Sources of International

COST-VOLUME-PROFIT Finance
ANALYSIS

Study Note - 9
SOURCES OF INTERNATIONAL FINANCE
9.1 Raising funds in foreign markets and investment in foreign
markets
This Section includes:
· Need for Foreign Capital
· Official Foreign Source of Finance
· Non Official Foreign Source Of Finance
INTRODUCTION :
Most countries of the world which raced to the path of economic and industrial development
had to depend on foreign capital to some extent. Under developed countries like India have to
depend on foreign capital for financing their development programmes as they suffer from
low level of income and low level of capital accumulation. The degree of dependence, how-
ever, varies from country to country depending upon its level of mobilization of domestic
capital, technology development, attitude of the government, etc. But the fact cannot be de-
nied that foreign capital contributes in many ways to the process of rapid economic growth
and industrialization.
NEED FOR FOREIGN CAPITAL :
The need for foreign capital in a developing country like India arises on account of the following:
1. Inadequacy of Domestic Capital: In view of the inadequacy of domestic capital, foreign
capital is needed to meet the huge requirements of development projects in the path of rapid
economic development and inustrialisation.
2. The Technology Gap: As compared to the advanced countries there is a lot of technology
gap which necessitates import of foreign technology. Such technology usually comes along
with foreign capital in the form of private foreign investment or foreign collaborations. Thus,
there is utmost need of foreign capital.
3. The Initial Risk: Due to lack of experience, expertise and heavy initial risk, there is
always a lack of flow of domestic capital into lines of production. The foreign capital taking
initial risk stimulates the flow of domestic capital and stock entrepreneurship.
4. Development of Basic Infrastructure: There is also a lack of basic infrastructure which
is very essential for the economic development of the underdeveloped countries. Foreign capi-
tal helps in the development of infrastructural facilities such as transport, communication,
power etc.
5. Balance of Payment Support: During the process of economic development, the under-
developed countries usually face a crisis of balance of payments due to heavy imports of capi-
tal goods, technical know-how, spare parts and even industrial raw materials. Thus, foreign
capital is needed to face the crisis during this period.

682 Fianancial Management & International Finance

 The above pictorial presentation shows the divisions of foreign fapital

OFFICIAL FOREIGN SOURCE OF FINANCE :

1. Foreign Collaboration: In India joint participation of foreign and domestic capital has been
quite common in recent years. Foreign collaboration could be either in the form of joint partici-
pation between private firms, or between foreign firms and Indian Government, or between
foreign governments and Indian Government.
2. Bilateral Government Funding Arrangement: Generally, advanced countries provide aid
in the form of loans and advances, grants, subsidies to governments of under-developed and
developing countries. The aid is provided usually for financing government and public sector
projects. Funds are provided at concessional terms in respect of cost (interest), maturity, and
repayment schedule.
3. NRI Deposits and Investments: Non-resident Indian have always been making a contribu-
tion in Indian economy. Government has been making efforts to encourage their deposits and
investments. Various schemes have been devised which ensure higher returns; procedures
have been simplified to attract investments in primary and secondary market. Tax incentives
are given on interest earned and dividends received by NRIs.
4. Loans from International Financial Institutions : International Bank for Reconstruction
and Development (IBRD), International Monetary Fund (IMF), Asian Development Bank (ADB),
and World Bank have been the major source of external finance to India.
5. External Commercial Borrowing (CEB) : Our country has also been obtaining foreign capi-
tal in the form of external commercial borrowings from agencies like US EXIM Bank, Japanese
EXIM Bank, ECGC of UK, etc.

Fianancial Management & International Finance 683

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

NON OFFICIAL FOREIGN SOURCE OF FINANCE :

Foreign Direct Investment (FDI) :
Foreign direct investment is one of the most important sources of foreign investment in devel-
oping countries like India. It is seen as a means to supplement domestic investment for achiev-
ing a higher level of growth and development. FDI is permitted under the forms of invest-
ments.
1. Through financial collaborations / capital / equity participation;
2. Through Joint ventures and technical collaborations;
3. Through capital markets (Euro Issues);
4. Through private placements or preferential allotment.
Capital participation / financial collaboration refers to the foreign partner’s stake in the capital
of the receiving country’s companies while technical collaboration refers to such facilities pro-
vided by foreign partner as licencing, trade marks and patents (against which he gets lump
sum fee or royalty payments for specified period); technical services etc.
From investors’ point of view, the FDI inflows can be classified into the following groups.
(a) Market seeking: The investors are attracted by the size of the local market, which
depends on the income of the country and its growth rate.
(b) Lower cost : Investors are more cost-conscious. They are influenced by infrastructure
facilities and labour costs.
(c) Location and other factors: Technological status of a country, brand name, goodwill
enjoyed by the local firms, favourable location, openness of the economy, policies of the gov-
ernment and intellectual property protection granted by the government are some of the fac-
tors that attract investors to undertake investments.
Factors that attracts FDIs in India
The following factors can be held responsible for the flow of foreign direct investments in
India:
1. India has a well developed network of banking and financial institutions and an orga-
nized capital market open to foreign institutional investors that attracts them to under-
take investments.
2. India has vast potential of young entrepreneurs in the private sector. India skills and
competence is used as a base for carrying out production activities and export to
neighbour countries.
3. For the last few years there has been political stability in the country.
4. India enjoys good reputation among other countries as to honouring of its commit-
ments about repayment obligations, remittance of dividends etc.
5. India has vast potential of unskilled labour available at cheap rates as compared to
other countries, and vast natural resources that attract foreign investors.

684 Fianancial Management & International Finance

Factors that Discourage FDIs
Factors that discourage foreign investors to undertake investments in India include:
(i) High rates of taxation;
(ii) Lack of infrastructure facilities;
(iii) Favouritism in the selection of investment;
(iv) Complicated legal framework of rules, regulations procedures for foreign di-
rect investments into India;
(v) Lack of transparency.
Investments by Foreign Institutional Investors (FIIs)
SEBI (Foreign Institutional Investors) Regulations, 1995, define Foreign Institutional Investors
as an institution established or incorporated outside India which proposes to make investment
in India in securities. The regulations make it mandatory for FIIs to seek registration with SEBI
before operating in Indian securities market. Before granting certificate of registration, the
applicant’s track record, professional competence, financial soundness experience, general repu-
tation of fairness and integration is taken into consideration by SEBI.
Eligibility Criteria
An FII eligible to apply has to be:
1. An institution established or incorporated outside India as a pension fund or mutual
fund or investment trust;
2. An asset management company or nominee company or bank or institutional portfolio
manager, established or incorporated outside India and proposing to make investments
in India on behalf of a broad based fund;
3. A trustee or power of attorney holder established or incorporated outside India and
proposing to make investments in India on behalf of broad based funds.
By an amendment in October, 1996, university funds, endowments foundations or charitable
trusts or charitable societies were included.
Proprietary funds which are regulated in their home countries were also included under the
eligible list of FIIs later in February, 1997.
A certificate for registration once issued is valid for 5 years and can be renewed there after.
FIIs are required to obtain permission under the provisions of the FERA, 1973 in order to make
investment in India.
Investment Restrictions
FIIs are permitted to invest only in the following securities.
1. Securities in the primary and secondary markets including share, debentures and war-
rants of companies whether listed or to be listed on a recognized stock exchange in
India including OTC exchange of India.

