Professional Documents
Culture Documents
IFM Notes Full Rudramurthy Sir
IFM Notes Full Rudramurthy Sir
IFM Notes Full Rudramurthy Sir
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Rudramurthy B.V
BASICS
• Generally, Domestic Corporates face with only business and financial risks
only.
QUOTES:
1. Direct Quotes.
2. Indirect Quotes.
Direct Quote: One unit of foreign currency expressed in so many units of home
currency.
Indirect Quote: One unit of home currency expressed in so many units of foreign
currency. (1/DQ)
Exceptions:
Certain Currencies are always quoted for 100units instead of 1unit.
EX: Japanese Yen.
South Korean Won
Indonesian Rupiah
Caution:
All over the world, direct quotes are followed, except in UK and Euro countries where
indirect quotes are followed.
Bid Rate: It is the Buying rate of the Authorized dealer i.e. the Selling rate for the
customer.
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Rudramurthy B.V
Offer Rate: It is the Selling rate of the Authorized dealer i.e. the Buying rate for the
customer.
Cross Rates:
Authorized dealers may have quotation only for some popularly traded foreign
currencies. If a customer needs a quotation for a currency other than these currencies,
CROSS RATES are used.
PROBLEM:
Solution
a)
RM has $112500 to invest = $ 112500 = 50000 £
2.25
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Rudramurthy B.V
Problem
2. Indian Pharma ltd an Indian based foreign MNC is evaluating an overseas
investment proposal, India Pharma ltd exporter of pharmaceutical products is
considering to build a plant in United States the project will entail an initial outlay
of $ 100 million and it is expected to give the following cash flow over its life of 4
years
Solution
a) Home currency approach
Calculation of expected forward rate according to International Fischer effect
t
St = S0 1 + rhc
1 + rfc
S1 = 45 1 + 0.11 = 47.12
1 + 0.06
2
S2 = 45 1 + 0.11 = 49.35
1 + 0.06
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Rudramurthy B.V
3
S3 = 45 1 + 0.11 = 51.67
1 + 0.06
4
S4 = 45 1 + 0.11 = 54.11
1 + 0.06
Calculation of NPV
Year Cash Flow (in ER Cash Flow (in DF @ 15% DCF
million $) million Rs)
0 (100) 45.00 (4500) 1.0000 (4500)
1 30 47.12 1413.60 0.8696 1229.22
2 40 49.35 1974.00 0.7561 1492.63
3 50 51.67 2583.50 0.6575 1698.69
4 60 54.11 3246.60 0.5718 1856.25
4717.70 1776.79
rp = 3.6 %
Calculation of NPV
Years Cash Flow in million $ DF @ 9.8 % DCF
0 (100) 1 -100
1 30 0.9107 27.3224
2 40 0.8295 33.1784
3 50 0.7554 37.7714
4 60 0.6880 41.2802
39.5524
39.5244 × 45 = 1779.86
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Rudramurthy B.V
Problem
3. Barret Corporation presently has no existing business in France but is
considering the establishment of a subsidiary there. The following information is
given to assess this project
The initial investment required is FF 60 million. The existing spot rate is $ 0.20;
the initial investment in dollars is $ 12 million. In addition to FF 60 million
initial investment on plant and equipment, FF 10 million is needed for working
capital and will be borrowed by the subsidiary from French bank. The French
subsidiary of Barret will pay interest only on the loan each year at an interest of
10%.
The loan principal is to be paid in 10 years
The project will be terminated at the end of year 3, when subsidiary will be sold.
The price, demand, and variable cost of the product in France are as follows:
The exchange rate of the French Franc is expected to be $ 0.22 at the end of year
1, $0.25 at the end of year 2 and $ 0.28 at the end of year 3.
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Rudramurthy B.V
All cash flows received by the subsidiary are to be sent to the parent at the end
of each year. The subsidiary will use its working capital to support ongoing
operations.
The plant and equipment are depreciated over 10 years, using straight-line
depreciation method. Since the plant and equipment are initially valued at FF 60
million, the annual depreciation expense is FF 6 million.
In three years, the subsidiary is to be sold. Barret plans to let the acquiring firm
assume the existing French loan. The working capital will not be liquidated, but
will be used by the acquiring firm
Solution
a)
To find cash flow transferred to parent co
FF in million
Particulars 1 2 3
Sales 24 32.5 42
- Variable Cost 1 1.5 2.4
Contribution 23 31 39.6
- Fixed Cost 5 5 5
EBITD 18 26 34.6
- Depreciation 6 6 6
EBIT after Depreciation 12 20 28.6
- Interest 1 1 1
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Rudramurthy B.V
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
million FF ) million dollar)
0 (60) 0.20 (12) 1.0000 (12)
1 15.3 0.22 3.366 0.8696 2.9270
2 22.5 0.25 5.625 0.7561 4.2533
3 68.04 0.28 19.0512 0.6575 12.5265
7.7067
The above project shall be accepted since NPV is positive
b)
To find cash flow transferred to parent co
FF in million
Particulars 1 2 3
EBIT after Depreciation 12 20 28.6
- Interest - - -
EBT (after interest and depreciation) 12 20 28.6
- tax - - -
EAT 12 20 28.6
+ depreciation 6 6 6
EATBD 18 26 34.6
+ Salvage value (60 – (6×3)) - - 42
Cash flow transferable to parent co 18 26 76.6
- withholding tax 1.8 2.6 7.66
Cash flow transferred to parent co 16. 23.4 68.94
2
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
million FF ) million dollar)
0 (70) 0.20 (14) 1.0000 (14)
1 16.2 0.22 3.564 0.8696 3.0991
2 23.4 0.25 5.85 0.7561 4.4234
3 68.94 0.28 19.3032 0.6575 12.6922
6.2147
The above project shall be accepted since NPV is positive
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Rudramurthy B.V
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
million FF ) million dollar)
0 (60) 0.20 (12) 1.0000 (12)
1 19.83 0.22 4.3626 0.8696 3.7936
2 27.00 0.25 6.75 0.7561 5.1040
3 75.60 0.28 21.168 0.6575 13.9183
10.8158
Note: - For calculating interest time value of money is ignored
e)
Particulars
Cash Flow(FF) 17
- withholding tax @ 10 % 1.7
Cash Flow after WT 15.3
Cash Flow after WT in Dollar (15.3 × 0.22) 3.366
+ Salvage Value 30
Cash Flow in Dollar 33.366
Discounted cash inflow (DF @ 15 %)
(33.366 ×0. 8696) 29.015
- Discounted cash outflow 12
NPV 17.015
It is better to sell the subsidiary at the end of year 1 as higher NPV of $17.015
million is achieved under this situation.
4. Yes corporation expects to receive cash dividend from a French joint venture
over the coming 3 years. The first dividend is expected to be paid on 31/12/02 and
is expected to be € 720000 the dividend is then expected to grow 10 % per year
over the following 2 years, the current exchange rate is $0.9180/€ the weighted
average cost of capital for Yes corporation is 12 %.
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Rudramurthy B.V
b) What is the present value of expected Euro dividend stream if the Euro were to
depreciate at the rate of 3 % per annum against dollar?
Solution
a) Calculation of PV of dividends
Years 0 1 2 3
Expected dividend - 720000 792000 871200
WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118
Expected return (increase
by 4 % every year) 0.9180 0.9547 0.9929 1.0326
Present value of dividends - 613749 626900 640334 1880983
b) Calculation of PV of dividends
Years 0 1 2 3
Expected dividend - 720000 792000 871200
WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118
Expected return (decrease
by 3 % every year) 0.9180 0.8905 0.8637 0.8378
Present value of dividends - 572439 545350 519543 1637332
The project will be terminated at the end of year 3, when subsidiary will be sold.
The price, demand, and variable cost of the product in NZ are as follows:
The exchange rates of the NZD is expected to be $ 0.52 at the end of year 1,
$0.54 at the end of year 2 and $ 0.56 at the end of year 3.
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Rudramurthy B.V
All cash flows received by the subsidiary are to be sent to the parent at the end
of each year. The subsidiary will use its working capital to support ongoing
operations.
