International financial

management
Prof. S.Jayapandian
IFM is the application of the principles of
financial management to cross border
businesses
Cross border businesses are
>trade
>set upmarketing, servicing and
production
Corporates dealing in cross boarder
businesses are multi-national companies
MNCs
MNC
Multinational company is one which has
operating subsidiaries, branches or affiliates
located in foreign countries
It should have at least 5-6 subsidiaries
with strategic interaction to be recognised as
MNC.
Purposes of multinational dealings

>Exploring Market
>Seeking Raw material
>Minimizing Cost


Mode of operation

Direct sale to consumers
Consignment
Licensing
Franchising
Opening Branches
Establishing Subsidiaries
Entering into Joint ventures

Why cross border business?
Adam Smith(1776)
If a foreign country can supply us with a
commodity cheaper than we ourselves can
make it, better buy it of them with some part
of the product of our own industry employed
in such a way in which we have some
advantage
Countries due to their specific ecological,
ethnical and climatic conditions are
advantageously placed for the production of
certain goods. It would be to the advantage of all
concerned if each concentrates on its advantage
and exchange with other countries goods which
they could produce advantageously
eg. Assuming same currency for US and
Canada and both the countries can produce both
wheat and oranges, but at different costs

Wheat Oranges
US requirements (kgs ) 10m 15 m
Cost of production-kg($) 0.2 0.05
Total cost $ 2,000,000 750,000
Total = $2,750,000
CANADA- requirements (kgs) 8M 10M
Cost of production-kg($) 0.25 0.03
Total cost $ 2,000,000 300,000
Total = $2,300,000
Cost for both countries = $ 5.05m
It could be seen that US has an edge over Canada in the
production of wheat, where as Canada has advantage in
the production of oranges
Suppose US concentrates on wheat and Canada
on oranges and they exchange, then
US wheat cost for 18mkgs =$3.60 m
Canada oranges cost for 25mkgs =$0.75 m
Total for both =$ 4.35m(5.05m)
Total cost saving =$ -0.70m
US exchanges wheat @ $.21 =$1.68m
Canada exchanges orange$.03 = $.45m
Cost for US= -3.6+1.68 -.45 =$2.37 (2.75m)
Cost Savings =$ - 0.38m
Cost for Canada =-0.75-1.68 +0.45 =1.98m(2.3m)
Cost Savings =$ - 0.32m
Mutually advantageous .
Multinational trade would take place.

Process of internationalisation-FDI
Domestic production > export >licensing or
establishing sales subsidiaries > providing
service service > establishing distribution
system > establishing production abroad
>ceasing local production

Theories of internationalising
market imperfections theoryproduct differentiation
transaction cost theory domestic R&D, high cost
eclectic theory firm specific and location specific
advantages and internalising
product life cycle theory 1.R&D, 2.product
introduction in home market 3. growth stage
EXPORT 4.Setting production-maturity5.Importing
from advantageous locations/closing domestic
production
Exchanges between countries result in
either surplus or deficit to countries
How to pay for or receive the deficit or
surplus?
Not by the deficit countries currency.
Search for internationally acceptable means
of payment
Choice fell on precious metalsgold and
Silver
Emergence of international monetary
systems


International Monetary System
Set of policies, institutions,
practices, regulations and
mechanisms that determines
the rate at which one currency
is exchanged for other.
Evolution of the
International Monetary System
Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime:
1973-Present
Bimetallism: Before 1875
A double standard where both gold and
silver were used as international means of
payment and the exchange rates among
currencies were determined by either their
gold or silver contents.
Some countries were on the gold standard,
some on the silver standard, some on both.
Classical Gold Standard:
1875-1914
During this period in most major countries:
Gold alone was used for coinage
There was two-way convertibility between
gold and national currencies at a stable ratio.
Gold could be freely exported or imported.
The exchange rate between two countrys
currencies determined by their relative
gold contents.
Dollar was pegged at U.S.$30 = 1 ounce of gold
British pound pegged at 6 = 1 ounce of gold.
The exchange rate between $ and was
determined by the relative gold contents:
$=30ounce = =6ounce. i.e.. 30 :6
= $5 = 1

