Act, 1956.
10
and Instruments
b. Appointment of Lead Manager: A lead manager is responsible for the eventual
success or failure of a Euro-issue. Hence, an ideal lead manager is selected after a
preliminary meeting with the merchant bankers. The merchant bankers are
evaluated by considering various parameters such as: marketing ability, track
record, placement skills etc. Finally, a lead manager is appointed with the approval
from the government. The lead manager advises the company after considering
various factors such as the industry to which the company belongs, the
international monetary, and securities markets etc.
c. Finalization of Issue Structure: After the completion of formalities of issue
structure in consultation with the lead manager, the company must obtain a final
approval from the government. For this purpose, it has to submit information with
regard to entities involved in GDR and various parameters such as: currency, issue
price, taxation, negative pledge provisions etc. The government will approve the
issue if it is satisfied with the information provided.
The Documentation
A typical Euro-issue consists of various documents such as: prospectus, custodian
agreement, trust deed etc.
a. Prospectus: A prospectus is a major document containing all the relevant
information of an issue such as investment considerations, use of proceeds etc.
Initially, the company issues a prospectus referred to as pathfinder that
determines the potential demand for the equity being launched in the market. The
main prospectus must cover the following issues:
i. Financial Matters: In addition to the financials of the company, the
prospectus must provide statement with regard to accounting policies of
the company and a summary of significant differences that characterize
the Indian GAAP, UK GAAP, and US GAAP.
ii. Non-financial Matters: Prospectus should contain information related to
the background of the management, names of the nominee directors,
names of the financial institutions, and all other non-financial information
affecting the working of the company.
iii. Issue Particulars: Information such as issue size, the ruling domestic
price etc., should also be mentioned in the prospectus.
iv. Other Information: Information such as statement regarding application to a
foreign stock exchange for listing of securities, issue of global certificates to
a specified nominee, option provided to the lead manager to cover
over-allotment etc., should be stated in the prospectus.
b. Depository Agreement: This is an agreement between the issuing company and
the overseas depository. It contains rules for withdrawal of deposits, their
conversion into shares and procedure for the information transmission to be passed
onto the GDR holders etc.
c. Underwriting Agreement: This is an agreement between company and the
underwriter assuring the role of underwriters.
d. Subscription Agreement: According to this agreement the lead manager and the
syndicated members form a part of the investors who subscribe to GDRs or Euro
convertible bonds.
11
e. Custodian Agreement: In accordance with this agreement, the depository and the
custodian determine the process of conversion of underlying shares into depository
receipts and vice versa.
f. Trust Deed and Paying and Conversion Agreements: The trust deed provides
duties and responsibilities of trustees. On the other hand, paying and conversion
agreement facilitates the paying and conversion agency to perform typical banking
function.
g. Listing Agreement: Many companies issuing a GDR prefer Luxembourg Stock
Exchange as the listing requirements are simple to follow. The requirements of
London Stock Exchange are given in 48-hour documents. These documents must
include an application for admission of listing, a copy of any shareholder’s
resolution that is relevant to the issue of such securities etc.
The Launch
Two approaches, viz., Euro-equity Syndication and Segmented Syndication are used to
launch a Euro-issue. Euro-Equity syndication groups together the placement strengths
of the intermediaries, without any formal regional allocations. On the other hand,
segmented syndication forms a geographically targeted syndicate structure so that
broader distribution of paper can be achieved by consulting both institutional and retail
investors.
Marketing
Marketing activities are handled by the lead manager in consonance with the advertising
agency. A back-up material consisting of preliminary offering circular, interim financial
statements etc., is also prepared. Road shows play a significant role in launching any
GDR. They provide information of financials, operations and future profitability, and
growth prospects.
Pricing and Closing
Pricing plays a key role in the overall performance of a GDR after it is listed. The final
price is computed after the Book Runner closes the books after the completion of road
shows. The book-runner maintains the books for 1-2 weeks to facilitate potential
investors to place their order/bids with details of price and quantity. After analyzing all
the bids at the end, lead managers in consultation with the issuer will fix a particular
price for the issue and the same will be communicated to the bidders/investors and a
fresh demand figure is drawn. If there is excess demand the company uses the green
shoe option.
Costs
The cost incurred by a company is proportional to the issue size. The following table
indicates the total expenses incurred by a GDR issue:
Item Percent of issue amount

Underwriting Fee 0.60 – 1.00
Management Fee 0.60 – 1.00
Selling Commission 1.80 – 3.00
Total Fees 3.00 – 5.00
GDR Issue: Fees and Expenses
12
and Instruments
American Depository Receipts
Till the 1990s companies could issue separate receipts in the US (ADRs); and in Europe
(IDRs) to access both the markets. In April 1990 with the changes in Rule 144A and
Regulations of the Securities Exchange Commission (SEC) of the US permitted non-US
companies to raise capital in the US market without any need to register the securities
with the SEC or changing the financial statements to reflect the US accounting
principles.
The Instrument
ADR is a negotiable certificate denominated in dollar and represents non-US company’s

publicly traded equity. ADRs are classified into three levels based on the regulation and
privilege of each company’s issue.
i. ADR Level-I: This is the first step of an issuer in the US public equity market.
The issuer can broaden the market for existing shares subsequently diversifying
the investor base. Here, minimum disclosure is required by the SEC and the issuer
need not follow US GAAP. This instrument is traded in the US OTC market.
ii. ADR Level-II: At this level the company broadens the investor base for existing
shares to a larger extent and the significant disclosures must be made to the SEC.
The company can list its share on the American Stock Exchange (AMEX); or
New York Stock Exchange (NYSE).
iii. ADR Level-III: At this level ADR is used to raise fresh capital through public
offering in the US capital markets. The company must be registered with SEC and
must comply with the listing requirements of AMEX/NYSE while following
US-GAAP.
The intermediaries such as Merrill Lynch International Ltd., Goldmann Sachs & CC.
etc., play a significant role in issuing ADRs/GDRs.
Regulatory Framework
Securities and Exchange Commission (SEC) provides regulatory framework for ADRs.
It operates through two statutes, viz. the Securities Act of 1933 and the Securities
Exchange Act of 1934. Rule 415 of the securities Exchange Act of 1934 is related to
Shelf Registration and issue of ADRs. According to this rule only specific companies
are allowed to register the required document prior to the actual issuance of securities.
For this purpose, the issuers must prepare the prospectus in two parts: Basic and
Supplementary. The basic prospectus and the supplementary prospectus must be filed at
the time of shelf registration.
Potential
Companies interested in investing in certain blue chip companies in India are finding
GDRs/ADRs as most appropriate. BPL Cellular Holdings is the first company to receive
approval to issue ADR.
13
12.8 DEBT INSTRUMENTS
Eurobonds
In the international markets, the process of lending money by investing in bonds
initially started in the 19th century. The first Eurobond was made for US$15 million
only for the Italian motorway company – Autostrada.
The Instruments
Euro bonds are issued outside the country of the currency in which they are
denominated. They are listed on world’s stock exchanges such as, Luxembourg Stock
Exchange.
The characteristics of Eurobonds can be outlined as follows:
• No withholding of taxes of any kind on interests payments.
• The bonds are in bearer form with interest coupon attached.
• The bonds are listed on one or more stock exchanges but issues are generally
traded in the over-the-counter market.
Bond issue structures are classified into Fixed Rate Bonds and Floating-Rate Notes.
a. Fixed Rate Bonds/Straight Debt Bonds: These are unsecured interest bearing
securities that are redeemable at face value. They are floated in the domestic
markets or international markets and are denominated in the respective currencies
with fixed interest rates determined on the basis of a certain formula applicable in
a given market. The bonds issued in the Euro-market are called Euro-bonds and
have fixed interest rates with reference to the creditworthiness of the issuer. The
yields of these instruments depend on the short term interest rates. The most
commonly used benchmark in measuring these bonds is LIBOR.
b. Floating Rate Notes (FRNs): These notes are issued at a maturity period varying
from 5-7 years with coupon rates pegged to another security or
re-fixed at periodic intervals. The spreads or margin on these notes will be more
than 6 months LIBOR for Eurodollar deposit. The following are the various types
of FRNs:
Flip-flop FRNs: These notes facilitate the investors to convert the FRN into
3-month note with a flat 3-month yield for every 6 months. The investor has the
option to revert his decision and convert it to a perpetual note.
Mismatch FRNs: These notes are also known as rolling rate FRNs and have
semi-annual interest payments though the actual rate is fixed monthly.
Mini-Max FRNs: These notes are also known as collared FRNs and the investors
can earn a minimum rate as well as maximum rate on these notes.
Capped FRNs: In this type of FRN an interest rate cap is given over which the
borrower need not service the notes even when the LIBOR goes above that level.
VRN-Structured FRNs: These are long-dated notes with variable interest spreads
and margins over Libor.
Perpetual FRNs: These notes are irredeemable and are also known as perpetual
floaters or undated issues.
14
and Instruments
Procedure
The success of a bond issue depends to a great extent on the position and capabilities of
the bidders involved in launching the issue. After receiving the receipt of the mandate,
the mandated bank or lead manager has to take steps for the formation of a syndicate
group to complete bond issue formalities.
a. Syndication: The lead manager must conduct detailed negotiations with the issuer
in order to settle various terms and conditions along with a time table for carrying
on different stages of bond issue floatation. He must also draft documents such as:
prospectus, subscription agreement, underwriting agreement etc., with the help of
the legal counsels. International markets follow the traditional method of open
priced syndication procedures. Accordingly, the underwriter keeps the price open
till the subscription agreement is actually signed.
b. Launching, offering and Closing: On receiving receipts of various approvals
and authorizations by the issuer, the news regarding bond issue floatation is
communicated through a proper media. With the announcement of the bond issue
launch, invitations are sent to the underwriters and selling group members inviting
their support. After the execution of underwriting agreement the underwriter takes
up the issue and subsequently sells it. The underwriting involves three groups, viz.,
the managers, major underwriters, and minor underwriters. On the other hand,
selling group members do not take title as they undertake to sell the issue if
support is obtained. In the next stage i.e., offering, the terms consisting of coupon
rate and issue price are finalized. Pricing is determined based on underwriter’s
response and the same is undertaken a day before the offering. The lead manager
along with co-managers assesses the mood and response of the market and weighs
the response of underwriters accordingly. During this period, the issuer and the
lead manager conduct a sales campaign in the various markets by way of road
shows. The offering stage comes to an end when the actual sale of bonds, signing
of necessary agreements and publicity with regard to the transaction are
concluded.
Listing
Depending on the type of bond issue, the currency of denomination and the desire of the
issuer with regard to quotation, the bond issues are listed at one or more stock
exchanges. For example, the Eurobonds denominated in dollars are listed at
London/Luxembourg Stock Exchanges and the bonds denominated in French Franc at
Luxembourg Stock Exchange.
Clearing Arrangements
Clearing house arrangements facilitate new issue and secondary market operations.
Eurobonds are taken up either by Euroclear system (Brussels); or Cedel (Luxembourg)
which are interlinked by an electric bridge. They follow two distinct practices known as
fungible and non-fungible accounts in order to conclude transactions between parties.
The Present Scenario
In the early eighties, India relied heavily on Eurocredits. During the mid-eighties it
entered Japanese markets with floatation of privately placed Shibosai issues and later
followed by public bond issues in German and Swiss markets. By the end of the decade,
15
few public sector institutions floated Eurodollar issues for the first time. But because of
selective approvals by the government and/or sensitivities of the markets concerned, only
four organizations ventured into external bond markets prior to forex crisis of 1991 which
closed market doors to India. However, today the situation has improved and some of the
big Indian corporate houses have started tapping the international bond markets.
Foreign Bonds
Foreign bonds are issued by foreign entities for raising medium- or long-term finances
from domestic money centers in their domestic currencies. The following are the
various types of foreign bonds:
a. Yankee Bonds: These bonds are denominated in the US dollar and are issued by
foreign borrowers such as foreign governments, entities etc in the US bond market.
They are sponsored by US domestic underwriting syndicate and require
registration of Securities and Exchange Board of India before being sold in the
domestic US market.
b. Samurai Bonds: These bonds are issued by non-Japanese borrowers in the
domestic Japanese markets with a maturity period ranging between 3-20 years.
They are registered bonds and as such the settlement and administrative
procedures make them very costly. Two major parties are involved in a samurai
bond issue, viz., the securities house that acts as a lead manager and the bank that
acts as a chief commissioned company.
c. Bulldog Bonds: These bonds are denominated in sterling and are raised in
domestic securities market. The maturity of these bonds will be either for a very
short period (5 years) or for a very long period (25 years or above). Usually,
long-term institutional investors like pension funds and life insurance companies
subscribe to these bonds. These bonds are offered either by placing or by an offer
for sale and will be listed on the London Stock Exchange.
d. Shibosai Bonds: These bonds are privately placed bonds issued in the japanese
markets and are less stringent compared to Samurai or Euro or Yen bonds. These
bonds are offered to a different market segment which includes institutional
investors and banks etc. The eligibility criteria, amount, maturity etc are regulated
and governed by the guidelines of Japan’s Ministry of Finance (MoF).
Euro-Notes
In the mid-eighties there was a search for a instrument that would go beyond the interbank
market for arranging funds and which had wider support for resource raising through
primary investors in various markets. This led to the emergence of Euro-notes.
The Instrument
Euro-note is a flexible instrument and can be moulded to suit the specific requirements
of different types of borrowers. The following are the different types of Euro notes:
a. Commercial Paper (CP): These are unsecured promissory notes and are repaid at
a fixed amount on a certain future date. Euro notes underlying CP are called Euro
commercial paper. These are not underwritten and have a maturity period upto one
year. The documentation process is simple and includes information
memorandum, dealer agreement etc.
16
and Instruments
b. Note Issuance Facilities (NIFs): A NIF is a medium-term legally binding
commitment under which a borrower can issue short-term paper up to a maturity
period of one year. The underlying currency is mostly US dollar. Underwriting banks
purchase any notes which the borrower is unable to sell, and/or provide standing credit.
These can be re-issued periodically. Professional investors of NIFs include commercial
banks, non-financial institutions such as insurance companies and provident funds.
These instruments involve three major costs, viz., underwriting fee which has to be
paid on full amount of underwriting, a one-time management fees towards
restructuring, pricing, syndication etc., and margin on notes which is expressed either
in the form of spreads over LIBOR or built into the NIF pricing itself.
c. Medium-Term Notes (MTNs): These are fixed interest securities issued sequentially
with a maturity period of more than one year. These notes facilitate an issuer to issue
Euro notes for different maturities from a period ranging from one year to any desired
level of maturity. A Global MTN (G-MTN) can also be issued world wide. This
facilitates issuers of different credit ratings to raise finance by accessing both retail
and institutional investors.
The Indian Scenario
Only few banks and financial institutions could bring out CP and Revolving
Underwriting Facility (RUF) – type programs till 1994. Today, the liberalization of
international markets has paved the way for Indian borrowers to explore international
markets.
a. What are ADRs? Discuss the three levels of regulation under ADRs?
..………………………………………….………………………………………
..………………………………………….………………………………………
..………………………………………….………………………………………
b. What are NIFs?

..………………………………………….………………………………………
..………………………………………….………………………………………
..………………………………………….………………………………………
12.9 EURO CREDIT SYNDICATION

The Genesis
The genesis of Euro credits can be traced back to the late 1960s when the first syndicate
was organized by Banker’s Trust in an effort to arrange a large credit for Austria.
Syndicates are classified into club loans and syndicated loans. A private arrangement
between a lending bank and a borrower is called a club loan. On the other hand, when
the borrowers and lenders come together in an effort to execute an agreement defining
the terms and conditions, such loan is called syndicated loan. Today, syndicated Euro
credits on a variable interest rate basis have become most notable and popular financing
instruments in the international financial markets.
17
Documentation Formalities
In addition to syndication process, the lead manager undertakes loan documentation
which includes information memorandum and loan agreement. The information
memorandum contains information regarding borrowing entity, its details, ownership
and management. This memorandum is registered with a stock exchange and the lenders
rely on the information provided by it. The principal loan document is the loan
agreement and is signed by all the participating banks and the borrower. This document
describes the basic transaction, drawdown arrangements, interest rate and its
determination, commitment fees etc.
Pricing Methodology
The interest rate on loan will be LIBOR plus the spread maintained by the bank which
may range from 0.125% to 1.5% or remain constant over the life of loan or may be
changed after a certain fixed number of years. In addition to this the lead manager’s fee
will be 0.125% of loan and his commitment fees will be 0.5% on the undrawn loan
amount. Similarly, the agent’s fees will include total annual charges.
Offshore Banking
Offshore banking includes a bank offering its services to accept deposits from and
extend credit to foreign residents in any currency. These activities are exempted from
capital controls, taxes and reserve requirements.
12.10 STRATEGIC CONSIDERATIONS

Companies willing to tap the resources must consider important factors such as
instrument maturity and its impact on the asset liability balance (as external finances are
prone to several uncertainties). For this purpose each instrument must be compared with
the other on the basis of critical parameters (chosen by it). For example, Company X
which expects to receive state guarantee and has a capacity to adopt bullet repayment
can opt for bonds as the instrument. Credit rating agencies such as Standard & Poor and
Moody play a significant role in determining the suitable instrument for a company in
the international market.
12.11 SUMMARY
Indian companies can raise funds in the international markets through different
instruments such as debt, equity etc.
International bonds are classified into foreign bonds such as Yankee bonds, Samurai
bonds etc and Euro bonds such as commercial paper, medium term notes etc.
International equity markets can be accessed through Depository Receipts such as
GDRs, ADRs and IDRs.
Instruments such as FCCBs are treated as quasi-instruments.
The major international players include borrowers/issuers, lenders/investors and
intermediaries.
In the present scenario, Euro credits on a variable interest rate basis have become the most
popular financing instruments in the international markets.
18
and Instruments
12.12 GLOSSARY
Club Loan means the lending banks form a club and advance a loan. Hence, the name
club loans.
Fungible Account System contains details regarding identity of the owners but does
not provide the location of individual securities.
Green Shoe Option implies issuing additional GDRs in excess of the target amount.
Rule 144A is designed to facilitate certain investment bodies called Qualified
Institutional Buyers (QIBs) to invest in overseas (non-US) companies and those
companies that need not go through the SEC registration process.
12.13 SUGGESTED READINGS/REFERENCE MATERIALS


a. Euro-bonds: Bonds issued and sold outside the home country of the currency
are called Euro bonds. For example, a Yen denominated bond issued in US is
called Euro (yen) bond. Euronotes such as Commercial Paper (CP), Note
Issuance Facilities (NIF), and Medium-Term Notes (MTNs) with shorter
maturities can be issued by the companies. Euro-Commercial Paper which is
unsecured has a maturity of one year and is not underwritten. NIF is
underwritten and has a maturity period of one year. MTNs are
not-underwritten and are issued for a period of more than one year. International
capital markets facilitate borrowings in the form of Euro loans from the banks to
companies to serve various long-term; and medium-term needs.
b. International equity markets can be accessed through an intermediate instrument
called Depository Receipt (DRs). It is a negotiable certificate issued by a
depository bank towards beneficial interest in shares issued by a company. Such
shares are deposited with a local custodian appointed by the depository and the
receipts are issued by the custodian against the deposit of shares. In accordance
with the placements, DRs are referred to as Global Depository Receipts (GDRs),
American Depository Receipts (ADRs), and International Depository Receipts
(IDRs). Each of these receipts represents a specified number of shares in the
domestic markets.
a. Till the 1990s companies could issue separate receipts in the US (ADRs); and in
Europe (IDRs) to access both the markets. In April 1990 with the changes in
Rule 144A and Regulations of the Securities Exchange Commission (SEC) of
the US permitted non-US companies to raise capital in the US market without
any need to register the securities with the SEC or changing the financial
statements to reflect the US accounting principles.
19
The Instrument
ADR is a negotiable certificate denominated in dollar and represents non-US
company’s publicly traded equity. ADRs are classified into three levels based on
the regulation and privilege of each company’s issue.
i. ADR Level-I: This is the first step of an issuer in the US public equity
market. The issuer can broaden the market for existing shares
subsequently diversifying the investor base. Here, minimum disclosure is
required by the SEC and the issuer need not follow US GAAP. This
instrument is traded in the US OTC market.
ii. ADR Level-II: At this level the company broadens the investor base for
existing shares to a larger extent and the significant disclosures must be
made to the SEC. The company can list its share on the American Stock
Exchange (AMEX); or New York Stock Exchange (NYSE).
iii. ADR Level-III: At this level ADR is used to raise fresh capital through
public offering in the US capital markets. The company must be
registered with SEC and must comply with the listing requirements of
AMEX/NYSE while following US-GAAP.
b. Note Issuance Facilities (NIFs): A NIF is a medium-term legally binding
commitment under which a borrower can issue short-term paper up to a maturity
period of one year. The underlying currency is mostly US dollar. Underwriting
banks purchase any notes which the borrower is unable to sell, and/or provide
standing credit. These can be re-issued periodically. Professional investors of NIFs
include commercial banks, non-financial institutions such as insurance companies
and provident funds. These instruments involve three major costs, viz.,
underwriting fee which has to be paid on full amount of underwriting, a one-time
management fees towards restructuring, pricing, syndication etc., and margin on
notes which is expressed either in the form of spreads over LIBOR or built into the
NIF pricing itself.

A. Multiple Choices
1. A bull-dog bond is issued in which of the following markets?
a. UK market by UK borrower.
b. UK borrower in sterling by non-UK borrower and is listed.
c. UK borrower in sterling by non-UK borrower under private placement
and is unlisted.
d. Issued outside UK market by a UK borrower and is listed.
e. Issued by a non-UK borrower in non-sterling currency.
2. __________ are non-underwritten and have a maturity of more than one year.
a. Note issuance facilities
b. Medium-term notes
c. Commercial paper
d. GDRs
20
and Instruments
3. __________ is a private arrangement between lending banks and a borrower.
a. Club loan
b. Multiple component facility
c. Syndicated Euro credit
d. All of the above
e. Both (a) and (c) above.
4. Which of the following statements is/are true?
a. Private placement issues in Japanese Bond Market are known as Shibosai

bonds.
b. Bonds issued in domestic dollar market by foreign borrowers are called

Yankee bonds.
c. Foreign issues in the domestic sterling market are called Bulldog Bonds.
d. All of the above.
5. Which of the following instruments is underwritten and has a maturity period up to

one year?
a. Note issuance facilities.
b. ADRs.
c. Commercial paper.
d. Medium-term notes.
B. Descriptive
1. What is a GDR? Explain in detail the procedure involved in issuing a GDR and
mention the required documents.
2. Discuss in detail the different types of debt instruments and the procedure
involved in issuing those instruments.
3. Discuss about Euro credit syndication in detail.
practice only.
21
UNIT 13 INTERNATIONAL EQUITY
INVESTMENTS
Structure
13.1 Introduction
13.2 Objectives
13.3 Advantages of International Equity Investments
13.4 Risks of International Investments
13.5 International CAPM
13.6 Segmentation of Markets
13.7 International Listing
13.8 Guidelines for FII Investment in India
13.9 Summary
13.10 Glossary
13.1 INTRODUCTION
Integration of financial capital markets has resulted in efficient capital allocation across
economies. This has allowed investors to invest in equity investments of foreign
companies through domestic exchanges giving them diversification benefits. Now
companies have the advantage of accessing various international markets to raise funds.
13.2 OBJECTIVES
• Know the advantages of international equity investments;
• Understand the risks associated with international investments;
• Estimate international CAPM;
• Explain the segmentation of markets; and
• Recognize the guidelines for international listing and FII investments in India.
13.3 ADVANTAGES OF INTERNATIONAL EQUITY

INVESTMENTS
Diversification of capital through international equity investment will lead to reduction
of risk and increase in return to the investor. This happens because different countries
would be experiencing different points of the economic cycle at a given period of time.
Secondly, various factors such as tax structures, fiscal and monetary policies, political
International Equity Investments
conditions etc., will have different impacts on investment across countries. Further,
industrial structures also differ between countries. Hence, any international event will
affect the whole world differently. These factors allow scope for correlation between the
returns from these economies to be less than perfect and thus provide diversification
benefits. According to CAPM, even when the returns offered by the foreign securities
are less than that offered by the domestic securities, diversification may still benefit by
reducing the risk more than the reduction in returns.
The return on a foreign security is denominated in foreign currency. The rate at which
the realizations from the security would be converted into domestic currency will be
different from the rate at which conversion of currency occurred at the time of
investment, because of exchange rate fluctuations. Due to this, foreign security returns
in terms of domestic currency have two components. Classified into two components in
terms of domestic currency they are:
• Return from the underlying security in foreign currency terms.

