Strategic Financial Management
REVISION LECTURES – STRATEGIC FINANCIAL MANAGEMENT
TOPICS COVERED:
-
Foreign Exchange Risk Management
-
Derivatives- Options & Futures
-
Currency option & Futures
-
Interest Rate Risk Management
Foreign Exchange Exposure and Risk Management
FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
Topics to be covered:
Understanding whether to work with Bid or Ask
Purchasing power parity
Interest rate parity
Swap rate & Swap Points
Cross rate calculation
Arbitrage (Triangular & Interest rate)
Hedging Techniques:
- Forwards
- Futures
- Money Market Hedge
- Leading & Lagging
Cash Management
Nostro Account / Vostro Account / Loro Account
Cancellation / Extension / Early Delivery / Delayed delivery of Forward Contracts
Foreign Exchange Exposure and Risk Management
Understanding whether to work with BID OR ASK
Q.1
ABC Ltd (India) has imported goods from John Ltd (USA) and the invoice amount is $2,50,000. The spot
rate is quoted as ₹ / $ = 71.50 / 71.60. Calculate the Rupee outflow for ABC Ltd (India) to settle the
above payable.
A.1
The Indian company has imported goods and has a payable in dollars. Hence the Indian company will
be looking to buy dollars. The dollar buying rate will be 1$ = ₹ 71.60. Hence Rupee outflow to buy
$250000 @ 1$ = ₹ 71.60 will be $250000 x ₹ 71.60 = ₹ 179,00,000.
Q.2
Noida Ltd (India) has exported goods worth $500,000 to Texas Ltd (USA). The spot rate is being
quoted as $ / ₹ = 0.0133 / 0.0145. Calculate the rupee inflow for Noida Ltd on account of the export
transaction.
A.2
The Indian Company has exported goods and has a receivable of $500,000. The company will be
looking to sell $ and buy Rupee. Since the quote given is that of Rupee and we are looking to buy
Rupees the relevant rate for buying rupees will be 1Rs = $0.0145. Hence Rupee inflow by selling
$500000 @ 1Rs = $0.0145 will be ₹ 3,44,82,759.
Q.3
Dallas Ltd (USA) has imported machinery worth ¥ 500,00,000 from Yuto Ltd (Japan). The spot rate is
being quoted as ¥ / $ = 120.10 / 120.60. Calculate the dollar outflow for Dallas Ltd to settle the
payable.
A.3
Here US company has imported machinery from Japanese company and has a payable of ¥
500,00,000. Hence the company will be looking to buy ¥ and sell Dollars. The rate quoted is of dollars
and hence the rate for selling dollars will be 1 $ = ¥ 120.10. Hence dollar outflow to buy ¥ 500,00,000
@ 1 $ = ¥ 120.10 = $4,16,320
Purchasing Power Parity
Q.4
The inflation rates in India and UK are 10% and 4% per annum respectively. If the spot rate is 1 £ = ₹
95 find the 6 month forward rate using Purchasing Power Parity.
A.4
Spot
Interest rate (p.a.)
6 month forward rate
Or
Or
Interest Rate Parity
1 £ = ₹ 95
4% 10%
£ 1.02 = ₹ 95 + 5%
£ 1.02 = ₹ 99.75
£ 1 = ₹ 97.79
Q.5
The interest rates in India and USA are 8% p.a. and 3% p.a. respectively. If the spot rate is 1$ = ₹
72.10, find the 3 month forward rate using Interest rate parity.
A.6
Spot
Interest rate (p.a.)
6 month forward rate
Or
Or
1 $ = ₹ 72.10
3% 8%
$ 1.0075 = ₹ 72.10 + 2%
$ 1.0075 = ₹ 73.542
$ 1 = ₹ 72.99
Foreign Exchange Exposure and Risk Management
Swap rate / Swap Points
Q.6
Spot rate
₹/$
3-month swap points
Calculate the 3 month Forward Rate.
A.6
Notice that the swap bid (17) is lower than swap ask (20). This implies that the swap points have to be
added to the spot rate to arrive at 3-month forward rates.
Hence 3-month forward rate will be ₹ / $ = 71.2551/71.5445
Q.7
Spot rate
₹/$
3-month swap points
Calculate the 3 month Forward Rate.
A.7
In this case notice that swap bid (20) is greater than swap ask (17). This implies that the swap points
have to be reduced from the spot price to arrive at the forward price.
Hence 3-month forward rates will be ₹ / $ = 71.2514 / 71.5408
Q.8
Spot rate
₹/$
6-month swap points
Calculate the 6 month Forward Rate.
A.8
In this case notice that the swap bid (125) is smaller than swap ask (140). This implies that the swap
points have to be added to the spot rate to arrive at the forward rate.
Hence 6-month forward rate will be ₹ / $ = 71.2659/71.5565
Q.9
Spot rate
3-month swap rate
A.9
This is a case of swap rate because the swap bid and swap ask are expressed in decimals which
represent a rate. The treatment however remains the same – since swap bid (0.1400) is greater than
swap ask (0.1450) the swap rates have to be added to the spot rate to arrive at the forward rate.
