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INTERNATIONAL

FINANCE Forex Markets and Risk Associated

ABSTRACT Foreign Exchange Market is a

Market for buying and selling

Foreign Currencies

Sangapu Pranathi CA FINAL - SFM

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Contents Foreign Exchange Market ...................................................................................................................... 4

Terms used in Foreign Exchange Market ............................................................................................... 4

Equilibrium Exchange Rate .................................................................................................................... 5

Concept of Spread .................................................................................................................................. 6

Cross Rate ............................................................................................................................................... 6

Appreciation and Depreciation of Currency .......................................................................................... 6

Calculation of Forward Rates of a Currency based on Rate of Appreciation or Depreciation or from

Swap Points ............................................................................................................................................ 7

Interest Rate Parity ................................................................................................................................ 8

Purchasing Power Parity Theory ............................................................................................................ 8

Fischer Effect .......................................................................................................................................... 9

Term Arbitrage Operations .................................................................................................................... 9

Covered Interest Arbitrage .................................................................................................................... 9

Nostro, Vostro and Loro Accounts ....................................................................................................... 11

Foreign Exchange Risks ........................................................................................................................ 11

Managing Risk ...................................................................................................................................... 12

Exposure Netting .................................................................................................................................. 12

Can Forward Contracts be settled prior to the Maturity Date ........................................................... 12

Cross-Currency Roll Over ..................................................................................................................... 13

Money Market Hedge .......................................................................................................................... 13

Foreign Currency Convertible Bonds ................................................................................................... 14

Euro Convertible Bonds ........................................................................................................................ 14

Foreign Currency Risk Management .................................................................................................... 15

Illustrations – International Finance .................................................................................................... 16

Direct and Indirect Quotes ............................................................................................................... 16

Cross Currency Rates – Bid Rate/Ask Rate Determination ............................................................. 16

Computation of Gain – Cross Currency Rate ................................................................................... 17

Interest Rate Parity – Arbitrage ....................................................................................................... 17

Direct vs Cross Currency Quotes – Arbitrage Opportunity ............................................................. 18

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...................................................................................................................................................... 18

Computation of Forward Rates ....................................................................................................... 19

Evaluation of Supply Policy .............................................................................................................. 19

Evaluation of Cash Credit ................................................................................................................. 20

Measurement of Effect of Payment utilizing Cash Discount .......................................................... 20

Forward Contract – Honouring, Cancelling and Roll Over – Exporter’s Perspective ..................... 21

Renewal of Forward Contract .......................................................................................................... 24

Managing Risks – Billing Currency ................................................................................................... 24

Managing Risks using Forward Contract – Cancelling Forward Contract ....................................... 25

Interest Rate Parity .......................................................................................................................... 26

Managing Risks using Money Market Hedge .................................................................................. 27

Interest Rate Parity – Forward Discount Rates ............................................................................... 28

Interest Arbitrage ............................................................................................................................. 29

Interest Rate Parity Theory – Basics – Determination of Implied Interest Rate ............................ 30

Purchasing Power Parity Theory – Basics ........................................................................................ 31

Purchase Power Parity ..................................................................................................................... 31

Foreign Currency Risk Management – Future Spot Rates .............................................................. 31

Covered Interest Arbitrage .............................................................................................................. 32

Covered Interest Arbitrage .............................................................................................................. 33

Hedging Forex Risk – Money Market Hedge vs Forward Market Hedge ....................................... 34

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Money Market Hedge – Exporters Perspective .............................................................................. 35

Hedge for Exposure .......................................................................................................................... 36

Managing Risks – Evaluation of Alternative Hedging Tools............................................................ 36

International Finance – Risk Management – Options ..................................................................... 38

Hedging Mechanism ......................................................................................................................... 39

Foreign Exchange Exposure Risk – Profit Management .................................................................. 40

Managing Risks – Billing Currency ................................................................................................... 42

Evaluation of Foreign Project – Discount Rate ................................................................................ 42

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Foreign Exchange Market The foreign exchange market is the market in which participants are able to buy, sell, exchange and

speculate on currencies. Foreign exchange markets are made up of banks, commercial companies,

central banks, investment management firms, hedge funds, and retail forex brokers and investors.

The forex market is considered the largest financial market in the world.

The foreign exchange market – also called forex, FX, or currency market – trades currencies. Aside

from providing a floor for the buying, selling, exchanging and speculation of currencies, the forex

market also enables currency conversion for international trade and investments.

The forex market has unique characteristics and properties that make it an attractive market for

investors who want to optimize their profits.

Sectors: The Foreign Exchange Market has the following major sectors:

1. Spot Market

2. Forward and Futures Market

3. Currency Options Market

Determinants of Foreign Exchange Rates:

1. Interest Rate Differentials – Higher rate of Interest for a investment in a particular currency

can push up the demand for that currency, which will increase the exchange rate in favour of

that currency

2. Inflation Rate Differentials – Different countries have differing inflation rates, and as a

result, purchasing power of one currency will depreciate faster than currency of some other

country. This contributes to movement in exchange rate

3. Government Policies – Government may impose restriction on currency transactions.

Through RBI, the Government, may also buy or sell currencies in huge quantity to adjust the

prevailing exchange rates

4. Market Expectations – Expectations on changes in Government, changes in taxation

policies, foreign trade, inflation, etc. contributes to demand for foreign currencies, thereby

affecting the exchange rates

5. Investment Opportunities – Increase in Investment opportunities in one country leads to

influx of foreign currency funds to that country. Such huge inflow will amount to huge supply

of that currency, thereby bringing down the exchange rate

6. Speculations – Speculators and Treasury Managers influence movement in exchange rates

by buying and selling foreign currencies with expectations of gains by exploiting market

inefficiencies. The quantum of their operations affects the exchange rates.

Terms used in Foreign Exchange Market 1. Exchange Rate – It is the price of one currency quoted in terms of another currency

2. Spot Rate – It is the exchange rate applicable for an immediate settlement, i.e. the exchange

rate prevailing now

3. Forward Rate – It is the exchange rate contracted today for exchange of currencies at a

future date

4. Direct Quote – It refers to the expression of exchange rate where one unit of foreign

currency is expressed in terms of number of units of local/domestic currency

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5. Indirect Quote – It refers to quoting per unit of Local/Domestic Currency in terms of number

of units of Foreign Currency

6. Two Way Quote – Two Way Quote refers to quoting Exchange Rates by an Exchange Dealer

in terms of Buying Rate and Selling Rate

7. Bid Rate – Bid Rate is the price at which the Exchange Dealer will buy another currency. It is

also called as Buy Rate.

8. Offer Rate – Offer Rate is the Rate at which the Exchange Dealer will sell currency. It is also

called as Sell Rate or Ask Rate

9. American Quote – It refers to quoting per unit of any currency in terms of American Dollar

10. European Quote – It refers to quoting per unit of American Dollars in terms of any other

currency

Equilibrium Exchange Rate Equilibrium Exchange Rate is the one that balances the value of nation’s imports and exports. It is

based on the flow of goods and services. EER is also called as Trade Approach or Elasticities

Approach to determine the Exchange rate

Basis:

1. Higher Import – If the value of the nation’s imports exceeds the value of the nation’s

exports, then domestic currency will depreciate against the importing currency

2. Increased Demand for Forex – Import requires payment in Forex and therefore importers will

sell home currency to buy foreign currency, pushing up the demand and price of the foreign

exchange

3. Cheaper Imports – Since Foreign Currency appreciates, the nation’s exports become cheaper

to Foreign Countries. Imports become more expensive to domestic residents. This results in

increase in exports and fall in imports, until trade is balanced

4. Condition – For above purposes, exchange rate should be market determined and not

Government fixed.

Adjustment for Change in Trade Balances: The Speed of the adjustment depends on how responsive

or elastic, imports and exports are to Exchange Rate changes. Hence this approach to exchange rate

determination is called Elasticity Approach

Instruments for Change:

1. Full Employment Situation – If the nation is at or near full employment, a larger

depreciation of home currency is essential, to shift domestic resources to the production of

more exports

2. Unemployed Resource Situation – If the nation has huge amount of unemployed resources,

then the production should look out for import subtitles, to bring about an realignment in

the exchange rates

3. Government Policies – Government Policies may be required to reduce domestic

expenditure, and to release domestic resources to produce more exports and import

substitutes, and thus allow the elasticities approach to operate.

Elasticities Approach stresses on trade and flow of goods and services to determine exchange rate.

This theory explains the determination of exchange rate in the long run.

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Concept of Spread Spread is the difference between the dealer’s Ask Rate and Bid Rate.

Factors that determine the size of Spread are –

1. Stability of Exchange Rate – 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

2. Transaction Volume – 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.

Cross Rate Cross Rate denotes an exchange rate that does not involve the home 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.

When a Foreign Exchange Currency (A) is not traded locally, or no exchange rates are available in

terms of the local currency, but only in terms of some other foreign currency (B) and Currency B is

traded locally, then exchange rate can for Currency A can be obtained in terms of Local Currency.

Cross Currency using Two Way Routes: In case of Two Way Quotes, Exchange Rate between two

currencies A and B, using C should be determined as follows –

1. Bid Rate (A per unit of B) = Bid Rate of A per unit of C x Bid Rate of C per B

= Bid A/C + Bid C/B

2. Ask Rate (A per unit of B) = Ask Rate of A per unit of C x Ask Rate of C per unit of B

= Ask A/C + Ask C/B

Rule for Ascertaining Bid from Ask Rates:

1. Bid Rate (A per unit of B) = 1 ÷ Ask Rate (B per unit of A) = 1 ÷ Ask B/A

2. Ask Rate (A per unit of B) = 1 ÷ Bid Rate (B per unit of A) = 1 ÷ Bid B/A

Appreciation and Depreciation of Currency Appreciation:

1. Currency is said to have appreciated if its value has increased, i.e. an investor is required to

pay more for purchasing the currency

2. A Currency is said to be at Premium, if it is appreciating relative to another currency.

Depreciation:

1. Currency is said to have depreciated if its value has decreased, i.e. an Investor is required to

pay less for purchasing that currency

2. A Currency is said to be quoted at Discount, if it is depreciating relative to another currency

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Calculation of Forward Rates of a Currency based on Rate of Appreciation or Depreciation or from Swap Points Premium/Depreciation in Percentage:

1. Foreign Currency is Appreciating – Multiply the value of home currency by (1 + Appreciation

Percentage)

2. Foreign Currency is Depreciating – Multiply the value of Home Currency by (1 – Depreciation

Percentage)

3. Home Currency is Appreciating – Divide the value of Home Currency by (1 + Appreciation

Percentage)

4. Home Currency is Depreciating – Divide the Value of Home Currency by (1 – Depreciation

Percentage)

Home Currency Depreciation Rate ≠ Foreign Currency Appreciation Rate

Home Currency Appreciation Rate ≠ Foreign Currency Appreciation Rate

From Swap Points:

1. In case Spread is Positive – Add the Swap Points to the Spot Rate

2. In case Spread is Negative – Reduce the Swap Points from the Spot Rate

Swap Points are movement in Exchange Rate expressed in absolute terms, i.e. in value terms.

Spread = Ask Swap Less Bid Swap

Rule for ascertaining whether quoted at Premium/Discount [Based on Forward Rates]

Foreign Currency is Expressed Premium Discount

Under Direct Quote Forward Rate > Spot Rate Forward Rate < Spot Rate

Under Indirect Quote Forward Rate < Spot Rate Forward Rate > Spot Rate

Forward Rates are quoted in Terms of Swap Points:

Foreign Currency is Expressed Premium Discount

Under Direct Quote Swap Points are increasing Swap Points are Decreasing

Under Indirect Quote Swap Points are Decreasing Swap Points are Increasing

Computation of Annualized Appreciation/Depreciation:

1. For Direct Quotes = (𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆−𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆)

𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 × 𝟏𝟎𝟎 ×

𝟏𝟐 𝑴𝒐𝒏𝒕𝒉𝒔 𝒐𝒓 𝟑𝟔𝟓 𝑫𝒂𝒚𝒔

𝑷𝒆𝒓𝒊𝒐𝒅 𝒐𝒇 𝑸𝒖𝒐𝒕𝒆

Positive Result = Appreciation in %, Negative Result = Depreciation in %

2. For Indirect Quotes = (𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆−𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆)

𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 × 𝟏𝟎𝟎 ×

𝟏𝟐 𝑴𝒐𝒏𝒕𝒉𝒔 𝒐𝒓 𝟑𝟔𝟓 𝑫𝒂𝒚𝒔

𝑷𝒆𝒓𝒊𝒐𝒅 𝒐𝒇 𝑸𝒖𝒐𝒕𝒆

Positive Result = Appreciation in %, Negative Result = Depreciation in %

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Interest Rate Parity Interest rate parity is a theory in which the interest rate differential between two countries is equal

to the differential between the forward exchange rate and the spot exchange rate. Interest rate

parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange

rates and foreign exchange rates.

