Q1) Explain the concept of Basic Balance

The concept of the "basic balance" is a term used in macroeconomics to describe a specific
component of a country's balance of payments. The balance of payments is a record of a country's
economic transactions with the rest of the world, and it is divided into several components,
including the current account, capital account, and financial account. The basic balance is a subset
of the overall balance of payments.

The basic balance is calculated by combining two key components:

1. Current Account Balance: The current account measures the flow of goods, services, income, and
transfers between a country and the rest of the world over a specific period. It includes:
- Trade Balance: The difference between exports and imports of goods.
- Services Balance: The difference between receipts and payments for services like tourism,
transportation, and financial services.
- Income Balance: The difference between income earned by residents from foreign investments
and income earned by foreigners from domestic investments.
- Transfers: Unilateral transfers of money, such as foreign aid and remittances.

2. Net Income from Abroad: This component accounts for the net income earned or paid by a
country on its foreign investments. It is derived from the income balance in the current account.

The formula for calculating the basic balance is as follows:

Basic Balance = Current Account Balance+ Net Income from Abroad

The basic balance is considered a broader measure than the current account alone because it
includes the net income component. It provides insight into the overall economic relationship a
country has with the rest of the world, capturing both trade-related and income-related
transactions.

Interpreting the Basic Balance:

- Surplus: If the basic balance is positive, it indicates that a country is earning more from its
economic transactions (both trade and income) with the rest of the world than it is spending. This is
often referred to as a basic balance surplus.

- Deficit: If the basic balance is negative, it suggests that a country is spending more than it is
earning in its international economic transactions, resulting in a basic balance deficit.

Understanding the basic balance is essential for policymakers and economists as it provides insights
into a country's overall economic health in terms of its international economic relationships. It
helps assess the sustainability of a country's external position and its ability to meet its
international financial obligations.
Q2) Explain the dimensions that separate international and domestic
finance
The dimensions mentioned—currency and political risk, market imperfections, and an expanded
opportunity set—highlight key distinctions between international and domestic finance:

1. Currency and Political Risk:

a) Currency Risk: Changes in earnings which arise due to indexation of export proceeds and
import payments to exchange rate
b) Exposure: It is the amount by which inflows in any country differ from the outflows of that
currency. It can be understood in the terms of transaction exposure, translation exposure
and economic exposure. Exposure can sometimes be unavoidable, however no investor
should intentionally expose their position and should aim to maintain a square position
i. If spot rate changes against the position of the investor, a larger bank like SBI, ICICI,
BoB maybe able to accept the loss than the smaller banks in the same position
ii. Though exposure may lead to exchange risk, it in itself is not exchange risk
1. In forward contract, risk is looked as the mutually acceptable level of exchange,
irrespective of the spot and forward rate fluctuations
2. The possibility of loss due to future depreciation is minimized.

[EXTRA CONTENT FOR EXPOSURE]

iii. Translation Exposure:
1. Translation exposure, also known as accounting exposure, arises from the need to
convert the financial statements of a foreign subsidiary or branch into the
reporting currency of the parent company.
2. Fluctuations in exchange rates can lead to gains or losses in the translation of
foreign subsidiaries' financial statements when consolidated at the parent
company level. This exposure is not cash-flow related but affects reported income
and shareholders' equity.
3. If a U.S.-based company owns a subsidiary in Europe, changes in the euro-to-dollar
exchange rate can impact the reported value of the subsidiary's assets, liabilities,
revenues, and expenses when expressed in U.S. dollars.
iv. Transaction Exposure:
1. Transaction exposure, also known as contractual exposure, arises when a
company engages in international trade and has contractual obligations
denominated in foreign currencies.
2. Changes in exchange rates between the transaction date and the settlement date
can lead to gains or losses. This exposure affects cash flows and the cost or
revenue associated with specific transactions.
3. If a U.S. company sells goods to a European customer and agrees to receive
payment in euros, a depreciation of the euro against the U.S. dollar between the
sale and payment dates can affect the U.S. dollar value of the revenue received.
v. Economic Exposure:
1. Economic exposure, also known as operating exposure, arises from the impact of
exchange rate fluctuations on a company's future cash flows, market share, and
competitiveness.
 2. Economic exposure is broader and more strategic than transaction exposure. It
can affect a company's competitive position, pricing strategy, and market share. It
is related to the long-term impact of currency movements on a company's overall
business operations.
3. A U.S. company that faces increased competition from foreign competitors due to
a stronger U.S. dollar may experience a decline in market share and profitability,
highlighting the economic exposure to currency movements.
- International Finance: In international finance, transactions involve multiple currencies, leading
to exposure to exchange rate fluctuations. Currency risk arises due to the potential depreciation or
appreciation of currencies, impacting the value of assets and liabilities. Additionally, political risk is
significant, encompassing the potential for changes in government policies, geopolitical events, and
economic instability in foreign countries where investments are made.
- Domestic Finance: In contrast, domestic finance operates within a single currency and is
generally subject to lower currency risk. Political risk is usually more stable within a single-country
context, as domestic investments are influenced by the political and economic conditions of that
specific country.