Hence 3-month forward rate will be ₹ /$
= 71.3934 / 71.6875
₹/$
=
=
71.2534/71.5425
17/20
71.2534 / 71.5425
20/17
= 71.2534 / 71.5425
125/140
= 71.2534 / 71.5425
0.1400/0.1450
Foreign Exchange Exposure and Risk Management
Cross Currency Rate Calculation
Q.10
Given quotes
₹ / £ = 96.20
€ / £ = 1.20
Find the ₹ / € quote.
A.10
Notice in this case we require £ / € - but the given quote is € / £. Hence, we need to convert the given
quote of € / £ into a £ / € quote i.e. 1/1.20
₹ / € = 80.17
Q.11
₹ / $ = 71.10 / 71.25
$ / £ = 1.27 / 1.35
Find the cross-currency rate of ₹ / £.
Given quotes
A.11
For finding bid (we use the above equation but we will use the bid figures)
For finding ask: (we use the same equation as above but now we will use the ask figures)
Hence ₹ / £ = 90.297 / 96.1875
Bankers Margin on Quotes
Q.12
Given the following interbank rate and the margins calculate the merchant rates:
Spot
₹/$
=
75.25 / 75.45
Bankers margin
0.02% / 0.05%
Foreign Exchange Exposure and Risk Management
A.12
Spot
₹/$
Bankers margin
Hence Merchant (Retail rate)
=
=
=
75.25
/ 75.45
(-) 0.02%/ (+) 0.05%
75.23 /
75.49
Arbitrages
Q.13
From the following data identify whether any arbitrage exists:
Spot
1$
=
₹ 75.00
Interest rate per annum
3%
7%
3-month forward rate
1$
=
₹ 75.60
You may assume borrowing of $100 or ₹ 100, as the case may be, to prove the arbitrage.
A.14
Step 1: Using IRP we find the theoretical forward rate:
Spot
1$
=
₹ 75.00
Interest rate p.a
3%
7%
3 Month forward rate using IRP
(
)
Or
$1.0075 = ₹ 76.3125
Or
$1
= ₹ 75.74
Step 2: Compare the theoretical forward rate with the actual forward rate
3 Month theoretical forward rate 1$
=
₹ 75.74
Actual 3 Month forward rate quoted
1$
=
₹ 75.90
Step 3: Identify the overvalued currency
From Step 2 we can clearly see that dollar is overvalued against the rupee
Note: As per IRP dollar should be worth only ₹ 75.74. But it is being quoted at ₹ 75.90
thereby making it overvalued.
Step 4: Arbitrage strategy – Borrow in undervalued currency and Invest in overvalued
currency
In this case arbitrage profits can be made by borrowing in Rupees (which is undervalued) and Invest
in dollars (which is overvalued). So let us presume a borrowing of ₹ 100.
Day 1
Borrow ₹ 100 for 3 Months at an interest
rate of 7% p.a.
Sell ₹ 100 spot at 1$ = ₹ 75 and obtain
$1.3333
Invest $1.3333 at 3% p.a for 3 months which
$1.3433
will amount to $1.3333(1+
)=
Enter into a 3 Month forward contract to sell
$1.3433 @ 1$ = ₹ 75.90
Day 90
Investment matures and we receive
Deliver $1.3433 under the forward contract
at the contracted rate of 1$ = ₹ 75.90 and
receive
$1.3433
₹ 101.96
Foreign Exchange Exposure and Risk Management
Repay Borrowings of ₹ 100 together with
interest of 7% p.a. for 3 months i.e. Rs
(
)
Hence arbitrage profit per ₹ 100
(₹ 101.75)
₹ 0.21
Point to Ponder: We are borrowing at 7% and investing at 3% and still making profits. This
proves that interest rate arbitrage in case of foreign exchange is not as simple as
borrowing at lower rate and investing at higher rate.
Q.14
The following quotes are available:
Mumbai
₹/$
76.50
London
₹/£
₹ 94.00
New York
£/$
₹ 0.85
Find the arbitrage profits that can be made on $100,000.
A.14
Since the question requires finding profit on $100,000 it is to be presumed that $ is the home
currency.
We freeze one quote which has the home currency – In this case we can free the Mumbai quote of
₹ /$ = ₹ 76.50. (Alternatively you could have also frozen the other quote which contains dollar i.e. the
New York quote of £ / 4 = 0.85. Irrespective of which dollar quote you froze, the final answer will still
be the same).
Now using the ₹ / £ and £ / $ quote we derive the ₹ / $ quote using the concept of cross currency
quotes:
₹/$=₹/£x£/$
₹ / $ = 94 x 0.85 = ₹ 79.90.
Since the derived quote of ₹ / $ = 79.90 is not equal to frozen quote of ₹ / $ = 76.50 arbitrage profits
can be made by buying $ at ₹ 76.50 (Mumbai) and selling the same at ₹ 79.90 (in the derived market)
as under
Sell 1$ in New york @ 1$ =£ 0.85 and obtain
£ 0.85
Sell £ 0.85 in London @ 1gbp = ₹ 94 and obtain
₹ 79.90
Sell ₹ 79.90 in Mumbai @ 1$ = ₹ 76.50 and obtain $1.04
Hence by selling 1$ at the beginning you are able to obtain $1.04. Therefore arbitrage profit per 1$ is
$0.04. Hence arbitrage profit per $100,000 = $4000.
