TYBBI SEM 5: International Banking & Finance (Q.P. April 2025 with Solution)

 Paper/Subject Code: 44301/International Banking and Finance

TYBBI SEM 5: 

International Banking & Finance 

(Q.P. April 2025 with Solution)

Note: 1)All questions are compulsory.

2) Figures to the right indicate full marks

Q.1 A) Multiple Choice Questions (Any 8)

1) A deficit in the current account of the BoP means _________

a) The country is importing more than it is exporting

b) The country is receiving more investment from abroad than it is making

c) There is more money flowing into the country than out

d) There is a surplus in the capital account

2) The term "invisible trade" in the BoP refers to ________

a) Trade in goods

b) Trade in services, income, and transfers

c) Financial capital movements

d) Investment in physical assets

3) Offshore banks are typically located in _________

a) Countries with strict tax policies

b) Countries known as tax havens, such as the Cayman Islands and Switzerland

c) Developing countries

d) Countries with large populations

4) Foreign Portfolio Investment (FPI) typically involves __________

a) Direct ownership of physical assets

b) Investment in financial assets like stocks, bonds, and other securities

c) Building factories and infrastructure in a foreign country

d) Controlling management decisions in foreign companies

5) __________ is a major participant in the foreign exchange market.

a) Central banks

b) Retail investors

c) Real estate agents

d) Commodity traders

6) In the forex market, the term "bid price" refers to:

a) The price at which a dealer is willing to buy a currency 

b) The price at which a dealer is willing to sell a currency

c) The average price of a currency pair over time

d) The interest rate of foreign currency deposits

7) ________ is the primary goal of risk management.

a) Maximizing potential profits

b) Minimizing the impact of adverse events on financial performance

c) Eliminating all forms of business risk

d) Increasing volatility in financial markets

8) In an options contract, the right to buy an asset at a specific price before a certain date is called a _______

a) Put option

b) Call option

c) Swap

d) Forward contract

9) ________ is a common risk associated with cryptocurrency investments.

a) Guaranteed returns

b) Extreme price volatility

c) Government insurance protection

d) No fluctuation in value

10) _______ is a correspondent bank.

a) A bank that operates in multiple countries simultaneously

b) A foreign bank that provides services on behalf of another domestic bank in cross-border transactions

c) A bank that deals only in domestic currency transactions

d) A bank that offers retail services to international travelers

Q.1.B) State whether the following statements are True or False: (Any seven) (07)

1) Credit rating agencies only rate government bonds.

Ans: False

2) A Letter of Credit can only be used for international trade transactions.

Ans: False

3) The primary purpose of a forward contract is to hedge against price fluctuations in the underlying asset.

Ans: True

4) Translation risk is relevant to the income statement but not to the balance sheet.

Ans: False

5) FEDAI is a non-governmental organization that provides guidelines and standards for

Ans: True

foreign exchange dealings in India. 6) FEMA was enacted in India to replace the Foreign Exchange Regulation Act (FERA).

Ans: True

7) FCEBs are only issued by governments and not by private corporations.

Ans: False

8) American Depositary Receipts (ADRs) are a type of Depositary Receipt issued specifically for trading on U.S. exchanges.

Ans: True

9) Under a hard peg, the central bank has significant flexibility in adjusting monetary policy to respond to economic conditions.

Ans: False

10) A currency is considered fully convertible if it can be exchanged freely at market rates without restrictions or controls.

Ans: True

Q.2.a. Explain importance of international finance.            (08)

International finance plays a pivotal role in shaping the global economic landscape. It encompasses the financial interactions between countries, including foreign direct investment (FDI), international trade, exchange rates, and capital flows. Its importance stems from its ability to facilitate economic growth, provide access to diverse investment opportunities, mitigate risks, and foster global stability.

1. Facilitating International Trade and Investment:

International finance is the lifeblood of international trade and investment. It provides the mechanisms for businesses to conduct transactions across borders, manage currency risk, and access financing for international projects. Without international finance, companies would struggle to import and export goods and services, hindering economic growth and innovation.

• Trade Finance: International finance provides trade finance instruments such as letters of credit, export credit insurance, and factoring, which mitigate the risks associated with cross-border trade. These instruments enable businesses to engage in international trade with greater confidence, knowing that they will be paid for their goods and services.

• Foreign Direct Investment (FDI): FDI, a key component of international finance, involves companies investing directly in foreign countries by establishing subsidiaries, acquiring foreign companies, or engaging in joint ventures. FDI brings capital, technology, and expertise to host countries, boosting economic growth and creating jobs.

2. Promoting Economic Growth:

International finance contributes significantly to economic growth by facilitating the efficient allocation of capital across borders. Countries with limited domestic savings can attract foreign investment to finance infrastructure projects, develop industries, and create jobs.

• Capital Flows: International capital flows, including FDI, portfolio investment, and bank lending, enable capital to move from countries with surplus savings to countries with investment opportunities. This efficient allocation of capital boosts economic growth in recipient countries and generates returns for investors in source countries.

• Technology Transfer: FDI often involves the transfer of technology and know-how from developed countries to developing countries. This technology transfer can improve productivity, enhance competitiveness, and accelerate economic development.

3. Diversifying Investment Opportunities:

International finance provides investors with access to a wider range of investment opportunities than would be available in a purely domestic market. By investing in foreign assets, investors can diversify their portfolios, reduce risk, and potentially enhance returns.

• Global Equity Markets: International finance allows investors to invest in stocks listed on foreign stock exchanges. This provides access to companies in different industries and countries, diversifying portfolios and reducing exposure to domestic market risks.

• International Bonds: Investors can also invest in bonds issued by foreign governments and corporations. International bonds offer diversification benefits and can provide higher yields than domestic bonds.

4. Managing Currency Risk:

International finance provides tools and techniques for managing currency risk, which arises from fluctuations in exchange rates. Businesses and investors engaged in international transactions are exposed to currency risk, which can impact their profitability and investment returns.

• Hedging: International finance offers hedging instruments such as forward contracts, futures contracts, and options, which allow businesses and investors to lock in exchange rates and protect themselves from currency fluctuations.

• Currency Diversification: Holding assets in multiple currencies can also help to mitigate currency risk. By diversifying currency holdings, investors can reduce the impact of exchange rate movements on their overall portfolio.

5. Fostering Global Stability:

International finance plays a crucial role in maintaining global financial stability. International organizations such as the International Monetary Fund (IMF) and the World Bank work to promote financial stability by providing financial assistance to countries facing economic crises and by promoting sound macroeconomic policies.