Other Notes on Interest Rate Parity Theory:

1. IRPT defines the relationship between the interest rates and the exchange rates of the two

countries. Under IRPT, Forward Premium or discount on a currency should be equal to the

interest rate differential between the countries concerned

2. It states that the high interest rate on a currency is offset by the forward discount, and low

interest rate is offset by forward premium.

3. It implies that the exchange rate differential will be equivalent to the interest rate

differential between the two countries, i.e. it equates interest rate differentials to Forward

Premium/Discount on the foreign currency

4. Exchange Rate Differential = Interest Rate Differential

5. 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑅𝑎𝑡𝑒

𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒=

[1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑖𝑛 𝐻𝑜𝑚𝑒 𝐶𝑜𝑢𝑛𝑡𝑟𝑦]

[1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑖𝑛 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐶𝑜𝑢𝑛𝑡𝑟𝑦]

6. IRPT plays a fundamental role in foreign exchange markets, enforcing an essential link

between short-term interest rates, spot exchange rates and forward exchange rates. It will

work well in international capital markets, where there are no restrictions for flow of funds

from one country to another, and the tax rates are similar among the countries

Purchasing Power Parity Theory Macroeconomic analysis relies on several different metrics to compare economic productivity and

standards of living between countries and across time. One popular metric is purchasing power

parity (PPP).

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies

through a market "basket of goods" approach. According to this concept, two currencies are in

equilibrium or at par when a market basket of goods (taking into account the exchange rate) is

priced the same in both countries

Exchange Rate Differential = Inflation Rate Differential

Forward Rate = [Spot Rate] x [(1 + Inflation Rate in Home Country)/(1 + Inflation Rate in Foreign

Country)]

Limitations:

1. Import and Export Restrictions – Restrictions such as quotas, tariffs and laws will makes it

difficult to buy goods in one market and sell them in another. This would mean that for

some products, there may not be comparable prices.

2. Difference in Costs – PPPT does not consider effect of transaction cost. When a comparable

product is not manufactured in one country, it is transported into it. Therefore, for some

products the transportation costs do get added up, and for some there may not be such

costs. This would mean that PPPT cannot hold good in all conditions and for all goods

3. Other Factors – Inflation alone does not affect Exchange Rates. Other factors such as

interest rates, government intervention, etc. significantly affect the exchange rates.

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Fischer Effect Fischer Effect:

1. Nominal Interest Rate comprises of real interest rate and expected rate of inflation.

Generally, the real interest rate is expected to be the same. Therefore, nominal interest rate

adjusts when the inflation rate is expected to change

2. Nominal Interest Rate will adjust to reflect to changes in inflation rates, i.e. if the inflation

rate is high, the nominal interest rate will be high. When Inflation rate is low, the nominal

interest rate will also be low.

3. 1 + Nominal Interest Rate = [1 + Real Interest Rate] x [1 + Inflation Rate]

International Fischer Effect:

1. International Capital Markets are generally perfect. Therefore, equivalent risk investments in

two countries should offer the same real rate of return. Therefore, nominal interest rate

varies to the extent inflation rate varies amongst different countries

2. Nominal Interest Rate differential must be equivalent to the expected inflation rate

differential between two countries

3. 𝟏+𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑯𝒐𝒎𝒆 𝑪𝒐𝒖𝒏𝒕𝒓𝒚

𝟏+𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒆 𝒐𝒇 𝑭𝒐𝒓𝒆𝒊𝒈𝒏 𝑪𝒐𝒖𝒏𝒕𝒓𝒚=

𝟏+𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑯𝒐𝒎𝒆 𝑪𝒐𝒖𝒏𝒕𝒓𝒚

𝟏+𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 𝒇𝒐 𝑭𝒐𝒓𝒆𝒊𝒈𝒏 𝑪𝒐𝒖𝒏𝒕𝒓𝒚

4. International Fischer Effect = Interest Rate Parity Theory = Purchasing Power Parity

Term Arbitrage Operations 1. Arbitrage is the activity of making risk less profits. Arbitrage involves buying and selling of

the same commodity in different markets

2. A Number of pricing relationships exist in the foreign exchange and other markets, whose

violation would imply the existence of arbitrage opportunities – the opportunity to make a

profit without risk or investment

3. 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 centres at

the same time or of difference between Cross Rates and Actual Rates

Covered Interest Arbitrage Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against

exchange rate risk. Covered interest rate arbitrages the practice of using favourable interest rate

differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward

currency contract. Covered interest arbitrage is only possible if the cost of hedging the exchange risk

is less than the additional return generated by investing in a higher-yielding currency. Such arbitrage

opportunities are uncommon, since market participants will rush in to exploit an arbitrage

opportunity if one exists, and the resultant demand will quickly redress the imbalance. An investor

undertaking this strategy is making simultaneous spot and forward market transactions, with an

overall goal of obtaining riskless profit through the combination of currency pairs. Covered interest

arbitrage is not without its risks, which include differing tax treatment in various jurisdictions,

foreign exchange or capital controls, transaction costs and bid-ask spreads.

It is the act of making profit by factoring the following and entering into a sequence of activities –

1. Spot Exchange Rate

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2. Forward Exchange Rate

3. Risk Free Interest Rate for Home Currency

4. Risk Free Interest Rate for Foreign Currency

Interest Rate Parity theory does not hold well based on the prevailing spot rate and the forward

rates available.

Steps in Covered Interest Arbitrage:

1. Identify Future Spot Price based on Interest Rate Parity Theory

2. Compare Future Spot Price with Forward Rate available for the period

3. If Future Spot Price > Forward Rate, i.e. Forward Rate is undervalued, Buy Forward. Sell

Spot.

Action Time Activity

Borrow Now Borrow in Foreign Currency at its Borrowing Rate

Contract Now Enter into Forward Contract for buying Foreign Currency at the Maturity Date

Convert Now Sell Foreign Currency at Spot Rate and realize the proceeds in Home Currency

Invest Now Invest the Home Currency available in Home Currency Deposits

Realize Maturity Realize the maturity value of Home Currency Deposits

Honour Maturity Honour the Forward Contract for buying Foreign Currency at Forward Rates using the Home Currency Deposit proceeds

Repay Maturity Repay the Foreign Currency Liability using the Foreign Currency bought

Gain Maturity Foreign Currency Bought Less Foreign Currency Settled

4. If Future Spot Rate < Forward Rate, i.e. Forward Rate is overvalued. Sell Forward. Buy Spot

Action Time Activity

Borrow Now Borrow in Home Currency at its Borrowing Rate

Contract Now Enter into Forward Contract for Selling Foreign Currency at the Maturity Date

Convert Now Buy Foreign Currency at Spot Rate, using the amount borrowed

Invest Now Invest the Foreign Currency available in Foreign Currency Deposits

Realize Maturity Realize the maturity value of Foreign Currency Deposits

Honour Maturity Honour the Forward Contract for selling the maturity proceeds of Foreign Currency Deposits at Forward Contract Rates to realize Home Currency

Repay Maturity Repay the Home Currency Liability using the proceeds of Forward Sale

Gain Maturity Home Currency proceeds on Forward Contract sale Less Home Currency Liability paid including interest

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Nostro, Vostro and Loro Accounts Nostro Account

Home Currency of one country is foreign currency for other country. Conversion of foreign currency

in to home currency is the fundamental of foreign exchange. Therefore in order to put through the

foreign exchange transaction, the bank which is authorized to deal in foreign exchange, maintains an

account with its overseas Bank to keep stocks of foreign currencies. Normally, such account is a

current account in the books of the overseas Bank. For example, an Indian bank authorized to deal in

foreign exchange maintain an account with overseas bank in USA in US Dollar such account

maintained in the foreign currency at foreign centre by Indian bank is said as ‘Nostro Account’ .

Nostro is an Italian word which literally means ‘Our’. So the ‘Nostro Account’ of the Indian bank with

its branch/correspondents in USA is said as ‘Our Accounts with you’.

Vostro Account

For the similarly reason, foreign bank of other country authorized to deal in foreign currency

maintains an accounts with overseas Bank to keep stocks of foreign currencies (home currency of

the country in which the overseas branches/ correspondents is situated) for the purpose of putting

through the foreign exchange transactions. For example XYZ bank of USA maintains an account with

a Bank in India in Indian Rupee such account maintained in the foreign currency at foreign centre by

foreign bank is said as ‘Vostro Account’. ‘Vostro’ is an Italian word which literally means ‘Your’. So

the ‘Vostro Account’ of the foreign bank with Indian bank in India is said as ‘YOUR Accounts with Us’.

Loro Account

The terms Nostro (Our) and Vostro (Your) are used in the bilateral correspondence between the

concerned two Banks i.e. the Bank maintaining the account and the Bank in whose book the account

is maintained. But in such correspondence when third bank account is referred it is said as LORO

account. For example when XYZ bank of India is maintaining an account with ABC Bank in New York

USA in USD when PQR bank of India refers the said account in correspondence with XZY Bank, Now

YORK it is said LORO account . LORO is an Italian word which literally means ‘Their’. Loro account

means ‘Third Party Account’.

Foreign Exchange Risks Foreign-exchange risk refers to the potential for loss from exposure to foreign exchange rate

fluctuations.

Foreign-exchange risk is similar to currency risk and exchange-rate risk.

Foreign-exchange risk is the risk that an asset or investment denominated in a foreign currency will

lose value as a result of unfavourable exchange rate fluctuations between the investment's foreign

currency and the investment holder's domestic currency.

Holders of foreign bonds face foreign-exchange risk, because those types of bonds make interest

and principal payments in a foreign currency. For example, let's assume XYZ Company is a Canadian

company and pays interest and principal on a $1,000 bond with a 10% coupon rate in Canadian

dollars (CAD). If the exchange rate at the time of purchase is $1 CAD: $1 USD, then the 10% coupon

payment is equal to $100 Canadian, and because of the exchange rate, it is also equal to US$100.

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Now let's assume a year from now the exchange rate is 1:0.85. Now the bond's 10% coupon

payment, which is still $100 Canadian, is worth only US$85. Despite the issuer's ability to pay, the

investor has lost a portion of his return because of the fluctuation of the exchange rate.

Foreign-exchange risk is an additional dimension of risk which offshore investors must accept. As a

result, open positions in non-dollar-denominated items may need to be closed. Though foreign-

exchange risk specifically addresses undesirable movements that might result in losses, it is possible

to benefit from favourable fluctuations with the potential for additional value above and beyond

that of an already-stable investment.

Managing Risk 1. Exposure netting i.e. creating an offsetting borrowing or asset. Also called Money Market

Operations

2. Forward Exchange Contracts

3. Currency Futures and Options

4. Appropriate Capital Structure

5. Diversified production, Marketing and Financing

6. Currency Swap Arrangement

Exposure Netting 1. Exposure Netting is the act of offsetting exposures in one currency with exposures in the

same or another currency

2. The objective of netting, is to offset the likely loss is one exposure, with the likely gain in

another

3. It is a form of hedging foreign exchange exposure risks. When a Firm opts for exposure

netting. It hedges its risk without taking any forward cover or options cover

Can Forward Contracts be settled prior to the Maturity Date 1. Forward Contracts can be settled only on the maturity date

2. Honouring Before Maturity Date or Cancelling Before Maturity Date:

a. Cancellation of Original Contract – Honouring the contract before the maturity date

would require the party to cancel the original contract

b. New Contract for Reversal – Cancellation of Original Contract is done by entering into

a reverse forward contract for the same maturity period. The reverse forward contract

is entered into on a date of cancellation of first contract. The rate under the reversing

contract need not be the same as the exchange rate under the original contract rate

c. Cash Settlement – Since both the contracts are maturing on the same date, and the

exchange rate difference is known now, cash settlement is done after adjusting for

expenses

3. Roll over of Forward Contract

a. This refers to a situation, when the party to the Forward Contract wishes to

postpone the performance of his obligation

b. Cancellation of Original Contract by entering into a reverse contract for the same

maturity. This is the same as cancellation discussed above

c. A Fresh Forward Contract is entered into, to postpone the performance of obligation

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Cross-Currency Roll Over 1. Cross-Currency Roll Over contracts are contracts to cover overseas leg of long-term foreign

exchange liabilities or assets

2. Roll Over charge or benefit depends on forward premium or discount, which is a function of

interest rate differentials between US dollar and the other currency

3. There is no risk of currency appreciation or depreciation in the overseas leg

4. Under the roll over contract, the basic rate of exchange is fixed, but loss or gain arises at the

time of each roll over depending upon the market conditions

5. The cover is initially obtained for six months and later extended for further period of six

months

6. Roll over for a maturity period exceeding six months is not possible, since quotes are not

available for period beyond six months, in the inter-bank market

Money Market Hedge 1. Money Market Operations refers to creating an equivalent asset or liability against a Foreign

Currency Liability or Receivable. It involves a series of transactions for taking the opposite

position

2. It involves creating an Foreign Currency Asset (Deposits) or Foreign Currency Liability

(Borrowings), based on the position it is

3. In hedging Foreign Currency risk under the Money Market Operations route, the following

steps are involved –

a. Identification of Position, i.e. whether the Firm wants to hedge its position against a

Foreign Currency Receivable [Asset] or a Foreign Currency Payable [Liability]

b. Creation of Foreign Currency Liability or Asset, such that at the time of maturity –

Foreign Currency Liability including Interest = Foreign Currency Receivables

Foreign Currency Asset including Interest = Foreign Currency Payable

Hedging against Foreign Currency Receivables:

Firm will receive foreign currency at maturity. To realize it in home currency, the Firm will SELL

Foreign Currency at Maturity

Foreign Currency Receivables is an Asset = Under Money Market Hedge, Liability in Foreign Currency

should be created Firm should borrow in Foreign Currency and Invest in Home Currency

1. Borrow Now – Borrow in Foreign Currency, at its Borrowing Rate, which including the

interest payable thereon till the maturity, will be equivalent to the Foreign Currency

Receivable at the time of maturity

Amount Borrowed = [Foreign Currency]/[1 + Borrowing Interest Rate for the period Till

Maturity]

2. Convert Now – Convert the Foreign Currency Borrowings at Spot Rate to Local/Home

Currency. Home Currency Realized = Borrowings x Bid Rate for the Foreign Currency in terms

of Home Currency

3. Invest Now – Invest the Home Currency realized in Home Currency Deposits

4. Realize on Maturity – Realize the Maturity value of Home Currency Deposits

5. Receive on Maturity – Receive the Foreign Currency Remittance from the Customer abroad

6. Repay on Maturity – Repay the Foreign Currency Loan using the inward remittance from the

Foreign Customer

14 | P a g e

Hedging against Foreign Currency Payable:

Firm will pay Foreign Currency at Maturity. To repay the Liability, the Firm will BUY Foreign Currency

at Maturity.

