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Gold specie standard

ADR
American option
American quotes
Arbitrage
Balance of visible trade
Bill of lading
Bond with option
Bulls and bears in foreign exchange
Bulls vs beasrs
Contingent credit line
Crawling peg
Crawling peg
Crawling peg mechanism
Custodian bank
Depository receipts
Devaluation and revaluation of currency
Direct quote
Dirty float
Errors and omissions account in the BOP
Euro as a currency
Euro- as currency ofEU
Euro currency bonds vs euro currency notes
Euro equities
European option
Fiat money
Floating exchange rate
Foreign aid
GDR
Global depository receipt (GDR)
Hedging
Hot money
Hot money
Independent float
Inflation risk
Liberalized exchange rate management
London interbank offer rate (LIBOR)
Marking to market
Monetization of gold
Money changer
Nostro and vostro accounts
Overall balance
Position risk
Put option
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RBI intervention
Samurai bond
Strike price
Transactions above the line in BOP
Translation exposure
Treatment of goodwill in BOP
Unsponsored depository receipts
Value date
Vehicle currency
Vehicle currency
Vehicle currency
Yankee bonds

An American Depositary Receipt (or ADR) represents ownership in the

shares of a non-U.S. company and trades in U.S. financial markets. The stock
of many non-US companies trade on US stock exchanges through the use of
ADRs. ADRs enable U.S. investors to buy shares in foreign companies without
the hazards or inconveniences of cross-border & cross-currency transactions.
ADRs carry prices in US dollars, pay dividends in US dollars, and can be
traded like the shares of US-based companies.

Definition American option

An option which can be exercised at any time between the purchase date and the expiration date.
Most options in the U.S. are of this type. This is the opposite of a European-style option, which
can only be exercised on the date of expiration. Since an American option provides an investor
with a greater degree of flexibility than a European style option, the premium for an American
style option is at least equal to or higher than the premium for a European-style option which
otherwise has all the same features. also called American-style option.

[Q:] What is arbitrage? What markets do arbitrageurs usually trade on?

[A:] Terrific question! Let's start from the definition. The Economics Glossary defines arbitrage
opportunity as "the opportunity to buy an asset at a low price then immediately selling it on a
different market for a higher price." If I can buy an asset for $5, turn around and sell it for $20
and make $15 for my trouble, that is arbitrage. The $15 I gain represents an arbitrage profit.

Arbitrage profits can occur in a number of different ways. We'll look at a few examples:

1. One good, Two markets

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Suppose Walmart is selling the DVD of Shaft in Africa for $10. However, I know that on eBay
the last 20 copies of Shaft in Africa on DVD have sold for between $25 and $30. Then I could go
to Walmart, buy copies of the movie and turn around and sell them on eBay for a profit of $15 to
$20 a DVD. It is unlikely that I will be able to make a profit in this manner for too long, as one
of three things should happen:

1. Walmart runs out of copies of Shaft in Africa on DVD

2. Walmart raises the price on remaining copies as they've seen an increased demand for the
movie
3. The supply of Shaft in Africa DVDs skyrockets on eBay, which causes the price to fall.

The visible balance is that part of the balance of trade figures that refers to international
trade in physical goods, but not trade in services; it thus contrasts with the invisible
balance.

Most countries do not have a zero visible balance: they usually run a surplus or a deficit.
This will be offset by trade in services, other income transfers, investments and monetary
flows, leading to an overall balance of payments. The visible balance is affected by
changes in the volumes of imports and exports, and also by changes in the terms of trade.

In aggregate, the World often appears to have a negative visible balance with itself; i.e.
imports of goods appear to exceed exports. There are numerous causes for this, such as
measuring imports on a cost, insurance and freight basis while measuring exports on a
free on board basis, or statistical errors occurring when imports are more closely recorded
than exports.

A bill of lading (sometimes referred to as a BOL,or B/L) is a document

issued by a carrier to a shipper, acknowledging that specified goods have
been received on board as cargo for conveyance to a named place for
delivery to the consignee who is usually identified. A through bill of lading
involves the use of at least two different modes of transport from road, rail,
air, and sea. The term derives from the noun "bill", a schedule of costs for
services supplied or to be supplied, and from the verb "to lade" which means
to load a cargo onto a ship or other form of transport.

Bond option

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In finance, a bond option is an OTC-traded financial instrument that facilitates an option to buy
or sell a particular bond at a certain date for a particular price. It is similar to a stock option with
the difference that the underlying asset is a bond. Bond options can be valued using the Black
model.
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The present market value for the bond is referred to as the spot price while the future value as per
the option is referred to as the strike price.

[edit] Types

• A European bond option is an option to buy or sell a bond at a

certain date in future for a predetermined price.

• An American Bond option is an option to buy or sell a bond on or

before a certain date in future for a predetermined price.

[edit] Example

Trade Date: 1 March 2003 Maturity Date: 6 March 2006 Option Buyer: Bank A Underlying
asset: FNMA Bond. Spot Price: $101 , Strike Price: $102

On the Trade Date, Bank A enters into an option with Bank B to buy certain FNMA Bonds from
Bank B for the Strike Price mentioned. Bank A pays a premium to Bank B which is the premium
percentage multiplied by the face value of the bonds.

At the maturity of the option, Bank A either exercises the option and buys the bonds from Bank
B at the predetermined strike price, or chooses not to exercise the option. In either case, Bank A
has lost the premium to Bank B.

[edit] Embedded option

The term "bond option" is also used for option-like features of some bonds. These are an
inherent part of the bond, rather than a separately traded product. These options are not mutually
exclusive, so a bond may have lots of options embedded.

• A callable bond allows the issuer to buy back the bond at a

predetermined price at certain time in future. The holder of such a
bond has, in effect, sold a call option to the issuer. Callable bonds
cannot be called for the first few years of their life. This period is
known as the lock out period.

• A puttable bond allows the holder to demand early redemption at a

predetermined price at certain time in future. The holder of such a
bond has, in effect, purchased a put option on the bond.

• A convertible bond allows the holder to demand conversion of bonds

into the stock of the issuer at a predetermined price at certain time
period in future.
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• An exchangeable bond allows the holder to demand conversion of

bonds into the stock of a different company, usually a public subsidiary
of the issuer, at a predetermined price at certain time period in future.

[edit] Relationship with caps and floors

European Put options on zero coupon bonds can be seen to be equivalent to suitable caplets, i.e.
interest rate cap components, whereas call options can be seen to be equivalent to suitable
floorlets, i.e. components of interest rate floors. See for example Brigo and Mercurio (2001),
who also discuss bond options valuation with different models.

[edit] Uses

The major advantage of a bond option is the Locking-in price of the underlying bond for future
thereby reducing the credit risk associated with the fluctuations in the bond price.

hen the market is going up - bulls are in control. When bulls are in control -
its called a bullish market.

Bulls are BUYERS - Bears are SELLERS - so when there are more BUYERS
(bulls) - its called a Bullish Market - when there are more SELLERS (bears) -
its called a Bearish Market.

Bullish market is also referred to as uptrend market or you can simply say
the market is bullish.

