Eliminating Interest Differentials Through Forward Contracts

The assignment discusses the concept of investing in domestic assets and foreign assets with different interest rates. The central bank decides the interest rates to eliminate the interest differential between two countries, ensuring no arbitrage opportunities for investors. This is achieved by making the return on domestic deposits equal to the return on foreign deposits using forward contracts. The forward exchange rate differs from the spot exchange rate in terms of premium or discount, reflecting the interest rate differentials and making returns equal from domestic or foreign assets.

INTERNATIONAL
FINANCIAL
MARKET AND
BANKING
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Table of Contents
Introduction................................................................................................................................1
(1). Roles of Banks in the economic development of the country:.......................................1
(2). Purchasing Power and Interest Rate Parity:....................................................................4
CONCLUSION:.........................................................................................................................7
REFERENCES:..........................................................................................................................8
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INTRODUCTION
Financial institutions such as banks play a very important role in economic
development. Central banks are termed as reserve bank and also the banker's bank of every
country. The primary function of the central bank is the monitoring and controlling the credit
and money supply and interest rates of the country (Hardie and Howarth, 2013). This report
helps in identifying that how central bank control the inflation and deflation in the economy.
Moreover, it throws light on manner in which purchasing power affects the country’s
development. Finally, the interest rate parity is discussed that aims at making no arbitrary
position of investment in domestic and foreign land.
(1). Roles of Banks in the economic development of the country:
Banks act as an active part in the economic development of the country. If the
banking system in a country is effective and disciplined then it brings a rapid growth in the
various sectors of the country. Oman lies in UAE where Islamic is adopted. However, Oman
banks have no Islamic financial institutions and its financial sector comprises domestic
banks. Banks in Oman having a business model strongly focused on corporate and retail
lending with limited investment banking. Moreover, derivative exposure is very small and the
role of wholesale funding is also limited (Park and Essayyad, 2012).
Role of Banks:
Oman commercial banks play a vital role in developing the country. The role of
Oman banks can be explained in the following points:
Capital Formation: Oman Commercial banks accept deposits from individuals and
businesses. These deposits are then available for businesses for the productive purpose of the
country. Therefore, the banks are not only to the collect the financial resources but it also
provides the financial assistance for Oman's economic development. Hence, it is clear that
banks take part in the capital formation by accepting deposits and lending operations.
Investment in new enterprises: Organizations do not invest their money in new sectors
because of involvement of risks. Oman banks provide the short term as well as medium term
loans to fulfil their investment requirements. Thus, entrepreneurs invest in new enterprises
(Valdez and Molyneux, 2010). In turn, time credit and the productive capacity will be
increased also the investment will be encouraged.
Promotion of trade and industry: In all the countries, banks promote the trade within
industries. Oman banks also promote the trade by providing various services to them. The use
of bank drafts, check and bills of exchange also the letter of credit promotes both national as
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well as international trade. Therefore, it will greatly help to expand the Oman trade and
industry.
Development of agriculture: Agriculture in Oman is very important for centuries. The
government's economic development policy emphasizes the expansion of agricultural sectors.
Therefore, the banks of Oman are providing credit facilities for the development of
agriculture and small scale industries in rural areas. This in turn helps in increasing the
agricultural production of the economy (Buckle and Beccalli, 2011).
Balanced development: Commercial Banks play an important role so as to achieve
balanced development in different regions of the country. Oman banks transfer the amount of
surplus capital from developed regions to less developed regions. Therefore, the trader will
be able to get adequate amount of capital for meeting their business requirements
(Eichengreen, Barry and Hausmann, 2010). This in turn increases the trade and production in
the economy also the country's economic development.
Influencing economic activity: Oman banks can influence the economic activity of the
country by influencing the credit availability and the interest rate. It directly affects the Oman
economic development because low interest rate encourages the investment. Moreover, credit
creation activities can raise demand as well as economic production.
Therefore, it can be concluded that in Oman; banks highly encourage the trade and
investment and the economic production of the country in order to make economic
development. Moreover, banks also take part in virtual banking now days (Cetorelli and
Goldberg, 2011). It provides the banking services by the use of information technology
without direct recourse of customer and the bank. It includes the internet banking facilities
and use of electronic machines such as ATM. Hence, it can be said that in Oman banks are
taking part for the development of the country.
Types of Bank: There are different types of banks situated in Oman. As the
monitoring authority, there is a central bank of Oman (CBO) established in December, 1974
and began operations on 1st April, 1975. The central bank of Oman is headquartered in Ruwi.