Fianancial Management & International Finance 685

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

2. Units of schemes floated by domestic mutual funds including UTI;

3. Dated government securities w.e.f. February, 1997;
4. Derivatives trade on a recognized stock exchange;
5. Commercial paper.
FIIs are now permitted to invest in unlisted companies. Transactions in government securi-
ties, commercial paper including treasury bills shall be carried as per Reserve Bank of India
rules. All investments by FIIs are subject to government of India guidelines. The general
obligations and responsibilities of FIIs include appointment of a domestic custodian, appoint-
ment of a designated bank, maintenance of proper books of accounts, record, appointment of a
compliance officer and submission of information, records or documents as may be required
by SEBI.
In case, FII fails to comply with any condition subject to which certificate has been granted or
contravenes any of the provisions of the Act then it shall be liable to the penalty of suspension
or cancellation of certificate as per SEBI (Procedure for Holding Enquiry Officer and Imposing
Penalty) Regulations, 2002.
Government of India guidelines place no restriction on the volume of investment minimum or
maximum for the purpose of entry of FIIs in the primary and secondary market and prescribes
no lock in period of such investments. Portfolio investments in primary or secondary markets
initially were subject to a ceiling of 24% of issued share capital for all the total holdings of all
registered FIIs, in any one company. The limit was enhanced to 30% w.e.f. April 1997. In 2001-
02 the government raised this limit to 49% w.e.f September, 2001; the level of FDI in various
sectors has been raised to 74% or even beyond this in various sectors. The holdings of a single
FII in any company is subject to a ceiling of 10% of total issued capital.
NRI Investments In India
Developing countries require more and more investments to accelerate the rate of growth.
India has embarked on a plan to industrialise the country to accelerate antipoverty programmes.
The liberalization process started since 1991 is to attract more investments from outside the
country. Non-Resident Indians have always been making a contribution in Indian economy.
The present policy of Indian Government is to amend laws which placed obstacles in attract-
ing foreign investments and simplifying rules and regulations for setting up new undertak-
ings.
Meaning of NRI
Before discussing the gamut of NRI investments, it will be necessary to know who is a Non-
resident Indian. The term Non-resident is very broad and includes:
(i) Non-resident persons of Indian Nationality and
(ii) Non-resident foreign citizens. Non-resident foreign citizens may further be of two
Types:
(a) Non-resident foreign citizens of Indian origin and
(b) Non-resident foreign citizens of non-Indian origin.

686 Fianancial Management & International Finance

Non-resident Indians have different meaning under Foreign Exchange Regulation Act (FERA),
1973 and Income Tax Act, 1961. It is the nationality and purpose of stay of an individual
outside India which is relevant for determining the residential status for FERA whereas period
of stay outside India determines the status of a person under Income Tax Act. Non-resident
persons of Indian origin are given special treatment in respect of investment in India. They are
almost treated at par with non-resident Indian nationals and are collectively referred to as
Non-resident Indians (NRI).
Non-resident Indians are covered under the following categories:
1. Indian citizens who stay abroad for employment, business or vocation or for other
purposes stating their intention to stay abroad for indefinite period;
2. Indian citizens working abroad on assignments with Foreign Government / Govern-
ment Agencies or International Agencies etc.;
3. Officials of the Central and state Government and public sector undertakings deputed
abroad on temporary assignments or posted to their offices abroad.
Modes of NRI Investments
The role of NRI’s in Indian economy has been well recognized by the government which has
constantly made efforts to encourage their deposits and investments. Government has been
devising schemes which give higher returns, providing liberalizations in existing schemes,
simplifying procedures and removing bureaucratic bottlenecks. The changes in New Indus-
trial Policy, 1991 are designed to attract significant capital flows into India on a sustained basis.
They are also aimed to encourage technology collaborations between Indian and foreign com-
panies.
NRI investments are both direct and indirect. Direct investments are in shares, debentures,
other securities, etc. and indirect investments are in the form of mopping up their surplus
funds into savings accounts, mutual funds etc. Some of the investment schemes for NRI’s are
discussed here:
1. Investments in Govt. Securities, UTI Units etc. NRI’s can freely purchase central and state
governments securities and units of UTI by either transferring money from foreign countries
through normal banking channels or by withdrawing money from their accounts in India. The
banks are also allowed to credit interest, dividend, sale and maturity proceeds to the non-
resident accounts or through stock exchanges in India provided it is done through authorized
dealers.
2. Investment in SBI Bonds and India Development Bonds State Bank of India issued “NRI
Bonds” in 1998 and India Development bonds in 1991 for NRI’s. These were close ended
schemes and investments are not allowed now in these schemes.
3. Investments in Proprietorship / Partnership Concerns The Central Government has al-
lowed NRI’s to invest by way of capital contribution in any proprietary or partnership concern
engaged in any industrial, commercial or trading activity on repatriations basis. The profits
accruing to the NRI may be credited to ordinary Non-resident Rupee Account or may be
ploughed back in the business itself.

Fianancial Management & International Finance 687

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

The funds must come through normal banking channels. The business where investment has
to be made should not deal in land and immovable property. There is no need to obtain prior
approval of Reserve Bank but it can be informed of the details later on.
4. Investment in New Issues of Shares / Debentures In 1992, NRI’s have been allowed to take
up or subscribe on non-repatriation basis the shares or convertible debentures issued, whether
by public issue or private placement, by a company incorporated in India. They can also be
given rights / bonus shares and these certificates can be sent out of India. Any income accru-
ing from such investments or sale price of these securities will be credited to their NRI ac-
counts.
Investments in new issues under the Forty (40) per cent scheme are now allowed on repatria-
tion basis also. NRI’s can subscribe to new issues of shares or convertible debentures of any
new or existing company with the right of repatriation of the capital invested and income
earned thereon, provided the aggregate issue, to non-residents qualify for the facility of repa-
triation does not exceed 40 per cent of the face value of the new issue. Such investment can be
made only in private or public limited companies raising capital for setting up new industrial
/ manufacturing projects or for expansion or diversification etc. Such investments can also be
made in companies engaged in hospitals, hotels, shipping and development of computer soft-
ware and oil exploration services.
5. Deposits with Companies Companies can accept deposits from NRI’s within the limits
prescribed by Reserve Bank of India. The company accepting such deposits will apply for
permission to RBI with details of deposits and NRI’s will not be required to get separate per-
mission.
6. Investments in Commercial Paper & Mutual Funds NRI’s can invest in Commercial paper
issued by Indian Companies in non-repatriation basis. CP issued to NRI’s will not be transfer-
able.
They are also allowed to invest in mutual funds floated by private / public sector banks /
financial institutions. Such investments can also be made through secondary market. The
funds accepting such investments will get an approval from Reserve Bank of India.
7. Investment in Priority Industries NRI’s are permitted to invest with full repatriation
benefits upto 100 percent in the issue of equity shares or convertible debentures of a private /
public limited Company engaged in or proposing to engage in high priority industries. The
investments by NRI’s should cover foreign exchange requirements for import of capital goods.
Any income out of these investments can be freely remitted except in case of consumer goods
industries where the outflow on account of dividend is balanced by export earnings of the
company. The proposed project should not be located within 25 K.M. from the periphery of
the city have a population of more than 10 lakhs as per 1991 census. It means that government
wants to utilize NRI funds for industrializing new areas or under-developed areas.
8. Investment in Other Industries NRI’s can invest in sick industrial units. Such units must
be incurring losses for consecutive three years, its shares are selling at a discount for 2 years
and financial institutions have formulated rehabilitation plans for such sick units. Such in-
vestments are allowed on the following conditions:

