International Financial System Session 1-3: Prof. Rishika Nayyar FORE School of Management

International
Financial System
Session 1-3
Prof. Rishika Nayyar
FORE School of Management
Objective of the course
• Understand the need and special features of international finance and financial system.
• Understand the need of studying international finance.
• How has the international monetary system evolved- main focus on the determination of currency
exchange rates in each phase.
• Foreign exchange market.
• Balance of payment, understanding of the record of transactions.
• International Banking, Equity and Bond market.
• Corporate governance and its relation to finance.
• Foreign direct investment.
Why international finance?
• Globalized and integrated world economy.

• Production and consumption of goods and services has been highly globalized.
CASE IN POINT: Wimbledon Tennis Ball- manufacturer, Slazenger- headquartered in London.
• Travels 11 countries, 4 continents before being manufactured in Bataan (Philippines).
• Clay shipped from South Carolina in the USA, silica from Greece, magnesium carbonate from Japan,
zinc oxide from Thailand, sulphur from South Korea and rubber from Malaysia to Bataan where the
rubber is vulcanized – a chemical process for making the rubber more durable.
• Wool then travels from New Zealand to Stroud in Gloucestershire, where it is turned into felt and
then sent back to Bataan in the Philippines.
• Petroleum naphthalene from Zibo in China and glue from Basilan in the Philippines are brought to
Bataan where Slazenger manufacture the ball. Finally tins are shipped in from Indonesia and once the
balls have been packaged they are sent to Wimbledon.
Why international finance?
• Integration of financial markets; Deregulation of international capital markets.

• Internationally diversified investment portfolios; increasing FPIs.
• Cross listing of companies on foreign stock exchanges.
• Trade liberalization.
• Multinational corporations (as of 2018- 60,000 MNCs controlling more than 5,00,000
subsidiaries- UNCTAD World Investment Report).
What’s special about international finance?
• Sovereign governments have the right to regulate the movement of goods, capital, and people
across their borders.
Foreign exchange risk
• In integrated financial markets, individuals or households may also be seriously exposed to
uncertain exchange rates.
• Suppose 1 INR = USD 0.015 and an Indian investor buys 10 shares of a US company at
USD 200 each, amounting to USD 2000 (in INR terms ~ 1,33,300) After one year, let’s say
the investment is worth 10 percent more, amounting to USD 2200.
• But if the USD has depreciated say after 1 year, 1 INR = USD 0.020, the Indian value of
the investment would be (2200/0.020 = 1,10,000).
• So the investor would actually lost the money in INR (home/domestic currency terms).
• The foreign exchange risk does not encounter in purely domestic transactions.
• Exchange rate uncertainty has pervasive influence on all the major economic
functions, including consumption, production, and investment.
Political risks
• Ranges from unexpected changes in tax rules to outright expropriation of assets held
by foreigners.
• It arises from the fact that a sovereign country can change the “rules of the game” and
the affected parties may not have effective recourse.
• Example: Vodafone Essar Tax case in India (2007) (amendment to tax laws with a
retrospective effect).
• April 2012- Argentine government nationalized a majority stake in YPF, the country’s largest
oil company, worth approximately $10 billion, held by the Spanish parent company, Repsol,
accusing the latter for underproducing oil in Argentina.
• Broadly, the seizure of YPF is a part of the campaign to bring strategic industries under
government control.
Market imperfections
• World economy is integrated more than it was 10 or 20 years back, but a variety of barrier still
hamper free movements of people, goods, services, and capital across national boundaries.
• Frictions and impediments (legal restrictions, transaction and transportation costs etc.),
information assymetries prevent markets to function perfectly. “MNCs are a gift of market
imperfections”!
Expanded opportunity sets

• Firms can locate production in any country or region of the world to maximize their performance and
raise funds in any capital market where the cost of capital is the lowest.
• Individual investors can also benefit greatly if they invest internationally rather than domestically.
• Holding internationally diversified portfolio than purely domestic portfolio. Stock returns tend to
covary less across countries than within a given country.
Goal: maximize the benefits from the global opportunity set, while judiciously controlling currency and
political risks and managing various market imperfections.
Financial managers of MNCs should learn how to manage foreign exchange and political risks using
proper tools and instruments, deal with (and take advantage of) market imperfections, and benefit from
the expanded investment and financing opportunities. By doing so, financial managers can contribute to
shareholder wealth maximization.
International Monetary System
Why study International Monetary System?
• Integrated world economy; Globalization;

• Increasing flow of goods, services, people, finance across borders.
• Different countries- different currencies
• Framework and mechanism which determines the value of one country’s currency vis-à-vis
other.
• Rules of international payments system.
• A brief history of IMS- how international transactions have been consummated over the
centuries; how was the value of one country’s currency determined with respect to another’s.
International Monetary System- Evolution
• 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
• Bimetallism was a “double standard” in the sense that both gold and silver were used
as money.
• Some countries were on the gold standard (Britain after 1816; US after 1873), some on
the silver standard (China, India, Germany, Holland), and some on both (Britain
maintained bimetallism until 1816 after which it abolished the free coinage of silver;
US dollar dropped silver dollar after 1873).
• Both gold and silver were used as an international means of payment, and the
exchange rates among currencies were determined by either their gold or silver
contents.
Example:
1. Exchange rate between currencies where one country is on a gold or silver standard
and another is on a bimetallic standard
a. Great Britain- Fully Gold standard; France- Bimetallic standard
Exchange rate between Britain Pound and French Franc was determined by the gold
content of the two currencies.
b. Germany- Fully Silver standard; France- Bimetallic standard
Exchange rate between German Mark and French Franc was determined by the silver
content of the two currencies.
2. Exchange rate between currencies where one country is on a gold standard and
another is on a silver standard-
This involved finding out exchange rate of both the currencies vis-à-vis the currency of
the country on a bimetallic standard.
Therefore, following the example 1-
The exchange rate between Britain Pound and German Mark was determined by their
exchange rates against the franc.
• Countries on bimetallic standard often experienced Gresham’s law: Bad money

(abundant) drives out good (scarce) money!
Classical Gold Standard: 1875-1914
• First full-fledged gold standard- 1821 in Great Britain; notes from the Bank of England
were made fully redeemable for gold.
• France- effectively from 1850s but formally adopted the standard in 1878; Germany-
1875; US- 1879; Russia and Japan- 1897.
• During this period in most major countries:
• Gold alone was assured of unrestricted coinage.
• There was two-way convertibility between gold and national currencies at a stable
ratio.
• Gold could be freely exported or imported.
• In order to support unrestricted convertibility into gold, banknotes need to be backed
by a gold reserve of a minimum stated ratio.
• Domestic money stock should rise and fall as gold flows in and out of the country.
• Money supply was linked with the inflow and outflow of gold from the country.
• The exchange rate between two country’s currencies would be determined by their
relative gold contents.
Example:
• Britain Pound- 6 pounds per ounce of gold;
• French Franc- 12 Francs per ounce of gold;
Exchange rate between GBP and FF would be 2 Francs per pound.
• Fostered a regime of stable exchange rates, providing a conducive environment for
international trade and investment.
• Provided for an automatic correction of imbalances in the balance of payments account

of the countries via price-specie-flow mechanism (David Hume).
• Suppose Great Britain exported more to France than France exported to Great Britain.
• GB- Trade Surplus (Net exports); more gold flows into the country---money
supply increases--- inflation--- price rise make GB’s export uncompetitive---
Decrease in exports--- trade surplus wiped out.
• France- Trade deficit (Net imports); gold outflow--- money supply decreases–
price level comes down--- exports increase.
• Net exports (imports) are accompanied by a net inflows (outflow) of gold in (from)
the country.
• Also provided for correction of misalignment of the exchange rate via cross-border
flows of gold.
Suppose in exchange market: 1 GBP is trading at 1.8 FF--- Pound is undervalued and
France is overvalued.
• Nobody would like to buy overvalued FF and sell undervalued GBP in the exchange
market. People would be interested in buying GBP for Franc from the market.
• Since people only want to buy, not sell, pounds at the exchange rate of Fr1.80/£, the
pound will eventually appreciate to its fair value, namely, Fr2.0/£.
This is possible because the gold standard provided for a two way convertibility between
gold and national currencies
Suppose a person needs 1000 FF, a simple solution is

• Buy Gold from the bank of England in return for pounds; ship the gold to France and
sell it for FF.
• How much gold to buy: (1000FF/12) = 83.33 ounces (PS: these ounces of gold are
needed to covert them into 1000 FF in France where 1 ounce of gold = 12 FF)
• 1 ounce of gold from BOE – 6 GBP, Pounds needed: 6* 83.33 ~ GBP 500.
• Ship 83.33 ounce of gold to France where 1 ounce fetches 12FF = 83.33*12 = FF 1000
• Cost if 1000 FF were purchased from the market--- 1000/1.8 = GBP 555.56
Interwar Period: 1915-1944
• The onset of WW-I marked the end of classical gold standard.

• All major countries suspended the redemption of banknotes in gold. Suffered from
hyperinflation.
• 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 the gold standard, but participants lacked the political
will to “follow the rules of the game.”
• In the backdrop of Great Depression of 1929. Britain experienced massive outflow of
gold. Gold reserves fell to a point where it was impossible to maintain the gold
standard- Britain then got off the gold standard, followed by various other counties
such as Canada, Sweden, Austria, Japan, France, and the US.
• No coherent international monetary system prevailed- the result for international trade
and investment was profoundly detrimental.
Bretton Woods System: 1945-1972
• July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire.

