1.

INTRODUCTION
1. Risk Return trade off
Let us first have a brief discussion about the relationship between RiskReturn-Value before we start our discussion on international finance. Financial decisions often involve selection between alternative courses of actions each having a distinct advantage and disadvantage. Should the company build a plant with a capacity of one million tonnes or two million tonnes? !apital budgeting decision"# should it finance its investment with more debt or lesser debt? !apital structure planning"# should it be liberal in granting credit to its customer or have a stringent credit policy? $orking capital management". %n all these decisions# the first option namely high capacity plant# more debt in capital structure and liberal credit# promises the company high return# at the same time these decisions results in the company taking greater risk also. %t is e&actly the opposite for the second option where spectacular returns are not possible at the same time the risk is also not so much. $hen incremental return is needed# necessarily incremental risk needs to be taken. 'owever how much risk should be taken to achieve the incremental returns depends on the impact the decision has on the value the shareholders wealth. (his can be understood with the help of following e&ample. Example 1: Particulars Company X Company Y )&pected )*S +, +Re.uired return +,/ +0/ 1r. 2 an investor has to decide which company3s share should be bought. 2dvise him regarding the course of action. %t is normal for any investor to e&pect more return when the risk is more. For e&ample when an investor puts money in a bank deposit he is satisfied with a return of 4/ but if he invests the same money in a mutual fund scheme he e&pects 50/--,/ return. %n our e&ample company 6 is less risky and company 7 has more risk. 'ence the market re.uires higher return from 7 than from 6. (o conclude# the re.uired return represents the risk of the companies.

(he advantage of company 7 is that it promises more return as seen from high e&pected )*S and the disadvantage is that the company is more risky as evident from its higher re.uired return. %t is vice versa for company 6. (he value of the company3s share is the price the market is willing to pay for it. %n case of company 6# market is willing to pay Rs +,, as 1*S if the )*S is Rs +, re.uired return is +,/". Since the )*S of the company is Rs +, the 1*S of 6 is Rs+,,. Similarly for company 7# the market is willing to pay Rs +,, as 1*S if the )*S is Rs +0 re.uired return is +0/". Since the e&pected )*S of the company is only Rs +- the 1*S of 7 is Rs 89.9: +-;+0/". !ompany 6 is better since its value 1*S" is higher than 7. $hy company 73s value is low? For the investor# the company 73s incremental return )*S" is lesser than the incremental risk he is taking to earn that )*S. %t is not only important to ma&imi<e profit# it is also important to see how much risk one is taking to get the e&tra profit. %n case of 7 the risk taken is more than the return obtained and hence the value drops. (hus value is the product of two variable namely risk and return. Exhibit 1
RE!"R# R$ %

V&'"E
Relationship between Risk-Value and return and value Return EP 1ore 1ore Less Less Risk Required return 1ore 1ore Less Less Value Less 1ore Value 1ore Less

(o conclude# a company should take financial decisions in such a way that it should not only ma&imi<e profit but also ma&imi<e the wealth. $ealth ma&imi<ation involves two aspects namely profit ma&imi<ation and managing risk.

2. Currency Risk

2round the world# barriers to international trade and capital flows has been vastly reduced paving way to increased flow of capital# movement of goods and provision of services. %n %ndia also liberali<ation of economy happened during the last decade. 2s a result %ndian firms now have wider options relating to funding their operations# market for their goods# source of supply of materials# workforce# capital e.uipments etc. 2long with option comes the comple&ity in making choices and vulnerability of business to events happening globally either directly or indirectly. $e have already seen that risk management is a vital function of finance managers. Risk is nothing but uncertainty in cash flows. 2 bank deposit is considered by an investor as less risky because he knows with certain amount of assurance what he is going to get as interest# but the same cannot be said about a dividend from a company3s share and hence investors will feel investment in shares to be more risky. =ormally companies are confronted with two types of risks namely >usiness risk and financial risk. >usiness risk arises due to the investment decisions of the company like the pro?ects undertaken# assets used etc. For e&ample a company which has undertaken pro?ects which gives stable cash flows is said to be having low business risk than the company whose pro?ect cash flows are highly uncertain. Similarly companies which are capital intensive and having to spend huge amount of fi&ed cost in its production cost is said to be having more business risk. Financial risk arises due to the way in which a company funds its operation. For e&ample a company having high debt content in its capital structure is said to be having high financial risk. !ompanies which do business beyond borders are e&posed to one more type of risk called as currency risk. !urrency risk arises because of uncertainty in cash flows due to e&change rate fluctuations. Let us under stand this with the help of the following e&ample. Example (: 2n %ndian firm e&ported goods worth Rs +, lakhs to a customer in @S. 'e priced the goods in dollars based on the prevailing e&change rate between Rs and A which happened to be A+ B Rs C, i.e the sale was priced at A50,,, +,L;C,". (he payment is due after - months.

'ere the sale has been effected and say the e&porter also is protected through bank guarantee in case of default by the customer. 'ence there is no business risk in this transaction. Still there e&ists uncertainty for the investor. 'e does not know his rupee realisation as it depends on the e&change rate that would prevail after - months. Suppose the dollar depreciates and becomes Rs -4# the e&porter gets only Rs 4:0,,, A50,,, & -4" for his sale# while the value of goods sold three months back was Rs +, lakhs. (his uncertainty in cash flows arising due to e&change rate fluctuations is what we refer as currency risk. (he foreign currency receivable or payable

which is e&posed to risk of e&change rate fluctuation is called as D)&posureE. %n the above e&ample the %ndian firm is having a receivable e&posure. %f the %ndian firm has to pay dollars for imports# then such e&posure is called as payable e&posure. Exhibit ) (

0usiness Risk

1inancial Risk

Currency Risk

!otal Risk

(he concepts in international financial management predominantly deal with the management of this currency risk. 'ere we would be discussing various strategies to reduce this currency risk like Forward hedging# 1oney market hedging# 'edging through currency futures and options. (he word 'edging means Da risk reducing strategyE. )ven though hedging is the main aspect that would be discussed# we would also deal with some profit generating strategies like !urrency arbitrage# !overed interest arbitrage# speculations in futures etc. (hese strategies can be devised to generate profit when there e&ist imperfection in the market.

2. BASICS IN INTERNATIONAL FINANCE

>efore we proceed to discuss the concepts mentioned above# we should have some basic understanding about certain terms and certain basic mathematics used in foreign e&change market. (his segment >asics in %nternational Financial 1anagement deals with the same. (he areas to be discussed in this segment are as belowF 1* !ypes o+ ,uotes (* !ypes o+ Rates and pread

-* .irect to $ndirect quote ) +or a t/o /ay quotes

2* Cross rates

1. Types of Quotes
)very market .uotes the price of the commodity traded in it. For e&ample in the vegetable market we have price for apples# oranges etc# in bullion market we have .uotes for gold and silver# in the share market we have the .uotes for shares of different companies and so on. Similarly in the foreign e&change market we have the .uote for the foreign currencies. Foreign currencies are also commodities like apple# gold or share# which has a price at which it can be bought or sold. (he currency market can give the .uotes for the currencies in two ways namely Girect .uote and %ndirect .uote. Girect .uote is the natural way of saying price for a commodity. For e&ample when we ask what is the price of an apple and the seller says + apple B Rs 0# it is called as direct .uote. Hn the other hand if we ask how many apples Re + can buy and the sell says Re + can buy ,.5, apples +;0"# it is an indirect .uote. Similarly in the e&change market if +A B Rs C, is given as the .uote# it is called as direct .uote. %f the .uote is Re + B A,.,50 +;C,"# it is indirect .uote. Girect .uote means e&pression of one unit of foreign currency in so many units of local currency eg +A B Rs C,I + euro B Rs 00. %ndirect .uote means e&pression of one unit of local currency in so many units of foreign currency. )g Re + B A,.,50I Re + B )uro ,.,+8. +;Girect .uote B %ndirect .uote and +;%ndirect .uote B Girect .uote. #ote: !ertain currencies like Japanese 7en# South Korean $on and %ndonesian rupaih are always .uoted for +,, units.

Exhibit)-

,uotes

.irect quote

$ndirect quote

4ne unit o+ +orei5n currency 6 so many units o+ local currency

4ne unit o+ local currency 6 so many units o+ +orei5n currency

3o/ to read a quote: Suppose a .uote is given as followsF A;L B +.:9. (his has to be read as +L B A+.:9. $hat is there in the denominator should be read as + unit and what is there in the numerator should be read as so many units. $hen we find this .uote in =ew 7ork# then it is direct .uote one unit of foreign currency L in so many units of local currency A" and the same .uote in London is an indirect .uote one unit of local currency L in so many units of foreign currency A". Exhibit 2: Currencies and their symbols
Country 2ustralia !anada Genmark )1@ Finland %ndia %ran Japan Kuwait 1e&ico =orway Saudi 2rabia Singapore South 2frica Sweden Swit<erland @nited kingdom @nited states Currency Gollar Gollar Krone )uro 1arkka Rupee Rial 7en Ginar *eso Krone Riyal Gollar Rand Krona Franc *ound Gollar ymbol 2A !an A Gkr M F1 Rs R% N KG *s =Kr SR SA R Skr SFr or !'F L A

Example -: Following are the .uotes given by >anker at 1umbai. .irect 7 $ndirect +O 5O -O CO +A B Rs.C-.+8 +L B Rs.:8.98 +%=R B )uro ,.,+8C +,, %ndo Rupiah B Rs.,.0,uote the 4pposite Rate

%dentify the .uote as Girect or %ndirect .uote. 2lso compute the Girect for %ndirect Puote and Vice Q Versa.

olution: +A B Rs C-.+8 +L B Rs.:8.98 +%=R B )uro ,.,+8C +,, %ndo Rupiah B Rs.,.0.irect7$ndirect Girect Girect %ndirect Girect + + + + 4pposite rate %=R B A ,.,5-5 +;C-.+8" %=R B L ,.,+5: +;:8.98" )uro B Rs 0C.-0 +;,.,+8C" %=R B %ndo Rupiah +88.94 +,,;,.0-"

2. Types of Rates
2uthori<ed dealers generally banks" are the persons who deal in foreign currencies. 2ll foreign currency transactions in our country should be routed only through authori<ed dealers. (hese authori<ed dealers buy foreign currency from the customers at Low rate and sell to them the foreign currency at high rate. (he rate at which they buy from the customer is called as >id rate and the rate at which they sell to the customer is called as offer rate or ask rate. (he difference between the >id rate and offer rate is called as spread. Spread is the profit to the dealer for foreign currency trading.

Exhibit)8

Rates

0id Rate

4++er Rate

0uyin5 rate +or the 0ank ellin5 rate +or the customer

ellin5 rate +or the bank 0uyin5 rate +or the customer

$hen we do problems care should be taken to use proper rate for doing the computations. $hen we have receivables in foreign currency# we will be selling foreign currency to authori<ed dealer or authori<ed dealer will buy from us foreign currency and he will buy at the >id rate. So simply remember that when we have receivable in foreign currency# use >id rate. Similarly when we have payables in foreign currency we should use offer rate. For e&ample as an e&porter# the relevant rate for us is >id rate and as an importer we should use offer rate. Spread B Hffer rate Q >id rate. =ormally spread is also e&pressed as /. Spread as a / B Hffer rate Q >id rate" ; Hffer rate. Example 2 .irect ,uote aO %=R;AC-.:5 Q C-.4C bO %=R;)uro 0C.CC Q 0C.9: cO %=R;+,,N ,.-449-,.-444 Find out >id Rate and offer Rate. 2lso find out the spread. )&press the spread in / olution: .irect ,uote %=R;A C-.:5 Q C-.4C %=R;)uro 0C.CC Q 0C.9: %=R;+,,N 0id C-.:5 0C.CC 4++er C-.4C 0C.9: pread ,.55 ,.5pread as 9 ,.55;C-.4C & +,, B ,.0,/ ,.5-;0C.9: & +,, B ,.C5/ ,.,,,-;,.-444&+,,B,.,:0/ 0id Rate 4++er Rate pread pread 9

,.-449 ,.-444 ,.,,,-

,.-449-,.-444 Example 8: ,uotation CC.+5 Q CC.50 5-.+5 Q 5-.-+5.+5 Q +5.5+ C9.45 Q C:.,+ Exposure +,,,, 50,,, +:00, +4,5C Position )&porter %mporter )&porter %mporter "se Recei:able 7 Payable

!hoose the correct rate and compute the receivable or payable olution: ,uotation CC.+5 Q CC.50 5-.+5 Q 5-.-+5.+5 Q +5.5+ C9.45 Q C:.,+ Exposure Position "se +,,,, )&porter >id +,,,, & 50,,, %mporter Hffer 50,,, & +:00, )&porter >id +:00, & +4,5C %mporter Hffer +4,5C & R or P CC.+5 B CC+5,, 5-.-- B 08-50, +5.+5 B 5+5:,9 C:.,+ B 84C-+8

R * R *

3. Direct to Indirect quote Two way quote

)arlier we have seen how to convert a direct .uote into an indirect .uote and vice versa. (he %ndirect .uote was inverse of the direct .uote and the direct .uote was the inverse of the %ndirect .uote. For e&ample Rs;A B C, is a direct .uote. (he %ndirect .uote is A;Rs B ,.,50 +;C,". =ow we would see how to convert direct to indirect .uote when two way .uotes are given i.e bid rate and offer rate are given. 0id rate o+ $ndirect quote 6 174++er rate o+ .irect 4++er rate o+ $ndirect quote 6 170id rate o+ .irect 0id rate o+ .irect quote 6 174++er rate o+ $ndirect 4++er rate o+ .irect quote 6 170id rate o+ $ndirect quote quote quote quote

For e&ample# if the direct .uote in a bank in !hennai for the dollar is Rs;A B C5-CC the indirect .uote is computed as followsF >id rate of %ndirect .uote A;Rs" B +;Hffer rate of direct .uote B +;CC B ,.,55:

Hffer rate of %ndirect .uote A;Rs" B +;>id rate of direct .uote B +;C5 B ,.,5-8 (he indirect .uote A;Rs" B ,.,,5:-,.,5-8. %n the above e&ample the >id rate of +A B C5 in direct .uote means that the bank will buy from the customer +A at Rs C5. $e can also understand the same as the bank selling Rs C5 for +A. %f Rs C5 is sold for +A# then what will be the selling rate of Re +? %t is nothing but +;C5 B ,.,5-8. (he bank sells one dollar for Rs C5 or sells one rupee for A,.,5-8. 'ence the bid rate if direct .uote is the offer rate indirect .uote i.e the buying .uote for one currency is the selling .uote for another. %n the same way the remaining three formulas can be understood. Example ; .irect ,uote aO %=R;A C-.:5 Q C-.4C bO %=R;)uro 0C.CC Q 0C.9: cO %=R;+,,N ,.-449-,.-444 Find out >id Rate and offer Rate for the indirect .uote and write the indirect .uote 0id Rate 4++er Rate $ndirect quote

olution: .irect quote %=R;A C-.:5 Q C-.4C %=R;)uro 0C.CC Q 0C.9: %=R;+,,N ,.-449-,.-444 0id rate +;C-.4C +;0C.9: +,,;,.-4444 4++er rate +;C-.:5 +;0C.CC +;,.-449 $ndirect quote A;Rs ,.,558-,.,554 )uro;Rs ,.,+8--,.,.,+8C +,,N;Rs 50,.,9-50,.50

4. Cross rates
Some times e&change rate .uotes between two currencies may not be readily available. %n such a case we can use a common currency .uotation to arrive at the .uotes. For e&ample# an %ndian firm has sold goods to a customer in 1e&ico and it is priced in pesos and in %ndia and in 1e&ico the e&change rate for Rs;*eso is not available. (he rate Rs;*eso can be obtained using a common currency .uote like A# )uro etc which are traded in all countries. (his procedure of obtaining e&change rate .uote between two

currencies with the help of a common currency is called as cross rates. Let us see cross rates computation with the help of the following e&amples.

Example <: aO A ; L B +.05C, bO )uro ; L B 5.0+0, cO A ; L B +.00-: Q 04 dO 'KA ; %=R B ,.+909 Q :, Find out the cross rates. olution: Part a: N;L 5-0.5, A;L +.05C, N;A N ; L & A ; L B 5-0.5, & +.05C, B -08.CC Part b: (;)uro +;5,0.8, )uro;L 5.0+0, (;L (; )uro & )uro ; L B +;5,0.8, & 5.0+0, B ,.,+55 Part c: ,uote )uro;A A;L )uro;L )uro;A & A;L" Part d: ,uote SA;%=R %=R;'KA SA ; 'KA SA;%=R 6 %=R;'KA" 0id rate +;5-.4,-, B ,.,C+8+; ,.+9:, B 0.488, ,.,C+8- 6 0.488, B ,.50,0 4++er rate +;5-.4,,, B ,.,C+8C +;,.+909 B 9.,-89 ,.,C+8C 6 9.,-89 B ,.5059 0id rate ,.+485 +.00-: ,.+485 & +.00-: B ,.-,:4 4++er rate ,.+445 +.0004 ,.+445&+.0004 B ,.-,44 N ; L B 5-0.5, )uro ; ( B 5,0.8, )uro ; A B ,.+485 Q 45 %=R ; SA B 5-.4,,, Q -, N;AB (;LB )uro ; L B SA ; 'KA B

3. FORWARD CONTRACTS
1. Introduction to forward

contracts
%n the first segment we saw that receivables or payables in foreign currency occurring on a future date are e&posed to currency risk. $e do not know how much will be the realisation or payment in home currency since the cash flow depends on the e&change rate prevailing on the date of conversion. So to mitigate the currency risk a company would like to adopt a hedging strategy. 2s we already know# hedging is nothing but risk eliminating strategy. Hne of the popularly used hedging strategies is forward hedging. Example =: 2n %ndian firm e&ported goods worth Rs +, lakhs to a customer in @S. 'e priced the goods in dollars based on the prevailing e&change rate between Rs and A which happened to be A+ B Rs C, i.e the sale was priced at A50,,, +,L;C,". (he payment is due after - months. (he >ank is .uoting a months forward rate for A at Rs C5. Giscuss about the risk e&posure the firm is having and suggest a way to cover this e&posure. (he %ndian firm is having a receivable e&posure. %f the dollar depreciates in months# then the firm will not reali<e the value of the goods e&ported. Say the dollar is .uoted at Rs -4 after - months# then the customer will reali<e only Rs 4:0,,, A50,,, & -4". (he loss due to e&change rate variation is Rs 50,,, +,L Q 4.:0L". (o remove the uncertainty in rupee realisation# the firm can enter into a forward contract with the bank to sell A50,,, after - months at the forward rate .uoted by the bank here the bank has .uoted Rs C5 as forward rate". %rrespective of the e&change rate prevailing on the date of conversion# the bank will buy and the firm should sell the dollar at Rs C5. (hus on the spot itself today itself" the %ndian firm is in a position to know its rupee realisation for a conversion which is to take place on a future date. %t may be argued that# the forward contract is good for the %ndian firm if the dollar depreciates but it would be at a disadvantage if the dollar appreciates. Suppose after - months the dollar rises to Rs C0# the %ndian firm could have reali<ed Rs ++50,,, A50,,, & C0" but due to forward contract it reali<ed only Rs +,0,,,, A50,,,&C5". (his argument is incorrect. (he ob?ective of entering into forward is to ensure certainty in cash flow and not to make profit from e&change rate fluctuations. (he firm should try to make profit from its business of buying and selling goods and not by buying and selling currency. %f the company is able to secure a certain cash flow at the end of months through forward# the forward is said to have achieved its ob?ective# which in fact is achieved through forward. (o summarise# Forward contract is a contract for sale or purchase of foreign currency on a future date with the e&change rate decided now. %t is the most popularly used hedging strategy against currency risk.

