CA-FINAL
SFM
FOREIGN EXCHANGE
EXPOSURE AND RISK
MANAGEMENT
RAJESH RITOLIA, FCA
HELPING HAND INSTITUTE
G-80, 2ND FLOOR, GUPTA COMPLEX, LAXMI NAGAR, DELHI-92
PH: 9350171263, 9910071263
Email: rritolia@correctingmyself.in; Web: correctingmyself.in
Note:
(a)
Video CD of missing classes will be provided free of cost
(b)
Updated notes can be downloaded free of cost from our website: correctingmyself.in
(c)
Updated classes can be covered in future at free of cost
Positive Thoughts
EVEN A SMALL DOT CAN STOP A BIG SENTENCE. BUT FEW MORE DOTS CAN GIVE A
CONTINUITY. AMAZING BUT TRUE, EVERY ENDING CAN BE A NEW BEGINNING.
DON’T WASTE TODAY FOR WHAT HAPPENED YESTERDAY
LIFE IS JUST LIKE A BEACH. WE ARE MOVING WITHOUT END. NOTHING STAY WITH US.
WHAT REMAIN WITH US IS THE MEMORIES OF SOME SPECIAL PEOPLE WHO TOCHED US
AS WAVE.
I AM RESPONSIBLE FOR WHAT I SAY, NOT FOR WHAT YOU UNDERSTAND.
THE WORLD IS CHANGED BY YOUR EXAMPLE, NOT BY YOUR OPINION.
BE A GOOD PERSON, BUT DO NOT WASTE TIME TO PROVE IT
Chapter Analysis
THEORY
8
7
6
5
4
3
2
1
0
M11
N11
M12
N12
M13
N13
M14
N14
M15
N15
PRACTICAL
25
20
15
10
5
0
M11
N11
M12
N12
M13
N13
M14
N14
M15
N15
Chap – 10
SUMMARY OF FOREX
Index
Particulars
Summary of Topics
10.0
FOREIGN
MARKET
10.0.1
MARKET PARTICIPANTS
Non-bank Entities; Banks; Speculators; Arbitrageurs; Governments.
10.0.2
Fixed
and
Floating
Exchange Rates
In some countries the government fixes the rate of exchange called ‘fixed exchange rate’ for its own
currency. This is called ‘official rate of exchange’.
EXCHANGE
Every firm and individual operating in international environment faces problems with foreign exchange
i.e., the exchange of foreign currency into domestic currency and vice-a-versa. Because the value of
one currency relative to another is constantly changing, the conversion become risky. It has resulted in
the foreign exchange risk management becoming one of the basic issues in international financial
management.
In other countries, the rates move, depending on the demand and supply pressures and will be further
influenced by market forces and economic conditions of the respective countries. This is called ‘floating
exchange rate’.
10.0.3
International
Instruments
Credit
10.1
Foreign
Exchange
Exposure or Risk /
Types of Exchange
Rate Risk
Transaction Exposure; Translation Exposure; Economic Exposure
10.1.1
RISK CONSIDERATIONS
Financial Risk, Business Risk, Credit or Default Risk, Country Risk, Interest Rate Risk, Political Risk,
Market Risk, Foreign Exchange Risk
10.1.2
Techniques for Managing
Risk/
Methods
of
Managing Risk
Open position No hedging, Forward contract, Currency Futures or Option, Futures contract, Money
market hedge, Netting, Matching, Leading and lagging, Price variation, Invoicing in foreign Currency,
Assets and liability management, Arbtirage, Foreign Currency Bank Account
10.2
Exchange
Determination
A foreign exchange rate, represents the value of a specific currency compared to that of another
country.
Rate
Telegraphic or Cable Transfer; Mail Transfer; Banker’s Draft and Banker’s Cheques; Letter of Credit;
International Money Orders; Buying and Selling Rates; TC Buying and Selling Rates.
The currency listed on the left is called the reference (or base) currency while the one listed to the right
is the quote (or term) currency.
In the Foreign exchange market, the quote may be denoted as direct or indirect.
Direct Quote
It indicates the number of units of the domestic currency required to buy one unit of foreign currency.
Example: $1 = Rs.45 is a direct quotation for US $ in India.
Indirect Quote
It indicates the number of units of foreign currency that can be exchanged for one unit of the domestic
currency.
Example Rs.1 = US $ 0.02065 is an indirect quotation in India.
Direct Quote
= 1/Indirect Quote
10A.1
Q No
Exam
Chap – 10
SUMMARY OF FOREX
American Quote
It refers to quoting per unit of any currency in terms of American Dollars
European Quote
It refers to quoting per unit of American Dollars in terms of any other currency.
10.3
Party who is affected
by Foreign exchange
fluctuation
In foreign Exchange transaction, Only one party remains at risk. The Party whose payable/ receivable
currency are different from his domestic currency remains at risk.
10.4
Spot and forward rate
Spot Exchange Rates: The spot exchange rate is the current rate at which one currency can be
immediately converted into another currency. The spot rate is the rate paid for delivery within two
business days after the day the transaction takes place.
10A.2
A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the currency
at some future date. They agree to transact a specific amount of currency at a specific rate at a
specified future date.
It is set and agreed by the parties and remains fixed for the contract period regardless of the
fluctuations in the spot exchange rates in future.
If funds to fulfill the contract are available on hand or are due to be received by the business, the
hedge is considered to be ‘covered’.
In situations where funds to fulfill the contract are not available but have to be purchased in the spot
market at some future date, then such a hedge is known as ‘uncovered’.
Forward contract is not entered into for gain or loss but it is entered into to make payable/ receivable
certain or risk free. Entering into forward contract is known as hedging.
10.5
10.6
10.7
Relationship between
Spot
Rate
and
Forward
Rates/Expected Spot
Rate/maturity
Spot
Rate
Difference between Spot rate and future rate is known as premium or discount in any one currency
Premium/Dis on LHC ≠ Dis/Premium on RHC
Currency is said to have appreciated if its value has increased, i.e. USD 1 = Rs.40 becomes USD 1 =
Rs.42. Here the value of USD has increased.
Currency is said to have depreciated if its value has decreased, i.e. USD 1 = Rs.41 becomes USD 1 =
Rs.39. Here the value of USD has decreased.
Premium/(Discount)
in
% may be ascertained
as follows
Premium/(Discount) on LHC for period of Quote = (FR-SR)*100/SR
If SR and Prem/ Disc
is given, then we can
calculate FR or ESR
or MSR as follows
If premium/ Dis is on LHC Currency = 1 LHC = SR*(1+-Prem/Disc)
Calculation of Gain or
loss due to foreign
Exchange fluctuation
Rules for calculation of Gain/ Loss on Foreign Exchange Transaction
Rule-1
If foreign currency is to be received in future [FC-Sell; DC-Buy]
1
Premium/(Discount) on RHC for period of Quote = (SR-FR)*100/FR
If premium/ Dis is on RHC Currency = 1 LHC = SR/(1+-Prem/Disc)
2
Chap – 10
SUMMARY OF FOREX
10A.3
If foreign currency is to be paid [FC-Buy; DC-Sell]
Rule-2
for conversion of one
currency
to
another
currency
10.7.1
10.7.2
If required/available currency and LHC is same, then at the time of conversion we will multiply with
Exchange rate
If required/available currency and LHC is different, then at the time of conversion we will divide with
Exchange rate
Calculate gain loss if no
hedging is done
Compare TSR vs MSR
Calculate gain
hedging is done
if
Compare TSR vs FR
Whether hedging should
be done or not
Compare ESR vs FR
loss
3
If MSR is not given, then we can assume ESR as MSR
4
N-03
5
M-03
Calculate ESR and FR of Same maturity date, then we should compare both rates as follows
Always think about LHC
If LHC is receivable and is to be sold – Select Higher of ESR and FR for decision
If LHC is payable and to be purchased - Select Lower of ESR and FR for decision
ESR
ESR = ESR1*P1 + ESR2*P2 + ESR3*P3
10.7.3
Calculation
of
through probability
10.7.4
Analysis of Decision of
hedging
on
maturity
Date
Compare FR vs MSR
10.8
Cross Rates
Cross Rate denotes an exchange rate that does not involve the required currency. It is an exchange
rate between the currencies of two countries that are not quoted against each other, but are quoted
against one common currency.
8-10
10.9
Two Way Quote
Two way quotes refer to quoting exchange rates by an exchange dealer in terms of buying (Bid)
Rate and selling (Ask) Rate.
11
Bid rate is the rate at which the dealer is willing to buy LHC. In other words it is selling rate of LHC for
customer.
Offer (Ask) Rate is the rate at which Dealer is willing to sell LHC. In other words it is buying rate of
LHC for customer.
$ 1 = Rs.48.80 - 48.90.
Dealer is willing to buy $ at Rs.48.80 (sell rupees and buy dollars), while he will sell $ at Rs. 48.90 (buy
rupees and sell dollars).
From the Dealer point of view: First is Buying Rate and Second is Selling rate of LHC
From the Customer point of view: First is Selling Rate and Second is Buying rate of LHC
Spread
The difference between the bid and the offer is called the spread.
Spread (%) = [Bid – Ask]*100/Bid
Spread (Amt) = [Bid – Ask]
6-7
M-14
Chap – 10
SUMMARY OF FOREX
Conversion
of
direct
quote into indirect quote
10.10
1$ = Rs.40.00 – 40.05
Rs.1 = $1/40.05 – 1/40.00 = $0.0249 – 0.025
Swap Points are movement in Exchange Rate expressed in absolute terms, i.e. in value terms
Swap Points
10A.4
12-13
If Swap points is given in ascending order (increasing order) or spread is positive, we add it to right
hand side currency to calculate Forward Rate. It indicates that the left hand side currency is at
premium.
If forward margin is given in decending order (decreasing order) we deduct it from right hand side
currency to calculate Forward rate. It indicates that the left hand side currency is at discount.
10.11
Analysis of decision of
hedging under two
Quote rates
10.12
Money Market Hedge
14-15
Money Market Operations refers to creating an equivalent asset or liability against a Foreign Currency
Liability or Receivable.
16-18
Under money market operation the following steps are taken.
If foreign currency is to
be received in future
[Assets in FC]
Borrowing in FC [Creating Liability in FC] = Amount of borrowing (X) = Amount receivable in FC/(1 +
PIRFC)
M-09-O
N-15
M-15
M-10-O
N-13
N-09
N-12
N-08
Convert FC to DC = Domestic Currency receivable (Y) = (X)*Today SR or (X)/Today SR
N-08
Investment in Domestic Currency [Creating Assets in DC] = Amount to be invested = Y
M-07
On Maturity Date
Receive and Repay FC
Realisation of Investment in DC - Amount to be received = (Y)*(1+PIRDC)
If foreign currency is to
be
paid
in
future
[Liability in FC]
Deposits in FC [Creating Assets in FC] = Deposit (X) = Amount payable in FC/ (1 + PIRFC)
Borrowing and Convert [Creating Liability in DC] = Amount to be borrowed (Y) = (X)*Today SR or
(X)/Today SR
On Maturity Date
Receive and Repay FC
Repayment of Borrowing in DC = Amt to Repay = (Y)*(1+PIRDC)
10.12.1
Money market with Tax
rate
For incorporation of tax, calculate tax saving on Intt and Foreign Exchange Gain/ Loss as follows:
19
(a) Interest rate should be taken as net of tax. Intt (1-Tax Rate);
(b) Calculate Gain/ Loss due to change in exchange rate and calculate tax/ tax saving on them.
10.13
Cancellation
Forward Contract
of
10.13.1
&
10.13.2
Cancellation of Forward
Contract on or before
maturity
Forward contract can be cancelled at the request of the customer. This request may be made on or
before or after maturity date. Original forward Contract can be cancelled by entering into reverse
contract.
If the request is made on or before the maturity date
The bank recovers/pays, as the case may be, the difference between the contracted rate and the rate
at which the cancellation is affected.
20
21-23
N-04
M-02
Chap – 10
10.13.3
10.13.4
10.14
10.14.1
SUMMARY OF FOREX
Cancellation
after
maturity date but before
15th day of maturity
If the request is made after the maturity date
If customer did not
approach bank, then
cancellation on 15th Day
from
the
date
of
maturity
In the absence of any instructions from the customer
Extension
contract
of
forward
10A.5
24
Gain to Customer is not paid to him, but loss to customer is recovered from him
25
Contracts which have matured are automatically cancelled on the fifteenth day from the date of
maturity. In case the fifteenth day falls on a Saturday or holiday, the contract is cancelled on the next
working day. Exchange difference, if any, is recovered from the customer, but customer is not paid any
gain accruing to him from such cancellations.
Extension of Forward contract involves
26
Cancelation of Old contract + New forward contract as per requirement
Extension of Forward
Contract with margin
money
If bank charges Margin Money, then Buying/ Selling rate for customer will be
THEORIES
OF
EXCHANGE
RATE
DETERMINATION/PARITY
CONDITIONS
IN
INTERNATIONAL
FINANCE
There are three theories of exchange rate determination - Interest rate parity, Purchasing power parity
and International Fisher effect
10.15.1
Interest Rate
Theorem
Forward exchange rate of the two countries is determined by various factors like, interest rate, inflation
rate, GDP, Monetary Policy etc.
Interest rate parity theory assumes that the forward exchange rate of the two countries is determined
by their interest rate differential assuming other factors remain constant.
[1 + PIR[RHC]]*SR/[1 + PIR[LHC]]
FR under IRPT =
Prem/(Dis)
on
under IRPT =
LHC
Prem/(Dis)
on
under IRPT =
RHC
N-15
M-15
N-10-O
Selling Rate for LHC = Rate Selected as per rule - Margin Money Payable to Bank
10.15
Parity
27-28
Buying Rate for LHC = Rate Selected as per rule + Margin Money Payable to Bank
[PIR[RHC] - PIR[LHC]]*100/[1 + PIR[LHC]] OR
[FR[IRPT] - SR]*100/SR
[PIR[LHC] - PIR[RHC]]*100/[1 + PIR[RHC]] OR
[SR - FRIRPT]*100/FRIRPT
Under IRPT, the currency whereof, the interest rate is higher will be at discount and the currency
whereof, the interest rate is lower will be at premium in future.
Whether IRPT Exists or
not/Interest Rate and FR
are in equibilrium ?
If FRIRPT = FRActual then IRPT exists OR
Arbitrage Profit
If IRPT does not exists, then arbitrage profit is possible
IF SR, FR and IR of one
currency is given, then
FRGiven = FRIRPT = [1 + PIR[RHC]]*SR/[1 + PIR[LHC]] or
If Prem/(Dis)IRPT = Prem/(Dis)Actual then IRPT exists
29-31
N-12
N-08
M-04
M-13
Chap – 10
SUMMARY OF FOREX
calculate IR of another
currency by assuming
that IRPT exists
FRIRPT/SR = [1 + PIR[RHC]]/[1 + PIR[LHC]]
IF
SR,
IR
of
one
currency and prem/(Dis)
in one currency is given,
then calculate IR of
another
currency
by
assuming
that
IRPT
exists
1st we will calculate FR
10A.6
IF premium/ Dis is on LHC, then FR or ESR: 1 LHC = SR*(1+-Prem/Disc)
IF premium/ Dis is on RHC, then FR or ESR: 1 LHC = SR/(1+-Prem/Disc)
2nd we will calculate interest rate of another currency by applying
FRcalculated = FRIRPT = [1 + PIR[RHC]]*SR/[1 + PIR[LHC]] or
FRIRPT/SR = [1 + PIR[RHC]]/[1 + PIR[LHC]]
10.15.2
PURCHASING POWER
PARITY
THEORY
(PPPT)
PPP says that the exchange rate between two currencies must be proportional to the price level of
goods in two countries.
The Absolute PPP
The Absolute PPP is based on the preposition that a commodity costs the same regardless of what
currency is used to buy or where it is selling. If a book costs £4 in UK and exchange rate is £.60 per $,
then the book will cost £ 4/.60 = $ 6.66 in the U.S.
32-34
N-08
There are two forms of PPP, Absolute and Relative.
The Absolute PPP assumes that:
(i)
(ii)
(iii)
The transaction costs are nil,
There is no barrier to trade, and
The goods are identical.
Relative PPP
Relative PPP suggests that the change in exchange rate is determined by the difference in the inflation
rate in two countries.
FR under PPPT =
[1 + PIFR[RHC]]*SR/[1 + PIFR[LHC]]
Prem/(Dis)
on
under PPPT =
LHC
Prem/(Dis)
on
under PPPT =
RHC
[PIFR[RHC] - PIFR[LHC]]*100/[1 + PIFR[LHC]] OR
[FR[PPPT] - SR]*100/SR
[PIFR[LHC] - PIFR[RHC]]*100/[1 + PIFR[RHC]] OR
[SR - FRPPPT]*100/FRPPPT
Under PPPT, the currency whereof, the inflation rate is higher will be at discount and the currency
whereof, the inflation rate is lower will be at premium in future.
10.15.3
Whether PPPT Exists or
not/Inflation Rate and
FR are in equibilrium ?
If FRPPPT = FRActual then PPPT exists OR
Arbitrage Profit
If PPPT does not exists, then arbitrage profit is possible
INTERNATIONAL
FISHER EFFECT (IFE)
(1+ Nominal Interest) = (1 + Real Interest rate)*(1 + Inflation Rate)
FR under IFE =
[1 + PNIR[RHC]]*SR/[1 + PNIR[LHC]]
M-10
If Prem/(Dis)PPPT = Prem/(Dis)Actual then PPPT exists
35-36
M-13
Chap – 10
SUMMARY OF FOREX
10A.7
Under PPPT, the currency whereof, the Nominal Interest rate is higher will be at discount and the
currency whereof, the nominal interest rate is lower will be at premium in future.
10.16
Cross Rate
way Quotes
in
Two
All above concepts will be same except cross rates is to be calculated
37-43
N-14
M-14
M-14
N-13
N-13
M-13
N-11
M-09
N-05
M-05
10.16.1
Cancellation of Forward
Contract
and
Cross
Rates
10.17
Arbitrage
Operation/Currency
Arbitrage
44
N-15
The process of buying goods/currency in one market and selling the same in another market is known
as arbitrage. Arbitrage profit is risk less profit.
There are two types of arbitrage in forex markets:
(i) Exchange rate arbitrage and
(ii) Interest rate arbitrage.
10.18
Exchange
Arbitrage
Geographical
Arbitrage
Rate
or
It refers to a situation in which one currency is cheaper in one foreign exchange market and costlier in
the other one. A person may purchase the currency at lower rate in one market, may sell at the higher
rate in the other market and make a profit. This profit arises at the same time.
Buying at lower rate and selling at higher rate.
Exchange rate arbitrage transactions may be classified in terms of the number of markets involved.
Thus, we may have two-point and three-point arbitrage.
10.18.1
Two-point arbitrage
Two-point arbitrage concerns two currencies in two geographically separated markets.
45-47
10.18.2
Cross
rate
Arbitrage/Three-point
(triangular) arbitrage
It covers three geographical area
48-49
10.18.3
Four-point arbitrage
It covers four geographical area
50
10.18.4
Arbitrage Profit with
Margin Money
If LHC is to be bought, Margin money should be added to Exchange Rate
51
International Portfolio
International Portfolio means investment in foreign securities
10.19
N-08-O
N-14
If LHC is to be sold, Margin money should be deducted from Exchange Rate
52-55
M-12
Chap – 10
SUMMARY OF FOREX
10A.8
Management
Return from investment
in Domestic Security
(P1-P0+Div + Intt)*100/P0
Return from investment
in foreign Security =
(1+Return from Security)(1 +- Prem/Dis on Invested Currency) – 1
10.19.1
SD
of
return
from
international investing
√(SDx)2 + (SDFEF)2 + 2(SDX)(SDFEF)CORXFEF
10.20
Covered
Arbitrage
An interest arbitrage is possible when the forward premium or forward discount between two currencies
does not equal the interest rate differential.
Interest
56
57-58
N-13
N-10
If IRPT exists, then Interest arbitrage is not possible. As premium or discount in currency would be
equal to interest rate differential of two countries.
N-06
M-06
If IRPT does not exist, then Interest arbitrage is possible.
If FRActual = FRIRPT then arbitrage is not possible
Borrowing in LHC
Investment in RHC
&
Borrowing in RHC
Investment in LHC
&
If FRIRPT > FRActual i.e. FR Actual is Undervalued OR
If Prem on LHC < Loss of Intt on LHC OR
Alternative Method for
calculation of Arbitrage
profit
If FRIRPT < FRActual i.e. FR Actual is Overvalued OR
If Prem on LHC > Loss of Intt on LHC
Arbitrage Profit (in term of %) = Return from Invested Currency – Borrowing Cost
Borrowing Amt*Arbitrage Profit in %
10.20.1
Arbitrage Profit in case
of
Continuous
Compounding Interest
59
10.20.2
Covered
Interest
Arbitrage in case of
Single
Quote
with
transaction cost
If there is transaction cost for foreign transaction, then return from foreign investment may be
calculated as follows
10.20.3
Covered
Interest
Arbitrage in case of Two
Quote
Trial and Error Method
61-63
10.21
Foreign
Currency
Payment with Interest
Question will give option, whether we should pay immediately or after some time with interest
64-65
M-12
60
(1+Return from investment)(1 +- Prem/(Dis) on invested currency)(1-TC)2 – 1
We will calculate inflow and outflow under both option and then we will accept those option beneficial to
us
M-12
M-15
N-14
N-12
N-11
Chap – 10
10.21.1
SUMMARY OF FOREX
Letter of credit is an instrument issued in the favour of the seller by the buyer bank assuring that
payment will be made after certain timer frame depending upon the terms and conditions agreed.
Letter of Credit
10A.9
66
N-08-O
M-15
67-68
M-07
N-15
Under letter of credit, Bank charges commission and interest.
Commission is payable at the beginning of period.
Repayment of LC is made along with interest at maturity date.
10.22
10.23
International working
capital management
MNC have various branches or subsidiaries in many countries. MNC manages cash in two ways
Centralised
Management
Cash
Under this system, branches having surplus cash transferred immediately to HO and any deficit of cash
in any branches are met by HO. Any borrowing/ Surplus of cash is managed by HO
Decentralised
Management
Cash
Under this system, each branches manage their cash independently. Borrowing/ Deposit are done by
branches. At the end of period (like month, quarter etc) surplus cash in any branch are transferred to
HO and deficit of cash in any branch are met by HO
Currency Swaps refer to the arrangement where principal and interest payments in one currency are
exchanged for such payments in another currency. It is another method of hedging.
CURRENCY SWAPS
69-71
M-13
N-12
A currency swap can consist of three stages.
(i)
A spot exchange of principal.
(ii) Continuing exchange of interest payments during the term of the swap.
(iii) Re-exchange of principal on maturity
10.24
NOSTRO,
VOSTRO
AND LORO ACCOUNTS
These accounts are Nostro, Vostro and Loro accounts meaning "our", "your" and "their".
Nostro Accounts:
A Domestic bank's foreign currency account maintained by the bank in a foreign country and in the
home currency of that country is known as Nostro Account or "our account with you". For example, An
Indian bank's Swiss franc account with a bank in Switzerland.
72
N-05
73-74
N-06
Actual inflow of foreign currency is credited to this account and actual outflow of foreign currency is
debited to this account.
A Nostro is our account of our money, held by you
10.25
Vostro account
It is the local currency account maintained by a foreign bank/branch. It is also called "your account with
us". For example, Indian rupee account maintained by a bank in Switzerland with a bank in India.
Loro account
Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit
to an account of a third bank.
Netting [Method
Hedging]
Types of netting
of
NETTING: Netting involves offsetting exposures in one currency with exposures in the same or another
currency. The basic idea behind the netting is to transfer only net amounts, usually within a short
period.
Bilateral Netting: Company X exports goods to Company Y for US $2 million and imports goods worth
$1.5 million from Company Y. Their dates of maturity are the same, so they can offset net payment.
M-13
Chap – 10
SUMMARY OF FOREX
10A.10
Multilateral Netting: It involves netting of risk exposure among more than two company. It is
performed by the central treasury where several subsidiaries interact with head office.
10.26
Matching [Method of
Hedging]
The foreign exchange rate risk can be eliminated or reduced, if the company which is having exposure
to receipts and payments in the same currency. The company can off set its payments against its
receipts if it can plan properly. This can be managed by operating a bank account in overseas to offset
the transaction. The basic requirement for a matching operation is the two-way cash flow in the same
foreign currency is called ‘natural matching’. If the matching involves between two currencies whose
movements are expected to run closely is called ‘parallel matching’.
10.27
Leading and Lagging
[Method of Hedging]
Leading: A firm having exposure to pay foreign currency, can make payments in advance prior to
due date called “Leads” to take advantage of lesser rate of foreign currency. In such cases, the firm
should consider the interest loss on opportunity to deploy funds elsewhere.
75-76
M-12
77
N-04
Lagging: If the firms delays the payments over the due date to take advantage of the exchange
fluctuation it is called “Lags”. The technique used in this is to delay payment of weak currencies and
bring forward payment of strong currecies.
10.28
Other
methods
hedging
of
Price Variation [Method of Hedging]
Invoicing in foreign currency [Method of Hedging]
Assets and Liability Management
Maintaining a foreign currency Bank account
10.29
10.30
When
Transaction
date
and
forward
contract
date
are
different
We will Compare SR of Contract date and FR for calculating Prem/Dis
Cross-Currency
Over
Cross Currency Roll Over contacts are contracts to cover long term foreign exchange liabilities or
assets. The cover is initially obtained for six months & later extended for further period of 6 months &
so on. Forward rate beyond 6 months is not available in market.
Roll
We will Compare SR of Transaction Date and FR for calculating Operating Profit
78
Under the Roll over contracts the basic rate of exchange is fixed but loss or gain arises at the time of
each Roll over depending upon the market conditions.
Roll-over-forward contract is one where forward contract is initially booked, for the total amount of
loan, etc. to be repaid. As and when installment falls due, the same is paid by the customer in foreign
currency at the exchange rate fixed in forward exchange contract. The balance amount of the contract
is rolled over (extended) till the due date of next installment. The process of extension, continues till
the loan amount has been repaid.
10.31
Misc Question
79-86
N-09
N-15
M-09
M-14
M-08
N-12
N-07
N-12
N-07
10.32
Theory
Explain the significance of LIBOR in international Financial Transactions.
1
M-11
Chap – 10
SUMMARY OF FOREX
Operations in foreign exchange market are exposed to a number of risks." Discuss
10A.11
2
N-14
N-14
N-07
What is the meaning of (i) Interest rate parity and (ii) Purchasing power parity
3
M-11
Write short notes on Arbitrage Operation
4
N-08
Write short notes on Nostro, Vostro and Loro Account
5
M-12
Explain the term ‘Exposure Netting’, with an example
6
M-12
N-15
N-04
Write short notes on Leading and Lagging
7
N-11
M-15
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.1
10.0 FOREIGN EXCHANGE MARKET
Every firm and individual operating in international environment faces problems with foreign exchange i.e., the exchange of foreign currency into domestic currency and vice-a-versa. Because
the value of one currency relative to another is constantly changing, the conversion become
risky. It has resulted in the foreign exchange risk management becoming one of the basic issues
in international financial management.
The foreign exchange transactions (i.e., for the sale and purchase of foreign currencies) take
place in foreign exchange market which provides a mechanism for transfer of purchasing power
from one currency to another. This market is not a physical entity like the Mumbai stock
exchange or a trading center, rather it is a network of telephones among banks, foreign
exchange dealers and brokers etc.
The foreign exchange market operates at four levels.
At the first level, are tourists, importers, exporters, investors, etc. These are the immediate users
and suppliers of foreign currencies.
At second level are the commercial banks which act as clearing houses between users and
earners of foreign exchange.
At the third level are foreign exchange brokers through whom the nation's commercial banks
even out their foreign exchange inflows and outflows among themselves.
Finally, at the fourth and highest level is the nation's central bank which acts as the lender or
buyer of last resort when the nation's total foreign exchange earnings and expenditures are
unequal. The central bank then either draws down its foreign exchange reserves or adds to them.
10.0.1 MARKET PARTICIPANTS
The participants in the foreign exchange market can be categorized as follows:
(i) Non-bank Entities: Many multinational companies exchange currencies to meet their import
or export commitments or hedge their transactions against fluctuations in exchange rate.
Even at the individual level, there is an exchange of currency as per the needs of the
individual.
(ii) Banks: Banks also exchange currencies as per the requirements of their clients.
(iii) Speculators: This category includes commercial and investment banks, multinational
companies and hedge funds that buy and sell currencies with a view to earn profit due to
fluctuations in the exchange rates.
(iv)Arbitrageurs: This category includes those investors who make profit from price differential
existing in two markets by simultaneously operating in two different markets.
(v) Governments: The governments participate in the foreign exchange market through the
central banks. They constantly monitor the market and help in stabilizing the exchange rates.
10.0.2 Fixed and Floating Exchange Rates
(a)
In some countries the government fixes the rate of exchange called ‘fixed exchange rate’ for
its own currency. This is called ‘official rate of exchange’. These rate will be fixed by the
respective government from time to time for the betterment of their economy.
(b)
In other countries, the rates move, depending on the demand and supply pressures and will
be further influenced by market forces and economic conditions of the respective countries.
This is called ‘floating exchange rate’.
10.0.3 International Credit Instruments
The following are the International Credit Instruments
Telegraphic or Cable Transfer: The remittance of foreign exchange through TT is sent by
telegraph or cable. The customer who intend to remit funds through TT will approach the
authorized dealer and purchase a TT and pay money to the dealer in the currency of his country
and will ask the dealer to make payment in foreign currency to his payee situated in foreign
country. Since the remittance is sent through cable, no specimen signature would be there for
verification and hence code numbers are used to identify the genuinity of the remittance. TT
mode of remittance is the fastest as compared to other forms. The payee receives the amount on
the same day. The dealer will charge for the services rendered in this form.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.2
Mail Transfer: In MT, customer pay to authorized dealer in currency of his own country ask him
to remit money by mail to be payable to payee in the foreign country. Dealer will make an order
on its corresponding bank in the foreign country to make payment to the payee. In this mode of
remittance, more time would be taken than in the case of TT.
Banker’s Draft and Banker’s Cheques: The banker’s draft or cheque is drawn by a bank on its
foreign correspondent and is remitted by the buyer.
Letter of Credit: It is a method of making trade payment, especially while dealing with unknown
traders. Through this instrument, it is ensured of specific performance by both the parties. The
importer makes an application to his bank to establish letter of credit in favour of the beneficiary,
through another bank. The another bank shall in turn advice the beneficiary.
International Money Orders: These money orders are issued by the post office of respective
countries. The money order is issued in home currency and the post offices in the receiving
country have to convert them into local currency when paying to the payee.
Buying and Selling Rates: Currency buying rate is applicable when a purchase of foreign
currency is undertaken by bank. Currency Selling rate is applicable when a selling of foreign
currency is undertaken by bank.
TC Buying and Selling Rates: Traveller’s cheque buying rate is applicable for purchase of
foreign currency traveller’s cheque by the bank. Traveller’s cheque Selling rate is applicable for
selling of foreign currency traveller’s cheque by the bank.
10.1 Foreign Exchange Exposure or Risk / Types of Exchange Rate Risk
[Nov-2007] [M-3] Operations in foreign exchange market are exposed to a number of risks."
Discuss.
[Nov-2014] [M-4] [RTP-Nov-2014-20b] What are the risks to which foreign exchange
transactions are exposed?
Solution
A firm dealing with foreign exchange may be exposed to foreign currency exposures. The
exposure is the result of possession of assets and liabilities and transactions denominated 'in
foreign currency. When exchange rate fluctuates, assets, liabilities, revenues, expenses that have
been expressed in foreign currency will result in either foreign exchange gain or loss. A firm
dealing with foreign exchange may be exposed to the following types of risks:
(a) Transaction Exposure: A firm may have some contractually fixed payments and receipts in
foreign currency, such as, import payables, export receivables, interest payable on foreign
currency loans etc. All such items are to be settled in a foreign currency. Unexpected
fluctuation in exchange rate will have favourable or adverse impact on its cash flows. Such
exposures are termed as transactions exposures.
(b) Translation Exposure: The translation exposure is also called accounting exposure or
balance sheet exposure. It is basically the exposure on the assets and liabilities shown in the
balance sheet and which are not going to be liquidated in the near future. It refers to the
probability of loss that the firm may have to face because of decrease in value of assets due
to devaluation of a foreign currency despite the fact that there was no foreign exchange
transaction during the year.
(c) Economic Exposure: Economic exposure measures the probability that fluctuations in
foreign exchange rate will affect the value of the firm. The intrinsic value of a firm is
calculated by discounting the expected future cash flows with appropriate discounting rate.
The risk involved in economic exposure requires measurement of the effect of fluctuations in
exchange rate on different future cash flows.
10.1.1 RISK CONSIDERATIONS
There are several types of risk that an investor should consider and pay careful attention to. They
are:
(i)
Financial Risk: It is the potential loss or danger due to the uncertainty in movement of
foreign exchange rates, interest rates, credit quality, liquidity position, investment price,
commodity price, or equity price, as well as the unpredictability of sales price, growth, and
financing capabilities.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.3
(ii) Business Risk: On a micro scale, business risk involves the variability in earnings due to
variation in the cash inflows and outflows of capital investment projects undertaken. This
risk, also known as investment risk, may materialize because of forecasting errors made in
market acceptance of products, future technological changes, and changes in costs related to
projects.
(iii) Credit or Default Risk: This is the risk that a company or individual will be unable to pay
the contractual interest or principal on its debt obligations. This type of risk is of particular
concern to investors who hold bonds within their portfolio. Government bonds have the least
amount of default risk and least amount of returns while corporate bonds tend to have the
highest amount of default risk but also the higher interest rates. Bonds with lower
chances of default are considered to be “investment grade,” and bonds with higher
chances are considered to be junk bonds.
(iv) Country Risk: This refers to the risk that a country would not be able to honour its financial
commitments. When a country defaults it can harm the performance of all other financial
instruments in that country as well as other countries it has relations with.
(v) Interest Rate Risk: It refers to the change in the interest rates. A rise in interest rates
during the term of an investor’s debt security hurts the performance of stocks and bonds.
(vi) Political Risk: This represents the financial risk that a country's government will suddenly
change its policies.
(vii) Market Risk: It is the day-to-day fluctuations in a stocks price. Also referred to as volatility.
(viii) Foreign Exchange Risk: Foreign exchange risk applies to all financial instruments that
are in a currency other than your domestic currency.
10.1.2 Techniques for Managing Risk/ Methods of Managing Risk
The aim of foreign exchange risk management is to stabilize the cash flows and reduce the
uncertainty from financial forecasts.
(i)
Open position No hedging.
(ii)
Forward contract
(iii)
Currency Futures or Option
(iv)
Futures contract
(v)
Money market hedge
(vi)
Netting
(vii) Matching
(viii) Leading and lagging
(ix)
Price variation
(x)
Invoicing in foreign Currency
(xi)
Assets and liability management
(xii) Arbtirage
(xiii) Foreign Currency Bank Account
10.2 Exchange Rate Determination
a)
A foreign exchange rate, which is also called a forex rate or currency rate, represents the
value of a specific currency compared to that of another country.
b)
Exchange rates are determined in the foreign exchange market, which is open to a wide
range of different types of buyers and sellers where currency trading is continuous.
The currency listed on the left is called the reference (or base) currency while the one listed
to the right is the quote (or term) currency.
c)
In the Foreign exchange market, the quote may be denoted as direct or indirect.
Direct Quote
It indicates the number of units of the domestic currency required to buy one
unit of foreign currency.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.4
Example: $1 = Rs.45 is a direct quotation for US $ in India.
Indirect
Quote
It indicates the number of units of foreign currency that can be exchanged for
one unit of the domestic currency.
Example Rs.1 = US $ 0.02065 is an indirect quotation in India.
Direct Quote
= 1/Indirect Quote
American
Quote
It refers to quoting per unit of any currency in terms of American Dollars
European
Quote
It refers to quoting per unit of American Dollars in terms of any other currency.
10.3
Transaction
Foreign Exchange Risk (FER)
a)
Mr Ram of India, Purchase or sale goods in India.
No
b)
Mr Ram of India, Purchase or sale goods with USA and
Invoice is in Rs.
He is not in FER but USA importer
is at FER
[DC-Rs. and payable/receivable currency – Rs.]
c)
Mr Ram of India, Purchase or sale goods with USA and
Invoice is in $.
He is in FER but USA importer is
not at FER
[DC-Rs. and payable/receivable currency – $]
Note
In foreign Exchange transaction, Only one party remains at risk. The Party whose payable/
receivable currency are different from his domestic currency remains at risk.
10.4 Spot and forward rate
[Dec-2006] [M-5] Write short notes on relationship between Spot Rate and forward rate.
a)
There are two types of rates in the market. These are Spot Exchange rate and Forward
Exchange Rates.
b)
Spot Exchange Rates: The spot exchange rate is the current rate at which one currency
can be immediately converted into another currency. The spot rate is the rate paid for
delivery within two business days after the day the transaction takes place.
Example
On 01/01/2012 Ram buys goods from UK and paid £1,00,000 on the same day.
Exchange rate as on 01/01/2012 £ 1 = Rs.68 [It is known as spot rate]
Rs. required to buy £1,00,000 at spot rate = £1,00,000*68 = Rs.6800000
c)
A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the
currency at some future date. They agree to transact a specific amount of currency at a
specific rate at a specified future date.
The forward exchange rate is set and agreed by the parties and remains fixed for the
contract period regardless of the fluctuations in the spot exchange rates in future.
Forward rates are usually quoted for fixed periods of 30, 60, 90 or 180 days from the day of
the contract.
If funds to fulfill the contract are available on hand or are due to be received by the business,
the hedge is considered to be ‘covered’.
In situations where funds to fulfill the contract are not available but have to be purchased in
the spot market at some future date, then such a hedge is known as ‘uncovered’.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.5
Example for class On 01/01/2013, Mr A wants to buy flat in 90 days.
Suppose, today rate of Flat 1 = Rs.68 lacs [Known as Spot Rate]
Over the next 90 days the rate of flat may rise or decline
Mr A has two options
(a) He may wait till 90 days and on 90th day, he will buy flat at spot rate prevailing on 90th day.
Due to no hedging, amount of his liability is uncertain as flat rate may increase or decrease.
(b) To make his liability certain, he may enter into contract with Mr B to buy Flat on 90th day.
Flat rate quoted by Mr B for forward contract
£ 1 = Rs.68.10 lacs [This is known as Forward rate for 90 days] [It will be applicable on 90th
day but fixed and quoted today]
On 90th day, whatever may be the spot rate, Mr A will buy Flat @ Flat 1 = Rs.68.10 lacs
Suppose on 90th day
Spot rate
Flat 1 = Rs.65 lacs
Flat 1 = Rs.68 lacs
Flat 1 = Rs.70 lacs
Option 1 - If no hedging is done, i.e. no forward contract is entered into
Applicable rate for flat
Flat 1 = Rs.65 lacs
Flat 1 = Rs.68 lacs
Flat 1 = Rs.70 lacs
Note: We may conclude if no hedging is done, then payable/receivable amt is not certain and
will be decided on the date of maturity. Till maturity date, party remains at risk.
If hedging is done, i.e Mr A enter into forward contract with Mr B for purchase of Flat @ 68.10
lacs
Applicable rate
Flat 1 = Rs.68.10 lacs
Flat 1 = Rs.68.10 lacs
Flat 1 = Rs.68.10 lacs
Gain or loss to Mr A due to hedging
Outflow under no hedging
Rs.6500000
Rs.6800000
Rs.7000000
Outflow under hedging
Rs.6810000
Rs.6810000
Rs.6810000
Rs.310000 Loss
Rs.10000 Loss
Rs.190000 Gain
Gain/ (Loss) due to hedging
Conclusion: Forward contract is not entered into for gain or loss but it is entered into to make
payable/ receivable certain or risk free. Entering into forward contract is known as hedging.
Example: On 01/01/2013, an Indian firm buys electronics from a British firm with payment of
£1,00,000 in 90 days.
Suppose, today exchange rate £ 1 = Rs.68 [Known as Spot Rate]
Over the next 90 days the £ may rise or decline against the Rs.
The Indian importer has two options
(c) He may wait till 90 days and on 90th day, he will buy £100000 at spot rate prevailing on 90th
day. Due to no hedging, amount of his liability is uncertain as foreign exchange rate may
increase or decrease.
(d) To make his liability certain, he may enter into contract with bank or forex dealer to buy
£1,00,000 on 90th day.
Exchange rate quoted by Bank or Forex Dealer for forward contract
£ 1 = Rs.68.10 [This is known as Forward rate for 90 days] [It will be applicable on 90th day
but fixed and quoted today]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.6
On 90th day, whatever may be the spot rate, importer will buy £100000 @ £ 1 = Rs.68.10
Suppose on 90th day
Spot rate
£ 1 = Rs.65
£ 1 = Rs.68
£ 1 = Rs.70
Option 1 - If no hedging is done, i.e. no forward contract is entered into
Applicable rate
£ 1 = Rs.65
Rs. required to buy
£100000 =
£100000*65
Rs.6500000
£ 1 = Rs.68
=
£100000*68
Rs.6800000
£ 1 = Rs.70
=
£100000*70
Rs.7000000
=
Note: We may conclude if no hedging is done, then payable/receivable amt is not certain and
will be decided on the date of maturity. Till maturity date, party remains at risk.
If hedging is done, i.e Indian importer enter into forward contract with bank for purchase of
£100000 @ 68.10
Applicable rate
£ 1 = Rs.68.10
Rs. required to buy
£100000 =
£100000*68.10
Rs.6810000
£ 1 = Rs.68.10
=
£100000*68.10
Rs.6810000
£ 1 = Rs.68.10
=
£100000*68.10
Rs.6810000
=
Gain or loss to Importer due to hedging
Spot rate on date of Maturity
£ 1 = Rs.65
£ 1 = Rs.68
£ 1 = Rs.70
Outflow under no hedging
Rs.6500000
Rs.6800000
Rs.7000000
Outflow under hedging
Rs.6810000
Rs.6810000
Rs.6810000
Gain/ (Loss) due to hedging
Rs.310000 Loss
Rs.10000 Loss
Rs.190000 Gain
Conclusion: Forward contract is not entered into for gain or loss but it is entered into to make
payable/ receivable certain or risk free. Entering into forward contract is known as hedging.
10.5 Relationship between Spot Rate and Forward Rates/Expected Spot Rate/maturity
Spot Rate [Q-1]
ICAI
RTP
ICWA
a)
Difference between Spot rate and future rate is known as premium or discount in any one
currency
b)
Premium/Dis on LHC ≠ Dis/Premium on RHC
c)
Appreciation/Premium
Currency is said to have appreciated if its value has increased, i.e. an investor is required to
pay more for purchasing that currency
Example: USD 1 = Rs.40 becomes USD 1 = Rs.42. Here the value of USD has increased. An
investor is required to pay more Rupees to acquire one USD.
Depreciation/ Discount
Currency is said to have depreciated if its value has decreased, i.e. an investor is required to
pay less for purchasing that currency.
Example: USD 1 = Rs.41 becomes USD 1 = Rs.39. Here the value of USD has decreased. An
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.7
investor is required to pay lesser amount in Rupees in acquire one USD.
d)
Premium/(Discount) in % may be ascertained as follows
Premium/(Discount) on LHC for period of Quote =
(FR-SR)*100/SR
Premium/(Discount) on LHC p.a. =
(FR-SR)*100*12M/(SR*Period of Quote)
Premium/(Discount) on RHC for period of Quote =
(SR-FR)*100/FR
Premium/(Discount) on RHC p.a. =
(SR-FR)*100*12M/(FR*Period of Quote)
Question-1
Today SR $ 1 = Rs.46
Today FR of 6 months $1 = Rs.51 or Rs.44
Calculate Premium/Discount on $ and Rs. for 6 months and p.a.
Question-1A [SP]
SR $ 1 = Rs.48
FR of 3 months $1 = Rs.51 or Rs.47
Calculate Premium/ Discount on $ and Rs. for 3 months and p.a.
10.6 If SR and Prem/ Disc is given, then we can calculate FR or ESR or MSR as follows
[Q-2]
ICAI
RTP
ICWA
If premium/ Dis is on LHC Currency
If premium/ Dis is on RHC Currency
1 LHC = SR*(1+-Prem/Disc)
1 LHC = SR/(1+-Prem/Disc)
Note: Euro is currency of 16 countries participating in common currency. Belgium, Germany,
Greece, Spain, France, Ireland, Italy, Luxemburg, The Netherlands, Austria, Portugal, Finland,
Cyprus, Malta, Slovakia, and Slovenia.
