Under interest rate parity, the forward premium or discount on a currency is equal to:

The interest rate differential between the two countries

The difference in their rates of economic growth

The ratio of their foreign exchange reserves

The difference in their corporate tax rates

US dollar deposits held in banks outside the United States

Euro deposits held in banks in the United States

Dollars that may be spent only in the European Union

A currency jointly issued by the United States and the European Union

In multinational capital budgeting, the cash flows that should be discounted are those:

The parent can actually receive after remittance restrictions and taxes

The project generates in the host country, before any restriction

The host country's government collects as tax

Equal to the accounting profit of the subsidiary

The special purpose vehicle in a securitisation transaction is kept bankruptcy-remote in order that:

The originator's own insolvency cannot reach the assets backing the securities

The originator can reclaim the pool whenever it chooses

The investors become shareholders of the originator

The receivables need not be rated by any agency

A depository receipt issued by an Indian company and traded on a United States exchange is:

A Foreign Currency Convertible Bond

Triangular arbitrage in the foreign exchange market exploits an inconsistency among:

Three currencies, where the implied cross rate does not match the quoted one

Three banks quoting the same pair identically

Three consecutive forward maturities of one currency

Three commodity prices in one market

Business Finance II: Risk, Securitisation and International Finance

The second half of Unit 4 leaves the single firm behind. It starts with how risk is measured and which part of it the market pays you for, moves through asset securitisation, and then crosses the border: the international monetary system, the foreign exchange market and the ways a firm covers itself against it, the instruments through which Indian companies raise money abroad, arbitrage, and capital budgeting when the cash flows come back in another currency. The recurring examinable idea is that only risk you cannot diversify away earns a return, and the recurring calculation is a parity relation.

1. Risk and return: the part you are paid for

Risk is the variability of actual return around the expected one, measured by the standard deviation of returns, or by the coefficient of variation when two investments of different size are compared. Its decisive division is not into large and small but into two kinds that behave differently in a portfolio.

The two components of total risk
Component	Source	Can diversification remove it?	Is it rewarded?
Systematic, or market risk	Interest rates, inflation, policy, the business cycle	No — it moves every security together	Yes, and it is measured by beta
Unsystematic, or specific risk	A strike, a lost contract, a bad product, a lawsuit	Yes — one firm's bad year offsets another's good one	No, because it costs nothing to remove

🎯 Why the market pays for only one of them

An investor who can remove a risk for free will not pay to bear it, and unsystematic risk is removed for free simply by holding many securities. So no security can command a higher expected return for carrying it. Systematic risk cannot be escaped by any portfolio, so bearing it is a real service and earns a real premium. That single argument is the whole of the capital asset pricing model's logic, and it is why beta and not standard deviation sits in its formula.

Beta measures how much a security moves with the market: a beta of one moves with it, above one amplifies it, below one damps it, and a negative beta moves against it. The capital asset pricing model then prices the security at Ke = Rf + β(Rm − Rf), where the bracket is the market risk premium. Portfolio risk falls as securities are added, but only so far — it approaches the market's own risk and cannot go below it.

2. Asset securitisation

Securitisation converts a pool of illiquid assets that produce a predictable stream of receipts — housing loans, car loans, credit card receivables, lease rentals — into tradable securities. The originator sells the pool to a special purpose vehicle, which issues securities to investors against the cash the pool will generate, and the receipts service those securities.

The originator — usually a bank or a finance company — assembles a homogeneous pool of receivables and sells it.
The special purpose vehicle buys the pool and is deliberately kept bankruptcy-remote, so that the originator's own failure cannot reach the assets backing the securities.
Credit enhancement and rating raise the quality of the issue above that of the originator, through over-collateralisation, a guarantee or a subordinated tranche.
The investors hold pass-through certificates, where collections are passed on as they arrive, or pay-through securities, where the vehicle restructures the timing into tranches.

ℹ️ What the originator actually gains

Three things: illiquid assets become cash immediately, the assets leave the balance sheet so capital is freed for fresh lending, and the risk on that pool passes to the investors. The last of those is also the danger, because an originator who no longer bears the loss has less reason to check who it lends to — which is the mechanism behind the 2008 crisis and a fair question in this unit.