• Crisis Management: The IMF provides financial assistance to countries facing balance of payments crises, helping them to stabilize their economies and avoid contagion to other countries.

• Surveillance: The IMF also conducts surveillance of member countries' economies, providing advice on macroeconomic policies and identifying potential risks to global financial stability.

6. Challenges and Risks:

While international finance offers numerous benefits, it also presents challenges and risks. These include:

• Volatility: International financial markets can be volatile, with rapid capital flows and exchange rate fluctuations. This volatility can create uncertainty for businesses and investors.

• Contagion: Financial crises in one country can quickly spread to other countries through international financial linkages. This contagion can have devastating consequences for the global economy.

• Regulatory Arbitrage: Differences in regulations across countries can create opportunities for regulatory arbitrage, where businesses exploit loopholes in regulations to avoid taxes or other obligations.

b. Explain advantages of foreign portfolio investment.        (07)

1. Diversification of Investments

One of the biggest advantages of FPI is diversification. By investing in stocks, bonds, and securities in different countries, investors spread their risk. If one country faces an economic slowdown, losses may be offset by gains in another market. This reduces overall portfolio risk.

2. Access to Higher Returns

Investors can take advantage of growth opportunities in emerging or fast-growing economies. For example, if interest rates or stock market returns are higher abroad compared to the investor’s home country, FPI allows them to benefit from those opportunities.

3. Liquidity and Flexibility

FPI involves financial assets like equities and bonds, which can be quickly bought and sold in international markets. This gives investors high liquidity, meaning they can easily enter or exit positions without long-term commitments.

4. No Management Responsibility

Unlike Foreign Direct Investment (FDI), FPI does not involve owning or managing companies or physical assets. Investors only purchase financial securities, so they are free from operational responsibilities, making FPI less complicated and less risky from a management standpoint.

5. Development of Host Country’s Financial Markets

When foreign investors buy stocks and bonds, they inject capital into the host country. This increases liquidity, deepens financial markets, and often leads to better transparency and governance in domestic companies.

6. Economic Growth for Host Country

Foreign portfolio inflows can help fund domestic companies, improve access to credit, and support infrastructure development. As a result, FPI contributes to the overall economic development of the host nation.

7. Exchange Rate Benefits

Investors can gain not only from returns on securities but also from favorable movements in foreign exchange rates. For instance, if the host country’s currency appreciates, the investor earns extra returns when converting back to their home currency.

8. Lower Entry Barriers

FPI is easier and faster to undertake compared to FDI. It usually requires less capital and fewer legal approvals, making it accessible to a larger pool of investors.

OR

Q.2.c.Explain meaning of GDR. Also explain parties involved in GDR.                (08)

A Global Depositary Receipt (GDR) is a financial instrument that allows companies to raise funds from international markets. It is a negotiable certificate issued by an overseas depository bank that represents ownership of a certain number of shares in a domestic company. These underlying shares are kept with a custodian bank in the company’s home country, while the GDRs themselves are issued and traded abroad.

GDRs are usually denominated in US dollars or euros and are listed on international stock exchanges such as the London Stock Exchange, Luxembourg Stock Exchange, or Singapore Exchange. They give foreign investors an easy way to invest in companies from other countries without the need to directly purchase shares in the company’s domestic stock market.

For the issuing company, GDRs are an important tool because they provide access to a larger pool of international investors, diversify sources of capital, and enhance the company’s global visibility and credibility.

Parties Involved in GDR

1. Issuing Company

   • This is the domestic company that needs to raise capital from global markets.

   • It issues shares in its home country, which are then deposited with a custodian bank.

   • The company benefits by gaining access to foreign investors and raising funds in hard currencies like USD or EUR.

2. Domestic Custodian Bank

   • A bank located in the home country of the issuing company.

   • It holds the original shares on behalf of the overseas depository bank.

   • Its role is to safeguard the underlying shares and ensure that the depository bank can issue GDRs based on them.

3. Overseas Depository Bank

   • A foreign bank (usually a large international bank) that actually issues the GDRs to investors in global markets.

   • It acts as an intermediary between investors and the custodian bank.

   • The depository bank is responsible for ensuring that GDR holders receive dividends, bonuses, or any corporate benefits declared by the issuing company.

4. Investors (Foreign Investors)

   • These can be individuals, institutional investors, or funds based in international markets.

   • They purchase GDRs on foreign stock exchanges.

   • Investors enjoy economic benefits such as dividends, though they often do not get direct voting rights in the issuing company.

d. Explain features of Bretton woods system.            (07)

The Bretton Woods System was established in July 1944 at a conference held in Bretton Woods, New Hampshire (USA), attended by 44 countries. The main aim was to create a stable international monetary order after World War II. It laid the foundation for modern international financial institutions like the International Monetary Fund (IMF) and the World Bank.

Features of the Bretton Woods System

The Bretton Woods system, established in 1944, was a landmark achievement in international monetary cooperation. It aimed to create a stable and predictable exchange rate regime, promote international trade, and foster economic growth in the post-war era. The system's key features can be summarized as follows:

1. Fixed Exchange Rates

At the heart of the Bretton Woods system was a commitment to fixed exchange rates. Each member country agreed to peg its currency to the US dollar, which, in turn, was convertible to gold at a fixed rate of $35 per ounce. This created a system of par values, where exchange rates between currencies were relatively stable and predictable.

The rationale behind fixed exchange rates was to reduce exchange rate volatility, which was seen as a major impediment to international trade and investment. By providing a stable currency environment, businesses could engage in cross-border transactions with greater confidence, fostering economic integration and growth.

2. The US Dollar as the Reserve Currency

The US dollar played a central role in the Bretton Woods system as the primary reserve currency. This meant that countries held US dollars as a significant portion of their foreign exchange reserves, and used them to settle international transactions. The dollar's convertibility to gold at a fixed rate provided a credible anchor for the entire system.

The dollar's dominance stemmed from the United States' economic strength and its large gold reserves at the time. The US economy emerged from World War II relatively unscathed, and its industrial capacity was unmatched. This made the dollar a natural choice as the world's reserve currency.

3. The International Monetary Fund (IMF)

The International Monetary Fund (IMF) was established as a key institution of the Bretton Woods system. Its primary purpose was to promote international monetary cooperation and provide financial assistance to countries facing balance of payments difficulties.

The IMF played a crucial role in maintaining the stability of the fixed exchange rate system. When a country experienced a temporary balance of payments deficit, it could borrow from the IMF to finance the deficit and maintain its currency's peg to the dollar. The IMF also provided technical assistance and surveillance to help countries manage their economies effectively.

