Month: September 2022

Pricing of Swaps

A swap is an agreement between two parties to exchange a series of cash flows, which can also be viewed as a series of forward contracts. Swap pricing is the determination of the initial terms of the swap at the inception of the contract. On the other hand, swap valuation is the determination of market value during the life of the swap contract.

Swaps are equivalent to a series of forward contracts, each created at the swap price. If the present value of the payments in a swap or forward contract is not zero, then the party who will receive the greater stream of payments must pay the other party the present value of the difference, i.e., the net value.

Interest Rate Swaps

An interest rate swap is an agreement to exchange one stream of interest payments for another, based on a specified principal amount, over a specified period of time. Here is an example of a plain vanilla interest rate swap with Bank A paying the LIBOR + 1.1% and Bank B paying a fixed 4.7%:

As in most financial transactions, a swap dealer is between the two parties taking a commission on the trade.

At inception, the value of an interest rate swap is zero. Therefore, the fixed rate on the swap has to be such that the present value of the fixed payments is equal to the present value of the floating payments. A received fixed-rate swap should be treated as buying a fixed-rate bond and issuing a floating rate bond:

Value of swap (receiving fixed) =Value of fixed-rate bond (long)–Value of floating-rate bond (short)

Back to Back Loan

A back-to-back loan, also known as a parallel loan, is when two companies in different countries borrow offsetting amounts from one another in each other’s currency as a hedge against currency risk. While the currencies and interest rates (based on the commercial rates of each locale) remain separate, each loan will have the same maturity date.

Companies could accomplish the same hedging strategy by trading in the currency markets, either cash or futures, but back-to-back loans can be more convenient. These days, currency swaps and similar instruments have largely replaced back-to-back loans. All the same, these instruments still facilitate international trade.

Normally, when a company needs access to money in another currency it trades for it on the currency market. But because the value of some currencies can fluctuate widely, a company can unexpectedly wind up paying far more for a given currency than it had expected to pay. Companies with operations abroad may seek to reduce this risk with a back-to-back loan.

The benefits of back-to-back loans include hedging in the exact currencies needed. Only major currencies trade in the futures markets or have enough liquidity in the cash markets to facilitate efficient trade. Back-to-back loans most commonly involve currencies that are either unstable or trade with low liquidity. High volatility in such trading creates greater need among companies in those countries to mitigate their currency risk.

Back-to-Back Loan Risks

In pursuing back-to-back loans, the biggest problem companies face is finding counterparties with similar funding needs. And even if they do find appropriate partners, the terms and conditions desired by both may not match. Some parties will enlist the services of a broker, but then brokerage fees have to be added to the cost of the financing.

In India, the states directly cannot borrow from external agencies such as IDA. The Union Government plays a role of intermediary. Before 2004, the states in India received all the external assistance on the terms as decided by the Union Budget. The loans were transferred to India states as per the below flowchart:

External Agency →Government of India →State Governments.

The External agency here means the banks such as World Bank etc. We should know that India has been a “blend borrower” in the World Bank. This means that it used to borrow on 50:50 rations of IBRD Loans and IDA Credits. The ratio could change also. Now the Government of India passed the funds to states on basis of 70:30 Loans to Grant ratio. This means that this loan to grant ratio was regardless of the loan: credit composition from the World Bank.

The States argued that the Central Government was pocketing the concessional components of the loans borrowed from the external agencies and they should be allowed to approach the market directly. The Central Government argued that since it (central government) is bearing the currency risks too, the pocketing of concessional component was a fair trade. On this matter, the 12th Finance Commission recommended passing loans on ‘Back-to-Back’ basis to State Governments. This implied that

• States are encouraged to approach the market directly
• States would face same terms and conditions as that of Union Government such as concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules on account of their access to finance from bilateral and multilateral sources.
• States would be exposed to uncertain movements in international rates of interest and currency exchange rates.

This means that though now states enjoy the same conditions as the Union enjoys, they are also exposed to the exchange risks. This recommendation was accepted by the Government of India for general category states and the arrangement came into effect from April 1, 2005. For special category states (Northeastern states, Uttarakhand, Himachal and J&K), external borrowings are in the form of 90 per cent grant and 10 per cent loan from the Union Government.

Passing loans on ‘Back-to-Back’ basis to State Governments implies that States would face identical terms and conditions (including concessional interest rates, grace period and maturity profile, commitment charges and amortization schedules) on account of their access to finance from bilateral and multilateral sources, as is faced by the Union Government.