Question–2 [Example-ICWA]
In the spot market USD 1 = Rs.40, if in the forward market (1 Year)
(a) If Dollar is appreciating by 10%.
(b) If Dollar is depreciating by 10%.
(c) If Rupee is appreciating by 10%.
(d) If Rupee is depreciating by 10%.
Question-2A The spot rate of exchange is 2.5 Northland dollars to the pound. If, at the end of
the six months the Northland dollar has (i) gained 4%, (ii) lost 2% or iii) remained stable. What
will be the 6 months forward rate.
Question-2B [SM-12] [SP] Suppose that 1 French franc could be purchased in the foreign
exchange market for 20 US cents today. If the franc appreciated 10% tomorrow against the
dollar, how many francs would a dollar buy tomorrow? [Ans: 4.5455 FF]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.8
10.7 Calculation of Gain or loss due to foreign Exchange fluctuation [Q-3 to 7]
ICAI
M-03
M-06
N-03
M-06
IRPT
ICWA
Rule-1
If foreign currency is to be received in future [FC-Sell; DC-Buy]
If foreign currency is to be paid [FC-Buy; DC-Sell]
Rule-2 for conversion of one currency to another currency
If required/available currency and LHC is same, then at the time of conversion we will multiply
with Exchange rate
If required currency and LHC is different, then at the time of conversion we will divide with
Exchange rate
Example: On 01/01/2013, an Indian firm buys electronics from a British firm with payment of
£1,00,000 in 90 days.
On 01/01/2013
TSR £ 1 = Rs.68
ESR of 90 days £ 1 = Rs.70 or 66
FR of 90 days £ 1 = Rs.68.10
On 31/03/2013
MSR £ 1 = Rs.65 or Rs.71
Rule 1 [£ - payable] [Rs. - Sell and £ - Buy]
[Rule 2 – If required and LHC is same, then multiply otherwise divide]
Rs required to buy £ 100000 at today SR = £100000*68 = Rs.6800000
Rs required to buy £ 100000 at FR = £100000*68.10 = Rs.6810000
Rs required to buy £ 100000 at ESR = £100000*70 = Rs.7000000 or
Rs required to buy £ 100000 at ESR = £100000*66 = Rs.6600000
Rs required to buy £ 100000 at MSR = £100000*65 = Rs.6500000 or
Rs required to buy £ 100000 at MSR = £100000*71 = Rs.7100000
Case-1 Calculate gain loss if no hedging is done
(a)
Compare TSR vs MSR
(b)
If MSR is not given, then we can assume ESR as MSR
(c)
Calculation on Maturity Date
Rs. payable at today Spot Rate = Rs.6800000
Rs. payable at Maturity Spot Rate = Rs.6500000 or Rs.7100000
Gain/(Loss) if no hedging is done = Rs.6800000-6500000 = Rs.300000 Gain or
Gain/(Loss) if no hedging is done = Rs.6800000-7100000 = Rs.- 300000 Loss or
Case-2 Calculate gain loss if hedging is done
(a)
Compare TSR vs FR
(b)
Calculation on Maturity Date
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.9
Rs. payable at today Spot Rate = Rs.6800000
Rs. payable at FR = Rs.6810000
Gain/(Loss) if hedging is done = Rs.6810000-6800000 = -10000 loss or
Case-3 Whether hedging should be done or not
(a)
Compare ESR vs FR
(b)
To be decided on current date i.e. 01/01/2013
Rs. payable at FR = Rs.6810000
Rs. payable at ESR = Rs.7000000 or Rs.6600000
If ESR is Rs.70, then hedging should be done
If ESR is Rs.66, then hedging should not be done
Case-4 Decision of hedging is right or wrong
(a)
Compare FR vs MSR
(b)
To be analysed on maturity date i.e. 31/03/2013
Rs. payable at FR = Rs.6810000
Rs. payable at MSR = Rs.6500000 or Rs.7100000
If MSR is Rs.60, then decision of hedging was wrong
If MSR is Rs.71, then decision of hedging was right
10.7.1 Calculate gain loss if no hedging is done
Question-3 [SM-13] A Fleur Co, has shipped goods to an American importer under a letter of
credit arrangement, which calls for payment at the end of 90 days. The invoice is for $1,24,000.
Presently the exchange rate is 5.70 Frech francs to the $. If the French franc were to strengthen
by 5% by the end of 90 days what would be the transactions gain or loss in French francs? If it
were to weaken by 5%, what would happen? [Ans: Expected Loss-FF 33728; Expected Gain – FF37200]
Question-3A B Ltd, has shipped goods to an USA importer for $ 10000 due in 90 days.
Today Spot Rate $ 1 = Rs.45
If Rs. will depreciate by 10% in 90 days, calculate gain or loss due to foreign exchange
fluctuation. [Ans: Gain of Rs.50000]
10.7.2 Analyse whether we should enter into forward contract or not
Calculate ESR and FR of Same maturity date, then we should compare both rates as follows
Always think about LHC
If LHC is receivable and is to be sold
If LHC is payable and to be purchased
Select Higher of ESR and FR for decision
Select Lower of ESR and FR for decision
Gain or loss to Importer or Exporter
Importer (Buys FC and Sells DC)
Exporter (Buys DC and Sells FC)
DC is at Prem or FC is at Dis
Gain
DC is at Prem or FC is at Dis
Loss
DC is at Dis or FC is at Prem
Loss
DC is at Dis or FC is at Prem
Gain
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.10
Question-4 [Nov-2003] [M-6] A company operating in Japan has today effected sales to an
Indian company, the payment being, due 3 months from the date of invoice. The invoice amount
is 108 lakhs yen. At today's spot rate, it is equivalent to Rs.30 lakhs. It is anticipated that the
exchange rate will decline by 10% over the 3 months period and in order to protect the yen
payments, the importer proposes to take appropriate action in the foreign exchange market. The
3-months forward rate is presently quoted as 3.3 yen per Rupee.
You are required to calculate
(a) Whether forward contract should be entered into or not. [Not Part of Exam Question]
(b) Expected loss if hedging is not done. [Ans: Expected Loss if no Forward Contract is taken – Rs.3.33lacs;]
(c) Show loss if hedging is done. [Expected Loss under Forward Contract – Rs.2.73 lacs]
Question-4A [May-1998] A company operating in a country having the dollar as its unit
of currency has today invoiced sales to an Indian company, the payment being due three
months from the date of invoice. The invoice amount is $13750 and at today's spot rate of
$ 0.0275 per Re. is equivalent to Rs.5,00,000.
It is anticipated that exchange rate will decline by 5% over the three month period and in
order to protect the dollar proceeds to take appropriate action through foreign market. The
three months forward rate is quoted as $ 0.0273 per Rs.1
You are required to calculate
(a) Whether forward contract should be entered into or not. [Not Part of Exam Question]
(b) Expected loss if hedging is not done. [Ans: Expected Loss if no Forward Contract is taken – Rs.26315.80;]
(c) Show loss is hedging is done. [Expected Loss under Forward Contract – Rs.3663]
Question-4B [SM-9] [SP]
10.7.3 Calculation of ESR through probability
If Prem/(Dis) is given on any one currency
If ESR is given with probability
IF prem/(Dis) is on LHC,
ESR = ESR1*P1 + ESR2*P2 + ESR3*P3
then ESR: 1 LHC = SR*(1+-Prem/Disc)
IF prem/(Dis) is on RHC,
then ESR: 1 LHC = SR/(1+-Prem/Disc)
Question-5 [CS-Dec-99] In September, 1998, the Multinational Industries Inc. assessed the
March, 1999 spot rate for pound sterling at the following rates:
$ 1.30/£ with probability 0.15
$ 1.35/£ with probability 0.20
$ 1.40/£ with probability 0.25
$ 1.45/£ with probability 0.20
$ 1.50/£ with probability 0.20
What is the expected spot rate for March, 1999? [Ans: 1.405 $]
If the six-month forward rate is $ 1.40, should the firm sell forward its 1000 pound receivables
due in March, 1999? [Ans: No]
Question-5A [May-2003] [M-6] [ICWA-June-2008] [SP] In March, 2003, the Multinational
Industries makes the following assessment of dollar rates per British pound to prevail as on
1.9.2003.
$/Pound
1.60
1.70
1.80
1.90
Probability
0.15
0.20
0.25
0.20
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
2.00
10B.11
0.20
(i) What is the expected spot rate for 1.9.2003? [Ans: $1.81]
(ii) If, as of March, 2003, the 6-month forward rate is $ 1.80, should the firm sell forward its
pound receivables due in September, 2003? [Ans: No]
10.7.4 Analysis of Decision of hedging on maturity Date
For analysis of decision, we should compare FR and actual SR of Maturity
Question-6 X Ltd. an Indian company has an export exposure of 100 lacs yen, value September
end. The current spot rate is yen 310 = Rs.100
It is estimated that Yen will depreciate and estimated rate will be yen 334.88 = Rs.100. Forward
rate for September, 1998 Yen 320.24 = Rs.100.
You are required:
(i)
To calculate the expected loss if hedging is not done.
[Ans: Expected Loss if no hedging is done – Rs.2.397
lacs]
(ii) How the position will change with company taking forward cover?[Expected
loss if Forward Contract is
entered into – Rs.1.031 lacs]
(iii) If the spot on 30th September, 1998 was eventually Yen 322.23 = Rs.100. Is the decision to
take forward cover justified? [Ans: Yes]
Question-7 [SM-17] A UK company, is due to receive 5,00,000 Northland dollars in six month's
time for goods supplied. The company decides to hedge its currency exposure by using the
forward market. The spot rate of exchange is 2.5 Northland dollars to the pound. The forward
rate of exchange is 2.5354 Northland dollars to the pound.
Calculate how much UK company actually gains or loses as a result of the hedging transaction if,
at the end of the six months, the pound, in relation to the Northland dollar, has (i) gained 4%,
(ii) lost 2% or (iii) remained stable. [Ans: Expected gain – 4900 £; Expected Loss – 6874 £; Expected gain – 2792 £]
10.8 Cross Rates [Q-8 to 10]
ICAI
M-14
IRPT
ICWA
M08
Cross Rate denotes an exchange rate that does not involve the required currency. It is an
exchange rate between the currencies of two countries that are not quoted against each other,
but are quoted against one common currency.
Question-8 SR is
$1 = Rs.50;
$1 = Yen 200;
Calculate Exchange rate between Rs. and Yen
Question-9 SR is
$1 = Rs.50;
$1 = Yen 200;
Pound 1 = Yen 300
Calculate Exchange rate between Rs. and Pound
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.12
Question-10 [Nov-1998] X Ltd., an Indian Company has an export exposure of 10
million (100 lacs) yen, payable September end. Yen is not directly quoted against Rupee.
The current spot rates are INR/USD = Rs.41.79 and JPY/USD = 129.75. It is estimated that
yen will depreciate against $ to 144 level and Rs. to depreciate against $ to Rs.43. Forward
rates for September 1998 are INR/USD = Rs. 42.89 and JPY/USD = 137.35.
You are required to:
(i) Calculate the expected loss if hedging is not done. How the position will change if the firm
takes forward cover? [Ans: Expected Loss if no hedging is done – Rs.0.2347M; Expected loss if Forward Contract is entered
into – Rs.0.21921M]
(ii) If the spot rate on 30th September 1998 was eventually INR/USD = Rs.42.78 and JPY/USD =
137.35, is the decision to take forward cover justified? [Ans: Yes]
Question-10A [May-2014] [M-8] JKL Ltd an Indian company has an export exposure of JPY
10,00,000 payable August 31, 2014. Japanese Yen (JPY) is not directly quoted against Indian
Rupee.
The current spot rates are:
USD 1 = Rs.62.22
USD 1 = JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to depreciate
against US $ to Rs. 65.
Forward rates for August 2014 are
USD 1 = Rs.66.50
USD 1 = JPY 110.35
Required:
(i) Calculate the expected loss, if the holding is not done. How the position will change, if the
firm takes forward cover?
(ii) If the spot rates on August 31,2014 are:
USD 1 = Rs. 66.25
USD 1 = JPY 110.85
Is the decision to take forward cover justified ?
Summary of above questions
Whether we should enter into Forward Contract or not
Compare ESR and FR of Maturity
Expected Gain/(Loss) if hedging is not done
Compare CSR and ESR of Maturity
Expected Gain/(Loss) if hedging is done
Compare CSR and FR of Maturity
Reduction in loss due to Hedging
Compare ESR and FR of Maturity
Whether decision to enter into contract was right or
wrong
Compare SR of maturity and FR of
Maturity
10.9 Two Way Quote [Q-11]
ICAI
IRPT
ICWA
(a)
Two way quotes refer to quoting exchange rates by an exchange dealer in terms of
buying (Bid) Rate and selling (Ask) Rate.
(b)
Bid rate is the rate at which the dealer is willing to buy LHC. In other words it is selling rate
of LHC for customer.
The bid price is the highest price that someone is willing to pay at that moment.
Chap – 10
(c)
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.13
Offer (Ask) Rate is the rate at which Dealer is willing to sell LHC. In other words it is
buying rate of LHC for customer.
The asking price is the lowest price at which someone is willing to sell at that moment.
(d)
Spread
The difference between the bid and the offer is called the spread.
If the exchange rate is expected to be stable, the spread will be narrow. If the exchange
rate is volatile, the spread will be wider.
Where volume of transactions is very high, the Bid-Offer Spread will be very low. In case of
a thinly-traded currency, the spread will be wider.
Spread (%) = [Bid – Ask]*100/Bid
Spread (Amt) = [Bid – Ask]
For example, a dealer may quote $ 1 = Rs.48.80 - 48.90.
It means that he is willing to buy $ at Rs.48.80 (sell rupees and buy dollars), while he will sell $
at Rs. 48.90 (buy rupees and sell dollars).
From the Dealer point of view: First is Buying Rate and Second is Selling rate of LHC
From the Customer point of view: First is Selling Rate and Second is Buying rate of LHC
Conversion of direct quote into indirect quote
1$ = Rs.40.00 – 40.05
Rs.1 = $1/40.05 – 1/40.00 = $0.0249 – 0.025
Question-11 Calculate how much sterling pounds exporters would receive or how much sterling
pounds importers would pay, in each of the following situations:
(i)
A UK exporter receives a payment of 80,000 guilders from a Dutch customer.
[Ans: Pound
22408.96]
(ii) A UK exporter receives a payment from a French customer of FF 1,50,000.
[Ans: Pound 13940.52]
(iii) A UK importer buys goods from a Japanese supplier and pays 1 million yen. [Ans: Pound 4282.65]
(iv) A UK importer pays a German consultancy firm DM 1,20,000 under service contract.
[Ans:
Pound 37825.06]
Spot rates per sterling pound are as follows:
Pound 1 = Guilders 3.55 - 3.57
Pound 1 = FF 10.73 – 10.76
Pound 1 = JY 233.50 – 235.50
Pound 1 = DM 3.1725 – 3.1775
Question-11A [SP] Calculate how many rupees A Ltd., a New Delhi based firm, will receive or
pay for its following four foreign currency transactions:
i)
The firm receives dividend amounting to Euro 1,12,000 from its French Associates
Company. [Ans: Rs.6272000]
ii)
The firm pays interest amounting to 2,00,000 Yens for its borrowings from Japanese Bank.
[Ans: Rs.8820000]
iii)
The firm exported goods to USA and has just received USD 3,00,000.
Given: 1$= Rs.40.00/40.05
1 Euro= Rs.56.00/56.04
100 Yens = Rs.44.00/44.10
[Ans: Rs.12000000]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.14
10.10 Swap Points [Q-12 to 13]
ICAI
IRPT
ICWA
a)
Swap Points are movement in Exchange Rate expressed in absolute terms, i.e. in value
terms
a)
If Swap points is given in ascending order (increasing order) or spread is positive, we add it
to right hand side currency to calculate Forward Rate. It indicates that the left hand side
currency is at premium.
b)
If forward margin is given in decending order (decreasing order) we deduct it from right
hand side currency to calculate Forward rate. It indicates that the left hand side currency is
at discount.
[Example-ICWA]
Spot Rate
Swap Points
Forward Bid Rate
Forward Ask Rate
USD 1 = Rs.40-41
0.50-0.60
Rs.40+0.50 = Rs.40.50
Rs.41+0.60 = Rs.41.60
USD 1 = Rs.40-41
0.80-0.70
Rs.40-0.80 = Rs.39.20
Rs.41-0.70 = Rs.40.30
Question-12 A Foreign Exchange Dealer has forwarded the following quotes on USD spot, 1
month forward, 2 months forward and 3 months forward
Spot
Rs.45 - 45.20
1 USD
1 Month
0.18 - 0.22
2 Months
0.25 - 0.30
3 Months
0.32 - 0.30
Calculate 1 month, 2 months and 3 months forward rates.
Question-13 Calculate how many rupees a New Delhi based firm will receive or pay for its
following four foreign currency transactions
a)
Purchasing $1,00,000 on 2 months forward basis.
b)
Selling 70,000 Canadian Dollars on 3 months forward basis.
c)
Purchasing 8,25,000 Japanese Yens on 1 month forward basis.
1$
1 CD
100 Yens
Spot
Rs.40.00/40.10
Rs.34.90/35.00
Rs.33.00/33.10
1 month Swap Point
5/6 paise
0.10/0.20
0.11/0.10
[Ans: Rs.4000000]
[Ans: Rs.2450000]
2 months Swap Points
11/10 paise
0.11/0.12
0.12/0.13
[Ans: Rs.272250]
3 months Swap Point
10/11 paise
0.10/0.11
0.14/0.15
10.11 Analysis of decision of hedging under two Quote rates [Q-14 to 15]
ICAI
M-09-O
IRPT
ICWA
M-06
Question-14 A merchant in the U.K. has agreed to sell goods to an importer in the U.S.A at an
invoiced price of $90,000. Of this amount, $45,000 will be receivable at one month of shipment
and $45,000 on the last day of third month after shipment.
The quoted foreign exchange rates ($ per Pound) at the date of shipment are as follows:
One month
1.687 - 1.690
Three month
1.680 - 1.684
The merchant decides to enter into appropriate forward exchange contracts through his bank.
Comment on the wisdom of hedging in this instance, assuming that the spot rates at the dates of
receipt of the two installments of $45,000 were. [Ans: If Forward Cover is taken, then excess receipts of £408]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
First installment
1.694 - 1.696
Second installment
1.700 - 1.704
10B.15
Question-15 [May-2009-O] [M-6] [ICWA-4] The following 2-way quotes appear in the
foreign exchange market
Spot Rate
Rs.46.00/Rs.46.25
Rs/US $
2-months FR
Rs.47.00/Rs.47.50
Required
(a) How many US dollars should a firm sell to get Rs.25 lakhs after 2 months?
[Ans: $53191.49]
(b) How many Rupees is the firm required to pay US $ 2,00,000 in the spot market?
[Ans:
Rs.9250000]
(c) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee
investment is 10% p.a. Should the firm encash the US $ now or 2 months later?
Question-15A [ICSI-Dec-2003] [SP] The following rate appear in the foreign exchange
market:
Spot
Rs.45.80/Rs.46.05
Rs/US $
2-months forward
Rs.46.50/Rs.47.00
Required
(i)
How many US dollars should a firm sell to get Rs.5 Cr after 2 months? [Ans: $0.107527 Cr]
(ii) How many Rupees is the firm required to pay US $ 2,00,000 in the spot market? [Ans:
Rs.9210000]
(iii) Assume the firm has US $50,000. How many rupees does the firm obtain in exchange of
US$?
10.12 Money Market Hedge [Q-16 to 19]
ICAI
IRPT
ICWA
M-07
M-08
N-12
19
N-08
M-06
N-13
8
N-08
M-06
M-15
6
N-09
M-07
M-10-O
M-08
N-15
M-08
a)
Money Market Operations refers to creating an equivalent asset or liability against a Foreign
Currency Liability or Receivable.
Under money market operation the following steps are taken.
b)
If foreign currency is to be received in future [Assets in FC]
i)
Borrowing in FC [Creating Liability in FC]
The concern will borrow an amount in foreign currency, which together with the interest on it
should be equal to foreign currency to be received.
Amount of borrowing (X) = Amount receivable in FC/(1 + PIRFC)
ii)
Convert
He will convert FC into Domestic currency at today SR
Domestic Currency receivable (Y) = (X)*Today SR or (X)/Today SR
iii)
Investment in Domestic Currency [Creating Assets in DC]
Invest this converted Domestic currency for the period during which foreign currency receipt
is outstanding.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.16
Amount to be invested = Y
iv)
On Maturity Date
Receive and Repay FC
Use the foreign currency receipt to repay the amount borrowed along with interest due
thereon in foreign currency.
v)
Realisation of Investment
Finally receive the amount lent in home currency together with interest.
Amount to be received = (Y)*(1+PIRDC)
c)
If foreign currency is to be paid in future [Liability in FC]
i)
Deposits in FC [Creating Assets in FC]
Firm will make Deposit in Foreign Country
Deposit (X) = Amount payable in FC/ (1 + PIRFC)
ii)
Borrowing and Convert [Creating Liability in DC]
He will convert the deposit amount into domestic currency and borrow this converted home
currency for the period during which foreign currency receipt is outstanding.
Amount to be borrowed (Y) = (X)*Today SR or (X)/Today SR
iii)
On Maturity Date
Receive and Repay FC
Pay supplier of Foreign Country with Deposit in Foreign Country.
iv)
Repayment of Borrowing in DC
Finally repay the amount borrowed in home currency together with interest thereon.
Amt to Repay = (Y)*(1+PIRDC)
Example for understanding of Money Market Operation
Mr Ram of Delhi has sold goods of Rs.10000 to Mr Shyam of UP on 01/01/2013.
Amt is to be received in 3 months
Mr Ram wants to settle UP Transaction by today.
How Mr Ram can settle UP transaction today which is due in 3 months through money market Operation.
Interest rate = 12% p.a.
Solution
Mr Ram will get bill discounted from UP bank for 3 months say @12% p.a.
Amt receivable by Mr Ram from UP bank in Delhi today = Rs.10000/1.03 = Rs.9708.73
We can say that Mr Ram has taken of borrowing of Rs.9708.73 from UP Bank for 3 months @ 3%
After 3 months
Ram will repay its borrowing & Interest after receiving Rs.10000 from Mr Shyam.
Hence through money market operation, Ram has settled UP Transaction by today.
Question-16 [Nov-2008] [M-6] [Nov-2009] [M-7] [CS-June-2008-M-12] An exporter is a
UK based company. Invoice amount is $3,50,000. Credit period is three months. Exchange rates
in London are:
Spot rate
3 month forward rate
($/£) 1.5865 – 1.5905
($/£) 1.6100 – 1.6140
Rates of interest in money market:
$
£
Deposit
7%
5%
Loan
9%
8%
Compute and show how a money market hedge can be put in place. Compare and contrast the
outcome with a forward contract. [Ans: Pound receivable under forward cover = £216852.50; Under money
market = £ 217904.44]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.17
Question-16A [ICWA-8] [SP] [Similar Question-Illustration-13, 14]
Sunny Ltd. (SL), have exported goods to UAE for Universal Apparatus (UA) 5,00,000 at a credit
period of 90 days. Rupee is appreciating against the UA and SL is exploring alternatives to
mitigate loss due to UA Depreciation. From the following information, analyze the possibility of
Money Market Hedge
Foreign Exchange Rate
Money Market Rates
Bid
Ask
Currency
Deposit
Borrowings
Spot
Rs.11.50
Rs.11.80
UA
9%
12%
3 Months FR
Rs.11.20
Rs.11.40
Rs.
8%
10%
Question-16B [Nov-2008] [M-6] [RTP-Nov-2012-19]
Question-17 [May-2007] [M-8] [Nov-2015] [M-8] XYZ Ltd. a US firm will need £3,00,000 in
180 days. In this connection, the following information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K.
US
180 days deposit rate
4.5%
5%
180 days borrowing rate
5%
5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $
0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate
Probability
$ 1.91
25%
$ 1.95
60%
$ 2.05
15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(i)
a forward contract [Ans: $ 588000]
(ii) a money market hedge [Ans: $602933.98]
(iii) an option contract [Ans: $594900]
(iv) no hedging [Ans: $ 586500]
Show calculations in each case.
Question-17A [May-2010-O] [M-8] [SP] A Ltd of U K has imported some chemical worth of
USD 3,64,897 from one of the US suppliers. The amount is payable in six months time. The
relevant spot and forward rates are:
Spot Rate
USD 1.5617 – 1.5673
6 months Forward Rate
USD 1.5455 – 1.5609
The borrowing rates in UK and US are 7% and 6% respectively and the deposit rates are 5.5%
and 4.5% respectively.
Currency options are available under which one option contract is for GBP 12,500. The option
premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096
(put option) for 6 months period
The company has three choices:
(i) Forward Cover [Ans: GBP 236102.89]
(ii) Money Market Cover; and [Ans: GBP 236510.10]
(iii)
Currency Option [Ans: GBP 227923.00]
Which of the alternatives is preferable by the company?
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.18
Question-17B
Question-17C
Question-18 [RTP-May-2015-6] [RTP-Nov-2013-8] Columbus surgical Inc. is based in US
has recently imported surgical raw materials from the UK and has been invoiced for £480,000,
payable in 3 months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £138,000, payable in 3 months, and the French
customer has been invoiced for €590,000, payable in 4 months.
Current spot and forward rates are as follows:
SR
$ 1 = £ 0.9830-0.9850
3 months FR $ 1 = £ 0.9520-0.9545
SR
€ 1 = $ 1.8890-1.8920
4 months FR € 1 = $ 1.9510-1.9540
Current money market rates are as follows:
UK
:
10.0% - 12.0% p.a.
France:
14.0% - 16.0% p.a.
USA:
11.5% - 13.0% p.a.
You as Treasury Manager are required to show how the company can hedge its foreign exchange
exposure using Forward markets hedges and suggest which the best hedging technique is.
10.12.1 Money market with Tax rate
For incorporation of tax, calculate tax saving on Intt and Foreign Exchange Gain/ Loss as follows:
(c) Interest rate should be taken as net of tax. Intt (1-Tax Rate);
(d) Calculate Gain/ Loss due to change in exchange rate and calculate tax/ tax saving on them.
Question-19 On March 1, 1979, the B Ltd. bought from a foreign firm electronic equipment that
will require the payment of LC 9,00,000 on May 31, 1979. The spot rate on March 1, 1979, is LC
10 per dollar, the expected future spot rate is LC 8 per dollar, and the ninety-days forward rate is
LC 9 per dollar. The US interest rate is 12%, and the foreign interest rate is 8%. The tax rate for
both countries is 40%. The B Ltd. is considering three alternatives to deal with the risk of
exchange rate fluctuations.
(i)
To enter the forward market to buy LC 9,00,000 at the ninety-days forward rate in effect on
May 31, 1979.
(ii) To borrow an amount in dollars to buy the LC at the current spot rate. This money is to be
invested in government securities of the foreign country; with the interest income, it will
equal LC 9,00,000 on May 31, 1979.
(iii) To wait until May 31, 1979, and buy LCs at whatever spot rate prevails at that time.
Which alternative should the B Ltd. follow in order to minimize its cost of meeting the future
payment in LCs? Explain. [Ans: Under Forward Cover – $96000; Under Money Market - $90533.60; Under no
Hedging - $103500]
10.13 Cancellation of Forward Contract [Q-20 to 25]
ICAI
N-04
IRPT
ICWA
M-04
a)
Forward contract can be cancelled at the request of the customer. This request may be made
on or before or after maturity date. Original forward Contract can be cancelled by entering
into reverse contract.
b)
If the request is made on or before the maturity date
The bank recovers/pays, as the case may be, the difference between the contracted rate and
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.19
the rate at which the cancellation is affected.
c)
If the request is made after the maturity date
Gain to Customer is not paid to him, but loss to customer is recovered from him
d)
In the absence of any instructions from the customer
Contracts which have matured are automatically cancelled on the fifteenth day from the
date of maturity. In case the fifteenth day falls on a Saturday or holiday, the
contract is cancelled on the next working day. Exchange difference, if any, is recovered
from the customer, but customer is not paid any gain accruing to him from such
cancellations.
e)
Cancellation of forward contract on or before maturity date
In
case
Purchase
Forward
of
Contract Date 01/01/2011
To be cancelled on 31/01/2011
We will enter new FSC[for period 31/01/2011 to 31/03/2011] – Original FPC
To be cancelled on 28/02/2011
We will enter new FSC [for period 28/02/2011 to 31/03/2011] – Original FPC
To be cancelled on 25/03/2011
We will enter new FSC [for period 25/03/2011 to 31/03/2011] – Original FPC
Maturity
date
31/03/2011]
To be cancelled on 31/03/2011
In case of Sale
Forward
To be cancelled on 31/01/2011
We will sell at Spot Rate[31/03/2011] – Original FPC
Original FSC – We will enter new FPC [for period 31/01/2011 to 31/03/2011]
To be cancelled on 28/02/2011
Contract Date 01/01/2011
Maturity
date
31/03/2011]
Original FSC – We will enter new FPC [for period 28/02/2011 to 31/03/2011]
To be cancelled on 25/03/2011
Original FSC – We will enter new FPC [for period 25/03/2011 to 31/03/2011]
To be cancelled on 31/03/2011
Original FSC – We will purchase at SR[31/03/2011]
Question-20
On 01/01/2012, Mr. A entered into Forward sale Contract for $10000 for 31.03.2012
As on 01/01/2012
Spot Rate is $1 = Rs.44.00 – 44.50
3 Months Forward Rate $ 1 = Rs.45.00 – 45.50
Mr A wants to cancel the Forward contract as on
31.01.2012
28.02.2012
31.03.2012
10.04.2012
15.04.2012
SR $1=Rs.44–44.30
SR $1=Rs.46–46.30
SR $1=Rs.48–48.30
SR $1=Rs.43–43.30
SR $1=Rs.49–49.30
FR of 2 Mont $1=Rs.44.50–44.80
FR 1 month $1=Rs.46.50–46.80
NA
NA
NA
FR of 3 Mont $1=Rs.46–46.50
FR 2 month $1=Rs.47.50–47.80
NA
NA
NA
Show how the transaction will be settled.
10.13.1 Cancellation of Forward Contract before maturity
Question-21 [May–2002] [M-6] A customer with whom the Bank had entered into 3 months
forward purchase contract of French Francs 10,000 @ Rs.27.25. Customer comes to bank after 2
months and requests for cancellation of the contract. On this date, the prevailing rates are:
Spot
1 Swiss Franc: Rs.27.30 - 27.35
One month forward
1 Swiss Franc: Rs.27.45 - 27.52
What is the loss or gain to customer on cancellation? [Ans: Loss to Customer Rs.2700]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.20
Question-21A [Nov-2004] [M-4] [SP] A customer with whom bank had entered into
3 months forward purchase contract for Swiss Franks 100000 at the rate of Rs.36.25. A
Customer comes to the bank after two months and requests cancellation of the contract.
On this date, the rates are:
Spot
CHF 1 = Rs.36.30 – 36.35
One Month Forward = Rs.36.45 – 36.52
Determine the amount of Profit or Loss to the customer due to cancellation of the contract.
[Ans: Loss to customer Rs.27000]
10.13.2 Cancellation of Forward Contract on maturity date
Question-22 SBI has booked a forward purchase contract for USD 1,00,000 due 14th March,
2003 @ Rs.48.25. On maturity, the customer fails to deliver the Dollars and requests for
cancellation of the contract. Spot rate on 14th March, 2003: USD =Rs.48.6525/Rs.48.7325. What
amount of gain/loss will be payable to/receivable from customer? [Ans: Loss to Customer Rs.48250]
Question-22A [ICWA-Dec-2006] [SP] NBA Bank Ltd. transacted the following forward
transactions on March 19, 1999.
(i)
Sold $ 10,00,000 three months forward to Alpha Manufacturing Co. Ltd at Rs.44.50
(ii)
Purchased Euro 10,00,000 two months forward from Beta Trading Co. Ltd at Rs.47.20
On May 19, 1999 both the customers approached the bank for the cancellation of their contract.
The following exchange rates prevailed on that day:
Spot
One-month forward
Rs./$
Rs./Euro
44.60/65
47.75/85
15/20
25/35
Calculate the amount to be paid to or recovered from customers due to the cancellation of the
forward contract. [Ans: Gain to Alpha – Rs.25000; Loss to Beta – Rs.650000]
Question-23 [ICWA-7]
On 01.04.2007, Sangeet International concluded a contract for purchase of 1,000,000 Blue Ray
Discs from an American Company at $1.48 per Disc, to be supplied over the next 3 Months. SI is
required to make the payment immediately upon receipt of all the discs.
To meet the obligation, SI had booked a Forward Contract with its bankers to buy USD 3 Months
hence. The following are the Exchange Rates on 01.04.2007 —
SR $ 1 = Rs.41.30 -41.70
3 Months FR $ 1 = Rs.42.00 – 42.50
On 01.07.2007, the American Company expressed its inability to supply the last instalment of
300,000 Blue Ray Disks due to export restrictions in US, and requested SI to settle for the
quantity supplied.
Spot Rate on 01.07.2007 was $ 1 = Rs.40.90 - 41.20.
(a) Ascertain the total cash outgo for SI for purchase of 700,000 Discs.
(b) Would total cash outgo undergo any change if the American Company had informed on
01.06.2007, when the following exchange rates were available —
Spot $ 1 = Rs. 41.70 -42.20
1-Months Forward $ 1 = Rs. 42.10 - 42.50
10.13.3 Cancellation after maturity date but before 15th day of maturity
a)
In case of Purchase Forward
To be cancelled on 10/04/2011
Contract Date - 01/01/2011
We will sell at SR[10/04/2011] – Original FPC
Maturity date 31/03/2011]
b)
In case of Sale Forward
To be cancelled on 10/04/2011
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Contract Date - 01/01/2011
10B.21
Original FSC – We will purchase at SR[10/04/2011]
Maturity date 31/03/2011]
Question-24 XYZ Ltd. booked a forward sale contract for USD 500,000 @ 46.20 due on 5 March.
The customer did not contact the bank on due date. However, on 10th March, the customer
requests the bank to cancel the contract. On this date, spot rate is Rs.46.28/ Rs.46.35. What
amount of gain/loss will be payable to / receivable from customer? [Ans: Loss to Customer - Rs.75000]
Question-24A [SP] Bank of India has booked a forward sale contract for USD 1,00,000 @
48.42 due 10th March, 2003. The customer did not Contact the bank on due date. However, on
14, March, 2003, the customer requests the bank to cancel the contract. On this date, spot rate
is Rs.48.50/Rs.48.57 What amount of gain/loss will be payable to/receivable from customer?
10.13.4 If customer did not approach bank, then cancellation on 15th Day from the date
of maturity
a)
In case of Purchase Forward
To be cancelled on 15/04/2011
Contract date - 01/01/2011
We will sell at SR[15/04/2011] – Original FPC
Maturity date 31/03/2011]
b)
In case of Sale Forward
To be cancelled on 15/04/2011
Contract date - 01/01/2011
Original FSC – We will purchase at SR[15/04/2011]
Maturity date 31/03/2011]
Question-25 ABC Ltd. booked a forward Sale contact for USD 200,000 due on 5 March, @
Rs.46.10. The customer did not contact the bank on / before / after the date of maturity. Given
the following Spot rates, what amount of gain / loss will be payable to/ receivable from
customer?
19 March
20 March
21 March
46.17/46.25
46.18/ 46.26
46.19/46.27
[Ans: Loss to customer - Rs.32000]
Question-25A [SP] A bank had booked a forward sale contract for USD 1,00,000 due 10th
March, 2003 @ 48.42. The customer did not Contact the bank on before/after the date of
maturity. Given the following spot rates, what amount of gain/loss will be payable to/receivable
from customer?
24th March, 2003 (Mon.)
25th March, 2003
26th March, 2003
48.49/48.57
48.50/48.58
48.51/48.59
10.14 Extension of forward contract [Q-26 to 28]
ICAI
N-2010-O
M-04
M-2015
M-09
RTP
M-15
ICWA
5
a)
First we will cancel Original Forward contract as we have done earlier.
b)
Then we will enter into new forward contract as per requirement for further period
c)
Extension of Forward contract involves
Cancelation of old contract + New forward contract as per requirement
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.22
th
Question-26 On 15 July, PNB booked a forward sale contact for USD 2,50,000 due on August
30 @ Rs.48.35. On 10th Aug, the customer requests the bank to extend the forward contact for
30th Sept. Foreign Exchange rates on 10th August are:
Spot
Forward 30th Aug.
Forward 30th Sept.
48.1325-48.1675
47.6625 -47.7175
47.4425-47.5375
At what rate the contact will be extended? What amount of loss/gain will be receivable
from/payable to customer? [Ans: Rs.171875 loss to customer]
Question-26A [SP] ABC Ltd. booked a forward sale contract for USD 100,000 @ 46.25 due on
12 August. On 8 August the customer requests the bank to extend the forward contract for 15
September. Foreign exchange rates on 8 August are:
Spot
Forward rate of 12th August
Forward rate of 15th September
46.03 - 46.07
45.56 - 45.72
45.34 - 45.54
At what rate the contract will be extended? What amount of loss/ gain will be receivable from/
payable to customer? [Ans: Rs.53000 gain to customer; New forward rate $ 1 = Rs.45.34]
10.14.1 Extension of Forward Contract with margin money
(a)
If bank charges Margin Money, then Buying/ Selling rate for customer will be
Buying Rate for LHC = Rate Selected as per rule + Margin Money Payable to Bank
Selling Rate for LHC = Rate Selected as per rule - Margin Money Payable to Bank
Question-27 [Nov-2010-O] [M-4] An importer requests his bank to extend the forward
contract for US $20,000 which is due for maturity on 30th Oct, 2010, for a further period of 3
months. He agrees to pay the required margin money for such extension of the contract.
Contracted Rate – US $ 1 = Rs.42.32
The US Dollar quoted on 30.10.2010
Spot – $1 = Rs.41.50 - 41.52
3 month’s Premium – 0.87%-0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respectively.
Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and [Ans: Loss to
customer – Rs.17022.50]
(ii) The rate of new forward contract. [Ans: Rs.41.9898]
Question-27A [RTP-May-2015-5] An exporter requests his bank to extend the forward
contract for US $20,000 which is due for maturity on 30th Oct, 2014, for a further period of 3
months. He agrees to pay the required margin money for such extension of the contract.
Contracted Rate – US $ 1 = Rs.62.32
The US Dollar quoted on 30.10.2014
Spot – $1 = Rs.61.50 - 61.52
3 month’s Discount – 0.93%-0.87%
Margin money for buying and selling rate is 0.45% and 0.20% respectively.
Compute:
(iii) The cost to the importer in respect of the extension of the forward contract, and
(iv)The rate of new forward contract.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.23
Question-27B [CS-Dec-2008] [SP] An Indian telecom company has approached PNB for
forward contract of £ 500000 delivery on 31.05.2008. The bank has quoted a rate of Rs.61.60/£
for the purchase of £ from the customer. But on 31.05.2008, the customer informed the bank
that it was not able to deliver the pound sterling as anticipated receivable from London has not
materialized and requested the bank to extend the contract for delivery by 31.07.2008.
The following are the market quotes available on 31.05.2008
Spot (Rs/£)
1 month Forward Premium
2 Month Forward Premium
3 Month Forward Premium
62.60/65
20/25
42/46
62/68
Flat charges for cancellation of forward contract is Rs.500
You are required to find out the extension charges payable by the telecom company.
Question-28 [May-2015] [M-9] An importer booked a forward contract with his bank on 10th
April for USD 200000 due on 10th June @ Rs.64.4000. The bank covered its position in the
market at Rs.64.2800
The exchange rates for dollar in the interbank market on 10th June and 20th June were:
10th June
20th June
Spot USD 1 =
Rs.63.8000/8200
Rs.63.6800/7200
Spot/ June
Rs.63.9200/9500
Rs.63.8000/8500
July
Rs.64.0500/0900
Rs.63.9300/9900
Aug
Rs.64.3000/3500
Rs.64.1800/2500
Sep
Rs.64.6000/6600
Rs.64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 20th
June for extension of contract with due date on 10th Aug.
Rates rounded to 4 decimal in multiples of 0.0025
On 10th June, Bank Swaps by selling spot and buying one month forward.
10.15 THEORIES OF EXCHANGE RATE DETERMINATION/PARITY CONDITIONS IN
INTERNATIONAL FINANCE [Q-29 to 36]
ICAI
M-04
M-09
N-08
M-04
M-10
M-04
N-12
M-05
RTP
M-13
ICWA
19
[May-2011] [M-4] What is the meaning of (i) Interest rate parity and (ii) Purchasing power
parity
There are three theories of exchange rate determination - Interest rate parity, Purchasing power
parity and International Fisher effect
10.15.1 Interest Rate Parity Theorem
a)
Forward exchange rate of the two countries is determined by various factors like, interest
rate, inflation rate, GDP, Monetary Policy etc.
Interest rate parity theory assumes that the forward exchange rate of the two countries is
determined by their interest rate differential assuming other factors remain constant.
b)
FR under IRPT =
c)
Prem/(Dis) on LHC under IRPT =
[1 + PIR[RHC]]*SR/[1 + PIR[LHC]]
[PIR[RHC] - PIR[LHC]]*100/[1 + PIR[LHC]] OR
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.24
[FR[IRPT] - SR]*100/SR
Prem/(Dis) on RHC under IRPT =
[PIR[LHC] - PIR[RHC]]*100/[1 + PIR[RHC]] OR
[SR - FRIRPT]*100/FRIRPT
d)
Under IRPT, the currency whereof, the interest rate is higher will be at discount and the
currency whereof, the interest rate is lower will be at premium in future.
e)
Whether IRPT Exists or not/Interest
Rate and FR are in equibilrium ?
If FRIRPT = FRActual then IRPT exists OR
If Prem/(Dis)IRPT = Prem/(Dis)Actual then IRPT exists
f)
If forward exchange rate is determined using interest rate parity theory, one cannot take
advantage of interest rate difference in two countries. Parity Conditions are expected to hold
in the long-run, but not always in the short term
g)
If IRPT does not exists, then arbitrage profit is possible
Question-29 [May-2004] [M-9] The US Dollar is selling in India at Rs. 45.50. If the interest
rate for a 6 month borrowing in India is 8% p.a. and the corresponding rate in USA is 2%,
(i) What is the expected/fair 6 month forward rate for US Dollar in India; and
(ii) What is the rate of forward premium or discount on $?
(iii) What is the rate of forward premium or discount on Rs.?
(iv)Do you expect US Dollar to be at a premium or at discount in the Indian forward market;
(v) If actual FR of 6 months is $ 1 = Rs.47, Actual Prem/Dis on $; [Not Part of Exam Question]
(vi)Whether IRPT exists or not? [Not Part of Exam Question]
Question-29A [Nov-2012] [M-5] The US Dollar is selling in India at Rs. 55.50. If the interest
rate for a 6 month borrowing in India is 10% per annum and the corresponding rate in USA is
4%,
(i) What is the expected 6 month forward rate for US Dollar in India; and
(ii) What is the rate of forward premium or discount on $?
(iii) Do you expect US Dollar to be at a premium or at discount in the Indian forward market;
(iv) If actual FR of 6 months is $ 1 = Rs.58, Actual Prem/Dis on $; [Not Part of Exam Question]
(v) Whether IRPT exists or not? [Not Part of Exam Question]
Question-29B [SP]
(a) The spot Danish Krone rate is $ 0.15986 and the three month forward rate is $ 0.1590. The
three month treasury bill rate in the United States is 6.25% p.a. and in Denmark 7.50% p.a.
(i) Calculate forward premium or discount on Danish Krone
(ii) Are the forward rates and interest rate in equilibrium?
(iii) Work out the forward rate if the forward rate or interest rate are in equilibrium.
Question-29C [Nov-2002] [M-4]
Question-29D [Nov-2008] [M-4] [RTP-May-2013-19]
Question-30 [May-2001] [M-10] Shoe Company sells to a wholesaler in Germany. The
purchase price of a shipment is 50,000 deutsche marks with term of 90 days. Upon payment,
Shoe Company will convert the DM to dollars. The present spot rate for DM per dollar is 1.71,
whereas the 90-day forward rate is 1.70. You are required to calculate and explain
(i)
If Shoe Company were to hedge its foreign exchange risk, what would it do? What
transactions are necessary?
(ii) Is the deutsche mark at a forward premium or at a forward discount?