• Purpose: Discuss and design the postwar international monetary system.
• Achieve exchange rate stability without resorting to an international gold standard.
• Result of negotiations: creation of International Monetary Fund (IMF) and sister
affiliate- International Bank of Reconstruction and Development (IBRD), known as
World Bank.
• The IMF embodied explicit set of rules about the conduct of international monetary
policies and was responsible for enforcing these rules.
• IBRD- Chiefly responsible for financing individual development projects.
• Each country established a par value in relation to the U.S. dollar, which was pegged
to gold at $35 per ounce.
German
British mark French
pound franc
Each country was responsible for
Par
maintaining its exchange rate within r
Pa lue Value
P
Va ar
lue
(+,-)1 percent of the adopted par Va
value by buying or selling foreign U.S. dollar
exchanges as necessary.
Pegged at $35/oz.
Gold
• U.S. dollar was the only currency that was fully convertible to gold - Dollar-based
gold-exchange standard.
• Countries could use gold as well as foreign exchange as an international means of
payment.
• Therefore, held U.S. dollars, as well as gold, for use as an international means of
payment.
• Advantages of this system: Offsets the deflationary effects of limited world’s gold
stock (i.e., limited reserves); Countries could earn interest on their foreign exchange
reserves; Saving transaction costs associated with transporting gold across countries.
• International trade and investment witnessed high growth during 1950s- 60s due to
amply supply of monetary reserves and stable exchange rates.
Bretton Woods System: 1945-1972; Triffin
Paradox
• Indicated by Prof. Robert Triffin- Dollar based gold exchange standard would collapse
in the long run.
• To satisfy the growing need for reserves of other countries--- US had to supply
dollars--- run balance of- payments (BoP) deficit continuously.
• Under the gold-exchange system, the reserve-currency country should run
balance-of-payments deficits to supply reserves, but if such deficits are large and
persistent, they can lead to a crisis of confidence in the reserve currency itself, causing
the downfall of the system.
• This dilemma, known as the Triffin paradox , was indeed responsible for the eventual
collapse of the dollar-based gold exchange system in the early 1970s.
Bretton Woods System: 1945-1972; Special
Drawing Rights (SDRs)
• To partially alleviate the pressure on the dollar as the central reserve currency, the IMF
created an artificial international reserve called the SDR in 1970.
https://www.imf.org/en/About/Factsheets/Sheets/2016/08/01/14/51/Special-Drawing-R
ight-SDR
• SDR- A basket currency comprising major individual currencies, was allotted to the
members of the IMF, who could then use it for transactions among themselves or with
the IMF.
• In addition to gold and foreign exchanges, countries could use the SDR to make
international payments.
• Initially- SDR was designed to be the weighted average of 16 currencies of those
countries whose shares in world exports were more than 1 percent.
• The percentage share of each currency in the SDR was about the same as the country’s
share in world exports.
Bretton Woods System: 1945-1972; Special
Drawing Rights (SDRs)
• In 1981, however, the SDR was greatly simplified to comprise only five major currencies:
U.S. dollar, German mark, Japanese yen, British pound, and French franc.
• The weight for each currency is updated periodically, reflecting the relative importance of
each country in the world trade of goods and services and the amount of the currencies held as
reserves by the members of the IMF. Basket reviewed every 5 years.
• Now, SDR is composed of five major currencies—the U.S. dollar, Euro, British pound,
Japanese yen, and the Chinese renminbi (added in 2016).
• Two criteria to be met: export criteria (currency should be issued by and IMF member and is
also one of the top 5 world exporters); freely usable (widely used to make payments for
international transactions and widely traded in the principal exchange markets).
• The value of SDR- Determined daily based on market exchange rates; tends to be more
stable than the value of any individual currency included in the SDR.
The Flexible Exchange Rate Regime:
1973-Present
• Outcome of the Jamaica Agreement (1976) between the IMF members. Key elements-
• Flexible exchange rates were declared acceptable to the IMF members, and central
banks were allowed to intervene in the exchange markets to iron out unwarranted
volatilities.
• Gold was officially abandoned (i.e., demonetized) as an international reserve asset.
Half of the IMF’s gold holdings were returned to the members and the other half
were sold, with the proceeds to be used to help poor nations.
• Non-oil-exporting countries and less-developed countries were given greater
access to IMF funds.
• The exchange rate under this regime became substantially more volatile than they were
under the BW system.
Current Exchange Rate Arrangements
• Classified by the IMF, based on member countries’ actual, de facto arrangements.

• Classification is primarily based on the extent to which the exchange rate is determined
by the market rather than by official government action, with market-determined rates
generally being more flexible.
• 10 separate regimes are identified-
1. No separate legal tender: Currency of another country circulates as the sole legal
tender. Implies a complete surrender of the monetary authority’s control over the
domestic monetary policy (e.g., Ecuador, El Salvador, and Panama).
2. Currency board: An extreme form of the fixed exchange rate regime under which
local currency is full backed by the U.S. dollar or another chosen standard
currency (e.g., Hong Kong, Bulgaria, and Brunei)
• Domestic currency has to be fully backed by the foreign assets (i.e., foreign currency).
• Leaves little room for discretionary monetary policy.
• Eliminates traditional central bank functions such as monetary control (fixing interest
rates) and lender of last resort.
• The economic conditions of the foreign country determines the interest rates.
3. Conventional peg: The country formally pegs its currency at a fixed rate to another
currency or a basket of currencies.
• The country authorities stand to maintain the fixed parity through-

• Direct intervention (i.e., via sale or purchase of foreign exchange in the market) or;
• Indirect intervention (e.g., via interest rate policy, imposition of foreign exchange
regulations).
• No commitment to irrevocably keep the parity.
• Exchange rate may fluctuate within narrow margins of less than (+,-) 1 percent around
a central rate—or the maximum and minimum value of the spot market exchange rate
must remain within a narrow margin of 2 percent for at least six months.
• Examples include Jordan, Saudi Arabia, and Morocco.
4. Stabilized arrangement: Entails a spot market exchange rate that remains within a
margin of 2% for 6 months or more (e.g., Indonesia, Singapore, and Lebanon).
5. Crawling peg: Involves the confirmation of the country authorities’ de jure
exchange rate arrangement.
• The currency is adjusted periodically in small amounts at a fixed rate or in
response to changes in selective quantitative indicators, such as past inflation
differentials vis-à-vis major trading partners, differentials between the inflation
target and expected inflation in major trading partners.
• Similar constraints on monetary policy as in the case of conventional peg system.
(e.g., Honduras and Nicaragua).
6.
6. Crawl like arrangement: The exchange rate must remain within a narrow margin of 2
percent relative to a statistically identified trend for six months or more. The country
does not officially follow crawling peg. E.g. Ethiopia, China, and Croatia.
7. Exchange rates with crawling bands: The currency is maintained within certain
fluctuation margins of at least ±1 percent around a central rate-or the margin between the
maximum and minimum value of the exchange rate exceeds 2 percent-and the central
rate or margins are adjusted periodically at a fixed rate or in response to changes in
selective quantitative indicators. Tonga is the only example.
8. Other managed arrangement: This category is a residual, and is used when the
exchange rate arrangement does not meet the criteria for any of the other categories.
Arrangements characterized by frequent shifts in policies may fall into this category.
Examples are Costa Rica, Switzerland, and Russia.
9. Floating (also called Managed Floating with No Predetermined Path for the
Exchange Rate): Largely market determined, without an ascertainable or predictable
path for the rate.
Foreign exchange market intervention may be either direct or indirect, and serves to
moderate the rate of change and prevent undue fluctuations in the exchange rate, but
policies targeting a specific level of the exchange rate are incompatible with floating.
Examples include Brazil, Korea, Turkey, and India.
10. Free floating: Intervention occurs only exceptionally and aims to address disorderly
market conditions; authorities confirm intervention has been limited to at most 3
instances in the previous 6 months, each lasting no more than 3 business days (e.g.,
Australia, Canada, Mexico, Japan, U.K., U.S., and euro zone)
Concluding IMS
• European Monetary System (based on European Currency Unit and Exchange rate
mechanism);
• Rise of Chinese RMB-
• Maintained a fixed exchange rate of RMB vis-à-vis USD at 8.27 per USD for a long time.
• 2005- One time revaluation to 8.11 RMB per USD; allowed to float as per market demand and
supply.
• RMB was allowed to appreciate for next 3 years (2006-2008).
• 2008- RMB reverted to fixed exchange rate at 6.28 per USD. To avoid heightened economic
uncertainty caused by GFC, 2008.
• 2010-Floated again.
• Close link with USD- a daily “central parity rate” is fixed and announced before the start of each
trading day. Serves as a midpoint of the band. RMB/USD X rate is allowed to vary 2% around this
point.
Concluding IMS
• Fixed versus flexible exchange rate system. An ideal IMS?