The plant and equipment are depreciated over 10 years, using straight-line
depreciation method. Since the plant and equipment are initially valued at 50
million NZD, the annual depreciation expense is 5 million NZD.
In three years, the subsidiary is to be sold. X plans to let the acquiring firm
assume the existing NZ loan. The working capital will not be liquidated, but will
be used by the acquiring firm. When it sells the subsidiary X corporation
expected to receive 52 million NZD after subtracting capital gain tax, assume
that this amount is not subjected to a withholding tax
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Rudramurthy B.V
subsidiary, and that X Corp. original forecasts for years 2 and 3 have not
changed. Should X Corp. divest the subsidiary? Explain
Solution
a)
To find cash flow transferred to parent co
NZD in million
Particulars 1 2 3
Sales 20. 25.5 31.8
- Variable Cost 0 5 2.4
1.2 1.75
Contribution 18. 23.8 29.4
- Fixed Cost 8 6 6
6
EBITD 12. 17.8 23.4
- Depreciation 8 5 5
5
EBIT after Depreciation 7.8 12.8 18.4
- Interest 2.8 2.8 2.8
EBT (after interest and depreciation) 5 10 15.6
- tax 1.5 3 4.68
EAT 3.5 7 10.92
+ depreciation 5 5 5
EATBD 8.5 12 15.92
- withholding tax 0.8 1.2 1.59
5
EATBD after Withholding tax 7.6 10.8 14.33
+ Salvage value 5 - 52
-
Cash flow transferred to parent co 7.6 10.8 66.33
5
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 20 % DCF
million NZD ) million dollar)
0 (50) 0.50 (25) 1.0000 (25)
1 7.65 0.52 3.978 0.8333 3.3150
2 10.80 0.54 5.832 0.6944 4.0500
3 66.33 0.56 37.1448 0.5787 21.4958
3.8608
The above project shall be accepted since NPV is positive
b)
To find cash flow transferred to parent co
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Rudramurthy B.V
NZD in million
Particulars 1 2 3
EBIT after Depreciation 7.8 12.8 18.4
- Interest - - -
EBT (after interest and depreciation) 7.8 12.8 18.4
- tax 2.34 3.84 5.52
EAT 5.46 8.96 12.88
+ depreciation 5 5 5
EATBD 10.4 13.9 17.88
- withholding tax 6 6 1.8
1.05 1.4
EATBD after Withholding tax 9.41 12.5 16.08
+ Salvage value - 6 70
-
Cash flow transferred to parent co 9.41 12.5 86.08
6
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 20 % DCF
million FF ) million dollar)
0 (70) 0.50 (35) 1.0000 (35)
1 9.41 0.52 4.8932 0.8696 4.0777
2 12.56 0.54 6.7824 0.7561 4.7100
3 86.08 0.56 48.2048 0.6575 27.8963
1.684
The above project shall be accepted since NPV is positive the original proposal is
more feasible as NPV of original proposal is higher compared to new proposal.
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
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Rudramurthy B.V
e)
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
million NZD ) million dollar)
0 (50) 0.50 (25) 1.0000 (25)
1 7.65 0.52 6.11 0.8333 5.0917
2 10.80 0.54 7.992 0.6944 5.5500
3 14.33 + SV 0.56 30.4648 0.5787 17.6350
0
By reverse method we get (14.33 + SV) × 0.56 = 30.4648
Therefore SV = 40.07
f)
Particulars
Cash Flow(FF) 10.46
- withholding tax @ 10 % 1.05
Cash Flow after WT 9.41
Cash Flow after WT in Dollar (9.41 × 0.52) 4.89
+ Salvage Value 27
Cash Flow in Dollar 31.89
Discounted cash inflow (DF @ 15 %) (31.89
× 0. 8333) 26.58
- Discounted cash outflow 25
NPV 1.577
It is better not sell the subsidiary at the end of year 1 NPV of $1.577 million is
achieved under this situation which is less than the actual NPV of $ 3.8608 million.
Adjusted NPV
In this NPV method all cash flows are discounted at weighted average cost of
capital and it is assumed that uncertainty is involved in different cash flow schemes
are same.
Adjusted NPV method provides the flexibility of adopting the different
discount factors for different cash flow schemes. Higher the uncertainty involved
from a cash flow scheme, higher is the discount factor and vice versa.
Problem
6. A 10 million USD is invested in Thailand for a period of 5 years. It is financed
by 50 % debt and 50 % equity, normally the cost of debt would be 12 % for
project of this type in Thailand, the world bank is however willing to lend us 5
million USD at a subsidized rate of 10 %. The project is expected to generate 3
million USD operating cash flow every year for a period of 5 years and the
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Rudramurthy B.V
marginal tax rate is 40 %.Calculate adjusted NPV for the above project assuming
discount rate of 14.6%.
Solution
Cash Flow Scheme 1:
Operating cash flow 3 million every year to be discounted at the rate of 14.6 %.
Depreciation: - The French government will allow the company to depreciate the
plant and equipment using straight-line method, the depreciation expense sill be
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Rudramurthy B.V
FF 4 million per year the live of the project is excepted to be 5 years. The forecast
price and sales schedule for the next 5 years are as given below
Exchange Rate: - The spot exchange rate of the French Franc is Rs 6.6 the
forecasted exchange rate for all future period is Rs 6.8
Remittance: - All profits after tax realized are to be transferred to the parent at the
end of each year. The French government plans to impose no restrictions on the
remittance of cash flows but will impose a 5 % withholding tax on funds remitted
by subsidiary to the parent as mentioned earlier.
Additional Considerations
1. Assume that all funds are blocked until the end of 5th year this funds can be
reinvested locally to yield 6 % annually after taxes, show the calculations
and comment on the result.
2. Assume the following exchange rate scenario and recalculate your results
Alternative 1
Year Exchange Rate
1 6.80
2 6.90
3 6.95
4 7.00
5 7.05
Alternative 2
Year Exchange Rate
1 6.55
2 6.50
3 6.40
4 6.38
5 6.35
Solution
Calculation of cash flow to parent company
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Rudramurthy B.V
Particulars 1 2 3 4 5
Sales 30 30 52 66 81.6
- Variable Cost 11 11 24 30 36
Contribution 19 19 28 36 45.6
- Fixed Cost 1.5 1.5 1.5 1.5 1.5
EBITD 17.5 17.5 26.5 34.5 44.1
- Depreciation 4 4 4 4 4
EBIT 13.5 13.5 22.5 30.5 40.1
- Interest (10 × 8 %) 0.8 0.8 0.8 0.8 0.8
EBT 12.7 12.7 21.7 29.7 39.3
- Tax - - - - -
EAT 12.7 12.7 21.7 29.7 39.3
+ Depreciation 4 4 4 4 4
EATBD 16.7 16.7 25.7 33.7 43.3
+ Working Capital - - - - 10
- Repayment of loan - - - - 10
- Withholding Tax 0.84 0.84 1.29 1.69 2.17
Cash Flow
Transferred to 15.8 15.8 24.4 32.0 41.13
parent company 6 6 1 1
Calculation of NPV
Years Cash Flow Exchange Cash Flow DF @10% DCF
(FF in Rate (Rs in
million) million)
0 (20) 6.6 (132) 1 (132)
1 15.86 6.8 107.85 0.9091 98.04
2 15.86 6.8 107.85 0.8264 89.13
3 24.41 6.8 164.63 0.7513 123.69
4 32.01 6.8 217.67 0.6830 148.67
5 41.13 6.8 279.68 0.6209 173.66
502.22
Additional consideration
a)
Interest for 1st year = 16.7 × (1.06)4 = 21.08
Interest for 2nd year = 16.7 × (1.06)3 = 19.89
Interest for 3rd year = 25.7 × (1.06)2 = 28.88
Interest for 4th year = 33.7 × (1.06)1 = 35.72
Interest for 5th year = 43.3 × (1.06)0 = 43.30
Calculation of NPV
Years Cash Flow Exchange Cash Flow DF @10% DCF
(FF in Rate (Rs in
million) million)
0 (20) 6.6 (132) 1 (132)
1 21.08 6.8 143.34 0.9091 130.31
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Rudramurthy B.V
Calculation of NPV
Years Cash Flow Exchange Cash Flow DF @10% DCF
(FF in Rate (Rs in
million) million)
0 (20) 6.60 (132) 1 (132)
1 15.86 6.80 107.85 0.9091 98.04
2 15.86 6.90 109.43 0.8264 90.44
3 24.21 6.95 169.65 0.7513 127.46
4 32.01 7.00 224.07 0.6830 153.04
5 41.13 7.05 289.97 0.6209 180.05
517.03
Alternative 2
Calculation of NPV
Years Cash Flow Exchange Cash Flow DF @10% DCF
(FF in Rate (Rs in
million) million)
0 (20) 6.60 (132) 1 (132)
1 15.86 6.55 103.88 0.9091 94.44
2 15.86 6.50 103.09 0.8264 85.20
3 24.21 6.40 156.22 0.7513 117.37
4 32.01 6.38 204.22 0.6830 139.49
5 41.13 6.35 261.18 0.6209 162.17
466.67
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Rudramurthy B.V
The following five economic relationships arise due to the prevalence of “law or one
price” and international arbitraging opportunities.