(iii) What is the implied differential in interest rates between the two countries? (Use IRPT
assumption)
Chap – 10
h)
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.25
IF SR, FR and Interest rate of one currency is given, then we can calculate Interest rate of
another currency by assuming that IRPT exists
FRGiven = FRIRPT = [1 + PIR[RHC]]*SR/[1 + PIR[LHC]] or
FRIRPT/SR = [1 + PIR[RHC]]/[1 + PIR[LHC]]
i)
IF SR, Interest rate of one currency and prem/(Dis) in one currency is given, then we can
calculate Interest rate of another currency by assuming that IRPT exists
1st we will calculate FR
IF premium/ Dis is on LHC, then FR or ESR: 1 LHC = SR*(1+-Prem/Disc)
IF premium/ Dis is on RHC, then FR or ESR: 1 LHC = SR/(1+-Prem/Disc)
2nd we will calculate interest rate of another currency by applying
FRcalculated = FRIRPT = [1 + PIR[RHC]]*SR/[1 + PIR[LHC]] or
FRIRPT/SR = [1 + PIR[RHC]]/[1 + PIR[LHC]]
Question-31 [Nov-2000] [M-8] [ICWA-9] The following table shows interest rates for the US
dollar and French francs. The spot exchange rate is 7.05 francs per dollar. Complete the missing
entries:
3 Months
11.5%
19.5%
?
?
Dollar interest rate (Annually compounded)
Franc interest rate (Annually compounded)
Forward francs per dollar
Forward discount on FF per cent per year
6 Months
12.25%
?
?
-6.3%
For 1 year
?
20%
7.52
?
Question-31A [SP]
j)
Limitations of Interest Rate Parity Model
In recent years the interest rate parity model has shown little proof of working.
In many cases, countries with higher interest rates often experience it’s currency appreciate
due to higher demands and higher yields and has nothing to do with risk-less arbitrage.
10.15.2 PURCHASING POWER PARITY THEORY (PPPT)
ICAI
Nov-2008
M-4
May-2010
M-4
a)
ICSI
ICWA
In the general economic analysis, the value of a currency in one country is determined by
the amount of goods and services that can be purchased with a unit of the currency, this is
called the purchasing power of the currency. PPP says that the exchange rate between two
currencies must be proportional to the price level of goods in two countries.
Suppose certain bundle of goods in U.S.A. costs U.S. $ 10 and the same bundle in India
costs, Rs. 450/- then the exchange rate between Indian Rupee and U.S. Dollar is $1 = Rs.
45.
b)
If the exchange rate is such that purchasing power parity does not exist between the two
currencies, then the exchange rate between these currencies will adjust until the purchasing
power parity prevails.
Example
Suppose current Spot Rate 1 USD = 10 Mexican Pesos (MXN) on the exchange rate market.
In the USA wooden baseball bats sell for $40 while in Mexico they sell for 150 pesos.
Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15 USD
if we buy it in Mexico.
Clearly there’s an advantage to buying the bat in Mexico, so consumers are much better off
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.26
going to Mexico to buy their bats.
If consumers decide to do this, we should expect to see three things happen:
1. American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they
go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. This
will cause the Mexican Peso to become more valuable relative to the U.S. Dollar.
2. The demand for baseball bats sold in the United States decreases, so the price American
retailers charge goes down.
3. The demand for baseball bats sold in Mexico increases, so the price Mexican retailers
charge goes up.
Eventually these three factors should cause the exchange rates and the prices in the two
countries to change such that we have purchasing power parity.
If the U.S. Dollar declines in value to 1 USD = 8 MXN, the price of baseball bats in the United
States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos
each, we will have purchasing power parity.
This is because a consumer can spend $30 in the United States for a baseball bat, or he can
take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in
Mexico and be no better off.
c)
Purchasing Power Parity and the Long Run
Purchasing-power parity theory tells us that price differentials between countries are not
sustainable in the long run as market forces will equalize prices between countries and
change exchange rates in doing so. In the long run having different prices in the United
States and Mexico is not sustainable because an individual or company will be able to gain an
arbitrage profit by buying the good cheaply in one market and selling it for a higher price in
the other market.
d)
There are two forms of PPP, Absolute and Relative.
The Absolute PPP is based on the preposition that a commodity costs the same regardless
of what currency is used to buy or where it is selling. If a book costs £4 in UK and exchange
rate is £.60 per $, then the book will cost £ 4/.60 = $ 6.66 in the U.S.
The Absolute PPP assumes that:
(iv) The transaction costs are nil,
(v) There is no barrier to trade, and
(vi) The goods are identical.
e)
Relative PPP suggests that the change in exchange rate is determined by the difference in
the inflation rate in two countries.
f)
FR under PPPT =
g)
Prem/(Dis) on LHC under PPPT =
Prem/(Dis) on RHC under PPPT =
[1 + PIFR[RHC]]*SR/[1 + PIFR[LHC]]
[PIFR[RHC] - PIFR[LHC]]*100/[1 + PIFR[LHC]] OR
[FR[PPPT] - SR]*100/SR
[PIFR[LHC] - PIFR[RHC]]*100/[1 + PIFR[RHC]] OR
[SR - FRPPPT]*100/FRPPPT
h)
Under PPPT, the currency whereof, the inflation rate is higher will be at discount and the
currency whereof, the inflation rate is lower will be at premium in future.
i)
Whether PPPT Exists or not/Inflation
Rate and FR are in equibilrium ?
If FRPPPT = FRActual then PPPT exists OR
If Prem/(Dis)PPPT = Prem/(Dis)Actual then PPPT exists
j)
If PPPT does not exists, then arbitrage profit is possible
k)
Criticism of Purchasing Power Parity (PPP) Theory
1. Limitations of the Price Index : As seen above in the relative version the PPP theory
uses the price index in order to measure the changes in the equilibrium rate of exchange.
However, price indices suffer from various limitations and thus theory too.
2. Neglect of the demand / supply Approach : The theory fails to explain the
demand/supply of foreign exchange. Because in actual practice the exchange rate is
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.27
determined according to the market forces such as the demand for and supply of foreign
currency.
3. Unrealistic Approach : Since the PPP theory uses price indices which itself proves to be
unrealistic. The reason for this is that the quality of goods and services included in the
indices differs from nation to nation. Thus, any comparison without due significance for the
quality proves to be unrealistic.
4. Unrealistic Assumptions : PPP theory is based on the unrealistic assumptions such as
absence of transport cost. Also it wrongly assumes that there is an absence of any barriers to
the international trade.
5. Neglects Impact of International Capital Flow : The PPP theory neglects the impact
of the international capital movements on the foreign exchange market. International capital
flows may cause fluctuations in the existing exchange rate.
Question-32 [ICWA-11]
A Laptop Bag is priced at $ 105.00 at New York. The same bag is priced at Rs.4,250 in Mumbai.
(a) Determine Exchange Rate in Mumbai.
(b) If, over the next one year, price of the bag increases by 7% in Mumbai and by 4% in New
York, determine the price of the bag at Mumbai and-New York?
(c) Determine the exchange rate after one year
(d) Determine the appreciation or depreciation in $ and Rs. in one year from now.
Question-32A [SP] The spot rate is Rs.36.00/$. Inflation rates in India and USA are expected
to be 8% and 3% respectively. What is the expected rate of depreciation of the rupee? What is
expected rate of appreciation of dollar?
Question-33 You are given the following information:
Spot rate
3-month forward rate
DM 1.50/$
DM 1.51/$
The inflation rate in Germany is 4%. Calculate the inflation rate in the USA assuming that
Purchasing Power Parity holds goods even in the short run. [Ans: 1.32%]
Question-34 [Nov-2008] [M-4] [RTP-May-2013-19] The rate of inflation in USA is likely to
be 3% per annum and in India it is likely to be 6.5%. The current spot rate of US $ in India is
Rs.43.40. Find the expected rate of US $ in India after one year and 3 years from now using
purchasing power parity theory.
Question-34A [May-2010] [M-4] The rate of inflation in India is 8% p.a. and in USA it is 4%.
The current spot rate for USD in India is Rs.46. What will be the expected rate after one year and
after 4 years applying the purchasing power parity theory.
10.15.3 INTERNATIONAL FISHER EFFECT (IFE)
a)
According to the IFE, ‘nominal risk-free interest rates contain a real rate of return and
anticipated inflation’. This means if investors of all countries require the same real return,
interest rate differentials between countries may be the result of differential in expected
inflation.
The IFE theory suggests that foreign currencies with relatively high interest rates will
depreciate because the high nominal interest rates reflect expected inflation. The nominal
interest rate would also incorporate the default risk of an investment.
b)
The Fisher Effect stating that
(1+ Nominal Interest) = (1 + Real Interest rate)*(1 + Inflation Rate)
c)
FR under IFE =
d)
Prem/(Dis) on LHC under IFE =
[1 + PNIR[RHC]]*SR/[1 + PNIR[LHC]]
[PNIR[RHC] - PNIR[LHC]]*100/[1 + PNIR[LHC]] OR
[FRIFE - SR]*100/SR
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Prem/(Dis) on RHC under IFE =
10B.28
[PNIR[LHC] - PNIR[RHC]]*100/[1 + PNIR[RHC]] OR
[SR – FRIFE]*100/FRIFE
e)
Under PPPT, the currency whereof, the Nominal Interest rate is higher will be at discount and
the currency whereof, the nominal interest rate is lower will be at premium in future.
f)
Whether IFE Exists or not/Nominal
Interest
Rate
and
FR
are
in
equibilrium ?
If FRIFE = FRActual then IFE exists OR
If Prem/(Dis)IFE = Prem/(Dis)Actual then IFE exists
Question-35
SR
GBP 1 = USD 1.5339
Current Nominal interest rate in the U.S. is 5% and 7% in Great Britain
Question-36 Spot rate 1$ = Rs.45.50, 1 year forward rate 1$ = 45.9461. Real interest rate in
India is 8%. Real interest rate in USA is 6%. Inflation rate in India is 4%. Find the inflation rate
in USA.
10.16 Cross Rate in Two way Quotes [Q-37 to 44]
All above concepts will be same except cross rates is to be calculated
ICAI
M-05
M-08
N-05
M-04
M-09
M-06
N-11
M-05
M-13
M-05
N-13
M-05
N-13
M-04
M-14
M-05
M-14
M-08
N-14
M-05
N-15
M-05
RTP
N-14
ICWA
9
Question-37
i) Rs./ £: 74.00 -74.50 (ii)
Rs./CHF 26.00 -26.60 find CHF/£.
Question-38
Spot rate
$1 = Rs.45.00 – 45.40
Pound 1 = $ 1.60 – 1.65
Pound 1 = AD 3.00 – 3.50
AD 1 = SD 1.50 – 1.60
Calculate Cross rate between Rs. and SD
Question-38A [ICWA-Dec-2002] [SP] Your bank wants to calculate Rs TT selling rate of
Exchange for DM since a deposit of DM 100000 in a FCNR A/c has matured, when
Euro 1 = DM 1.95583 (Locked in rate)
Euro 1 = $ 1.0234/43
$1
= Rs.48.51/53
What is the Rs. TT selling rate for DM currency?
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.29
Question-39 [Nov-2005] [M-4] [CS-June-2009-M-4] You sold Hong Kong Dollar
1,00,00,000 on spot to your customer at Rs.5.70 & covered yourself in London Market on the
same day, when the exchange rates were.
US $ 1 = HK $ 7.588-7.592
Local inter bank market rates for US $ were
US $ 1= Rs.42.70 – 42.85
Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage.
[Ans: Cover Rate = Rs.5.647; profit to Bank = Rs. 5,30,000]
Question-39A [May-2013] [M-5] A Bank sold Hong Kong Dollars 40,00,000 value spot to its
customer at Rs.7.15 and covered itself in London Market on the same day, when the exchange
rates were US$ 1 = HK$ 7.9250 – 7.9290
Local interbank market rates for US$ were
Spot US$ 1 = Rs.55.00 – 55.20
You are required to calculate rate and ascertain the gain or loss in the transaction. Ignore
brokerage.
You have to show the calculations for exchange rate up to four decimal points.
Question-39B [Nov-2014] [M-5]
Question-39C [May-2014] [M-5]
Question-40 [Nov-2013] [M-5] You, a foreign exchange dealer of your bank, are informed
that your bank has sold a TT on Copenhagen for DK 1000000 at the rate of DK 1 = Rs.6.515
You are required to cover the transaction either in London or New York market. The rates on that
date are as under.
Mumbai – London
Mumbai – New York
London – Copenhagen
New York – Copenhagen
Pound 1 = Rs.74.30 – 74.32
$ 1 = Rs.49.25 – Rs.49.2625
Pound 1 = DK 11.42 – 11.435
$ 1 = DK 7.567 – 7.584
In which market will you cover the transaction, London or New York, and what will be the
exchange profit or loss on the transaction? Ignore brokerages.
Question-41 [May-2005] [M-8] [Nov-2011] [M-5] [May-2014] [M-8] On January 28,
2005 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under
an irrecoverable LC. However, due to Bank Strikes, the bank could affect the remittance only on
February 4, 2005. The interbank market rates were as follows:
Bombay US $ 1
London Pound 1
Pound 1
January 28
Rs. 45.85- 45.90
US $ 1.7840-1.785
SGD 3.1575-3.1590
=
=
=
February 4
45.91-45.97
1.7765-1.7775
3.1380-3.1390
The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to
gain or loss due to the delay? [Ans: Loss to importer Rs. 228250]
Question-41A [ICWA-1] [SP]
On 25th March 2007, a customer requested his bank to remit DG 12,50,000 to Holland in payment
of import of diamonds under an irrevocable LC. However due to bank strikes, the bank could
affect the remittance only on 2nd April 2007. The inter bank market rates were as followsPlace
25.03.2007
02.04.2007
Bombay [$/Rs.100]
2.2873 - 2.2962
2.3063 - 2.3159
London[US$/Pound]
1.9120 -1.9135
1.9050 - 1.9070
4.1125 - 4.1140
4.0120 - 4.0130
DG/Pound
The bank wishes to retain an exchange margin of 0.25%. How much does the customer stand to
gain or lose due to the delay?
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.30
Question-42 [Nov-2013] [M-4] XYZ Bank, Amsterdam, wants to purchase Rs.25 m against £
for funding their Nostro account and they have credited LORO account Bank of London.
Calculate the amount of £’s credited. Ongoing inter-bank rates are per $, Rs.61.3625/3700 & per
£, $ 1.5260/70
Question-43 [May-2009] [M-6] [RTP-Nov-2014-9] Your forex dealer had entered into a
cross currency deal and had sold US $ 10,00,000 against EURO at US $ 1 = EUR 1.4400 for spot
delivery.
However, later during the day, the market became volatile and the dealer in compliance with his
management's guidelines had to square - up the position when the quotations were:
Spot US$1
1 month margin
2 month margin
Spot US$1
1 month margin
2 month margin
INR 31.4300/4500
25/20
45/35
Euro 1.4400/4450
1.4425/4490
1.4460/4530
What will be the gain or loss in the transaction?
10.16.1 Cancellation of Forward Contract and Cross Rates
Question-44 [Nov-2015] [M-5] A Bank enters into a Forward Purchase TT covering an Export
Bill for Swiss Francs 1,00,000 at Rs.32.40 due on 25th April and covered itself for same delivery
in the Local Inter Bank Market as Rs.32.42. However, on 25th March, Exporter sought for
cancellation of the contracts as the tenor of the bill is changed
In Singapore Market, Swiss Francs were quoted against US Dollars as under:
Spot
1 month Forward
2 months Forward
3 months Forward
USD 1 = Sw Francs 1.5076/1.5120
1.5150/1.5160
1.5250/1.5270
1.5415/1.5445
And in the Interbank Market US Dollars were quoted as under:
Spot
Spot/April
Spot/ May
Spot/ June
USD 1 = Rs.49.4302/0.4455
0.4100/.4200
0.4300/0.4400
0.4500/0.4600
Calculate the cancellation charges payable by the customer, If extra Margin required by the Bank
is 0.10% on buying and selling.
10.17 Arbitrage Operation/Currency Arbitrage [Q-45 to 51]
ICAI
N-08-O
M-06
RTP
N-14
ICWA
10
[Nov-2008] [M-4] Write short notes on Arbitrage Operation
Arbitrage Operations: Arbitrage is the buying and selling of the same commodity in different
markets or with different dealers. Business operation involving the purchase of foreign exchange,
gold, financial securities, or commodities in one market and their almost simultaneous sale in
another market, in order to profit from price differentials existing between the markets.
These transactions refer to advantage derived in the transactions of foreign currencies by taking
the benefits of difference in rates between two currencies at two different centers at the same
time or of difference between cross rates and actual rates.
Arbitrage is not a method of hedging foreign exchange risk in a real sense. It is however a
method of making profits from foreign exchange transactions.
a)
The process of buying goods/currency in one market and selling the same in another market
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.31
is known as arbitrage. Arbitrage profit is risk less profit.
b)
There are two types of arbitrage in forex markets:
(i) Exchange rate arbitrage or Geographical Arbitrage and
(ii) Interest rate arbitrage.
10.18 Exchange Rate Arbitrage or Geographical Arbitrage
a)
It refers to a situation in which one currency is cheaper in one foreign exchange market and
costlier in the other one. A person may purchase the currency at lower rate in one market,
may sell at the higher rate in the other market and make a profit. This profit arises at the
same time.
Buying at lower rate and selling at higher rate.
b)
Exchange rate arbitrage transactions may be classified in terms of the number of markets
involved. Thus, we may have two-point and three-point arbitrage.
10.18.1 Two-point arbitrage
a)
Two-point arbitrage concerns two currencies in two geographically separated markets.
Question-45 [ICWA-Example]
SR £1 = $1.55 in London and
SR £1 = $1.60 in New York
If you have $ 1000000, is there any arbitrage profit possible?
Note
b)
The sale of dollars in London would have strengthened sterling and pushed the value of the
pound above $1.55. At the same time, the sale of sterling in New York would have caused
sterling to weaken there, pushing its value below $1.60. The action of arbitrageurs would
bring the rates of exchange in the two centres together. In long run arbitrage profit is not
possible.
c)
If there is transaction costs, there arbitrage profit may not be possible.
d)
In case of 2 way quotes, we will follow trial and error method
Question-46 [ICWA-Example]
SR £1 = $1.5495 – 1.5505 in London and
SR £1 = $1.5995 – 1.6005 in NY and
Note
The profits would have been lower because of the bid-offer spread.
e)
One Exchange Rate is direct and another is indirect
i)
We will convert both exchange rate is same quote
ii)
Then we will apply trial and error method
Question-47
Singapore Spot
1$
= CHF 1.3689 - 1.4150
New York
1 CHF
= $ 0.7090 - 0.7236
Can you make through Attribute?
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.32
Question-47A
Spot Rate (Switzerland)
1$ = CHF 1.3689 – 1.3695
Spot Rate (USA)
1CHF = $ 0.7090 – 0.7236
You have 1 million CHF. What amount of profit you can make from arbitrage?
10.18.2 Cross rate Arbitrage/Three-point (triangular) arbitrage
ICAI
Nov-2008-O
M-6
ICSI
ICWA
Dec-2003
a)
In three point arbitrage, we will first sell available currency in one market
b)
Then we will sell same currency in another market
Question-48 [ICWA-Example]
In NY USD 1 = CHF 1.6639 – 1.6646 – (i) [CHF/USD]
In London USD 1 = Euro 0.9682 – 0.9686 – (ii) [Euro/USD]
In Australia Euro 1 = CHF 1.6410 – 1.6423 – (iii) [CHF/Euro]
Assume we have with $ 1 millon, how we can make profit.
Question-48A [Ex-ICWA] Followings are the spot exchange rates quoted at three different
forex markets.
£1 = $ 1.5715-721 – (i) [$/£]
$1 = ¥ 106.090-120 - (ii) [¥/$]
£1 = ¥ 176.720-831 – (iii) [¥/£]
You have £1m. Calculate arbitrage profit if any.
Three-point (triangular) arbitrage in single Quote
Question-49 [Nov-2008-O] [M-6] Followings are the spot exchange rates quoted at three
different forex markets:
USD/INR
GBP/INR
GBP/USD
48.30 in Mumbai
77.52 in London
1.6231 in new York
The arbitrageur has USD1,00,00,000. Assuming that there are no transaction costs, explain
whether there is any arbitrage gain possible from the quoted spot exchange rates.
Question-49A [CS-Dec-2003] [SP]
10.18.3 Four-point arbitrage
Question-50 [ICWA-3]
Given the following $/£
1.3670/1.3708
S.Fr/DEM
1.0030/1.0078
$/S.Fr
0.8790 / 0.8803
DEM / £
1.5560 /1.5576
Find out if any arbitrage opportunity exists.
If so, show how $10,000 available with you can be used to generate risk - less profit.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.33
10.18.4 Arbitrage Profit with Margin Money
(a)
If LHC is to be bought, Margin money should be added to Exchange Rate
(b)
If LHC is to be sold, Margin money should be deducted from Exchange Rate
Question-51 [RTP-Nov-2014-10] Followings are the spot exchange rates quoted at three
different forex markets:
USD/INR
59.25/59.35 in Mumbai
GBP/INR
102.50/103.00 in London
GBP/USD
1.70/1.72 in New York
The arbitrageur has USD 1,00,00,000. Assuming that bank wishes to retain an exchange margin
of 0.125%, explain whether there is any arbitrage gain possible from the quoted spot exchange
rates.
10.19 International Portfolio Management [Q-52 to 56]
ICAI
M-12
RTP
ICWA
M-05
a)
International Portfolio means investment in foreign securities
b)
Return from investment in Domestic Security
c)
Return from investment
foreign Security =
d)
Prem/Disc on Invested currency may be given
e)
If Prem/ Disc on invested currency is not given, then FER at to and t1 must be given and we
can calculate Prem/ Dis as follows
in
(P1-P0+Div + Intt)*100/P0
(1+Return from Security)(1 +- Prem/Dis on Invested
Currency) – 1
If Invested currency is LHC
Prem/Disc on invested currency [LHC] = (FR-SR)*100/SR
If Invested currency is RHC
Prem/Disc on invested currency [RHC] = (SR-FR)*100/FR
Question-52 [SM-11] Price of the bond in USA in the beginning of the period is $100 and it is $
105 at the end of the period. The coupon interest during the period is $7. The US dollar
appreciates during this period by 3%.
Find the return of investment of USA Investor from USA Bond.
Find the return of investment of Foreign Investor from USA Bond.
Question-52A Price of the bond in the beginning of the period is $100 and it is $ 105 at the end
of the period. The coupon interest during the period is $7.
If SR at beginning is $ 1 = Rs.50 and SR after 1 year $ 1 = Rs.51.50, then
Find the return of investment of USA Investor from USA Bond.
Find the return of investment of Foreign Investor from USA Bond.
Question-52B Return of American Bond is 12%.
If SR at beginning is $ 1 = Rs.50 and SR after 1 year $ 1 = Rs.51.50, then
Find the return of investment of USA Investor from USA Bond.
Find the return of investment of Foreign Investor from USA Bond.
Question-53 [May-2012][M-5] The price of a bond just before a year of maturity is $ 5,000.
Its redemption value is $ 5,250 at the end of the said period. Interest is $ 350 p.a. The Dollars
appreciates by 2% during the said period. Calculate the rate of return.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.34
Question-53A A French investor invested 1 m Euros in Indian stock market when the spot rate
was 1 Euro = Rs.55.50. The investment appreciated by 8% in terms of rupees during the year.
The year end spot rate is 1 Euro = Rs.57.67. What is the rate of return of the French investor?
Question-53B If the current exchange rate is Euro 1.50/£, one year forward contract rate is
Euro 1.56/£, the interest rate in a British Government security is 7%. Find risk free rate of return
for the French investor if the investment is made for one year.
Question-53C
Question-53D
Question-53E
Question-54 You are a Chinese investor considering the purchase of one of the following
securities. (FV of the Chinese Govt Security is CY 100 and that of the French Govt Security is
Euro 100)
Bond
French Govt
Chinese Govt
Time Horizon
6 months
6 months
Coupon
7.50%
6.50%
Price
100
100
Calculate the expected % change in FE rate which would result in the two having bonds having
equal total return in CY over 6 months time horizon. Verify your calculations assuming the
Chinese investor invested CY 1,00,000 and the foreign exchange rate at the time of investment
was: 1 Euro = 5 CY.
Question-55 An American based FII is looking to invest US$ 10 million in an emerging market.
After a careful analysis of future prospects, India and Malaysia are shortlisted. For the next year,
which is also the holding period for the FII, expected rates of return are 20% and 16% in India
and Malaysian markets respectively. Withholding tax rates applicable on the returns earned are
20% in India and 10% in Malaysia. Other information available with the Fll includes
Exchange rate:
Rs./$ spot
MS/$ spot
Expected inflation for the next year:
India
Malaysia
US
43.50/43.60
3.80/3.82
4.0%
6.0%
2.0%
Assuming that the PPP holds good, where should the FII invest?
10.19.1 SD of return from international investing
f)
Expected return from security
Rf + B(Rm – Rf) – Detail discussion in portfolio
g)
SD of return from international
investing
√(SDx)2 + (SDFEF)2 + 2(SDX)(SDFEF)CORXFEF
Question-56 Risk free rate in China is 12%. An Austrian company is considering the investment
in some Chinese securities. These securities have a beta of 1.48 and the variance of their return
is 20%. Rm in China is 22%. The Chinese Yuan is likely to depreciate by 5.56% annually against
the Euro with a variance of 15%. Coefficient of Correlation between the returns from investment
in these securities and those from exchange fluctuation is 0.21. Find the expected annual return
and variance of the investment of the Austrian investor.
Benefits of International Portfolio
(a) Reduce Risk: International investment aids to diversify risk as the gains from diversification
within a country are therefore very much limited, because macro economic factors of different
countries vary widely and do not follow the same phases of business cycles, different countries
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.35
have securities of different industries in their market portfolio leading to correlation of expected
returns from investment in different countries being lower than in a single country.
(b) Raise Return through better Risk – Return Trade off: International Investment aids to raise
the return with a given risk and/or aids to lower the risk with a given rate of return. This is
possible due to profitable investment opportunities being available in an enlarged situation and at
the same time inter country dissimilarities reduce the quantum of risk.
10.20 Covered Interest Arbitrage [Q-57 to 63]
ICAI
RTP
M-06
M-08
M-12
2
N-06
M-05
M-12
3
N-10
M-08
N-13
M-08
a)
ICWA
An interest arbitrage is possible when the forward premium or forward discount between
two currencies does not equal the interest rate differential.
This may be done by buying one currency in the spot market and simultaneously selling it in
the forward market and using the spot proceeds to invest in an asset denominated in the
spot currency; when the asset matures, the proceeds are used to fulfill the forward contract
and the arbitrage transaction concludes with a risk free profit.
b)
If IRPT exists, then Interest arbitrage is not possible. As premium or discount in currency
would be equal to interest rate differential of two countries.
(i)
If FRActual = FRIRPT then arbitrage is not possible
(ii)
If Prem/DisActual = Prem/DisIRPT then arbitrage is not possible
Example
SR $ 1 = Rs.50
FR of 1 year $ 1 = Rs.52.83
Investment in India
Investment in USA
Interest in India = 12%
Interest rate in USA = 6%
Invest Rs.100000 in India for 1 year @
12% p.a.
Invest $2000 in USA for 1 year @ 6% p.a.
At the end of 1 year
At the end of 1 year
Investment value at the end of 1 year =
Rs.100000*1.12 = Rs.112000
Investment value at the end of 1 year =
$2000*1.06 = $2120
Convert $ 2120 at FR
Rs. receivable
Rs.112000
at
FR
=
$2120*52.83
=
Note: In the above situation, IRPT exists hence return from both investment is same.
Interest arbitrage is not possible.
c)
If IRPT does not exist, then Interest arbitrage is possible.
(i)
If FRActual ≠ FRIRPT then arbitrage is possible
(ii)
If Prem/DisActual ≠ Prem/DisIRPT then arbitrage is possible
d)
Steps for calculation of Arbitrage Profit
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.36
Borrowing in LHC & Investment in RHC
Borrowing in RHC & Investment in LHC
If FRIRPT > FRActual i.e. FR Actual is Undervalued
If FRIRPT < FRActual i.e. FR Actual is Overvalued
If Prem on LHC < Loss of Intt on LHC OR
If Prem on LHC > Loss of Intt on LHC
If Disc on LHC > Gain of Intt on LHC
If Disc on LHC < Gain of Intt on LHC
Step for calculation of arbitrage profit if borrowing in LHC and investment in RHC
Action
Time
Activity
Borrow
Now
Borrow in LHC at its Borrowing Rate.
Convert
Now
Sell LHC at Spot Rate and realize the proceeds in Home Currency.
Invest
Now
Invest in RHC at deposit rate
Realize
Maturity
Realize the maturity value of RHC
Honour
Maturity
Convert RHC into LHC at FR
Repay
Maturity
Repay the LHC Liability.
Gain
Maturity
LHC Bought Less LHC Settled.
Step for calculation of arbitrage profit in borrowing in RHC and investment in LHC
Action
Time
Activity
Borrow
Now
Borrow in RHC at its Borrowing Rate.
Convert
Now
Buy LHC at Spot Rate, using the amount borrowed.
Invest
Now
Invest in LHC at deposit rate
Realize
Maturity
Realize the maturity value of LHC
Honour
Maturity
Convert LHC into RHC at FR
Repay
Maturity
Repay borrowing with interest
Gain
Maturity
RHC Received - RHC paid
Alternative Method for calculation of Arbitrage profit
(1) Calculate return from currency in which investment is made
= (1+Return from investment)[1 + Prem/(Dis) on invested currency] – 1
(2) Calculate arbitrage profit
Arbitrage Profit (in term of %) = Return from Invested Currency – Borrowing Cost
Arbitrage Profit (in term of Amt) = Borrowing Amt*Arbitrage Profit in %
Question-57 [Nov-2006] [M-5] [CS-June-2012-M-4] [ICWA-10]
Spot rate
1 US $ =
180 days Forward rate for
1 US $ =
Annualised interest rate for 6 months (Rs.)
Annualised interest rate for 6 months ($)
Rs. 48.0123
Rs. 48.8190
12%
8%
Is there any arbitrage Profit possibile? If yes, how an arbitrageur can take the situation, if he is
willing to borrow Rs.40,00,000 or US $ 83312. [Ans: Arbitrage Profit = $206.61]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.37
Question-57A [CS-Dec-2012-M-4]
Spot rate
1$ =
6 Month Forward rate for 1 $ =
Annualised interest rate for 6 month ($)
Annualised interest rate for 6 month (Rs.)
Rs. 43.30
Rs. 43.70
4%
8%
You are required to show what are the transactions the trader will execute to receive the
arbitrage gain, if he is willing to borrow Rs.43.30 m or $ 1m, assuming that no transaction cost
or taxes exist.
Question-57B [ICWA-Dec-2004]
Spot rate
1£ =
1 Year Forward rate for 1 £ =
Annualised interest rate in US
Annualised interest rate in UK
$ 1.50
$ 1.48
5%
8%
Is there any arbitrage possibility? If yes, how an arbitrageur can take the situation, if he is willing
to borrow $10,00,000
Question-57C [May-2006] [M-8] [Nov-2010] [M-8]
Question-57D
Question-57E [CS-June-2010-M-4]
Question-58 [Nov-2013] [M-8] Your’s Bank London Office has surplus funds to the extent of
USD 500000 for a period of 3 months. The cost of the funds to the bank is 4% p.a. It proposes to
invest these funds in London, New York or Franfurt and obtain the best yield, without any
exchange risk to the bank. The following rates of interest are available at the three centres for
investment of domestic funds there at for a period of 3 months.
London
5% p.a. ; New York 8% p.a. ; Frankfurt
3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot
1.5350/90
1 month
15/18 ; 2 month - 30/35 ; 3 months - 80/85
London on Franfurt
Spot
1.8260/90
1 month
60/55; 2 month - 95/90; 3 months - 145/140
At which center, will be investment made & what will be the new gain (to the nearest pound) to
the bank on the invested funds?
10.20.1 Arbitrage Profit in case of Continuous Compounding of Interest
Question-59 [RTP-May-2012-2]
Spot rate
1$ =
Annualised interest rate in US
Annualised interest rate in UK
£ 0.75
8%
5%
Assuming that interest is compounded on daily basis then at which forward rate of 2 year there
will be no opportunity for arbitrage.
Further show how an investor could make risk less profit, if two year forward price is 1 $ = 0.85
£
Given e-0.06 = 0.9413 & e-0.16 = 0.852, e0.16 = 1.1735, e-0.1 = 0.9051
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.38
10.20.2 Covered Interest Arbitrage in case of Single Quote with transaction cost
e)
If there is transaction cost for foreign transaction, then return from foreign investment may
be calculated as follows
(1+Return from investment)(1 +- Prem/(Dis) on invested currency)(1-TC)2 – 1
Question-60 [ICWA-Dec-2005] Consider the following
Spot rate
1 DM =
1 Year Forward rate for 1 DM =
Annualised interest rate in US
Annualised interest rate in DM
$ 0.75
$ 0.77
9%
7%
(i) Assuming no transaction cost or taxes exist, do covered arbitrage profits exists in the above
situation? Explain.
(ii) Suppose now that transaction cost in the foreign exchange market equal 0.25% per
transaction. Do unexploited covered arbitrage profit opportunities still exist.
10.20.3 Covered Interest Arbitrage in case of Two Quote
f)
In case of two way quote, there is more than 1 FER, hence we should follow trial and error
method
Question-61 [ICWA-Dec-2003]
Interest rates for 3 months in US and Canada are as follows:
Currency
US
Canada
Borrow
4%
4.5%
Sport Rate
$ 1 = Can $ 1.235 – 1.240
Forward Rate
$ 1 = Can $ 1.255 – 1.260
Invest
2.5%
3.5%
Advice the currency in which borrowing and lending for 3 months needs to be done for a US
Company. Take 3 months = 90/360 Days.
Question-61A [SP]
Spot
1$
= Rs.47.00 – 47.20
1 year forward
1$
= Rs.47.50 – 47.70
Interest rates
= Rs. 8%; $ 5% p.a.
Is there opportunity for covered interest arbitrage? Is there arbitrage opportunity?
Question-61B [SM-18] [ICWA-12]
Questiom-62 [ICWA-17] [SP]
Your Company has to make a US $ 1 Million payment in three month’s time. The dollars are
available now. You decide to invest them for three months and you are given the following
information.
(a) The US deposit rate is 8% p.a.
(b) The sterling deposit rate is 10% p.a.
(c) The spot exchange rate is S 1.80 / pound.
(d) The three month forward rate is $ 1.78/ pound.
(i) Where should your company invest for better results?
(ii) Assuming that the interest rates and the spot exchange rate remain as above, what forward
rate would yield an equilibrium situation?
(iii) Assuming that the US interest rate and the spot and forward rates remain as in the original
question, where would you invest if the sterling deposit rate were 14% per annum?
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.39
Questiom-63 [RTP-May-2012-3]
True Ltd is an old line producer of cosmetics products made up of herbals. Their products are
popular in India and all over the world but are more popular in Europe.
The company invoice in Indian Rupee when if exports to guard itself against the fluctuation in
exchange rate. As the company is enjoying monopoly position, the buyer normally never
objected to such invoices. However, recently an order has been received from whole-saler of
France for FF 80,00,000. The other conditions of the order are as follows:
(a) The delivery shall be made within 3 months
(b) The invoice should be FF
Since, company is not interested in losing this contract only because of practice of invoicing in
Indian in Indian Rupee. The export manager Mr E approached the banker of Company seeking
their guidance and further course of action.
The banker provided following information to Mr E
(a) Spot Rate 1 FF = Rs.6.60
(b) 90 days FR 1 FF = 6.50
(c) Interest rate in India is 9% and in France is 12%
Mr E entered into forward contract with banker for 90 days to sell FF at above mentioned rate.
When the matter come for consideration before Mr A, accounts manager of Company, he
approached you.
(i) Whether there is an arbitrage opportunity exists or not.
(ii) Whether the action taken by Mr E is correct and if bank agrees for negotiation of rate,
then at what rate forward rate company should sell FF to bank
10.21 Foreign Currency Payment with Interest [Q-64 to 66]
ICAI
N-08-O
M-06
N-11
M-06
N-12
M-08
N-14
M-08
M-15
M-05
RTP
M-15
ICWA
4
(a)
Question will give option, whether we should pay immediately or after some time with
interest
(b)
We will calculate inflow and outflow under both option and then we will accept those option
beneficial to us
Question-64 [Nov-2011] [M-6] [CS-June-2010-M-8] An Indian importer has to settle an
importer bill for $ 1,30,000. The exporter has given the Indian exporter two opinions:
i)
Pay immediately without any interest charges.
ii)
Pay after three months with interest at 5% p.a.
The importer’s bank charges 15% on overdrafts. The exchange rates in the market are as
follows:
Spot rate (Rs. /$): 48.35/48.36
3 Months forward rate (Rs. /$): 48.81/48.83
The importer seeks your advice. Give your advice.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.40
Question-64A [ICWA-Dec-2003] [ICWA-Dec-2002] [ICWA-June-2006] An import house
in India has bought goods from Switzerland for SF10,00,000. The exporter has given the India
Company two Options:
Pay immediately the bill for SF 10,00,000
Pay after 3 months with interest @5% p.a.
The importer bank charges 14% on overdrafts. If the exchange rates are as follows, what should
the company do?
Spot rate
(Rs./SF)
30 - 30.5
3 Month FR
(Rs./SF)
31.10 – 31.60
Question-64B [Nov-2014] [M-8]
Question-64C [May-2015] [M-5]
Question-65 [Nov-2012] [M-8] Z Ltd importing goods worth $ 2m, requires 90 days to make
the payment. The overseas supplier has offered a 60 days interest free credit period and for
additional credit for 30 days an interest of 8% p.a.
The bankers of Z Ltd offer a 30 day loan at 10% p.a. and their quote for exchange rate is as
follows:
Spot rate
$ 1 = Rs.56.50
60 days FR
$ 1 = Rs.57.10
90 days FR
$ 1 = Rs.57.50
You are required to evaluate the following options:
(i) Pay the supplier in 60 days; or
(ii) Avail the supplier’s offer of 90 days credit.
10.21.1 Letter of Credit
(a)
Letter of credit is an instrument issued in the favour of the seller by the buyer bank assuring
that payment will be made after certain timer frame depending upon the terms and
conditions agreed.
Under letter of credit, Bank charges commission and interest.
(b)
Commission is payable at the beginning of period.
Repayment of LC is made along with interest at maturity date.
Question-66 [CS-June-2007-M-10] [CS-Dec-2004-M-8] [Nov-2008-O] [M-6] [RTP-May2015-4] Astro Ltd. is planning to import a machine from Japan at a cost of 7640 yen. The
company can avail loans at 12% interest p.a. with quarterly rests with which it can import the
machine. However, there is an offer from Tokyo branch of an India based bank extending credit
of 180 days at 1.5% p.a. against opening of an irrevocable letter of credit.
Other Information
Present exchange rate Rs. 100 = 382 yen.
180 days' forward rate Rs. 100 = 388 yen.
Commission charges for letter of credit at 2% per 12 months.
Advise whether the offer from the foreign branch should be accepted?
Question-66A [SM-10] [CS-June-2006-M-4] [SP] Indigo Ltd. is planning to import a multipurpose machine from Japan at a cost of 7,200 lakhs yen. The company can avail loans at 15%
interest per annum with quarterly rests with which it can import the machine. However, there is
an offer from Tokyo branch of an India based bank extending credit of 180 days at 2% per
annum against opening of an irrevocable letter of credit.
Other Information
Present exchange rate Rs. 100 = 360 yen.
180 days' forward rate Rs. 100 = 365 yen.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.41
Commission charges for letter of credit at 2% per 12 months.
Advise whether the offer from the foreign branch should be accepted?
10.22 International working capital management [Q-67 to 68]
ICAI
M-07
M-08
RTP
N-15
ICWA
19
A
MNC have various branches or subsidiaries in many countries. MNC manages cash in two
ways
i)
Centralised Cash Management – Under this system, branches having surplus cash transferred
immediately to HO and any deficit of cash in any branches are met by HO. Any borrowing/
Surplus of cash is managed by HO
ii)
Decentralised Cash Management – Under this system, each branches manage their cash
independently. Borrowing/ Deposit are done by branches. At the end of period (like month,
quarter etc) surplus cash in any branch are transferred to HO and deficit of cash in any
branch are met by HO
Question-67 [May-2007] [M-8] [RTP-Nov-2015-19]
AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are as below:
U.S.
$12.5 million
U.K.
£ 6 million
Following exchange rate information are obtained:
$/Rs.
Spot
0.0215
30 days forward
0.0217
Annual borrowing/deposit rates (Simple) are available.
Rs.
6.4%/6.2%
$
1.6%/1.5%
£
3.9%/3.7%
The Indian operation is forecasting a cash deficit of Rs.500 million.
It is assumed that interest rates are based on a year of 360 days.
(i)
£/Rs.
0.0149
0.0150
Calculate the cash balance at the end of 30 days period in Rs. for each company under each of the
following scenarios ignoring transaction costs and taxes:
(a)
Each company invests/finances its own cash balances/deficits in local currency independently.
Cash balances are pooled immediately in India and the net balances are invested/borrowed for
the 30 days period.
Which method do you think is preferable from the parent company’s point of view?
(b)
(ii)
Question-68 An Indian firm wants to take advantage of some short term business opportunity in
France and for this purpose the firm needs Euro 1,00,000 for 4 months. The firm can borrow the
required funds either in rupees or in Euros. The following foreign exchange rates are prevailing in
the market:
Spot Rate
49.95/50.00
4 months forward rate:
50.00/50.05
The interest rate prevailing in the market:
2 months
Rs.12.00% p.a.
Euro 6.00%
4 months
Rs.11.40% p.a.
Euro 6.60%
Advise the firm whether it should borrow in Euros or in rupees.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.42
10.23 CURRENCY SWAPS [Q-69 to 71]
ICAI
a)
RTP
N-12
1
M-13
6
ICWA
Currency Swaps refer to the arrangement where principal and interest payments in one
currency are exchanged for such payments in another currency. It is another method of
hedging.
A currency swap can consist of three stages.
(iv)A spot exchange of principal.
(v) Continuing exchange of interest payments during the term of the swap.
(vi)Re-exchange of principal on maturity
b)
Type of Currency Swap
(i) Fixed for Fixed Currency Swap: The interest payments exchanged are payable under
Fixed Rate Basis for both the contracting parties.
(ii) Fixed for Floating Currency Swap: Interest payments exchanged are payable under Fixed
Rate Basis for one party and Floating Rate basis the other party.
(iii) Floating for Floating Currency Swap: Interest payments exchanged are payable under
Floating Rate Basis for both the parties. However, the base for fixing the floating rates is the
same for both the parties, i.e. LIBOR or MIBOR etc.
Question-69 A US company wishes to lend $ 1,00,000 to its Japanese subsidiary. At the same
time a Japanese company wishes to land approximately the same amount to its US subsidiary.
The parties are brought together by an Investment Bank for making parallel loans. The US
company will lend $ 1,00,000 to US subsidiary of Japanese company 4 years @ 13%. Principal
and interest are payable only at the end of 4 years in dollars.
The Japanese company will lend to the Japanese subsidiary of US company 14 millions Yen at
10% for 4 years. The current exchange rate is 140 Yen per dollar. However the dollar is expected
to decline by 5 yen per dollar per years. For each of next 4 years
(i) What amount of yens the Japanese company will receive from Japanese subsidiary of US
company after 4 years? What will be dollar equivalent of this company. [Ans: 20497400 Yen;
$170811.67]
(ii) How many dollars US company will receive after 4 years From US subsidiary of Japanese Co?
[Ans: $163047.36]
(iii) Which party is better off in this deal?
Question-70 Galeplus plc has been invited to purchase and operate a new telecommunications
centre in the republic of Perdian. The purchase price is 2,000 million Rubbits. The centre would
be sold back to the Perdian Government for an agreed price of 4,000 million Rubbits after 3
years. Galeplus would supply three years technical expertise and trading for local staff, for three
years, @ annual cost of 40 million Rubbits.
The relevant risk adjusted discount rate may be assumed to be 15% per year.
(i) Whether Project should be accepted or not.
(ii) Galeplus’s bank have suggested using currency swap for the purchase price of the factory,
with the swap of principal immediately and in three year’s time both swaps at today’s spot rate.
The bank would charge a fee of 0.25% per year (in sterling) for arranging the swap.
Exchange rates:
Spot
1 year forward rate
2 year forward rate
3 year forward rate
85.4
93.94
103.334
113.67
Rubbits/£
Rubbits/£
Rubbits/£
Rubbits/£
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.43
Assuming the swap takes place as described, provide a reasoned analysis, as to whether Galeplus
should accept the invitations or not.
Question-70A [SP] A US company has been offered a contract of construction a dam in an
underdeveloped country for which it shall be paid Peasas, the local currency of that country. The
construction will take be completed in one year. On completion the US Company will receive
3000m Peasas. The project requires an immediate spending of 2000m Peasas. The US Company
requires a return of 10% in Dollar terms. Given the following rates, should the project be
accepted?
