Expectations Theory of Interest Rates A theory that purports to explain the shape of the yield curve, or the term

structure of interest rates. The forces that determine the shape of the yield curve have been widely debated among academic economists for a number of years. The American economist Irving Fisher advanced the expectations theory of interest rates to explain the shape of the curve. According to this theory, longer-term rates are determined by investor expectations of future short-term rates. In mathematical terms, the theory suggests that: (1 + R2)2 = (1 + R1) x (1 + E(R1)) where R2 R1 E(R1) = = = the rate on two-year securities, the rate on one-year securities, the rate expected on one-year securities one year from now.

The left side of this equation is the amount per dollar invested that the investor would have after two years if he invested in two-year securities. The right side shows the amount he can expect to have after two years if he invests in one-year obligations. Competition is assumed to make the left side equal to the right side. The theory is easily generalized to cover any number of maturity classes. And however many maturity classes there may be, the theory always explains the existence of longerterm rates in terms of expected future shorter-term rates. The expectations theory of interest rates provides the theoretical basis for the use of the yield curve as an analytical tool by economic and financial analysts. For example, an upward-sloping yield curve is explained as an indication that the market expects rising short-term rates in the future. Since rising rates normally occur during economic expansions, an upward-sloping yield curve is a sign that the market expects continued expansion in the level of economic activity. Financial analysts sometimes use this equation to obtain a market-related forecast of future interest rates. It can be rewritten as follows: E(R1) = [(1 + R2)2 / (1 + R1)] - 1 The equation suggests that the short-term rate expected by the market next period can be obtained from knowledge of rates today.

What Is A Cross Rate? In terms of currency trading, a cross rate is stated as the currency exchange rate variance between two foreign currencies. The cross rate only applies to currencies in question that are not of the domestic currency where the currency trading is taking place. For instance if one is currency trading in the U.S. Markets between the Euro and Australian Dollar, that would qualify as a cross rate. To use an example: a currency exchange rate given by a U.S. business news network between the Yen and the British Pound would and is referred to as a cross rate. If that same U.S. business network offered the current rate between the US Dollar and the British Pound, it would not be considered a cross rate. In times past it was commonplace for those to assume any transaction not involving the US Dollar was a cross rate. This however is not true based on the cross rate s definition in currency trading international markets.

Applying Cross Rates In Currency Trading While the knowing the cross rate between any two given currencies is important to the investor trading in currencies, it has other implications as well. These implications can make regular market investors stand up and take notice too. This is because a currency exchange rate between two foreign countries can indicate future market movements on the stock and bonds markets of the world. For instance if the Yen is trading up against the Euro on the Forex market on Monday, it will most likely indicate that the Japanese and other Asian markets are going to be trading higher. For an investor in the United States this can be an early indicator that the US stock markets will also open higher the following day. While the currency exchange rate is not always a solid indicator of stock market performance, it is certainly an important component to monitor. Cross Rate Currency Calculation When stocks are exchanged using different currencies and neither currency is the official currency of the country where the exchange quote is given, a cross rate can be used to facilitate the exchange.

In order to perform a cross rate currency calculation, the following four pieces of information are required.

   

Originating Currency: the three letter currency code the amount is currently in. Amount: a decimal that contains the number of units of originating currency to be converted. Target Currency: the three letter currency code the amount will be converted to. Market Maker: the market maker that is associated with the current company or plan

Hedging with Forwards

Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Historically, the foremost instrument used for exchange rate risk management is the forward contract. Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement would easily eliminate exchange rate risk, but it has some shortcomings, particularly getting a counter party who would agree to fix the future rate for the amount and time period in question may not be easy. In Malaysia many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course the bank in turn may have to do some kind of arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because there exists no formal trading facilities, building or even regulating body.

