Tag: Innovative Financial Services Mumbai University BMS Notes

In finance, a foreign exchange option (Commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.

The foreign exchange options market is the deepest, largest and most liquid market for options of any kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency options was notionally valued by the Bank for International Settlements at $578.3 trillion in 2019.

Terms

Call option: The right to buy an asset at a fixed date and price.

Put option: The right to sell an asset at a fixed date and price.

Foreign exchange option: The right to sell money in one currency and buy money in another currency at a fixed date and rate.

Strike price: The asset price at which the investor can exercise an option.

Spot price: The price of the asset at the time of the trade.

Forward price: The price of the asset for delivery at a future time.

Notional: The amount of each currency that the option allows the investor to sell or buy.

Ratio of notionals: The strike, not the current spot or forward.

Numéraire: The currency in which an asset is valued.

Non-linear payoff: The payoff for a straightforward FX option is linear in the underlying currency, denominating the payout in a given numéraire.

Change of numéraire: The implied volatility of an FX option depends on the numéraire of the purchaser, again because of the non-linearity of xà 1/x.

In the money for a put option, this is when the current price is less than the strike price, and would thus generate a profit were it exercised; for a call option the situation is inverted.

A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller.

Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Trading currency options involves a wide variety of strategies available for use in forex markets. The strategy a trader may employ depends largely on the kind of option they choose and the broker or platform through which it is offered. The characteristics of options in decentralized forex markets vary much more widely than options in the more centralized exchanges of stock and futures markets.

Traders like to use currency options trading for several reasons. They have a limit to their downside risk and may lose only the premium they paid to buy the options, but they have unlimited upside potential. Some traders will use FX options trading to hedge open positions they may hold in the forex cash market. As opposed to a futures market, the cash market, also called the physical and spot market, has the immediate settlement of transactions involving commodities and securities. Traders also like forex options trading because it gives them a chance to trade and profit on the prediction of the market’s direction based on economic, political, or other news.

Option on Spot

The term spot price is not limited to options or stocks you can use it when referring to the current market price of any security. It is most commonly used with securities which besides the spot market also have futures or forward markets, such as commodities, currencies or interest rates.

For instance, you can hear about the “gold spot price” as opposed to gold futures prices, or you can “buy euros on the spot market” as opposed to the forward market. Generally, spot price is the price for immediate delivery or settlement (in practice, immediate typically means settled within a very few, like 1-3, days), while a futures or forward price, although agreed now, is for settlement at a given date in the future (e.g. one month or even one year from now).

Futures & Futures Style Options

An option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a strike price on or before the option’s expiration date. These work similarly to stock options, but differ in that the underlying security is a futures contract.

Most options on futures, such as index options, are cash settled. They also tend to be European-style options, which means that these options cannot be exercised early.

A proposed contract to replace many traditional options on futures contracts. Unlike traditional options, the buyer of a futures-style option does not prepay the premium. Buyers and sellers post margin as in a futures contract, and the option premium is marked to the market daily. Valuation differs from traditional futures options primarily in the analysis of the timing of cash flows associated with the buyer’s nonpayment of an upfront premium.

An option on a futures contract is very similar to a stock option in that it gives the buyer the right, but not obligation, to buy or sell the underlying asset, while creating a potential obligation for the seller of the option to buy or sell the underlying asset if the buyer so desires by exercising that option. That means the option on a futures contract, or futures option, is a derivative security of a derivative security. But the pricing and contract specifications of these options does not necessarily add leverage on top of leverage.

An option on an S&P 500 futures contract, therefore, can be thought of as a second derivative of the S&P 500 index since the futures are themselves derivatives of the index. As such, there are more variables to consider as both the option and the futures contract have expiration dates and their own supply and demand profiles. Time decay (also known as theta), works on options futures the same as options on other securities, so traders must account for this dynamic.

For call options on futures, the holder of the option would enter into the long side of the contract and would buy the underlying asset at the option’s strike price. For put options, the holder of the option would enter into the short side of the contract and would sell the underlying asset at the option’s strike price.

For calls:

ITM: underlying price > strike price

OTM: underlying price < strike price

For puts it’s the opposite:

ITM: underlying price < strike price

OTM: underlying price > strike price

For both calls and puts:

ATM: underlying price = strike price

A Currency option is a derivative contract which gives the buyer of the option the right, but not the obligation, to buy or sell the currency at a stated date and at a predetermined price. The seller of the contract has the obligation to honour the contract when the contract is exercised. The dynamics and mechanism of currency options trading are very similar to equity options.

There are two types of currency options: Call and Put. A call option gives the right to buy and a put option gives the right to sell. In every transaction, one currency is bought and another sold.

Benefits of opting for the USD-INR pair in the currency derivatives market

Any resident Indian or NRI can participate in the USD-INR pair, even if there is no underlying, up to a limit. This is unlike the forward market where you can only hedge an underlying currency exposure.

The bid-ask spreads are as low as 0.0025 in the near month pair and that substantially reduces the liquidity risk while trading. Also, the USD-INR is a fairly liquid pair and is possible to get quotes both ways with minimal risk.

Unlike the forward market mechanism, which is a closed market, the USD-INR pair is based on the transparent market mechanism. This makes it a lot more preferable for individual traders with limited access to information and insights. In fact, like your normal equity / F&O trading screen, you can log into your trading terminal and see the 5 best buy and sell quotes with volumes that reduces information asymmetry substantially.