Hedging Techniques
Q.15
Amar Industries Ltd has today (1-1-2019) exported goods with an invoice value of $1,00,000 due in 3
month time i.e., on 31-3-2019. Upon enquiry it has received the following rates:
Spot
₹/$
= 71.40 / 71.60
3 month forward
₹/$
= 73.10/73.20
The following quotes on the exchanges prevail on 1-1-2019 for dollar futures having a contract size of
$50,000:
Foreign Exchange Exposure and Risk Management
Future expiry month
January 2019
February 2019
March 2019
Price quoted on the exchange on
1-1-19 for futures contract
71.95 / 72.05
72.80/72.90
73.25/73.40
Margin money per
contract
₹50,000
₹55,000
₹60,000
Evaluate whether the company should enter into a forward contract or futures contract given the
following additional information:
Spot rate on 31-3-2019
₹/$
72.30
Interest rate applicable for Amar Industries Ltd is 12% p.a.
You may assume that all the futures contracts expire on the last day of the respective months.
A.15
a. Forward contract:
Rupee inflow if the company enters into a forward contract to sell $1,00,000 3 months forward @ 1$
= ₹ 73.10 will be : $100,000 x ₹ 73.10 = ₹ 73,10,000
b. Futures contract:
The company is an exporter and has a dollar receivable, it will be looking to sell dollars and buy
rupees. Since the futures being traded are dollar futures, the company will sell the dollar futures.
Further, the receivable is due on 31-3-2019 – hence the company will sell the March futures. Since
the lot size is $50,000, the company will sell 2 lots of March 2019 futures @ 1$ = ₹ 73.25. On the due
date i.e. on 31st March 2019, the futures contract will be squared off at the price at which the futures
contract will be trading on the exchange on 31st March 2019. Now, in this question the price at which
the March futures is trading on the expiry date is not given. However, since we know that on the
maturity date the price of futures will be equal to the spot price, we can solve the problem on the
assumption that the price of March futures on 31st March 2019 will be 1$ = ₹ 72.30 (which is the spot
price on 31st March 2019).
Date
1-1-2019
31-3-2019
31-3-2019
Transaction
Sell 2 contracts of March dollar futures @
Square off (i.e. Purchase) 2 contracts of March dollar futures
@
Profit on futures per 1$
Total profits on futures = 2 contracts x $50,000 x ₹ 0.95 [A]
Rupee inflow by selling $100,000 spot @ 1$ = ₹ 72.30 [B]
Total Rupee inflow [C] = [A] + [B]
Less: Interest on Margin @12% p.a. for 3 months on ₹ 1,20,000
[D]
Net Inflow on account of undertaking futures [C] –[D]
1$ = ₹ 73.25
1$ = ₹ 72.30
₹ 0.95
₹ 95,000
₹ 72,30,000
₹ 73,25,000
(₹ 3,600)
₹ 73,21,400
Hence it is beneficial to opt for futures contract since the rupee inflow is higher as compared to
futures.
Foreign Exchange Exposure and Risk Management
Q.16
Jaipur Industries Ltd has an import payable obligation of $200,000 due in 3 month time i.e. on 31-082019. It is confused as to whether to opt for forward contract or to use futures to hedge its foreign
exchange risk. The following rates prevail today i.e., 1-06-2019:
Spot
₹/$
= 70.45 / 70.65
3 month forward rate
₹/S
= 71.59 / 71.77
3 months futures (lot size $50,000) expiring on August 31st are being dealt today (i.e. 1-6-2019) @ 1$
= ₹ 71.60/71.76.
Advise Jaipur Industries Ltd whether it should hedge its foreign exchange risk by using forwards or
futures given the following additional information:
Spot rate on 31-08-2019
₹/$
= 73.05/73.10
August futures is trading on 31-8-19 on the exchange at 1$ = ₹ 73.06 / 73.11. Future contracts are
subject to margin requirement of ₹ 25,000 per contract and the cost of capital to Jaipur Industries
Ltd is 9% p.a.
A.16
a. Forward contract:
Rupee outflow to settle the payable of $200,000 if a forward contract is entered into @ 1$ = ₹ 71.77
will be : $200,000 x ₹ 71.77
= ₹ 1,43,54,000.
b. Futures contract
The company is an importer and has a dollar payable - it will be looking to buy dollars and sell rupees.
Since the futures being traded are dollar futures, the company will buy the dollar futures. Further, the
receivable is due on 31-8-2019 – hence the company will buy the August 2019 futures. Since the lot
size is $25,000, the company will buy 8 lots of August 2019 futures @ 1$ = ₹ 73.11. On the due date
i.e. on 31st August 2019, the futures contract will be squared off at the price at which the futures
contract will be trading on the exchange on 31st August 2019. Now, in this question the price at which
the August futures is trading on the expiry date is given. Hence the August futures will be squared off
(i.e. sold) on August 31st at 1$ = ₹ 73.06.
