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1.What is the theory of Purchasing Power Parity? How is the rate of exchange determined in terms of PPP theory?
2.Describe the components of financial system.
3.Write a comprehensive note on Classical Theory of Rate of Interest.
4.What is securitization? Explain its nature and the process of securitization. What benefits accrue from securitization?
5.Which are the various types of money market instruments? Discuss any six of those.
6.Write a comprehensive note on various types of money market dealers.
1.(a How does the value system of society links itself with the business proposition?
(b) Explain the linkage between values and organisational performance
2.(a)Examine the concept of social responsibility of business in light of the rights the businesses have.
(b)Outline the reasons for the view that businesses should not merely pursue profits?
3.(a)"Compare and contrast the major forms of market structures on the ethical parameters
(b) What is meant by ethical behaviour? What are its advantages?
4.(a)Discuss the fundamental principles of ethical policy.
(b) What responsibilities does the organization carry towards the suppliers and the dealers?
5.(a)Highlight the composition of the district consumer disputes redressal agency.
(b) What is meant by TRIPS? What is its significance in GATT?
6.(a)What is meant by racial discrimination? Discuss the various patterns of racial discrimination that is witnessed/ observed in international business groups.
(b) Highlight the relationship between ethics, economics and politics in determining the fair price of a product.
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1.What is the theory of Purchasing Power Parity? How is the rate of exchange determined in terms of PPP theory?
Purchasing Power Parity (PPP)
Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP suggests that transactions on a country's current account, affect the value of the exchange rate on the foreign exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate.
PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one price.
The Law of One Price (LoOP)
The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Consider the following information about movie video tapes sold in the US and Mexican markets.
Price of videos in US market (P$v) $20
Price of videos in Mexican market (Ppv) P150
Spot exchange rate (Ep/$) 10 p/$
The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by the spot exchange rate as shown,
To see why the peso price is divided by the exchange rate (rather than multiplied) notice the conversion of units shown in the brackets. If the law of one price held, then the dollar price in Mexico should match the price in the US. Since the dollar price of the video is less than the dollar price in the US, the law of one price does not hold in this circumstance.
The next question to ask is what might happen as a result of the discrepancy in prices. Well, as long as there are no costs incurred to transport the goods, there is a profit-making opportunity through trade. For example, US travelers in Mexico who recognize that identical video titles are selling there for 25% less might buy videos in Mexico and bring them back to the US to sell. This is an example of "goods arbitrage." An arbitrage opportunity arises whenever one can buy something at a low price in one location and resell at a higher price and thus make a profit.
Using basic supply and demand theory, the increase in demand for videos in Mexico would push the price of videos up. The increase supply of videos on the US market would force the price down in the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the price of videos in the US may fall to $18. At these new prices the law of one price holds since,
The idea between the law of one price is that identical goods selling in an integrated market, where there are no transportation costs or differential taxes or subsidies, should sell at identical prices. If different prices prevailed then there would be profit-making opportunities by buying the good in the low price market and reselling it in the high price market. If entrepreneurs acted in this way, then the prices would converge to equality.
Of course, for many reasons the law of one price does not hold even between markets within a country. The price of beer, gasoline and stereos will likely be different in New York City than in Los Angeles. The price of these items will also be different in other countries when converted at current exchange rates. The simple reason for the discrepancies is that there are costs to transport goods between locations, there are different taxes applied in different states and different countries, non-tradable input prices may vary, and people do not have perfect information about the prices of goods in all markets at all times. Thus, to refer to this as an economic "law" does seem to exaggerate its validity.
From LoOP to PPP
The purchasing power parity theory is really just the law of one price applied in the aggregate, but, with a slight twist added (more on the twist a bit later). If it makes sense from the law of one price that identical goods should sell for identical prices in different markets, then the law ought to hold for all identical goods sold in both markets.
First, let's define the variable CB$ to be the cost of a basket of goods in the US denominated in dollars. For simplicity we could imagine using the same basket of goods used in the construction of the US consumer price index (CPI$). The CPI uses a market basket of goods which are purchased by an average household during a specified period. The basket is determined by surveying the quantity of different items purchased by many different households. One can then determine, on average, how many units of bread, milk, cheese, rent, electricity, etc. are purchased by the typical household. You might imagine, it's as if all products are purchased in a grocery store, with items being placed in a basket before the purchase is made. CB$ then represents the dollar cost of purchasing all of the items in the market basket. We shall similarly define CBp to be the cost of a market basket of goods in Mexico denominated in pesos.
Now if the law of one price holds for each individual item in the market basket, then it should hold for the market baskets as well. In other words,
If this condition holds between two countries then we would say PPP is satisfied. The condition says that the PPP exchange rate (pesos per dollars) will equal the ratio of the costs of the two market baskets of goods denominated in local currency units. Note that the reciprocal relationship is also valid.
