Tag: International Finance Mumbai University BMS Notes

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.

Activity	Day
Trading	Rolling Settlement Trading	T
Clearing	Custodial Confirmation	T+1 working days
	Delivery Generation	T+1 working days
Settlement	Securities and Funds pay in	T+2 working days
	Securities and Funds pay out	T+2 working days
	Valuation Debit	T+2 working days
Post Settlement	Auction	T+2 working days
	Auction settlement	T+3 working days
	Bad Delivery Reporting	T+4 working days
	Rectified bad delivery pay-in and pay-out	T+6 working days
	Re-bad delivery reporting and pickup	T+8 working days
	Close out of re-bad delivery and funds pay-in & pay-out	T+9 working days

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:

Activity	Day
Trading	Rolling Settlement Trading	T
Clearing	Custodial Confirmation	T+1 working days
	Delivery Generation	T+1 working days
Settlement	Securities and Funds pay in	T+2 working days
	Securities and Funds pay out	T+2 working days
Post Settlement	Assigning of shortages for close out	T+2 working days
	Reporting and pick-up of bad delivery	T+4 working days
	Close out of shortages	T+4 working days
	Replacement of bad delivery	T+6 working days
	Reporting of re-bad and pick-up	T+8 working days
	Close out of re-bad delivery	T+9 working days

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.

Trading is the exchange of goods or services between two or more parties. So if you need gasoline for your car, then you would trade your dollars for gasoline. In the old days, and still in some societies, trading was done by barter, where one commodity was swapped for another.

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the domestic currency of the consolidated entity.

Investors and businesses exporting or importing goods and services, or making foreign investments, have an exchange-rate risk but can take steps to manage (i.e. reduce) the risk.

A trade may have gone like this: Person A will fix Person B’s broken window in exchange for a basket of apples from Person B’s tree. This is a practical, easy to manage, day-to-day example of making a trade, with relatively easy management of risk. In order to lessen the risk, Person A might ask Person B to show his apples, to make sure they are good to eat, before fixing the window. This is how trading has been for millennia: a practical, thoughtful human process.

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies.

Types of Foreign Exchange Risk

Transaction risk

Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.

For example, a Canadian company with operations in China is looking to transfer CNY600 in earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would instead of CAD86 (CNY600/7).

Economic risk

Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.

Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country. Macroeconomic conditions include exchange rates, government regulations, and political stability. When financing an investment or a project, a company’s operating costs, debt obligations, and the ability to predict economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those economic risks. For instance, when an American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company’s ability to operate the plant, such as changing laws or even seizing the plant, or to otherwise make it difficult for the American company to move its profits out of Spain. As a result, all possible risks that outweigh an investment’s profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment. Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods.

International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds. However, economic risk can also create opportunities and profits for investors globally. When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries. Investors should always be aware of possible changes by the foreign regulatory authorities. Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries. For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.

When making a comprehensive economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment. In a macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations, and commodity-price and stock-market fluctuations. It is equally critical to identify the stability of the economic system. Before initiating an investment, a firm should consider the stability of the investing sector that influences the exchange-rate changes. For instance, a service sector is less likely to have inventory swings and exchange-rate changes as compared to a large consumer sector.

Translation risk

Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.

For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance which is in Chinese yuan is translated into Canadian dollar for reporting purposes.

Contingent risk

A firm has contingent risk when bidding for foreign projects, negotiating other contracts, or handling direct foreign investments. Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign-exchange risk contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that, if accepted, would result in an immediate receivable. While waiting, the firm faces a contingent risk from the uncertainty as to whether or not that receivable will accrue.

Managing risk

Transaction hedging

Firms with exposure to foreign-exchange risk may use a number of hedging strategies to reduce that risk. Transaction exposure can be reduced either with the use of money markets, foreign exchange derivatives such as forward contracts, options, futures contracts, and swaps or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting. Each hedging strategy comes with its own benefits that may make it more suitable than another, based on the nature of the business and risks it may encounter.