4. The International Bank for Reconstruction and Development (IBRD)

Also known as the World Bank, the International Bank for Reconstruction and Development (IBRD) was another key institution created at Bretton Woods. Its initial focus was on providing financial assistance for the reconstruction of war-torn Europe and Japan.

Over time, the IBRD's mandate expanded to include promoting economic development in developing countries. It provides loans, grants, and technical assistance to support projects in areas such as infrastructure, education, and health.

5. Capital Controls

The Bretton Woods system allowed countries to impose capital controls, which are restrictions on the flow of capital across borders. This was seen as necessary to maintain the stability of the fixed exchange rate system.

Capital controls allowed countries to manage their balance of payments and prevent speculative capital flows from destabilizing their currencies. They also gave governments greater control over monetary policy, allowing them to pursue domestic economic objectives without being unduly constrained by external pressures.

6. Adjustable Peg System

While the Bretton Woods system was based on fixed exchange rates, it was not a rigid system. Countries were allowed to adjust their currency's peg to the dollar under certain circumstances, such as when they faced a fundamental disequilibrium in their balance of payments.

This flexibility, known as the adjustable peg system, was intended to provide a safety valve for countries facing persistent economic difficulties. However, it also created opportunities for speculation, as investors could anticipate currency devaluations and profit from them.

Q.3.a.Explain determinants of exchange rate.               (08)

1. Interest Rates

• Mechanism: Higher interest rates offer better returns on savings, bonds, and other investments. Investors from abroad move money into that country to capture higher yields. To do so, they exchange their currency for the local one, raising its demand.

• Example: If the U.S. raises interest rates while Japan keeps them low, global investors shift capital into U.S. assets. This pushes the dollar up and the yen down.

• Short run vs. long run: In the short run, even small interest rate changes can cause sharp currency movements. In the long run, the effect depends on whether those higher rates are sustainable without fueling inflation.

2. Inflation Rates

• Mechanism: Low inflation keeps a currency’s purchasing power stronger compared to others. High inflation erodes value, making exports less competitive and discouraging investment.

• Example: If Turkey’s inflation is much higher than the EU’s, the Turkish lira will tend to depreciate against the euro.

• Short run vs. long run: Inflation impacts accumulate over time. In the short run, traders may focus more on interest rates, but in the long run, inflation differences (purchasing power parity) strongly influence exchange rates.

3. Economic Growth and Stability

• Mechanism: Strong GDP growth signals a healthy economy that attracts investors, boosting currency demand. Stability—political and economic—adds confidence.

• Example: If India grows at 7% while Europe stagnates, investors might prefer Indian assets, raising demand for the rupee. But if India faces political turmoil, that advantage can reverse.

• Short run vs. long run: Growth boosts currencies when it is consistent and sustainable. Short bursts of growth can strengthen a currency temporarily, but instability quickly offsets gains.

4. Balance of Trade (Current Account Balance)

• Mechanism: Exports create demand for a country’s currency because foreign buyers need it to pay. Imports create supply of a currency in foreign markets.

• Example: China’s persistent trade surplus has historically supported the yuan’s strength (though capital controls and central bank policies also matter).

• Short run vs. long run: Trade balances move slowly, so they have a steady, long-run effect. But markets often react quickly if trade data suggests big shifts in surpluses or deficits.

5. Capital Flows and Investment

• Mechanism: Foreign direct investment (like building a factory) and portfolio investment (stocks, bonds) both increase demand for a currency. On the other hand, capital flight—money leaving a country—weakens the currency.

• Example: If multinational companies build major facilities in Vietnam, they need to buy Vietnamese dong, strengthening it. Conversely, if investors fear a crisis (like in Argentina), they dump the peso, causing depreciation.

• Short run vs. long run: Investment flows can change quickly with global sentiment, so they’re powerful in the short run. Long run, they depend on fundamentals like stability and profitability.

6. Government and Central Bank Actions

• Mechanism: Central banks can directly buy or sell their currency to influence its price (intervention). They also set interest rates and monetary policy, which indirectly affect exchange rates.

• Example: The Bank of Japan has a history of intervening to weaken the yen to support exporters. Similarly, the U.S. Federal Reserve’s monetary tightening tends to strengthen the dollar.

• Short run vs. long run: Direct intervention can shift rates briefly, but unless supported by fundamentals, the effect fades. Long-run trends depend on broader economic policies.

7. Speculation and Expectations

• Mechanism: Currency traders make bets on where exchange rates are headed. If they expect a currency to rise, they buy now, which drives it up immediately. This can become self-fulfilling.

• Example: Before Brexit, markets speculated heavily against the British pound, leading to sharp declines even before policies or trade balances changed.

• Short run vs. long run: Speculation drives short-run volatility, sometimes overshooting fundamentals. Long run, speculation tends to align with economic reality.

b. Explain meaning and advantages of foreign currency swaps.            (07)

A foreign currency swap is a contractual agreement between two parties to exchange principal and/or interest payments on a loan denominated in one currency for equivalent payments in another currency. It is essentially a combination of a spot transaction and a forward transaction. The parties agree to exchange currencies at the outset of the agreement (the spot transaction) and re-exchange them at a specified future date (the forward transaction). In between, they also exchange interest payments based on the notional principal amounts.

Unlike a currency option, a currency swap obligates both parties to make the agreed-upon exchanges. It's a more complex instrument than a simple forward contract, offering greater flexibility in managing currency exposures and accessing international capital markets.

Advantages of Foreign Currency Swaps

Foreign currency swaps offer several advantages to businesses and investors:

1. Currency Risk Management (Hedging): This is perhaps the most significant advantage. Companies with foreign currency exposures can use swaps to hedge against fluctuations in exchange rates. By swapping future cash flows into their domestic currency, they can lock in a known exchange rate and eliminate the uncertainty associated with currency movements. This is particularly useful for companies with significant import/export activities or foreign subsidiaries.

2. Access to Cheaper Financing: Companies can often obtain financing at a lower cost by borrowing in a currency where they have a comparative advantage and then swapping the proceeds into their desired currency. For example, a US company might be able to borrow USD at a lower interest rate than JPY. It can then swap the USD into JPY to fund its Japanese operations, effectively obtaining JPY financing at a more favorable rate. This is known as "arbitrage" or "synthetic borrowing."

3. Diversification of Funding Sources: Currency swaps allow companies to access a wider range of funding sources in different currencies. This can reduce their reliance on domestic capital markets and diversify their funding base.