In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

The general swap can also be seen as a series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap. The legs can be almost anything but usually one leg involves cash flows based on a notional principal amount that both parties agree to. This principal usually does not change hands during or at the end of the swap; this is contrary to a future, a forward or an option.

In practice one leg is generally fixed while the other is variable,that is determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price.

Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps.

Types

Modern financial markets employ a wide selection of such derivatives, suitable for different purposes. The most popular types include:

Interest rate swap

Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.

Currency swap

Counterparties exchange the principal amount and interest payments denominated in different currencies. These contracts swaps are often used to hedge another investment position against currency exchange rate fluctuations.

Commodity swap

These derivatives are designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.

Debt-Equity Swaps

Debt or equity swaps act as a refinancing deal that involves the exchange of debt for equity. In this swap, the debt holder gets an equity position for the cancellation of the debt. It paves a way for struggling companies to relocate their capital structure. Since such companies can’t pay off their debts, they opt to get involved in debt-equity swaps to delay the payment. While some debt holders have to agree to this swap due to bankruptcy, others do have a choice in the matter as some companies engage in debt-equity swaps to reap the benefits of the favourable market conditions. The covenants in the bond indenture may oppose and prevent the swap without consent. For instance, businesses often offer attractive trade ratios like 1:2 wherein the bondholder receives stocks worth twice the value of his bonds, which makes the trade more enticing.

Credit default swap

A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps became somewhat notorious due to their impact on the 2008 Global Financial Crisis.

In CDS, both the parties get into an agreement in which the one pays the lost principal and interest of a loan to the CDS buyer in case a borrower defaults on the loan. CDS swap was one of the major contributing factors in the 2008 financial crisis along with poor risk management and excessive leverage as the investors offset their credit risk with that of another investor. The majority of the CDS contracts are maintained via an ongoing premium payment (which is quite similar to the regular premiums due on an insurance policy) and usually involve mortgage-backed securities or municipal and corporate bonds.

Total Return Swaps

In total return swaps, the overall returns from an asset are traded for a fixed (or variable) interest rate. This exposes the party that is paying the fixed rate to the underlying asset which is usually a stock, bond or index. Hence the second party can reap benefits from this asset without actually owning it. The parties involved in this swap are called total return payer and total return receiver.

• The primary options vs swaps difference is that an option is a right to buy/sell an asset on a particular date at a pre-fixed price while a swap is an agreement between two people/parties to exchange cash flows from different financial instruments. The seller or writer of a call option would however have the obligation to sell the asset that’s underlying at a pre-set price if the call option is exercised. In a swap, both parties are obliged for the cash flow exchange.
• Another swap vs option difference is that options involve the trading of securities as per their actual value and not merely the cash flows as in swap contracts.
• A key difference between swap and option is that a swap is not traded via the exchanges. A swap is an over-the-counter (OTC) derivative type that is customised and traded privately between two parties whereas an option can be either an OTC or exchange-traded derivative.
• Acquiring an option involves premium payment whereas there is no such payment involved in a swap.

Futures and Forwards

The definitions should make clear why there can be confusion surrounding these derivatives. Every contract type involves an agreement to make an exchange at a certain pre-defined future date. Given the nearly identical description, Futures and Forwards are the most similar contracts.

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract: often referred to as futures is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts that futures are publicly traded on an exchange while forwards are privately traded results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.

Assume Alice and Bob enter into a Forward contract where they agree to exchange 1 Bitcoin at the current price of $10,000 three months from now. Bob is the seller and thus has a short position, while Alice the buyer and therefore has a long position. If the actual price of Bitcoin rises to $11,000 by the end of the contract, it would mean a loss of $1,000 to Bob. Bob has to deliver 1 Bitcoin, which he has to buy for $11,000, for which he’ll only receive the agreed price of $10,000. On the other hand, Alice will have a profit of $1,000. She gets 1 Bitcoin for the agreed price of $10,000, while it is worth $11,000. This is the final outcome for both the Forward and Futures contract at the expiry date.

Different types of derivatives have different pricing mechanisms. A derivative is simply a financial contract with a value that is based on some underlying asset (e.g. the price of a stock, bond, or commodity). The most common derivative types are futures contracts, forward contracts, options and swaps. More exotic derivatives can be based on factors such as weather or carbon emissions.

Options Pricing Basics

Options are also common derivative contracts. Options give the buyer the right, but not the obligation, to buy or sell a set amount of the underlying asset at a pre-determined price, known as the strike price, before the contract expires.