• Favourable returns from the underlying investment currency fluctions.
Hence, any expected returns on a foreign security can be represented as follows:
The expected domestic returns on foreign currency,
rf + S …Eq. (1)
Where,
rf is the expected return in foreign currency terms; and
s is the expected change in the exchange rate.
13.4 RISKS OF INTERNATIONAL INVESTMENTS

Risks in international investments can be broadly classified into country risk (political
risk); and currency risk (exchange risk). Any uncertainty related to conversion of
realization proceeds into domestic currency by the investor is called ‘country risk’. This
may occur when the foreign government restricts the conversion of its currency for
several reasons. If the uncertainty is related to the rate at which the realization proceeds
have to be converted into domestic currency, then it is known as ‘currency risk’. Risk
can arise due to unfavorable movement of exchange rate. This risk can be hedged to a
certain extent by using various financial instruments such as forwards, futures or
options. While taking such a step the hedging costs must be considered. Currency risk
can also be reduced by investing in international equities. So any loss suffered because
of weakening of currency of one country will be partially offset by the gains earned on
stronger currencies. Country risk cannot be measured, but the currency risk can be
measured and factored into the risk of foreign investment. From Eq. (1) it follows that
the variance of domestic currency returns on foreign investment:
Var(rf) + Var( S ) + 2 Cov(rf, S ) …Eq. (2)

According to this equation, the risk on foreign investment includes the variability of the
returns on the foreign security, the variability of the exchange rate and the covariance
between the exchange rate and the returns on the foreign security. This implies that
23
exchange rates increase the riskiness of a foreign investment by volatility. The
diversification benefits of international investments can be seen more clearly in the
following figure:
Figure 1: The Benefits of International Diversification

with Hedged and Unhedged Exchange Risk
13.5 INTERNATIONAL CAPM

According to International CAPM, the market portfolio includes all the securities
available in any of the countries, and the beta of a security measures the sensitivity of
the security returns to a change in the returns on this extended market portfolio. So,
restricting investments to the domestic market would mean being below the efficiency
frontier. According to this theory, the return on a security is given by,
ri = rf + (rw – rf)
Where,
rf = World risk-free rate of return.
βw = World beta of the security.
C ov(ri , rw )
=
Var(rw )
rw = Return on the world-market portfolio.
The international CAPM is given in the following
Figure 2: The International CAPM

24
This model is not suitable in the real life because of the difficulties involved in
estimating various variables. However the implications of this model are very
significant while evaluating the usefulness of international investments.
13.6 SEGMENTATION OF MARKETS

Segmentation of markets may occur because of various factors such as follows:
Regulations restricting foreign investments: The regulations restricting or prohibiting
he foreign investments do not allow the market forces to enable integration of markets.
Non-convertibility of currencies: Non-convertibility of currencies disables investors
from investing in foreign securities and this result in segmentation of markets.
Home-country bias: Some investors prefer to invest only in domestic securities and
this again prevents integration of markets.
Indirect barriers: Investment in foreign securities is sometimes restricted by indirect
barriers such as non-availability of information with regard to foreign securities etc.
13.7 INTERNATIONAL LISTING

Various companies get their shares listed on the stock exchange of foreign countries
either through direct listing or through Global Depository Receipt (GDR). A GDR is
denominated in the currency of the country in which it is issued and is listed and traded
on a domestic stock exchange. The investors are not subjected to any regulations of the
issuing country and as such the country risk reduces to a large extent. Other technical
aspects such as conversion of dividend payments into domestic currency, collection of
financial reports etc., are all done by the domestic depository on behalf of the investors.
Thus, the domestic listing of international diversification exposes the investor to many
of its risks.
a. List the major risks involved an international investment.
……………………….……………………………………………………...........
……………………….……………………………………………………...........
……………………….……………………………………………………...........
b. List out the reasons for segmentation of markets.
……………………….……………………………………………………...........
……………………….……………………………………………………...........
……………………….……………………………………………………...........
25
13.8 GUIDELINES FOR FOREIGN INSTITUTIONAL INVESTORS
(FII) INVESTMENT IN INDIA
Foreign residents have been permitted to make portfolio investments since September
1992 and these investments are regulated by the SEBI (Foreign Institutional Investors
(FII)) Regulations, 1995. Investors investing in GDRs, FCCBs and FCBs issued by
Indian companies are not covered by these regulations.
Securities and Exchange Board of India (Foreign Institutional Investors)
Regulations, 1995
Section 30 of the Securities and Exchange Board of India Act, 1992, (15 of 1992)
prescribes the following regulations.
Chapter I – Preliminary
Short Title and Commencement: These regulations are called Securities and
Exchange Board of India (Foreign Institutions Investors) Regulations, 1995 and will be
effective from the date of their publication in the official Gazette.
Definitions: In these regulations, we come across various terms such as act, certificate,
designated bank, domestic portfolio manager, enquiry officer, foreign institutional
investor, form, institution schedule etc. All these term are defined under the Securities
and Exchange Board of India Act and some were subsequently amended according to
the requirement. For example, a certificate is defined as “a certificate of registration
granted by the Board under these regulations.” Similarly, a designated bank is defined
as “any bank in India, which has been authorized by the Reserve Bank of India to act as
a banker to Foreign Institutional Investors.” Later a sub-regulation “cc” was inserted by
the SEBI (Foreign Institutional Investors) Amendment Regulations, 2000 with regard to
the term ‘designated bank’.
Chapter II – Registration of Foreign Institutional Investor
Application for Certificate: A person holding a certificate of Board under these
regulations can only deal in securities as a Foreign Institutional Investor and application
for the same will be made to the Board in Form A. If such application has been made
prior to the commencement of these regulations, then it will be treated as a deemed
application and will be dealt accordingly. Similarly, the person certified as Foreign
Institutional Investor prior to the commencement of regulations will be allowed to
continue performing the same role.
Furnishing of Information, Clarification and Personal Representation: Sometimes
the Board may call the applicant for further information or clarification or for personal
representation regarding his activities in the process of granting a certificate.
Application to Conform to the Requirements: According to the provisions of
sub-regulations (3) and (4) of regulation 3, any application, which does not follow the
instructions specified in the form, will be rejected by the Board. But before rejection, the
applicant will be given reasonable opportunity to correct any objection as indicated by the
Board.
Consideration of Application: To grant the certificate the Board will take into account
the applicant’s track record, financial soundness etc. At the same time it considers
whether the applicant is permitted under provisions of Foreign Exchange Regulation
Act, 1973 by Reserve Bank of India for making investments in India as a FII. Similarly,
the board also confirms whether the applicant is an institution established or
26
incorporated outside India as pension fund or mutual fund or investment trust and if the
applicant is an asset management company, nominee company, bank trustee, or a porter
of account holder etc. While considering the application the Board in accordance with
clause (iv) will verify if the applicant has been in existence for a period of 5 years,
whether it is legally permitted to invest in securities outside the country of its
incorporation or establishment and so on.
Procedure and Grant of Certificate: If the Board is satisfied that the application along
with the information provided is as specified, then within three months from the date of
application made, it will grant a certificate in Form B, provided fees is paid in
accordance with the second schedule.
Validity of Certificate: The certificate and its renewal will be valid for a period of five
years from the date of its sanction or renewal.
Application for Renewal of Certificate: The Foreign Institutional Investor must make
an application for renewal in Form A before three months of expiry period specified in
the certificate.
Conditions for Grant or Renewal of Certificate to Foreign Institutional Investors:
The following are some of the conditions laid down for grant or renewal of certificate:
• The applicant must abide by the provisions of these regulations.
• He shall before making any investments in India, enter into an arrangement with
a designated bank with regard to foreign currency account or a special
non-resident rupee.
• He shall appoint a domestic custodian and before making any investments in
India, enter into an agreement with the domestic custodian providing for
custodial services with regard to securities.
• Others.
Procedure where Certificate is not Granted: If the application for grant or renewal of
a certificate is not in accordance with regulation 6, it is rejected by the board, which
communicates to the applicant in writing stating the reasons for the same. However,
within 30 days from the date of receipt of communication, the applicant can apply to the
Board for reconsideration of its decision. The board shall convey the decision with
regard to reconsideration as soon as possible.
Application for Registration of Sub-accounts: A Foreign Institutional Investor shall
obtain permission from the Board, for registration of each sub-account on behalf of the
person he proposes to make investments in India. Any such approval granted by the
Board prior to the commencement of these regulations will be deemed to have been
granted by the Board under these regulations. The application must contain all the
particulars specified in Para 1 of Annexure B to Form A of the first schedule.
Procedure and Grant of Registration of Sub-Accounts: To permit registration of

sub-accounts, the Board will consider various aspects such as, whether the applicant is
an institution or fund or portfolio established outside India and proposes to invest in
India. It also verifies whether the applicant is a Broad Based Fund. At the same time the
Board also confirms whether the applicant holds certificate of registration as FII and he
is authorized to invest on behalf of sub-account.
27
Chapter III – Investment Conditions and Restrictions
Commencement of Investment: A FII can invest in securities in India only when he
complies with the provisions of this chapter.
Investment Restrictions: A FII can invest only in securities in the primary market or
secondary market, units of schemes floated by domestic mutual funds, dated
government securities etc. The equity and equity related investments made by FII in
India, either on his own account or on sub-account must not be less than seventy percent
of total investments of FII in India. Further, maximum amount of investment in debt
securities is subject to conditions laid down by the Board. Additional conditions such as
– no transactions on the stock exchange shall be carried forward etc., must be fulfilled
by the FII. Unless otherwise specified by the Board, all the securities will be registered
in the name of FII, provided he is making investment on his own or the registration can
be made in the name of the sub-account. In the former case, the purchase of equity
shares of each company by FII must not exceed five percent of total issued capital of
that company. Similarly in the latter case, the investment on behalf of each sub-account
must not exceed five percent of the total issued capital of the company. All the
investments by FII shall be subjected to Government of India guidelines.
Chapter IV – General Obligations and Responsibilities

Appointment of Domestic Custodian: FII or a global custodian on behalf of FII shall
enter into an agreement with domestic custodian to act as the custodian of securities for
FII. The FII must ensure whether the domestic custodian is monitoring his investments
in India and he is reporting to the Board regularly etc. More than one domestic
custodian can be appointed with prior permission of the Board. But, only one custodian
is appointed for a single sub-account of FII.
Appointment of Designated Bank: A branch of a bank approved by RBI will be

appointed as designated bank by FII for the purpose of opening a foreign currency
denominated account and special non-resident rupee account.
Investment Advice in Publicly Accessible Media: An FII or any of his employees

cannot render directly or indirectly any investment advice about any security in publicly
accessible media until and unless a disclosure of his interest including long or short
position with regard to that particular security is made, while giving such advice. In case
of the employee, interest of his dependent family members and employer along with
long and short positions of the security must be disclosed.
Maintenance of proper books of accounts, records etc: Every FII must maintain
following books of accounts, records and documents:
• True and fair accounts relating to remittance of initial corpus for buying, selling
and realizing capital gains of investment made from the corpus;
• Accounts of remittances to India for investments in India and realizing capital

gains on investments made from such remittances;
• Bank statement of accounts;
• Contract notes relating to purchase and sale of securities; and
• Communication from and to the domestic custodian regarding investments in

securities.
28
The place where the above specified books are kept or maintained must be intimated to
the Board in writing.
Preservation of Books of Accounts, Records etc: According to Regulation 18, every
FII must preserve the books of accounts, records and documents for a minimum period
of five years.
Appointment of Compliance Officer: Every FII must appoint a compliance officer
who will monitor the compliance of act, rules and regulations, guidelines etc., issued by
the Board or Central Government. Any non-compliance observed by the officer will be
immediately and independently reported to the Board.
Information to the Board: Any information, record or documents related to the
activities of FII must be submitted to the Board or RBI as per the requirement. FII
must also disclose information relating to the terms of and parties to off-shore
derivative instruments such as Participatory Notes etc entered into by it or its
sub-accounts or affiliates with regard to securities listed or to be listed in any stock
exchange in India.
13.9 SUMMARY
International equity investment facilitates efficient allocation of capital across the
world.
The return on a foreign security is denominated in foreign currency.
International investments involve country risk or political risk.
According to international CAPM, the market portfolio includes all the securities
available in any of the countries.
The beta of a security measures the sensitivity of the security returns to a change in the
returns of extended market portfolio.
Segmentation of markets takes place because of regulations restricting foreign
investments, indirect barriers, home-country bias etc.
Shares of various companies are listed on stock exchange of foreign countries either
through direct listing or GDR.
SEBI (Foreign Institutional Investors) Regulations, 1995 provide various guidelines
with regard to FIIs investment in India.
13.10 GLOSSARY
Board Based Fund is a fund established or incorporated outside India and has at least
fifty investors, with no single individual investor holding more than five percent of
shares or units of fund.
Country Risk is the risk perceived by a non-resident while dealing with a country in a
commercial and/or investment transaction, which arises out of political and economic
factors.
Capital Asset Pricing Model (CAPM) states that diversifying investments over a
number of securities helps an investor to reduce his risk for a given level of return or
increase his return for a given level of risk, provided the returns on the securities are
having a negative correlation or low positive correlation.
GDR is a financial asset representing direct ownership of a specified number of shares
of a foreign company.
29

a. Risks in international investments can be broadly classified into country risk
(political risk); and currency risk (exchange risk). Any uncertainty related to
conversion of realization proceeds into domestic currency by the investor is
called ‘country risk’. This may occur when the foreign government restricts the
conversion of its currency for several reasons. If the uncertainty is related to the
rate at which the realization proceeds have to be converted into domestic
currency, then it is known as ‘currency risk’. Risk can arise due to unfavorable
movement of exchange rate.
b. Segmentation of markets may occur because of various factors such as follows:
Regulations restricting foreign investments: The regulations restricting or
prohibiting the foreign investments do not allow the market forces to enable
integration of markets.
Non-convertibility of currencies: Non-convertibility of currencies disables
investors from investing in foreign securities and this results in segmentation of
markets.
Home-country bias: Some investors prefer to invest only in domestic securities
and this again prevents integration of markets.
Indirect barriers: Investment in foreign securities is sometimes restricted by
indirect barriers such as non-availability of information with regard to foreign
securities etc.

A. Multiple Choices
1. Which of the following will result in segmentation of markets?
a. Home-country bias.
b. Indirect barriers.
c. Regulations restricting foreign investments.
d. Non-convert biting of currencies.
2. Which of the following risks cannot be measured?
a. Currency Risk.
b. Country Risk.
c. Political Risk.
d. Both (b) and (c) of the above.
3. GDR does not give rise to which of the following risks?
a. Country risk.
b. Political risk.
c. Currency risk.
d. Foreign investment risk.
30
4. SEBI (Foreign Institutional Investors) Regulations, 1995 do not apply to
investors investing in which of the following instruments issued by Indian
companies?
a. GDRs.
b. FCCBs.
c. FCBs.
B. Descriptive
1. Explain in detail International CAPM.
2. Explain in detail guidelines for FII investments in India.
C. Problems
1. Exchange rates at the beginning of 2004 and 2005 were Rs.23.53 and
Rs.25.53 per S$. The percentage on Singapore securities is as follows:
a. 50%
b. –25%
c. 25%.
Calculate the net return to the Indian Investor.
2. An Australian investor invests Rs.1 million in Health Labs Ltd. in India, whose
shares are listed on Bombay Stock Exchange. The beta of security is 1.65 and
variance of returns is 25(%). Appreciation of Australian dollar against rupees is
3% with a variance of 10(%). Return on BSE index is 12% annualized and return
on long-dated Indian government securities is 6.5%. Making an assumption that
the correlation between the return on scrip and Rs./AUS$ exchange rate is zero,
estimate the expected return and risk of the Australian investor for one year
period.
practice only.
31
UNIT 14 SHORT-TERM FINANCIAL
MANAGEMENT
Structure
14.1 Introduction
14.2 Objectives
14.3 Cash Management in Multinational Corporations
14.4 Centralized Cash Management System
14.5 Practical Issues in Cash Management
14.6 Summary
14.7 Glossary
14.1 INTRODUCTION
A multinational corporation can be defined as an entity which has branches or
subsidiaries spread over many countries. Since multinational corporations have
operations in different countries, the financial transactions will also be denominated in
multiple currencies. Hence, financial management of short-term assets and liabilities in
an MNC is much more important and complex in nature. It involves management of
current assets and current liabilities denominated in different currencies. As they
conduct financial transactions in multiple currencies, cash management in MNCs plays
a significant role.
14.2 OBJECTIVES
• Understand cash management in multinational corporations;
• Discuss centralized cash management system; and
• Identify the practical issues in cash management.
14.3 CASH MANAGEMENT IN MULTINATIONAL

CORPORATIONS
A Multinational Corporation requires the services of a finance manager to make
appropriate lending and borrowing decisions, with the following objectives:
• To maximize the return by proper allocation of short-term investments.
• To minimize the cost of borrowing by borrowing in various money markets.

Short-term Financial Management
To attain these objectives, the MNCs must determine strategies taking into
consideration the following aspects:
• International Fisher Effect, i.e., the borrowing cost in a particular currency and
the relationship between nominal interest rate between the currencies and
anticipated exchange rates of the currencies.
• The exchange risk of the MNC consequent to the firm’s exposure in different
currencies with regard to the receivables and payables.
• The level of risk acceptable to the management of the MNC.
• The availability of tools for hedging.
• Tax structure prevailing in various countries.
• Political environment and the consequent risk relating to various countries.
For the purpose of short-term borrowings or investment, the MNCs can make use of
various international financial instruments such as CPs, Bankers Acceptances, CDs,
bank loans etc.
Fisher’s equation derives a relationship between the nominal interest (i), the real interest
rate (r); and expected rate of inflation. As such, Fisher’s open equation is given by
iA – iB = Ŝe (A / B)
Where,
Ŝ (A / B) = expected appreciation of currency B against currency A.
When the interest rate parity holds good, funds can be borrowed or invested in any
currency. But, in some situations cost of borrowing/yield on investment will differ in
different markets. When the forward rates are unbiased estimates of future spot rates,
then a speculator does not gain by entering into a forward contract.
If we consider the speculators as risk averse, then Risk Premium (RP) must also be
taken into account. Hence, the carrier equation can be written as:
iA – iB = Ŝe (A / B) + RP.
Here, interest parity implies that,
F (A/B) = Se (A/B) + RP.
Where,
F (A/B) is the forward rate; and
Se(A/B) is the expected future spot rate.
When such a situation exists in the markets, the MNC will compare the effective cost of
borrowing on covered basis for different currencies. This decision will be further
influenced by the firm’s perception with regard to forward rate and future spot rate.
When a firm is not risk averse, it can choose uncovered investment as its approach is to
profit from forecasting of future spot rates.
33
14.4 CENTRALIZED CASH MANAGEMENT SYSTEM
The subsidiaries of an MNC will have different cash positions, receivables and payables
in the same currency or different currencies. One subsidiary may have more receivables
in US dollars and may enjoy short position while another subsidiary having huge dollar
payables may experience a long position with same maturity. All these situations call
for a proper and centralized cash management system for the smooth flow of financial
transactions.
Advantages
i. Netting: Under centralized cash management system, all cash transactions of
group companies i.e. cash inflows and outflows in different currencies among
various subsidiaries of the parent company or subsidiaries with parent company
are settled through netting. Here, the receivables are netted against payables and
net cash flows are settled between group subsidiaries. Transactions between
subsidiaries involve leading and lagging of receivables/payables and this enables
matching of maturities.
ii. Management of Currency Exposure: A centralized cash management system
enables efficient exchange risk management. A parent company considering the
complete picture of receivables and payables in different subsidiaries chalks out
a corporate strategy for exchange risk management. This strategy helps in
reducing transaction cost of hedging which would otherwise be incurred by each
subsidiary.
iii. Pooling of Cash: Under centralized cash management system, cash surplus of
different subsidiaries is transferred to subsidiaries experiencing cash deficit. This
eliminates borrowing cost to the deficit units.
Problems Involved in Centralized Cash Management System

• A centralized cash pooling system is not suitable when a subsidiary has to meet
some unforeseen expenditure.
• Fund transfer through centralized cash management system also involves cost.
• Sometimes the subsidiaries may experience delay in transfer of funds and cash
availability.
• Exchange control regulations of the country in which the subsidiary is located
also influence the cash flows from the subsidiary to other group corporates or to
the parent company.
• Tax structure of a particular country where the subsidiary is located will lead to
serious implications.
• A centralized cash management system is usually based in the same place as the
parent company, as such it may not be within reach any of the major financial
centres.
34
14.5 PRACTICAL ISSUES IN CASH MANAGEMENT
Irrespective of centralized or decentralized cash management systems, the treasurer
has to make a cost benefit analysis, to arrive at effective decisions. He has to consider
all the possible alternatives and must choose the most optimal alternative.
Transaction Costs
Transaction costs play a significant role in determining financing or investing decisions.
In addition to transaction costs, selection of the currency either for
investments/borrowing depends on the availability of instruments with required
maturity and degree of liquidity.
The MNCs experience various typical situations in practice. For example, when funds
are in surplus, but not sufficient to invest in the market, the company will be in a
dilemma as to what should the investment decision be. Here, investment decision can be
taken based on break even size of investment that can be obtained from.
E = M[(k – i)/(k – d)]
Where,
E = Surplus funds at break even level.
M = Minimum lot of investment.
k = Interest rate on borrowed funds.
i = Rate of interest for investment.
d = Rate of interest for deposit.
a. Mention the objectives of cash management.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b. Discuss the advantages of Centralized Cash Management System.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
c. List out the issues involved with Centralized Cash Management System.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
14.6 SUMMARY
Multinational Corporations (MNCs) establish subsidiaries in different countries that
conduct financial transactions in multiple currencies. Hence a cash management system
is very essential for the smooth running of the corporation.
A Centralized Cash Management System facilitates netting, pooling and management of
currency exposure.
When the interest rate parity holds good, funds can be borrowed or invested in any
currency.
35
Along with transaction costs, selection of the currency either for investments/borrowing
depends on the availability of instruments with required maturity and degree of
liquidity.
Interest rates and exchange rates are essential in decision making with regard to
management of short-term funds.
14.7 GLOSSARY
Forward Rate is the rate quoted today for buying/selling a foreign currency at a future
date.
Leading means bringing forward or advancing receivables or payables, for the purpose
of managing exchange exposure.
Spot Rate is the rate quoted today for a currency to be delivered after two working
days.