4. Asset-Liability Management: Financial institutions can use currency swaps to manage their asset-liability mismatches. For example, a bank with USD-denominated assets and JPY-denominated liabilities can use a currency swap to match the currency of its assets and liabilities, reducing its exposure to currency risk.

5. Enhanced Investment Returns: Investors can use currency swaps to enhance their investment returns by taking advantage of interest rate differentials between countries. For example, an investor might borrow in a low-interest-rate currency and invest in a high-interest-rate currency, using a currency swap to hedge against exchange rate risk. This strategy is known as a "carry trade."

6. Flexibility: Currency swaps can be customized to meet the specific needs of the parties involved. The notional principal amount, interest rates, payment frequency, and maturity date can all be tailored to match the underlying cash flows being hedged or the investment strategy being pursued.

7. Avoidance of Exchange Controls: In some countries, exchange controls may restrict the ability of companies to directly borrow or invest in foreign currencies. Currency swaps can provide a way to circumvent these restrictions and access international capital markets.

OR

Q.3.c.Explain risks faced by corporates and banks.                            (08)

Corporations face a multitude of risks that can impact their financial performance, operations, and reputation. These risks can be broadly categorized as follows:

Risks Faced by Corporates

1. Market Risk

   • Exposure to changes in exchange rates, interest rates, and commodity prices.

   • Example: An exporter in India earning in dollars risks losses if the rupee suddenly strengthens.

2. Credit Risk

   • Risk that customers or counterparties fail to pay on time or default.

   • Example: A company selling on credit to a foreign buyer may not get paid if the buyer’s business collapses.

3. Liquidity Risk

   • Risk of not having enough cash or easily sellable assets to meet short-term obligations.

   • Example: A company with heavy short-term debt may struggle if sales slow down.

4. Operational Risk

   • Losses from failures in internal processes, systems, human errors, or fraud.

   • Example: A cyberattack or supply chain breakdown.

5. Regulatory and Legal Risk

   • Changes in laws, taxation, or trade restrictions that affect business operations.

   • Example: A sudden ban on exports or new environmental rules raising costs.

6. Reputation Risk

   • Damage to brand image leading to loss of customer trust and sales.

   • Example: A product safety scandal or social media backlash.

Risks Faced by Banks

1. Credit Risk

   • The biggest risk for banks: borrowers (corporates or individuals) may default on loans.

2. Market Risk

   • Changes in interest rates, bond yields, equity prices, or currency values can reduce the value of a bank’s assets.

   • Example: A rise in interest rates can lower the value of fixed-rate bonds a bank holds.

3. Liquidity Risk

   • Banks must always be ready to honor withdrawals and payments. If depositors withdraw suddenly (a “bank run”), liquidity can dry up.

4. Operational Risk

   • System failures, cyberattacks, employee misconduct, or poor processes.

   • Example: Fraud by staff or hacking of online banking systems.

5. Regulatory and Compliance Risk

   • Banks are tightly regulated. Non-compliance with capital adequacy norms, anti–money laundering laws, or other regulations can lead to penalties or even loss of license.

6. Interest Rate Risk

   • Banks borrow short-term (deposits) and lend long-term (loans). If rates move unfavorably, their profit margin (net interest income) shrinks.

7. Reputation and Strategic Risk

   • Loss of trust can quickly lead to customer flight. Poor management decisions can also damage profitability and survival.

d. Distinguish between FERA and FEMA.                        (07)

Q.4.a.Explain meaning and features of international banking in detail.                    (08)

Meaning of International Banking

International banking refers to banking services and financial transactions that cross national borders. It involves banks providing services to clients (corporates, individuals, and governments) in more than one country. These services include accepting deposits, giving loans, facilitating international trade, foreign exchange, investment banking, and managing global capital flows.

Simply put, international banking connects money, businesses, and financial systems across countries.

Features of International Banking

1. Cross-border operations

   • International banks operate beyond their home country, either through branches, subsidiaries, or representative offices abroad.

   • Example: HSBC operates in over 60 countries.

2. Foreign currency dealings

   • International banks handle multiple currencies, offer foreign currency accounts, and deal in foreign exchange markets.

3. Support for international trade

   • They provide trade finance services like letters of credit, export-import financing, and guarantees to help businesses trade safely across borders.

4. Global capital mobility

   • International banks help channel funds between countries by facilitating loans, investments, and capital market activities.

5. Risk management services

   • They offer hedging instruments like forwards, swaps, and options to protect clients from exchange rate, interest rate, or commodity price fluctuations.

6. Large-scale transactions

   • International banking deals with big volumes, often involving governments, multinational corporations, and institutional investors.

7. Regulatory complexity

   • These banks must follow regulations not only in their home country but also in host countries where they operate. They also comply with international standards like Basel norms.

8. Technological integration

   • International banks rely heavily on advanced digital systems for cross-border payments, global money transfers, and real-time risk management.

9. Diverse client base

   • Clients range from multinational companies and governments to expatriates and high-net-worth individuals needing cross-border banking.

10. Contribution to globalization

• By moving capital, funding trade, and offering global financial services, international banks play a major role in integrating economies.

b. Explain risk management through hedging.                (07)

Meaning of Hedging in Risk Management

Hedging is a strategy used to reduce or offset the risk of unfavorable price, interest rate, or exchange rate movements. Instead of trying to make a profit, the goal of hedging is protection—to lock in costs or revenues and bring certainty to future cash flows.

Think of it like insurance: you may pay a cost (or give up some potential upside), but you’re shielded from bigger losses.

How Hedging Manages Risk

Hedging works by taking an opposite position in a related financial instrument. If the original exposure loses value, the hedge gains value, and vice versa. This reduces the net impact of the risk.

Common Hedging Methods

1. Forward Contracts

   • Agreement to buy or sell an asset (like currency or commodity) at a fixed price on a future date.

   • Example: An Indian exporter expecting payment in dollars after 3 months can enter a forward contract to sell those dollars at today’s rate, eliminating exchange rate risk.

2. Futures Contracts

   • Similar to forwards but traded on organized exchanges with standard terms.

   • Example: An airline company may hedge fuel costs by buying crude oil futures.

3. Options

   • Provide the right (but not the obligation) to buy or sell at a set price.

   • Example: An importer can buy a currency call option, ensuring they won’t pay above a certain rate for foreign currency.

4. Swaps

   • Agreements to exchange cash flows (interest rate swaps, currency swaps).

   • Example: A company with a floating-rate loan may swap it for a fixed-rate loan to avoid interest rate fluctuations.