EXAMPLE
Countries on gold standard
Countries From
1.UK
2.GERMANY
3.SCANDINAVIAN COUNTRIES
4.FRANCE,BELGIUM,SWIZ,ITALY,GREECE
5.HOLLAND
6.URUGUAY
7.US
8.AUSTRIA
9.CHILE
10.JAPAN
11.RUSSIA
12.DOMINICAN REPUBLIC
13.PANAMA
14.MEXICO
1816-1914,1926-1931
1871-1913,1924-1931
1873
1874
1875
1876
1879-1971
1892
1895
1897
1898
1901
1904
1905

Advantages
>Highly stable exchange rates
>Provided environment conducive to
international trade and investment
>Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-
specie-flow mechanism.
Price-Specie-Flow Mechanism
Suppose Great Britain exported more to France than
France imported from Great Britain.
This cannot persist under a gold standard.
Net exports of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
Britain.
This flow of gold will lead to a lower price level in France and,
at the same time, a higher price level in Britain.
- The resultant change in relative price levels will slow
exports from Great Britain and encourage exports from
France.
- reverse flow of gold; equilibrium restored
Shortcomings of gold standard:

The supply of newly minted gold is so limited
that the growth of world trade and investment
was hampered on account of insufficient
monetary reserves.
It is delicate system-a fair weather craft of
doubtful sea worthiness on stormy.
Gold standard was sinned against than
sinning
Inter-war Period: 1915-1944
Exchange rates fluctuated as countries widely
used predatory depreciations of their
currencies as a means of gaining advantage in
the world export market.
Attempts were made to restore gold standard, but
participants lacked the political will to follow the
rules of the game.
Result :international trade and investment was
profoundly affected.
Bretton Woods System:
1945-1972
>meeting of 44 nations at Bretton Woods, New
Hampshire in 1944
>to design a post-war international monetary
system.
>goal was stability in exchange rate without gold
standard.
>result - creation of IMF and IBRD (World Bank).
Bretton Woods System:
1945-1972
>Under the Bretton Woods system, U.S. dollar
pegged to gold at $35 per ounce and other
currencies pegged to the U.S. dollar.
>Each country responsible for maintaining its
exchange rate within 1% of the adopted par
value by buying or selling foreign reserves($ or
gold) where necessary.
>Bretton Woods system was a dollar-based gold
exchange standard.
Bretton Woods System:
1945-1972
German
mark
British
pound
French
franc
U.S. dollar
Gold
Pegged at
$35/oz.
Par
Value
Collapse of fixed exchange system
>Pressure to devalue dollar led to collapse
>President Johnson financed Vietnam war by printing
money, resulting in high inflation and high spending
on imports
>August 8, 1971, Nixon announced dollar no longer
convertible into gold.
Countries agreed to revalue their currencies against the
dollar
March 19, 1972, Japan and most of Europe floated their
currencies
In 1973. Bretton Woods failed as key currency (dollar) was
under speculative attack

The Flexible Exchange Rate
Regime: 1973-Present.
Flexible exchange rates were declared
acceptable to the IMF members.
Central banks were allowed to intervene in the
exchange rate markets to iron out
unwarranted volatilities.
Gold was abandoned as an international
reserve asset.
Non-oil-exporting countries and less-
developed countries were given greater
access to IMF funds.
Current Exchange Rate
Arrangements
Free Float
largest number of countries, about 48, allow market
forces to determine their currencys value.
Managed Float /selective intervention
About 25 countries combine government intervention
with market forces to set exchange rates.
Pegged to another currency
Such as the U.S. dollar or euro.-Dubai, Singapore
No national currency
Some countries do not bother printing their own, they
just use the U.S. dollar. For example, Ecuador,
Panama, and El Salvador have dollarized.
European Monetary System
Eleven European countries maintain exchange
rates among their currencies within narrow
bands, and jointly float against outside
currencies ( TargetZoneArrangement)
Objectives:
To establish a zone of monetary stability in Europe.
To coordinate exchange rate policies vis--vis non-
European currencies.
To pave the way for the European Monetary Union.
Euro was introduced as the currency
Balance of Payments
The Balance of Payments is the statistical
record of a countrys international
transactions over a certain period of time
presented in the form of double entry book-
keeping.
Components of BOP
Current Account (CA) and
Capital/Financial Account (KA)
Official Reserves Account