1. PURCHASE POWER PARITY (PPP)
2. FISHER EFFECT (FE)
3. INTERNATIONAL FISHER EFFECT (IFE)
4. INTEREST RATE PARITY(IRP)
5. FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT
RATES (UFSR)
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Rudramurthy B.V
If international arbitrage enforces the law of one price, then the exchange rate
between the home currency and domestic goods must be equal to the exchange rate
between home currency and foreign goods.
In other words, one unit of home currency should have the same purchasing
power worldwide. Ex: - If a pen costs Rs 50 in India and the same model pen costs $1
in US, then exchange rate shall be $1 = Rs 50.
For same purchasing power to remain constant world wide, the foreign
exchange rate must change approximately the same as difference between the
domestic and foreign rates of inflation.
Purchasing power parity in its absolute version states that price levels should
be same world wide when expressed in common currency. A unit of home currency
should have the same purchasing power worldwide. This theory is application of law
of one price to national price levels or else arbitrage opportunities would exist.
However, absolute PPP ignores the effects of transportation costs, tariffs quotas and
other restrictions and product differentiations in free trade.
The relative version of PPP states that the exchange rate between the home
currency and foreign currency will adjust to reflect changes in the price levels of two
countries. Ex: - If inflation in India is 5 % and in US is 2% then the rupee value of the
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Rudramurthy B.V
USD must rise by about 3 % to equalize the Rupee price of goods in both the
countries.
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
Ex: - The US (hc) and Switzerland (fc) are running annual inflation rates of 5 % and
3 % respectively and the spot rate is SFr 1 = $0.75 then calculate the PPP rate after
1,2 and 3 years
et = e0 (1 + ih)t
(1 + if)t
Point ‘A’ on the parity line is an equilibrium point wherein 3 % change in inflation is
offset by 3 % appreciation in foreign currency, whereas Point ‘B’ is at disequilibrium
since 3 % change in inflation is offset just by 1 % appreciation in foreign currency.
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Rudramurthy B.V
ét = et × (1 + ih)t
(1 + if)t
Empirical Evidence: -
The strictest version of PPP, that all goods and financial assets obey the law of
one price is demonstrably false. The risk and costs of shipping goods internationally
as well as government erected barriers to trade and capital flows, are at times high
enough to cause exchange adjusted prices to systematically differ between countries.
The general conclusion from empirical study of PPP is that theory holds up
well in long run, but not as well over shorter time-periods. Thus in long run the real
exchange rate tends to revert to its predicted value of e 0. That is if ét > e0, then the real
exchange rate should fall over time towards e0. Where as if ét < e0 the real exchange
rate should rise over time towards e0.
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Rudramurthy B.V
The real interest rate shall be adjustable to reflect expected inflation to obtain
the nominal interest rate. According to Fisher effect the interest rate(r) is made of two
components
a) Real interest rate (a)
b) Expected inflation rate (i)
Therefore
(1 + Nominal interest rate) = (1 + real interest rate) (1 + expected inflation rate)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
However often approximated ‘r’ is calculated as equal to ‘a + i’.
Ex: If required real interest rate is 3 % and expected inflation rate is 10 %. Calculate
the nominal interest rate
(1 + r) = (1 + a) (1 + i)
(1 + r) = (1 + 0.03) (1 + 0.10)
(1 + r) = 1.133
r = 0.133 or 13.3 %
Alternatively
r = a + i + ai
r = 0.03 + 0.10 + (0.03) (0.10) = 0.133 or 13.3 %
According to FE the lender should not only be compensated for interest (3 %) but also
for depreciation in principal value by (10.3 %) for passage of time
“According to generalized version of FE the real returns are equalized across
the countries through arbitrage” i.e. ah = af. If expected real returns were higher in one
currency than the other, capital would flow from the second to the first currency.
In an equilibrium with no government interference, the nominal interest rate
differential will approximately equal the anticipated inflation differential between the
two currencies.
rh – rf = ih – if
∆ NIR = ∆ Inflation
Where rh and rf represents nominal interest rate at home country and foreign
country respectively, ih and if represents inflation at home country and foreign country
respectively.
In other words, according to FE,
(1 + rh)t = (1 + ih)t
(1 + rf)t (1 + if)t
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Rudramurthy B.V
According to PPP
∆ ER = ∆ IR
et = (1 + ih)t …………………………(1)
e0 (1 + if)t
According to FE
(1 + NIR) = (1 + RIR) (1 + IR)
(1 + r) = (1 + a) (1 + i)
i.e. ∆ ER = ∆ NIR
Therefore
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Rudramurthy B.V
et = e0 (1 + rh)t
(1 + rf)t
According to IFE, the interest rate differential between any two countries is an
unbiased predictor of the future change in spot exchange rate. Hence currency with
higher interest rates will depreciate and those with low interest rates will appreciate.
Point ‘A’ on parity line is at equilibrium whereas point ‘B’ outside the parity
line is not at equilibrium.
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Rudramurthy B.V
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PARITY CONDITIONS
∆ ER = ∆ IR
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
∆ ER = ∆ NIR
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Rudramurthy B.V
et = (1 + rh)t
e0 (1 + rf)t
et = e0 (1 + rh)t
(1 + rf)t
Ft = (1 + rh)t
e0 (1 + rf)t
Ft = ē t
Ft – e0 = ēt –e0
e0 e0
Problems
Solution
= FR – SR × 360 .
SR Forward contract period in days
= 3.8142 %
Interest differential = 12 % - 8 % = 4%
Since interest differential is grater than forward rate differential an arbitrager shall
prefer investment in that country where interest rate is higher. Thus, investment shall
be done in India and funds shall be borrowed from US.
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Rudramurthy B.V
Loan amount to be refund along with interest = 100000 + (100000 × 0.08 × 6/12)
= $104000
Arbitrage profit = $104016 - $104000 = $16
Solution
= FR – SR × 360 .
SR Forward contract period in days
= 4.536 %
Interest differential = 12 % - 8 % = 4%
Since forward rate differential is grater than interest differential, invest in that
country’s currency which is expected to appreciate. Here in this case borrow in India
and invest in US.
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Rudramurthy B.V
Loan amount to be refund along with interest = 100000 + (100000 × 0.12 × 6/12)
= Rs106000
Arbitrage profit = Rs106379 – Rs106000 = Rs 379
Solution
= FR – SR × 360 .
SR Forward contract period in days
= 0.067 %
Interest differential = 8 % - 5 % = 3%
Since interest differential is grater than forward rate differential an arbitrager shall
prefer investment in that country where interest rate is higher. Thus, investment shall
be done in France and funds shall be borrowed from US.
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Rudramurthy B.V
Loan amount to be refund along with interest = 100000 + (100000 × 0.05 × 6/12)
= $102500
Arbitrage profit = $103965 – $102500 = $1465.34
4. Assume the buying rate for DM (Dutch Mark) spot in New York is $ 0.40
a) What would you expect the price of USD to be in Germany?
b) If the dollar to be quoted in Germany at DM 2.6 how is the market supposed
to react?