An Example of Hedging Using Forward Agreement Assume that a Malaysian construction company, Bumiways just won a contract to build a stretch of road in India. The contract is signed for 10,000,000 Rupees and would be paid for after the completion of the work. This amount is consistent with Bumiways minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per Rupee. However, since the exchange rate could fluctuate and end with a possible depreciation of Rupees, Bumiways enters into a forward agreement with First State Bank of India to fix the exchange rate at RM0.10 per Rupee. The forward contract is a legal agreement, and therefore constitutes an obligation on both sides. The First State Bank may have to find a counter party for this transaction either a party who wants to hedge against the appreciation of 10,000,000 Rupees expiring at the same time or a party that wishes to speculate on an upward trend in Rupees. If the bank itself plays the counter party, then the risk would be borne by the bank itself. The existence of speculators may be necessary to play the counter party position. By entering into a forward contract Bumiways is guaranteed of an exchange rate of RM0.10 per Rupee in the future irrespective of what happens to the spot Rupee exchange rate. If Rupee were to actually depreciate, Bumiways would be protected. However, if it were to appreciate, then Bumiways would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Bumiways proceeds with the hedging since it knows an exchange rate of RM0.10 per Rupee is consistent with a profitable venture.

Arbitrage
Arbitrage (sometimes called risk arbitrage or merger arbitrage) is a special type of investment operation that is meant to generate profit with little or no risk. By taking advantage of special situations that arise in the security markets from time to time, an investor can exploit price discrepancies created by special situations, increasing his net worth regardless of whether the market itself advances. This article discusses two of the more common arbitrage operations - those arising from mergers and liquidations as well as the formula necessary to value the potential return on capital employed.

Corporate Mergers and Acquisitions When a publicly traded company is acquired, the acquiring entity makes a tender offer to the current shareholders inviting them to sell their stock at a price usually above the quoted price on theexchanges or over-the-counter market. As soon as the tender offer is announced, arbitragers will rush in and purchase the security on the open market then turn around and sell it directly to the acquiring company for the higher price. A Fictional Example of Risk Arbitrage in Mergers and Acquisitions Acme Industries, Inc. decides to acquire one hundred percent of Smith Enterprises. Smith s stock trades on the over-the-counter market and is quoted at $15 per share. Acme s management makes a tender offer in the amount of $25 per share. This means that for a few, brief moments, an arbitrager can buy shares of Smith Enterprises for $15 each on the open market, turn around and tender (i.e., sell) them to Acme for $25. Through this operation, the arbitrager has made a quick profit of $10 per share from thespread that existed between the market price and the tender price. It is hardly practical to make a significant profit by attempting to jump into the market the moment a tender offer is announced; very few shares could be acquired before the price had been driven up due to the sudden demand flooding the market from would-be arbitragers. Instead, two methods of risk arbitrage developed which I call pre-emptive and post-tender. In the former type of operation, the arbitrager purchases shares of a company which he believes will be taken over in the coming days or months. If he turns out to be correct, he will fully benefit from the spread between the price he paid and the tender offer. The risk he runs, however, is that a company is not acquired. Since he must rely on rumors and gut feeling to predict which companies will be acquired and for what price, pre-emptive arbitrage is inherently more speculative in nature than its counterpart. As a result, it tends to be far less profitable on the whole. Post-tender arbitrage, however, deals only in situations where a tender offer has already been announced by a potential acquirer. Despite the $25 standing offer Acme has made for the common stock of Smith Enterprise, it may sell for only $24.00 on the market (the reason for this discrepancy is too complicated and time consuming to be of value to the average investor). This difference of $1.00 per share may seem small; looks can be deceiving. Due to the short amount of time the investment is held, the indicated annual return on such a commitment is remarkably high. Graham s Indicated Annual Return Formula for Risk Arbitrage