2. Forward pre discount

iu

and Forward

(he forward rate .uoted by the bank may be either greater than spot rate or less than spot rate. %f the forward rate is more than spot rate# then forward is said to be .uoted at premium and if the forward rate is less than spot rate# then the forward is said to be .uoted at discount. Exhibit);

1or/ard

Premium
1or/ard rate > spot rate

.iscount
1or/ard rate ? spot rate

(he forward premium or discount can be represented in annuali<ed / which would be very useful for us when we discussed further concepts like covered interest arbitrage etc.
1or/ard rate pot rate X 1@@ X pot rate n 1(

Forward premium or discount in annualized % =

3. !utri"#t forward and Forward wit# swap points

Forward rates can be given in two ways namely Hutright forward and Forward with swap points. For e&ample if the bank .uotes - months forward as Rs;A C- - C0 it means that the - months forward bid rate is C5 and forward offer rate is C-. (his way of .uoting forward is called as outright forward. (he forward rate can also be given as followsF Spot rate Rs;A B C+ Q C5 Swap points 5;-. (he forward can be computed by adding or subtracting the swap points to the spot. %n the above e&ample forward bid rate is C+R5 B Cand forward offer rate is C5R- B C0. %f the swap point are premium swap

points# then add it to the spot and if it is discount swap points then reduce it from the spot. 'ow to know whether swap points are premium or discount swap points? %f the swap points are in ascending order then it is premium swap point and if the swap points are in descending order then it is discount swap points. %n the above e&ample if the swap points are given as -;5# the forward is a discount forward because the swap points are descending and hence needs to be subtracted from spot. (he forward bid rate is C+-- B -8 and the forward offer rate is C5-5 B C,.

Exhibit)<

1or/ard

4utri5ht

pot B

/ap points

Premium s/ap
&scendin5: &dd

.iscount s/ap
.escendin5 : 'ess

Example A: aO Spot + @SA B C0.+5 -C0.5C - months forward rate C0.-: Q C0.C4 !omments on the forward as outright or spot with swap points Find out premium;discount in annuali<ed / bO Spot Rate + @SA B C0.,+ - C0.+5 - months ,.5C - ,.-9 swap points !omments on the forward as outright or spot with swap points Find out premium;discount in annuali<ed / cO Spot rate + @SA B 50.C0 - 50-9,

9 months swap points ,.+5 - ,.,: !omments on the forward as outright or spot with swap points Find out premium;discount in annuali<ed / . olution: Part a: (ype of forward Hutright forward *remium or discount Forward premium *remium in / Forward rate Q Spot rate";Spot rate & +,, & +5;n >id premium C0.-: - C0.+5";C0.+5 & +,, & +5;- B 5.55/ Hffer premium C0.C4 - C0.5C";C0.5C & +,, & +5;- B 5.5+/ Part b: (ype of forward *remium or discount Forward bid rate Forward offer rate *remium in / >id premium Hffer premium Part c: (ype of forward *remium or discount Forward bid rate Forward offer rate *remium in / >id premium Hffer premium Spot with swap points Forward discount because swap points 50.C0 - ,.+5 B 50.-50.9, - ,.,: B 50.0Forward rate Q Spot rate";Spot rate & 50.-- Q 50.C0";50.C0 & +,, & +5;9 B 50.0- Q 50.9,";50.0- & +,, & +5;9 B Spot with swap points Forward premium because swap points ascending C0.,+R,.5C B C0.50 C0.+5R,.-9 B C0.C8 Forward rate Q Spot rate";Spot rate & +,, & +5;n C0.50 - C0.,+";C0.,+ & +,, & +5;- B 5.+-/ C0.C8 - C0.+5";C0.+5 & +,, & +5;- B -.+4/

descending

+,, & +5;n ,.4C// ,.00/

4. FORWARD RATE DETERMINATION

%n the earlier segment we had an introductory discussion about forward e&change rate. %n this segment we are going to see how forward e&change rates are theoretically determined. $e would be seeing two theories of forward rate determination namely purchasing power parity theory and %nterest rate parity theory.

1. $urc#asin" power parity t#eory %$$$&

Exchan5e rate determination usin5 PPP: )&change rate is nothing but price of one currency in relation to another currency. 2s per *** e&change rate between currencies is based on law of one price. $e can understand how *** theory derives e&change rate between two currencies with the help of the following e&ample. Example 1@: 2 transistor is sold in @S for A+,,. 2 similar transistor is also sold in %ndia at Rs C,,,. 2s per *** theory what should be the e.uilibrium e&change rate? %f actually the e&change rate is +A B Rs 0, what opportunities are there for an arbitrageur? %t could be seen that the purchasing power of A+,, is e.ual to the purchasing power of Rs C,,,. 'ence we can say that A+,, B Rs C,,,. From this parity we could arrive at the e&change rate between dollar and rupees as +A B C,,,;+,, B Rs C,. (hus as per *** theory# the e.uilibrium or theoretically correct e&change rate is +A BRs C,. $hen the actual e&change rate is +A B Rs 0, *** parity is absent. Gue to this the transistor is now cheaper in %ndia because in @S the price of transistor is A+,, and in %ndia the price is Rs C,,, and in dollar e.uivalent it is ?ust A8, C,,,;0,". 2 customer instead of purchasing the transistor in @S for A+,, can purchase the same in %ndia by paying Rs C,,, after converting ?ust A8,. Gue to this in %ndia dollar supply will increase because people from abroad sell dollars and convert into rupees for buying the transistor and at the same time the demand for transistors also increase in %ndia because people from abroad buy transistor in %ndia as it is available cheap. Gue to increase in supply of dollars# its price or value reduces it drops below Rs 0," and due to increase in demand for the transistor# its price increases increases beyond Rs C,,,". $hen this process continues for some time e.uilibrium in e&change rate occurs and *** between dollar and rupees is restored. Puote for foreign currency under *** can be written as under

1 unit o+ +orei5n currency 6 Price o+ 5oods in home country Price o+ the 5oods in +orei5n country

1or/ard rate determination usin5 PPP theory (his law of one price can be e&tended to find out theoretical forward rate also. Let us see how forward rate is arrived using *** theory. Example 11: 2 transistor is sold in @S for A+,,. 2 similar transistor is also sold in %ndia at Rs C,,,? %nflation in %ndia is +,/ and in @S is 9/. !alculate the e.uilibrium forward rate using *** parity theory. olution: !oday Hne transistor in @S B A+,, Hne transistor in %ndia B Rs C,,, Spot e&change rateF A+,, B Rs C,,,I +A B Rs C,,,;+,, B Rs C, &+ter one year: Hne transistor in @S B A+,, S+.,9O B A+,9 Hne transistor in %ndia B Rs C,,, S+.+,O B Rs CC,, Forward rateF A+,9 B Rs CC,,I +A B Rs CC,,;+,9 B Rs C+.0+ 3o/ can the +or/ard calculated abo:e be called as equilibrium +or/ardC (he forward rate of +A B Rs C+.0+ establishes parity in purchasing power between %ndia and @S. 2t the end of first year if we want to buy a transistor in @S# we need to pay A+,9 to buy it. (he same transistor in %ndia cost Rs CC,, or in dollar terms it is A+,9 RsCC,,;C+.0+". $hether a customer goes to @S with rupees and converts into dollars and buys or comes to %ndia# sells dollar and convert into rupees and buy# the e.uivalent cost is same in both countries. %n @S the commodity is cheap due to low inflation but the dollar has appreciated to become costly to purchase. %n %ndia the rupee has weakened and become cheaper to purchase but the commodity price is more due to high inflation. (he advantage in @S is that the product is cheaper to buy but disadvantage is that the currency is costly to buy. %n %ndia it is vice versa. %f the forward rate is other than +A BRs C+.0+# then there will be no parity in purchasing power between %ndia and @S and scope for arbitrage e&ist.. Forward rate under *** can be calculated using the formulaF

1 unit of foreign currency = Spot rate x [1+Inflation rate in home country ] [1+ Inflation rate in foreign country]

%n our e&ample applying this formula forward rate isF +A B C, & +.+,;+.,9" B Rs C+.0+ @nder *** theory# the country which has low inflation rate will have its currency .uoted at premium and country in which the inflation rate is high will have its currency traded at discount. 'ere @SA is trading at premium in forward market because the inflation is low in @S. 2s per *** theory the difference in inflation rates between two countries will be appro&imately e.ual to the annuali<ed premium or discount /. Check: 2nnuali<ed / premium B FR-SR";SR & +,, &+5;n B C+.0+ Q C,";C,&+,, &+5;+5 B -.:8 / or C/ appro&". (he inflation rate difference is also C/ +,/ - 9/"

2. Interest rate parity %IR$&

Forward rate computation under interest rate parity theory is on the same lines as *** theory. (he only difference is that we use interest rates of both countries in place of inflation rates for forward computations. %n this %R* theory# the country where the interest rates are low will have its currency .uoted at premium and the country which is having high interest rate will have its currency value weakened. (he interest rate differential and the forward premium will appro&imately be e.ual. 2ll these we can understand through the following e&ample. Example 1(: Spot e&change rate Rs;A B C, %nterest rate in %ndia B +,/ p.a %nterest rate in @S B 0/ p.a

!alculate the e.uilibrium forward e&change rate using %R*. 2lso e&plain why this forward is called as e.uilibrium forward.

pot rateF +A B Rs C,

&+ter one year +A at 0/ interest rate in @S will grow to A+ S+.,0O B A +.,0 Rs C, at +,/ interest rate in %ndia will grow to Rs C, S+.+,O B Rs CC Forward rateF A+.,0 B Rs CCI +A B Rs CC;+.,0 B Rs C+.4, 2lternatively forward rate can be calculated using the %R* formula

1 unit of foreign currency = Spot rate x [1+Interest rate in home country ] [1+ Interest rate in foreign country]

%n our e&ample applying the formula forward rate isF +AB Rs C, & +.+,;+.,00" B Rs C+.4, &nalysis o+ $nterest rate parity concept Let us take two investors having different ideas about the opportunities the above facts presents. %nvestor + thinks that money can be borrowed in @S at a cheaper rate of 0/ and can be deposited in %ndia at a higher rate of +,/. 'e plans to use this interest rate difference to his advantage. Hn the other hand another person investor 5 sees that dollar is .uoted at premium in the forward market and feels that he could borrow some rupees today and buy dollar at spot when it is cheaper and later sell it at premium to make profit in currency market. %n nut shell investor + wants to make profit in money market and investor 5 wants to make profit in currency market. Let us see who succeeds. $n:estor 1 strate5y &ction at spot +. >orrow A+,, T0/ in @S for one year 5. !onvert A+,, into Rs C,,, +,, & C," -. %nvest Rs C,,, in %ndia T+,/ for one year &ction a+ter one year +. Realise investment with interest Rs C,,, +.+," B Rs CC,, 5. !onvert into A using forward rate Rs CC,, ; C+.4, B A+,0 -. Repay borrowing with interest A+,, +.,0" B A+,0 C. (ake home A+,0 - A+,0 B , %nvestor + borrowed at 0/ and invested at +,/ and planned to take home a profit of 0/. >ut to his surprise he has gained nothing through this strategy. $hy his gain is nil? $hat happened to the 0/ interest advantage? %nvestor + sold dollar at spot for Rs C, and when he reconverted the rupees into dollar in the forward market he purchased the dollar at Rs C+.4,. i.e he sold dollars at Rs C, and purchased it back at Rs C+.4,. (his loss in currency

market has totally swallowed the gain made in money market# leaving nothing for the investor to take home as gain. $n:estor ( strate5y &ction at spot +. >orrow 5. !onvert -. %nvest &ction a+ter one year +. Realise investment with interest 5. !onvert into rupees using forward rate -. Repay borrowing with interest C. (ake home

RsC,,, T+,/ in %ndia for one year RsC,,, into A+,, C,,,; C," A+,, in @S T0/ for one year A+,, +.,0" B A+,0 A+,0 & C+.4, B Rs CC,, RsC,,, +.+," B Rs CC,, Rs CC,, Q RsCC,, B ,

%nvestor 5 bought dollar at spot for Rs C, and sold it in the forward market of Rs C+.4, and e&pected to take home a profit of Rs +.4, per dollar. Hnce again for him also the gain is nil why? %nvestor 5 borrowed money at +,/ in %ndia and invested in @S only at 0/. (he gain made in the currency market is eaten up by the loss of interest in money market. (hus it could be seen that the e.uilibrium forward computed under %R* offsets interest rate differential with the forward premium or discount and closes the door for arbitrageur to make any arbitrage gain. !heckF 2nnuali<ed / premium B FR-SR";SR & +,, &+5;n B C+.4, Q C,";C,&+,, &+5;+5 B C.:0 / or 0/ appro&". (he interest rate difference is also 0/ +,/ - 0/"

5. COVERED INTEREST ARBITRAGE [CIA]

%f the forward rate is arrived using %R* theory it is seen that# the interest rate differential is offset by the premium or discount on the currency and an investor cannot make arbitrage gain by borrowing in one currency and investing in other currency because what he gains or loses in money market is completely offset by what he gains or loses in currency market. >ut# the forward rate .uoted by banks need not be the theoretical forward e.uilibrium forward" calculated under %R*. %n such a case there is a scope of making arbitrage gain by borrowing in one currency and investing in another. (his process is called as !overed %nterest 2rbitrage. !%2 arises when %R* is absent or in other words the actual forward rates .uoted by the banks are different from the theoretical forward calculated using %R*.

1. 'teps in Co(ered Interest )r*itra"e )pproac# 1

=ow we are going to first list the steps for solving a covered interest arbitrage problem# then apply these steps with the help of an e&ample and finally make a thread bare analysis of what happens in covered interest arbitrage. Exhibit = C$& !EP
1* $denti+y the local currency and +orei5n currency +or the quote 5i:en in the problem (* Calculate the annualiDed +or/ard premium or discount 9 -* &pply rule 2d?usted Foreign %nterestULocal %nterestF >orrow locally V %nvest abroad. 2d?usted Foreign %nterestWLocal %nterest F>orrow abroad V %nvest locally 2* &ction pot >orrow !onvert %nvest Eaturity date Realise Reconvert Repay borrowing >ook profit

2d?usted foreign interest B Foreign %nterest rate R *remium or Foreign interest rate Q Giscount.

Example 1-: Spot e&change rate Rs;A B C, ituation 1: %nterest rate in %ndia B +,/ p.a %nterest rate in @S B 0/ p.a Hne year forward rate .uoted by the bank F Rs;A B C ituation (: %nterest rate in %ndia B 9/ p.a %nterest rate in @S B :/ p.a Hne year forward rate .uoted by the bank F Rs;A B -4

Show how a person can make arbitrage gain by using the dise.uilibrium

e&isting in money market and foreign currency market. %f you borrow rupees# take the borrowings to be Rs C,,,I %f you borrow in dollars# take the borrowings to be A+,,.

olution:
tep 1 tep ( tep -

ituation 1: 1or/ard rate 1F 6 Rs 2 Local currencyF Rupees Foreign currencyF Gollars FR Q SR";SR & +,, & +5;n B C--C,";C, & +,, & +5;+5B :.0/ Local interest rate B +,/ Foreign interest rate B 0/ 2d?usted foreign interest rate B Foreign interest rate R *remium B 0/ R :.0/ B +5.0/ StrategyF Since 2d?usted foreign interest rate U Local interest rateI >orrow in local currency Rs" and %nvest in foreign currency A" pot >orrow Rs C,,, T +,/ for one year !onvert Rs C,,, into A+,, C,,,;C," using spot e&change rate. %nvest A+,, in @S at 0/ interest rate for one year Eaturity date Realise deposit with interest B A+,, & S+.,0O B A +,0 !onvert A+,0 into Rs C0+0 A+,0 & C-" using forward rate Repay borrowing with interest B Rs C,,, & S+.+,O B Rs CC,, >ook profit B C0+0 Q CC,, B Rs ++0.

%dentification of currency Forward premium / 2pply rule

tep 2

2ction

ituation (: 1or/ard rate 1F 6 Rs -A

tep 1 tep ( tep %dentification of currency Forward discount / 2pply rule Local currencyF Rupees Foreign currencyF Gollars FR Q SR";SR & +,, & +5;n B -4-C,";C, & +,, & +5;+5 B -5.0/ Local interest rate B 9/ Foreign interest rate B :/ 2d?usted foreign interest rate B Foreign interest rate - Giscount B :/ - 5.0/ B C.0/ StrategyF Since 2d?usted foreign interest rate W Local interest rateI >orrow in foreign currency A" and %nvest in Local currency Rs" pot >orrow A +,, T :/ for one year !onvert A+,, into RsC,,, A+,,&C," using spot

tep 2

2ction

e&change rate. %nvest Rs C,,, in %ndia at 9/ interest rate for one year Eaturity date Realise deposit with interest B C,,, & S+.,9O B Rs C5C, !onvert Rs C5C, into A +,8.:5 Rs C5C,;-4" using forward rate Repay borrowing with interest B A+,, & S+.,:O B A+,: >ook profit B +,8.:5 Q +,: B A+.:5.