688 Fianancial Management & International Finance

 (i) Investments can be made either by purchasing equity shares of existing share
holders or by subscribing to new issues of such Companies;
(ii) Bulk investment on private placement basis even upto 100 per cent of equity
Capital of sick unit.
(iii) The funds should come either as fresh foreign remittance or from NRI accounts;
(iv) The capital brought in will not be repatriated before 5 years.
(v) The sick unit will not be allowed to deal in real estate business or agricultural
plantation activities.
9. Investment in Housing & Real Estate Development NRI’s are permitted to invest upto 100
per cent in the new issue of equity shares / convertible debentures of Indian Companies engaged
in the following areas:
(i) Development of serviced plots and construction of built up residential premises;
(ii) Real estate covering construction of residential and commercial premises
including Business centres and offices;
(iii) Development of township;
(iv) City and region level urban infrastructure including roads bridges;
(v) Manufacturing of building materials;
(vi) Financing of housing development.
A permission from Reserve Bank of India is essential for making investments in above men-
tioned schemes. Repatriation of original investment is not allowed before 3 years.
The need for NRI investments is realized by the Government of India and that is why it has
made a number of schemes for attracting their funds. Various laws have been amended to
simplify the procedures for bringing NRI funds into the country. Indian economy needs more
and more investments in every activity. Infrastructural investments are inadequate to develop
a base for accelerating industrialization. Both direct and indirect investments are allowed to
NRI’s. They can take part in industrial activity by even investing 100 per cent money in certain
areas. On the other hand they can invest in mutual fund schemes and may deposit funds with
Commercial banks which too ultimately will be used for productive purposes.

Euro Issues
After the onset of the process of globalization of Indian economy, the govt. thought it imperative
to allow the companies in India to raise funds from foreign market in foreign exchange. It may
be noted that in case of foreign capital, the foreign exchange is involved, so, it is controlled and
regulated by the RBI and the govt. Euro issues are outside the ambit of SEBI. In November1993,
the govt. announced the scheme of issue of securities by Indian companies in capital markets

Fianancial Management & International Finance 689

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

abroad. This scheme is known as “issue of foreign currency convertible bonds and ordinary
shares scheme 1993”. The scheme has been reviewed and several amendments have been made
in the scheme from time to time.

The scheme has permitted Indian companies to two types of securities:

(a) Foreign currency convertible bonds ,and
(b) Equity shares through depositary receipts.
The regulatory provisions of these securities are as follows:
Foreign Currency Convertible Bonds (FCCBs):the FCCB means bonds issued in accordance
with the relevant scheme and subscribed by a non-resident in foreign currency and convertible
into depositary receipts or ordinary shares of the issuing company in any manner, either in
whole or in part, on the basis of any equity related warrants attached to debt instruments. A
company seeking to issue FCCBs should have consistent track record of good performance for
a period of three years. The FCCBs are unsecured; carry a fixed rate of interest and an option
for conversion into affixed number of equity shares of the issuer company. Interest on
redemption price (if conversion option is no exercised) is payable in dollars. Interest rates are
very low by Indian domestic standards. FCCBs are denominated in any freely convertible
foreign currency, generally in US $.

FCCB has been popular with issuers. Local debt markets can be restrictive with comparatively
short maturities and high interest rates. On the other hand, straight equity may cause a dilution
in earnings, and certainly dilutions in control, which many share holders, especially major
family share holders, would find unacceptable. Thus the low many coupon security which
defers share holders dilution for several years in form of FCCB, can be alternative to issuer.
Foreign investor also prefer FCCBs because of dollar denominated servicing, the conversion
option and the arbitrage opportunities presented by conversion of the FCCBs into equity at
discount on prevailing market price in India.

The major drawbacks of FCCBs are that the issuing company cannot plan capital structure as it
is not assured of conversion of FCCBs. Moreover, the projections for cash outflows at the time
of maturity cannot be made. In addition, FCCBs would result in creation of external debt for
the country, as there would be foreign exchange outflow from the country if conversion option
is not exercised by the investors. Some other regulations of FCCBs are

690 Fianancial Management & International Finance

 (1) Interest payment on bond, until the conversion option is exercised, shall be subjected
to TDS @ 10%

(2) Conversion of FCCBs into shares shall not give rise to capital gain in India.

(3) Transfer of FCCBs shall not give rise to capital gain in India.

Depository Receipts (DRs): A DR means any instrument in the form of depository receipt or
certificate created by the overseas depository bank outside India and issued to non-resident
investors against the issue of ordinary shares. In depository receipt, negotiable instrument
evidencing a fixed number of equity shares of the issuing company generally denominated in
U.S. $. DRs are commonly used by the company which sells their securities in international
market and expanding their share holdings abroad. These securities are listed and traded in
international stock exchanges. These can be either American depository receipt (ADR) or glo-
bal depositary receipt (GDR). ADRs are issued in case the funds are raised through retail mar-
ket in United States. In case of GDR issue, the invitation to participate in the issue cannot be
extended to retail US investors.

While DR is denominated in any freely convertible foreign currency, generally in US dollars

are issued by the depository in the international market, the underlying shares denominated
in Indian rupees are issued in the domestic market by the issuing company. These shares are
issued by the company are custodized in the home market with the local bank called custo-
dian.

An investor has an option to convert the DR into fixed number of equity shares of Issuer Com-
pany after a cooling period of 45 days. He can do so by advising the depository. The depository
in turn, will instruct the custodian about cancellation of DR and release the correspondence
shares infavour of non resident investor, for being sold directly on behalf of the non-resident
or being transferred in books of accounts of the issuing company in the name of the non resi-
dent. Once the underlying shares are released, the same cannot be recustodized. In addition,
shares acquired in open market cannot be custodized. Until such conversion the DRs, which
are negotiable, are traded on an overseas stock exchange, entitled for dividend in dollar but
that carry no voting rights, yield rupee dividend and are tradable on Indian stock exchanges
like another equity shares. Some other regulatory provisions are:

i. DR may be issued for one or more underlying shares.

ii. Dividend on shares will be subjected to TDS @10%.

iii. Transfer or trading of DR outside India will not give rise to any capital gain in
India.