Trade off between national policy independence and international economic integration.
An ideal IMS, should provide-
• Liquidity- sufficient monetary reserves to support the growth of international trade
• Adjustment- effective mechanism to restore the BoP disequilibrium when it is
disturbed.
• Confidence- offer a safeguard to prevent crises of confidence in the system that
result in panicked flights from one reserve to another.
Asian Financial Crisis
• Started with Thailand, 1997.

• Spread to other Asian countries- Indonesia, Korea, Malaysia, Philippines.
Origins-
• Liberalization of financial markets and free flows of capital across countries.
• Hot money bubble in Asian countries, high economic growth rate of 8-12% per annum
during late 1980s and early 1990s. Asian economic miracle.
• Fixed or stable exchange rate encouraged excessive risk taking by both borrowers and
lenders.
• As governments tried to control overheated economy, asset prices (assets that were
used as collaterals for loans) came down. Quality of bank loans declined.
• Mid 1990s- US recovered from recession, Federal Reserve raised interest rates, US
dollar appreciated, causing currencies pegged to it also appreciate.
• Thai Baht appreciated- hurt exports.
• With a shock in both exports and foreign investments, asset prices which were
leveraged by large amounts of credits further declined as foreign investors panicked
and began to withdraw.
• Massive capital outflow put pressure on currency of Thailand and other Asian
countries.
• Thai government initially injected liquidity to domestic financial system and tried to
defend the exchange rate by drawing on its foreign exchange reserves.
• Ultimately, it was forced to devalue the Baht or let it float as it exhausted its foreign
reserves.
• The sudden collapse of Baht touched off a panicky flight of capital from other Asian
countries with a high degree of financial vulnerability.
• Contagion of currency crisis was caused at least in part by the panicky flight of capital
from the Asian countries for a fear of spreading crisis.
• Fear itself became self-fulfilling.
• Impossible Trinity.
International
Financial System
Session 4-6
Foreign Exchange Market
• Two-tier market:
• Wholesale or inter-bank market
The interbank market is a network of international banks operating in financial centers around
the world. A network of banks that trade currencies with each other. Each has a currency
trading desk called a dealing desk.
In inter-bank market, each trade represents an agreement between the banks to exchange the
agreed amounts of currency at the specified rate on a fixed date.
Minimum trade sizes are one million of the base currency, such as €1 million of EUR/USD or
$1 million of USD/JPY.
Accounts for approximately 93% of trading volume (BIS, 2019)
Dictates currency values.
• Retail or client market- market where companies and individuals trade.
Bank Market Share

The 10 biggest players in the foreign JP Morgan Chase 12.13%
exchange market, according to UBS 8.25%
Euromoney's 2018 FX Survey XTX Markets 7.36%
“FX Survey 2018: Overall Results
Bank of America Merrill Lynch 6.20%
Citi 6.16%
HSBC 5.58%
Goldman Sachs 5.53%
Deutsche Bank 5.41%
Standard Chartered 4.49%
State Street 4.37%
• Market Participants- 5 groups-

• International banks
Core of FX market. Primary function is to buy and sell foreign currency as their own business,
i.e. the “make a market” in foreign exchange. They serve their retail clients (the bank
customers) in conducting foreign commerce or making international investments in financial
assets.
These banks maintain trading operations to facilitate speculation for their own accounts, called
proprietary trading (or prop trading for short), and to provide currency trading services for their
customers.
• Bank customers- includes MNCs, money managers, private speculators; who require
foreign exchange for conducting foreign commercial transactions or making foreign
investments in financial and other assets.
• Non-bank dealers, consists of non-banking financial institutions such as investment banks,

mutual funds, pension funds and hedge funds that operate independently in the inter-bank
market.
• Makes up 55% of the volume of trade in inter-bank market (BIS, 2019)
• Foreign exchange brokers- are dealers who buy or sell foreign currencies but do not take a
position themselves. Help clients get better rate on the currency trade my making available
different quotes offered by dealers. Charge a commission.
Forex brokers in India- Interactive brokers, AvaTrade, XM Group, FXPro etc
https://www.forexbrokers.com/guides/india
• Central Banks- intervene in the FOREX market to maintain the official or unofficial target of the
forex rate for its home currency.
• Intervention- process of using foreign currency reserves to buy one’s own currency in order to
decrease its supply and this increase its value in the foreign exchange market, or alternatively
selling one’s own currency in order to increase its supply and lower its price.
Correspondent Banking Relationships
• The inter-bank market is a network of correspondent banking relationships, with large commercial banks
maintaining demand deposit accounts with one another.
• Demand deposit accounts- correspondent banking accounts.
EXAMPLE-
1. US importer wants to purchase goods from Dutch exporter invoiced in Euro, cost- €7,50,000
2. rate (US Bank): $ 1.3092 / € 1.00
3. If the price is acceptable to the importer, US bank will debit the importer’s demand deposit account for $
981900 = €7,50,000 * 1.3092.
4. US Bank will then instruct its correspondent bank in the euro zone, EZ bank to debit its correspondent
bank account €7,50,000 and to credit that amount to Dutch exporter’s bank account.
Correspondent Banking Relationships
5. US Bank will then credit its book $981900, as an offset to the same amount of debit to US
importer’s account, to reflect the decrease in its correspondent bank account balance with EZ
bank.
The entire communication between the US bank and EZ bank takes place over SWIFT (Society for
Worldwide Interbank Financial Telecommunication).
SWIFT allows international commercial banks to communicate instructions to one another. It is a
private nonprofit message transfer system with headquarters in Brussels.
SWIFT
• The Swift network connects around 8300 banks, financial institutions and companies operating
208 countries.
• As and when two counterparties undertake a transaction, SWIFT transports the message to both
financial parties in a standard form. As the forex market is mainly an OTC market, SWIFT
message provides some kind of legitimacy to the transactions.
“SWIFT is solely a carrier of messages. It does not hold funds nor does it manage accounts on
behalf of customers, nor does it store financial information on an ongoing basis. As a data carrier,
SWIFT transports messages between two financial institutions. This activity involves the secure
exchange of proprietary data while ensuring its confidentiality and integrity”.
SWIFT
• For every participating member, SWIFT assigns a unique code. This code is used to transport
messages.
Different SWIFT codes assigned to HSBC

bank operating at different places.
Spot FX Market and Rate
• The spot FX market involves almost the immediate purchase or sale of foreign exchange.
• Cash settlement: T+2 days (i.e., within 2 business days after the transaction for trade between
the currency pair is made.
Foreign Exchange Rate: Price of domestic currency in terns of a foreign currency. Value of Indian
Rupee in terms of the US dollars: 69.10INR/USD
Spot Exchange Rate: Exchange rate for a transaction that requires immediate delivery of foreign
exchange. Rate at which trades in spot FX market takes place.
Direct Quote and Indirect Quote
Foreign Exchange Rate
• Direct Quote: Domestic currency price of one unit of foreign currency; e.g. 69.10 INR/USD.
• Indirect Quote: Foreign currency price of one unit of domestic currency; e.g. 0.014USD/INR.
• Can also be quoted as American Quote or European Quote.
• American Quote: Direct Quote from the US perspective: Price of one unit of foreign currency
quoted in terms of US dollar, S($/£): 1.9077.
• European Quote: Indirect Quote from the US perspective: Price of one unit of US dollar quoted
in terms of foreign currency, S(£/$): 0.5242
• Most currencies in the inter-bank market are quoted in European terms; i.e. US dollars quoted is
priced in terms of foreign currency.
Foreign Exchange Rate
• American and European Quotes are reciprocals of each other-

• American Quote for USD and GBP: S($/£): 1.9077.
• European Quote: S (£/$) = 1/ S ($/£) = 1/1.9077 = 0.5242.
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Cross Exchange Rate
• A cross exchange rate is the exchange rate between a currency pair where neither currency is
the US dollar.
• Calculated from the US dollar exchange rates for the two currencies, using either American or
European term quotations.
EXAMPLE: Suppose we have American quotes for Britain Pound (GBP) and Euro.
S($/£): 1.5405
S($/€): 1.3902
Calculate cross exchange rate between GBP and Euro S(€/£)
Cross Exchange Rate
• S(€/£) = S($/£)/ S($/€)

= 1.5405/1.3092 = 1.1767; 1 GBP costs 1.1767 Euro.
Analogously, S (£/ €) = S($/€)/S($/£) = 1.3092/1.5405 = 0.8499; 1 Euro costs 0.8499 GBP
If spot rates are given in European Terms

S(£/$): 0.6491
S(€/$): 0.7638
Cross Exchange Rate
S(€/£) = S(€/$)/ S(£/$) = 0.7638/ 0.6491

= 1.1767
Bid-Ask Spread
• A bid is the exchange rate in one currency at which a dealer will buy another currency.
• An ask is the exchange rate at which a dealer will sell another currency.
• The difference between the bid and the ask is called bid-ask spread.
S($/£): $1.5400 - $1.5405
Buying and selling one unit of denominator currency.
Bid: S($/£): 1.5400 ---- Dealer buys 1 GBP for USD 1.5400
Ask: S($/£): 1.5405------ Dealer sells 1 GBP for USD 1.5405
Ask> Bid---- Selling Price > Buying Price---- Difference– Spread
1.54- First two digits are called “big figure”. Second two digits- “small figure”
Bid-ask spread- 5 points----- 00 to 05 --- 1.5400 – 1.5405
Bid-Ask Spread
Bid: S($/£): 1.5400 ---- Dealer buys 1 GBP for USD 1.5400
----- Sells 1 USD for GBP (1/1.5400 = 0.6494)----- Ask (GBP/USD)
Ask: S($/£): 1.5405------ Dealer sells 1 GBP for USD 1.5405

----- Buys 1 USD for GBP (1/1.5405 = 0.6491)----- Bid (GBP/USD)
Therefore, from American quotation (Bid-Ask) of a currency pair (USD/GBP), the European
Quotation (Bid-Ask) of same currency pair (GBP/USD) can be calculated
Bid-Ask Spread
S (£/$): 0.6491 – 0.6494
Bid Ask
S (USD/GBP) 1.5400 1.5405
S (GBP/USD) (1/1.5405) (1/1.5404)

= 0.6491= 0.6494
Cross Rate Trading Desk
• Dealing room of large banks are set up with traders dealers trading against the USD in all the
major currencies: Japanese Yen, euro, Canadian Dollar etc., and the local currency.
• Infeasible to maintain trading desk for all the currency pairs.
Cross-Rate Trading desk- Dealing in two currencies where none is USD.