Date
Transaction
1-6-2019
Buy 8 contracts of August dollar futures @
1$ = ₹ 73.11
31-8-2019
Square off (i.e. Sell ) 8 contracts of August dollar futures @
1$ = ₹ 73.06
Loss on futures per 1$
₹ 0.05
Total Loss on futures =8 contracts x $25,000 x ₹ 0.05 [A]
(₹ 10,000)
31-8-2019
Rupee outflow for buying $200,000 spot @ 1$ = ₹ 73.10 [B]
(₹1, 46,20,000)
Total Rupee outflow [C] = [A] + [B]
(₹1, 46,30,000)
Interest on Margin @9% p.a. for 3 months on ₹ 2,00,000 [D]
(₹ 4,500)
Net outflow on account of undertaking futures [C] +[D]
(₹1, 46,34,500)
Hence it will be beneficial for the company to enter into a forward cover, as the outflow is lower.
Q.17
Pushpak Ltd has an export receivable of £ 100,000 due 3 month time i.e. 31st March 2020. The
company has decided to hedge its foreign exchange exposure by using futures contract. The following
information is available to it today (1-1-2020):
Spot
£ /₹ = 0.0105174
3 Months March futures are trading at £ /₹ =0.010384 (Lot size: ₹ 24,07,500)
Foreign Exchange Exposure and Risk Management
Margin requirement: ₹ 10,000 per lot.
Find the total inflow to the company based on the following additional information:
Spot as on 31-3-2020
₹ / £ = 0.010636
st
On 31 March 2020, the March futures are also trading at ₹ / £ = 0.010636
The relevant interest rate applicable for Pushpak Ltd is 10% p.a.
A.17
The company is an exporter and has a dollar receivable - it will be looking to sell dollars and buy
rupees. Since the futures being traded are Rupee futures (lot size is given in rupees – hence the
conclusion that futures being traded are rupee contracts), the company will buy the rupee futures. In
order to determine the number of contracts of rupee future the company should purchase, we first
need to find the rupee equivalent exposure value of £ 100,000 at the future rate of 1 ₹ = 0.010384.
Rupee equivalent exposure value of £ 100,000 @ 1Rs. = £ 0.010384
= ₹ 96,30,200
Size of each lot
= ₹ 24,07,500
Therefore, no of lots to be purchased: 96,30,200 / 24,07,500
= 4 lots
Date
Transaction
1-1-2020
Buy 4 contracts of March Rupee futures @
1 ₹ = £ 0.010384
31-3-2020
Square off (i.e. Sell ) 4 contracts of March rupee futures @
1 ₹= £ 0.010636
£ 0.000252
Profit on futures per 1 ₹
Total profits on futures = 4 contracts x ₹24,07,500 x £
£ 2426.76
0.000252 [A]
31-3-2019
Rupee inflow by selling $102426.76 spot @ 1 ₹ = £ 0.010636
₹ 96,30,196
[B]
Less: Interest on Margin @10% p.a. for 3 months on ₹ 40,000
(₹ 1,000)
[C]
Net Inflow on account of undertaking futures [B] –[C]
₹ 96,29,196
Q.18
Venus Ltd, an Indian company, has exported good having an invoice value of $200,000 to Halloween
Ltd of USA due in 3 months’ time. The spot rate is being quoted at ₹ / $ = 75.00 / 75.10. The 3-month
forward rate is quoted as ₹ / $ = 75.30 / 75.40. The interest rates for deposits and borrowings in India
and USA are as under:
Country
Deposit rate (p.a.)
Borrowing rate (p.a.)
India
7%
10%
USA
3%
6%
Advise which of the following method of hedging is most beneficial to Venus Ltd:
a. Forward contract
b. Money Market Hedge
A.18
If Forward contract is entered into:
Receivable
$200,000
Due in
3 months
3 Month forward rate for selling dollars
1$ = ₹ 75.30
Rupee Inflow if forward contract is entered into for selling $200,000 @ 1$ = ₹ 75.30 will be ₹
1,50,60,000.
Foreign Exchange Exposure and Risk Management
If Money Market Hedge (MMH) is executed:
Since we have a receivable in dollars (asset) to create a MMH we need to create a liability (i.e.
Borrow) in dollars.
Amount to be borrowed
Present Value of $200,000 @ 6% p.a for 3 months
= $197044.33
Rupee inflow by selling $197044.33 spot @ 1$ = ₹ 75 =
Add: Interest earned @ 7% p.a for 3 months =
Total Rupee Inflow under MMH
₹ 1,47,78,324.75
₹ 2,58,620.68
₹ 1,50,36,945.43
Conclusion:
Rupee inflow under forward contract
₹ 1,50,60,000
Rupee inflow under Money Market Hedge
₹ 1,50,36,945.43
Hence it is beneficial to opt for forward contract since the rupee inflow is higher under Forward
contract.
Q.19
A.19
Bronx Ltd (USA) has imported electronic goods from Otto Ltd (Germany) with an invoice value of €
100,000 due in 6 months. The spot rate is quoted at $/ € =1.13 / 1.15. The 6-month forward rate is
being quoted as $/ € = 1.20 / 1.22. The interest rates of USA and Germany are as below:
Country
Deposit rate (p.a.)
Borrowing rate (p.a.)
