Examination Paper of Foreign Trade management
IIBM Institute of Business Management 7
IIBM Institute of Business Management
Examination Paper MM.100
Foreign Exchange Management
Section A: Objective Type (30 Marks)
This section consists of Multiple Choice Questions and Short Questions
Answer all the questions
Part one carry 1 mark each and Part Two questions carry 5 marks each.
Part One:
1. It is established to help countries in reconstructing their economies in the post World War II?
a. International Monetary Fund
b. World Bank
c. International Finance Corporation
d. International Development Association
2. The exchange rates which is variable between currencies and determined by demand and supply
a. Floating Exchange Rate System c. Fixed Exchange Rate System
b. Free Float d. Managed float
3. The branches which do not maintain independent foreign currency accounts but have powers to
operate the accounts falls under
a. Category A c. Category B
b. Category C d. Category D
4. _____ quote is given by a bank to its retail customers
a. Merchant Quote c. Interbank Quote
b. American Quote d. European Quote
5. To take the base rate and add the appropriate margin to it is an
a. Spot TT Buying Rate c. Spot TT Selling Rate
b. Forward TT Buying Rate d. Forward TT Selling Rate
6. Which of the following is not an assumption to Law of One Price
a. Movement of Goods c. No Transaction Costs
b. No Tariffs d. Relative Form of PPP
7. The approach in which the value of a currency is determined by the relative demand and supply
of money and, the relative demand and supply of bonds is
a. The Monetary Approach c. Exchange Rate Volatility Approach
c. The Asset Approach d. The Portfolio Balance Approach
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 8
8. Which of the following is the most important currency in the world after the collapse of Bretten
Woods
a. Yen c. US Dollar
b. Sterling d. DM
9. Option Forward is a
a. Forward Contract entered along with buying a call option.
b. Forward Contract entered along with writing a put option
c. Forward Contract entered by buying or selling at a future date.
d. Forward Contract entered by buying or selling over a period.
10. Hedging aims to
a. Increase Profits c. Reduce Costs
b. Maximize Profits d. Minimize Risk
Part Two:
1. Differentiate between Forward Rates and Expected Spot Rates?
2. Write a note on ‘Swaps’?
3. Differentiate between Bid Rate and Ask Rate?
4. Write a note on ‘Interest Rate Parity’?
Section B: Caselets (40 Marks)
This section consists of Caselets
Answer all the questions
Each Caselet carries 20 marks each.
Detailed information should form the part of your answer (Word limit 150 to 200 Words)
Caselet 1
International asset swaps can be used to achieve international diversification without eroding the level
of foreign exchange reserves and weakening local market development. These asset swaps demand
limited foreign currency flows, which implies that there is a need for only net gains or losses to be
exchanged. Asset swaps protect foreign investors from market manipulation and expropriation risk and
have much lower transaction costs than outright investments. In spite of all this, asset swaps are
constrained by the attractiveness of local markets to foreign investors, and by various regulatory issues
covering counter-party risk, collateral considerations, accounting, valuation, and reporting rules.
Institutional investors, especially pension funds and life insurance companies, are becoming the major
participants in the financial systems of many developing countries. In some cases like Egypt, Malaysia or
END OF SECTION A
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 9
Sri Lanka, the sector is dominated by public agencies, but in several countries, including Argentina,
Brazil, Chile, Cyprus, Hungary, Mauritius and especially South Africa private institutions play a prominent
role in the accumulation of long-term financial resources. But in most developing countries, pension
funds and other institutional investors operate under strict limitations on their foreign investments,
mainly because of the shortage of foreign exchange reserves and the fear of capital flight.