The primary goal of option pricing theory is to calculate the probability that an option will be exercised, or be in-the-money (ITM), at expiration. Underlying asset price (stock price), exercise price, volatility, interest rate, and time to expiration, which is the number of days between the calculation date and the option’s exercise date, are commonly used variables that are input into mathematical models to derive an option’s theoretical fair value.

Aside from a company’s stock and strike prices, time, volatility, and interest rates are also quite integral in accurately pricing an option. The longer that an investor has to exercise the option, the greater the likelihood that it will be ITM at expiration. Similarly, the more volatile the underlying asset, the greater the odds that it will expire ITM. Higher interest rates should translate into higher option prices.

The best-known pricing model for options is the Black-Scholes method. This method considers the underlying stock price, option strike price, time until the option expires, underlying stock volatility and risk-free interest rate to provide a value for the option. Other popular models exist such as the binomial tree and trinomial tree pricing models.

Swaps Pricing Basics

Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific period of time. Swaps offer great flexibility in designing and structuring contracts based on mutual agreement. This flexibility generates many swap variations, with each serving a specific purpose. For instance, one party may swap a fixed cash flow to receive a variables cash flow that fluctuates as interest rates change. Others may swap cash flows associated with the interest rates in one country for that of another.

The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties agree to exchange interest payments. For example, assume Bank A agrees to make payments to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A based on a floating interest rate.

Models:

The Expectancy Model

The Expectancy Model of futures pricing states that the futures price of an asset is basically what the spot price of the asset is expected to be in the future.

This means, if the overall market sentiment leans towards a higher price for an asset in the future, the futures price of the asset will be positive.

In the exact same way, a rise in bearish sentiments in the market would lead to a fall in the futures price of the asset.

Unlike the Cost of Carry model, this model believes that there is no relationship between the present spot price of the asset and its futures price. What matters is only what the future spot price of the asset is expected to be.

This is also why many stock market participants look to the trends in futures prices to anticipate the price fluctuation in the cash segment.

The Cost of Carry Model

The Cost of Carry Model assumes that markets tend to be perfectly efficient. This means there are no differences in the cash and futures price. This, thereby, eliminates any opportunity for arbitrage the phenomenon where traders take advantage of price differences in two or more markets.

When there is no opportunity for arbitrage, investors are indifferent to the spot and futures market prices while they trade in the underlying asset. This is because their final earnings are eventually the same.

The model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair price can be arrived at.

In short, the price of a futures contract (FP) will be equal to the spot price (SP) plus the net cost incurred in carrying the asset till the maturity date of the futures contract.

FP = SP + (Carry Cost – Carry Return)

Here Carry Cost refers to the cost of holding the asset till the futures contract matures. This could include storage cost, interest paid to acquire and hold the asset, financing costs etc. Carry Return refers to any income derived from the asset while holding it like dividends, bonuses etc. While calculating the futures price of an index, the Carry Return refers to the average returns given by the index during the holding period in the cash market. A net of these two is called the net cost of carry.

The bottom line of this pricing model is that keeping a position open in the cash market can have benefits or costs. The price of a futures contract basically reflects these costs or benefits to charge or reward you accordingly.

There are primarily two categories of people who enter into any of the above contracts.

Hedgers

The first category is of those people who use it as a tool for hedging their risk of unfavorable price movement of an asset in the future. They enter into the futures contract to fix a price for their trade. This minimizes any uncertainty as well as the risk of prices going up or down in the future.

Speculators

The second category is those of speculators. They have no intention of taking the physical delivery of the asset. They look to make quick profits at the expiry of the contract by differences in the price of the asset at that date.

Futures contracts may seem similar to options as both can be settled in the near future. But there is a major difference between the two. Options just give a right to trade in the asset at the time of expiry of the contract or even before. They do not create an obligation to do the same. But futures contracts generate an obligation to settle the contract at the expiry of the time period.

Commodities Futures

Commodities are tangible assets that investors can physically buy and sell. The most common commodities in which investors buy futures contracts are oil, metals, natural gas, food grains, etc. The security behind such contracts is the assets themselves.

Commodities futures are very important for managing price risk, especially to people like farmers. The primary producer of crops or the farmer can enter into a futures contract to sell his produce at a particular price at a particular date in the future. This way, he gets an assurance of the price he will get for his efforts. He can be free from the tension of losses because of the price going down in the future. Similarly, the purchaser of food grains from the farmer will also know in advance the price which he has to pay for the food grains. He can accordingly plan his production if the product is a raw material for his further production. Or he may sell the produce at a higher rate and ensure that he makes a profit from the trade. Oil and gold are other important commodities in which futures contracts play a major role globally.