Some of the provisions relating to euro issues are as follows:

1. Euro issue shall be considered as direct foreign investment in the issuing company.

2. There is no limit on the number of euro issues to be floated by a company in one year.

Fianancial Management & International Finance 691

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

3. Investment of proceeds of euro issues cannot be made in stock market and real estate.
However, the funds can be used for prepayment of scheduled payment of external
commercial borrowings.

4. Within the framework, GDR raising companies will be allowed full flexibility in de-
ploying the proceeds. Up to maximization of 25% of total proceeds may be used for
general corporate restructuring including working capital requirements of the com-
pany raising the GDR.

5. The company can be required to specify the proposed end uses of the issue proceeds at
the time of making their application, and will be required to submit the quarterly state-
ment of utilization of funds for the approved end uses, duly certified by the auditors.

6. Currently, companies are permitted to access foreign capital market through foreign
currency convertible bonds for (i) Restructuring of external debt which helps to lengthen
maturity and soften terms, and (ii) For end use of funds which confirm to the norms
prescribed by the govt. for external commercial borrowings (ECBs) from time to time.
In addition to these, not more than 25% of FCCB proceeds may be used for general
corporate restructuring including working capita requirements.

7. Companies will not permit to issue warrants along with their euro issue.

8. Companies may retain the proceeds abroad or may remit into India in anticipation of
the use of funds for approved end uses.

9. Both the in-principle and final approvals will be valid for three months from the date of
their respective issue.

Considering the funding requirements of unlisted companies, it has been decided to permit all
unlisted companies to float Euro/ADR issue provided they fulfill the three year track record
eligibility requirement. These unlisted companies floating GDR/ADR/FCCB issues would,
however, need to comply with the standard listing requirement of listing on the domestic
stock exchange within 3 years of having started making profit.

In February 2002, the government has allowed two-way fungibility of shares issued under the
euro issues. Two-way fungibility means reissue of ADR/GDR in place of shares which were
issued by way of conversions of ADR/GDR. Some of the regulatory provisions relating to two
way fungibility are:

a) Re-issuance of ADR/GDR would be permitted to the extent of ADRs/GDRs which

have been redeemed into underlying shares.

b) Transaction would be effected through SEBI registered brokers and under the RBI guide-
lines.

c) The re-issuance of ADR/GDR will takes place through custodian.

692 Fianancial Management & International Finance

 d) For creation of ADR/GDR the Indian broker will purchase the shares from stock ex-
changes, for which money will come from overseas buyer.

e) Overseas depositor will issue ADR/GDR to the foreign investors.

f) A monthly report of two way fungibility is to be submitted to the RBI and SEBI.

g) The two-way fungibility process is demand driven and the company is not involved in it.
Since 1994, several companies are have raised foreign capital through Euro issues (both
FCCB and DR). Some of these companies are Reliance, Dr. Reddy’s lab, Indian Rayon,
etc.

Benefits of Euro-issues to Issuing company

· International capital market is very large and liquid, and can absorb issues larger size.

· Better corporate image of issuing company both in India and abroad among bankers,
customers, etc.

· Proceeds can be used for import and acquisition abroad.

· It will broaden the shareholders base and enhance investors quality.

· It normally offers better comparative share value.

· The cost of raising equity funds from international market is generally lower than the
cost domestic issues.

· It implies acceptance by sophisticated western investors which in turn would help to

enhance the image of the company and its product internationally.

Benefits of Euro-Issues to the Investors

· Euro issues are allowed to be issued only by the companies with proven track record.

· It is listed and traded in international stock exchanges in the dematerialized form and
hence is free from delivery and settlement problems.

· It is generally denominated in US Dollars and hence reduces the foreign exchange risk.

· Dividend and interest on investment in Euro issues instruments may carry concessional
tax rates.

· Market for most of the script is more liquid and hence facilitates faster entry and exit.

· Investors in Euro-issues are not required to comply with a large number of complex
formalities and regulations normally required for investment through domestic stock
exchanges.

Fianancial Management & International Finance 693

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

Issue of ADRs by an Indian Company: An Indian company may think of floating an ADR
issue primarily with an intention of getting its shares listed at NASDAQ or New York Stock
Exchange. ADR issue should be attempted in two phases:

i. Preparing for the ADR issue: Before a company goes for issue of ADRs, it has to ad-
equately and systematically prepare for it. It has to prepare the business plan for which
the funds are required. Next, it should get fair valuation of its equity shares. The cur-
rent market price, projected earnings and intrinsic worth will help in this matter. The
company has to prepare and redraft its financial statements for last at least 3 years as
per US GAAP.

It has to empanel and select merchant bankers in the US capital market. These would
include Overseas Depository, Legal Advisors and Certified Public Accountants. The
company then has to obtain necessary approval from the government. Thereafter, it
has to get itself registered with the Securities Exchange Commission of US and the
NYSE or NASDAQ where the ADRs are planned to be listed. Then the company can
proceed with the offer of ADRs to the investors for which Roadshows. Presentations,
conference, etc. may be planned.

ii. Offering the ADRs: The ADRs are issued through the depository mechanism. The
subscription list will be kept open as per the SEC regulations. If the company has opted
for green shoe option, it has to prepare for this also. Once the subscriptions are received
in the designated overseas banks, the company shall create shares and will hand over
these shares to the custodian in India. The depository shall issue ADRs to the foreign
investors against the underlying shares.

The foreign investors can transact in the ADRs either by selling at the stock exchange, or can
get the underlying shares handing over the ADRs to the depository. These underlying shares
can then be sold at the recognized stock exchange in India.

694 Fianancial Management & International Finance

 9.2 Forward (Interest) Rate Agreements – FRAS
This Section includes:
· Forward Rate Agreements (FRA)
· Interest Rate Guarantee (IRG)

INTRODUCTION :

The foreign exchange market is undoubtedly the world’s largest financial market. It is a market
where one country’s currency is traded for another’s. Most of the trading takes place in few
currencies. Viz. US Dollar, Euro, Great Britain Pound, Japanese Yen, the four major currencies
of the world.

The foreign exchange market is an over the counter market, so there is no single location where
the trader’s get together. Instead market participants are located in major commercial and
investment banks around the world.

FORWARD RATE AGREEMENTS (FRA) :

Forward contracts helps the company to freeze the rate at which the currency will be bought or
sold and the forward rate agreement (FRA) freezes the rate at which interest will be paid on a
prospective borrowing arrangement. In other words, FRA is an agreement to borrow or to lend
a sum of money in the future, at any interest rate, which is fixed at the time the arrangement is
made.

For example : A forward rate agreement is entered into today under which X Ltd will borrow
from the bank Rs.100 crores one year from today at 10%. Like any forward contract, both par-
ties are obliged to contract.