The imposition of exchange controls on investment in foreign assets affects the financial performance of
pension funds and insurance companies. Exchange controls prevent an international diversification of
risk and a reduction in the exposure of contractual savings institutions to domestic currency and market
risk. Pension funds and other institutional investors in most developing countries are not generally
allowed to invest overseas. Even OECD countries, until the early 1980s, used to apply tight quantitative
restrictions on overseas investments by local institutions. The most common rationale for such
restrictions is to reduce the risk of capital ‘flight’, especially institutionalized capital flight. Another
rationale is to invest the locally mobilized long-term savings ‘at home’ to stimulate the development of
local capital markets and enhance employment opportunities for the same workers. Even in the absence
of legal limitations on foreign investing by local institutional investors, there are other significant
barriers—the most important are risk of expropriation by foreign governments and transaction costs.
These costs can be so large that they may offset any diversification benefits that would otherwise
accrue, especially when relatively low volumes of funds are involved. International diversification
improves the risk/return trade-off of investment portfolios by reducing the exposure to cyclical and
long-term structural shifts in local economic performance. In the US, where the large local economy is
highly diversified and where presence of global corporations provides an indirect avenue of
international diversification, overseas assets are less than 12% of total assets, although this represents a
significant increase over time. Removing exchange controls and fully integrating with international
capital markets should be the ultimate objective of policy in all developing countries. However,
complete removal of exchange controls is often constrained by the paucity of foreign exchange reserves
and the fear of stimulating capital flight, especially if confidence in future stability is low.
Asset swaps are clearly a second best option compared to the lifting of exchange controls. Developing
countries should consider authorizing their institutional investors to engage in international asset swaps.
But they should authorize to use properly designed swap contracts, preferably based on the basket of
liquid securities, permit only global investment banks to act as counter-parties, require use of global
custodians, properly monitor credit risk, maintain adequate collateral, and adopt market-to-market
valuation rules.
Questions
Q 1. How does the international asset swap mechanism work? Explain.
Q2. Discuss the various benefits of international asset swaps.
Caselet 2
The RBI held the view, for long, that strong exchange reserves need to be maintained, due to the bad
experience India had to go through in 1991. It has been a widely known policy of the RBI to keep
accumulating dollar reserves, whenever there are strong inflows of foreign funds, which also ensures
that the rupee does not appreciate much. The policy has, over the years, resulted in the foreign
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 10
exchange reserves increasing to over $100 billion. However, this policy has also led to the RBI being
criticized for interfering in the foreign exchange markets too often.
Several justifications have been given for this policy. The first one, as mentioned in the opening
sentence, is the lack of confidence in the international architecture. That is, the liquidity support
available to a country when it suffers from Balance of Payments problems could be inadequate, not
available when needed urgently, or be set with political preconditions not acceptable to the country
facing the problems. The second reason is often the desire to contain the risks that may arise from
external shocks. External private capital often comes in when the country is doing well and exits at the
first indication of trouble. Having large reserves is essential to contain the panic conditions that prevail
in the markets in such situations. The third reason is the opportunity created by the current excessive
liquidity in the international financial markets and the associated low interest rates. If the interest rates
escalate later, capital may again reverse its direction, and flow to the markets in the developed
countries. Reserves accumulated at present will be helpful to withstand such shocks later. The final
reason, which is no less important, is that foreign currency reserves are required to withstand the
periodical volatility in the foreign exchange markets. The markets of emerging economies are less
efficient and cannot be depended upon to make automatic adjustments to correct the volatility in the
markets. Similarly, a politically sensitive event like the Pokhran blasts or skirmishes with Pakistan on the
border can cause a lot of Non-Resident Indians (NRIs) who are currently pumping money into the
country to withdraw it over night. Such swings in sentiment can play havoc with the exchange rates, and
the government will be called on to play a stabilizing role in such a situation.
The consistent accumulation of dollars has been often stopping the rupee from appreciating, though
there have been strong inflows of the dollar, on numerable counts in the past. The resultant liquidity
released into the system used to be sterilized by the RBI through issue of government securities. To an
extent, the inclination of the banks to invest in government securities beyond the statutory
requirements has come in handy for the RBI in achieving stability in the exchange rate of the rupee.