Spot rate:
1 year forward rate:
1 USD =50 Peasas
1 USD =48 Peasas
Will your answer change if a bank offers a currency swap on the following terms?
i)
The US company may lend $ 40m to bank for 1 year at zero interest rate
ii)
The bank will lend the US company 2000m Peasas for 1 year at 10% p.a. interest; the loan
and the interest to be paid in Peasas.
Question-70B [RTP-Nov-2012-1] [RTP-May-2013-6] [SP] Drilldip Inc. a US based company
has a won a contract in India for drilling oil field. The project will require an initial investment of
Rs.500 crore. The oil field along with equipments will be sold to Indian Government for Rs.740
crore in one year time. Since the Indian Government will pay for the amount in Indian Rupee
(Rs) the company is worried about exposure due exchange rate volatility.
You are required to:
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1 US$ =Rs.50 in one
year, then should the company opt for this option or should it just do nothing. The spot rate
after one year is expected to be 1 US$ =Rs.54. Further you may also assume that the Drilldip
can also take a US$ loan at 8% p.a.
Question-71 A Canadian company has been awarded a contract to build a Power House in XYZ
country. The currency of that country is XYZ Mark. The contract price is 150m XYZ Mark, to be
paid on the completion of the work. The work will be completed in one year. The Canadian
company will be required to spend 60m XYZ marks immediately and another 60m after 9
months. The required rate of return is 12%.
A bank has offered the following swap:
(a) A currency swap of 60m XYZ Marks per Canadian Dollar immediately and the reverse
currency swap for the same amount at the same exchange rate after 1 year.
(b) The Canadian company will pay interest @ 15% p.a., payable in XYZ Marks after 1 year .The
bank will pay interest @ 10% p.a., payable in Canadian Dollars after one year.
Applying the following Foreign Exchange rates and assuming that the swap is undertaken, advise
whether the contract should be taken:
Spot rate
1 Canadian Dollars
=12 XYZ Marks
1 year forward
1 Canadian Dollars
=13 XYZ Marks
10.24 NOSTRO, VOSTRO AND LORO ACCOUNTS [Q-72]
ICAI
N-05
M-07
RTP
M-13
ICWA
18
[May-2012] [M-4] [RTP-Nov-2015-20a] Write short notes on Nostro, Vostro and Loro
Account
a)
In interbank transactions, foreign exchange is transferred from one account to another
account and from one centre to another centre. Therefore, the banks maintain three types of
current accounts in order to facilitate quick transfer of funds in different currencies. These
accounts are Nostro, Vostro and Loro accounts meaning "our", "your" and "their".
Chap – 10
b)
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.44
Nostro Accounts: A Domestic bank's foreign currency account maintained by the bank in a
foreign country and in the home currency of that country is known as Nostro Account or "our
account with you". For example, An Indian bank's Swiss franc account with a bank in
Switzerland.
Actual inflow of foreign currency is credited to this account and actual outflow of foreign
currency is debited to this account.
A Nostro is our account of our money, held by you
c)
Vostro account is the local currency account maintained by a foreign bank/branch. It is also
called "your account with us". For example, Indian rupee account maintained by a bank in
Switzerland with a bank in India.
d)
The Loro account is an account wherein a bank remits funds in foreign currency to another
bank for credit to an account of a third bank.
e)
Exchange position
Exchange position is the net balance of the aggregate purchases and sales made by the bank
in a particular currency. This is thus an overall position of the bank in a particular currency.
While determining this position, not only actual inflows and outflows of the that currency is
considered but “commitment to pay” and “entitlement to receive” are also considered. For
ex: A bank purchase a foreign currency bill (say $10000). The transaction will be entered
into exchange position immediately on the purchase of the bill. Later on when the bill is
realized, it will not be entered into the exchange position again.
Ex:
Suppose customer in India has to send $50000 to its business associates at USA. How this can be
done through Nostro Account
He will deposit equivalent Rs in India in his account and the bank will transfer the fund/ Issue DD
for foreign currency in USA. This transfer is called TT Sale/ Remittences/ TT Issue. This transfer
will be debited to Nostro Account.
Similarly if person in USA send $50000 in India. He will deposit equivalent $ in USA in Nostro
Account and the bank will transfer Rs. in India. This transfer is called TT Purchase.
f)
Effect on Nostro A/c and Statement of Position on Foreign Currency
Type
of
Transaction
Explanation
Nostro A/C
Position
Foreign
Currency
DD
purchase/
payment
A Ltd of India receives a DD of $5000 issued
in its favour from Washington. They approach
its bank for getting this amount. The bank
pays them the rupee value of $5000.
Credited/Added
on the date of its
presentation
Added on the
date of its
Receipts
DD
issue/sale
Mr Rahim approaches it bank to get a DD of
$1000 issued in favour of person at USA. The
bank charges Rs.46000 and issues the DD
Debited/deducted
on the date of its
presentation
Deducted on
the date of its
Issue
TT
Sale/
Remittences/
TT Issue
Telegraphic Transfer immediately
Debited on
same date
the
Deducted on
the same date
TT Purchase
Telegraphic Transfer immediately
Credited on the
same date
Added on the
same date
Purchase
bill
of
exchange
Bank purchase bill of Foreign Currency which
will mature in future
NA
Added on the
purchase
date
Realisation of Bill purchased earlier
Credited
realisation
on
NA
Bank Sold forward Contract for foreign
Debited
on
Deducted
Forward
in
on
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Sale
currency
Forward
Purchase
Bank purchased
foreign currency
forward
Contract
for
10B.45
Maturity Date
Contract
date
Credited
on
Maturity Date
Added on the
Contract
date
Question-72 An Indian Bank has its Nostro account with Bank of America. From the following
details of the transactions of a particular day, prepare the Nostro Account.
$
Opening balance
$ 20000 overdrawn
Purchase TT
$50000
Issued DD on new York
$20000
TT remittance outward
$25000
Purchase bill of exchange maturity 1 month
$75000
Forward sales
$75000
Export bills, purchased earlier, realized
$45000
(a) What steps the Indian Bank will take if it wants to maintain a credit balance of $20000 in its
Nostro Account.
(b) Prepare exchange position for the above mentioned question assuming that the opening
exchange position is overbought $5000.
Question-72A [Nov-2005] [M-7] [RTP-May-2013-18] [ICWA-32] You as a dealer in
foreign exchange have the following position in Swiss Francs on 31s1 October, 2004:
Swiss francs
Balance in the Nostro A/c credit
1,00,000
Opening position over bought
50,000
Purchase a bill on Zurich
80,000
Sold forward TT
60,000
Forward purchase contract cancelled
30,000
Remitted TT
75,000
Draft on Zurich cancelled
30,000
What steps would you take, if you are required to maintain a credit Balance of Swiss Francs
30,000 in the Nostro A/c and keep as overbought position on Swiss Francs 10,000?
10.25 Netting [Method of Hedging] [Q-73 to 74]
ICAI
N-06
RTP
ICWA
M-04
Nov-2004 [M-5] Explain the term ‘Exposure Netting’, with an example
May-2012 [M-4] Meaning and advantage of netting
a)
NETTING: Netting involves offsetting exposures in one currency with exposures in the same
or another currency. The basic idea behind the netting is to transfer only net amounts,
usually within a short period.
b)
Types of netting
Bilateral Netting: Company X exports goods to Company Y for US $2 million and imports
goods worth $1.5 million from Company Y. Their dates of maturity are the same, so they can
offset net payment.
Multilateral Netting: It involves netting of risk exposure among more than two company.
It is performed by the central treasury where several subsidiaries interact with head office.
3
Advantages
(a) Lower transaction costs as a result of fewer transaction
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.46
(b) Regular settlement may reduce in foreign exchange rate risk of group companies.
Question-73 [Nov-2006] [M-4] [ICWA-22] Following are the details of cash inflows and
outflows in foreign currency denominations of MNP Co. an Indian export firm, which have no
foreign subsidiaries:
Currency
Inflow
Outflow
Spot rate
Forward rate
US $
4,00,00,000
2,00,00,000
48.01
48.82
French Franc (FFr)
2,00,00,000
80,00,000
7.45
8.12
U.K. £
3,00,00,000
2,00,00,000
75.57
75.98
Japanese Yen
1,50,00,000
2,50,00,000
3.20
2.40
(i)
Determine the net exposure of each foreign currency in terms of Rupees.
(ii)
Are any of the exposure positions offsetting to some extent?
Question-74 A UK Company has its subsidiaries in three countries- India, USA and South Africa.
At the end of the year the inter- Company balances were as follows:
(a) The Indian subsidiary is owed Rs.14.00 million by the South Africa subsidiary
(b) Indian subsidiary owes $ 1 million to US subsidiary
(c) South Africa subsidiary owed 1.40m south Africa Rands (R) by the US subsidiary
(d) South Africa subsidiary owes $ 1m to US subsidiary
The foreign currency rates are: 1 Pound =2$ =Rs.70 =10R
The holding company instructed the subsidiaries to settle the balances on net basis. Assuming
that the statutes of all the companies permit this type of settlement, what the different
subsidiaries will do?
10.26 Matching [Method of Hedging]
ICAI
a)
RTP
ICWA
MATCHING: The foreign exchange rate risk can be eliminated or reduced, if the company
which is having exposure to receipts and payments in the same currency. The company can
off set its payments against its receipts if it can plan properly. This can be managed by
operating a bank account in overseas to offset the transaction. The basic requirement for a
matching operation is the two-way cash flow in the same foreign currency is called ‘natural
matching’. If the matching involves between two currencies whose movements are expected
to run closely is called ‘parallel matching’.
Ex: An Indian exporter exports finished goods to US firm and he will also import the raw material
from the US firms. Then the receipts and payment transactions can be offset at the origin itself
by operating a bank account in US for convenience.
10.27 Leading and Lagging [Method of Hedging] [Q-75 to 76]
ICAI
M-12
RTP
ICWA
M-08
[Nov-2011] [M-4] [RTP-May-2015-20a] Write short notes on Leading and Lagging
1
Leading: A firm having exposure to pay foreign currency, can make payments in advance
prior to due date called “Leads” to take advantage of lesser rate of foreign currency. In such
cases, the firm should consider the interest loss on opportunity to deploy funds elsewhere.
2
Lagging: If the firms delays the payments over the due date to take advantage of the
exchange fluctuation it is called “Lags”. The technique used in this is to delay payment of
weak currencies and bring forward payment of strong currecies.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.47
Question-75 Kamat Ltd is importing a special equipment from US for an amount $50,000,
payable in 3 months. The current spot rate US $ 1 = Rs.45.35. It is expected that the dollar will
strengthen against rupee in 3 months and the spot rate at the end of 3 moths would be
Rs.46.50. The borrowing cost is 8% p.a. Calculate the cash flow of transaction.
Question-75A [SP] D Ltd is supplying goods worth $1,00,000 to US importer and the amount is
payable after 4 months time. The current spot rate US $ 1 = Rs.45.36. It is expected that the Rs.
will strengthen against $ in 4 months and the spot rate at the end of 4 moths would be Rs.44.50.
The importer accepts to pay immediately if 2% cash discount is offered by D Ltd. The current
borrowing rate is 8%.
Question-76 [May-2012] [M-8] NP Co. has imported goods for $7,00,000. The amount is
payable after 3 months. The company has also exported goods for $4,50,000 and this amount is
receivable in 2 months. For receivable amount a forward contract is already taken at Rs.48.90
The market rates for Rs. and $ are as follows:
Spot
$ 1 = Rs.48.50 – 48.70
2 months
$ 1 = 25/30 points
3 months
$ 1 = 40/45 points
The company wants to cover the risk and it has two options as under:
(a) To cover payable in the forward market and
(b) To lag the receivable by one month and cover the risk only for the net amount. No interest for
delaying the receivables is earned.
Evaluate both the options if the cost of Rs. funds is 12%. Which option is preferable.
10.28 Other methods of hedging
a)
Price Variation [Method of Hedging]
When there is expected variation in foreign exchange rate, either party may ask for
adjustment of price variation in the invoice amount or contract price. But in practice, this
would possible only for the strong party who is in a position to dictate terms to other.
b)
Invoicing in foreign currency [Method of Hedging]
Sellers will usually wish to sell in their own currency or the currency in which they incur cost.
This avoids foreign exchange exposure. But buyers' preferences may be for other currencies.
The seller’s ideal currency is either his own, or one which is stable relative to it. But often
the seller is forced to choose the market leader’s currency. Whatever the chosen currency, it
should certainly be one with a deep forward market. For the buyer, the ideal currency is
usually its own or one that is stable relative to it, or it may be a currency of which the
purchaser has reserves.
c)
Assets and Liability Management
This technique can be used to manage balance sheet, income statement or cash flow
exposures.
In essence, asset and liability management can involve aggressive or defensive postures. In
the aggressive attitude, the firm simply increases exposed cash inflows denominated in
currencies expected to be strong or increases exposed cash outflows denominated in weak
currencies. By contrast, the defensive approach involves matching cash inflows and outflows
according to their currency of denomination, irrespective of whether they are in strong or
weak currencies.
d)
Maintaining a foreign currency Bank account
The exporting firm can maintain separate bank accounts for each currency in which it
transacts and delay the conversion into home currency until favourable situation to take
place. The major drawbacks of this method is that liquidity problems arises if funds are kept
for long time waiting for favourable situation.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.48
10.29 When Transaction date and forward contract date are different [Q-77]
ICAI
N-04
RTP
ICWA
M-04
(a)
We will Compare SR of Contract date and FR for calculating Prem/Dis
(b)
We will Compare SR of Transaction Date and FR for calculating Operating Profit
Question-77 [Nov-2004] [M-4] Excel Exporters are holding an Export bill in US Dollar
1,00,000, due 60 days hence. They are worried about the falling USD value which is
currently at Rs.45.60 per USD. The concerned Export Consignment has been the priced on
an exchange rate of Rs.45.50 per USD. The firm's bankers have quoted a 60 day forward
rate of Rs.45.20
Calculate:
(i)
Rate of discount quoted by Bank [Ans: 5.262% discount on $]
(ii) The probable loss of operating profit if the forward sale is agreed to. [Ans: Expected loss if
hedging is done – Rs.30000]
10.30 Cross-Currency Roll Over [Q-78]
ICAI
RTP
ICWA
a)
Cross Currency Roll Over contacts are contracts to cover long term foreign exchange
liabilities or assets. The cover is initially obtained for six months & later extended for further
period of 6 months & so on. Forward rate beyond 6 months is not available in market.
b)
Under the Roll over contracts the basic rate of exchange is fixed but loss or gain arises at the
time of each Roll over depending upon the market conditions.
c)
Roll-over-forward contract is one where forward contract is initially booked, for the total
amount of loan, etc. to be repaid. As and when installment falls due, the same is paid by the
customer in foreign currency at the exchange rate fixed in forward exchange contract. The
balance amount of the contract is rolled over (extended) till the due date of next installment.
The process of extension, continues till the loan amount has been repaid.
Question-78 A person gets an interest free loan of USD 3,00,000. Repayment is to be done in
three equal half yearly installments. Assume the following rates
A
B
C
D
Today Six months forward rate
At the end of six months, Spot Rate
Six months forward
At the end of one year, Spot rate
Six months forward
At the end of one & half year, Spot rate
Rs.42
Rs.43
Rs.43.40
Rs.44
Rs.44.50
Rs.45
-
42.50
43.10
43.50
44.10
44.60
45.10
Find the amount he has to pay in rupees in following three cases
(i) No hedging (ii) Three separate forward contracts one today, one after six months and one
after one year from today (iii) Rupee roll over forward
Question-78A An Indian corporate completes a project of value, $1 million in the middle east on
31/12/96. The contract has been executed on deferred payment terms and the necessary
permission for late realization of export proceeds has been obtained from the RBI. The company
has to bear the currency risk however till 1/1/99 when payment will be realized. When the
corporate approaches its bank, it is informed that contracts of maturity greater than six months
cannot be structured. It hence opts for six-month roll over cover.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.49
The following are the spot rates (Rs./$) and six-month forward rates (Rs./$) prevailing at the end
of each roll over period. Determine the cash flows and compare the result with a situation when
the corporate leaves the exposure uncovered. Cost of capital for the company is 20%.
Date
1/1/97
1/7/97
1/1/98
1/7/98
1/1/99
Spot Rate (Rs./$)
35.00
35.15
35.25
35.35
35.45
Six-month Forward Rate
35.20
35.30
35.35
35.50
35.60
10.31 Misc Question [Q-79 to 86]
ICAI
RTP
N-07
M-08
N-12
N-07
M-04
N-12
M-08
M-08
N-13
9
M-09
M-06
N-15
18
N-09
M-12
M-14
18
ICWA
18
Question-79 [May-2008] [M-8] [RTP-Nov-2012-18] Company is considering hedging its
foreign exchange risk. It has made a purchase on 1st January, 2008 for which it has to make a
payment of US $ 50,000 on September 30, 2008. The present exchange rate is 1 US $ = Rs. 40.
It can purchase forward 1 US $ at Rs.39. The company will have to make upfront premium of 2%
of the forward amount purchased. The cost of funds to the company is 10% p.a. and the rate of
Corporate tax is 50%. Ignore taxation. Consider the following situations and compute the
Profit/Loss the company will make if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is Rs. 42 per US $. [Ans: Rs.108075]
(ii) If the exchange rate on September 30, 2008 is Rs. 38 per US. [Ans: Rs.91925]
Question-80 [Nov-2007] [M-8] [RTP-Nov-2015-18] [RTP-May-2014-18] [ICWA-15]
Following information relates to AKC Ltd. which manufactures some parts of an electronics device
which are exported to USA, Japan and Europe on 90 days credit terms.
Cost and sales information:
Variable cost per unit
Export sale price per unit
Receipts from sale due in 90
Japan
Rs.225
Yen 650
Yen 7800000
USA
Rs.395
US$10.23
US$102300
Europe
Rs.510
Euro 11.99
Euro/Rs. 95920
Yen/Rs.
2.147-2.437
2.397-2.427
2.423-2.459
US$/Rs.
0.0214-0.0217
0.0213-0.0216
0.02144-0.02156
Euro/Rs.
0.0177-0.0180
0.0176-0.0178
0.0177-0.0179
Foreign exchange rate information:
Spot market
3months forward
3 months spot
Advice AKC Ltd by calculating average contribution to sale ratio whether it should hedge it’s
foreign currency risk or not.
Question-81 [May-2009] [M-6] [ICWA-2] You have following quotes from Bank A and Bank
B:
Spot
3 month
6 month
Spot
3 month
Bank A
USD/CHF 1.4650/55
5/10
10/15
GBP/USD1.7645/60
25/20
Bank B
USD/CHF 1.4653/60
GBP/USD1.7640/50
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
6 month
10B.50
35/25
Calculate
(i) How much minimum CHF amount you have to pay for 1 Million GBP spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap points for
Spot over 3 months?
Question-82 [Nov-2007] [M-4] [RTP-Nov-2012] [ICWA-19] [SP] A USA based company is
planning to set up a software development unit in India. Software developed at the Indian unit
will be bought back by the US parent at a transfer price of US $10 millions. The unit will remain
in existence in India for one year, the software is expected to get developed within this time
frame.
The US based company will be subject to corporate tax of 30 per cent and a withholding tax of 10
per cent in India and will not be eligible for tax credit in the US. The software developed will be
sold in the US market for US $ 12.0 millions. Other estimates are as follows:
Rent for fully furnished unit with necessary hardware in India
Man power cost (80 software professional will be working for 10 hours each day)
Administration and other costs
Rs.15,00,000
Rs.400 per man hour
Rs.12,00,00
Advice the US company on financial viability of the project. The rupee dollar rate is Rs.48/$
Question-83 [Nov-2009] [M-12] M/s Omega Electronics Ltd. exports air conditioners to
Germany by importing all the components from Singapore. The company is exporting 2,400 units
at a price of Euro 500 per unit. The cost of imported components is S$ 800 per unit. The fixed
cost and other variables cost per unit are Rs. 1,000 and Rs. 1,500 respectively. The cash flows in
Foreign currencies are due in six months. The current exchange rates are as follows:
Rs/Euro
R/S$
51.50/55
27.20/25
After six months the exchange rates turn out as follows:
Rs/Euro
R/S$
(i)
52.00/05
27.70/75
You are required to calculate loss/gain due to transaction exposure.
(ii) Based on the following additional information calculate the loss/gain due to transaction and
operating exposure if the contracted price of air conditioners is Rs. 25,000 :
(iii) The current exchange rate changes to
Rs/Euro
51.75/80
R/S$
27.10/15
Price elasticity of demand is estimated to be 1.5
Payments and receipts are to be settled at the end of six months.
Question-84 [SM-16] U.S. Imports co., purchased 100,000 Mark’s worth of machines from a
firm in Dortmund, Germany the value of the dollar in terms of the mark has been decreasing. The
firm in Dortmund offers 2/10, net 90 terms. The spot rate for the mark is dollar 0.55; the 90
days forward rate is $0.56.
a. Compute the $ cost of paying the account with in the 10 days.
b. Compute the $ cost of buying a forward contract to liquidate the account in 90 days.
c. The differential between part a and part b is the result of the time value of money (the
discount for prepayment) and protection from currency value fluctuation. Determine the
magnitude of each of these components.
Question-85 [ICSI-Dec-2006-M-5] Management of an Indian company is contemplating to
import a machine from USA at a cost of US$15,000 at today’s spot rate of $0.0227272 per Rs.
Finance Manager opines that in the present foreign exchange market scenario, the exchange rate
may shoot up by 10% after 2 months and accordingly he proposes to defer import of machine.
Management thinks that deferring import of machine will cause a loss of Rs.50,000 to the
company in the coming two months.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.51
You are asked to express your views, giving reasons as to whether the company should go for
purchase of machine right now or defer purchase for two months.
Question-86 [RTP-Nov-2013-9] ABN Amro Bank, Amsterdam, wants to purchase Rs.15 m
against $ for funding their Vostro account with Canara Bank, New Delhi. Assuming the inter bank,
rates of $ is 51.3625 – 3700, what would be the rate Canara Bank would quote to ABN Amro
Bank? Further if the deal is stuck, what would be the equivalent $ amount.
10.32 Theory [Q-1 to 7]
Question-1 [May-2011] [M-4] Explain the significance of LIBOR in international Financial
Transactions.
Solution-1
LIBOR stands for London Inter Bank Offered rate. Other features of LIBOR are as follows:
(a) It is base rate of exchange with respect to which most international financial transactions are
priced.
(b) It is used as a base rate for a large number of financial products such as options and swap.
(c) Banks also use LIBOR as the base rate when setting the interest rate on loans, savings and
mortgages.
(d) It is monitored by large number of professional and private individuals world wide.
Question-2 [Nov-2007] [M-3] Operations in foreign exchange market are exposed to a
number of risks." Discuss.
[Nov-2014] [M-4] [RTP-Nov-2014-20b] What are the risks to which foreign exchange
transactions are exposed?
Solution-2
A firm dealing with foreign exchange may be exposed to foreign currency exposures. The
exposure is the result of possession of assets and liabilities and transactions denominated 'in
foreign currency. When exchange rate fluctuates, assets, liabilities, revenues, expenses that have
been expressed in foreign currency will result in either foreign exchange gain or loss. A firm
dealing with foreign exchange may be exposed to the following types of risks:
(a) Transaction Exposure: A firm may have some contractually fixed payments and receipts
in foreign currency, such as, import payables, export receivables, interest payable on
foreign currency loans etc. All such items are to be settled in a foreign currency.
Unexpected fluctuation in exchange rate will have favourable or adverse impact on its
cash flows. Such exposures are termed as transactions exposures.
(b) Translation Exposure: The translation exposure is also called accounting exposure or
balance sheet exposure. It is basically the exposure on the assets and liabilities shown in
the balance sheet and which are not going to be liquidated in the near future. It refers to
the probability of loss that the firm may have to face because of decrease in value of
assets due to devaluation of a foreign currency despite the fact that there was no foreign
exchange transaction during the year.
(c) Economic Exposure: Economic exposure measures the probability that fluctuations in
foreign exchange rate will affect the value of the firm. The intrinsic value of a firm is
calculated by discounting the expected future cash flows with appropriate discounting
rate. The risk involved in economic exposure requires measurement of the effect of
fluctuations in exchange rate on different future cash flows.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.52
Question-3 [May-2011] [M-4] What is the meaning of (i) Interest rate parity and (ii)
Purchasing power parity
Solution-3
Forward exchange rate of the two countries is determined by various factors like, interest rate,
inflation rate, GDP, Monetary Policy etc.
Interest rate parity theory assumes that the forward exchange rate of the two countries is
determined by their interest rate differential assuming other factors remain constant.
FR under IRPT = [1 + PIR[RHC]]*SR/[1 + PIR[LHC]]
In the general economic analysis, the value of a currency in one country is determined by the
amount of goods and services that can be purchased with a unit of the currency, this is called the
purchasing power of the currency. PPP says that the exchange rate between two currencies must
be proportional to the price level of goods in two countries.
Question-4 [Nov-2008] [M-4] Write short notes on Arbitrage Operation
Arbitrage Operations: Arbitrage is the buying and selling of the same commodity in different
markets or with different dealers. Business operation involving the purchase of foreign exchange,
gold, financial securities, or commodities in one market and their almost simultaneous sale in
another market, in order to profit from price differentials existing between the markets.
These transactions refer to advantage derived in the transactions of foreign currencies by taking
the benefits of difference in rates between two currencies at two different centers at the same
time or of difference between cross rates and actual rates.
Arbitrage is not a method of hedging foreign exchange risk in a real sense. It is however a
method of making profits from foreign exchange transactions.
Question-5 [May-2012] [M-4] [RTP-Nov-2015-20a] Write short notes on Nostro, Vostro
and Loro Account
a)
In interbank transactions, foreign exchange is transferred from one account to another
account and from one centre to another centre. Therefore, the banks maintain three types of
current accounts in order to facilitate quick transfer of funds in different currencies. These
accounts are Nostro, Vostro and Loro accounts meaning "our", "your" and "their".
b)
Nostro Accounts: A Domestic bank's foreign currency account maintained by the bank in a
foreign country and in the home currency of that country is known as Nostro Account or "our
account with you". For example, An Indian bank's Swiss franc account with a bank in
Switzerland.
Actual inflow of foreign currency is credited to this account and actual outflow of foreign
currency is debited to this account.
A Nostro is our account of our money, held by you
c)
Vostro account is the local currency account maintained by a foreign bank/branch. It is also
called "your account with us". For example, Indian rupee account maintained by a bank in
Switzerland with a bank in India.
d)
The Loro account is an account wherein a bank remits funds in foreign currency to another
bank for credit to an account of a third bank.
Question-6 [Nov-2004 [M-5] Explain the term ‘Exposure Netting’, with an example
[May-2012] [M-4] Meaning and advantage of netting
a)
NETTING: Netting involves offsetting exposures in one currency with exposures in the same
or another currency. The basic idea behind the netting is to transfer only net amounts,
usually within a short period.
b)
Types of netting
Bilateral Netting: Company X exports goods to Company Y for US $2 million and imports
goods worth $1.5 million from Company Y. Their dates of maturity are the same, so they can
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
10B.53
offset net payment.
Multilateral Netting: It involves netting of risk exposure among more than two company.
It is performed by the central treasury where several subsidiaries interact with head office.
3
Advantages
(a) Lower transaction costs as a result of fewer transaction
(b) Regular settlement may reduce in foreign exchange rate risk of group companies.
Question-7 [Nov-2011] [M-4] [RTP-May-2015-20a] Write short notes on Leading and
Lagging
1
Leading: A firm having exposure to pay foreign currency, can make payments in advance
prior to due date called “Leads” to take advantage of lesser rate of foreign currency. In such
cases, the firm should consider the interest loss on opportunity to deploy funds elsewhere.
2
Lagging: If the firms delays the payments over the due date to take advantage of the
exchange fluctuation it is called “Lags”. The technique used in this is to delay payment of
weak currencies and bring forward payment of strong currecies.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Solution-1
Today SR $ 1 = Rs.46
(a)
If Today FR of 6 months $1 = Rs.51
Premium or discount on LHC ($) of 6 months = (FR-SR)/SR = (51-46)/46 = 0.1087 = 10.87%
Premium on ($) p.a. = 10.87%*12/6 = 21.74%
Premium or discount on (Rs.)
Premium or discount on RHC (Rs.) of 6 months = (SR-FR)/FR = (46-51)/51 = -0.0980 = -9.80%
Discount on (Rs.) p.a. = 9.80%*12/6 = 19.60%
(b)
If Today FR of 6 months $1 = Rs.44
Premium or discount on LHC ($) of 6 months = (FR-SR)/SR = (44-46)/46 = -0.0435 = -4.35%
Discount on ($) p.a. = 4.35%*12/6 = 8.70%
Premium or discount on (Rs.)
Premium or discount on RHC (Rs.) of 6 months = (SR-FR)/FR = (46-44)/44 = 0.0454 = 4.54%
Premium on (Rs.) p.a. = 4.54%*12/6 = 9.08%
Solution-1A
SR = $ 1 = Rs.48
(a) If FR of 3 months is $1 = Rs.51
Perm/ Disc on LHC [$] = (FR-SR)*100/SR = (51-48)*100/48 = 6.25% for 3 months
Perm/ Disc on LHC [$] = 6.25%*12/3 = 25% for 12 months
(b) If FR is $1 = Rs.47
Perm/ Disc on LHC [$] = (FR-SR)*100/SR = (47-48)*100/48 = -2.08% for 3 months
Perm/ Disc on LHC [$] = -2.08%*12/3 = -8.33% for 12 months
(c) If FR is $1 = Rs.51
Perm/ Disc on RHC [Rs] = (SR-FR)*100/FR = (48-51)*100/51 = - 5.88% for 3 months
Perm/ Disc on LHC [Rs.] = - 5.88%*12/3 for 12 months = -23.5204% p.a.
(d) If FR is $1 = Rs.47
Perm/ Disc on RHC [Rs] = (SR-FR)*100/FR = (48-47)*100/47 = 2.13% for 3 months
Perm/ Disc on LHC [Rs.] = 2.13% *12/3 for 12 months = 8.52%
Solution-2
Today SR: 1 $ = Rs.40.
(a) Appreciation on $ is 10% [Premium on LHC is given]
FR of one year: $ 1 = Rs.40*(1+Prem on $)
1 $ = Rs.40*1.1 = Rs.44
FR of 1 year: 1 US $ = Rs.44
(b) Depreciation on $ is 10% [Discount on LHC is given]
FR of one year $ 1 = Rs.40*(1-Dis on $)
1 $ = Rs.40*0.9 = Rs.36
FR of 1 year: 1 US $ = Rs.36
(c) Appreciation on Rs. is 10% [Premium on RHC is given]
FR of one year $ 1 = Rs.40/(1+Prem on Rs.)
1 $ = Rs.40/1.1 = Rs.36.36
FR of 1 year: 1 US $ = Rs.36.36
(d) Depreciation on Rs. [RHC] is 10% [Discount on LHC is given]
FR of one year $ 1 = Rs.40/(1-Dis on Rs.)
1 $ = Rs.40/0.9 = Rs.44.44
FR of 1 year: 1 US $ = Rs.44.44
10C.1
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.2
Solution-2A
Today SR 1 Pound = ND 2.5
(i) Appreciation on ND is 4% [Premium is on RHC given]
FR of 6 months: 1 Pound = ND 2.5/(1+Prem on ND)
1 Pound = ND 2.5/1.04 = ND 2.40
FR of 6 months: Pound 1 = ND 2.40
(ii) Depreciation on ND [RHC] is 2% [Discount is on RHC given]
FR of 6 months: 1 Pound = ND 2.5/(1 - Dis on ND)
1 Pound = ND 2.5/0.98 = ND 2.55
FR of 6 months: Pound 1 = ND 2.55
(iii) Depreciation on ND [RHC] is 0%
FR of 6 months Pound 1 = ND 2.5
Solution-2B
Today SR is 1 FF = 0.2 US$.
Currency appreciation on FF is 10% [Premium is on LHC given]
Therefore ESR of tomorrow 1 FF = $0.2*(1+Prem on FF)
1 FF = 0.2*1.1 = 0.22 $
Therefore 1 US $ = 1/0.22 = 4.5455 FF
Solution-3
A Fleur Co is to receive $ 124000 in 90 days [$ is FC and FF is DC for Fleur Co] [$ - Sell; FF – Buy]
Today SR: $ 1 = FF 5.70
FF which would have been receivable by selling $124000 at today SR = $124000*5.70 = FF 706800
(a)
FF strengthening by 5%, hence [Premium on RHC is given]
SR at maturity: $ 1 = FF 5.70/(1+Prem on RHC)
SR at maturity: $ 1 = FF 5.70/1.05
SR at maturity: $ 1 = FF 5.428
FF actually receivable by selling $124000 at SR of maturity = $124000*5.428 = FF 673072
Loss due to fluctuation = FF receivable at SR of maturity - FF receivable at today SR = FF673072 - FF706800 = FF 33728
(b)
FF weakening by 5% means [Discount on RHC is given]
SR at maturity: $ 1 = FF 5.70/(1-Dis on RHC)
SR at maturity: $ 1 = FF 5.70/0.95
SR at maturity: $ 1 = FF 6
FF receivable by selling $124000 at SR of maturity = $124000*6 = FF 744000
Expected Gain due to fluctuation = FF744000 – FF706800 = FF 37200
Solution-3A
(a)
B Ltd has shipped goods to USA and is to receive $ 10000 in 90 days [$ is FC and Rs. is DC for B Ltd] [$ - Sell; Rs – Buy]
Today SR is $ 1 = Rs.45
Rs. will depreciate by 10% in 90 days, [Discount on RHC is given]
SR at maturity: $ 1 = Rs.45/(1-Dis on Rs.)
SR at maturity: $ 1 = Rs.45/(1-0.1)
SR at maturity: $ 1 = Rs.50
Rs. which would have been receivable by selling $10000 at today SR = $10000*45 = Rs.450000
Rs. actually receivable by selling $10000 at SR of maturity = $10000*50 = Rs.500000
Gain/ Loss due to fluctuation = Rs. actually receivable at SR of Maturity – Rs. receivable at today SR
= Rs.500000 – Rs.450000 = Rs.50000
Solution-4
Indian company has imported goods worth Yen 108 lacs and will pay in 3 months [Indian Co will buy Yen and will sell Rs.]
Calculation of Current Spot rate
Rs.30 lacs = Yen 108 lacs
Rs.1 = Yen 108/30
Rs.1 = Yen 3.6
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.3
3 months FR Rs.1 = Yen 3.30
Anticipated decline in Exchange rate = 10%. [Decline is in Rs. (LHC), as Importer losses when DC declines] [Discount is
on LHC]
ESR of maturity: Rs.1 = Yen 3.6*(1-0.1) = Yen 3.24
(a) Rs. is LHC and Indian Importer will buy Yen and will sell Rs., hence he would like to sell Rs. at higher of ESR and FR
FR is higher than ESR hence Importer should enter into FC.
(b) If no hedging is done
Rs. required to pay Yen 108 Lacs at today SR = Rs.30 Lacs
Rs. required to pay Yen 108 Lacs at ESR of Maturity = Yen 108/3.30 = Rs.33.33 lacs
Expected loss if no hedging is done = Cost under ESR – Cost under Current SR = 33.33 – 30 = Rs.3.33 lacs
(c) If Forward Contract is entered into.
Rs. required to pay Yen 108 Lacs at FR = Yen 108/3.24 = Rs.32.73 lacs
Loss if hedging is done = Cost under FR – Cost under Current SR = 32.73 – 30 = Rs.2.73 lacs
Suggestion: If the exchange rate risk is not covered with forward contract, the expected exchange loss is Rs. 3.33lakhs.
This could be reduced to Rs. 2.73lakhs if it is covered with Forward contract. Hence, taking forward contract is suggested.
Saving due to Forward Contract = 33.33 –32.73 lacs = Rs.0.6 lacs
Solution-4A
Indian company has imported goods worth $13750 and will pay in 3 months [Indian Co will buy $ and will sell Rs.]
Current Spot rate
Rs.500000 = $ 13750
Rs.1 = $ 0.0275
3 months FR: Rs.1 = $ 0.0273
Anticipated decline in Exchange rate = 5%. [Decline is in Indian Rs, as Importer losses when DC declines]
ESR at maturity date: Rs.1 = $ 0.0275*(1-0.05) = $ 0.026125
(a) Rs. is LHC and Indian Importer will buy $ and will sell Rs., hence he would like to sell Rs. at higher of ESR and FR
FR is higher than ESR hence Importer should enter into FC.
(b) If no hedging is done
Rs. required to pay $13750 at Current SR = Rs.500000
Rs. required to pay $13750 at ESR of maturity = $ 13750/0.026125 = Rs.526315.80
Expected loss if no hedging is done = Cost under ESR – Cost under Current SR = 526315.80 – 500000 = Rs.26315.80
(c) If Forward Contract is entered into.
Rs. required to pay $13750 at FR = $13750/0.0273 = Rs.503663
Expected loss if hedging is done = Cost under FR – Cost under Current SR = 503663 – 500000 = Rs.3663
Suggestion: If the exchange rate risk is not covered with forward contract, the expected exchange loss is Rs.26315.80
This could be reduced to Rs.3663 if it is covered with Forward contract. Hence, taking forward contract is suggested.
Saving due to Forward Contract = 26315.80-3663 = Rs.22652.80
Solution-5
Today Sep, 1998
(i) ESR for March 1999 is
£ 1 = $ 1.30*0.15 + 1.35*0.2 + 1.40*0.25 + 1.45*0.20 + 1.50*0.20 = $ 0.195 + 0.27 + 0.35 + 0.29 + 0.30 = $ 1.405
ESR of March 1999, £ 1 = $1.405
(ii) Today Sep, 1998
ESR for March 1999 £ 1 = $ 1.405
FR for March 1999 £ 1 = $ 1.40
Pound is LHC, hence check out whether Pound is to be sold or purchased.
As per question Pound is to be sold, and we should sell at higher rate and higher rate is ESR, hence we should not enter
into forward contract.
Alternative Method
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.4
$ receivable by selling 1000 pound at ESR = 1000*1.405 = $1405
$ receivable by selling 1000 pound at FR = 1000*1.400 = $1400
Receipts under ESR is more than FR, hence we should not enter into Forward Contract
Solution-5A
Today March, 2003
(i) ESR for Sep 2003 is
£ 1 = $ 1.60*0.15 + 1.70*0.2 + 1.80*0.25 + 1.90*0.20 + 2.00*0.20 = $ 1.81
ESR of Sep 2003, £ 1 = $1.81
(ii) Today March, 2003
ESR for Sep 2003 £ 1 = $ 1.81
FR for Sep 2003 £ 1 = $ 1.80
Since Pound is LHC, hence check out whether Pound is to be sold or purchased.
As per question Pound is receivable & it is to be sold, hence we should sell at higher rate and higher rate is ESR, hence
we should not enter into forward contract.
Solution-6
Indian company has an export exposure and will receive Yen 100 lacs in 3 months [X Ltd will Sell Yen and will buy Rs.]
Current Spot Rate:
Rs.100 = Yen 310
Forward Rate Sept End =
Rs.100 = Yen 320.24
Expected Spot Rate Sep end =
Rs.100 = Yen 334.88
Rs. receivable by selling Yen 100 Lacs at Current SR = Yen 100/3.10 = Rs.32.258 lacs [Recorded in books]
Rs. receivable by selling Yen 100 Lacs at ESR of Sep = Yen 100/3.3488 = Rs.29.861 lacs
Rs. receivable by selling Yen 100 Lacs at FR of Sep = Yen 100/3.2024 = Rs.31.227 lacs
(i) If no Forward Contract is entered into.
Expected loss if no hedging is done = Rs. Receivable under ESR – Rs. Receivable under Current SR
= 29.861 – 32.258 = - Rs.2.397 lacs
(ii) If Forward Contract is entered into.
Loss if hedging is done = Rs. Receivable under FR – Receivable under Current SR = 31.227 – 32.258 = - Rs.1.031 lacs
Loss under forward cover is less than loss under without hedging, hence we should enter into forward cover.
Alternative Solution
LHC is Rs.
Since Exporter will purchase Rs. and sell Yen hence, he would be willing to buy Rs. at lower rate i.e at forward rate.
He should enter into forward contract.
(iii) We have entered into forward cover as per (ii)
If actual spot rate on 30th September, 1998 Rs.100 = Yen 322.23
Rs. which would have been receivable at actual spot rate of Sep 30 = Yen 100/3.2223 = Rs.31.034 lacs
Receipt under forward contract = Rs.31.227 lacs
Since more money is received under forward cover, hence Decision was right.
Solution-7
UK company is to receive ND 500000 in 6 months, and it will buy Pound and will sell ND
Current Spot Rate £1 = 2.50 ND
FR of 6 months £1 = 2.5354 ND
As per question, Forward cover is undertaken by UK Company
£ receivable by selling ND 500000 at FR = ND 500000/2.5354 = 1,97,208 £
Actual Spot Rate on maturity Date
(i) If Pound is Strength by 4% [Premium on LHC is given]
Actual SR at maturity £1 = 2.50*1.04 = 2.60 ND
If Forward cover is not undertaken then £ receivable by selling ND 500000 at actual SR of Maturity date
= 500000/2.60 = 1,92,308 £
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.5
Gain due to Forward Cover = 197208 – 192308 = 4900 £
(ii) If Pound is lost by 2% [Discount on LHC is given]
Actual SR at maturity: £1 = 2.50*0.98 = 2.45 ND
If Forward cover is not undertaken then £ receivable by selling ND 500000 at actual SR of Maturity date
= 500000/2.45 = 2,04,082 £
Loss due to Forward Cover = 2,04,082 – 1,97,207 = 6874 £
(iii) If Pound is Stable £1 = 2.50 ND
If Forward cover is not undertaken then £ receivable by selling ND 500000 at actual SR of Maturity date
= 500000/2.50 = 2,00,000 £
Loss due to forward cover = 2,00,000 – 1,97,207 = 2792 £
Solution-8
SR $ 1 = Rs.50 (Rs/$)
SR $ 1 = Yen 400 (Yen/$)
Required Exchange Rate
Rs./Yen = (Rs./$)*($/Yen)
Yen 1 = Rs. 50*1/400
Yen 1 = Rs.0.25
Required Exchange Rate
Yen/Rs. = (Yen/$)*($/Rs.)
Rs. 1 = Yen 400*1/50
Rs. 1 = Yen 4
Solution-9
$1 = Rs.50 (Rs./$)
$1 = Yen 200 (Yen/$)
Pound 1 = Yen 300 (Yen/Pound)
Required Exchange Rate
Rs./Pound = (Rs./$)*($/Yen)*(Yen/Pound)
Pound 1 = Rs. 50*(1/200)*300 = Rs.75
Pound 1 = Rs.75
Required Exchange Rate
Pound/Rs. = (Pound/Yen)*(Yen/$)*($/Rs.)
Rs. 1 = Pound (1/300)*(200)*(1/50) = Pound 0.0133
Rs 1 = Pound 0.0133
Solution-10
X Ltd an Indian Co is to receive Yen 100 lacs in Sep end [X Ltd will sell Yen and will buy Rs.]
In the given situation, the direct quote of INR/USD and JPY/USD are given. We have to calculate cross rate between
USD/INR
Current Spot Rate
USD 1 = Rs.41.79 (Rs./$)
USD = Yen 129.75 (Yen/$)
Required Cross Rate
Rs./Yen = (Rs./$)* ($/Yen) = Rs.41.79*1/129.75 ; Yen 1 = Rs.0.322081 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $1/Rs.41.79 * Yen 129.75 ; Rs.1 = Yen 3.10481
Forward Rate of Sep
USD 1 = Rs.42.89 (Rs./$)
USD 1 = Yen 137.35 (Yen/$)
Required cross rate
Rs./Yen = (Rs./$)*($/Yen) = Rs.42.89*1/137.35 ; Yen 1 = Rs.0.312268 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $(1/42.89)*137.35 = Rs.1 = Yen 3.202378
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.6
Expected Spot Rate of Sep
It is estimated that yen will depreciate against $ to 144 level and Rs. to depreciate against $ to Rs.43
USD 1 = Rs.43 (Rs./$)
USD = Yen 144 (Yen/$)
Required Cross Rates
Rs./Yen = (Rs./$)* ($/Yen) = Rs.43*1/144 ; Yen1 = Rs.0.298611 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $(1/43)*144 ; Rs.1 = Yen 3.348837
Exchange rate between Rs. and Yen
Current SR Yen 1 = Rs.0.322081
ESR of Maturity date Yen 1 = Rs.0.298611
FR of Maturity Yen1 = Rs.0.312268
Rs. receivable by selling Yen 10M at Current SR = Yen 10M * Rs.0.322081 = Rs.3.22081M
Rs. receivable by selling Yen 10M at ESR of maturity = Yen 10M * Rs.0.298611 = Rs.2.98611 M
Rs. receivable by selling Yen 10M at FR = Yen 10M * Rs.0.312268 = Rs.3.12268 M
(i)
If hedging is not done:
Expected Loss = Rs. Receivable under Current SR – Rs. Receivable under ESR of Maturity
= Rs.3.22081M - Rs.2.98611M = Rs.0.2347M
If hedging is done:
Expected Loss
= Rs. Receivable under Current SR – Rs. Receivable under FR
= Rs.3.22081M - Rs.3.12268 M = Rs.0.098 M
Loss is more if hedging is not done, hence hedging should be done.