You can access the USD-INR pair either through your broker or directly from your internet trading platform which adds to the convenience and reduces the hassles of trading

Trading in the USD-INR Futures in the currency derivatives market

As traders intending to take positions in the USD-INR pair, you need to understand a basic difference vis-à-vis the equity markets. When you buy the equities, you are actually betting on the price of the equity to go up. On the contrary when you are buying the USD-INR paid, you are actually betting on the US dollar to appreciate or in other words you are expecting the INR to depreciate against the US dollar. If you are actually expecting the INR to appreciate against the dollar then you should be selling the USD-INR futures. Settlement of currency derivatives will happen on the last working day of the month which will also be the date for interbank settlements in Mumbai. Unlike commodities trading, all USD-INR pairs as well as pairs with Pound, Euro and Yen are all necessarily cash settled.

Currency Options Contract Specifications

Four types of currency pairs are available for trading in currency options-

• USD-INR
• EUR-INR
• GBP-INR
• JPY-INR

Lot Size: The lot size varies depending on the currency pair. For USD-INR, 1 lot size denotes USD 1000. For EURINR, 1 lot size is EUR 1000. For GBPINR, it is GBP 1000 and for JPYINR, it is JPY 10000.

Underlying: The underlying would be the exchange rate in Indian rupees for each currency pair.

Exercise Style: European in nature which means the contracts can either be squared off by taking an opposite position or can be exercised on expiry.

Tick Size: The strike price interval in these contracts is Rs 0.25.

Contract Cycle: There are three monthly contracts and 1 quarterly contract.

Margin: Premium for buying and SPAN + Exposure margin for selling

Expiration day: Two days prior to the last working day of the month.

Forward is a transaction where two different currencies are exchanged between accounts on the prefixed future value date.

The exchange of currencies takes place on the prefixed accounts, on the same value date. The Client is protected from adverse movements in future FX rates, but he also does not benefit from favourable movements.

 Foreign Exchange forwards avoid uncertainty and are therefore valid instruments for Clients to mitigate the foreign exchange risk for future transactions denominated in a foreign currency.

 On the trading day of the Forward transaction the Client is obliged to place a collateral deposit at the Bank. If the parties do not agree otherwise, the amount of the deposit is 15% of the forward nominal value.

The minimum size of the transaction is EUR 500.000 or its equivalent in other currency (if the parties do not agree otherwise). (Precondition of the transaction is a valid spot-forward frame agreement.)

Forward points are the number of basis points added to or subtracted from the current spot rate of a currency pair to determine the forward rate for delivery on a specific value date. When points are added to the spot rate this is called a forward premium; when points are subtracted from the spot rate it is a forward discount. The forward rate is based on the difference between the interest rates of the two currencies (currency deals always involve two currencies) and the time until the maturity of the deal.  Forward points are also known as the forward spread.

Forward points are used to calculate the price for both an outright forward contract and a foreign currency swap. Points can be calculated and transactions executed for any date that is a valid business day in both currencies. The most commonly traded forward currencies are the U.S. dollar, the euro, Japanese yen, British pound and Swiss franc.

Forwards are most commonly done for periods of up to one year. Prices for further out dates are available, but liquidity is generally lower. In an outright forward foreign exchange contract, one currency is bought against another for delivery on any date beyond spot. The price is the spot rate plus or minus the forward points to the value date. No money changes hands until the value date.

In a foreign exchange swap, a currency is bought for the near date (usually spot) against another currency, and the same amount is sold back for the forward date. The rate for the forward leg of the swap is the near date rate plus or minus the forward points to the far date. Money changes hands on both value dates.

Discount Spreads

In contrast to the forward spread, a discount spread is the currency forward points that are subtracted from the spot rate, to obtain a forward rate for a currency. In the currency markets, forward spreads, or points, are presented as two-way quotes; that is, they have a bid price and an offer price. In a discount spread, the bid price will be higher than the offer price, while in a premium spread, the bid price will be lower than the offer price.

The forward margin, or forward spread, reflects the difference between the spot rate and the forward rate for a certain commodity or currency. The difference between the two rates can either be a premium or a discount, depending on if the forward rate is above or below the spot rate, respectively.

Forward Margins & Forwards Markets

Foreign exchange markets are global exchanges (notable centers in London, New York, Singapore, Tokyo, Frankfurt, Hong Kong and Sydney), where currencies are traded virtually around the clock. These are large and highly active traded financial markets around the world, with an average daily traded volume of $6.6 trillion in early 2019.

Institutional investors such as banks, multinational corporations, hedge funds and even central banks are active participants in these markets.

Similar to foreign exchange markets, commodities markets attract (and are only accessible to) certain investors, who are highly knowledgeable in the space. Commodities markets can be physical or virtual for raw or primary products. Major commodities by liquidity include crude oil, natural gas, heating oil, sugar, RBOB gasoline, gold, wheat, soybeans, copper, soybean oil, silver, cotton, and cocoa. Investment analysts spend a great deal of time speaking with producers, understanding global macro trends for supply and demand for these products around the world, and even take into account the political climate to assess what their prices will be in the future.

Standardized forward contracts are also referred to as futures contracts. While forward contracts are private agreements between two parties and carry a high counterparty risk, futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default.

Interest rate parity (IRP) is a theory according to which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors then cannot earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity. Interest rate parity takes on two distinctive forms: uncovered interest rate parity refers to the parity condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate.

Economists have found empirical evidence that covered interest rate parity generally holds, though not with precision due to the effects of various risks, costs, taxation, and ultimate differences in liquidity. When both covered and uncovered interest rate parity hold, they expose a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate. This relationship can be employed to test whether uncovered interest rate parity holds, for which economists have found mixed results. When uncovered interest rate parity and purchasing power parity hold together, they illuminate a relationship named real interest rate parity, which suggests that expected real interest rates represent expected adjustments in the real exchange rate. This relationship generally holds strongly over longer terms and among emerging market countries.