Solution
a) The price of USD in Germany is expected to be (1÷0.4) = 2.5 DM/$
b) Since dollar is cheaper in New York, Buy dollar at the rate of 2.5 DM/$ in
New York and sell the same in Germany at the rate of 2.6 DM/$ thus making
an arbitrage profit of DM 0.1/$.
5. You have called your foreign exchange trader and asked for quotation on the
spot, 1-month, 3-month and 6-month forward rate. The trader has responded with
the following
$ 0.2479/81, 3/5, 8/7, 13/10
Swap points: - Forward rates can be expressed by giving spot rates and their
respective swap points
E.g.1:- 3/5 in the above problem indicates premium swap point since bid swap point is
lesser than ask swap point/offer swap point.
E.g.2:- 8/7 in the above problem indicates discount swap point since bid swap point is
greater than ask swap point/offer swap point.
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Rudramurthy B.V
b) €(4.0306/4.0339)/USD
Spot Euros can be bought at bankers offer rate of $ 0.2481/€
Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling
rate will be banker’s buying rate.
= FR – SR × 360 .
SR Forward contract period in days
= 2.42 %
= FR – SR × 360 .
SR Forward contract period in days
= 1.13 %
= FR – SR × 360 .
SR Forward contract period in days
= 0.806 %
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Rudramurthy B.V
a) What is the premium on the forward French Franc? What is the interest
rate differential between France and US? Is there an incentive for covered
interest arbitrage?
d) Calculate the cost covered interest arbitrage and suggest whether covered
interest arbitrage was required considering above cost of hedging.
Solution
a) Calculation of Forward premium on French Franc
= FR – SR × 360 .
SR Forward contract period in days
= 40 %
2. Convert the above dollars into French Franc using spot rate.
= 4000/0.200 = ₣ 20000
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= FR – SR × 360 . × 100
SR Forward contract period in days
= 3.34 %
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2. Convert the above Canadian dollars into USD using spot rate.
b)
Calculation of Forward rate differential
= FR – SR × 360 . × 100
SR Forward contract period in days
= 5.14 %
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2. Convert the above Indian Rupees into Yen using spot rate.
et = e0 (1 + rhc)t
(1 + rfc)t
et = 25 (1 + 0.10)1
(1 + 0.06)1
FR = Rs 25.94
et = 25 (1 + 0.10)0.75
(1 + 0.06)0.75
FR = Rs 25.7046
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et = e0 (1 + rhc)t
(1 + rfc)t
et = 40 (1 + 0.10)1
(1 + 0.06)1
FR = Rs 41.509
10. Following are rates quoted in Mumbai for British Pound Rs/BP = 52.60/70
and three month forward rate 20/70, interest rate in India is 8 %, interest rate in
London is 5 %. Verify weather there is any scope for Covered interest arbitrage if
you borrow in RS (India).
Solution
Spot rate: Rs/BP = 52.60/70 = 52.60/52.70
Forward rate: Rs/BP = 52.80/53.40
Strategy: Borrow in India and invest in London
2. Convert the above Indian Rupees into Pounds using spot rate.
= 100000/52.70 = £ 1898
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2. Convert the above London Pounds into Rupees using spot rate.
Note: - Covered Interest Arbitrage with two-way quote should be done using trial and
error method; both strategies can give loss because of “SPREAD”
b) T = T × € = 1 . × 2.5150 = 0.0122
£ € £ 205.80
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12. A foreign exchange trader quotes for Belgium Franc spot, 1-month, 3-month
and 6-month forward rate to US based treasurer
$ 0.02478/80, 4/6, 9/8, 14/11
a) Calculate the outright quote for 1, 3, 6 month forward.
b) If treasurer wished to buy Belgium Franc 3-months forward, how much would
you pay in Dollars?
c) If you wanted to purchase USD 1-month forward, how much would you have
to pay in Belgium Franc?
d) Assuming Belgium Franc was brought what is the premium or discount in the
1, 3, 6 month forward rate in annual percentage?
e) What do the above quotations imply in respect of term structure of interest in
USA and Belgium?
Solution
a) Assume you are buying Euros
Particulars Buying Rate Offer Rate
Spot Rate 0.02478 0.02480
1 Month Forward Rate 0.02482 0.02486
3 Month Forward Rate 0.02469 0.02472
6 Month Forward Rate 0.02464 0.02469
Swap points: - Forward rates can be expressed by giving spot rates and their
respective swap points
E.g.1:- 4/6 in the above problem indicates premium swap point since bid swap point is
lesser than ask swap point/offer swap point.
E.g.2:- 9/8 in the above problem indicates discount swap point since bid swap point is
greater than ask swap point/offer swap point.
b) The treasurer can buy Belgium Franc 3-month forward at his bid rate of
$ 0.02469/Belgium Franc
Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling
rate will be banker’s buying rate.
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Rudramurthy B.V
= FR – SR × 360 .
SR Forward contract period in days
= FR – SR × 360 .
SR Forward contract period in days
= 1.45 %
= FR – SR × 360 .
SR Forward contract period in days
= 1.13 %
13. Dutch Mark spot was quoted at $0.4/DM in New York, the price of Pound
Sterling was quoted at $1.8/£
a) What would you expect the price of Pound to be in Germany?
b) If the Pound were quoted in Frank Fort at DM 4.40/£ what would you do
to profit from the above situation
Solution
e) DM = DM × $ = 1 . × 1.8 = 4.5
£ $ £ 0.4
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f) Buy 1 pound for DM 4.4 in Frank Fort and with the above pound buy $1.80 in
New York and with the above dollars buy DM 4.5 in Germany thus arbitrage
will make profit of DM 0.1 for an investment of DM 4.40
15. Brun Herbal products located in India is an old line producer of herbal teas
and medicines, their products are marketed throughout India and Europe
Brun Herbal generally invoices in rupees when it sells to foreign customers in
order to guard against exchange rate changes however company has received an
order from large wholesaler in France for ₣ 40 lakhs of its product. The condition
is that the delivery should be in 3 months time and order invoiced in French Franc.
The manager decides to contact firm’s bankers for suggestions about hedging the
exchange rate exposure.
The banker informs company that spot rate is 1 ₣ = Rs 6.60 thus invoice
amount should be Rs 26400000. The 90-day forward rate for Rs and ₣ and USD
are 1₣ = Rs 6.50 and 1$ = 42.0283. The banker offers to setup Forward hedge for
selling FFr receivable for Rupee based on cross forward exchange rates implicit in
forward rate against dollar, what would be your decision if you were manager of
Brun Herbal? Show the relevant calculations
Interest rates in India and France are 9 % Pa and 12 % Pa respectively.
Solution
Selective hedging (receivable position)
FSP > FR do not hedge
FSP < FR hedge
Calculation of expected future spot price according to IRP
Interest rate differential = Forward differential
Interest rate differential = 12% - 9% = 3 %
Forward rate for 90 days should be calculated
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6.6 90
x – 6.6 = -3 × 6.6
4 × 100
x – 6.6 = -0.0495
x = 6.5505
i.e. 90-day forward for 1₣ = Rs 6.5505
Hence it would be advisable for the company not to hedge its risk by selling
French Franc forward. Expected spot price (1₣ = Rs 6.5505) is greater than
forward rate (1₣ = Rs 6.5)
16. In Frank Fort the French Franc is selling for DM 0.4343 spot and the 3-month
forward rate is DM 0.4300. The 3-month Euro DM inter bank rate is 5.75 % and
the Euro French inter bank rate is 9 %.
a) Are exchange rate and money market rate in equilibrium? Why?
b) Is there any way to take advantage of the situation? If so how?
c) What rate trends would appear in the market if a large number of
operators took the action indicated in (B) above?
Solution
a) Calculation of interest rate differential
3-month Euro-DM inter bank rate = 5.75 %
3-month Euro-FFr inter bank rate = 9 % .
Interest differential = 3.25 %
= FR – SR × 360 .