In Forex, during the bullish market - the base currency is gaining value
and the quote currency is losing value.

For EUR/USD - if this pair is bullish that means EURO is gaining value while
USD is losing value.

Since Currencies are traded in pairs the negative effect of one currency has
be a positive for other.

hen the market is going down - bears are in control. When bears are in
control - its called a bearish market.

BEARS are SELLERS as opposed to BULLS who are BUYERS - when there are
MORE SELLERS (bears) than BUYERS(bulls) - its called a Bearish Market.

Bearish market is also referred to as downtrend market or you can simply

 6

say the market is bearish.

In Forex, during the bearish market - the base currency is losing value
and the quote currency is gaining value.

For EUR/USD - if this pair is bearish that means EURO is losing value while
USD is gaining value.

Since Currencies are traded in pairs the negative effect of one currency
becomes positive for other.

The IMF's Contingent Credit Lines (CCL)

The IMF introduced the Contingent Credit Lines (CCL) in 1999 as part of its efforts to
strengthen member countries' defenses against financial crisis. For various reasons, the facility
was never used. In November of 2003, the CCL was allowed to expire on its scheduled sunset
date.

The CCL as a precautionary line of defense

As part of its response to the rapid spread of turmoil through global financial markets during the
Asian crisis of 1997-98, the IMF introduced the Contingent Credit Lines (CCL) in the spring of
1999. The CCL was intended to provide a precautionary line of defense for members with sound
policies, who were not at risk of an external payments crisis of their own making, but were
vulnerable to contagion effects from capital account crises in other countries. Under the facility,
an IMF member that met the demanding eligibility criteria could draw on a large pre-specified
amount of resources if hit by a financial crisis due to factors outside of the member's control.

In the fall of 2000, several changes were made to the terms of the CCL to make it more
attractive. These changes led to more automatic access to the first portion of the loan. In
addition, the interest rate on the CCL was reduced relative to that applying to the Supplemental
Reserve Facility, a facility used to support member countries that are already experiencing a
crisis. The commitment fee was also reduced.

To qualify for the CCL, an IMF member would have had to meet four criteria:

1. No expected need for IMF resources. The member must have been pursuing policies that were
considered unlikely to bring about a need for IMF financing-except because of contagion.

2. A positive assessment of policies and progress toward adherence to internationally accepted

standards.
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3. Constructive relations with private creditors and progress towards limiting external
vulnerability.

4. A satisfactory macroeconomic and financial program and a commitment to adjust policies.

Commitments of funds under the CCL would have been made for up to one year on a stand-by
basis. While there was no general access limit, it was expected that commitments under the
facility would typically have been in the range of 300-500 percent of the member's quota.
Countries drawing under the CCL would have been expected to repay within one year to 18
months of the date of each disbursement. The surcharge over the IMF's normal market-based
loan rate would have begun at 150 basis points, rising to 350 basis points, depending on the
duration of the drawing.

The 2003 review of the CCL

The CCL remained unused and, in March 2003, the Executive Board began a review of the
facility. Directors considered a number of factors that may have discouraged use of the CCL.
Potentially eligible countries may have lacked confidence that a CCL would be viewed as a sign
of strength rather than weakness. These countries may also have been concerned about the risk of
negative fallout if they were to be considered ineligible at a future date. There had been some
uncertainty about whether Fund resources under a CCL would in fact be readily available in the
event of need, as the release of funds would require Executive Board approval. And, finally,
many potentially eligible countries had reduced their vulnerability to external shocks through
reserve accumulation, the adoption of flexible exchange rates, and other reforms, reducing the
perceived demand for insurance in the form of a CCL.

During the review, Directors gave extensive consideration to further modifications of the CCL,
as well as to alternative ways to achieve its objectives. There was strong support among many
Directors to extend the facility beyond the sunset date built into the CCL decision, allowing time
for its design to be further improved or alternative means found to achieve its objectives. A few
Directors felt that, even if the CCL were never used, it provided an incentive for countries to
pursue good policies. Nonetheless, support for its extension fell well short of the 85 percent of
votes necessary, and the CCL was allowed to expire on November 30, 2003.

Directors highlighted a number of considerations they thought should dispel possible concerns
raised by the CCL's expiration. First, as the Fund's record of helping members facing capital
account crises shows, the IMF stands ready to move quickly and flexibly to approve the use of
Fund resources and to adjust the level and the phasing of access to the member's need when
conditions so require and permit. Second, the Fund's strengthened surveillance, support for
greater transparency, and technical assistance operations are contributing to promoting sound
policies, and helping to prevent crises more generally. And third, recent innovations in the
financial architecture, improvements in market differentiation across different borrowers, and
stronger policy efforts by many emerging market countries seem to have lessened the threat of
contagion that the CCL was intended to avert.
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Moreover, Directors urged that efforts continue to assess the ways in which the IMF's
instruments and policies could be further improved to strengthen their ability to prevent crises. A
fuller accounting of Director's views on specific avenues for exploration can be found at
http://www.imf.org/external/np/sec/pn/2003/pn03146.htm.

g Peg

What Does Crawling Peg Mean?

A system of exchange rate adjustment in which a currency with a fixed
exchange rate is allowed to fluctuate within a band of rates. The par value of
the stated currency is also adjusted frequently due to market factors such as
inflation. This gradual shift of the currency's par value is done as an
alternative to a sudden and significant devaluation of the currency.

Investopedia explains Crawling Peg

For example, in the 1990s, Mexico had fixed its peso with the U.S. dollar.
However, due to the significant inflation in Mexico, as compared to the U.S.,
it was evident that the peso would need to be severely devalued. Because a
rapid devaluation would create instability, Mexico put into place a crawling
peg exchange rate adjustment system, and the peso was slowly devalued
toward a more appropriate exchange rate.

What Does Devaluation Mean?

A deliberate downward adjustment to a country's official exchange rate relative to other
currencies. In a fixed exchange rate regime, only a decision by a country's government (i.e
central bank) can alter the official value of the currency. Contrast to "revaluation".

Investopedia explains Devaluation

There are two implications for a currency devaluation. First, devaluation makes a country's
exports relatively less expensive for foreigners and second, it makes foreign products relatively
more expensive for domestic consumers, discouraging imports. As a result, this may help to
reduce a country's trade deficit.

Dirty Float

What Does Dirty Float Mean?

A system of floating exchange rates in which the government or the
 9

country's central bank occasionally intervenes to change the direction of the

value of the country's currency. In most instances, the intervention aspect of
a dirty float system is meant to act as a buffer against an external economic
shock before its effects become truly disruptive to the domestic economy.

Also known as a "managed float".

Investopedia explains Dirty Float

For example, country X may find that some hedge fund is speculating that its
currency will depreciate substantially, thus the hedge fund is starting to
short massive amounts of country X's currency. Because country X uses a
dirty float system, the government decides to take swift action and buy back
a large amount of its currency in order to limit the amount of devaluation
caused by the hedge fund.

A dirty float system isn't considered to be a true floating exchange

rate because, theoretically, true floating rate systems don't allow for
intervention.

Exchange Rate

What Does Exchange Rate Mean?