a. A Multinational Corporation requires the services of a finance manager to make
appropriate lending and borrowing decisions, with the following objectives:
• To maximize the return by proper allocation of short-term investments.
• To minimize the cost of borrowing by borrowing in various money

markets
To attain these objectives, the MNCs must determine strategies taking into
consideration the following aspects:
• International Fisher Effect, i.e., the borrowing cost in a particular

currency and the relationship between nominal interest rate between the
currencies and anticipated exchange rates of the currencies.
• The exchange risk of the MNC consequent to the firm’s exposure in

different currencies with regard to the receivables and payables.
• The level of risk acceptable to the management of the MNC.
• The availability of tools for hedging.
• Tax structure prevailing in various countries.
Political environment and the consequent risk relating to various countries.
36
b. Advantages of centralized cash management systems: Centralized cash
management system helps in smooth flow of financial transactions. The
following are the advantages of the same:
i. Netting: Under centralized cash management system, all cash

transactions of group companies i.e. cash inflows and outflows in
different currencies among various subsidiaries of the parent company or
subsidiaries with parent company are settled through netting. Here, the
receivables are netted against payables and net cash flows are settled
between group subsidiaries. Transactions between subsidiaries involve
leading and lagging of receivables/payables and this enables matching of
maturities.
ii. Management of Currency Exposure: A centralized cash management

system enables efficient exchange risk management. A parent company
considering the complete picture of receivables and payables in different
subsidiaries chalks out a corporate strategy for exchange risk
management. This strategy helps in reducing transaction cost of hedging
which would otherwise be incurred by each subsidiary.
iii. Pooling of Cash: Under centralized cash management system, cash

surplus of different subsidiaries is transferred to subsidiaries experiencing
cash deficit. This eliminates borrowing cost to the deficit units.
c. Problems Involved in Centralized Cash Management System:
• A centralized cash pooling system is not suitable when a subsidiary has to

meet some unforeseen expenditure.
• Fund transfer through centralized cash management system also involves

cost.
• Sometimes the subsidiaries may experience delay in transfer of funds and

cash availability.
• Exchange control regulations of the country in which the subsidiary is

located also influence the cash flows from the subsidiary to other group
corporates or to the parent company.
• Tax structure of a particular country where the subsidiary is located will

lead to serious implications.
A centralized cash management system is usually based in the same place as the
parent company, as such it may not be within reach any of the major financial
centres.
37
A. Multiple Choices
1. Which of the following are the internal techniques for managing foreign
exchange exposure?
a. Netting.
b. Futures.
c. Options.
d. Leading and Lagging.
e. Both (a) and (d) of the above.
2. Pooling of cash eliminates which of the following with regard to cash deficit
subsidiary units?
a. Transactions cost.
b. Receivables cost.
c. Borrowing cost.
3. Reporting currency of a firm is____________.
a. The currency in which most of the assets and liabilities are held.
b. The currency in which most of the receivables and payables are held.
c. The currency in which the financial statements are published.
d. The currency in which the external borrowings are denominated.
4. International cash management mainly deals with which of the following
aspects?
a. Giving sufficient independence to individual securities.
b. Deciding whether hedging is required or not.
c. Striking the right balance between decentralization and centralization.
d. Centralizing and minimizing independence of subsidiaries.
5. Netting is _____________.
a. Facilitated by centralized cash management
b. An internal hedging technique
c. A tool for management of forex risk
d. Applicable only to large companies
38
B. Descriptive
1. Explain Cash Management System in Multinational Corporations.
2. Explain advantages and disadvantages of Centralized Cash Management System
in Multinational Corporations.
C. Problems
1. Company X, a multinational company has its subsidiaries in Switzerland, UK
and Singapore. The cash positions of the three subsidiaries for the month of
March 2005 were as follows:
Swiss Subsidiary : Cash surplus of SFr 15,000,000
Singapore Subsidiary : Cash deficit of S$35,000,000.
UK Subsidiary : Cash deficit of £3,000,000.
Determine the cash requirement if the company adopts:
a. Decentralized cash management
b. Centralized Cash Management.
The exchange rates are SFr 1.5/$, S$1.75/$ and $1.60/£.
2. Supreme INC. a multinational company has surplus funds of $4,000,000 in
America for 90 days. It is further planning to invest the fund for 90 days, either as
90-day deposit in banks or invest in CDs for 90 days. A British Bank offers an
interest rate of 5.5% on 90-day deposit. The interest rate on CD is 7% and the
minimum size of the investment is 5,000,000, in multiples of 5,000,000. The
overdraft charges applicable to the company is 10%. Determine the break-even
size of investment in CD and suggest whether the company should invest in CD or
not. At the same time, compare the gain/loss if the company decides to invest in a
CD against the investment in bank deposits.
practice only.
39
UNIT 15 INTERNATIONAL
ACCOUNTING AND
TAXATION
Structure
15.1 Introduction
15.2 Objectives
15.3 International Accounting
15.4 International Taxation
15.5 Summary
15.6 Glossary
15.1 INTRODUCTION
International Accounting includes principles of accounting, reporting practices and their
classification, patterns of accounting development, international and regional
harmonization, foreign currency translation, foreign exchange risk, international
comparisons of consolidation accounting and inflation accounting etc. International
Taxation deals with tax policies of different countries and their implications.
15.2 OBJECTIVES
• Understand the concepts of international accounting; and,
• Discuss international taxation.
15.3 INTERNATIONAL ACCOUNTING

Multinational Corporations (MNCs) need to translate foreign currency denominated
assets, liabilities, earnings and expenses into their reporting currency, i.e., their
domestic currency. The foreign currency transactions of a firm can be broadly classified
as:
• Transactions in a foreign currency (for example, Exports, Imports, Foreign
currency loans etc.) required to be stated in domestic currency terms.
• Foreign operations whose financial statements need to be translated into the
domestic currency.
Foreign operations are further classified into two types:
• Integral Foreign Operations: Operations which extend over domestic operations
are called integral foreign operations. For example, a transaction wherein a foreign
branch buys goods only from the head office and sells them is called integral
foreign operation.
International Accounting
and Taxation
• Independent Foreign Operations: Any entity which works independently by
experiencing its own expenses, incomes, assets and liabilities is called an
independent foreign operation.
Reporting of Foreign Currency Transactions
Reporting of foreign currency transactions in India is governed by Accounting
Standard-11, prescribed by ICAI. Accordingly, a transaction in a foreign currency must
be translated at the spot rate as on the date of transaction. A foreign currency
transaction, which gives rise to a receivable or payable, is settled at a date later to the
transaction date. However, the spot rate as on the date of settlement may differ from the
rate applicable to the transaction and this results in an exchange gain/loss. According to
the standard, this gain/loss must be recognized in the same year in which the settlement
takes place. Receivables or payables, which are not settled by the balance sheet date,
must be translated at the spot rate as on that date and this has to be done on all
subsequent balance sheet dates until each receivable/payable is settled. Further, any
exposure resulting from foreign currency transactions is covered using forward
contracts or other hedging tools. According to the standard the difference between the
contract rate and spot rate as on the date of transaction must be recognized as income or
expenditure and spread over the life of the contract. Similarly any profit/loss arising due to
cancellation/intention of a forward contract should be mentioned for as income or
expenditure for that period.
Translation of Financial Statements of a Foreign Entity
The assets and liabilities of a foreign subsidiary/company is denominated in foreign
currency, has to be translated into domestic currency units to accommodate them in
financial statements. These translations can be done by using various methods such as
current/non-current method, monetary/non-monetary method, temporal method and
current rate method. These methods require the knowledge of certain terms such as
historical exchange rate, current or closing exchange rate and average rate.
Historical Exchange Rate: The exchange rate at which the transaction was actually
recorded settled is called historical exchange rate.
Current or Closing Exchange Rate: The exchange rate prevailing on the date of
translating the accounts is called current or closing exchange rate.
Average Rate: The exchange rate prevailing over a certain period of time is called
average rate.
Current/Non-current Method
According to this method all current assets and liabilities are converted at the closing
rate while all non-current assets and liabilities are converted at the historical rates. All
the items of income and expenditure are converted at the average rate for a specific
period excluding items related to non-current assets and liabilities. The non-current
assets and liabilities are covered at historical rate and as such, this method exposes only
the current assets and liabilities to exchange rate movements.
Monetary/Non-monetary Method
According to this method assets and liabilities are classified into monetary and non-
monetary items. Monetary items include money held, assets and liabilities to be
received or paid in fixed or determinable amounts of money. The monetary assets and
liabilities such as cash accounts, receivables are translated at closing rate and non-
monetary items such as inventory, building etc., are translated at the historical rate.
Items, which appear in the income statement, are translated at the average rate
excluding items such as depreciation, cost of raw material consumed etc., Depreciation
41
and such other items are translated at the rate at which the corresponding non-monetary
assets or liabilities are translated. Difference between items of income statement results
in mismatches.
Temporal Method
Temporal method classifies the items on historical cost basis or market price basis. All
the items of balance sheet that are recorded on historical cost basis are translated at the
historical rate and those recorded on current value are translated at closing rate. The
items of income statement are translated at average rate excluding items related to
non-monetary items.
Current Rate Method
According to this method all assets liabilities, incomes and expenditures are translated
at current or closing rate.
a. Define International Accounting.
…………………………………………………….……………………………..
…………………………………………………….……………………………..
…………………………………………………….……………………………..
b. Discuss current/non-current method.
…………………………………………………….……………………………..
…………………………………………………….……………………………..
…………………………………………………….……………………………..
The Indian Accounting Standard

Accounting Standard-11 also governs translation of foreign assets, liabilities, incomes
and expenses of a foreign branch or any other integrated foreign operation and
accounting treatment of any gain or loss arising as a result of exchange rate movements.
Similarly, the translation of any foreign currency denominated asset or liability of a
domestic company is also governed by Accounting Standard-11. According to this
standard, in addition to the fixed asset which is translated at the historical rate, its value
must be adjusted for any increase or decrease in the value of any liability taken for
purchasing that particular asset. The following are also prescribed by the Accounting
Standard-11:
• Exchange gains or losses should be accounted in the same period in which they
arise.
• All foreign currency transactions of such an entity should be translated at the spot
rate as on the date of the transaction or as an alternative, an average rate may be
used for a group of transactions.
• Various items in the financial statements of a foreign branch should be translated

in accordance with the principles specified above.
42
and Taxation
Illustration 1
Nirmal Traders, an Indian company has the following foreign currency assets and
liabilities:
Long-term loan $15,000

Investments $10,000
Real asset in US $20,000
The exchange rate at the beginning of the year was Rs.45/$. At the end of the year it
was Rs.47/$. The rate when the real estate was bought was Rs.35/$.
At the beginning of the year, the assets and liabilities will be translated at:
Long-term loan $15,000 @ Rs.45/$ = Rs.6,75,000
Investments $10,000 @ Rs.45/$ = Rs.4,50,000
Real estate $20,000 @ Rs.35/$ = Rs.7,00,000
Net foreign currency assets
= Rs.(4,50,000 + 7,00,000 – 6,75,000) = Rs.4,75,000
At the end of the year, the assets and liabilities will be translated at:
Long-term loan $15,000 @ Rs.47/$ = Rs.7,05,000
Investments $10,000 @ Rs.47/$ = Rs.4,70,000
Real estate $20,000 @ Rs.35/$ = Rs.7,00,000
Net foreign currency assets
= Rs.(4,70,000 + 7,00,000 – 7,05,000) = Rs.4,65,000
The difference between Rs.4,75,000 and Rs.4,65,000 (i.e., Rs.10,000) will be booked as
exchange loss in the profit and loss account.
15.4 INTERNATIONAL TAXATION

When a firm operates in more than one country, it has to face multiple tax rules. Every
country has its own tax rules and tax is levied depending on the residential status of the
business entity and the place of the firm’s source of income. The Income Tax Act
determines the tax rules in India and subsequently amends them from time to time. The
concessions given to Indian exporters are in the form of exempt incomes and deductions
allowed to be finally claimed from total income. Various incentives provided are as follows:
• Section 10A of the Income Tax Act states that any new industrial undertaking
established in a Free Trade Zone or Export Processing Zone to manufacture and
produce articles or things or computer software during the previous year
2003-04 onward, can claim tax exemption for a period of 10 years from the year
in which production commences. This exemption cannot be claimed by
undertakings beginning to manufacture or produce after 31.3.2009.
Note: The benefit of this deduction is available to any undertaking only up to the
A.Y. 2018-19.
43
• Section 10B of the Income Tax Act states that any newly established 100 percent
Export Oriented Unit (EOU) can claim complete tax exemption for a period of 10
years from the year in which production commences. This deduction is not
available after assessment year 2009-10.
Deductions in case of both sections 10A and 10B

Amount of deduction = (Export turnover/total turnover) x Profits of the business
Period of Deduction
First 5 consecutive assessment years 100% of profits and gains
Next 2 assessment years 50% of profits and gains
Next 3 assessment years Amount transferred to “Special Economic
Zone Reinvestment Allowance Reserve
Account” or 50% of profits and gains,
whichever is lower.
• Section 10AA of the Act states that newly established units in Special Economic
Zones (SEZs) can claim tax exemption for 15 years from the year production
commences.
Amount of Deduction: The amount of deduction is based on the quantum of
profit derived from export of articles or things or services including computer
software.
Amount of deduction = (Export turnover/Total turnover) x Profits of the business
Period of Deduction
First 5 consecutive assessment years 100% of profits and gains

Next 5 assessment years 50% of profits and gains
Next 5 assessment years 50% of profits and gains provided the
same amount is debited to P&L A/c and
the same amount is transferred to
“special economic zone reinvestment
allowance reserve account”
• Section 10BA of the Act states that a special deduction can be claimed with regard
to profits derived by an undertaking from the export of artistic hand-made wooden
articles. This deduction is not applicable if an undertaking avails deduction v\s
10A or 10B.
Amount of Deduction
Amount of deduction = (Export turnover/total turnover) x Profits of the business
Note: The benefit of this deduction is available to an undertaking only up to the
A.Y. 2009-10.
Taxation of Exchange Gains or Loses

In accordance to the Income Tax Act, an income becomes taxable if it is of the
revenue nature. On the other hand, an expense becomes tax deductible if it is of
the revenue nature. The same rule applies to any particular gain or loss.
44
and Taxation
Double Taxation
Double Taxation acts as an impediment to international trade. Consequently income
earned by a firm in a foreign country is taxed twice, once in the country in which it is
earned and again in the country to which the firm belongs. This double taxation leads to
reduction in after-tax income available to the firm. This in turn reduces benefits of
international trade. For example, a company based in US undertakes and finishes a
project in India. The company is eligible to receive $1,00,000 for the project. This
income is subjected to a withholding tax @20 percent. Similarly, the company income
is taxable @20 percent in the US. The after tax income of the company from the project
will be as follows:
Pre-tax income = $100,000
Withholding tax = $20,000
Home tax payable = $20,000
Post-tax income = $60,000
To overcome the effect of double taxation many countries have entered into bilateral
treaties with other countries. Under bilateral treaty, even when the income of the two
countries is taxed twice in the respective countries, the tax is split between the countries
in such a way that the tax payable by the company does not exceed the amount that
would have been payable, when the income was taxable only in one country. When
bilateral treaty is not available unilateral relief is provided to the entity in the form of a
tax credit.
a. Define Double Taxation.
…………………………………………………….…………………………….
…………………………………………………….…………………………….
…………………………………………………….…………………………….
b. Give an illustration for Double Taxation.
…………………………………………………….…………………………….
…………………………………………………….…………………………….
…………………………………………………….…………………………….
15.5 SUMMARY
International accounting and taxation play a significant role in international trade due to
multiplicity of rules in different countries of the world.
Knowledge of various implications related to international accounting and taxation is a
must in order to make decisions with regard to international trade.
45
15.6 GLOSSARY
A Tax Credit is provided by way of reduction in the tax payable by the entity on an
international transaction by the amount it has paid as withholding taxes.
Withholding Tax is the tax that an entity has to pay to a foreign government on
incomes earned in that country.


a. International Accounting
When a firm operates in more than one country, it has to face multiple tax rules.
Every country has its own tax rules and tax is levied depending on the residential
status of the business entity and the place of the firm’s source of income. The
Income Tax Act determines the tax rules in India and subsequently amends them
from time to time. The concessions given to Indian exporters are in the form of
exempt incomes and deductions allowed to be finally claimed from total income.
b. Current/Non-current method
According to this method all current assets and liabilities are converted at the
closing rate while all non-current assets and liabilities are converted at the
historical rates. All the items of income and expenditure are converted at the
average rate for a specific period excluding items related to non-current assets
and liabilities. The non-current assets and liabilities are covered at historical rate
and as such, this method exposes only the current assets and liabilities to
exchange rate movements.
a. Double Taxation acts as an impediment to international trade. Consequently
income earned by a firm in a foreign country is taxed twice, once in the country
in which it is earned and again in the country to which the firm belongs. This
double taxation leads to reduction in after-tax income available to the firm. This
in turn reduces benefits of international trade.
b. A company based in US undertakes and finishes a project in India. The company
is eligible to receive $1,00,000 for the project. This income is subjected to a
withholding tax @20 percent. Similarly, the company income is taxable @20
percent in the US. The after tax income of the company from the project will be
as follows:
Pre-tax income = $100,000
Withholding tax = $20,000
Home tax payable = $20,000
Post-tax income = $60,000
46
and Taxation
A. Multiple Choices
1. A newly established 100 percent EOU can claim tax exemption under which of the
following sections of Income Tax Acts?
a. Section 10B.
b. Section 10A.
c. Section 10AA.
d. Section 10BA.
2. Which of the following is an example of non-monetary item?
a. Inventory.
b. Cash.
c. Accounts Receivables.
d. Accounts Payables.
3. Under current rate method, assets, liabilities, income and expenditures are
translated at which of the following rates?
a. Average rate.
b. Historical rate.
c. Closing rate.
d. Market rate.
e. Annual rate.
4. Which accounting standard governs the reporting of foreign currency
transaction?
a. Accounting standard-8.
b. Accounting standard-7.
c. Accounting standard-10.
d. Accounting standard-11.
e. Accounting standard-9.
5. Foreign operations that are just an extension of domestic operations are
called_______.
a. Independent foreign operations
b. Dependent foreign operations
c. Integral foreign operations
d. Normal foreign operations
B. Descriptive
1. Explain in details the rules for reporting foreign currency transactions.
2. Explain in detail double taxation.
practice only.
47
NOTES
48

Nos.
MANAGEMENT

16. Trade Blocks

MBA-0000
Block
5
INTERNATIONAL TRADE
UNIT 16
Trade Blocks 5
UNIT 17
Foreign Trade Policy 20
UNIT 18
Documentary Credits 30
UNIT 19
Export Finance and Exchange Control
Regulations Governing Exports 43
UNIT 20
Import Finance and Exchange Regulations
Relating to Import Finance 61
Expert Committee


Director Director

Director Director
Prof. P. Ramnath
Director
IBS Chennai

Ms. Anitha Prof. Bratati Ray





The ICFAI University Press, Hyderabad.

BLOCK 5 INTERNATIONAL TRADE
This block introduces the readers to international trade. After World War – II, the
economies of different regions showed greater interest in forming regional groups to
enhance international trade in their regions. To boost cross border trade, institutions
such as the World Trade Organization were set up. In addition to this, international
cartels were formed and multinational and bilateral treaties were concluded. This block
highlights the significance of export-import policies that are being formulated by the
Indian government to promote international trade in the country. This unit discusses the
importance of documentary credits, the various parties involved, and the types of Letters
of Credit. This block also covers regulations related to export and import finance.
Unit 16 discusses the need and interests of various regional group formations to
promote international trade, mostly post-World War-II. This unit focuses on the
structure of WTO and explains the bilateral and multinational treaties and policies.
Unit 17 outlines the historical perspective and rationale behind trade regulations in
India. The Export Import Policy formulated by the government includes regulatory
framework. Besides, it defines the objectives to promote various sectors for exports and
imports.
Unit 18 signifies the importance of various documents required in international trade.

This unit highlights the Uniform Customs and Practice for Documentary Credits
(UCPDC) guidelines which govern the operations of Letters of Credit (LCs). Further,
this unit covers various parties to Letters of Credit, the mechanism of LC operation, and
the various kinds of LCs.
Unit 19 deals with the incentives available to exporters and the exchange control
regulations guiding exports.
Unit 20 outlines import finance and various exchange control regulations guiding
importers. Further, the prerequisites for opening LCs and customs procedure for
clearance of imports in India have been discussed extensively.
UNIT 16 TRADE BLOCKS
Structure
16.1 Introduction
16.2 Objectives
16.3 World Trade Organization (WTO)
16.4 International Cartels
16.5 Multinational and Bilateral Treaties
16.6 European Community (EC)
16.7 North American Free Trade Area (NAFTA)
16.8 United Nations Conference on Trade and Development (UNCTAD)
16.9 US – Russia Bilateral Investment Treaty
16.10 Germany – India Bilateral Treaty
16.11 Trade, Aid and Development
16.12 DOHA Conference 2001
16.13 Cancun Conference 2003
16.14 Summary
16.15 Glossary
16.1 INTRODUCTION
The political misconceptions and unexpected economic hurdles in the
post-World War II period led to the formation of trade blocks, regional groupings and
treaties. A trade block can be defined as a large free trade area formed by one or more
tax, tariff and trade agreements. There are many trade blocks such as the WTO,
OPEC, etc.
16.2 OBJECTIVES
• Understand international economic institutions (WTO, OPEC etc.);
• Understand the role of international cartels;
• Discuss the relevance of multinational and bilateral treaties;
• Identify US-Russia bilateral investment treaty; and,
• Recognize the objectives of Trade, Aid and Development.
16.3 WORLD TRADE ORGANIZATION (WTO)
International Trade Organization (ITO) was established in 1944 to set rules and
regulations for international trade. However, the ITO charter was never ratified and an
interim agreement called the General Agreement on Tariffs and Trade (GATT) was formed. It
was replaced by the World Trade Organization (WTO) established during the Uruguay
Round of Multilateral Trade Negotiations in 1994. The WTO became an international
organisation that set rules and regulations for international trade and also resolved disputes
of its member countries. By December 15, 2005, the number of member countries
increased to 149. The WTO head quarters is situated at Geneva, Switzerland. All the
member countries must provide each other the most favoured nation status to boost trade
among themselves with certain trade concessions. The major functions of WTO are:
• Limit harmful trade practices.

• Act as a forum for multilateral trade negotiations.
• Cooperate with other international institutes who involve in global policy-
making.
• Oversee national trade policies.
• Administer the understanding on rules and procedures governing the settlement
of disputes (Dispute Settlement Understanding (DSU).
Structure of WTO
WTO is headed by the Ministerial Conference. This is the supreme authority which
makes decisions with regard to all the matters that fall under Multilateral Trade
Agreements. All the representatives of member countries form a General Council to
regulate the operations of WTO Agreement and also the decisions made by the
ministerial conference. The council also acts as the Dispute Settlement Body (DSB);
and a Trade Policy Review Body (TPRB) with respective chairpersons. Other councils
present under WTO are Council for Trade in Goods, Council for Trade in Services and
Council for Trade Related Aspects of Intellectual Property Rights (TRIPS). They are
headed by a General Council and can have their subsidiaries situated elsewhere. The
ministerial conference appoints a Director General to the Secretariat of the WTO.
WTO Agreement
The agreement establishing the World Trade Organisation is referred to as the WTO
agreement in the Final Act (An act embodying the results of Uruguay Round of
Multilateral trade negotiations). Accordingly, the WTO facilitates a common platform
for carrying trade among its member countries with regard to agreements and associated
legal instruments included in the Annexures of WTO agreement. The WTO Agreement
includes the following Annexures:
• The agreements and associated legal instruments included in the Annexures 1, 2