Advantages

It protects the borrower from adverse movements in market rates of interest. Incidentally, on
the date of entering into the FRA there may or may not exist an underlying loan. Three situa-
tions are contemplated :

a. You don’t have an existing loan. You go to a banker indicating that you would like to
borrow Rs.100 crores two years form today. You want to freeze the rate. You enter into
an FRA for either a fixed rate or a floating rate.

b. You have an existing loan with a bank contracted at a certain fixed rate for the duration
of the loan. In this case, FRA cannot be used as hedging a tool to freeze interest rate
since the rate is already a frozen fixed rate.

c. You have an existing loan with a bank contracted at a floating rate. You could get into
a FRA under which say two years from today onwards you would have a fixed rate to
say 9%.

Fianancial Management & International Finance 695

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

On the specified date if the originally contracted rate turns out to be different from the FRA
rate, the differential will have to be received or paid. If actual original rate is higher than what
is agreed upon under FRA, the bank compensates the borrower. On the other hand, if the
actual original rate at the specified future date is lower than what is agreed upon under FRA
the borrower is required to pay the differential.

INTEREST RATE GUARANTEES (IRG) :

Interest Rate guarantees are true options in that they hedge the company against adverse inter-
est rate movements, but allow it to take advantage of favorable movements. In taking a deci-
sion on whether to use IRG or otherwise, cost in respect of other alternatives, such as Futures
Contracts, is also taken into account, and the most favorable alternative, which leads to the
lowest cost, is chosen.

Your firm will have $1,000,000 in 3 months’ time, for a 6-month period. Nobody is sure what
interest rates will prevail in the future. Some analyst’s think rates will increase, others feel they
will fall. You want to protect your firm against the risk of a reduced return on your funds. You
can use the Forward-Rate Agreements to protect yourself, but you know that if you use For-
ward-Rate Agreements now you will give up the possibility of benefiting from higher interest
rates. In these circumstances, interest-rate guarantee products can be very useful. An Interest-
Rate Guarantee is a product, which can be very useful in these circumstances. Basically, it is an
option on a Forward-Rate Agreement. It allows you a period of time during which you have
the right to buy a Forward-Rate Agreement at a set price. The guarantee protects you against a
fall in interest rates while giving you the freedom to enjoy a better return if rates increase. If
you want this guarantee you will need to pay a higher premium.

Illustration

Suppose you will have a deposit of $1,000,000 for a 6-month period beginning in 3 months’
time. You want to protect your firm against lower interest rates and guarantee a minimum
return of 5%. You can buy an Interest-Rate Guarantee at this rate of 5%. Let us see how the
option would work.

Examples

• In 3 months’ time the 6-month Libor sets at 4.5% you use your Interest-Rate Guarantee
and will receive a compensation for the 0.5% difference in interest rates so that your 5%
return is protected.

• In 3 months’ time the 6-month Libor sets at 5.5%. You choose not to use your guarantee
and instead you will deposit your funds at the higher rate. In these circumstances the
Interest-Rate Guarantee protected you against lower interest rates and also allowed
you to take advantage of the rise in interest rates.

696 Fianancial Management & International Finance

The benefits

The guarantee will give you full protection against falling interest rates.

The guarantee will give you freedom to benefit if rates increase.

If you decide that you do not need the guarantee, you can sell it back

Features

• You can get an Interest-Rate Guarantee whenever you need once customized to your
requirement.

• Interest rate guarantees are available for all major currencies and different maturities

• One can get Interest-Rate Guarantees from a bank other than the one who holds the
cash. Interest-Rate Guarantee can be used for any cash held or expected to have.

The price of your Interest-Rate Guarantee will depend on

• the guaranteed rate;

• how long you want the Option for; and

• how often interest rates are changing.

Interest rate Guarantee hedges the interest rate for a single period of up to one year.
Guarantee commission paid to the guarantor is comparable to option premium.

The comparison between Forward Rate Agreement and Interest Rate Guarantee are

· FRA covers the period which is mutually agreed by the parties of the contract,
but in IRG covers only a fixed period generally one year.

· IRG provides protect from one side i.e. adverse movement of interest rates. In
case of FRA, it covers both adverse and favorable movements. It simply hedges
the risk.

· FRA is similar to Forward contract and IRG is an option contract.

Fianancial Management & International Finance 697

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

9.3 Exposures in International Finance

This Section Includes:
· Transaction Exposure
· Translation Exposure
· Economic Exposure
· Political Exposure

INTRODUCTION :
The exposure indicates a situation of being open or being vulnerable to risks. As soon as a firm
enter into transactions dealings involve foreign currency, it is exposed to foreign exchange
risk. The dealings may be related to sale or purchase of goods and services, overseas invest-
ments or financing its operations in foreign currencies by issue of shares/debentures/loans to
foreign investors.

The exposure of a firm to variations in exchange rates, may be of four types:

i. Transaction Exposure
ii. Translation Exposure
iii. Economic Exposure
iv. Political Exposure
(i) TRANSACTION EXPOSURE :
Usually there is a time gap between sale of goods and services and the receipt and payment.
During this period the exchange rates may change and there may arise a risk due to exchange
rates. This risk is known as transaction exposure. A transaction exposure occurs when a value
of future transaction, though known with certainty, is dominated in some currency other than
the domestic currency. In such cases, the monetary value is fixed in terms of foreign currency
at the time of agreement which is completed at a later date. For example, an Indian exporter
is to receive payment in Roubles 90 days time for an export made today. His receipt in Roubles
is fixed and certain but as far as the revalue is concerned, it is uncertain and will depend
upon the exchange rate prevailing at the time of receipt. All fixed money value subjected to
transaction exposure. The transaction exposure look at the effects of fluctuations denominated
in foreign currency. It may be noted that if the payment is denominated in foreign currency,
then the importer carries the risk of transaction exposure. However, if the payment in do-
mestic currency of the importer then the risk of transaction exposure goes with the exporter.
So, the receipts and payments denominated in foreign currency have transaction exposure. If
receipts (denominated in foreign currency) are more than payment (denominated in foreign
currency), the decrease in value of foreign currency will cause exchange loss and apprecia-
tion in the value of foreign currency will bring exchange gains. However, if receipts are lower
than the payments, decrease in value of currency will create gain and appreciation will cre-
ate losses.

698 Fianancial Management & International Finance

(ii) TRANSLATION EXPOSURE :
Translation exposure is the profit or loss associated with converting foreign currency denomi-
nated assets / liabilities (also income and expenses) in reporting currency. It emerges when for
the limited purpose of financial reporting, items of income, expenses, assets & liabilities de-
nominated in foreign currency translated into home currency, i.e., reporting currency. The
effect of such translation need not necessarily affect the cash flows of an entity. [Risk under
this category relates to the accounting treatment of changes in exchange rates for reporting
purposes and is some what technical. And it is governed by accounting standard -11 revised
and issued by the Accounting Standard Board, and is dealt with there elaborately.

(iii) ECONOMIC EXPOSURE:

When an exchange rate changes, one currency depreciates and the importers of that country
would pay more for the current transactions. This is known as transaction exposure. The other
effect of the change in exchange rate would be that goods will be dearer and customers have to
pay more for the same product. This would affect the future cash flows by affecting the sales
and competitiveness.
In case, the currency of the exporter’s country depreciates, the exporter stands to gain in terms
of current transaction. The goods /services will become cheaper relative to competing coun-
tries and there exists a possibility of making increased sales and profits. This is known as the
economic exposure of the firm.