USA
3%
5%
German
1%
2%
Bronx Ltd (USA) is contemplating whether to enter into a forward contract or execute a Money
market hedge to protect itself from exchange risk. Advise.
If forward contract is entered into
Payable
€ 100,000
Due in
6 months
Dollar outflow for Bronx Ltd (USA) if forward contract is entered into to buy € 100,000 6 month
forwards @ 1 € = $1.22 will be:
$1,22,000
If Money Market Hedge (MMH) is executed
Since we have a payable in euros (liability) to execute MMH we need to create an asset (i.e. invest) in
euros.
Amount to be invested in euros
Present value of € 100,000 @1% p.a for 6 months
= € 99502.49
Dollar outflow to buy € 99502.49 spot @ 1 € = $1.15 will be $1,14,427.86
Add: Interest cost @ 5% p.a for 6 month
$ 2,860.70
Total dollar outflow under Money market hedge
$ 1,17,288.56
Conclusion:
Dollar outflow under forward contract
$1,22,000.00
Dollar outflow under Money Market Hedge
$1,17,288.56
Hence Money Market Hedge is preferable since the dollar outflow under MMH is lower than the dollar
outflow under forward contract.
Foreign Exchange Exposure and Risk Management
Q.20
Renuka Industries Ltd is supposed to make payment of $ 1,00,000 today when the spot rate is ₹/$ =
70/72. One month forward is available at $ 1 = Rs. 71.80/72.10 and the penal interest for late payment
would at 12% p.a. Company’s cost of capital is 15%. The company is in a dilemma as to whether make
the payment today or to have it lagged by one month. You, as the financial advisor to the company
are required to advise the company suitably showing the calculations justifying your advice.
A.20
[A] Rupee outflow if the payment is made today:
Rupee outflow to settle the payable of @100,000 @ 1$ = ₹ 72
Add: Interest cost on the outflow @ 15% p.a. for 1 month
Total outflow
₹ 72,00,000
₹ 90,000
₹ 72,90,000
[B] Rupee outflow if the payment is lagged by one month:
Amount payable
Add: Penal interest for lagging @12% p.a. for 1 month
Total payable
Rupee outflow to settle the above at 1$ = ₹ 72.10
$100,000
$1,000
$1,01,000
₹ 72,82,100
Conclusion: It is beneficial to make the payment after 1 month, since the rupee outflow in such a case
is lower than the rupee outflow of making the payment today.
Q.21
Pawan Products Ltd (PPL) has imported goods from Madison Ltd (USA) invoice value being $ 75 lakhs
and payable in 3 months’ time. The spot rate is quoted at ₹ / $ = ₹ 71.80 / ₹ 72.05 and 3-month
forward rates are quoted at ₹ / $ = 73.10/73.45. Interest rates applicable to Pawan Products Ltd are
as under:
India
USA
Deposit rate Borrowing
Deposit rate Borrowing
rate
rate
3 Months
10%
13%
4%
6%
The company can lead the payment (i.e. make the payment early), although, in such an event it will
get a discount of 3%
The company is considering 3 alternatives for hedging:
a. Enter into a forward contract.
b. Execute a Money Market Hedge
c. Opt for Leading the payment
A.21
Payable
Due in
$75, 00,000
3 months
a. Forward contract entered
Rupee outflow to settle the payable of $ 75,00,000 if forward contract is entered @ 1$ = ₹ 73.45 will
be ₹ 55,08,75,000.
b. Money Market Hedge (MMH):
Since we have a payable, to execute a Money Market Hedge, we need to invest in dollars.
Foreign Exchange Exposure and Risk Management
Amount to be invested
PV of $75,00,000 @ 4% p.a. for 3 months
$74,25,742.57
Rupee outflow to buy $74,25,742.57 spot @ 1$ = ₹ 73.45
= ₹ 54,54,20,792.10
Add: Interest @ 13% p.a. for 3 months
= ₹ 1,77,26,175.74
Total rupee outflow under MMH
= ₹ 56,31,46,967.80
Or say (rounded off) ₹ 56,31,46,968
c. Leading
Amount payable
$75,00,000
Less: Leading discount 3%
$ 2,25,000
Net Payable
$72,75,000
Rupee outflow if above payment made today @ 1$ = ₹ 73.45
= ₹ 53,43,48,750
Add: Interest on above @ 13% p.a. for 3 months
= ₹ 1,73,66,334
Total rupee outflow under leading
= ₹ 55,17,15,084
Conclusion:
Rupee outflow under forward contract
₹ 55,08,75,000
Rupee outflow under Money Market Hedge
₹ 56,31,46,968
Rupee outflow under Leading
₹ ₹ 55,17,15,084
Hence the taking a forward contract would be the cheapest option for the company.
Cash Management
Q.22
Jyoti Industries Ltd a company based in India has subsidiaries in U.S. and U.K. The subsidiaries have
forecasted that they will be having surplus funds for the next 30 days as under:
U.S.
$12.5 million
U.K.
£ 6 million
Following exchange rate information is obtained:
$/₹
£/ ₹
Spot
0.0215
0.0149
30 days forward
0.0217
0.0150
Annual borrowing/deposit rates (Simple) are available.