Suppose a customer wants to trade out of GBP into Swiss Franc (SF)--- sell GBP and buy SF.
Currency against currency trade.
How are such trades handled?

Bank will first sell USD to buy GBP and then buy USD to sell SF.
Calculation of cross exchange rate Bid-Ask Spread
Given- S (USD/GBP): USD 1.5400- USD1.5405

S(GBP/USD): GBP 0.6491- GBP 0.6494
S(USD/Euro): USD 1.3087- USD 1.3092
S( Euro/USD): Euro 0.7638- Euro 0.7641
Calculate Bid-Ask spread for S(Euro/GBP) and S (GBP/Euro)
S (bid) (Euro/GBP)= S (bid) (Euro/USD) * S (bid) (USD/GBP)

= 0.7638*1.5400 = 1.1763
Reciprocal of S(bid) (Euro/GBP)= S (ask) of (GBP/Euro) = 1/1.1763 = 0.8501
S (ask) (Euro/GBP)= S (ask) (Euro/USD) * S (ask) (USD/GBP)

= 0.7641* 1.5405= 1.1771
Reciprocal of S(ask) (Euro/USD)= S (bid) of (GBP/Euro) = 1/1.1771 = 0.8495
Hence,
S (Euro/GBP): Euro 1.1763 – Euro 1.1771
S (GBP/Euro): GBP 0.8495 – GBP 0.8501
Cross rate bid-ask spread are larger than American/ European bid-ask spread.
Implicitly incorporate the bid-ask spread of 2 transactions that are necessary for trading out of one
non-dollar currency into another.
Cross-Rate Foreign Exchange Transactions
Given
S (USD/GBP): 1.5400 – 1.5405
S (USD/Euro): 1.3087 – 1.3092
S (GBP/USD): 0.6491 – 0.6494

S (Euro/USD): 0.7638- 0.7641
Bank customer wants to sell GBP 1,000,000 for Euro

2 transactions
1. Bank will buy GBP and sell USD

2. Bank will buy USD and sell Euro
For 1--- Bank’s bid rate for GBP against USD--- S(USD/GBP): USD 1.5400 /GBP
Customer will receive = GBP 1,000,000 * (USD 1.5400/GBP) = USD 1540000
For 2---- Bank’s bid rate for USD against Euro---- S(Euro/USD): Euro 0.7638/USD
This will translate into--- USD 1540000 * 0.7638 (Euro)/USD = Euro 11,76,252
Bank customer has effectively sold GBP 1000000 for Euro 11,76,252
The cross exchange rate applied is --- S (Euro/GBP) = Euro 11,76,252 / GBP 1000000
= Euro 1.1763/GBP 1
Case 2: Bank customer wants to sell Euro 1000000 for GBP

Forward FX Market
• Segment of the foreign exchange market where currencies are traded not for immediate delivery, but for
delivery on any future date, say, after fortnight, 30 days, 90 days and so on.
• The forward market involves contracting today for the future purchase or sale of foreign exchange.
• The rate (forward exchange rate) at which the trade will take place in the future is locked in on the day the
contract is entered.
• Forward exchange rates are usually higher (premium) or lower (discount) than the spot exchange rate.
• Quoted for maturity period- 1, 3, 6,9 and 12 months.
• Settlement date of a 3 month forward transaction--- 3 calendar months from the spot settlement date for
the currency.
https://www.barchart.com/forex/quotes/%5EEURUSD/forward-rates
https://www.fxempire.com/currencies/usd-inr/forward-rates
Forward Premium or Discount
• Expressed as an annualized percentage deviation from the spot rate.
f(INR/j) = [(F(n) (INR/j)- S(INR/j))/ S(INR/j)] * 360/days

Forward FX Market
Value date
Suppose a currency is purchased on 1 August.
If it is a spot transaction, the currency will be delivered on 3 August.
If it is a one-month forward contract- the “value date” will be 3 September.
If value date falls on a holiday- the subsequent date is the value date.
Broken-date contract- Contract with maturity period different from the standard- 1,3,6,9 months.
To suit the needs of the parties to the contract.
Maturity period: 35 days
Forward FX Market
What will be the forward rate for 1 month and 10 days (broken day contract) if:
S (INR/USD): 60-60.10
1-month forward(INR/USD): 60.50-60.70
3-month forward (INR/USD): 60.80-61.10
Buying rate: 50 + [(80-50)*(10days /60 days)] = 55 60.50 + (60.80-60.50)*(10/60)= 60.55

Selling rate: 70 + [(110-70)*(10 days /60 days)]= 77 60.70 + (61.10-60.70)*(10/60) = 60.77
Forward rate for 1 month and 10 days (INR/USD): 60.55 – 60.77
Long and Short Forward Positions
• Buying or selling foreign currency in the forward market.

• If the customer or bank buys foreign currency in the forward market- long position.
• If the customer or bank sells foreign currency in the forward market- short position.
• By using forward contract, one can “lock in” the forward price for forward purchase or sale of
foreign exchange.
• Regardless of what the spot price is on the maturity date of the forward contract, the trader buys
(long position) or sells (short position) at the agreed rate.
Suppose F1(INR/USD): 68.05

S(1) INR/USD: 69.05
INR has depreciated against USD.
If trader has taken a long position for USD 10,000.
Under 1 month forward contract, trader will have to buy USD 10,000 at F1 (INR/USD): 68.05=
10,000 * 68.05 = INR 680500, at the value date.
In the absence of forward contract, trader would have to buy from the market at S(1) INR/USD:
69.05 = USD 10,000 * 69.05 = INR 690500
Profit from entering long forward contract when the currency is expected to appreciate:
690500-680500= 10000
If trader has taken a short position
Under 1 month forward contract, trader will have to sell USD 10,000 at F1 (INR/USD): 68.05=
10,000 * 68.05 = INR 680500
In the absence of forward contract, trader would sell in the market at S(1) INR/USD: 69.05 = USD
10,000 * 69.05 = INR 690500
Loss from entering short forward contract: 680500 - 690500= (-)10000
What if spot rate after 1 month is INR/USD: 67.05?

Speculative Forward Position
Case- Expectation- INR is going to appreciate against USD over next 3 months.
Speculative activity-
Enter a 3 month forward short contract (INR/USD). Suppose Rate F(3) (INR/USD): 68.05
Short contract--- Short sell USD for INR in the forward market.
Situation after 3 months: Expectations are realized: S(INR/USD): 67.10

---- INR has appreciated as expected.
---- The speculator has entered forward short contract
Speculative Forward Position
• Under the contract, the speculator has to deliver USD.
At the end of 3 months, he or she will first buy USD from the spot market at the rate of
67.10INR/USD.
Under the terms of forward contract, he or she will deliver the USD at the agreed rate of
68.05INR/USD
Speculative profit per USD= INR 68.05 – INR 67.10 = INR 0.95
Profit Long position in USD -
Profit if INR depreciates
0
INR appreciates 68.05 S (INR/USD) after 3
INR depreciates
months
Loss Short position in USD-

Loss if INR depreciates
Determination of Exchange Rate
• Market forces of demand and supply of currencies in the foreign exchange market.
1. Relative Price Levels (US and India)

• Influences international trade patterns
• Inflation in the home country (India)- dampens the demand for domestically produced goods in
domestic as well as foreign market.
• Exports fall, imports rise.
• Exports fall- supply of foreign currency (USD) in home market falls (demand of INR in FEM
falls).
• Imports rise- demand of foreign currency (USD) in the home market increases (supply of INR in
FEM rises).
Determination of Exchange Rate
• The resulting demand and supply pressure causes foreign currency (USD) to appreciate against
domestic currency (INR).
• Countries experiencing high rates of inflation- currency depreciates.
INR/USD Initial Exchange Rate (INR/$): 65
1. Price level rises in India.
2. Exports decline (Supply of US dollars falls)--
New Supply Curve-S2
68
65 3. Imports rises (Demand for USD increases).
New Demand Curve- D2
4. Demand for USD increases, supply declines.
Hence USD appreciates against Indian Rupee
or Rupee depreciates against USD. Exchange
Rate post inflation (INR/$): 68.
Relative Interest Rates
• US and India
• Suppose interest rate in India rises in comparison to the US.
• Investors in both the countries would want to invest in INR denominated securities to get the
benefits of higher rate of return.
• Supply of USD increases as the US investors convert their purchasing power from USD to INR.
• USD depreciates against INR.
• Hence for a country with higher interest rates- currency appreciates.
Relative Economic Growth Rates
• High economic growth rate in a country will attract foreign investment.