However, the situation changed from early last year (2003), when the rupee started appreciating against
the dollar. At the same time, the rupee has been depreciating against other major currencies like the
Euro and Yen, indicating that the appreciation is basically due to the weakness of the dollar against
these currencies. The RBI, this time, chose to allow some amount of appreciation of the rupee, against
dollar. The appreciation gained momentum due to inflows of dollars continuing, with the NRIs
encouraged by the gain of the rupee. Added to this, the prices of crude oil fell, easing the pressure on
the need for payments for oil imports. With the fear of losing out due to further improvement in the
rupee exchange rate, exporters also rushed to remit the dollars to India, pushing the exchange rate
further up. The sustained positive current account balance also appears to have had its impact in
generating positive sentiments for the rupee. It has been alleged, however, that most of the fund flows
to India are to gain from the arbitrage. Investors always prefer to invest in a currency that is
appreciating, so that they can gain from the interest and also from the appreciation if the currency.
However, this argument is refuted on several counts. The spread on the NRI deposits is capped at 2.5%
and is often not more than forward premium on the dollar in the Indian market. The investment by the
FIIs in debt funds is limited to $1 billion, all the FIIs put together. This cap prevents them from making
any meaningful arbitrage gains. The variability in interest rates in the two currencies involved, keeping in
view the narrow spreads, can add risk to the seemingly risk-less arbitrage. In view of these arguments, it
can be said that the flow of dollars into India is driven by factors other than the strength of the rupee
and the resultant opportunities for arbitrage.
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 11
Questions
-
Q 1. What measures according to you the RBI should take to manage rupee-dollar exchange rates?
Q2. Do you think appreciation of rupee against dollar have any significant adverse impact on the Indian
economy? Discuss.
Section C: Applied Theory (30 Marks)
This section consists of Long Questions
Answer all the questions
Each question carries 15 marks each.
Detailed information should form the part of your answer (Word limit 200 to 250 Words
1. How many types of Exposures are there in terms of Exchange Risk?
2. Write a note on
International Monetary Fund
International Finance Corporation
International Development Association
----------------------------------------------------------------------***---------------------------------------------------------------
END OF SECTION B
END OF SECTION C
IIBM Institute of Business Management 7
IIBM Institute of Business Management
Examination Paper MM.100
Foreign Exchange Management
Section A: Objective Type (30 Marks)
This section consists of Multiple Choice Questions and Short Questions
Answer all the questions
Part one carry 1 mark each and Part Two questions carry 5 marks each.
Part One:
1. It is established to help countries in reconstructing their economies in the post World War II?
a. International Monetary Fund
b. World Bank
c. International Finance Corporation
d. International Development Association
2. The exchange rates which is variable between currencies and determined by demand and supply
a. Floating Exchange Rate System c. Fixed Exchange Rate System
b. Free Float d. Managed float
3. The branches which do not maintain independent foreign currency accounts but have powers to
operate the accounts falls under
a. Category A c. Category B
b. Category C d. Category D
4. _____ quote is given by a bank to its retail customers
a. Merchant Quote c. Interbank Quote
b. American Quote d. European Quote
5. To take the base rate and add the appropriate margin to it is an
a. Spot TT Buying Rate c. Spot TT Selling Rate
b. Forward TT Buying Rate d. Forward TT Selling Rate
6. Which of the following is not an assumption to Law of One Price
a. Movement of Goods c. No Transaction Costs
b. No Tariffs d. Relative Form of PPP
7. The approach in which the value of a currency is determined by the relative demand and supply
of money and, the relative demand and supply of bonds is
a. The Monetary Approach c. Exchange Rate Volatility Approach
c. The Asset Approach d. The Portfolio Balance Approach
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 8
8. Which of the following is the most important currency in the world after the collapse of Bretten
Woods
a. Yen c. US Dollar
b. Sterling d. DM
9. Option Forward is a
a. Forward Contract entered along with buying a call option.
b. Forward Contract entered along with writing a put option
c. Forward Contract entered by buying or selling at a future date.
d. Forward Contract entered by buying or selling over a period.