2. Market Imperfections:

- International Finance: International markets often face imperfections such as incomplete

information, different regulatory environments, and variations in market structures across
countries. Barriers to trade and investment, cultural differences, and varying legal systems
contribute to market imperfections, making international financial markets more complex.
- Domestic Finance: Domestic financial markets benefit from a more homogenous regulatory
environment, a common legal system, and a shared cultural context. While imperfections exist,
domestic financial markets tend to be more transparent and accessible, with fewer barriers to entry
compared to international markets.

3. Expanded Opportunity Set:

- International Finance: One of the key features of international finance is the expanded
opportunity set it offers. Investors can diversify their portfolios by investing in assets from different
countries and regions. This diversification allows for exposure to a broader range of economic
conditions, industries, and risk factors.
- Domestic Finance: The opportunity set in domestic finance is inherently more limited in terms
of geographic diversity. Domestic investors may have access to a narrower range of assets and
industries compared to their international counterparts. However, they may still benefit from the
depth and stability of their domestic markets.
Q3) Explain convertibility of a currency. Is INR convertible?
Currency convertibility refers to the ease with which a country's currency can be exchanged or
converted into another currency or asset, typically without significant restrictions or limitations.
The level of convertibility of a currency reflects the degree of openness of a country's financial
system to international transactions and capital flows. There are generally three main types of
currency convertibility:

1. Fully Convertible Currency:

A currency is considered fully convertible when there are no restrictions or limitations on its
exchange into other currencies, and it can be freely traded in the foreign exchange market.
a) Characteristics:
i. Investors and businesses can buy or sell the currency without restrictions.
ii. There are no limitations on the movement of capital in and out of the country.
iii. The exchange rate is determined by market forces of supply and demand.
b) The U.S. dollar (USD) and the euro (EUR) are examples of fully convertible currencies.

2. Partially Convertible Currency:

A partially convertible currency is one that can be traded for some purposes but has restrictions or
limitations on certain transactions or capital movements.
a) Characteristics:
i. certain transactions may be subject to controls or limitations.
ii. Capital flows may face restrictions, especially for speculative purposes.
iii. The exchange rate may be subject to both market forces and official intervention.
b) The Chinese yuan (CNY) was historically considered partially convertible due to restrictions
on capital movements, although China has gradually liberalized its currency policies.

3. Non-Convertible Currency:
A non-convertible currency is one that cannot be freely traded or exchanged in the international
market, and its use is often restricted to domestic transactions.
a) Characteristics:
i. The currency is not traded in the foreign exchange market.
ii. Capital movements in and out of the country are heavily restricted.
iii. The exchange rate may be fixed or subject to strict government control.
b) The North Korean won (KPW) is an example of a non-convertible currency.

The decision to adopt a particular level of convertibility is influenced by a country's economic

policies, monetary and exchange rate policies, and overall economic conditions. While full
convertibility allows for greater flexibility and integration into the global financial system, some
countries may impose restrictions to manage capital flows, stabilize their currencies, or control
speculative activities. Changes in the convertibility status of a currency can have significant
implications for international trade, investment, and economic stability.
The Indian rupee (INR) is partially convertible .
India has adopted a managed floating exchange rate system, and there are certain restrictions and
controls on the convertibility of the rupee for specific transactions. The level of convertibility is
categorized into two main parts:

1. Current Account Convertibility:

- India allows a significant degree of convertibility on current account transactions. Current
account convertibility pertains to transactions related to trade in goods and services, interest,
dividends, and short-term capital flows.
- Individuals and businesses can engage in transactions such as importing and exporting goods
and services, making and receiving payments for trade, and repatriating profits and dividends with
fewer restrictions.

2. Capital Account Convertibility:

- Capital account convertibility refers to the ability to freely convert and transfer capital in and out
of the country. As of the last update, India has not adopted full capital account convertibility.
- There are restrictions on certain capital transactions to manage and control the flow of
speculative capital and to maintain stability in the financial markets.
- The Reserve Bank of India (RBI) and the government periodically review and adjust capital
account convertibility policies based on economic conditions and policy considerations.

3. Liberalization Efforts:
- Over the years, India has taken steps to liberalize its foreign exchange policies and move towards
greater convertibility.
- Reforms have been implemented to simplify procedures and ease restrictions, allowing for a more
open and flexible foreign exchange regime.

The Indian Rupee operates under a managed float exchange rate system, where the exchange rate
is influenced by market forces but may also be subject to intervention by the Reserve Bank of India
to manage volatility.

India has taken a cautious approach toward full capital account convertibility to ensure financial
stability and to prevent excessive volatility in its financial markets. The government and the RBI
have gradually implemented reforms to liberalize the capital account while maintaining some level
of control to manage risks.
Q4) With suitable illustrations explain the flow of foreign currency in cross
border trade settlement.
Article 2(m) of the Foreign Exchange Management Act, 1999 (FEMA) defines "foreign exchange"
under Indian law as anything that is not INR.

Article 2(n) explains "Foreign exchange" as foreign currency and includes,—

(i) deposits, credits and balances payable in any foreign currency,
(ii) drafts, travelers cheques, letters of credit or bills of exchange, expressed or drawn in Indian
currency but payable in any foreign currency,
(iii) drafts, travelers cheques, letters of credit or bills of exchange, drawn by banks, institutions or
persons outside India, but payable in Indian currency.

"NOSTRO" and "VOSTRO" are terms used in international banking to describe accounts held by one
bank on behalf of another bank. These accounts facilitate foreign exchange and trade transactions
between banks and help streamline cross-border financial operations.