Interest rate parity (IRP) plays an essential role in foreign exchange markets by connecting interest rates, spot exchange rates, and foreign exchange rates.

IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of IRP is that hedged returns from investing in different currencies should be the same, regardless of their interest rates.

IRP is the concept of no-arbitrage in the foreign exchange markets (the simultaneous purchase and sale of an asset to profit from a difference in the price). Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.

The formula for IRP is:

where:

F0 = Forward Rate

S0 = Spot Rate

ic = Interest rate in country c

ib =Interest rate in country b

Assumptions

Interest rate parity rests on certain assumptions, the first being that capital is mobile – investors can readily exchange domestic assets for foreign assets. The second assumption is that assets have perfect substitutability, following from their similarities in riskiness and liquidity. Given capital mobility and perfect substitutability, investors would be expected to hold those assets offering greater returns, be they domestic or foreign assets. However, both domestic and foreign assets are held by investors. Therefore, it must be true that no difference can exist between the returns on domestic assets and the returns on foreign assets. That is not to say that domestic investors and foreign investors will earn equivalent returns, but that a single investor on any given side would expect to earn equivalent returns from either investment decision.

Important

Interest rate parity is an important concept. If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage strategy. For example, let us look at the scenario where the forward exchange rate is not in equilibrium with the spot exchange rate.

If the actual forward exchange rate is higher than the IRP forward exchange rate, then you could make an arbitrage profit. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract. At maturity of the forward contract, you would exchange the money back into your home currency and pay back the money you borrowed. If the forward price you locked in was higher than the IRP equilibrium forward price, then you would have more than the amount you must pay back. You have essentially made riskless money with nothing but borrowed funds.

Interest rate parity is also important in understanding exchange rate determination. Based on the IRP equation, we can see how changing the interest rate can affect what we would expect the spot rate to be at a later date. For example, by holding the foreign country interest rate steady and increasing the home country’s interest rate, we would expect the home country currency to appreciate in relation to the foreign currency. This would affect the expected exchange rate.

The structure of the forex market is rather unique because major volumes of transactions are done in Over-The-Counter (OTC) market which is independent of any centralized system (exchange) as in the case of stock markets.

The participants in this market are:

• Major commercial banks
• Central Banks
• Investment banks
• Corporations for international business transactions
• Speculators
• Hedge funds
• Pension and mutual funds
• Insurance companies
• Forex brokers

Market Participants

In the above diagram, we can see that the major banks are the prominent players and smaller or medium sized banks make up the interbank market. The participants of this market trade either directly with each other or electronically through the Electronic Brokering Services (EBS) or the Reuters Dealing 3000-Spot Matching.

The competition between the two companies; The EBS and the Reuters 3000-Spot Matching in forex market is similar to Pepsi and Coke in the consumer market.

Some of the largest banks like HSBC, Citigroup, RBS, Deutsche Bank, BNP Paribas, Barclays Bank among others determine the FX rates through their operations. These large banks are the key players for global FX transactions. The banks have the true overall picture of the demand and supply in the overall market, and have the current scenario of any current. The size of their operations effectively lay down the bid-ask spread that trickles down to the lower end of the pyramid.

The next tier of participants are the non-bank providers such as retail market makers, brokers, ECNs, hedge funds, pension and mutual funds, corporations, etc. Hedge funds and technology companies have taken significant chunk of share in retail FX but very less foothold in corporate FX business. They access the FX market through banks, which are also known as liquidity providers. The corporations are very important players as they are constantly buying and selling FX for their cross-border (market) purchases or sales of raw or finished products. Mergers and acquisitions (M&A) also create significant demand and supply of currencies.

Sometimes, governments and centralized banks like the RBI (in India) also intervene in the Foreign Exchange market to stop too much volatility in the currency market. For instance, to support the pricing of rupees, the government and centralized banks buy rupees from the market and sell in different currencies such as dollars; conversely, to reduce the value of Indian rupees, they sell rupees and buy foreign currency (dollars).

The speculators and retail traders that come at the bottom of the pyramid pay the largest spread, because their trades effectively get executed through two layers. The primary purpose of these players are to make money trading the fluctuations in the currency prices. With the advancement of technology and internet, even a small trader can participate in this huge forex market.

Currency pair

If you are new to the forex market and have just started trading Forex online, you may find yourself overwhelmed and confused both at a time by the huge number of available currency pairs inside your terminal (like the MetaTrader4, etc.). So what are the best currency pairs to trade? The answers is not that straightforward as it varies with each trader and its terminal window or with what exchange (or OTC market) he is trading. Instead, you need to take the time to analyse different pairs of currencies against your own strategy to determine the best forex pairs to trade on your accounts.

The trade in Forex market occurs between two currencies, because one currency is being bought (buyer/bid) and another sold (seller/ask) at the same time. There is an international code that specifies the setup of currency pairs we can trade. For example, a quote of EUR/USD 1.25 means that one Euro is worth $1.25. Here, the base currency is the Euro (EUR), and the counter currency is the US dollar.