SR Forward contract period in days
= 3.96 %
Since interest rate differential is not equal to forward rate differential there
exists no equilibrium between exchange rate and money market.
b) Since there is no equilibrium between exchange rates and money market there
exists arbitrage opportunity.
Strategy: - Borrow in France and invest in Germany.
1. Borrow ₣ 100000 at the rate of 9 % pa for 3 months
2. Convert the above French Franc into Dutch Mark using spot rate.
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17. A trader works for New York bank, the spot exchange rate against Canadian
dollar is USD 0.9968 and 1-month and 1-year forward rates are USD 0.9985 and
USD 1.0166 respectively. Twelve-month interest rate in USA and Canada may be
taken as 6.45 % and 4.46 % respectively.
a) What is the forward premium as annual percentage?
b) Which currency is at a premium? Why?
The trader becomes party to some insider information which suggests
the US interest rate will rise by 1 % pa during the next month. The
bank has a rule that in foreign exchange markets “Buy equals Sell” this
means that for any currency the total of long positions must be equal to
the total of short positions but this aggregation disregards maturity.
c) Indicate the mechanism of two operations by which you may trade in
expectation of profit for the bank. Should the insider information turns out
to be well founded
Solution
a) Calculation of Forward premium or discount
= FR – SR × 360 .
SR Forward contract period in days
= FR – SR × 360 .
SR Forward contract period in days
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0.9968 90
= 1.99 %
2. Convert the above Canadian Dollars into USD using spot rate.
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18. Your company has to make USD 2 million payment in 3 months time, the
dollars are available now. You decide to invest them for 3 months and you are
given the following information.
The US deposit rate is 8 % pa
The sterling deposit rate is 9 % pa
The spot expected rate is $ 1.81/£
The 3-month forward rate is $ 1.78/£
a) Where should your company invest for better returns?
b) Assume that the US interest rates and the spot expected return
remain as above, what forward rate would yield an equilibrium situation?
c) Assuming that the US interest rate, Spot and forward rates
remains as in the original question, where would you invest if the sterling
deposit rate is 14 % pa?
d) With the originally stated spot and forward rates and the
same dollar deposit rate, what is the equilibrium sterling deposit rate?
Solution
a) Alternative 1: -
Invest USD 1 million in US at the rate of 8 % pa for 3 months
Interest income = 1 million × 8 % × 3/12 = US $20000
Alternative 2:-
Invest in London at the rate of 10 % pa for 3 months
1. Convert 1 million USD into equivalent pounds using spot rate.
= 1000000 ÷ 1.8 = £ 555556
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x – 1.8 = -0.009
x = $ 1.79
Expected future spot rate = $ 1.79
c)
1) Invest £ 555556 at the rate of 14 % pa for 3 month
= FR – SR × 360 . × 100
SR Forward contract period in days
= 4.44 %
Interest in London = Interest in US + FRD
= 8 % + 4.4 %
= 12.44 %
Alternative method
£ 555556 + x % = $ 1020000
i.e. at what rate if we invest £ 555556 in London for 3 months after converting the
gain into USD should be $ 1020000 then only attain a sterling deposit rate
equilibrium
1020000 ÷ 1.78 = £ 573033
555556 + x % = 573033
x % = 573033 – 555556
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x % = 17478
For £ 555556 ======== interest amount is £ 17478
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Types of Exposure
1. Accounting Exposure/Translation Exposure
2. Economic Exposure
a) Operating Exposure
b) Transaction Exposure
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Under this method all current assets and current liabilities of foreign
affiliated are translated into home currency at the current exchange rate while
the non current assets and non current liabilities are translated at historical
rate.
2. Monetary and Non Monetary method
According to this method all monetary assets and monetary liabilities
are translated at current rates where as non monetary assets and non monetary
liabilities are translated at historical rates.
Monetary items are those items which represent a claim to receive or
an obligation to pay a fixed amount of foreign currency units.
Eg: - Cash, accounts receivable (Debtors + Bills Receivable), accounts
payable (Creditors + Bills Payable), other current liabilities, long term debts
etc.
Non Monetary items are those items that do not represent a claim to
receive or an obligation to pay a fixed amount of foreign currency units.
Eg: - Stock, fixed assets, equity shares, preference shares etc.
3. Temporal Method
It is a modified version of monetary and non monetary method the
only difference between monetary and non monetary method is valuation of
stock.
Under monetary and non monetary method, stock is considered as non
monetary assets and it is valued at historical rate where as under temporal
method stock is valued at historical rate if it is shown at cost price or valued at
current rate if it is shown at market price.
4. Current Rate Method
Under this method all balance sheet items are translated at current
exchange rate except for shareholders equity (Share Capital + Reserve &
Surplus) which is translated at historical rate.
Cash CR CR CR CR
Receivables CR CR CR CR
Inventory CR HR HR /CR CR
Fixed Assets HR HR HR CR
Payables CR CR CR CR
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Long term HR CR CR CR
Debt
Net worth HR HR HR HR
Problems
Particulars Amount
Cash FC 100
Account Receivable FC 150
Inventory FC 200
Solution
Monetary &
Current &
Particulars FC Non Temporal Current Rate
Non Current
Monetary
Cash 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100
Account
150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150
Receivables
Assets
Inventory 200 200 ×1 = $200 200 ×2 = $400 200 ×1 = $200 200 ×1 = $200
Fixed Assets 250 250 ×2 = $500 250 ×2 = $500 250 ×2 = $500 250 ×2 = $250
Current Liabilities 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100
Long term Debt 300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300
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Liabilities
Net worth 300 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600
The Expected return as on 01/01/2007 was CAN$ 1.6 per USD determine
Farm product accounting exposure on 01/01/2008 using current rate method and
monetary and non-monetary method.
Solution
Monetary & Non
Particulars CAN$ Current Rate
Monetary
Cash 100000 ÷ 1.8 = $ 55556 ÷ 1.8 = $ 55556
Account
220000 ÷ 1.8 = $ 122223 ÷ 1.8 = $ 122223
Receivables
Assets
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Liabilities
Net worth 620000 ÷ 1.6 = 387500 ÷ 1.6 = 387500
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HEDGING
Hedging is a particular currency exposure, means establishing an offsetting
currency position so as to lock in the home currency value for the currency exposure
and eliminate currency fluctuation risk.
Problems
1. In March multinational industry incorporation assesses the September spot
rate for Sterling at the following rates
$ 1.30/£ with probability 0.15
$ 1.35/£ with probability 0.20
$ 1.40/£ with probability 0.25
$ 1.45/£ with probability 0.20
$ 1.50/£ with probability 0.20
a) What is the expected spot rate for September?
b) If 6-month forward rate is $1.40 should the firm sell forward its pound
500000 receivable
c) During receivable what factors are likely to affect multinational
industry hedging decision
Solution
a) Calculation of expected spot rate for the month of September
Total $1.405/£
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Eg: - If A limited has $ 10000 receivable position and $ 6000 payable position both
for 3 months exposure netting can be done and it is enough if A limited hedges for
$ 4000 receivable positions
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Which hedging alternative would you recommend? The first rate is the
borrowing rated and second rated is the lending rate.
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Rudramurthy B.V
Solution
Forward Market Hedge
Payable position CAN $ 40 million after 3 months
Spot rate $ 0.7307 - $ 0.7312 per CAN $
Forward rate $ 0.7320 - $ 0.7341 per CAN $
Forward market payable = CAN $ 40 million × $ 0.7341
Forward market payable = $ 29.364 million
US Canada
Explanation
Pepsi Company has a payable exposure of CAN $ 40 million after 3
months.
The Present Value (PV) of C $ 40 million should be invested as on today
in a Canada bank so that along with interest it will mature at C $ 40
million after 3 months.