5. Natural Hedging

   • Matching revenues and costs in the same currency or aligning assets and liabilities.

   • Example: A U.S. company with sales in euros might borrow in euros, so payments and receipts balance out.

Advantages of Hedging

Hedging offers several advantages, including:

• Reduced risk: Hedging can reduce the potential for losses from adverse price movements.

• Increased certainty: Hedging can provide greater certainty about future cash flows and profitability.

• Improved financial planning: Hedging can make it easier to plan for the future by reducing uncertainty about future prices and exchange rates.

• Protection of profit margins: Hedging can help businesses protect their profit margins by locking in prices for inputs or outputs.

Disadvantages of Hedging

Hedging also has some disadvantages, including:

• Cost: Hedging can be costly, as it involves paying premiums or commissions to enter into hedging contracts.

• Reduced potential for profit: Hedging can reduce the potential for profit if prices move in a favorable direction.

• Complexity: Hedging can be complex and require specialized knowledge and expertise.

• Basis risk: Basis risk is the risk that the price of the asset being hedged will not move in perfect correlation with the price of the hedging instrument. This can result in the hedge being less effective than expected.

Examples of Hedging in Practice

• Airlines: Airlines use hedging to protect themselves from fluctuations in jet fuel prices. They may enter into forward contracts or futures contracts to lock in the price of jet fuel for future delivery.

• Farmers: Farmers use hedging to protect themselves from fluctuations in crop prices. They may enter into forward contracts or futures contracts to sell their crops at a specified price on a future date.

• Manufacturers: Manufacturers use hedging to protect themselves from fluctuations in the prices of raw materials. They may enter into forward contracts or futures contracts to buy raw materials at a specified price on a future date.

• Investors: Investors use hedging to protect their portfolios from market downturns. They may buy put options on stock indexes or individual stocks to protect against losses.

OR 

Q.4.c.Calculate forward rates of Euro to Dollar for various maturities based on following data:        (07)

Spot Euro against dollar is 1 EURO-1.3787/1.3797

Euro to Dollar

Swap Points

1 month

30/25

2 months

60/50

3 months

80/70

4 months

95/90

Q.4.d.Calculate Mid-rate, Spread, Spread % and Inverse quote for EUR/USD 1.5580/1.5600.    (07)

Q.5.a. Explain meaning and types of letter of credit.                (08)

A Letter of Credit (LC), also known as a documentary credit, is a written undertaking by a bank (the issuing bank) to pay a beneficiary (the seller or exporter) a specified sum of money, up to a stated limit, within a prescribed time, upon presentation of stipulated documents that conform strictly to the terms and conditions of the credit. In essence, it substitutes the bank's creditworthiness for that of the buyer (the applicant or importer), providing assurance to the seller that payment will be made upon fulfilling the agreed-upon conditions.

The primary purpose of an LC is to mitigate the risks associated with international trade, particularly the risk of non-payment by the buyer and the risk of non-delivery by the seller. It provides a secure payment mechanism that benefits both parties involved in the transaction.

Types of Letters of Credit 

1. Revocable Letter of Credit

• This type can be altered or canceled by the issuing bank at any time without notifying the seller.

• Since it provides no real protection to the seller, it is rarely used in modern trade.

2. Irrevocable Letter of Credit

• Once issued, it cannot be changed or canceled without the consent of all parties (buyer, seller, and issuing bank).

• This gives the seller strong assurance that the terms will not change unexpectedly.

• Today, almost all LCs are irrevocable.

3. Confirmed Letter of Credit

• Apart from the issuing bank, another bank (usually located in the seller’s country) also guarantees payment.

• This protects the seller in case the issuing bank or the buyer’s country faces political or financial issues.

• Example: A seller in India may want a European bank to confirm a LC issued by a small African bank.

4. Unconfirmed Letter of Credit

• Only the issuing bank is responsible for payment.

• Cheaper than a confirmed LC but carries more risk for the seller if the issuing bank is unreliable.

5. Sight Letter of Credit

• Payment is made “on sight,” meaning once the seller presents the required documents and the bank verifies them, payment is immediate.

• Useful for sellers who want quick payment.

6. Usance / Time Letter of Credit

• Payment is not immediate but deferred to a future date, such as 30, 60, or 90 days after the documents are accepted.

• Gives the buyer extra time to sell the goods before making payment.

7. Back-to-Back Letter of Credit

• Used when a middleman or trader is involved.

• The first LC is used by the intermediary to open a second LC in favor of the actual supplier.

• Helps intermediaries who don’t have enough capital but need to fulfill a buyer’s large order.

8. Transferable Letter of Credit

• Allows the first beneficiary (usually a middleman or trading company) to transfer part or all of the credit to another supplier.

• Common in international trade when intermediaries arrange shipments from manufacturers.

9. Standby Letter of Credit (SBLC)

• Works more like a safety net or guarantee than a primary payment method.

• The bank promises to pay the seller only if the buyer defaults or fails to fulfill the contract.

• Often used in construction projects or service contracts.

10. Revolving Letter of Credit

• Used when there are multiple shipments over time.

• The credit amount automatically renews after each payment until the contract is completed.

• Saves time and paperwork in long-term supply agreements.

Example

Let’s say an exporter in China is selling machinery worth $100,000 to an importer in the USA.

1. The importer asks their bank (the issuing bank) to open a Letter of Credit in favor of the exporter.

2. The LC states that the exporter must ship the machinery and provide documents like:

   • Bill of lading (proof of shipment)

   • Commercial invoice

   • Insurance documents

3. Once the exporter ships the goods and submits the documents to their bank, the bank verifies them.

4. If everything matches, the exporter gets paid.

5. The importer then repays their bank.

b. Explain reasons for growth of Eurocurrency market.                (07)

The Eurocurrency market is an international money market where banks accept deposits and make loans in currencies that are different from the country’s domestic currency.

For example:

• A US dollar deposit in a bank in London is “Eurodollar.”

• A Japanese yen deposit in a bank in Singapore is “Euroyen.”

The Eurocurrency market, which refers to currencies held outside their country of origin, has experienced substantial growth since its inception. Several factors have contributed to this expansion:

1. Regulatory Avoidance

One of the primary drivers behind the growth of the Eurocurrency market is the desire to avoid domestic regulations. Banks operating in the Eurocurrency market are often subject to fewer regulations than those operating in their home countries. This includes reserve requirements, interest rate controls, and other restrictions.