and 3 of the WTO agreement are referred to as Multilateral Trade Agreements.
• The agreements and associated legal instruments included in the Annex 4 are
referred as Plurilateral Trade Agreements.
• General Agreement on Tariffs and Trade 1994 as specified in Annex1A is referred
as GATT 1994 and it is legally distinct from GATT 1947.
6
Trade Blocks
Multilateral Agreement on Trade in Goods
Different types of trade agreements are:
i. Agreement on Balance of Payment: While imposing restrictions to correct
balance of payment deficits the members must consider price based measures
such as import surcharges, import deposits etc.
ii. Agreement on Agriculture: It facilitates opening of national markets to
international competition through normal customs duties in the place of
non-tariff measures. The agreement also helps to reduce government aids by
checking overproduction. It also covers subsidies and measures such as domestic
subsidy, export subsidy and sanitary and phyto-sanitary measures. Domestic
subsidies are classified into non-product specific subsidies and product specific
subsidies, which are summed up to arrive at total subsidies. At any point of time,
total subsidies should not exceed 10% of the total agriculture production value of
that particular year. In the case of export subsidies, WTO members must
decrease the value of direct export subsidies to 36% below the 1986-90 base
period and at the same time their quantity by 21%. For developing countries the
reductions must be 2/3rds that of developed countries over a period of 10 years.
There are no reductions for Least Developed Countries (LDCs). Sanitary and
phyto-sanitary measures relate to food safety and animal and plant health
measures. The agreement chalks out the procedures and criteria for the
assessment of risk and determination of appropriate levels of phyto-sanitary or
sanitary protection.
iii. Agreement on Textiles and Clothing: It facilitates integration of the textiles and
clothing sector into GATT 1994 in accordance with strengthened GATT rules and
disciplines. This integration (trade in products such as tops and yarns, made-up
textile products, fabrics etc., will be governed by general rules of GATT) would
occur in following four phases:
• First phase as on 1st January 1995 – Each party would integrate products
which accounted for not less than 16 percent of its total volume of
imports in 1990.
• Second phase as on 1st January 1998 – Products which accounted for not
less than 17 percent of 1990 imports would be integrated.
• Third phase as on 1st January 2002 – Products which accounted for not
less than 18 percent of 1990 imports would be integrated.
• Fourth phase as on 1st January 2005 – All remaining products would be
integrated at the end of the transition period.
Agreement on Trade Related Aspects of Investment Measures (TRIMs)
This agreement recommends removal of all trade related investment measures within a
period of five years. It recognizes that certain investment measures restrict and distort
trade. Hence, it requires mandatory notification of all non-conforming TRIMs and their
disposal within two years for developed countries, within five years for developing
countries and within seven years for least-developed countries. The WTO has established
7
a committee on TRIMs to supervise the implementation of commitments and
subsequently report to the council of trade in goods annually.
General Agreement on Trade in Services
General Agreement on Trade in Services (GATS), a multilateral agreement is the first to
provide legally enforceable rights to trade in all services. The three basic principles of
GATS are:
• It covers all the services excluding those provided in the exercise of
governmental authority.
• Absence of any discrimination in favor of national providers.
(National Treatment Principle).
• Absence of any discrimination between other members of the agreement. (Most
Favored Nation (MFN) principle.)
1. Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS)
This agreement considers seven types of intellectual property. They are:
i. Copyright and Related Rights: Copyright protects the rights of authors of
literary and artistic works such as books, paintings etc., for a minimum
period of 50 years after the death of the author.
ii. Trademarks: A sign or a combination of signs which can distinguish the
goods or services of one firm from those of the other is called a
trademark.
iii. Geographical Indications: They refer to the identity of a good originating
in the territory of a member/region/locality where a given quality or
reputation is essentially attributed to its geographical origin.
iv. Industrial Designs: These designs are protected for a period of ten years.
The main purpose is to provide protection for the investment results in the
development of new technology.
v. Patents: Patents are provided for inventions in different areas of
technology and they must be capable of industrial application.
vi. Integrated Circuits: They provide protection to the layout designs/
topographics of integrated circuits for a period of ten years.
vii. Trade Secrets: Any trade secret having commercial value will be
protected against the breach of confidence or unfair commercial use.
2. Dispute Settlement System
Any dispute brought to the notice of WTO by the member countries will be
settled by specially appointed independent experts on the basis of their
interpretation of the agreements and commitment of the individual country. This
system recommends settlement of differences between countries through
consultation or seeking justice from the WTO on legal grounds.
3. Plurilateral Trade Agreements (PTA)
The plurilateral agreement includes the following agreements:
i. Agreement on Trade in Civil Aircraft.
ii. Agreement on Government Procurement.
iii. International Dairy Agreement.
iv. International Bovine Meat Agreement.
The first agreement was made at Geneva in April 1979. The other three
agreements were drawn at Marrakesh on 15 April, 1994.
8
Trade Blocks
16.4 INTERNATIONAL CARTELS
The government or private companies situated in different countries form an
international cartel, agreeing to restrict competition among themselves to exploit their
joint monopoly power. The members of the cartel export to the rest of the world
alternative quantities of cartelized goods at alternative prices. A cartel to be successful
must satisfy the following conditions:
• The elasticity of demand for imports by the rest of the world must be low in the
relevant price range.
• The cartel members must adhere to the official set of policies as voted by them.
A high monopoly price can be maintained by the international cartel until and unless
any selfish member of the cartel tries to grab greater profits in a competitive manner. An
example of an international cartel is Organization of Petroleum Exporting Countries
(OPEC).
Organization of Petroleum Exporting Countries (OPEC)
OPEC is a permanent, intergovernmental organization, which originated at the Baghdad
Conference between September 10–14, 1960. For the initial five years OPEC had its
headquarters in Geneva, Switzerland which was shifted to Vienna, Austria, on
September 1, 1965. OPEC’s objectives include co-coordinating and unifying petroleum
policies among member countries, facilitating secure fair and stable prices for petroleum
producers, providing efficient, economic and regular supply of petroleum to consuming
nations and giving a fair return on capital to those investing in the industry.
The following are the member countries of OPEC at present:
Founding Members Other Members
Iran Qatar (1961)
Iraq Indonesia (1962)
Kuwait Socialist Peoples Libyan Arab Jamahiriya (1962)
Saudi Arabia United Arab Emirates (1967)
Venezuela Algeria (1969)
Nigeria (1971)
Functioning of OPEC
OPEC facilitates availability of statistical data to its member countries by way of
publications such as OPEC Bulletin (monthly), OPEC Review (Quarterly), Annual
Report and Annual Statistical Review. It also provides financial help from its fund to
the developing countries for international growth. The Member Countries arrange
meetings at various levels of interest, including meetings of petroleum and economic
experts, country representatives and special purpose bodies such as committees to
address various environmental affairs. Decisions with regard to supply of oil production
to expected demand are taken at the Meeting of the OPEC Conference and all such
information is communicated through OPEC Press Releases.
a. What is an International Cartel?

…………………………………………..……………………………………….
…………………………………………..……………………………………….
…………………………………………..……………………………………….
9
b. Discuss the functions of WTO in brief.
…………………………………………..……………………………………….
…………………………………………..……………………………………….
…………………………………………..……………………………………….
16.5 MULTINATIONAL AND BILATERAL TREATIES

A treaty signed between two countries with regard to matters such as peace, aviation
and trade is called a bilateral treaty. If more than two countries sign a treaty, it is called
a multinational treaty. An example of multinational treaty is General Agreement for
Tariffs and Trade (GATT).
General Agreement for Tariffs and Trade (GATT)
GATT is a multinational treaty which came into effect in January, 1948. It provides a
common platform where different countries can discuss matters related to international
trade.
Trade Negotiations under the GATT
The major trade negotiations that took place under GATT are as follows:
• Geneva Round (1948): 23 countries. GATT enters into force.
• Annecy Round (1949): 13 countries.
• Torquay Round (1951): 38 countries.
• Geneva Fourth Round (1956): 26 countries. Tariff reductions. Strategy set for
future GATT policy toward developing countries, improving their positions as
treaty participants.
• Dillon Round (1962): 26 countries. Tariff reductions. Named after C. Douglas
Dillon, then US Undersecretary of State.
• Kennedy Round (1967): 62 countries. Tariff reductions. It called for an across-
the-board reduction rather than a product-by-product specification, for the first
time. The anti-dumping agreement was rejected by the US Congress.
• Tokyo Round (1979): 102 countries. Reduced non-tariff trade barriers and tariffs
on manufactured goods. Improvement and extension of GATT system.
• Uruguay Round (1986): 125 countries. Created the World Trade Organization to
replace the GATT treaty. Reduced tariffs and export subsidies, reduced other
import limits and quotas over the next 20 years, agreement to enforce patents,
trademarks, and copyrights (TRIPS), extending international trade law to the
service sector (GATS) and open up foreign investment. It also made major
changes in the dispute settlement mechanism of GATT.
• Doha Round.
16.6 EUROPEAN COMMUNITY (EC)

The European Community or European Common Market was created in 1957 by the
signing of the Treaty of Rome under the name of European Economic Community. The
word ‘Economic’ was removed from its name by the Maastricht treaty in 1992. One of
the first major accomplishments of the EC was the establishment (1962) of common
price levels for agricultural products and removal of internal tariffs on certain products
in 1968. The main objective of EC was to establish a customs union.
10
Trade Blocks
Common Agricultural Policy (CAP)
The European Community after many negotiations agreed to a Common Agriculture
Policy (CAP). Accordingly, every member country has a green rate at which the support
prices are converted into national prices. There are no trade barriers in the movement of
agricultural goods between countries. Imports from the rest of the world are permitted
when the demand over domestic production of farm products is more. Though the
economic community gained advantage in the agriculture sector through CAP, it could
not provide farm products to the consumers at cheaper and stable rates.
Common Fisheries Policy
The Common Fisheries Policy came into effect from February 1971. It covers
marketing of fresh frozen and preserved fish and provides equal access to fishing areas
for all European Economic Community (EEC) nationals along with provisions for
certain kinds of offshore fishing.
The European Monetary Union (EMU)
European Monetary System (EMS) was established by the European Council in 1978
and began functioning in March 1979. The EMS brought forth an EC currency zone to
unify various economies to facilitate growth. It also established the European Currency
Unit (ECU) as a means of settlement between the EC currencies and Central banks. The
member countries of EMS also provide credit facilities to each other such as very short-
term finance for a period of 45 days to help the deficit countries to defend their exchange
rate parities.
Factor Mobility
European community facilitates free movement of workers and their families, services
and capital between countries without any permit. They enjoy all the rights to work and
are subject to the same tax issues as nationals of the country to which they have shifted.
Regional Development Policy
The regional development policy reduces the variations between different regions and
mitigates the backwardness of those that are less favored. The European community
provides help to various regions through the European Investment Bank (EIB), the
European Social Fund (ESF), and the European Regional Development Fund (ERDF).
Common Transport Policy
The main objectives of common transport policy are as follows:
• Elimination of obstacles in the way of the establishment of common market.
• Free movement of transport services within the member countries.
• General organization of the transport system with the EC.
Of all the above objectives the EC could achieve only the first objective.
India and EC
India entered into an agreement with the European Community with regard to
commercial and economic cooperation. Inspite of increase in Indian exports to EC, the
Indian imports amount to only 0.6% of total imports of the EC. The exports related to
food and food products, drugs and pharmaceuticals and durable consumer goods
including electronic equipment must be in accordance with the EC’s standards and
certification. Any deviation from the specified standards will lead to a ban on those
products from EC.
11
Critical Appraisal
The European community could positively achieve factor mobility between countries.
The member countries have experienced high rates as well as investment and growth in
income. The EC also signed special association agreements with East European
Countries. However, the EC could not successfully achieve a complete economic and
political union.
16.7 NORTH AMERICAN FREE TRADE AREA (NAFTA)

North American Free Trade Area (NAFTA) came into force on 1st January 1984. It
consists of three countries, USA, Canada and Mexico which agreed to eliminate tariffs
over a period of 15 years. Accordingly free trade area between USA and Canada was
established in 1988. The agreement covers consumer safety, tariff reduction, financial
and direct investment matters etc. Its other objectives include lowering of trade barriers,
more accessibility to financial services, creation of North American Development Bank
and so on.
16.8 UNITED NATIONS CONFERENCE ON TRADE AND

DEVELOPMENT (UNCTAD)
United Nations Conference on Trade and Development (UNCTAD) was created in 1964
to facilitate a forum to enable the developing countries to discuss various issues related
to their economic development. UNCTAD must fulfill the following objectives
identified over a period of time through a number of meetings:
Trade in Manufactured Goods (GSP)
The exports of manufacturers, semi-manufacturers and some agricultural items from the
developing countries enter into developed countries at duty-free or reduced rates. At
present 14 GSP schemes are available in 29 preference giving countries. More than 90%
of total preferential imports are accounted by EU, Japan and the US.
Trade in Primary Commodities
UNCTAD has recommended the creation of a common fund to stabilize the prices of
primary products through buffer stocks. Consequently, the exporters of primary
products will get higher prices and the importance of such primary products will not be
subjected to any uncertain price fluctuations due to speculation.
Development Finance
The UNCTAD meetings over a number of years could not solve the problems of debt
and development of LDCs. They merely created a forum where ideas were exchanged.
According to the Economist, UNCTAD has lost the initiative on debt to the IMF and on
development to the World Bank. The debt issue has been taken over by the IMF
because it acts as a bank itself and the World Bank has both money and effective advice
to promote development.
Economic Cooperation among LDCs
The LDCs took the initial step towards economic cooperation at the ministerial meeting
of G-77 (held in New York) and decided to launch the Global System of Tariff
Preferences (GSTP). The UNCTAD VI recommended the initiation of a number of
cooperative measures such as harmonization of LDCs policies, rules, regulations and
12
Trade Blocks
practices governing technology in all aspects, training and exchange of personnel etc.
As the economies of LDCs are very competitive in nature, their problems can be
overcome by mutual help and trust. They have to work in close cooperation with each
other. UNCTAD is only a forum where they can meet, discuss and make plans for
regional economic cooperation.
16.9 US – RUSSIA BILATERAL INVESTMENT TREATY

The Bilateral Investment Treaty (BIT) was signed by the representatives of the Russian
Federation and the United States on June 17, 1992. Consideration of this treaty was on
the Duma’s legislature agenda for June of 1997. The US government, with the help of
embassy and the chamber, tried to raise awareness among investors and members of the
Duma about the significance of ratification of this treaty to increase investment flows
between the two countries. The treaty provided the investors the following basic
guarantees:
• It ensures that the companies from each country are treated as favorably as their
competitors.
• Clear limits are imposed on the expropriation of investments and it ensures that
investors are fairly compensated.
• It guarantees the US and Russian investors the right to transfer funds into and out
of the countries in which the investment has been made without delay using a
market rate of exchange.
• It gives investors the right to submit an investment dispute with the treaty partner’s
government to international arbitration. There is no necessity to use that country’s
domestic courts.
• It gives investors the right to engage the top managerial personnel of their choice,
without considering their nationality.
16.10 GERMANY – INDIA BILATERAL TREATY

This treaty focuses on creating favorable conditions to boost the investments by
individuals and corporates of either country in the other country. Its objectives are as
follows:
• National treatment and most favored nation treatment to the other country.
• Guarantee against nationalization of investments made by the investor from the
other country.
• Compensation for losses, repatriation of investment and returns.
This treaty also guarantees reciprocal protection to the investments made in order to
increase business initiatives from both India and Germany. Once the treaty is ratified,
the agreement will initially be for a period of ten years from the date of ratification.
16.11 TRADE, AID AND DEVELOPMENT

The term Aid may refer to military aid, commercial transactions, and food aid and
development assistance. The main objectives of an ‘aid’ include development, security,
humanitarism etc. Development has also increased in the world due to organizations
such as UNCTAD, UNIDD, GATT, UNICEF, ILO, and World Bank etc. These
organizations have established management development Centers and programs in various
parts of the developing world. To boost the development in the developing countries, the
United Nations formed the Generalized System of Preferences (GSP) in 1977. Much of
13
the world trade has taken place between developed industrialized nations only.
The percentage share of total world trade between developed and developing countries is
very low.
Aid or Trade?
Today, LDCs believe that trade is more essential than aid for the development of their
economy. The developed countries are not providing the required aid to the developing
countries. In accordance with UNCTAD’s resolution it is obligatory on their part to
contribute 1% of their national income to LDCs. But figures show that they have not
contributed even 0.5% of their national income. A policy which favors trade can be
successful only when there is an increase in the domestic savings equal to the rise in
export earnings. Trade can take the place of aid when the price levels in the developing
economies are stabilized. On the whole trade as well as aid are both essential for growth
and development.
16.12 DOHA CONFERENCE 2001

The Fourth WTO Ministerial Conference was held in Doha, Qatar from
9 to 14 November 2001, to assist developing countries implement WTO agreements,
covering issues related to agriculture, services, industrial tariffs, investment, and trade
and competition policy.
Agriculture
The negotiations began in early 2000, under Article 20 of the WTO Agriculture
Agreement. By November 2001, 121 governments submitted a number of negotiating
proposals. The Doha declaration built on the work already undertaken, confirmed and
elaborated the objectives, and chalked a timetable. Agriculture became a part of the
single undertaking whereby virtually all the linked negotiations had to end by 1 January
2005.Further; the declaration reconfirmed the long-term objective, i.e., to establish a fair
and market-oriented trading system through a program of fundamental reform.
Market Access for Non-agricultural Products
The declaration agreed to the negotiations which attempt to decrease or eliminate tariff
peaks, high tariffs, and tariff escalation, as well as non-tariff barriers, in particular on
products having export potential in the developing countries.
Trade Related Aspects of Intellectual Property Rights (TRIPS)
The declaration stressed the importance of implementing the Agreement on TRIPS by
facilitating access to existing medicines as well as research and development in new
medicines.
Transparency in Government Procurement
The declaration recommended a multilateral agreement on transparency in government
procurement. The Negotiations would be limited to the extent of transparency and
subsequently it would not impose any restriction on the countries giving preference to
domestic supplies and suppliers. It also guaranteed adequate technical assistance and
support for competence during the negotiations and implementation thereafter.
14
Trade Blocks
Trade Facilitation
The declaration identified the need to release and clear the goods, including those in
transit and the need for greater technical assistance in this area.
Trade and Investment
The declaration recognized the need for a multilateral frame work in order to secure
transparent and stable atmosphere of long-term cross-border investment, particularly
foreign direct investment which will contribute to the expansion of trade and the need
for increased technical assistance in this field.
Dispute Settlement System
The declaration confirmed the negotiations with regard to improvement and clarification
of the Dispute Settlement Understanding. The negotiations were to be made on the basis
of work done till date in addition to the proposals made by the members.
Trade and Environment
In order to increase the mutual support of trade and environment, the Doha declaration
agreed to the following:
• The relationship between existing WTO rules and specific trade obligations set
out in Multilateral Environmental Agreements (MEAs).
• Procedures for regular information exchange between MEA Secretariats and the
relevant WTO committees, and the criteria for the granting of observer status.
• The reduction or, as appropriate, elimination of tariff and non-tariff barriers to
environmental goods and services.
Electronic Commerce
The work done so far shows that electronic commerce creates new challenges and
opportunities for trade for members at all stages of development, and as such the
declaration recognizes the importance of creating and maintaining an environment
which favors the future development of electronic commerce.
Trade, Debt and Finance
The declaration examines the relationship between trade, debt and finance, and of any
possible recommendations that boost the capacity of the multilateral trading system.
Work Program
January 1, 2005, was declared the last date for completing all the negotiations and May
2003 was the cut off date for dispute settlement system. A Trade Negotiation
Committee was under the general council was authorized to supervise the on going
negotiations and it had to hold its first meeting prior to January 31, 2002. It had to
determine proper negotiating mechanisms according to the requirement to oversee the
pace of negotiations.
16.13 CANCUN CONFERENCE 2003

Cancun Conference 2003 was the 5th ministerial meet of WTO. The main objective was
to oversee the progress of negotiations and other work carried on under the Doha
Development Agenda. It also confirmed the declarations and the decisions taken at
Doha.
15
Highlights
Singapore Issues
The Singapore issues include trade and investments, trade and competition policy;
transparency in government procurement; and trade facilitation. These issues were taken
up after a seven year period to arrive at a certain consensus. But this attempt did not
yield any useful results. A number of controversies were raised by the member countries
and they could not arrive at a single decision. Inspite of all the efforts this issue was not
resolved until the last day of the conference.
The Cotton Proposal

The issue was brought out in the General Council and Agriculture Committee by Benin,
Burkina Faso, Chad and Mali. The proposal was supported by Canada, Australia,
Argentina, Cameroon, Guinea, South Africa, Bangladesh, Senegal and India. US felt
that the industrial policies supporting the production of synthetic fiber were responsible
for falling cotton and as such it recommended discussions in order to deal with the
problems arising in the production process. Finally the committee decided to discuss this
issue in the informal meeting in the future days.
Cambodia and Nepal Membership

The membership agreements of Cambodia and Nepal were approved by the ministers in
a formal session on 11th September, 2003. These two countries joined the WTO as
147th and 148th members.
a. Mention the basic guarantees provided by US – Russia Bilateral Investment

Treaty.
……………….……………………………………………………………...........
……………….……………………………………………………………...........
……………….……………………………………………………………...........
b. What do you mean by NAFTA?
……………….……………………………………………………………...........
……………….……………………………………………………………...........
……………….……………………………………………………………...........
End without Consensus
Many ministers criticized the issues which were raised to bridge the gaps. They felt that
the agriculture text was either too ambitious or was not motivating enough. They
differed in their opinion with regard to the launch of negotiations on Singapore
issues. They were not satisfied with the non-agricultural market access text, which
included tariff cutting formula and sectoral deals. Many African and Caribbean
countries stated that the draft did very little on differential treatment in the case of
developing countries.
16
Trade Blocks
16.14 SUMMARY
A trade block can be defined as a large free trade area formed by one or more tax, tariff
and trade agreements.
WTO acts as a watchdog to the international trade, as it regularly examines the trade
regimes of individual members.
The government or private corporations situated in different countries form an
international cartel, agreeing to restrict competition among themselves in order to
exploit their joint monopoly power.
The OPEC concentrates on the stability and prosperity of the international petroleum
market.
Bilateral investment treaty was signed by the representatives of the Russian Federation
and the United States on June 17, 1992.
Germany – India Bilateral Treaty focuses on creating favorable conditions in order to
boost the investments by individuals and companies of either country in the other
country.
The European community aims to create customs Union and this objective could be
achieved to a certain extent.
The Fourth WTO Ministerial Conference was held in Doha, Qatar from
9 to 14 November 2001.
Canun Conference 2003 was the 5th ministerial meet of the WTO.
16.15 GLOSSARY
Free Trade Area is an area designated by the government of a country to which goods
may be imported for processing and subsequent export on duty-free basis.
World Bank is a supranational body which extends loans at concessional rates to
member countries for projects having high economic priority.

• Francis Cherunilam, International Business Environment.

Self-Assignment Question – 1
a. International Cartel
The government or private companies situated in different countries form an
international cartel, agreeing to restrict competition among themselves to exploit
their joint monopoly power. The members of the cartel export to the rest of the
world alternative quantities of cartelized goods at alternative prices. A cartel to
be successful must satisfy the following conditions:
i. The elasticity of demand for imports by the rest of the world must be low
in the relevant price range.
ii. The cartel members must adhere to the official set of policies as voted by them.
A high monopoly price can be maintained by the international cartel until and
unless any selfish member of the cartel tries to grab greater profits in a
competitive manner. An example of an international cartel is Organization of
Petroleum Exporting Countries (OPEC).
17
b. The World Trade Organization (WTO) is an international organisation that set
rules and regulations for international trade and also resolved disputes of its
member countries. The WTO head quarters is situated at Geneva, Switzerland.
All the member countries must provide each other the most favoured nation
status to boost trade among themselves with certain trade concessions. The major
functions of WTO are:
• Limit harmful trade practices.
• Act as a forum for multilateral trade negotiations.
• Cooperate with other international institutes who involve in global policy-

making.
• Oversee national trade policies.
• Administer the understanding on rules and procedures governing the

settlement of disputes (Dispute Settlement Understanding (DSU).
a. The Bilateral Investment Treaty (BIT) was signed by the representatives of the
Russian Federation and the United States on June 17, 1992. Consideration of this
treaty was on the Duma’s legislature agenda for June of 1997. The US
government, with the help of embassy and the chamber, tried to raise awareness
among investors and members of the Duma about the significance of ratification
of this treaty to increase investment flows between the two countries. The treaty
provided the investors the following basic guarantees:
• It ensures that the companies from each country are treated as favorably
as their competitors.
• Clear limits are imposed on the expropriation of investments and it
ensures that investors are fairly compensated.
• It guarantees the US and Russian investors the right to transfer funds into
and out of the countries in which the investment has been made without
delay using a market rate of exchange.
• It gives investors the right to submit an investment dispute with the treaty
partner’s government to international arbitration. There is no necessity to
use that country’s domestic courts.
• It gives investors the right to engage the top managerial personnel of their
choice, without considering their nationality.
b. North American Free Trade Area (NAFTA) came into force on 1st January 1984.
It consists of three countries, USA, Canada and Mexico which agreed to
eliminate tariffs over a period of 15 years. Accordingly free trade area between
USA and Canada was established in 1988. The agreement covers consumer
safety, tariff reduction, financial and direct investment matters etc. Its other
objectives include lowering of trade barriers, more accessibility to financial
services, creation of North American Development Bank and so on.
18
Trade Blocks
A. Multiple Choices
1. A sign or a combination of signs which can distinguish the goods or a service of
one firm from those of the other is called _____________.
a. Copyright
b. Geographical Indicator
c. Trade Mark
d. Patent
e. Integrated Circuits.
2. A treaty signed between two countries with regard to matters such as peace,
aviation and trade is called a ______________.
a. Bilateral Treaty
b. General Agreement
c. Multinational Treaty
d. Trade Treaty
3. According to UNCTAD the developed countries must contribute______ percent
of their national income to the LDCs.
a. 0.5 percent
b. 1 percent
c. 2 percent
d. 1.5 percent
e. 3 percent.
4. Doha Conference deals with which of the following issues?
a. Agriculture.
b. Services.
c. Industrial Tariffs.
d. Investment.
5. Which of the following is included in the Plurilateral Trade Agreement?
a. Agreement on Trade in Civil Aircraft.
b. International Bovine Meat Agreement.
c. Agreement on Government Procurement.
d. International Dairy Agreement.
B. Descriptive
1. Define WTO. Explain in detail the structure of WTO.
2. Discuss in detail Multilateral Agreement on Trade in goods.
3. Explain the functions of OPEC.
4. Explain in detail Doha Conference 2001.
5. Explain in detail the following:
a. US – Russia Bilateral Investment Treaty.
b. Germany – India Bilateral Treaty.
practice only.
19
UNIT 17 FOREIGN TRADE POLICY
Structure
17.1 Introduction
17.2 Objectives
17.3 Historical Perspective
17.4 Objectives of the Foreign Trade Policy (2004-2009)
17.5 Foreign Trade Policy (2004-2009)
17.6 Trade Regulations Governing Imports/Exports
17.7 Summary
17.8 Glossary
17.1 INTRODUCTION
Liberalization has led to increase in trade benefits to the countries involved resulting in
efficacious and growth driven economic policies. For India to become a major player in
world trade, an all-encompassing, comprehensive view needs to be taken for the overall
development of the country’s foreign trade. While increase in exports is of vital
importance, we have also to facilitate those imports, which are required to stimulate our
economy.[v1] Coherence and consistency among trade and other economic policies is
important for maximizing the contribution of such policies to development. Thus, while
incorporating the existing practice of enunciating an annual Exim policy, it is necessary
to go much beyond and take an integrated approach to the developmental requirements
of India’s foreign trade.
17.2 OBJECTIVES
• Understand the historical perspective and the rationale behind trade regulations in
India;
• Define the objectives of the Foreign Trade Policy (2004-2009);
• Know the main features of the Foreign Trade Policy (2004-2009); and
• Identify trade regulations governing exports/imports.
17.3 HISTORICAL PERSPECTIVE