• Economic growth rate in India > Economic growth rate in the US
• Foreign investment will move to India--- India-US specific case- US investors convert USD into
INR to invest in India. Supply of USD increases- USD depreciates against INR.
• Broad situation (global level): For fast growing economies (ex. India)- Demand for INR in the
FEM rises.
• INR appreciates.
• Economic growth causes the domestic currency to become stronger as compared to the foreign
currency.
Some other factors
Political and Economic Risk:

• Higher political and economic risk in a country leads to depreciation of its currency.
• Risk averse temperament of investors
Market expectations:
• If market expects US dollar to depreciate in future due to expected fall in interest rates
(Monetary Expansion), they would start selling off their current US dollar holdings which
depresses USD value today.
Real and Nominal Exchange Rates
Nominal exchange rate- Ratio between the value of two currencies at a particular point of time.
Real exchange rate- Price-adjusted nominal exchange rate
E(r) = E * Domestic price indices/Foreign price indices
E(r) = E * (P/P*)
If the price index in India and the US rises from 100 in 2017 to 120 and 110 respectively in 2019
and if the nominal exchange rate between the 2 currencies between the two time periods remain
INR/USD: 67, the real exchange rate will move to-
Real and Nominal Exchange Rates
E(r) = 67 * (120/110) = 73.09
In floating exchange rate regime, nominal exchange rate moves automatically with a change in the
price level. But in a fixed exchange rate regime, it does not happen so because exchange rates
are administered.
As a result, there is a gap between nominal and real exchange rate in fixed exchange rate regime.
International
Financial System
Session on PPP
and IRP
Exchange rates in the long-run
PURCHASING POWER PARITY
Law of one price: In competitive markets (free of transportation costs and official barriers to trade
such as tariffs) identical goods sold in different countries must sell for the same price when their
prices are expressed in terms of same currency.
• Simple way to understand:
• Price of sweater in the US (in USD)= USD 45
• Then price of sweater in London (when quoted in USD) should also be USD 45.
• Implies one price prevails?
• How? If you have USD 45 in your hand, you can buy the same sweater in the US as well as
London.
Law of one price
• Explanation: Exchange rate between USD and GBP

Example:
• Suppose S(USD/GBP): 1.50
• This means: 1 GBP= 1.50 USD?
• Price of sweater in the US= USD 45
• 45/1.5 = GBP 30
• Then the price of sweater in London (in GBP) should be GBP 30, for the law of one price to hold.
Law of one price
• Suppose S (USD/GBP): 1.45 and sweater is selling in Britain at GBP 30

• Dollar price of sweater in Britain: 30*1.45 = USD 43.50
• Dollar price of sweater in the US: USD 45
• Arbitrage: Buy sweater from Britain and sell in the US.
• Push Britain prices up and lower down prices in the US market- until they are equal in 2
locations.
Law of one price
• So, the law of one price implies that the dollar price of good “i” is the same wherever it is sold.
i i
P US
= E(USD/GBP) * (P London
)
USD 45= 1.50* GBP 30
Equivalently, the dollar/pound exchange rate is (by rearranging the above equation)
i i
E(USD/GBP)= P US
/ (P London
)
Purchasing Power Parity
• The theory of purchasing power parity states that the exchange rate between two currencies
equals the ratio of the countries’ price levels (i.e. the money price of a reference basket of goods
and services).
E(USD/GBP)= P US/ (P London)
• Example:
• Price of reference commodity basket in the US= USD 200
• Price of same commodity basket in the London = GBP 160
• So, exchange rate = USD 200/GBP 160= 1.50 USD per GBP.
Purchasing Power Parity
• Now, suppose price level in the US increases by 3 times,

• USD 200* 3 = USD 600
• New exchange rate would be : USD 600/ GBP 160 = 3.75 USD per GBP
• USD has depreciated.
• Why?
• Because price level in the US has increased.
Relationship between PPP and Law of one
price
• The law of one price applies to individual commodities

• Note the “i” in the equation for law of one price:
E(USD/GBP)= Pi US / (Pi London)
• PPP, on the other hand, applies to general price level (which is a composite of the prices of
all commodities that enter into the reference basket). Basket of goods and services
• Note the equation of PPP:
E(USD/GBP)= P US / (P London)
Relationship between PPP and Law of one
price
• Hence, if law of one price holds true for every commodity, PPP must hold automatically as long
as the reference baskets used to compute price levels in different countries is the same.
• Reference basket- iphone, sweater, burger, laptop

• Law of one price holds for all these commodities
• PPP will automatically apply.
• Price level in US/ Price level in London = Exchange rate (USD/GBP)
For PPP to hold, it is also important that the same commodities are included in the same
proportion in domestic market basket and world market basket. If it is not so, PPP will not hold
even if the law of one price holds for all the commodities.
Absolute and relative PPP
• S(USD/GBP)= P US / (P London) : Absolute PPP
• Relative PPP states that the percentage changes in the exchange rate between
two currencies over any period equals the difference between the percentage
change in national price levels.
[S (USD/GBP) t – S (USD/GBP) t-1] / S (USD/GBP) t-1
= [(P US, t - P us, t-1) / (Pus, t-1)] - [(P London, t - P London, t-1) / (P London, t-1)]
Percentage change (increase) in price in London= 10%, in US=5%
[S (USD/GBP) t – S (USD/GBP) t-1] / S (USD/GBP) t-1 = = -5%

Absolute and relative PPP
• [S (USD/GBP) t – S (USD/GBP) t-1] / S (USD/GBP) t-1 = = -5%
• USD/GBP= 1.50 – (5% of 1.50) = 1.425

• USD/GBP = 1.425
•Precise(specification of relative PPP: St (A/B) / S0 (A/B) = (1+ I A) t / (1+ I B) t

•S/1.50 = (1+0.05)/(1+0.10)
•Inflation rate differential = [(1+ I A) t / (1+ I B) t ]-1

Fisher Effect
• Relationship between nominal and real interest rate.

• Decomposition of nominal interest rate in to 2 parts- real interest rate and expected rate of
inflation.
• Simply, nominal interest rate = real interest rate + inflation
• More precisely, 1+ nominal interest rate = (1+real interest rate) (1+ expected rate of inflation)
• 1 + r = (1+a) (1+I)
• When an investor thinks of investment, he is interested in a particular nominal interest rate which
covers both the expected inflation and the required real interest rate.
Fisher Effect
• Suppose required real interest rate: 4%

• Expected rate of inflation : 10%
• Required nominal rate of interest would be = (1+0.04) (1+0.10) – 1 = 14.4%
• The concept of real interest rate applies to all investment- domestic and foreign.
• An investor invests in a foreign country if the real interest rate differential is in his favour.
• When such differential exists, arbitrage begins in the form of international capital flow that
ultimately equals the real interest rate across countries.
• Suppose interest rate is India: 5%, in US: 4%
• Capital will begin flowing from the USA to India.
Fisher Effect
• Declining volume of capital will raise the real interest rate in the USA.
• Increasing volume of capital will push down the real interest rate in India.
• The capital flow will continue unto the real interest rate in the two countries become equal.
• This means that the process of arbitrage helps equate the real interest rate across countries and
since the real interest rate is equal in different countries, the country with higher nominal interest
rates must be facing a higher rate of inflation.
International Fisher Effect- Combined effect
of interest rate and inflation
• Combination of the conditions of the PPP theory and Fishers effect (closed proposition).
• PPP theory suggests that exchange rate is determined the inflation rate differentials.
• Fisher effect suggests that the nominal interest rate is higher in a country with high inflation rate.
• Combining these two propositions, the international fishers effect suggests that- the interest rate
differential shall equal inflation rate differential.
• (1+ r A) / (1+ r B) = (1+ I A) / (1+ I B)
• Interest rate differential : (1+ r A) / (1+ r B)-1
• Inflation rate differential : (1+ I A) / (1+ I B) -1

• Interest rate differential - Inflation rate differential =0
• (1+ r A) / (1+ r B) = (1+ I A) / (1+ I B)
• The rational behind the proposition- an investor likes to hold assets denominated in currencies
expected to depreciate only when the interest rate in those assets is high enough to compensate
the loss on account of depreciating exchange rate.
Equality between interest rate and inflation rate differential
Example- Expected rate of inflation (over next year), India: 8 percent; US: 3 percent
Exchange rate in the beginning of the year- S(INR/USD): 60
--- Exchange rate at the end of the year --- using relative PPP specification---
• St (A/B) / S0 (A/B) = (1+ I A) t / (1+ I B) t

= 60 (1.08/1.03) = 62.91
Further, if interest rate in India: 7%, US: 4%. At the end of the period interest rate in India will rise
to an extent that will equate approximately the inflation rate differential.
St (INR/USD) / S0 (INR/USD) = (1+ r India) / (1+ r USA)

62.91/60 = (1+ r India) / 1.04 ~ 9 %
• Interest rate differential = (1.09/1.04) -1 = 4.81%

• Inflation rate differential = (1.08/1.03)-1 = 4.85%
Interest Rate Parity
• Theory for determination of exchange rate in the forward market.