10. Hedging aims to
a. Increase Profits c. Reduce Costs
b. Maximize Profits d. Minimize Risk
Part Two:
1. Differentiate between Forward Rates and Expected Spot Rates?
2. Write a note on ‘Swaps’?
3. Differentiate between Bid Rate and Ask Rate?
4. Write a note on ‘Interest Rate Parity’?
Section B: Caselets (40 Marks)
This section consists of Caselets
Answer all the questions
Each Caselet carries 20 marks each.
Detailed information should form the part of your answer (Word limit 150 to 200 Words)
Caselet 1
International asset swaps can be used to achieve international diversification without eroding the level
of foreign exchange reserves and weakening local market development. These asset swaps demand
limited foreign currency flows, which implies that there is a need for only net gains or losses to be
exchanged. Asset swaps protect foreign investors from market manipulation and expropriation risk and
have much lower transaction costs than outright investments. In spite of all this, asset swaps are
constrained by the attractiveness of local markets to foreign investors, and by various regulatory issues
covering counter-party risk, collateral considerations, accounting, valuation, and reporting rules.
Institutional investors, especially pension funds and life insurance companies, are becoming the major
participants in the financial systems of many developing countries. In some cases like Egypt, Malaysia or
END OF SECTION A
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 9
Sri Lanka, the sector is dominated by public agencies, but in several countries, including Argentina,
Brazil, Chile, Cyprus, Hungary, Mauritius and especially South Africa private institutions play a prominent
role in the accumulation of long-term financial resources. But in most developing countries, pension
funds and other institutional investors operate under strict limitations on their foreign investments,
mainly because of the shortage of foreign exchange reserves and the fear of capital flight.
The imposition of exchange controls on investment in foreign assets affects the financial performance of
pension funds and insurance companies. Exchange controls prevent an international diversification of
risk and a reduction in the exposure of contractual savings institutions to domestic currency and market
risk. Pension funds and other institutional investors in most developing countries are not generally
allowed to invest overseas. Even OECD countries, until the early 1980s, used to apply tight quantitative
restrictions on overseas investments by local institutions. The most common rationale for such
restrictions is to reduce the risk of capital ‘flight’, especially institutionalized capital flight. Another
rationale is to invest the locally mobilized long-term savings ‘at home’ to stimulate the development of
local capital markets and enhance employment opportunities for the same workers. Even in the absence
of legal limitations on foreign investing by local institutional investors, there are other significant
barriers—the most important are risk of expropriation by foreign governments and transaction costs.
These costs can be so large that they may offset any diversification benefits that would otherwise
accrue, especially when relatively low volumes of funds are involved. International diversification
improves the risk/return trade-off of investment portfolios by reducing the exposure to cyclical and
long-term structural shifts in local economic performance. In the US, where the large local economy is
highly diversified and where presence of global corporations provides an indirect avenue of
international diversification, overseas assets are less than 12% of total assets, although this represents a
significant increase over time. Removing exchange controls and fully integrating with international
capital markets should be the ultimate objective of policy in all developing countries. However,
complete removal of exchange controls is often constrained by the paucity of foreign exchange reserves
and the fear of stimulating capital flight, especially if confidence in future stability is low.
Asset swaps are clearly a second best option compared to the lifting of exchange controls. Developing
countries should consider authorizing their institutional investors to engage in international asset swaps.
But they should authorize to use properly designed swap contracts, preferably based on the basket of
liquid securities, permit only global investment banks to act as counter-parties, require use of global
custodians, properly monitor credit risk, maintain adequate collateral, and adopt market-to-market
valuation rules.
Questions
Q 1. How does the international asset swap mechanism work? Explain.
Q2. Discuss the various benefits of international asset swaps.
Caselet 2
The RBI held the view, for long, that strong exchange reserves need to be maintained, due to the bad
experience India had to go through in 1991. It has been a widely known policy of the RBI to keep
accumulating dollar reserves, whenever there are strong inflows of foreign funds, which also ensures
that the rupee does not appreciate much. The policy has, over the years, resulted in the foreign
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 10
exchange reserves increasing to over $100 billion. However, this policy has also led to the RBI being
criticized for interfering in the foreign exchange markets too often.