1. NOSTRO Account: "NOSTRO" is a Latin term that means "ours" in English. In banking, a NOSTRO
account is an account held by a bank in a foreign country in the currency of that country and it is
their own account ("ours") in the foreign bank.
- Usage: NOSTRO accounts are used by banks to facilitate international trade and foreign
exchange transactions. They hold foreign currency in these accounts to conduct transactions with
foreign banks.
- Example: If ABC Bank (U.S.) has a NOSTRO account with XYZ Bank (India) in Indian Rupees, it
means ABC Bank has an account in India denominated in Indian Rupees. This facilitates ABC Bank's
transactions in Indian Rupees.

2. VOSTRO Account: "VOSTRO" is also a Latin term that means "yours" in English. In banking, a
VOSTRO account is an account held by a foreign bank with a local bank in the local currency and is
the foreign bank's account ("yours").
- Usage: VOSTRO accounts are used by foreign banks to hold funds in the local currency. This
enables them to conduct transactions in the local market and provides a mechanism for the local
bank to handle the transactions on behalf of the foreign bank.
- Example: If XYZ Bank (India) has a VOSTRO account with ABC Bank (U.S.) in U.S. Dollars, it means
XYZ Bank has an account in the U.S. denominated in U.S. Dollars. This facilitates XYZ Bank's
transactions in U.S. Dollars.

3. Mirror NOSTRO Account: A "mirror NOSTRO" account could be an account held by a bank in its
own country, denominated in its own local currency, but structured to mirror the transactions and
balances of a NOSTRO account held in a foreign country.
- Purpose : This hypothetical account could be used to replicate the foreign exchange and trade
transactions of the original NOSTRO account, allowing the bank to manage its exposure to foreign
currency transactions more effectively.
4. Mirror VOSTRO Account : A "mirror VOSTRO" account could be an account held by a foreign
bank in its home country, denominated in its local currency, but structured to mirror the
transactions and balances of a VOSTRO account held with a local bank in another country.
- Purpose : This hypothetical account could be used by the foreign bank to replicate the local
currency transactions and balances of the original VOSTRO account, facilitating seamless
transactions in the local market.
Consider, SCI as an Indian company that is exporting goods to
Mac-Miller in USA and receives foreign exchange (USD) as
payment for those good. They have a contract that specifies
and stipulates the terms of trade, the purchase order, the
invoicing etc is done in accordance to the contract.

If bill is drawn in $, then:

Particulars Dr Cr
Mac Miller A/C $ 100
To Indian NOSTRO A/C $ 100
Indian Mirror NOSTRO A/C Rs 8000
To SCI A/C Rs. 8000

If bill is drawn in Rs, then:

Particulars Dr Cr
Mac Miller A/C $ 100
To BONY Mirror VOSTRO A/C $ 100
Indian VOSTRO A/C Rs 8000
To SCI A/C Rs. 8000
Q5) How can exchange risk be managed by hedging. Distinguish between
spot and forward rates.
Hedging is a risk management strategy that involves taking actions to offset or reduce the impact of
adverse price movements in an asset or liability. The primary goal of hedging is to protect against
potential losses and create a more stable financial position. Here's an explanation of how hedging
reduces risk using an example:

Let's consider a scenario where a U.S.-based company, ABC Inc., plans to sell its products to a
European customer for €1 million. The payment is due in three months. The exchange rate at the
current time is $1/€. The company faces a foreign exchange risk because the value of the euro may
fluctuate during the three-month period, and the final amount received in U.S. dollars may differ
from the expected amount.

1. Without Hedging: ABC Inc. decides not to hedge its foreign exchange risk and expects to receive
€1 million after three months.
When Euro appreciates
If the euro strengthens to $.75/€ at the time of payment, ABC Inc. would receive $ 750,000
(€1,000,000 * $.75/€).
ABC Inc. faces a lower U.S. dollar receipt than anticipated, leading to a potential loss due to the
adverse movement in the exchange rate.
When Euro depreciates
If the euro weakens to $1.25/€ at the time of payment, ABC Inc. would receive $ 1,250,000
(€1,000,000 * $1.25/€).
ABC Inc. faces a higher U.S. dollar receipt than anticipated, leading to a potential profit due to the
positive movement in the exchange rate.

2. With Hedging (Forward Contract):

- Hedging Strategy: ABC Inc. decides to hedge its foreign exchange risk by entering into a forward
contract to sell €1 million in three months at a predetermined rate of $1.18/€.
- Outcome: Regardless of the future exchange rate, ABC Inc. is committed to receiving $1,180,000
(€1,000,000 * $1.18/€) through the forward contract. So exchange rate can be $0.75/€ or $1.25/€,
ABC Inc will receive $1.18/€
- Impact: The hedging strategy protects ABC Inc. from unfavorable exchange rate movements,
ensuring a fixed amount in U.S. dollars.
- While the euro appreciated, the hedging strategy limits the gain to the agreed-upon rate, resulting
in a missed opportunity for higher U.S. dollar receipts.
- The hedging strategy provides a higher U.S. dollar amount than the spot market, mitigating the
impact of euro depreciation.