• The equilibrium is achieved when the forward rate differential is approximately equal to the
interest rate differential.
• In other words, forward rate differs from the spot rate by an amount that represents the interest
rate differential.
• In the process, the currency of a country with lower interest rate should be at a forward premium
in relation to the currency of a country with higher interest rate.
• Assumptions- no transaction cost, no taxes, no political risk.
• Equating forward rate differential with interest rate differential
A * (n-day F – S)/S = (1+ r A) / (1+ r B) -1
A= 360/n
F = (S/A) [(1+ r A) / (1+ r B) -1] + S

Interest rates: India: 10%; USA: 7%

Spot exchange rate (INR/USD): 60
Calculate 90 day forward rate.
F = 60/4 [(1.10/1.07)-1] + 60 = 60.42 --- Depreciation of INR against USD
Higher interest rate in India will push down the forward value of INR from 60/USD to 60.42/USD.
Covered Interest Arbitrage
• When forward rate differential is not equal to the interest rate differential, covered interest arbitrage will
begin and it will continue till the two differentials become approximately equal.
• A positive interest rate differential (India-US) is offset by annualized forward discount.
• A negative interest rate differential is offset by annualized forward premium.
Example: Suppose spot rate (INR/USD) : 60

3-month forward rate (INR/USD): 60.28
Interest rates- India: 18%, USA: 12%
IRD- 1.45 FRD- 1.9

IRP- Equation
•[1+ Interest rate (country A)] = [1+ Interest rate (country B)] * [ F
(A/B) / S (A/B)]
•(1+0.045) = (1+0.03) (60.28/60)

•1.045
•1.034
• Borrow USD 1000 at 12% interest p.a. for 3 months.

• Convert USD into INR at spot rate : S (INR/USD): 60 = INR 60,000.
• Invest INR 60,000 at 18% interest p.a. for 3 months.
• Selling INR 90-day forward at 90 day F (INR/USD): 60.28.
• After 3 months, liquidate the INR 60, 000 investment. Proceeds (with interest): 60,000 * (18/100)
* (3/12) = 2700… Proceeds = 62700.
• Sell INR 62700 for USD at F (INR/USD): 60.28, to get USD 1040.
• Repay loan in the USA: USD 1000 + interest (1000 @12% for 3 months): USD 1030.
• Profit = USD 1040- USD 1030 = USD 10
• So long as inequality continues between the forward rate differential and the interest rate
differential, arbitrageurs will profit and the process of arbitrage will go on.
• The differential will wipe out for the following reasons-
• Borrowing in the USA will raise the interest rate there.
• Investing in India will push down interest rates because of increased inflow of invested funds.
• Buying INR will increase spot rate of INR against USD.
• Selling INR forward will depress the forward rate of INR.
The first two actions will narrow the interest rate differential (5.37%) and while last two actions
will widen the forward rate differential (~1.9%)
Uncovered Interest Arbitrage
• The arbitrageur does not take advantage of the forward market and does not go for any forward
contract.
• The decision behind profit making depends upon the expectation about future spot rate, in as
much as the interest rate differential between two countries leads to changes in future spot rate.
• If interest rate differential is equal to changes in the future spot rate, uncovered interest arbitrage
will exist.
(1+ r A) / (1+ r B) = [S (A/B) e+1 – S (A/B)] / S (A/B)
S (A/B) e+1 – Expected future spot rate
Uncovered Interest Arbitrage
• So long as the equality is not reached, the arbitrageurs will go for uncovered interest arbitrage.
• Interest rates- India: 7%, US: 4%---- interest rate differential (1.07/1.04) -1 = 2.88%
• If the arbitrageur expects a depreciation of 4% in the future spot rate of INR against USD.
• Invest in US denominated securities. Will fetch greater amount of INR at a future date.
Numerical- PPP
• End of 2017-18 : S (INR/USD): 63.91

• Inflation in India during 2018-19: 7%
• Inflation in the US during 2018-19: 4%
• Calculate –
1. Inflation rate differential
2. 2. Exchange rate at the end of 2018-19=
1. [(1+.07)/(1+0.04)] -1
2. St (A/B) / S0 (A/B) = (1+ I A) t / (1+ I B) t
= St (A/B) / 63.91 = (1.07)/(1.04)
St (A/B)= 65.75
Numerical - IRP
• S (USD/GBP): 1.50
• 3-month F (USD/GBP): 1.52
• 3 month interest rate: US: 8% p.a. ----- 2%
• UK: 5.8% p.a.----- 1.45%
Assume: You can borrow GBP 10,00,000 and USD 15,00,000
Numerical - IRP
Interest rate differential : [(1+0.02)/(1+0.0145)] -1 : 0.54%

Forward rate differential : [(1.52-1.50)/1.50] * (360/90) = 0.0533= 5.33%
Use the IRP equation

Numerical - IRP
1. Borrow USD 15,00,000; Interest payable after 3 months @ 2%: USD 30,000
2. Convert USD 15,00,000 into GBP using S(USD/GBP): 1.50: (15,00,000/1.50) = GBP 10,00,000
3. Invest GBP 10,00,000 in London for 3 months @ 1.45%; Interest receivable: GBP 14,500
4. Sell GBP forward at 3 month F (USD/GBP): 1.52----- GBP 10,14,500 * 1.52 = USD 15,42,040
5. Repay USD loan with interest: USD 15,30,000
6. Arbitrage Profit: USD 15,42,040 – USD 15,30,000 = USD 12,040
IRP- 2
•Suppose that the current spot exchange rate is FF6.25/$ and the three-month forward exchange rate is FF6.28/$.
The three-month interest rate is 5.6% per annum in the U.S. and 8.8% per annum in France. Assume that you can
borrow up to $1,000,000 or FF6,250,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in
terms of U.S. dollars. Also determine the magnitude of arbitrage profit.
b. Assume that you want to realize profit in terms of French francs. Show the covered arbitrage process and
determine the arbitrage profit in French francs.
As discussed in the class, the question can be solved by using the exchange rates as given (i.e., no need of
converting the given indirect quote for USD into direct quote for USD). However, if you are more
comfortable with working with direct for USD- you can convert. The care has to be taken regarding
designating the countries as A and B. Direct Quote for USD implies US is country A and other country
(France here) is country B.
USING EXCHANGE RATES AS GIVEN IN THE QUES
S = FF 6.25/$; F = FF 6.28/$ (Maintaining/ Using indirect quote for USD) Country A- France; Country B- US (See in the
shared IRP note)
US Interest = 1.40%; France Interest = 2.20%
(1+ Interest France) = (1+ Interest USA) [(F FF/USD)/S (FF/USD)]
(1+0.022) = (1+0.014) (6.28/6.25) = 1.022>1.018 (Invest in France, Borrow in US)
(1) Borrow $1,000,000; repayment: (1,000,000 * 1.014)= $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000 (1,000,000 * 6.25 = FF 6,25,00,000
(3) Invest in France; maturity value = FF 6,25,00,000 * 1.022 = FF 63,87, 500.
(4) Sell FF63,87,500 forward for 63,87,500 / 6.28 = $1,017,118.
Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.
b. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Buy $1,014,000 forward for FF6,367,920.
Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920.
S = FF 6.25/$ = $0.16/FF; F = FF 6.28/$ = $0.1592/FF; (Converting indirect quote for USD into direct quote for
USD)
US Interest = 1.40%; France Interest = 2.20%, Direct quote for US (US/FF): US- Country A, France- Country B-
See the shared IRP note.
(1+ Interest US) = (1+ Interest France) [(F USD/FF)/S (USD/FF)]
(1+0.014) = (1+0.022) (0.1592/0.16) = 1.027 1.014< 1.0169 (Invest in France and Borrow in US)
(1) Borrow $1,000,000; repayment: (1,000,000 * 1.014)= $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000 (1,000,000 * 6.25 = FF 6,25,00,000
(3) Invest in France; maturity value = FF 6,25,00,000 * 1.022 = FF 63,87, 500.
(4) Sell FF63,87,500 forward for 63,87,500 / 6.28 = $1,017,118.
Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.
b. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Buy $1,014,000 forward for FF6,367,920.
Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920.
A note on IRP
When interest rate differential is not equal to forward rate differential, interest rate parity
does not exist.
While determining the arbitrage profit, the following equation should be used to find out
where should an investor borrow from and where should the investment be made-
[1+ Interest rate (country A)] = [1+ Interest rate (country B)] * [ F (A/B) / S (A/B)]
If L.H.S > R.H.S: Invest in country A and Borrow in country B

If L.H.S < R.H.S: Borrow in country A and invest in country B
Country A is usually the home country of the investor, but it is not necessary that the
information on this would be given in every question.
International
Financial System
BoP and CG
Why study Balance of Payment (BoP)?
1. Provides a detailed information concerning the demand and supply of a

county’s currency.
• For example, if India imports more than it exports, then this means that the
supply of INR is likely to exceed the demand in the foreign exchange market,
ceteris paribus .
• INR would be under pressure to depreciate against other currencies.
• On the other hand, if India exports more than it imports, then the INR would be
likely to appreciate.
Why study Balance of Payment (BoP)?
2. Signal a country’s potential as a business partner for the rest of the world.
• A country experiencing BoP difficulty may not be able to expand imports
from the outside world.
• Impose measures to restrict imports, discourage capital outflows.
3. Can be used to evaluate the performance of the country in international

economic competition. Persistent trade deficits imply lack of international
competitiveness in country’s domestic industries.
What is Balance of Payments (BoP)?
• The measurement of all international economic transactions between the

residents of a country and foreign residents is done with the help of a statement
called the balance of payments (BOP) account.
• The statistical record of a country’s international transactions over a certain
period of time presented in the form of double-entry bookkeeping.
• International Economic Transactions- involve at least 2 currencies and 2
countries.
• Examples: Import and Export of goods and services; cross-border investments
in businesses, bank accounts, bonds, stocks, and real estate.
• The BOP is a cash flow statement that records the flow (receipt/payment) of foreign
exchange between countries.
• In general, any transaction resulting in a payment to foreigners is entered in the BoP
as a debit and is given a negative (-) sign.
• Any transactions resulting in a receipt from foreigners is entered as a credit and is
given a positive (+) sign.
• Credit entries in India’s balance of payments result from foreign sales of India’s
goods and services, financial claims, and real assets.
• Debit entries, on the other hand, arise from India’s purchases of foreign goods and
services, financial claims, and real assets.
• Based on the double entry principle.