The price of one country's currency expressed in another country's currency.
In other words, the rate at which one currency can be exchanged for
another. For example, the higher the exchange rate for one euro in terms of
one yen, the lower the relative value of the yen.

Investopedia explains Exchange Rate

In most financial papers, currencies are expressed in terms of U.S. dollars,
while the dollar is commonly compared to the Japanese yen, the British
pound and the euro. As of the beginning of 2006, the exchange rate of one
U.S. dollar for one euro was about 0.84, which means that one dollar can be
exchanged for 0.84 euros.

Related Terms
 10

Floating Exchange Rate

What Does Floating Exchange Rate Mean?

A country's exchange rate regime where its currency is set by the foreign-
exchange market through supply and demand for that particular currency
relative to other currencies. Thus, floating exchange rates change freely and
are determined by trading in the forex market. This is in contrast to a "fixed
exchange rate" regime.

Investopedia explains Floating Exchange Rate

In some instances, if a currency value moves in any one direction at a rapid
and sustained rate, central banks intervene by buying and selling its own
currency reserves (i.e. Federal Reserve in the U.S.) in the foreign-exchange
market in order to stabilize the local currency. However, central banks are
reluctant to intervene, unless absolutely necessary, in a floating regime.

What Does Inflation Mean?

The rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to
stop severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum.

Investopedia explains Inflation

As inflation rises, every dollar will buy a smaller percentage of a good. For
example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a
year.

Most countries' central banks will try to sustain an inflation rate of 2-3%.

What Does Pegging Mean?

1. A method of stabilizing a country's currency by fixing its exchange rate to that of another
country.
 11

2. A practice of and investor buying large amounts of an underlying commodity or security close
to the expiry date of a derivative held by the investor. This is done to encourage a favorable
move in market price.

Investopedia explains Pegging

1. Most countries peg their exchange rate to that of the United States.

2. An investor writing a put option would practice pegging so that he or she will not be required,
due to lowering prices, to purchase the underlying security or commodity from the option holder.
The goal is to have the option expire worthless so that the premium initially received by the
writer is protected.
side from factors such as interest rates and inflation, the exchange rate is one of the most
important determinants of a country's relative level of economic health. Exchange rates play a
vital role in a country's level of trade, which is critical to most every free market economy in the
world. For this reason, exchange rates are among the most watched, analyzed and
governmentally manipulated economic measures. But exchange rates matter on a smaller scale as
well: they impact the real return of an investor's portfolio. Here we look at some of the major
forces behind exchange rate movements.

Before we look at these forces, we should sketch out how exchange rate movements affect a
nation's trading relationships with other nations. A higher currency makes a country's exports
more expensive and imports cheaper in foreign markets; a lower currency makes a country's
exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can
be expected to lower the country's balance of trade, while a lower exchange rate would increase
it.

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 rule of thumb, 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. (To
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learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)

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. (For
further reading, see What Is Fiscal Policy?)

3. Current-account deficits: The current account is the balance of trade between a country and
its trading partners (see Understanding The Current Account In The Balance Of Payments),
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 (as
determined by Moody's or Standard & Poor's, for example) 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
 13

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.

Conclusion
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 capital gains derived from 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.

Custodian bank

A custodian bank, or simply custodian, is a financial institution responsible for safeguarding a

firm's or individual's financial assets. The role of a custodian in such a case would be the
following: to hold in safekeeping assets such as equities and bonds, arrange settlement of any
purchases and sales of such securities, collect information on and income from such assets
(dividends in the case of equities and coupons in the case of bonds), provide information on the
underlying companies and their annual general meetings, manage cash transactions, perform
foreign exchange transactions where required and provide regular reporting on all their activities
to their clients. Custodian banks are often referred to as global custodians if they hold assets for
their clients in multiple jurisdictions around the world, using their own local branches or other
local custodian banks in each market to hold accounts for their underlying clients. Assets held in
such a manner are typically owned by pension funds.

In relation to American Depositary Receipts (ADRs), a local custodian bank (also known as a
sub-custodian or agent bank) is a bank in a country outside the United States that holds the
corresponding amount of shares of stock trading on the home stock market represented by an
 14

ADR trading in the U.S, with each multiple representing some multiple of the underlying foreign
share. This multiple allows the ADRs to possess a price per share conventional for the US
market (typically between $20 and $50 per share) even if the price of the foreign share is
unconventional when converted to US dollars directly. This bank acts as custodian bank for the
company that issues the ADRs in the U.S. stock.

A depositary receipt (DR) is a type of negotiable (transferable) financial security that is traded on
a local stock exchange but represents a security, usually in the form of equity, that is issued by a
foreign publicly listed company. The DR, which is a physical certificate, allows investors to hold
shares in equity of other countries. One of the most common types of DRs is the American
depositary receipt (ADR), which has been offering companies, investors and traders global
investment opportunities since the 1920s.

Since then, DRs have spread to other parts of the globe in the form of global depositary receipts
(GDRs) (the other most common type of DR), European DRs and international DRs. ADRs are
typically traded on a U.S. national stock exchange, such as the New York Stock Exchange
(NYSE) or the American Stock Exchange, while GDRs are commonly listed on European stock
exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually denominated
in U.S. dollars, but can also be denominated in euros.

How Does the DR Work?

The DR is created when a foreign company wishes to list its already publicly traded shares or
debt securities on a foreign stock exchange. Before it can be listed to a particular stock exchange,
the company in question will first have to meet certain requirements put forth by the exchange.
Initial public offerings, however, can also issue a DR. DRs can be traded publicly or over-the-
counter. Let us look at an example of how an ADR is created and traded:

Example
Say a gas company in Russia has fulfilled the
requirements for DR listing and now wants to list its
publicly traded shares on the NYSE in the form of an
ADR. Before the gas company's shares are traded freely
on the exchange, a U.S. broker, through an international
office or a local brokerage house in Russia, would
purchase the domestic shares from the Russian market
and then have them delivered to the local (Russian)
custodian bank of the depository bank. The depository
bank is the American institution that issues the ADRs in
America. In this example, the depository bank is the
Bank of New York. Once the Bank of New York's local
custodian bank in Russia receives the shares, this
custodian bank verifies the delivery of the shares by
informing the Bank of New York that the shares can
now be issued in the United States. The Bank of New
York then delivers the ADRs to the broker who initially
 15

purchased them.

Based on a determined ADR ratio, each ADR may be

issued as representing one or more of the Russian local
shares, and the price of each ADR would be issued in
U.S. dollars converted from the equivalent Russian price
of the shares being held by the depository bank. The
ADRs now represent the local Russian shares held by
the depository, and can now be freely traded equity on
the NYSE.

After the process whereby the new ADR of the Russian

gas company is issued, the ADR can be traded freely
among investors and transferred from the buyer to the
seller on the NYSE, through a procedure known as intra-
market trading. All ADR transactions of the Russian gas
company will now take place in U.S. dollars and are
settled like any other U.S. transaction on the NYSE. The
ADR investor holds privileges like those granted to
shareholders of ordinary shares, such as voting rights
and cash dividends. The rights of the ADR holder are
stated on the ADR certificate.