3. Comparison:
- Without Hedging: ABC Inc. is exposed to exchange rate fluctuations, leading to uncertainty and
potential losses.
Beneficial impact due to euro appreciation, but variability in U.S. dollar receipts.
Adverse impact due to euro depreciation, resulting in lower U.S. dollar receipts.
 - With Hedging: ABC Inc. has reduced its risk by locking in a predetermined exchange rate,
providing certainty about the U.S. dollar amount it will receive.
Limited gain compared to the spot market but certainty in U.S. dollar receipts, reducing variability.
Higher U.S. dollar receipts than the spot market, mitigating the impact of euro depreciation.

In this example, the use of a forward contract serves as a hedging tool, allowing ABC Inc. to mitigate
the risk associated with foreign exchange rate movements. While hedging doesn't eliminate risk
entirely, it provides a level of protection and allows businesses to plan and budget more
effectively in the face of market uncertainties. The cost of hedging, such as the forward contract's
premium, is a trade-off for the risk reduction benefits.

Spot rates and forward rates are both used in the context of foreign exchange markets to quote
currency exchange rates, but they represent different aspects of currency trading.

Spot Rate Forward Rate

The spot rate, also known as the spot The forward rate is the agreed-upon
exchange rate, is the current market rate exchange rate for a currency pair at
at which a currency can be bought or some specified future date. It represents
sold for immediate delivery (settlement) the rate at which two parties agree to
and payment. It represents the exchange exchange currencies at a future point in
rate for a transaction that occurs "on the time.
spot" or immediately.
The settlement period for a spot The settlement or delivery of currencies
transaction is typically very short, often in a forward contract occurs at a
taking place within two business days. specified future date, which can be days,
weeks, months, or even years after the
date of the agreement.
Spot rates are commonly used for Forward rates are often used for hedging
immediate transactions, such as when against currency risk or for businesses
individuals or businesses need to and investors who anticipate future
exchange currencies for immediate currency needs. They allow parties to
delivery, such as in travel or trade. lock in an exchange rate in advance,
providing protection against adverse
currency movements.

Key Differences:
1. Timing: Spot rates apply to transactions for immediate delivery and settlement (within a short
period, usually two business days), while forward rates apply to transactions that will be settled at a
future date.

2. Purpose: Spot rates are used for immediate transactions, such as everyday currency exchanges,
trade settlements, or travel-related currency conversions. Forward rates are typically used for
hedging against future exchange rate movements or for planning future currency transactions.
3. Market Determination: Spot rates are determined by the current supply and demand conditions
in the foreign exchange market. Forward rates, on the other hand, are agreed upon by two parties
in a forward contract and may not necessarily reflect the current spot market conditions.

4. Flexibility: Spot rates are less flexible as they represent the current market rate. Forward rates
offer the flexibility to lock in a future exchange rate, providing a degree of certainty for future
transactions.
Q6) Derive equation of PPP and state its limitations
Purchasing Power Parity (PPP) is an economic theory
and method used to compare the relative value of
currencies, particularly in the context of exchange rates.
Traces its origins to Ricardo’s comparative cost
advantage and fully developed by Prof. Gustev Castell, a
Swedish economist.

PPP: Exchange Rate (ER) is ratio of prices of basket of

goods into a country’s currency. ER Must take into
account inflation, keeping other things constant.
Law of One Price: if same commodity is sold in different
currencies, when measured in same currency has the
same price, then law of one price holds.

Inflation differentials between two countries can influence exchange rates.

1. According to PPP theory, exchange rates should adjust to equalize the price levels of identical
goods and services in different countries.
a) If inflation is higher in one country than another, the currency of the high-inflation country
is expected to depreciate.
2. Inflation differentials can impact the forward premium or discount.
a) If inflation is expected to be higher in one country, it may contribute to a positive forward
premium (indicating expected currency appreciation) or a negative forward discount
(indicating expected depreciation).

While PPP can be a useful concept, it has several limitations and challenges:

1. Assumption of Identical Goods: PPP assumes that identical goods and services are sold in
different countries, and any difference in prices is due to exchange rate movements. In reality,
goods and services may vary significantly across countries in terms of quality, brand, and other
factors, leading to deviations from PPP.

2. Transportation and Transaction Costs: PPP does not account for transportation costs, trade
barriers, and transaction costs, which can affect the actual prices of goods in different countries.
These costs can contribute to persistent deviations from PPP.

3. Non-Tradable Goods: PPP is more applicable to tradable goods, but many goods and services are
non-tradable or have limited international markets. For such goods, local supply and demand
conditions, as well as regulatory factors, can have a significant impact on prices, leading to
deviations from PPP.

4. Differences in Taxation and Regulations: Variations in taxation policies, regulatory

environments, and government interventions can affect prices differently in different countries,
causing PPP to be less accurate in predicting exchange rates.
5. Timing and Adjustment Lags: Adjustments to prices and exchange rates may not occur
immediately. There can be significant time lags before prices adjust to changes in exchange rates,
leading to deviations from PPP in the
short to medium term.

6. Different Inflation Rates: PPP

assumes that inflation rates are similar
across countries. If inflation rates
differ, PPP may not accurately reflect the
changes in exchange rates. High
inflation in one country can lead to a
depreciation of its currency relative to the
currency of a country with lower
inflation.

7. Speculative Activities: Currency

exchange rates are influenced by
speculative activities in financial
markets. Factors such as investor
sentiment, market expectations, and geopolitical events can lead to short-term fluctuations that
deviate from PPP.