To calculate the value of a potential arbitrage commitment, Benjamin Graham, the father of value investing created the following formula, which he discussed in length in the 1951 edition of Security Analysis; its creation was heavily influenced by Meyer H. Weinstein s classic 1931 book, Arbitrage in Securities (Harper Brothers). Indicated annual return = [GC L (100% - C)] YP Let G be the expected gain in points in the event of success; L be the expected loss in points in the event of failure; C be the expected chance of success, expressed as a percentage; Y be the expected time of holding, in years; P be the current price of the security Graham's formula can be used to evaluate the potential return on the risk arbitrage operation in the Acme and Smith merger. The expected gain in the event of success is $1.00 (the spread between the $24.00 quoted price on the open market and the $25 Acme tender offer). If the merger fails to occur, the Smith stock may fall to its pre-tender offer of $15 per share (in many cases, history has proven otherwise; once a company is in play as a takeover target, its stock may remain inflated in anticipation of another acquirer materializing. We shall disregard this possibility for the sake of conservatism). Hence, the expected loss in points in the event of failure is $9. Assume there are no antitrust concerns, so the likelihood of consummation is 95%. Also assume the investor expects to hold his shares for one month (1/12 or 8.33% of a year) until the transaction is complete. The current price of the security is $15 per share. Plugging these into Graham s formula, the investor gets the following: Indicated annual return = [1 x .95 9 (1.00 - .95)] .0833 x 24 Indicated annual return = [.95 .45] 2 Indicated annual return = 25% In other words, had the investor been able to earn the same return on his capital for the entire year as he did during the holding period of this investment, he would have earned twenty five percent. In a world where the historic annual return on long-term equities has hovered around twelve percent, this is mouth watering. Liquidations From time to time, corporations will liquidate their operations in whole or part. As the liquidation unfolds, the funds are paid out to the shareholders. An investor that feels he can reasonably estimate the eventual proceeds from the liquidation process can evaluated the potential arbitrage operation with Graham s formula just as easily as opportunities arising from acquisitions and mergers. There is empirical evidence suggesting that these types of risk arbitrage operations are particularly profitable. According to Christopher Ma, William Dukes and R. Daniel Pace in Why Rock the Boat? The Case of Voluntary Liquidation (The Journal of Investing, Summer 1997, p. 71), A 1997 study of voluntary liquidations between 1961 and 1985 found that the average annual return for investment in securities

from the date of their liquidation announcement until their final liquidating distribution was 44.4%. On average, the liquidation securities substantially outperformed the general market, shareholders recouped their initial investment within one year and the liquidation process was completed in just over two years. Capstone On the whole, risk arbitrage can been a source of steady and dependable profits over long periods of time. Market conditions, however, will make these operations more or less scarce and more or less attractive. It is the responsibility of the investor to exercise sound judgment and decide at what time and in what amount he is willing to engage in these types of operations. Many institutional investors set aside a portion of their portfolio (ten or twenty percent, for example) that is dedicated to arbitrage commitments, special opportunities, liquidations and other specialized investing practices.

The Optimum Pricing Model

Profit analysis. Microeconomic theory suggests that as output increases, the marginal cost (MC) per unit might rise (due to the low of diminishing returns) and whenever the firm is faced with a downward sloping demand curve, the marginal revenue (MR) per unit will decline. Eventually, a level of output will be reached where the extra cost of marking one extra unit of output is greater than the extra revenue obtained from its sale. It would then be unprofitable to make and sell that extra unit. Profits will continue to be maximized only up to the output level where (mc) has risen to be exactly equal to MR. Profit are maximized at the point where MC = MR, at a volume of Qn units. If we add a demand or average revenue curve to the graph we can see that an output level of qn, the sales price per unit would be pn. Deriving demand curve When there is a linear relationship between demand and price, the equation for the demand curve is P = a - BQ / Q Where p = the price Q = the quantity demanded A = the price at which demand would be nil B = the amount by which the price changes for each stepped change in demand Q = the stepped change in demand A=(current price)+(current quantity at current price/charge in quantity when price in charged by$)X$B The demand function above shows how price (P) varies with quentity (Q).Alternatively you can always rearrange the equation to show how the quantity sold varies with the price chargeed. Optimum pricing in practice .

The approach of optimal pricing with its prediction of a single predictable equilibrium price is important in economics. However in practice organizations rarely use the technique. The problems in applying optimal pricing occur for the following reasons.

It assumes that the demand curve and total costs can be identified with certainty. This is unlikely to be so. It ignores the market research costs associated with acquiring knowledge of demand. It assumes the firm has no productive constraint which could mean that the equilibrium point between supply and demand cannot be reached. It assumes that the organization wishes to maximize profits. In fact it may have other objectives. It assumes that price is the only influence on quantity demanded . we have seen that this is for from the case.