.
Balance of Payments
The BP includes three accounts:
(1) current accounta record of
all merchandise exports, imports,
and services plus unilateral
transfers of funds;
(2) the capital accounta record of
direct investment, portfolio
investment, and short-term capital
movements to and from countries;
(3) the official reserves accounta record of exports and imports of gold,
increases or decreases in foreign exchange, and increases or decreases in
liabilities to foreign central banks;
The Current Account
Includes all imports and exports of
goods and services.
Includes unilateral transfers of foreign
aid.
If the debits exceed the credits, then a
country is running a trade deficit.
If the credits exceed the debits, then a
country is running a trade surplus.
The Capital Account
The capital account measures the
difference between the countrys sales of
assets to foreigners and the countrys
purchases of foreign assets.


The capital account is composed of
Foreign Direct Investment (FDI), portfolio
investments and other investments.
The Official Reserves Account
Official reserves assets including gold,
foreign currencies, SDRs , reserve
positions in the IMF.
It is the means of settling international
indebtedness
The Balance of Payments
Identity
BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account


Are trade deficits a problem?

A trade deficit is not necessarily a bad
thing (e.g. when growing domestic
industries attract foreign investments)
However, if a country persistently runs a
trade deficit this is something to worry
about (e.g. vulnerability to loss of foreign
investors confidence)


Current account deficit reflects a shortage
of saving over investment; current account
surplus reflects an excess of saving over
investment.

Any current account deficit must be
matched by an equal capital account
surplus, and vice versa.

Data on Indias merchandise trade and
commodity-wise details furnished by the
Directorate General of Commercial
Intelligence and Statistics (DGCI&S)
It is also available in RBI reports


Table 1: Indias Merchandise Trade:
April-December
(US $ million)
Items 2005-06 R 2006-07 P
Exports 73,382 89,543
(29.9) (22.0)
Imports 105,101 131,178
(37.8) (24.8)
Oil Imports 31,477 43,825
(46.9) (39.2)
Non-Oil Imports 73,624 87,353
(34.3) (18.6)
Trade Balance -31,719 -41,635
P: Provisional; R: Revised.
Figures in parentheses show percentage change over the previous year.
Source: DGCI&S.
What is forex?
Foreign Exchange means the rate at which a countrys
currency is exchanged for another countrys currency
Eg.Rs.40.37 = $1
Exchange market is the arrangement for determining and
buying and selling of different currencies
Players in exchange markets are
>Banks
>Central bank
>Exchange brokers and
>Users

Types
of transactions
Dealing
Speculating
Arbitrage
Terms:
Bid (buy) and Ask/ offer (sell)
How quoted
In Rupees
= Rs.82.00 / 83 .53
$ = Rs.40.400/ 41.44
= Rs.55.4005/56.49
SF=33.5437/ 34.61
First is buy rate; second sell rate
Two way quote =market makers
Quotes are among bankers
Spread is their margin
Spread= Difference/Buy rate*100
Exercise=work out margin on the above quotations
Spread%
= Rs.82.00 /83 .53 =1.87%
$ = Rs.40.400/ 41.44 =2.57%
= Rs.55.4005/56.49 =1.97%
SF=33.5437/ 34.61 =3.18%

Ways of quoting
American quote :how many units of home
currency is exchangeable for one unit of foreign
currency---direct quote
In India, Rs.40.56/ 40.95 = 1 $ =AQ
European quote: how many units of foreign
currency is exchangeable for one unit of home
currency---indirect quote
IF 1 Re quoted at $0.0246 / 0.0216 = EQ
Note :in indirect quote, sell rate would be less
than buy rate- why?