Forward and futures contracts serve similar purposes: they both allow transactions that take place in the future for a specified price at a specified rate that offset otherwise adverse exchange fluctuations. Forward contracts are more flexible, to an extent, because they can be customized to specific transactions, whereas futures come in standard amounts and are based on certain commodities or assets, such as other currencies. Because futures are only available for certain currencies and time periods, they cannot entirely mitigate risk, because there is always the chance that exchange rates will move in your favor. However, the standardization of futures can be a part of what makes them attractive to some: they are well-regulated and are traded only on exchanges.

Two popular and inexpensive methods companies can use to minimize potential losses is hedging with options and forward contracts. If a company decides to purchase an option, it is able to set a rate that is “At-worst” for the transaction. If the option expires and it’s out-of-the-money, the company is able to execute the transaction in the open market at a favorable rate. If a company decides to take out a forward contract, it will set a specific currency rate for a set date in the future.

Currency invoicing refers to the practice of invoicing transactions in the currency that benefits the firm. It is important to note that this does not necessarily eliminate foreign exchange risk, but rather moves its burden from one party to another. A firm can invoice its imports from another country in its home currency, which would move the risk to the exporter and away from itself. This technique may not be as simple as it sounds; if the exporter’s currency is more volatile than that of the importer, the firm would want to avoid invoicing in that currency. If both the importer and exporter want to avoid using their own currencies, it is also fairly common to conduct the exchange using a third, more stable currency.

If a firm looks to leading and lagging as a hedge, it must exercise extreme caution. Leading and lagging refer to the movement of cash inflows or outflows either forward or backward in time. For example, if a firm must pay a large sum in three months but is also set to receive a similar amount from another order, it might move the date of receipt of the sum to coincide with the payment. This delay would be termed lagging. If the receipt date were moved sooner, this would be termed leading the payment.

Another method to reduce exposure transaction risk is natural hedging (or netting foreign-exchange exposures), which is an efficient form of hedging because it will reduce the margin that is taken by banks when businesses exchange currencies; and it is a form of hedging that is easy to understand. To enforce the netting, there will be a systematic-approach requirement, as well as a real-time look at exposure and a platform for initiating the process, which, along with the foreign cash flow uncertainty, can make the procedure seem more difficult. Having a back-up plan, such as foreign-currency accounts, will be helpful in this process. The companies that deal with inflows and outflows in the same currency will experience efficiencies and a reduction in risk by calculating the net of the inflows and outflows, and using foreign-currency account balances that will pay in part for some or all of the exposure.

Translation Hedging

Translation exposure is largely dependent on the translation methods required by accounting standards of the home country. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods. Firms can manage translation exposure by performing a balance sheet hedge, since translation exposure arises from discrepancies between net assets and net liabilities solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure.

A common technique to hedge translation risk is called balance-sheet hedging, which involves speculating on the forward market in hopes that a cash profit will be realized to offset a non-cash loss from translation. This requires an equal amount of exposed foreign currency assets and liabilities on the firm’s consolidated balance sheet. If this is achieved for each foreign currency, the net translation exposure will be zero. A change in the exchange rates will change the value of exposed liabilities to an equal degree but opposite to the change in the value of exposed assets.

Companies can also attempt to hedge translation risk by purchasing currency swaps or futures contracts. Companies can also request clients to pay in the company’s domestic currency, whereby the risk is transferred to the client.

Strategies other than financial hedging

Firms may adopt strategies other than financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of less foreign-exchange risk exposure.

By putting more effort into researching alternative methods for production and development, it is possible that a firm may discover more ways to produce their outputs locally rather than relying on export sources that would expose them to the foreign exchange risk. By paying attention to currency fluctuations around the world, firms can advantageously relocate their production to other countries. For this strategy to be effective, the new site must have lower production costs. There are many factors a firm must consider before relocating, such as a foreign nation’s political and economic stability.

An international portfolio is a selection of stocks and other assets that focuses on foreign markets rather than domestic ones. If well designed, an international portfolio gives the investor exposure to emerging and developed markets and provides diversification.