Pricing and Cross-Trading

When any DR is traded, the broker will aim to find the best price of the share in question. He or
she will therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price
of the local share on the domestic market. If the ADR of the Russian gas company is trading at
US$12 per share and the share trading on the Russian market is trading at $11 per share
(converted from Russian rubles to dollars), a broker would aim to buy more local shares from
Russia and issue ADRs on the U.S. market. This action then causes the local Russian price and
the price of the ADR to reach parity. The continual buying and selling in both markets, however,
usually keeps the prices of the ADR and the security on the home market in close range of one
another. Because of this minimal price differential, most ADRs are traded by means of
intramarket trading.

A U.S. broker may also sell ADRs back into the local Russian market. This is known as cross-
border trading. When this happens, an amount of ADRs is canceled by the depository and the
local shares are released from the custodian bank and delivered back to the Russian broker who
bought them. The Russian broker pays for them in roubles, which are converted into dollars by
the U.S. broker.

The Benefits of Depositary Receipts

The DR functions as a means to increase global trade, which in turn can help increase not only
volumes on local and foreign markets but also the exchange of information, technology,
regulatory procedures as well as market transparency. Thus, instead of being faced with
 16

impediments to foreign investment, as is often the case in many emerging markets, the DR
investor and company can both benefit from investment abroad. Let's take a closer a look at the
benefits:

For the Company

A company may opt to issue a DR to obtain greater exposure and raise capital in the world
market. Issuing DRs has the added benefit of increasing the share's liquidity while boosting the
company's prestige on its local market ("the company is traded internationally"). Depositary
receipts encourage an international shareholder base, and provide expatriates living abroad with
an easier opportunity to invest in their home countries. Moreover, in many countries, especially
those with emerging markets, obstacles often prevent foreign investors from entering the local
market. By issuing a DR, a company can still encourage investment from abroad without having
to worry about barriers to entry that a foreign investor might face.

For the Investor

Buying into a DR immediately turns an investors' portfolio into a global one. Investors gain the
benefits of diversification while trading in their own market under familiar settlement and
clearance conditions. More importantly, DR investors will be able to reap the benefits of these
usually higher risk, higher return equities, without having to endure the added risks of going
directly into foreign markets, which may pose lack of transparency or instability resulting from
changing regulatory procedures. It is important to remember that an investor will still bear some
foreign-exchange risk, stemming from uncertainties in emerging economies and societies. On the
other hand, the investor can also benefit from competitive rates the U.S. dollar and euro have to
most foreign currencies.

Conclusion
Giving you the opportunity to add the benefits of foreign investment while bypassing the
unnecessary risks of investing outside your own borders, you may want to consider adding these
securities to your portfolio. As with any security, however, investing in ADRs requires an
understanding of why they are used, and how they are issued and traded.

by Reem Heakal,

Currency Devaluation and Revaluation

• Under a fixed exchange rate system, devaluation and revaluation are official
changes in the value of a country's currency relative to other currencies. Under a
floating exchange rate system, market forces generate changes in the value of the
currency, known as currency depreciation or appreciation.

• In a fixed exchange rate system, both devaluation and revaluation can be conducted
by policymakers, usually motivated by market pressures.

• The charter of the International Monetary Fund (IMF) directs policymakers to

avoid "manipulating exchange rates...to gain an unfair competitive advantage over
 17

other members."

At the Bretton Woods Conference in July 1944, international leaders sought to insure a stable
post-war international economic environment by creating a fixed exchange rate system. The
United States played a leading role in the new arrangement, with the value of other currencies
fixed in relation to the dollar and the value of the dollar fixed in terms of gold—$35 an ounce.
Following the Bretton Woods agreement, the United States authorities took actions to hold down
the growth of foreign central bank dollar reserves to reduce the pressure for conversion of
official dollar holdings into gold.

During the mid- to late-1960s, the United States experienced a period of rising inflation. Because
currencies could not fluctuate to reflect the shift in relative macroeconomic conditions between
the United States and other nations, the system of fixed exchange rates came under pressure.

In 1973, the United States officially ended its adherence to the gold standard. Many other
industrialized nations also switched from a system of fixed exchange rates to a system of floating
rates. Since 1973, exchange rates for most industrialized countries have floated, or fluctuated,
according to the supply of and demand for different currencies in international markets. An
increase in the value of a currency is known as appreciation, and a decrease as depreciation.
Some countries and some groups of countries, however, continue to use fixed exchange rates to
help to achieve economic goals, such as price stability.

Under a fixed exchange rate system, only a decision by a country's government or monetary
authority can alter the official value of the currency. Governments do, occasionally, take such
measures, often in response to unusual market pressures. Devaluation, the deliberate downward
adjustment in the official exchange rate, reduces the currency's value; in contrast, a revaluation
is an upward change in the currency's value.

For example, suppose a government has set 10 units of its currency equal to one dollar. To
devalue, it might announce that from now on 20 of its currency units will be equal to one dollar.
This would make its currency half as expensive to Americans, and the U.S. dollar twice as
expensive in the devaluing country. To revalue, the government might change the rate from 10
units to one dollar to five units to one dollar; this would make the currency twice as expensive to
Americans, and the dollar half as costly at home.

Under What Circumstances Might a Country Devalue?

When a government devalues its currency, it is often because the interaction of market forces and
policy decisions has made the currency's fixed exchange rate untenable. In order to sustain a
fixed exchange rate, a country must have sufficient foreign exchange reserves, often dollars, and
be willing to spend them, to purchase all offers of its currency at the established exchange rate.
When a country is unable or unwilling to do so, then it must devalue its currency to a level that it
is able and willing to support with its foreign exchange reserves.

A key effect of devaluation is that it makes the domestic currency cheaper relative to other
currencies. There are two implications of a devaluation. First, devaluation makes the country's
exports relatively less expensive for foreigners. Second, the devaluation makes foreign products
 18

relatively more expensive for domestic consumers, thus discouraging imports. This may help to
increase the country's exports and decrease imports, and may therefore help to reduce the current
account deficit.

There are other policy issues that might lead a country to change its fixed exchange rate. For
example, rather than implementing unpopular fiscal spending policies, a government might try to
use devaluation to boost aggregate demand in the economy in an effort to fight unemployment.
Revaluation, which makes a currency more expensive, might be undertaken in an effort to reduce
a current account surplus, where exports exceed imports, or to attempt to contain inflationary
pressures.

Effects of Devaluation
A significant danger is that by increasing the price of imports and stimulating greater demand for
domestic products, devaluation can aggravate inflation. If this happens, the government may
have to raise interest rates to control inflation, but at the cost of slower economic growth.

Another risk of devaluation is psychological. To the extent that devaluation is viewed as a sign
of economic weakness, the creditworthiness of the nation may be jeopardized. Thus, devaluation
may dampen investor confidence in the country's economy and hurt the country's ability to
secure foreign investment.

Another possible consequence is a round of successive devaluations. For instance, trading

partners may become concerned that a devaluation might negatively affect their own export
industries. Neighboring countries might devalue their own currencies to offset the effects of their
trading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economic
difficulties by creating instability in broader financial markets.