Exercises
1. in London =Rs.83 per
2. In Swiss =SF1.25 per$
3. In Dubai = DH 3.75 per $
4.In Singapore =S $ 3.15 per
5. In France = $1.76 per FF
Could you identify which of the quotes are
AQ and EQ?
Types of rates
1. Spot rates
2. Forward rates
3. Cross rates
Spot rate is the rate prevailing on a
particular point of time.
Delivery of spot deal is 2 days
WHAT IS CROSS RATE?
Usually countries quote the exchange rates
of other countries in relation to their
currencies. The exchange rate among the
countries currencies, worked out from the
quotations, is the cross rate
.
Rupee Pound Sterling 89.54. 89.74
Rupee Dollar 43.90 44.25
A wants to find out how many units of $ a could buy, or buy rate
of $ for a .He could sell a for Rs.89.54, with the proceed buy $
@ Rs.44.25 = $2.0235- buy rate
If he wants to know the sell rate of $ for a ,he could sell $ @
Rs.43.90 and with the proceeds buy @Rs.89.74 . He needs =$
2.0442 to get a --sell rate
The cross rate = 2.0235 / 2.0442
Cross rate could also be worked out mechanically by crossing the
rates



Rupee Pound Sterling : . 89.54. 89.74

Rupee Dollar : 43.90 44.25.


Note: currency to be exchanged is denominator
Cross rate of $ to = 89.54 / 44.25
89.74 / 43.90
=2.0235 / 2.0442
.
Cross rates -examples
Rupee Pound Sterling : 89.54 89.74
Rupee Dollar : 43.90 44.25
Rate (value) of $ to a =$2.0235 -2.0442
Rupee Dollar : 43.90 44.25
Rupee Pound Sterling : 89.54 89.74
Rate (value) of to a $ = 0.489 - 0.494

Work out cross rate of SF to
and to SF


INR SF Rs.31.40/34.55
INR Rs.52.60 / 56.85
SF to = 1.52 / 1.81
to SF = 0.55 / 0.66


UTILITY OF CROSS RATE
Cross rates between two centers would reveal opportunities for
arbitrage. Arbitrageurs would first work out the cross rate between
two centers for a currency and buy in cheap center and
sell in dear center and in the process brings about equilibrium
rates. Eg.
Quotation for and $ in India
and Re =Rs.55.85
$ and Re = 40.40
In London, is quoted at $ 2.02 and 1.50
Cross rate of in India per $ = 40.40 / 55.85 = 0.72337 and in
London =1.50 / 2.02 = 0.7426
Arbitrageur finds per $ is cheap in London compared to
India.


He would buy for a $, 0.7426 in London, sell the in
India @ 0.72337 and realise s $ 1.02658(.7426 / .72337)
and makes a gain of $0.02658 per $ transaction.
Gain would induce demand for in London
(supply of $ ) and in India supply of (demand for$ ).
would strengthen against $ in London and weaken in
India till equilibrium reached.
Alternatively, arbitrageurs could also work out cross
Rate of $ per in India at $1.3824(55.85 / 40.40) and
in London at $1.347(2.02/1.50).$ cheap in India. Buy $
for in India(1.3824) and sell in London @1.347,realise.
1.02628 Gain 0.02628 per transaction.
Find out whether there is opportunity for arbitrage
when
Exchange Rate in India:
Japanese (1000) = Rs.310 and
Swedish Kroner =Rs.5.50
In New York:
$7.67 per (1000) and $ 0.136 per
SK
Cross rate in India
S. Kroner 56.36 = (1000)
Cross rate in New York
S. Kroner 56.40 = (1000)
S. Kroner per (1000 is cheap in NY
Buy SK at 56.40 in NY for (1000), sell in India @
56.36 and realise 1.0007 (1000) . Profit per
(1000) = 0. 0007 (1000)
in NY,Demand for SK would strengthen SK
and supply of (1000) would weaken (1000).
In India, supply of SK would weaken its rate and
demand for (1000) would strengthen it ,till
Equilibrium reached