India 6.4%/6.2%
USA
1.6%/1.5%
UK
3.9%/3.7%
The Indian operation is forecasting a cash deficit of ₹ 500 million.
(i) Calculate the cash balance at the end of 30 days period in ₹ 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.
(b)
Cash balances are pooled immediately in India and the net balances are invested /
borrowed for the 30 days period.
(ii)Which method do you think is preferable from the parent company’s point of view?
Foreign Exchange Exposure and Risk Management
A.22
Option A: Each Company invests / finances its own cash balances / deficits
Capital
Interest
Interest for 1
rate
month
India
(₹ 5,00,000) 6.4% p.a. (₹ 2667)
USA
$12,500
1.5% p.a. $15.625
UK
£ 6,000
3.7% p.a. £ 18.50
Net cash balance at the end of 30 days in Rupees
Total
(₹ 5,02,667)
$12,515.625
£ 6,018.50
Option B: If cash balances are pooled immediately
Cash deficit in India
Cash balance brought in from:
USA: $12,500 @ 1 ₹ = $0.0215
₹ 5,81,395
UK : $6,000 @ 1 ₹ = £ 0.0149
₹ 4,02,685
Net Surplus after pooling immediately
Add: Interest earned @ 6.2% p.a. for 1 month
Net cash balance after 30 days
(figures in ‘000)
Exchange
Balance in
rate
Rupees
(₹ 5,02,667)
1₹=$0.0217 ₹ 5,76,757
1₹=£0.0150 ₹ 4,01,233
₹ 4,75,323
(₹ 5,00,000)
₹ 9,84,080
₹ 4,84,080
₹
2,501
₹ 4,86,581
Hence it is advisable to opt for Option B i.e. pool the cash balance immediately as it will result in
higher balance in rupees at the end of 30 days.
Nostro / Vostro / Loro
Q.23
Assume your bank is maintaining a Nostro Account in Euro with Deutsche Bank, Frankfurt
Opening Balance (Nostro A/c)
€ 20,000
Opening Position (over bought)
€ 15000
The following transactions were carried out:
TT Purchased
€ 1,50,000
Draft Issued
€ 20,000
Outward TT Remittance
€ 1,25,000
Purchase of Bill payable at Milan
€ 2,75,000
Forward sales
€ 2,75,000
Export Bill realised
€ 45,000.
What steps should be taken if the bank wishes to maintain a credit balance of € 70,000 in the Nostro
account and an overbought position of
A.24
Statement of Exchange Position
Particulars
Opening Position (over bought)
TT Purchases
Issue of Draft
TT Remittances
Bill Purchased
Forward sales
Total
Purchase (Long
Position)
€ 15,000
€ 1,50,000
Sales (Short
Position)
€ 20,000
€ 1,25,000
€ 2,75,000
€ 4,40,000
€ 2,75,000
€ 4,20,000
Foreign Exchange Exposure and Risk Management
Balance – over bought
(*) TT Sale Spot
€ 20,000
€ 20,000
After the TT sale spot of € 20,000, the balance in Statement of exchange position will be NIL i.e. the
position will be square.
Nostro A/c (Euro)
Particulars
Amount
Particulars
Particulars
By Opening Balance
20,000
To TT Remittance
1,25,000
By TT Purchases
1,50,000
To TT Sale (Spot) to get the
By Export bill realised
45,000
balance to the desired level of
70000 € (*)
20,000
To Bal c/d
70,000
2,15,000
2,15,000
Point to ponder: Always balance and achieve the target balance for NOSTRO ACCOUNT first and then
balance the Statement of exchange position.
Q.24
You as a dealer in foreign exchange have the following position in Pounds as on 31-8-2019.
Balance in Nostro A/c (Credit)
£ 1,00,000
Opening position (over bought)
£ 50,000
Bill on London Purchased
£ 80,000
TT forward sale
£ 60,000
Forward purchase contract cancelled
£ 30,000
TT Remittance
£ 75,000
Draft on London Cancelled
£ 30,000
What steps are to be taken if it is desired to maintain a credit balance of £ 30,000 in the Nostro
Account and keeping an overbought position of £ 10,000.
A.24
Statement of Exchange Position
Particulars
Purchase (Long
Position)
Opening Position (over bought)
£ 50,000
Bill on London Purchased
£ 80,000
TT Forward sale
Forward purchased cancelled
TT Remittance
Draft on London cancelled
£ 30,000
Total
£ 1,60,000
Balance – over sold
(*) TT Purchase Spot
£ 5,000
Sales (Short
Position)
£ 60,000
£ 30,000
£ 75,000
£ 1,65,000
£ 5,000
After the TT purchase spot of £ 5,000, the balance in Statement of exchange position will be NIL i.e.
the position will be square. However, since it is desired to keep a overbought balance of £ 10,000, the
bank should enter into a forward purchase for £ 10,000. The forward purchase will make the balance
Foreign Exchange Exposure and Risk Management
in exchange statement an overbought balance – but it will not affect the Nostro A/c since it is a
forward purchase and there is no cash movement today
Nostro A/c (Pounds)
Particulars
Amount
Particulars
Particulars
By Opening Balance
1,00,000
To TT Purchase (Spot) to get the
To TT Remittance
75,000
balance to the desired level of
5,000
30,000£ (*)
To Bal c/d
30,000
1,05,000
1,05,000
Point to ponder: Always balance and achieve the target balance for NOSTRO ACCOUNT first and then
balance the Statement of exchange position.
