| unit 3 world financial markets institutions risks

Back to Study material

Unit – 3World Financial Markets & Institutions & Risks Q1) What is Euro Bonds? What are its various types?A1) A Eurobond is a debt capital market instrument issued in a “Eurocurrency” through a syndicate of issuing banks and securities houses, and distributed internationally when issued, that is sold in more than one country of issue and subsequently traded by market participants in several international financial centres. The Eurobond market is divided into sectors depending on the currency in which the issue is denominated. Types of Eurobonds:There are three types of Eurobonds, of which two are international bonds. A domestic bond is a bond issue in a country by a resident of that country.

Straight Bond: Bond is one having a specified interest coupon and a specified maturity date. Straight bonds may issue with a floating rate of interest. Such bonds may have their interest rate fixed at six-month intervals of a stated margin over the LIBOR for deposits in the currency of the bond. So, in the case of a Eurodollar bond, the interest rate may base upon LIBOR for Eurodollar deposits.

Convertible Eurobond: The Eurobond is a bond having a specified interest coupon and maturity date. But, it includes an option for the hold to convert its bonds into an equity share of the company at a conversion price set at the time of issue.

Medium-term Eurobond: Medium-term Euro notes are shorter-term Eurobonds with maturities ranging from three to eight years. Their issuing procedure is less formal than for large bonds. Interest rates on Euro notes can fix or variable. Medium-term Euro-notes are similar to medium-term roll-over Eurodollar credits. The difference is that in the Eurodollar market lenders hold a claim on a bank and not directly on the borrower.

Q2) Give an account about the innovations in Euro Bond Market.A2) The first Eurobond issues were in the form of ‘straights’ that is borrowing at a fixed rate of interest but the Eurobond market has since developed so that many issues now have innovative features. These days a good proportion of Eurobond issues are at floating rates of interest and are called floating rate notes, while another major innovation is that a higher percentage of issues are in the euro. Such bonds are attractive to international investors that wish to diversify away from the US dollar.Other innovations include the issue of convertible Eurobonds whereby the investor has the right to convert the bond into shares in the company at a predetermined price; some Eurobonds are issued with warrants attached which can be traded separately giving the holder the right to buy shares at a predetermined price; and many Eurobond issues also have a 'call-back' feature which enables the issuer to buy back the issue should it wish to do so. More recently, in some Eurobond issues the principal to be returned to the investor is linked to movements in a broad market index such as the Nikkei. An even more recent innovation are asset-backed Eurobonds, in which illiquid assets such as the outstanding loans of a bank are sold in the form of a Eurobond promising to pay a given coupon based on the income from the outstanding loans. Such bonds can still have a AAA rating because the bond will typically be over- collaterized, that is backed up by loans with a face value considerably higher than that of the bond so even if allowance is made for default on some of the outstanding loans the Eurobond investor can expect to receive full payment. In recent years, the Eurobond market has been opened up to governments from so-called emerging markets such as Argentina, Mexico, Venezuela, South-Africa, China, Poland and South Korea. Some high-risk countries such as Argentina and Mexico were paying in 1996 as much as 500 to 600 basis points above the equivalent US Treasury bond rates; while other emerging countries such as China, Poland and South Africa can get away with borrowing at a spread of 150 basis points or less. In many ways the Eurobond market has the potential to provide a valuable source of funding for emerging-market governments, although such borrowers are of a higher risk than traditional Eurobond borrowers. All of these innovative features, as well as the fact that interest is paid once a year and the lower liquidity of Eurobonds compared to Treasury bonds, make it quite difficult to compare the yields on Eurobonds with standard Treasury and corporate bonds. Nonetheless, a typical Eurobond offers a premium over the standard Treasury bond of between 20 to 150 basis points depending on the credit rating of the issuer. More importantly, from the viewpoint of the issuer the typical cost savings of a Eurobond issue compared to a domestic bond issue can range from 25 to 200 basis points. Q3) What do you mean by International forex market? What are the roles that are performed by a forex manager?A3) The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market. The foreign exchange market is unique because of the following characteristics:

its huge trading volume, representing the largest asset class in the world leading to high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed income; and

the use of leverage to enhance profit and loss margins and with respect to account size.