FORWARD RATE
Forward contract is an agreement to buy
or sell a certain quantity of a countrys
currency, at a predetermined rate in
terms of home currency, on a specified
date.
Purpose OF FORWARD RATE
> Traders to hedge
> Speculators to benefit by risk taking
Arbitrageurs to make money without taking
risk by matching differences in different
markets.
Bankers to square their position

Bankers square their position
1.By reducing the quote, when in excess buy
position
Eg. From 40.90 41.25 per dollar, to say 40.75-
41.10
2. When in excess sell, by increasing the quote
Eg. From 40.90 41.25 per dollar, to say 41.05-
41.40
How it works?
Forward Rate Quotes
1.Outright F Rate = exact rate eg. 3 months forward
rate for $=Rs.40.90 41.25
2.Swap rate = quoting either at premium or at
discount.
Eg: Rupee $ spot = 40.65
3 months forward Outright rate = 40.45
Formula for calculating swap:
Swap rate= Forward Rate Spot rate x 12 X 100
Spot rate contracted months
= 40.45 40.65 x 12 x 100 = - 1.97%
40.65 3
Swap rate =- 1.97
Exercises: Work out swap rates in
the following

Currency Spot rate
Rs
3 months F. rate
Rs
Sterling
Euro
Swiss franc
UAE DH
78.70
52.60
31.40
10.50
80.20
53.85
30.55
11.05
SOLUTION
Sterling == 7.62%
Euro == 9.51%
Swiss franc== -10.83%
UAE DH ==20.95%
Exercises: Work out outright quotes
for 3 monthsin from swaps

Currency Spot rate Forward swap%
Sterling
Euro
Swiss franc
UAE DH
78.70
52.60
31.40
10.50
6%
-8%
-10%
12%
outright forward rates
Sterling =78.70* 1.015 = 79.88
Euro = 52.60* .98 = 51.55
Swiss franc = 31.40 *.975 = 30.615
UAE DH = 10.50 * 1.03 = 10.815


Factors destabilising exchange
rates
Differential rates of interest between
countries
and differential inflation rates between
countries
Or both
Forward rate would be equal to spot rate if
the rate of interest and rate of inflation
between countries remain the same.
First consider rate of interest (and assuming
inflation rate to be same).
$ spot rate Rs.40.35. Rates of interest in
India and US are same at 6%.
A trader requires 3 months forward dollar to pay
for imports. He could enter FC or buy and hold
if Forward rate differed from Spot rate.

How he does it?
He could borrow Rs.40.35 at 6 %in India
for3 months ,buy $ at spot rate (40.35),and
invest in US at 6% for 3 months.
At the end of 3 months, he would realise
$1.015 and the cost in India =Rs.40.95525
$1.015 = Rs.40.95525
$1 = 40.35
Spot rate and forward rates remain same


Spot rate and forward rate differ due to different
rates of interest between countries
In the same example, if the rate of interest in India
is 8% and in US 6%, then the difference in the rates
would get reflected in the forward exchange rate. 3
months forward rate would be the difference in interest
rates * spot rate or
1.02 / 1.015 *40.35= Rs.40.55
The formula for forward rate is therefore
FR = (1+rh) / (1+rf) *SR
Exercise: confirm the forward rate through the buy and
hold route