&nalysis o+ C$& steps 2rbitrage is nothing but a process of buying in a cheaper place and selling in the place where the price is high. 1oney market is a market where money is bought and sold. $hen we buy money we call it as borrowings for which the price is the interest paid and when we sell money we call it as deposits for which the price we get is interest received. %n money market arbitrage gain can be made by borrowing at low interest and investing at high interest. (hat is the reason why in situation + when the ad?usted foreign interest rate is more than local interest rate# we deposited in foreign currency more interest" and borrowed in local currency less interest" and it is vice versa in situation 5. $hen we decided where to borrow and where to invest# we did not compare foreign interest rate and local interest rateI instead we compared ad?usted foreign interest rate and local interest rate why? (here a difference between local investment and investment in foreign currency. $hen we invest locally the entire interest earned can be taken home immediately but when we invest in foreign currency# the maturity proceeds has to be converted into local currency before we take home the earnings. 'ence there are two cash flows that take place for foreign currency investments namely %nterest earned and gain or loss on conversion. %f the forward is at premium# our conversion of foreign currency into local currency gives us more inflows in term of local currency and it is vice versa if the forward is at discount. (herefore the effective earnings from a foreign currency is the interest earned plus premium on conversion or the interest earned minus discount on conversion. (his is what we call as ad?usted foreign interest rate. $e compare ad?usted foreign interest rate with local interest rate because foreign investment involves conversion gain and loss also. %n situation +# dollar interest rate is only 0/ compared to rupee interest rate of +,/# still we invest in dollars because the interest along with premium on conversion gives us +5.0/ compared to ?ust +,/ given by %ndian rupee. Similarly in situation 5# rupee interest is 9/ while interest given by dollar investment is :/ but still we invested in rupees because upon conversion

the dollar interest is eroded by discount on conversion and the effective earnings works out to only C.0/ against 9/ rupee investment gives.

2. 'teps in Co(ered Interest )r*itra"e )pproac# 2

=ow we are going to see the alternative way of doing !%2 problem. 2s we did in the previous discussion# we would first list down the steps# understand its application with the help of an e&ample and finally make an analysis of what we have done. From the e&hibit given below it could be seen that the action step in approach + and 5 are e&actly same. Hnly the step 5 and step - differs between both approaches. %n approach + we decide where to borrow and invest by comparing effective interest rates earned and in approach 5 we do it by comparing theoretical and actual forward rates. Exhibit A:

C$&

!EP

1* $denti+y the local currency and +orei5n currency +or the quote 5i:en in the problem (* Calculate theoretical +or/ard rate usin5 $RP theory -* &pply rule 2ctual forwardU(heoretical forwardF >orrow locally V %nvest abroad. 2ctual forwardW(heoretical forward F >orrow abroad V %nvest locally 2* &ction pot >orrow !onvert %nvest Eaturity date Realise Reconvert Repay borrowing >ook profit

(heoretical forward B Spot rate & +R%nterest rate in home country " +R %nterest rate in foreign country"

Let us solve e&ample +- once again using approach 5F

ituation 1: 1or/ard rate 1F 6 Rs 2-

tep 1 tep ( tep -

%dentification of currency (heoretical forward 2pply rule

tep 2

2ction

Local currencyF Rupees Foreign currencyF Gollars Spot rate & +R'ome currency interest"; +RForeign currency interest"I +A B Rs C, +.+,;+.,0" B Rs C+.4, 2ctual forward rate F +A B Rs C (heoretical forward rate F +A B Rs C+.4, StrategyF Since 2ctual forwardU(heoretical forwardF >orrow locally V %nvest abroad. pot >orrow Rs C,,, T +,/ for one year !onvert Rs C,,, into A+,, C,,,;C," using spot e&change rate. %nvest A+,, in @S at 0/ interest rate for one year Eaturity date Realise deposit with interest B A+,, & S+.,0O B A +,0 !onvert A+,0 into Rs C0+0 A+,0 & C-" using forward rate Repay borrowing with interest B Rs C,,, & S+.+,O B Rs CC,, >ook profit B C0+0 Q CC,, B Rs ++0.

ituation (: 1or/ard rate 1F 6 Rs -A

tep 1 tep ( tep %dentification of currency (heoretical forward 2pply rule Local currencyF Rupees Foreign currencyF Gollars Spot rate & +R'ome currency interest"; +RForeign currency interest"I +A B Rs C, +.,9;+.,:" B Rs -4.9 2ctual forward rate F +A B Rs -4 (heoretical forward rate F +A B Rs -4.9 StrategyF Since 2ctual forwardW(heoretical forwardF >orrow abroad V %nvest locally. pot >orrow A +,, T :/ for one year !onvert A+,, into RsC,,, A+,,&C," using spot e&change rate. %nvest Rs C,,, in %ndia at 9/ interest rate for one year Eaturity date Realise deposit with interest B C,,, & S+.,9O B Rs C5C, !onvert Rs C5C, into A +,8.:5 Rs C5C,;-4" using forward rate Repay borrowing with interest B A+,, & S+.,:O B A+,: >ook profit B +,8.:5 Q +,: B A+.:5.

tep 2

2ction

&nalysis o+ C$& steps

(heoretical forward rate is the e.uilibrium forward rate where !%2 is not possible. 2t the theoretical forward rate the interest rate differential will appro&imately e.ual forward premium or discount. 2bout all this we have already discussed elaborately through e&ample +5 in the %R* segment itself. =ow when the actual forward is different from the theoretical forward# then scope for arbitrage e&ists. $hen actual forward U theoretical forward# it means the actual forward has over priced the foreign currency. (his is what has happened in situation + where the dollar which is really worth only Rs C+.4, was .uoted in forward market for Rs C-. $hen dollar is over priced in forward market# we should be selling it in the forward market# to sell dollar we should borrow some rupees today and buy dollars and deposit it. (hat is why when actual forward e&ceeds theoretical forward we deposit in foreign currency. %t is vice versa when actual forward is less than theoretical forward. Students can follow any of the two approaches to do !%2 problem based on their comfort level and the re.uirement of the .uestion. >oth approaches have the same ob?ective of identifying the arbitrage opportunity and devising suitable strategy to make arbitrage profit. 2pproach + identifies arbitrage through money market by comparing interest rates"# whereas approach 5 identifies through the currency market by comparing theoretical and actual forwards.

3. 'teps in Co(ered Interest )r*itra"e two way quote

(ill now we have seen covered arbitrage for a single .uote. =ow we will see how to do covered interest arbitrage for a two way .uote. Single .uote means the buying and selling rate of a currency is same and two way .uote means bid rate and offer rate will be given. %n case of two way .uote# the !%2 will not have Steps + to - discussed above. $e will do directly the step C DactionE discussed above. 1oreover it is not possible for us to identify in any manner the profit giving arbitrage strategy i.e identify where to borrow and where to invest. $e have to do it only on trial and error basis only. Let us understand !%2 process for a two way .uote with the help of the following e&ampleF Example 12 Following are the rates .uoted at >ombay for >ritish poundF Rs 7 0P - m 1or/ard s/ap points $nterest rates 05.9, ; :, 5, ; :,

$ndia 'ondon

8/ 0/

%s it possible for the investor to make arbitrage profit? %f you borrow rupees# take the borrowings to be Rs +,,,,,,I %f you borrow in >*# take the borrowings to be >*+,,,,,. olution: Exchan5e rates Particulars 0id rate 4++er rate Spot rate 05.9, 05.:, Swap points 5, :, 2scending Q *remium" Forward rate 05.8, 0-.C, 05.9,R,.5," 05.:,R,.:," Let us see whether any arbitrage gain e&ist when the investor borrows in rupees and invest in pounds. trate5y 1 !ransactions at pot

>orrow Rs +,,,,,, T 8/ for - months !onvert Rs 0,,,,, into L+84:0 Rs +,,,,,,;05.:," using spot offer rate. offer rate is used because we buy pounds at bankers selling rate" %nvest L+84:0 in London at 0/ interest rate for - months

!ransactions on Eaturity date Realise deposit with interest B L+84:0& S+.,+50O B L+45+5. %nterest for one year is 0/ so interest for - months is 0 & -;+5 B +.50/" !onvert L+45+5 into Rs +,+C-4C L+45+5 & 05.8," using forward bid rate. in the forward market bid rate is used because we sell pounds at bankers buying rate" Repay borrowing with interest B Rs +,,,,,& S+.,5O B Rs +,5,,,,. %nterest for one year is 8/ so interest for - months is 8 & -;+5 B 5/. Loss B +,+C-4C - +,5,,,, B Rs 09,9.

Since the strategy of borrowing in rupees and investing in pounds gives loss# we will now check for any arbitrage gain when the investor borrows in pounds and invest in rupees. trate5y (

!ransactions at

pot

>orrow L+,,,,, T 0/ for - months !onvert L+,,,,, into Rs059,,,, L+,,,,, & 05.9," using spot bid rate. >id rate is used because we sell pounds at bankers buying rate" %nvest Rs 059,,,, in %ndia at 8/ interest rate for - months

!ransactions on Eaturity date Realise deposit with interest B 059,,,, & S+.,5O B Rs 0-905,,. !onvert Rs 0-905,, into L+,,C:5 Rs 0-905,,;0-.C," using forward offer rate. offer rate is used because in the forward market we buy pounds at bankers selling rate" Repay borrowing with interest B L+,,,,, & S+.,+50O B L+,+50,. >ook profit B +,,C:5 Q +,+50, B L ::8.

&nalysis: Strategy + >orrow in rupees and invest in pounds" and strategy 5 >orrow in pounds and invest in rupees" are e&actly opposite strategies. %n case of strategies which are e&actly opposite# loss in one strategy should necessarily be the gain in the other. For e&ample buying in !hennai and selling in Gelhi gives loss means naturally selling in !hennai and buying in Gelhi should give us profit. (o our surprise in this two - way .uote !%2# both strategies gives us loss. 'ow this has happened? (o answer this .uestion let us have some facts summari<ed for ready referenceF !ime trate5y 1 trate5y ( Eoney market >orrow at 8/ 0/ %nvest at 0/ 8/ *rofit or loss in / S-/O -/ Currency market Spot >uy pounds at Rs Sell pounds at Rs 05.:, 05.9, Forward Sell pounds at Rs >uy pounds at Rs 05.8, 0-.C, *rofit or loss on conversion ,.+, S,.8,O per L
*lease refer strategy + and 5 computations to pick the data written in this summary table

%n case the forward rate is .uoted at premium# we will make profit on conversion if we buy at spot low rate" and sell at forward rate high rate" i.e strategy + will give profit in currency market and it will be e&actly opposite in strategy 5 i.e when sell at spot and buy at forward. $e also know that for a forward to be .uoted at premium# the foreign interest rate should be low and

the local rate should be high. 'ence strategy + gives loss in money market and strategy 5 gives us profit in money market. =ormally when %R* holds good# the profit or loss in money market interest rate differential" will e&actly offset profit or loss in currency market and both strategies will give nil profit. %f %R* fails then any one of the strategy gives profit. %f premium on conversion currency market difference" is stronger then the interest rate difference money market difference"# strategy + will give us profit. Hther wise strategy 5 will give us profit. %n our e&ample the profit in currency market of Rs ,.+, per pound is insufficient to cover up -/ loss in money market. %f in strategy 5 the loss on conversion is same Rs ,.+, per pound# then the money market gain of -/ would have recovered it fully and given us an arbitrage gain. @nfortunately the loss on conversion is not Rs ,.+, per pound but Rs ,.8,. (he strategy 5 also gives us loss because the -/ gain in money market is insufficient to cover ,.8, per pound loss in currency market. (he ne&t .uestion is why the gain on conversion in strategy + is different from loss on conversion in strategy 5? (he reason for this is that# in a two way .uote# the gain or loss in currency market is not only determined by forward premium or discounts but also by the spread the banker charges. (he forward premium or discount will surely favour one strategy but the spread will always act against the investor because investor buys at offer rate selling price of the bank" and sells at bid rate purchase price of the bank". %n both strategies spreads operates against the investor# in strategy + it pulls down profit on conversion and in strategy 5 it increases the loss on conversion thus giving investor less profit in strategy + and more loss in strategy 5. (o conclude %n a single .uote !%2 only two factors influence arbitrage process namely interest rates and forward premium or discount. >ut in twoway .uote a third factor called as spread also determines the arbitrage process. 2s regards %nterest rates and forward premium or discount# if one of them is disadvantageous the other would be beneficial but spread always is disadvantageous to the arbitrageur. For a two way .uote to be successful in giving profit# either the interest rate difference or forward premium;discount# which ever gives us benefit should be strong enough to overtake disadvantage of the other and the disadvantage caused due to spread.

6. MONEY MARKET HEDGING [MMH]

%t is already known that hedging strategy means risk reducing strategy. %n international finance any strategy which ensures certain cash flows in home currency for future receivables or payables is a hedging strategy. %n other words# a strategy which immuni<es receivable or payable e&posure from

e&change rate fluctuation is a hedging strategy. 2lready we have discussed one hedging strategy called forward# now we will be discussing yet another hedging strategy called as 1oney market hedging 11'".

1. +oney +arket ,ed"e Recei(a*.es

=ow let us see first how to hedge a receivable e&posure using 11'. $e are going to first list the steps for solving a 11' receivable problem# then apply these steps with the help of an e&ample and finally make a thread bare analysis of what happens in 111 and a comparison of 11' with forward cover and its relationship with %R* theory and !%2. Exhibit 1@

EE3

teps

1* $denti+y the +orei5n currency exposure (* Calculate the PV o+ exposure usin5 +orei5n interest rate as discount rate -* 0orro/ the PV o+ exposure at +orei5n interest rate +or the exposure period a5ainst the recei:able 2* Con:ert the amount borro/ed into local currency usin5 spot rate 8* .eposit the amount con:erted at local interest rate +or exposure period ;* Realise the deposit amount /ith interest*

Example 18: 2n %ndian firm is to receive A+,,,,, after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF %nterest rate in %ndia +,/ %nterest rate in @S 0/ Spot e&change rate Rs;A C, !alculate the rupee realisation after one year if the e&posure is hedged using 11' !ompare 11' with forward and say which is best if Hne year forward is A+ B Rs C Hne year forward is A+ B Rs -4 Hne year forward is theoretical forward as per %R*

olution: 1 )&posure ( *V of e&posure calculated using Gollar interest rate as discount rate A+,,,,, receivable A+,,,,, & +;+.,0 B A405-8

- >orrow against dollar receivable and repay the borrowing on maturity date using the receivables 2 !onvert the amount borrowed to local currency using spot e&change rate 8 Geposit the amount converted at local interest rate ; Realise deposit with interest

A405-8 T 0/ for + year A405-8 & C, B Rs -8,405, Rs -8,405, T +,/ for + year Rs -8,405, & +.+, B Rs C+4,C:5

See e&hibit ++ for the diagrammatic presentation of 11' receivable Exhibit 11

I/DI)

0'

.eposit Rs -=@A8(@

0orro/ FA8(-=

Con:ert usin5 spot rate o+ Rs 2@

From the above it could be seen that# the rupee inflow for the dollar receivable after one year is Rs C+4,C5. (his amount is known today itself and is not influenced by future e&change rate movement. $hatever be the e&change rate after one year we will surely get the aforesaid inflow because nowhere in our computation we have used any future e&change rate for conversion.

Comp ounde d G 1@9 1 year

E@

E@

PV o+ expos ure G 89 1 year

Realise Rs 21A@2<(

Exposure F1@@@@@

E1 (

E1 (

&nalysis: %n the above e&ample the %ndian firm is having a receivable of A+,,,,, after one year. %t does not want to want to convert this receivable into rupees after a year as there is a risk of e&change rate fluctuation. 'ence it borrows foreign currency e.ual to *V of e&posure so that the amount borrowed with interest matures to an amount e.ual to e&posure# which can be later paid with the help of dollar receivable. (he borrowing gives the %ndian firm the foreign currency receivable today itself which it can convert to rupees immediately at spot rate rather than waiting for the receivable and converting it after a year. (his rupee realised today is then deposited in a local bank and later realised after one year. (he rupee realisation after a year in 11' does not depend on any future e&change rates# it depends on three factors namely SaO foreign interest rate SbO local interest rate and ScO spot e&change rate# all the three being known at spot itself. (hus 11' removes uncertainty in cash realisation and hence is an effective currency hedging strategy. EE3 :s C$& 11' is almost similar to !%2 with a motive to hedge rather than making an arbitrage gain. !%2 is a speculative tool while 11' is a hedging tool. $e can understand the similarity and difference between the two by looking at the action steps. n + 5 C 0 9 : C$& >orrow !onvert %nvest Realise Reconvert Repay out of proceeds from reconversion >ook profit EE3 >orrow !onvert %nvest Realise !ollect receivables in foreign currency Repay out of receivables =o profit because receivables e.uals the repayment amount of borrowings.