It is responsible for maintaining the stability of the country's currency Omani rial. It ensures
financial stability in the country. The CBO also administers and participates in the bank
deposit insurance systems as it provides high level of security of deposit to commercial
banks. Moreover, there are some commercial banks situated in Oman such as National Bank
of Oman, Oman Arab Bank, Oman international Banks, Bank Muscat, Bank Dhofar and
Bank Sohar. The Minimum capital requirement for commercial banks is RO 50 million
(Beck, Demirgüç-Kunt and Levine, 2010). In addition to it, there are also some foreign banks
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are established named Bank of Baroda, Banque Banorabe, Citibank, HSBC bank, National
bank of Abu Dhabai, standard chartered bank and Barclays Bank. The attractiveness of the
Omani Banking Industry is that more and more foreign banks are getting license into the
sultanate. Three foreign banks named Qatar National Bank, Bank of Beirut and Gulf
Merchant Group has received approval from Oman central bank to establish a new retail and
commercial bank. The minimum capital requirement is RO10 million for establishing a
foreign bank in Oman. Moreover, there are some specialized banks such as Omani Housing
Bank, Oman Development Bank and Alliance Housing Bank. The Alliance Housing Bank
was the first private sector bank opened in January, 1988 to provide housing Loans and
relieve some pressure on the Omani Housing bank. The Bank is established with the aim of
providing housing loan facilities to the country.
Financial development relation to economic development: A prerequisite for
economic growth in every country is financial development. Finance plays an important role
in the economic growth as well as economic development. Development of financial section
of the country is helps in attaining continuous economic growth.
Financial development means the development of financial system including markets,
institutions and financing tools. Robust financial markets are considered as a mechanism for
the economic development of country. Moreover, it demands for powerful financial
institutions. Financial systems functions include information about investment opportunities,
aggregating savings and also monitoring the investments. Moreover, it facilitates the
exchange of goods and services. This in turn reduces the transaction cost (Grubel and Herbert
2014). In addition to it, it helps in optimum allocation of resources lead to economic growth
as well as the economic development. The relationship between financial development and
economic development can be seen on the basis of GDP Growth level. The economic
development of country is identifying by adding the financial development and the economic
growth. It can be in terms of different factors such as export, human capital also the
agriculture value added. For continuous growth, an important problem is about the optimum
uses of financial resources that are obtained from various economic activities. The
relationship between financial development and economic development helps the policy
makers in structuring the effective policy. In Oman, there is different financial indicators
investigates the short run and long run relationship between financial as well as economic
development. There is a positive relationship exists between financial and economic
development in Oman due to the economic growth. In Oman, the policies are designed in
such a way to encourage further investments in the financial and banking systems so as to
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make economic growth of the country. Moreover, in Oman there is a huge impact of financial
development in terms of trade openness. Banks provide credit facilities to the trade so as to
make economic growth. On contrary, they provide loans according to the business
requirement for different time duration so financial sources are available for the
organizations. Thus, it helps them in increasing the economic productivity (Claessens and
Forbes, 2013). This in turn, ensures economic growth and the development of the country.
The central bank of Oman is regulatory authority to manage the nation's money supply.
Moreover, the Oman banks are involving in mobilization of funds from the savers and offer
these funds to required sectors. Banks provide finance in terms of loan so the economic
development is affected. Furthermore, they offer capital lending more to the production
process that aims in contributing in company’s capital. Moreover, the Islamic banks
guarantee to Muslim that their contract would not include the interest factor. Therefore, it is
clear that financial development is considered as an important component of the overall
development strategy. It can be characterized by annual economic growth factor. The
financial institutions tries to build economic system stable (Eakins, and Mishkin, 2012).
Moreover, countries with better functioning banks and the other financial markets grow faster
than the other countries. Financial system mitigates the risks associated with individual’s
projects, firms and industries. In addition to it, it diversifies the risk and earns higher the
return from investments. Therefore, it can be concluded that economic development is very
much affected by the financial development of the country.
(2). Purchasing Power and Interest Rate Parity:
Purchasing Power: Purchasing power is the number of goods and services that can be
bought from one unit of any currency. In another words, it is the value of a currency that is
expressed in terms of the amount of goods or services that one unit of money can buy. It is
very important indicator of economy because inflation decreases the amount of goods and
services that would be purchase from one unit. Therefore, inflation decreases the purchasing
power of money because the goods or services will be available at higher rate in this time.
However, in deflation goods or services will be available to customer at lower rate. Hence, it
increases the purchasing power of money. Moreover, the buying power is also affected by the
income level if monetary income of consumers are increasing then their purchasing power
would also tend to rise and vice versa. It affects every aspects of economy like if purchasing
power decreases it implies rising the cost of goods or services contribute to high cost of living
as well as high interest rates. Thus, it affects the global market and result will be falling in
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credit rating therefore all these factors contribute to economic crisis. In investment terms, it is
expressed as the dollar amount of credit available to customers to buy additional securities.