3. The international monetary system

The system is the set of rules by which exchange rates are determined and international payments settled. Four regimes are named in sequence, and each ended because of a defect in the one before.

The four regimes
Regime	How the rate was fixed	Why it ended
Gold standard	Each currency defined in gold, so rates followed from the mint parities	The discipline was too rigid to survive the wars and the Depression
Bretton Woods	Dollar convertible into gold, other currencies pegged to the dollar	The US could not hold convertibility; suspended in 1971
Floating rates	Supply and demand in the market, with or without central bank intervention	Still in force for the major currencies
Managed float and pegs	Market-determined but steered; India follows a managed float	Current arrangement for most emerging economies

4. The foreign exchange market, and covering the risk

The foreign exchange market has a spot segment for immediate delivery and a forward segment for delivery at an agreed future date. A currency trades at a forward premium when its forward rate buys more of the other currency than the spot rate does, and at a discount when it buys less — and which way round depends on the quotation, which is where most errors begin.

Exchange rate exposure is of three kinds, and the syllabus expects the distinction. Transaction exposure is the risk on a contracted cash flow not yet settled; translation or accounting exposure is the effect on the consolidated statements of restating a foreign subsidiary; economic or operating exposure is the effect of rate changes on the present value of future operating cash flows, which is the largest and the one no accounting entry captures.

Forward contract — lock the rate today for a future date. Removes the risk entirely and removes the upside with it.
Futures — the same idea in a standardised, exchange-traded form, margined daily.
Option — the right without the obligation, so the downside is capped and the upside kept, in exchange for a premium paid up front.
Swap — exchange one stream of payments for another, commonly a currency swap of principal and interest in two currencies.
Money market hedge — borrow in one currency, convert at spot and invest in the other, so the future receipt is already matched by a liability.
Natural hedge, leading and lagging — match receipts and payments in the same currency, or advance and delay settlement, without entering any contract at all.

🧠 Forward or option, in one question

If the question says the firm wants certainty about the rate, it wants a forward. If it says the firm wants protection against an adverse move while keeping the benefit of a favourable one, it wants an option, and the premium is the price of that asymmetry. The two are never both correct, and the word to look for is whether the upside is to be kept.

5. Euro currency, GDRs and ADRs

A Euro currency deposit is a deposit held in a bank outside the country whose currency it is — Eurodollars are dollars in a bank outside the United States, and the prefix has nothing to do with Europe or with the euro. The market grew because such deposits escape the domestic reserve requirements and regulation of the issuing country, which lets the bank quote a narrower spread.

A depository receipt lets a company raise equity abroad without listing there directly. The shares are deposited with a domestic custodian, and an overseas depository issues receipts against them which trade in the foreign market in the foreign currency. The holder owns the economic interest in the shares but is not on the company's register of members.

GDR against ADR
Point	GDR	ADR
Where it trades	Outside the United States, commonly London or Luxembourg	In the United States
Regulator to satisfy	The listing exchange's rules	The Securities and Exchange Commission, which is stricter
Typical use	Raising equity from several markets at once	Reaching American investors specifically

⚠️ Euro does not mean Europe

Euroyen are yen deposits held outside Japan, and they may sit in Singapore. A Euro-issue by an Indian company is an issue abroad in foreign currency and need not involve Europe at all. The prefix means 'outside its home jurisdiction', and a question naming Eurodollars in a Tokyo bank is testing exactly that.

6. Arbitrage and multinational capital budgeting

Arbitrage is the simultaneous purchase and sale of the same thing in two markets to profit from a price difference, without risk and without net investment. Because arbitrageurs act the moment a gap appears, the gap closes, and the parity relations below are simply the statement of what the market looks like once they have finished.

Two-point arbitrage exploits the same currency pair quoted differently in two centres; three-point or triangular arbitrage exploits an inconsistency among three currencies, where the cross rate implied by two quotes does not match the third.
Interest rate parity — the forward premium or discount on a currency equals the differential in interest rates between the two countries. If it did not, covered interest arbitrage would be profitable, so the relation holds because it is enforced rather than because anyone agreed to it.
Purchasing power parity — the change in the exchange rate over time tracks the difference in inflation between the two countries, so a currency in a high-inflation economy depreciates.
The international Fisher effect joins the two: the nominal interest differential reflects the expected inflation differential, and therefore the expected change in the spot rate.