Foreign Currency Payable is a Liability Under Money Market Hedge, Asset in Foreign Currency

should be created Firm should borrow in Home Currency and Invest in Foreign Currency

1. Borrow now – Borrow in Home Currency, sum equivalent to amount required for investing

in Foreign Currency Deposits, which would yield at maturity, an amount equivalent to the

Foreign Currency Liability

Amount Borrowed = [Foreign Currency Payable/(1 + Forex Deposit Rate for the Period till

maturity) x Spot Ask Rate]

2. Convert Now – Convert the Home currency Borrowings into Foreign currency at Spot Rate

3. Invest Now – Invest the Foreign Currency purchased in Foreign Currency Deposits

4. Realize on Maturity – Realize the maturity value Foreign Currency Deposits

5. Settle on Maturity – Use the Maturity value of Foreign Currency Deposits to settle the

Foreign Currency Liability

6. Repay on Maturity – Repay the amount borrowed in Home Currency along with Interest

Foreign Currency Convertible Bonds A foreign currency convertible bond (FCCB) is a type of convertible bond issued in a currency

different than the issuer's domestic currency. In other words, the money being raised by the issuing

company is in the form of a foreign currency. A convertible bond is a mix between a debt and equity

instrument. It acts like a bond by making regular coupon and principal payments, but these bonds

also give the bondholder the option to convert the bond into stock.

These types of bonds are attractive to both investors and issuers. The investors receive the safety of

guaranteed payments on the bond and are also able to take advantage of any large price

appreciation in the company's stock. (Bondholders take advantage of this appreciation by means

warrants attached to the bonds, which are activated when the price of the stock reaches a certain

point.) Due to the equity side of the bond, which adds value, the coupon payments on the bond are

lower for the company, thereby reducing its debt-financing costs.

Euro Convertible Bonds A Euro-Convertible Bond (ECB) is a hybrid security with the properties of both stock and bond.

Further, since there are two currencies involved in this hybrid security, in addition to the conversion

option, there is also a currency option embedded. We employed Least Square Monte Carlo

simulation (LSM) approach developed by Long-staff and Schwartz (2001) to value ECB. The value of

conversion option and currency option embedded in ECB were extracted from the differences

between values of pure corporate bond, convertible bond (CB), and ECB. We also investigate the

effects of exchange rate volatility, stock price volatility and correlations of state variables to the

value of ECB.

15 | P a g e

Foreign Currency Risk Management LIBOR – London Inter-Bank Offered Rate

LIBOR is the rate at which various banks participate in the London Money Market for short term

investments

It is the most active interest rate market in the world. LIBOR rates vary right throughout the day and

is calculated for even short periods such as one day. London is also a major global financial centre,

and hence is relevant of transactions in major foreign currencies such as US Dollars, Swiss Franc, and

Japanese Yen. Due to the extent of activity and also due to the importance of the London Money

Market in international currency transactions, LIBOR is used in determining the price of many

financial derivatives across the world.

16 | P a g e

Illustrations – International Finance Direct and Indirect Quotes Identify whether the following are Direct Quotes or Indirect Quotes. Also provide the

corresponding Indirect/Direct Quote –

(a) Hong Kong Dollar 1 = Rs. 5.50

(b) Re. 1 = Chinese Yuan 0.19

(c) GBP 1 = Rs. 83.50

(d) Euro per Rupee = 0.0175

(e) Malaysian Ringgit [MYR] 1 = Rs. 12.50

(f) Japanese Yen [JPY] 1 = Rs. 35

Quote Nature of Quote

Explanation Inverse Quote

Hong Kong Dollar 1 = Rs. 5.50 Re. 1 = Chinese Yuan 0.19 GBP 1 = Rs. 83.50 Euro per Rupee = 0.0175 Malaysian Ringgit [MYR] 1 = Rs.12.50 Japanese Yen [JPY] 1 = Rs. 35

Direct Indirect Direct

Indirect Direct Direct

HC per unit of FC FC per unit of HC HC per unit of FC FC per unit of HC HC per unit of FC HC per unit of FC

Re. 1 = HKD 0.1818 CNY 1 = Rs. 5.2631 Re. 1 = GBP 0.0120

Euro 1 = Rs. 57.1429 Re. 1 = MYR 0.08

Re. 1 = JPY 2.8571

Cross Currency Rates – Bid Rate/Ask Rate Determination Determine the Quotes for USD/GBP and GBP/USD for the quotes available at Indian Bank –

(a) Rs./USD = Rs. 40.50 – 40.80, (b) Rs. /GBP = Rs. 80.20 – 80.60

Quote for USD/GBP:

USD/GBP = USD

Rs ×

𝑅𝑠

𝐺𝐵𝑃

𝐔𝐒𝐃

𝐑𝐬= 𝟏 ÷

𝑹𝒔

𝑼𝑺𝑫

Bid Rate = 1 ÷ Rs/USD [Ask Rate] = 1/40.80 = USD 0.024510 per Rs. 1

Ask Rate = 1 ÷ Rs./USD [Bid Rate] = 1/40.50 = USD 0.024691 per Rs. 1

USD/GBP:

Bid Rate = Bid Rate of USD/Rs. X Bid Rate of Rs/GBP

= USD 0.024510/Rs. X 80.20/GBP = USD 1.9657/GBP

Ask Rate = Ask Rate of USD/Rs. X Ask Rate of Rs./GBP

= USD 0.024691/Rs. X 80.60/GBP = USD 1.9901/GBP

Therefore, the Quote is USD/GBP = USD 1.9657 – 1.9901

Quote for GBP/USD

Bid Rate = 1/Ask Rate of (USD/GBP) = 1/1.9901 = 0.5025

Ask Rate = 1/Bid Rate of (USD/GBP) = 1/1.9657 = 0.5087

Therefore quote is GBP/USD = GBP 0.5025 – 0.5087

17 | P a g e

Computation of Gain – Cross Currency Rate You Sold Hong Kong Dollar 1,00,00,000 value Spot to your customer at Rs. 5.70 and covered

yourself in London Market in the same day, when the Exchange Rates were – USD 1 = HKD 7.5880

– 7.5920

Local Inter-Bank Market Rates for USD were – Spot USD = Rs. 42.70 – 42.85

Calculate Cover Rate and ascertain the Profit or Loss in the transaction. Ignore Brokerage.

The Bank has sold HKD to its customer. Therefore, to cover itself, the Bank would have bought HKD

from London Market. Therefore, Bid Rate is relevant. Relevant Rate for Banks opposite position is Ask

Rate,

Rs/HKD Ask Rate = Rs/USD [Ask Rate] x USD/HKD [Ask Rate]

Rs/HKD = 42.85/USD x 1/7.588 = Rs. 5.6471 per HKD

Computation of Gain or Loss

Rate at which Bank has sold HKD to customer Less: Rate at which Bank has bought HKD from London Market

Rs. 5.7000 (Rs. 5.6472)

Gain per HKD Sold Rs. 0.0528

HKD Sold 100 Lakhs

Total Gain to Bank – HKD 100 Lakhs x 0.0528 per HKD Rs. 5.28 Lakhs

Interest Rate Parity – Arbitrage Given the following information –

Exchange Rate – Canadian Dollar 0.666 per DM [Spot]

Canadian Dollar 0.671 per DM [3 Months]

Interest Rates – DM 8% p.a.

Canadian Dollar 10% p.a.

What Operations would be carried out to earn the possible arbitrage gains?

Exchange Rates Canadian Dollar/DM = Spot Rate = 0.666

3 Months Forward Rate = 0.671

Theoretical Forward Rate [Canadian Dollar/DM] = Spot Rate × 1+Canadian Dollar Interest Rate

1+DM Interest Rate

= 0.666 × 1 + [0.10 ×

3 Months12 Months]

1 + [0.08 × 3 Months

12 Months]= 0.666 × 1.025 ÷ 1.02 = 0.6693

Actual Forward Rate 0.671 > Theoretical Forward Rate 0.6693. Therefore, course of action for

arbitrage gain: Buy Spot. Sell forward as follows –

Now [Action at T0] 1. Borrow in Canadian Dollars at 10% p.a. for 3 Months 2. Convert Canadian Dollars into DM at Spot Rate 3. Invest DM at 8% p.a. for 3 Months 4. Enter into Forward at T0 for Selling DM into Canadian Dollars at T3

Later [Action at T3] 1. Realize Maturity Proceeds of DM Deposits 2. Sell/Convert DM into Canadian Dollars under Forward Contract 3. Repay Canadian Dollar Liability 4. Balance in Hand would be profit

18 | P a g e

Direct vs Cross Currency Quotes – Arbitrage Opportunity Given the following -

$/£ - 1.3670 – 1.3708 S.Fr/DEM – 1.0030 – 1.0078 $/S.Fr – 0.8790 – 0.8803

And if DEM/£ in the market are 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 profits.

Calculation of Cross Rate –

BID [DEM/£] = Bid [$/£] x Bid[S Fr/$] x Bid[DEM/S Fr] = Bid[$/£] x 1/Ask[$/SFr] x 1/Ask[SFr/DEM]

= 1.3670 x 1/0.8803 x 1/1.0078 = 1.54086

ASK [DEM/£] = Ask[$/£] x Ask[DEM/SFr] = Ask[$/£] x 1/Bid[$/SFr] x 1/Bid[SFr/DEM]

= 1.3708 x 1/0.8790 x 1/1.0030 = 1.55483

Cross Rate - DEM/£ - 1.54086 – 1.55483

Market Rate – DEM/£ - 1.556 – 1.5576

Arbitrage:

Buying Foreign Currency [Converting Home Currency into Foreign Currency]

Selling Foreign Currency [Converting Foreign Currency into Home Currency]

Direct Quote, Relevant Rate is

Ask Rate Bid Rate

Indirect Quote, Relevant Rate is

1 / Bid Rate 1 / Ask Rate

19 | P a g e

Computation of Forward Rates The United States Dollar is selling in India at Rs. 45.50. If the Interest Rate for a 6 Months

borrowing in India is 8% per annum and the corresponding rate in USA is 2%.

1. Do you expect United States Dollar to be at a premium or at discount in the Indian

Forward Market

2. What is expected 6 months forward rate for United States Dollar in India, and

3. What is the rate of Forward Premium or discount?

Premium or Discount:

Indian Interest Rate of 8% is higher than US Interest Rate of 2% per annum

Rupee is expected to weaken at a higher rate than US Dollar. Therefore, US Dollar will be quoted at a

premium in the forward market

Calculation of Forward Rate:

Forward Rate [FR] = Spot Rate × [1 + Home Currency i. e. India Rate for Forward Premium

1 + Foreign Currency Rate i. e. USD Rate for Forward Premium]

= 45.50 × 1 + 8% × 6/12

1 + 2% × 6/12= 45.50 × [

1 + 4%

1 + 1%] = 45.50 ×

1.04

1.01= 𝑅𝑠. 46.8515

Computation of Premium:

Forward Premium = Forward R𝑎𝑡𝑒 − Spot Rate

Spot Rate × 100 ×

12 Months

Forward Period

= 46.8515 − 45.50

45.50× 100 ×

12 Months

6 Months= 5.95%

Evaluation of Supply Policy A Firm is contemplating import of a consignment from the USA for a value of USD 10000. The firm

requires 90 Days to make payment. The Supplier has offered 60 Days Interest-Free credit and is

willing to offer additional 30 Days credit at an interest rate of 6% per annum. The Bankers of the

firm offer a short term loan for 30 days at 9% per annum. The Banker’s quotation for foreign

exchange is:

Spot 1 USD = RS. 46.00

60 Day Forward 1 USD = Rs. 46.20

90 Day Forward 1 USD = Rs. 46.35

You are required to advice the firm as to whether it should –

(a) Pay the supplier in 60 days, or

(b) Avail the Supplier’s offer of 90 days credit

Cash Outflows under the two options are -

Alternative 1 Alternative 2

Supplier’s Credit Bank Loan

60 Days Nil Interest 30 Days @ 9% p.a.

90Days 30 Days Credit @ 6%pa NA

Amount in USD 10000 10000

Applicable Forward Rate 46.20 46.35

Amount in INR 462000 463500

Interest in INR 3465 [462000 x 9% x 1/12]

2318 [463500 x 6% x 1/12]

Total Cash Flows Rs. 465465 Rs. 465818

Alternative 1 is better because of lower cash outflows.