Alternative Solution
LHC is Yen
Since Exporter will purchase Rs. and sell Yen Hence, he would be willing to Sell Yen at higher rate i.e at forward rate.
He should enter into forward contract.
(ii) If actual SR on 30th September 1998 was eventually INR/USD = Rs.42.78 and JPY/USD = 137.85, is the decision to
take forward cover justified.
Actual Spot Rate on Maturity:
USD 1 = Rs.42.78 (Rs./$)
USD = Yen 137.85 (Yen/$)
Required
Rs./Yen = (Rs./$)* ($/Yen) = Rs.42.78*1/142.78 ; Yen 1 = Rs.0.299622 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $1/Rs.42.78*Yen 137.78 ; Rs.1 = Yen 3.220664
Cross Rate
FR of Sep Yen 1 = Rs.0.300161
Actual SR of Sep Yen1 = Rs.0.299622
Rs. receivable by selling Yen 10M at FR = Yen 10M * Rs.0.300161 = Rs.3.00161M
Rs. receivable by selling Yen 10M at Actual SR of maturity = Yen 10M * Rs.0.299622 = Rs.2.99622M
Gain due to Hedging = Receivable under FR - Receivable under Actual Spot Rate
= Rs.3.00161M - Rs.2.99622M = Rs.00539
Hence decision was correct
Alternative Answer
Yen is to be sold and it is better to sell at higher of FR and ASR. FR is higher that ASR, hence decision was correct
Solution-10A
JKL Ltd an Indian Co is to receive JPY 10 lacs in Aug end [JKL Ltd will sell JPY and will buy Rs.]
In the given situation, the direct quote of Rs./USD and JPY/USD are given. But we have to calculate cross rates between
JPY/Rs.
Current Spot Rate
USD 1 = Rs.62.22 (Rs./$)
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.7
USD = Yen 102.34 (Yen/$)
Required Cross Rate
Rs./Yen = (Rs./$)* ($/Yen) = Rs.62.22*1/102.34 ; Yen 1 = Rs.0.607973 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = 102.34/62.22 ; Rs.1 = Yen 1.644809
Forward Rate of Aug
USD 1 = Rs.66.50 (Rs./$)
USD 1 = Yen 110.35 (Yen/$)
Required cross rate
Rs./Yen = (Rs./$)*($/Yen) = Rs.66.50*1/110.35 ; Yen 1 = Rs.0.602628 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $(1/66.50)*110.35 = Rs.1 = Yen 1.659398
Expected Spot Rate of Aug
It is estimated that yen will depreciate against $ to 124 level and Rs. to depreciate against $ to Rs.65
USD 1 = Rs.65 (Rs./$)
USD = Yen 124 (Yen/$)
Required Cross Rates
Rs./Yen = (Rs./$)* ($/Yen) = Rs.65*1/124 ; Yen1 = Rs.0.524194 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $(1/65)*124 ; Rs.1 = Yen 1.907692
Exchange rate between Rs. and Yen
Today SR Yen 1 = Rs. 0.607973
ESR of Maturity date Yen 1 = Rs. 0.524194
FR of Maturity Yen1 = Rs. 0.602628
Rs. receivable by selling Yen 10 L at Current SR = Yen 10L * Rs.0.607973 = Rs.6.07973 Lacs
Rs. receivable by selling Yen 10 L at ESR of maturity = Yen 10L * Rs.0.524194 = Rs.5.24194 Lacs
Rs. receivable by selling Yen 10 L at FR = Yen 10 L * Rs.0.524194 = Rs. 6.02628 Lacs
(i)
If hedging is not done:
Expected Loss = Rs. Receivable under Current SR – Rs. Receivable under ESR of Maturity
= Rs.6.07973 - Rs.5.24194 = Rs.0.83779 Lacs
If hedging is done:
Expected Loss = Rs. Receivable under Current SR – Rs. Receivable under FR
= Rs.6.07973 - Rs.6.02628 = Rs.0.5345 Lacs
Loss is less if hedging is done, hence hedging should be done.
Alternative Solution
LHC is Yen
Since Exporter will purchase Rs. and sell Yen Hence, he would be willing to Sell Yen at higher rate i.e at ESR. FR is
greater than RSE, hence he should not enter into forward contract.
(ii) If actual SR on 31st Aug, 2014 was eventually INR/USD = Rs.66.25 and JPY/USD = 110.85, is the decision to take
forward cover justified.
Actual Spot Rate on Maturity:
USD 1 = Rs.66.25 (Rs./$)
USD = Yen 110.85 (Yen/$)
Required
Rs./Yen = (Rs./$)* ($/Yen) = Rs.66.25*1/110.85 ; Yen 1 = Rs.0.597654 OR
Yen./Rs. = (Yen/$)* ($/Rs.) = $1/Rs.110.85/66.25 ; Rs.1 = Yen 1.673208
Cross Rate
FR of Sep Yen1 = Rs. Rs. 0.602628
Actual SR of Sep Yen1 = Rs. 0.597654
Rs. receivable by selling Yen 10 L at FR = Yen 10 L*Rs.0.602628 = Rs.6.02628 Lacs
Rs. receivable by selling Yen 10M at Actual SR = Yen 10 L*Rs.0.597654 = Rs.5.97654 Lacs
Gain due to Hedging = Receivable under FR - Receivable under Actual SR
= Rs.6.02628 – 5.97654 = Rs.0.04974 lacs
Hence decision of hedging was right
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.8
Alternative Answer
Yen is to be sold and it is better to sell at higher of FR and ASR. FR is higher than ASR, hence decision was correct
Solution-11
(i)
We will check which currency is to be sold and purchased.
[UK exporter receive Guilder 80000 hence he will sell guilders and will buy Pound]
Check out which currency is LHC
SR Pound 1 = Guilders 3.55 – 3.57
Pound is LHC and it is to be purchased, hence 2nd rate would be applicable for customer i.e. 3.57
If available currency and LHC are same then multiply otherwise divide it.
Pound receivable by selling Guilders 80000 at Spot rate = Guilders 80000/3.57 = Pound 22408.96
(ii)
We will check which currency is to be sold and purchased.
[UK exporter receive FF 150000 hence he will sell FF and will buy Pound]
Check out which currency is LHC
SR Pound 1 = FF 10.73 – 10.76
Pound is LHC and it is to be purchased, hence 2nd rate would be applicable for customer i.e. 10.76
If available currency and LHC are same then multiply otherwise divide it.
Pound receivable by selling FF 150000 at Spot rate = FF 150000/10.76 = Pound 13940.52
(iii)
We will check which currency is to be sold and purchased.
[UK importer pay Yen 1M hence he will Purchase Yen and will Sell Pound]
Check out which currency is LHC
SR Pound 1 = Yen 233.50 – 235.50
Pound is LHC and it is to be Sold, hence 1st rate would be applicable for customer i.e. 233.50
If available currency and LHC are same then multiply otherwise divide it.
Pound required to buy Yen 1M at Spot rate = Yen 1 m/233.50 = Pound 4282.655
(iv)
We will check which currency is to be sold and purchased.
[UK importer pay DM 120000 hence he will Purchase Dm and will Sell Pound]
Check out which currency is LHC
SR Pound 1 = FF 3.1725 – 3.1775
Pound is LHC and it is to be Sold, hence 1st rate would be applicable for customer i.e. 3.1725
If available currency and LHC are same then multiply otherwise divide it.
Pound required to buy Dm 120000 at Spot rate = DM 120000/3.1725 = Pound 37825.06
Solution-11A
(i) A Ltd received Euro 112000 and will sell it and will buy Rs.
[Euro is LHC and it is to be sold]
Spot Rate 1 Euro = Rs.56.00 - 56.04
[Euro is LHC and it is to be sold, hence 1st rate would be applicable 56.00
If available currency and LHC are same then multiply otherwise divide it.]
Rs receivable by selling Euro 112000 at Spot rate = Euro 112000*56 = Rs.62,72,000
(ii) A Ltd will pay Yen 200000 as interest
[A Ltd will buy Yen and will sell Rs.]
100 Yens = Rs.44.00 - 44.10
[Yen is LHC and it is to be purchased, hence 2nd rate would be applicable 44.10
If available currency and LHC are same then multiply otherwise divide it.]
Rs required to buy Yen 200000 at Spot rate = Yen 200000*44.10 = Rs.88,20,000
(iii) A Ltd received $ 300000 and will sell it and will buy Rs.
Exchange Rate 1$ = Rs.40.00 - 40.05
$ is LHC and it is to be sold, hence 1st rate would be applicable 40.00
If available currency and LHC are same then multiply otherwise divide it.
Rs receivable by selling $ 300000 at Spot rate = $ 300000*40 = Rs.12000000
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.9
Solution-12
1 USD
Order
Spot Rate
Action
Forward Rate
1 Month
0.18 - 0.22
Increasing Order
Rs.45 - 45.20
Add Swap rate
Rs.45.18 - 45.42
2 Months
0.25 - 0.30
Increasing Order
Rs.45 - 45.20
Add Swap rate
Rs.45.25 - 45.50
3 Months
0.32 - 0.30
Decreasing Order
Rs.45 - 45.20
Deduct Swap rate
Rs.44.68 - 44.90
Solution-13
(a)
Delhi based Firm purchases $100000 at Forward rate of 2 months [Buy - $; Sell – Rs.]
Current Spot Rate $ 1 = Rs.40.00 – Rs.40.10
Swap Rate of 2 months = 11 – 10 paise [Decreasing order]
Forward Rate of 2 months $ 1 = Rs. (40.00 - 0.11) – (40.10 - 0.10) = Rs.39.89 – 40.00
[$ is LHC and it is to be purchased, hence 2nd rate would be applicable 40.00
If available currency and LHC are same then multiply otherwise divide it.]
Rs. required to buy $100000 at forward rate of 2 months = $ 100000*40 = Rs.40,00,000
(b)
Delhi based Firm selling CD 70000 at Forward rate of 3 months
Current Spot Rate CD 1 = Rs.34.90 – Rs.35.00
Swap Rate of 3 months = 10 – 11 paise [Increasing order]
Forward Rate of 3 months CD 1 = Rs. (34.90 + 0.10) – (35.00 + 0.11) = Rs.35.00 – 35.11
CD is LHC and it is to be sold, hence 1st rate would be applicable 35.00
If available currency and LHC are same then multiply otherwise divide it.
Rs. receivable by selling CD 70000 at forward rate of 3 months = CD 70000*35 = Rs.24,50,000
(c)
Delhi based Firm purchases Yen 825000 at Forward rate of 1 month
Current Spot Rate Yen 100 = Rs.33.00 – Rs.33.10
Swap Rate of 1 months = 11 – 10 paise [Decreasing order]
Forward Rate of 1 months Yen 100 = Rs. (33.00 - 0.11) – (33.10 - 0.10) = Rs.32.89 – 33.00
[Yen is LHC and it is to be purchased, hence 2nd rate would be applicable 33.00
If available currency and LHC are same then multiply otherwise divide it]
Rs. required to buy Yen 825000 at forward rate of 1 months = Yen 825000*33/100 = Rs.2,72,250
Solution-14
Forward Rate of one Month
Forward Rate of Three Month
Actual Spot Rate at one month
Actual Spot Rate at three month
£1
£1
£1
£1
=
=
=
=
$1.687
$1.680
$1.694
$1.700
-
$1.690
$1.684
$1.696
$1.704
UK exporter will receive $, hence he will sell $ and he will buy £. [For Understanding]
LHC is £, hence he will enter into forward purchase contract of one and three months @ $1.690 and $1.684.
(i) Pounds receivable by selling $ 90,000 at FR = $ 45000/1.690 + $ 45000/1.684 = £ 53349
Had he not been entered into forward cover, then he would have purchased £ at actual spot rate of one and three months
i.e. @ $1.696 & $1.704
(ii) Pounds receivable by selling 90,000 dollars at actual SR of maturity = 45000/1.696 + 45000/1.704 = £ 52941
If forward cover is taken there is an excess receipts of (53349 – 52941) = £408
Hence Decision of Forward Cover was right
Solution-15
(a)
Forward rate of Two Months $1 = Rs.47.00 – Rs.47.50
Firm to get Rs.25 lacs by selling $ at forward rate of 2 months [Firm will buy Rs. and will sell $]
$ is LHC and it is to be sold, hence 1st rate would be applicable @ 47.00
$ required to get Rs.25 lakhs after 2 months at FR = Rs.2500000/47 = $53191.49
(b)
Current Spot Rate $ 1 = Rs.46.00 – Rs.46.25
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.10
Firm to pay $ 2 lacs at Spot market [Firm will buy $ and will sell Rs.]
$ is LHC and it is to be purchased, hence 2nd rate would be applicable @ 46.25
Rs. required to get $ 2 lakhs at CSR = $ 200000*46.25 = Rs.9250000
(c) Enchasing US $ 69000 now Vs 2 month later
We have $69000 in US bank Account.
(i) If we en-cash it now at Current Spot Rate
Current Spot Rate $ 1 = Rs.46.00 – Rs.46.25 [Selling $ and buying Rs.] [$ is LHC and it is to be sold, hence 1st rate
would be applicable 46.00]
Rs. receivable by converting $ 69000 at SR = $ 69000*46 = Rs.3174000
Invest Rs.3174000 @10% p.a. for 2 months in India
Total amount receivable after 2 months with interest = 3174000*1.01667 = Rs.3226911
(ii) If we encash $69000 after 2 months at Forward rate of two months
Forward rate of Two Months $1 = Rs.47.00 – Rs.47.50 [Selling $ and buying Rs.] [$ is LHC and it is to be sold, hence 1st
rate would be applicable 47.00]
Rs. receivable by selling $ 69000 at forward rate = $69000*47 = Rs.3243000
It is better to encash the proceeds after 2 months and get foreign exchange fluctuation gain.
Solution-15A
(i)
Forward rate of Two Months $1 = Rs.46.50 – Rs.47.00
Firm to receive Rs.5 cr by selling $ at forward of 2 months [For understanding firm will buy Rs. and will sell $] [$ is LHC
and it is to be sold, hence 1st rate would be applicable @ 46.50]
$ required to get Rs.5 cr after 2 months at FR = Rs.5/46.50 = $0.107527 Cr
(ii)
Current Spot Rate $ 1 = Rs.45.80 – Rs.46.05
Firm to pay $ 2 lacs by selling Rs. at Spot market [For understanding firm will buy $ and will sell Rs.] [$ is LHC and it is to
be purchased, hence 2nd rate would be applicable @ 46.05]
Rs. required to get $ 2 lakhs at SR = $ 200000*46.05 = Rs.9210000
(iii)
Current Spot Rate $ 1 = Rs.45.80 – Rs.46.05
Firm has $ 50000 & to receive Rs. by selling $ at spot market [$ is LHC and it is to be sold, hence 1st rate would be
applicable @ 45.80]
Rs. receivable by selling $ 50000 at SR = $ 50000*45.80 = Rs.2290000
Solution-16
Current Spot Rate
£ 1 = $1.5865 – 1.5905
3 months forward rate
£ 1 = $1.6100 – 1.6140
UK exporter is to receive $350000 in 3 months
(i) Forward Cover
If he takes forward cover of 3 months @ 1.6140 [Selling $ and buying £]
£ receivable by selling $350000 at FR = $350000/1.6140 = £216852.50
(ii) Money Market
Interest Rate
Currency
Deposit Rate
Borrowing Rate
Interest p.a.
PIR of 3 months
Interest p.a.
PIR of 3 months
$
7%
7/4 = 1.75%
9%
9/4 = 2.25%
£
5%
5/4 = 1.25%
8%
8/4 = 2%
UK exporter is to receive $350000 in 3 months [Assets in FC]
Today
(a) UK exporter will borrow from USA for 3 months @2.25% [Creating liability in FC]
Borrowing Amt in $ = Invoice Amt in $/(1 + PIRUSA) = 350000/1.0225 = $ 342298.29
(b) UK Exporter will Convert $342298.29 in pounds at CSR @1.5905 [Selling $ and buying £]
Equivalent £ receivable
= $342298.29/1.5905 = £215214.27
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.11
(c) UK Exporter will Deposit £215214.27 for 3 months in U K @ 1.25% [Creating Assets in DC]
At the end of 3 months
(a) Borrowing in USA and interest thereon will be repaid by amt receivable from supplier in USA.
(b) In UK, Amount Receivable = Amount of Deposit*(1 + PIRUK) = £215214.27*1.0125 = £217904.44
Pound Receivable
(i) Under forward cover = £216852.50
(ii) Under Money Market = £217904.44
Hence, hedging through money market is preferred
Solution-16A
Current Spot Rate
UA 1 = Rs. 11.50 – 11.80
3 months FR
UA 1 = Rs. 11.20 – 11.40
SL is to receive UA 500000 in 90 days [Buying Rs. and selling UA]
(i) Forward Cover [UA is LHC and is to be sold hence first rate will apply]
SL will sell UA 500000 at FR @ UA 1 = Rs.11.20
Rs. receivable by selling UA 500000 at FR = UA 500000*11.20 = Rs.5600000
(ii) Money Market
Interest Rate
Currency
Deposit
Borrowings
Interest p.a.
PIR of 6 months
Interest p.a.
PIR of 6 months
UA
9%
9/4 = 2.25%
12%
12/4 = 3%
Rs.
8%
8/4 = 2%
10%
10/4 = 2.50%
SL is to receive UA 500000 in 3 months [Assets in FC]
Today
(a) SL will borrow UA for 3 months @3% [Creating Liability in FC]
Borrowing Amt in UA = Receivable Amt in UA/(1 + PIRUA) = 500000/1.03 = UA 485436.90
(b) SL will Convert UA 485436.90 in Rs. at spot rate @11.50 [Buying Rs. and Selling UA]
Rs. receivable by selling UA 485436.90 at SR = UA 485436.90*11.50 = Rs.5582524
(c) SL will Deposit Rs.5582524 for 3 months in India @ 2% [Creating Assets in DC]
At the end of 3 months
(a) Borrowing in UA and interest thereon will be repaid from supplier
(b) In India, Amount receivable in Rs. = Amount of Deposit*(1 + PIRRs.) = Rs.5582524*1.02 = Rs.5694174
Comment: Receivable is more in case of MM, hence MM is preferable
Alternative Solution
Evaluation: Money Market Hedge is possible only if the 3-Month FR is lower than value of Spot Bid in the next three 3
Months (computed by applying IRPT Formula)
Value of FR of 3 months under IRPT = (1+PIRRHC)*SR/(1+PIRLHC) = 1.02*11.50/1.03 - 1.02*11.80/1.03
FR under IRPT: UA 1 = Rs.11.388 – 11.685
Actual FR: UA 1 = Rs. 11.20 – 11.40
Value of Spot Bid ` 11.37 in 3 Month’s time > Forward Bid Rate of ` 11.20
⇒ Therefore, there is a possibility for Money Market Hedge
Solution-17
Spot Rate
£1 = $ 2
Forward Rate of 180 days
£1 = $ 1.96
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.12
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days [Buying £ and selling $]
(i) Forward Cover
If it takes forward cover of 180 days @ 1.96
$ required to buy £300000 at forward rate = £300000*1.96 = $ 588000
(ii) Money Market
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 6 months
Interest p.a.
PIR of 6 months
$
5.5%
5.5/2 = 2.75%
5%
5/2 = 2.50%
£
5%
5/2 = 2.50%
4.50%
4.50/2 = 2.25%
XYZ Ltd is to pay £300000 in 180 days [Liability in FC]
Today
(a) XYZ Ltd will deposit in UK for 180 days @ 2.25% [Creating Assets in FC]
Deposit Amt in £ = Invoice Amt /(1 + PIRUK) = £ 300000/1.0225 = £ 293398.53
(b) XYZ Ltd will Convert £ 293398.53 into $ at spot rate @2
Equivalent $ required = £ 293398.53*2 = $ 586797.06
(c) XYZ Ltd will borrow $ 586797.06 for 180 days in USA @ 2.75% [Creating liability in DC]
At the end 180 days
(a) Deposit in UK and interest thereon will be used to pay UK exporter
(b) In USA, Amount payable for borrowing = Amount of Borrowing*(1 + PIRUSA) = $ 586797.06*1.0275 = $602933.98
(iv) No hedge option:
Expected Spot Rate after 180 days £ 1 = 1.91*0.25 + 1.95*0.60 + 2.05*0.15 = $ 1.955
If no hedging is done, then
$ required to pay £ 300000 at ESR of maturity = £ 300000*1.955 = $ 586500
Option
Amt Payable ($)
Forward Cover
588000.00
Money market
602933.98
Call Option
594900.00
No Hedging
586500.00
Minimum cost is in case of No hedging, hence XYZ Ltd should remain open.
Solution-17A
Current Spot Rate
GBP 1 = USD 1.5617 – 1.5673
6 months Forward Rate
GBP 1 = USD 1.5455 – 1.5609
A Ltd of U K has imported some chemical and has to pay USD 364897 in 6 months [Buy USD and sell GBP]
(i) Forward Cover
If it takes forward cover of 6 months @ 1.5455 [Buying USD and Selling GBP]
GBP required to buy USD 364897 at FR = USD 364897/1.5455 = GBP 236102.89
(ii) Money Market
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 6 months
Interest p.a.
PIR of 6 months
$
6%
6/2 = 3%
4.50%
4.50/2 = 2.25%
£
7%
7/2 = 3.50%
5.50%
5.50/2 = 2.75%
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.13
A Ltd is to pay USD 364897 in 6 months [Liability in FC]
Today
(a) A Ltd will deposit in USA for 6 months @2.25% Creating Assets in FC]
Deposit Amt in USD = Invoice Amt in USD/(1 + PIRUSA) = 364897/1.0225 = USD 356867.48
(b) A Ltd will Convert USD 356867.48 in GBP at spot rate @1.5617 [Buying USD and Selling GBP]
Equivalent GBP payable = USD 356867.48/1.5617 = GBP 228512.18
(c) A Ltd will borrow GBP 228512.18 for 6 months in U K @ 3.50% [Creating Liability in DC]
At the end of 6 months
(a) Deposit in USA and interest thereon will be used to pay USA exporter
(b) In UK, Amount payable for borrowing = Amount of Borrowing*(1 + PIRUK) = GBP 228512.18*1.035 = GBP 236510.10
Option
Forward cover
GBP 236102.89
Money market
GBP 236510.10
Currency option
GBP 227923.00
The company should take currency option for hedging the risk.
Solution-18
SR
$ 1 = £ 0.9830-0.9850
3 months FR
$ 1 = £ 0.9520-0.9545
(i) CS Inc has imported raw material from UK and £480000 is payable in 3 months
(ii) CS Inc has exported goods in India and receivable £ 138000 in 3 months
Net £342000 is payable in 3 months [$ - Sell; £ - Buy]
(a) Forward Cover
$ required to pay £342000 in 3 months at 3 months FR = £342000/0.9520 = $ 359243.70
(b) Money Market Cover
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 3 months
Interest p.a.
PIR of 3 months
$
13.0%
13/4 = 3.25%
11.50%
11.50/4 = 2.875%
£
12%
12/4 = 3.00%
10%
10/4 = 2.50%
CS Inc is to pay £342000 in 3 months [Liability in FC]
Today
(a) CS Inc will deposit in UK for 3 months @2.50% [Creating Assets in FC]
Deposit Amt in UK = Invoice Amt in £/(1 + PIRUK) = 342000/1.025 = £ 333658.50
(b) CS Inc will convert £333658.50 in $ at spot rate @0.9830 [Buying £ and Selling $]
Equivalent $ payable = £333658.50/0.9830 = $339428.80
(c) CS Inc will borrow $339428.80 for 3 months in USA @ 3.25% [Creating Liability in DC]
At the end of 3 months
(a) Deposit in UK and interest thereon will be used to pay UK exporter
(b) In USA, Amount payable for borrowing = Amount of Borrowing*(1 + PIRUSA) = $339428.80*1.0325 = $350460.20
Option
Forward cover
$ 359243.70
Money market
$ 350460.20
The company should go for money market
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.14
(ii) CS Inc has exported goods and €590000 is receivable in 4 months [$ - Buy; € - Sell]
SR
€ 1 = $ 1.8890-1.8920
4 months FR
€ 1 = $ 1.9510-1.9540
(a) Forward Cover
$ receivable by selling €590000 in 4 months at 4 months FR = € 590000*1.9510 = $ 1151090
(b) Money Market Cover
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 3 months
Interest p.a.
PIR of 3 months
$
13.0%
13/3 = 4.333%
11.50%
11.50/3 = 3.833%
€
16%
16/3 = 5.333%
14%
14/3 = 4.667%
CS Inc is to receive €590000 in 4 months [Assets in FC]
Today
(a) CS Inc will borrow from France for 4 months @5.333% [Creating liability in FC]
Borrowing Amt in France = Invoice Amt in €/(1 + PIRF) = 590000/1.05333 = €560128.40
(b) CS Inc will convert €560128.40 in $ at spot rate @1.8890 [Buying $ and Selling €]
Equivalent $ receivable = €560128.40*1.8890 = $1058083
(c) CS Inc will deposit $1058083 for 4 months in USA @ 3.833% [Creating Assets in DC]
At the end of 4 months
(a) Borrowing in France and interest thereon will be repaid from receivable in France
(b) In USA, Amount receivable from deposit = Amount of Deposit*(1 + PIRUSA) = $1058083*1.03833 = $1098639
Option
Forward cover
$ 1151090
Money market
$ 1098639
The company should go for Forward Cover
Solution-19 [P]
On March, 1, 1979, the USA company imports goods having invoice value in exporter currency 900000 LC
USA Company will pay LC 900000 on 31st May, 1979
Spot Rate
$1 = LC 10
Forward Rate of three Month
$1 = LC 9
Expected Future Spot Rate at the end three Month
$1 = LC 8
Tax Rate in both Countries = 40%
$ required to pay LC 900000 at today spot rate = LC 900000/10 = $90000 [Recorded in Books on date of transaction]
(i) Under Forward Cover
If forward cover is under taken to purchase 900000 LC at 3 month
$ Required to pay LC 900000 at forward rate = $ 900000/9 = $ 100000
Loss under Forward = $100000 - $90000 = $10000
Tax Rate = 40%
Tax Saving on Such Loss = $10000*TR = $10000*0.4 = $4000
Net Payment under forward cover = Actual Payment under forward rate – Tax saving = $100000-$4000 = $96000
Cost of Equipment under Forward Cover = $96000
[Note: Not part of Answer – If there is no tax rate, then cost of equipment under Forward Cover = $ 100000]
(ii) Money Market Operation
Interest Rate
Chap – 10
Currency
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Interest rate
Interest rate [NOT]
Interest p.a.
PIR of 3 months
12%
12/4 = 3%
3%*(1-0.4)
1.8%
8%
8/4 = 2%
2%*(1-0.4)
1.2%
$
LC
10C.15
USA Company will pay LC 900000 on 31st May, 1979
Today
(a) US Company will deposit in Foreign Country for 3 months @ 1.2%[NOT]
Deposit Amt in LC = Invoice Amt in LC/(1 + PIRFC) = 900000/1.012 = LC 889328.06
Spot Rate $1 = LC 10
(b) US Company will Convert LC 889328.06 in $ at spot rate
$ Required to deposit in LC = LC 889328.06/10 = $ 88932.806
(c) US Co will borrow $ 88932.806 for 3 months in US @ 1.8% [NOT]
At the end of 3 months
(a) Deposit in Foreign Country and interest thereon will be used to pay Foreign Supplier
(b) In USA, Amount payable for borrowing = Amount of Borrowing*(1 + PIR$) = $ 88932.806*1.018= $ 90533.60
Cost of Equipment under MM = $90533.60
(iii) If wait till actual payment [No Hedging]
Payment in Dollars at Expected spot rate of 3 months = $90000/8 = $112500
Foreign exchange Loss = $112500 - $90000 = $22500
Tax Saving on Loss = $ 22500*40% = $9000
Net Payment in Dollar under no hedging = $112500 - $9000 = $103500
Cost of Equipment under no hedging = 103500
[Note: Not part of Answer – If there is no tax rate, then cost of equipment under no hedging = $112500]
Option
Cost of Equipment
Forward cover
$ 96000
Money market
$ 90533.60
No Hedging
$ 103500
Cost of Equipment is minimum under money market hedging, hence it should be followed
Solution-21
Bank has entered into forward purchase contract, hence customer would have entered into forward sale contract for FF
10000 @ Rs.27.25
From Customers point of view
Original contract is Forward Sale for FF 10000 in 3 months
To cancel the FSC before maturity, customer has to enter into another forward purchase contract of same maturity date
for FF 10000.
After 2 months
One month forward rate: SF 1 = Rs.27.45 – Rs.27.52 [buying FF and Selling Rs.]
Customer will enter into one month forward purchase contract for FF 10000 @Rs.27.52
Gain/ (Loss) to customer on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable under FPC
= FF10000*27.25 – FF10000*27.52 = Rs.272500 – Rs.275200 = Rs.2700 loss to customer
The Banker will receive Rs.2700 from customer on cancellation of original forward sale contract.
Solution-21A
Bank has entered into forward purchase contract, hence customer would have entered into forward sale contract for FF
100000 @Rs.36.25
From Customers point of view
Original contract is Forward Sale for FF 100000 in 3 months
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.16
To cancel the Forward sale contract before maturity, customer has to enter into another forward purchase contract of
same maturity date for FF
After 2 months
One month forward rate SF 1 = Rs.36.45 – Rs.36.52 [buying FF and Selling Rs.]
Customer will enter into one month forward purchase contract for FF 100000 @ Rs.36.52
Gain/ (Loss) to customer on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable under FPC
= FF 100000*36.25 – FF 100000*36.52 = Rs.3625000 – Rs.3652000 = Rs.27000 loss to customer
The Banker will receive Rs.27000 from customer on cancellation of forward sale contract.
Solution-22
Bank has entered into forward purchase contract, hence customer would have entered into forward sale contract for USD
100000 @ Rs.48.25 due on 14th March.
From Customers point of view.
Original contract is Forward Sale for USD 100000
To cancel the Forward sale contract on maturity, customer has to enter into another Spot purchase contract for USD.
On Maturity Date
Spot rate USD 1 = Rs.48.6525 – Rs.48.7325 [buying $ and Selling Rs.]
Customer purchase USD 100000 @ Rs.48.7325
Gain/ (Loss) to customer on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable on spot purchase
= $ 100000*48.25 – $ 100000*48.7325 = Rs.4825000 – Rs.4873250 = Rs.48250 loss to customer
The Banker will receive Rs.48250 from customer on cancellation of forward sale contract.
Solution-22A
(i) Transaction with Alpha Manufacturing Co
On 19, March, 1999, bank has entered into forward sale contract, hence Alpha Manufacturing Co would have entered into
forward purchase contract for $ 100000 @ Rs.44.50 due in 3 months
On May, 19, 1999 - The customer approaches bank for cancellation of contract.
To cancel the Forward purchase contract before maturity, Alpha has to enter into another forward sale contract of same
maturity date for $ 100000.
At the end of 2 months
SR $1 = Rs.44.60 – 44.65
Swap Points of one month = 0.15-0.20 [Increasing Order]
Calculation of one month Forward Rate = SR + Swap Points
One month FR
$ 1 = Rs.44.75 – 44.85
For cancellation of FPC, Alpha Manufacturing Co will enter into FSC of 1 month for $ 100000 @44.75
Gain/ (Loss) to Alpha on cancellation of Original FPC = Rs. receivable under FSC – Rs. payable under FPC
= $ 100000*44.75 – $ 100000*44.50 = Rs.4475000 – Rs.4450000 = Rs.25000 Gain to Alpha
Loss to Banker = Rs.25000 and will be paid by Bank to Alpha
(ii) Transaction with Beta Trading Co
On 19, March, 1999, bank has entered into FPC, hence Beta Trading Co would have entered into FSC for Euro 1000000 @
Rs.47.20 due in 2 months
On May, 19, 1999 - The customer approaches bank for cancellation of contract.
Spot Rate, Euro 1 = Rs.47.75 – 47.85
To cancel the FSC on maturity, Beta has to purchase Euro 1000000 at SR @47.85
Gain/ (Loss) to Alpha on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable under spot purchase
= Euro 1000000*47.20 – Euro 1000000*47.85 = Rs.47200000 – Rs.47850000 = Rs.650000 Loss to Beta
Gain to Banker = Rs.650000
Bankers will realize Rs.650000 from customer.
Solution-23
SR $ 1 = Rs.41.30 -41.70
3 Months FR $ 1 = Rs.42.00 – 42.50
Cost per disc = $ 1.48
Purchase qty of disc = 1000000
$ payable for entire purchase contract = 1000000*1.48 = $1480000 [Buying $ and selling Rs.]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.17
On 01.04.2007, SI has entered into FPC for $1480000 @ $1 = Rs.42.50 due in 3 months
On 01.07.2007
Actual Purchase = 700000 Disc
$ required to pay for above purchase = 700000*1.48 = $1036000
Spot Rate on 01.07.2007 was $ 1 = Rs.40.90 - 41.20.
1. Out of $1480000, $1036000 will be paid for purchase of 700000 disc
2. Balance $ 444000 will be sold at spot rate of 01.07.2007 @ $ 1 = Rs.40.90
Rs. required to buy $ 1480000 at FR = $ 1480000*42.50 = Rs.62900000
Rs. receivable by selling $ 444000 at SR of 01.07.2007 = $444000*40.90 = Rs.18159600
(a) Net cost of 700000 disc = Rs.62900000 - Rs.18159600 = Rs.44740400
(b) American Company informs on 01.06.2007
On 01.06.2007
Spot $ 1 = Rs. 41.70 -42.20
1-Months Forward $ 1 = Rs. 42.10 - 42.50
If American Company had informed on 01.06.2007 about non availability of 300000 discs, then SI would cancelle FPC for
$444000 on 01.06.2007 by entering into FSC of 1 months for $ 444000 @ $1 = Rs.42.10
Rs. receivable by selling $ 444000 at FR of 1 months = $444000*42.10 = Rs.18692400
Then net cost of 700000 disc = Rs.62900000 - Rs.18692400 = Rs.44207600
Solution-24
XYZ booked a FSC for $ 500000 @ 46.20 due on 5 March.
XYZ approaches to Bank on 10th March for cancellation. [After maturity Date]
Spot Rate on 10/03 - $ 1 = Rs.46.28 – Rs.46.35
For cancellation of FSC, XYZ will purchase $500000 at spot rate of 10/03 @Rs.46.35 [Buying $, Selling Rs.]
Gain/ (Loss) to XYZ on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable under Spot Purchase
= $ 500000*46.20 – $ 500000*46.35 = Rs.23100000 – Rs.23175000 = Rs.75000 Loss to XYZ
Rs.75000 will be recovered from XYZ.
Note: Had it been gain to customer than it will not be paid to customer as contract is cancelled after due date.
Solution-24A
Bank has booked Forward Sale Contract for $ 100000 @ Rs.48.42 due on 10th March 2003.
It means Customer has booked a forward purchase contract for $ 100000 @ Rs.48.42 due on 10th March 2003.
The customer approaches to Bank on 14th March for cancellation after maturity date.
Spot Rate on 14th March $ 1 = Rs.48.50 - 48.57 [Buying Rs. and selling $]
For cancellation of FPC, customer has to sale $100000 on Spot rate of 14th March @ Rs.48.50
Gain/ (Loss) to customer on cancellation of Original FPC = Rs. receivable on spot sale – Rs. payable under FPC
= $ 100000*48.50 – $ 100000*48.42 = Rs.4850000 – Rs.4842000 = Rs.8000 Gain to Customer
Rs.8000 will not be paid to customer as it has been cancelled after maturity date.
Solution-25
ABC Booked forward sale contract for $ 200000 @ Rs.46.10 due on 5 March.
If the customer does not report, the contract will automatically be cancelled on 20th march by reverse contract.
Spot Rate on 20th march
$ 1 = Rs.46.18 – 46.26
For cancellation of FSC of customer, on behalf of customer, bank will purchase $200000 @46.26
Gain/ (Loss) to ABC on cancellation of Original FSC = Rs. receivable under FSC – Rs. payable under spot purchase
= $ 200000*46.10 – $ 200000*46.26 = Rs.9220000 – Rs.9252000 = Rs.32000 loss to Customer
Solution-25A
Bank has booked forward sale contract, hence customer would have booked forward purchase contract for $ 100000 @
Rs.48.42 due on 10th March.
If the customer does not report, the contract will automatically be cancelled on 25th march by reverse contract.
Spot Rate on 25th march
$ 1 = Rs.48.50 – 48.58
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.18
For cancellation of FPC of customer, on behalf of customer, bank will sell $100000 @48.50
Gain/ (Loss) to customer on cancellation of Original FPC = Rs. receivable under spot sale – Rs. payable under FPC
= $ 100000*48.50 – $ 100000*48.42 = Rs.4850000 – Rs.4842000 = Rs.8000 gain to Customer
This gain won’t be given to the customer, will be retained by the bank as contract is cancelled after maturity date
Solution-26
Since PNB has entered into forward sale contract, hence customer would have entered into forward purchase contract for
$ 250000 @Rs.48.35 due on 30th Aug,
From Customers point of view
Original contract is Forward Purchase for $.
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into a new forward Contract
To cancel the Forward purchase contract before maturity, customer has to enter into another forward sale contract for FF
of same maturity date.
On 10th Aug,
Forward rate of 30th Aug, $ 1 = Rs.47.6625 – Rs.47.7175 [buying Rs. and Selling $]
Customer will enter into forward sale contract for $ 250000 @Rs.47.6625
Gain or (Loss) to customer
= Sale Value – Purchase Cost
= 250000*47.6625 – 250000*48.35 = 11915625 – 12087500 = Rs.171875 loss to customer
The Banker will receive Rs.171875 from customer against cancellation of forward purchase contract.
On 10th August:
Forward rate of Sep 30, $1 = Rs.47.4425-47.5375
For extension of forward contract, customer will purchase new forward contract for 30th sep for $250000 @47.5375
Solution-26A
ABC Ltd entered into a forward sale contract for $100000 due on 12th Aug @46.25
The customer approaches on 8th Aug for extension of contract to 15th Sep.
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into new forward sale Contract
On 8th Aug,
FR of 12th Aug - $ 1 = Rs.45.56 – 45.72
For Cancellation of original FSC, ABC Ltd will enter into FPC of 12th Aug for purchase of $ 100000 @ 45.72
Gain or (Loss) to customer on cancellation of original FSC = Sale Value – Purchase Cost
= 100000*46.25 – 100000*45.72 = 4625000 – 4572000 = Rs.53000 gain to customer
On 8th August:
Forward rate of Sep 15, $1 = Rs.45.34 - 45.54
For extension of forward contract, customer will enter into new FSC for 15th sep for $100000 @45.34
Solution-27
Importer have entered into a forward purchase contract for purchase of $20000 due on 30th Oct @42.32
The importer approaches bank on 30th Oct for extension of contract for 3 months
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into new forward purchase Contract for further 3 months
On 30th Oct,
SR - $ 1 = Rs.41.50 – 41.52
For Cancellation of original FPC, Importer will sell $ 20000 at SR @ 41.50 & Less Margin Money 0.075% [Here Customer
is selling but Bank is buying, hence buying margin money rate will apply]
Sale value of $20000*41.50
Less: Margin Money @0.075%
Rs.830000.00
Rs.622.50
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Net Proceeds
Rs.829377.50
Less: Purchase cost of $20000 @ 42.32 as contracted
Rs.846400.00
Loss on cancellation of Contract to Customer
10C.19
Rs.17022.50
(ii) Calculation of FR of 3 months
Spot rate on $1 = Rs.41.50 - 41.52
Prem on $ for 3 months 0.87%-0.93% [Swap point is in ascending order]
FR of 3 months - $ 1 = Rs.41.50*1.0087 - 41.52*1.0093
FR of 3 months - $ 1 = Rs.41.861 - 41.906
For extension of forward contract, importer will enter into FPC of 3 months for $20000 @41.906
Add: Margin Money 0.20% [Here Customer is buying but Bank is selling, hence selling margin money rate will apply]
Forward purchase rate with margin money - $ 1 = Rs.41.906*1.002 = Rs.41.9898
Solution-27A
Importer have entered into a forward sale contract for purchase of $20000 due on 30th Oct @62.32
The importer approaches bank on 30th Oct for extension of contract for 3 months
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into new forward purchase Contract for further 3 months
On 30th Oct,
SR - $ 1 = Rs.61.50 – 61.52
For Cancellation of original FSC, exporter will buy $ 20000 at SR @ 61.52 & add Margin Money 0.20% [Here Customer is
buying but Bank is selling, hence selling margin money rate will apply]
Purchase rate = 61.52 + 61.52*0.2% = 61.52+0.12 = 61.64
Sale value of $20000*62.32
Rs.1246400
Less: Purchase Value $20000*61.64
Rs.1232800
Gain to Customer
Rs.13600
(ii) Calculation of FR of 3 months
Spot rate on $1 = Rs.61.50 - 61.52
Discount on $ for 3 months 0.93%-0.87% [Swap point is in descending order]
FR of 3 months - $ 1 = Rs.61.50*(1-0.0093) - 61.52*(1-0.0087) = Rs.60.93 – 60.98
For extension of forward contract, exporter will enter into FSC of 3 months for $20000 @60.93
Less: Margin Money 0.45% [Here Customer is selling but Bank is buying, hence buying margin money rate will apply]
Forward sale rate with margin money - $ 1 = Rs.60.93*(1 - 0.0045) = Rs.60.66
Solution-27B
An Indian Company entered into a forward sale contract for sale of £ 500000 due on 31.05.2008 @ Rs.61.60 per £.
The customer approaches on 31.05.2008 for extension of contract to 31.07.2008.
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into new forward sale Contract
On 31.05.2008,
Spot (Rs/£)
62.60/65
For Cancellation of original FSC, An Indian Company will enter into purchase contract for £ 500000 at spot rate @ 62.65
Gain or (Loss) to customer = Sale Value – Purchase Cost
= 500000*61.60 – 500000*62.65 = 30800000 – 31325000 = - Rs.525000 Loss to customer
Flat charges for cancellation = Rs.500
Total loss due to cancellation = Rs.525000 + Rs.500 = Rs.525500
On 31.05.2008:
2 Month Forward Premium
Since forward premium is in ascending order, hence
42/46
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.20
2 Months forward rate (Rs/£) = 63.02/11
For extension of forward contract, customer will enter into FSC for 31.07.2008 for £ 500000 @63.02
Solution-28
Importer have entered into a forward purchase contract for purchase of USD 200000 due on 10th June @64.40
The importer approaches bank on 20th June for extension of contract due on 10th Aug
Extension involves two things
(i) Cancellation of existing contract
(ii) Entering into new forward purchase Contract due on 10th Aug
On 20th June,
SR - USD 1 = Rs.63.68 – 63.72
For Cancellation of original FPC, Importer will sell USD 200000 at SR @ 63.68 & Less Margin Money 0.1%
(i) Cancellation Rate = Rs.63.68 – 63.68*0.1% = 63.68-0.0636 = Rs.63.6163
(ii) Loss to customer = 200000*(64.40 – 63.6163) = Rs.156740
Pending other part
Solution-29
Current Spot Rate
$1
Interest Rate (Rs.)
PIR of 6 months (Rs.)
Interest Rate ($)
PIR of 6 months ($)
=
=
=
=
=
Rs.45.50
8% p.a.
4%
2% p.a.