8. Globalization and Market Imperfections: The increasing interconnectedness of global markets

does not necessarily imply immediate convergence of prices. Market imperfections, information
asymmetries, and institutional differences can hinder the rapid adjustment of prices to their PPP
values.

In practice, while PPP provides a theoretical framework for understanding exchange rate
movements, it is important to consider its limitations and use it as one of several tools for analyzing
currency values. Many analysts and policymakers also consider other factors, such as interest rates,
economic indicators, and investor sentiment, when making predictions about exchange rate
movements.

2 quotations will be given – tell which currency is at forward?

Short note – Evolution of euro/ from Bretton woods to euro
Best year to look at dev of intl monetary scheme = 1994, when WW2 ended, European economy
devasted, only strong economy left – US – sway over monetary scheme since.

Conference held in brettonwoods – objective- decide upon post war world monetary order. Gave
birth to 2 imp intl insti – World bank (IBRD)- responsible for reconstruction and dev of economy,
that were devasted, with long term financial assistance and IMF – principal incharge of world
liquidity, BOP adjustments and exchange rate mechanism. Constitution of IMF- 3 fundamental
principles a) quota – contri decided resource based quota, borrowing power from IMF and voting
power in IMF decision making. B) convertibility – US undertook obligation to convert $ into gold at
the rate 35$ to 1 fine ounce of gold. To acquire gold, all countries started accumulating $ by
invoicing in $ => increased $demand in mkt. the rate quoted remained fixed and thus fixed
exchange rate system came into place. Every country fixed ER of currency with, inturn converted
into gold, parity once decided remained fixed unless fundamental disequilibrium exist in BOP.

Problem with BW: FER => world trade volume started increasing, countries accumulating $
reserves, approach IMF convert $ to gold, supply of gold with US treasury inelastic, IMF realized,
difficult to meet demand for conversion=> situation = run on gold. Aug 1971, pres Nixon,
unilaterally withdrew conversion of $ to gold= collapse of FER, today flexible ER, exch rate
determined based on DD and SS of currency.

Countries in favour of FER, restore – first response : snake in tunnel arrangement i.e. limiting
movement of currency within tunnel. Some European countries – intra community trade more imp
– and all accepted this sys. Later it failed: higher oil prices in 1973, higher inflation differences and
current acc balances = countries withdrew – wanted to devaluate their currency further – complete
collapse.
Further development –
a) EMS – European monetary sys – evolution of SIT, restricted to members of EU
b) ECU – European currency unit – basket of member countries of European community included
pound, Belgian franc, mark-deustch, Italian lira,etc. – to form new monetary sys.
c) ERM – exchange rate mechanism – established parity grids b/w above member countries with
parity = +- 2.25 => allowed to fluctuate within this range, strengthening SIT.
d) EMU - Economic monetary unit – ERM parity grid worked effectively well – increased trade in
members – proposal of MU – single currency, economic union

Convergence criteria – rate of interest and inflation rate (exchange rate and CA sustainability)
countries that fulfilled signed Maastricht conference – treaty - MT 1999 – accepted common
currency Euro. USD importance decreased as EU only traded in euro + Global demand
Problem - Danish rejected
ratification of MT – monetary union path not smooth. Denmark and UK signle currency proponents.

1. Short note –Rupee ambition

The notes that I found-
As far as Indian economy is concerned current scenario is such – Indian economy launch in 2023,
international rupee wherein it is expected that some 30 countries will be exchanging currency with
india bypassing USD/euro. It is expected that if INR will become a global currency, demand for USD
will be eroded and create Indian rupee shortage in market. Oil, gas, defene these are largest
imports by india and if invoicing is done in rupees then it will boost reserves in our country.

What I could find on the net-

  India is the world's sixth-largest economy and is expected to grow at a rate of 7% in the
coming years. This is making the rupee a more attractive currency for international
investors.
 RBI has been making a "conscious effort to internationalise the rupee". RBI is of the view
that Indian rupee has the potential become an “internationalized currency”
 the disruptions in payments caused by Russia-Ukraine war provided a good opportunity to
insist on export settlement in rupees.
 when several countries were trying to find an alternative to the USD in Intl transactions in
light of sanctions on Russia for the war in Ukraine
 internationalisation of rupee is a process that involves use of rupee for more and more CBT.
This involves promoting the rupee for current account transactions and foreign trade.
 This requires a further opening up of the currency settlement and a strong currency swap
and forex market. It would also need fully convertiblilty of the currency and a restriction
free CBT of funds.
 Currently USD, euro, Japanese yen and pound sterling are leading reserve currencies in
world.
 Internationalisation of rupee will reduce the currency risk of Indian business by protecting
them against currency volatility. It will also reduce the need to maintain foreign reserves,
making india more insulated from external shocks. Provide india with a bargaining power in
international markets
 In March 2023, the Reserve Bank of India (RBI) introduced the Special Vostro Rupee
Accounts SVRAs mechanism, allowing banks from 18 countries to hold rupee-denominated
accounts. This facilitates rupee settlements for trade transactions with these countries,
reducing reliance on foreign currencies and potentially lowering transaction costs.
 The internationalization of the rupee is still at an early stage, but it is gaining momentum. As
India's economy continues to grow, the rupee is likely to become a more important currency
in the global financial system.

