International Financial Management

Topics: Foreign exchange market, Exchange rate, Bretton Woods system Pages: 16 (5022 words) Published: June 25, 2012
Section A: Objective type
Part One:
1). Foreign exchange market in India is relatively very

Answer: b). Small

2). Balance of payment is a systematic record of all ___________ during a given period of time. Answer: c). Economic Transactions

3). Merchandise trade balance, services balance & balance on unilateral transfer are the part of _________ account.

Answer: a). Current Account

4). Interest rate swaps can be explained as an agreement between ___________ parties

Answer: b). Two

5). Capital account convertibility in India evolved in August

Answer: c).1994

6). Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates

Answer: b). Interest rate & exchange rate

7). The two kind of swap in the forward market are

Answer: d). Forward swap & Option Swap

8). FEMA stands for

Answer: c). Foreign Exchange Management Act

9). Exchange rate quotation methods are

Answer: c). Direct and Indirect

10). International Fisher effect or generalized version of the Fisher effect is a combination of

Answer: c). PPP theory and Fisher’s closed proposition.

Part Two:
1). Write a short note on “Interest Rate Parity System” for exchange rates. Interest rate parity system is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. Interest rate parity is one of the methods developed to explain exchange rate movements. Interest rate parity condition states that foreign exchange markets are in equilibrium when expected returns on deposits in a given period in one currency are equal to the expected returns on deposits in another currency when both the returns are measured in terms of a common currency. According to interest rate parity the difference between the interest rates paid on two currencies should be equal to the differences between the spot and forward rates. There are 2 different types of Interest rate Parity

1). Covered Interest Rate parity: Covered interest rate parity states that the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. 2). Uncovered Interest Rate Parity: Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against other currency might be neutralized by a change in the interest rate differential. If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different. In that case the investor would opt for the following 1). Borrow in the currency with the lower rate

2). Convert the cash at spot rates.
3). Enter into a forward contract to convert the cash plus the expected interest at the same rate. 4). Invest the money at the higher rate.
5). Convert back through the forward contract.
6). Repay the principal and the interest, knowing the latter will be less than the interest received. The covered and uncovered interest rate parity conditions relate the price of foreign and domestic financial assets. In equilibrium both conditions hypothesize the rate of return to these assets will be equalized across countries. The main difference between the two in that Covered Interest Rate parity contains no risk and is well established in recent decades amongst the OECD economies for short term instruments.

Implications of Interest Rate Parity Theory: If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency. If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign...
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