(ill step C both are similar but in 11' we take the deposit realisation home because it is the cash inflow in local currency from the foreign currency receivable. >ut in !%2 it is reconverted because the proceeds are re.uired to repay the borrowings in foreign currency earlier made. %n 11' the borrowings is made against the foreign currency receivable and hence the borrowings will be repaid not through the reconversion proceeds of our deposit realisation but out of receivables in foreign currency. 1or/ard :s* EE3 ituation 1or/ard $n+lo/ under $n+lo/ election

+ 5 -

Rs CRs -4 Rs C+.4,C:

+or/ard A+,,,,, & CB Rs C-,,,,, A+,,,,, & -4 B Rs -4,,,,, A+,,,,,&C+.4,C: B Rs C+4,C:,

under EE3 Rs C+4,C:5 Rs C+4,C:5 Rs C+4,C:5

Forward 11' %ndifferent

#ote: !heoretical +or/ard Spot rate & +R Foreign interest rate"; +RLocal interest" B C, & +.+,;+.,0" B Rs C+.4,C:. 2 firm should go for either forward hedging or 11' which ever is beneficial to it. %t should be observed that when the actual forward is same as the theoretical forward# the 11' and Forward hedge will give the same realisation. (his is evident from situation - where the rupee realisation under both the options is same. For receivable hedging# if actual forward is more than theoretical forward# forward cover is better and if it otherwise 11' is better. ituation 2ctual forward U (heoretical forward 2ctual forward W (heoretical forward 2ctual forward B (heoretical forward Recei:able 3ed5in5 Forward cover 11' %ndifferent Payable 3ed5in5 11' Forward cover %ndifferent

2. +oney +arket ,ed"e $aya*.es

=e&t let us see how to hedge a payable e&posure using 11'. $e are going to first list the steps for solving a 11' payable problem# then apply these steps with the help of an e&ample and finally understand how a 11' payable works. Exhibit 1(

EE3

teps

1* $denti+y the +orei5n currency exposure (* Calculate the PV o+ exposure usin5 +orei5n interest rate as discount rate -* .eposit the PV o+ exposure at +orei5n interest rate +or the exposure period /hose maturity proceeds can be used to meet +orei5n currency payable 2* 0uy +orei5n currency equal to PV o+ exposure at spot rate to make the deposit* 8* 0orro/ local currency to +inance the out+lo/ required +or purchase o+ +orei5n currency stated in step 2 ;* Repay the amount borro/ed /ith interest on the maturity date*

Example 1;: 2n %ndian firm has imported goods worth A+,,,,, for which the payment is to be made after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF %nterest rate in %ndia %nterest rate in @S Spot e&change rate Rs;A +,/ 0/ C,

!alculate the rupee outflow after one year if the e&posure is hedged using 11' !ompare 11' with forward and say which is best if Hne year forward is A+ B Rs C Hne year forward is A+ B Rs -4 Hne year forward is theoretical forward as per %R*

olution: 1 )&posure ( *V of e&posure calculated using Gollar interest rate as discount rate - Geposit dollar at spot whose proceeds can be used to settle payable e&posure when they become due 2 Sell local currency at spot to buy the dollars re.uired to make deposit 8 >orrow the amount re.uired in step C at local interest rate ; Repay borrowings with interest A+,,,,, *ayable A+,,,,, & +;+.,0 B A405-8 A405-8 T 0/ for + year A405-8 & C, B Rs -8,405, Rs -8,405, T +,/ for + year Rs -8,405,&+.+, B Rs C+4,C:5

See e&hibit +- for the diagrammatic presentation of 11' payable

Exhibit 1-

I/DI)

0'

0orro/ Rs -=@A8(@

.eposit FA8(-=

Con:ert usin5 spot rate o+ Rs 2@

From the above it could be seen that# the rupee outflow for the dollar payable after one year is Rs C+4,C5. (his amount is known today itself and is not influenced by future e&change rate movement. $hatever be the e&change rate after one year# our outflow will be the aforesaid amount only not more not less because nowhere in our computation we have used any future e&change rate for conversion. &nalysis: %n the above e&ample the %ndian firm is having a payable e&posure of A+,,,,, after one year. %t does not want to want to buy these dollars after one year to make its payment as there is a risk of e&change rate fluctuation. 'ence it buys some dollars today itself e.ual to *V of e&posure and deposit it in the foreign country so that the amount deposited with interest matures to an amount e.ual to e&posure# which can be used to meet the payable

Comp ounde d G 1@9 1 year

E@

E@

PV o+ expos ure G 89 1 year

Repay Rs 21A@2<(

Exposure F1@@@@@

E1 (

E1 (

e&posure. %t sells %ndian rupees at spot and to buy the dollars re.uired to make the deposit. (o finance the dollar purchase it borrows rupees locally and repays it on maturity along with interest. (he rupee outflow after a year in 11' does not depend on any future e&change rates# it depends on three factors namely SaO foreign interest rate SbO local interest rate and ScO spot e&change rate# all the three being known at spot itself. (hus 11' removes uncertainty in cash outflow related to the foreign currency payable and hence is an effective currency hedging strategy. 1or/ard :s* EE3 ituation + 5 1or/ard Rs CRs -4 Rs C+.4,C: 4ut+lo/ under +or/ard A+,,,,, & CB Rs C-,,,,, A+,,,,, & -4 B Rs -4,,,,, A+,,,,,&C+.4,C: B Rs C+4,C:, 4ut+lo/ under EE3 Rs C+4,C:5 Rs C+4,C:5 Rs C+4,C:5 election 11' Forward %ndifferent

#ote: !heoretical +or/ard Spot rate & +R Foreign interest rate" ; +RLocal interest" B C, & +.+,;+.,0" B Rs C+.4,C:. 2 firm should go for either forward hedging or 11' which ever is beneficial to it.

. MONEY MARKET HEDGING TWO!WAY "UOTE

$e have seen in the previous discussions 11' receivables and payables for a single .uote. %n e&amples +0 and +9 the spot rate was given as +A B Rs C,# we took it as buying rate for A when we bought it and selling rate when we sold it i.e. the buying and selling rate were one and the same. =ow we will look at 11' problems where >id rate and offer rate are given separately i.e. two-way .uote in currency market is given. Similarly the interest rates in %ndia and @S were given as +,/ and 0/. %f we deposited money we took it as deposit rate and when we borrowed it we took it as lending rate. 'owever in reality banks charge higher interest for lending and give lower interest for deposit i.e. money market also has two-way .uotes. %n this segment we will look at 11' steps when two-way .uotes are given for both currency and money market. =ow first let us list the steps for 11' receivable and payable for a two-way .uote# and apply them in an e&ample problem and then analyse them in detail.

Exhibit 12

EE3
n
+ 5

teps t/o /ay quotes

EE3 payable %dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency deposit rate as discount rate Geposit the *V of e&posure at foreign currency deposit rate for the e&posure period whose maturity proceeds can be used to meet foreign currency payable >uy foreign currency e.ual to *V of e&posure at spot o++er rate to make the deposit. >orrow local currency at lendin5 rate to finance the outflow re.uired for purchase of foreign currency stated in step C Repay the amount borrowed with interest on the maturity date.

C 0

EE3 recei:able %dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency lendin5 rate as discount rate >orrow the *V of e&posure at foreign currency lending rate for the e&posure period against the receivable !onvert the amount borrowed into local currency using spot bid rate Geposit the amount converted at local currency deposit rate for e&posure period Realise the deposit amount with interest.

(he above steps are illustrated through the following e&amples. (he first e&ample illustrates for 11' receivable and the second illustrates 11' payables. Example 1<: 2n %ndian firm is to receive A+,,,,, after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF %nterest rate in %ndia +,/ - +5/ %nterest rate in @S 0/ - 8/ Spot e&change rate Rs;A C, - C5 !alculate the rupee realisation after one year if the e&posure is hedged using 11' !ompare 11' with forward and say which is best if one year forward swap point is 5;-.

olution: 1acts: $nterest rate " Geposit rate Q 0/ Lending rate Q 8/ $nterest rate $ndia Geposit rate Q +,/ Lending rate Q +5/ pot exchan5e rate >id rate Q C, Hffer rate Q C5 1or/ard rate >id rate Q C,R5 B C5

Hffer rate Q C5R- B C0 EE3 recei:ables 1 )&posure ( *V of e&posure calculated using Gollar lending rate as discount rate - >orrow against dollar receivable and repay the borrowing on maturity date using the receivables 2 !onvert the amount borrowed to local currency using spot bid rate 8 Geposit the amount converted at local deposit rate ; Realise deposit with interest A+,,,,, receivable A+,,,,, & +;+.,8 B A4504C A4504C T 8/ for + year A4504C & C, B Rs -:,-:,C Rs -:,-:,C T +,/ for + year Rs -:,-:,C & +.+, B Rs C,:C,:C

Exhibit 18: Pictorial representation o+ EE3 recei:able /ith t/o /ay quotes

I/DI)

0'

.eposit Rs -<@-<@2

0orro/ FA(8A2

Con:ert usin5 spot bid rate o+ Rs 2@

E@

E@

Compou nded G 1@9 1 year H'ocal cur dep rateI

PV o+ exposure G =9 1 year H1or cur lendin5 rateI

Realise Rs 2@<2@<2

Exposure F1@@@@@

E1 (

E1 (

Comparison bet/een EE3 and 1or/ard hed5in5 Particulars Rupee realisation under 11' Rupee realisation under forward Computation !omputed earlier A+,,,,, & C5 use forward bid rate" &mount Rs C,:C,:C Rs C5,,,,,

Since 11' gives higher rupee realisation it should be selected. Example 1=: 2n %ndian firm has imported goods worth A+,,,,, for which the payment is to be made after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF %nterest rate in %ndia +,/ - +5/ %nterest rate in @S 0/ - 8/ Spot e&change rate Rs;A C, - C5 !alculate the rupee outflow after one year if the e&posure is hedged using 11' !ompare 11' with forward and say which is best if one year forward swap point is 5;-.

olution: EE3 payables 1 )&posure ( *V of e&posure calculated using Gollar deposit rate as discount rate - Geposit dollar at spot whose proceeds can be used to settle payable e&posure when they become due 2 Sell rupees and >uy dollars at spot offer rate to make the above deposit. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest Comparison bet/een EE3 and 1or/ard hed5in5 Particulars Rupee outflow under 11' Rupee outflow under forward Computation &mount !omputed earlier Rs CC8,,,, A+,,,,, & C0 Rs C0,,,,, use forward bid rate" A+,,,,, *ayable A+,,,,, & +;+.,0 B A405-8 A405-8 T 0/ for + year A405-8 & C5 B Rs C,,,,,, Rs C,,,,,, T +5/ for + year Rs C,,,,,,&+.+5 B Rs CC8,,,,

Since 11' gives lower rupee outflow it should be selected.

Exhibit 1;: Pictorial representation o+ EE3 payable /ith t/o /ay quotes

I/DI)

0'

0orro/ Rs 2@@@@@@ .eposit FA8(-=

Con:ert usin5 spot o++er rate o+ Rs 2(

&nalysis:

.ata used Foreign currency lending rate Spot bid rate

Local currency deposit rate

Compou nded G 1(9 1 year H'ocal cur lend rateI

E@

E@

PV o+ exposure G 89 1 year H1or cur deposit rateI

Repay Rs 22=@@@@

Exposure F1@@@@@

E1 (

E1 (

EE3 Recei:able
Reason %n 11' receivable we borrow at spot the *V of e&posure and repay the borrowing using the receivable e&posure. Since we borrow we use lending rate and since we borrow in foreign currency we use foreign currency lending rate. (he foreign currency borrowed is then converted into home currency. Since we sell foreign currency# we would be selling at bankers buying rate bid rate". Since we sell it today we use spot bid rate. (he conversion proceeds is then deposited in local banks# hence we use local currency deposit rate.

EE3 Payable
.ata used Foreign currency deposit rate Reason %n 11' payable we deposit at spot the *V of e&posure and use its maturity proceeds to meet the foreign currency payable. Since we deposit we use deposit rate and since we deposit in foreign currency we use foreign currency deposit rate. Spot offer For depositing the foreign currency# we buy foreign currency rate at spot. Since we buy foreign currency we would be buying at bankers selling rate offer rate". Since we buy it today we use spot offer rate. Local (o buy the foreign currency we borrow local currency. 'ence currency we use local currency lending rate. lending rate

#. MONEY MARKET HEDGING D$%&'()* + E,-$ -.(&'

4++shore markets or euro markets 1oney market can be classified into two types namely )uro currency market )uro market" and Gomestic market. For e&ample @SA can be deposited either with a bank in @S or with a bank in London also. (he deposit of @SA with a bank in London is called as )uro dollar deposit and deposit of @SA with a bank in =ew 7ork is a domestic deposit. Similarly when a person borrows @SA from a bank in Frankfurt it is called as )uro dollar loan and the same @SA if he borrows with a bank in !hicago it is called as domestic loan. %n nut shell euro currency deposit refers to deposit in a currency with a bank outside the home country of that currency and euro currency loan refers to borrowings in a currency with a bank outside the home country of that currency. (he word D)uroE used should be understood as DinternationalE and should not be confused with the currency )uro. 'ence from the aforesaid discussion it could be understood that# for every currency there are two markets namely domestic market and )uro market. Geposit and lending of a currency in its own country is domestic market and deposit and lending of a currency outside its own country is )uro market for that currency. Gue to market imperfections interest rates for a currency may be different in domestic and euro market. For e&ample a domestic yen deposit may give 9/ interest whereas an euro yen deposit may give 8/ interest. Further it should also be noted that sometimes domestic firms may be prohibited to access euro market of their own currency and non-residents may be prohibited to access domestic market of a currency by the laws of countries. %n this

conte&t how money market hedging will be affected is the sub?ect matter of discussion in this segment. Exhibit ) 1<
!ypes o+ $nterest rates

.omestic .eposit Rate

.omestic lendin5 rate

Euro deposit rate

Euro lendin5 rate

.eposit Rate +or residents

'endin5 rate +or residents

.eposit rate +or #on)Res

'endin5 rate +or #on)Res

=ow let us see how 11' should be done when euro rates are given. 2s usual first we will list the steps for 11' receivables and payables# then through an illustration learn to apply the steps and then analyse the computation. Exhibit 1=

EE3
n
+ 5

teps Euro rates

EE3 payable %dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency euro deposit rate as discount rate Geposit the *V of e&posure at foreign currency deposit rate for the e&posure period whose maturity proceeds can be used to meet foreign currency payable >uy foreign currency e.ual to *V of e&posure at spot o++er rate to make the deposit. >orrow local currency at domestic lendin5 rate to finance the outflow re.uired for purchase of foreign currency stated in step C Repay the amount borrowed with interest on the maturity date.

EE3 recei:able %dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency euro lendin5 rate as discount rate >orrow the *V of e&posure at foreign currency lending rate for the e&posure period against the receivable !onvert the amount borrowed into local currency using spot bid rate Geposit the amount converted at local currency domestic deposit rate for e&posure period Realise the deposit amount with interest.

1. +oney +arket ,ed"e Recei(a*.es 1uro rates

Example 1A: 2n %ndian firm is to receive A+,,,,, after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF Gomestic rupee interest rate )uro rupee interest rate Gomestic dollar rate )uro dollar rate Spot e&change rate Rs;A +,/ - +5/ ++/ - +-/ 0/ - 8/ 9/-4/ C, - C5

!alculate the rupee realisation after one year if the e&posure is hedged using 11' olution: 1acts: .omestic $nterest rate " F Geposit rate Q 0/ Lending rate Q 8/ Euro $nterest rate " F Geposit rate Q 9/ Lending rate Q 4/ .omestic $nterest rate $#R Geposit rate Q +,/ Lending rate Q +5/ Euro $nterest rate $#R Geposit rate Q ++/ Lending rate Q +-/ pot exchan5e rate >id rate Q C, Hffer rate Q C5 EE3 recei:ables 1 )&posure ( *V of e&posure calculated using Gollar euro lending rate as discount rate - >orrow against dollar receivable and repay the borrowing on maturity date using the receivables 2 !onvert the amount borrowed to local currency using spot bid rate 8 Geposit the amount converted at domestic %=R deposit rate ; Realise deposit with interest A+,,,,, receivable A+,,,,, & +;+.,4 B A4+:CA4+:C- T 4/ for + year A4+:C- & C, B Rs -994:5, Rs -994:5, T +,/ for + year Rs -994:5, & +.+,

B Rs C,-9945 Exhibit 1A: Pictorial representation o+ EE3 recei:able /ith Euro rates

I/DI)

0'

.eposit Rs -;;A<(@

0orro/ FA1<2-

Con:ert usin5 spot bid rate o+ Rs 2@

E@

E@

2. +oney +arket ,ed"e paya*.es 1uro rates

Example (@: 2n %ndian firm has imported goods worth A+,,,,, for which the payment is to be made after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF Gomestic rupee interest rate )uro rupee interest rate Gomestic dollar rate )uro dollar rate +,/ - +5/ ++/ - +-/ 0/ - 8/ 9/-4/

Compound ed G 1@9 1 year H'ocal cur domestic dep rateI

PV o+ exposur e G A9 1 year H1or cur euro lendin5 rateI

Realise Rs 2@-;;A(

Exposure F1@@@@@

E1 (

E1 (

Spot e&change rate Rs;A C, - C5 !alculate the rupee realisation after one year if the e&posure is hedged using 11' olution: EE3 payables 1 )&posure ( *V of e&posure calculated using )uro Gollar deposit rate as discount rate - Geposit dollar at spot whose proceeds can be used to settle payable e&posure when they become due 2 Sell rupees and >uy dollars at spot offer rate to make the above deposit. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest A+,,,,, *ayable A+,,,,, & +;+.,9 B A4C-C, A4C-C, T 9/ for + year A4C-C, & C5 B Rs -49558, Rs -49558, T +5/ for + year Rs C,,,,,,&+.+5 B Rs CC-::0C

Exhibit (@: Pictorial representation o+ EE3 payable /ith Euro rates

I/DI)

0'

0orro/ Rs -A;((=@ .eposit FA2-2@

Con:ert usin5 spot o++er rate o+ Rs 2(

&nalysis:

.ata used Foreign currency euro lending rate Local currency domestic deposit rate .ata used Foreign

Compou nded G 1(9 1 year H.omes tic lend rateI

E@

E@

PV o+ exposure G ;9 1 year H1or cur euro deposit rateI

Repay Rs 22-<<82

Exposure F1@@@@@

E1 (

E1 (

EE3 Recei:able
Reason %n 11' receivable we borrow at spot the *V of e&posure and repay the borrowing using the receivable e&posure. Since we borrow we use lending rate# since we borrow in foreign currency we use foreign currency lending rate and since nonresidents can borrow in euro market we use euro lending rate. (he conversion proceeds is then deposited in local banks# hence we use local currency deposit rate and since resident can make only domestic deposit and not euro deposit# domestic deposit rate is used.

EE3 Payable
Reason %n 11' payable we deposit at spot the *V of e&posure and

currency use its maturity proceeds to meet the foreign currency euro deposit payable. Since we deposit we use deposit rate# since we rate deposit in foreign currency we use foreign currency deposit rate and since non-residents can deposit only in euro market we use euro deposit rate. Local (o buy the foreign currency we borrow local currency. 'ence currency we use local currency lending rate and residents can borrow lending rate only in domestic money market hence we use domestic lending rate.

/. CONCE0T OF LEADING [W)(1$,( E,-$ -.(&']

Leading refers to advancement of receivable or payables. >y advancing the e&posure# risk can be eliminated because conversion is done at spot and hence not dependent on future e&change rate fluctuation. 'owever when we want the receivables to be advanced# we cannot demand the entire amount due# the other party will demand cash discount for paying the money earlier. Similarly when we want to pay money earlier# we may re.uest the other party to give discounts. 'ow much cash discount should be given? 'ow to do hedging using leading strategy? $hat is the difference between leading and 11'? are the issues we would be discussing in this segment. =ow first let us list the steps for leading receivable and payable e&posures# and apply them in an e&ample problem and then analyse them in detail.