Since the 1930s, various international organizations such as the International Monetary Fund
(IMF) have been established to help nations coordinate their trade and foreign exchange policies
and thereby avoid successive rounds of devaluation and retaliation. The 1976 revision of Article
IV of the IMF charter encourages policymakers to avoid "manipulating exchange rates...to gain
an unfair competitive advantage over other members." With this revision, the IMF also set forth
each member nation's right to freely choose an exchange rate system.

What Does Direct Quote Mean?

A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In
other words, it involves quoting in fixed units of foreign currency against variable amounts of the
domestic currency.

Investopedia explains Direct Quote

For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1.
Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.
 19

A foreign exchange rate of one currency, usually the domestic currency, per
unit of a different currency. In terms of U.S. dollars, a direct quote is the
number of a foreign currency that one dollar could buy. For example, a direct
quote for the Euro could be US$1.50 = 1 Euro.

In economics, the balance of payments, (or BOP) measures the payments that flow between any
individual country and all other countries. It is used to summarize all international economic
transactions for that country during a specific time period, usually a year. The BOP is determined
by the country's exports and imports of goods, services, and financial capital, as well as financial
transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and
obligations received from foreigners (credits). Balance of payments is one of the major indicators
of a country's status in international trade, with net capital outflow.[citation needed]

The balance, like other accounting statements, is prepared in a single currency, usually the
domestic. Foreign assets and flows are valued at the exchange rate of the time of transaction.

[edit] IMF definition

The IMF definition: "Balance of Payments is a statistical statement that summarizes

transactions between residents and nonresidents during a period."[1] The balance of payments
comprises the current account, the capital account, and the financial account. "Together,
these accounts balance in the sense that the sum of the entries is conceptually zero."[1]

• The current account consists of the goods and services

account, the primary income account and the secondary income
account.
• The financial account

[edit] Balance of payments identity

The balance of payments identity states that:

Current Account = Capital Account + Financial Account + Net Errors

and Omissions

This is a convention of double entry accounting, where all debit entries must be booked along
with corresponding credit entries such that the net of the Current Account will have a
corresponding net of the Capital and Financial Accounts:
 20

where:

• X = exports
• M = imports
• Ki = capital inflows
• Ko = capital outflows

Rearranging, we have:

yielding the BOP identity.

The basic principle behind the identity is that a country can only consume more than it can
produce (a current account deficit) if it is supplied capital from abroad (a capital account
surplus).[2]

Mercantile thought prefers a so-called balance of payments surplus where the net current account
is in surplus or, more specifically, a positive balance of trade.

A balance of payments equilibrium is defined as a condition where the sum of debits and
credits from the current account and the capital and financial accounts equal to zero; in other
words, equilibrium is where

This is a condition where there are no changes in Official Reserves.[3] When there is no change in
Official Reserves, the balance of payments may also be stated as follows:

or:

Canada's Balance of Payments currently satisfies this criterion. It is the only large monetary
authority with no Changes in Reserves.[4]
 21

Business Definition for: Net Errors And Omissions

• the net amount of the discrepancies that arise in calculations of

balances of payments

the euro

The euro is the single currency shared by (currently) 16 of the European Union's Member States,
which together make up the euro area. The introduction of the euro in 1999 was a major step in
European integration. It has also been one of its major successes: around 329 million EU citizens
now use it as their currency and enjoy its benefits, which will spread even more widely as other
EU countries adopt the euro.

When the euro was launched on 1 January 1999, it became the new official currency of 11
Member States, replacing the old national currencies – such as the Deutschmark and the French
franc – in two stages. First introduced as a virtual currency for cash-less payments and
accounting purposes, while the old currencies continued to be used for cash payments and
considered as 'sub-units' of the euro, it then appeared in physical form, as banknotes and coins,
on 1 January 2002.

The euro is not the currency of all EU Member States. Two countries (Denmark and the United
Kingdom) agreed an ‘opt-out’ clause in the Treaty exempting them from participation, while the
remainder (many of the newest EU members plus Sweden) have yet to meet the conditions for
adopting the single currency. Once they do so, they will replace their national currency with the
euro.

Which countries have adopted the euro – and when?

199 Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the

9 Netherlands, Austria, Portugal and Finland

200
Greece
1

200
Introduction of euro banknotes and coins
2

200
Slovenia
7

200 Cyprus, Malta

 22

200
Slovakia
9

The euro and Economic and Monetary Union

All EU Member States form part of Economic and Monetary Union (EMU),
which can be described as an advanced stage of economic integration based
on a single market. It involves close co-ordination of economic and fiscal
policies and, for those countries fulfilling certain conditions, a single
monetary policy and a single currency – the euro.

The process of economic and monetary integration in the EU parallels the

history of the Union itself. When the EU was founded in 1957, the Member
States concentrated on building a 'common market'. However, over time it
became clear that closer economic and monetary co-operation was desirable
for the internal market to develop and flourish further. But the goal of
achieving full EMU and a single currency was not enshrined until the 1992
Maastricht Treaty (Treaty on European Union), which set out the ground rules
for its introduction. These say what the objectives of EMU are, who is
responsible for what, and what conditions Member States must meet in order
to adopt the euro. These conditions are known as the 'convergence criteria'
(or 'Maastricht criteria') and include low and stable inflation, exchange rate
stability and sound public finances.

Who manages it?

When the euro came into being, monetary policy became the responsibility
of the independent European Central Bank (ECB), which was created for that
purpose, and the national central banks of the Member States having
adopted the euro. Together they compose the Eurosystem.

Fiscal policy (tax and spending) remains in the hands of individual national
governments – though they undertake to adhere to commonly agreed rules
on public finances known as the Stability and Growth Pact. They also retain
full responsibility for their own structural policies (labour, pension and capital
 23

markets), but agree to co-ordinate them in order to achieve the common

goals of stability, growth and employment.

Who uses it?

The euro is the currency of the 329 million people who live in the 16 euro-
area countries. It is also used, either formally as legal tender or for practical
purposes, by a whole array of other countries such as close neighbours and
former colonies.

It is therefore not surprising that the euro has rapidly become the second
most important international currency after the dollar, and in some respects
(e.g. the value of cash in circulation) has even overtaken it.

Why do we need it?

Apart from making travel easier, a single currency makes very good
economic and political sense. The framework under which the euro is
managed makes it a stable currency with low inflation and low interest rates,
and encourages sound public finances. A single currency is also a logical
complement to the single market which makes it more efficient. Using a
single currency increases price transparency, eliminates currency exchange
costs, oils the wheels of the European economy, facilitates international
trade and gives the EU a more powerful voice in the world. The size and
strength of the euro area also better protect it from external economic
shocks, such as unexpected oil price rises or turbulence in the currency
markets.

Last but not least, the euro gives the EU’s citizens a tangible symbol of their
European identity, of which they can be increasingly proud as the euro area
expands and multiplies these benefits for its existing and future members.

European Option

What Does European Option Mean?

An option that can only be exercised at the end of its life.
 24

Investopedia explains European Option

In other words, you must ride the rollercoaster until the maturity date, and only
then can you cash in.

What Does Fiat Money Mean?