Stock Futures

Index futures first appeared in India in the year 2000. These were followed by individual stock futures a couple of years later. There are several advantages of trading in stock futures. The biggest one is leverage. Before trading in stock futures, you need to deposit an initial margin with the broker. If the initial margin is, say, 10 per cent, you can trade in Rs 50 lakh worth of futures by paying just Rs 5 lakh to the broker. The larger the volume of transactions, the higher your profit. But the risks are also more significant. You can trade stock futures on stock exchanges like the BSE and NSE. However, they are available only for a specified list of stocks.

Index Futures

Index futures can be used to speculate on the movements of indices, like the Sensex or Nifty, in the future. Let’s say you buy BSE Sensex futures at Rs 40,000 with an expiry date of the month. If the Sensex rises to 45,000, you stand to make a profit of Rs 5,000. If it goes down to Rs 30,000, your losses, in that case, would be Rs 5,000. Index futures are used by portfolio managers to hedge their equity positions should share prices fall. Some of the index futures in India include Sensex, Nifty 50, Nifty Bank, Nifty IT etc.

Currency Futures

Currency futures are contracts on the exchange price of currencies. The parties to the contract fix an exchange rate for the exchange of two currencies on a specific date in the future. Such contracts help nullify the exchange rate risk that may arise in the case of international trade over a period of time. Usually, the parties close these contracts before the date of expiry as per their need.

For example, suppose Mr.X has an investment in India that is due to mature in November this year. One USD is equal to 75 INR at the current exchange rate. He can buy currency futures and lock the current exchange rate of USD to INR. Thus, he will be sure of what investment amount he will receive at this currency exchange rate, no matter what the currency exchange rate is at that time.

Interest rate futures

An interest rate future is one of the different types of futures. It’s a contract to buy or sell a debt instrument at a specified price on a predetermined date. The underlying assets are government bonds or treasury bills. You can trade these on the NSE and the BSE.

Applications of derivatives

Now that we have learnt the functions and advantages and types of derivatives, here is a closer look on how they are used:

Hedgers: Hedging is a market mechanism by which an investor protects erosion of asset value due to an adverse price movement. Hedgers therefore, use derivatives especially during market volatility. This is to streamline future cash flow and ensure that there is minimal loss of asset value in the future.

So, for example, an investor has a stock portfolio of Rs5 lakh. He may not be keen on liquidating any positions ahead of key macroeconomic events such as budget or monetary policy announcements. He may, therefore, choose to protect his portfolio by shorting index futures. He can also choose to pay a fixed cost in the form of a premium and purchase a put option instead.

Speculators: Speculators, in a way are the exact opposite of hedgers. Rather than protecting their portfolio, they look at making higher gains in a shorter time frame. A speculator may therefore want to take advantage of price movements during times of volatility and make a large profit in the process.

For example, if a speculator has the idea that the price of company A may fall in a few days due to policy announcements, he would choose to short sell the shares of company A ahead of the event. If the fall takes place as per his expectations, he has the opportunity to make a good profit. On the other hand, if the stock price of A rises against his expectations, he will suffer a hefty loss.

Arbitrageurs: The main objective of an arbitrageur is to exploit the price differentials in different markets. He will therefore buy an asset at a cheaper rate in one market and sell it at a higher rate in another. This results in a low risk profit opportunity. However, such windows of opportunities are very brief in the derivatives market and may turn out to be a risky trade.

Benefits:

Underlying Asset price determination

Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

Access to unavailable assets or markets

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Global financial markets witnessed turbulent conditions during 2007-08 as the crisis in the US sub-prime mortgage market deepened and spilled over to markets for other assets. Concerns about slowdown in the real economy propelled a broad-based re-pricing of growth risk by the end of the year.

Money Markets:

The policies initiated by central banks and the guarantees offered by governments assuaged to an extent the funding pressures that were evident in the international financial markets during September and October 2008. The spreads between Libor and overnight index swaps (OIS) have been gradually narrowing.

In the UK, however, bank funding markets came under renewed pressure. The Sterling Libor-OIS spreads slightly widened and the inter-bank term lending remained subdued during late January and February 2009.