Cancellation /Extension / Early Delivery / Delayed Delivery of Forward Contracts
Q.25
On 15th January 2019 you as a banker booked a forward contract for $ 300,000 for your import
customer deliverable on 15th March 2019 at Rs. 75.1250. On due date customer requests, you to
cancel the contract. On this date quotation for $ in the inter-bank market is as follows:
Spot
1 $ = 75.5000 / 6000
Spot / April
3000 / 3200
Spot / May
3300 / 3500
Assuming that the flat charges for the cancellation is Rs. 100 and exchange margin is 0.10%,
then determine the cancellation charges payable by the customer.
A.25
It is given that the customer is an importer. Hence the customer would have entered into a forward
contract to buy $300,000 (i.e banker to sell) @ 1$ = ₹ 75.1250. Simultaneously the bank would have
entered into a 15th March forward contract to buy $250,000 to keep his position square.
Upon the customer seeking cancellation on the due date (on 15th March 2019), the bank will sell
$300,000 spot @ 1$ = ₹ 75.50 minus Margin 0.10% = ₹ 75.4245.
The Bank has purchased the dollars @ 1$ = ₹ 75.1250 and the same has been sold off at 1$ = ₹
75.4245. Hence the resultant profit of $300,000 x (₹ 75.4245-₹ 75.1250) = ₹89850 + ₹ 100 = ₹ 89,950
will be to the account of the customer.
Q.26
An exporter has entered into a 3-month forward contract to sell Singapore dollars S$ 50,000 at the
rate of Rs. 52.2500. However, after 2 months your customer comes to you and request cancellation of
the contract. On that date quotation for Singapore dollars in the market is as follows:
Spot
1 S$ = Rs. 52.6000 / 6500
1 month forward
1 S$ = Rs. 52.7500 / 8200
Determine the cancellation charges payable by the customer.
Foreign Exchange Exposure and Risk Management
A.26
The exporter has entered into a 3 month forward contract to sell S$ 50,000 (i.e. banker to buy) @ 1S$
= ₹ 52.25. Simultaneously the bank would have entered into a 3 month forward sell to keep its
position square.
Upon the customer seeking cancellation after 2 months (i.e. 1 month before the due date), the bank
will enter into a 1 month buy forward @ 1S$ = ₹ 52.82.
Hence the bank has sold Singapore dollars @ 1S$ = ₹ 52.2500 and purchased the same at 1S$ =
₹ 52.82. The resultant loss of S$50,000 x (₹ 52.25 – ₹ 52.82) = ₹ 28,500 will be to the account of the
customer.
Q.27
Manish Traders is an export house based in Mumbai. It has an export receivable of $10,000 due in 2
month time It enters into a forward contract to sell the export receivables @ 1$ = ₹ 72.52 and the
banker simultaneously covered himself in the interbank market at ₹ 72.59. However, on the due date,
after 2 months the exporter approaches the bank with a request for extension of the forward
contract by one month. On this date quotation of $ in the market was as follows:
Spot
₹ 72.68 / 72.72
1 month forward
₹ 72.64 / 72.74
Determine the extension charges payable by the customer assuming exchange margin of 0.10% on
buying as well as selling.
A.27
The customer being an exporter has entered into a forward contract to sell dollars @ 1$ = ₹ 72.52
(bank to buy dollars). The banker simultaneously would have entered into a 2 month forward contract
to sell dollars to keep its position square.
Upon the customer seeking extension on the due date, the bank will first have to cancel the original
contract. To do this, the bank will buy spot @ 1$ = ₹ 72.74 + 0.10% = ₹ 72.81. Hence the banker has
sold dollars @ 1$ = ₹ 72.52 and then purchased the same @ 1$ = ₹ 72.81.
The resultant loss of $10,000 x (₹ 72.52 – ₹ 72.81) = ₹ 2900 will be to the account of the customer.
The above completes the cancellation process. Now, since the customer seeks to extend the contract
by 1 month, a fresh 1 month forward contract will be entered wherein the customer (being an
importer) will buy 1 month forward @ 1$ = ₹ 72.74 + Margin 0.10% = ₹ 72.81.
Q.28
An exporter who is due to receive $10,000 in 3-month time from now i.e.1-4-19 enters into a forward
contract today (1-1-2019) to sell the dollars @ 1$ = ₹ 75.80. After a month (on 1-2-19) the exporter
delivers the dollars received under the said contract and requests the banker to settle early delivery.
The rates prevailing on 1-2-19 are as under:
Spot
₹/$
75.75 / 75.90
2 months forward ₹ / $
75.85 / 75.95
The Prime lending rate of interest may be assumed at 12% p.a.
Foreign Exchange Exposure and Risk Management
A.28
The customer, being an exporter, has entered into a 3 month forward contract to sell $10,000 @ 1$ =
₹ 75.80 (i.e. bank to buy). The banker, simultaneously, would have entered into a 3 month forward
contract to sell the dollars to maintain a square position.