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Conclusion: - Money Market hedge shall be preferred for the above problem
3. DC corporation is a US based software consultant specialized in financial
software for several fortune 500 it has an office in India, UK, Europe and
Australia. In 2002 DC corporation required £ 100000 in 180 days and had 4
options before it
⇒ Forward Market Hedge
⇒ Money Market Hedge
⇒ Option Hedge
⇒ No Hedge
Its analyst developed the following information which was used to asses
the alternative solution
Current spot rate of £ is $ 1.50 and 180-day forward rate of £ is $ 1.48
Interest rates were as follows
Particulars UK US
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A call option on £ that expires in 180 days has an exercise price of 1.5 and
a premium of $ 0.02. The future spot rate in 180 days are forecasted as follows
$ 1.44 20 %
$ 1.46 60 %
$ 1.53 20 %
An analysis of hedging technique should be made and advice DC
corporation on the best alternative for hedging
Solution
Forward Market Hedge
DC Corporation has payable position £ 100000 in 180 days
To meet the above payment DC Corporation has to buy bounds at prevailing
forward rate
180-day forward rate $ 1.48/£
Forward market hedge = £ 100000 × 1.48 = $148000
US UK
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No Hedge
Calculation of Expected future spot price
The probability of exercising the call option is 0.2(20 %); the probability of not
exercising the call option is 0.8 (80 %)
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$ 1.49
DC Corporation shall not hedge as the no hedge option is the lowest value in
all the set of alternatives
4. P Company is a US based multinational Pharmaceutical company is evaluating
an export sale of its extremely effective cholesterol reduction drug. The purchase
would be for 750 million Indonesian Rupaiah, which current spot rate of
RP 8800/$ translates into a little more than $ 85000 although not a big sale, the
policy of P Company dictates that sale must be settled at least for a minimum
gross margin which results at $ 78000 on the above sale
The current 90-day forward rate is 9800 RP/$. Although this appears to be
unattractive, P Company has to contact several major banks before even finding
the forward quote on the RP the consequences of currency forecasters at the
movement however is that the Rupaiah is holding out relative study. The possible
rate of RP is RP 9400 over the coming 90 days analyze the prospective sale and
make the hedging recommendation.
Solution
Given
Spot rate = RP 8800/$
90-day forward rate = RP 9800/$
Expected future spot rate = RP 9400/$
Since P Company has receivable exposure of RP 750 million
Hedging Strategy: - Forward market hedge
P Company should go to forward market and short the Indonesian Rupaiah.
90-day forward market rate is RP 9800/$
Therefore cash inflow = 75000000/98000 = $ 76530
The company’s policy is not to sell below $ 78000 but if the company sell
today then they will get $ 85227.27 using the spot rate of RP 8800/$.
P Company has a expectation of future spot rate of RP 9400/$ then the
company need not go for hedging option as it will give the cash inflow of $ 79787.23
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750000000/9400 = $ 79787.23
Decision: - By taking ‘not hedging option’, company can receive $ 79787.23 which is
more than their minimum expectation of $ 78000. Hence company can opt for not
hedging. But the company’s business is not to make profit by doing currency business
they are in pharmaceutical business if they do not hedge or if they expose their
receivables open they will get $ 79787.23 but expected future spot price may not
become true then company loose their minimum expectation of $ 78000
5. Hindustan Lever Uniliver’s Subsidiary in India, procures much of its toiletries
product line form Japanese Company. Due to shortage of working capital in India
payment terms by Indian importers are typically 180 days or longer. Hindustan
Lever wishes to hedge 8.5 million Japanese Yen payable.
Although options are not available on the Indian Rupee, forward rates are
available against Yen. Additionally a common practice in India is for companies
like Hindustan Lever to work with a currency agent who will in this case lock in
current spot exchange rate in exchange for 4.85 % fee.
Using the following exchange rate and interest rate data, recommend a
hedging strategy
Spot rate ¥/$ = ¥ 120.60/$
Spot rate Rs/$ = Rs 47.75/$
180-day forward rate ¥/Rs = ¥ 2.4000/Rs
Expected spot rate in 180 days = ¥ 2.6000/Rs
180-day Yen investment rate = 1.5 %
180-day Rupee investment rate = 8.0 %
Hindustan Lever’s cost of capital =12 %
Solution
Given
Spot rate ¥/$ = ¥ 120.60/$
Spot rate Rs/$ = Rs 47.75/$
Hence ¥/Rs = 120.6/47.75 = 2.5257
180-day forward rate ¥/Rs = ¥ 2.4000/Rs
Expected spot rate in 180 days = ¥ 2.6000/Rs
180-day Yen investment rate = 1.5 %
180-day Rupee investment rate = 8.0 %
Hindustan Lever’s cost of capital =12 %
Agent exchange rate commission is 4.85 %
No Hedge
= ¥ 8.5 million/Rs 2.6 = Rs 3.2692 million
Forward Market Hedge
Buy 8.5 million Yen in forward market at the spot rate of ¥ 2.4 /Rs
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India Japan
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Solution
Money Market Hedge
India Japan
Option Hedge
Particulars A B
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$ 5168331 $ 5075554
Particulars A B
If FSP > 1.782 for option A and 1.773 for option B then option hedge shall be
preferred over forward market hedge.
7. Nike International needs to order supplies 2 months ahead of delivery date. It
is considering an order from Japanese that requires a payment of ¥ 12.5 million
payable as of the delivery date. Nike has two option or choice
a. Purchase 2 call option contracts each option contract size is ¥ 6250000
b. Purchase one future contract representing ¥ 12.5 million
c. The future price of yen has historically exhibited a slight discount form
the existing spot rate however the firm likes to use currency option to hedge in
Japanese Yen for transaction 2 months in advance. Nike would prefer hedging
since it is uncomfortable to leave position open giving historical volatility of
Yen.
The current Yen spot rate is $ 0.0072 there are 2 call options available, call A
with an excise price of 5 % above spot price with premium of 2 % the price to be paid
per Yen if the option is exercised. Call B with an excise price of 10 % above spot
price with premium of 1.5 % the price to be paid per Yen if the option is exercised.
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The 2-month future price of Yen is $ 0.006912 as an analyst you have been
asked to answer insight of how to hedge assume the spot rate remain unchanged after
2 months.
a) Calculate option exercise price and premium for both the call options
b) If Nike decides to use call option to hedge Yen which call option should it use.
c) If Nike decides to allow Yen to be un-hedged, will it benefit? If so calculate
trade-off.
d) Which is the optimal choice for the company, call A or call B or future
contract if the spot price on expiry becomes $ 0.00781?
Solution
a) Calculation of Option exercise price and premium
Particulars A B
b)
Particulars A B
$ 96390 $ 100485
c) No hedge
= 12500000 × 0.0072
= $ 90000
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2-month future price of the Yen is assumed to be $ 0.006912 then the payable
exposure will be
= 12500000 × 0.006912
= $ 86400
d) If the spot price on expiry is $ 0.00781 call option A shall be preferred since
FSP > SP
Particulars A B
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0.7
6
0.72 0.7 Exercise 0.04 0.01 0.03 -0.03
6
0.74 Exercise 0.01 0.01 0.01 -0.01
0.7
0.76 Exercise/Lapse 0.01 0.01 -0.01 0.01
6
0.78 Lapse - 0.01 -0.01 0.01
0.7
0.79 6 Lapse - 0.01 -0.01 0.01
0.7
6
10. An Indian importer is required to pay US $ 10 lakh on June 30, 2000. The
import of goods took place on April 1, 2000. Following further details are
furnished
Spot rate on April 1, 2000 = Rs 44.25/37
3-month forward rate = Rs 44.54/73
Strike price of option (3 months) = Rs 44.50
Option premium = 0.25
What will happen to importer if he takes the following?
a) Forward cover
b) Option cover
The spot prices on June 30, 2000 are
1) 45.0/1
2) 44.00/12
Solution
a) Forward market cover
Payable exposure = $ 1000000 Spot rate = 44.25/44.37
3-month forward rate = 44.54/44.73
Payable exposure after 3 months
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0.06 1.61
0.03 1.65
0.01 1.60
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Solution
Solution
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US Equity index 14 % 15 %
German Equity index 18 % 20 %
b. Calculation of covariance
COVUG = σU × σG × rUG
COVUG = 15 × 20 ×0.34
COVUG = 102
c. Calculation of risk of the portfolio
σP2 = σU2 WU2+ σG2 WG2 + 2 COVUG WU WG
σP2 = (15)2 (0.4)2 + (20)2 (0.6)2 + 2 × 0.4 ×0.6 ×102
σP2 = 228.96
σP = 15.13
2. Boing Company and Uniliver company are from US and UK, an investor is
evaluating a two asset portfolio of the following two securities
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Uniliver Company 16 % 24 %
a. What is the expected return and the risk of the portfolio if they are
equally weighed?