20 | P a g e

Evaluation of Cash Credit Strat-up Ltd is planning to import a multi-purpose machine from Japan at a cost of 3400 Lakhs Yen.

The company can avail loans at 18% interest per annum with quarterly rests with which it can

import machine. However, there is an offer from Tokyo branch of an Indian Bank extending credit

of 180 days at 2% per annum against opening of an irrevocable letter of credit.

Other information –

1. Present Exchange Rate – Rs. 100 = 340 Yen

2. 180 Days Forward Rate – Rs. 100 = 345 Yen

3. Commission charges for Letter of Credit at 2% per 12 months

Advice whether offer from the foreign branch should be accepted.

Here Start-up Ltd has two Options –

1. Option I – Borrow amount at 18% per annum and pay for the cost of machine

2. Option II – Accept Letter of Credit and accept credit of 180 Days and pay Commission

Charges of 2% per annum.

Option – I Cash Flow under Cash Credit

Cost of Machine = Amount Borrowed = [¥ 3400 Lakhs x Rs. 100/¥ 340] = Rs. 1000

Amount Payable including Interest [Rs. 1000 x (1 + 0.18/4)2] = Rs. 1092.03

Option – II Cash Flows under Letter of Credit Option

Payable towards Letter of Credit Charges:

Amount Borrowed [by utilising Cash Credit Facility] – Rs. 10 Lakhs

(LC Commission ¥3400 Lakhs x 2% x 6/12 x 100/¥340]

Amount payable including Interest [Rs. 10 x (1 + 0.18/4)2] = Rs. 10.92 Lakhs

Payable towards LC at the end of 180 Days:

Amount payable towards LC Liability Add: Interest at 2% p.a. for 180 Days [Payable in ¥] 3400 x 2% x 180/365 Days

¥ 3400.00 ¥ 33.53

Total Amount Payable [In ¥] ¥ 3433.53

Total Amount payable in INR [¥3433.53 x Rs. 100/¥ 345] Rs. 995.23

Total Cash Outflows under LC Option = Rs. 10.92 Lakhs + Rs. 995.23 Lakhs = Rs. 1006.15 Lakhs

Total Outflows under Option II [LC Option] is lower than Cash Outflow under Option I [Cash Credit

Facility]. Therefore, LC Route should be followed.

Measurement of Effect of Payment utilizing Cash Discount A-Rev Instrument Ltd, an American Company purchased 3,00,000 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 100 marks is $ 53 [i.e. 100 Marks], the 90 days forward rate is $ 54.50

1. Compute USD cost of paying the account within 10 Days

2. Compute USD cost of buying a forward contract to liquidate the account in 90 days

3. The differential between (1) and (2) is the result of time value of money (the discount for

prepayment) and protection from currency value fluctuation. Determine the magnitude of

each of these components.

2/10, Net 90 means, the amount due should be paid within 90 Days. If paid within 10 Days, a cash

discount of 2% can be availed.

21 | P a g e

Cost of paying within 10 Days:

Amount paid = Marks 300000 x (100 – Discount 2%) x USD 53/for 100 Marks

= 300000 x 98% x 0.53 = USD 155820

Cost of Buying Forward Contract to liquidate within 90 Days:

Amount payable under Forward Contract = Marks 300000 x Forward Rate of USD 54.50/100 marks

= 300000 x 0.545 = USD 163500

Measurement of effect of Time Value of Money and Protection from Forex Fluctuation:

This is similar to measurement of Variances under Standard Costing

Effect of paying within 10 Days = USD 163500 – USD 155820 = USD 7680

Effect of Time Value of Money: It is the Discount measured in Forward Rate [since the extent of

discount represents the time value of money] Material Usage Variance

= [Amount payable in 90 Days Less Amount payable within 10 Days] x Forward Rate

= [Marks 300000 – Marks 294000] x USD 54.50/100 Marks = USD 3270

Effect of Protection from Devaluation: It is the saving in actual amount paid due to exchange rate

differences [saving due to rate differences can be measured only on actual payments] Rate

Variances

= [90 Days Forward Rate Less Spot Rate] x Amount payable within 10 Days

= [USD 54.50/100 Marks Less USD 53.00/100 Marks] x 294000 Marks = USD 4410

Forward Contract – Honouring, Cancelling and Roll Over – Exporter’s Perspective Prince Exports Limited [PEL], on 1st January 20XX entered into a 3-Month Forward Contract for

selling USD 100000. The relevant rates on various dates are –

Date Nature of Quote Quote

01.01.20XX Spot

3-Month Forward Rs. 41.50 – 41.70 Rs. 42.40 – 42.80

01.02.20XX Spot

2-Month Forward 3-Month Forward

Rs. 42.10 – 42.40 Rs. 42.30 – 42.60 Rs. 42.50 – 42.80

01.03.20XX Spot

1-Month Forward 2-Month Forward

Rs. 41.00 – 41.40 Rs. 42.00 – 42.30 Rs. 42.40 – 42.70

01.04.20XX Spot

1-Month Forward Rs. 40.50 – 40.80 Rs. 40.80 – 41.00

Explain the further course of Action if PEL –

1. Honours the contract on –

a. 01.02.20XX

b. 01.03.20XX

c. 01.04.20XX, and converts the Export Proceeds in the same date

2. Cancels the contract on –

a. 01.02.20XX

b. 01.03.20XX

c. 01.04.20XX, as the Export Proceeds did not materialize

3. Rolls over the contract for –

a. 3-Months on 01.02.20XX

b. 2-Months on 01.03.20XX

c. 1-Months on 01.04.20XX, as the Export Proceeds did not materialize

Also determine the cost/gain of that action. Ignore transaction costs.

22 | P a g e

I. Honours the Contract on -

1. 01.02.20XX

a. Original deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 2-Month Forward Contract for buying

USD 100000 at Rs. 42.60 [Forward Ask Rate] for reversal of Original Contract

c. Statement of Difference – Net Difference between the original 3-Month Forward Sell

Contract and 2-Month Forward Buy Contract should be settled i.e. USD 100000 x [3-

Month Forward Sell Rate [Bid Rate] as on 01.01.20XX Rs, 42.40 Less 2-Month Forward

Buy Rate [Ask Rate] as on 01.02.20XX Rs. 42.60] = Rs. 20000 i.e. Rs. 20000 to be paid to

Banker

d. Sell Spot – Sell the Export Proceeds of USD 100000 at the Spot Bid Rate of Rs. 42.10

e. Cost of Settlement – Rs. 20000

2. 01.03.20XX

a. Original Deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 1-Month Forward Contract for buying

USD 100000 at Rs. 42.30 [Forward Ask Rate] for reversal of Original contract

c. Settlement of differences – Net differences between the original 3-Month Forward Sell

Contract and 1-Month Forward Buy Contract should be settled i.e. USD 100000 x (3-

Month Forward Sell Rate [Bid Rate] as on 01.01.20XX Rs. 42.40 Less 1-Month Forward

Buy Rate [Ask Rate] as on 01.03.20XX Rs. 42.30) = Rs. 10000 to be received from Banker

d. Sell Spot – Sell the export proceeds of USD 100000 at the Spot Bid Rate of Rs. 41.00

e. Gain on Settlement = Rs. 10000

3. 01.04.20XX

a. No Further Action needed

b. No Gain or Loss

II. Cancels the Contract on –

1. 01.02.20XX

a. Original Deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 2-Month Forward Contract for buying

USD 100000 at Rs. 42.60 [Forward Ask Rate] for reversal of original contract

c. Settlement of Differences – Net difference between the original 3-Month Forward Sell

Contract and 2-Month Forward buy Contract should be settled i.e. USD 100000 x (3-

Month Forward Sell Rate – Bid Rate as on 01.01.20XX Rs. 42.40 Less 2-Month Forward

Buy Rate – Ask Rate as on 01.02.20XX Rs. 42.60) = Rs. 20000 to be paid to Banker

d. Cost of Cancellation – Rs. 20000

2. 01.03.20XX

a. Original Deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 1-Month Forward Contract for buying

USD 100000 at Rs. 42.30 [Forward Ask Rate] for reversal of original contract

c. Settlement of Difference – Net difference between the original 3-Month Forward Sell

Contract and 1-Month Forward Buy Contract should be settled i.e. USD 100000 x [3-

Month Forward Sell Rate – Bid Rate as on 01.01.20XX Rs. 42.40 Less 1-Month Forward

Buy Rate [Ask Rate] as on 01.03.20XX Rs. 42.30] = Rs. 10000 to be received from Banker

d. Gain on Cancellation Rs. 10000

3. 01.04.20XX

a. Original deal – Sell Contract should be cancelled

b. Buy Spot – Therefore, PEL should buy USD 100000 at the Spot Ask Rate Rs. 40.80 for

cancellation of original contract

23 | P a g e

c. Settlement of Difference – Net Difference between the original 3-Month Forward Sell

Contract and Spot Buy Contract should be settled i.e. USD 100000 x [3-Month Forward

Sell Rate – Bid Rate as on 01.01.20XX Rs. 42.40 Less Spot Ask Rate as on 01.03.20XX Rs.

40.80] = Rs. 160000 to be received from Banker

d. Gain on Cancellation – Rs. 160000

III. Rolls Over the Forward Contract to 01.05.20XX

1. 01.02.20XX

a. Original deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 2-Month Forward Contract for buying

USD 100000 at Rs. 42.60 [Forward Ask Rate] for reversal of Original Contract

c. Settlement of Differences – Net Difference between the Original 3-Month Forward Sell

contract and 2-Month Forward Buy Contract should be settled i.e. USD 100000 x [3-

Month Forward Sell Rate – Bid Rate as on 01.01.20XX Rs. 42.40 Less 2-Month Forward

Buy Rate – Ask Rate as on 01.02.20XX Rs. 42.60] = Rs. 20000 to be paid to Banker

d. Sell Forward – PEL Should sell USD 100000 at 3-Months Forward Bid Rate of Rs. 42.50

e. Cost of Rollover – Rs. 20000

2. 01.03.20XX

a. Original Deal [Sell Contract] should be cancelled

b. Buy Forward – Therefore, PEL should enter into a 1-Month Forward Contract for buying

USD 100000 at Rs. 42.30 [Forward Ask Rate] for reversal of Original contract

c. Settlement of differences – Net differences between the original 3-Month Forward Sell

Contract and 1-Month Forward Buy Contract should be settled i.e. USD 100000 x (3-

Month Forward Sell Rate [Bid Rate] as on 01.01.20XX Rs. 42.40 Less 1-Month Forward

Buy Rate [Ask Rate] as on 01.03.20XX Rs. 42.30) = Rs. 10000 to be received from Banker

d. Sell Forward – Sell the export proceeds of USD 100000 at 2-Months Forward Bid Rate of

Rs. 42.40

e. Gain on Rollover= Rs. 10000

3. 01.04.20XX

a. Original Deal [Sell Contract] should be cancelled

b. Buy Spot – Therefore, PEL should buy USD 100000 at Spot Ask Rate Rs. 40.80 for

cancellation of original contact

c. Settlement of Difference – Net Difference between the original 3-Month Forward Sell

Contract and Spot Buy Contract should be settled i.e. USD 100000 x [3-Month Forward

Sell Rate – Bid Rate as on 01.01.20XX Rs. 42.40 Less Spot Ask Rate as on 01.03.20XX Rs.

40.80] – Rs. 160000 to be received from Banker

d. Sell Forward – PEL should sell export proceeds of USD 100000 at 1-Month Forward Bid

Rate of Rs. 40.80

e. Gain on Rollover – Rs. 160000

24 | P a g e

Renewal of Forward Contract An Importer requests his Bank to extend the Forward Contract for USD 20000 which is due for

maturity on 30th October 20XX, for a further period of 3 Months. He agrees to pay the required

margin money for such extension of the contract

1. Contract Rate – USD = Rs. 42.32

2. The USD quoted on 30.10.20XX – Spot – 41.5000/41.5200, 3-Months Premium –

0.87%/0.93%

3. Margin Money for Buying and Selling Rate is 0.075% and 0.20% respectively

Compute – (a) Cost of the Importer in respect of the extension of the Forward Contract, (b) Rate of

New Forward Contract.

Importer Will Buy Foreign Currency Therefore, he would enter into a Forward Purchase

Contract Forward Ask Rate is relevant.