On 1-2-19 upon the customer effecting the early delivery, the banker will take delivery of the dollars
and sell it spot @ 1$ = ₹ 75.75. It will simultaneously also enter into a 2 month forward contract to
buy dollars @ 1$ = ₹ 75.95. This sale of dollars spot at ₹ 75.75 and buying it 2 month forward at ₹
75.95 will result in a swap loss of $10000 x (₹ 75.75 – ₹ 75.95) = ₹ 2000 which will be recovered from
the customer.
On 1-2-19 , the bank sells the dollar at ₹ 75.75 but it will have to pay the customer the contracted
rate of ₹ 75.80. This results in blockage of funds to the extent of $10000 x (₹ 75.80 – ₹ 75.75) = ₹
500. On this funds blockage, the bank will charge interest @12% p.a. for 2 months i.e. ₹ 10.
CA Final – M2019 (Similar question)
Others
Q.29
An Indian company obtains the following quotes (₹ / $)
Spot
35.90 / 36.10
3-month forward rate
36.00 / 36.25
6-month forward rate
36.10 / 36.40
The company needs dollar funds for 6 months. Determine whether the company should borrow in
dollars or rupees given the following interest rates:
3-month Interest rate
₹: 12%, $: 6 %
6-month interest rate
₹: 11.50% $: 5.5%
Also determine what should be the rate of interest after 3 months to make the company indifferent
between 3 months borrowing and 6 months borrowing in case of:
a. Rupee borrowing
b. Dollar borrowing
Note: For the purpose of calculation, you take units of dollar and rupee as 100 each
CA Final: N-2018
A.29
a. If the company borrows in $
Assume the company borrows
$100.00
Add: Interest @ 5.5% p.a for 6 months
$2.75
Amount repayable after 6 months $102.75
Applicable 6 month forward rate ₹ 36.40
Cash outflow in Indian Rupees
₹ 3740.10
b. If company borrow equivalent amount in Indian rupees then outflow would be as under:
Equivalent amount ₹ 36.10 x 100 ₹ 3610.00
Add: Interest @ 11.50% p.a for 6 months
₹ 207.58
Cash outflow in Indian Rupees
₹ 3817.58
Foreign Exchange Exposure and Risk Management
Hence it will be beneficial to borrow in dollars since it results in a lower rupee outflow.
(ii) Let “i” be the interest rate of rupee borrowing which makes the borrowing indifferent between 3
months and 6 months:
(1+0.03)(1+i) = (1+0.0575)
Solving the above we get i = 2.67% for 3 months or 10.68% p.a.
Similarly for the dollar borrowing:
(1+0.015)(1+i) = (1+0.0275)
Solving the above we get i= 1.232% for 3 months or 4.93% p.a.
Q.30
K Ltd. currently operates from 4 different buildings and wants to consolidate its operations into one
building which is expected to cost ` 90 crores. The Board of K Ltd. had approved the above plan and to
fund the above cost, agreed to avail an External Commercial.
Borrowing (ECB) of GBP 10 m from G Bank Ltd. on the following conditions:
• The Loan will be availed on 1st April, 2019 with interest payable on half yearly rest.
• Average Loan Maturity life will be 3.4 years with an overall tenure of 5 years.
• Upfront Fee of 1.20%.
• Interest Cost is GBP 6 months LIBOR + Margin of 2.50%.
• The 6-month LIBOR is expected to be 1.05%.
K Ltd. also entered into a GBP-INR hedge at 1 GBP = INR 90 to cover the exposure on account of the
above ECB Loan and the cost of the hedge is coming to 4.00% p.a.
As a Finance Manager, given the above information and taking the 1 GBP = INR 90:
(i) Calculate the overall cost both in percentage and rupee terms on an annual basis.
(ii) What is the cost of hedging in rupee terms?
(iii) If K Ltd. wants to pursue an aggressive approach, what would be the net gain/loss for K
Ltd. if the INR depreciates/appreciates against GBP by 10% at the end of the 5 years
assuming that the loan is repaid in GBP at the end of 5 years?
Ignore time value and taxes and calculate to two decimals.
A.30
Calculation of overall cost
Interest & Margin (A)
Hedging Cost (B)
Total (A+B)
One-time fee: 1.20%
Avg duration = 3.4%
Per annum cost = 1.20%/3.4
Total Cost 7.55+0.35
3.55%
4%
7.55
0.35%
7.90%
Overall Cost in Rupee terms@ GBP 1 = 10,000,000 X 7.90% X 90
= ₹ 71,100,000
Foreign Exchange Exposure and Risk Management
(ii) Cost of Hedging in Rupee terms
₹ 13,60,000 x 90 = ₹ 12,24,00,000 or ₹ 12.24 crores
Profit or loss under aggressive approach
If INR Depreciates by 10%
Re loss per £ = 90 x 10%
Total loss on £ 10 mn
Less: Cost of hedging saved
Net Loss
₹9
₹ 90 mn
(₹ 36 mn)
₹ 54 mn
If INR Appreciates by 10%
Re gains per £ = 90 x 10%
Total gain on £ 10 mn
Add: Cost of hedging saved
Net Gain
₹9
₹ 90 mn
₹ 36 mn
₹ 126 mn