1%
(i) Calculation of the FR under IRPT [Rs. is RHC and $ is LHC]
FR under IRPT (Rs./$) = (1 + PIRRs.)*SR/(1 + PIR$) = (1 + 0.04)*45.50/(1 + 0.01) = Rs.46.851
(ii) Prem/ Dis on $ (LHC) under IRPT = [PIR[RHC] - PIR[LHC]]*100/[1 + PIR[LHC]]
= (0.04 – 0.01)*100/1.01 = 2.97%
Prem p.a. on $ = 2.97*2 = 5.94%
Alternative
Prem/ Dis on $ (LHC) under IRPT = (FRIRPT - SR)*100/SR = (46.85 – 45.50)*100/45.50 = 2.967%
(iii) Prem/ Dis on Rs. (RHC) under IRPT = (SR-FRIRPT)*100/FRIRPT = (45.50 – 46.85)*100/46.85 = - 2.881%
Dis p.a. on Rs. = 2.881*2 = 5.762%
(iv) Under the given circumstances, the USD is expected to quote at a premium as the interest rate in India is higher than
interest rate in USA
(v) Actual Prem/ Dis on $ (LHC) = (FRActual - SR)*100/SR = (47.00 – 45.50)*100/45.50 = 3.29%
Prem p.a. on $ = 3.29*2 = 6.58%
(vi) Whether IRPT exists or Not
FRIRPT $ 1 = Rs.46.851
FRActual $ 1 = Rs.47
Since FR under IRPT is not equal to Actual FR, hence IRPT does not exist.
Alternative
Prem on $ under IRPT = 2.97%
Prem on $ Actual = 3.29%
Since Prem on $ above is not equal, hence IRPT does not exist.
Solution-29A
Spot
Interest
PIR of 6
Interest
PIR of 6
$1
Rate (Rs.)
months (Rs.)
Rate ($)
months ($)
=
=
=
=
=
Rs.55.50
10% p.a.
5%
4% p.a.
2%
(i) Calculation of the FR under IRPT [Rs. is RHC and $ is LHC]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.21
FR under IRPT (Rs./$) = (1 + PIRRs.)*SR/(1 + PIR$) = (1 + 0.05)*55.50/(1 + 0.02) = Rs.57.13
(ii) Prem/ Dis on $ (LHC) under IRPT = [PIR[RHC] - PIR[LHC]]*100/[1 + PIR[LHC]]
= (0.05 – 0.02)*100/1.02 = 2.94%
Prem p.a. on $ = 2.94*2 = 5.88%
Alternative
Prem/ Dis on $ (LHC) under IRPT = (FRIRPT - SR)*100/SR = (57.13 – 55.50)*100/55.50 = 2.936%
(iii) Under the given circumstances, the USD is expected to quote at a premium as the interest rate in India is higher than
interest rate in USA
(iv) Actual Prem/ Dis on $ (LHC) = (FRActual - SR)*100/SR = (58.00 – 55.50)*100/55.50 = 4.504%
Prem p.a. on $ = 4.504*2 = 9.008%
(v) Whether IRPT exists or Not
FRIRPT $ 1 = Rs.57.13
FRActual $ 1 = Rs.58
Since FR under IRPT is not equal to Actual FR, hence IRPT does not exist.
Alternative
Prem on $ under IRPT = 2.936%
Prem on $ Actual = 4.504%
Since Prem on $ above is not equal, hence IRPT does not exist.
Solution-29B
Spot
Actual FR 3 Month
Interest Rate (DK)
PIR of 3 months (DK)
Interest Rate ($)
PIR of 3 months ($)
DK 1
DK 1
=
=
=
=
=
=
$0.15986
$0.15900
7.5% p.a.
1.875%
6.25% p.a.
1.5625%
(i) Actual Prem/ Dis on DK (LHC) = (FRActual - SR)*100/SR = (0.159 – 0.15986)*100/0.15986 = - 0.537%
Dis p.a. on DK = - 0.537%*4 = - 2.148%
(ii) Prem/Dis on DK (LHC) under IRPT = (PIR$ - PIRDK)*100/(1 + PIRDK)
= (0.015625 – 0.01875)*100/(1.01875) = - 0.3067%
Discount on DK under IRPT = 0.3067%
Discount on $ Actual = 0.537%
Since Prem on DK above is not equal, hence IRPT does not exist.
Hence, the forward exchange rate is not based on interest rate parity or not in equilibrium with interest rate.
(iii) If IRPT Exists
Calculation of the FR under IRPT [$ is RHC and DK is LHC]
FR under IRPT ($/DK) = (1 + PIR$)*SR/(1 + PIRDK) = (1 + 0.015625)*0.15986/(1 + 0.01875) = $0.15937
FR of 3 months under IRPT DK 1 = $0.15937
Solution-30
Spot
$1
FR of 90 days $ 1
=
=
DM 1.71
DM 1.70
(i) To hedge foreign exchange risk, shoe co can take forward contract, by selling DM 50,000 in forward Market @ $ 1 =
DM 1.70
$ receivable by taking forward contract = DM50,000/1.70 = $29411.76
$ receivable under Spot Rate = DM50,000/1.71 = $29239.77
Benefit by forward Contract = 29411.76 – 29239.77 = $171.99
(ii)
Prem/ Dis on $ (LHC) = (FRActual - SR)*100/SR = (1.70 – 1.71)*100/1.71 = - 0.5848%
$ is at discount and DM is at premium
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.22
(iii) Interest rate differential is just another name of premium or discount of one currency in relation to another currency.
IF IRPT exists
Discount on $ under IRPT = Actual Discount on $ = 0.5848%
Hence Interest rate differential = Discount on $ under IRPT = 0.5848%
Solution-31
SR 1 $ = FF 7.05 [$ is LHC and FF is RHC]
(i) For 3 months
Interest
PIR of 3
Interest
PIR of 3
Rate ($)
months ($)
Rate (FF)
months (FF)
=
=
=
=
11.5% p.a.
2.875%
19.5% p.a.
4.875%
Assuming IRPT Exists
FR under IRPT (FF/$) = (1 + PIRFF)*SR/(1 + PIR$) = (1 + 0.04875)*7.05/(1 + 0.02875) = FF 7.187
(a) FR of 3 months under IRPT $ 1 = FF 7.187
(b) Discount on FF (RHC) = (SR - FRIRPT)*100/FRIRPT = (7.05 – 7.187)*100/7.187 = - 1.906%
Discount p.a. on FF = 1.906*4 = 7.624%
(ii) For 6 months
Interest Rate ($)
PIR of 6 months ($)
Discount on FF
Discount on FF for 6 months
=
=
=
=
12.25% p.a.
6.125%
6.3% p.a.
3.15%
Discount on FF (RHC) is given, hence
FR of 6 months = SR/(1-Dis on FF) = 7.05/(1-0.0315) = 7.279
(a) FR of 6 months $ 1 = FF 7.279
Assuming IRPT Exists
FR/SR = [1 + PIRFF]/[1 + PIR$]
7.279/7.05 = [1 + PIRFF]/[1.06125]
1 + PIRFF = 7.279*1.06125/7.05 = 1.095
PIR on FF = 0.095 = 9.5%
(b) Interest rate on FF p.a. = 9.5%*2 = 19%
(iii) For 1 year
Interest Rate (FF)
FR of 1 year
=
20% p.a.
$ 1 = FF 7.52
(a) Discount on FF (RHC) = (SR – FRGiven)*100/FRGiven = (7.05 – 7.52)*100/7.52 = - 6.25%
Discount p.a. on FF = 6.25%
(b) Assuming IRPT Exists
FR/SR = [1 + IRFF]/[1 + IR$]
7.52/7.05 = [1.20]/ [1 + IR$]
1 + IR$ = 1.20*7.05/7.52 = 1.125
IR$ = = 0.125 = 12.5% p.a.
Particulars
3 Months
6 Months
1 Year
IR$ p.a.
11½%
12¼%
12 ½%
IR$ p.a.
19½%
19%
20%
Forward Francs per Dollar
7.187
7.279
7.52
Forward Discount on Franc (Percent per Year)
(7.624%)
(6.3%)
6.25%
Solution-32
Bag price at NY = $ 105
Same bag price in Mumbai = Rs.4250
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.23
a) Exchange Rate in Mumbai (Purchasing Power Parity Theory)
Bag price at NY = Bag price in Mumbai
$ 105 = Rs.4250
$ 1 = Rs.40.476
Exchange Rate in Mumbai per $ = Rs.40.4762
b) Price in a Year’s time
Inflation in Mumbai = 7%
Inflation in NY = 4%
Price of bag in Mumbai = Prevailing Price*(1 + Inflation Rate) = Rs.4250*1.07 = Rs.4,547.50
Price of bag in New York = Prevailing Price x (1 + Infaltion Rate) = USD 105*1.04 = USD 109.20
c) Exchange Rate in New York (after one year)
Assuming PPPT holds good
Exchange rate after one year (Rs./$) = (1 + IFRRs.)*SR/(1 + IFR$) = (1 + 0.07)*40.476/1.04 = Rs.41.64
d)
Premium/Discount on $ (LHC) under PPPT = [PIFRRs. – PIFR$]*100/[1 + PIFR$] = (0.07 – 0.04)/1.04 = 0.0288 = 2.88%
OR
Premium/Discount on $ (LHC) under PPPT = [FRPPPT - SR]*100/SR = (41.64-40.476)*100/40.476 = 2.87%
Premium on $ = 2.88%
Premium/Discount on Rs. (RHC) under PPPT = [PIFR$–PIFRRs.]*100/[1+PIFRRs.] = (0.04 – 0.07)/1.07 = - 0.0280 = 2.80%
OR
Premium/Discount on Rs. (RHC) under PPPT = [SR - FRPPPT]*100/ FRPPPT = (40.476 - 41.64)*100/41.64 = - 2.79%
Discount on Rs. = 2.79%
Solution-32A
SR
$1 = Rs.36 [Rs. is RHC and $ is LHC]
Inflation Rate (USA)
= 3%
Inflation Rate (India)
= 8%
Based on PPPT
Premium/Discount on Rs. (RHC) under PPPT = [PIFR$–PIFRRs.]*100/[1+PIFRRs.] = (0.03 – 0.08)*100/1.08 = - 4.629%
Premium/Discount on $ (LHC) under PPPT = [PIFRRs. – PIFR$]*100/[1 + PIFR$] = (0.08 – 0.03)*100/1.03 = 4.854%
Solution-33
SR
$1 = DM 1.50 [DM is RHC and $ is LHC]
FR of 3 months
$1 = DM 1.51
IFRDM = 4% p.a.;
PIFRDM of 3 months = 1%
PPPT holds good, hence
FRActual = FRPPPT = 1.51
FRPPPT of 3 months = (1 + PIFRDM)*SR/(1 + PIFR$) = (1.01)*1.50/(1 + PIFR$)
(1 + PIFR$) = 1.01*1.50/1.51 = 1.0033
PIFR ($)
= 1.0033 – 1 = 0.0033 = 0.33%
Annual Inflation rate ($)
= 0.33*4 = 1.32%
Solution-34
SR
$1 = Rs. 43.40 [Rs. is RHC and $ is LHC]
IFRRs. = 6.5% p.a.
IFR$ = 3% p.a.
According to Purchasing Power Parity
FRPPPT of 1 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.065*43.40/1.03 = Rs.44.87
So spot rate after one year $ 1 = Rs.44.87
FRPPPT of 2 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.065*44.87/1.03 = Rs.46.39
So spot rate after 2 year $ 1 = Rs.46.39
FRPPPT of 3 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.065*46.39/1.03 = Rs.47.96
FR of 3 years
$ 1 = Rs.47.96
Alternative Solution
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.24
FRPPPT of 3 year = (1 + IFRRs.)3*SR/(1 + IFR$)3 = (1.065*1.065*1.065*43.40)/(1.03*1.03*1.03) = Rs.47.97
FR of 3 years
$ 1 = Rs.47.97
Solution-34A
SR
$1 = Rs. 46 [Rs. is RHC and $ is LHC]
IFRRs. = 8% p.a.
IFR$ = 4% p.a.
According to Purchasing Power Parity
FRPPPT of 1 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.08*46/1.04 = Rs.47.77
So spot rate after one year $ 1 = Rs.47.77
FRPPPT of 2 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.08*47.77/1.04 = Rs.49.60
So spot rate after 2 year $ 1 = Rs.49.60
FRPPPT of 3 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.08*49.60/1.04 = Rs.51.50
FR of 3 years
$ 1 = Rs.51.50
So spot rate after 3 year $ 1 = Rs.51.50
FRPPPT of 4 year = (1 + IFRRs.)*SR/(1 + IFR$) = 1.08*51.50/1.04 = Rs.53.48
FR of 4 years
$ 1 = Rs.53.48
Alternative Solution
FRPPPT of 4 year = (1 + IFRRs.)4*SR/(1 + IFR$)4 = (1.08*1.08*1.08*1.08*46)/(1.04*1.04*1.04*1.04) = Rs.53.49
FR of 4 years
$ 1 = Rs.53.49
Solution-35
SR
GBP 1 = USD 1.5339 [GBP is LHC and USD is RHC]
NIRUSD = 5%
NIRGBP = 7%
FR under IFE = [1 + PNIRUSD]*SR/[1 + PNIRGBP] = 1.05*1.5339/1.07 = 1.505
FR of 1 year under IFE
GBP 1 = USD 1.505
Solution-36
SR
$ 1 = Rs.45.50 [Rs. is RHC and $ is LHC]
1 year FR
$ 1 = Rs.45.9461
= 8%
RIRRs.
RIR$
= 6%
IFRRs.
= 4%
NIR in India = (1 + RIRRs.)(1 + IFRRs.) - 1= (1.08*1.04) – 1 = 12.32%
Apply IFE
FRActual = FR under IFE = 45.9461
FR under IFE = [1 + PNIRRs.]*SR/[1 + PNIR$]
45.9461 = 1.1232*45.50/[1 + PNIR$]
1 + PNIR$ = 1.1232*45.50/45.9461 = 1.11229
PNIR$ = 1.11229 – 1 = 0.11229 = 11.229%
NIR in USA = 11.229%
(1 + NIR$) = (1 + RIR$)(1 + IFR$)
(1 + IFR$) = (1 + NIR$)/(1 + RIR$) = 1.11229/1.06 = 1.04933
IFR$ = 1.04933 – 1 = 0.04933 = 4.933%
IFR in USA = 4.933%
Solution-37
1£
= Rs.74.00 -74.50
Rs./ £
1 CHF
= Rs.26.00 -26.60
Rs./CHF
Required
(a) (CHF/£) = (CHF/Rs.)*(Rs./£) = 74/26.60 – 74.50/26 = 2.7819 – 2.8653
£ 1 = CHF 2.7819 – 2.8653
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.25
(b) (£/CHF) = (£/Rs.)*(Rs./CHF) = 26/74.50 – 26.60/74 = 0.3489 – 0.3594
CHF 1 = £ 0.3489 – 0.3594
Solution-38
Spot rate
$1 = Rs.45.00 – 45.40 (Rs/$)
Pound 1 = $ 1.60 – 1.65 ($/P)
Pound 1 = AD 3.00 – 3.50 (AD/P)
AD 1 = SD 1.50 – 1.60 (SD/AD)
Required
Rs./SD = (Rs./$)*($/P)*(P/AD)*(AD/SD) = (45.00*1.60)/(3.50*1.60) – (45.40*1.65)/(3*1.50) = 12.85 – 16.64
SD 1 = Rs.12.85 – 16.64
Solution-38A
Euro 1 = DM 1.95583 (Locked in rate)
[DM/Euro]
Euro 1 = $1.0234 - 1.0243
[$/Euro]
$1
[Rs./$]
= Rs.48.51-48.53
Requirement
Rs./DM = Rs./$ * $/Euro * Euro/DM
Bid Price DM 1 = 48.51*1.0234 * 1/1.95583 = 25.382
Ask Price DM 1 = 48.53*1.0243 * 1/1.95583 = 25.416
Solution-39
The Dealer sold HK$ 10000000 on spot @ HK$ 1 = Rs.5.70
To covers it self, He will buy HK$ 10000000 from the market at market selling rate.
Exchange rate
US $ 1 = HK $ 7.588-7.592 [HK $/US $]
US $ 1= Rs.42.70 – 42.85 [Rs./US $]
Required cross rate
Rs./HK $
= (Rs./US $) * (US $/HK $)
HK $ 1
= Rs.42.70*1/7.592 – 42.85*1/7.588
HK $ 1
= Rs.5.624 – 5.647
Since Bank had sold HK $ @ Rs.5.70 and to cover himself, he will purchase HK $ at spot rate @5.647
Gain or loss to Bank
= Sale price – Purchase Price
= HK $ 10000000*5.70 – 10000000*5.647 = Gain Rs.530000
Solution-39A
Exchange rate
US $ 1 = HK $ 7.9250-7.9290 [HK $/US $]
US $ 1= Rs.55.00 – 55.20 [Rs./US $]
Required cross rate
Rs./HK $
= (Rs./US $) * (US $/HK $)
HK $ 1
= Rs.55/7.9290 – 55.20/7.9250
HK $ 1
= Rs.6.9365 – 6.9653
Since Bank had sold HK $ @ Rs.7.15 and to cover himself, he will purchase HK $ at spot rate @6.9653
Gain or loss to Bank
= Sale price – Purchase Price
= HK $ 4000000*7.15 – 4000000*6.9653 = 28600000 – 27844000 = Gain Rs.738800
Solution-40
Mumbai – London
Pound 1 = Rs.74.30 – 74.32
(Rs./P)
London Market
London – Copenhagen
Pound 1 = DK 11.42 – 11.435
(DK/P)
London Market
Mumbai – New York
$ 1 = Rs.49.25 – Rs.49.2625
(Rs./$)
New York Market
New York – Copenhagen
$ 1 = DK 7.567 – 7.584
(DK/$)
New York Market
(i) Cross rates between DK and Rs. in London Market
Rs./DK = (Rs./P)*(P/DK) = Rs.74.30/11.435 – 74.32/11.42 = Rs.6.4976 – 6.5078
DK 1 = Rs. 6.4976 – 6.5078
(ii) Cross rates between DK and Rs. in NY Market
Rs./DK = (Rs./$)*($/DK) = Rs.49.25/7.584 – 49.2625/7.567 = Rs.6.4939 – 6.5101
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
DK 1 = Rs. 6.4939 – 6.5101
Dealer has sold DK 1000000 @ DK 1 = Rs.6.515
To cover himself he will buy DK 1000000 [buying DK and Selling Rs.]
Buying rate of DK in London
DK 1 = Rs.6.5078
Buying rate of DK in NY
DK 1 = Rs.6.5101
Dealer will buy at lower of above rate i.e. DK 1 = 6.5078
Gain/(Loss) on settlement = Sale – Purchase = 1000000*6.515 - 1000000*6.5078 = Rs.7200
Solution-41
Calculation of Cross Rate between Rs. and SGD on January 28
In Bombay
$ 1 = Rs.45.85 – 45.90 [Rs./$]
In London
Pound 1 = $ 1.784 – 1.785 [$/P]
In London
Pound 1 = SGD 3.1575 – 3.1590 [SGD/P]
Required cross rate between Rs. and SGD
Rs./SGD
= (Rs./$) * ($/P) * (P/SGD)
SGD 1
= Rs. 45.85*1.784*1/3.1590 – 45.90*1.785*1/3.1575
SGD 1
= Rs. 25.89313 – 25.94822
Calculation of Cross Rate between Rs. and SGD on Feb 4
In Bombay
$ 1 = Rs.45.91 – 45.97 [Rs./$]
In London
Pound 1 = $ 1.7765 – 1.7775 [$/P]
In London
Pound 1 = SGD 3.1380 – 3.1390 [SGD/P]
Required cross rate between Rs. and SGD
Rs./SGD
= (Rs./$) * ($/P) * (P/SGD)
SGD 1
= Rs. 45.91*1.7765*1/3.1390 – 45.97*1.7775*1/3.1380
SGD 1
= Rs. 25.98252 – 26.0394
If payment made on 28th Jan [Buying SGD and selling Rs.]
Rs. required to pay SGD 25 lacs at rate of 28th Jan = SGD 25*25.94822 = Rs.648.7055 lacs
Bank Margin 0.125% = 648.7055*0.125% = Rs.0.8108 las
Total Payment = Rs.648.7055 + Rs.0.8108 = Rs.649.516 lacs
If payment made on 4th Feb
Rs. required to pay SGD 25 lacs at rate of 4th Feb = SGD 25*26.0394 = Rs.650.985 lacs
Bank Margin 0.125% = 650.985*0.125% = Rs.0.8137 las
Total Payment = Rs.650.985 + Rs.0.8137 = Rs.651.7987 lacs
Loss due to Bank Strike = 651.7987 – 649.516 = 2.2827 lacs
Solution-41A
Calculation of Cross Rate between Rs. and DG on 25.03.2007
In Bombay
Rs. 1 = Rs.0.022873 – 0.022962 [$/Rs.]
In London
Pound 1 = $ 1.912 – 1.9135 [$/P]
In London
Pound 1 = DG 4.1125 – 4.1140 [DG/P]
Required cross rate between Rs. and DG
Rs./DG
= (Rs./$) * ($/P) * (P/DG)
DG 1
= Rs.1.912/(0.022962*4.1140) – 1.9135/(0.022873*4.1125)
DG 1
= Rs.20.2401 – 20.3422
Calculation of Cross Rate between Rs. and DG on 02.04.2007
In Bombay
Rs. 1 = Rs.0.023063 – 0.023159 [$/Rs.]
In London
Pound 1 = $ 1.9050 – 1.9070 [$/P]
In London
Pound 1 = DG 4.012 – 4.013 [DG/P]
Required cross rate between Rs. and DG
Rs./DG
= (Rs./$) * ($/P) * (P/DG)
DG 1
= Rs.1.9050/(0.023159*4.013) – 1.9070/(0.023063*4.012)
DG 1
= Rs.20.4977 – 20.6098
If payment made on 25.03.2007 [Buying DG and selling Rs.]
Rs. required to pay DG 1250000 at rate of 25.03.2007 = DG 1250000*20.3422 = Rs.25427750
Bank Margin 0.25% = 25427750*0.25% = Rs.63569
10C.26
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.27
Total Payment = Rs.25427750 + 63569 = Rs.25491319
If payment made on 02.04.2007 [Buying DG and selling Rs.]
Rs. required to pay DG 1250000 at rate of 02.04.2007 = DG 1250000*20.6098 = Rs.25762250
Bank Margin 0.25% = 25762250*0.25% = Rs.64405
Total Payment = Rs.25762250 + 64405 = Rs.25826655
Loss due to Bank Strike = 25826655 - 25491319 = Rs.335336
Solution-42
SR
$ 1 = Rs.61.3625 – 61.3700
SR
£ 1 = $ 1.5260 – 1.5270
To purchase Rs., XYZ Bank shall first purchase $ by selling £ and then purchase Rs. by selling $
(i) $ required to purchase Rs.2500000 = Rs.25000000/61.3625 = $ 4074150
(ii) £ required to buy $ 40741.50 = $ 4074150/1.5260 = £ 2669823
Solution-43
SR
$ 1 = Rs.31.43 – 31.45
SR
$ 1 = Euro 1.44 – 1.445
Forex Dealer has sold $ 1000000 @ Euro 1.44 for spot delivery.
To square up his short position, he will buy $ 1000000 @ Euro 1.445
Gain/(Loss) on square up of transaction = Sale – Purchase = $1000000*1.44 - $1000000*1.445 = Euro 5000 Loss
Further answer as per suggested
To pay loss of Euro 5000 he will buy Euro at SR @ $ 1 = Euro 1.44
$ required to buy euro 5000 = Euro 5000/1.44 = $ 3472.22
Rs. required to buy $ 3472.22 at SR @ 31.45 = $3472.22*31.45 = Rs.109201.30 [Loss in Rs.]
Solution-44
Bank has entered into forward purchase contract, hence customer would have entered into forward sale contract for sale
of SF 100000 @ Rs.32.40
Rs. receivable by selling SF 100000 under forward contract = SF 100000*32.40 = Rs.3240000
From Customers point of view
Original contract is Forward Sale for SF 100000 in 3 months
To cancel the FSC before maturity, customer has to enter into another forward purchase contract of same maturity date
for SF 100000.
On 25th March,
1 month forward rate USD 1 = SF 1.5150/1.5160 [SF – Buy, USD – Sell] [Selling rate would be applicable]
USD required to buy SF 100000 @ 1.5150 = SF 100000/1.5150 = USD 66006.60
Spot rate USD 1 = Rs.49.4302/0.4455
Spot/ April USD 1 = 0.4100/0.4200 [Ascending Order]
1 month forward rate USD 1 = Rs. 49.8402/49.8655 [USD – Buy, Rs.- Sell] [Buying Rate would be applicable]
Margin of Bank = 0.1%
Applicable rate = 49.8655*1.001 = Rs.49.9154
Rs. required to buy USD 66006.60 = USD 66006.60*49.9154 = Rs.3294746
Loss to Customer on cancellation of FSC = 3294746-3240000 = Rs.54746
Alternative Method
Cross Rate between Rs. and SF
Rs./SF = (Rs./USD)*(USD/SF) = 49.9154/1.5150
SF 1 = Rs.32.9475
Rs. required to buy SF 100000 = SF 100000*32.9475 = Rs.3294750
Loss to Customer on cancellation of FSC = 3294750-3240000 = Rs.54750
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.28
Solution-45
SR £1 = $1.55 in London and
SR £1 = $1.60 in New York
Sterling is undervalued in London and overvalued in New York. Provided that capital was free to
flow between the two centres, arbitrageurs would attempt to exploit, and hence profit from, the
differential by selling dollars for pounds in London and reselling the pounds in New York.
Arbitrage Profit is possible as follows:
Buying Rate of £ 1 in London = $1.55
Selling Rate of £ 1 in NY = $1.60
Since selling rate is more than buying rate, hence arbitrage profit is possible
Arbitrage Profit per £ = Selling Rate – Buying Rate = $1.60 - $1.55 = $0.05
The arbitrageur would sell $1 million in London, hence
£ receivable by selling $ 1000000 in London = $1000000/1.55 = £645,161.29.
$ receivable by selling £645,161.29 in NY = £645,161.29*1.60 = $10,32,258.06
Arbitrage Profit = $32258.06
Solution-46
SR £1 = $1.5495 – 1.5505 in London and
SR £1 = $1.5995 – 1.6005 in NY and
Option 1
Buy £ in London and Sell £ in NY
Buying Rate of £ 1 in London
= $1.5505
Selling Rate of £ 1 in NY
= $1.5995
Since selling rate is more than buying rate, hence arbitrage profit is possible
Arbitrage Profit per £ = Selling Rate – Buying Rate = $1.5995 - $1.5505 = $0.049
Option 2
Buy £ in NY and Sell £ in London
Buying Rate of £ 1 in NY
= $1.6005
Selling Rate of £ 1 in London
= $1.5495
Since selling rate is less than buying rate, hence arbitrage profit is not possible in potion 2
Hence total arbitrage profit under option 1
£ receivable by selling $ 1m in London = $1000000/1.5505 = £644,953.20.
$ receivable by selling £644,953.20 in NY = £644,953.20*1.5995 = $10,31,603
Arbitrage Profit = $1000000 - $1031603 = $31603
Solution-47
Singapore
New York
1$
1$
= CHF 1.3689 - 1.4150
= CHF 1/0.7236 – 1/0.7090 = CHF 1.3820 - 1.4104
Option 1
Buy $ in Singapore and Sell $ in NY
Buying Rate of $ 1 in Singapore
= CHF 1.4150
Selling Rate of $ 1 in NY
= CHF 1.3820
Since selling rate is less than buying rate, hence arbitrage profit is not possible in option 1
Option 2
Buy $ in NY and Sell $ in Singapore
Buying Rate of $ 1 in NY
= CHF 1.4104
Selling Rate of $ 1 in Singapore
= CHF 1.3689
Since selling rate is less than buying rate, hence arbitrage profit is not possible in option 2
Hence, there is no arbitrage opportunity because of spread
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Solution-47A
Spot Rate (Switzerland)
Spot Rate (Switzerland)
Spot Rate (USA)
1$ = CHF 1.3689 – 1.3695
1CHF = $ 0.7302 – 0.7305
1CHF = $ 0.7090 – 0.7236
Option 1
Buy CHF in Switzerland and Sell CHF in USA
Buying Rate of CHF 1 in Switzerland
= $0.7305
Selling Rate of CHF 1 in USA
= $0.7090
Since selling rate is less than buying rate, hence arbitrage profit is not possible in option 1
Option 2
Buy CHF in USA and Sell CHF in Switzerland
Buying Rate of CHF 1 in USA
= $0.7236
Selling Rate of CHF 1 in Switzerland
= $0.7302
Since selling rate is more than buying rate, hence arbitrage profit is possible in option 2
Arbitrage Profit per CHF = Selling Rate – Buying Rate = $0.7302 - $0.7236 = $0.0066
Hence total arbitrage profit under option 2
$ receivable by selling CHF 1m in Switzerland = CHF1000000*0.7302 = $730200
CHF receivable by selling $730200 in USA = $730200/0.7236 = CHF1009121
Arbitrage Profit = CHF 1000000 - CHF 1009121 = CHF 9121
Solution-48
In NY USD 1 = CHF 1.6639 – 1.6646 – (i) [CHF/USD]
In London USD 1 = Euro 0.9682 – 0.9686 – (ii) [Euro/USD]
In Australia Euro 1 = CHF 1.6410 – 1.6423 – (iii) [CHF/Euro]
We have $ 1000000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell $ 1,000,000 in London, Euro receivable = $ 1000000*0.9682 = Euro 968200
(b) Sell Euro 968200 in Australia, CHF receivable = Euro 968200*1.6410 = CHF1588816
(c) Sell CHF 1588816 in NY, $ receivable = CHF 1588816/1.6646 = $ 954473
Loss due to above process = $1000000 - $ 954473 = $ 45527
Option 2
(a) Sell $ 1,000,000 in NY, CHF receivable = $ 1000000*1.6639 = CHF 1663900
(b) Sell CHF 1663900 in Australia, Euro receivable = CHF 1663900/1.6423 = Euro 1013152
(c) Sell Euro 1013152 in London, $ receivable = Euro 1013152/0.9686 = $ 1045996
Gain due to above process = $1045996 - $ 1000000 = $ 45996
Arbitrage profit under option 2 = $ 45996
Alternative Method
Calculate Cross rates between USD and CHF from (ii) and (iii)
CHF/USD = (CHF/Euro)*(Euro/USD) = 1.6410*0.9682 – 1.6423*0.9686 = 1.5888 – 1.5907
USD 1 = CHF 1.5888 – 1.5907 in London
USD 1 = CHF 1.6639 – 1.6646 in NY
Option 1
Buy USD in London and Sell USD in NY
Buying Rate of USD 1 in London
= CHF 1.5907
Selling Rate of USD 1 in NY
= CHF 1.6639
Since selling rate is more than buying rate, hence arbitrage profit is possible in option 1
Arbitrage Profit per USD = Selling Rate – Buying Rate = CHF 1.6639 – CHF 1.5907 = CHF 0.0732
Hence total arbitrage profit under option 1
CHF receivable by selling $ 1m in NY = $1000000*1.6639 = CHF 1663900
Euro receivable by selling CHF 16663900 in Australia = CHF 1663900/1.6423 = Euro 1013152
$ receivable by selling Euro 1013152 in London = Euro 1013152/0.9686 = $ 1045996
Arbitrage Profit = $ 45996
10C.29
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Solution-48A
£1 = $ 1.5715-721 – (i) [$/£]
$1 = ¥ 106.090-120 - (ii) [¥/$]
£1 = ¥ 176.720-831 – (iii) [¥/£]
We have $ 1000000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell £ 1,000,000 in (i), $ receivable = £ 1000000*1.5715 = $ 1571500
(b) Sell $ 1571500 in (ii), ¥ receivable = $1571500*106.09 = ¥ 166720435
(c) Sell ¥ 166720435 in (iii), £ receivable = ¥ 166720435/176.831 = £ 942823
Loss due to above process = £1000000 - £ 942823 = £ 57177
Option 2
(a) Sell £ 1,000,000 in (iii), ¥ receivable = £ 1000000*176.72 = ¥ 176720000
(b) Sell ¥ 176720000 in (ii), $ receivable = ¥ 176720000/106.12 = $ 1665284
(c) Sell $ 1665284 in (i), £ receivable = $ 1665284/1.5721 = £ 1059273
Gain due to Arbitrage process = £1059273 - £ 1000000 = £ 59273
Arbitrage profit under option 2 = £ 59273
Alternative Method
Calculate Cross rates between £ and $ from (ii) and (iii)
$/£ = ($/¥)*(¥/£) = 1176.720/106.120 – 176.831/106.090
£ 1 = $ 1.6652 – 1.6668 – (iv)
£1 = $ 1.5715-721 – (i)
Option 1
Buy £ in (i) and Sell £ in (iv)
Buying Rate of £ 1 in (i)
= $ 1.5721
Selling Rate of £ 1 in (iv) = $ 1.6652
Since selling rate is more than buying rate, hence arbitrage profit is possible in option 1
Arbitrage Profit per £ = Selling Rate – Buying Rate = $1.6652 – $1.5721 = $0.0931
Hence total arbitrage profit under option 1
¥ receivable by selling £ 1m in (iii) = £1000000*1.76.72 = ¥ 1767200
$ receivable by selling ¥ 1767200 in (ii) = ¥ 1767200/1.06.12 = $ 1665285
£ receivable by selling $ 1665285 in (i) = $ 1665285/1.5721 = £ 1059274
Arbitrage Profit = £59274
Solution-49
Spot rate quoted in Markets
In Mumbai
$1
= Rs.48.30
In London
GBP1
= Rs.77.52
In New York
GBP1
= $1.6231
We have $ 10000000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell $ 10000000 in Mumbai, Rs. receivable = $ 10000000*48.30 = Rs.483000000
(b) Sell Rs.483000000 in London, GBP receivable = Rs.483000000/77.52 = GBP 6230650
(c) Sell GBP 6230650 in NY, $ receivable = GBP 6230650*1.6231 = $ 10112968
Gain due to Arbitrage process = $ 10112968 - $ 10000000 = $ 112968
Arbitrage profit under option 1 = £ 112968
Alternative Solution
Calculate cross rates between $ and Rs. through New York and London Compare it with rate of Mumbai. OR
Required cross rate
Rs./$ = (Rs./GBP)*(GBP/$) = 77.52*1/1.6231
$1 = Rs.47.76046 [Cross between New York and London]
$1 = Rs.48.30 [Rate in Mumbai given]
Since $ is costly in Mumbai, hence it should be sold in Mumbai and purchased from new York.
1. Rs. receivable by selling $10000000 in Mumbai = $10000000 * 48.30 = Rs.483000000
10C.30
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
2. GBP receivable by selling Rs.483000000 in London = Rs.483000000/77.52 = GBP6230650.15
3. $ receivable by selling GBP6230652.15 in NY = GBP 6230650.15*1.6231 = $10112968.26
Arbitrage gain = $10112968.26 - $10000000 = $112968.26
Solution-50
£ 1 = $ 1.367-1.3708 – (i) [$/£]
DEM 1 = SF 1.003 – 1.0078 - (ii) [SF/DEM]
SF 1 = $ 0.879 – 0.8803 – (iii) [$/SF]
£ 1 = DEM 1.556 – 1.5576 – (iv) [DEM/£]
We have $ 10000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell $ 10000 in (i), £ receivable = $ 10000/1.3708 = £ 7295
(b) Sell £ 7295 in (iv), DEM receivable = £ 7295*1.556 = DEM 11351
(c) Sell DEM 11351 in (ii), SF receivable = DEM 11351*1.003 = SF 11385
(d) Sell SF 11385 in (iii), $ receivable = SF 11385*0.879 = $ 10007
Gain due to Arbitrage process = $ 10007 - $ 10000= $ 7
Alternative Method
Calculate Cross rates between £ and $ from (ii), (iii) and (iv)
$/£ = ($/SF)*(SF/DEM)*(DEM/£) = 0.879*1.003*1.556 – 0.8803*1.0078*1.5576 = 1.3718 – 1.3818
£ 1 = $ 1.3718 – 1.3818 – (v)
£ 1 = $ 1.367-1.3708 – (i)
Option 1
Buy £ in (i) and Sell £ in (v)
Buying Rate of £ 1 in (i)
= $ 1.3708
Selling Rate of £ 1 in (v)
= $ 1.3718
Since selling rate is more than buying rate, hence arbitrage profit is possible in option 1
Arbitrage Profit per £ = Selling Rate – Buying Rate = $1.3718 – $1.3708 = $0.001
We have $ 10000 [Selling $ means buying £]
Hence total arbitrage profit under option 1
£ receivable by selling $ 10000 (i) = $ 10000/1.3708 = £ 7295
$ receivable by selling £ 7295 in (v) = £ 7295*1.3718 = $ 10007
Arbitrage Profit = $ 7
Solution-51
USD 1 = Rs. 59.25 – 59.35 – (i) [Rs./$]
GBP 1 = Rs. 102.50 – 103.00 - (ii) [Rs./GBP]
GBP 1 = USD 1.70 – 1.72 (iii) [USD/GBP]
Arbitrageur have $ 10000000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell $ 10,000,000 in (iii) [GBP-LHC-Buy; $-Sell-RHC]
Since GBP is LHC and which is to be purchased, margin money will be added on exchange rate
Exchange rate = 1.72*(1+0.00125) = 1.722
GBP receivable = $ 10000000/1.722 = GBP 5807201
(b) Sell GBP 5807201 in (ii), [GBP-LHC-Sell; Rs.-Buy-RHC]
Since GBP is LHC and which is to be sold, margin money will be deducted from exchange rate
Exchange rate = 102.50*(1-0.00125) = 102.37
Rs. receivable = GBP 5807201*102.37 = Rs.594483166
(c) Sell Rs.594483166 in (i), [$-LHC-Buy; Rs.-RHC-Sell]
Since $ is LHC and which is to be purchased, margin money will be added in exchange rate
Exchange rate = 59.35*(1+0.00125) = 59.42
$ receivable = Rs.594483166/59.42 = Rs.10004765
Arbitrage Profit = $ 4765
10C.31
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.32
Solution-52
B0 = $ 100
B1 = $105
Interest received from bond = $7
Return of investment of American Bond for one year = (B1 – B0 + Intt)*100/B0 = (105+7-100)*100/100 = 12%
Premium on $ (Known as invested currency) = 3%
(a) Return of investment of USA Investor from USA Bond = Return of American Bond = 12%
(b) Return of investment of Foreign Investor from USA Bond = (1+Return of American Bond)*(1+Prem on $) – 1
= 1.12*1.03-1 = 0.1536 = 15.36%
Solution-52A
B0 = $ 100
B1 = $105
Interest received from bond = $7
Return of investment of American Bond for one year = (B1 – B0 + Intt)*100/B0 = (105+7-100)*100/100 = 12%
In this question, in place of premium on invested currency, FER at beginning and year end is given, hence we can
calculate Premium/Discount on invested currency as follows
Premium/ Discount on $ (Invested & LHC) = (FR – SR)*100/SR = (51.50-50)*100/50 = 3%
Premium on $ = 3%
(a) Return of investment of USA Investor from USA Bond = Return of American Bond = 12%
(b) Return of investment of Foreign Investor from USA Bond = (1+Return of American Bond)*(1+Prem on $) – 1
= 1.12*1.03-1 = 0.1536 = 15.36%
Solution-52B
In this question, in place of price of securities, Return of security is given
Return of investment in American Bond for one year = 12%
Premium/ Discount on $ (Invested & LHC) = (FR – SR)*100/SR = (51.50-50)*100/50 = 3%
Premium on $ = 3%
(a) Return of investment of USA Investor from USA Bond = Return of American Bond = 12%
(b) Return of investment of Foreign Investor from USA Bond = (1+Return of American Bond)*(1+Prem on $) – 1
= 1.12*1.03-1 = 0.1536 = 15.36%
Solution-53
B0 = $5000
B1 = $5250
Interest received from bond = $350
Return of investment from Bond for one year = (B1 – B0 + Intt)*100/B0 = (5250+350-5000)*100/5000 = 12%
Premium on $ (Known as invested currency) = 2%
Return of investment for Foreign Investor = (1+Return of Bond)*(1+Prem on $) – 1 = 1.12*1.02-1 = 0.1536 = 14.24%
Solution-53A
Return of investment in Rs. = 8%
SR at to
Euro 1 = Rs.55.50
SR at t1
Euro 1 = Rs.57.67
Invested currency = Rs.
Premium/ Discount on Rs. (Invested & RHC) = (SR – FR)*100/FR = (55.50-57.67)*100/57.67 = -3.76%
Discount on Rs. = 3.76%
Return of investment of French Investor = (1+Return of investment in Rs.)*(1-Discount on Rs.) – 1
= 1.08*(1-0.0376)-1 = 0.0393 = 3.93%
Solution-53B
Return of investment in British Security = 7%
SR at to
£ 1 = Euro 1.50
FR of t1
£ 1 = Euro 1.56
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.33
Invested currency = £
Premium/ Discount on £ (Invested & LHC) = (FR – SR)*100/SR = (1.56-1.50)*100/1.50 = 4%
Premium on £ = 4%
Return of investment of French Investor = (1+Return of investment in British Security)*(1+Premium on £) – 1
= 1.07*1.04-1 = 0.1128 = 11.28%
Solution-54
Return
Return
Return
Return
of
of
of
of
investment
investment
investment
investment
in
in
in
in
Chinese Security = 6.50% p.a.
Chinese Security = 3.25% for 6 months
French Security = 7.50% p.a.
French Security = 3.75% for 6 months
Return of investment of Chinese Investor in Chinese Security = 3.25%
Return of investment of Chinese Investor in French Security
= (1+Return of investment in French Security)*(1+Premium/Dis on Euro) – 1
= 1.0375*(1+Premium/Dis on Euro)-1
As per Question, both investment has equal return to calculate Prem/ Dis on Euro
Return of investment of Chinese Investor in Chinese Security = Return of investment of Chinese Investor in French
Security
0.0325 = 1.0375*(1+Premium/Dis on Euro)-1
1+Premium/Dis on Euro = 1.0325/1.0375
Premium/Dis on Euro = 0.995 – 1 = - 0.005 = - 0.5%
To make both return equal, discount on Euro = 0.5%
(ii)
If Spot Rate Euro 1 =CY 5
Discount on Euro = 0.05%
Expected FER after 6 moths = 5*(1-0.005) = 4.975 CY
To make both return equal, Expected FER after 6 moths Euro 1 = 4.975 CY
Verification of Answer
Option 1 Investment in Chinese Security
CY 100000 is invested in Chinese Security for 6 months
CY receivable at the end of 6 months = CY 100000*1.0325 = CY 103250
Option 2 Investment in French Security
Today
(i) CY 100000 is converted into Euro at SR = CY 100000/5 = Euro 20000
(ii) Invest Euro 20000 in French Security for 6 months @3.75%
At the end of 6 months
(a) Euro receivable at the end of 6 months = Euro 20000*1.0375 = Euro 20750
(b) CY receivable by converting Euro 20750 at ESR of 6 months = Euro 20750*4.975 = CY 103231
Note: The above difference is due to round off.
Solution-55
IFRRs. = 4% p.a.; IFR$ = 2% p.a.; IFRMS = 6% p.a.
SR
$ 1 = Rs.43.50 – 43.60
SR
$ 1 = MS 3.80 – 3.82
Assuming PPPT holds good
FRPPPT of 1 year (Rs./$) = (1 + IFRRs.)*SR/(1 + IFR$) = 1.04*43.50/1.02 - 1.04*43.60/1.02 = Rs.44.35 – 44.45
FRPPPT of 1 year (MS/$) = (1 + IFRMS)*SR/(1 + IFR$) = 1.06*3.80/1.02 - 1.06*3.82/1.02 = MS 3.949 – 3.969
If Investment is made in India
Interest rate = 20%
Tax rate = 20%
Interest rate (NOT) = 20% * (1-0.2) = 16%
Today we will convert $ into Rs., hence SR Rs.43.50 will apply
At year end, we will convert Rs. into $, hence FR 44.45 will apply
Currency in which investment is made = Rs.
Prem/Dis on Rs. (RHC) = (SR-FR)*/FR = (43.50-44.45)*100/44.45 = - 2.13%
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.34
Total return from investment in India = (1 + Return from investment)*(1-Dis on Rs.)
= 1.16*(1-0.0213) - 1 = 0.1352 = 13.52%
If Investment is made in Malaysia
Interest rate = 16%
Tax rate = 10%
Interest rate (NOT) = 16% * (1-0.1) = 14.60%
Today we will convert $ into MS, hence SR Rs.3.80 will apply
At year end, we will convert MS into $, hence FR 3.969 will apply
Currency in which investment is made = MS
Prem/Dis on MS (RHC) = (SR-FR)*/FR = (3.80-3.969)*100/3.969 = - 4.258%
Total return from investment in Malaysia = (1 + Return from investment)*(1-Dis on MS)
= 1.146*(1-0.04258) - 1 = 0.0972 = 9.72%
Comment: Since return of India is more than Malaysia, hence investment should be made in India.