Because the cost of a market basket of goods is used in the construction of the country's consumer price index, PPP is often written as a relationship between the exchange rate and the country's price indices. However, it is not possible merely to substitute the price index directly for the cost of the market basket used above. To see why, let's review the construction of the CPI.
INTEREST RATE PARITY
refers to the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that HEDGED returns from investing in different currencies should be the same regardless of the level of their interest rates.
There are two versions of interest rate parity:
Covered Interest Rate Parity
UNCOVERED INTEREST RATE PARITY
Read on to learn about what determines interest rate parity and how to use it to trade the forex market.
Calculating Forward Rates
FORWARD EXCHANGE RATES for currencies refer to exchange rates at a future point in time, as opposed to SPOT EXCHNAGE RATES which refer to current rates. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to ARBITRAGE .
The basic equation for calculating forward rates with the U.S. dollar as the base currency is:
Forward Rate = Spot Rate X (1 + Interest Rate of Overseas country)
(1 + Interest Rate of Domestic country)
Forward rates are available from banks and currency dealers for periods ranging from less than a week to as far out as five years and beyond. As with spot currency quotations, forwards are quoted with a BID - ASK SPREAD .
Consider U.S. and Canadian rates as an illustration. Suppose that the spot rate for the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for the moment). One-year interest rates (priced off the zero-coupon yield curve are at 3.15% for the U.S. dollar and 3.64% for the Canadian dollar.
Using the above formula, the one-year forward rate is computed as follows:
1 USD = 1.0650 X (1 + 3.64%) = 1.0700 CAD
(1 + 3.15%)
The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to 50. If this difference (forward rate – spot rate) is positive, it is known as a forward premium ; a negative difference is termed a forward discount.
A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In the example shown above, the U.S. dollar trades at a forward premium against the Canadian dollar; conversely, the Canadian dollar trades at a forward discount versus the U.S. dollar.
Can forward rates be used to predict future spot rates or interest rates? On both counts, the answer is no. A number of studies have confirmed that forward rates are notoriously poor predictors of future spot rates. Given that forward rates are merely exchange rates adjusted for interest rate differentials, they also have little predictive power in terms of forecasting future interest rates.
Covered Interest Rate Parity
According to covered interest rate parity, forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exist.
In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate. Typically, the investor would take the following steps:
Borrow an amount in a currency with a lower interest rate
Convert the borrowed amount into a currency with a higher interest rate
Invest the proceeds in an interest-bearing instrument in this (higher interest rate) currency
Simultaneously hedge exchnage risk by buying a forward contract to convert the investment proceeds into the first (lower interest rate) currency
The returns in this case would be the same as those obtained from investing in interest-bearing instruments in the lower interest rate currency. Under the covered interest rate parity condition, the cost of hedging exchange risk negates the higher returns that would accrue from investing in a currency that offers a higher interest rate.
Covered Interest Rate Arbitrage
Consider the following example to illustrate covered interest rate parity. Assume that the interest rate for borrowing funds for a one-year period in Country A is 3% per annum, and that the one-year deposit rate in Country B is 5%. Further, assume that the currencies of the two countries are trading at par in the spot market (i.e., Currency A = Currency B).
1 Borrows in Currency A at 3%
2 Converts the borrowed amount into Currency B at the spot rate
3 Invests these proceeds in a deposit denominated in Currency B and paying 5% per annum
The investor can use the one-year forward rate to eliminate the exchange risk implicit in this transaction, which arises because the investor is now holding Currency B, but has to repay the funds borrowed in Currency A. Under covered interest rate parity, the one-year forward rate should be approximately equal to 1.0194 (i.e., Currency A = 1.0194 Currency B), according to the formula discussed above.
What if the one-year forward rate is also at parity (i.e., Currency A = Currency B)? In this case, the investor in the above scenario could reap riskless profits of 2%. Here's how it would work. assume the investor:
1 Borrows 100,000 of Currency A at 3% for a one-year period
2 Immediately converts the borrowed proceeds to Currency B at the spot rate
3 Places the entire amount in a one-year deposit at 5%
4 Simultaneously enters into a one-year forward contract for the purchase of 103,000 Currency A
After one year, the investor receives 105,000 of Currency B, of which 103,000 is used to purchase Currency A under the forward contract and repay the borrowed amount, leaving the investor to pocket the balance - 2,000 of Currency B. This transaction is known as covered interest rate arbitrage.
Market forces ensure that forward exchange rates are based on the interest rate differential between two currencies, otherwise arbitrageurs would step in to take advantage of the opportunity for arbitrage profits. In the above example, the one-year forward rate would therefore necessarily be close to 1.0194.