Eurocurrency Market.
A Eurocurrency Market is a money market that provides banking services to a variety of customers by using foreign currencies located outside of the domestic marketplace. The concept does not have anything to do with the European Union or the banks associated with the member countries, although the origins of the concept are heavily derived from the region. Instead, the Eurocurrency Market represents any deposit of foreign currencies into a domestic bank. For example, if Japanese yen is deposited into a bank in the United States, it is considered to be operating under the auspices of the Eurocurrency Market. The Eurocurrency Market has its roots in the World War II era. While the war was going on, political challenges caused by the takeover of the continent by the Axis Powers meant that there was a limited marketplace for trading in foreign currency. With no friendly government operations within the European marketplace, the traditional economies of the nations were displaced, along with the currencies. To combat this, especially due to the fact that many American companies were tied to the well-being of business behind enemy lines, banks across the world began to deposit large sums of foreign currency, creating a new money market. One of the factors that make the Eurocurrency Market unique compared to many other money market accounts is the fact that it is largely unregulated by government entities. Since the banks deal with a variety of currencies issued by foreign entities, it is difficult for domestic governments to intervene, particularly in the United States. However, with the establishment of the flexible exchange rate system in 1973, the Federal Reserve System was given powers to stabilize lending currencies in the event of a crisis situation. But one problem that arises is that these crises are not defined by the regulations, meaning that intervention must be established based on each case and the Federal Reserve must work directly with central banks around the world to resolve the matter. This adds to the volatility of the Eurocurrency Market. Despite its name, the Eurocurrency Market is primarily influenced by the value of the American dollar. Nearly two-thirds of all assets around the globe are represented by U.S. currency. The challenge with foreign banks revolves around the fact that regulations enforced by the Federal Reserve are really only enforceable within the U.S. The taxation level and exchange rate of the American dollar varies depending on the nation. For example, an American dollar in Vietnam is worth more than it is in Canada, further influencing the market.

FOREIGN EXCHANGE REGULATIONS IN INDIA India has liberalized its foreign exchange controls. Rupee is freely convertible on current account. Rupee is also almost fully convertible on capital account for non-residents. Profits earned, dividends and proceeds out of the sale of investments are fully repatriable for FDI. There are restrictions on capital account for resident Indians for incomes earned in India. The Reserve Bank of India s Foreign Exchange Department administers Foreign Exchange Management Act 1999(FEMA). Foreign Exchange Management (transfer of securities to any person resident outside India) Regulation as amended from time to time regulates transfer for issue of any security by a person resident outside India. Repatriation of investment capital and profits earned in India (i) All foreign investments are freely repatriable, subject to sectoral policies and except for cases where Non Resident Indians choose to invest specifically under non-repatriable schemes. Dividends declared on foreign investments can be remitted freely through an Authorized Dealer. (ii) Non-residents can sell shares on stock exchange without prior approval of RBI and repatriate through a bank the sale proceeds if they hold the shares on repatriation basis and if they have necessary NOC/ tax clearance certificate issued by Income Tax authorities. (iii) For sale of shares through private arrangements, Regional offices of RBI grant permission for recognized units of foreign equity in Indian company in terms of guidelines indicated in Regulation 10.B of Notification No. FEMA.20/2000 RB dated May 2000. The sale price of shares on recognized units is to be determined in accordance with the guidelines prescribed under Regulation 10B(2) of the above Notification. (iv) Profits, dividends, etc. (which are remittances classified as current account transactions) can be freely repatriated. Acquisition of Immovable Property by Non-resident A person resident outside India, who has been permitted by Reserve Bank of India to establish a branch, or office, or place of business in India (excluding a Liaison Office), has general permission of Reserve Bank of India to acquire immovable property in India, which is necessary for, or incidental to, the activity. However, in such cases a declaration, in prescribed form (IPI), is required to be filed with the Reserve Bank, within 90 days of the acquisition of immovable property. Foreign nationals of non-Indian origin who have acquired immovable property in India with the specific approval of the Reserve Bank of India cannot transfer such property without prior permission from the Reserve Bank of India. Please refer to the Foreign Exchange Management (Acquisition and transfer of Immovable Property in India) Regulations 2000 (Notification No. FEMA.21/ 2000-RB dated May 3, 2000).

Acquisition of Immovable Property by NRI An Indian citizen resident outside India (NRI) can acquire by way of purchase any immovable property in India other than agricultural/ plantation /farm house. He may transfer any immovable property other than agricultural or plantation property or farm house to a person resident outside India who is a citizen of India or to a Person of Indian Origin resident outside India or a person resident in India.