Borrow a $ in US at 6%, convert into rupee =
Rs.40.35 Invest in India for 3 months= Rs.41.157
US borrowing at the end of 3 months =$1.015
$1.015 = 41.157
$ 1 = Rs.40.55
EXERCISES
Work out, with interest rates of 6% in India, three
months forward rate for
1. with 7% in UK. Spot rate for is Rs.84.20
2.$ with interest rate of 5%. Spot rate is Rs.40.35
3.DH with interest rate of 8%.Spot rate is
Rs.11.40


3 months Forward rates
= (1.015 / 1.0175)* 84.20= 83.99
$ = (1.015 / 1.0125)*40.35= 40.45
DH= (1.015 / 1.02) * 11.40= 11.34
FR and the SR on the date of expiration of
forward contract, tend to be same.
UBFR is equilibrium rate .
If FR is different from UBFR, there will be
mismatch in the rate of a currency between two
quotes. This mismatch offers opportunity for
arbitrage profits.
This opportunity is covered interest arbitrage
Arbitrageurs would step in and bring back
Equilibrium rate .
How this happens?
Example
Spot $ =Rs.40.35-3 months forward Rs.40.25
Interest rates-- India 8% US 6%
Arbitrageur would work out UBFR ,which in this
case is Rs.40.55
Official FR at 40.25 is biased. In Forward $ is quoted
weak against Rupee. Arbitrageurs would buy $ in
forward marker at Rs.40.25 and cash it on
expiration date at Rs.40.55,which would be the spot rate
on strike date. Or he would take the investment route

Arbitrageur could borrow $1m @6% for 3 months
in US, convert at spot rate into Rs.40.35m in
India, invest in India for 3 months and cover the
proceeds (Rs.41.157m) in forward market into
$1.0225341m at the official FR.
At the end of 3 months, his loan amount would
accumulate to $1.015m.His net gain $0.0075341
m in 3 months for an investment of $1m.
Lesson: when the rate of interest in a country is
higher than that of another, it would attract more
foreign investment and it would become strong in
the spot, but weak in forward .
Consequences :
Initial REACTIONS
Rupee will become strong in spot- more supply of
spot $ and more demand for spot rupee
$ will become strong in forward market-more
demand for forward $ and more supply of
forward rupee
Consequential Effects
1.Demand for $ would increase in US and rate of
interest in US would rise.
2.Supply of money would depress interest rate in India .
Till equilibrium rate (of Rs.40.55 ) is reached.
Arbitrage is thus the price discovery mechanism
Ascertain covered interest arbitrage
opportunity in the following
India-Rs US -$ UK - UAE- DH

Spot rate
3 months forward
Rate of interest


6%
40.35 84.20 11.40
40.25 85.45 10.20
7% 5% 8%
1.In $ no opportunity
2. In , UBFR =84.41as against FR of
85.45arbitrageurs would sell F till rate
reached UBFR
In DH, UBFR = 11.344as against FR of
Rs.10.20arbitrageurs would buy F $ by
paying Rs10.20 and encash it at Rs.11.344 on
expiration date. Or take the investment route.
Transactions would continue till UBFR reached
Exercise
Spot rate of exchange in India is Rs 44 to a
dollar and a three months forward rate is
Rs.43. Interest Rate in India changes from
6% to 7% as against the rate of interest in
US, which remained at 6% .How does an
arbitrageur act and restores equilibrium
1 m. Dollar borrowed in US would be $1.015 in 3
months. $1m ; converted at spot rate into
Rs.44m; invested @7%= Rs. 44.77 m in 3
months, covered in forward @43 = $1.04116m =
profit of $0.02616m.Profit spurs investment into
India. Spot rupee demand increases and spot
rate moves up. Demand for $ in US Would
increase US interest rate. Inflow of funds would
reduce interest rate in India. Forward $ would
become stronger till equilibrium reached. Covered
interest rate arbitrage would remove bias.
Determinants of exchange rate
In the Short run, supply and demand
In the Long run, purchasing power parity as
impacted by
>Change in rates of interest
<Change in rates of inflation
< Both
.
Demand
>Trade- payment for imports
>Payment for services availed of
>Transfers of foreigners living in a host country
>Tourists visiting other countries, business trips,
education abroad
>Payment of interest and repayment of
borrowings
>Investment abroad
>Payment of dividend and repatriation of capital
>Donations , gifts and lines of credit