Control on import trade in India was visible for the first time during the World War II
when limitations were placed under Defense of India Rules (DIR). From September
1946 import control was taken over by Emergency Provisions (Continuance) Ordinance.
The ordinance was replaced by Import and Export (Control) Act, 1947. This Act was
soon replaced by Foreign Trade (Development and Regulation) Act, 1992. With the
advent of liberalization, the government of India made important changes to the import
export policy of 1985. Consequently Exim Policy 1992-1997 was introduced. On 31st
August, 2004 Government of India, brought into light Foreign Trade Policy
(2004-2009) in place of Exim policy (2002-2007).
Foreign Trade Policy
17.4 OBJECTIVES OF THE FOREIGN TRADE POLICY
(2004-2009)
The main objectives of this policy are:
• To double the percentage share of global merchandise within the next five years.
• To increase the economic growth by supplying required raw materials,
intermediaries, consumable components etc.
• To increase the technological scope and growth of Indian Agriculture Industry
and services.
• To supply the consumers with high quality of goods and services at global
competitive prices.
17.5 FOREIGN TRADE POLICY (2004-2009)

Foreign trade policy 2004-2009 has attempted to integrate the trade policy with the
country’s economic growth. The key strategies of this policy are:
• Loosen controls.
• Develop an atmosphere of trust and transparency.
• Make the procedures easy and at the same time reduce transaction costs.
• Follow the principle that ‘duties and levies should not be exported’.
• Discover and develop different areas in order to take India to global heights with
regard to manufacturing, trading and services.
Special Focus Initiatives of the Policy are:
• Sectors with scope for export prospects along with employment potential in
semi-urban and rural areas have been recognized as thrust sectors and
accordingly clear-cut sectoral schemes have been formulated.
• Sectoral initiatives in the remaining sectors will be brought out from time to
time.
• For the Towns of Export Excellence the threshold limit is reduced from Rs.1,000
to Rs.250 crore.
Special focus initiatives were brought about in the following areas:
a. Package for Agriculture: To increase the exports of fruits, vegetables, flowers
etc., a new scheme called Vishesh Krishi Upaj Yojana has been announced.
Import of seeds, bulbs, planting material and export of plant portions, extracts
and derivatives have been liberalized. Duty free import of capital goods can be
taken up under EPCG scheme and these goods can be lodged at any place in the
Agri Export Zone.
b. Gems and Jewelry: Duty free import of consumables for metals excluding gold
and platinum will be permitted to the extent of 2% of FOB value of goods.
Similarly duty free re-import claim of any rejected jewelry will be permitted up
to 5%. Gold (18 carat or more) can be imported under the replenishment scheme.
c. Handlooms & Handicrafts: Duty free import in case of trimmings and
embellishments for this sector has been increased to 5% of FOB value of
exports. Import of the same in addition to any samples is exempted from CVD.
A new special economic zone for handicrafts will be sanctioned.
21
d. Leather & Footwear: Any machinery and equipment with regard to Effluent
Treatment plants used in leather industry will no longer come under customs
duty. Duty free claims of import trimmings, embellishments and footwear parts
in this sector are raised to 3% of FOB value of goods. In the same way duty free
import of certain goods is raised to 5%.
e. Export Promotion Schemes: New schemes such as target plus, Vishesh Krishi
Upaj Yojana and Served from India Scheme have been introduced to increase the
growth of exports.
Under the target plus scheme exporters who have obtained quantum growth in
exports can claim duty free credit depending on incremental exports which are
considerably greater than the actual export target fixed. For incremental growth
more than 20%, 25% and 100%, the exporter can claim duty free credits upto
5%, 10% and 155% of FOB value of incremental exports. Vishesh Krishi Upaj
Yojana is a special agriculture produce scheme and the exporters can claim
duty free credit upto 5% of FOB value of exports. Served from India scheme is
a reproduction of the DFEC scheme in order to boost export of services.
Individual service providers earning 5 lakh in foreign exchange and remaining
service providers earning 10 lakh in foreign exchange can claim duty credit up to
10% of total foreign exchange earned.
f. EPCG: To minimize the problems of exporters more flexibility with regard to
export obligation is provided under EPCG. Export obligation in case of distinct
projects will be computed on the basis of concessional duty allowed to the
exporters. Transfer of capital goods to group companies and managed hotels is
now available under EPCG.
g. DFRC: Import of fuel under DFRC can be transferred to marketing agencies
recognized and authorized by the Ministry of Petroleum and Natural gas.
h. DEPB: This scheme will be continued as it is, until a new scheme is prepared by
consulting exporters.
i. New Status Holder Categorization: A new scheme classifying status holders as
Star Export Houses has been introduced. The categorization is as follows:
Category Total performance over three years:
• One Star Export House 15 crore.
• Two Star Export House 100 crore.
• Three Star Export House 500 crore.
• Four Star Export House 1500 crore.
• Five Star Export House 5000 crore.
j. EOUs: Under Foreign Trade Policy 2004-2009, EOUs will be exempted from
service tax in accordance with the exported goods and services. In case of EOUs
capital goods will be imported based on self-certification. DTA units which will be
converted to EOUs will be provided income tax privileges on plant and machinery.
k. Free Trade and Ware Housing: A new scheme to introduce free trade and
warehousing zone with a minimum outlay of Rs.100 crore and 5 lakh square feet
area has been announced. These units will enjoy all benefits that are applicable to
SEZ units.
l. Services Export Promotion Council: A Services Export Promotion council will
be established to chart new opportunities for prominent services in significant
markets along with appropriate strategies in association with sector players and
authorized nodal bodies of service industry.
22
m. Common Facilities Center: Common facility centers will be established in
order to facilitate home based service providers in specific areas such as multi-
media operations, engineering and architectural design etc.
n. Procedural Simplifications and Rationalization Measures: Second-hand
capital goods will be allowed for import without any age constraint. In order to
reduce transaction costs, all exporters with a turnover of Rs.5 crore and those with
good track record will be exempted from submitting bank guarantee in any of the
schemes. Number of returns and forms to be filed is minimized in consultation
with Customs and Excise Department. All the exported goods and services will
be exempted from service tax.
o. Pragati Maidan: Pragati Maidan will be changed into a world-class complex
accommodating 10,000 delegates with hi-tech equipment and multi parking
facility for 9,000 vehicles.
p. Legal Aid: To cover legal expenses involved in the process of trade, all the
eligible exporters recommended by the export promotion council will be
provided required finance.
q. Grievance Redressal: To provide speedy redressal of grievances occurring in

the trade, the government has formulated a new mechanism.
r. Quality Policy: Exporters can make use of digitally signed applications and
electronic fund transfer techniques to pay application fees and all the DGFT
offices will be controlled through a central server. This would enable faster
processing of applications.
s. Board of Trade: An expert in trade policy or a distinguished person will be

nominated as the President of Board of trade along with a Secretariat and a
Budget Head. Board of trade will be restructured to play a significant role.
a. What are the objectives of Foreign Trade Policy 2004-2009?
………….……………..…………………………………………………………
………….……………..…………………………………………………………
………….……………..…………………………………………………………
b. What is the special focus initiatives brought under Foreign Trade Policy 2004-09?
………….……………..…………………………………………………………
………….……………..…………………………………………………………
………….……………..…………………………………………………………
23
17.6 TRADE REGULATIONS GOVERNING IMPORTS/EXPORTS
Various trade regulations controlling exports and imports mentioned in the trade policy
issued by the Commerce Minister should be followed without any choice by the
exporters, importers, authorized dealers and other market players involved in the
export/import business.
Trade Regulations Governing Imports
Indian imports can be categorized into freely importable items or Open General License
(OGL) items and the negative list items. Items such as paraffin wax, collator machine,
microfilm camera etc., can be imported freely without any import licenses. The items
not included under the first category fall under the negative list. These items are either
banned, prohibited or restricted and include canalized items which can be imported only
through government trading monopolies.
Import Licenses: A license which is issued specifically for imported goods is called an
import license and such goods can be imported by an ‘actual user’ only. The validity
period of each license is specified and only those items categorized under import license
can be imported. There are different types of licenses such as regular license, advanced
license, licenses with export obligations and special import licenses.
Regular License: These licenses are granted to those items which come under normal
import policy and are issued to any eligible person in accordance with the policy.
Advance License: Advance licenses are released under the duty exemption scheme.
Duty free imports are allowed on fulfilling value addition and export obligation not
exceeding the specified period of time.
Licenses with Export Obligations: These licenses are issued to the importer with an
‘export obligation’. In other words, the importer of capital goods must export certain
quantity of goods manufactured using the imported capital goods to some place situated
outside India.
Special Import License (SIL): These licenses are issued as an export incentive to the
Indian exporters and its value is attached to earnings from export. This license helps
import certain consumer goods among other items. SIL works as an import permit and
is traded in the market, at a premium on its value.
Transferability of Licenses
When all the required formalities are complete, the transferable license holder can
transfer it to a third party by making an appeal to the licensing department before the
expiry of 36 months from the date of issue.
Endorsement of Import License
If a license is of transferable nature, the same is mentioned in the license. Such a licence
holder can transfer part or whole of it to the entitled importers with reference to the
provisions of import policy.
24
Validity of Import License/Certificates/Permission/CCPS
The validity of import licence/certificate/permission from the date of issue of
licence/certificate/permission is as follows:
i. Advance Licence (including Advance Licence 24 months

for Annual Requirement), DFRC and
Replenishment licence for Gem & Jewellery
ii. EPCG licence (other than spares) 36 months
iii. EPCG Licence for Spares, refractories, catalyst Co-terminus with the Export
and consumables Obligation Period of the
EPCG Licence.
iv. Others including CCP and Duty Entitlement 24 months
Passbook Scheme, unless otherwise specified.
v. Advance Licence for deemed export (including 24 months or Co-terminus with
Advance Licence for Annual Requirement). the contracted duration of
execution of the project
whichever is later.
Duty Entitlement Pass Book Scheme (DEPB)
According to this scheme the exporter can obtain credit as a specified percentage of
FOB value of exports in a freely convertible currency. This credit is realizable on export
of goods which are mentioned in the list notified by the Director General of Foreign
trade through public notice.
Diamonds, Gems and Jewelry Export Promotion Scheme
In order to increase the exports of diamonds, gems and jewelry the exporters are
provided Replenishment (REP) licenses and Diamond Imprest licenses to import the
required inputs such as raw/cut and polished diamonds, gold etc.
Replenishment Licenses
The exporters of diamonds or gems listed in Appendix-26 of the handbook of
procedures (Vol. I) under Foreign Trade policy only are given the replenishment
license. The Gem REP licenses can be obtained in accordance with the scale provided in
Appendix-26A. An application for the Gem REP license must be submitted to the
license authority in Appendix-25 and in the form provided in Appendix-13A. If EP
copy of the shipping bill and custom attested invoice is surrendered to the nominated
agencies, the exporter shall submit a self-certified photocopy of the same in addition to
the certificate from the nominated agency. These applications must be submitted within
6 months from the month or quarter in which the export proceeds are obtained along
with consolidated application for all exports in month or quarter.
Diamond Imprest License
The exporter of cut and polished diamonds being a status holder is eligible for this type
of license to the extent of 5% of export performance of cut and polished diamonds in the
earlier year. Application must be submitted in the desired form to the Regional licensing
Authority with the name and address of his banker and also a certificate from the banker
stating that no export bills are over due for a period exceeding six months. An export
obligation related to every consignment must be completed in a period not exceeding 5
months from the date of consignment clearance through the customs department.
25
Bank Guarantee and Legal Undertaking (LUT)
To clear import consignment a bank guarantee/legal undertaking is needed.

This obligation can be waived if the export obligation is completed earlier to the
imports. In the absence of LUT limit the exporter must get a bank guarantee upto 50%
of CIF value of the license. LUT/Joint LUT limits for various categories of exporters
are given in the following table:
Table 1
Type of Exporter Limits
1. Super Star Trading House and Units within the Unlimited.
same group/public sector undertaking and units
within the same group.
2. Export House/Trading House/Star Trading Up to five times of FOB value of
House and units within the same group. exports effected in the preceding
licensing year/current year.
3. Exporters having performance of past exports Up to two times of FOB value of
but not covered under S.No. 1 and 2 above. exports made during the
preceding licensing year.
4. Any overseas company with its branch office in Up to 50% of annual average
India with an annual average turnover in turnover of the preceding three
diamonds during preceding three licensing years, licensing years.
being not less than Rs.150 crore.
Extension of Export Obligation Period
The licensing authority will permit a six month extension from the date on which the
original export obligation of the license expires. A composition fee of 1% of the unfulfilled
FOB Value of export obligation with regard to CIF value of imports is paid for which an
extension is requested. Further extension can be sought, if a composition fee of 5% is paid.
Diamond Dollar Account
Diamond dollar account is useful to importers in retaining their proceeds from exports in
dollars. Opening of such an account is not compulsory and this allows an exporter to maintain
his rupee account, if necessary. This account is operated with reference to RBI conditions.
Trade Regulations Governing Exports
There are various trade regulations governing different types of exports such as cash
exports, project exports and deemed exports.
Cash Exports: When the proceeds of the exports are realized within a period of six
months from the shipment date or the due date of payment which ever is earlier, such
exports are called cash exports and are executed in accordance with FEDAI rules.
Project Exports: Export of turnkey projects, civil construction contracts and
engineering goods on deferred payment terms are called project exports which are
normally of high value.
Deemed Exports: Exports which do not leave the country are called deemed exports.
To be called deemed exports goods must be supplied to a project which is sponsored by
multilateral/bilateral agencies such as ADB or they must be supplied against an order
received under international competitive bidding. Sometimes, the goods may be
supplied to projects mentioned by the Government of India. The present trade policy
permits free export of all the goods, excluding those goods governed by ITC (HS)
export and import goods classification or some other provision or law related to the
policy. Indian exports just as the imports, are broadly classified into open general
license and the negative list. Negative list includes goods which are restricted,
prohibited and canalized.
26
In certain cases according to the conditions given by the Director General of Foreign
Trade Policy some items are permitted for exports without license. Export of items
listed under negative list requires registration and a membership certificate from the
Export Promotion Council (EPC). The exporter should hold a license issued by the
license authority for the same purpose. He should get himself registered with the EPC
and also get a Registration and Membership Certificate. Export value of goods must be
declared by the exporter before the goods are exported except in certain cases such as
trade samples, goods imported freely on re-export scheme etc.
17.7 SUMMARY
The Gulf crisis in the 1990s necessitated major economic and policy reforms in India.
Liberalization ushered in a number of reforms and fillips in the Indian export sector.
On 31st August, 2004 Government of India brought into light Foreign Trade Policy
(2004-2009), in the place of Exim policy (2002-2007).
Special focus initiatives were brought in areas such as agriculture, handlooms, gems and
jewelry.
The Indian exports and imports are governed by different trade regulations.
The procedures, terms and conditions mentioned in the trade policy must be followed
by all the exporters and importers.
17.8 GLOSSARY
If the proceeds of exports are realized within 6 months from the date of shipment or the
due date for payment whichever is earlier, such exports are called Cash Exports.
Customs Tariff are the charges imposed by the government and most other
governments on imported and/or exported goods.
Exim Bank is the Export Import Bank of India, which encourages foreign trade by
extending credit.
Export License is a permit required to export commodities falling in the negative list.
Import License is a license required and issued by the DGFT authorizing the entry of
foreign goods into the country.

• Francis Cherunilam. International Trade and Export Management.

a. The Government of India, brought into light Foreign Trade Policy
(2004-2009) in place of Exim policy (2002-2007).
The main objectives of this policy are:
• To double the percentage share of global merchandise within the next five
years.
• To increase the economic growth by supplying required raw materials,
intermediaries, consumable components etc.
• To increase the technological scope and growth of Indian Agriculture
Industry and services.
• To supply the consumers with high quality of goods and services at global
competitive prices.
27
b. Special Focus policy Initiatives of the Foreign Trade Policy (2004-2009) are:
• Sectors with scope for export prospects along with employment potential
in semi-urban and rural areas have been recognized as thrust sectors and
accordingly clear-cut sectoral schemes have been formulated.
• Sectoral initiatives in the remaining sectors will be brought out from time
to time.
• For the Towns of Export Excellence the threshold limit is reduced from
Rs.1,000 to Rs.250 crore.
Special focus initiatives were brought about many areas, the major sectors
covered were:
• Package for Agriculture: To increase the exports of fruits, vegetables,
flowers etc., a new scheme called Vishesh Krishi Upaj Yojana has been
announced. Import of seeds, bulbs, planting material and export of plant
portions, extracts and derivatives have been liberalized. Duty free import
of capital goods can be taken up under EPCG scheme and these goods can
be lodged at any place in the Agri Export Zone.
• Gems and Jewelry: Duty free import of consumables for metals excluding
gold and platinum will be permitted to the extent of 2% of FOB value of
goods. Similarly duty free re-import claim of any rejected jewelry will be
permitted up to 5%. Gold (18 carat or more) can be imported under the
replenishment scheme.
• Handlooms & Handicrafts: Duty free import in case of trimmings and
embellishments for this sector has been increased to 5% of FOB value of
exports. Import of the same in addition to any samples is exempted from
CVD. A new special economic zone for handicrafts will be sanctioned.
• Leather & Footwear: Any machinery and equipment with regard to
Effluent Treatment plants used in leather industry will no longer come
under customs duty. Duty free claims of import trimmings, embellishments
and footwear parts in this sector are raised to 3% of FOB value of goods. In
the same way duty free import of certain goods is raised to 5%.

A. Multiple Choices
1. Which of the following items does not require import licence?
a. Paraffin Wax.
b. Collator Machine.
c. Microfilm Camera.
d. Asbestos fiber.
2. Items which can be imported only by the government trading policies are called
___________.
a. Restrictive items
b. Canalized items
c. Prohibited items
d. Special items
28
3. Which of the following is the validity period for Export Promotion Capital Goods
License?
a. 12 months.
b. 15months.
c. 20 months.
d. 24 months.
e. 30 months.
4. Which of the following is/are essential to a person exporting items under negative
list?
a. Registration from Export Promotion Council.
b. Membership certificate from Export Promotion Council.
c. Export license.
5. Export of onions falls under which of the following export categories?

a. Restricted goods.
b. Prohibited goods.
c. Regular goods.
d. Canalized goods.
e. Perishable goods.
B. Descriptive
1. Explain in detail various trade regulations governing Indian imports and exports.
2. Explain various special focus initiatives brought under Foreign Trade Policy
(2004-2009).
3. Explain different types of import licenses.
practice only.
29
UNIT 18 DOCUMENTARY CREDITS
Structure
18.1 Introduction
18.2 Objectives
18.3 Letter of Credit
18.4 Parties to a Letter of Credit
18.5 How does a Letter of Credit Operate?
18.6 Different Kinds of Letters of Credit
18.7 Documents under Letter of Credit
18.8 Certificate of Origin
18.9 Incoterms
18.10 Summary
18.11 Glossary
18.1 INTRODUCTION
International trade involves various complexities and problems. This may be due to
various reasons. The parties to a sale contract are located in different countries and are
governed by different legal systems. Also, the currencies of the two countries are
different. Further, the trade and exchange regulations applicable to both the parties may
differ. In such a situation, a seller who ships goods will be apprehensive whether he will
receive payment from the buyer. The buyer, on the other hand, will be concerned
whether the seller will ship the goods ordered for and deliver them in time. Given these
complexities, a need for an ideal method of settling international trade payments was
felt and so came the usage of documentary credits, commonly known as LC, into vogue.
Documentary credit or Letter of Credit plays a significant role in settling international trade
payments occurring in the course of international trade. The International Chamber of
Commerce (ICC) has issued certain guidelines in the name of Uniform Customs and
Practice for Documentary Credits (UCPDC) to provide uniform interpretation of
terminology used under documentary credit.
18.2 OBJECTIVES
• Understand the meaning of Letter of Credit;
• Identify the role of parties to a Letter of Credit;
• Comprehend the operational methodology of Letter of Credit;
• Know the different kinds of Letters of Credit; and
• Recognize the need for documents under a Letter of Credit.
Documentary Credits
18.3 LETTER OF CREDIT
Letter of Credit (LC) implies the settlement of a predetermined amount against
documents to the beneficiary through an issuing bank working on behalf of an
applicant. UCPDC defines a letter of credit as “Any arrangement, however named or
described, whereby a bank (the “Issuing Bank”), acting at the request and on the
instructions of a customer (the “Applicant”) or on its own behalf:
i. Is to make a payment to or to the order of a third party (the “Beneficiary”), or is to
accept and pay bills of exchange (“Draft(s)” drawn by the Beneficiary).
OR
ii. Authorizes another bank to effect such payment, or to accept and pay such bills of
exchange (Draft(s)).
OR
iii. Authorizes another bank to negotiate against stipulated documents, provided that
the terms and conditions of the credit are complied with.”
18.4 PARTIES TO A LETTER OF CREDIT

Certain important parties to a Letter of Credit are:
The Applicant: The buyer of goods is the applicant and is responsible to pay the seller
through the issuing bank, which opens an LC in accordance with his instructions. An
issuing bank can act either as an applicant or an issuer.
The Issuing Bank: A bank which opens the LC according to the instructions of the
applicant to pay the predetermined amount to the beneficiary as per terms and
conditions is called an issuing bank.
The Beneficiary: The seller of goods, to whom the payment is made by the buyer
through the issuing bank by means of LC is called the beneficiary.
The Advising Bank: A bank which advises the beneficiary regarding the credit after
checking the authenticity of credit is called an advising bank.
Confirming Bank: The advising bank or any other bank which is authorized by the
issuing bank may take up the role of a confirming bank and add its confirmation to the
LC opened by the issuing bank.
Nominated Bank: The Issuing bank designates a bank as a Nominated bank for the
following purpose:
• Pay if the LC is a payment LC.

• Incur a deferred payment undertaking.
• Accept drafts, if the credit stipulates so.
• Negotiate.
Reimbursement Bank: A bank which honors the reimbursement claim while settling
any negotiation/ acceptance/payment attributed to it by the paying, negotiating or
accepting bank is called the reimbursement bank.
31
Rights and Responsibilities of Parties to an LC
According to UCPDC 500 the following are the rights and responsibilities of parties to LC:
• All parties should deal with documents only. In other words they should not deal
with goods/services, or performances concerning the documents.
• Beneficiary enjoys the right to secure payment after presenting the required documents
under the LC. Similarly shipping the goods as per the LC and subsequently putting
forward the documents in time for negotiation is the duty of exporter.
• Negotiating Bank: The negotiating bank after verifying the terms and conditions
of the credit should make payment according to LC and put forward the essential
documents to the opening bank. When the beneficiary receives his payment,
reimbursement is made to the negotiating bank by the opening bank for the
payment.
• Opening Bank: Documents received from the negotiating bank should be
examined by opening bank within 7 days and any discrepancy in the documents
must be intimated to the negotiating bank as soon as possible.
• Advising Bank: As per instructions of the opening bank, the advising bank,
should verify the authenticity of the LC and advise the beneficiary accordingly.
• Confirming Bank: Confirming bank adds its conformity to the LC and receives
reimbursement from the issuing bank in addition to confirmation charges.
• Applicant to the LC: The buyer or importer must make payment under LC to the
opening bank against release of stipulated documents.
a. What is a Letter of Credit?
…………………………………………….…………………………….............
…………………………………………….…………………………….............
…………………………………………….…………………………….............
b. Explain in brief rights and responsibilities of parties to a Letter of Credit.
…………………………………………….…………………………….............
…………………………………………….…………………………….............
…………………………………………….…………………………….............
18.5 HOW DOES A LETTER OF CREDIT OPERATE?