Three Month Forward Rate as at 30.10.20XX: assumed that the Premium rates are annualized

1. Bid Rate – Spot Bid Rate Rs. 41.50 + 0.87% x 3/12 = Rs. 41.5903

2. Ask Rate – Spot Ask Rate Rs, 41.52 + 0.93% x 3/12 = Rs. 41.6165

3. Hence, the New Forward Contract Rate – Rs. 41.6165

Course of Action:

1. Cancel Contract – Original Deal [Buy Contract] should be cancelled

2. Sell Spot – So, Importer should sell USD 20000 at the Spot Bid Rate Rs. 41.50 for cancellation

of original contract

3. Settlement of Difference – Net Difference between the original 3-Month Forward Buy

Contract and Spot Sell Contract should be settled, i.e.

USD 20000 x 3-Mnth Forward Ask Rate as on 31.10.20XX Rs. 42.32 [Payable]

Add: Margin Payable [0.075% of 846400] 846400

635

Total Payable 847035

Less Spot Bid Rate as on 30.10.20XX USD 20000 x 41.50 [Receivable] Less: Margin Payable [0.20% of 830000]

830000 (1660)

Total Receivable 828340

Net Payable by the Importer = Cost to the Importer 18695

Margin on Forward Contracts are assumed to be payable at the time of settlement.

Managing Risks – Billing Currency APCL has imported a 7-color Gravure Printing Machine from Germany costing Euro 445000. APCL

can get the invoice either Euro or Deutsche Marks 1.20 Million. 6-Month Forward Rate for Euro is

Rs. 58.50 – 58.90. Quote for 6-Month Forward Deutsche Marks (DM) is not available in India. But it

is quoted at discount against the Dollar in International Exchanges at USD 52.50 – 52.80 for every

DM 100. The Spot Rate for DM at international market is at USD 51.40 – 51.60. The rates for USD

in Mumbai is as follows – Spot Rs. 40.50 – 40.70, 6-Month Forward Rs. 41.40 – 41.70

APCL is an Importer.

Reasoning -

1. Importer will buy Foreign Currency for settlement of Foreign Currency Liability

2. The Currency of payment should depreciate for the importer to pay less in Indian Rupees.

25 | P a g e

Analysis –

1. Spot Rates for Euro is not available, therefore, conversion at the time of payment should be

compared

2. 6-Month Forward Ask Rate in Rupees for 100 Deutsche Marks (using Cross Currency

Equivalent) us Rs. 22.0176 [Rs. 41.70 per USD x USD 52.80 per 100 DM]

3. Rupee Equivalent if amount to be paid in –

a. Euro = Euro 445000 x Forward Ask Rate Rs. 58.90 per Euro = Rs. 26210500

b. DM = DM 1200000 x Forward Ask Rate Rs. 22.0176 per DM = Rs. 26421120

4. Rupee paid under Euro Option is lesser than rupee outflow under DM by Rs. 210620

Managing Risks using Forward Contract – Cancelling Forward Contract On 01.04.20XX, Rangam Entertainment concluded a contract for purchase of 1000000 Blue Ray

Discs from an American Company at $ 1.48 per Disc, to be supplied over the next 3 Months.

Rangam Entertainment are required to make the payment immediately upon receipt of all the

discs.

To meet the obligation, Rangam Entertainment had booked a Forward Contract with its bankers to

buy USD 3 Months hence. The following are the Exchange Rates on 01.04.20XX –

Spot – Rs. 41.30 – 70

3 Months Forward – Rs. 42.00 – 50

On 01.07.20XX, the American Company expressed its inability to supply the last instalment of

300000 Blue Ray Discs due to export restrictions in US, and requested Rangam to settle for the

quantity supplied. Spot Rate on 01.07.20XX was Rs. 40.90 – 41.20.

1. Ascertain the total cash outgo for Rangam for purchase of 700000 Discs

2. Would total cash outgo undergo any change if the American Company had informed on

01.06.20XX, when the following Exchange Rates were available –

Spot Rate – Rs. 41.70 – 42.20

1-Month Forward – Rs. 42.10 – 42.50

Cash Flows will be on two counts –

1. Purchase of USD for settling supply of 700000 Units of Blue Ray Discs

2. Cancellation of Forward Contract to the extent of Purchase Price of 300000 Units

American Company informs on 01.07.20XX

Amount to be paid for Supply of 700000 Discs Purchase Cost of 700000 Discs [700000 x USD 1.48 per Disc] Rupee Outflow for Purchase of USD 1036000 x 42.50 [Forward Ask Rate]

USD 1036000 Rs. 44030000

Cost/Gain on Cancellation of Forward Contract on due date Purchase Cost of 300000 Discs @ $1.48 Amount payable under Forward Contract for USD 444000 at 3-Month Forward Ask Rate of Rs. 42.50

Less: Amount on Selling USD 444000 at Spot Bid Rate Rs. 40.90 for Cancellation Cost/Gain on Cancellation

USD 444000

Rs. 18870000

(Rs. 18159600) Rs.710400

Total Cash Outflow for purchase of 700000 units of Blue Ray Discs 44030000 + 710400

44740400

1. Original Deal to Buy Contract should be cancelled

2. Sell Spot – Rangam should sell USD 444000 at the spot bid rate Rs. 40.10 for cancellation of

original contract on 01.07.20XX

3. Settlement of Differences – Net Differences between the original 3-Month Forward Buy

Contract and Spot Sale Contract should be settled i.e.

26 | P a g e

USD 444000 x [3-Month Forward Ask Rate as on 01.04.20XX Less Spot Bid Rate on

01.07.20XX

Rs. 710400 to be paid to the Banker

American Company informs on 01.06.20XX

Amount to be paid for supply of 700000 Units 44030000

Cost/Gain on cancellation of Forward Contract on 01.06.20XX Purchase Cost of 300000 Discs @ 1.48 $ Amount payable on cancellation of Forward Contract for USD 444000 at 3-Month Forward Ask Rate of Rs. 42.50 Less: Amount receivable on selling USD 440000 at 1-Month Forward Bid Rate of Rs. 42.10 for cancellation as on 01.06.20XX Cost/Gain on cancellation

USD 444000

Rs. 18870000

(Rs. 18692400)

Rs. 177600

Total Cash Outflow for purchase of 700000 units of Blue Ray Discs Rs. 44207600

1. Original Deal – Buy Contract should be cancelled

2. Sell Forward – Therefore, Rangam should enter into a 1-Month Forward contract for sale of

USD 444000 at Rs. 42.10 for reversal of original contract

3. Settlement of Difference – Net Difference between the original contract and the new

contract should be settled i.e.

USD 444000 x [3-Month Forward Ask Rate as on 01.04.2007 Rs. 42.50 Less 1-Month

Forward Sell Rate as on 01.06.20XX Rs. 42.10

Rs. 177600 to be paid to the Banker

Interest Rate Parity Singapore Dollar and Indian Rupees rates are available to you as under:

Spot Rate – 20.725 Rs/SGD

0.04825 SGD/Rs.

90 Days Rates – 20.687 Rs/SGD

0.04834 SGD/Rs

Singapore prime Interest Rate as on date is 9.5% [1 year = 365 Days]

1. Explain what is implied about the Indian Interest Rate

2. Calculate and comment on Indian Interest Rate if the forward exchange rate was 0.04795

SGD/INR

3. Calculate and comment on the 90 days forward rate on SGD if Indian Interest Rate was 8%

Implied Interest Rate -

Let Prime Interest Rate for 90 Days be x

Using Interest Parity Theory –

Forward Rate = Spot Rate x (1 + Singapore Prime Interest Rate)/(1 + Indian Interest Rate)

SGD 0.04834 = SGD 0.04825 x (1 + 0.095x90/365)/ (1 + x)

1 + x = SGD 0.04825 x (1.0234)/ SGD 0.04834

X = 1.0215 – 1 = 0.0215 = 2.15% for 90 days

Therefore, per annum Indian Interest Rate = 0.0215 x 365/90 = 8.72%

Indian Interest Rate if the Forward Exchange Rate is 0.04795 SGD/INR

Using Interest Rate Parity Theory –

Forward Rate = Spot Rate x (1 + Singapore Prime Interest Rate)/ (1 + Indian Interest Rate)

SGD 0.04795 = SGD 0.04825 x (1 + 0.095x90/365)/ (1 + x)

1 + x = SGD 0.04825 x (1.0234)/SGD 0.04795

X = 1.0298 – 1 = 0.0298 = 2.98% for 90 days

27 | P a g e

Therefore, per annum Indian Interest Rate = 0.0298 x 365/90 = 12.09%

Forward Rate if Indian Rupee rate is 8%

Forward Rate = Spot Rate x (1 + Singapore Prime Interest Rate)/ (1 + Indian Interest Rate)

= SGD 0.04825 x (1 + 0.095x90/365)/ (1 + 0.08x90/365)

= SGD 0.04825 x 1.0234/1.01973 = SGD 0.04842

Managing Risks using Money Market Hedge Aditya Enterprises have exported goods to UAE for Arab Emirates Dirham [AED] 500000 at a credit

period of 90 days. Rupee is appreciating against the AED and Aditya Enterprises is exploring

alternatives to mitigate loss due to AED Depreciation.

From the following information, analyse the possibility of Money Market Hedge -

Foreign Exchange Rates

Spot Rate 3-Month Forward Rate

Rs. 11.50 – 11.80 Rs. 11.20 – 11.40

Money Market Rates

Deposit Borrowings

AED Rupees

9% 8%

12% 10%

Aditya will sell AED 500000 in 3 Months

Money Market Hedge is possible only if the 3-Month Forward Rate is lower than value of Spot Bid in

the next three 3 Months [computed by applying AED Borrowing Rate and Rupee Deposit Rate]

Value of Spot Bid Rate in 3 Months = Spot Bid Rate × [1 + Rupee Deposit Rate for 3 Months]

[1 + AED Borrowing Rate for 3 Months]

= 𝑅𝑠. 11.50 × [1 + 8% ×

312]

[1 + 12% ×3

12]= 𝑅𝑠. 11.50 × [1 + 0.02] ÷ [1 + 0.03] = 𝑅𝑠. 11.37

Value of Spot Bid Rate Rs. 11.37 in 3 Months’ time > Forward Bid Rate of Rs. 11.20

Therefore there is a possibility for Money Market Hedge

Inference – AED 500000 receivables is an Asset Under Money Market Hedge, Liability is AED

should be created

Aditya should borrow AED for 3 Months, which along with interest would amount to AED 500000 in

3 Months.

Action Date Activity

Borrow Now

Borrow an amount of AED at 12% p.a. for 3 Months so that, the total liability including interest for 3 months, is AED 500000

AED 500000 ÷ [1 + Interest Rate for 3 Months] AED 500000 ÷ [1 + 12% x 3/12 Months] AED 500000 ÷ 1.03 = AED 485436.8932 should be borrowed

Convert Now Convert AED 98465.4321 into Rupees at Spot Rate [Bid Rate since AED is sold] AED 485436.8932 x Rs. 11.50 = Rs. 5582524

Invest Now Invest Rs. 5582824 in Rupee Deposit for 3 Months at 8% p.a.

28 | P a g e

Realize 3 Months

Hence

Realize the maturity value of rupee deposit. Amount received will be – 5582524 x [1 + Interest Rate for 3 Months] 5582524 x [1 + 8% x 3/12] 5582524 x [1.02] = Rs. 5694175

Receive 3 Months

Hence Receive the AED 500000 from the customer abroad

Repay 3 Months

Hence

Repay the AED Loan using the Money received from the customer abroad. Amount payable = amount borrowed AED 485436.8932 x [1 + 12%x3/12] = USD 485436.8932 x 1.03 = AED 500000

Amount saved by Utilizing Money Market Hedge:

Enter into 3-Month Forward Sale Contract for sale of AED 500000 at Rs. 11.20

Sell AED 500000 3 Months from now at Rs. 11.20

Amount in Hand in 3 Months = AED 500000 x Rs. 11.20 = Rs. 5600000

Amount saved under Money Market Hedge –

Under Money Market Hedge Rs. 5694175

Less: Under Forward Contract is Rs. 5600000

Amount Saved Rs. 94175

Hedging Risks using Money Market Operations will be advantageous to Aditya.

Interest Rate Parity – Forward Discount Rates The following table shows interest rates and exchange rates for the US Dollar and French Franc.

The Spot Exchange rate is 7.05 Francs per Dollar. Complete the missing entries –

3-Months 6-Months 1 Year

Euro Dollar Interest Rate [Annual] 11.50% 12.25% ?

Euro Franc Interest Rate [Annual] 19.50% ? 20%

Forward Francs per Dollar ? ? 7.52

Forward Discount on Franc [% per Year] ? (6.3%) ?