Recent financial market developments have also blurred the distinction between different segments of the financial markets. Creditors and investors now compete with each other for good financial transactions. In addition, borrowers can now structure the best deals available in the entire market rather than focusing on specific market segments. By borrowing in the most accessible financial market segment and then swapping aspects of the debt to other markets, successful borrowers tailor the currency, cost, maturity, and form of their financial transactions to their financial needs.

These developments in international financial markets do entail some adverse consequences for developing country borrowers. Lenders and investors can be more selective in choosing their financial transactions, using swaps and other hedging techniques to pass on unacceptable risks. Given the present shortage of available financing, securitization provides flexibility and more accessible financing to creditworthy borrowers, limiting the options available to less creditworthy borrowers, such as developing countries. Borrowers can mitigate this impact by structuring financing proposals that address the risk concerns of specific groups of financial actors. It is easier for investors to assess specific project-related risks than the numerous categories of risk that can affect general purpose financing. Borrowers should also structure their funding proposals to link the timing, amount, and currency of their repayment obligations more directly to cash flow.

If developing countries are to gain access to international financing, they will need to ascertain how investors perceive the risks associated with their debt issue in relation to the risks associated with other debt issues. Investor perception can be influenced by commercial and political risk assessments of the borrower and the anticipated marketability of the debt instruments. All developing countries who borrow, regardless of their dealings with international financial markets, should make an effort to understand some of the new financing techniques. By doing so, borrowers with access to international financial markets can maximize the benefits they derive from funds raised in these markets, while borrowers with no present access to these markets can apply these techniques to renegotiate existing commercial bank debt. Debt managers and their lawyers who understand the new financing techniques may also be able to use this information in developing overall international borrowing strategies.

Risk and uncertainty are often used interchangeably in financial management literature. However, there are differences between the two and they represent strictly different ideologies. In this brief article, we will highlight the points that differentiate these two terms, risk and uncertainty, when they are used in Finance parlance.

Risk is the process of potential loss for a firm. The concept of risk is broad in finance. In finance, the risk is associated with a bad outcome occurring or a good outcome not occurring at all. For instance,

• If the income falls down below a certain mark, it is a risk for the company.
• If the business grows 10% instead of the projected 20% rate, that is also a kind of risk for the company.

Uncertainty

Uncertainty refers to an absence of certainty, that is, there is no guarantee of something happening in the present or the future. There is an absence of a given outcome in uncertainty. Since the outcome of an event is not certain, there is hardly any measure of uncertainty. That is, we cannot measure uncertainty in the business world. It is a process that can just be stated but not measured.

For example, let’s say that a business can earn 10% or 20% of profit within the next two years. However, it is uncertain because we cannot measure it. So, there is a kind of probability attached to uncertainty which is improbable in the case of risk.

Risks & Uncertainties in International Finance

When an organization decides to engage in international financing activities, it takes on additional risk along with the opportunities. The main risks that are associated with businesses engaging in international finance include foreign exchange risk and political risk.

These challenges may sometimes make it difficult for companies to maintain constant and reliable revenue. In this article, we’ll review the strategies companies can employ to reduce the impact of the risks they face from doing business internationally.

Foreign exchange risk occurs when the value of an investment fluctuates due to changes in a currency’s exchange rate. Foreign exchange risk is also known as FX risk, currency risk, and exchange-rate risk. When a domestic currency appreciates against a foreign currency, profit or returns earned in the foreign country will decrease after being exchanged back to the domestic currency. Due to the somewhat volatile nature of the exchange rate, it can be quite difficult to protect against this kind of risk, which can harm sales and revenues.

The risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than where it is headquartered. For example, a company based in Canada that does business in China; i.e., receives financial transactions in Chinese yuan reports its financial statements in Canadian dollars, is exposed to foreign exchange risk.

Uncertainties in International Finance

Uncertainty is one concept in finance and accounting that should be deeply understood. Business owners, as well as investors, want to access credible and honest financial statements during times of uncertainty.

Through generally accepted accounting principles, including those that are from the Financial Accounting Standards Board, there are now processes that can be used to identify, record, and disclose uncertainty. Using accounting principles consistently makes it possible to compare financial records from various periods.

How to Turn Uncertainty into an Advantage

The only thing certain thing about uncertainty is that it can happen anytime, and when it does, no company is exempt from feeling its effects. Therefore, the most effective thing to do is to prepare for it and turn it into an advantage. Here’s how:

1. Forecasting is essential

Companies who rely on annual budgets are finding themselves in shallow waters nowadays because the figures may no longer be applicable even before a specific financial year is over. This is why forecasting and updating plans regularly are important.