2. Distinguish clearly between spot and forward and with suitable

illustration
The delivery under a foreign exchange contract can be made in one of the following ways:
• SPOT – purchase and sale of foreign currency now for immediate delivery
• Forward – purchase and sale of foreign currency now for future delivery at contracted rate
and debt
In foreign exchange transactions the transactions are not completed on the same date. The actual
exchange of currencies may take place at different time periods

For instance let us suppose that there are two banks in the foreign exchange transaction. Bank of
India agrees to buy from Bank of Baroda, British pounds one lakh. The actual exchange may take
place (1) on the same day or (2) two days later or (3) Some day late say after a month.
In case 1, where the agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as ‘cash transaction’. It is also known as ‘value today’.
In case 2, if the settlement takes place, within two days, the rate of exchange effective for the
transaction is known as spot rate.
In case 3, while the delivery and payment takes place after a month, then the transaction in which
the exchange of currencies takes place at a specified future date is known as forward transaction.

A forward foreign exchange contract is an agreement between two parties to exchange one
currency for another at some future date. The rate at which the exchange is to be made, the
delivery date and the amounts involved are fixed at the time of agreement.
The rate of exchange applicable to the forward contract is called the forward exchange rate and the
market for forward transaction is known as forward market

Forward rate may be the same as the spot rate for the currency then it is expressed as ‘at par’ with
the spot rate.
Forward exchange operations carry the same credit risk as spot transactions but for longer periods
of time; however, there are significant exchange risks involved.
Spot provides immediate liquidity, while forward allows parties to hedge against future exchange
rate movements.

3. Cross rate exchange/ other exch

Exchange rate is the rate at which one currency gets converted into other currency directly. When
this is not the case, this means direct quote is not available. Then rate between 2 currencies is
obtained by using intermediary currency (usually USD). Many currency pairs are only inactively
traded, so their exchange rate is determined through their relationship to a widely traded third
currency.
Hence cross rate may be defined as an exchange rate which is calculated from two (or more) other
rates. It is the rate in which neither currency is USD. Thus the rate for the Deutschmark to the
Indian Rupee will be derived as the cross rate from the US dollar to the Deutschmark and the US
dollar to the rupee.

To calculate cross rates, 2 transactions are being computed-

1. The first being the individual trading their one specific currency (EUR, JPY, GBP, etc.) for that
same equivalent value in U.S. dollars.
2. Once U.S. dollars have been received, an exchange occurs again when the U.S. dollars are
traded for the second specific currency.

For example, a Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the
Mexican peso (MXN or the old peso symbol, Ps) and the Japanese yen (JPY or ¥) are commonly
quoted against the U.S. dollar (USD or $).

the Mexican importer can buy one U.S. dollar for MXN19.6596, and with that dollar can buy
JPY112.67. The cross rate calculation would be as follows:

Cross rate = D|j / D|i

Where D = USD, j = foreign currency, i = domestic currency

Cross rate is also obtained by chain rule

NUMERICAL -
EURO is quoted in NY market as IE =1.1193 / 1.1197 (EURO against USD)
And rate of INR against USD is 1$= 71.70 / 71.72
Find rate of EURO against INR

Cross rate = D|j / D|i = 1.1193/ (1/71.70) = 1.1193*71.70 = 80.25

This question is on arbitrage calculation -

 4. Premium or discount using FC => quotation
The delivery under a foreign exchange contract can be made in one of the following ways:
 SPOT – purchase and sale of foreign currency now for immediate delivery
 Forward – purchase and sale of foreign currency now for future delivery at contracted rate and
debt

 If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making
the contract the forward exchange rate is said to be at par

 Forward Rates are quoted either at a higher (premium) or lower (discount) rate than the spot
rate. This is because in a free exchange market, the rates would be based on demand and
supply, with the currency in excess supply tending to be cheaper and a scarce one costlier.

 The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot
rate when one dollar buys more units of another currency, say rupee, in the forward than in the
spot rate on a per annum basis.

Premium. In a foreign exchange market, the amount by which a currency is more expensive for
future delivery than for spot (immediate) delivery
 The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot
rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is
also usually expressed as a percentage deviation from the spot rate on a per annum basis

Discount. In the foreign exchange market, the amount by which a currency is cheaper for future
delivery than for spot (immediate) delivery.

 Always premium will be added to and discount deducted from the spot rate to arrive at the
forward rate in the case of direct quotation

NUMERICAL
Given two quotations –

SPOT USD:CHF 1.5677 / 1.5685

FWD USD:CHF 1.5575 / 1.5585
(Explanation - To buy USD against CHF, the rate 1.5677 will apply)

Under direct method

Steps –
1. Identify base currency – one which is not quoted. Here USD is not quoted => base currency
2. (Fmid – Smid)/ Smid * 12 * 100 = premium or discount
3. = (1.5585 – 1.5685)/1. 5685 * 12 * 100 = -7.73
4. Since the value comes out negative, USD is at discount relative to CHF. CHF is selling at
premium of 7.73%

5. Computation of exchange rate – with suitable illustration explain

following TT selling, buying and bill
The purchases are made at a lower price and the sale at a higher price, with the differential being
the exchange profit. The maxim practiced by the banks is „Buy Low Sell High’ for direct quotations.
In the foreign exchange market, quotations are always ‘two-way’ i.e. for both buying and selling.
The „two way‟ quote for U.S.Dollar would appear as USD 1 = Rs.61.50/52 where the buying rate is
Rs.61.50 and the selling rate is Rs.61.52.. The buying rate is known as the ‘Bid’ rate and the selling
rate as the ‘Offer’ rate.