I. 3-Months Forward Rate –

Forward Rate = Spot Rate × 1 + Franc Interest rate for 3 Months

1 + Dollar Interest Rate for 3 Months

= 7.05 × 1 + 19.5% ×

312

1 + 11.50% ×3

12

= 7.05 × 1.04875

1.02875= 7.05 × 1.019441 = 𝐅𝐫 𝟕. 𝟏𝟖𝟕𝟏

II. 3-Months Forward Discount Rate –

Forward Discount Rate = [Forward Rate − Spot Rate]

Spot Rate× 100 ×

12 Months

n Months

= 7.1871 − 7.05

7.05× 100 ×

12

3= 𝟕. 𝟕𝟖% 𝐩. 𝐚.

III. 6-Months Forward Rate –

Forward Discount Rate = [Forward Rate − Spot Rate]

Spot Rate× 100 ×

12 Months

n Months

6.3% = FR − 7.05

7.05× 100 ×

12

6

Forward Rate = Fr. 7.2721

IV. 6-Months Franc Interest Rate –

29 | P a g e

Forward Rate = Spot Rate × 1 + Franc Interest rate for 3 Months

1 + Dollar Interest Rate for 3 Months

7.2721 = 7.05 × 1 +

𝑥2

1 + 12.25% ×6

12

6-Months Franc Interest Rate – 18.94% per annum

V. 1-Year Dollar Interest Rate –

Forward Rate = Spot Rate × 1 + Franc Interest rate for 3 Months

1 + Dollar Interest Rate for 3 Months

7.52 = 7.05 ×1 + 0.2

1 + 𝑥

1 Year Dollar Interest Rate = 12.5% per annum

VI. 1-Year Forward Discount Rate –

Forward Discount Rate = [Forward Rate − Spot Rate]

Spot Rate× 100 ×

12 Months

n Months

= [7.52 − 7.05]

7.05× 100 ×

12

12= 𝟔. 𝟔𝟕%

3-Months 6-Months 1 Year

Euro Dollar Interest Rate [Annual] 11.50% 12.25% 12.50%

Euro Franc Interest Rate [Annual] 19.50% 18.94% 20%

Forward Francs per Dollar 7.1871 7.2721 7.52

Forward Discount on Franc [% per Year] (7.78%) (6.3%) (6.67%)

Interest Arbitrage Calculate the Arbitrage possibilities from the following information -

Spot Rate USD = Rs. 42.0010

6 Months Forward Rate USD = Rs. 42.8020

Annualized Interest Rate on 6 Months Rupee Annualized Interest Rate on 6 Month Dollar

12% 8%

Using Interest Rate Parity Theory, Theoretical Forward Rate may be computed as follows –

Theoretical Forward Rate = 42.001 x [1 + Rupee Interest Rate]/ [1 + Dollar Interest Rate]

= 42.001 x [1 + 0.12/2]/ [1+ 0.08/2]

= 42.001 x [1.06]/[1.04]

= Rs. 42.8087/ USD

Actual Forward Rate = Rs. 42.8020/ USD

Since Theoretical Forward Rate is higher than the Actual Forward Rate, Arbitrage exists and there is

difference of 42.8087 – 42.8020 = Rs. 0.0067/USD

Hence, a person can gain by buying Dollars at the rate of [0.0067/42.001] 0.016% per Dollar of

Investment.

Activity –

1. Buy Dollars by taking loan @ 8% in US

2. Convert Dollars into Rupees at the Spot Rate of Rs. 42.001/USD

3. Invest in India @ 12% pa for 6 Months

4. Realize the investment in Rupees

5. Convert this into USD @ Rs. 42.8020

6. Repay the USD with Interest

30 | P a g e

Cash Flow:

Buy USD 1000 by taking a loan @ 8% p.a. Amount payable after 6 Months [$ 1000 + 8% for 6 Months]

USD 1040

Covert $ 1000 into Rupees Equivalent @ Rs. 42.001/USD and Amount of Rs. 42000 to be invested at 12% p.a. for 6 Months

Rs. 42000

Amount realized at the end of 6 Months from Indian Deposits Rs. 42000 + 12% for 6 Months

Rs. 44520

Equivalent Amount payable in Rupees @ Rs. 42.8020 = 44520 ÷ 42.8020 USD 1040.16

Arbitrage Gain USD 0.16

Interest Rate Parity Theory – Basics – Determination of Implied Interest Rate The Spot rate for USD at Tokyo is 135 Yen. The interest rate in Japan for 90-Days Treasury bill is

7.30% p.a. Determine the implied interest rate in USA if Forward Rare for USD is (a) 133 Yen, (b)

135 Yen, and (c) 137 Yen.

What inferences can be drawn if forward rate for USD is 140 Yen

Forward Rate of USD under Interest Rate Parity approach –

Forward Rate = Spot Rate of Yen x [1 + Interest Rate of Japan]/[1 + Interest rate of USA]

Interest rate of USA = [Spot Rate of Yen x [1 + Interest Rate of Japan]/[Forward Rate]] – 1

If Forward Rate is

133 Yen 135 Yen 137 Yen 140 Yen

For the above forward rate, implied Interest rate in USA for 90 Days is -

135 × 1.018

133− 1

3.33%

135 × 1.018

135− 1

1.80%

135 × 1.018

137− 1

0.314%

135 × 1.018

140− 1

(1.84%)

Annualized Rate [above rate x 365/90]

13.51% [3.33% x 365/90]

7.30% [1.80 x 365/90]

1.27% [0.314 x 365/90]

See Note

Note –

If the implied interest rate is negative, then the following inferences may be drawn –

Interest Rate – Not Sole determination – Interest Rate is not the sole determinant of the forward

rate. Other factors such as inflation rate, political scenario, and economic scenario are significantly

affecting the forward rates.

31 | P a g e

Purchasing Power Parity Theory – Basics On a given day, a Pen-Drive costs $ 22.84 in New York, S $ 69 in Singapore, and Ruble 3240 in

Moscow.

1. If the law of one price held, ascertain the exchange rate between the three countries?

2. The actual exchange rates on that day was USD 1 = S $ 1.63, USD 1 = Ruble 250. Where

would it be beneficial to buy the Pen-Drive?

Exchange Rates – Law of One Price = Product will cost the same anywhere

Countries – Base Currency/Foreign Currency Direct Quote Indirect Quote

Singapore/USD USD 1 = S$ 3.02 [S$69/USD 22.84]

S$ 1 = USD 0.3311 [1/3.02]

Russia/USD USD 1 = Ruble 141.8564 [Ruble 3240/USD 22.84]

Ruble 1 = USD 0.0070 [1/141.8564]

Russia/Singapore S$ 1 = Ruble 46.9565 [Ruble 3240/S$ 69]

Ruble 1 = S$ 0.0213 [1/46.9565]

Where to Buy? The Price of Pen-Drive in different countries will be converted into a common

currency base [USD] –

Place Price per Pen-Drive [in USD]

New York USD 22.84 [given]

Moscow Ruble 3240 x [1/250] = USD 12.96

Singapore S$ 69 x [1/6.3] = USD 42.3313

The Price of the Pen-Drive is least in Moscow. Therefore, Buying at Moscow should be preferred.

Purchase Power Parity Mayank Tennis Rackets cost UKP 100 in UK and 150 in The US. The current exchange rate is UKP1 =

$ 1.50.Explain what happens if inflation, which is presently 0% in both the UK and US, increases to

10% in the US?

Exchange rate in US [Purchasing Power Parity Theory] –

Exchange Rate in US = Tennis Racket in US ÷ Tennis Racket in UKP

= USD 150 ÷ UKP 100

= USD 1.50/UKP

Effect of Inflation –

Price in USD = Prevailing price x [1 + Rate of Inflation] USD 150 x (1 + 10%) USD 165

Price in UK = Prevailing Price [since there is no inflation] UKP 100

Exchange rate in US after 1 Year = USD 165/UKP 100 USD 1.65/UKP

Depreciation of USD = [1 + Inflation Rate in US]/[1 + Inflation Rate in UK] – 1 = 1.1/1 – 1 = 0.10

10%

Future Spot Rate USD/UKP = Price in US/Price in UKP in Year = 165/100 USD 1.65/UKP

Foreign Currency Risk Management – Future Spot Rates The ratio of inflation in India is 8% per annum and in the USA it is 4%. The Current Spot Rate for

USD in India is Rs. 46. What will be the expected rate after 1 year and after 4 years applying the

Purchasing Power Parity Theory?

Future Spot Rate = Spot Rate ×[1 + India Inflation rate]4

[1 + US Inflation Rate]4

One Year = 46 x 1.08/1.04 = Rs. 47.7692

Four Years = 46 x [1.08/1.04]4 = 46 x 1.3605/1.1699 = Rs. 53.4943

32 | P a g e

Covered Interest Arbitrage Ashok has a surplus cash of Rs. 1 Crore from a property sale. He has got another 6 months to

invest in another property to save Capital Gains Tax. He approaches you for investment advice for

putting his money either in rupees or US Dollars

The pertinent details are –

1. Money Market Rate in – India is 6% and in USA is 4.50%

2. Exchange Rates in India – Spot Rate - Rs. 40.30 – 40.70 and 6 Months Forward Rate – Rs.

41.90 – 42.20

Advice on the course of action and the net benefit to Ashok.

Evaluation of Proposition to invest in USD:

By comparing Theoretical Forward Rate (under Interest Rate Parity Analysis) and the actual

Forward Rates available.

Forward Rate = Spot Rate ×[1 + Indian Interest Rate]

[1 + US Interest Rate]

Forward Bid Rate = 40.30 x [1 + 6%x6/12]/ [1 + 4.50%x6/12]

= 40.30 x [1.03]/[1.0225]

= Rs. 40.59

Forward Ask Rate = 40.70 x [1 + 6%x6/12]/ [1 + 4.50%x6/12]

= 40.70 x [1.03]/ [1.0225]

= Rs. 41.00

Theoretical Forward Rate under Interest Rate Parity Theory is Rs. 40.59 – 41.00, which is not in line

with the forward rate available. Therefore, there is a possibility of arbitrage.

Theoretical Rate is less than the actual forward rates. The means that the US Dollar is expected to

appreciate at a higher pace than the differential interest rate would influence. Therefore, it is

advisable to invest in USD.

By Comparing the Actual Forward Bid Rate with the Theoretical Value of a Forward Ask Rate under

Interest Rate Parity Analysis

Spot Ask Rate is the rate at which USD can be bought for investment. Forward Ask Rate is the

theoretical value of the dollar invested. Actual Forward Bid Rates reflects the rate at which USD in

hand can be sold, if a Forward Contract is entered into. If the actual forward bid rate is more than

theoretical forward ask rate, there is scope for arbitrage by investing in USD.

Theoretical Forward Ask Rate = Rs. 41.00

Actual Forward Bid Rate = Rs. 41.90

Since the Actual Forward Bid Rate is Rs. 41.90, money invested in dollar would fetch more value than

what the differential interest rate in US and India would permit. Therefore, it is advisable to invest in

USD.

Activity Date Action

Convert INR into USD Now Convert Rs. 10000000 into USD Dollars at Spot Ask Rate = 10000000 ÷ 40.70 per USD = USD 245700.25

Invest USD Now Invest USD 245700.25 in USD Deposits carrying interest rate @ 4.50% p.a. with a maturity value of USD 251228.51 [Investment USD 245700.25 + Interest at 4.50% p.a. for 6 months USD 5528.26]

Enter into a Forward Contract

Now Enter into a Forward Contract for sale of USD 251228.51 at the Forward Bid Rate of Rs. 41.90

33 | P a g e

Realize 6 Months hence

Realize the proceeds on maturity of USD Deposits amounting to USD 251228.51

Conclude Forward Contract

6 Months hence

Convert USD 251228.51 into rupees at the Forward BID rate of 41.90 and realize Rs. 10526475

If Ashok had invested in Rupee Deposits, he would have earned Rs. 300000 [Rs. 1 Crore x 6% x 6/12].

By investing in USD Deposits and also taking a Forward Cover, he has earned Rs. 526475 [10526475 –

1000000]

Covered Interest Arbitrage Following are the rates quoted at Bombay for Pound Sterling –

Rate – INR/GBP Spot – 82.60/90

3-Month Forward – 20/70

Interest Rates [Annualized] for 3 Months India – 8%

London – 5%

Verify whether there is any scope for covered interest arbitrage by borrowing in rupee.

Alternate – 1 Outflow at the end of Period Amount borrowed in INR – Add: Interest payable – [100000 x 8% x 3/12] Outflow at the end of the Period

Rs. 100000 Rs. 2000 Rs. 102000

Inflow at the end of the Period GBP obtained by converting money borrowed at Spot Rate {Ask Rate} [100000/82.9] Invest the GBP 1206.2726 @ 5% x 3/12 Interest receivable at the end of period [£ 1206.2726 x 5% x 3/12] Total Amount Receivable in £ at the end of the period [1206.2726 + 15.078] Forward Rate [Bid Rate] – 82.60 + 0.20 Premium Convert GBP received in INR at Forward Rate – 82.80 x £ 1221.3510

£ 1206.2726 1.25% £ 15.0784 £ 1221.3510 Rs. 82.80 Rs. 101128

Total Cash Loss [102000 – 101128] Rs. 872

Cash Loss in % of Money Invested 0.872% [872/100000]

Alternate 2 Forward Rate [Bid Rate] Rate at which GBP can be sold [82.60 + 0.20 Premium]

Rs. 82.80

Estimated Future Value [Under Interest Rate Parity Analysis] 82.90 × (1 + 8% ×3

12)

(1 + 5% ×3

12)

Rs. 83.5141

Loss Per GBP Invested [without removing effect of interest on Investment]

Rs. 0.7141

Interest on Loss per GBP Invested [0.7141 x 5% x 3/12] Rs. 0.0089

Loss per GBP Invested [after removing effect of interest on GBP investment] 0.7141 + 0.0089

Rs. 0.7230

Loss per GBP Invested [0.7230/82.90] 0.872%

34 | P a g e

Hedging Forex Risk – Money Market Hedge vs Forward Market Hedge An exporter is a UK based company. Invoice amount is $ 350000.