Multinational capital budgeting is ordinary capital budgeting with three complications added. The cash flows arise in a foreign currency and have to be converted or discounted consistently; the relevant flows are those the PARENT can actually receive, not those the project generates, because exchange control, withholding tax or blocked funds may trap some of them; and the discount rate must reflect the political and exchange risk of the host country rather than the parent's domestic cost of capital.

⚠️ Parent cash flows, not project cash flows

A project can be profitable in the host country and worthless to the parent if the money cannot be brought home. The standard question describes a project with healthy local earnings and a restriction on remittance, and the correct treatment is to value only what actually reaches the parent. Discounting the project's own flows is the error the question is built to catch.

Key takeaways

Only systematic risk is rewarded, because unsystematic risk can be removed for free by diversifying — which is why beta and not standard deviation sits in the CAPM formula.
Securitisation turns illiquid receivables into tradable securities through a bankruptcy-remote vehicle, and the risk transfer that makes it attractive is also what weakens the originator's incentive to lend carefully.
Transaction exposure is on a contracted flow, translation exposure on the consolidated statements, and economic exposure on the value of future operations — the largest, and the one no entry records.
The Euro prefix means outside the home jurisdiction, not Europe: Eurodollars are dollars banked outside the United States and may sit in Singapore.
In multinational capital budgeting value only the flows the parent can actually receive, and discount at a rate reflecting the host country's risk rather than the parent's domestic cost of capital.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Which kind of risk is NOT rewarded by a higher expected return in the capital asset pricing model?
1. Unsystematic risk
2. Systematic risk
3. Market risk
4. The risk measured by beta
Show answer
Answer: A — Unsystematic risk
Unsystematic or firm-specific risk — a strike, a lost contract, a lawsuit — disappears in a portfolio, because one firm's bad year is offset by another's good one, and it costs the investor nothing to remove it. An investor who can eliminate a risk for free will not pay to bear it, so no security can command a premium for carrying it. Systematic risk, also called market risk and measured by beta, cannot be diversified away by any portfolio, so bearing it is a genuine service that earns a genuine premium. The last three options are three names for the same thing.
Under interest rate parity, the forward premium or discount on a currency is equal to:
1. The interest rate differential between the two countries
2. The difference in their rates of economic growth
3. The ratio of their foreign exchange reserves
4. The difference in their corporate tax rates
Show answer
Answer: A — The interest rate differential between the two countries
Interest rate parity holds that the forward premium or discount offsets the interest differential exactly, because otherwise covered interest arbitrage would be riskless and profitable: borrow in the low-interest currency, convert at spot, invest in the high-interest currency and sell the proceeds forward. Arbitrageurs acting on any gap close it, so the relation holds because it is enforced by trading rather than because anyone agreed to it. Growth rates and reserves influence exchange rates through other channels but have no such parity relation, and tax rates do not enter the calculation at all. It is inflation differentials, not tax or growth, that purchasing power parity links to the change in the spot rate.
Eurodollars are:
1. US dollar deposits held in banks outside the United States
2. Euro deposits held in banks in the United States
3. Dollars that may be spent only in the European Union
4. A currency jointly issued by the United States and the European Union
Show answer
Answer: A — US dollar deposits held in banks outside the United States
The Euro prefix means a deposit held outside the jurisdiction that issues the currency, and it has nothing to do with Europe or with the euro as a currency. Eurodollars are dollars banked outside the United States and may perfectly well sit in Singapore or Tokyo; Euroyen are yen held outside Japan. The market exists because such deposits escape the domestic reserve requirements and regulation of the issuing country, which allows the bank to quote a narrower spread between its deposit and lending rates. The name predates the euro currency entirely.
In multinational capital budgeting, the cash flows that should be discounted are those:
1. The parent can actually receive after remittance restrictions and taxes
2. The project generates in the host country, before any restriction
3. The host country's government collects as tax
4. Equal to the accounting profit of the subsidiary
Show answer
Answer: A — The parent can actually receive after remittance restrictions and taxes