Currency that a government has declared to be legal tender, despite the fact that it has no
intrinsic value and is not backed by reserves. Historically, most currencies were based on
physical commodities such as gold or silver, but fiat money is based solely on faith.

Investopedia explains Fiat Money

Most of the world's paper money is fiat money. Because fiat money is not linked to physical
reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation's paper
currency, the money will no longer hold any value.

What Does Floating Exchange Rate Mean?

A country's exchange rate regime where its currency is set by the foreign-exchange market
through supply and demand for that particular currency relative to other currencies. Thus,
floating exchange rates change freely and are determined by trading in the forex market. This is
in contrast to a "fixed exchange rate" regime.

Investopedia explains Floating Exchange Rate

In some instances, if a currency value moves in any one direction at a rapid and sustained rate,
central banks intervene by buying and selling its own currency reserves (i.e. Federal Reserve in
the U.S.) in the foreign-exchange market in order to stabilize the local
currency. However, central banks are reluctant to intervene, unless absolutely necessary, in a
floating regime.

Foreign aid

the international transfer of capital, goods, or services from a country or international

organization for the benefit of the recipient country or its population. Aid can be economic,
military, or emergency humanitarian (e.g., aid given following natural disasters).

Global Depositary Receipt - GDR

 25

What Does Global Depositary Receipt - GDR Mean?

1. A bank certificate issued in more than one country for shares in a foreign
company. The shares are held by a foreign branch of an international bank. The
shares trade as domestic shares, but are offered for sale globally through the
various bank branches.

2. A financial instrument used by private markets to raise capital denominated in

either U.S. dollars or euros.

Investopedia explains Global Depositary Receipt - GDR

1. A GDR is very similar to an American Depositary Receipt.

2. These instruments are called EDRs when private markets are attempting to
obtain euros.

In finance, a hedge is a position established in one market in an attempt to offset

exposure to price fluctuations in some opposite position in another market with the
goal of minimizing one's exposure to unwanted risk. There are many specific
financial vehicles to accomplish this, including insurance policies, forward contracts,
swaps, options, many types of over-the-counter and derivative products, and
perhaps most popularly, futures contracts. Public futures markets were established
in the 1800s to allow transparent, standardized, and efficient hedging of agricultural
commodity prices; they have since expanded to include futures contracts for
hedging the values of energy, precious metals, foreign currency, and interest rate
fluctuations.

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of wheat and other crops
fluctuate constantly as supply and demand for them vary, with occasional large moves in either
direction. Based on current prices and forecast levels at harvest time, the farmer might decide
that planting wheat is a good idea one season, but the forecast prices are only that - forecasts.
Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual
price of wheat rises a lot between planting and harvest, the farmer stands to make a lot of
unexpected money, but if the actual price drops by harvest time, he could be ruined.
 26

If the farmer sells a number of wheat futures contracts equivalent to his crop size at planting
time, he effectively locks in the price of wheat at that time - the contract is an agreement to
deliver a certain number of bushels of wheat on a certain date in the future for a certain fixed
price. He has hedged his exposure to wheat prices; he no longer cares whether the current price
rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about
being ruined by a low wheat price at harvest time, but he also gives up the chance at making
extra money from a high wheat price at harvest times.

Hedging means reducing or controlling risk. This is done by taking a position in the futures
market that is opposite to the one in the physical market with the objective of reducing or
limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels
will be countered by changes in the value of a futures position. For instance, a wheat farmer can
sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the
loss in the cash market position will be countered by a gain in futures position.

How hedging is done

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of
ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take positions based on
the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket
profits whenever there are inefficiencies in the prices. However, they ensure that the prices of
spot and futures remain correlated.

Example - case of steel

An automobile manufacturer purchases huge quantities of steel as raw material for automobile
production. The automobile manufacturer enters into a contractual agreement to export
automobiles three months hence to dealers in the East European market.

This presupposes that the contractual obligation has been fixed at the time of signing the
contractual agreement for exports. The automobile manufacturer is now exposed to risk in the
form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer
can buy steel futures contracts, which would mature three months hence. In case of increasing or
decreasing steel prices, the automobile manufacturer is protected. Let us analyse the different
scenarios:

Increasing steel prices

If steel prices increase, this would result in increase in the value of the futures contracts, which
the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But
 27

the automobile manufacturer needs to buy steel in the physical market to meet his export
obligation. This means that he faces a corresponding loss in the physical market.

But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in
the physical market, the automobile manufacturer can square off his position in the futures
market by selling the steel futures contract, for which he has an open position.

Decreasing steel prices

If steel prices decrease, this would result in a decrease in the value of the futures contracts, which
the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But
the automobile manufacturer needs to buy steel in the physical market to meet his export
obligation.

This means that he faces a corresponding gain in the physical market. The loss in the futures
market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the
physical market, the automobile manufacturer can square off his position in the futures market
by selling the steel futures contract, for which he has an open position.

This results in a perfect hedge to lock the profits and protect from increase or decrease in raw
material prices. It also provides the added advantage of just-in time inventory management for
the automobile manufacturer.

Understanding the meaning of buying/long hedge

A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to
hedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an
exposure in the physical market and want to lock- in prices, use the buying hedge strategy.
Benefits of buying hedge strategy:

• To replace inventory at a lower prevailing cost.

• To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price increase of a
commodity in the spot market that has already been sold at a specific price but not purchased as
yet. It is very common among exporters and importers to sell commodities at an agreed-upon
price for forward delivery. If the commodity is not yet in possession, the forward delivery is
considered uncovered.

Long hedgers are traders and processors who have made formal commitments to deliver a
specified quantity of raw material or processed goods at a later date, at a price currently agreed
upon and who do not have the stocks of the raw material necessary to fulfill their forward
commitment.

Understanding the meaning of selling/short hedge

 28

A selling hedge is also called a short hedge. Selling hedge means selling a futures contract to
hedge.

Uses of selling hedge strategy.

• To cover the price of finished products.

• To protect inventory not covered by forward sales.
• To cover the prices of estimated production of finished products.

Short hedgers are merchants and processors who acquire inventories of the commodity in the
spot market and who simultaneously sell an equivalent amount or less in the futures market. The
hedgers in this case are said to be long in their spot transactions and short in the futures
transactions.

Understanding the basis

Usually, in the business of buying or selling a commodity, the spot price is different from the
price quoted in the futures market. The futures price is the spot price adjusted for costs like
freight, handling, storage and quality, along with the impact of supply and demand factors.

The price difference between the spot and futures keeps on changing regularly. This price
difference (spot - futures price) is known as the basis and the risk arising out of the difference is
defined as basis risk. A situation in which the difference between spot and futures prices reduces
(either negative or positive) is defined as narrowing of the basis.

A narrowing of the basis benefits the short hedger and a widening of the basis benefits the long
hedger in a market characterized by contango - when futures price is higher than spot price. In a
market characterized by backwardation - when futures quote at a discount to spot price - a
narrowing of the basis benefits the long hedger and a widening of the basis benefits the short
hedger.

However, if the difference between spot and futures prices increases (either on negative or
positive side) it is defined as widening of the basis. The impact of this movement is opposite to
that as in the case of narrowing.