Base rate is the rate derived from ongoing market rate, based on which buying / selling rates are
quoted for merchant transactions. The interbank rates are normally for spot deliveries and
applicable in TT Selling, Bill selling, TT buying. Base rate for Bill buying is on interbank forward
purchase rates.

Exchange rate is the rate at which one currency gets converted into other or price of 1 unit of
Foreign currency in terms of other, if we consider foreign currency as a commodity then it is
available for purchase and sale in a market that is forex market just as price of any commodity is
displayed by the shopkeeper similarly foreign currency is displayed by authorized dealers in the rate
card. There are 4 transactions mainly carried out in a forex market and when carrying out these
transactions either you purchase foreign currency from shop called bank at the rate displayed in the
price list or exchange rate card. Broadly any transaction is either acquisition i.e. purchase of foreign
currency or disposal that is sale of foreign currency. A typical rate card therefore displays buy and
sell rates. Here it should be noted whether transaction attracts purchase/ sell rate, should be
looked from banker’s perspective. Simply means when customer purchases, the banker sells FC and
vice versa. The transactions result in purchase and sale which are merchandise or non merchandise
in nature. OR/IR are non-merchandise transaction where merchandise flow doesn’t take place.
Whereas merchandise transaction involves imp of goods and export of goods. In fact the whole
gamut of international finance is based on the above 4 transactions.

The computation of exchange rate with respect to these 4 transactions depend on administrative
costs incurred towards completion of transaction or time taken by the banker in processing the
transaction.

Principle Types of Selling Rates

When a bank sells foreign exchange it receives Indian rupees from the customer and parts with
foreign currency. Selling rates primarily depend on admin costs.

1. TT SELLING
Telegraphic transfer involves an electronic transfer of funds from one bank to another. TT selling
rate is the rate at which a bank or currency exchange facility sells foreign currency through a
telegraphic transfer. It is the outflow of FC for different purposes like – outward remittance,
application fee, exam fee, conference/ study tour abroad.

In this case the consumer will be buying FC and banker is selling FC and therefore sell rate is
applicable.

BASE RATE + MARGIN = TT SELLING

 Interbank spot sell low

By interbank spot sell we mean to meet the demand of the customer, the banker has approached in
the interbank market to purchase FC demanded by the customer. Suppose interbank quoted rs 60
spot rate to this loading is made which is called as margin and since the time taken or
administrative cost incurred by the banker is less the margin loaded is also less, say 0.20 paise and
the rate arrived is 60.20

2. BILL SELLING
In this case the corporate customer who has approached bank for making payment of import bill
drawn on him by foreign party. Any bill means BOE, various types of invoices, packing list, weight
list, certificate analysis and quality that is various documents are drawn which are commercial and
transport documents - B/L, risk bearing documents and other documents. All this when tied
together make an import bill. In cross border import dealing most of the bills are drawn under LOC
which is nothing but bank’s conditional commitment to pay and the banker would pay if documents
listed above are according to terms and conditions of LOC. In other words scrutiny part is extremely
important before effecting the payment for import bill.
Unlike transactions like outward remittance, administrative cost/ work involved in dealing with the
corporate customer is much higher and therefore margin or loading is also higher.
The base rate here is again interbank spot sell to which loading is made on higher side to arrive at
bid selling rate.
For example, if interbank spot sell is rs 60 loading will be 0.50 and bill selling would be 60.50
Thus bill selling rate is always worse than TT selling due to higher loading.

BASE RATE + MARGIN = BILL SELLING

Interbank spot sell higher side

Principal Types of Buying Rates

In a purchase transaction the bank acquires foreign exchange from the customer
and pays him in Indian rupees. Buying rate primarily depends on Whether value date is arrived or
not. By value date we mean the date at which NOSTRO A/C is credited/ debited.

3. TT BUYING

As far as TT buying rate is concerned it is a case of export bills sent on collection basis earlier which
means Indian party has drawn a bill on foreign customer towards export made. Foreign customer
has paid the bill and NOSTRO is already credited in other words value date is already arrived.
Suppose in this case interbank has quoted 59 rs then bank will deduct margin which is known as
reverse loading. Suppose this margin is 0,20 paise then bank will pass on 58.80 rs to exporter
customer

BASE RATE + MARGIN = TT SELLING

Interbank spot purchase reverse loading

4. BILL BUYING RATE

In Case of export bill however, value date is not received unlike imp bill on collection discussed
earlier. The value date here will be received on due date only. However since the exporter
customer’s working capital is blocked he would approach the banker with a request to
negotiate/purchase/ discount the bill. Since the value date is at some later stage in order to finance
the exporter customer the bank would approach the interbank and ask for forward quote which
again depends upon whether in the forward market curreny is at premium or discount. If it is at
premium the forward base rate would be rs 61 to which again loading is done on reverse side i.e.
margin deducted. The rate quoted finally would be bill buying rate where base rate is unlike all
earlier illustrations. It is forward and therefore interbank fwd purchase.\