Exhibit (1

teps in 'eadin5
n
+ 5

'eadin5 recei:able %dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency lendin5 rate as discount rate 2sk the customer to pay at spot the *V of e&posure. (he difference between the e&posure and the *V of e&posure is the cash discount given to customer for asking him to lead the payment. !onvert the amount realised from the

%dentify e&posure !alculate the *V of e&posure using +orei5n currency deposit rate as discount rate *ay the supplier *V of e&posure at spot. (he difference between the e&posure and the *V of e&posure is the cash discount obtained from supplier for leading the payables. >uy foreign currency e.ual to *V of

'eadin5 payable the foreign currency

customer into local currency using spot bid rate Geposit the amount converted at local currency deposit rate for e&posure period Realise the deposit amount with interest.

e&posure at spot o++er rate to make the payment. >orrow local currency at lendin5 rate to finance the outflow re.uired for purchase of foreign currency stated in step C Repay the amount borrowed with interest on the maturity date.

1. 2eadin" recei(a*.es
Example (1: 2n %ndian firm is to receive A+,,,,, after one year. %t wants to cover its e&posure by leading the receivables for which it has collected the following dataF %nterest rate in %ndia +,/ - +5/ %nterest rate in @S 0/ - 8/ Spot e&change rate Rs;A C, - C5 !alculate the rupee realisation after one year if the e&posure is hedged using leading. olution: 1 )&posure ( *V of e&posure calculated using Gollar lending rate as discount rate - Hffer cash discount and ask the customer to pay at spot the *V of e&posure. 2 !onvert the amount realised from customer to local currency using spot bid rate 8 Geposit the amount converted at local deposit rate ; Realise deposit with interest A+,,,,, receivable A+,,,,, & +;+.,8 B A4504C !ustomer paysF A4504C !ash discount givenF A:C,9 A4504C & C, B Rs -:,-:,C Rs -:,-:,C T +,/ for + year Rs -:,-:,C & +.+, B Rs C,:C,:C

Exhibit ((: Pictorial representation o+ 'eadin5 recei:ables

I/DI)

0'

.eposit Rs -<@-<@2

Realise on spot a+ter o++erin5 C. FA(8A2

Con:ert usin5 spot bid rate o+ Rs 2@

E@

E@

&nalysis: %n the above e&ample the %ndian firm has to receive A+,,,,, from its customer after one year. %f it re.uests the amount to be paid immediately the customer has to borrow and pay. (he customer has to pay interest on the money borrowed. 'e would like to ensure that the maturity amount of the borrowing which he has to repay after one year does not e&ceed A+,,,,,. 'ence he can borrow only the *V of e&posure A4504C" so that at the borrowing interest rate of 8/ it matures to A+,,,,, at the end of one year. (herefore the customer will not pay A+,,,,, today# instead he will borrow and pay only A4504C and ask for a cash discount of A:C,9 which is nothing but the interest cost of his borrowing. %t should be observed that the leading strategy gives the same result as a 11' strategy see e&hibit +0". %n 11' we borrow and in leading we ask the customer to borrow and compensate his interest cost by giving cash discount.

Compou nded G 1@9 1 year H'ocal cur dep rateI

PV o+ exposure G =9 1 year H1or cur lendin5 rateI

Realise Rs 2@<2@<2

Exposure F1@@@@@

E1 (

E1 (

2. 2eadin" $aya*.es
Example ((: 2n %ndian firm has imported goods worth A+,,,,, for which the payment is to be made after one year. %t wants lead its e&posure for which it has collected the following dataF %nterest rate in %ndia %nterest rate in @S Spot e&change rate Rs;A +,/ - +5/ 0/ - 8/ C, - C5

!alculate the rupee outflow after one year if the e&posure is hedged using leading.

olution: 1 )&posure ( *V of e&posure calculated using Gollar deposit rate as discount rate - 2vail cash discount and settle the payable at spot by paying *V of e&posure. 2 Sell rupees and >uy dollars at spot offer rate to make the above payment. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest &nalysis: %n the above e&ample the %ndian firm has to pay A+,,,,, to its customer after one year. %f it pays the amount immediately# it gives the supplier a chance to deposit the amount and earn an interest of 0/. (he supplier can pass this interest as cash discount to the firm. %t should be observed that the leading strategy gives the same result as a 11' strategy see e&hibit +9". %n 11' we deposit *V of e&posure# earn interest and use the maturity proceeds to settle payables on due date. %n leading# instead of depositing *V of e&posure# the firm pays it to the supplier and in place of interest it earns cash discount. A+,,,,, *ayable A+,,,,, & +;+.,0 B A405-8 Firm paysFA405-8 !ash discountFAC:95 A405-8 & C5 B Rs C,,,,,, Rs C,,,,,, T +5/ for + year Rs C,,,,,,&+.+5 B Rs CC8,,,,

Exhibit (-: Pictorial representation o+ leadin5 payables

I/DI)

0'

0orro/ Rs 2@@@@@@

Pay on spot FA8(-= J a:ail C.

Con:ert usin5 spot o++er rate o+ Rs 2(

%n the earlier segment we saw how to do leading for receivables and payables without euro rate being given. =ow in this segment see leading how leading should be done when two rate are given for a currency namely euro rates and domestic rates. First we will list down the steps# then apply these steps through an e&ample and finally make an analysis by comparing with 11' with euro rates. Exhibit (2

Compou nded G 1(9 1 year H'ocal cur lend rateI

E@

E@

PV o+ exposure G 89 1 year H1or cur deposit rateI

Repay Rs 22=@@@@

Exposure F1@@@@@

E1 (

E1 (

12. CONCE0T OF LEADING [W)(1 E,-$ -.(&']

teps in 'eadin5 /ith Euro rates

n 'eadin5 recei:able 'eadin5 payable

+ 5

%dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency domestic lendin5 rate as discount rate 2sk the customer to pay at spot the *V of e&posure. (he difference between the e&posure and the *V of e&posure is the cash discount given to customer for asking him to lead the payment. $e use domestic lending rate to calculate *V of e&posure because the customer borrows in domestic market the re.uired sum and settles the payment. !onvert the amount realised from the customer into local currency using spot bid rate Geposit the amount converted at local currency deposit rate for e&posure period Realise the deposit amount with interest.

%dentify the foreign currency e&posure !alculate the *V of e&posure using +orei5n currency domestic deposit rate as discount rate *ay the supplier *V of e&posure at spot. (he difference between the e&posure and the *V of e&posure is the cash discount obtained from supplier for leading the payables. Supplier can deposit money at domestic deposit rate# it is used for calculating *V of e&posure. >uy foreign currency e.ual to *V of e&posure at spot o++er rate to make the payment. >orrow local currency at lendin5 rate to finance the outflow re.uired for purchase of foreign currency stated in step C Repay the amount borrowed with interest on the maturity date.

1. 2eadin" wit# 1uro rates Recei(a*.es

Example (-: 2n %ndian firm is to receive A+,,,,, after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF Gomestic rupee interest rate )uro rupee interest rate Gomestic dollar rate )uro dollar rate Spot e&change rate Rs;A +,/ - +5/ ++/ - +-/ 0/ - 8/ 9/-4/ C, - C5

!alculate the rupee realisation after one year if the e&posure is hedged using leading and 11' $hich strategy is best leading or 11'

1acts:

.omestic $nterest rate " F Geposit rate Q 0/ Lending rate Q 8/ Euro $nterest rate " F Geposit rate Q 9/ Lending rate Q 4/ .omestic $nterest rate $#R Geposit rate Q +,/ Lending rate Q +5/ Euro $nterest rate $#R Geposit rate Q ++/ Lending rate Q +-/ pot exchan5e rate >id rate Q C, Hffer rate Q C5 KaL 'eadin5 recei:ables 1 )&posure A+,,,,, receivable ( *V of e&posure calculated using domestic A+,,,,, & +;+.,8 Gollar lending rate as discount rate B A4504C - Hffer cash discount and ask the customer to !ustomer paysF A4504C pay at spot the *V of e&posure. !ash discount givenF A:C,9 2 !onvert the amount realised from customer A4504C & C, B Rs -:,-:,C to local currency using spot bid rate 8 Geposit the amount converted at local Rs -:,-:,C T +,/ for + currency domestic deposit rate year ; Realise deposit with interest Rs -:,-:,C & +.+, B Rs C,:C,:C KbL EE3 recei:ables 1 )&posure A+,,,,, receivable ( *V of e&posure calculated using Gollar euro lending A+,,,,, & +;+.,4 rate as discount rate B A4+:C- >orrow against dollar receivable and repay the A4+:C- T 4/ for + borrowing on maturity date using the receivables year 2 !onvert the amount borrowed to local currency A4+:C- & C, using spot bid rate B Rs -994:5, 8 Geposit the amount converted at domestic %=R Rs -994:5, T +,/ deposit rate for + year ; Realise deposit with interest Rs -994:5, & +.+, B Rs C,-9945 &nalysis: 'eadin5 EE3 a comparison For a receivables e&posure# in a leading strategy# the firm asks its customer to borrow and pay immediately and compensate him for the interest through cash discount and in 11' the firm borrows instead of asking the customer to borrow and in place of cash discount it incurs interest cost. %t could be seen that# whether the firm borrows on its own or the customer borrows on behalf of the firm# the same interest cost is incurred and hence leading V 11' are .ualitatively same. 'owever when we have two types of interest rates for the foreign currency namely domestic rates and euro rates# then the situation is different. (he firm which has foreign currency receivable cannot access

domestic foreign currency market as it is accessible only to residents and can borrow only in euro market. Hn the other hand the person# from whom the foreign currency is receivable# can borrow in domestic foreign currency market but will be prohibited to access euro market. %n this situation we cannot continue to say that the interest paid by the firm under 11' or the cash discount given by it under leading strategy will be same because the firm borrows at euro interest rates and hence the interest paid will be euro rates and the customer borrows at domestic rates due to which the cash discount offered to him will be at domestic interest rate. (herefore if the domestic foreign currency lending rate is lower than the euro foreign currency lending rate# it would be better to go for a leading than 11' because the cash discount will be lower than the interest cost i.e. the customer can borrow cheaper in the domestic money market rather than the firm borrowing at a higher interest rate in euro market. %t is vice versa if the euro foreign currency rate is lower than the domestic foreign currency rate. Exhibit (8: Pictorial representation o+ 'eadin5 recei:ables /ith euro rates

I/DI)

0'

.eposit Rs -<@-<@2

Realise on spot a+ter o++erin5 C. FA(8A2

Con:ert usin5 spot bid rate o+ Rs 2@

E@

E@

Compou nded G 1@9 1 year H'ocal cur dep rateI

PV o+ exposure G =9 1 year H1or cur domestic lendin5 rateI

Realise Rs 2@<2@<2

Exposure F1@@@@@

E1 (

E1 (

Exhibit (;: Pictorial representation o+ EE3 recei:able /ith Euro rates

I/DI)

0'

.eposit Rs -;;A<(@

0orro/ FA1<2-

Con:ert usin5 spot bid rate o+ Rs 2@

E@

E@

From e&hibit 50 and 59 it could be see that every thing is same for Leading and 11' e&cept for the interest rate used for calculating *V of e&posure. %n leading we used 8/ domestic A borrowing rate" and in 11' we use 4/ )uro A borrowing rate". (he reason is that# when the %ndian firm borrows dollars# it can do so only in the euro dollar market at 4/ interest but the same borrowing can be done by the 2merican customer in domestic dollar market for ?ust 8/ and avail the interest cost as cash discount. (hat is the reason why leading cheaper than 11'. >y leading# in spot we have A4504C in hand for conversion but in 11' we have only A4+:C- in hand for conversion. 'ence rupee inflow in leading is more than the inflow under 11''.

Compound ed G 1@9 1 year H'ocal cur domestic dep rateI

PV o+ exposur e G A9 1 year H1or cur euro lendin5 rateI

Realise Rs 2@-;;A(

Exposure F1@@@@@

E1 (

E1 (

2. 2eadin" wit# 1uro rates $aya*.es

Example (2: 2n %ndian firm has imported goods worth A+,,,,, for which the payment is to be made after one year. %t wants to cover its e&posure using 11' for which it has collected the following dataF Gomestic rupee interest rate +,/ - +5/ )uro rupee interest rate ++/ - +-/ Gomestic dollar rate 0/ - 8/ )uro dollar rate 9/-4/ Spot e&change rate Rs;A C, - C5 !alculate the rupee realisation after one year if the e&posure is hedged using leading and 11' $hich strategy is best leading or 11' olution: KaL 'eadin5 Payables 1 )&posure ( *V of e&posure calculated using domestic Gollar deposit rate as discount rate - 2vail cash discount and settle the payable at spot by paying *V of e&posure. 2 Sell rupees and >uy dollars at spot offer rate to make the above payment. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest KbL EE3 payables 1 )&posure ( *V of e&posure calculated using )uro Gollar deposit rate as discount rate - Geposit dollar at spot whose proceeds can be used to settle payable e&posure when they become due 2 Sell rupees and >uy dollars at spot offer rate to make the above deposit. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest A+,,,,, *ayable A+,,,,, & +;+.,9 B A4C-C, A4C-C, T 9/ for + year A4C-C, & C5 B Rs -49558, Rs -49558, T +5/ for + year Rs C,,,,,,&+.+5 A+,,,,, *ayable A+,,,,, & +;+.,0 B A405-8 Firm paysFA405-8 !ash discountFAC:95 A405-8 & C5 B Rs C,,,,,, Rs C,,,,,, T +5/ for + year Rs C,,,,,,&+.+5 B Rs CC8,,,,

B Rs CC-::0C &nalysis: 'eadin5 EE3 a comparison For a payable e&posure# in a leading strategy# the firm settles its due at spot but re.uest for a cash discount from the supplier for early payment. Since the supplier gets the money earlier# he can deposit the amount an earn interest. (his interest benefit he passes on as cash discount to the firm. %n 11' the firm itself makes deposit of *V of e&posure and utili<es the maturity amount to settle the payables. %n leading the supplier deposits and passes the interest income as cash discount and in 11' the firm deposits on its own and earns interest income. %n both cases the same benefit is obtained but in different names. 'ence leading and 11' are .ualitatively same. 'owever when we have two types of interest rates for the foreign currency namely domestic rates and euro rates# then the situation is different. (he firm which has foreign currency payable cannot access domestic foreign currency market as it is accessible only to residents and can deposit only in euro market. Hn the other hand the person# to whom the foreign currency is to be paid# can deposit in domestic foreign currency market but will be prohibited to access euro market. %n this situation we cannot continue to say that the interest received by the firm under 11' or the cash discount received by it under leading strategy will be same because the firm deposits at euro interest rates and hence the interest received will be euro rates and the supplier deposits at domestic rates due to which the cash discount offered by him will be at domestic interest rate. (herefore if the domestic foreign currency deposit rate is higher than the euro foreign currency deposit rate# it would be better to go for a leading than 11' because the cash discount will be higher than the interest income i.e. the supplier can deposit currency at a higher rate in the domestic money market rather than the firm depositing at a lower interest rate in euro market. %t is vice versa if the euro foreign currency rate is higher than the domestic foreign currency rate. From e&hibit 5: and 58 it could be see that every thing is same for Leading and 11' e&cept for the interest rate used for calculating *V of e&posure. %n leading we used 0/ domestic A deposit rate" and in 11' we use 9/ )uro A deposit rate". (he reason is that# when the %ndian firm deposits dollars to meet payables# it can do so in the euro dollar market at 9/ interest but the same deposit will be done by the 2merican supplier in domestic dollar market for a mere 0/ and pass it on as cash discount. %t is better for the %ndian fim to invest on its own in the euro market rather than asking the supplier to invest in domestic market and getting a cash discount. (he outflow under 11' in spot is only A4C-C, but it is A405-8 in case of leading because the interest earned by making deposit is more than the cash discount received from the supplier. Gue to lesser payables at spot in foreign currency# the rupee outflow is also less in case of 11' as compared to leading.

Exhibit (<: Pictorial representation o+ leadin5 payables /ith euro rates

I/DI)
0orro/ Rs 2@@@@@@ Con:ert usin5 spot o++er rate o+ Rs 2(

0'
Pay on spot FA8(-= J a:ail C.

Exhibit (=: Pictorial representation o+ EE3 payable /ith Euro rates

Compou nded G 1(9 1 year H'ocal cur lend rateI Compo unded G 1(9 1 year H.omes tic lend rateI

E@

E@

PV o+ exposure G 89 1 year H1or cur domestic deposit rateI

Repay Rs 22=@@@@

Exposure F1@@@@@

E1 (

E1 (

I/DI)
0orro/ Rs -A;((= @

0'

.eposit

Con:ert usin5 spot o++er rate o+ Rs 2(

FA2-2@

E@

E@

PV o+ exposure G ;9 1 year H1or cur euro deposit rateI

Repay Rs22-<<8 2

Exposure F1@@@@@

E1 (

E1 (

11. LEADING 3 MMH ! FORWARD

=ow let us see a comprehensive illustration on using forward# 11' and leading in hedging a currency e&posure. Example (8: 2n 2merican firm has a +8,-day payable of 2usA+,#,,#,,, to an 2ustralian supplier. (he market rates areF 2us A ; A spot F +.-C:0 I +8, day forward +.--C: @SA +8,-day interest rateF +,/ p.a. 2us A +8,-day euro interest rateF 8/ p.a. 2us A +8,-day domestic interest rateF 4.0/ p.a.