Chiragra Chakrabarty is vice president, training, consultancy & research initiatives, Multi
Commodity Exchange of India.

RISK AND returns in the case of an investment are like the two sides of the same coin. Though
high returns are the basic motive behind investment, the dodgy element of risk cannot be
overlooked. Now, future is uncertain, so one has to protect oneself from future uncertainties. So
one hedges against possible uncertainties and mitigates risk by counterbalancing.
 29

Hedging is practised in day-to-day life. For example, when we are kids, our parents get us
vaccinated against many diseases so we are not affected by the said diseases in future. Another
example is insurance. When people decide to hedge, they are insuring themselves against a
negative event. This doesn’t prevent the negative event from happening; if it does happen but
you’re properly hedged, the impact of the event is reduced. However in the financial market,
hedging is more complicated than insurance; hedging against investment risk calls for using
market instruments strategically to offset the risks arising from any adverse price movement.

Hedging refers to a method of reducing the risk of loss caused by price fluctuation. Portfolio
managers and corporations use hedging techniques to reduce their exposure to various risks.
Before going into how hedging is done, let me brief you with the basic hedging strategies:

Options:

The right, but not the obligation, to buy or sell a specified quantity of the underlying asset at a
fixed price (called exercise price), on or before the expiration date. There are two kinds of
options.

1. Call option: The right to buy a specified quantity of the underlying asset at a fixed
exercise price on or before the expiry date.
2. Putoption: The right to sell a specified quantity of the underlying asset at a fixed exercise
price on or before the expiration date.

Futures :

A contractual agreement, made only on the trading floor of a futures exchange, to buy or sell a
particular commodity, financial instrument, etc, at a pre-determined price in future. Futures
contracts detail the quality and quantity of the underlying asset; they are standardised to facilitate
trading on a futures exchange. Some futures contracts may call for physical delivery of the asset,
while others are settled in cash.

Mechanism of hedging:

As we know hedging is done to reduce or control risk. This can be done by taking a position in
the futures market or by buying a put option with the objective of reducing or limiting the risks
associated with price fall. Let’s see examples of both.

Futures:

For a garment manufacturer and exporter, cotton is an essential raw material. The exporter enters
into a contractual agreement to export shirts three months hence to dealers in the European
market. This means that a contractual obligation has been fixed at the time of signing the
 30

contract for exports. The garment manufacturer is now exposed to the risk of rising cotton prices.
In order to hedge against price risk, the garment manufacturer can buy futures contracts on
cotton, which will mature three months hence. In case of a rise in cotton prices, the manufacturer
is protected from the risk of loss. Let’s analyse the different scenarios:

A rise in cotton price: If cotton prices rise, it will lead to an increase in the value of the futures
contract, which the cotton manufacturer has bought. Therefore he earns a profit in his futures
transaction. But the manufacturer has to buy cotton in the physical market in order to meet his
export obligation. Since cotton prices have risen he faces a loss in the physical market. But his
losses will be offset by his gains in the futures market. The cotton manufacturer can recover the
loss incurred in the physical market by selling the futures contract, in which he has an open
position (called closing out, technically).

A fall in cotton price: If cotton prices fall, it will lead to erosion in the value of the futures
contract, which the cotton manufacturer has bought. This way the manufacturer will incur a loss
on his futures contract. But the manufacturer has to buy cotton in the physical market. Since
cotton prices have declined in the physical market, he gains. Therefore the losses incurred in the
futures market will be offset by the gains made in the physical market. This way one can hedge
against possible losses arising from fluctuation in raw material prices.

Options: One of the other popular strategies of hedging involves the use of the options market.
Let’s take an example:

Suppose you buy 100 shares of ABC Company @ Rs 100 per share. Now you want to minimise
your risk of loss. You can do this by buying a put option or writing (or selling) a call option.
Buying the put option gives you the right to sell your shares at a predetermined price.

Suppose the exercise or strike price (predetermined price) is Rs 100 per share. Now if the price
of the share falls to Rs 80, being the holder (buyer) of the put option you have the right to
exercise your option, which means you can sell the share @ Rs 100 per share, thereby making a
profit of Rs 20 per share. This way you can hedge against the risk of fall in the price of shares.

One can hedge against interest rate, currency, etc. Some other hedging tools apart from what
have been discussed above can also be used in hedging such as by selling short, etc. Risk is an
essential yet precarious element associated with investment. Regardless of what kind of investor
one aims to become, a basic knowledge of hedging strategies will lead to better awareness.
Whether or not you decide to use derivatives, learning about how hedging works will help
advance your understanding of the market. It will always help you become a better investor.

Hot Money
 31

What Does Hot Money Mean?

Money that flows regularly between financial markets in search for the highest short
term interest rates possible.

Investopedia explains Hot Money

CDs are an example of hot money. Should a borrower offer the lender a higher rate
of interest than that offered by the current borrower, the current borrower stands to
lose their loan.

In economics, hot money refers to funds which flow into a country to take advantage of a
favourable interest rate, and therefore obtain higher returns. They influence the balance of
payments and strengthen the exchange rate of the recipient country while weakening the
currency of the country losing the money. These funds are held in currency markets by
speculators as opposed to national banks or domestic investors. As such, they are highly volatile
and will be shifted to another foreign exchange market when relative interest rates make this
more profitable.

Hot money is a major factor in capital flight, illicit financial flows, and the ability of developing
nations to finance their debt. As large sums of money can move very quickly to take advantage
of small fluctuations in interest rates and currency values, countries which have difficulty raising
money through the sale of long-term bonds are particularly susceptible to short-term interest rate
pressure, particularly during periods of rapid inflation. These types of transactions were largely
responsible for the currency crises in Mexico and Asia during the 1990s. See 1994 economic
crisis in Mexico and East Asian financial crisis.

In part to reduce the influence of hot money on a nation’s economy, a few nations have
minimum time requirements for investment. For example, Chile requires all foreign investments
to be put in a one-year-locked account. Although this sort of control reduces investment in a
country, it also makes its economy less susceptible to currency flight.

Hot money can be used to estimate illicit financial flows by focusing strictly on the net errors
and omissions line-item in a country's external accounts. The net errors and omissions figure
balances credits and debits in a country's external accounts and reflects unrecorded capital flows
and statistical errors in measurement. A persistently large and negative net errors and omissions
figure is interpreted as an indication of illicit financial flows.

inflation risk

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The possibility that the value of assets or income will decrease as inflation shrinks
the purchasing power of a currency. Inflation causes money to decrease in value at
some rate, and does so whether the money is invested or not.
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Inflation Risk

Inflation Risk exposure reflects a stock's sensitivity to unexpected changes in the inflation rate.
Unexpected increases in the inflation rate put a downward pressure on stock prices, so most
stocks have a negative exposure to Inflation Risk. Consumer demand for luxuries declines when
real income is eroded by inflation. Thus, retailers, eating places, hotels, resorts, and other
"luxuries" are harmed by inflation, and their stocks therefore tend to be more sensitive to
inflation surprises and, as a result, have a more negative exposure to Inflation Risk. Conversely,
providers of necessary goods and services (agricultural products, tire and rubber goods, etc.) are
relatively less harmed by inflation surprises, and their stocks have a smaller (less negative)
exposure. A few stocks attract investors in times of inflation surprise and have a positive
Inflation Risk exposure.