• Each transaction is recorded twice- as a debit (-) and credit (+) entry.
Balance of Payments Accounts
Balance of
Payments
Account
Capital and
Current
Financial
Account
Account
Goods Services Current Capital Financial

Income
Trade Trade Transfers Account Account
Current Account
• The current account includes all international transactions with receipts or payment
flows occurring within the current year.
It consists of four sub-categories:
• Merchandise trade- exports and imports of tangible goods;
• Services trade- invisible trade- payments and receipts for legal, consulting, and
engineering services, royalties for patents and intellectual properties, insurance
premiums, shipping fees, and tourist expenditures;
Current Account
• Income (Primary income)- payments and receipts of interest, dividends, and other
income on foreign investments that were previously made.
• Current/Unilateral transfers (Secondary income)- Unlike other accounts in the

balance of payments, unilateral transfers have only one-directional flows, without
offsetting flows. Examples include foreign aid, reparations, official and private
grants, and gifts.
• For the purpose of preserving the double-entry bookkeeping rule, when goods,
services, or assets are provided without a corresponding return of something of
economic value, the corresponding entry is made as a transfer.
Recording of Current Account Transactions-
Double Entry Book Keeping
• Exports- Sale of goods to foreigners- Credit (+) in current account.

Corresponding entry- Financial account- Banking assets (deposits) increase (because
foreign currency has flown in)- Debit entry (-).
If the importer uses balance from his foreign currency account held in India to make the
payment, it will represent reduction of bank’s (foreign currency) liability- debit (-) entry.
• Imports- Purchase of goods from foreigners- Debit (-) in current account.
Corresponding entry- Financial account- Banking assets (deposits) decrease (because
foreign currency flows out)- Credit entry (+).
Current Account Balance- J Curve Effect
• Current Account Balance- receipt from foreigners on account of merchandise and

services trade (exports), primary income, unilateral transfers minus payments to
foreigners on account of merchandise and services imports, payment of interest
dividend etc., grants and aids.
• Especially the trade balance tends to be sensitive to exchange rate changes.
• Generally, as a country’s currency depreciates against the currencies of major trading
partners, its exports should rise and imports should fall, improving the trade balance.
As happened in Turkey during 2017-18.
• The said effect, however, depends on the responsiveness/elasticity of imports and

exports to the exchange rate changes.
• A depreciation will begin to improve the trade balance immediately if imports and
exports are responsive to the exchange rate changes.
• If imports and exports are inelastic, the trade balance will worsen following a
depreciation.
• Depreciation– increase in imports prices.
• Domestic residents may continue to purchase the imported products- consumption
habit or unavailability of domestic substitutes in the short run.
• With higher prices of imports- the country comes to spend more on imports.
• Following the currency’s depreciation- domestic goods become cheaper, but foreigners
may not be able to switch to less expensive products from foreign countries for the
similar reasons.
• Exports may not rise immediately.
• Continued imports at higher prices and inelastic exports would lead to worsening of
trade balance.
• Hence, following the depreciation, trade balance may at first deteriorate for a while.
• Eventually, however, the trade balance will tend to improve over time.
• In the long run, both imports and exports tend to be responsive to exchange rate
changes, exerting positive influences on the trade balance.
• This reaction of the trade balance to a depreciation or devaluation is referred to as the
“J-curve” effect
Financial Account
• The financial account consists of three components:

• Foreign direct investment- Investor acquires a measure of control of the foreign
business. Acquisition of 10 percent or more of the voting shares of a business is
considered giving a measure of control to the investor.
• Portfolio investment- Sales and purchases of foreign financial assets such as stocks
and bonds that do not involve a transfer of control to the investor.
• Other asset investment- Includes transactions in currency, bank deposits, trade
credits, and so forth.
Capital Account
• Includes capital transfers and acquisitions and disposal of non-produced, non-financial assets
between residents and foreigners.
• Non-produced, non-financial assets include natural resources such as land, mineral rights,
intangible assets etc.
• These transactions results in transfer of wealth between countries.
• Example- The US government forgives USD 1 billion in debt owed to it by the government of
Pakistan, US wealth will decline by USD 1 billion. Debit (Negative entry) of USD 1 billion in
capital account is recorded.
• Corresponding credit in financial account- USD 1 billion to represent the reduction of USD
assets held abroad.
Statistical Discrepancy
• Theoretically, BoP should always balance, but in practical terms, it rarely does.
• If every BoP credit automatically generates an equal counterpart debit, and vice versa,
how is the difference possible?
• Information about the offsetting debt and credit items associated with a given
transaction may be collected from different sources.
For example- information about the import debit and export debit, i.e., foreign goods
have entered the country, and local goods have left the country- comes from the customs
office/custom inspector.
Information about the payment in both the directions (credit period usually involved)-
comes from bank.
Statistical Discrepancy
• Represents errors and omissions.

• Determined in the residual manner.
Autonomous and Accommodating flows
When we compute the cumulative balance of payments including the current account,
capital account, and the statistical discrepancies, we obtain the so-called overall balance
or official settlement balance. All the transactions comprising the overall balance take
place autonomously for their own sake.
The overall balance is significant because it indicates a country’s international payment
gap that must be accommodated with the government’s official reserve transactions.
Official Reserve Account
• Includes transactions undertaken by the authorities to finance the overall balance and
intervene in foreign exchange markets.
• When a country must make a net payment to foreigners because of a BoP deficit, the
central bank of the country should either run down its official reserve assets , such as
gold, foreign exchanges, and SDRs, or borrow anew from foreign central banks.
• On the other hand, if a country has a balance-of-payments surplus, its central bank will
either retire some of its foreign debts or acquire additional reserve assets from
foreigners.
Official Reserve Account and Intervention
• When the government (India) wish to support the value of their currency (INR) in the
foreign exchange markets, they sell foreign exchanges, SDRs, or gold to “buy” local
currency (INR). Official reserves (assets) decrease.
• These transactions, which give rise to the demand for INR, will be recorded as a credit
entry under official reserves.
• On the other hand, if governments would like to see a weaker currency, they “sell” local
currency and buy gold, foreign exchanges, and so forth. Official reserves (assets)
increase.
• These transactions, which give rise to the supply of local currency, will be recorded as a
debit entry under official reserves.
• The more actively governments intervene in the foreign exchange markets, the greater
the official reserve changes.
Balance of Payments Identity
• When the balance-of-payments accounts are recorded correctly, the combined balance of
the current account (BCA), the financial account (BFA), the capital account (BKA), and
the reserves account (BRA) must be zero, that is,
BCA+ BFA+ BKA+ BRA = 0
• Under the fixed exchange rate regime, the combined balance on the current, capital and
financial account will be equal in size, but opposite in sign, to the changes in official
reserves.
BCA+ BFA+ BKA= - BRA
• For ex: If a country runs a deficit on the overall balance, the central bank of the country
can supply foreign exchange reserves out of its reserve holdings.
Corporate Governance Around the World
• Corporate governance can be defined as the economic, legal, and institutional