(he 2ustralian authorities have imposed a restriction on 2ustralian firms which prevents them from borrowing in the euro market. Similarly# nonresidents cannot make money-market investment in 2ustralia. (he 2merican firm wants to evaluate the following four alternative hedging strategiesF aO >y Forward. bO >y 1oney market hedging cO >y Leading. dO >y Leading with a forward. 1acts:
pot rate 1or/ard rate .ollar interest rate &us dollar euro interest rate &us dollar domestic interest rate +A B 2us A +.-C:C or + 2us A B A,.:C5+ +A B 2us A +.--C: or + 2us A B A,.:C45 +,/ p.a 8/ p.a 4.0/ p.a

4ption 1: 1or/ard 3ed5in5 Exposure 1or/ard F out+lo/ a+ter ; months 2us A +,#,,#,,, payable A,.:C45 A:C45,,

4ption (: Eoney Earket 3ed5in5 1 )&posure ( *V of e&posure calculated using )uro 2A deposit rate as discount rate 8/ p.a or C/ per 9m" 2A+,,,,,, *ayable 2A+,,,,,&+;+.,C B 2A49+0-8

- Geposit in euro market 2A at spot whose proceeds can be used to settle payable e&posure when they become due 2 Sell A and >uy 2A at spot offer rate to make the above deposit. 8 >orrow the amount re.uired in step C at local lending rate ; Repay borrowings with interest at +,/ p.a or 0/ per 9 months

2A49+0-8 T 8/ for 9 months 2A49+0-8 & ,.:C5+ B A :+-008 A:+-008 T +,/ for 9 months A :+-008&+.,0 B A :C45-0

Exhibit (A: Pictorial representation o+ EE3 payable /ith Euro rates

0'

)0'

0orro/ F <1-88= .eposit &FA;18-=

Con:ert usin5 spot o++er rate o+ F@*<2(1

4ption -: 'eadin5 payables 1 )&posure ( *V of e&posure calculated using 2A domestic deposit rate as discount rate 4.0/ p.a or 2A+,,,,,, *ayable 2A+,,,,,,&+;+.,C:0 B 2A40C90C

Compou nded G 1@9 ;m H.omes tic lend rateI

E@

E@

PV o+ exposure G =9 ;m H1or cur euro deposit rateI

Repay F<2A(-8

Exposure &F1@@@@@@

E;

E;

2 8 ;

C.:0 / p.a" 2vail cash discount and settle the payable at spot by paying *V of e&posure. Sell A and >uy 2A at spot offer rate to make the above payment. >orrow the amount re.uired in step C at local lending rate Repay borrowings with interest at +,/ p.a or 0/ per 9 months

Firm paysF2A40C90C !ash discount F2A C0-C9 2A40C90C & ,.:C5+ B A :,8CC4 A :,8CC4 T +,/ for 9 months A :,8CC4 &+.,0 B A :C-8:+

Exhibit -@: Pictorial representation o+ leadin5 payables /ith euro rates

0'

)0'

0orro/ F<@-22A

Pay on spot &FA82;82 J a:ail C.

Con:ert usin5 spot o++er rate o+ Rs 2(

4ption 2: 'eadin5 /ith +or/ard 1 )&posure ( *V of e&posure calculated using 2A domestic deposit rate as discount rate 4.0/ p.a or C.:0 2A+,,,,,, *ayable 2A+,,,,,,&+;+.,C:0 B 2A40C90C

Compou nded G 1@9 ;m H'ocal cur lend rateI

E@

E@

PV o+ exposure G A*89 ;m H1or cur domestic deposit rateI

Repay F<2-=<1

Exposure &F1@@@@@@

E;

E;

/ p.a" - 2vail cash discount and settle the payable at spot by paying *V of e&posure. 2 >orrow 2A in the euro market to settle the payables 8 1aturity amount of the borrowings ; *urchase 2A at 9m forward rate and repay the borrowing.

Firm paysF2A40C90C !ash discount F2A C0-C9 2A40C90C T 8/ for 9m 2A 40C90C & +.,C B 2A 4458C, 2A4458C, & ,.:C45 B A :C-8-0

Exhibit -1: Pictorial representation o+ leadin5 payables /ith +or/ard

10R! )3 +4T

)0'

0orro/ in euro mkt &F A82;82

Pay on spot &FA82;82 J a:ail C.

Con:ert usin5 spot o++er rate o+ Rs 2( Com poun ded G= 9 ;m

E@ E@

PV o+ exposure G A*89 ;m H1or cur domestic deposit rateI

Repay &F AA(=2@ by pur it in +/d mkt +or F<2-=-8

Exposure &F1@@@@@@

E;

E;

Conclusion: 4ption Forward 11' Leading Leading with forward Cash out+lo/ A:C45,, A:C45-0 A:C-8:+ A:C-8-0

Select leading or leading with forward which gives us lower outflows. Further it could be observed that Forward and 11' give same cash flow and Leading and leading with forward gives same cash flows ignore small difference which is due to rounding off of decimals". (he reason is due to presence of %R* i.e. the theoretical forward is same as actual forward.

12. E40OSURE NETTING

$hen a company has both receivable and payable e&posure# then it should not do conversion# instead it should use its foreign currency receivables to settle the foreign currency payables. (his process on using receivables e&posure to settle payables e&posure is called as e&posure netting. =etting has two advantagesF %t eliminates currency risk because no conversion takes place on the receivables or payables. Hnly when currency conversion takes place e&change rate is used. Hnly when e&change rate is used risk of e&change rate fluctuation e&ists. Loss on account of spread can be avoided because when we sell foreign currency received we sell at banks bid rate lower rate" and when we buy foreign currency for meeting payables# we buy at banks offer rate higher rate". (hus our buying rate of foreign currency is more than our selling rate and in nutshell we incur a loss e.ual to banks spread if netting possibility is ignored.

(here are two types of netting. *erfect netting and =etting with timing difference. %n case of perfect netting both receivables and payables occur at the same time and in case of timing difference one occurs earlier and other occurs later. Let us see how netting is done with the help of the following e&ample. Example (; (he $oolworth !orporation3s @S2 is committed to the following transactionsF 1ake interest payment to a French bank of FFr +,, in 4, days Receive G)1 +9, for goods sold to Xerman retailer in +8, days

Receives FFr +,, in payment for sales to French manufacturer in 4, days 1ake G)1 +9, payment to Xerman supplier for product in 4, days.

%nterest rates are as under 4,-day interest rate G)1 4.0/ p.a. +8,-day interest rate G)1 8.50/ p.a. 4,-day interest rate @SG5.,/ p.a. +8,-day interest rate @SG 5.0/ p.a.

Gemonstrate how the @S !ompany can achieve certainty of value for its future payables and receivables.

olution: 11r .EE +,, 4, days" +9, +8, days" +,, 4, days" +9, 4, days"

Recei: e Pay #ettin5 Possibilities

*ayable of FFr +,, can be netted of against receivables of FFr +,,. Since receivables and payables occur at the same time i.e. after 4, days# perfect netting is possible. G)1 +9, receivable also can be netted off against G)1 +,, payable but perfect netting not possible because of timing difference. *ayable occurs first after 4, days and then receivable occurs after +8, days.

4ptions a:ailable +or nettin5 cash +lo/ /ith timin5 di++erence 4ption 1: teps in option 1 strate5y Find out present value of payable e&posure >orrow the aforesaid amount for 9 months against the receivable e&posure Geposit the amount for - months so that the maturity proceeds can be used to settle payables after - months Repay the borrowings after 9 months using receivable realisation.

Computations:

1 *V of )&posure ( 2 8 ; <

G1 +9, & +;+.,5-:0 B G1 +09.54 +R4.0/;C" B +.,5-:0" >orrow G1 +09.54 for 9 months at 8.50/ p.a Geposit G1 +09.54 for - months at 4.0/ Settle payables 1aturity value of deposit B G1 +9, +09.54 & +.,5-:0" Settle payables using the maturity value of deposit 1V value of borrowing +09.54 & +.,C+50 B G1+95.:C +R8.50/;5" B +.,C+50" !ollect receivables G1 +9, )&posure re.uiring +95.:C Q +9, B G15.:C hedging

Exhibit -1: Pictorial representation o+ option 1

E@

E.E 1;@ payable

E;
.E 1;@ recei:able

0orro/ PV o+ .E1;@ +or ;m

Repay borro/in5 /ith $nt .E 1;(*<2

.eposit immediately +or - m

Eatures /ith interest to .E 1;@

"n netted exposure .E (*<2

4ption (: teps in option ( strate5y >orrow G1 +9, at the end of -rd month for - months Settle payable e&posure of G1 +9, using the borrowed money Repay the - month borrowing at the end of 9 months using receivable realisation.

Computations:

1 ( 2 <

>orrow in -rd month Settle payables Realise receivable at the end of 9th month Repay borrowing with interest )&posure re.uiring hedging

G1 +9, at 4.0/ p.a for - months G1 +9, G1 +9, G1 +9, & +.,5-:0 B G1 +9-.8, +9-.:C Q +9, B G1 -.8,

Exhibit -(: Pictorial representation o+ option (

E@

E-

E;

.E 1;@ payable

.E 1;@ recei:able

Go not hin g

0orro/ .E 1;@

Repay borro/in5 /ith $nt .E 1;-*=@

"n netted exposure .E -*=@

Conclusion: (he company should go for the option + to tackle timing difference and in that option only the un netted e&posure is minimum.

13. CURRENCY FUTURES

1. 0/D1R'T)/DI/5 C0RR1/C6 F0T0R1'
%n our earlier segments we had discussion about forward contracts. Forward contract is a contract entered into by a person with an authori<ed dealer to buy or sell foreign currency at an agreed rate on a future date. For e&ample if an e&porter is to receive A +,,,,, after - months# and if the bank is .uoting a - months forward rate as +A B Rs C,# the e&porter can make a

forward sell of A+,,,,,. 2s a result of this contract# the e&porter sells to the authori<ed dealer A+,,,,, after - months at Rs C, and reali<e C, lakhs irrespective of the e&change rate movements. !urrency futures contract# like a forward contract# is a contract for e&change of one currency for another on a future date# with the e&change rate being fi&ed at the time of entering into the contract itself. 'owever there are differences between a forward contract and a futures contract. Let us understand with the help of e&amples details about a futures contract and how they are different from forwards. Example (<: Spot e&change rateF +A ,+.,:.,8" B Rs C,.+0 September futures contract trading at +AB Rs C5.-0 1r. 6 bought five September futures contract Hn September the futures closed at +A B Rs C5.0, + future contract si<e is A+50,,,

). Traded e7c#an"e

in

Futures

Futures contracts are e&change traded contracts while forward contracts are not. Let us understand the meaning of e&change traded contract with an e&ample. Suppose 1r. 2 wants to purchase shares of a particular company and he has a friend who wants to sell the same company3s shares. 1r. 2 pays consideration and his friend makes delivery. (his is an over the counter transaction between two identifiable buyer and seller. (he same share 1r. 2 can also buy from a stock e&change. 'ere he places a buy order through a broker in the stock e&change and purchases the share through the stock market. %n this case 1r. 2 does not know who his counter party is. (he buy contract with his friend is tailor made# over the counter contract# while the buy order with the stock e&change is an e&change traded contract. %n the former case there is a counter party risk i.e risk of one party not fulfilling the commitment# while in the later case the stock e&changes have legal authority to enforce all the contracts entered in it. (here are two types of e&changes for buying and selling shares. Hne is the stock e&change where the transactions taking place are spot transactions. (his means the delivery and settlement takes place on the same day or

ma&imum not more than two days. (his is what we refer as spot market or cash market. (here e&ists another market called as FVH market futures and options market" where the shares are not traded but contracts on shares like futures and option contracts are traded. For e&ample in the FVH market# 2 Ltd3s September futures are traded at Rs +0,, per share means# a person can buy or sell a September futures contract of 2 Ltd at Rs +0,, per share. %f he buys the future contract# he has agreed to buy the 2 Ltd shares on September at Rs +0,, and if he sells 2 Ltd3s futures# he has agreed to sell the 2 Ltd shares on September at Rs +0,,. (o conclude the cash market gives the today3s price and the futures market gives the future price. %n cash market the spot transactions mature on the same day. %n futures market when the contract matures? %n a futures e&change# suppose for 2 Ltd3s shares there are four futures contracts traded namely 1arch futures# June futures# September futures and Gecember futures. (he 1arch futures contract will e&pire on 1arch end# June futures on June end and so on. 2 future contract e&pires on at the end of the month to which it relates. $e have been discussing about market for purchase and sale of shares because it is more easily understandable. =ow let us see what market e&ists for foreign currency. Foreign currency market can be classified into three typesF pot market or cash marketF 1r. 2 goes to an authori<ed dealer trading in foreign currency like banks. 1oney changers etc and buys A +,,,,, at the prevailing e&change rate spot rate". (his is spot market for the foreign currency. 1or/ard market: 1r. 2 does not want A+,,,,, today# but after - months. 'e once again can approach the authori<ed dealers like and enter into a forward contract for the purchase of the foreign currency. (his is the forward market. Currency +utures marketF %nstead of going to authori<ed dealer and entering into a forward contract# he can go to currency futures e&change and buy currency futures. (he currency futures e&change is the place where futures contract on currencies are traded in the same way as how stock futures on stocks are traded in a FVH e&change. (he following are some of the organi<ed e&changes where currency futures trading are doneF !hicago 1ercantile e&change !1)" %nternational monetary market %11"

London %nternational Financial Futures )&change L%FF)" (okyo %nternational Financial Futures )&change =ew 7ork Financial Futures )&change Sydney Futures )&change Singapore %nternational 1onetary )&change 'ong Kong Futures e&change 'KF)" Geutsche (ermin >ose# Frankfurt G(>" *hiladelphia >oard of (rade =ow let us continue discuss how currency futures are traded in the futures e&change and how they are different from forwards.

8. Types contract

of

futures

(here are two types of future contracts namely buy futures and sell futures. %n e&ample + 1r. 6 has bought five September futures which are now trading in the market at Rs C5.-0. %f a person has bought a September future contract at Rs C5.-0# it means that he has agreed to buy +A at Rs C5.-0 in September when the contract matures. Similarly if he has sold the September futures at Rs C5.-0# he has agreed to sell A+ in September at Rs C5.-0. (he buy futures is also called as Long futures and the sell futures is also called as Short futures.

C. 'tandardi9ed contracts
%n the futures market a person cannot buy or sell in any .uantity. (he contract will be in form of standardi<ed contract si<e. %n this e&ample the contract si<e is A+50,,,. %f he buys one dollar futures contract# he has agreed to buy A+50,,,# if he buys two contracts then it is A50,,,, and so on. %n the futures market he cannot buy to his e&act re.uirement say if he wants to buy on A5,,,,, he cannot do so because he has to buy or sell only in standardi<ed lots. >ut in forward market it is tailor madeI he can enter into a forward contract with a bank to buy A5,,,,, on September. %n this e&ample 1r. 6 has bought five future contracts# which means he has agreed to buy A950,,, A+50,,, & 0 contracts" in the futures market. 1orei5n exchan5e 1utures Eercantile Exchan5e Currency traded *ound X>*" !anadian A !2G" contract peci+ication in Chica5o

Contract siDe 950,, X>* +,,,,, !2G

7en +50,,,,, yen Swiss franc !'F" +50,,, Gelivery months contracts"F 1arch# June# Sep and Gec Source F !1)

D. 'ett.e de.i(ery

ent not necessari.y t#rou"#

Futures contracts can be closed without delivery. %n our e&ample + 1r. 6 agreed to buy A950,,, at Rs C5.-0 on September. =ormally if this happens to be a forward contract# he should pay Rs 59C98:0, A950,,, & C5.-0" and take delivery of A950,,,. >ut in case of futures contract# he can close the buy futures contract on the maturity date through a counter sell futures contract for A950,,, at Rs C5.0,. (he contract is closed by paying the difference in price in case of loss or taking home the difference in price in case of profit. %n our e&ample on maturity date the position of 1r. 6 is as followsF >uy futures F A950,,, & Rs C5.-0 B Rs 59C98:0, Sell futures F A950,,, & Rs C5.0, B Rs 590950,, >ook margin 0-+50,,-054-:0," B Rs 4-:0,

1r. 6 comes out of the futures market with a profit of Rs +8:0,. 'ere the contract is closed without paying price or taking delivery. Suppose on the maturity date# the futures market has .uoted A+ B C5# then 1r. 6 would have come out of the futures market with a loss of Rs 5+8:0, SC5-C5.-0O & 950,,,". %n the later case 1r. 6 settles the contract by paying difference in price and in earlier case the contract is settled by paying 1r. 6 the price difference.

1. 17it *efore date

aturity

%n our e&ample# suppose 1r. 6# who bought a September futures contract on ,+.,:.,8# wants to close his futures position on ,0.,:.,8 itself. !an he do so? %n other words# is it possible for a person who has entered into a futures contract# to come out of it before maturity date? 7es# it is possible. 'e can close his futures buy position on ,0.,:.,8 by making a counter futures sell. 'e pays the difference in price in case of loss or takes home the difference in price in case of profit. For e&ample# if on ,0.,:.,8 the September futures are trading at Rs C5.C,# he can make futures sell on that date at that price and close out his buy position. 'ere he makes a profit of Rs -+50, SC5.C,-C5.-0O &950,,,". (o conclude# from

,+.,:.,8 to ,0.,:.,8# 1r. 6 is said to be having an open buy position in the futures market# which he closes through selling futures on ,0.,:.,8.

F. +arkin" arket

to

$hen 1r. 6 comes out the futures market on ,0.,:.,8# he comes out with a profit of Rs -+50,. (he entire profit Rs -+50, will not be booked on ,0.,:.,8. *rofit or loss will be booked on daily basis by the futures e&change and will be debited or credited to the margin account of the position holder about margin accounts we have a discussion later". (o elaborate# at the end of each trading day# the futures e&change automatically closes a open futures buy position by selling futures at the day3s closing price or closes a open sell position by buying futures at the day3s closing price and debits or credits the profit or loss to the margin account of the person holding the futures. %n the ne&t day# the e&change once again automatically opens the futures buy or sell position at the previous day closing futures price it is also the current day opening price".(his process is referred as 1arking to 1arket. Let us understand this through the following e&ampleF Example (=: 1r. 6 took a long position in dollar futures bought futures" on ,+.,:.,8 when the futures were trading at Rs C5.-0. 'e closed his position on ,0.,:.,8 by making a future sell at Rs C5.C,. 'e bought 0 dollar futures contract. (he si<e of each contract is A+50,,,. (he closing futures price during the period when his position was open is given below. .ate Closin5 +utures price ,+.,:.,8 C5.-9 ,5.,:.,8 C5.C0 ,-.,:.,8 C5.50 ,C.,:.,8 C5.-, ,0.,:.,8 C5.C, Show how 1r. 6 will take book profit or loss from futures market?

olution: %t seen that# the futures e&change daily closes the open buy position by selling futures at the day3s closing price and reopens by buying on ne&t day3s opening price. (he daily profit or loss is then credited to margin account. .ate 0uy price ,+.,:.,8 C5.-0 ,5.,:.,8 C5.-9 ell price C5.-9 C5.C0 Pro+it or &mount credited or loss per F KdebitedL to mar5in a7c ,.,+ A950,,, & ,.,+ B 950, ,.,4 A950,,, & ,.,4 B 0950,

,-.,:.,8 C5.C0 ,C.,:.,8 C5.50 ,0.,:.,8 C5.-, #et credit Example (A:

C5.50 C5.-, C5.C,

S,.5,O ,.,0 ,.+, @*@8

A950,,, & ,.5, B S+50,,,O A950,,, & ,.,0 B -+50, A950,,, & ,.+, B 950,, -1(8@

1r. 7 took a Short position in dollar futures Sold futures" on ,+.,:.,8 when the futures were trading at Rs C5.-0. 'e closed his position on ,0.,:.,8 by making a future buy at Rs C5.C,. 'e sold 0 dollar futures contract. (he si<e of each contract is A+50,,,. (he closing futures price during the period when his position was open is given below. .ate Closin5 +utures price ,+.,:.,8 C5.-9 ,5.,:.,8 C5.C0 ,-.,:.,8 C5.50 ,C.,:.,8 C5.-, ,0.,:.,8 C5.C, Show how 1r. 7 will take book profit or loss from futures market?

olution: %t seen that# the futures e&change daily closes the open Sell position by buying futures at the days closing price and reopens by Selling on ne&t days opening price. (he daily profit or loss is then credited to margin account. .ate ell price ,+.,:.,8 C5.-0 ,5.,:.,8 C5.-9 ,-.,:.,8 C5.C0 ,C.,:.,8 C5.50 ,0.,:.,8 C5.-, #et credit 0uy price C5.-9 C5.C0 C5.50 C5.-, C5.C, Pro+it or loss per F S,.,+O S,.,4O ,.5, S,.,0O S,.+,O K@*@8L &mount credited or KdebitedL to mar5in account A950,,, & ,.,+ B S950,O A950,,, & ,.,4 B S0950,O A950,,, & ,.5, B +50,,, A950,,, & ,.,0 B S-+50,O A950,,, & ,.+, B S950,,O K-1(8@L

5. deposits

+ar"in

(he futures e&change# in order to ensure performance# will re.uire the persons who buy future contracts and sell future contracts# to deposit margin money with the clearing house of the e&change. (his is referred as initial margin. @sually :0/ of this initial margin will be set aside as maintenance margin. (his margin account will be debited or credited with loss or profit from

futures as discussed in the marking to market procedure. %f the balance falls below a certain level maintenance margin"# then the trader receives a margin call from the clearance house to deposit the amount in specified time. %f the trader fails# his open futures position would be automatically closed without his consent. (o keep his futures contract alive# the trader should be alert to make deposits whenever margin call is received.