• Reserve Requirements: Domestic banks are typically required to hold a certain percentage of their deposits as reserves with the central bank. These reserves earn little or no interest, reducing the bank's profitability. Eurocurrency deposits are often exempt from these reserve requirements, allowing banks to lend out a larger portion of their deposits and earn higher profits.

• Interest Rate Controls: Some countries impose controls on the interest rates that banks can charge or pay. These controls can distort the market and make it difficult for banks to compete. The Eurocurrency market offers a way to bypass these controls, allowing banks to offer more competitive interest rates.

• Other Regulations: Other regulations, such as capital controls and restrictions on foreign exchange transactions, can also hinder the operations of domestic banks. The Eurocurrency market provides a way to circumvent these regulations, allowing banks to operate more freely.

2. Political and Economic Instability

Political and economic instability in some countries has also contributed to the growth of the Eurocurrency market. Individuals and businesses in these countries may seek to hold their funds in a more stable currency and a more secure location. The Eurocurrency market provides a convenient way to do this.

• Safe Haven: Eurocurrency deposits are often seen as a safe haven for funds during times of political or economic uncertainty. This is because they are held in stable currencies and are subject to fewer regulations than domestic deposits.

• Diversification: Holding funds in the Eurocurrency market can also provide diversification benefits. By holding funds in different currencies and different locations, individuals and businesses can reduce their exposure to risk.

3. Technological Advancements

Technological advancements have also played a significant role in the growth of the Eurocurrency market. The development of new communication and information technologies has made it easier and cheaper to conduct cross-border financial transactions.

• Electronic Transfers: Electronic funds transfer systems have made it possible to move money quickly and easily between different countries. This has reduced the cost and time associated with international transactions, making the Eurocurrency market more accessible.

• Information Technology: Information technology has also made it easier for banks to manage their Eurocurrency operations. Banks can now track their deposits and loans in real-time, and they can use sophisticated risk management tools to manage their exposure to currency and interest rate risk.

4. Increased International Trade and Investment

The growth of international trade and investment has also fueled the growth of the Eurocurrency market. As businesses engage in more cross-border transactions, they need access to foreign currencies to finance their activities. The Eurocurrency market provides a convenient source of these currencies.

• Trade Finance: The Eurocurrency market is used extensively to finance international trade. Banks provide loans in various currencies to businesses that are importing or exporting goods and services.

• Foreign Direct Investment: The Eurocurrency market is also used to finance foreign direct investment. Companies that are investing in foreign countries often borrow funds in the Eurocurrency market to finance their investments.

5. Arbitrage Opportunities

The Eurocurrency market provides opportunities for arbitrage, which is the practice of taking advantage of price differences in different markets to make a profit. Banks can borrow funds in one currency and lend them in another currency, profiting from the difference in interest rates.

• Interest Rate Arbitrage: Banks can borrow funds in a currency with low interest rates and lend them in a currency with high interest rates. This allows them to earn a profit without taking on any significant risk.

• Currency Arbitrage: Banks can also profit from differences in exchange rates. They can buy a currency in one market and sell it in another market, profiting from the difference in prices.

6. Lack of Exchange Controls

The absence of exchange controls in many countries has facilitated the growth of the Eurocurrency market. Exchange controls restrict the ability of individuals and businesses to move money across borders. The lack of these controls allows funds to flow freely into and out of the Eurocurrency market.

• Capital Mobility: The free flow of capital is essential for the functioning of the Eurocurrency market. Without capital mobility, it would be difficult for banks to attract deposits and make loans in different currencies.

• Reduced Transaction Costs: The absence of exchange controls also reduces transaction costs. Individuals and businesses do not have to pay fees or taxes to convert currencies, making it cheaper to participate in the Eurocurrency market.

7. Sovereign Wealth Funds

The rise of sovereign wealth funds (SWFs) has also contributed to the growth of the Eurocurrency market. SWFs are government-owned investment funds that invest in a variety of assets, including foreign currencies. These funds often hold a significant portion of their assets in the Eurocurrency market.

• Large-Scale Investments: SWFs are large investors, and their investments can have a significant impact on the Eurocurrency market. Their demand for Eurocurrency deposits can drive up interest rates and increase the overall size of the market.

• Diversification: SWFs often invest in the Eurocurrency market to diversify their portfolios. By holding funds in different currencies and different locations, they can reduce their exposure to risk.

OR 

Q.5.a. Explain risk management through hedging.            (08)

Hedging is a risk management strategy used to offset potential losses that may be incurred due to adverse price movements. It involves taking an offsetting position in a related asset or market. The primary goal of hedging is not to generate profit, but to reduce or eliminate the risk of loss.

In simple terms, hedging is like taking out an insurance policy. Just as insurance protects against unforeseen events, hedging protects against unfavorable price changes.

Types of Risks Managed Through Hedging

1. Price Risk

   • Example: A farmer fears that wheat prices will drop before harvest.

   • Hedge: The farmer sells wheat futures today to lock in a selling price.

2. Currency (Exchange Rate) Risk

   • Example: An Indian company exporting goods to the US fears the US dollar might depreciate.

   • Hedge: The company uses a forward contract to fix the exchange rate in advance.

3. Interest Rate Risk

   • Example: A company with variable-rate debt fears interest rates may rise.

   • Hedge: It enters into an interest rate swap to switch to fixed-rate payments.

4. Commodity Risk

   • Example: An airline company fears jet fuel prices will rise.

   • Hedge: It buys fuel futures to lock in the cost.

5. Equity (Stock Market) Risk

• Example: An investor holds shares but fears short-term market volatility.

• Hedge: They buy put options to limit downside risk.

Common Hedging Instruments

1. Forwards – Agreements to buy/sell an asset at a fixed price on a future date.

2. Futures – Standardized contracts traded on exchanges, similar to forwards.

3. Options – Give the right (not the obligation) to buy/sell at a predetermined price.

4. Swaps – Agreements to exchange cash flows (like fixed for floating interest).

Examples of Hedging in Risk Management

1. Commodity Price Risk

A farmer expects to harvest wheat in three months. He fears the price may fall.

• He enters a futures contract to sell wheat at today’s price.

• If prices drop later, he still sells at the agreed higher price, protecting his income.

2. Foreign Exchange Risk

An Indian company has to pay $1 million to a US supplier in 6 months. If the rupee weakens, the payment will cost more.

• The company enters a forward contract to buy $1 million at today’s exchange rate.

• This locks in the cost and removes currency risk.

3. Interest Rate Risk

A company with variable-rate debt fears interest rates will rise.