Role of Forex ManagerThere are many people who are confused with the responsibilities of a foreign exchange manager; therefore, with giving an outline of Foreign Exchange Manager Job Description, you and other people are sure to understand its significance:

Manage trading functions in order to meet corporate goals financially.

Be up to date with all of the latest financial developments, not only with the country’s economy, but also with other countries.

Monitor a large scale of foreign exchange functions and operations within the banking environment. This will include all transactions and remittances in the field.

Manage the research on both foreign and domestic markets, with the use of fundamental and technical analysis. Must also be able to provide appropriate solutions or recommendations for all clients that they can handle.

Review reconciliation sheets and ensure that all sheets are balanced accordingly to the regulations and laws of the industry and bank.

Maintain the relationship between international or counterpart financial institutions.

These are the key responsibilities that a foreign exchange manager has. Being able to show these responsibilities are sure to make people understand the significance of the position for foreign exchange firms. Q4) What do you mean by International Equity Market? List the prime benchmarks of International equity Market

[1].A4) An equity market is a hub in which shares of companies are issued and traded. The market comes in the form of an exchange –which facilitates the trade between buyers and sellers – or over-the-counter (OTC) in which buyers and sellers find each other. The equity market is also referred to as the stock market and is one of the most important leading indicators of the market economy. It also plays a pivotal role in supporting a market-based economy since it is the bridge between providing capital to companies who require it and providing investments for investors who are seeking a return on their investment. A benchmark is an unmanaged group of securities which are considered as a 'benchmark' to measure a fund's/stock's performance. Benchmarks are generally broad market indices like BSE Sensex, CNX Nifty of the Indian stock market with which mutual fund returns are compared.If a fund returned 59% in a particular year, but the benchmark Sensex returned 70%, this infers the fund underperformed compared to the Sensex benchmark.

A benchmark indicates directly the fund manager's performance. Over the years, the use of benchmarks has expanded far beyond their original role as a general indicator of market sentiment and direction. They have become central to investment management, with an impact on active management, asset allocation, and performance measurement and reward as well as passive indexing. In India, the NSE Nifty the BSE Sensex act as the benchmark indices. They are believed to indicate the performance of the entire stock market. In the same manner, an index which is made up of pharma stocks is assumed to portray the average price of stocks of companies operating in the pharmaceutical industry.Benchmark Indices: S&P BSE Sensex, a collection of 30 best-performing stocks and Nifty 50, a collection of 50 best-performing stocks are indicators of BSE and NSE respectively. They are considered benchmark indices because they are the most concise, use the best practices to regulate the companies they pick and hence are the best points of reference for how the markets are doing in general. Q5) Distinguish between ADR and GDR.A5) American Depositary Receipt (ADR)It is listed only on American stock exchanges (i.e., NYSE, AMEX, NASDAQ) and can only be traded in the U.S. They pay investors dividends in U.S. dollars and are issued by a bank in the U.S.An American depositary receipt (ADR, and sometimes spelled depository) is a negotiable security that represents securities of a foreign company and allows that company's shares to trade in the U.S. financial markets. Shares of many non-U.S. companies trade on U.S. stock exchanges through ADRs, which are denominated and pay dividends in U.S. dollars, and may be traded like regular shares of stock. ADRs are also traded during U.S. trading hours, through U.S. broker-dealers. ADRs simplify investing in foreign securities by having the depositary bank "manage all custody, currency and local taxes issues".The first ADR was introduced by J.P. Morgan in 1927 for the British retailer Selfridges on the New York Curb Exchange, the American Stock Exchange's precursor. They are the U.S. equivalent of a global depository receipt (GDR). Securities of a foreign company that are represented by an ADR are called American depositary shares (ADSs). Global Depositary Receipt (GDR)It is a general term for a depositary receipt that consists of shares from a foreign company. Therefore, any depositary receipt that did not originate from your home country is called a GDR.Many other countries around the world, such as India, Russia, the Philippines, and Singapore also offer depositary receipts.The GDR or Global Depository Receipt is a negotiable instrument or certificate in form of depository receipt issued by an Overseas Depository Bank outside India against shares or Foreign Currency Convertible Bonds of an Indian company. Most importantly the GDR is represented in US dollar currency. GDRs help the domestic company to get exposure to the global equity markets by raising foreign currency capital or equity. Global Depository Receipts may be enlisted in any Overseas Stock Exchanges and are transacted Over The Counter (OTC) or Otc market or even among the Qualified Institutional Buyers(QIB) or Institutional investors. They are freely tradable like other dollar expressed securities and transferrable certificate or Debt instruments and can be bought by non-resident investors only. The features of GDR are given below.