The economic value of an asset, or collection of assets, is the present value of the future cash
flows that the asset would generate. For a firm, the economic value is the present value of the
future cash flows. The economic exposure refers to the profitability that the changes in foreign
exchange rate will affect the value of the firm. Since the intrinsic value of the firm is equal to
sum of the present values of future cash flows discounted at an appropriate rate of return, the
risk contained in economic exposure requires a determination of the effect of changes in ex-
change rates on each of the expected future cash flows.

The value of the foreign assets or foreign subsidiary is affected not only by the business risk
but also by the exchange rate risks. The value of the foreign operation at any time depends
upon the future cash flows, expected exchange rate and the appropriate discount rate to be
applied to find out the present values.

Economic exposure is a broader and more subjective concept than the transaction and transla-
tion exposure because it involves potential effects of changes in exchange rates on all opera-
tion of the firm. So, the measurement of economic exposure requires that a detailed analysis of
the effects of exchange rate changes should be made.

Fianancial Management & International Finance 699

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

(iv) POLITICAL EXPOSURE :

Political risk refers to consequences that political activities in a country may have on the value
of a firm’s overseas operations.

Explanation: while political risks can cause either a negative or positive effect on the value of
the firm. We confine ourselves to adverse effects, on any firm operating in a foreign market.

Political risk includes :

· Discrimination against foreign business.

· Compulsory acquisition of properties of government.

· Boycott of products

· Rules specifying the use of labour and materials, or prices setting constraints.

· Exchange controls-limitations on the extent to which a country’s currency can be used

to transfer funds or restrictions on the conversion of currency into other currencies.

· Tax regulations biased against foreign investment, or foreign operations.

The link between transactions or events attributable to political risk, and change in exchange
rate, is rather week. Nevertheless, such risks associated with operations in a foreign center
cannot be ignored either.

The political risks are perceived to be high in foreign country, does not necessarily follow that
a company should refrain from investing in a country, if the project returns are large enough to
justify taking on that risk. The bottom line is- assess the risk- reward ratio and take decision.

700 Fianancial Management & International Finance

9.4 Parity Theorems
This section includes:
· Theory of Purchasing Power Parity (PPP)
· Theory of Interest Rate Parity (IRP)
· International Fisher Effect (IFE):
INTRODUCTION :
Foreign exchange includes Foreign Currency, Drafts, Bills, Letters of credit and travellers
cheques that are denominated and eventually payable in foreign currency. Exchange rate is
the price of foreign currency expressed in terms of local currency. The factors influencing rates
are the purchasing power parity (inflation). The differences between two countries, vis-a-vis
inflation and interest are addressed and suggested means are expressed to bring and
equilibrium.
THEORY OF PURCHASING POWER PARITY (PPP) :

This theory was enunciated by Gustav Cassel. Purchasing power of a currency is determined
by the amount of goods and services that can be purchased with one unit of that currency. If
there is more than one currency, it is fair and equitable that the exchange rate between these
currencies provides the same purchasing power for each currency. This is referred to as pur-
chasing power parity.
It is ideal if the existing exchange rate is in tune with this cardinal principle of purchasing
power parity. On the contrary, if the existing exchange rate is such that purchasing power
purity does not exist in economic terms, it is a situation of disequilibrium. It is expected that
the exchange rate between the two currencies conform eventually to purchasing power parity.
Likewise, if the rate of inflation is different in two countries, the floating exchange rate should
accordingly vary to reflect that difference. Let us consider two countries, A and B. The rate of
inflation in the country A is higher than that in the country B. As a result, imports of the
country A increases since the price of foreign goods tend to be lower. Similarly exports from
the country A decreases since the prices of its goods appear to be higher to foreigners (resi-
dents of country B included). This situation cannot persist for long. In consequence, the cur-
rency of country A will depreciate with respect to that of the country B.
If ih and if are the inflation rates in the home country and the foreign country; and ERo is the
value in terms of home currency for one unit of foreign currency at the beginning of the given
period and ER t is the value in terms of home currency at the end of the period,
ERt (1 + in ) t
then =
ER0 (1 + i f ) t

(1 + in )
Change in the exchange rate =
(1 + i f )

Fianancial Management & International Finance 701

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

Criticism of the PPP Theory

Conceptually, this theory is sound. However, there are a number of recognized factors that
prevent this theory from determining exchanges rates, in practice. Some of the major factors in
this regard are:
1. Government intervention, directly in the exchange markets or indirectly through trade
restrictions;
2. Speculation in the exchange market;
3. Structural changes in the economy of the countries;
4. Continuation of long-term flows in spite of the disequilibrium between purchasing
power parity and exchange rates.
Another criticism leveled against this theory is that the rate of inflation or the relevant price
level indices are not well defined. Questions pertaining to what constitutes an appropriate
sample and weight assigned to each commodity are not satisfactorily answered. For example,
should the sample represent all the goods and services, or only those that are traded interna-
tionally?
The theory takes into account only the movement of goods and services and not that of capital.
In operational terms, it is concerned only with the current account segment of the balance of
payment and not with the total BOP.
Above all, this theory ignores the fact that a currency may be an instrument of payment by
other countries (e.g. US dollar). In this situation the exchange rate may evolve in a manner that
has nothing to do with the price levels of the country (i.e. the USA).
The PPP theory can be considered as an ideal theory to determine exchange rates in specific
situations, such as high inflation or monetary disturbances. In such situations, the response to
individuals to changes in value of real and monetary assets can be expected to be strong and
the exchange rate prediction by PPP theory may turn out to be realistic.
Absolute Purchasing Power Parity : A theory which states that the exchanqe rate between one
currency and another is in equilibrium when their domestic purchasing powers at that rate’of
exchange are equivalent. In short, what this means is that bundle of goods should cost the
same in India and the United States once you take the exchange rate into account. To see why,
we’ll use an example.
First suppose that one Australian Dollar (AUD) is currently selling for 25 Indian Rupees (INR)
on the exchange rate market. In Australia cricket bats sell for AUD 40 while in India they sell
for only Rs.800. Since 1 AUD = Rs.25, then while the bat costs AUD 40 if we buy it in Australia,
it costs only AUD 32 if we buy it in India. Clearly there’s an advantage to buying the bat in
India, so consumers are much better off going to India to buy their bats. If consumers decide to
do this, we should expect to see three things happen :
1. Australian consumers would buy Indian Rupees in order to buy cricket bats in India. So
they go to an exchange rate office and sell their Australian Dollars and buy Indian Rupees.
This will cause the Indian Rupee to become more valuable relative to the Australian Dollar.