Commonly Used Currency Pair

The most traded, dominant and strongest currency is the US dollar. The primary reason for this is the size of the US economy, which is the world’s largest. The US dollar is the preferred base or reference currency in most of the currency exchange transactions worldwide. Below are some of the most traded (high liquidity) currency pairs in the global forex market. These currencies are part of most of the foreign exchange transactions. However, this is not necessarily the best currency to trade for every trader, as this (which currency pair to choose) depends on multiple factors:

• EUR/USD (Euro – US Dollar)
• GBP/USD (British Pound – US Dollar)
• USD/JPY (US Dollar – Japanese Yen)
• USD/CHF ( US Dollar – Swiss Franc)
• EUR/JPY ( Euro – Japanese Yen)
• USD/CAD (US Dollar – Canadian Dollar)
• AUD/USD (Australian Dollar – US Dollar)

As prices of these major currencies keep changing and so do the values of the currency pairs change. This leads to a change in trade volumes between two countries. These pairs also represent countries that have financial power and are traded heavily worldwide. The trading of these currencies makes them volatile during the day and the spread tends to be lower.

EUR/USD Currency Pair

The EUR/USD currency pair is considered to be the most popular currency pair and has the lowest spread among modern world forex brokers. This is also the most traded currency pair in the world. About 1/3rd of all the trade in the market is done in this currency pair. Another important point is that this forex pair is not too volatile. Therefore, if you do not have that much risk appetite you can consider this currency pair to trade.

The Bid-Ask Spread

The spread is the difference between the bid price and the ask price. The bid price is the rate at which you can sell a currency pair and the ask price is the rate at which you can buy a currency pair (EUR/USD).

Buy Limit

A pending order to buy a currency at a lower price (whatever price trader wants to buy) than the current one.

Buy Stop

A pending order to buy a currency at a higher price (whatever price trader wants to execute) than the current one.

Sell Limit

A pending order to sell a currency pair at a higher price (whatever price trader wants to sell) than the current price.

Sell Stop

A pending order to sell a currency pair at a lower price (buy high, sell low).

Leverage and Margin

In this chapter, we will learn about leverage and margin and how these influence the financial market.

Hedging

Hedging is basically a strategy which is intended to reduce possible risks in case prices movement against your trade. We can think of it with something like “insurance policy” which protects us from particular risk (consider your trade here).

To protect against a loss from a price fluctuation in future, you usually open an offsetting position in a related security. Traders and investors usually use hedging when they are not sure which way the market will be heading. Ideally, hedging reduces risks to almost zero, and you end up paying only the broker’s fee.

To open a position in an off-setting instrument

The offsetting instrument is a related security to your initial position. This allows you to offset some of the potential risks of your position while not depriving you of your profit potential completely. One of the classic examples would be to go long say an airline company and simultaneously going long on crude oil. As these two sectors are inversely related, a rise in crude oil prices will likely cause your airline long position to suffer some losses but your crude oil long helps offset part or all of that loss. If the oil prices remain steady, you may profit from the airline long while breaking even on your oil position. If the prices of oil go down, the oil long will give you losses but the airline stock will probably rise and mitigate some or all your losses. So, hedging helps to eliminate not all but some of your risks while trading.

To buy and/or sell derivative (future/forward/option) of some sort in order to reduce your portfolio’s risk as well as reward exposure, as opposed to liquidating some of your current positions. This strategy may come handy where you do not want to directly trade with your portfolio for a while due to some market risks or uncertainties, but you rather not liquidate part or all of it for other reasons. In this type of hedging, the hedge is straightforward and can be calculated precisely.

Stop Losses

A stop-loss is an order placed in your trading terminal to sell a security when it reaches a specific price. The primary goal of a stop loss is to mitigate an investor’s loss on a position in a security (Equity, FX, etc.). It is commonly used with a long position but can be applied and is equally profitable for a short position. It comes very handy when you are not able to watch the position.

Stop-losses in Forex is very important for many reasons. One of the main reason that stands out is no one can predict the future of the forex market every time correctly. The future prices are unknown to the market and every trade entered is a risk.

Forex traders can set stops at one fixed price with an expectation of allocating the stoploss and wait until the trade hits the stop or limit price.

Stop-loss not only helps you in reducing your loss (in case trade goes against your bet) but also helps in protecting your profit (in case trade goes with the trend). For example, the current USD/INR rate is 76.25 and there is an announcement by the US federal chairperson on whether there will be a rate hike or not. You expect there will be a lot of volatility and USD will rise. Therefore, you buy the future of USD/INR at 76.25. Announcement comes and USD starts falling and suppose you have put the stop-loss at 76.05 and USD falls to 75.5; thus, avoiding you from further loss (stop-loss hit at 66.05). Inversely in case USD starts climbing after the announcement, and USD/INR hit 77.25. To protect your profit you can set stop-loss at 77.05(assume). If your stop-loss hit at 77.05(assume), you make profit else, you can increase your stop-loss and make more profit until your stop-losses hit.

Functions of Foreign Exchange Market

Foreign Exchange Market is the market where the buyers and sellers are involved in the buying and selling of foreign currencies. Simply, the market in which the currencies of different countries are bought and sold is called as a foreign exchange market.

Types of Foreign Exchange Transactions

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for another at an agreed exchange rate on a definite date.

Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.

Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.

Future Transaction: The future transactions are also the forward transactions and deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds:

The forward contracts can be customized on the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized.

The future contracts can only be traded on the organized exchanges,while the forward contracts can be traded anywhere depending on the client’s convenience.

No marginis required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.

Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk.

Option Transactions: The foreign exchange option gives an investor theright, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.

Settlement Date

The settlement cycle in stock markets refers to the time between the trade date, when an order is executed in the market, and the settlement date, when participants exchange cash for securities or shares. Sebi has given the option to exchanges to adopt T+1 based on their readiness from year 2022. The Sebi circular states that if the stock exchange wants to opt for the T+2 settlement cycle in between, it will have to give notice one month in advance.