Several justifications have been given for this policy. The first one, as mentioned in the opening
sentence, is the lack of confidence in the international architecture. That is, the liquidity support
available to a country when it suffers from Balance of Payments problems could be inadequate, not
available when needed urgently, or be set with political preconditions not acceptable to the country
facing the problems. The second reason is often the desire to contain the risks that may arise from
external shocks. External private capital often comes in when the country is doing well and exits at the
first indication of trouble. Having large reserves is essential to contain the panic conditions that prevail
in the markets in such situations. The third reason is the opportunity created by the current excessive
liquidity in the international financial markets and the associated low interest rates. If the interest rates
escalate later, capital may again reverse its direction, and flow to the markets in the developed
countries. Reserves accumulated at present will be helpful to withstand such shocks later. The final
reason, which is no less important, is that foreign currency reserves are required to withstand the
periodical volatility in the foreign exchange markets. The markets of emerging economies are less
efficient and cannot be depended upon to make automatic adjustments to correct the volatility in the
markets. Similarly, a politically sensitive event like the Pokhran blasts or skirmishes with Pakistan on the
border can cause a lot of Non-Resident Indians (NRIs) who are currently pumping money into the
country to withdraw it over night. Such swings in sentiment can play havoc with the exchange rates, and
the government will be called on to play a stabilizing role in such a situation.
The consistent accumulation of dollars has been often stopping the rupee from appreciating, though
there have been strong inflows of the dollar, on numerable counts in the past. The resultant liquidity
released into the system used to be sterilized by the RBI through issue of government securities. To an
extent, the inclination of the banks to invest in government securities beyond the statutory
requirements has come in handy for the RBI in achieving stability in the exchange rate of the rupee.
However, the situation changed from early last year (2003), when the rupee started appreciating against
the dollar. At the same time, the rupee has been depreciating against other major currencies like the
Euro and Yen, indicating that the appreciation is basically due to the weakness of the dollar against
these currencies. The RBI, this time, chose to allow some amount of appreciation of the rupee, against
dollar. The appreciation gained momentum due to inflows of dollars continuing, with the NRIs
encouraged by the gain of the rupee. Added to this, the prices of crude oil fell, easing the pressure on
the need for payments for oil imports. With the fear of losing out due to further improvement in the
rupee exchange rate, exporters also rushed to remit the dollars to India, pushing the exchange rate
further up. The sustained positive current account balance also appears to have had its impact in
generating positive sentiments for the rupee. It has been alleged, however, that most of the fund flows
to India are to gain from the arbitrage. Investors always prefer to invest in a currency that is
appreciating, so that they can gain from the interest and also from the appreciation if the currency.
However, this argument is refuted on several counts. The spread on the NRI deposits is capped at 2.5%
and is often not more than forward premium on the dollar in the Indian market. The investment by the
FIIs in debt funds is limited to $1 billion, all the FIIs put together. This cap prevents them from making
any meaningful arbitrage gains. The variability in interest rates in the two currencies involved, keeping in
view the narrow spreads, can add risk to the seemingly risk-less arbitrage. In view of these arguments, it
can be said that the flow of dollars into India is driven by factors other than the strength of the rupee
and the resultant opportunities for arbitrage.
Examination Paper of Foreign Trade management
IIBM Institute of Business Management 11
Questions
-
Q 1. What measures according to you the RBI should take to manage rupee-dollar exchange rates?
Q2. Do you think appreciation of rupee against dollar have any significant adverse impact on the Indian
economy? Discuss.
Section C: Applied Theory (30 Marks)
This section consists of Long Questions
Answer all the questions
Each question carries 15 marks each.
Detailed information should form the part of your answer (Word limit 200 to 250 Words
1. How many types of Exposures are there in terms of Exchange Risk?
2. Write a note on
International Monetary Fund
International Finance Corporation
International Development Association
----------------------------------------------------------------------***---------------------------------------------------------------
END OF SECTION B
END OF SECTION C
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