702 Fianancial Management & International Finance

 2. The demand for cricket bats sold in Australia decreases, so the price Australian retailers
charge goes down.
3. The demand for cricket bats sold in India increases, so the price Indian retailers charge
goes up.
Eventually these three factors should cause the exchange rates and the prices in the two countries
to change such that we have purchasing power parity. If AUD declines in value to 1 AUD =
Rs.23, the price of cricket bats in the AUD goes down to AUD 38 each and the price of cricket
bats in India goes up to Rs. 874 each, we will have purchasing power parity. This is because a
consumer can spend AUD 38 in Australia for a cricket bat, or he can take his AUD 38, exchange
it for Rs. 874 (since 1 AUD = Rs.23) and buy a cricket bat in India and be no better off.
Purchasing-power parity theory tells us that price differentials between countries are not
sustainable in the long run as market forces will equalize prices between countries and change
exchange rates in doing so. The example of consumers going overseas to buy cricket bats may
seem unrealistic as the expense of the longer trip would wipe out any savings you get from
buying the bat for a lower price. However it is not unrealistic to imagine an individual or
company buying hundreds or thousands of the bats in India then shipping them to Australia
for sale. In the long run having different prices in Australia and India is not sustainable because
an individual or company will be able to gain an arbitraae profit by buying the good cheaply in
one market and selling it for a higher price in the other market.
Thus Absolute PPP says that,
PIndia = Spot (Rs.lAUD) × PAustralia implies
Spot Exchange rate (Rs./AUD) = PIndia/PAustralia
Thus it is the price levels in countries that determine the exchange rate.
Since the price for any one good should be equal across markets, the price for any combination
or basket of goods should be equalized.
So, why Purchasing Power Parity theory doesn’t always work in practice?
Anything which limits the free trade of goods will limit the opportunities people have in taking
advantage of these arbitrage opportunities. A few of the larger limits are :
1. Import and Export Restrictions : Restrictions such as quotas, tariffs and laws will make it
difficult to buy goods in one market and sell them in another. If there is a 300% tax on
imported cricket bats, then in our first example it is no longer profitable to buy the bat in
India instead of the Australia. Australia could also just pass a law make it illegal to import
cricket bats.
2. Travel Costs : If it is very expensive to transport goods from one market to another, we
would expect to see a difference in prices in the two markets.
3. Perishable Goods : It may be simply physically impossible to transfer goods from one
market to another. There may be a place which sells cheap sandwiches in Indore, but that
doesn’t help me if I’m living in Delhi. Of course, this effect is mitigated by the fact that
many of the ingredients used in making the sandwiches are transportable, so we’d expect
that sandwich makers in Delhi and Indore should have similar material costs.

Fianancial Management & International Finance 703

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

4. Location : You can’t buy a piece of property in Indore and move it to New Delhi. Because
of that realestate prices in markets can vary wildly. Since the price of land is not the same
every where, we would expect this to have an impact on prices, as retailers in New Delhi
have higher expenses than retailers in Indore.
So while purchasing power parity theory helps us understand exchange rate differentials,
exchange rates do not always converge in the long run the way PPP theory predicts.
Absolute PPP works as a theoretical construct to understand an imaginary world of perfect
competition. It does not serve well as a practical model to forecast exchange rates.
As a practical matter, a relative version of PPP has evolved, which states that the change in the
exchange rate over time is determined by the difference in the inflation rates of the two countries.
THEORY OF INTEREST RATE PARITY :
There is a relationship between the foreign exchange market and the money market. This
relationship affects the rate of exchange as well as the difference between sopot rate and for-
ward rate. The IRP says that the spread between the forward rate and the sopt rate should be
equal but opposite in sign to the difference in interest rates between two countries. So, as per
IRP, a change in interest rate in any country will affect the exchange rates of its currency with
other currencies and vice-a-versa. The basic principle is that there is an interconnection be-
tween the interest rates and the exchange rates. As per IRP, the forward exchange rates be-
tween two currencies will be equal to the spot rate adjusted for the interest rates differential
between the currencies. According to IRP, the currency of one country with a lower interest
rate should be at a forward premium in terms of the currency of the country with the higher
interest rates. So, in an efficient market, the interest rate differential should be equal to the
forward rate differential. When this condition is met, the forward rate is said to be at interest
parity and the quilibrium prevails in the exchange market.
When the nominal interest rates differ from one country to another, the spot rate and the for-
ward rate will also be different. The relationship can be expressed as follows:

Forward Rate 1 + rh
=
Spot Rate 1 + rf
Where rh is the home interest rate and rf is the foreign country rate.
Criticism of the theory of Interest Rate Parity
The theory of interest rate parity is a very useful reference for explaining the differential be-
tween the spot and future, exchange rate, and international movement of capital. Accepting
this theory implies that international finance markets are perfectly competitive and function
freely without any constraints. However, reality is much more complex. Some of the major
factors that inhibit the theory from being put into practice are as follows:
Availability of funds that can be unused for arbitrage is not infinite. Further, the importance of
capital movements, when they are available, depends on the credit conditions practiced be-
tween the financial places and on the freedom of actions of different operators as per the rules
of the country in vogue.

704 Fianancial Management & International Finance

Exchange controls certainly place obstacles in the way of theory of interest rate parity. The
same is true about the indirect restrictions that can be placed on capital movement in the short
run.
Interest rate is only one factor affecting the attitude and the behaviour of arbitrageurs. In the
other words, capital movements do not depend only on interest rates. Other important factors
are concerned with liquidity and the case of placement.
Speculation is an equally important element. This becomes very significant during the crisis of
confidence in the future of currency. The crisis manifests in terms of abnormally high pre-
mium or discount – much higher that what the interest rate parity can explain.
Fisher effects
All interest rates in a country are nominal interest rates consisting of two elements:
a) The real interest rate, and
b) The expected rate of inflation
The real interest rate is also known as the real required rate of return. The expected rate of
inflation embodies an inflation premium sufficient to compensate lenders or investors for ex-
pected loss of purchasing power. So, the nominal interest rate depends on the rate of inflation
and is defined as:
Nominal Interest Rate = (1+ Real Rate) (1+ Inflation Rate) – 1
The real interest rate is relatively stable over time and is identical every where, but the nominal
interest rate will vary by the differences in expected rates of inflation. The Fisher Effect says
that the real interest rates are equalized across the countries, otherwise arbitrage will take
place. So, in the equilibrium stage, the nominal rate differential will approximately equal the
anticipated inflation rate differential. This can be stated follows:
(1 + rh ) (1 + ih )
=
(1 + rf ) (1 + i f )
Where rh and rf are nominal interest rates for home currency and foreign currency and ih and if
are inflation rates.
So, the Fisher Effect analyses the relationship between the interest rates and the expected infla-
tion. The countries with higher rate of inflation will have higher nominal interest rates.

Implications of IRP
l If domestic interest rates are less than foreign interest rates, foreign currency must trade
at a forward discount to offset any benefit of higher interest rates in foreign country to
prevent arbitrage. IRP states that if foreign currency does not trade at a forward discount
or if the forward discount is not large enough to offset the interest rate advantage of foreign
country, then arbitrage opportunity exists for domestic investors. In such case, domestic
investors can benefit by investing in the foreign market.
l If domestic interest rates are more than foreign interest rates, foreign currency must trade
at a forward premium to offset any benefit of higher interest rates in domestic country to
prevent arbitrage. If foreign currency does not trade at a forward premium or if the forward
premium is not large enough to offset the interest rate advantage of domestic country,
arbitrage opportunity exists for foreign investors. Foreign investors can benefit by investing
in the domestic market.