Dematerialised settlement

NSE Clearing follows a T+2 rolling settlement cycle. For all trades executed on the T day, NSE Clearing determines the cumulative obligations of each member on the T+1 day and electronically transfers the data to Clearing Members (CMs). All trades concluded during a particular trading date are settled on a designated settlement day i.e. T+2 day. In case of short deliveries on the T+2 day in the normal segment, NSE Clearing conducts a buy in auction on the T+2 day itself and the settlement for the same is completed on the T+3 day, whereas in case of W segment there is a direct close out. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded. The settlement schedule for all the settlement types in the manner explained above is communicated to the market participants vide circular issued during the previous month.

Rolling Settlement

In a rolling settlement, for all trades executed on trading day. i.e. T day the obligations are determined on the T+1 day and settlement on T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded.

Limited Physical Market

Settlement for trades is done on a trade-for-trade basis and delivery obligations arise out of each trade. The settlement cycle for this segment is same as for the rolling settlement viz:

International business refers to the trade of goods, services, technology, capital and/or knowledge across national borders and at a global or transnational scale.

It involves cross-border transactions of goods and services between two or more countries. Transactions of economic resources include capital, skills, and people for the purpose of the international production of physical goods and services such as finance, banking, insurance, and construction. International business is also known as globalization.

To conduct business overseas, multinational companies need to bridge separate national markets into one global marketplace. There are two macro-scale factors that underline the trend of greater globalization. The first consists of eliminating barriers to make cross-border trade easier (e.g. free flow of goods and services, and capital, referred to as “free trade”). The second is technological change, particularly developments in communication, information processing, and transportation technologies.

Every country has its own taxation structure according to which they determine the taxability of people residing there and also taxability of the people who does not belongs to their country but with some means they are related to their nation in their form of assessee or deemed assessee.

So, for recoverability of tax from the income generated in other nations by NRI’s DTAA was formed and secondly, to ensure that this taxability of income does not lead to double taxation of Same income in both the countries.

There is an unusual tension in the world of corporate taxation. On the one hand, countries compete vigorously to lure businesses and investors within their borders by offering numerous profit- and cost-based tax incentives, driving their tax rates down. On the other hand, governments decry these multinational enterprises once they have been successfully attracted to the country for not paying their fair share of corporate taxes, leaving the burden to fall on often-struggling local firms.

The idea of a minimum tax rate is not new. At the local level countries have been using modern forms of minimum taxation since at least the 1960s, taxing businesses on income generated based on activity undertaken within their territory. The goal of this “local” (domestic) minimum taxation is to prevent erosion of the tax base from the excessive use of what is known as “tax preferences.” These tax preferences take the form of credits, deductions, special exemptions, and allowances and usually result in a reduction in the amount of tax a corporation owes. By instituting a corporate minimum tax rate, governments guarantee a floor on the businesses’ contribution to the public purse.

Minimum taxes are typically computed using an alternative simplified tax base that avoids the complexities of the standard corporate tax base. They are often based on turnover (gross income or receipts) or assets (net or gross). A third alternative uses modified definitions for corporate income that explicitly limit the number of deductions and exemptions allowed.

Using a new database of minimum corporate tax regimes worldwide, we show how minimum taxes have grown in popularity over the past few decades. Turnover-based minimum taxes are the most prevalent and tend to be found in countries with higher statutory corporate tax rates (the rate imposed by law). Countries that levy a minimum tax also tend to report higher corporate tax revenue as a share of GDP.

Foreign Tax Credit

The foreign tax credit is a non-refundable tax credit for income taxes paid to a foreign government as a result of foreign income tax withholdings. The foreign tax credit is available to anyone who either works in a foreign country or has investment income from a foreign source.

The foreign tax credit is a tax break provided by the government to reduce the tax liability of certain taxpayers. A tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from their taxable income, and it reduces the total tax bill of an individual dollar to dollar.

Companies outsource to avoid certain types of costs. Among the reasons companies elect to outsource include avoidance of burdensome regulations, high taxes, high energy costs, and unreasonable costs that may be associated with defined benefits in labour union contracts and taxes for government mandated benefits. Perceived or actual gross margin in the short run incentivizes a company to outsource. With reduced short run costs, executive management sees the opportunity for short run profits while the income growth of the consumers base is strained. This motivates companies to outsource for lower labor costs. However, the company may or may not incur unexpected costs to train these overseas workers. Lower regulatory costs are an addition to companies saving money when outsourcing.

Import marketers may make short run profits from cheaper overseas labour and currency mainly in wealth consuming sectors at the long run expense of an economy’s wealth producing sectors straining the home county’s tax base, income growth, and increasing the debt burden. When companies’ offshore products and services, those jobs may leave the home country for foreign countries at the expense of the wealth producing sectors. Outsourcing may increase the risk of leakage and reduce confidentiality, as well as introduce additional privacy and security concerns.

“Offshoring” is a company’s relocation of a business process from one country to another. This typically involves an operational process, such as manufacturing, or a supporting process, such as accounting. Even state governments employ offshoring. More recently, offshoring has been associated primarily with the sourcing of technical and administrative services that support both domestic and global operations conducted outside a given home country by means of internal (captive) or external (Outsourcing) delivery models. The subject of offshoring, also known as “outsourcing,” has produced considerable controversy in the United States. Offshoring for U.S. companies can result in large tax breaks and low-cost labour.

International project appraisal also known by a variety of names such as internal company analysis, profiling the organization, capability or resource audit position and strategic advantage analysis, is the process of evaluating a company’s posture relative to its business competition within and outside the country, overall performance and its capability in terms of strengths and weaknesses.