Credit period is 3 Months.

Exchange Rates Spot Rate [$/£] 1.5865 – 1.5905

3 Month Forward Rate [$/£] 1.6100 – 1.6140

Rate of Interest in Money Market Deposit Rates

$ - 7%; £ - 5% Borrowing Rates

$ - 9%; £ - 8%

Compute and show how a money market hedge can be put in place

Compare and contrast the outcome with a forward contract

The Given quotes are indirect quotes for the USD in terms in GBP, the same when converted in terms

of GBP per USD [£/$] using the formula Bid Rate = (1 ÷ Ask Rate) is as follows –

Spot Rate – [£/$] 0.6287 – 0.6303

3-Month Forward Rate – [£/$] 0.6196 – 0.6211

The Exporter sell USD 350000 in 3 Months

Money Market Hedge is possible only if the 3-Month Forward Rate is lower than value of Spot Bid in

the next three months (computed by applying USD Borrowing Rate and GBP Deposit Rate)

𝑺𝒑𝒐𝒕 𝑩𝒊𝒅 𝒊𝒏 𝟑 𝑴𝒐𝒏𝒕𝒉𝒔’ 𝑻𝒊𝒎𝒆 = 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 ×[𝟏 + 𝑮𝑩𝑷 𝑫𝒆𝒑𝒐𝒔𝒊𝒕 𝑹𝒂𝒕𝒆 𝒇𝒐𝒓 𝟑 𝑴𝒐𝒏𝒕𝒉𝒔]

[𝟏 + 𝑼𝑺𝑫 𝑩𝒐𝒓𝒓𝒐𝒘𝒊𝒏𝒈 𝑹𝒂𝒕𝒆 𝒇𝒐𝒓 𝟑 𝑴𝒐𝒏𝒕𝒉𝒔]

= 0.6287 ×(1 + 5%𝑝. 𝑎. 𝑓𝑜𝑟 3 𝑀𝑜𝑛𝑡ℎ𝑠)

(1 + 9% 𝑝. 𝑎. 𝑓𝑜𝑟 3 𝑀𝑜𝑛𝑡ℎ𝑠)

= 0.6287 ×1.0125

1.0225= 𝐔𝐒𝐃 𝟎. 𝟔𝟏𝟗𝟔

Value of Spot Bid USD 0.6226 in 3 Months’ time > Forward Bid Rate of USD 0.6196

Therefore, there is a possibility for Money Market Hedge

USD 350000 Receivable is an Asset Under Money Market Hedge, liability in USD should be created

The Exporter should borrow USD for 3 Months, which along with Interest would amount to USD

350000 in 3 Months.

Action Date Activity

Borrow Now Borrow an amount of USD at 9% p.a. for 3 Months so that, the total liability including interest for 3 Months, is USD 350000 = USD 350000 ÷ (1 + Interest Rate for 3 Months) = USD 350000 ÷ (1 + 9% x 3/12) = USD 350000 ÷ 1.0225 = USD 342298.2885 should be borrowed

Convert Now Convert USD 342298.2885 into Rupees at Spot Rate [Bid Rate since USD is sold] = USD 342298.29 x 0.6287 = GBP 215202.93

Invest Now Invest GBP 215202.93 in Pound Deposit for 3 months at 5% p.a.

Realize 3 Months’ hence Realize the maturity value of Pound Deposit. Amount received will be – = GBP 215202.93 x [1 + Interest Rate for 3 Months] = GBP 215202.93 x [1 + 5% x 3/12] = GBP 215202.93 x [1 + 0.0125] = GBP 217892.97

Receive 3 Months’ hence Receive the USD 350000 from the customer abroad

Repay 3 Months’ hence Repay the USD Loan using the money received from the customer abroad. Amount Payable = Amount Borrowed USD 342298.2885 x (1 + 9% x 3/12) = USD 342298.2885 x 1.0225 = USD 350000

35 | P a g e

Amount saved by utilizing Money Market Hedge

Enter into 3-Month Forward Sale Contract for sale of USD 350000 at 0.6196

Sell USD 350000 3-Months from now at 0.6196

Amount in GBP in hand in 3 Months = USD 350000 x 0.6196 = GBP 216860

Amount saved under money Market Hedge

Under Money Market Hedge GBP 217893

Less Under Forward Contract GBP 216860

Amount Saved GBP 1033.00

Hedging Risks using Money Market Operations will be advantageous to the Exporter.

Money Market Hedge – Exporters Perspective An Indian exporting firm, Tamara and Bros, would be cover itself against likely depreciation of

pound sterling. The following data is given –

Receivables of Tamara and Bros - £ 500000

Spot Rate – Rs. 56.00/£

Payment Date – 3-Months

3-Months Interest Rate – India – 12% p.a. and UK – 5% p.a.

What should the Exporter do?

From the data given, it is possible to cover the Risk of Tamara and Bros by way of a money market

hedge.

The Exporter sell GBP 500000 in 3 Months

GBP 500000 Receivables in an Asset – Under Money Market hedge, liability in GBP should be created

The Exporter should borrow GBP for 3 Months, which along with interest would amount to GBP

500000 in 3 Months.

Action Date Activity

Borrow Now Borrow an amount of GBP at 5% p.a. for 3 Months so that, the total liability including interest for 3 Months, is GBP 500000 = GBP 500000 ÷ (1 + Interest Rate for 3 Months) = GBP 500000 ÷ (1 + 5% x 3/12) = GBP 500000 ÷ 1.0125 = GBP 493827.1605 should be borrowed

Convert Now Convert GBP 493827.1605 into Rupees at Spot Rate [Bid Rate since GBP is sold] = GBP 493827.1605 x 56.00 = Rs. 27654320.9877

Invest Now Invest Rs. 27654320.9877 in Rupee Deposit for 3 months at 12% p.a.

Realize 3 Months’ hence Realize the maturity value of Rupee Deposit. Amount received will be – = Rs. 27654320.9877 x [1 + Interest Rate for 3 Months] = Rs. 27654320.9877 x [1 + 12% x 3/12] = Rs. 27654320.9877 x [1 + 0.03] = Rs. 28483950.6173

Receive 3 Months’ hence Receive the GBP 500000 from the customer abroad

Repay 3 Months’ hence Repay the GBP Loan using the money received from the customer abroad. Amount Payable = Amount Borrowed GBP 493827.1605 x (1 + 5% x 3/12) = GBP 493827.1605 x 1.0125 = GBP 500000

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Hedge for Exposure A Hedger wants to hedge $ 25 Million in a 90 day Euro Dollar contract having a contract size of $ 1

Million to take care of an exposure from June 1, 20XX to August 31st, 20XX. How many contracts

should he trade?

Equivalency ratio is to be calculated since the contract period differs from the Exposure Period.

1. Period June 1, 20XX to August 31, 20XX = 92 Days

2. Contract Period = 90 Days

3. Equivalency Ratio = 92/90

Number of Contracts to be traded = Value of Portfolio x Equivalency Ratio = 25/1 x 92/90 = 25.56 =

26 Contracts

Managing Risks – Evaluation of Alternative Hedging Tools An American Company has preferred to avail the technical expertise of a Singapore based Secure

Telephone and Facsimile Communication Services Company, for which it is required to pay an

initial fee of Singapore Dollars [S $] 100000 in a months’ time. A Cash Discount of 2% is available,

if the remittance is made immediately. The Company is considering Forward Rates, Money Market

Hedge and Options for Hedging.

Evaluate the alternative hedging tools from the following information –

1. Foreign Exchange Rates –

a. Spot [US $/S $] 0.6420 – 0.6500

b. 1-Month Forward [US $/S $] 0.6320 – 0.6390

2. Options Quotes –

a. Exercise Price [US $/S $] 0.6250

b. 30-Day Call Premium = USD 0.0030 per USD

c. 30-Day Put Premium = USD 0.0100 per USD

d. Contract Size – USD 5000

3. Deposit Rates – USD 6% p.a. and SGD 12% p.a.

4. Borrowing Rates – USD 9% p.a. and SGD 15% p.a.

Forward Contract Hedge:

Liability to be settled in Singapore Dollars S$ 100000

Forward Ask Rate [US Company has to buy Singapore Dollars. Therefore, Ask Rate is relevant]

USD 0.6390

Cash Outflow in USD [SGD 100000 x USD 0.6390/SGD] USD 63900.00

Present Value of Cash Outflow – Discounted using Cost of Borrowing for USD = Cash Outflow ÷ [1 + USD Borrowing Rate for 1 Month] = USD 63900 ÷ [1 + 9% x 1/12] = USD 63900 ÷ 1.0075

USD 63424.32

Spot Settlement availing Cash Discount

Liability to be settled in Singapore Dollars Less Cash Discount at 2% [S$ 100000 x 2%]

S$ 100000 S$ 2000

Net Amount to be settled S$ 98000

Spot Ask Rate [US Company has to buy Singapore Dollars. Therefore, Ask Rate is relevant]

USD 0.6500

Cash Outflow in USD [S$ 98000 x USD 0.6500/S$] USD 63700

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Money Market Hedging

American Company has to settle S$ 100000 in one month. Therefore, it will BUY USD 100000 in 30

Days.

S$ 100000 payable is a Liability Under Money Market Hedge, asset in S$ should be created The

Company should invest in S$ for 3 Months, which along with Interest would yield S$ 100000 in 3

Months It should borrow in USD for investing in GBP

Action Date Activity

Borrow Now Borrow in USD at 9% an amount equivalent to S$ (at Spot Rate), which if invested at 12% p.a., will yield S$ 100000 in 1 Month Therefore, S$ required to be invested = S$ 100000 ÷ [1 + S$ Deposit Interest Rate for 1 Month] = S$ 100000 ÷ [1 + 12% x 1/12] = S$ 100000 ÷ [1.01] = S$ 99009.90 Amount to be borrowed = S $ to be invested x Spot Rate [Ask Rate] = S$ 99009.90 x USD 0.65/S$ = USD 64356.44

Convert Now Convert USD 64356.44 into S$ at Spot Rate [Ask Rate since S$ is bought] = USD 64356.44 ÷ USD 0.6500/S$ = S$ 99009.90

Invest Now Invest S$ 99009.90 in S$ Deposit for 1-Month at 12% p.a.

Realize 30-Days’ hence Realize the maturity value of S$ Deposit. Amount received will be S$ 100000

Receive 30-Days’ hence Settle the S$ 100000 liability to the Singapore vendor using the maturity proceeds of the S$ Deposits

Repay 30-Days’ hence Repay the USD Loan. Amount Payable = Amount Borrowed USD 64356.44 x [1 + 9% x 1/12] = USD 64356.11 x 1.0075 = $ 64839.11

Options

S$ 100000 payable in one month’s time is a liability. Therefore, the American Company will buy S$

100000by SELLING USD in 1 Month.

S$ 100000 is a Liability under Option Route, the American Company will buy S$ 100000 in a

months’ time and sell USD The Company should take PUT Option [Right to Sell] for selling USD in

1 Month

Number of Option Contracts required

Liability to be settled in Singapore Dollar S$ 100000

Exercise Price USD 0.6250

USD Required [Liability S$ 100000 x Exercise Price USD 0.6300/S$] USD 62500

Contract Size USD 5000

Therefore, Number of Contracts required [USD required 63000 ÷ Contract Size 5000 = 12.5, rounded off to]

13

USD Outflow in Option Transaction

Value of Contract [No. of Contracts 13 x Contract Size USD 5000] Add Premium Payable [Contract Value USD 65000 x Premium Rate USD 0.0100]

USD 65000.00 USD 650.00

Total Cash Outflow under Option Route USD 65650.00

S$ Receivable for 13 Contracts at Exercise Price of USD 0.6250/S$ = Contract Value USD 65000 ÷ 0.6250/S$] Less S$ Required to settle vendor liability

S$ 104000.00

S$ 100000.00

Excess S$ in Hand [to be converted into USD] S$ 4000.00

Forward Bid Rate [USD/SGD] USD 0.6320

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Conversion of S$ in hand into USD [S$ 4000 x USD 0.6320] USD 2528.00

Net Cash Outflow under Option Route [USD 65650 – USD 2528] USD 63122.00

Net Cash Outflow after one month [USD 65000 – USD 2528] USD 62472.00

Present Value of Cash Outflow after 1-Month [Discounted at USD Borrowing Rate of 9%] = USD 62472.00 ÷ [1 + 9% p.a. for one month] = USD 62472 ÷ [1+0.0075] Present Value of Premium Outflow

USD 62006.95

USD 650.00

Present Value of USD Outflow under Option Transaction USD 62656.95

Evaluation of Alternatives –

Present Value of USD Ranking

Forward Market Hedge USD 63424.32 2

Spot Settlement USD 63700.00 3

Money Market Hedge [Amount borrowed in USD] USD 64356.44 4

Option Contract USD 62656.95 1

The American Company should prefer the Option Contract Route for settling the S$ Liability of

100000 as it has the lowest USD Outflow.