Fianancial Management & International Finance 705

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

Interest rate parity plays a fundamental role in foreign exchange markets, enforcing an essential
link between short-term interest rates, spot exchange rates and forward exchange rates.

Covered Interest Arbitrage

First, let us examine what is an, uncovered interest arbitrage. Uncovered interest arbitrage is
the notion that the forward exchange rate is an unbiased estimate of the future spot rate.
Uncovered interest arbitrage assumes that, on average, an investor who borrows in a low interest
rate country, converts the funds to the currency of a high interest rate country, and lends in
that country will not realize a profit or suffer a loss. It follows from uncovered interest arbitrage
that the expected return of a forward contract equals 0 percent
A covered interest arbitrage exists when an arbitrage profit can be made. The process of
borrowing in one currency and simultaneously investing in another with the exchange risk
hedged in the forward market is referred to Covered Interest Arbitrage.
If domestic interest rates are higher than the foreign interest rates, an arbitrageur would do the
following :
He would borrow in foreign currency, convert receipts to domestic currency at the prevailing
spot rate, invest in domestic currency denominated securities (as domestic securities carry
higher interest). At the same time he would cover his principal and interest from this investment
at the forward rate. At maturity, he would convert the proceeds of the domestic investment at
prefixed domestic forward rate and payoff the foreign liability. The difference between the
receipts and payments serve as profit to customer.
If foreign interest rates are higher than the domestic interest rates, an arbitrageur would do the
following :
He would borrow in domestic currency, convert receipts to foreign currency at the prevailing
spot rate, invest in foreign currency denominated securities (as foreign securities carry higher
interest). At the same time he would cover his principal and interest from this investment at
the forward rate. At maturity, he would convert the proceeds of the foreign investment at the
prefixed forward rate and payoff the domestic liability. The difference between the receipts
and payments serve as profit to customer.
Example :
$ Interest rate = 2% for 90 days in US £ Interest rate = 3% for 90 days in UK
Spot $/£ = 1.50 90 day forward $/£ = 1.50
Arbitrageur does the following :
Step I Borrow $1.50 million in US for 90 days.
Step II Convert to £ at the prevailing spot rate Le. 1.50 to get £1 million
Step III Buy 90 days Deposit at UK Bank yielding 3% for 90 days.
Step IV Sell £1.03 million forward [£1 million + £0.03 million interest on deposit] at forward
rate of 1.50 per £.
Step V At maturity he gets £ 1.03 million
Step VI Against his forward contract selling which he has booked he would get

706 Fianancial Management & International Finance

 1.50 × £ 1.03 = $1.545 million dollars
Compare this with 1.50 × 1.02= $1.530 million dollars he would have got by depositing directly
in US deposits. Thus he made a profit of $1.545 – $1.530 = 0.015 million dollars i.e. $15000.
INTERNATIONAL FISHER EFFECT (IFE):
IFE holds that the interest rates differentials should reflect the expected movement in the spot
exchange rates, i.e., the spot exchange rate should move an equal amount but in a different
direction to the difference in interest rates in two countries. The spot rate of a currency with
higher interest rate would depreciate and that of a lower interest rate would appreciate.
So, the interest rate differentials between two countries are offset by the spot and forward
exchange rates which is as follows:
S1 1 + rh
=
S0 1 + rf
Where S0 = Current Spot Rate
S1 = Future Sport Rate
rh = Home Interest Rate
rf = Foreign Exchange Rate

Advangates of International Fisher Effect

l Uses interest rate differentials to explain changes in exchange rates
l Assumes real interest rates are the same globally
l Believes high nominal rates indicate, potentially higher inflation and probable weakening
of the currency

Fianancial Management & International Finance 707

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

9.5 Foreign Direct Investment (FDI)

This Section includes:

· FDI Cash Flows

· Factors attracts FDIs
· Factors that discourage FDIs

INTRODUCTION :
Foreign investment into a country can come in form of direct investment or portfolio invest-
ment. Portfolio investment takes the form of acquisition of tradeable securities either in pri-
mary or secondary market. For is preferred for its direct nature. It implies a more lasting inter-
est and controlling voice in the management. Theoretically, FDI is less violates that the portfo-
lio investment.

FDI CASH FLOWS :

Foreign direct investment is one of the most important sources of foreign investment in devel-
oping countries like India. It is seen as a means to supplement domestic investment for achiev-
ing a higher level of growth and development. FDI is permitted under the forms of invest-
ments.

1. Through financial collaborations / capital / equity participation;

2. Through Joint ventures and technical collaborations;

3. Through capital markets (Euro Issues);

4. Through private placements or preferential allotment.

Capital participation / financial collaboration refers to the foreign partner’s stake in the capital
of the receiving country’s companies while technical collaboration refers to such facilities pro-
vided by foreign partner as licencing, trade marks and patents (against which he gets lump
sum fee or royalty payments for specified period); technical services etc.

From investors’ point of view, the FDI inflows can be classified into the following groups.

a) Market seeking: The investors are attracted by the size of the local market, which de-
pends on the income of the country and its growth rate.

b) Lower cost : Investors are more cost-conscious. They are influenced by infrastructure
facilities and labour costs.

c) Location and other factors:Technological status of a country, brand name, goodwill

enjoyed by the local firms, favourable location, openness of the economy, policies of
the government and intellectual property protection granted by the government are
some of the factors that attract investors to undertake investments.

708 Fianancial Management & International Finance

FACTORS THAT ATTRACTS FDIS IN INDIA :

The following factors can be held responsible for the flow of foreign direct investments in
India:

1. India has a well developed network of banking and financial institutions and an orga-
nized capital market open to foreign institutional investors that attracts them to under-
take investments.

2. India has vast potential of young entrepreneurs in the private sector. India skills and
competence is used as a base for carrying out production activities and export to
neighbour countries.

3. For the last few years there has been political stability in the country.

4. India enjoys good reputation among other countries as to honouring of its commit-
ments about repayment obligations, remittance of dividends etc.

5. India has vast potential of unskilled labour available at cheap rates as compared to
other countries, and vast natural resources that attract foreign investors.

FACTORS THAT DISCOURAGE FDIS :

Factors that discourage foreign investors to undertake investments in India include:

(i) High rates of taxation;

(ii) Lack of infrastructure facilities;

(iii) Favouritism in the selection of investment;

(iv) Complicated legal framework of rules, regulations procedures for foreign

direct investments into India;

(v) Lack of transparency.

Fianancial Management & International Finance 709

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

FDI Inflows

Foreign Direct Investment is an important avenue through which investment takes place in
India. The importance of FDI extends beyond the financial capital that flows into the country.
In addition, foreign direct investment can be a tool for brining knowledge, and integration into
global production chains, which are the basis of a successful exports strategy.

The following shows FDI Inflows:

710 Fianancial Management & International Finance