Significance of International Project Appraisal

1. The organization’s deficiency should also be compared with those of its successful competitors. Such perceptive self-appraisal when matched with environmental analysis facilities management to grasp the opportunities and combat the threats inherent in the environment.
2. International project appraisal has such a vital significance in international corporate planning. Without such am-exercise it will not be possible to formulate economic strategy for an organization on the objective basis.
3. It helps the management in choosing the most suitable niche for the organization.
4. Economic opportunities may bound in different parts of the globe.
5. Position audit of the organization highlights its distinctive capabilities on which empire of foreign business can be gainfully built. It also enables management to formulate suitable competitive strategy.
6. It focuses sharply on the areas where it is strong and can operate most effectively. With, this kind analysis the management can decide on the type of business, company should engage in a country and what business abandon.
7. It provides an insight into the weakness of the organization, through this way the management can take steps to remove the weaknesses of the organization in the long run.

Steps in International Project Appraisal

With the intention of developing the strategic advantage profile of an organization the management should first collect information from external or internal sources both from formal as well as informal channels and then interpret as well as informal channels and then interpret them incisively to determine its strengths and weaknesses. The following steps involved in international project appraisal.

1. Identifying strategic factors: The first step in the process of corporate analysis is the identification of all those factors which are crucial to the success of an international organization. These factors may relate to different aspects of the organization. These factors could conveniently be found in different functional areas such as marketing and finance personal, research and development.
2. Determining the importance of factors: After identifying crucial factors for corporate appraisal the management will have to determine the importance of each of these factors. Since all the factors may not be of equal value to the organization for accomplishing its purpose, it will be very necessary to attach due importance to them.
3. Determining strengths and weaknesses: Once the relative significance of different factors has been assessed the management should then attempt to determine the position of the organization in each of these factors. Normally the strengths and weakness of a firm can be assessed by with the firm’s own past results, comparing with accomplishment of competitors and also by comparing with what they ought to be.
4. Constructing strategic advantage profile of a firm: After weighing the significance of each factor for the company in its environment, the management compiles a strategic advantage profile for the firm and compares it with profiles successful competitors of the potential of host countries to develop a pattern of the firms’ strengths and weaknesses relative to its present and proposed product market strategy.

International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries, or the international aspects of an individual country’s tax laws as the case may be. Governments usually limit the scope of their income taxation in some manner territorially or provide for offsets to taxation relating to extraterritorial income. The manner of limitation generally takes the form of a territorial, residence-based, or exclusionary system. Some governments have attempted to mitigate the differing limitations of each of these three broad systems by enacting a hybrid system with characteristics of two or more.

Many governments tax individuals and/or enterprises on income. Such systems of taxation vary widely, and there are no broad general rules. These variations create the potential for double taxation (where the same income is taxed by different countries) and no taxation (where income is not taxed by any country). Income tax systems may impose tax on local income only or on worldwide income. Generally, where worldwide income is taxed, reductions of tax or foreign credits are provided for taxes paid to other jurisdictions. Limits are almost universally imposed on such credits. Multinational corporations usually employ international tax specialists, a specialty among both lawyers and accountants, to decrease their worldwide tax liabilities.

With any system of taxation, it is possible to shift or recharacterize income in a manner that reduces taxation. Jurisdictions often impose rules relating to shifting income among commonly controlled parties, often referred to as transfer pricing rules. Residency-based systems are subject to taxpayer attempts to defer recognition of income through use of related parties. A few jurisdictions impose rules limiting such deferral (“anti-deferral” regimes). Deferral is also specifically authorized by some governments for particular social purposes or other grounds. Agreements among governments (treaties) often attempt to determine who should be entitled to tax what. Most tax treaties provide for at least a skeleton mechanism for resolution of disputes between the parties.

Systems of taxation vary among governments, making generalization difficult. Specifics are intended as examples, and relate to particular governments and not broadly recognized multinational rules. Taxes may be levied on varying measures of income, including but not limited to net income under local accounting concepts (in many countries this is referred to as ‘profit’), gross receipts, gross margins (sales less costs of sale), or specific categories of receipts less specific categories of reductions. Unless otherwise specified, the term “income” should be read broadly.

Jurisdictions often impose different income-based levies on enterprises than on individuals. Entities are often taxed in a unified manner on all types of income while individuals are taxed in differing manners depending on the nature or source of the income. Many jurisdictions impose tax at both an entity level and at the owner level on one or more types of enterprises. These jurisdictions often rely on the company law of that jurisdiction or other jurisdictions in determining whether an entity’s owners are to be taxed directly on the entity income. However, there are notable exceptions, including U.S. rules characterizing entities independently of legal form.

In order to simplify administration or for other agendas, some governments have imposed “Deemed” income regimes. These regimes tax some class of taxpayers according to tax system applicable to other taxpayers but based on a deemed level of income, as if received by the taxpayer. Disputes can arise regarding what levy is proper. Procedures for dispute resolution vary widely and enforcement issues are far more complicated in the international arena. The ultimate dispute resolution for a taxpayer is to leave the jurisdiction, taking all property that could be seized. For governments, the ultimate resolution may be confiscation of property, incarceration or dissolution of the entity.

Other major conceptual differences can exist between tax systems. These include, but are not limited to, assessment vs. self-assessment means of determining and collecting tax; methods of imposing sanctions for violation; sanctions unique to international aspects of the system; mechanisms for enforcement and collection of tax; and reporting mechanisms.

Taxation systems

Countries that tax income generally use one of two systems: territorial or residence-based. In the territorial system, only local income from a source inside the country is taxed. In the residence-based system, residents of the country are taxed on their worldwide (local and foreign) income, while nonresidents are taxed only on their local income. In addition, a small number of countries also tax the worldwide income of their non-resident citizens in some cases.