An international portfolio appeals to investors who want to diversify their assets by moving away from a domestic-only portfolio. This type of portfolio can carry increased risks due to potential economic and political instability in some emerging markets, There also is the risk that a foreign market’s currency will slip in value against the U.S. dollar.

Over the recent past, the growth of the economies of China and India greatly exceeded those of the U.S. That created a rush to invest in the stocks of those countries. Both are still growing fast, but an investor in the stocks of either nation now would have to do some research to find stocks that have not already seen their best days.

The search for new fast-growing countries has led to some winners and losers. Not long ago, investors going for fast growth were looking to the CIVETS nations. They were Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa. Not all of those countries would still be on any investor’s list of promising economies.

Advantages

Diversifies Currency Exposure: When investors buy stocks for an international portfolio, they are also effectively buying the currencies in which the stocks are quoted. For example, if an investor purchases a stock that is listed on the London Stock Exchange, the value of that stock may rise and fall with the British pound. If the U.S. dollar falls, the investor’s international portfolio helps to neutralize currency fluctuations.

International credit: Investors may be able to access an increased amount of credit in foreign countries, allowing the investor to utilize more leverage and generate a higher return on their equity investment.

May Reduce Risk: Having an international portfolio can be used to reduce investment risk. If U.S. stocks underperform, gains in the investor’s international holdings can smooth out returns. For example, an investor may split a portfolio evenly between foreign and domestic holdings. The domestic portfolio may decline by 10% while the international portfolio could advance 20%, leaving the investor with an overall net return of 10%. Risk can be reduced further by holding a selection of stocks from developed and emerging markets in the international portfolio.

Market Cycle Timing: An investor with an international portfolio can take advantage of the market cycles of different nations. For instance, an investor may believe U.S. stocks and the U.S. dollar are overvalued and may look for investment opportunities in developing regions, such as Latin America and Asia, that are believed to benefit from capital inflow and demand for commodities.

Limitations

Increased Transaction Costs: Investors typically pay more in commission and brokerage charges when they buy and sell international stocks, which reduces their overall returns. Taxes, stamp duties, levies, and exchange fees may also need to be paid, which dilute gains further. Many of these costs can be significantly reduced or eliminated by gaining exposure to an international portfolio using ETFs or mutual funds.

Political and Economic Risk: Many developing countries do not have the same level of political and economic stability that the United States does. This increases risk to a level that many investors don’t feel they can tolerate. For example, a political coup in a developing country may result in its stock market declining by 40%.

Manipulation of Security Prices: Government and powerful brokers can influence the security prices. Governments can heavily influence the prices by modifying their monetary and fiscal policies. Moreover, public sector institutions and banks swallow a big share of securities traded on stock exchanges.

Unequal Access to Information: Wide cross-cultural differences may be a barrier to GPM. It is difficult to disseminate and acquire the information by the international investors beforehand. If information is tough to obtain, it is difficult to act rationally and in a prudent manner.

Floating Exchange Rate System:

Floating exchange rates are neither characterized by par values, nor by official exchange rates. This allows complete flexibility of exchange rates unlike the rigidity of currency movements under the fixed rate system.

Independently floating:

Under the ‘independent’ or ‘free’ float, the exchange rates are market-determined and central banks intervene only to moderate the speed of change or to prevent excessive fluctuations without any attempt to maintain it or drive it to a particular level.

About 35 countries, including the US, the UK, Japan, Switzerland, Germany, France, New Zealand, Mexico, Australia, Canada, and Brazil have adopted independently floating exchange rate regimes.

Managed float with no pre-determined path for the exchange rate:

Although currencies are allowed to fluctuate on a daily basis with no official boundaries, national governments may and sometimes do intervene so as to prevent their currencies from moving too far in a certain direction.

Such a system is known as ‘managed’ or ‘dirty’ float contrary to ‘free’ or ‘clean’ float wherein currencies are allowed to move freely without government intervention. Such exchange rate arrangements prevail in about 48 countries, including India, Singapore, the Russian Federation, Malaysia, Kenya, Thailand, Indonesia, Tanzania, Bangladesh, and Mauritius.