Alternative Solution
(i) If Investment is made in India
Today
(a) Convert $ 10 m into Rs. at SR = $ 10*43.50 = Rs.435 Million
(b) Rs. 435 M is invested in India @20% or @ 16% (NOT)
At the end of 1st year
(a) Rs. receivable from investment in India = Rs.435*1.16 = Rs.504.60 m
(b) Convert Rs. 504.60 m into $ at FR = Rs.504.60/44.45 = $ 11.352 Million
(ii) If Investment is made in Malaysia
Today
(a) Convert $ 10 m into MS at SR = $ 10*3.80 = MS 38 Million
(b) MS 38 M is invested in Malaysia @16% or @ 14.4% (NOT)
At the end of 1st year
(a) MS receivable from investment in Malaysia = MS 38*1.144 = MS 43.472 m
(b) Convert MS 43.472 m into $ at FR = MS 43.472/3.969 = $ 10.952 Million
Comment: Since return of India is more than Malaysia, hence investment should be made in India.
Solution-56
RF in China = 12%; Beta of Chinese Security = 1.48; Variance of Return of Chinese Security = 20%; Rm in China = 22%
Expected return in Chinese Security = Rf + B(Rm – Rf) = 12% + 1.48 (22%-12%) = 26.80%
Currency in which investment is made = CY
Discount in CY = 5.56%
Return from investment of Austrian Company in Chinese Security = (1+Return from Security)(1-Dis on CY) - 1
= (1 + 0.268)(1 - 0.0556) - 1 = 19.75%
Risk of Foreign Investment
Variance of security = 20%; Variance of FEF = 15%
SD
= √(SDX)2 + (SDFEF)2 + 2(SDX)(SDFEF)RXFEF = √(0.20) + (0.15) + 2x0.21x0.4472x0.3873 = √42.27 = 6.5%
Solution-57
Today SR $ 1 = Rs.48.0123
FR of 6 months $ 1 = Rs.48.819
IRRs. = 12%; IR$ = 8%
PIR for 6 months on Rs. = 6%
PIR for 6 months on $ = 4%
WN-1 Decision of borrowing and investment
Premium or discount on $ [LHC] = (FR-SR)*100/SR = (48.8190 – 48.0123)/48.0213 = 1.679% Prem on $ for 6 months
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.35
Loss of Intt on $ for 6 months = 6% - 4% = 2%
Since loss of interest is more than gain of premium, hence investment should be made in Rs. and borrowing in $.
WN-2 Calculation of Arbitrage Profit
By above any of the method, we came to know that borrowing in $ and investment in Rs. to make arbitrage profit
Method-1 Steps Method
Today
1. Borrow US$ 83312 for 6 months @ 4%
2. Convert US$ 83312 into Rs. at SR = $83312*48.0123 = Rs.40,00,000
3. Invest Rs.4000000 for 6 months @ 6%
After 6 months
1. Rs. receivable from investment = Rs.4000000*1.06 = Rs.4240000
2. Convert Rs.4240000 into $ at FR = Rs.4240000/48.8190 = $ 86851.43
3. Repayment of borrowing in $ = $ 83312*1.04 = $86644.48
Arbitrage profit = $ 86851.43 - $86644.48 = $ 206.95
Method-2 Comparison of Return [Ignore]
Currency in which investment is made = Rs.
Discount on Rs. [RHC] = (SR-FR)*100/FR = (48.0123 - 48.819)*100/48.819 = - 1.652% Dis on Rs. for 6 months
Return from investment in Rs. = (1 + PIRRs.)(1 - Dis on Rs.) – 1 = 1.06*(1-0.01652) – 1 = 0.04248 = 4.248%
Hence, arbitrage return %
= Total Return from investment – Borrowing Cost
= 4.248% – 4% = 0.248%
Arbitrage profit in $ = Amount of Borrowing*Arbitrage return = 83312*0.248% = $206.61
Solution-57A
Today SR $ 1 = Rs.43.30
FR of 6 months $ 1 = Rs.43.70
IRRs. = 8%; IR$ = 4%
PIR for 6 months on Rs. = 4%
PIR for 6 months on $ = 2%
WN-1 Decision of borrowing and investment
Method 1
Premium or discount on $ [LHC] = (FR-SR)*100/SR = (43.70 – 43.30)*100/43.30 = 0.923% premium on $ for 6 months
Loss of Intt on $ for 6 months = 4% - 2% = 2%
Since loss of interest is more than gain of premium on $, hence investment should be made in Rs. and borrowing in $.
WN-2 Calculation of Arbitrage Profit
By above any of the method, we came to know that borrowing in $ and investment in Rs. to make arbitrage profit
Method-1
Today
1. Borrow US$ 1000000 for 6 months @ 2%
2. Convert US$ 1000000 into Rs. at SR = $1000000*43.30 = Rs.43300000
3. Invest Rs.43300000 for 6 months @ 4%
After 6 months
1. Rs. receivable from investment = Rs.43300000*1.04 = Rs.45032000
2. Convert Rs.45032000 into $ at FR = Rs. 45032000/43.70 = $ 1030481
3. Repayment of borrowing in $ = $ 1000000*1.02 = $1020000
Arbitrage profit = $ 1030481 - $1020000 = $ 10480.55
Method-2 [Ignore]
Borrowing in $ and investment in Rs.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.36
Currency in which investment is made = Rs.
Discount on Rs. [RHC] = (SR-FR)*100/FR = (43.30 – 43.70)*100/43.70 = - 0.9153% Dis on Rs. for 6 months
Return from investment in Rs. = (1 + PIRRs.)(1 - Dis on Rs.) – 1 = 1.04*(1-0.009153) – 1 = 0.03048 = 3.048%
Hence, arbitrage return %
= Total Return from investment – Borrowing Cost
= 3.048% – 2% = 1.048%
Arbitrage profit in $ = Amount of Borrowing*Arbitrage return = 1000000*1.048% = $10480
Solution-57B
Today SR £ 1 = $ 1.50
FR of 1 year £ 1 = $ 1.48
IR£ = 8%; IR$ = 5%
Various methods for taking decision of borrowing and investment
Method 1
Premium or discount on £ [LHC] = (FR-SR)*100/SR = (1.48 – 1.50)*100/1.50 = - 1.333% Dis on £
Gain of Intt on £ = 8% - 5% = 3%
Since Gain of interest is more than Loss of Discount on £, hence investment should be made in £ and borrowing in $.
Calculation of Arbitrage Profit
By above any of the method, we came to know that borrowing in $ and investment in £ to make arbitrage profit
Today
1. Borrow $ 1000000 for 1 year @ 5%
2. Convert $ 1000000 into £ at SR = $1000000/1.50 = £ 666667
3. Invest £ 666667 for 1 year @ 8%
At the end of 1 year
1. £ receivable from investment = £ 666667*1.08 = £ 720000
2. Convert £ 720000 into $ at FR = £ 720000*1.48 = $ 1065600
3. Repayment of borrowing in $ = $ 1000000*1.05 = $1050000
Arbitrage profit = $ 1065600 - $1050000 = $ 15600
Solution-58
Surplus fund = $ 500000
Cost of Fund = 4% p.a.
Option 1 Investment in NY
Interest rate of NY = 8% p.a.
PIR of NY for 3 months = 2%
(a) $ 500000 is invested for 3 months in NY @ 2%
(b) $ receivable at the end of 3 months = $ 500000*1.02 = $ 510000
(c) $ payable at the end of 3 months = $ 500000*1.01 = $ 505000
(d) Arbitrage Profit = $ 5000
Today SR
Pound 1 = $ 1.5350 – 1.5390
Swap points of 3 months 80/85 (Increasing Order)
FR of 3 months Pound 1 = $ 1.543 – 1.5475
(e) Pound receivable by selling $ 5000 at FR = $ 5000/1.5475 = Pound 3231
Arbitrage Profit = Pound 3231
Option 2 Investment in London
Interest rate of London = 5% p.a.
PIR of London for 3 months = 1.125%
(a) $ 500000 is converted into Pound at SR = $ 500000/1.539 = Pound 324886
(b) Invest Pound 324886 for 3 months @ 1.125% in London
(c) Pound receivable at the end of 3 months = Pound 324886*1.0125 = Pound 328947
(c) Pound required to pay $ 505000 at FR = $ 505000/1.543 = Pound 327284
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.37
(d) Arbitrage Profit = Pound 328947 –Pound 327284 = Pound 1663
Option 3 Investment in FF
Interest rate of FF = 3% p.a.
PIR of FF for 3 months = 0.75%
Today SR
Pound 1 = FF 1.8260 – 1.8290
Swap points of 3 months 145/140 (decreasing Order)
FR of 3 months Pound 1 = FF 1.8115 – 1.815
(a) $ 500000 is converted into Pound at SR = $ 500000/1.539 = Pound 324886
(b) Pound 324886 is converted into FF at SR = Pound 324886*1.826 = FF 593242
(c) Invest FF 593242 for 3 months @ 0.75% in FF
(d) FF receivable at the end of 3 months = FF 593242*1.0075 = FF 597691
(e) Pound receivable by converting FF 597691 at FR = FF 597691/1.815 = Pound 329306
(f) Pound required to pay $ 505000 at FR = $ 505000/1.543 = Pound 327284
(g) Arbitrage Profit = Pound 329306 –Pound 327284 = Pound 2022
Comment: Maximum profit is in case of NY, hence investment should be made in NY
Solution-59
Today SR $ 1 = £ 0.75 [$ is LHC and £ is RHC]
IR£ = 5%; IR$ = 8%
(i) If IRPT exists then Arbitrage profit is not possible,
FR of 2 years under IRPT (£/$) = e£*SR/e$ = e0.05*2*0.75/e0.08*2 = e0.1*0.75/e0.16
= *0.75/e-0.1*e0.16 = 0.75/(0.9051*1.1735) = 0.706
FR of 2 years $ 1 = £ 0.706
(ii) Actual FR of 2 years $ 1 = £ 0.85
WN-1 Decision of borrowing and investment
Method 1
Premium or discount on $ [LHC] = (FR-SR)*100/SR = (0.85 – 0.75)*100/0.75 = 13.33% Premium on $
Gain of Intt on $ = 8% - 5% = 3% p.a.
Since Gain of interest and there is premium on $, hence investment should be made in $ and borrowing in £.
Calculation of Arbitrage Profit
Today
1. Borrow £ 100000 for 2 year @ 5% p.a. CCI
2. Convert £ 100000 into $ at SR = £100000/0.75 = $ 133333.33
3. Invest $ 133333.33 for 2 year @ 8% CCI
At the end of 2nd year
1. $ receivable from investment = 133333.33*ert = 133333.33*e0.08*2 = 133333.33*e0.16 = 133333.33*1.1735
= $ 156466.66
2. Convert $156466.66 into £ at FR = $156466.66*0.85 = £ 132996.66
3. Repayment of borrowing in $ = £ 100000*ert = 100000*e0.05*2 = 100000/e-0.1 = 100000/0.9051 = £110485.03
Arbitrage profit = £ 132996.66 - £110485.03 = £ 22511.63
Solution-60
(i)
Spot Rate
DM 1 = $ 0.75
FR of 1 Year
DM 1 = $ 0.77
IRDM = 7%; IR$ = 9%
WN-1 Decision of borrowing and investment
Method 1
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.38
Premium or discount on DM [LHC] = (FR-SR)*100/SR = (0.77-0.75)*100/0.75 = 2.667% Prem p.a.
Loss of Intt on DM for 3 months = 9% - 7% = 2%
Since Loss of interest is less than gain of premium on DM, hence investment should be made in DM and borrowing in $
WN-2 Calculation of Arbitrage Profit
By above any of the method, we came to know that borrowing in $ and investment in DM to make arbitrage profit
Method-1
Today
1. Borrow $ 10000 for 1 year @ 9%
2. Convert $ 10000 into DM at SR = $10000/0.75 = DM 13333.33
3. Invest DM 13333.33 for 1 year @ 7%
At the end of 1 year
1. DM receivable from investment = DM 13333.33*1.07 = DM 14266.66
2. Convert DM 14266.66 into $ at FR = DM 14266.66*0.77 = $ 10985.33
3. Repayment of borrowing in $ = $ 10000*1.09 = $10900
Arbitrage profit = $ 10985.33 - $10900 = $ 85.33
Arbitrage profit in DM = Arbitrage profit in Borrowing currency * FR = $ 85.33/0.77 = DM 110.8182
(ii) Transaction Cost = 0.25% per transaction
Method-1
Today
1. Borrow $ 10000 for 1 year @ 9%
2. Convert $ 10000 into DM at SR = $10000/0.75 = DM 13333.33
3. Transaction Cost = DM 13333.33*0.25% = DM 33.33
4. Invest DM 13300 for 1 year @ 7%
At the end of 1 year
1. DM receivable from investment = DM 13300*1.07 = DM 14231
2. Convert DM 14231 into $ at FR = DM 14231*0.77 = $ 10957.87
3. Transaction Cost = $ 10957.87*0.25% = $ 27.39
4. Net receivable = $ 10957.87 - $ 27.39 = $ 10930.48
3. Repayment of borrowing in $ = $ 10000*1.09 = $10900
Arbitrage profit = $ 10930.48 - $10900 = $ 30.48
Arbitrage profit in DM = Arbitrage profit in Borrowing currency * FR = $ 30.48/0.77 = DM 39.58
Solution-61
SR
FR of 3 months
$ 1 = Can $ 1.235 – 1.240
$ 1 = Can $ 1.255 – 1.260
Apply Trial and Error method
Option 1 Borrow in $ and investment in CD
Today
(i) Borrow $10000 @ 4% p.a. for 3 months
(ii) Convert $10000 into CD at SR = $10000*1.235 = CD 12350
(iii) Invest CD 12350 for 3 months @3.5% p.a.
After 3 months
(i) CD receivable from investment = CD 12350*1.00875 = CD 12458.06
(ii) Convert CD 12458.06 in $ at FR = CD 12458.06/1.260 = $ 9887.349
(iii) Repay loan in $ = $10000*1.01 = $ 10100
Loss due to above process = 10100 – 9887.349 = $212.651
Option 2 Borrow in CD and investment in $
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Today
(i) Borrow CD 10000 @ 4.5% p.a. for 3 months
(ii) Convert CD 10000 into $ at spot rate = CD 10000/1.24 = $8064.516
(iii) Invest $ 8064.516 for 3 months @2.5% p.a.
After 3 months
(i) $ receivable from investment = $ 8064.516*1.00625 = $ 8114.919
(ii) Convert $ 8114.919 in CD at FR = $ 8114.919*1.255 = CD 10184.22
(iii) Repay loan in CD = CD 10000*1.01125 = CD 10112.50
Arbitrage profit = 10184.22 – 10112.50 = CD 71.72
Comment: Hence arbitrage is possible under option 2
Solution-61A
Apply Trial and Error method
SR
1$
= Rs.47.00 – 47.20
1 year FR
1$
= Rs.47.50 – 47.70
Option 1 Borrow in $ and investment in Rs.
Today
(i) Borrow $10000 @ 5% p.a. for 1 year
(ii) Convert $10000 into Rs. at SR = $10000*47 = Rs.470000 [Selling $ and buying Rs.]
(iii) Invest Rs.470000 for 1 year @8% p.a.
After 1 year
(i) Rs. receivable from investment = Rs.470000*1.08 = Rs.507600
(ii) Convert Rs.507600 in $ at FR = Rs.507600/47.70 = $ 10641.51 [Selling Rs. and buying $]
(iii) Repay loan in $ = $10000*1.05 = $ 10500
Arbitrage Profit = 10641.51 – 10500 = $141.51
Comment: Arbitrage is possible under option 1
Option 2 Borrow in Rs. and investment in $
(i) Borrow Rs.10000 @ 8% p.a. for 1 year
(ii) Convert Rs.10000 into $ at SR = Rs.10000/47.20 = $211.8644 [Selling Rs. and buying $]
(iii) Invest $211.8644 for I year @5% p.a.
After 1 year
(i) $ receivable from investment = $ 211.8644*1.05 = $ 222.4576
(ii) Convert $ 222.4576 in Rs. at FR = $ 222.4576*47.50 = Rs.10566.74 [Selling $ and buying Rs.]
(iii) Repay loan in Rs. = Rs. 10000 * 1.08 = Rs.10800
Loss = 10800 – 10566.74 = Rs. 233.26
Solution-62
$ deposit rate = 8% p.a.; £ deposit rate = 10% p.a.
SR £ 1 = $ 1.80
3 months FR
£ 1 = $ 1.78
(i) Invest for better results
Option 1 – Investment in US
(a) Invest $ 1000000 in US for 3 moths @ 2%
(b) $ receivable in 3 months from Deposit = $ 1000000*1.02 = $ 1020000
Option 2 – Investment in UK
(a) Convert $ 1000000 into £ at SR = $ 1000000/1.80 = £ 555555.60
(b) Invest £ 555555.60 in Uk for 3 moths @ 2.5%
(c) £ receivable in 3 months from Deposit = £ 555555.60*1.025 = £ 569444.50
(d) Convert £ 569444.50 into $ at FR = £ 569444.50*1.78 = $ 1013611
Comment: Receivable in Option 1 is higher. Hence, company should invest in US Deposits.
(ii)
$ deposit rate = 8% p.a.; £ deposit rate = 10% p.a.
SR £ 1 = $ 1.80
10C.39
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
3 months FR under IRPT ($/£) = (1 + PIR$)*SR/(1 + PIR£) = (1 + 0.02)*1.80/(1 + 0.025) = $ 1.7912
3 months FRIRPT £ 1 = $ 1.7912
(iii)
$ deposit rate = 8% p.a.; £ deposit rate = 14% p.a.
SR
£ 1 = $ 1.80
3 months FR
£ 1 = $ 1.78
Option 1 – Investment in US
(a) Invest $ 1000000 in US for 3 moths @ 2%
(b) $ receivable in 3 months from Deposit = $ 1000000*1.02 = $ 1020000
Option 2 – Investment in UK
(a) Convert $ 1000000 into £ at SR = $ 1000000/1.80 = £ 555555.60
(b) Invest £ 555555.60 in Uk for 3 moths @ 3.5%
(c) £ receivable in 3 months from Deposit = £ 555555.60*1.035 = £ 575000
(d) Convert £ 575000 into $ at FR = £ 575000*1.78 = $ 1023500
Comment: Receivable in Option 2 is higher. Hence, company should invest in UK Deposits.
Solution-63
Rs. Interest rate = 9% p.a.; FF Interest rate = 12% p.a.
SR FF 1 = Rs. 6.60
90 days FR
FF 1 = Rs. 6.50
(i) Arbitrage Profit
Premium or discount on FF [LHC] = (FR-SR)*100/SR = (6.50-6.60)*100/6.60 = -1.5151% Dis 3 months
Gain of Intt on FF for 3 months = 3% - 2.25% = 0.75%
Since gain of interest is less than loss of premium on FF, hence Arbitrage Opportunity is available
(i) Decision of Mr E is correct or not
FR under IRPT (Rs./FF) = (1 + PIRRs.)*SR/(1 + PIRFF) = (1 + 0.0225)*6.60/(1 + 0.03) = Rs.6.55
Actual FR
FF 1 = Rs.6.50
FF is to be sold in future and should be sold at higher rate, hence decision of Mr E was not correct
Solution-64
SR
$ 1 = Rs.48.35/48.36
3 Months FR
$ 1 = Rs.48.81/48.83
Interest rate = 15% p.a.
Option 1: Pay immediately the bills for $ 130000
Today
(i) Rs. required to pay $ 130000 at today SR = $ 130000*48.36 = Rs.6286800
(ii) Take Overdraft of Rs.6286800 for 3 months @15% p.a.
(iii) Repayment of OD with interest at the end of 3 months = Rs.6286800*1.0375 = Rs.6522555
Option 2: Pay after 3 months, with interest @5% p.a.
Amount payable = $ 130000
Total payment after 3 months with interest = $ 130000 * 1.0125 = $ 131625
Rs. required to pay $ 131625 at FR = $ 131625*48.83 = Rs.6427249
Comment – Cost is lesser in case of option 2, It is suggested to pay after 3 months
Solution-64A
SR
SF 1 = Rs.30 - 30.5
3 Month FR
SF 1 = Rs.31.10 – 31.60
Interest rate = 14%
Option 1: Pay immediately the bills for SF-10,00,000
Today
(i) Rs. required to pay SF 10,00,000 at today SR = SF 1000000*30.50 = Rs.30500000
(ii) Take Overdraft of Rs.30500000 for 3 months @14% p.a.
10C.40
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
(iii) Repayment of OD with interest at the end of 3 months = Rs. 30500000*1.035 = Rs.31567500
Option 2: Pay after 3 months, with interest @5% p.a.
Amount payable = SF 1000000
Total payment with interest = SF 1000000*1.0125 = SF 1012500
Rs. required to pay SF 1012500 at FR = SF 1012500*31.60 = Rs.31995000
Analysis – Rs. outflow is lesser in case of alternative I, It is suggested to pay bill immediately.
Solution-65
Spot rate
$ 1 = Rs.56.50
60 days FR
$ 1 = Rs.57.10
90 days FR
$ 1 = Rs.57.50
Interest rate for loan
= 10% p.a.
Option 1 Pay the supplier in 60 days
Z Ltd to pay $ 2m and for this purpose, it will borrow from Bank for 30 days @ 10% p.a.
Rs. required to pay $ 2m at FR of 2 months = $ 2m*57.10 = Rs.114.20 m
Z Ltd will borrow Rs.114.20 m from bank for 30 days @ 10% p.a.
After 30 days
Borrowing and interest payable to bank = Rs.114.20*1.00833 = Rs.115.15 m
Option 2 Pay supplier in 90 days
Z Ltd will pay after 90 days with interest @8% p.a. for 1 month
Amt payable after 90 days = $ 2*1.00667 = $2.01334 m
Rs. required to pay $ 2,.01334 at FR of 90 days = $2.01334*57.50 = Rs.115.7671 m
Comment: Option 1 is preferable
Solution-66
Cost of machine = Yen 7640
Today Spot Rate Rs.100 = Yen 382
Cost of machine in Rs. = Yen 7640/3.82 = Rs.2000
Option 1 (To finance the purchase by availing loan at 12% per annum):
To pay cost of machine, Astro Ltd will take Loan of Rs.2000 for 6 months @12 p.a. quarterly rest
Particulars
Rs.
Cost of machine
st
Interest for 1 Quarter = Rs.2000*0.03
nd
Interest for 2
Quarter = (Rs.2000 + Rs.60)*0.03
Total amt to be repaid after 6 months
2000.00
60.00
61.80
2121.80
Alternatively, interest may also be calculated on compounded basis, i.e.
Rs. 2,000 × [1.03]2 = Rs. 2,121.80
Option 2 To accept the offer from foreign branch for Opening LC
Commission payable on LC = 2% p.a.
Commission payable for 6 months = 1%
Commission payable for LC of 6 months = Yen 7640*1% = Yen 76.40
Rs. required to pay commission at spot rate = Yen 76.40/3.82 = Rs.20
Astro Ltd will take Loan of Rs.20 for 6 months @12 p.a. quarterly rest
After 6 months
Repayment of Loan with interest taken for commission = Rs.20*1.03*1.03 = Rs.21.22
Payment of LC and interest thereon at the end of 180 days = Yen 7640*1.0075 = Yen 7697.30
Rs. required to pay Yen 7697.30 at FR = Yen 7697.30/3.88 = Yen 1983.84
Total Cost under option 2 = Rs.1983.84 + Rs.21.22 = Rs.2004.86
Advise: Option No.2 is cheaper. Hence, the LC offer can be accepted.
10C.41
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.42
Solution-66A
Cost of Machine = Yen 7200 lacs
Today SR
Rs.100 = Yen 360
Cost of machine in Rs. = Yen 7200/3.60 = Rs.2000 lacs
Option 1 (To finance the purchase by availing loan at 15% p.a.)
To pay cost of machine, Indigo Ltd will take Loan of Rs.2000 lacs for 6 months @15 p.a. quarterly rest
Particulars
Rs. in lacs
Cost of machine
2000.00
st
Interest for 1 Quarter = Rs.2000*0.0375
nd
Interest for 2
75.00
Quarter = (Rs.2000 + Rs.75)*0.0375
77.81
Total amt to be repaid after 6 months
2152.81
Alternatively, interest may also be calculated on compounded basis, i.e.
Rs. 2,000 × [1.0375]2 = Rs. 2,152.81 lakhs
Option 2 To accept the offer from foreign branch for Opening LC
Commission payable on LC = 2% p.a.
Commission payable for 6 months = 1%
Commission payable for LC of 6 months = Yen 7200*1% = Yen 72 lacs
Rs. required to pay commission at SR = Yen 72/3.6 = Rs.20 lacs
Indigo Ltd will take Loan of Rs.20 for 6 months @15 p.a. quarterly rest
After 6 months
Repayment of Loan with interest taken for commission = Rs.20*1.0375*1.0375 = Rs.21.53 lacs
Payment of LC and interest thereon at the end of 6 months = Yen 7200*1.01 = Yen 7272lacs
Rs. required to pay Yen 7272 lacs at FR = Yen 7272/3.65 = Rs. 1992.329 lacs
Total Cost under option 2 = Rs.1992.329 + 21.53 = Rs.2013.859 lacs
Advise: Option No.2 is cheaper. Hence, the LC offer can be accepted.
Solution-67
a) Cash Balances: Acting independently
Amt (in lacs)
Capital
Action
Interest Rate
Amt in 30 days
30 days FR
- Rs.
5000
Borrowing
6.4%/12 = 0.533%
- 5000*1.00533 = Rs.5026
1
- Rs.5026.65
U.S
$ 125
Deposit
1.5%/12 = 0.125%
$ 125*1.00125 = $ 125.15
U.K
Pound 60
Deposit
3.7%/12 =
0.3083%
P 60*1.003083 = P 60.184
Rs.1 =
$0.217
Rs.1 =£
0.015
$125.15/0.0217 =
Rs.5767.28
£ 60.184/0.015 = Rs.4012.26
India
4752.26
At the end of month, surplus in India = Rs.4752.26 lacs
(b) Cash Balances:- Immediate Cash pooling
India
U.S
U.K
Capital
SR
Amt in Rs.
- Rs. 5000
$ 125
Pound 60
1
Rs.1 = $0.0215
Rs.1 =£ 0.0149
- Rs.5000
$ 125/0.0215 = $ 5813.95
P 60/0.0149 = P 4026.85
= Rs.4840.80
HO will invest Rs.4840.80 for30 days in India @ 6.2% p.a.
Amt receivable after 30 days = Rs.4840.80*1.005166 = Rs.4865.808 lacs
Comment: Immediate cash pooling is preferable as it maximizes cash surplus
Solution-68
SR
4 months FR
The interest rate
2 months
Euro 1 = Rs.49.95/50.00
Euro 1 = Rs.50.00/50.05
prevailing in the market:
Rs.12.00% p.a.
Euro 6.00%
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
4 months
Rs.11.40% p.a.
10C.43
Euro 6.60%
Option 1
Borrowing Euro 100000 for 4 months @ 2.2%
Repayment of borrowing at the end of 4 months = Euro 100000*1.022 = Euro 102200
Rs. required to repay Euro 102200 at FR = Euro 102200*50.05 = Rs.5115110
Option 2
Borrowing in Rs.
Rs. required for Euro 100000 at SR = Euro 100000*50 = Rs.5000000
Borrow Rs.5000000 for 4 months @ 3.8%
Repayment of borrowing at the end of 4 months = Rs.5000000*1.038 = Rs.5190000
Comment: Euro Borrowing is recommended
Solution-69
Exchange Rate
Year 1
=
140 – 5 =
135
Year 2
=
135 – 5 =
130
Year 3
=
130 – 5 =
125
Year 4
=
125 – 5 =
120
(i) Final Receipts to Japanese Company from Japanese Subsidiary of US Co
Under currency swap,
US Company gave loan of $100000 to US Subsidiary of Japanese Company for 4 years @ 13% p.a.
Total loan repayable by Japanese Subsidiary of US Company to Japanse Co =
th
$ equivalent at 4 year end = Yen 20497400/120
=
14000000*(1.1)4 = Yen 20497400
$170811.67
(ii)
Under currency Swap, Japanese Company gave loan of 14 Million Yen to Japan Subsidiary of US Company for 4 years @
10% p.a.
Final Receipts to US Company from US Subsidiary of Japanese Co = 100000*(1.13)4 = $ 163047.36
(iii) Gain to Japanese Co due to currency Swap = $170811.67 - $ 163047.36 = $ 7764.31
Solution-70
(i)
Cost of Center = R 2000m
Outflow at T0
Operating Cost = R 40m
Outflow at T1 to T3
Sale Price of Center = R 4000m
Inflow at T3
SR
£ 1 = R 85.40
1 Year FR
£ 1 = R 93.94
2 Year FR
£ 1 = R 103.334
3 Year FR
£ 1 = R 113.67
Analysis of Project (Amt in m)
Year
Particulars
Amt in R
FER
Amt in £
PVF = 15%
PV in £
0
Cost of Project
-2000
£ 1 = R 85.40
- 23.419
1
- 23.419
1
Operating Cost
-40
£ 1 = R 93.94
- 0.426
0.870
- 0.371
2
Operating Cost
-40
£ 1 = R 103.334
- 0.387
0.757
- 0.293
3
Operating Cost
-40
£ 1 = R 113.67
- 0.352
0.658
- 0.232
3
Sale of Center
4000
£ 1 = R 113.67
35.190
0.658
23.155
NPV
-1.16
Comment: NPV is negative, hence project should not be accepted
(ii)
(a) Under Currency Swap, Galeplus will pay £ 23.419 in its country to it Bank and its Bank will pay R 2000 to Galeplus in
Republic of Perdian for Center at today SR
(b) Under Currency Swap, Galeplus will receive back £ 23.419 in its country from its Bank and its Bank will receive R
2000 from Galeplus in Republic of Perdian from proceeds of R 4000 at Today SR
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.44
(c) For Currency Swap, Bank is charging 0.25% per year (in sterling)
Bank Charges p.a. = £ 23.419*0.25/100 = £ 0.0585
Analysis of Project under currency Swap (Amt in m)
Year
Particulars
Amt in R
FER
Amt in £
PVF = 15%
PV in £
0
Cost of Project (Under Currency Swap)
-2000
£ 1 = R 85.40
- 23.419
1
- 23.419
1
Operating Cost
-40
£ 1 = R 93.94
- 0.426
0.870
- 0.371
2
Operating Cost
-40
£ 1 = R 103.334
- 0.387
0.757
- 0.293
3
Operating Cost
-40
£ 1 = R 113.67
- 0.352
0.658
- 0.232
3
Sale of Center (Paid under Currency Swap)
2000
3
Sale of Center (4000-2000)
2000
£ 1 = R 113.67
17.595
0.658
11.578
3
Receive under Currency Swap
23.419
0.658
15.410
1-3
Bank Charges
-0.0585
2.285
-0.134
NPV
-2.539
Comment: NPV is positive, hence project should be accepted
Solution-70A
(i)
Cost of Dam = P 2000m
Outflow at T0
Sale Price of Dam = P 3000m
Inflow at T1
SR
$ 1 = P 50
1 Year FR
$ 1 = p 48
Analysis of Project (Amt in m)
Year
Particulars
0
Cost of Dam
1
Sale Price of Dam
Amt in P
FER
Amt in $
PVF = 10%
PV in $
-2000
$ 1 = P 50
- 40
1
- 40
+3000
$ 1 = P 48
+62.50
0.909
56.812
NPV
16.812
Comment: NPV is positive, hence project should be accepted
(ii)
(a) Under Currency Swap, US Co will pay $ 40 m in its country to its Bank at 0 interest and its Bank will pay P 2000m to
US Co in foreign country at interest rate of 10% p.a.
(b) Under Currency Swap, US Co will receive back $ 40m in its country from its Bank and its Bank will receive P 2200m
from US Co in foreign country from proceeds of P 3000m
Analysis of Project under currency Swap (Amt in m)
Year
Particulars
Amt in p
0
Cost of Dam (Under Currency Swap)
3
Sale of Dam (Paid under Currency Swap)
3
Sale of Dam (3000-800)
3
Receive under Currency Swap
FER
-2000
Amt in $
PVF = 10%
PV in $
- 40
1
- 40
16.67
0.909
15.15
40
0.909
36.36
NPV
11.51
2200
800
$ 1 = P 48
Comment: NPV is positive, hence project should be accepted
Comment: The swap option has reduced the NPV, US co should not go for currency swap
Solution-70B
(a) The following swap arrangements can be entered by Drillip.
(i) Swap a US$ loan today at an agreed rate with any party to obtain Indian Rupees (Rs.) to make initial investment.
(ii) After one year swap back the Indian Rupees with US$ at the agreed rate. In such case the company is expected to be
in risk only on the profit earned from the project.
(b)
Today SR
1 US$ =Rs.50
ESR of 1 year
1 US$ =Rs.54
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.45
Interest rate of US Borrowing = 8%
Cost of Project = Rs.500 Cr
Outflow at T0
Sale Price of Project = Rs.740 Cr
Inflow at T1
Analysis of Project without Swap (Amt in Cr)
Year
Particulars
0
Cost of Project
1
Interest Cost = 10*8%
1
Sale Price of Project
Amt in Rs.
FER
Amt in $
-500
$ 1 = Rs.50
-10
-0.8
+740
$ 1 = Rs.54
13.70
NPV
2.9
Analysis of Project with Swap (Amt in Cr)
Year
Particulars
Amt in Rs.
FER
Amt in $
0
Cost of Project (Under Currency Swap)
-500
$ 1 = Rs.50
-10
1
Interest Cost = 10*8%
1
Sale Price of Project (Paid under Currency Swap)
+500
1
Sale Price of Project (740-500)
+240
1
Receiving back of amt paid under currency swap
-0.8
$ 1 = Rs.54
4.44
10
NPV
3.64
Swapping in better
Solution-71
SR
CD 1 = XYZ Marks 12
1 year FR
CD 1 = XYZ Marks 13
Prem on CD = 13-12/12 = 8.33% p.a.
Premium for 9 months = 8.33% * 9/12 = 6.25%
Hence, Forward rate for 9 months CD 1 = XYZ Marks 12*1.0625 = XYZ Marks 12.75
Cost of Project = XYZ Marks 60m
Outflow at T0
Cost of Project = XYZ Marks 60m
Outflow at T9 months
Sale Price of Project = XYZ Marks 150m
Inflow at T1
Required rate of return = 12%
Cost of Project in CD = 60/12 = CD 5m
Outflow at T0
Under Currency Swap,
- Today, Canadian Co will pay CD 5m in its country to its Bank at 10% interest and its Bank will pay XYZ Marks 60m to
Canadian Co in XYZ country at interest rate of 15% p.a.
- At year end
- Canadian Co will receive back = CD 5*1.1 = CD 5.5m
- Canadian Co will pay back = XYZ Marks 60*1.15 = XYZ Marks 69m
Analysis of Project under currency Swap (Amt in m)
Year
Particulars
Amt in
Marks
0
Cost of Project (Under Currency Swap)
-60
0.75
Cost of Project
-60
1
Sale of Project (Paid under Currency
Swap)
69
1
Sale of Dam (150-69)
81
3
Receive Back under Currency Swap
Comment: NPV is positive, hence project should be accepted
FER
Amt in
CD
PVF =
12%
PV in
CD
-5
1
-5
CD 1 = Marks
12.75
-4.706
0.917
-4.315
CD 1 = Marks 13
6.23
0.892
5.557
5.5
0.892
4.906
NPV
1.148
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.46
Solution-72
Type of Transaction
Explanation
Nostro A/C ($)
Position in $
-20000
5000
+50000
+50000
Opening Balance
Purchase TT
Immediately Transferred
DD Issue on New York
It will be debited to Nostro A/c on its present
TT Remittance
Immediately Transferred
Purchase
bill
of
maturity 1 month
-20000
-25000
exchange
It will be credited to Nostro A/c on maturity
date
Forward Sales
It will be debited to Nostro A/c on maturity date
Export bills, purchased earlier,
realized
It will not come in Position as it has already
been added
-25000
+75000
-75000
+45000
Total
50000
Balance Required
10000
20000
TT Sale
(50000-20000)
30000
Over Sold Position
-30000
20000
Solution-72A
Type of Transaction
Explanation
Nostro A/C (SF)
Opening Balance
Position in SF
100000
50000
Purchase bill
It will be credited to Nostro A/c on maturity
date
+80000
Forward Sales
It will be debited to Nostro A/c on maturity
date
-60000
Forward purchase has already been added in
position, hence on cancellation it should be
deducted
-30000
Forward
Cancelled
Purchase
Contract
TT Remittance
Immediately Transferred
Draft on Zurich Cancelled
On issued on draft, it has already been
deducted from position, hence on cancellation
it should be added
-75000
-75000
+30000
Total
25000
-5000
Balance Required
30000
10000
TT Purchase
(30000-25000)
5000
5000
Forward Purchase
10000
Over bought Position
10000
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account to Sw. Fcs. 30,000.
This would bring down the oversold position on Sw. Fcs. As Nil.
Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy forward Sw. Fcs. 10,000.
Solution-73
(i) Net exposure of each foreign currency in Rupees
US$
FFr
UK
Japan Yen
Inflow
(Millions)
Outflow
(Millions)
Net Flow
(Millions)
Spread (FR – SR)
Net Exposure
(Millions)
40
20
30
15
20
8
20
25
20
12
10
-10
0.81
0.67
0.41
-0.80
16.20
8.04
4.10
8.00
(ii) Off Setting Position:
(a) Net Exposure in all the currencies are offset by better forward rates. In the case of USD. F Fr and UK Pound, the net
exposure is receivable, and the forward rates are quoted at a premium for these currencies.
(b) In case of Japanese Yen, the net exposure is payable, and the forward rate is quoted at a discount. Therefore, a
better forward rate is also offsetting the net payable in Japanese Yen.
Solution-74
Particulars
Indian Subs
USA Subs
S Africa Subs.
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
Indian subsidiary is owed Rs.14 m by South Africa Subsidiary = Rs.14m/70
+£ 0.20m
Indian subs owes $ 1 m to US Subsidiary = $1 m/2
- £ 0.50m
South Africa subsidiary is owed R 1.4m by US Subsidiary = R 1.4m/10
South Africa subsidiary owes $ 1m to US subsidiary = $1m/2
Net receivable/(Payable)
- £ 0.30m
10C.47
-£ 0.20m
+£ 0.50m
-£ 0.14m
+£ 0.14m
+£ 0.50m
-£ 0.50m
£ 0.86m
- £ 0.56m
Indian Subsidiary should pay the USA Subsidiary £ 0.30m = £ 0.30m*2 = $ 0.60m
South Africa Subsidiary should pay the USA Subsidiary 0.56m = 0.56m*2 = $ 1.12m
Solution-75
SR
$ 1 = Rs.45.35
ESR at end of 3 months
$ 1 = Rs.46.50
Borrowing Cost = 8%p.a.
Option 1 Pay toady by borrowing [Leading]
(a) Rs. required to pay $ 50000 at SR = $ 50000*45.35 = Rs.2267500
(b) Borrow Rs.2267500 for 3 months @ 2%
(c) Repayment of borrowing with interest = Rs.2267500*1.02 = Rs.2312850
Option 2 Pay after 3 months
(a) Rs. required to pay $ 50000 at ESR of 3 months = $ 50000*46.50 = Rs.2325000
Comment: Net gain due to lead strategy = 23,25,000 – 23,12,850 = Rs.12,150
Solution-75A
SR
$ 1 = Rs.45.36
ESR at end of 4 months
$ 1 = Rs.44.50
Borrowing Cost = 8%p.a.
$ receivable in 4 months = $ 100000
Option 1 Receive toady and giving 2% discount
(a) $ receivable = $100000*0.98 = $ 98000
(b) Rs. receivable by selling $ 98000 at SR = $ 98000*45.36 = Rs.4445280
(c) Deposit Rs.4445280 for 4 months @ 2.67%
(d) Amt Receivable from deposit with interest = Rs.4445280*1.0267 = Rs.4563969
Option 2 Receivable after 4 months
(a) Rs. receivable by selling $ 100000 at ESR of 4 months = $ 100000*44.50 = Rs.4450000
Comment: Net gain due to leading strategy = 4563969 – 4450000 = Rs.113969
Solution-76
SR
$ 1 = Rs.48.50 – 48.70
2 months Swap Points
$ 1 = 25/30 points [Increasing Order]
3 months Swap Points
$ 1 = 40/45 points [Increasing Order]
FR of 2 months
$ 1 = Rs.48.75 – 49.00
FR of 3 months
$ 1 = Rs.48.90 – 49.15
(a)
(i) NP Co is to pay $ 700000 in 3 months for which no Forward Contract has been entered. Hence to cover risk, NP Co will
enter into FPC for $ 700000 @ 49.15 [Buying $ and Selling Rs.]
Rs. Payable in 3 months to pay $ 700000 at FR of 3 months = $ 700000*49.15 = Rs.34405000
(ii) NP Co is to receive $ 450000 in 2 months for which FSC has been entered into @ 48.90.
Rs. receivable in 2 months = $ 450000*48.90 = Rs.22005000
Deposit Rs.22005000 for 1 months @ 12% p.a.
At the end of 3 months
Amt Receivable from deposit = Rs.22005000*1.01 = Rs.22225050
Amt payable in 3 months = Rs.34405000
Net amt payable in 3 months = 34405000-22225050 = Rs.12179950
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.48
(b) Original FSC of $ 450000 is to be cancelled by entering into FPC of 2 months @49
Gain/(Loss) on Cancellation of FSC of $ 450000 = Sale – Purchase = $ 450000*48.90 – $ 450000*49 = - Rs.45000
Borrow Rs.45000 for 3 months @ 12% p.a.
$ 450000 receivable is delayed by one month, hence [Lagging]
Receivable in 3 months = $ 450000
Payable in 3 months = $ 700000
Net payable in 3 months = $ 250000
To cover risk, NP Co will enter into FPC for $ 250000 @ 49.15
At the end of 3 months
(a) Rs. required to pay $ 250000 at FR of 3 months = $ 250000*49.15 = Rs.12287500
(b) Repayment of Borrowing = Rs.45000*1.03 = Rs.46350
Total payment at the end of 3 months = Rs.12287500+46350 = Rs.12333850
Comment: Since net payable amount is least in case of option 1, hence the company should go for option 1
Note: In the question it has not been clearly mentioned that whether quotes given for 2 and 3 months (in point terms)
are premium points or direct quotes. Although above solution is based on the assumption that these are direct quotes,
but student can also consider them as premium points and solve the question accordingly.
Solution-77
Excel Exporter has exported goods of $100000 @Rs.45.50
$100000 is to be received in 60 days
[For understanding Excel Exporter will sell $ & will buy Rs.]
Today Spot rate $ 1 = Rs.45.60
Today FR of 60 days $ 1 = Rs.45.20
(i) Rate of Discount on $ [LHC] = FR-SR/SR = (45.20 – 45.60)/45.60 = -0.00877 = -0.877% for 2 months
Rate of Discount on $ p.a. = -0.877*12/2 = 5.262%
(ii) If Forward Contract is entered into.