Countries with a residence-based system of taxation usually allow deductions or credits for the tax that residents already pay to other countries on their foreign income. Many countries also sign tax treaties with each other to eliminate or reduce double taxation. In the case of corporate income tax, some countries allow an exclusion or deferment of specific items of foreign income from the base of taxation.

Individuals

The following table summarizes the taxation of local and foreign income of individuals, depending on their residence or citizenship in the country. It includes 244 entries: 194 sovereign countries, their 40 inhabited dependent territories (most of which have separate tax systems), and 10 countries with limited recognition. In the table, income includes any type of income received by individuals, such as work or investment income, and yes means that the country taxes at least one of these types.

Source of income

Determining the source of income is of critical importance in a territorial system, as source often determines whether or not the income is taxed. For example, Hong Kong does not tax residents on dividend income received from a non-Hong Kong corporation. Source of income is also important in residency systems that grant credits for taxes of other jurisdictions. Such credit is often limited either by jurisdiction or to the local tax on overall income from other jurisdictions.

Source of income is where the income is considered to arise under the relevant tax system. The manner of determining the source of income is generally dependent on the nature of income. Income from the performance of services (e.g., wages) is generally treated as arising where the services are performed. Financing income (e.g., interest, dividends) is generally treated as arising where the user of the financing resides. Income related to use of tangible property (e.g., rents) is generally treated as arising where the property is situated. Income related to use of intangible property (e.g., royalties) is generally treated as arising where the property is used. Gains on sale of realty are generally treated as arising where the property is situated.

Gains from sale of tangible personal property are sourced differently in different jurisdictions. The U.S. treats such gains in three distinct manners:

a) Gain from sale of purchased inventory is sourced based on where title to the goods passes.

b) Gain from sale of inventory produced by the person (or certain related persons) is sourced 50% based on title passage and 50% based on location of production and certain assets.

c) Other gains are sourced based on the residence of the seller.

In specific cases, the tax system may diverge for different categories of individuals. U.S. citizen and resident alien decedents are subject to estate tax on all of their assets, wherever situated. The non-resident aliens are subject to estate tax only on that part of the gross estate which at the time of death is situated in the U.S. Another significant distinction between U.S. citizens/RAs and NRAs is in the exemptions allowed in computing the tax liability.

Where differing characterizations of an item of income can result in differing tax results, it is necessary to determine the characterization. Some systems have rules for resolving characterization issues, but in many cases, resolution requires judicial intervention. Note that some systems which allow a credit for foreign taxes source income by reference to foreign law.

Income

Some jurisdictions tax net income as determined under financial accounting concepts of that jurisdiction, with few, if any, modifications. Other jurisdictions determine taxable income without regard to income reported in financial statements. Some jurisdictions compute taxable income by reference to financial statement income with specific categories of adjustments, which can be significant.

A jurisdiction relying on financial statement income tends to place reliance on the judgment of local accountants for determinations of income under locally accepted accounting principles. Often such jurisdictions have a requirement that financial statements be audited by registered accountants who must opine thereon. Some jurisdictions extend the audit requirements to include opining on such tax issues as transfer pricing. Jurisdictions not relying on financial statement income must attempt to define principles of income and expense recognition, asset cost recovery, matching, and other concepts within the tax law. These definitional issues can become very complex. Some jurisdictions following this approach also require business taxpayers to provide a reconciliation of financial statement and taxable incomes.

Deductions

Systems that allow a tax deduction of expenses in computing taxable income must provide for rules for allocating such expenses between classes of income. Such classes may be taxable versus non-taxable, or may relate to computations of credits for taxes of other systems (foreign taxes). A system which does not provide such rules is subject to manipulation by potential taxpayers. The manner of allocation of expenses varies, rules provide for allocation of an expense to a class of income if the expense directly relates to such class, and apportionment of an expense related to multiple classes. Specific rules are provided for certain categories of more fungible expenses, such as interest. By their nature, rules for allocation and apportionment of expenses may become complex. They may incorporate cost accounting or branch accounting principles, or may define new principles.

Thin capitalization

Most jurisdictions provide that taxable income may be reduced by amounts expended as interest on loans. By contrast, most do not provide tax relief for distributions to owners. Thus, an enterprise is motivated to finance its subsidiary enterprises through loans rather than capital. Many jurisdictions have adopted “Thin Capitalization” rules to limit such charges. Various approaches include limiting deductibility of interest expense to a portion of cash flow, disallowing interest expense on debt in excess of a certain ratio, and other mechanisms.

Enterprise restructure

The organization or reorganization of portions of a multinational enterprise often gives rise to events that, absent rules to the contrary, may be taxable in a particular system. Most systems contain rules preventing recognition of income or loss from certain types of such events. In the simplest form, contribution of business assets to a subsidiary enterprise may, in certain circumstances, be treated as a nontaxable event. Rules on structuring and restructuring tend to be highly complex.

A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financial instrument.

Real options valuation, also often termed real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right but not the obligation to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, real options valuation could examine the opportunity to invest in the expansion of a firm’s factory and the alternative option to sell the factory.

Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security.[5] A further distinction is that option holders here, i.e. management, can directly influence the value of the option’s underlying project; whereas this is not a consideration as regards the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management also have to create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task. Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.

Real options differ thus from financial options contracts since they involve real (i.e. physical) “underlying” assets and are not exchangeable as securities.

Options relating to project size

Where the project’s scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.

• Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce at higher rate if needed. Management then has the option (but not the obligation) to expand; i.e. exercise the option should conditions turn out to be favourable. A project with the option to expand will cost more to establish, the excess being the option premium, but is worth more than the same without the possibility of expansion. This is equivalent to a call option.
• Option to contract: The project is engineered such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future expenditures constitutes option exercise. This is the equivalent to a put option, and again, the excess upfront expenditure is the option premium.
• Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and off. Management may shut down part or all of the operation when conditions are unfavorable (a put option), and may restart operations when conditions improve (a call option). A flexible manufacturing system (FMS) is a good example of this type of option. This option is also known as a Switching option.

Options relating to project life and timing

Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant projects is valuable, and constitutes optionality. Growth options are perhaps the most generic in this category these entail the option to exercise only those projects that appear to be profitable at the time of initiation.

• Initiation or deferment options: Here management has flexibility as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an American styled call option.
• Delay option with a product patent: A firm with a patent right on a product has a right to develop and market the product exclusively until the expiration of the patent. The firm will market and develop the product only if the present value of the expected cash flows from the product sales exceeds the cost of development. If this does not occur, the firm can shelve the patent and not incur any further costs.
• Option to abandon: Management may have the option to cease a project during its life, and, possibly, to realize its salvage value. Here, when the present value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the exercising of a put option. This option is also known as a Termination option. Abandonment options are American styled.
• Sequencing options: This option is related to the initiation option above, although entails flexibility as to the timing of more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these sequentially or in parallel. Here, observing the outcomes relating to the first project, the firm can resolve some of the uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the development of the other projects. If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy. Related here is also the notion of Intraproject vs. Interproject options.
• Option to prototype: New energy generation and storage systems are continuously being developed due to climate change, resource scarcity, and environmental laws. Some systems are incremental innovations of existing systems while others are radical innovations. Radical innovation systems are risky investments due to their relevant technical and economic uncertainties. Prototyping can hedge these risks by spending a fraction of the cost of a full-scale system and in return receiving economic and technical information regarding the system. In economic terms, prototyping is an option to hedge risk coming at a cost that needs to be properly assessed.

Options relating to Project operation

Management may have flexibility relating to the product produced and /or the process used in manufacture. This flexibility constitutes optionality.

• Output mix options: The option to produce different outputs from the same facility is known as an output mix option or product flexibility. These options are particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good are typically low, and management would wish to change to a different product quickly if required.
• Input mix options: An input mix option process flexibility allows management to use different inputs to produce the same output as appropriate. For example, a farmer will value the option to switch between various feed sources, preferring to use the cheapest acceptable alternative. An electric utility, for example, may have the option to switch between various fuel sources to produce electricity, and therefore a flexible plant, although more expensive may actually be more valuable.
• Operating scale options: Management may have the option to change the output rate per unit of time or to change the total length of production run time, for example in response to market conditions. These options are also known as Intensity options.

International project appraisal also known by a variety of names such as internal company analysis, profiling the organization, capability or resource audit position and strategic advantage analysis, is the process of evaluating a company’s posture relative to its business competition within and outside the country, overall performance and its capability in terms of strengths and weaknesses.

Non-DCF Techniques

Payback period and Accounting Rate of Return are the two techniques of project appraisal belonging to the non-DCF group. Under the payback period, an effort is made to determine the period it will take to recover the initial investment in the project.

DCF Techniques

Net Present Value (NPV) and the Internal Rate of Return (IRR) are the two popular DCF methods.

Steps in International Project Appraisal

With the intention of developing the strategic advantage profile of an organization the management should first collect information from external or internal sources both from formal as well as informal channels and then interpret as well as informal channels and then interpret them incisively to determine its strengths and weaknesses. The following steps involved in international project appraisal.

• Identifying strategic factors: The first step in the process of corporate analysis is the identification of all those factors which are crucial to the success of an international organization. These factors may relate to different aspects of the organization. These factors could conveniently be found in different functional areas such as marketing and finance personal, research and development.
• Determining the importance of factors: After identifying crucial factors for corporate appraisal the management will have to determine the importance of each of these factors. Since all the factors may not be of equal value to the organization for accomplishing its purpose, it will be very necessary to attach due importance to them.
• Determining strengths and weaknesses: Once the relative significance of different factors has been assessed the management should then attempt to determine the position of the organization in each of these factors. Normally the strengths and weakness of a firm can be assessed by with the firm’s own past results, comparing with accomplishment of competitors and also by comparing with what they ought to be.
• Constructing strategic advantage profile of a firm: After weighing the significance of each factor for the company in its environment, the management compiles a strategic advantage profile for the firm and compares it with profiles successful competitors of the potential of host countries to develop a pattern of the firms’ strengths and weaknesses relative to its present and proposed product market strategy.

Significance of International Project Appraisal

• The organization’s deficiency should also be compared with those of its successful competitors. Such perceptive self-appraisal when matched with environmental analysis facilities management to grasp the opportunities and combat the threats inherent in the environment.
• International project appraisal has such a vital significance in international corporate planning. Without such am-exercise it will not be possible to formulate economic strategy for an organization on the objective basis.
• It helps the management in choosing the most suitable niche for the organization.
• Economic opportunities may bound in different parts of the globe.
• Position audit of the organization highlights its distinctive capabilities on which empire of foreign business can be gainfully built. It also enables management to formulate suitable competitive strategy.
• It focuses sharply on the areas where it is strong and can operate most effectively. With this kind analysis the management can decide on the type of business, company should engage in a country and what business abandon.
• It provides an insight into the weakness of the organization; through this way the management can take steps to remove the weaknesses of the organization in the long run.