2. Shift to automation

Manual collection of data takes up more time than actually analyzing it, which is why it is often too late when problems are identified. Business organizations should shift to automation because it cuts the time needed for data collection and analysis.

3. Efficient reporting of finances

Automation also contributes to achieving financial reports that are efficient and accurate.

4. Self-service is key

Stakeholders are an important component of an organization, which is why providing self-service apps is helpful. For example, users can use a specific app that lets them open their accounts and evaluate the data by themselves. This not only gives them the freedom to do so anytime it is convenient for them but it also frees up work for the organization’s IT team, letting them concentrate on more important processes.

A change in a country’s balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter balance of payments.

Balance of Payments and Exchange Rates

A balance of payment is a statement of all transactions made between entities in one country and the rest of the world over a specific time frame, such as a quarter or a year. Two dynamics are in play which links a country’s balance of payment and changes in the value of its currency: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

Exchange Rate Impacts:

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data:

BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

• Where: X is exports of goods and services,
• M is imports of goods and services,
• (X-M) is known as Current Account Balance
• CI is capital outflows,
• CO is capital outflows,
• (CI-CO) is known as Capital Account Balance
• FI is financial inflows,
• FO is financial outflows,
• (FI-FO) is known as Financial Account Balance
• FXB is official monetary reserves such as foreign exchange and gold

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system.

a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not approximate zero, the government is expected to intervence in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervence in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called devaluation or revaluation, while a change in floating exchange rates is called either depreciation or appreciation.

b) Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the market‘s valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process, the government signals exchange market participants that it intends to take measures to preserve the currency‘s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics. For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.

c) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term.

The International Centre for Settlement of Investment Disputes (ICSID) is an international arbitration institution established in 1966 for legal dispute resolution and conciliation between international investors and States. ICSID is part of and funded by the World Bank Group, headquartered in Washington, D.C., in the United States. It is an autonomous, multilateral specialized institution to encourage international flow of investment and mitigate non-commercial risks by a treaty drafted by the International Bank for Reconstruction and Development’s executive directors and signed by member countries. As of May 2016, 153 contracting member states agreed to enforce and uphold arbitral awards in accordance with the ICSID Convention.

The centre performs advisory activities and maintains several publications.

Governance

ICSID is governed by its Administrative Council which meets annually and elects the centre’s secretary-general and deputy secretary-general, approves rules and regulations, conducts the centre’s case proceedings, and approves the centre’s budget and annual report. The council consists of one representative from each of the centre’s contracting member states and is chaired by the President of the World Bank Group, although the president may not vote. ICSID’s normal operations are carried out by its secretariat, which comprises 40 employees and is led by the secretary-general of ICSID. The secretariat provides support to the Administrative Council in conducting the centre’s proceedings. It also manages the centre’s Panel of Conciliators and Panel of Arbitrators. Each contracting member state may appoint four persons to each panel. 15 In addition to serving as the centre’s principal, the secretary-general is responsible for legally representing ICSID and serving as the registrar of its proceedings. As of 2012, Meg Kinnear serves as the centre’s secretary-general.

Features of the ICSID Convention

The ICSID Convention provides the basic procedural framework for conciliation and arbitration of investment disputes arising between ICSID Member States and investors that qualify as nationals of other Member States. It is a treaty among Member States establishing an independent, impartial and self-contained system.

ICSID proceedings are delocalized from domestic procedures. This means that local courts do not intervene in the ICSID process. Some implications of the self-contained system and other main features include:

• Awards in ICSID Convention arbitrations are final and binding, and may not be set aside by the courts of any Member State (Article 53 of the Convention).
• The limited post-award remedies available are set out in the Convention itself (Articles 49 to 52 of the Convention).
• All Members States, whether or not parties to the dispute, recognize and enforce ICSID Convention monetary awards as final judgments in any Member State (Article 54 of the Convention).
• Once disputing parties consent to ICSID arbitration and unless they agree otherwise, they accept ICSID arbitration as the exclusive remedy (Article 26 of the Convention).
• A Member State cannot give diplomatic protection to any of its nationals which have consented to arbitration under the Convention, except in limited circumstances (Article 27 of the Convention).
• The place of proceedings, i.e., where hearings are held, has no legal significance in Member States (Articles 62 to 63 of the Convention).
• Participants enjoy immunity from legal process in the conduct of the proceedings (Articles 21 to 22 of the Convention).