• It enters into an interest rate swap to pay a fixed rate instead of floating.

• This stabilizes its loan payments.

4. Equity Risk

An investor holds shares in a company but fears a short-term fall in prices.

• They buy a put option, which gives the right to sell shares at a set price.

• If prices fall, the option protects against heavy losses

Example

• A coffee importer in India needs to pay $1 million in three months.

• Today, $1 = ₹83. But the importer worries the dollar might rise to ₹85.

• To hedge, the importer signs a forward contract with a bank to buy $1 million at ₹83.50 in three months.

• If the dollar goes up to ₹85, the importer is safe because he locked in at ₹83.50.

• If the dollar falls to ₹82, he loses the benefit of cheaper dollars but avoids risk.

b. Explain different types of letter of credit.            (07)

Types of Letters of Credit 

1. Revocable Letter of Credit

• This type can be altered or canceled by the issuing bank at any time without notifying the seller.

• Since it provides no real protection to the seller, it is rarely used in modern trade.

2. Irrevocable Letter of Credit

• Once issued, it cannot be changed or canceled without the consent of all parties (buyer, seller, and issuing bank).

• This gives the seller strong assurance that the terms will not change unexpectedly.

• Today, almost all LCs are irrevocable.

3. Confirmed Letter of Credit

• Apart from the issuing bank, another bank (usually located in the seller’s country) also guarantees payment.

• This protects the seller in case the issuing bank or the buyer’s country faces political or financial issues.

• Example: A seller in India may want a European bank to confirm a LC issued by a small African bank.

4. Unconfirmed Letter of Credit

• Only the issuing bank is responsible for payment.

• Cheaper than a confirmed LC but carries more risk for the seller if the issuing bank is unreliable.

5. Sight Letter of Credit

• Payment is made “on sight,” meaning once the seller presents the required documents and the bank verifies them, payment is immediate.

• Useful for sellers who want quick payment.

6. Usance / Time Letter of Credit

• Payment is not immediate but deferred to a future date, such as 30, 60, or 90 days after the documents are accepted.

• Gives the buyer extra time to sell the goods before making payment.

7. Back-to-Back Letter of Credit

• Used when a middleman or trader is involved.

• The first LC is used by the intermediary to open a second LC in favor of the actual supplier.

• Helps intermediaries who don’t have enough capital but need to fulfill a buyer’s large order.

8. Transferable Letter of Credit

• Allows the first beneficiary (usually a middleman or trading company) to transfer part or all of the credit to another supplier.

• Common in international trade when intermediaries arrange shipments from manufacturers.

9. Standby Letter of Credit (SBLC)

• Works more like a safety net or guarantee than a primary payment method.

• The bank promises to pay the seller only if the buyer defaults or fails to fulfill the contract.

• Often used in construction projects or service contracts.

10. Revolving Letter of Credit

• Used when there are multiple shipments over time.

• The credit amount automatically renews after each payment until the contract is completed.

• Saves time and paperwork in long-term supply agreements.

Example

Let’s say an exporter in China is selling machinery worth $100,000 to an importer in the USA.

1. The importer asks their bank (the issuing bank) to open a Letter of Credit in favor of the exporter.

2. The LC states that the exporter must ship the machinery and provide documents like:

   • Bill of lading (proof of shipment)

   • Commercial invoice

   • Insurance documents

3. Once the exporter ships the goods and submits the documents to their bank, the bank verifies them.

4. If everything matches, the exporter gets paid.

5. The importer then repays their bank.

Q.5. Write short notes on any three:                        (15)

a. Bitcoin

Meaning and Origin

Bitcoin is the world’s first cryptocurrency, introduced in 2009 by an anonymous person or group using the name Satoshi Nakamoto. It was designed to be a peer-to-peer electronic cash system that allows people to transfer money directly without relying on banks or governments.

The key innovation behind Bitcoin is the blockchain—a public, decentralized ledger that records all transactions in a secure and transparent way.

Features of Bitcoin

1. Decentralization

   • No central bank or government controls Bitcoin.

   • The system is maintained by a global network of computers (nodes).

2. Blockchain Technology

   • Every transaction is recorded on a public ledger.

   • Once added, records cannot easily be altered, making it secure and tamper-proof.

3. Limited Supply

   • Only 21 million bitcoins will ever exist.

   • This fixed supply makes Bitcoin scarce, similar to precious metals like gold.

4. Mining Process

   • New bitcoins are generated through “mining.”

   • Miners solve complex mathematical problems to validate transactions, and in return, they earn new bitcoins.

5. Digital and Divisible

   • Bitcoin is entirely digital and has no physical form.

   • It can be divided into smaller units, the smallest being 1 Satoshi = 0.00000001 BTC.

6. Volatility

   • Its value can rise or fall dramatically within short periods.

   • This makes it attractive to traders but risky for stable transactions.

Uses of Bitcoin

• Payments: Enables quick, borderless, and low-cost transactions.

• Investment: Seen as “digital gold” and used as a hedge against inflation.

• Remittances: Helps people send money internationally without traditional banking fees.

• Innovation: Opened the door to thousands of other cryptocurrencies and blockchain applications.

Advantages of Bitcoin

1. Decentralized Control – Free from government or central bank interference.

2. Transparency and Security – Blockchain ensures tamper-resistant records.

3. Lower Transaction Costs – Especially for cross-border payments.

4. Accessibility – Anyone with internet access can use Bitcoin.

5. Scarcity – Limited supply can help preserve value.

Disadvantages of Bitcoin

1. Volatility – Prices fluctuate sharply, making it unreliable for everyday use.

2. Scalability Issues – The network can be slow and expensive during high demand.

3. Regulatory Concerns – Many governments are cautious or restrictive about its use.

4. Irreversible Transactions – Mistaken or fraudulent transactions cannot be reversed.

5. Association with Illegal Activities – Its anonymity has made it popular for illicit uses.

b. Disadvantages of FDI

1. Profit Repatriation

• Foreign companies often send a large share of their profits back to their home country.

• This reduces the host country’s foreign exchange reserves and limits the economic benefit.

2. Loss of Control Over Key Sectors

• Heavy foreign investment in sensitive industries (like telecom, defense, or energy) may give outsiders too much influence over the host country’s economy.

• This can create dependency and reduce national sovereignty.

3. Threat to Domestic Industries

• Local firms may find it hard to compete with large multinational corporations that have superior technology, global networks, and financial strength.

• Small businesses may get pushed out of the market.

4. Technology Dependence

• While FDI can bring advanced technology, the host country may become dependent on foreign know-how.