Supply
>Export receipts
>Receipts for services rendered abroad
>Remittances by non-residents abroad
>Tourists from other country
>Transfers
Receipt of interest and loan already made abroad
Foreigners investing in the host country
Receipt of dividend and principal from abroad
Gifts and donations received from abroad
In the long run, exchange rate is determined
by their relative purchasing power in their
countries caused by
<Change in rates of interest--
<Change in rates of inflation
< Change in both
Change in interest and or inflation would affect
the countrys currencys purchasing power
Which would in turn affect its exchange rate..
PPP
What a currency could buy in terms of goods and
services in home country vs. how many units of
the other countrys currency required to buy the
same quantity of goods or service in that country.
Eg. Wheat in US 5 kgs for a $ , in India Rs.8 per
Kg. How many rupees are required to command
the quantity purchased by a dollar will determine
$ exchange rate
PPP = 1$ =8 kgs in US; in India, 5 kgs would
cost Rs.40 (8*5 ).
There fore 1 $ = Rs. 40



Work out rate of exchanges between India and the
countries based on PPP

COUNTRY PRICE OF WHEAT/kg
Srilanka
Pakistan
Singapore
UK
India
SNR 15
PNR 11.50
S$ 0.31
0.10
Rs.8
Direct quote
1.Sri lankan Rupee = 0.53 INR
2. Pakistan Rupee = 0.70 INR
3. Singapore $ = 25.81 INR
4. = 80 INR





PPP Measured in terms of WPI and rate of
Inflation is on annual basis.

The Wholesale Price Index (WPI) was first
published in India in 1902
Current basis is 1993-94 ---100
A total of 435 commodities. Data on price level
is tracked and weighted
weightage
primary article 22.02 %
fuel,power 14.23 %
manufactured products 63.75 %
WPI at beginning of 2007=198 POINTS
Current Inflation Rate
2.69% (30
th
June 2007 )==WPI =203.33points
Suppose INR on 1.1.2007 was 42.12 per dollar
Rate of inflation in India during the year 2.69%--
US 5.65%
Formula = SR * (1+ h
i
/ f
i
)
The Current $ Rate would be = 42.12 * ( 1.0269
/ 1.0565) = Rs.40.94
Alternatively ,If during the year, US inflation is
5.65% and Indian inflation is 7.2,
the exchange rate would have beenbe
42.12*(1.072/1.0565) = Rs.42.74
The exchange rate for the next year would be
based on the rate at the end of this year
Current year 2007 $= Rs. 40.35
Suppose next year inflation in India 3% and
in US 2.5%, the rate of exchange for next
year (2008)would be
40.35 *(1.03/1.025) = Rs.40.55
On the other hand, if expected inflation in
India next year 3% and US 4%, the rate of $
would be
40.35(1.03 / 1.04) =Rs.39.96
Formula for PPP

Forward Rate of exchange =
(1+h
i
) / (1 + f
i
) = e
t
/e
o or
=
FR =(1+h
i
) / (1 + f
i
) *SR

Where h
i
is inflation at home, f
i
is inflation in the foreign
country, e
t
is exchange rate at
t
time and e
o
is spot
rate

Eg. Spot rate RS. 40.30 per dollar, inflation India 5% US
6 %, rate of exchange would move to 1.05 / 1.06*
40.30 =39.92


Work out FR for 2008 for each
currency when
Country Exchange Rate
2007Rs
Inflation 2008
India
UK--
USA-$
Singapore-S$
Dubai DH
Japan--(1000)
-
82.56
40.35
25.26
9.95
310
2.95%
3.45%
4.75%
3.75%
7.50%
1.25%
UK-- = Rs. 82.16
USA-$ = Rs. 39.66
Singapore-S$ = Rs. 25.07
Dubai DH = Rs. 9.53
Japan--(1000)= Rs.315.20