,. Forward Futures

:s

=ow let us conclude our discussion on introduction to currency futures by distinguishing between forward and future contracts. n Currency +or/ards >ilateral contract =o standardi<ed contract si<e =o margin re.uired !ontract settled only by delivery and payment !ash e&changed only on the due date Currency +utures !ontract traded on a organi<ed e&change Standardi<ed contract si<e

+ 5 C 0 9 :

futures

1argin is re.uired from all participants !ontracts can be settled even without delivery

Gaily booking of profit or loss and e&change of cash takes place through the procedure of 1arking to 1arket. !ounter party risk e&ist =o counter party risk since e&change is there to enforce performance. !ontract mostly closed 2 person can come out of the contract any only on delivery date time by taking the opposite position in the futures market.

2. ,1D5I/5 T,!R05, C0RR1/C6 F0T0R1'

%n part +# we had some basic understanding about how a currency future market operates. =ow let us see the uses of currency futures. !urrency futures can be used for the purpose of SaO 'edging foreign currency receivable. SbO 'edging foreign currency receivable ScO speculation to earn profits. %n this part we will see how currency futures can be used for hedging foreign currency receivables and payables. 'ow futures are used as speculative tool can be seen in the Gerivatives modules.

). ,ed"in" Recei(a*.es

Example -@: Hn January 0# an %ndian firm e&ported goods to an @S firm for a consideration of AC,,,,, receivable on +0 th of February. (he spot e&change rate is Rs;A B CC and 1arch dollar futures is trading at Rs;A B C0. Suggest a strategy to the %ndian firm to hedge its receivable e&posure. Hn +0 th February if the e&change rate in cash market drops to Rs;A B -4 and on the same date the 1arch futures is trading at Rs;A B C+. !alculate the hedge efficiency. Redo the computations if the spot e&change rate on +0 th February is Rs C: and the dollar futures are trading on that day at Rs C9. For computations assume futures contract si<e to be A:0,,,.

olution: (he strategy in the future market can be either long buy" currency future or short sell" currency future. (he selection is very simple. $hen we have a foreign currency receivable# what will we do in case of a forward? Hbviously we go for a forward sell to eliminate uncertainty in rupee realisation# do the same in futures market also i.e Short currency futures. (he %ndian firm should short five dollar 1arch futures contracts C,,,,,;:0,,," at Rs;A C0. (his means that# the firm agrees to sell A -:0,,, A:0,,, & 0" on 1arch at Rs C0 per A. %t should be seen that# though the e&posure of the %ndian firm is A C,,,,,# it is able to cover only A -:0,,, through futures because of standardi<ed contract si<e. (he company could have selected June# September or Gecember futures contract# instead it has selected 1arch contract because it is the nearest futures contract e&piring after +0th February. Position on 18th 1ebruary (@@=: Part KaL: pot rate on con:ersion date is Rs -A and 1utures price is Rs 21 Cash market: (he firm will receive AC,,,,, from its customer. %t will approach an authori<ed dealer and convert it into Rs at the spot rate prevailing on that date# which is given as Rs -4. (he rupee realisation on conversion will be AC,,,,, & -4 B Rs +09,,,,,. 1utures market:

(he firm will close on February +0 th its open sell position by taking buy position on that date at Rs;A C+. (he profit or loss from futures contract is computed as belowF Particulars Short futures Long futures *rofit from futures market (otal rupee realisationF Particulars Realisation from cash market Realisation from future market (otal realisation &mount +09,,,,, +0,,,,, +:+,,,,, Computation &mount A-:0,,, & C0 Rs +98:0,,, A-:0,,, & C+ Rs +0-:0,,, Rs +0,,,,,

&nalysis: %n the cash market the company has lost Rs 5,,,,,, AC,,,,, & SCC--4O" due to depreciation in the dollar e&change rate. 'owever due to futures hedging# the loss of Rs 5, lakhs in the cash market is compensated to the e&tent of Rs +0 lakhs in the futures market. (he efficiency of the hedge can be computed using hedge ratio. 'edge ratio B *roportion of cash market gain SlossO made up by future market gain SlossO B +0L;5,L B ,.:0. *erfect hedging is said to have happened if the hedge ratio is +. (his is very rare because SaO we cannot hedge to our re.uirement due to standard contract si<e in futures market. SbO (he futures price and cash market price though move in same direction may not move at the same rate. Part KbL: pot rate on 18th 1eb* is Rs2< and +utures are traded at Rs 2; Cash market: (he firm will receive AC,,,,, from its customer and will approach an authori<ed dealer and convert it into Rs at the spot rate prevailing on that date# which is given as Rs C:. (he rupee realisation on conversion will be AC,,,,, & C: B Rs +88,,,,,. 1utures market: (he firm will close on February +0 th its open sell position by taking buy position on that date at Rs;A C9. (he profit or loss from futures contract is computed as belowF Particulars Computation &mount

Short futures A-:0,,, & C0 Long futures A-:0,,, & C9 Loss from futures market (otal rupee realisationF Particulars Realisation from cash market Realisation from future market (otal realisation &nalysis:

Rs +98:0,,, Rs +:50,,,, Rs -:0,,,

&mount +88,,,,, S-:0,,,O +8C50,,,

%n the cash market the company has gained Rs +5,,,,, AC,,,,, & SC:CCO" due to appreciation in the dollar e&change rate. 'owever due to futures hedging# the gain of Rs +5 lakhs in the cash market is offset by loss of Rs -.:0 lakhs in the futures market. (he efficiency of the hedge can be computed using hedge ratio. 'edge ratio B *roportion of cash market gain;SlossO made up by future market gain;SlossO B -.:0L;+5L B -+.50/.

8. ,ed"in" $aya*.es
Example -1: Hn January 0# an %ndian firm imported goods from an @S firm for a consideration of AC,,,,, payable on +0 th of February. (he spot e&change rate is Rs;A B CC and 1arch dollar futures is trading at Rs;A B C0. Suggest a strategy to the %ndian firm to hedge its payable e&posure. Hn +0 th February if the e&change rate in cash market drops to Rs;A B -4 and on the same date the 1arch futures is trading at Rs;A B C+. !alculate the hedge efficiency. Redo the computations if the spot e&change rate on +0 th February is Rs C: and the dollar futures are trading on that day at Rs C9. For computation assume the futures contract si<e to be A:0,,,. olution: (he strategy in the future market can be either long buy" currency future or short sell" currency future. 2s already discussed select the strategy by asking a simple .uestion# what will we do for a payable e&posure in case of a forward contract? Hbviously we go for a forward buy to eliminate uncertainty in rupee outflow# do the same in futures market also i.e long currency futures or buy currency futures.

(he %ndian firm should buy five 1arch dollar futures contracts C,,,,,;:0,,," at Rs;A C0. (his means that# the firm agrees to buy A -:0,,, A:0,,, & 0" on 1arch at Rs C0 per A. %t should be seen that# though the e&posure of the %ndian firm is A C,,,,,# it is able to cover only A -:0,,, through futures because of standardi<ed contract si<e. (he company could have selected June# September or Gecember futures contracts# instead it has selected 1arch contract because it is the nearest futures contract e&piring after +0th February. Position on 18th 1ebruary (@@=: Part KaL: Rs 21 pot rate on con:ersion date is Rs -A and 1utures price is

Cash market: Hn +0th Feb. the firm will have to pay AC,,,,, to its supplier. %t will approach an authori<ed dealer buy AC,,,,, at the spot rate prevailing on that date# which is given as +A B Rs -4. (he rupee outflow on conversion will be AC,,,,, & -4 B Rs +09,,,,,. 1utures market: (he firm will close on February +0 th its open buy position by taking sell position on that date at Rs;A C+. (he profit or loss from futures contract is computed as belowF Particulars Computation &mount Short futures A-:0,,, & C+ Rs +0-:0,,, Long futures A-:0,,, & C0 Rs +98:0,,, Loss in futures market Rs +0,,,,, (otal rupee outflowF Particulars Hutflow in cash market Loss in future market (otal realisation &nalysis: %n the cash market the company has gained Rs 5,,,,,, AC,,,,, & SCC-4O" due to depreciation in the dollar e&change rate. 'owever due to futures hedging# this gain of Rs 5, lakhs in the cash market is eroded to the e&tent of Rs +0 lakhs in the futures market. (hus the company ended up in paying Rs 0,,,,, e&tra than what it should have paid in spot AC,,,,, & CC Q Rs +:+,,,,,". (he efficiency of the hedge can be computed using hedge ratio. &mount +09,,,,, +0,,,,, +:+,,,,,

'edge ratio B *roportion of cash market gain SlossO made up by future market gain SlossO B +0L;5,L B ,.:0. *erfect hedging is said to have happened if the hedge ratio is +. (his is very rare because SaO we cannot hedge to our re.uirement due to standard contract si<e in futures market. SbO (he futures price and cash market price though move in same direction may not move at the same rate. Part KbL: pot rate on 18th 1eb* is Rs2< and +utures are traded at Rs 2; Cash market: Hn +0th Feb. the firm will have to pay AC,,,,, to its customer and will approach an authori<ed dealer to buy AC,,,,, at the spot rate prevailing on that date# which is given as Rs C:. (he rupee outflow for buying AC,,,,, will be AC,,,,, & C: B Rs +88,,,,,. 1utures market: (he firm will close on February +0 th its open buy position by taking sell position on that date at Rs;A C9. (he profit or loss from futures contract is computed as belowF Particulars Short futures Long futures Xain from futures market (otal rupee outflowF Particulars Hutflow in cash market Xain from future market (otal outflow &nalysis: %n the cash market the company has lost Rs +5,,,,, AC,,,,, & SC:-CCO" due to appreciation in the dollar e&change rate. 'owever due to futures hedging# this loss of Rs +5 lakhs in the cash market is offset by a gain of Rs -.:0 lakhs in the futures market. (he efficiency of the hedge can be computed using hedge ratio. 'edge ratio B *roportion of cash market gain;SlossO made up by future market gain;SlossO B -.:0L;+5L B -+.50/. &mount +88,,,,, S-:0,,,O +8C50,,, Computation &mount A-:0,,, & C9 Rs +:50,,,, A-:0,,, & C0 Rs +98:0,,, Rs -:0,,,

14. C,--&5*6 O7()$5'

>efore going through this currency options# the reader is re.uested to go through in detail the options part of Gerivatives module to understand the basics of an options contract. $e will ?ust have a brief recap of what is discussed in that module. !urrency option is a financial instrument that gives the option holder a right and not an obligation to buy or sell a given amount of foreign e&change at a fi&ed price per unit for a specified time period till e&piry date". %n other words a currency option is a contract for future delivery of specific currency in e&change for another in which the holder buyer" of the option has the right to buy call" or sell put" a particular currency at an agreed price strike price or e&ercise price" for a period. (he seller of the option gets premium from the buyer of the option for giving the right. (here are two types of options namely call and put options. !all option gives its holder the right to buy a foreign currency and put option confers on its holder the right to sell. For payable e&posure we use call option and for receivables e&posure we use put option. )very currency option has got three price elements SaO strike price# which is the agreed price for buying or selling the foreign currency. SbO *remium# which is the consideration given to the writer for selling the option or right. ScO Spot price# the price of the foreign currency on a given day. (he option premium amount should be paid upfront at the time of entering into the option contract itself.

%n this segment we

are going to discuss the following issuesF 'edging using currency option !all option vs. Forward buy *ut option vs. Forward sell !aps and Floors

1. ,ed"in" usin" a currency option

Like forward# 11'# Leading# =etting and Futures# options are also a very popularly used hedging strategy. 2 call option which gives its holder the right to buy a specific currency at an agreed price# can be used to hedge payable e&posure and a *ut option which gives a similar right to sell# can be used to

hedge payable e&posure. Let us see with an e&ample how e&posure can be hedged using options. Recei:ables 3ed5in5 Example -( 7our !ompany has a +5 month receivables of G1 +#,,#,,,# the current Rs.;G1 spot rate is Rs.5,# rupee interest rate is 5+/ p.a. and G1 interest rate is +,/ p.a. you are considering a forward hedge at the current forward rate of Rs.55. 2n )&ecutive of another company tells you that he recently bought a *ut on G1 +#,,#,,, at a strike price of Rs.5C.0, and is willing to sell it to you at a premium of Re.+ per G1 or Rs.+#,,#,,, for the entire contract. (he *ut matures at the same time as your payable and is a )uropean put. $hat should you do? olution: (he are three strategies for hedging the receivables e&posure namely SaO Forward hedging SbO 11' and ScO 'edging through put option. (hat strategy which gives the ma&imum rupee inflow should be selected. 1acts: pot rate 1or/ard rate .E interest rate Rupee interest rate Put option strike price 4ption premium HcostI +G1 B Rs 5, +G1 B Rs 55 +,/ p.a 5+/ p.a +G1 B Rs 50.8, Re + per G1

4ption 1: 1or/ard 3ed5in5 Exposure 1or/ard Rupee in+lo/ a+ter one year

G1 +,,,,, Receivable Rs 55 Rs 55,,,,,

4ption (: Eoney Earket 3ed5in5 1 )&posure ( *V of e&posure calculated G1 interest rate as discount rate - >orrow G1 at spot whose 1aturity value can be paid using the G1 receivables arising at the end of the year. 2 Sell the G1 borrowed at spot rate and convert into rupees. 8 Geposit the rupee realisation at rupee interest rate G1+,,,,, Receivable +,,,,, & +;+.+, B G1 4,4,4 G1+,,,,, T +,/ for one year G1+,,,,, & 5, B Rs 5,,,,,, Rs 5,,,,,, T 5+/ for one year

; Realise deposit with interest 4ption -: Currency options Exposure trike price Rupee in+lo/ a+ter one year Premium per .E Premium +or entire contract Hpaid up+rontI 1V o+ premium a+ter one year #et in+lo/ +rom put option election: 1or/ard hed5in5 Eoney Earket 3ed5in5 Put option hed5in5

Rs 5,,,,,,&+.5+ B Rs 5C5,,,,

G1 +,,,,, Receivable Rs 50.8, Rs 508,,,, Re + Rs +,,,,, G1+,,,,, & +" +,,,,, & +.5+ B Rs +5+,,, Rs 5C04,,, 508,,,, Q +5+,,,"

Rs 55,,,,, Rs 5C5,,,, Rs 5C04,,,

*ut option gives us the ma&imum rupee inflow after one year and hence it should be selected. (his is the minimum inflow from put option. %f on the maturity date the e&change rate is more than Rs 50.8,# then we allow the option to lapse and sell the G1 at the higher e&change rate prevailing on that date. (his fle&ibility is not there for the other hedging strategies. Payables 3ed5in5 Example -7our !ompany has a +5 month payable of G1 +#,,#,,,# the current Rs.;G1 spot rate is Rs.5,# rupee interest rate is 5+/ p.a. and G1 interest rate is +,/ p.a. you are considering a forward hedge at the current forward rate of Rs.55. 2n )&ecutive of another company tells you that he recently bought a call on G1 +#,,#,,, at a strike price of Rs.5, and is willing to sell it to you at the historic premium of Rs.+ per G1 or Rs.+#,,#,,, for the entire contract. (he call matures at the same time as your payable and is a )uropean call. $hat should you do?

olution: (he are three strategies for hedging the payables e&posure namely SaO Forward hedging SbO 11' and ScO 'edging through call option. (hat strategy which gives the minmum rupee outflow should be selected.