Uncovered Interest Rate Parity
Uncovered interest rate parity (UIP) states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. Theoretically, if the interest rate differential between two countries is 3%, then the currency of the nation with the higher interest rate would be expected to depreciate 3% against the other currency.
In reality, however, it is a different story. Since the introduction of floating exchange rates in the early 1970s, currencies of countries with high interest rates have tended to appreciate, rather than depreciate, as the UIP equation states.
The Interest Rate Parity Relationship Between the U.S. and Canada
Let us examine the historical relationship between interest rates and exchange rates for the U.S. and Canada, the world's largest trading partners. The Canadian dollar has been exceptionally volatile since the year 2000. After reaching a record low of US61.79 cents in January 2002, it rebounded close to 80% in the following years, reaching a modern-day high of more than US$1.10 in November 2007.
Looking at long-term cycles, the Canadian dollar depreciated against the U.S. dollar from 1980 to 1985. It appreciated against the U.S. dollar from 1986 to 1991 and commenced a lengthy slide in 1992, culminating in its January 2002 record low. From that low, it then appreciated steadily against the U.S. dollar for the next 5 and a half years.
For the sake of simplicity, we use prime rates to test the UIP condition between the U.S. dollar and Canadian dollar from 1988 to 2008.
Based on prime rates, UIP held during some points of this period, but did not hold at others, as shown in the following examples:
1 The Canadian prime rate was higher than the U.S. prime rate from September 1988 to March 1993. During most of this period, the Canadian dollar appreciated against its U.S. counterpart, which is contrary to the UIP relationship.
2 The Canadian prime rate was lower than the U.S. prime rate for most of the time from mid-1995 to the beginning of 2002; as a result, the Canadian dollar traded at a forward premium to the U.S. dollar for much of this period. However, the Canadian dollar depreciated 15% against the U.S. dollar, implying that UIP did not hold during this period as well.
3 The UIP condition held for most of the period from 2002, when the Canadian dollar commenced its commodity -fueled rally, until late 2007, when it reached its peak. The Canadian prime rate was generally below the U.S. prime rate for much of this period, except for an 18-month span from October 2002 to March 2004.
Hedging Exchange Risk
Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a forward contract is highly inflexible, because it is a binding contract that the buyer and seller are obligated to execute at the agreed-upon rate.
Interest rate parity is fundamental knowledge for traders of foreign currencies. In order to fully understand the two kinds of interest rate parity, however, the trader must first grasp the basics of forward exchange rates and hedging strategies. Armed with this knowledge, the forex trader will then be able to use interest rate differentials to his or her advantage. The case of U.S. dollar/Canadian dollar appreciation and depreciation illustrates how profitable these trades can be given the right circumstances, strategy and knowledge.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics , the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds , increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating is a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments . If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and derived from capital gains any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.
There are three types of exchange rate risk exposure for a Financial Planner or a Risk manager:-
1 Translation exposure
2 Transaction exposure
3 Economic exposure
Translation exposure is the change in accounting income and balance sheet statements caused by changes in exchange rates. Under the rules of Financial Accounting Standards Board, a US company must determine a functional currency for all and each of its offshore subsidiaries. If such a subsidiary is a stand alone firm with vertical or horizontal integration with the particular country, the functional currency can be the local currency otherwise it has to the dollar.
Transaction exposure is the gain or loss that might occur during settlement of foreign exchange transaction. Such a transaction could be the sale / purchase of product or services lending or borrowing of money or any other transaction involving mergers and acquisitions.
Economic exposure, the most important of the three, is the change in value of a company that accompanies an unanticipated change in the exchange rates. There is a clear distinction between the anticipated and the unanticipated change of exchange rates. The anticipated change has already been factored into the valuation of the company by the market forces. The unanticipated comes as an unforeseen risk.
The fluctuations in exchange rates subject firms operating in the international environment to as many as three types of exposure to exchange rate risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
The first of these, transaction exposure, is the risk of gains or losses that occurs when a firm engages in commercial transactions in which the currency of the transaction is foreign to the firm; i.e., it is denominated in a foreign currency. This is the type of exchange rate risk that we have looked at the various ways of managing via futures, forward contracts, options and money market hedges.
Another means of hedging transaction exposure is through what is known as a currency swap. With a currency swap, two companies can agree to exchanging set amounts of currency at fixed rates of exchange. Of course, the fixed rates of exchange will be set to reflect interest rate differentials (Interest Rate Parity). Swaps help a company faced with possible foreign exchange restrictions and a lack of forward markets.