The buyer of goods instructs the issuing bank to open a letter of credit to make payment
to the overseas seller. This letter of credit is forwarded to the advising bank to advise
the seller or beneficiary regarding the credit. After verification of LC by beneficiary, he
ships the goods to the buyer on submitting essential documents to the negotiating bank
in order to receive payment. The negotiating bank on receiving receipt from the
commercial bank and bill of lading from the exporter examines the documents and
32
Documentary Credits
makes payment to the seller. The same is claimed as reimbursement by the negotiating
bank from the issuing bank after sending the required documents. The issuing bank puts
forward the commercial invoice and other essential documents to the buyer and the bill
is paid by the buyer after checking the documents. When the bill is paid all the shipping
documents concerned are given to the buyer.
18.6 DIFFERENT KINDS OF LETTERS OF CREDIT

Letter of credit is classified into different types, based on its nature and functions.
Based on Scope for Cancellation
a. Revocable Letter of Credit: A Letter of Credit which can be canceled or
amended by the issuing bank without any prior intimation to any concerned party
is called a revocable letter of credit.
b. Irrevocable Letter of Credit: A Letter of Credit which cannot be cancelled or
amended by the issuing bank in any way without the consent of parties is called an
irrevocable Letter of Credit.
c. Confirmed Letter of Credit: A Letter of Credit which has confirmation from
confirming bank in addition to the issuing bank is called confirmed Letter of
Credit.
Based on Mode of Payment
a. Payment Credit: Payment made to the seller after presenting all the submission of
the required documents as per the terms and conditions of LC is called payment
credit.
b. Deferred Payment Credit: Payment made according to the due dates specified in
the credit is called deferred payment credit.
c. Acceptance Credit: The payment made by the drawee bank as per the tenor
specified by the seller on submitting the bill of exchange is called acceptance credit.
d. Negotiation Credit: While acceptance credit and deferred payment credit are usance
credits, negotiation credit is sometimes sight credit and at others, usance credit.
When freely negotiable negotiation credit occurs at a bank, which is treated as the
nominated bank and the beneficiary can submit his documents with any bank. But
when the negotiable credit is restricted, the issuing bank nominates some specified
banks and the beneficiary can submit his documents only to these banks.
Based on Tenor
a. Sight Credit: Payment made immediately or on sight is called sight credit. Here
drawing of drafts is not mandatory and the payment can be made by submitting
required documents.
b. Usance Credit: It is also termed as term credit, which requires drafts to be drawn
on the drawee indicating the tenor. These drafts are accepted by the drawee and aid
for at the end of usance period.
Based on Availability Style
a. Revolving Credit: Revolving credit is the credit available to the beneficiary and
can be reinstated to the original amount on drawing. The amount taken revolves
according to time and value. On account of revolving credit’s inclination to lose
the credit amount, a banker should always be careful opening such credits.
33
b. Installment Credit: Under this credit, full value of goods can be shipped in
installments as per time periods specified. The exporter should be conversant with
article 41 of UCPDC guidelines while using installment credit.
c. Deferred Credit: Deferred credit is useful when a buyer of goods, following
verification of goods or assessment of goods value considering quality, shortages,
etc., pays for a portion of such goods. This credit is called deferred credit because
of its deferred payment date of undrawn balance.
d. Transit Credit: A bank which is not located in beneficiary’s country but located
in some other country will advise while opening an LC. Such a situation may arise
when the bank opening the LC lacks correspondence with any bank situated in the
beneficiary’s country. Sometimes transit credit can be opened by other countries
when the beneficiary country is not willing to accept the same.
e. Reimbursement Credit: Reimbursement credit implies a credit which is
denominated in the currency of a third country other than the applicant’s country
or beneficiary’s country. In certain situations, in case of credits, a
paying/accepting/negotiating bank is reimbursed in a manner other than by debit to
the Vostro Account of the opening bank or by credit to the Nostro Account of the
paying/accepting/negotiating bank which is held with opening bank. Such credits
are also referred as reimbursement credits.
f. Anticipatory Credit: When amount is paid to the exporter at pre-shipment stage
expecting export of goods and bills submission at a later date, then such credit is
called anticipatory credit. This credit may be ‘Red clause credit’ or ‘Green clause
credit’. When advance payment is made to the beneficiary for purchasing raw
materials or processing or packing of goods, it is known as Red clause credit.
Green clause credit provides credit towards advance payment of warehousing and
insurance at the port where goods are stored awaiting availability of ship or
shipping space in addition to purpose mentioned under red clause credit. Today,
these two types of credits are considered outdated and are used only occasionally.
Others
a. Standby Letter of Credit: Under standby letter of credit, credit is extended when
a party’s nonperformance of agreement is certified. This type of credit is available
mostly in countries like USA where financial guarantees are not permitted by law.
b. Transferable Credit: A credit which can be transferred only once from the first
beneficiary to second beneficiary is called transferable credit. Further, it is not
possible to transfer the same credit to a third beneficiary by the second beneficiary.
The terms and conditions of transferable credit resemble the original credit
excluding the credit amount, unit prices, insurance percentage terms, period of
validity and shipment.
c. Back-to-Back Credit: A credit which is opened against the security of main credit
by the first beneficiary is called Back-to Back credit. By such an act, the first
beneficiary can reimburse by submitting documents collected through back-to-
back credit under the main credit. Back-to-back letter of credit may be required
when the buyer is not agreeing to open a transferable letter of credit or when the
beneficiary is not interested in revealing the supply source to the buyer or when
34
Documentary Credits
the original supplier desires payment against documents for goods but the
beneficiary does not the have the required funds. Bankers consider back-to-back
credit less safer than transferable credit.
18.7 DOCUMENTS UNDER A LETTER OF CREDIT

Documents prepared and submitted by the exporter to the negotiating bank for the
purpose of shipment under Letter of Credit should be free from any defects. Otherwise
the negotiating bank can return the documents to further rectify the mistakes or
altogether refuse to negotiate the documents suggesting to send them on collection basis
or can take any other action. The exporter while submitting the documents should check
whether the documents include commercial invoice, transport document (bill of lading
or seaway bill or airway bill), certificate of inspection, packing list, and insurance
documents and in certain cases a certificate of goods origin also.
Invoice
A commercial invoice is a document referring to contract of sale and purchase and is
prepared by the exporter or importer and contains information regarding the consignor’s
name, consignee’s name, description of goods consigned, name of steamer, date of
transport document, country of origin, price etc. The following are some of the points to
be remembered while making an invoice:
• The invoice should be made in the name of the applicant.
• It should be signed by the maker. Description of goods specified in the

invoice should correspond to the description given in the letter of credit.
Similarly, other conditions like quantity of goods, unit price, delivery terms,
etc. should conform to those stipulated in the Letter of Credit.
• The invoice should be drawn in the same currency of LC unless otherwise

specified.
• The invoice should not include any charges not stipulated in the LC. Also, the
gross value of invoice should not exceed the credit amount.
• Final amount of invoice or the percentage of drawing as permitted in the LC

should correspond with the draft amount.
Bill of Lading
A document issued by the shipping company or its agent, accepting the receipt of goods
for carriage to be sent to the consignee in the similar condition in which they were
received is called bill of lading. A bill of Lading must satisfy certain essential
requirements such as follows:
• Show the name of the carrier and must be issued by a named carrier or his agent.
The bill of lading must also be signed by the named carrier or his agent.
• Bear a distinct number.
• Indicate the date and place of issuance.
• Indicate the name of consignor and consignee.
• Indicate a brief description of goods being carried.
35
A bill of lading should not unless otherwise specified by the terms of the LC:
• Be a chartered party bill of lading.
• Indicate that the carrying vessel is propelled by sail only.
• Be issued by a freight forwarder (unless he himself is acting as a carrier or

agent).
• Indicate that the goods are or will be loaded on “DECK”.
• Be a claused bill of lading.
A bill of lading can (unless otherwise prohibited):
• Bear title such as “combined transport B/L” “combined transport document or

combined transport B/L” or “port to port B/L”.
• Be a short form or blank backed bill of lading.
• Indicate a place of taking incharge different from the port of loading and or place
of final destination as different from the port of discharge.
• Indicate that the goods are carried in containers, pallets, etc.
• Be a FIATA combined transport B/L known as FIATA FBL approved by ICC

issued by the freight forwarder.
• Show clauses such as “shippers load and count” or “said by shipper to contain”
etc. with reference to goods covered by bill of lading
• Show the shipper as the third party other than the beneficiary.
• Be deemed as “clean on board” if it is an on board bill of lading without any

super imposed clauses or notations expressed in declaring the defective
conditions of the goods and or the packagings.
Insurance Document
Insurance is a must in situations where the goods in transit are exposed to serious perils
in order to protect the insured against any risk such as loss or damage of goods arising
from such perils. Insurance document is issued by an insurance company or an
underwriter or their representative such as an agent. This document must be signed by
the issuer and should be dated. It must be mentioned in the same currency as the letter
of credit and it should contain the name of assured along with the details of the goods
insured. The document must be issued for an amount of 110% of CIF/CIP value of
goods unless it is specifically mentioned.
Other Documents
In addition to above documents, a letter of credit may need further documents such as
bill of exchange, pre-shipment inspection certificate, health certificate, shipping
company’s certificate, beneficiary’s declaration, packing list and so on. When these
documents are called under LC various aspects such as certification of the facts in the
documents as required by the LC etc., must be considered carefully.
36
Documentary Credits
18.8 CERTIFICATE OF ORIGIN
Certificate of origin plays a significant role in determining the origin of goods for the
purpose of determining payment methods according to Exchange control Authorities.
The importer of goods calls for a certificate from the exporter of goods mentioning the
origin of goods and the same is duly certified by the Chamber of Commerce or any
other authorized body in his country. All the details in this document must match with
the details in other documents.
a. Based on the mode of Payment, list the types of LCs.
…………………………………………….……………………………………
…………………………………………….……………………………………
…………………………………………….……………………………………
b. Define Certificate of Origin.
…………………………………………….……………………………………
…………………………………………….……………………………………
…………………………………………….……………………………………
18.9 INCOTERMS
In the cross border sales contracts a group of trade terms or incoterms
(an acronym for international commercial terms) are used in order to differentiate the
risks and responsibilities of trading parties involved in the movement of goods between
the parties. The following are the trade terms and their explanation:
EXW Ex Works (... named place)
This implies that the seller of the goods has dispatched the goods if he places the goods
within the reach of the buyer either at the seller’s place or any other place mentioned
such as factory, warehouse etc.
FCA Free Carrier (... named place)
Free Carrier (FCA) implies that the seller’s obligation to dispatch the goods is complete
when he delivers the goods meant for exports into the hands of the person stated by the
buyer at the specified time and place.
FAS Free alongside Ship (... named port of shipment)
Free Alongside Ship means that the seller dispatches the goods when they are disposed
alongside the ship at the specified port.
FOB Free on Board (... named port of shipment)
The seller completes the delivery of goods when the goods cross the ship’s rail at the
specified port.
CFR Cost and Freight (... named port of destination)
Cost and freight implies that the cost and freights involved in the dispatch of goods will
be paid by the seller only. But any loss or damage caused to the goods after the seller
has dispatched the goods and the same has passed the ship’s rail in the port of shipment
will paid by the buyer and not by the seller.
37
CIF Cost, Insurance and Freight (...named port of destination)
Cost, insurance and freight implies that the seller in addition to the cost and freight
payment should also take up the obligation of acquiring marine insurance against
buyer’s risk in the course of transport of goods.
CPT Carriage Paid To (... named place of destination)
Carriage paid to refers to the payment of seller towards freight charges while
transporting the goods to the specified place.
CIP Carriage and Insurance Paid To (... named place of destination)
Carriage and insurance paid to refers to the obligation of the seller to acquire cargo
insurance against buyer’s risk in addition to CPT.
DAF Delivered at Frontier (... named place)
Delivered at Frontier (DAF) implies that the obligation of seller to deliver the goods
kept for export is finished when he delivers the goods to the stated destination but
before crossing the border of the neighboring country.
DES Delivered Ex Ship (... named port of destination)
Delivered Ex Ship (DES) refers to the fulfillment of seller’s obligation in delivering the
goods when they are kept within the reach of the buyer on the ship’s board. But the goods
are not cleared for import at the specified port of destination.
DEQ Delivered Ex Quay (... named port of destination)
Delivered Ex Quay (duty paid) (DEQ) refers to the fulfillment of seller’s obligation in
delivering the goods when they are kept within the reach of the buyer on the quay at the
port of destination cleared for importation.
DDU Delivered Duty Unpaid (... named place of destination)
Delivered Ex Ship (DES) refers to the fulfillment of seller’s minimum obligation in
delivering the goods when they are made available at the place of destination in the
importing country. The costs and risks arising in the course of transportation till the
place of destination, will be borne by the seller only.
DDP Delivered Duty Paid (... named place of destination)
Delivered Duty Paid (DDP) refers to the fulfillment of seller’s maximum obligation in
delivering the goods when they are made available at the place of destination in the
importing country. In this case also, the costs and risks arising in the course of
transportation till the place of destination will be borne by the seller only.
18.10 SUMMARY
Documentary credits or Letter of Credit (LC) is an important technique to settle
international trade payments. It is a settlement of predetermined amount against
applicant.
Important parties to letter of credit are the importer, issuing bank, beneficiary or
exporter, advising bank, confirming bank, nominated bank, and reimbursement bank.
LCs are opened by the buyer’s bank and the exporter is advised through a bank called
advising bank which is situated in the exporter’s country.
38
Documentary Credits
Rights and responsibilities of parties are mentioned in Uniform Customs and Practice
for Documentary Credits and the regulations issued by International Chamber of
Commerce.
Letter of credit is classified into different types based on the scope of cancellation,
mode of payment, tenor, availability style and others such as stand by letter of credit,
transferable credit, and back-to-back credit.
Documents such as commercial invoice, bill of lading, insurance documents are of

utmost importance under LC.
18.11 GLOSSARY
The Advising Bank advises the credit to the beneficiary after verification of its
authenticity.
Back-to-Back Credit is a credit that is opened against the security of another credit
called the main credit or the back-to-back credit.
A Bill of Lading is a document issued by the shipping company or its agent,

acknowledging the receipt of goods for carriage which are deliverable to the consignee
or his assignee in the same condition as they were received.
Certificate of Origin is a certified document detailing the origin of goods used in

foreign commerce.
Incoterms is an acronym for International Commercial Terms which are a series of 13

trade terms used in international sales contracts to clearly divide the risks and
responsibilities of buyers and sellers with regard to the movement of goods between
both parties.
Letter of Credit is an arrangement by means of which a bank (Issuing Bank) acting at

the request of a customer (Applicant), undertakes to pay to a third party (Beneficiary) a
predetermined amount by a given date according to agreed stipulations and against
presentation of stipulated documents.
Nostro Account is a bank’s account with a correspondent bank located in a foreign

country.
In a Stand by LC or Stand by Letter of Credit, the credit is payable upon certification

of a party’s non-performance of the agreement, of course upon adducing evidence to the
effect that payment has indeed been defaulted.
UCPDC is the standardized code of practice issued by the International Chamber of

Commerce in Paris covering Documentary Credits.

• Maurice D. Levi, International Finance.
39
18.13. SUGGESTED ANSWERS
Self-Assignment Question – 1
a. Letter of Credit (LC) implies the settlement of a predetermined amount against
applicant. UCPDC defines a letter of credit as “Any arrangement, however
named or described, whereby a bank (the “Issuing Bank”), acting at the request
and on the instructions of a customer (the “Applicant”) or on its own behalf:
i. Is to make a payment to or to the order of a third party (the “Beneficiary”),
or is to accept and pay bills of exchange (“Draft(s)” drawn by the
Beneficiary).
OR
ii. Authorizes another bank to effect such payment, or to accept and pay
such bills of exchange (Draft(s)).
OR
iii. Authorizes another bank to negotiate against stipulated documents,
provided that the terms and conditions of the credit are complied with.”
b. Rights and Responsibilities of Parties to an LC
According to UCPDC 500 the following are the rights and responsibilities of parties
to LC:
• All parties should deal with documents only. In other words they should
not deal with goods/services, or performances concerning the documents.
• Beneficiary enjoys the right to secure payment after presenting the required
documents under the LC. Similarly shipping the goods as per the LC and
subsequently putting forward the documents in time for negotiation is the
duty of exporter.
• Negotiating Bank: The negotiating bank after verifying the terms and
conditions of the credit should make payment according to LC and put
forward the essential documents to the opening bank. When the
beneficiary receives his payment, reimbursement is made to the
negotiating bank by the opening bank for the payment.
• Opening Bank: Documents received from the negotiating bank should
be examined by opening bank within 7 days and any discrepancy in the
documents must be intimated to the negotiating bank as soon as possible.
• Advising Bank: As per instructions of the opening bank, the advising
bank, should verify the authenticity of the LC and advise the beneficiary
accordingly.
• Confirming Bank: Confirming bank adds its conformity to the LC and
receives reimbursement from the issuing bank in addition to confirmation
charges.
• Applicant to the LC: The buyer or importer must make payment under
LC to the opening bank against release of stipulated documents.
40
Documentary Credits
a. Based on Mode of Payment, the LCs are of the following types:
• Payment Credit: Payment made to the seller after presenting all the
submission of the required documents as per the terms and conditions of
LC is called payment credit.
• Deferred Payment Credit: Payment made according to the due dates
specified in the credit is called deferred payment credit.
• Acceptance Credit: The payment made by the drawee bank as per the
tenor specified by the seller on submitting the bill of exchange is called
acceptance credit.
• Negotiation Credit: While acceptance credit and deferred payment credit
are usance credits, negotiation credit is sometimes sight credit and at others,
usance credit. When freely negotiable negotiation credit occurs at a bank,
which is treated as the nominated bank and the beneficiary can submit his
documents with any bank. But when the negotiable credit is restricted, the
issuing bank nominates some specified banks and the beneficiary can
submit his documents only to these banks.
b. Certificate of origin plays a significant role in determining the origin of goods
for the purpose of determining payment methods according to Exchange control
Authorities. The importer of goods calls for a certificate from the exporter of
goods mentioning the origin of goods and the same is duly certified by the
Chamber of Commerce or any other authorized body in his country. All the
details in this document must match with the details in other documents.

A. Multiple Choices
1. Bills under Letter of Credit with clause ‘restricted for negotiation’ can be
negotiated only by which of the following banks?
a. Nominated Bank.
b. Issuing Bank.
c. Advising Bank.
d. Both (a) and (c) of the above.
2. Documents under letter of credit received by the opening bank should be
scrutinized within _____ days from the date of receipt.
a. 10 days
b. 5 days
c. 3 days
d. 7 days
e. 12 days.
41
3. Insurance document unless specified should be issued for an amount of
___________.
a. 150% of CIF/CIP value of goods
b. 120 % of CIF/CIP value of goods
c 140 % of CIF/CIP value of goods
d. 110% of CIF/CIP value of goods
e. 130% of CIF/CIP value of goods.
4. The name/s of which of the following should be indicated when a bill of lading is
issued as “on board” bill of lading?
a. Exporter.
b. Importer.
c. Carrying Vessel.
5. Which of the following is the most recent version of international commercial

terms revised periodically in accordance to current trading practices?
a. Incoterms 2006.
b. Incoterms 2005.
c. Incoterms 2003.
d. Incoterms 2000.
e. Incoterms 2002.
B. Descriptive
1. How does a letter of credit operate?
2. Explain different types of Letters of credit.
3. Explain various International Commercial terms used in international sales
contracts.
4. ‘Documentary credits are an ideal method of settling international trade
payments.’ Explain.
practice only.
42
UNIT 19 EXPORT FINANCE AND
EXCHANGE CONTROL
REGULATIONS GOVERNING
EXPORTS
Structure
19.1 Introduction
19.2 Objectives
19.3 Incentives Available to Exporters
19.4 Gold Card Scheme for Exporters
19.5 Export Control Regulations Relating to Exports
19.6 Summary
19.7 Glossary
19.1 INTRODUCTION
Exports play a key role in the Indian economy. In order to give a boost to this sector,
various incentives are extended to exporters. Exports help in augmenting the country’s
foreign exchange reserves, besides generating employment. It also gives a boost to the
economic activity in the country ultimately improving the standard of living.
The requirement of finance for an exporter may arise either at the pre-shipment stage or
the post-shipment stage. Timely availability of credit at competitive rates enables an
exporter to produce quality goods and ship it within the delivery schedules prescribed
by the overseas buyer. It simply enhances the credibility of Indian exporters and in the
process increases the share in the market.
19.2 OBJECTIVES
• Get an idea of the incentives available to exporters; and
• Recognize the export control regulations relating to exports.
19.3 INCENTIVES AVAILABLE TO THE EXPORTERS

The Reserve Bank of India has brought out various incentives to boost exports. They are
as follows:
• Export earnings are not fully taxed.
• Exporters can avail finance at concessional rates of interest.
• Exporters are also granted loans against duty draw back entitlements.
• Exporters can retain a certain proportion of export proceeds in foreign currency in
the EEFC account at the rate of 70% in case of 100% E.O.U and 50% in case of
any other person residing in India.
Depending on the phase of export activity, export finance may be either
pre-shipment finance or post-shipment finance.
Pre-shipment Finance
Pre-shipment finance refers to short term funding for inventory and production costs
involved in manufacturing goods being exported. Using this finance the exporters can
procure raw materials, process, manufacture, store in warehouses, and ship the goods
for export. Pre-shipment finance can be further classified into the following:
i. Packing credit.
ii. Advance against incentives receivable from Government covered by ECGC
Guarantee.
iii. Advance against cheques/drafts received as advance payment.
Packing Credit
A loan or advance provided to the exporter to facilitate purchase of raw materials,
processing, packing based on Letter of Credit opened by him in his favor is called
Packing Credit. The Letter of Credit will be kept by the bank and will be later endorsed
specifying that packing credit has been utilized by the exporter.
Eligibility
To obtain pre-shipment finance an exporter must get an importer-exporter code number
from DGFT. A firm should not be listed under caution list/special approval list of RBI
or ECGC. Normally packing credit is provided to exporters who have the export
order/letter of credit in their name. It can also be provided based on the contract
concluded by the exchange of messages between parties. This is later followed by the
opening of LC; and the bank provides the credit depending on the communication.
Information provided includes name of the overseas buyer, dates of shipment, terms of
sale and payments etc. This type of credit is also extended to support manufacturers and
suppliers of goods who do not have LCs in their own name but oders have been placed
on them for supply of goods by an LC holder.
Type of Finance
Packing credit can be either unsecured or secured loan. When the packing credit is
provided in the initial stages of disbursement in the form of insecure loan or clean loan,
it is called extended packing credit. This becomes a secured loan when the exporter
receives a title to the goods.
Quantum of Finance
Quantum of loan provided should not be more than FOB value of goods or domestic
value of goods, which ever is less. Conversely, sometimes packing credit may be
extended even when the domestic cost of goods is higher than the FOB value, provided
the goods are covered by the export incentives of the Government of India and Export
Production Finance Guarantee.
Margin Requirements
The percentage of margin while providing pre-shipment finance by the banks will
depend on the nature of order, commodity, capability of the exporter etc. Margins serve
various purposes such as ensuring the exporter a stake in the business, taking care of the
value of the goods charged to the banker and so on.
44
Period of Finance
Banks determine the period for extending a packing credit taking into consideration
various factors such as the time required by an individual for procuring, manufacturing
or processing and shipping the goods. In case the export documents are not submitted
within 360 days from the date of advance, then the advances will not qualify for
concessive rate of interest. Further, if the goods are not exported within the period
specified, then the banks can charge interest calculated from the first day of advance at a
rate stated for ‘Export Credit Not otherwise Specified’.
Rates of Interest
The RBI fixed following interest rates which were effective till 31.10.2003.
Pre-shipment Credit (From the date of advance) Current Rate
a. i. Up to 180 Days Not exceeding BPLR minus
2.5 percentage points
ii. Beyond 180 days and up to 360 days Free
b. Against incentives receivable from government Not exceeding PLR minus
covered by ECGC guarantee (up to 90 days) 2.5 percentage points
Table 1
Note:
Free: The banks are free to determine rates of interest subject to BPLR and spread
guidelines.
Liquidation of Packing Credit
All the packing credit advances are liquidated from the funds received by the exporter
from the following sources either individually or as a combination.
• Proceeds of bill drawn for the exported commodities on its purchase, discounts, etc.
• Balances in Exchange Earners’ Foreign Currency A/C (EEFC A/C) and from
rupee resources of the exporter to the extent exports have actually taken place can
also be used to repay/prepay the advance.
If a particular advance is not liquidated then it will not qualify for concessional rate of
interest.
Substitution of Contracts
Sometimes even after the exporter utilizes the packing credit, the export order is not
executed either because of cancellation or some other reason beyond his control. In such
case the bank adjusts the packing credit used for the proceeds of some other export
order if the authorized dealer is happy with the commercial need for such a switch-over.
Pre-shipment Credit in Foreign Currency (PCFC)
This scheme provides pre-shipment credit to Indian exporters with regard to cash
exports at internationally competitive interest rates.
The exporter has the following options while using this export finance:
• Pre-shipment credit in rupees and the post-shipment credit either in rupees or
discounting/rediscounting of export bills under EBR Scheme.
• Pre-shipment credit in foreign currency and discount/rediscount of the export bills
in foreign currency under EBR scheme.
• Pre-shipment credit in rupees and then convert drawals into PCFC at the discretion
of the bank.
45
Liquidation of Credit
PCFC can be liquidated from the proceeds of export documents after their submission
for discounting/rediscounting under the EBR Scheme or by the grant of foreign
currency loans (D P bills) subjected to the mutual agreement between the exporters and
the bankers. This can also be repaid/ or prepaid out of balances in Exchange Earners’
Foreign Currency A/C (EEFC A/C), or from rupee resources of the exporter to the
extent exports have really taken place.
Advances against Incentives receivable from Government of India
This type of advance is usually granted at post-shipment stage and sometimes in
exceptional cases, where the value of material to be procured for export exceeds FOB
value of the contract. Taking into consideration the availability of receivables from the
Government of India, these advances are granted for a maximum period of 90 days
exceeding the FOB value.
a. Define (i) Pre-shipment Finance (ii) Post-Shipment Finance.
…………………………………………………….………………..…………
…………………………………………………….………………..…………
…………………………………………………….………………..…………
b. What is packing credit?
…………………………………………………….………………..…………
…………………………………………………….………………..…………
…………………………………………………….………………..…………
Advance Against Duty Drawback