Nature- A GDR is a negotiable instrument in exchange of shares or Foreign Currency Convertible Bonds for raising capital in foreign currency;

Denomination- GDRs are expressed in US Dollar currency;

Tradability- GDR is a freely tradable in Capital markets and a transferrable certificate in the form of depository receipts;

Listing- Global Depository Receipts are listed on Overseas Stock exchanges like American stock exchanges and is traded over the counter( Financial markets ) and among the Qualified Institutional Buyers;

Underlying Asset- A GDR is issued against the underlying asset or underlying shares which is Common stock or Equities or bonds of the domestic company as held by the Domestic custodian bank. Further, this share can be one or more than one share as the underlying asset of the GDR;

Redemption- A non-resident GDR investor can exchange his GDR against the equivalent shares or bonds only after 45 days of its allotment;

Q6) What is FERA? How does it differ from FEMA?A6) FERA was mainly formulated to deal with deep crunch of foreign exchange post world war II and hence was a rigid piece of legislation which have left all the businesspeople and Indian citizens at the mercy of Enforcement Directorate as violence of FERA was considered a criminal act and there were major penalties associated with it.Major Differences between FERA vs FEMA are:

Foreign Exchange Regulation Act (FERA)	Foreign Exchange Management Act (FEMA)
Parliament of India passed the Foreign Exchange Regulation Act in 1973	Parliament of India enacted the Foreign Exchange Management Act (FEMA) on 29 December 1999 replacing FERA.
ii. FERA came into force from January 1, 1974.	ii. FEMA came into force from June 2000.
iii. FERA was repealed in 1998 by Vajpayee Government	iii. FEMA succeeded FERA
iv. FERA has 81 sections	iv. FEMA has 49 sections
v. FERA was conceived with the notion that Foreign Exchange is a scarce resource.	v. FEMA was conceived with the notion that Foreign Exchange is an asset.
vi. FERA rules regulated foreign payments.	vi. FEMA focused on increasing the foreign exchange reserves of India, focused on promoting foreign payments and foreign trade.
vii. The objective of FERA was conservation of Foreign Exchange	vii. The objective of FEMA is Management of Foreign Exchange