b. If the weights are changed to 0.7 for Boing and 0.3 for Uniliver, what
is the Expected return and risk
Solution
a. Calculation of expected return on portfolio of equal weights
Calculation of risk of the portfolio of 0.7 and 0.3 for Boing and Uniliver respectively
σP2 = σB2 WB2+ σU2 WU2 + 2 rBU σB σU WB WU
σP2 = (22.8)2 (0.7)2 + (24)2 (0.3)2 + 2 × 0.6 × 24 × 22.8 × 0.7 × 0.3
σP2 = 444.45
σP = 21.08 %
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b. 50 % Anglo 50 % American
Expected return on portfolio
ERP = WAN × EAN + WAM × EAM
ERP = (0.5) (12.5) + (0.5) (10.8)
ERP = 11.65 %
Risk of the portfolio
σP2 = σAN2 WAN2+ σAM2 WAM2 + 2 rAN,AM σAN σAM WAN WAM
σP2 = (26.4)2 (0.5)2 + (22.5)2 (0.5)2 + 2 × 0.72 × 26.4 × 22.5 × 0.5 × 0.5
σP2 = 514.64
σP = 22.69 %
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c. 25 % Anglo 75 % American
Expected return on portfolio
ERP = WAN × EAN + WAM × EAM
ERP = (0.25) (12.5) + (0.75) (10.8)
ERP = 11.225 %
Risk of the portfolio
σP2 = σAN2 WAN2+ σAM2 WAM2 + 2 rAN,AM σAN σAM WAN WAM
σP2 = (26.4)2 (0.25)2 + (22.5)2 (0.75)2 + 2 × 0.72 × 26.4 × 22.5 × 0.25 × 0.75
σP2 = 488.71
σP = 22.11 %
Interpretation
Option ‘a’ shall be preferred based on return as it gives higher return and
option ‘c’ shall be preferred based on risks as it gives lower risks
Risk reward ratio
a. Risk / Return = 24.17 ÷ 12.075 = 2.0017
b. Risk / Return = 22.69 ÷ 11.650 = 1.9476
c. Risk / Return = 22.11 ÷ 11.225 = 1.9679
Option ‘b’ shall be preferred based on both risk and return i.e. an investor can
get a maximum return with minimum risk levels only if the weights of the two
securities are equal.
4. Assume the US dollar rate of return, standard deviation Risk free rate of return
and β value for three Baltic republic are given as follows
TRYENOR measure
TM = R p – R f
βp
TME = 1.12 – 0.42 = 0.42 TMLi = 1.6 – 0.42 = 1.18
1.65 1.00
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TRYENOR measure
SM = R p – R f
σp
SME = 1.12 – 0.42 = 0.0438
16
JM = R p – SML
JM = R p – [R f + β (ER m – R f)]
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Swaps
A swap is an agreement between two companies to exchange cash flows so as
to gain the difference.
Types of Swaps
1. Interest Rate Swaps
2. Currency Swaps
An interest rate swap is a swap where in a company borrows fixed rate of
interest (Comparative advantage in fixed rate interest) and ends up paying in floating
rate (wishes to pay floating rate of interest) by entering into swap agreement with
other company with opposite cash flows.
LIBOR (London Inter Bank Offer Rate)
It is the rate of interest at which bank deposits money with other banks in the
euro currency markets generally 1-month, 3-month, 6-month and 1-year LIBOR’s are
used.
Advantages of Swap
1. A swap agreement can be used to transform a floating rate of loan into fixed
rate of loan and vice versa.
2. A swap agreement can also be used to transform an asset turning fixed rate of
interest into an asset turning floating rate of interest.
Comparative Advantage Theory
The popularity of swaps comes into picture only because of
Comparative Advantage Theory.
According to this theory a company should borrow or invest for that
rate of interest in which it has comparative advantage.
But however it wants to satisfy its wish of opposite rate, it should enter
into swap agreement.
Critics of Comparative Advantage Theory argue that the benefit of
swap will not exist in reality because of arbitragers operating in market.
Comparative Advantage Theory makes an assumption that floating rate
of interest remains unchanged throughout the period of swap agreement.
However in reality floating rate might change due to change in the
creditworthiness of the company.
Currency Swap
It involves exchange of principal and interest payment of receipts and
payments in one currency with that of another currency.
Advantages of currency swap
Transformation of liabilities.
Transformation of assets.
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Problems
1. Company A and company B have been offered the following rates pa on a
$ 20 million 5 year loan
A 12 % LIBOR + 0.1 %
B 13.4 % LIBOR + 0.6 %
A 12 % LIBOR + 0.1 %
B 13.4 % LIBOR + 0.6 %
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2. Company ‘A’ wishes to borrow 10 million at a fixed rate for 5 years and has
been offered 11 % fixed or 6-month LIBOR + 1 %. Company B wishes to
borrow 10 million at a floating rate for 5 years and has been offered 10 %
fixed or 6-month LIBOR + 0.5 %. How do they enter into a Swap agreement
in which each benefit equally? What risk did this arrangement generate?
Solution
Calculation of interest rate differential
A 11 % 6-M LIBOR + 1 %
B 10 % 6-M LIBOR + 0.5 %
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Spot Rate: It is the rate paid for delivery within 2 business days after the date of
transaction, in other words it is the current exchange rate between 2 or more
currencies.
Forward Rate: It is rate quoted for delivery of foreign currency on a future day which
is established at the time of entering into the contract. Forward rates are usually
quoted for fixed periods of 30, 60, 90 and so on days.
Cross Rate: An exchange rate between two countries that is derived from the
exchange rate of those currencies with a 3rd known currency is known as cross rate of
exchange.
Forward: A forward contract is a tailor made contract whose terms are negotiated
between the buyer and the seller which are not traded on organized exchanges and are
useful to hedge forward receivables and payables where the exact date of such
transactions is not fixed or known.
Future: A future contract where quantity, date and delivery conditions are
standardized. The futures contracts are traded on organized exchanges which are
settled with the differences
Option: An option gives its owner the right to buy or sell an underlying asset on or
before a given date at a fixed price but with no obligation to buy or sell the same for a
fixed premium.
Swap: A swap is a contract between two counter parties to exchange two streams of
payments for an agreed period to time swaps may either be interest rate or currency
swaps
Currency future: A currency future is the price of a particular currency for settlement
at a specified future date. Currency futures are traded on future exchanges where the
contracts are freely transferable.
Call option: Call option gives the option holder the right to buy an asset at a fixed
price during a certain period without any obligation to buy.
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Put option: Put option gives the option holder the right to buy an asset at a fixed price
during a certain period without any obligation to buy.
Covered call: A covered call involves writing a call option or an asset along with
buying the asset. It is a covered call since potential obligation to deliver the stock is
covered by underlying stock in the portfolio.
Uncovered call: An uncovered call or naked call refers to a speculative position not
covered by an asset where the potentials of gains/losses are unlimited.
Dirty float: Dirty float refers to partly managed floating exchange rate wherein the
central bank intervenes to smoothen the fluctuation or to manage the value of the
domestic currency.
Clean float: Clean float it is left to the market forces of demand and supply to
determine the exchange rate.
Arbitrage: Arbitrage is the simultaneous purchase and sale of the same asset or
commodities on different markets to profit form price discrepancies.
Law of one price: In completive market characterized by numerous buyers and sellers
having low cost access to information exchange adjusted prices of identical tradable
goods and financial assets must be within transaction costs of equality world wide.
Difference between risk and exposure: Risk is the measure of uncertainty of expected
return meeting with actual return. Risk is a pact of exposure where higher the
exposure, higher is the degree of risk.