Consumer price index is used to measure the purchasing power (Ehrmann, Fratzscher and
Rigobon, 2011). Moreover, purchasing power parity explains that exchange rate between one
currency and another currency is in equilibrium point when the domestic purchasing power at
that exchange rate is equivalent. It is used to compare the countries income levels also the
other economic data such as cost of living and possible rate of inflation and deflation.
Interest rate parity: It is the interest rate difference between two countries that is
equal to the differential between forward exchange rate and spot exchange rate. Forward
exchange rate is the exchange rate at which a bank agrees to exchange one currency in term
of another at a future date in forward contracts with an investor. However, spot exchange rate
is the rate for immediate delivery contract. Ones the deal is made then delivery will be take
place on second day at the spot exchange rate. It plays an very important role in foreign
exchange market connecting interest rates, spot exchange rates also the exchange rate
between countries. It is based on two assumptions one is that capital is mobile means investor
can readily change the domestic assets to foreign assets. The second assumption is that assets
have perfect substitutability; it follows the similarities with reference to riskiness and
liquidity. Therefore, the investors would be expected to hold those assets that offer higher the
returns (Schnabl, 2012). Moreover, no difference will be existed in the returns from both
domestic as well as foreign assets respectively. It may be of two types covered interest rate
parity and uncovered interest rate parity. Covered interest rate parity states that the difference
between the interest rates between two countries is offset by spot or forward exchange rate
premium. However, Uncovered Interest rate theory says that expected appreciation or
depreciation of a currency is offset by lower or higher interest.
Purchasing power and interest rate parity relates to central bank operations: A
central bank has great involvement in the foreign exchange market because it wants to reduce
the volatility also it has specific target exchange rates. Banks use forward exchange rates to
hedge its future payable or receivables denominated in foreign currency by using a forward
exchange rates. Central bank is responsible for controlling the money supply in the country
by making monetary policy (Seccareccia, 2012). Central bank is the monetary authority of a
country and controls the money supply by control over interest rates in order to maintain
stability and achieve high economic growth. It is also known as credit control measure
constructed by central bank (Reinhart and Rogoff, 2010). Bank rates, open market operations
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and the reserve requirements are some of the tools aim at controlling credit facilities available
to country.
Bank rate: Bank rate is the minimum rate at which commercial bank can take loan or
rediscounts its bills of exchange from central bank (Saunders, Cornett and McGraw, 2006).
When central bank found the inflationary pressure in the economy then it will raise the bank
rates so the borrowing becomes costly for commercial bank. Moreover, commercial bank
raise their interest rates on loan therefore, the borrower will take less credit, this in turn,
create contraction of credit and the prices so the inflation is controlled. However, if prices
are decrease then central banks lower the bank rate this in turn, commercial bank also lower
the interest rates so the loans will be available at lower the interest rates to consumers.
Therefore, investment is encouraged also the output, employment and income and demand
will rise so the downward movement of prices will be checked.
Open market operations: Open market operations refer to sale and purchase of
securities in the money market by central bank. When prices are increases then there is a need
to control the inflation so the central bank will sell the securities (Rose and Hudgins, 2014).
Therefore, the reserves of commercial banks are reduced so they can not lend more to the
business. This in turn reduces the money supply and further investment is discouraged so the
prices will move downward. Moreover, it reduces the inflation and purchasing power will be
increased. On contrary, if the prices are decreased then central bank will purchase the
securities in the market. Therefore, more money will be available to commercial banks for
their lending purpose. So the output, investment, employment, demand and income will be
rises this in turn, prices will also tend to rise. Thus, purchasing power will be decreased.
Reserves: Every commercial bank is required to keep a certain percentage of its
total deposits in the form of reserve fund with central banks. The deposits include both time
and demand deposits. Time deposits mean that money is repaid after a certain time period
whereas demand deposits will be repaid on the customer's demand. Central bank usually
changes the reserve ratio so as to control the inflation and deflation situations. Central banks
will increase the reserve ratio in case of inflation (Eun and Resnick, 2010). Therefore, banks
have to keep more funds with the central banks so they can lend less money to customers.
This in turn, investment, output, employment, income and demand are adversely affected. So,
the prices will be decrease due to less demand and thus, inflation can be control. On contrary,
if prices are decreased, then central bank also decreased the reserves so commercial banks
can lend more money to business. Therefore, the investment is encouraged also the
employment, output, income and demand will be rise. This in turn, deflation is controlled due
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to increasing in demand. Therefore, it can be concluded that central bank plays a very
important role in controlling the economic cycles such as inflation and deflation. This in turn,
affects the purchasing power of the country's currency.