The managed float system is criticized on the ground that it allows governments to manipulate exchange rates for the benefit of their countries at the expense of others. For instance, a government may weaken its currency to attract foreign demand with an objective to stimulate its stagnant economy.

Pegged Exchange Rate System:

Pegging value of home currency to a foreign currency or a basket of currencies is known as pegged exchange rate system. Although the home currency value is fixed in terms of a foreign currency or unit of account to which it is pegged, it is allowed to move in line with that currency against other currencies. IMF classifies pegging exchange rate system as soft and hard pegs.

Soft pegs:

Conventional fixed peg:

The currency fluctuates for at least three months within a band of less than 2 per cent or ±1 per cent against another currency or a basket of currencies. The basket of currencies is formed from the geographical distribution of trade, services, or capital flows.

The monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via sales or purchase of foreign exchange in the market) or indirect intervention (i.e., via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or through intervention by other public institutions).

About 70 countries follow the conventional fixed peg arrangements, out of which 63 countries are pegged against a single currency whereas seven countries are pegged against other currency composites. The United Arab Emirates, Saudi Arabia, Qatar, Argentina, Egypt, Ethiopia, Kuwait, Oman, Syria, Venezuela, Vietnam, and Zimbabwe are among the 40 countries that peg their currencies to the US dollar.

The currencies of 19 countries, including Senegal, Niger, Gabon, Cameroon, and Malta, are pegged to the euro. Nepal and Bhutan peg their currencies to the Indian rupee, whereas the currencies of Swaziland, Namibia, and Lesotho are pegged to the South African Rand. Fiji, Iran, Morocco, Samoa, Seychelles, and Vanuatu peg their currencies against other currency composites.

Intermediate pegs:

Pegs within horizontal bands:

Currencies are generally not allowed to fluctuate beyond ±1 per cent of the central parity. Denmark, Slovak Republic, and Cyprus follow such an exchange rate system within a cooperative arrangement, whereas Hungary and Tonga adopt other band arrangements.

Crawling peg:

Under the crawling peg system, a currency is pegged to a single currency or a basket of currencies, but the peg is periodically adjusted with a range of less than 2 per cent in response to changes in selective micro-economic indicators, such as inflation differentials vis-a-vis major trading partners.

Maintaining a crawling peg imposes constraints on the monetary policy in a manner similar to a fixed peg system. China is among the six countries following such an exchange rate system, apart from Botswana, Azerbaijan, Iraq, Nicaragua, and Sierra Leone.

Crawling bands:

The currency is adjusted periodically at a fixed rate or in response to changes in selective quantitative macroeconomic indicators, with a range of fluctuation of 2 per cent or more. The degree of exchange rate flexibility is a function of the bandwidth.

The commitment to maintain the exchange rate within the band imposes constraints on monetary policy making, with the degree of policy independence being a function of the bandwidth. Costa Rica is the only country following the crawling bands exchange rate system.

Hard pegs:

Currency board arrangements:

Currency board arrangements refer to a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It combines restrictions on the issuing authority to ensure the fulfilment of its legal obligations.

The board must maintain foreign currency reserves for all the currency that it has printed. A currency board facilitates the stabilization of a country’s currency and maintains the confidence of foreign investors. About 13 countries have such arrangements. For instance, Hong Kong SAR, Djibouti, and Dominica have such an arrangement with the US dollar.

The currency board of a country maintains a reserve of the US dollar for every unit of home currency circulated. Bulgaria, Estonia, Lithuania, and Bosnia have such arrangements with euro, and Brunei Darussalam with Singapore dollars. Since 1983, Hong Kong has tied the value of the Hong Kong dollar with the US dollar.

Arrangements with no separate legal tender:

Replacement of a country’s local currency with US dollars is termed as ‘dollarization’. It may be formal or informal. Under this regime, the currency of another country circulates as the sole legal tender (formal dollarization) or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

Adopting such an exchange rate regime implies the complete surrender of the monetary authority’s independent control over domestic policies. Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama, and Timor-Leste do not have their own separate legal tender, and instead use the US dollars, whereas the euro is used in Montenegro and San Marino, and the Australian dollar in Kiribati.