Hard currency: A hard currency is a currency which is widely and popularly traded in
the market. It is also that currency which is expected to appreciate in future.
Soft currency: A soft currency lacks liquidity and is expected to depreciate in future.
Currency option: The right to buy/sell an underlying asset being a currency for a
premium without obligation to buy/sell.
Distinguish between absolute and relative PPP: Absolute PPP ignores the effect of
transportation cost, tariff, quotas and other restrictions and product differentiation in
free trade which is considered by relative PPP.
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Floor: A contract that protects the holder against the fall in prices below a certain
point or lower limit.
Dollarization: The complete replacement of local currency with the US dollar. It helps
in providing economic stability.
Agency cost: Cost of conflicting interest between subsidiary company and parent
company’s interest.
Activities of IFM
1. Financing activity: How to raise the fund and from what source (debt or
equity)
2. Investing activity: Where to invest (application of funds collected through
financing activity)
3. Dividend decision: It decides how much of profit to be distributed to share
holders as dividend and how much of profits to be retained
4. Liquidity decision or asset management decision: It studies the proportion of
current assets and fixed assets in the total asset of the firm. Higher the
proportion of current asset in the total asset of the firm, higher is the liquidity
and vice versa.
Ex of IFM
Borrowing money from USA (financing decision) and employing the same in
Japan (Investing decision).
Importance of IFM
1. Increasing boundaries of business
2. Growing financial instruments markets and systems
3. Changing political economy
4. Globalization
5. Changing socio-economic conditions
Differences from domestic FM
1. Exchange rate
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A.CURRENT ACCOUNT
1. Merchandise (goods) BOT XXX XXX
XXX
2. Invisibles (a + b + c) XXX XXX
XXX
a) Services XXX XXX
XXX
b) Transfers XXX XXX
XXX
c) Incomes (Investment incomes) XXX XXX
B. CAPITAL ACCOUNT
1. Foreign investment XXX XXX XXX
2. Loans XXX XXX XXX
3. Banking capital XXX XXX XXX
4. Rupee debt services XXX XXX XXX
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Merchandise imports and exports of goods and services are recorded in current
account whereas transactions related to financial assets or liabilities are
recorded in capital account.
Capital outflow is a debit entry whereas capital inflow is a credit entry
(netting)
Financial transfers and real transfers are recorded in current account.
Income form investment to be recorded in current account.
International monetary system
International monetary system is defined as the institutional frame work within
which international payment are made, movement of capital accommodated and
exchange rates among currencies are determined.
In short it is a complex whole of agreement, rules, institutions, mechanism and
policies regarding
1. Exchange rates
2. International payments
3. Flow of capital
Stages of International Monetary System
1. Bimetallism (Before 1875)
It is a double standard system of free coin age for both silver and gold.
Both silver and gold were used as international means of payment and the
exchange rate among countries currency were determined by either gold or
silver reserves
2. Classical Gold Standards (1875 – 1914) 39 years
Classical gold standards system as an international monetary system
lasted for about 40 years. During this period London became the center of
international financial system reflecting Britain’s advanced economy and its
predominant position in international trade.
Under the gold standards, the exchange rate between any two
currencies was determined by their gold content.
Ex: If 1 Kg of gold is 1000 £ and 1 kg of gold is 1500 $ then the exchange rate
between £ and $ is £ 1 = $ 1.5
3. Inter-war period (1915 – 1944) 29 years
World war first ended the classical gold standards in August 1914, as
all major countries suspend redemption of bank notes in gold countries, lacked
the political will to abide by the “rules of the game” and so automatic
adjustment mechanism of gold standards was unable to work. The event of
great depression 1929 accompanying financial crisis added for further
downfall of classical gold standards.
Paper standard came into being when gold standard was abandoned.
4. Breton Hood conference system (1945 – 1972) 27 years
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3. International taxation
Host country charges tax on income earned through a foreign project
and even with holding tax is also charged on remittances made to parent
company.
Due considerations shall be given to tax credits allowed by home
countries for payments of taxes in host countries.
4. Political risk or country risk
Changes in government policies of host country, entry and exit
barriers, fluctuation in tax rate, penalties and subsidies, nationalization
policy of host country etc determine the level of international project
acceptability.
5. Inflation
Rates of inflation between home country and host country act as a
factor for international project appraisal.
6. Salvage value
Salvage value offered by the host country at the time of repurchasing
the project determines a factor for international project appraisal.
There is great interest developed in recent years among private and official
lending institution in the systematic evaluation of country’s risk.
Need
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c) Reserve balance
3) Economic performance
It can be measured in terms of country’s rate of growth and rate of inflation
Indicators of Economic performance
a) GDP/GNP
b) Gross domestic savings/GNP
c) Gross domestic investment/GDP
4) Political instability
Direct effect: - It includes political protest like strikes, lock outs etc
Indirect effect: - Adverse consequences on growth, inflation, foreign exchange
reserve etc
5) Checklist approach
a) Identification of country risk factors
b) Assign weights
c) Prepare rating scale
d) Calculation of product (wt × rating scale)
e) Calculate country risk score
International Cost of Capital
It is the return what a total capital (domestic as well as international) expects
from a project.
International Capital Structure
It is the means of financing a project using an ideal mix of various sources of
capital like debt, equity and preference shares so as to maximize the value of firm and
minimize the overall cost of capital.
Differences in cost of capital for an MNC and domestic firm can be because of
the following factors
(1) Size of the firm
(2) Foreign exchange risk
(3) Access to international capital market
(4) International diversification effect
(5) Country risk
1. Political risk
2. Economic risk
Multinational Taxation
The objective of multinational taxation is to minimize the total tax burden on
multinational projects.
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Different countries charges tax based on either the source of income generated
from a particular place or based on residential status or a combination of both.
Double Taxation
An income earned in a foreign country may be charged to tax both in foreign
country as well as home country. This concept of charging tax twice for the same
income is called double taxation.
As provided in natural law, same income shall not be charged to tax twice.
Thus double taxation relief might be awarded based on section 90 (bilateral
agreement) and section 91 (unilateral agreement) of Indian Income Tax Act of 1961.
a) Bilateral agreement
b) Tax holiday
c) Deductions available under chapter (6) of Indian Income Tax Act of
1961.
d) Exemption under section 10 of Indian Income Tax Act of 1961.
e) Mutual benefits
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A multinational firm might maintain inventory and re-order level far in excess
of the economic order quantity. The following reasons shall be attributable for the
same.
1) Anticipating devaluation
If devaluation of local currency is expected in near future, after
devaluation imported inventory will cost more in local currency. Hence higher
level of inventory is maintained but however a trade off on higher holding cost
and high local interest rate is to be made.
2) Anticipating price freeze
When local government enforces price freeze following devaluation,
the organization establishes price of an imported item at a high level with
actual sales made at discount. In the event of devaluation sales continue at the
posted price but discounts are withdrawn
3) Purchase of forward contract
Future purchases can be hedged with exchange rate fluctuations by
entering into a forward by contract.
If the sale deed has the bills accepted by the buyer and endorsement of the
seller, it can be rediscounted with the banker and net investment in receivable can be
brought down to zero.
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Depository Receipts
A depository receipts is a negotiable instrument that usually represents a
company’s publicly traded securities (debt/equity) in foreign market.
Depository receipts are issued for stock traded abroad wherein an
intermediaries acts on behalf of the issuing company rises funds without listing the
securities mandatory on the respective country’s stock market.
1. High security
2. High liquidity
3. Diversification of risk
4. Higher return
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ADR GDR
1. ADR may be listed in New York 1. GDR may be listed in London
stock exchange. stock exchange
2. Issue expenses are more in ADR 2. Issue expenses are low in GDR
a compared to ADR
3. Compulsory voting rights to 3. Optional voting rights
investors 4. It is enough if you show a
4. US GAP has to be followed and reconciliation statement
re-accounting has to be done 5. GDR does not demand less
5. It demands more transparency of transparency as that of ADR
account
Futures Options
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money”.
Futures Options
4. Cost of forward is less since there 4. There exists transaction cost and
is no brokerage brokerage
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