Interest rate parity related to the central banks: Banks affect the domestic interest
rate by employing changes in its bank rates. If central banks rises the bank rate then
commercial bank will also tend to rise and vice versa (Bekaert and Hodrick, 2009).
Moreover, the central bank determines the bank rate keeping in mind the currency exchange
rates in terms of other countries so as to make equal return from domestic as well as foreign
investments. Under this situation, investor earns the equal return from investing in domestic
assets and foreign assets with different interest rates. Central bank decides the rates with the
objective of eliminating the interest differential of two different countries. Central banks
assure that no arbitrage opportunities will be exist for the investor because the return on
domestic deposits is equal to the foreign deposits return by the use of forward contracts. If it
does not happen then investor will make investment in higher return getting opportunities
whether domestic or foreign (Bank Financial Management, 2015). Therefore, the return will
be equivalent by making the following situation:
(1+ interest rate in domestic currency)= S/F(1+Interest rate in foreign currency)
Here, S- Current spot exchange rate
F- Forward exchange rate
Moreover, the forward exchange rate is differs from spot exchange rate in terms of
premium or discount. It is identified by using the following formula:
F= S(1+P)
Here, P is the premium if difference between forward and spot exchange rate is positive
or discount if the difference is negative (Berger, 2007). Thus, it is clear that in equilibrium
point, forward exchange rates premium or discount reflects the interest rate differentials and
make return equal from domestic or foreign assets.
CONCLUSION:
From the above report, it is clear that financial institutions are very important for the
economic growth of the country. They accept the bank’s deposits and satisfy the business
financial needs according to their requirements so as to make economic development.
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Moreover, the central bank is the higher authority which controls the nation's money supply
by implementing a monetary policy.
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REFERENCES:
Books and Journals
Beck, T., Demirgüç-Kunt, A. and Levine, R., 2010. Financial institutions and markets across
countries and over time: The updated financial development and structure database. The
World Bank Economic Review. 24(1). 77-92.
Bekaert, G. and Hodrick, R. J. 2009. International financial management. Pearson Prentice
Hall.
Berger, A. N. 2007. International comparisons of banking efficiency. Financial Markets,
Institutions & Instruments, 16(3). pp. 119-144.
Buckle, M. and Beccalli, E., 2011. Principles Of Banking And Finance. Available
through:<http://www.londoninternational.ac.uk/sites/default/files/
programme_resources/lse/lse_pdf/subject_guides/fn1024_ch1-4.pdf> [Accessed on
14th November 2015].
Cetorelli, N. And Goldberg, L. S. 2011. Global banks and international shock transmission:
Evidence from the crisis. IMF Economic Review. 59(1). pp. 41-76.
Claessens, S. and Forbes, K. 2013. International financial contagion. Springer Science &
Business Media.
Eakins, G. and Mishkin, S., 2012. Financial markets and institutions. Boston: Prentice Hall.
Ehrmann, M., Fratzscher, M. and Rigobon, R. 2011. Stocks, bonds, money markets and
exchange rates: measuring international financial transmission. Journal of Applied
Econometrics. 26(6). pp. 948-974.
Eichengreen, Barry and Hausmann, R., 2010. Other people's money: debt denomination and
financial instability in emerging market economies. University of Chicago Press.
Eun, C. S. and Resnick, B. G. 2010. International Financial Mgmt 4E. Tata McGraw-Hill
Education.
Grubel and Herbert G., 2014. A theory of multinational banking. PSL Quarterly Review.
Hardie, I. and Howarth, D., 2013. Market-Based Banking and the International Financial
Crisis. OUP Oxford, 2013.
Park, S. Y. and Essayyad, M., 2012. International Banking and Financial Centers. Springer
Science & Business Media.
Reinhart, C. M. and Rogoff, K. S., 2010. From financial crash to debt crisis. National Bureau
of Economic Research.
Rose, P. and Hudgins, S., 2014. Bank Management & Financial Services. 9th Edition.
Saunders, A., Cornett, M. M., & McGraw, P. A., 2006. Financial institutions management: A
risk management approach (Vol. 8). McGraw-Hill/Irwin.
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Schnabl, P., 2012. The international transmission of bank liquidity shocks: Evidence from an
emerging market. The Journal of Finance. 67(3). pp. 897-932.
Seccareccia, M., 2012. Financialization and the transformation of commercial banking:
understanding the recent Canadian experience before and during the international
financial crisis. Journal of Post Keynesian Economics. 35(2). pp. 277-300.
Valdez, S. and Molyneux, P., 2010. An Introduction to Global Financial Markets. Palgrave
Macmillan.
Online
Bank Financial Management, 2015. [pdf]. Available through:
<http://www.cefims.ac.uk/documents/sample-11.pdf>. Accessed on 14th November
2015].
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