A project can be profitable where it operates and worth nothing to the parent if the money cannot be brought home, so the valuation has to be built on what actually reaches the parent after exchange control, withholding tax and any blocked funds. This is the single most examined point in multinational capital budgeting, and the standard question describes strong local earnings together with a restriction on remittance precisely to see whether the candidate discounts the project's own flows instead. Tax collected by the host government is a cost rather than a flow to be valued, and accounting profit is not a cash flow at all.
A firm wants protection against an adverse exchange rate movement while keeping the benefit if the rate moves in its favour. The appropriate instrument is:
1. A currency option
2. A forward contract
3. A currency swap
4. A money market hedge
Show answer
Answer: A — A currency option
An option gives the right without the obligation to transact at a stated rate, so the holder abandons it when the market moves favourably and exercises it when the market moves against them. That asymmetry is exactly what the question describes, and the premium paid up front is its price. A forward contract locks the rate both ways and removes the upside along with the risk, which is why it suits a firm that wants certainty rather than protection. A swap exchanges one stream of payments for another and a money market hedge borrows and invests to create an offsetting position; both lock the outcome in the same way a forward does.
The special purpose vehicle in a securitisation transaction is kept bankruptcy-remote in order that:
1. The originator's own insolvency cannot reach the assets backing the securities
2. The originator can reclaim the pool whenever it chooses
3. The investors become shareholders of the originator
4. The receivables need not be rated by any agency
Show answer
Answer: A — The originator's own insolvency cannot reach the assets backing the securities
The whole point of the structure is that investors are buying the cash flows of the pool and not the credit of the company that originated it. Isolating the pool in a vehicle that cannot be drawn into the originator's insolvency is what makes that true, and it is why a securitised issue can be rated above the originator's own rating. A pool the originator could reclaim would not be a true sale and would defeat the isolation entirely. Investors hold securities against the pool rather than equity in the originator, and rating is more important in a securitisation rather than less, since credit enhancement and rating are what let the issue reach investors at all.
The effect of exchange rate changes on the present value of a firm's future operating cash flows is:
1. Economic exposure
2. Transaction exposure
3. Translation exposure
4. Settlement exposure
Show answer
Answer: A — Economic exposure
Economic or operating exposure is the effect of rate movements on the value of the business itself, working through competitiveness, prices, volumes and costs over time. It is the largest of the three and the one no accounting entry captures, because it concerns flows that have not yet arisen. Transaction exposure is narrower and concerns a cash flow already contracted but not yet settled, such as an invoice receivable in a foreign currency. Translation exposure is an accounting effect arising when a foreign subsidiary's statements are restated for consolidation. Settlement exposure is not one of the three categories the syllabus names.
A depository receipt issued by an Indian company and traded on a United States exchange is:
1. An American Depository Receipt
2. A Global Depository Receipt
3. A Foreign Currency Convertible Bond
4. A Euro currency deposit
Show answer
Answer: A — An American Depository Receipt
An American Depository Receipt is one issued and traded in the United States, and it therefore has to satisfy the Securities and Exchange Commission, which imposes stricter disclosure than most other markets. A Global Depository Receipt trades outside the United States, commonly in London or Luxembourg, and is used to reach several markets at once. A Foreign Currency Convertible Bond is debt that may later convert into equity, which is a different instrument altogether. A Euro currency deposit is a bank deposit held outside the currency's home country and is not a means of raising equity at all.
Triangular arbitrage in the foreign exchange market exploits an inconsistency among:
1. Three currencies, where the implied cross rate does not match the quoted one
2. Three banks quoting the same pair identically
3. Three consecutive forward maturities of one currency
4. Three commodity prices in one market
Show answer
Answer: A — Three currencies, where the implied cross rate does not match the quoted one
Triangular or three-point arbitrage takes two quoted rates, derives the cross rate they imply for the third pair, and profits when the market's actual quote for that pair differs. The trader converts through all three currencies and returns to the first with more than they started, without risk and without net investment. Three banks quoting identically leaves no gap to exploit, which is the condition arbitrage produces rather than the opportunity it needs. Forward maturities of one currency and commodity prices in a single market are not what this form of arbitrage operates on.