Consequent to the sharp depreciation of about 97 per cent in the Sucre, Ecuador’s currency, against the US dollar from 1990 to 2000, due to unstable trade conditions, high inflation, and volatile interest rates, Ecuador decided to replace its currency with the US dollar. As a result, dollarization showed positive effects as the economic growth increased and the inflation declined by November 2000.

The European Monetary System (EMS) was a multilateral adjustable exchange rate agreement in which most of the nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations in relative value. It was initiated in 1979 under then President of the European Commission Roy Jenkins as an agreement among the Member States of the EEC to foster monetary policy co-operation among their Central Banks for the purpose of managing inter-community exchange rates and financing exchange market interventions.

The European Monetary System (EMS) was an adjustable exchange rate arrangement set up in 1979 to foster closer monetary policy cooperation between members of the European Community (EC). The European Monetary System (EMS) was later succeeded by the European Economic and Monetary Union (EMU), which established a common currency, the euro.

The EMS functioned by adjusting nominal and real exchange rates, thus establishing closer monetary cooperation and creating a zone of monetary stability. As part of the EMS, the ECC established the first European Exchange Rate Mechanism (ERM) which calculated exchange rates for each currency and a European Currency Unit (ECU): an accounting currency unit that was a weighted average of the currencies of the 12 participating states. The ERM let exchange rates to fluctuate within fixed margins, allowing for some variation while limiting economic risks and maintaining liquidity.

The European Monetary System lasted from 1979 to 1999, when it was succeeded by the Economic and Monetary Union (EMU) and exchange rates for Eurozone countries were fixed against the new currency the Euro. The ERM was replaced at the same time with the current Exchange Rate Mechanism (ERM II).

History of the European Monetary System (EMS)

The early years of the EMS were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes in national interest rates were specifically used to keep all the currencies stable.

A new crisis for the EMS emerged in the early 1990s. Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the EMS in 1992. Britain’s withdrawal foreshadowed its later insistence on independence from continental Europe; Britain refused to join the eurozone, along with Sweden and Denmark.

During this time, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993, most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU created the European Monetary Institute, which became the European Central Bank (ECB) in 1998. The primary responsibility of the ECB was to institute a single monetary policy and interest rate.

At the end of 1998, the majority of EU nations simultaneouslyy cut their interest rates to promote economic growth and prepare for the implementation of the euro. In January 1999, a unified currency, the euro, was created; the euro is used by most EU member countries. The European Economic and Monetary Union (EMU) was also established, succeeding the EMS as the new name for the common monetary and economic policy organization of the EU.

Criticism of the European Monetary System (EMS)

Under the EMS, exchange rates could only be changed if both member countries and the European Commission were in agreement. This was an unprecedented move that attracted a lot of criticism.

In the aftermath of the global economic crisis of 2008-2009, significant tension between the principles of the EMS and the policies of national governments became evident.

Certain member states Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus pursued policies that created high national deficits. This phenomenon was later referred to as the European sovereign debt crisis. These countries could not resort to the devaluation of their currencies and were not allowed to spend to offset unemployment rates.

From the beginning, the European Monetary System (EMS) policy intentionally prohibited bailouts to ailing economies in the eurozone. Despite vocal resistance from EU members with stronger economies, the EMU finally established bailout measures to provide relief to struggling members.

Benefits of the European Monetary System

Working towards a single market

The EMS was considered an important step towards the establishment of the EU and the single market in Europe.

Ensuring currency stability

The EMS ensured currency stability in Europe during times of international market volatility.

Unity in Europe

The EMS promoted political and economic unity across Europe at a pivotal time in European history.

Drawbacks of the European Monetary System

Common monetary policy

The EMS promoted a common monetary policy; therefore, raising or decreasing interest rates affected all economies differently just like the exchange rate system.

Fixed exchange rates

Fixed exchange rates affected different members of the EMS in different ways, which were not beneficial to all economies. It became evident in the 1992 crisis.