BASE RATE + MARGIN = TT SELLING

Interbank FWD purchase

6. Explain case where bill buying rate is favourable than TT buying

Telegraphic Transfer Buying Rate:
 rate at which a bank or currency exchange facility purchases foreign currency through a
telegraphic transfer. Ex – inward remittance
 Telegraphic transfer involves an electronic transfer of funds from one bank to another.
TT buying = base rate (interbank spot purchase) – margin (reverse loading)

Bill Buying Rate:

 rate at which a bank or currency exchange facility purchases foreign currency through a bill
of exchange (also known as a draft or bill). Ex- export
 Bill of exchange - financial instrument - written order requiring a person or entity to pay a
certain amount of money on a specified date.
Bill buying rate = base rate (interbank forward purchase) – margin (on higher side)
Since export proceeds are realised in future when the delivery is made, the base is calculated on
interbank forward purchase rates.
Under this, when a bill is purchased, the proceeds will be realized by the bank after
the bill is presented to the drawee at the overseas center. Therefore, the rate quoted to the
customer would be based not on the spot rate in the inter bank market, but on the inter bank rate
for say 50 days forward. Therefore, the bank would be able to dispose of foreign exchange only
after 50 days; the rate to the customer would be based on the inter bank rate for 50 days forward
Generally the Bill buying rate is worse than TT buying rate due to higher margin. issuance of a TT is
comparatively simple and while the Rupee equivalent is recovered immediately, the payment made
overseas is at a later date, giving the Bank some float funds. In the case of an import bill, there is
considerably higher work like scrutiny of documents, follow up, folder maintenance etc. The
additional work involved is sought to be compensated by levying a bill collection commission and
selling the foreign currency at a „worse‟ rate as compared to the issuance of TT.
If the bill buying rate is lower (more favorable) than the TT buying rate, it means that the bank is
offering a better rate for customers who are selling foreign currency bills compared to the rate for
customers using telegraphic transfer.

In the forward market, currencies are traded for future delivery at an agreed-upon exchange rate.
The rate can be at a premium or a discount.
If, in the forward market, the currency is at a premium, it means that the future exchange rate is
higher than the current spot rate. If the base rate (interbank forward purchase) is higher due to the
forward premium. it means that the future exchange rate (for a future date) is higher than the
current spot rate.. so despite the higher margin in bill buying rate, the bill buying rate would now
be higher than TT buying rate. it implies the bill buying rate would be more favorable.

Customers purchasing bills can benefit from a more favorable base rate, resulting in a potentially
better deal compared to TT buying. The customer will be getting more rupees per dollar under the
forward rate than under the spot rate.

If, in the forward market, the currency is at a discount, it means that the future exchange rate is
lower than the current spot rate. Since dollar is at discount, forward dollar fetches lesser rupees
than spot dollars. In other words, longer the forward period involved, the bank is able to get dollar
from the customer at cheaper rate.
Compute with hypothetical illustration following exchange rates.
a) T.T. Selling
b) Bill Selling
c) T.T. Buying
d) Bill Buying

"Today we are living in a world of highly integrated & globalized economy" - Discuss with
reference to the necessity of studying International Finance.

Discuss in brief various statutes that govern cross border trade transactions with special
reference to "Exchange Control" regulation.

Explain with diagram Central Banks intervention in Foreign Exchange Market.

What factors led to the evolution of "EURO"

Distinguish clearly between a) Currency arbitrage, speculation & hedging b) Currency

forward & Futures.

Why "REAL EFFECTIVE EXCHANGE RATE" is more accurate measure than "SPOT
RATE".

Bill selling rate is always worse than T.T. Selling Rate, however "Bill Buying Rate" is at times
better than "T.T. Buying Rate" - Explain

a) Define NOSTRO and VOSTRO deposit Accounts

b) "Debit to VOSTRO ACCOUNT results into earnings of Foreign Currency" - Explain.

Compute the cross rate between a) NZS: STGL, when IStgE US $ 1.5734/40 and INZS US
$0.8277/82 b) You sold EURO 10,00,000 value SPOT to your customer at Rs. 48.33 and
covered yourself in London Market on the same day when exchange rates were as under SPOT
EURO US$ 0.9875/890 Local Interbank rates on the same day for USS were SPOT USS 1: Rs.
48.7000/8500. Calculate the cover rate and ascertain profit/loss.

"Derive the equation for Currency Interest Arbitrage".

"In spite of entering into Currency forward Contract, the corporate may incur losses, when
compared with SPOT-RATE" -Explain, What solution would you suggest in such a situation?

With suitable diagram explain Central Banks intervention in Forex Market.

Derive "Fisher's" Equation.

"Current Account is synonymous to trade account" - Explain.

In what way "Currency Option" has advantage over "Currency Forward".

"Inflation must reflect Exchange Rate" - Discuss.

Derive an equation for "Covered and Uncovered Interest Arbitrage".

Explain following as modes of Cross border Trade Financing- a) Suppliers Credit b) Buyers
Credit

The Rate Card displayed by Banker shows following under U.S. $ a) T. T. Selling Rate b) Bill
Buying Rate With hypothetical example compute above rates.

Define Offshore Currency. Explain the role played by Euromarket.

Short notes on – a) Syndicated Loans b) Major Funding Instruments c)

Exchange Rate Regimes