• Sometimes multinationals transfer outdated technology instead of the latest innovations.

5. Profit-Driven Approach

• Multinational corporations focus on profits, not necessarily on the host country’s development goals.

• They may avoid investing in rural areas or socially important but less profitable sectors.

6. Cultural and Social Impact

• FDI can lead to the spread of foreign cultural values through advertising and work practices.

• This sometimes erodes local culture and traditions.

7. Environmental Concerns

• Some foreign companies exploit natural resources aggressively in host countries.

• Weak enforcement of environmental laws can lead to pollution and ecological damage.

8. Economic Volatility

• FDI inflows may be large during good times but can dry up suddenly if global conditions worsen.

• Heavy reliance on FDI makes an economy vulnerable to global financial shocks.

9. Labor Concerns

• Multinational companies may offer lower wages, hire contract workers, or avoid unions.

• This can create inequality and unrest in the labor market.

c. Dealing room operations

Meaning of Dealing Room

A dealing room (also called a trading room or treasury room) is a specialized section in a commercial bank, investment bank, or financial institution where dealers buy and sell financial instruments such as foreign exchange, bonds, derivatives, equities, and money market instruments.

It is the nerve center of a bank’s treasury operations, handling both customer transactions and proprietary trading (the bank trading on its own account).

Functions of a Dealing Room

1. Foreign Exchange Operations

   • Buying and selling of foreign currencies for clients (importers, exporters, travelers).

   • Managing exchange rate risks through forwards, futures, and options.

2. Money Market Operations

   • Lending and borrowing short-term funds in the interbank market.

   • Managing liquidity by investing in treasury bills, commercial papers, and certificates of deposit.

3. Investment and Securities Trading

   • Buying and selling government securities, corporate bonds, and equities.

   • Managing interest rate risk and ensuring regulatory compliance with statutory liquidity ratios.

4. Risk Management

   • Using derivatives (swaps, futures, options) to hedge against risks like currency fluctuation, interest rate changes, or commodity price swings.

5. Advisory and Customer Service

   • Offering clients (corporates, exporters, importers) advice on hedging strategies and market conditions.

   • Executing deals on behalf of customers.

6. Proprietary Trading

   • Trading done by the bank itself to make profits, apart from serving customers.

   • Involves speculation, arbitrage, and exploiting short-term market movements.

Participants in a Dealing Room

• Dealers/Traders – Execute buy/sell orders in currencies, securities, and derivatives.

• Sales Team – Interface with clients, take orders, and provide market updates.

• Risk Managers – Monitor exposure, ensure trades stay within approved limits.

• Back Office – Handle confirmation, settlement, accounting, and reconciliation of trades.

• Middle Office – Focus on risk monitoring, compliance, and reporting.

Technological Setup

• Trading Terminals (like Bloomberg, Reuters Eikon) for real-time prices.

• Communication Systems (phones, electronic messaging, voice recording) to connect with clients and counterparties.

• Risk Management Systems to track positions, exposure, and regulatory compliance.

Importance of Dealing Room Operations

• Ensures efficient foreign exchange and money market transactions.

• Helps corporates manage risks related to exchange rates and interest rates.

• Provides liquidity to financial markets.

• Generates significant profits for banks through spreads, commissions, and proprietary trading.

d. Types Euro Bonds

Meaning of Eurobonds

A Eurobond is an international bond that is denominated in a currency different from the country where it is issued.

• Example: A bond denominated in US dollars but issued in London.

• Despite the name, “Euro” doesn’t mean the euro currency — it refers to the fact that these bonds are issued outside the borders of the country whose currency they are denominated in.

They are widely used by governments, multinational corporations, and international organizations to raise capital in global markets.

Types of Eurobonds

1. Straight (Fixed-Rate) Eurobonds

• Pay a fixed rate of interest (coupon) over the life of the bond.

• Very common type, offering predictable returns to investors.

2. Floating Rate Eurobonds

• Interest rates are not fixed but linked to a benchmark, such as LIBOR or EURIBOR, plus a margin.

• Protect investors from interest rate fluctuations.

3. Convertible Eurobonds

• Give bondholders the option to convert their bonds into a predetermined number of shares of the issuing company.

• Attractive to investors who want fixed income with the possibility of equity upside.

4. Zero-Coupon Eurobonds

• Issued at a discount and do not pay periodic interest.

• Investors earn returns at maturity when the bond is redeemed at face value.

5. Callable Eurobonds

• Allow the issuer to “call back” (redeem) the bond before maturity, usually if interest rates fall.

• Riskier for investors but cheaper for issuers.

6. Puttable Eurobonds

• Give investors the right to sell the bond back to the issuer before maturity at a specified price.

• Provides flexibility and reduces risk for investors.

7. Dual-Currency Eurobonds

• Coupons may be paid in one currency and principal in another.

• Useful for investors and issuers with exposure to multiple currencies.

8. Indexed Eurobonds

• Returns are linked to an index (like inflation, stock market index, or commodity prices).

• Offer protection against inflation or specific market risks.

e. Components of BOP

The Balance of Payments is a systematic record of all economic transactions between the residents of a country and the rest of the world during a specific period (usually one year).

It shows inflows and outflows of foreign exchange and helps measure a country’s financial position globally.

Components of BOP

1. Current Account

Records all short-term transactions in goods, services, income, and transfers.

• Trade Balance (Merchandise Account): Exports and imports of goods.

• Invisibles (Services): Payments for services like shipping, insurance, tourism, IT, banking, etc.

• Income: Earnings on investments (interest, dividends, profits) and compensation of employees.

• Current Transfers: One-way transfers such as remittances, gifts, foreign aid for current use.

2. Capital Account

Deals with capital transfers and acquisition/disposal of non-produced, non-financial assets (like land, natural resources, patents, copyrights).

• Generally small compared to the financial account.

• Includes things like debt forgiveness, migrant transfers, or sale/purchase of assets like trademarks.

3. Financial Account

Records investment flows (long-term and short-term) between countries.

• Foreign Direct Investment (FDI): Investment to acquire lasting interest and control in foreign businesses.

• Portfolio Investment: Investment in foreign stocks, bonds, and other securities without control.

• Other Investments: Loans, trade credits, banking capital, currency deposits.

• Reserve Assets: Transactions by the central bank in foreign exchange reserves, gold, SDRs (Special Drawing Rights), and IMF positions.

4. Errors and Omissions

• A balancing item to account for discrepancies due to data limitations, timing differences, or misreporting in international transactions.

• Ensures that total debits = total credits.