Pre-shipment finance is also provided against duty drawback entitlements that are
provisionally certified by the customs. These loans will be adjusted when the final
assessment is done by the customs which subsequently refunds, the duties. Banks
usually grant duty drawback loans towards post-shipment stage for a period of 90 days
at lower interest rates.
Role of Customs and C & F Agents
Services such as loading and unloading of goods, booking of space, customs clearance
etc., are provided by the freight forwarders on behalf of exporters and as such their
earnings include commissions paid towards these services.
Customs Formalities
The exporter must submit certain documents such as shipping bill in case of export by
sea or air and bill of export in case of export by road in order to receive customs
clearance. The following are the different kinds of shipping bills:
• White shipping bill prepared in triplicate to be submitted for export of duty free
goods.
• Green shipping bill prepared in quadruplicate to be submitted, for export of goods
under which duty drawback is to be claimed.
46
• Yellow shipping bill in triplicate to be submitted for export of dutiable goods.
• Blue shipping bill prepared in seven copies required for exports under the DEPB
scheme.
Other documents necessary for processing a shipping bill are GR forms, AR4 invoice,
inspection certificate, and purchase order of the buyer etc. Initially the customs
appraiser checks the quantity and value of goods in the shipping bill with that
mentioned in the LC or purchase order. He also checks whether the formalities such as
exchange control regulations, pre-shipment inspection etc., have been compiled with or
not. On completion of verification all the documents excluding the original GR form,
the original shipping bill and a copy of the commercial invoice are given to the
forwarding agent to be submitted to the dock appraiser. The customs department
submits the original GR form to the Reserve Bank of India. The dock appraiser endorses
on the duplicate copy of the shipping bill “Let Export”. The documents are then
returned to the forwarding agent who in turn submits them to the preventive officer of
the customs department. The customs officer endorses on the duplicate copy of the
shipping bill “Let Ship”. The forwarding agent hands over this duplicate copy to the
agent of the shipping company. Subsequently the captain of the ship carrying the goods
gives a “Mate Receipt” to the Shed Superintendent of the port. The mate receipt is given
to the forwarding agent after the payment of port charges. When the mate receipt is
shown to the preventing officer, he records the certificate of the shipment on all the
copies of the shipping bill, original and duplicate copies of the AR4. Finally the mate
receipt is submitted by the forwarding agent to the shipping company to obtain the bill
of lading. The exporter after shipping the goods must send a shipping advice to the
importer along with major documents such as non-negotiable copy of bill of lading,
invoice etc.
Post-shipment Finance
Post-shipment finance is provided to finance export sale receivables of the exporter. It
can be defined as any loan or advance granted or any other credit provided by an
institution to an exporter from India from the date of extending the credit after shipment
of goods to the date of realization of the export proceeds. Different types of post-
shipment finance are as follows:
• Negotiation/Payment/Acceptance of export documents under letter of credit.
• Purchase/discount of export documents under confirmed orders/export contracts, etc.
• Advances against export bills sent on collection basis.
• Advances against exports on consignment basis.
• Advances against undrawn balance on exports.
• Advances against receivables from the Government of India.
• Advances against retention money relating to exports.
• Advances against approved deemed exports.

47
Eligibility for Post-shipment Finance
Post-shipment finance is provided to the actual exporter or to an exporter in whose
name the export documents are transferred. Finance is also extended to deemed
exporters in the case of deemed exports. In case of cash exports the exporter must
submit documents such as GR form, PP form etc., along with shipping documents for
negotiation.
Quantum
Post-shipment finance is provided up to 100% of invoice value of the goods.
Period of Finance and Interest Rates Applicable
The exporter is provided post-shipment finance either on short-term basis or on long-
term basis depending on the payment terms offered by exporter to the overseas buyer.
On the other hand, interest rate depends on the nature of a bill. A demand bill or a sight
bill is payable immediately on presentation and as such lower interest is charged for a
maximum period of Normal Transit Period (NTP) as per FEDAI rules. If the sight bill is
not paid before the normal transit period, it is treated as an overdue bill and interest is
charged from the due date to 180 days starting from the date of shipment. For the period
exceeding date of shipment, higher rates of interest are charged. In case of usance bill
the terms of payment are mentioned on the bill. Accordingly, the importer is allowed a
grace period for the payment of bill and a concessional rate of interest is applicable up
to the notional due date. Lower interest rates are charged only up to a maximum period
of bill, taking into account the normal transit period fixed by FEDAI. Export bill having
a usance period of more than 90 days is not eligible for concessional rate of interest and
as such the banks can freely determine the rate of interest on such credit. When a usance
bill denominated in foreign currency is purchased and is not paid within 30 days after
normal transit period or even after 30 days of notional due date, then the foreign
currency amount is reversed from export bills. The bank will crystallize any unrealized
foreign currency amount in accordance with the prevailing TT selling rate. The rupee
equivalent amount converted is shown in the advances portfolio of the bank under the
head “Advances against overdue export bills realizable account”.
Rediscounting of Export Bills Abroad
The Reserve Bank of India introduced this scheme on 6th October 1993.
Accordingly, authorized dealers in India and exporters can rediscount their export
bills in the overseas market. For this purpose the exporters must satisfy the
following conditions:
• Exporters should go for direct discount export bills with overseas bank and/or
any other agency only through the branch of an authorized dealer permitted to
do so.
• Export bills should be discounted through designated bank/authorized dealer who
provides the packing credit facility.
Source of Funds
Authorized dealers instead of rediscounting their bills can make use of various foreign
exchange reserves available such as Exchange Earners’ Foreign Currency accounts
(EEFC), Resident Foreign Currency Accounts (RFC), Foreign Currency (Non-Resident)
48
Accounts (Banks) Scheme and Escrow Accounts to discount usance bills and retain
them in their portfolio. In case ofre-discount of bills, the authorized dealers can access the
local market which enables the country to save foreign exchange to the extent of re-
discounting cost. The authorized dealers can arrange a “Bankers’ Acceptance Facility”
(BAF) wherein each authorized dealer can have his own BAF limits fixed with an
overseas bank or a rediscounting or a factoring agency. Rediscounting can occur in any
convertible currency.
Eligibility Criteria
The scheme covers export bills having the usance period of 180 days from the date of
shipment including normal transit period and grace period.
Spread
In case of rediscounting of bills on recourse basis, the rate of interest on rediscounting is
not more than 0.75% over the 6 months LIBOR/EURO. ‘Without recourse’ facility
from overseas under LIBOR or any other facility is difficult to obtain.
Refinance
Under this scheme banks are not eligible for refinance against bills discounted/
rediscounted and as such the bills discounted/rediscounted in foreign currency are shown
separately from the export credit figures reported for drawing export credit refinance.
19.4 GOLD CARD SCHEME FOR EXPORTERS

The Gold Card Scheme was introduced in the Exim policy 2003-04 by the government
in consultation with the RBI. This scheme considers additional benefits to the exporters
based on the record of their performance. The following are some of the salient features
of this scheme:
• A Gold Card may be issued to all eligible exporters including those in the small
and medium sectors who satisfy the laid down conditions.
• Exporters with Gold Card, depending on their track record and creditworthiness,
will be granted better terms of credit including rates of interest than those extended
to other exporters by the banks.
• The charges schedule and fee-structure in respect of services provided by banks to
exporters will be comparatively lower than those provided to other exporters.
• Gold card holders would be given preference while granting packing credit in
foreign currency.
• The cards are given value addition through supplementary services like ATM,
Internet banking, International debit/credit cards as decided by the issuing banks.
19.5 EXPORT CONTROL REGULATIONS RELATING TO

EXPORTS
The various exchange control regulations governing the exports in India are issued and
regulated by the RBI. They are as follows:
Export Declaration Forms
According to FEMA, every individual or a firm involved in exporting business must
submit a declaration giving all the details regarding full value of exported goods in any of
the following declaration forms depending on the mode of export.
49
Mode Form
Exports made otherwise than by post GR form
Export by post PP form
Export of computer software SOFTEX form.
Declared to Customs Offices notified by the Central SDF form
Government which have introduced Electronic Data
Interchange (EDI) system for processing shipping bills.
Importer Exporter Code
An importer-exporter code number issued by DGFT is a must to every person/
firm/company engaged in export business. The export declaration form will be accepted
by the Customs, Post office and Department of Electronics only when this number is
mentioned in the declaration.
Methods of Repatriation of Export Proceeds
i. Foreign Exchange Management (Manner of Receipt & Payment) Regulations,
2000 specifies that the export proceeds of full value of exported goods must be
received through an authorized dealer. When the exporter receives payment
directly in the form of bank draft, pay order, personal cheque etc., the authorized
dealer will handle export documents only if such exporter’s track record is good
and he is convinced that the instrument represents payment for exports.
ii. The exporter can receive the proceeds of goods sold to overseas buyers on their
visits to India either by reimbursement against charge slips signed by the
International Credit Card (ICC) holders (overseas buyers) or as instantaneous
credit to the exporter’s bank account in India wherein the export documents are
handled by the authorized dealers. In the case of exports made outside India, the
payment can be made to the Authorized Dealers through the importer’s credit card.
The reimbursement from the card issuing bank/organization is received in the form
of foreign exchange.
iii. Export proceeds can also be paid from funds held in the Foreign Currency (Non-
resident) account and non-resident Rupee account.
iv. Foreign currency notes/foreign currency traveler cheques can be used by the
buyer, who is on a visit to the country, towards export proceeds.
v. A resident Indian can pay to a resident of Nepal in rupees.
vi. The export proceeds can also be paid in the form of Gems & Jewellery units in
SEZs and EOUs in the form of gold/silver/platinum equal to the value of Jewellery
exported.
Time Limit for Realization of Export Proceeds
Export proceeds must be realized either on the due date of payment or within six
months from the date of shipment whichever is earlier. If the exports are made to Indian
owned warehouses located abroad, then the maximum time period permitted for
realization of export proceeds is 15 months.
Exports under trade Agreement/Rupee Credits
When Government of India provides rupee credits or trade arrangements to the foreign
governments, export of goods is regulated according to rules laid down by the Trade
Control Authority in India and instructions provided by the Reserve Bank. The EXIM
50
bank also provides line of credit to commercial banks and financial institutions in
foreign countries in order to finance exports from India to those countries.
Protection against Transit risks under f.o.b, c & f etc. Contracts
When goods are exported on f.o.b or c&f basis, and an irrevocable letter of credit is not
opened, then, exporters must make sure that the shipment is sufficiently insured to cover all
risks of loss or any damage arising during the course of transit prior to shipment of goods.
Bid Bonds and Other Guarantees against Commodity Exports
Authorized dealers can provide guarantee to the overseas buyers if they are satisfied
with the bonafides of export transaction. The value of the guarantee as a percentage of
the values of the contract must be reasonable and the terms should comply with the
normal practice in the international trade and exchange control regulations.
The authorized dealers can also offer counter guarantees in favor of their branches,
correspondents abroad. The authorized dealer makes the payment due to the non-
resident beneficiaries when the bond/guarantee is invoked. But the same must be
reported to the Reserve Bank if the amount of remittance is more than US dollar 5000
and its equivalent.
Foreign Currency Accounts
Exporters holding a good track record are allowed to open foreign currency accounts with
the bank abroad for crediting export proceeds subject to certain terms and conditions.
A designated branch of the authorized dealer monitors this account. To open an account
the exporter must submit an application on the form EFC to the Exchange Control
department under whose jurisdiction he is functioning.
Counter Trade Arrangements
Reserve bank of India as a voluntary arrangement between the Indian party and the
overseas party permits opening of an escrow account to adjust the value of goods
imported into India against the value of goods exported from India. All these imports
and exports are expressed in international prices in accordance with the Foreign Trade
Policy and Foreign Exchange Management, 1999. Payments will be made on the
balances outstanding to the credit of the account. Any temporary surplus fund will be
held as a short-term deposit for a period of three months in a year and the interest there
of will be paid to the exporter at the applicable rates. There is no overdraft or loans
facility against the funds in the escrow account.
Export of good on Lease, Hire etc.
Goods cannot be sent outside India on lease or hire or as any other arrangement either
by land, sea or air without the permission from the Reserve Bank.
Participation in Trade Fairs Abroad
Any Indian exporter who desires to participate in Trade Fairs being conducted abroad
must submit an application to the Authorized Dealer. After verifying the application, the
authorized dealer will release the required foreign exchange, asking the exporter to
make a proper account of expenditure incurred. Exporters can also maintain a temporary
foreign currency account abroad to deposit the foreign exchange proceeds obtained
from the sale of goods at the trade. This account is closed, when the trade fair comes to
an end and all the proceeds are repatriated to India through normal banking channels in
a period of one month starting from the closing date of the fair. Details regarding the
above transaction must be reported to the RBI.
51
Project Exports and Service Exports
Indian exporters providing deferred payment terms to overseas buyers and those
participating in global tenders for undertaking turnkey/civil construction contracts
abroad must obtain prior approval of the Authorized Dealer, EXIM bank and Working
Group. The regulations with regard to project exports and service exports are given in
the revised Memorandum on Project Exports (PEM).
Export on Elongated Credit Terms
Exporters planning to export goods on elongated credit terms must submit a proposal
containing all the details to the concerned Regional Office of the Reserve Bank. To realize
the export proceeds of exports made on consignment basis, the approval of Authorized
Dealers is required which is provided upto 360 days from the date of shipment.
Shut out Shipments and Short Shipments
In case of short shipment, a GR form must be submitted to the customs department.
The authorized dealer must be informed of any delay in forwarding the notice to the
customs department. A duplicate copy of the GR form and the short shipment notice
must be submitted to RBI. If the shipment is completely shut out and the reshipment of
goods is also delayed, the exporter must submit a notice in duplicate to the Customs
department.
Shipment Lost in Transit
When the shipment for which payment is not yet received is lost in transit, the
Authorized Dealer must make sure that the insurance claim is made as soon as the loss
is known and a duplicate copy of export declaration containing information such as
insured amount of the shipment, name and address of insurance company etc.,
submitted to the RBI. If the claim is to be paid abroad, the Authorized Dealer must
initially collect the amount from his overseas branch or correspondent and then submit a
duplicate copy of the export declaration along with the authentication receipt to the RBI.
Exports by Air – Delivery of Goods only on Payment/Acceptance
In the case of exports made through air-consignments, the exporter must consign the
goods in favor of overseas branch/correspondent of the authorized dealer who forwards
the shipping documents for collection.
Consolidation of Air Cargo

When the air cargo is sent on the basis of consolidation, then the Airline Company’s
Master Airway Bill is provided to the Consolidating Cargo Agent who will in turn issue
his own House Airway Bills (HAWBs) to individual shippers.
Trade Discount
When the documentary bill of exports made through sea or air falls short of the value
declared on the GR form because of the trade discount, the Authorized Dealer accepts it
only when the exporter has declared such trade discount on the GR form at the time of
shipment and the same is accepted by the customers.
52
a. Define post shipment finance and list out different types of post-shipment
finances available in India?
…………………………………………………………………...………………
…………………………………………………………………...………………
…………………………………………………………………...………………
b. Discuss various methods of repatriation of export proceeds in brief.
…………………………………………………………………...………………
…………………………………………………………………...………………
…………………………………………………………………...………………
Advance Payment against Exports
Exporters can get advance payments from the overseas buyers, if the shipments are
monitored by the Authorized Dealer.
Part Drawings
Sometimes exporters do not draw bills for the full invoice value, but leave a certain
amount as undrawn. This will be accepted by the Authorized Dealer, if the following
conditions are satisfied.
• The undrawn balance is in conformity with the normal level of balance in that
particular line of trade, subject to a maximum of 10 percent of the export value and
• The exporter submits a declaration that the balance proceeds will be surrendered to
the AD within the prescribed period for realization.
Consignment Exports
An exporter who is exporting on consignment basis bearing all the risk subsequently
receives the remittance from the agent abroad. The agent/consignee is instructed by the
authorized dealer while forwarding the shipping documents, to deliver them only against
trust receipt to deliver sale proceeds by a specified date within the prescribed period in
order to receive export proceeds.
Deduction of Expenses from Sale Proceeds
Usually the agent deducts the expenses such as landing charges, warehouse rent etc.,
and then remits the net proceeds to the exporter.
Insurance on Consignment Exports
The freight and marine insurance should be arranged in India in the case of exports
made on consignment basis.
Establishment of Overseas Warehouses
Certain Indian organizations can establish warehouses abroad in order to help the Indian
exporters, subject to the following conditions:
• Applicant’s export outstanding does not exceed 5 percent of exports made during
the previous year.
• Applicant has had a minimum export turnover of USD 1,00,000 during the last year.
53
• Period of realization should be as applicable i.e., 180 days for non-status holder
exporters and 12 months for status holder exporters.
• All transactions should be routed through the designated branch of the Authorized
Dealer.
Deduction from Account Sales
Exporters owning overseas warehouses must submit the supporting bills/receipts in

original for deductions in account sales excluding petty items such as postage/cable
charges, stamp duty.
Dispatch of Shipping Documents

Shipping documents received from the exporter must be dispatched to the overseas
branch or correspondents of the Authorized Dealer as soon as possible.
Dispatch of Shipping Documents Direct to the Consignees
The Authorized Dealer can dispatch the shipping documents directly to the consignee or
his agent if advance payment or an irrevocable LC for the total export value is received.
Handing over Negotiable Copy of Bill of Lading to Master of Vessel/Trade
Representative
Reserve Bank permits the Authorized Dealers to deliver a copy of the bill of lading to
the master of the vessel or trade representative with regard to exports to certain
landlocked countries. This can be done only when LC is opened and the documents are
in conformance with the terms of LC.
Reduction in Value
To reduce the amount after the bills are sent for collection, the exporter must submit an
application with complete details to the bank. Subsequently the approval is granted if
certain conditions are satisfied. For example, the reduction in amount must not be more
than 10% of invoice value. Exporters with more than 3 years experience with a good
track record can reduce the amount without any ceiling.
Write-off of Unrealized Export Bills
If the exporter does not receive the outstanding export dues, he can request the
Authorized Dealer with supporting documents to write off the unrealized portion.
This request is approved if certain conditions such as follows are satisfied.
• The amount has been outstanding for one year or more.
• The aggregate amount of write off during a calendar year is not more than 10% of
the total export proceeds realized during the previous calendar year.
• Write off will also be permitted in case:
i. Of insolvency of the overseas buyer and a certificate from the official
liquidator has been obtained to that effect.
ii. It is not possible to trace the buyer over a long period of time and
supporting documentary evidence is provided to that effect.
iii. Others.
• The case is not the subject matter of any civil or criminal suit which is pending.
• The export incentives availed of has been surrendered by the exporter.
54
Change of Buyer/Consignee
When there is change in the buyer to whom the goods have been shipped, prior approval
of RBI is not required if the reduction in the value is not more than 10% and the exports
proceeds are received within the time period of 6 months from the date of shipment.
Extension of Time-Limit
If the exporter does not receive the export proceeds within 6 months but is expecting the
same, and if extension is provided, then he can submit an application to the RBI in the
form ETX along with the required documents for extension of time period. The RBI on
being fully convinced that the exporter is in no way responsible for the delay, allows the
authorized dealer to grant 3 months time where the invoice value of the exports does not
exceed US $ 1,00,000.
Payment of Claims by ECGC
The Authorized Dealer can write off the relative export bills and also delete it from the
XOS statement on receiving the receipt of application from the exporter supported with
documentary evidence from the ECGC confirming the settlement of claim with regard
to the outstanding bills. Such write offs are not eligible for 10 percent limit.
Export of Computer Software
Computer software can be exported either in physical form such as software prepared
on magnetic tapes or non-physical form such as transmissions directly abroad through
dedicated earth stations/satellite links. Procedures with regard to declaration of exports
in physical form are the same as in the case of other exports. On the other hand, export
of non-physical forms must be declared on SOFTEX form. This form consists three
copies marked as original, duplicate and triplicate with identical serial number. This
form is submitted for valuation along with the required documents to the Ministry of
Information Technology, Government of India at the Software Technology Parks of
India (STPIs) or at the Free Trade Zones (FTZs) or Export Processing Zones (EPZs) or
Special Economic Zones (SEZs) in India. After the certification of the form, the original
is sent to the nearest office of Exchange Control Department of RBI on the same day or
next day. The duplicate copy is returned to the exporter and triplicate copy will be retained
by the designated official. When the exporter submits to the authorized dealer, the
duplicate form within 21 days from the certification date for further negotiation or
cancellation, then the Authorized Dealer will keep such copy with himself until the
complete export proceeds are received.
Terms of Payment-Invoicing
• In the case of long duration contracts involving series of transmissions, the exporters
should bill the overseas clients once a month or according to the contract. The last
invoice must be issued within 15 days from the date of contract completion.
• In the case of contracts involving ‘one shot operation’, the invoice must be issued
within 15 days from the date of transmission.
• The exporter must provide SOFTEX form in triplicate to the concerned official
of the Government of India at STPI/EPZ/FTZ/SEZ for valuation/ certification
within 30 days from the date of invoice or the date of last invoice raised in a
month.
55
• The invoices raised on overseas clients will be subjected to valuation of export
value declared on SOFTEX form by the designated official of the Government of
India and a consequent amendment will be made in the invoice value, according to
the necessity.
Remittances Connected with Exporters
Exporters are allowed to retain a part of their export proceeds in a foreign currency
account known as the Exchange Earners Foreign Currency Account with an Authorized
Dealer in India. This account can either be current account, savings account or term
deposit.
Agency Commission
This commission on exports is allowed if certain conditions such as follows are
satisfied.
• The amount of commission must be declared on the export declaration form

(GR/SDF/PP/SOFTEX) and accepted by the customs authorities.
• Payment of Commission is not permitted on exports made by Indian partners with

regard to equity participation in an overseas joint venture/ wholly owned
subsidiary and also in the case of exports under Rupee Credit Route except for tea
& tobacco.
• The relative shipment has already been made.