framework in which corporate control and cash flow rights are distributed among
shareholders, managers, and other stakeholders of the company.
• Corporate governance is the system of rules, practices and processes by which a
company is directed and controlled.
• Corporate Governance refers to the way in which companies are governed and to what
purpose. It identifies who has power and accountability, and who makes decisions.
Key issues with a Public Corporation: Need
for Corporate Governance
• The public corporation, which is jointly owned by a multitude of shareholders protected
with limited liability, is a major organizational innovation of vast economic
consequences.
• It is an efficient risk sharing mechanism that allows corporations to raise large amounts
of capital.
• A key weakness is the conflict of interest between managers and shareholders.
• In principle, shareholders elect a board of directors, who in turn hire and fire the
managers who actually run the company.
• In a public company with “diffused” ownership-structure where a large number of
shareholders individually own tiny proportions of shares, the board of directors is
entrusted with the vital tasks of monitoring the management and safeguarding the
interests of shareholders.
Key issues with a Public Corporation: Need
for Corporate Governance
• In reality, management-friendly insiders often dominate the board of directors, with
relatively few outside directors who can independently monitor the management.
• In the case of Enron, Satyam corporation and similarly dysfunctional companies, the
boards of directors grossly failed to safeguard shareholder interests.
• With diffused ownership, few shareholders have strong enough incentive to incur the
costs of monitoring management themselves when the benefits from such monitoring
accrue to all shareholders alike.
• The benefits are shared, but not the costs. When company ownership is highly diffused,
this “free-rider” problem discourages shareholder activism.
Agency Problem
• The agency problem refers to the possible conflicts of interest between self-interested
managers as agents and shareholders of the firm who are the principals.
• Absence of complete contracts due to the impossibility of anticipating all future
contingencies.
• The manager and the investors, therefore, have to allocate the rights (control) to make
decisions under those contingencies that are not specifically covered by the contract.
• The outside investors may be neither qualified nor interested in making business
decisions, the manager often ends up acquiring most of this residual control right.
• Having captured residual control rights, the manager can exercise substantial discretion
over the disposition and allocation of investors’ capital.
Agency Problem
• Exorbitant Perquisites; Outright stealing.
• Problem more salient in companies with “free cash flows” operating in mature
industries.
• Free cash flows represent a firm’s internally generated funds in excess of the amount
needed to undertake all profitable investment projects, that is, those with positive net
present values (NPVs).
Remedies for the Agency Problem
Independent Board of Directors-
• If the board of directors remains independent of management, it can serve as an
effective mechanism for curbing the agency problem.
• Corporate Boards: The structure and legal charge of corporate boards vary greatly across
counties.
• In Germany the board is not legally charged with representing the interests of
shareholders, but is instead charged with representing the interests of stakeholders (e.g.
workers, creditors, etc.).
• In England, the majority of public companies voluntarily abide by the Code of Best
Practice on corporate governance. It recommends that there should be at least three
outside directors and that the board chairman and the CEO should be different
individuals.
• In Japan, most corporate boards are insider-dominated and primarily concerned with
the welfare of the keiretsu to which the company belongs.
Incentive Contracts-
• Managers own residual control rights which give them enormous discretion over how
to run the company; but own relatively little share of equity (not having cash flow
rights).
• This “wedge” between managerial control rights and cash flow rights may exacerbate
the agency problem.
• Solution: Many companies provide managers with incentive contracts, such as stocks
and stock options, in order to reduce this wedge and better align the interests of
managers with those of investors.
• With the grant of stocks or stock options, managers can be given an incentive to run the
company in such a way that enhances shareholder wealth as well as their own.
• But the problem of accounting manipulation still remains.
Concentrated Ownership-
• If one or a few large investors own significant portions of the company, they will have a
strong incentive to monitor management.
• For example, if an investor owns 51 percent of the company, he or she can definitely
control the management (he can easily hire or fire managers) and will make sure that
shareholders’ rights are respected in the conduct of the company’s affairs.
Accounting Transparency-
• Strengthening accounting standards can be an effective way of alleviating the agency
problem.
• If companies are required to release more accurate accounting information in a timely
fashion, managers may be less tempted to take actions that are detrimental to the interests
of shareholders.
• Reduces the information asymmetry between corporate insiders and the public and
discourage managerial self-dealings.
Debt-
• Managers have discretion over how much of a dividend to pay to shareholders, debt does
not allow such managerial discretion.
• If managers fail to pay interest and principal to creditors, the company can be forced into
bankruptcy and managers may lose their jobs.
• Borrowing can have a major disciplinary effect on managers, motivating them to curb
private benefits and wasteful investments and trim bloated organizations.
• Debt can be problematic in turbulent economic conditions.
Overseas Stock Listings-
• Companies domiciled in countries with weak investor protection can bond themselves
credibly to better investor protection by listing their stocks in countries with strong
investor protection, such as the United States and the United Kingdom.
• Outsourcing a superior corporate governance regime available in the United States via
cross-listings.
• Signals the company’s commitment to shareholder rights.
Overseas Stock Listings-
• Suppose a company continually performs poorly and all of its internal governance
mechanisms fail to correct the problem--- prompt an outsider (another company or
investor) to mount a takeover bid.
• May buy enough shares to gain control of the board, i.e., acquire the control rights of the
target and restructure the company.
• Replacing the managerial team; divest some assets or divisions; trim employment to
improve efficiency.
• The market for corporate control, if it exists, can have a disciplinary effect on managers
and enhance company efficiency.
Law and Corporate Governance
• Investors obtain certain rights that are legally protected.
• Right to elect the board of directors, receive dividends on pro-rate basis, participate in
shareholders’ meetings, and sue the company for expropriation.
• Empowering them to extract fair return from their investment.
• The content of law protection investors’ rights and the quality of law enforcement vary a
great deal across countries.
• Many of the differences in the international corporate governance system arises from the
differences in how well outside investors are protected by law from expropriation by
managers and other corporate insiders.
• The legal protection of the investors rights varies, depending on the historical origins of
national legal systems.
• The commercial legal systems (e.g., company, security, bankruptcy, and contract laws) of
most countries derive from relatively few legal origins:
• English common law
• French civil law
• German civil law
• Scandinavian civil law
• The civil law tradition is based on the comprehensive codification of legal rules. In
contrast, English common law is formed by the discrete rulings of independent judges on
specific disputes and judicial precedent.
• English common law countries tend to offer the strongest protection for investors.
• French and German civil law countries offer the weakest, and Scandinavian civil law
countries fall in the middle.
• The quality of law enforcement, as measured by the rule of law index, is the highest in
Scandinavian and German civil law countries, followed by English common law countries;
it is lowest in French civil law countries.

International Financial System Session 1-3: Prof. Rishika Nayyar FORE School of Management

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International

• Globalized and integrated world economy.

• Integration of financial markets; Deregulation of international capital markets.

Expanded opportunity sets

• Integrated world economy; Globalization;

• Bimetallism: Before 1875

• Countries on bimetallic standard often experienced Gresham’s law: Bad money

• Provided for an automatic correction of imbalances in the balance of payments account

Suppose a person needs 1000 FF, a simple solution is

• The onset of WW-I marked the end of classical gold standard.

• July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire.

• Classified by the IMF, based on member countries’ actual, de facto arrangements.

• The country authorities stand to maintain the fixed parity through-

• Fixed versus flexible exchange rate system. An ideal IMS?

• Started with Thailand, 1997.

Bank Market Share

• Market Participants- 5 groups-

• Non-bank dealers, consists of non-banking financial institutions such as investment banks,

Different SWIFT codes assigned to HSBC

• American and European Quotes are reciprocals of each other-

• S(€/£) = S($/£)/ S($/€)

Analogously, S (£/ €) = S($/€)/S($/£) = 1.3092/1.5405 = 0.8499; 1 Euro costs 0.8499 GBP

If spot rates are given in European Terms

S(€/£) = S(€/$)/ S(£/$) = 0.7638/ 0.6491

Ask: S($/£): 1.5405------ Dealer sells 1 GBP for USD 1.5405

S (£/$): 0.6491 – 0.6494

S (GBP/USD) (1/1.5405) (1/1.5404)

Cross-Rate Trading desk- Dealing in two currencies where none is USD.

How are such trades handled?

Calculation of cross exchange rate Bid-Ask Spread

Given- S (USD/GBP): USD 1.5400- USD1.5405

Calculate Bid-Ask spread for S(Euro/GBP) and S (GBP/Euro)

S (bid) (Euro/GBP)= S (bid) (Euro/USD) * S (bid) (USD/GBP)

S (ask) (Euro/GBP)= S (ask) (Euro/USD) * S (ask) (USD/GBP)

S (Euro/GBP): Euro 1.1763 – Euro 1.1771

S (GBP/Euro): GBP 0.8495 – GBP 0.8501

S (GBP/USD): 0.6491 – 0.6494

Bank customer wants to sell GBP 1,000,000 for Euro

1. Bank will buy GBP and sell USD

Case 2: Bank customer wants to sell Euro 1000000 for GBP

• Expressed as an annualized percentage deviation from the spot rate.

f(INR/j) = [(F(n) (INR/j)- S(INR/j))/ S(INR/j)] * 360/days

Buying rate: 50 + [(80-50)*(10days /60 days)] = 55 60.50 + (60.80-60.50)*(10/60)= 60.55

• Buying or selling foreign currency in the forward market.

Suppose F1(INR/USD): 68.05

If trader has taken a short position

What if spot rate after 1 month is INR/USD: 67.05?

Situation after 3 months: Expectations are realized: S(INR/USD): 67.10

• Under the contract, the speculator has to deliver USD.

Loss Short position in USD-

1. Relative Price Levels (US and India)

• High economic growth rate in a country will attract foreign investment.

Political and Economic Risk:

E(r) = 67 * (120/110) = 73.09

PURCHASING POWER PARITY

• Explanation: Exchange rate between USD and GBP

• Suppose S (USD/GBP): 1.45 and sweater is selling in Britain at GBP 30

• Now, suppose price level in the US increases by 3 times,

• The law of one price applies to individual commodities

Buying rate: 50 + [(80-50)(10days /60 days)] = 55 60.50 + (60.80-60.50)(10/60)= 60.55