LERMS

There was an urgency to overhaul the administered exchange rate system. The RBI Governor
formed an internal group with the members being O. P. Sodhani, Controller, Exchange Control
Department; P. B. Kulkarni, Chief Officer, Department of External Investments and Operations,
and this writer, who was Adviser (International Finance), as Convener.

There were inquisitive colleagues who were anxious to know what was going on and would have
liked to get into the act. We successfully kept our meetings and discussions confidential, often
without any documents but only hand-written notes.

The Governor indicated the terms of reference orally. We met on a few occasions and
recommended the Liberalised Exchange Rate Management System (LERMS), which was
approved by the Governor, and subsequently incorporated in the report of the High Level
Committee on Balance of Payments.

LERMS introduced, from March 1992, a dual exchange rate system in the place of a single
official rate. It consisted of one official rate for select government and private transactions and
the market-determined rate for the others.

It treated current and capital transactions in different ways. There were requirements of surrender
of foreign exchange by the public to banks with some exceptions.

The working of LERMS was smooth from the beginning, contrary to the fears in some quarters
that the rupee may undergo a steep depreciation. Some experts expected a market rate of Rs 50
per dollar.

When the scheme was introduced, forex dealers felt like prisoners of half a century being
suddenly released one morning and not knowing what to do, having lost all moorings in life!
However, they adjusted to the new situation quickly.
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The RBI announced the official rate. The Foreign Exchange Dealers Association of India
(FEDAI) intimated the market rate, called the Indicative Rate, to the Authorised Dealers (ADs)
for dollar, mark, yen and pound sterling at noon everyday.

The ADs were free to quote their own rates but, by and large, they were close to the FEDAI
rates.

The spread, measured as the difference between the official rate and the market rate as a
percentage of the former, ranged between 10.2 per cent and 15.8 per cent for ten days between
March 3, 1992, when the FEDAI announced the Indicative Rate for the first time, and March 13.

The stability of the spread was ensured by several factors. In the first place, there was a marked
improvement in NRI remittances through the banking channel, particularly from the Gulf, in
view of the facility to convert dollars into rupees at market rate to the extent of 60 per cent.

It was also the result of the Government permitting gold imports up to 5 kg by NRIs and other
returning Indians, once in six months. More than 90 tonnes were brought into the country before
the end of December 1992.

The decision to permit gold imports was linked to LERMS. It was part of the RBI's package of
measures for the external sector. The Apex Bank was felt that as long as gold imports were not
permitted the hawala market in foreign exchange would prevail. It was well known that the
demand for dollars in the unofficial market was linked to the financing of gold smuggled into the
country.

With a rising supply in the domestic market the margin for the smuggler came down drastically
from Rs 1,414 per 10 grams on April 17, 1992, before the reduction in import duty, to Rs 676 per
10 grams on December 24, 1992 marking a fall of 52 per cent. The trend in the decline in the
profit continued and it was no longer attractive for the smuggler to engage in illegal activity.

The depreciation of the rupee against the dollar vis-à-vis the official rate ranged between 25 and
30 per cent in February 1992 (before LERMS was introduced) in Hong Kong, New York,
Frankfurt, Dubai and other places where the currency was traded unofficially.

At the end of 1992 the rate came down to Rs 32 to a dollar — a depreciation of 4 per cent over
the market rate and 10 per cent over the weighted average rate of official and market rates. It
made the hawala transaction no longer attractive to the NRIs, who preferred the banking channel
for routing remittances to their families.

The RBI's foreign currency assets maintained a rising tend. They reached a level of $5.6 billion
on March 31, 1992, rising from $975 million on July 12, 1991. After accounting for assistance
received from bilateral and multilateral agencies, receipts under India Development Bond
Scheme and Remittances in Foreign Exchange (Immunities) Scheme 1991, about $1 billion
remained to be explained. It was essentially the result of reforms in the exchange rate system
leading, inter alia, to faster repatriation of export receipts and routing of remittances through
banking channels.
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From April 1, 1991 till March 31, 1992 purchases by the RBI from the ADs amounted to $1.8
billion against the net sales of $5.8 billion the previous year implying a turnaround of $7.6
billion.

LERMS had its detractors too. The export community considered the 40:60 rule as a tax on their
profession. But it was envisaged as a transitory measure and to help avoid a sudden increase in
government expenditure, fiscal deficit and inflation rate. In the next Budget a unified floating
rate based on market forces was introduced which continues till today.

What has been written in this article just skims the surface of the whole crisis. The central bank
has been undertaking a history project, and two volumes (1935-51 and 1951-67) have been
published.

After the preparation of the third volume covering 1967 to 1982, which awaits publication, the
bank disbanded the History Cell. It looks like the next volume may take time.

It is in this context that an ad hoc publication on the Gulf Crisis would be timely.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy,
RBI.)

The London Interbank Offered Rate (or LIBOR, pronounced /ˈlaɪbɔr/) is a daily reference
rate based on the interest rates at which banks borrow unsecured funds from other banks in the
London wholesale money market (or interbank market).

Mark-to-market or fair value accounting refers to the accounting standards of

assigning a value to a position held in a financial instrument based on the current
fair market price for the instrument or similar instruments. Fair value accounting
has been a part of US Generally Accepted Accounting Principles (GAAP) since the
early 1990s. The use of fair value measurements has increased steadily over the
past decade, primarily in response to investor demand for relevant and timely
financial statements that will aid in making better informed decisions.

mark To Market - MTM

What Does Mark To Market - MTM Mean?

1. A measure of the fair value of accounts that can change over time, such
as assets and liabilities. Mark to market aims to provide a realistic appraisal of an
institution's or company's current financial situation.
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2. The accounting act of recording the price or value of a security, portfolio or

account to reflect its current market value rather than its book value.

3. When the net asset value (NAV) of a mutual fund is valued based on the most
current market valuation.

Investopedia explains Mark To Market - MTM

1. Problems can arise when the market-based measurement does not accurately
reflect the underlying asset's true value. This can occur when a company is forced
to calculate the selling price of these assets or liabilities during unfavorable or
volatile times, such as a financial crisis. For example, if the liquidity is low or
investors are fearful, the current selling price of a bank's assets could be much
lower than the actual value. The result would be a lowered shareholders' equity.

This issue was seen during the financial crisis of 2008/09 where many securities
held on banks' balance sheets could not be valued efficiently as the markets had
disappeared from them. In April of 2009, however, the Financial Accounting
Standards Board (FASB) voted on and approved new guidelines that would allow
for the valuation to be based on a price that would be received in an orderly market
rather than a forced liquidation, starting in the first quarter of 2009.

2. This is done most often in futures accounts to make sure that margin
requirements are being met. If the current market value causes the margin account
to fall below its required level, the trader will be faced with a margin call.

3. Mutual funds are marked to market on a daily basis at the market close so that
investors have an idea of the fund's NAV.