Q7) Discuss the Scope of Foreign Exchange market.A7) The Scope or subject matter of Forex Market is comprised of all the working of its participants. The Participants in Foreign exchange market can be categorized into five major groups, viz.; commercial banks, Foreign exchange brokers, Central bank, MNCs and Individuals and Small businesses. a. Commercial Banks:The major participants in the foreign exchange market are the large Commercial banks who provide the core of market. As many as 100 to 200 banks across the globe actively “make the market” in the foreign exchange. These banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that require foreign exchange.b. Foreign Exchange Brokers:Foreign exchange brokers also operate in the international currency market. They act as agents who facilitate trading between dealers. Unlike the banks, brokers serve merely as matchmakers and do not put their own money at risk.They actively and constantly monitor exchange rates offered by the major international banks through computerized systems such as Reuters and are able to find quickly an opposite party for a client without revealing the identity of either party until a transaction has been agreed upon. This is why inter-bank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.c. Central banks:Another important player in the foreign market is Central bank of the various countries. Central banks frequently intervene in the market to maintain the exchange rates of their currencies within a desired range and to smooth fluctuations within that range. The level of the bank’s intervention will depend upon the exchange rate regime flowed by the given country’s Central bank.d. MNCs:MNCs are the major non-bank participants in the forward market as they exchange cash flows associated with their multinational operations. MNCs often contract to either pay or receive fixed amounts in foreign currencies at future dates, so they are exposed to foreign currency risk. This is why they often hedge these future cash flows through the inter-bank forward exchange market.e. Individuals and Small Businesses:Individuals and small businesses also use foreign exchange market to facilitate execution of commercial or investment transactions. The foreign needs of these players are usually small and account for only a fraction of all foreign exchange transactions. Even then they are very important participants in the market. Some of these participants use the market to hedge foreign exchange risk. Q8) Why the roles of FEDAI are important in Foreign Exchange Market? A8) Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956).The role and responsibilities of FEDAI are as follows:Formulations of FEDAI guidelines and FEDAI rules for Forex business.Training of bank personnel in the areas of Foreign Exchange Business.Accreditation of Forex Brokers.Advising/Assisting member banks in settling issues/matters in their dealings.Represent member banks on Government/Reserve Bank of India and other bodies.Rules of FEDAI also include announcement of daily and periodical rates to its member banks.FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India and various other market participants. FEDAI also maximizes the benefits derived from synergies of member banks through innovation in areas like new customized products, bench marking against international standards on accounting, market practices, risk management systems, etc. Q9) Explain the concept of Capital budgeting with an example.A9) Capital budgeting is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that company management uses to identify what capital projects will create the biggest return compared with the funds invested in the project. Each project is ranked by its potential future return, so the company management can choose which one to invest in first. Most business’ future goals include expanding their operations. This is difficult to do if the company doesn’t have enough capital or fixed assets. That is where capital budgeting comes into play.Capital budgets or capital expenditure budgets are a way for a company’s management to plan fixed asset sales and purchases. Usually these budgets help management analyze different long-term strategies that the company can take to achieve its expansion goals. In other words, the management can decide what assets it might need to sell or buy in order to expand the company. To make this decision, management typically uses these three main analyzes in the budgeting process: throughput analysis, discounted cash flows analysis, and payback analysis. ExampleObviously, capital budgeting involves difficult decisions. In most cases buying fixed assets is expensive and cannot be easily undone. The management has to decide to spend cash in the bank, take out a loan, or sell existing assets to pay for the new ones. Each one of these decisions comes with the eternal question: will they receive the proper return on investment? Because when you think about it, buying new fixed assets is no different than putting money any other investment. The company is buying equipment hoping that is will pay off in the future. Q10) State the techniques of Capital Budgeting. Explain the concept of NPV technique and its limitations.A10) The Capital Budgeting Techniques are employed to evaluate the viability of long-term investments. The capital budgeting decisions are one of the critical financial decisions that relate to the selection of investment proposal or the course of action that will yield benefits in the future over the lifetime of the project. Traditional methods
The traditional methods comprise of the following evaluation techniques:

Payback Period Method

Average Rate of Return or Accounting Rate of Return Method

Modern Methods
The modern methods comprise of the following evaluation techniques:

Net Present Value Method

Internal Rate of Return

Modified Internal Rate of Return

Profitability Index

Here we will discuss about Net Present Value Method of Capital Budgetting.The Net Present Value or NPV is a discounting technique of capital budgeting wherein the profitability of investment is measured through the difference between the cash inflows generated out of the cash outflows or the investments made in the project.The formula to calculate the Net Present value is:Net present value = n∑t=1 Ct / (1+r)t – C0Where, Ct = cash inflow at the end of year t
n= life of the project
r= discount rate or the cost of capital
Co= cash outflowDemerits of Net Present Value

The forecasting of cash flows is difficult because of several uncertainties involved in the operations of the firm.

It is difficult to compute the discount rate precisely. And this is one of the crucial factors in the computation of net present value as with the change in the discount factor the NPV results also changes.

Another problem is that it is an absolute measure, it accepts or rejects the projects only on the basis of its higher value irrespective of the cost of initial outlay.

Sign Up