The UBFR as calculated should be the spot
rate on the expiry of the period.
Forward rates quoted should be = to the PPP
If not, opportunity for arbitrage is open
Arbitrageurs on the look out for mismatch would
spring into action till the mismatch is removed
and PARITY restored
PPP brings about equilibrium in exchange
rates
Supposing $ is quoted at Rs.40.50.Wheat price in US1$
=5 kgs; in India a kg. of wheat is Rs.8.50. It means
that what a $ could buy in terms of wheat in US(5 kgs) ,
India needs Rs.42.50.
This might spur traders to buy @5 kgs. of wheat for a $
in America, export to India, sell for Rs.42.50, exchange
for $1.049 at the prevailing rate of Rs. 40.5, make profit
of $ 0.049 per $.
Imports of wheat in to India would increase and demand
for $ for payment . $ would become stronger (rupee
weak). Increased buy of wheat in US would increase its
price, ( increased supply would reduce price in India) till
the rate reaches equilibrium.

Repeat
The equilibrium is called unbiased forward
rate (UBFR)
If there is difference it would lead to arbitrage
and ultimately equilibrium reached
Forecasting forward exchange rate
Requirements for successful forecasting
>exclusive use of superior model
>access to prior information
>ability to predict govt. intervention
Techniques of forecasting
>market based
>model based
Techniques
Market based

Based on Forward rate coincides with the
spot rate of exchange on its strike date
(UBR)

Spot =Rs.82.65, interest in India 8%, in UK
9% and this rates are expected to
continue,
work out
1. forward rate for in 4 years in India and
2. forward rate for Re. in UK

India = spot rate Rs.82.65
4 years FR = Rs.83,65 * (1.08/ 1.09 )
4
=Rs.78.927642
In UK Re spot = 0.0120992
4 years Re FR = 0.0120992* (1.09 / 1.08)

= 0.0126698
Suppose rates of interest are expected to
change to
2008 India 8% UK 9%
2009 India 9% UK 9%
2010 India 10% UK 9%

WHAT WOULD BE FORWARD RATE
QUOTE FOR FOR ?
would quote at
FR 2008 Rs. 82.65 * 1.08 / 1.09 = Rs81.89
FR 2009 Rs.81.89 * (1.09/ 1.09 )= Rs.81.89
FR 2010 Rs. 81.89 * (1.10 / 1.09)=Rs.82.64

MODEL BASED
>Fundamental analysis
Relative inflation and interest rates, GDP
growth, changes in money supply
>Technical analysisbased on price and
volume movements.Charts and graphs to
note similar trends
Forecasting in controlled economy

Depends upon governmental intention
But there would be black market for rate
Black market rate would reflect equilibrium
rate
Real interest rate vs nominal
interest rate
Contracts are made on nominal rates.
Real (DESIRED) return (r) is nominal rate (a)adjusted
to rate of Inflation(i)Fishers effect
r = real rate +premium for inflation
r = (1+a)(1+i) -1,
Where r is the return (expected nominal rate),
a is real interest rate , i is inflation rate
Eg. Real interest rate 5%, expected inflation 6%,
Expected nominal rate would be =(1.05)(1.06)-1
=11.3%
Exercise work out inflation adjusted
expected rate in each country for each
investor
Investor Real rate Inflation rate-in
countries
A
B
C
D
6%
7%
5%
9%
1. 3.5%
2. 4.25%
3. 1.25%
4. 7%


Investor

Country 1
%

Country 2
%

Country 3
%

Country 4
%
A
B
C
D
9.71
10.75
8.68
12.82
10.51
11.55
9.46
13.63
7.33
8.34
6.31
10.36
13.42
14.49
12.35
16.63