Exposure netting refers to the ability to use opposite exposures to reduce the amount of risk that a firm is faced with. Just as we can create opposite risks with a futures contract or options, it is sometimes possible to create one transaction exposure in order to offset another. For example, if a U.S. firm has a payable to a British company in pounds (short position), it may want to invoice a receivable in pounds (long position) in order to create an offset. The company could then hedge only the net long (short) position and, thus, reduce its hedging costs. Many multinationals actually have a separate subsidiary that manages the worldwide exposure through netting, known as a reinvoice center.
A firm which has subsidiaries and assets in another country is subject to translation exposure. Translation exposure results as a consequence of the fact that a parent company must consolidate all of the operations of its subsidiaries into its own financial statements. Since a foreign subsidiary’s assets are carried on its books in a foreign currency, it is necessary to convert the foreign values into domestic currency for combining with the parent’s assets. Fluctuating exchange rates results in gains and losses occurring during the translation process. Since this type of exposure is related to balance sheet assets and liabilities, it is often referred to as accounting exposure.
The primary issue related to the translation of foreign asset values has to do with whether the proper exchange rate to use is the current rate of exchange or the historic rate of exchange that existed at the time that an asset was acquired. In order to see the possible gains and losses that can occur, let’s consider the following:
A U.S. company has a Mexican subsidiary that buys an asset for 12 million pesos in 20x1 when the exchange rate is 12 pesos per USD. Over the following year, inflation in Mexico is 50% while in the U.S. it is 0%. Of course, if purchasing power parity holds, then the exchange rate in one year should be 18 pesos per dollar.
If we use historical cost accounting, the asset will have a value of 12 million pesos on the Mexican subsidiary’s books. Translating this at the current exchange rate of 18 pesos/USD yields a US dollar value of
If we translate the historical cost of 12 million pesos at the historical exchange rate at the time of acquisition of 12 pesos/USD we get a US dollar value of
Thus, the correct value would be to use the historical exchange rate when the books are kept on an historical cost basis.
On the other hand, Mexico is a country that utilizes an inflation-adjusted (or current) accounting system where assets are indexed for inflation. Thus, the Mexican subsidiary would carry the asset on the books at 18 million pesos (12 million pesos * (1+50%) = 18 million pesos). Translating this using the current exchange rate of 18 pesos/USD yields
If the historical exchange rate were used, we would obtain the following value:
For the proper translation of value, we should either use the historic exchange rate with historical cost accounting or the current exchange rate with current accounting practices. For a foreign currency that has depreciated, we get the following general results (an appreciating currency would yield the opposite results):
Accounting Valuation Method
(Book Value) (Market Value)
Translation Historic No Change Increased Value
Rate Current Decreased Value No Change
In 1981, FASB 52 set the rules for U.S. GAAP accounting in which it stated that all asset and liability accounts must be translated at the current rate of exchange. Equity accounts are translated at historical rates of exchange. A separate account, ”Equity Adjustment from Translation”, is used to reflect translation gains and losses. The only exception to this is for assets in countries experiencing hyperinflation which is defined as cumulative inflation greater than 100% over a three-year period. In that case, historical exchange rates are allowed for non-monetary items (inventory/cost of goods sold, plant & equipment/depreciation).
In any event, translation exposure is not a real gain or loss in terms of making or losing money. The value of the asset is the value of the asset. The gain or loss results simply from translating from one currency to another. In that sense, one should not really worry about translation exposure (except to the extent that there is a perceived gain or loss from unsophisticated users of the financial statements).
While transaction exposure is an economic exposure in the sense that a real gain or loss can result (unlike translation exposure which is just an accounting gain or loss), the use of the term in this context is in reference to the risk associated with revenues, costs and demand for goods as foreign exchange rates fluctuate. Sometimes economic exposure is called “operating exposure” since it refers to the risk to operations. An example would be a devaluation of a foreign currency which would make your product relatively more expensive. Thus, it would be less competitive in the foreign country (as well as domestically), resulting in lower sales and lower profits.
How can a company hedge against economic exposure? There is no perfect hedge, but there are actions that a company can take to help offset the risks over the longer period of time.
Production Management –
• Product sourcing: Diversify your source of materials. If you are producing in a foreign country that experiences a devaluation, then some of the loss of sales and profits from your products becoming relatively more expensive is offset by the fact that some of your costs have become less expensive since they are now bought from a country with a weaker currency
• Shifting production: As sales drop due to a currency becoming more expensive, you can shift production to countries where a weaker currency results in lower costs, again protecting your profit margin even though sales will decline.
Marketing Management –
• Geographic diversification: If sales weaken in one country, they may increase in another due to a change in currency values
• Market segmentation: High-end (luxury) segment or low-end (economy)
• Market share versus profit margin
• Product differentiation: helps make product less sensitive to price changes
Financial Management –
• Arrange financing so that a decrease in sales from a weaker currency is offset by cheaper debt servicing costs.