Rs. receivable by selling $100000 at FR of 2 months = $100000*45.20 = Rs.4520000
Rs. receivable by selling $100000 at SR of Transaction date = $100000*45.50 = Rs.4550000
Expected operating loss if hedging is done = Sale Value as recorded in books – Receipts under Forward Cover
= 4550000 – 4520000 = Rs.30000
Solution-78
A person has to pay $300000 in 3 half yearly equal installments of $100000 each
(i) In case of No Hedging
A person will purchase $ 100000 at Spot rate of each 6 months
At the end of 6 months
SR $ 1 = Rs.43.00 – 43.10
Rs. required to pay $100000 at SR of 6 months @ 43.10 = $100000*43.10 = Rs.4310000
At the end of 12 months
SR $ 1 = Rs.44.00 – 44.10
Rs. required to pay $100000 at SR of 1 yr @ 44.10 = $100000*44.10 = Rs.4410000
At the end of 18 months
SR $ 1 = Rs.45.00 – 45.10
Rs. required to pay $100000 at SR of 1.5 yr @ 45.10 = $100000*45.10 = Rs.4510000
Total payment under no hedging = Rs.4310000 + Rs.4410000 + Rs.4510000 = Rs.13230000
(ii) In case of three separate forward contract
Today
FR of 6 months $ 1 = Rs.42 – 42.50
A person will enter into forward purchase contract of $ 100000 at FR @ $ 1 = Rs.42.50
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.49
At the end of 6 months
FR of 6 months $ 1 = Rs.43.40 - 43.50
(i) Rs. required to pay $100000 at FR = $100000*42.50 = Rs.4250000
(ii) A person will enter into next forward purchase contract of $ 100000 at FR @ $ 1 = Rs.43.50
At the end of 12 months
FR of 6 months $ 1 = Rs.44.50 - 44.60
(i) Rs. required to pay $100000 at FR = $100000*43.50 = Rs.4350000
(ii) A person will enter into next forward purchase contract of $ 100000 at FR @ $ 1 = Rs.44.60
At the end of 18 months
Rs. required to pay $100000 at FR = $100000*44.60 = Rs.4460000
Total payment under Forward Contract = 4250000 + 4350000 + 4460000 = Rs.13060000
(ii) Roll Over Contract
Payment of $3000000 to be made at 6 months, one year and One & half year $1000000 each time. The person enters
into a contract for 6 months forward purchase of $3000000 @ Rs.42.50
At Six Months time
Purchase of $300000 @42.50 and sale of $200000 at SR Rs.43
Net Payable
= Purchase cost – sales value = 300000*42.50 – 200000*43 = Rs.4150000
Now he will enter into a new 6 months forward purchase contract for $200000 @ Rs.43.50
At One year time
Purchase of $200000 @43.50 and sale of $100000 at SR Rs.44
Net Payable
= Purchase cost – sales value
= 2000000*43.50 – 1000000*44 = Rs.4300000
Now he will enter into a new 6 months forward purchase contract for $100000 @ Rs.44.60
At One and half year time
Purchase of $1000000 @44.60
Net Payable
= Purchase cost
= 1000000*44.60 = 4460000
Total payment under Rupee Roll Over
= Rs.(4150000 + 4300000 + 4460000) = Rs.12910000
Solution-78A
Under Forward Contract
On 1-1-97: The company enters 6 months forward sale contract for $ 1 Million @35.20
On 1-7-97: The company sells $ 1 million @35.20 as agreed but purchases $ 1 Million at Spot rate 35.51
Gain or Loss
= Sale Value – Purchase Cost
= (35.20– 35.15)* 1 Million = 0.05 Million rupee gain
The company enter into forward sale for $1 million for 6 months @35.30
On 1-1-98: The company sells $ 1 million @35.30 as agreed but purchases $ 1 Million at Spot rate 35.25
Gain or Loss
= Sale Value – Purchase Cost
= (35.30– 35.25)* 1 Million = 0.05 Million rupee gain
The company enter into forward sale for $1 million for 6 months @35.35
On 1-7-98: The company sells $ 1 million @35.35 as agreed but purchases $ 1 Million at Spot rate 35.35
Gain or Loss
= Sale Value – Purchase Cost
= (35.35– 35.35)* 1 Million = 0
The company enter into forward sale for $1 million for 6 months @35.50
On 1-1-99: The money will be received $ 1 million & it will be sold at agreed rate 35.50
Amt to received = 35.50 x 1 = Rs.35.50 Million
If no hedging is taken
On 1-1-99: The money will be received $ 1 million & it will be sold at Spot rate 35.45
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.50
Amt to received = 35.45 x 1 = Rs.35.45 Million
Cost of capital = 20%
PV of receipts under Forward Contract = 50000/1.1 + 50000/(1.1)2 + 35500000/(1.1)4 = Rs.24.33 Million
PV of receipts under no Forward Contract = 35450000/(1.1)4 = Rs.24.21 Million
Solution-79
Spot Rate $1 = Rs.40
Forward Rate of 9 months = Rs.39
[For Understanding Company will buy $ and sell Rs.]
Rs. required to make payment of $50000 at forward rate = $ 50000*39 = Rs.1950000
But for forward contract, company has to pay premium of 2%
Premium amount = Rs.1950000*2% = Rs.39000
Loss of Intt on Payment of Premium today = 39000*9/12*10% = 2925
Hence, total payment under forward cover = 1950000 + 39000 + 2925 = Rs.1991925
(i) If the exchange rate on September 30, 2008 is Rs. 42 per US $.
Rs. required to make payment of $50000 at actual spot rate = $ 50000*42 = Rs.2100000
Gain due to forward cover = Rs.2100000 – Rs.1991925 = Rs.108075
(ii) If the exchange rate on September 30, 2008 is Rs. 38 per US $.
Rs. required to make payment of $50000 at actual spot rate = $ 50000*38 = Rs.1900000
Loss due to forward cover = Rs. 1991925 – Rs.1900000 = Rs.91925
Solution-80
If foreign exchange risk in hedged.
Sum due
Unit input price
Unit sold
Variable cost per unit
Variable cost
Three months forward rate of selling
Rupee value of receipts
Contribution
Average contribution to sale ratio
Yen 7800000
Yen 650
12000
Rs.225
Rs.2700000
2.427
Rs.3213844
Rs.513844
US$ 102300
US$ 10.23
10000
395
Rs.3950000
0.0216
4736111
Rs.786111
Euro 95920
Euro 11.99
8000
510
Rs.4080000
0.0178
Rs.5388764
Rs.1308764
Total
Rs.10730000
Rs.13338719
Rs.2608719
19.56%
If risk is not hedged
Rupee value of receipt
Rs.3172021
Total Contribution
Average contribution to sale ratio
ACK Ltd. is advised to hedge its foreign currency exchange risk.
Solution-81 (i) To BUY 1 Million GBP Spot against CHF
SR USD 1 = CHF 1.4650 – 1.4655 [Bank A]
SR USD 1 = CHF 1.4653 – 1.4660 [Bank B]
SR GBP 1 = USD 1.7645 – 1.7660 [Bank A]
SR GBP 1 = USD 1.7640 – 1.7650 [Bank B]
1. First to BUY USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655
2. Then to BUY GBP against USD at a cheaper rate i.e. from Bank B
1 GBP= USD 1.7650
Cross rate would be
1 GBP = 1.7650*1.4655 CHF
1 GBP = CHF 2.5866
CHF required to buy GBP 1m = CHF 2.5866*1m = CHF 25,86,600
(ii)
SR USD 1 = CHF 1.4650 – 1.4655 [Bank A]
Swap Points of 3 months 5/10 [Increasing Order]
FR of 3 months =USD 1 = CHF 1.4655 - 1.4665
Rs.4744898
Rs. 5358659
Rs.13275578
Rs.2545578
19.17%
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
10C.51
SR GBP 1 = USD 1.7645 – 1.7660 [Bank A]
Swap Points of 3 months 25/20 [Decreasing Order]
FR of 3 months =GBP 1 = USD 1.7620 - 1.7640
Cross Rates
Spot rate
GBP 1 = CHF 1.4650*1.7645 - 1.4655*1.7660 = CHF 2.5850 - 2.5881
Forward Rate
GBP 1 = CHF 1.4655*1.7620 – 1.4665*1.7640 = CHF 2.5822 - 2.5869
Therefore 3 month swap points are at discount of 28/12.
Solution-82
Performa profit and loss account of the Indian software development unit
Revenue
Less costs:
Rent
Manpower (Rs.400x80x10x365)
Administrative and other costs
Earning before tax
Less tax
Earning after tax
Less: withholding tax (TDS)
Repatriation amount (in rupees)
Repatriation amount (in dollars)
Amt
$ 1,00,00,000
Exchange Rate
$ 1 = Rs.48
Rs.
48,00,00,000
$ 1 = Rs.48
11,95,00,000
36,05,00,000
10,81,50,000
25,23,50,000
2,53,35,000
22,71,15,000
$4.7million
15,00,000
11,68,00,000
12,00,000
Note : Students may assume the year of 360 days instead of 365 days as has been done in the answer provided above.
In such a case where a year is assumed to be of 360 days, manpower cost is Rs 11,52,00,000 and repatriated amount Rs
22,87,15,000.
Conclusion: The cost of development software in India for the US based company is $5.268 million. As the USA based
Company is expected to sell the software in the US at $12.0 million, it is advised to develop the software in India.
Solution-83
Sale 2400 units @ Euro 500 p.u.
Purchase 2400 units @ $ 800 p.u.
Fixed Cost = Rs.1000 p.u.
Variable Cost = Rs.1500 p.u.
Current Spot Rate
Euro 1 = Rs.51.50 – 51.55 [Selling rate is applicable]
$ 1 = Rs.27.20 – 27.25 [Buying rate is applicable]
(a) Profit at current Spot rates
2400 [Euro 500*51.50 - ($ 800*27.25 + 1000 + 1500)]
2400 [Rs. 25,750 - Rs. 24,300] = Rs. 34,80,000
Spot Rate after 6 month
Euro 1 = Rs.52.00 – 52.05 [Selling rate is applicable]
$ 1 = Rs.27.70 – 27.75 [Buying rate is applicable]
Profit after change in exchange rates
2400 [Euro 500*52.00 - ($ 800*27.75 + 1000 + 1500)]
2400 [Rs. 26,000 - Rs. 24,700] = Rs. 31,20,000
(i) Loss due to change in fluctuation = 3480000-3120000 = Rs.360000
(ii)
Profit based on new exchange rates
2400*[25000 - (800*27.15 + 1000 + 1500)]
2400*[25000 - 24220] = RS.18,72,000
Profit after change in exchange rates at the end of six months
2400*[25000 - (800*27.75 + 1000 + 1500)]
Chap – 10
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SOLUTION
2400*[25000 - 24700] = RS.7,20,000
Decline in profit due to transaction exposure
Rs. 18,72,000 - Rs. 7,20,000:: RS.11 ,52,000
(iii)
Current price of each unit in S$= RS. 25,000/ RS.51.50 = RS. S$ 485.44
Price after change in Exch. Rate= RS. 25,000/ RS. 51.75 = RS. S$ 483.09
Change in Price due to change in Exch. Rate
S$ 485.44 - S$ 483.09 = S$ 2.35 or (-) 0.48%
Price elasticity of demand = 1.5
Increase in demand due to fall in price
0.48 x 1.5 = 0.72%
Size of increased order = 2400 x 1.0072 = 2417 units
PROFIT
= 2417 [ Rs.25,000 - (800 x Rs.27.75 + Rs.1,000 + Rs.1,500)]
= 2417 [Rs.25,000 - Rs.24,700] = Rs.7,25,100
Therefore, decrease in profit due to operating exposure Rs.18,72,000 - Rs.7,25,100 = Rs.11,46,900
Solution-84
U.S. Imports co., purchased 100,000 Mark’s worth of machines from a firm in Dortmund
SR
DM 1 = $ 0.55
90 days FR
DM 1 = $ 0.56
a) If payment is made within 10 days, then 2% discount is given to US Import Co.
Net Payment payable by US Import Co = DM 100000*(1-0.02) = DM 98000
$ required to pay DM 98000 at SR = DM 98000*0.55 = $ 53900
b) If payment is made in 90 days, then 2% discount is not given to US Import Co.
Net Payment payable by US Import Co = DM 100000
$ required to pay DM 100000 at FR = DM 100000*0.56 = $ 56000
c)
Loss due to delay = 56000 – 53900 = $ 2100
Loss due to time value of money = DM (100000 – DM 98000)*0.56 = $ 1120
Loss due to FEF = DM 98000*(0.56 – 0.55) = $ 980
Solution-85
Indian Company is importer and is to pay $15000 [For understanding he will buy $ and sell Rs.]
Today SR Rs.1 = $0.0227272
Appreciation of 10% is given on Rs. because Importer gains when Domestic Currency increases.
Expected increase in Rs. = 10% in two months
ESR after 2 months Rs.1 = $0.0227272*1.10 = $0.025
Current cost of machine = $15000
If machine is purchased today, then
Cost of machine at today at today SR = $15000/0.0227272 = Rs.6,60,002
If machine is purchased after 2 months then
Cost of machine at ESR = $15000/$0.025 = Rs.6,00,000
Saving due to delay = Rs.660002 – 600000 = Rs.60002
Loss due to delay = Rs.50000
Net Saving due to delay = 60000 – 50000 = Rs.10000
Suggestion – It is suggested to purchase machine after 2 months.
Solution-86
SR $ 1 = Rs.51.3625 – 3700
ABN Amro Bank wants to deposit Rs. in its Vostro Acount. [$-LHC-Sell; Rs.-RHC-Buy]
Exchange rate would be $ 1 = Rs.51.3625
Equivalent $ amount = Rs.15000000/51.3625 = $ 292041.85
10C.52
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.1
Question-4B [SM-9] [SP] A company operating in a country having the dollar as its unit of
currency has today invoiced sales to an Indian company, the payment being due three months
from the date of invoice. The invoice amount is $ 7,500 and at today spot rate of $0.025 per
Re.1, is equivalent to Rs.3,00,000.
It is anticipated that the exchange rate will decline by 10% over the three months period and in
order to protect the dollar proceeds, the importer proposes to take appropriate action through
foreign exchange market. The three months forward rate is quoted as $0.0244 per Re.1.
You are required to calculate
(a) Whether forward contract should be entered into or not. [Not Part of Exam Question]
(b) Expected loss if hedging is not done. [Ans: Expected Loss if no Forward Contract is taken – Rs.33333.33]
(c) Show loss is hedging is done. [Expected Loss under Forward Contract – Rs.7377]
Solution-4B
Indian company has imported goods worth $7500 and will pay in 3 months
[Indian Co will buy $ and will sell Rs.]
Current Spot rate
Rs.300000 = $ 7500
Rs.1 = $ 0.025
3 months FR Rs.1 = $ 0.0244
Anticipated decline in Exchange rate = 10%. [Decline is in Indian Rs, as Importer losses when DC declines]
ESR of maturity: Rs.1 = $ 0.025*(1-0.1) = $ 0.0225
(a) Rs. is LHC and Indian Importer will buy $ and will sell Rs., hence he would like to sell Rs. at higher of ESR and FR
FR is higher than ESR hence Importer should enter into FC.
(b) If no Forward Contract is entered into.
Rs. required to pay $7000 at Current SR = Rs.300000
Rs. required to pay $7500 at ESR of maturity = $ 7500/0.0225 = Rs.333333.33
Expected loss if no hedging is done = Cost under ESR – Cost under Current SR = 333333.33 – 300000 = Rs.33333.33
(c) If Forward Contract is entered into
Rs. required to pay $7500 at FR = $7500/0.0244 = Rs.307377
Expected loss if hedging is done = Cost under ESR – Cost under Current SR = 307377 – 300000 = Rs.7377
Suggestion: If the exchange rate risk is not covered with forward contract, the expected exchange loss is Rs.33333.33
This could be reduced to Rs.7377 if it is covered with Forward contract. Hence, taking forward contract is suggested.
Saving due to Forward Contract = 33333.33 - 7377 = Rs.25956.33
Question-16B [Nov-2008] [M-6] [RTP-Nov-2012-19]
An Indian exporting firm, Rohit and Bros., would be covered itself against a likely depreciation of
pound sterling. The following data is given:
Receivables of Rohit and Bros
Spot rate
Payment date
3 month interest rate
What should the exporter do? [Ans: Rs.28483952]
Solution-16B
Rohit & Bros. of India is to receive £ 500,000 at the end of 3 months [Selling £ and buying Rs]
For hedging purpose, Rohit & Bros must do following steps.
Money Market
Interest Rate
Currency
India
UK
Interest Rate
Interest p.a.
PIR of 3 months
12%
12/4 = 3%
5%
5/4 = 1.25%
£500,000
Rs. 56.00/£
3-month
India : 12% p.a.
UK : 5% p.a.
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.2
Today
(a) Rohit & Bros will borrow from UK for 3 months @ 1.25% [Creating Liability in FC]
Borrowing Amt = Invoice Amt in £/(1 + PIRUK) = £ 500000/1.0125 = £ 493827.20
Spot Rate £ 1 = Rs.56
(b) Rohit & Bros will Convert £ 493827.20 in Rs. at spot rate @56
Equivalent Rs. receivable = £ 493827.20*56 = Rs.27654323.20
(c) Rohit & Bros will deposit Rs. 27654323.20 for 3 months in India @ 3% [Creating Assets in DC]
At the end of 3 months
(a) Borrowing in UK and interest thereon will be repaid from amt receivable from UK Importer
(b) In India, Amount receivable from Deposit = Amount of Deposit*(1 + PIRRs.) = Rs.27654323.20*1.03 = Rs.28483952
Question-17B F Ltd. is a medium sized UK company with export and import trade with the USA.
The following transaction are due
Sale of finished goods, cash receipts due in three months
Purchase of finished goods cash payment due in six months
$ 197,000
$ 293,000
Exchange rates (London Market)
$/£
£ 1= $1.7106-1.7140
£ 1 = $1.7024-1.7063
£ 1 = $1.6967-1.7006
Spot
Three months forward
Six months forward
Calculate the net sterling pounds receipts and payments that F Ltd. might expect for both its
three and six months transactions if the company hedges foreign exchange risk on
(1) forward foreign exchange market
(2) on money market operation basis. You may assume following interest rates:
Borrowing
12.50% p.a.
9% p.a.
Pound
$
Lending
9.50% p.a.
6% p.a.
[Ans: Pound receivable Under forward cover = £ 115454.50; Under Money Market = £ 115076.33]
Solution-17B
Spot Rate
Forward Rate of three Month
Forward Rate of six Month
£1 = $ 1.7106 – 1.7140
£1 = $ 1.7024 – 1.7063
£1 = $ 1.6967 – 1.7006
(A) F Ltd is to receive $197000 in 3 months
(i) Forward Cover
If it takes forward cover of 3 months @ 1.7063 [Selling $ and buying £]
£ receivable by selling $197000 at forward rate = $197000/1.7063 = £ 115454.50
(ii) Money Market
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 3 months
Interest p.a.
PIR of 3 months
$
9%
9/4 = 2.25%
6%
6/4 = 1.50%
£
12.50%
12.50/4 = 3.125%
9.50%
9.50/4 = 2.375%
F Ltd is to receive $197000 in 3 months [Assets in FC]
Today
(a) F Ltd will borrow from USA for 3 months @2.25% [Creating Liability in FC]
Borrowing Amt in $ = Invoice Amt in $/(1 + PIRUSA) = 197000/1.0225 = $ 192665.04
(b) F Ltd will Convert $192665.04 in pounds at spot rate @1.7140 [Selling $ and buying £]
Equivalent £ receivable
= $ 192665.04/1.7140 = £ 112406.67
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.3
(c) F Ltd will Deposit £ 112406.67 for 3 months in U K @ 2.375% [Creating Assets in DC]
At the end of 3 months
(a) Borrowing in USA and interest thereon will be repaid by amt receivable from supplier in USA.
(b) In UK, Amount Receivable from deposit = Amount of Deposit*(1 + PIRUK) = £112406.67*1.02375 = £115076.33
Pound Receivable
(i) Under forward cover = £115454.50
(ii) Under Money Market = £115076.33
(B) F Ltd is to pay $293000 in 6 months
(i) Forward Cover
If it takes forward cover of 6 months @ 1.6967 [for Understanding buying $ and selling £]
£ required to buy $293000 at forward rate = $293000/1.6967 = £ 172688.16
(ii) Money Market
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 6 months
Interest p.a.
PIR of 6 months
$
9%
9/2 = 4.50%
6%
6/2 = 3%
£
12.50%
12.50/2 = 6.25%
9.50%
9.50/2 = 4.75%
F Ltd is to pay $293000 in 6 months [Liability in FC]
Today
(a) F Ltd will deposit in USA for 6 months @3% [Creating Assets in FC]
Deposit Amt in $ = Invoice Amt in $/(1 + PIRUSA) = 293000/1.03 = $ 284466.02
(b) F Ltd will Convert $ 284466.02 in pounds at spot rate @1.7140 [Selling $ and buying £]
Equivalent £ payable = $ 284466.02/1.7106 = £ 166296.05
(c) F Ltd will borrow £ 166296.05 for 6 months in U K @ 6.25% [Creating Liability in DC]
At the end of 6 months
(a) Deposit in USA and interest thereon will be used to pay USA exporter
(b) In UK, Amount payable for borrowing = Amount of Borroing*(1 + PIRUK) = £166296.05*1.0625 = £176689.55
Pound Payable
(i) Under forward cover = £172688.16
(ii) Under Money Market = £176689.55
Hence hedging though Forward Cover is preferable
Question-17C [CS-Dec-2009-M-6] Silver Oak Ltd an Indian Company, is mainly engaged in
international trade with US and UK. It is currently 1st Jan. It will have to make a payment of $
7,29,794 in the coming 6 months time. The company is presently considering the various
alternatives in order to hedge its transactional exposure through its London office. The following
information is available:
Spot Rate
£ 1 = $ 1.5617 – 1.5773
6 months Forward Rate
£ 1 = $ 1.5455 – 1.5609
Money Market Rate
Borrow
Deposit
$
6%
4.5%
£
7%
5.5%
Foreign Currency options prices (Cents per £ for contract size £ 12,500.
Exercise Price
$1.70/£
Call Option (June)
Put Option (June)
3.7
9.6
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.4
Suggest which of the following hedging option is the most suitable for Silver Oak Ltd.
(i)
Forward Cover [Ans: £ 472205.80]
(ii) Money Market Cover; and [Ans: £ 473020.30]
(iii)
Currency Option [Ans: GBP 227923.00]
Solution-17C
Today Spot Rate
£ 1 = USD 1.5617 – 1.5773
6 months Forward Rate
£ 1 = USD 1.5455 – 1.5609
Silver Oak Ltd of U K has to pay $729794 in 6 months
(i) Forward Cover
If it takes forward cover of 6 months @ 1.5455 [for Understanding buying $ and selling £]
£ required to buy $ 729794 at forward rate = $729794/1.5455 = £ 472205.80
(ii) Money Market
Interest Rate
Currency
Borrowing Rate
Lending Rate
Interest p.a.
PIR of 6 months
Interest p.a.
PIR of 6 months
$
6%
6/2 = 3%
4.50%
4.50/2 = 2.25%
£
7%
7/2 = 3.50%
5.50%
5.50/2 = 2.75%
Silver Oak Ltd is to pay $ 729794 in 6 months [Liability in FC]
Today
(a) Silver Oak Ltd will deposit in USA for 6 months @2.25% [Creating Assets in FC]
Deposit Amt in USD = Payable Amt in USD/(1 + PIRUSA) = 729794/1.0225 = $ 713735
(b) Silver Oak Ltd will Convert USD 713735 in £ at spot rate @1.5617 [Buying $ and Selling £]
Equivalent £ payable = $ 713735/1.5617 = £ 457024.4
(c) A Ltd will borrow £ 457024.4 for 6 months in U K @ 3.50% [Creating Liability in DC]
At the end of 6 months
(a) Deposit in USA and interest thereon will be used to pay USA exporter
(b) In UK, Amount payable for borrowing = Amount of Borrowing*(1 + PIRUK) = £ 457024.4*1.035 = £ 473020.30
Option
Forward cover
£ 472205.80
Money market
£ 473020.30
Currency option
£ 455845
The company should take currency option for hedging the risk.
Question-29C [Nov-2002] [M-4] [SP] On 1st April, 3 months interest rate in the US
and Germany are 6.5% and 4.5% p.a. respectively. The $/DM spot rate is 0.656. What
would be the forward rate for DM for delivery on 30th June?
Solution-29C
Spot Rate
DM 1
Interest Rate ($)
PIR of 3 months ($)
Interest Rate (DM)
PIR of 3 months (DM)
=
=
=
=
=
$ 0.656
6.5% p.a.
1.625%
4.5% p.a.
1.125%
Calculation of the FR under IRPT [$ is RHC and DM is LHC]
FR under IRPT ($/DM) = (1 + PIR$)*SR/(1 + PIRDM) = 1 + 0.01625)*0.656/(1 + 0.01125) = $0.659
FR of 3 months under IRPT DM 1 = $ 0.659
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.5
Question-29D [Nov-2008] [M-4] [RTP-May-2013-19] On April 1, 3 months interest rate in
the UK and US $ are 7.5% and 3.5% p.a. respectively. The UK £/US $ spot rate is 0.7570. What
would be the forward rate for US $ for delivery on 30th June?
Solution-29D
Spot Rate
$1
Interest Rate ($)
PIR of 3 months ($)
Interest Rate (£)
PIR of 3 months (£)
=
=
=
=
=
£ 0.757
3.5% p.a.
0.875%
7.5% p.a.
1.875%
Calculation of the FR under IRPT [£ is RHC and $ is LHC]
FR under IRPT (£/$) = (1 + PIR£)*SR/(1 + PIR$) = (1 + 0.01875)*0.757/(1 + 0.00875) = £0.764
FR of 3 months under IRPT $ 1 = £ 0.764
Question-31A The financial press recently listed the following information about two currencies,
the dollar ($W) and the Eastland mark (Em).
Spot rates:
90 day rates:
2.0725 Em/$W
2.0687 Em/$W
Westland prime interest rate on the same day was 9.5%. Requirements:
Calculate and comment on the Eastland interest rate.
Solution-31A
SR
$W 1 = Em 2.0725 [$W is LHC and Em is RHC]
FR 0f 90 days
$W 1 = Em 2.0687
IR$W = 9.5% p.a.
PIR$W for 90 days = 9.5*90/360 = 2.375%
Assuming IRPT exists, hence
FR/SR = [1 + PIREm]/[1 + PIR$W]
2.0687/2.0725 = [1 + PIREm]/1.02375
[1 + PIREm] = 2.0687*1.02375/2.0725 = 1.0218
PIREm = 1.0218 – 1 = 0.0218 = 2.18%
IR on Em = 2.18*4 = 8.72% p.a.
Question-39B [Nov-2014] [M-5] Edelweiss Bank Ltd. sold Hong Kong Dollar 2,00,00,000 on
spot to its customer at Rs.8.025 & covered yourself in London Market on the same day, when the
exchange rates were.
US $ 1 = HK $ 7.588-7.592
Local inter bank market rates for US $ were
US $ 1= Rs.60.70 – 61.00
Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage.
Solution-39B
The Bank sold HK$ 20000000 on spot @ HK$ 1 = Rs.8.025
To covers it self, Bank will buy HK$ 20000000 from the market at market selling rate.
Exchange rate
US $ 1 = HK $ 7.588-7.592 [HK $/US $]
US $ 1= Rs.60.70 – 61.00 [Rs./US $]
Required cross rate
Rs./HK $
= (Rs./US $) * (US $/HK $)
HK $ 1
= Rs.60.70*1/7.592 – 61*1/7.588
HK $ 1
= Rs.7.9952 – 8.0390
Since Bank had sold HK $ @ Rs.8.025 and to cover himself, he will purchase HK $ at spot rate @8.0390
Gain or loss to Bank
= Sale price – Purchase Price
= HK $ 20000000*8.025 – 20000000*8.0390 = Loss Rs.280000
Question-39C [May-2014] [M-5] The Bank sold Hong Kong Dollar 1,00,000 on spot to its
customer at Rs.7.5681 & covered itself in London Market on the same day, when the exchange
rates were.
US $ 1 = HK $ 8.4409-8.4500
Local inter bank market rates for US $ were
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.6
US $ 1= Rs.62.7128 – 62.9624
Calculate cover rate & ascertain the profit or loss in the transaction ignore brokerage.
Solution-39C
The Bank sold HK$ 100000 on spot @ HK$ 1 = Rs.7.5681
To covers it self, Bank will buy HK$ 100000 from the market at market selling rate.
Exchange rate
US $ 1 = HK $ 8.4409 – 8.4500 [HK $/US $]
US $ 1= Rs.62.7128 – 62.9624 [Rs./US $]
Required cross rate
Rs./HK $
= (Rs./US $) * (US $/HK $)
HK $ 1
= Rs.62.7128*1/8.45 – 62.9624*1/8.4409
HK $ 1
= Rs.7.4216 – 7.4592
Since Bank had sold HK $ @ Rs.7.5681 and to cover himself, he will purchase HK $ at spot rate @7.4592
Gain or loss to Bank
= Sale price – Purchase Price
= HK $ 100000*7.5681 – 100000*7.4592 = Gain Rs.10890
Question-49A [CS-Dec-2003] Calculate the arbitrage gains possible on £10,000 from the
middle rates given below. Assume there are no transaction cost.
Rs.76.20 = £ 1 In London; Rs.46.60 = $ 1in Delhi
$ 1.5820 = £ 1 in New York.
Solution-49A
Currency rates prevailing in different cities
In London
Rs.76.20 = £ 1 [Rs/£]
In Delhi
Rs.46.60 = $ 1 [Rs/$]
In New York
$ 1.5820 = £ 1 [$/£]
We have £ 10000 and that is to be sold first and it has to be purchased as follows
Option 1
(a) Sell £ 10000 in London, Rs. receivable = £ 10000*76.20 = Rs.762000
(b) Sell Rs.762000 in Delhi, $ receivable = Rs.762000/46.60 = $ 16352
(c) Sell $ 16352 in NY, £ receivable = $ 16352/1.582 = £ 10336
Gain due to Arbitrage process = £ 10336 - $ 10000 = £ 336
Arbitrage profit under option 1 = £ 336
Alternative
To make arbitrage gains
Calculate cross rates between £ and Rs. through Delhi and New York and Compare it with rate of London.
[Rs./£] = Rs./$ * $/£ = 46.60 * 1.5820
£ 1 = Rs.73.7212 [Cross rates between delhi and new York]
£ 1 = Rs.76.20 [Rate in London]
Since £ is higher in London, hence it should be sold in London and purchased from New York.
1. Rs. receivable by selling £10000 in London = £10000*76.20 = Rs.762000
2. $ receivable by selling Rs.762000 in Delhi = Rs.762000/46.60 = $16351.93
3. £ receivable by selling $16351.93 in NY = $16351.93/1.5820 = £10336.24
Arbitrage gain = £10336.24 - £10000 = £336.24
Question-53C A Italian investor purchased Canadian Securities for CD 1950 1 year ago when
the FER was 1 Euro = 1.50 CD. The value of the security, now is CD 2340 and FER is Euro 1 =
1.80 CD. What is the rate of return of the Italian investor?
Solution-53C
B0 = CD 1950
B1 = CD 2340
Interest received from bond = 0
Return of investment from Canadian Security = (B1 – B0 + Intt)*100/B0 = (2340+0-1950)*100/1950 = 20%
SR at to
Euro 1 = CD 1.50
SR at t1
Euro 1 = CD 1.80
Invested currency = CD
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.7
Premium/ Discount on CD (Invested & RHC) = (SR – FR)*100/FR = (1.50-1.80)*100/1.80 = -16.67%
Discount on CD = - 16.67%
Return of investment of Italian Investor = (1+Return of investment in Security)*(1-Discount on CD) – 1
= 1.20*(1-0.1667)-1 = 0.0 = 0%
Question-53D [ICWA-June-2003] [CS-June-2008-M-4] During a year the price of British
Gilts (FV £100) rose from £103 to £105, while paying a coupon of £8. At the same time the
exchange rate moved from $/£ 1.70 to 1.58. What is the total return to an investor in USA who
invested in this security?
Solution-53D
Price of BG at beginning = £103
Price of BG at the end = £105
Interest received from BG = £8
Return from BG for one year = (P1 – P0 + D1)/P0 = (105 – 103 + 8)/103 = 9.70%
SR at to
£ 1 = $ 1.70
SR at t1
£ 1 = $ 1.58
Invested currency = £
Premium/ Discount on £ (Invested & LHC) = (FR – SR)*100/SR = (1.58-1.70)*100/1.70 = -7.05%
Discount on £ = 7.05%
Return of investment of USA Investor = (1+Return of investment in BG)*(1-Discount on £) – 1
= 1.097*(1-0.0705)-1 = 0.0196 = 1.96%
Question-53E An MF of Luxemburg plans to invest Euro 15m in domestic securities for 60 days.
What are the rate of return will the MF earn it invest either in China or Australia.
(a) Interest rate 60 days
(b) Chinese Govt = 6% p.a.
(c) Australia Govt = 3% p.a.
(d) Exchange rate Euro per unit of foreign currency.
Spot rate
60 days Forward Rate
Chinese Yuan
0.20
0.2010
Australian Dollar
0.500
0.5025
Assume 360 days in year.
Solution-53E
(i) From Chinese Security
SR
CY 1 = Euro
FR or 60 days
CY 1 = Euro
Return of investment in CG =
Return of investment in CG =
0.20
0.2010
6% p.a.
1% for 60 days
Invested currency = CY
Premium/ Discount on CY (Invested & LHC) = (FR – SR)*100/SR = (0.201-0.2)*100/0.2 = 0.5%
Premium on CY = 0.5%
Return of investment of CG = (1+Return of investment in CG)*(1+Premium on CY) – 1
= 1.01*1.005-1 = 0.015 = 1.5% for 60 days
Return of investment of CG p.a. = 1.5%*6 = 9%
(ii) From Australian Security
SR
AD 1 = Euro
FR or 60 days
AD 1 = Euro
Return of investment in AG =
Return of investment in AG =
0.50
0.5025
3% p.a.
0.5% for 60 days
Invested currency = AD
Premium/ Discount on AD (Invested & LHC) = (FR – SR)*100/SR = (0.5025-0.5)*100/0.5 = 0.5%
Premium on AD = 0.5%
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.8
Return of investment of AD = (1+Return of investment in AG)*(1+Premium on AD) – 1
= 1.005*1.005-1 = 0.010 = 1% for 60 days
Return of investment of AG p.a. = 1%*6 = 6%
Question-57C [May-2006] [M-8] [Nov-2010] [M-8] [N] Given the following information:
SR
DM 1 = CD 0.665
FR of 3 months
DM 1 = CD 0.670
Interest rate
-
DM 7% p.a.; Canadian Dollar 9% p.a.
What operations would be carried out to take the possible arbitrage gains?
Solution-57C
Spot Rate
DM 1 = CD 0.665
FR of 3 months DM 1 = CD 0.670
IRDM = 7%; IRCD = 9%
PIR of DM for 3 months = 1.75%; PIR of CD for 3 months = 2.25%
WN-1 Decision of borrowing and investment
Method 1
Premium or discount on DM [LHC] = (FR-SR)*100/SR = (0.670-0.665)*100/0.665 = 0.75188% Prem for 3 months
Loss of Intt on DM for 3 months = 2.25% - 1.75% = 0.5%
Since Loss of interest is less than gain of premium on DM, hence investment should be made in DM and borrowing in CD.
Method 2 [Ignore]
PIRDM = 1.75%; IRCD = 2.25%
Assuming investment is in DM
Premium or discount on DM [LHC] = 0.75188% Prem for 3 months
Return from investment in DM = (1 + PIRDM)*(1+Prem on DM) – 1 = 1.0175*(1+0.0075188) – 1 = 0.02515 = 2.515%
Return from investment in CD = 2.25%
Since Return of DM is more than return of CD, investment should be made in DM and borrowing in CD
Method 3 [Ignore]
FR under IRPT (CD/DM) = (1 + PIRCD)*SR/(1 + PIRDM) = (1.0225*0.665)/1.0175 = CD 0.6682
Actual FR of 3 months DM 1 = CD 0.670
If FRIRPT < FRActual i.e. FR Actual is Overvalued
DM is costly in Actual FR, hence we should sell DM in FR, accordingly investment should be made in DM and borrowing in
CD
WN-2 Calculation of Arbitrage Profit
By above any of the method, we came to know that borrowing in CD and investment in DM to make arbitrage profit
Method-1
Today
1. Borrow CD 10000 for 3 months @ 2.25%
2. Convert CD 10000 into DM at SR = CD 10000/0.665 = DM 15037
3. Invest DM 15037 for 3 months @ 1.75%
At the end of 3 months
1. DM receivable from investment = DM 15037*1.0175 = DM 15300
2. Convert DM 15300 into CD at FR = DM 15300*0.67 = CD 10251
3. Repayment of borrowing in CD = CD 10000*1.0225 = CD 10225
Arbitrage profit = CD 10251 – CD 10225 = CD 26
Method-2 [Ignore]
Borrowing in CD and investment in DM
Currency in which investment is made = DM
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.9
Return from investment in DM = 2.515%
Hence, arbitrage return %
= Total Return from investment – Borrowing Cost
= 2.515% – 2.25% = 0.265%
Arbitrage profit in CD = Amount of Borrowing*Arbitrage return = CD 10000*0.265% = CD 26.50
Question-57D [SP] A person borrowed $ 1,00,000 @ 8% p.a. for 3 months, converted the
Dollars in Rupees at spot rate 1$ =Rs.46.70/46.80. invested the Dollar proceed (i.e. Rupees) @
12% p.a. for three months purchased $ 1,02,000 on 3 months forward basis of $ 1
=46.75/46.80. What is the gain/loss? Assume no loss of time in any transaction.
Solution-57D
SR
$ 1 =Rs.46.70/46.80
FR of 3 months $ 1 =Rs.46.70/46.80
Today
(a) Borrow $100000 @ 8% p.a. for 3 months
(b) Convert $100000 at spot rate = $100000*46.70 = Rs.46,70,000
(c) Invest Rs.46,70,000 @12% p.a. for 3 months
After 3 Months
(a) Rs. receivable from investment = Rs.4670000*1.03 = Rs.4810100
(b) Repayment of borrowing in $ = $ 100000*1.02 = $ 102000
(c) Rs. required for repayment of $ 1020000 at FR =102000*46.80 = Rs.4773600
Arbitrage Gain = Rs.4810100 – Rs.4773600 = Rs.36500
Question-57E [CS-June-2010-M-4] The spot exchange rate is Rs.15/€ and the three months
forward exchange rate is Rs.15.20/€. The three month interest rate is 8% per annum in India
and 5.8% per annum in Germany. Assume that you can borrow as much as Rs.15 lakh or € 10
lakh.
(i) Determine whether the interest rate parity is currently holding.
(ii) How would you carry out covered interest arbitrage? Show all steps and determine the
arbitrage profit.
Solution-57E
Today SR € 1 = Rs.15
FR of 3 months € 1 = Rs.15.20
PIR for 3 months on Rs. = 2%
PIR for 3 months on € = 1.45%
(i) IRPT exists or not
FR under IRPT (Rs./ €) = (1 + PIRRs.)*SR/(1 + PIR€) = (1.02*15)/1.0145 = Rs.15.08
Actual FR of 3 months € 1 = Rs.15.20
Comment: Actual FR and FR under IRPT is not equal, hence IRPT does not exist
Method-1
Today
1. Borrow Rs. 1500000 for 3 months @ 2%
2. Convert Rs. 1500000 into € at SR = Rs.1500000/15 = €100000
3. Invest €100000 for 3 months @ 1.45%
After 3 months
1. € receivable from investment = €100000*1.0145 = €101450
2. Convert €101450 into Rs. at FR = €101450*15.20 = Rs.1542040
3. Repayment of borrowing in Rs. = Rs.1500000*1.02 = Rs.1530000
Arbitrage profit = Rs.1542040 – Rs.1530000 = Rs.12040
Method-2 [Ignore]
Premium or discount on € [LHC] = (FR-SR)*100/SR = (15.20 – 15)*100/15 = 1.33% premium on € for 3 months
Loss of interest on € = 2% - 1.45% = 0.55%
Premium on € is more than loss of interest on €, hence investment should be made in € and borrowing should be in Rs.
Calculation of Arbitrage Profit
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.10
By above any of the method, we came to know that borrowing in Rs. and investment in € to make arbitrage profit
Method-3 [Ignore]
Return from investment in € = (1 + PIR€)*(1+Prem on €) – 1 = 1.0145*(1+0.0133) – 1 = 0.027993 = 2.799%
Hence, arbitrage return %
= Total Return from investment – Borrowing Cost
= 2.799% – 2.00% = 0.799%
Arbitrage profit in € = Amount of Borrowing*Arbitrage return = Rs. 1500000*0.799% = Rs.11985
Question-61B [SM-18] [ICWA-12] Following are the rates quoted
Rs. / BP
52.60/70
Interest Rates
India
London
3m Forward
20/70
3 months
8%
5%
6m Forward
50/75
6 months
10%
8%
Verify whether there is any scope for covered interest arbitrage.
Solution-61B
Today spot rate
BP 1 = Rs.52.60 – 52.70
3 months FR
BP 1 = Rs.52.80 – 53.40
6 months FR
BP 1 = Rs.53.10 – 53.45
Option 1 Borrow in Rs.100000 & Investment in BP
Particulars
(a) Amount Borrowed
Interest rate
(b) Convert Rs.100000 into BP at SR
(c) Invest BP 1897.53 for the period
At maturity period
(a) BP receivable at maturity period
(b) Covert BP to Rs. At FR
(c) Repayment of borrowing
Loss
(3 months)
Rs.100000
2%
100000/52.70 = 1897.53
1.25%
(6 months)
Rs.100000
5%
= 1897.53
4%
1897.53*1.0125 = BP 1921.25
1921.25*52.80 = Rs.101442
Rs.102000
Rs.557
1897.53*1.04 = BP 1973.43
1973.43*53.10 = Rs.104789
Rs.105000
Rs.210
Comment: As the amount of Re. Received is less than the amount repaid there is no scope for covered interest arbitrage
in Option 1.
Option 2 Borrow in BP 100000 and invest in Rs.
Particulars
(a) Amount Borrowed
(b) Convert BP into Rs. at SR
(c) Invest Rs. for the period
At maturity period
(a) Rs. receivable from investment
(b) Cover Rs. to BP At FR
(c) Repayment of borrowing in BP
Gain/ Loss
(3 months)
BP 100000
100000*52.60 = Rs.5260000
2%
(6 months)
BP 100000
Rs.5260000
5%
5260000*1.02 = Rs.5365200
5365200/53.40 = BP 100471.9
BP 100000*1.0125 = BP 101250
(BP 778)
5260000*1.05 = Rs.5523000
5523000/53.45 = BP 103330.20
BP 100000*1.04 = BP 104000
(BP 669.78)
Comment: Arbitrage is not possible in both option
Question-64B [Nov-2014] [M-8] Gibralater Ltd has imported 5000 bottles of shampoo at
landed cost in Mumbai, of US $ 20 each. The company has the choice for paying the goods
immediately or in 3 months time. It has a clean overdraft limited where 14% p.a rate of interest
is charged.
Calculate which of the following method would be cheaper to Gibralater Ltd.
(i)
Pay in 3 months time with interest @ 10% and cover risk forward for 3 months.
(ii) Settle now at current Spot rate and pay interest of the overdraft or 3 months.
The rates are as follows:
Spot rate
3 Month swap
(Rs./$)
60.25 - 60.55
35/25
Solution-64B
SR
3 months swap
3 Month FR
$ 1 = Rs.60.25 - 60.55
35/25 (Decreasing Order)
$ 1 = Rs.59.10 – 60.30
Chap – 10 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT-SELF PRACTICE
10D.11
Interest rate = 14%
Total payment is to be made = 5000*20 = $ 100000
Option 1: Pay immediately the bills for $ 1,00,000
Today
(i) Rs. required to pay $ 1,00,000 at today SR = $ 100000*60.55 = Rs.6055000
(ii) Take Overdraft of Rs.6055000 for 3 months @14% p.a.
(iii) Repayment of OD with interest at the end of 3 months = Rs. 6055000*1.035 = Rs.6266925
Option 2: Pay after 3 months, with interest @10% p.a.
Amount payable = $ 100000
Total payment with interest = $ 100000*1.025 = SF 102500
Rs. required to pay $ 102500 at FR = $ 102500*60.30 = Rs.6180750
Analysis – Rs. outflow is lesser in case of alternative 2, It is suggested to pay bill after 3 months.
Question-64C [May-2015] [M-5] DEF Ltd has imported goods to the extent of USD 1 crore.
The payment terms are 60 days interest free credit. For additional credit of 30 days, interest @
7.75% p.a. will be charged.
The banker of DEF Ltd has offered a 30 days loan at the rate of 9.5% p.a. Their quotes for the
foreign exchange is as follows:
SR INR/USD
62.50
60 days FR INR/USD
63.15
90 days FR INR/USD
63.45
Which one of the following options would be better?
(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier’s offer of 90 days credit.
Solution-64C
SR
60 days FR
90 days FR
USD 1 = Rs.62.50
USD 1 = Rs.63.15
USD 1 = Rs.63.45
Option 1: Pay supplier within 60 days by taking loan from bank @ 9.5% interest for 30 days
(i) Rs. required to pay USD 1cr at 60 days FR = USD 1Cr*63.15 = Rs.63.15 Cr
(ii) Take Bank Loan of Rs.63.15 cr for 30 days @ 9.5% p.a.
(iii) Repayment of Bank Loan with interest at the end of 90 days = Rs.63.15 + 63.15*0.095/12 = Rs.63.15 + 0.5 =
Rs.63.65 Cr
Option 2: Pay after 3 months, with interest @7.75% p.a. for 30 days
Amount payable = USD 1 Cr
Total payment with interest = USD 1 Cr + 1*0.0775/12 = USD 1.0065 Cr
Rs. required to pay USD 1.0065 Cr at 90 days FR = USD 1.0065*63.45 = Rs.63.86 Cr
Analysis – Rs. outflow is lesser in case of alternative I, It is suggested to pay after 60 days