International Finance – Risk Management – Options A Ltd of UK has imported some chemical worth of USD 364897 from one of the US Suppliers. The

amount is payable in six months’ time. The relevant Spot and Forward Rate 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 Deposit Rates are 5.5% and

4.5% respectively.

Currency options are available under which one option contract is for GBP 12500. The Option

premium for GBP at a Strike Price of UDS 1.70/GBP is USD 0.037 [Call] and USD 0.096 [Put] for 6

months period. The Company has 3 Choices – (a) Forward Cover; (b) Money Market Cover; and (c)

Currency Option.

Which of the alternative is preferable by the Company?

Computation of Forward Cover Cash Flow

Given Quote is Indirect Quote. Forward Rates under Direct Quote is –

Bid Rate = 1 ÷ Indirect Ask Rate = 1 ÷ 1.5609 = 0.6407

Ask Rate = 1 ÷ Indirect Bid Rate = 1 ÷ 1.5455 = 0.647

A Ltd is an Importer. Therefore, he should buy Foreign Currency. Hence, Forward Ask Rate is

relevant. Therefore, GBP payable for acquiring USD 364897 x 0.6470 = GBP 236088.36

Computation of Money Market Cover Cash Flow

Importer – There is an existing Foreign Currency Liability Therefore, Foreign Current

Asset/Receivable should be acquired by borrowing in Home Currency as follows –

Action Time Description

Borrow Now Borrow in GBP at 7% an amount equivalent to USD, which if invested at 4.5%, will yield USD 364897 in 6 Months Therefore, USD to be invested = 364897 ÷ [1 + 4.5 x 6/12] = 364897 ÷ 1.0225 = USD 356867.48 Amount to be borrowed = USD to be invested x Spot Rate = USD 356867.48 x 1/1.5617 = GBP 228512.19 should be borrowed at 7% p.a.

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Convert Now Acquire USD out of borrowings of GBP 228512.19. USD received = USD 356867.48

Invest Now Invest USD 356867.48 in USD Deposits for 6 Months at 4.5% p.a.

Realize 6 Months Realize the Maturity value of USD Deposit along with interest. Amount Received = USD 364897

Settle 6 Months Settle the USD 364897 Liability to the US Vendor

Repay 6 Months Repay the GBP Loan with Interest = GBP 228512.19 x (1 + 7% x 6/12) = GBP 236510.12

Options Contract

Importer – Should pay Foreign Currency Liability – Therefore, Foreign Currency should be purchased –

Therefore, Home Currency should be sold – Therefore, relevant GBP Options = Put Options

I. Number of Options Contract

GBP to be sold = USD required 364897 ÷ Exercise Price 1.70 = GBP 214645.29

Number of Contracts = GBP Required ÷ Lot Size = 214645.29 ÷ 12500 = 17 Contracts

II. Number of USD to be acquired on Forward Contract

Total USD 364897 Less USD under Options 17 Contracts x 12500 GBP x USD 1.7 per GBP

= 364897 less 361250 = USD 3647

Cost of buying USD in Forward Market = USD 3647 x 0.6470 = GBP 2359.61

III. Premium payable for Options Contract

Options Contract 17 x Lot size GBP 12500 x Put Option Premium 0.096 = USD 20400

Premium payable Today in GBP (based on Spot Rate) = USD 20400 x 1/1.5617 = GBP 13062.69

Premium on Future Value Terms (based on GBP Borrowings for the above) = 13062.69 x 1.035 =

GBP 13519.88

IV. Total Cost under Options Contract

Upon Exercise of Options Contract (12500 x 17) GBP 212500.00

Forward Contract for Balancing USD GBP 2359.61

Premium GBP 13519.88

Total GBP 228379.49

Outflow in GBP terms is lowest under Options Contract. Therefore, Options Contract may be

preferred.

Hedging Mechanism The Finance Director of Jenna Ltd has been studying exchange rates and interest rates relevant to

India and USD. Jenna Ltd has purchased goods from the US Co., at a cost of $51 Lakhs payable in

dollars in three months’ time. In order to maintain profit margins the finance director wishes to

adopt, if possible, a risk free strategy that will ensure that the cost of the goods to Jenna Ltd., is no

more than Rs. 22 Crores.

Exchange Rates Bid Rates [INR/USD] Ask Rates [INR/USD]

Spot Rate 1 Month Forward 3 Months Forward

40.00 41.00 42.00

42.00 43.00 45.00

Interest Rates [available to Jenna Ltd]

Deposit Rates Borrowing Rates

India 1 Month

13%

15%

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3 Months’ 13% 16%

USA 1 Month 3 Months

7% 8%

10% 11%

Calculate whether it is possible for Jenna Ltd, to achieve a cost directly associated with this

transaction of no more than Rs. 22 Crores by means of a Forward Market Hedge, or Money Market

Hedge

Transactions costs may be ignored

Forward Market Hedge

Forward Markey Hedge is possible only if amount payable at Forward (Ask) Rate is lower than Rs. 22

Crores

Amount payable after 3 Months = USD 51 Lakhs x Rs. 45.00 (Forward Ask Rate) = Rs. 22.95 Crores

Since, the amount payable under Forward Rate is more than the desired level of Rs. 22 Crores, there

is no Forward Market Hedge

Money Market Hedge

Money Market Hedge is possible only in case of difference in rates of interest for borrowing and

investing.

Steps involved –

1. Borrow rupee equivalent of money to be invested at 16% p.a. for 3 months

2. Convert the money borrowed in Rupee to USD at Spot Rate [Bid]

3. Invest USD so converted in Dollar Deposits at 8% p.a. for 3 Months

4. Realize the Deposit including Interest and use the proceeds to settle the liability

Cash Flow

Amount payable after 3 Months USD 51.00 Lakhs

Amount to be invested @ 8% p.a. for realizing USD 51.00 Lakhs = USD 51 ÷ [1 + Interest Rate of 8% p.a. x 3/12] = 51.00 ÷ 1.02

USD 50.00 Lakhs

Amount to be borrowed = Amount to be Invested in USD 50.00 Lakhs x Spot Ask Rate Rs. 42.00/$

Rs. 2100.00 Lakhs

Interest Payable on Money Borrowed @ 16% p.a. for 3 Months = Rs. 21 Crores x 16% p.a. x 3/12

Rs. 84.00 Lakhs

Amount payable [Amount Borrowed Rs. 2100 + Interest Rs. 84] Rs. 2184.00 Lakhs

Since the amount payable is Rs. 21.84 Crores, i.e. less than Rs. 22 Crores, it is advisable to go by

Money Market hedge

Foreign Exchange Exposure Risk – Profit Management An Automobile company in Gujarat exports its goods to Singapore at a price of SGD 500 per unit.

The company also imports components from Italy and the cost of components for each unit is €

200. The company’s CEO executed an agreement for the supply of 20000 units on 01.01.2010 and

on the same date paid for the imported components. The Company’s variable cost of producing

per unit is Rs. 1250 and the allocable fixed costs of the company are Rs. 10000000.

The Exchange Rate as on 01.01.2010 were as follows -

Spot INR/SGD 33.00/33.04

INR/€ 56.49/56.56

Mr. A, the treasury manager of Company is observing the movements of Exchange Rates on a day

to day basis and his expected that the rupee would appreciate against SGD and would depreciate

against €. As per his estimates the following are expected rates for 30.06.2010.

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Spot INR/SGD 32.15/32.21

INR/€ 57.27/57.32

You are required to find out:

1. The Change in profitability due to transaction exposure for the contract entered into

2. How many units should the company increases its sales in order to maintain the current

profit level for the proposed contract in the end of June 20XX.

Company’s Existing Profits

Sales – 20000 x SGD 500 x Spot Bid Rate Rs. 33 Less: Variable Cost

Raw Material [Imported 20000 x €200 x Spot Ask Rs. 56.56 Manufacturing Cost [20000 x Rs. 1250] Fixed Cost

226240000 25000000 10000000

330000000

261240000

Existing Profit 68760000

Company’s Revised Profit [Due to Exchange Rate Fluctuation]

After Rupee appreciation against SGD and depreciation against €, the company’s profitability will be

Option A: Liability for Imported Units are paid immediately [As given in the question]

Sales [20000 Units x SGD 500 x Future Bid Rate Rs. 32.15 Less: Variable Cost

Raw Material [Imported 20000 x € 200 x Spot Ask Rs. 56.56 Manufacturing Cost [20000 Units x Rs. 1250] Fixed Cost [given]

226240000 25000000 10000000

321500000

261240000

Revised Profit 60260000

Reduction in Profit = Existing 68760000 Less Revised 60260000 = Rs. 8500000

Option B: Assuming Liability for Imported Units are paid at the end of 6 Months

Sales [20000 Units x SGD 500 x Future Bid Rate Rs. 32.15 Less: Variable Cost

Raw Material [Imported 20000 x € 200 x Future Ask Rs. 57.32 Manufacturing Cost [20000 Units x Rs. 1250] Fixed Cost [given]

229280000 25000000 10000000

321500000

264280000

Revised Profit 57220000

Reduction in Profit = Existing 68760000 Less Revised 57220000 = Rs. 11540000

Quantity Increase Required

Option A Option B

Sale Price per Unit [SGD 500 x Forward Bid 32.15] Less: Variable Cost

Raw Material [€200 x Spot Ask 56.56 / Future Ask 57.32 Manufacturing Cost

16075

11312 1250

16075

11464 1250

Contribution per Unit 3513 3361

Target Increase in Profit and Contribution 8500000 11540000

Target Increase in Quantity Sold 2420 Units 3434 Units

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Managing Risks – Billing Currency An Indian Exporter has received an order for supplying leather goods for Euro 1 Million, the

payment for which will be remitted in 30 Days. The Spot Rate per Euro is Rs. 58.50. Supposing he is

given an opportunity to either bill in Euro or in Rupees, which should he prefer, if one month

forward per Euro is (a) Rs. 59; (b) Rs. 58. What will be the position if he is an importer under the

above two cases (Option to raise invoice on him in either Rupee or Euro)?

Export Import

Forward Rate INR/EURO Rs. 59.00 Rs. 58.00 Rs. 59.00 Rs. 58.00

Spot Rate INR/EURO Rs. 58.50 Rs. 58.50 Rs. 58.50 Rs. 58.50

Relationship F > S F < S F > S F < S

Rupee is - Depreciating Appreciating Depreciating Appreciating

Effect Proceeds in Rupees will be

Higher

Proceeds in Rupees will be

Lower

Payment in rupees will be

Higher

Payment in Rupees will be

Lower

Position Beneficial Detrimental Detrimental Beneficial

Currency to be Opted Euro Rupees Rupees Euro

Evaluation of Foreign Project – Discount Rate ABC Ltd is considering a project in US, which will involve an initial investment of USD 11000000.

The project will have 5 Years life. Current Spot Rate is Rs. 48 per USD. The risk free rate in US is 8%

and the same in India is 12%. Cash Inflows from the project are as follows –

Years 1 2 3 4 5

Cash Inflow $ 2000000 2500000 3000000 4000000 5000000

Calculate the NPV of the project using Foreign Currency Approach. Required Rate of Return on this

project is 14%.

Computation of Discount Rate

It is assumed that the required rate of return of 14% [Risk adjusted Rate] is for Rupee inflows

1 + Risk Adjusted Rate = [1 + Risk Free Rate] x [1 + Risk Premium for the Project]

1 + 14% = (1 + 12%) x (1 + Risk Premium)

1 + Risk Premium = 1.14/1.12 = 1.01786

Risk Premium = 1.786%

Therefore, Risk Adjusted Discount Rate for Dollar Flows is

[1 + Risk Adjusted Discount Rate] = [1 + USD Risk Free Rate] x [1 + Project Risk Premium]

= [1 + 8%] x [1 + 1.786%]

= 1.08 x 1.01786 = 1.09929

Risk Adjusted Discount Rate = 1.09929 – 1 = 9.93%

Computation of Net Present Value [USD in Lakhs]

Year PVF @ 9.93% Cash Flow Disc. Cash Flow

Annual Cash Flows 1 2 3 4 5

0.910 0.827 0.753 0.685 0.623

20.00 25.00 30.00 40.00 50.00

18.20 20.68 22.59 27.40 31.15

Present Value of Cash Inflows Less: Initial Investment

120.12 (110.00)

NPV 10.12

Net Present Value [USD 10.12 x Spot Rate 48.00 per USD] Rs. 480.96

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