Overprice
Overprice of exports is prohibited, but some exceptional cases are referred to the RBI
with appropriate reasoning.
Export Claims
When the relative export proceeds are already realized and repatriated into India and at
the same time the exporter is not under the caution list of the Reserve Bank, only then
can the Authorized Dealer remit the export claims.
Dispatch of Goods not involving Foreign Exchange
When exports not involving any foreign exchange as confirmed by the Authorized
Dealer are made, GR/PP forms procedure is waived subject to the following conditions
• Export is made by post parcel or airfreight.
• Authorized Dealer is convinced that the transaction does not involve any foreign
exchange flow and value of shipment is not more than Rs.25,000.
19.6 SUMMARY
Government of India provides different kinds of incentives at concessional interest
rates.
Export finance is provided to exporters in the form of pre-shipment finance or post-
shipment finance depending on the requirement.
56
The most common form of credit supply are packing credit at pre-shipment stage and
discounting of bills at post-shipment stage either in Indian rupees or foreign currency.
Banks are extended loan guarantee facilities by ECGC, to encourage sanctioning of
loans and refinance facilities by Reserve Bank of India.
The Government in consultation with RBI introduced the gold card scheme for
exporters, in order to provide them additional benefits based on the past record of their
performance.
All the organizations/persons involved in the export business must comply with the
rules and regulations that define the mode of conducting exports.
19.7 GLOSSARY
Authorized Dealers are the persons authorized by the RBI to deal in foreign currencies.
Nostro Account is a bank account maintained with a bank located in another country,
in the currency of that country.
Escrow Account is a foreign currency account opened under a counter trade
arrangement.
Counter Trade Arrangement is a voluntary arrangement entered into between an
Indian party and an overseas party, whereby the value of goods imported into India is
adjusted against the value of exports from India.
Export of engineering goods on deferred payment terms and execution of turnkey
projects and civil construction contracts abroad are together called as Project Exports.
19.8 SUGGESTED READINGS/REFERENCE MATERIALS

• Mahajan, M.I. Export Do It Yourself.
• Mahajan, M.I. Export and Import.

a. Pre-shipment Finance
Pre-shipment finance refers to short term funding for inventory and production
costs involved in manufacturing goods being exported. Using this finance the
exporters can procure raw materials, process, manufacture, store in warehouses,
and ship the goods for export. Pre-shipment finance can be further classified into
the following:
i. Packing credit.
ii. Advance against incentives receivable from Government covered by
ECGC Guarantee.
iii. Advance against cheques/drafts received as advance payment.
57
b. Packing Credit
A loan or advance provided to the exporter to facilitate purchase of raw
materials, processing, packing based on Letter of Credit opened by him in his
favor is called Packing Credit. The Letter of Credit will be kept by the bank and
will be later endorsed specifying that packing credit has been utilized by the
exporter.
a. Define post shipment finance and list out different types of post-shipment
finances available in India?
Post-shipment finance is provided to finance export sale receivables of the
exporter. It can be defined as any loan or advance granted or any other credit
provided by an institution to an exporter from India from the date of extending
the credit after shipment of goods to the date of realization of the export
proceeds. Different types of post-shipment finance are as follows:
• Negotiation/Payment/Acceptance of export documents under letter of
credit.
• Purchase/discount of export documents under confirmed orders/export
contracts, etc.
• Advances against export bills sent on collection basis.
• Advances against exports on consignment basis.
• Advances against undrawn balance on exports.
• Advances against receivables from the Government of India.
• Advances against retention money relating to exports.
• Advances against approved deemed exports.
• Methods of Repatriation of Export Proceeds
b. List various methods of repatriation of export proceeds briefly.
i. Foreign Exchange Management (Manner of Receipt & Payment)
Regulations, 2000 specifies that the export proceeds of full value of
exported goods must be received through an authorized dealer. When the
exporter receives payment directly in the form of bank draft, pay order,
personal cheque etc., the authorized dealer will handle export documents
only if such exporter’s track record is good and he is convinced that the
instrument represents payment for exports.
ii. The exporter can receive the proceeds of goods sold to overseas buyers on
their visits to India either by reimbursement against charge slips signed by
the International Credit Card (ICC) holders (overseas buyers) or as
instantaneous credit to the exporter’s bank account in India wherein the
export documents are handled by the authorized dealers. In the case of
exports made outside India, the payment can be made to the Authorized
Dealers through the importer’s credit card. The reimbursement from the
card issuing bank/organization is received in the form of foreign
exchange.
iii. Export proceeds can also be paid from funds held in the Foreign Currency
(Non-resident) account and non-resident Rupee account.
58
iv. Foreign currency notes/foreign currency traveler cheques can be used by
the buyer, who is on a visit to the country, towards export proceeds.
v. A resident Indian can pay to a resident of Nepal in rupees.
vi. The export proceeds can also be paid in the form of Gems & Jewellery
units in SEZs and EOUs in the form of gold/silver/platinum equal to the
value of Jewellery exported.

A. Multiple Choices
1. Which of the following is a pre-shipment finance?
a. Advance against cheques
b. Packing credit
c. Advance against incentives receivable from government
d. All of the above
e. None of the above
2. The transit period determined by FEDAI is called _______________.
a. Nominal transit period
b. Notional transit period
c. Normal transit period
d. Negotiated period
e. Named transit period
3. Which of the following is not a export declaration Form?
a. GR form
b. PP form
c. QQ form
d. SDF form
e. SOFTEX form
4. Who issues the Importer-Exporter code number?
a. DGFT
b. ECGC
c. ICC
d. RBI
e. FEMA
5. SOFTEX form with regard to computer software must be submitted to which of
the following?
a. STPIs
b. FTZs
c. EPZs
d. SEZs
e. All of the above
59
B. Descriptive
1. Explain about Pre-shipment Finance and Post-shipment Finance provided to the
exporters.
2. Discuss in detail Gold Card scheme for exporters.
3. Explain various export control regulations with regard to exports.
practice only.
60
UNIT 20 IMPORT FINANCE AND
EXCHANGE REGULATIONS
RELATING TO IMPORT
FINANCE
Structure
20.1 Introduction
20.2 Objectives
20.3 Financing Imports
20.4 Prerequisites for Opening an Import Letter of Credit
20.5 Customs Procedure for Clearance of Imports into India
20.6 Exchange Control Regulations Governing Imports
20.7 Summary
20.8 Glossary
20.1 INTRODUCTION
In India, imports are controlled and regulated through import finance and its exchange
regulations in accordance with the Foreign Trade (Development and Regulation) Act,
1992. As a general rule, any credit facility extended to an importer is basically appraised
like any other domestic credit proposal, to ascertain that the business has scope to
generate cash flows that are sufficient to service the debt besides leaving a reasonable
profit with the borrowers. In addition to these normal credit appraisal techniques, banks
are expected to assess the loan requirement for compliance with trade and exchange
regulations that are applicable to the respective import activity.
20.2 OBJECTIVES
• Identify various methods of financing imports;
• Recognize the prerequisites for opening an import Letter of Credit;
• Understand the ustoms procedure for clearance of imports into India; and,
• Comprehend the exchange control regulations governing imports.
20.3 FINANCING IMPORTS

Under import financing, banks lend financial assistance for activities involving import
of plant and machinery, consumable inputs, channelized goods, opening of import letter
of credit, issuing deferred payment guarantees, assisting overseas seller in the interest of
the importer based on long-term credit. Banks also provide import finance through
different modes such as cash credit, loans against import trust receipt and direct
payment in foreign exchange to overseas sellers.
20.4 PREREQUISITES FOR OPENING AN IMPORT LETTER OF
CREDIT
An importer’s appeal to open a letter of credit is carefully examined by a bank with
regard to trade control requirements, exchange control requirements, credit norms of
RBI, UCPDC provisions and FEDAI and lastly, internal procedures of the bank.
A bank in accordance with exchange control guidelines can permit opening of letters of
credit by its own customers who are engaged in the trade. To open a letter of credit the
importer must submit an application-cum-agreement in the desired form to the bank. He
must also attach required documents such as exchange control copy of the import
license, pro-forma invoice, sale contract between importer and exporter and so on.
At the time of submission, the importer must carefully check all the procedural
formalities like terms and conditions mentioned, authorized signature at all the required
places on the form, validity of contract etc. On the other hand, to ensure the
creditworthiness of the importer, banks secure certain information such as possession of
importer exporter code by the importer, validity of import license and other information.
An import letter of credit should be in compliance with exchange control aspects. For
this purpose, the importer should have good knowledge about various exchange control
aspects. For example, any imports on cash basis remittance should be concluded with in
six months from the shipment date. When the bank is satisfied from all the corners, it
opens a letter of credit against the supplier of goods.
20.5 CUSTOMS PROCEDURE FOR CLEARANCE OF IMPORTS

INTO INDIA
The importer should present an import manifest to the customs department within 24
hours of the goods being dispatched. The manifest must contain information of all the
goods that are placed on board of vessel. The importer on receiving the information of
advent of goods must file a bill of entry in the desired form with the department of
imports under the customs house. Here, the submission date of the bill of entry is of
vital importance because the goods will be assessed as duty based on the rate prevailing
on the date of submission. After the bill of entry is noted by the imports department, it is
submitted at appraising counters along with documents such as import license,
certificate of origin, copy of letter of credit, exporter’s invoice, weight specifications,
double copy of packing list, customs declaration etc. The appraiser after verifying and
completing the bill of entry will get it countersigned by the Assistant Controller. Then
the bill is sent to the license department with a notification to dock the staff for scrutiny
of goods prior to clearance.
The appraising procedure for bill of entry may be the first check procedure or second
check procedure. In the first check procedure, after the preliminary examination of
documents presented, the appraiser returns the bill of entry ordering for scrutiny of
goods before the duty is assessed. In the second procedure, after the duty payment, the
importer or his representative must acquire the duplicate of bill of entry from the
customs department according to which the order for the scrutiny of goods is issued.
62
a. What is import financing?
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
b. List out the prerequisites for opening an import letter of credit.
…………………………………………………………………………………...
…………………………………………………………………………………...
…………………………………………………………………………………...
20.6 EXCHANGE CONTROL REGULATIONS GOVERNING

IMPORTS
Imports are regulated by following exchange control regulations in India:
Payment of Imports under Foreign Loans/Credits Arranged by Government of
India from Foreign Governments Institutions
When there is a necessity to import some goods in case of adverse balance of payments,
the government/RBI will acquire a line of credit from the Central Bank situated in
overseas supplier country. Payment will be made through letter of commitment method
or reimbursement method.
If the payment is through the former method, then the amount is paid directly by the
loan agency to the supplier of goods. Payment must be made in Indian rupees only to
the Government of India.
If reimbursement method is followed then the payment is initially made by the
government/RBI and is later reimbursed by the central bank of overseas supplier.
Advance Remittance
Advance remittance for imported goods is allowed by authorized dealers in case
certain conditions are satisfied, such as physical import of goods with in a period of 6
months into India from the remittance date and submission of documentary evidence
of import by the importer within a period of fifteen days with the conclusion of
relevant period.
Import Payment only on Behalf of Residents in India
Authorized Dealers can sell foreign exchange for the purpose of import payment only to
persons residing in India excluding Nepal and Bhutan.
Delivery of Import Document
Import documents received by the Authorized dealers can be sold to drawees of the bills
or actual importers or holders of letter of authority.
Time Limit for Settlement of Import Payments
Generally remittances against imports are to be completed within 6 month from the
shipment date. But importers are allowed to hold back a minor part of cost of goods for
the sake of performance guarantee etc. Authorized dealers sometimes permit payment
63
exceeding 6 month time period from the shipment date if the delay is due to disputes,
financial problems etc. A remittance against import of books is permitted without any
time limit if the prevailing interest is paid in accordance with rates mentioned in the
Master Circular on trade credits.
Payment of Commission on Imports
Commission of overseas supplier’s agent in India must be paid in Indian rupees in India
only. Authorized dealers, based on the application supported by the relevant documents
can also permit remittance of commission to the overseas buying agent of Indian
importer at rates not beyond 2.5% of the F.O.B value of goods along with or without
the cost of goods.
Payment of Interest on Imports
Authorized dealers are permitted to provide remittances based on interest accrued on
usance bills or any overdue interest to be paid on slight bills within a period of six
months from the shipment date according to the interest rates given in the Master
Circular on trade credits.
Application Forms for Remittances Connected with Imports
Applications regarding import remittances not excluding advance remittances should be
presented in Form A1 prescribed by RBI. It is available in three colors for different
types of remittances as follows:
• Remittance in foreign currency printed on white paper.
• Remittance by transfer of rupees to non-resident bank accounts printed on light
blue paper.
• Remittance through Asian Clearing Union printed on light yellow paper.
Form A2 can be used for the following payments:
• Import payments related to merchanting trade transactions.
• Payment to be made for import of technical services/collaboration or any other
kind of service.
• Overseas bank charges of import transactions in case remittance is provided
separately.
• Installments and interest based on short-term foreign currency loans/credit with
maturities not exceeding one year and loans obtained by export oriented units on
self liquidation basis.
• Repayment of loan/credit and payment of other charges which need RBI approval
for remittance.
Endorsement on Import Licenses
Import licenses should be endorsed by the authorized dealers with their stamp and
signature providing all the information regarding letters of credit opened/ forwarded
contract booked remittances made in foreign currency etc.
Manner of Rupee Payment
Payment of import bills by the importer should be received by authorized dealers either
by a debit to the importers account with themselves or by means of a crossed cheque
drawn by the importer on his other banks. In no case should payments against import
bills be accepted in cash.
64
Letters of Authority
When Exchange Control (EC) copy of the import license has been issued in favor of an
other party but not the applicant, the authorized dealers can open letters of credit or
provide remittances if that party has produced a letter of authority in his name from the
import license holder authorizing him to open a letter of credit or pay towards import.
Attestation of Invoices
A copy of invoice attested by the authorized dealer has to be submitted by the importer
as corroboratory evidence of the value of goods which are shown on the bill of entry
during clearance of goods.
Imports under Penalty
Authorized dealers allow remittance when the goods are imported in the absence of
authority but are cleared by customs department on paying the penalty.
Imports into Bond
Imports into bond which serve the purpose of re-export, do not require import license.
Any sale of foreign exchange against the imports is also not permitted.
Remittances against Replacement Imports
The following steps are to be followed when the goods are found to be short-supplied,
damaged, short-landed or lost in transit:
• In the absence of letter of credit, the Exchange Control (EC) copy of the import
license must be considered appropriate in replacing goods provided they are
shipped within the time period.
• If the authorized dealer opens a letter of credit and the exchange control copy is
already used against original goods, a case endorsement can be done by canceling
the value of goods lost and a fresh remittance to replace imports can be made
without informing the RBI.
• In case goods to be replaced are being shipped at a date later than the expiry of
license, the importer has to apply to import trade control authorities for the sake of
revalidation of license.
Surrender of Import Licenses to Exchange Control

With the opening of letter of credit, the exchange control copy of import license must be
kept by the authorized dealer and it must be forwarded to the Reserve Bank when it is
fully used along with R-Returns.
Import under Foreign Loans/Credits

A preposition to obtain foreign loans or credits for financing import of goods into India
must be initially presented to the Government of India, Ministry of Finance, ECB
Division, New Delhi for the approval. After receiving the application to borrow, the
importer must submit the application in the Form ECB1 to the office of the Reserve
Bank of India. Ultimately when the importer receives the approval from the RBI, the
credit agreement is complete. When the necessary formalities are complete the importer
can get the permission from RBI to draw the loan amount.
65
Sub Loans out of Lines of Credit/Loans obtained by Term Lending Institutions
Institutions such as IDBI, ICICI and IFCI permit RBI to sign agreements with Indian
sub borrowers and to receive personal guarantees of directors, promoters etc. in the
form of collateral/interim security.
Postal Imports
When bills are received through the postal service, the payments will be made by the
authorized dealer only if those imports can be usually imported through the postal
service.
Imports through Courier
Goods can be imported through courier in accordance with Courier Imports (Clearance)
Amendment Regulations, 1997. When the C.I.F value of the imported goods through
courier is less than Rs.1,00,000 the bill of entry must be submitted by the registered
courier service. If the value exceeds Rs.1,00,000 then a separate bill of entry must be
submitted for other imports.
Merchanting Trade
According to exchange control regulations of merchanting trade, goods can be imported
into India provided such transaction does not raise any foreign exchange outlay from
India for a transit period of more than three months. The rules and regulations regarding
exports are in accordance with export leg while those of imports are in accordance with
import leg of merchanting trade transactions.
Advance Remittances to Overseas Suppliers
Authorized dealers allow advance remittances to overseas suppliers in case the
exporters receive confirmed orders from the overseas buyers. If the advance remittance
is more than US 15000 dollars, a guarantee from a reputed international bank situated
outside India must be provided by the overseas seller.
Forward Exchange Contracts for Imports
Authorized dealers sometimes book forward contracts for imports in accordance with
certain regulations to provide for the exchange risks experienced by the importers. Such
contracts can be booked only for residents in India and for genuine transactions involving
exchange risk. The value of forward contract must not exceed the value of goods contracted
by the importer or the value of LC opened by the authorized dealer. The last date for
delivery of forward contract must not exceed 6 months from the date of
shipment/anticipated shipment date. The sale of contract must be properly verified by the
authorized dealer while booking the forward contract. Any cancellation of the forward
contract by the authorized dealers need not be notified to the Reserve Bank of India.
Follow-up for Submission of Evidence of Import Bill of Entry
According to exchange control regulations, an exchange control copy of bill of entry or
post wrapper to the authorized dealer must be presented by the importer without
exceeding a time period of 3 months from the remittance date. This acts as evidence in
proving that the goods have been actually imported into the country. After scrutinizing
the details of Exchange Control Copy against the details submitted by the importer at
the time of remittance, the authorized dealer must enter the same in the Bills Register.
The authorized dealer after receiving the exchange control copy must provide an
66
acknowledgement containing details such as name, address of the importer, code
number of the importer etc. If the exchange control copy is not submitted within 3
months from the date of remittance, then a reminder must be sent to the importer for
immediate submission of the copy. If the importer does not comply then a second
reminder must be sent. If he does not respond to this reminder also, then, the matter
must be notified to the RBI within 21 days from the date of issue.
Legal Expenses for Imports
When all the required documents are submitted by the clients, the authorized dealers
can pay the legal expenses connected to imports. If the payments are more than
1,00,000 US dollars, full details regarding the payment must be submitted on a quarterly
basis to the RBI.
20.7 SUMMARY
Banks play a significant role in providing import finance according to exchange control
guidelines.
An importer’s request to open a letter of credit is carefully examined by a bank in terms
of trade control requirements, exchange control requirements, credit norms of RBI,
UCPDC provisions and FEDAI and lastly internal procedures of bank.
Along with the application the importer must attach required documents such as
exchange control copy of the import license, pro forma invoice, sale contract between
importer and exporter etc.
The person responsible for conveyance of imported goods should present an import
manifest to the customs department within 24 hours of conveyance approach.
The importer on receiving the information of advent of goods must file a bill of entry in
the desired form with the department of imports under customs house.
Imports are regulated by various exchange control regulations in India.
20.8 GLOSSARY
Export License is a permit required to export commodities falling in the negative list.
The Foreign Exchange Dealers’ Association of India (FEDAI) is the

self-regulatory body for the Authorized Dealers in foreign exchange.
Import License is a license required and issued by the DGFT authorizing the entry of
foreign goods into the country.
Importer Exporter Code is a code number issued by the Director General of Foreign
Trade (DGFT) which is required to be indicated on export declaration forms submitted
by the exporter.

• Mahajan, M.I. Import Do It Yourself.
• Mahajan, M.I. Export and Import.
67
a. Under import financing, banks lend financial assistance for activities involving
import of plant and machinery, consumable inputs, channelized goods, opening
of import letter of credit, issuing deferred payment guarantees, assisting
overseas seller in the interest of the importer based on long-term credit. Banks
also provide import finance through different modes such as cash credit, loans
against import trust receipt and direct payment in foreign exchange to overseas
sellers.
b. An importer’s appeal to open a letter of credit is carefully examined by a bank
with regard to trade control requirements, exchange control requirements, credit
norms of RBI, UCPDC provisions and FEDAI and lastly, internal procedures of
the bank. A bank in accordance with exchange control guidelines can permit
opening of letters of credit by its own customers who are engaged in the trade.
To open a letter of credit the importer must submit an application-cum-
agreement in the desired form to the bank.
He must also attach required documents such as exchange control copy of the
import license, pro-forma invoice, sale contract between importer and exporter
and so on. At the time of submission, the importer must carefully check all the
procedural formalities like terms and conditions mentioned, authorized signature
at all the required places on the form, validity of contract etc.
On the other hand, to ensure the creditworthiness of the importer, banks secure
certain information such as possession of importer exporter code by the importer,
validity of import license and other information.
An import letter of credit should be in compliance with exchange control
aspects. For this purpose, the importer should have good knowledge about
various exchange control aspects. For example, any imports on cash basis
remittance should be concluded with in six months from the shipment date.
When the bank is satisfied from all the corners, it opens a letter of credit against
the supplier of goods.

A. Multiple Choices
1. Which of the following is allotted by the Director General of Foreign Trade?
a. Import License.
b. Export License.
c. Import-Export Code.
d. Import Letter of Credit.
68
2. Which of the following places restriction on purchase and sale of foreign
currency?
a. RBI.
b. FEMA.
c. Customs.
d. DGFT.
e. FEDAI.
3. Which of the following forms should be used for remittance through Asian
Clearing Union?
a. Form A1 printed on gray paper.
b. Form A1 printed on white paper.
c. Form A1 printed on light yellow paper.
d. Form A1 printed on light blue paper.
e. Form A1 printed on light pink paper.
4. Which of the following statements is true regarding Bill of Entry?
a. Bill of Entry should be submitted by the importer to the customs.
b. Clearance of imported goods is effected based on information provided in
Bill of Entry.
c. Bill of entry is a standardized document containing details like importer’s
name and address, description of goods, quantity etc.
d. Bill of Entry is important in assessing the duty based on current rate on
the date of its submission.
e. All of the above
5. Payment towards imports using Form A1 by persons, firms and companies in
India is ______________.
a. Obligatory
b. Not obligatory
c. Sometimes obligatory
d. Both (a) and (b) of the above
B. Descriptive
1. Explain in detail the perquisites for opening an import Letter of Credit.
2. How does customs clearance of imports into India take place?
3. ‘There are various exchange control regulations governing imports into India.’
Explain these regulations in detail.
practice only.
69
NOTES
70

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MBA-0000

Prof. Y. K. Bhushan Dr. O. P. Gupta

Dr. Lata Chakravorty Prof. D. S. Rao

Prof. P. Bala Bhaskaran Dr. Dhananjay Keskar

Course Preparation Team

Shri T. S. Rama Krishna Rao Prof. Hilda Amalraj

Ms. Anita Prof. Bratati Ray

Ms. C. Padmavathi Dr. Vijaya Lakshmi S

Ms. Sudha Dr. Vunyale Narender

Ms. Sunitha Suresh Prof. Arup Chowdhury

© The ICFAI University Press, All rights reserved.

Ref. No. IF SLM – 072011R B1

The ICFAI University Press, Hyderabad

1.3 NEED TO STUDY INTERNATIONAL FINANCE

1.4 MEANING AND IMPLICATIONS OF GLOBALIZATION

1.5 INTEGRATION OF FINANCIAL MARKETS

1.8 SUGGESTED READINGS/REFERENCE MATERIAL

1.9 SUGGESTED ANSWERS

• Why does international trade take place?

2.3 THEORY OF ABSOLUTE ADVANTAGE

2.4 THEORY OF COMPARATIVE ADVANTAGE

2.5 HECKSCHER-OHLIN MODEL

2.6 IMITATION-GAP THEORY

2.7 INTERNATIONAL PRODUCT LIFE CYCLE THEORY

a. Explain in brief the significance of comparative advantage theory.

b. Define ‘demand lag’ and ‘imitation lag’.

2.8 DEVELOPMENTS ON THE INTERNATIONAL TRADE FRONT

2.9 TRADE BARRIERS

When tax is levied on internationally traded goods, it is known as tariff. If it is collected

Reasons for Imposition of Trade Barriers

• It is a source of revenue to the government.

• It improves the economic condition of the country.

• It results in free trade implications.

• It protects the domestic industry that has great growth potential.

• It acts as a retaliator for other countries imposing trade barriers.

• It reduces expenditure in foreign currency by the citizen, to improve balance of

• Increase in cost of foreign goods and shift in domestic demand towards

• Due to higher price consumers consume less of that particular good.

• Tariff generates revenue for the government.

a. Elucidate in brief risks in international trade.

b. Discuss tariff barriers vs. non-tariff barriers.

Simultaneous export and import of a product by a particular country is called intra-

2.12 SUGGESTED READINGS/REFERENCE MATERIAL

2.13 SUGGESTED ANSWERS

3.3 The Role of Exim Bank of India in Trade Finance

3.3.2 Lending to Indian Companies

3.3.3 Lending to Foreign Governments and Foreign Companies

3.3.4 Lending to Indian Banks

3.4 Global Trade Finance Limited

3.5 Exchange Control Regulations Related to Merchant Transactions

3.8 Suggested Readings/Reference Material

3.9 Suggested Answers

3.10 Terminal Questions

3.3 THE ROLE OF EXIM BANK OF INDIA IN TRADE FINANCE

1. Direct Assistance 1. Buyers’ Credit 1. Bill Rediscounting

3.3.2 Lending to Indian Companies

i. Supplies made in India to World Bank/IDA-aided projects against international

ii. Supplies to free-trade zones/100 percent export oriented units.

iii. Sales to foreign shipping companies.

Assistance to Export-Oriented Units

Forfaiting is a common form of financing export related receivables. It is similar to Bill

Figure 1: A Flow Chart of a Forfaiting Transaction

Self Assessment Questions – 1