1acts: pot rate 1or/ard rate .E interest rate Rupee interest rate Put option strike price 4ption premium HcostI +G1 B Rs 5, +G1 B Rs 55 +,/ p.a 5+/ p.a +G1 B Rs 5, Re + per G1

4ption 1: 1or/ard 3ed5in5 Exposure 1or/ard Rupee in+lo/ a+ter one year G1 +,,,,, *ayable Rs 55 Rs 55,,,,,

4ption (: Eoney Earket 3ed5in5 1 )&posure ( *V of e&posure calculated G1 interest rate as discount rate. - Geposit G1 at spot whose 1aturity value can be use to settle the payable e&posure arising after one year. 2 >uy the G1 at spot to make the above deposit. 8 >orrow rupees re.uired to buy the G1 stated in step C. ; Repay borrowing with interest. 4ption -: Currency options Exposure trike price Rupee out+lo/ a+ter one year Premium per .E Premium +or entire contract Hpaid up+rontI 1V o+ premium a+ter one year !otal out+lo/ +rom call option election: 1or/ard hed5in5 Eoney Earket 3ed5in5 Put option hed5in5 Rs 55,,,,, Rs 5C5,,,, Rs 5+5+,,, G1 +,,,,, Receivable Rs 5, Rs 5,,,,,, Re + Rs +,,,,, G1+,,,,, & +" +,,,,, & +.5+ B Rs +5+,,, Rs 5+5+,,, 5,,,,,, R +5+,,," G1+,,,,, *ayable +,,,,, & +;+.+, B G1 4,4,4 G1+,,,,, T +,/ for one year G1+,,,,, & 5, B Rs 5,,,,,, Rs 5,,,,,, T 5+/ for one year Rs 5,,,,,,&+.5+ B Rs 5C5,,,,

!all option gives us the least rupee outflow after one year and hence it should be selected. (his is the ma&imum outflow from call option. %f on maturity date the e&change rate is less than Rs 5,# then we allow the option to lapse and buy the G1 at the lower e&change rate prevailing on that date. (his fle&ibility is not there for the other hedging strategies.

2. Ca.. option :s Forward 8uy

Strike price of a call option and forward e&change rate in a forward buy contract are agreed price at which a foreign currency can be bought on a future date. (he only difference is that# in case of the forward contract the party is tied to that price i.e. if on the maturity date the e&change rate is lower# he still has to buy only at the agreed forward rate. %n call option the fle&ibility factor is incorporated. %f on the maturity date the e&change rate reduces# then the call option holder can allow the call to lapse and buy at the lower e&change rate prevailing in the market. (his is the advantage with call option. >ut the cost for getting this advantage is the premium paid on the option which is absent in forward contract. (hus the advantage of a call option is its fle&ibility and the advantage of forward contract is the absence of premium cost. $hen call option is good and when forward is good is the sub?ect matter of discussion in this segment. Example: -2 2n %ndian firm buys a call on A+,#,,#,,, with a strike of Rs C,;A at a premium of Rs ,.:0;A. (he interest opportunity cost is 9/ p.a and the maturity is +8, days. SaO $hat is the break even maturity spot rate beyond which the firm makes a net gain? SbO Suppose the si& month forward rate at the time the option was bought was Rs C,.0,;A. $hat is the range of maturity spot rate for which the option would prove to better than the forward cover? For what range of values would the forward cover be better? olution: Part a: 0reak e:en Eaturity spot rate 1aturity spot rate is the e&change rate that is actually .uoted in the market on the maturity date of the option. >reak even maturity spot rate is a maturity spot rate at which the call holder neither gains nor losses from buying the call option. trike price Rs C,

4ption premium Rs ,.:0 1V o+ option premium ,.::50 ,.:0 & +.,-" 4ut+lo/ +rom call on maturity date C,.::50 C,R,.::50" H0reak e:en maturity spot rateI 1aturity spot rate U >reak even maturity spot rate 1aturity spot rate B >reak even maturity spot rate 1aturity spot rate U >reak even maturity spot rate !all gives positive payoff =o profit no loss Loss from call

#ote: (he ma&imum loss that occurs in a call option its premium paid. Check: E P C5 C,.::50 -4 trike price C, C, C, Exercise or not 7es 7es =o 0ene+it o+ call 5 ,.::50 , 1V o+ Premium paid -,.::50 -,.::50 -,.::50 Pro+it or loss +.55:0 , -,.::50

Part b: 1or/ard :s call option E P -4.:5:0 -4.:5:9 -4.:5:C Conclusion: Eaturity spot rate > -A*<(<8 Forward Eaturity spot rate 6 -A*<(<8 %ndifferent Eaturity spot rate > -A*<(<8 !all option Exercise 4ut+lo/ =o =o =o -4.:5:0 -4.:5:9 -4.:5:C 1V o+ premium ,.::50 ,.::50 ,.::50 !otal out+lo/ C,.0,,, C,.0,,+ C,.C444 1/d C,.0,,, C,.0,,, C,.0,,, Remarks %ndifferent Fwd !all

3. $ut option :s Forward se..

Strike price of a put option and forward e&change rate in a forward sell contract are agreed price at which a foreign currency can be sold on a future date. (he only difference is that# in case of the forward contract the party is tied to that price i.e. if on the maturity date the e&change rate is higher# he still has to sell only at the agreed forward rate. %n put option the fle&ibility factor is incorporated. %f on the maturity date the e&change rate appreciates# then the put option holder can allow the put to lapse and sell at the higher e&change rate prevailing in the market. (his is the advantage with put option. >ut the cost for getting this advantage is the premium paid on the option which is absent in forward contract. (hus the advantage of a put

option is its fle&ibility and the advantage of forward contract is the absence of premium cost. $hen put option is good and when forward is good is the sub?ect matter of discussion in this segment. Example: -8 2n %ndian firm buys a put on A+,#,,#,,, with a strike of Rs C,;A at a premium of Rs ,.:0;A. (he interest opportunity cost is 9/ p.a and the maturity is +8, days. SaO $hat is the break even maturity spot rate beyond which the firm makes a net gain? SbO Suppose the si& month forward rate at the time the option was bought was Rs C,.0,;A. $hat is the range of maturity spot rate for which the option would prove to better than the forward cover? For what range of values would the forward cover be better? olution: Part a: 0reak e:en Eaturity spot rate 1aturity spot rate is the e&change rate that is actually .uoted in the market on the maturity date of the option. >reak even maturity spot rate is a maturity spot rate at which the put holder neither gains nor losses from buying the put option. trike price 4ption premium 1V o+ option premium $n+lo/ +rom put on maturity date H0reak e:en maturity spot rateI Rs C, Rs ,.:0 ,.::50 ,.:0 & +.,-" -4.55:0 C,-,.::50"

1aturity spot rate U >reak even maturity spot rate 1aturity spot rate B >reak even maturity spot rate 1aturity spot rate U >reak even maturity spot rate

Loss from put =o profit no loss *ut gives positive payoff

#ote: (he ma&imum loss that occurs in a put option its premium paid. Check: E P C5 -4.55:0 -4 trike price C, C, C, Exercise or not =o 7es 7es 0ene+it o+ call , ,.::50 + 1V o+ Premium paid -,.::50 -,.::50 -,.::50 Pro+it or loss -,.::50 , ,.55:0

Part b: 1or/ard :s call option

E P C+.5:50 C+.5:59 C+.5:5C

Exercise =o =o =o

$n+lo/ C+.5:50 C+.5:59 C+.5:5C

1V o+ premium -,.::50 -,.::50 -,.::50

#et in+lo/ C,.0,,, C,.0,,+ C,.C444

1/d C,.0,,, C,.0,,, C,.0,,,

Remarks %ndifferent *ut Fwd

Conclusion: Eaturity spot rate > 21*(<(8 *ut option Eaturity spot rate 6 21*(<(8 %ndifferent Eaturity spot rate > 21*(<(8 Forward

E8&-*)'& 0-$9:&%'
,uestion #o: 1 $denti+y quotes

Following are the quotes given by Banker at Mumbai. Identify the quote as Direct or Indirect quote. Also compute the Direct for Indirect uote and !ice " !ersa.
.irect 7 $ndirect +O 5O -O CO 0O +A B Rs.C-.+8 +L B Rs.:8.98 +%=R B )uro ,.,+8C +,, %ndo Rupiah B Rs.,.0+ 'KA B Rs.0.0C 4pposite Rate

,uestion #o : ( !/o /ay quotes : .irect From the following find out >id Rate and offer Rate. 2lso find out the spread. .irect ,uote aO %=R;AC-.:5 Q C-.4C bO %=R;)uro 0C.CC Q 0C.9: cO %=R;+,, N,.-449-,.-444 dO %=R;L :8.,, Q :8.+5 eO %=R;'KA 0.+C-0.-5 ,uestion #o: !/o /ay quotes: $ndirect Find out the indirect .uote for items referred in PuestionF 5 $ndirect ,uote 0id Rate 4++er Rate aO bO cO dO eO ,uestion #o : 2 &pplication o+ bid and o++er Puotation CC.+5 Q CC.50 5-.+5 Q 5-.-+5.+5 Q +5.5+ C0.8: Q 4-.,, C9.45 Q C:.,+ )&posure +,,,, 50,,, +:00, +5,0, +4,5C *osition )&porter %mporter )&porter )&porter %mporter )&porter Receivable ; *ayable 0id Rate 4++er Rate pread pread 9

85.++ Q 54.,, +50,,, ,uestion #o : 8 Cross Rates Find out the cross rates from the followingF aO A ; L B +.05C, N ; L B 5-0.5,

N;AB

bO )uro ; L B 5.0+0, cO A ; L B +.00-: Q 04 dO A ; L B 5.,,+0 Q -, eO 'KA ; %=R B ,.+909 Q :,

)uro ; ( B 5,0.8, )uro ; A B ,.+485 Q 45 A ; SFr B ,.9490 Q :, %=R ; SA B 5-.4,,, Q -,

(;LB )uro ; L B L ; SFr B SA ; 'KA B

,uestion #o: ; Meneral &pplications 2ssuming you are the calling bank and the following rates are .uoted for @.SA against SFR Gay + 5 +.9495;:8 +.944,;:,.0 +.:,5:;C5

a. Hn which day is it cheaper to buy @.S.A; w.r.t. SFR b. 'ow many @.S.A do you need to buy +,,, SFR on Gay + c. $hat is the spread on Gay 5 d. %f you e&changed A50,, for SFR C509.:0 on which day did you e&change ,uestion #o: < Meneral &pplication 2 Ltd re.uested its banker to issue a demand draft for A+,,,,# spot. (he banker .uoted the following %=R;A CC.-0:0-CC.-850. %t is normal for the banker to charge ,.+0/ for e&change margin for all foreign currency transactions. Find out a. 'ow much the company should pay? b. %n case the company had +0,,,A for conversion to %=R# how much the company reali<e? c. %f the demand draft referred to in SaO were to be cancelled a week later by the company and the rate is %=R;A CC.-550-CC.-44+# how much the company will be reali<ing from the banker. !ancellation charge of Rs.50, will be taken. ,uestion #o: = Cross 0order $n:estments Suppose 2l Kramer plans to invest in 1artin# ltd. a >ritish corporation that is currently selling for L0, per share. 2l has A++5 0,, to invest at the current e&change rate of A5.50; L+. a. 'ow many shares can 2l purchase? b. $hat is his net return if the price of 1artin# ltd.# all the end of the year is L9, and the e&change rate at that time is A5.,,;L+. c. Getermine 2l3s return in SbO if the ending price of the stock is LC0 and the ending rate of e&change is A5.0,;L+. ,uestion #o: A 1or/ard Premium or .iscount 0asics aO Spot + @SA B C0.+5 -C0.5C - months forward rate C0--: - C0-C4 !omments on the forward as outright or spot Find out premium;discount in annuali<ed / bO Spot Rate + @SA B C0.,+ - C0.+5 - months ,.5C - ,.-9 swap points Find out forward rate. Spot rate + @SA B 50.C0 - 50-9, 9 months swap points ,.+5 - ,.,: Find out Forward Rate.

cO

,uestion #o : 1@ 1or/ard ,uote) /ap points any day (oday is 2pril +4. 7ou see the following .uotes given by the bankerF %=R ; @SGF Spot C8.809, ; C8.8095 Forward 2pril F 5,, ; -,, Forward 1ay F 0,, ; :,, Forward June F ++,, ; +0,, Forward July F +4,, ; 50,, Find the rate for buying @SG delivery July +4. ,uestion #o : 11 &pplication o+ bid and o++er +or/ard Spot Puotation CC.+5 Q CC.50 5-.+5 Q 5-.-+5.+5 Q +5.5+ Swap *oints ,.+5 Q ,.+: ,.++ Q ,.,8 ,.50 Q ,.C5 )&posure +,,,, 50,,, +:00, *osition )&porter %mporter )&porter Receivable ; *ayable

C0.8: Q 4-.,, ,.+5 Q ,.,C +5,0, )&porter ,uestion #o: 1( $mpact o+ &ppreciation .epreciation SaO Suppose that + French franc could be purchased in the foreign e&change market for 5, @S cents today. %f the franc appreciated +, percent tomorrow against the dollar# how many francs would a dollar buy tomorrow? SbO F Ltd a French co.# has shipped goods to an 2merican importer tinder a letter of credit arrangement# which calls for payment at the end of 4, days. (he invoice is for A+#5C#,,,. *resently the e&change rate is 0.:, French francs to the A if the French franc were to strengthen by 0/ by the end of 4, days what would be the transactions gain or loss in French francs? %f it were to weaken by 0/ what would happen? ,uestion #o: 1$nterest Rate parity a. Suppose the spot .uotation of a Singapore dollar is Rs.50 with interest rate in Singapore at 9,/ arid in %ndia at +,/# what shall be the forward rate an year later? Find out the forward .uote for 5:, days instead of -90 days an year. 2lso find out the indirect .uote for spot# one year and 5:, days forward. b. Hn +st 2pril# - months interest rate in @S and Xermany are 9.0/ and C.0/ per annum respectively. (he A;G1 spot is ,.909,. $hat would be the forward rate for G1 for delivery on -,th June? ,uestion #o : 12 $nterest Rate Parity (he following table shows interest rates for the @SA and FFr. (he spot e&change rate :.,0 FFr per dollar. !omplete the missing figuresF

#All the percentage rates are annuali$ed%

- months Gollar %nterest Rate Franc %nterest Rate Forward Franc per Gollar ++.0/ +4.0/ ? ; months +5.50/ ? ? 1( months ? 5,/ :.05,,

Forward Gollar *remium / ? 9.:5/ ? ,uestion #o : 18 Purchasin5 po/er parity %n 5,,, a (ransistor cost A55.8C in =ew 7ork# SA94 in Singapore# and -5C, rubles in 1oscow. SiO %f the law of one price held# what was the e&change rate between @S dollars and Singapore dollar? >etween @S dollars and rubles? SiiO (he actual e&change rates in 5,,, were 009.+- @SA+ and 50, rublesB@SA+. $here would you prefer to buy your (ransistor? ,uestion #o: 1; Currency &rbitra5e Find out 2rbitrage *ossibilities from the following. %f so from where investment should

start? 2ssume there is no transaction cost. Rs.00.0,,, B L+ in London. Rs.-0.950 B A+ in Gelhi. A+.085, B L+ in =ew 7ork. ,uestion #o: 1< Co:ered $nterest &rbitra5e) in5le quote %s covered interest arbitrage possible in the following situation? %f so where to invest? 'ow much shall be the gain? aO Spot !an A +.-+:;S. Forward 9 1onths +.540, !an A;A @SA - +,,;oF !an A - 9/. bO Spot +,, N B Rs.-0.,,5 Forward 9 1onths Rs.-0.4,+,F %=R - +5/F 7 -:/. cO Spot +A B 0.4,,, FFr Forward 9 1onths FFr 9.,,+5F @SA - -/F FFr - 9/ dO Spot !an A +.0+C, ; A. Forward 9 1onths !an 0+.0005 ; A !an +,/ @S 9/. ,uestion #o: 1= Co:ered $nterest arbitra5e)!/o /ay quote Following are the rates .uoted at >ombay for >ritish poundF Rs ; >* - m Forward 05.9, ; :, 5, ; :, %nterest Rates - months %ndia 8/ London 0/

9 m Forward 0, ;:0 9 months +,/ 8/ Verify whether there is any scope for covered interest arbitrage if you borrow rupees. ,uestion #o :1A Co:ered interest arbitra5e (he following table shows the annual interest rate Sannually compoundedO and e&change rates against the dollar for different currencies. 2re there any arbitrage opportunities? %f so# how could you secure a positive cash flow today# while <eroing out all future cash flows?

Interest rates and e&change rates

$nterest RateN Percenta5e @nited States SdollarO !ostaguana SpulgaO $estonia SrupleO Xloccamorra SpintO 50 8 pot Exchan5e RateO +,#,,, 5.9 +:.+ 1)Year 1or/ard Exchan5e RateO ++#4C5 5.90 +8.5

2nglosa&ophonia SwaspO C.+ 5.5.58 =umber of units of foreign currency that can be e&changed forA+ ,uestion #o: (@ 1or/ard :s Eoney market 3ed5e $mporter (he finance director of * Ltd.# has been studying e&change rates and interest rates relevant to %ndia and @S2. * Ltd. has purchased goods from the @S !o. at a cost of A 0+ Lakhs payable in dollars in three months time. %n 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 * Ltd. is no more than Rs.55 crores. )&change rates Spot C, Q C5 %nterest rates Savailable to * Ltd.O $ndia .eposit rate K9L 0orro/in5 rate K9L Rs ; Gollar - months forward C5 - C0 " & .eposit rate K9L 0orro/in5 rate K9L

+-.,, +9.,, 8.,, ++.,, !alculate whether it is possible for * Ltd. to achieve a cost directly associated with transaction of no more than Rs.55 crores by means of a forward market hedge# or money market hedge. (ransactions costs may be ignored. ,uestion #o: (1 1or/ard :s Eoney Earket 3ed5e /ith taxation Hn 1arch +# the > Ltd. bought from a foreign firm electronic e.uipment that will re.uire the payment of L! 4#,,#,,, on 1ay -+. (he spot rate on 1arch +# is L! +, per dollarI

the e&pected future spot rate is L! A per dollarI and the ninety-days forward rate is L! 4 per dollar. (he @S interest rate is +5 percent# and the foreign inter est rate is 8 percent. (he ta& rate for both countries is C, percent. (he > Ltd. is considering three alternatives to deal with the risk of e&change rate fluctuations. a. (o enter the forward market to buy L! 4#,,#,,, at the ninety - days forward rate in effect on 1ay -+. b. (o borrow an amount in dollars to buy the L! at the current spot rate. (his money is to be invested in government securities of the foreign countryI with the interest income# it will e.ual L! 4#,,#,,, on 1ay -+. c. (o wait until 1ay -+ and buy L!s at whatever spot rate prevails at that time. $hich alternative should the > Ltd. follow in order to minimi<e its cost of meeting the future payment in L!s? )&plain. ,uestion #o: (( Eoney Earket 3ed5in5 - Recei:ables 2ustralian firm has a 4, day receivable !2G receivable of !2G +, million. %t has access to domestic as well as offshore money markets. (he fore& and interest rates in the market are 2@G;!2G spot +.+,50;-0 4, days swap 5,;-,. %nterest rates are !2G 0.50;0.0, and 2@G C.:0;0.,,. $ith a forward contract how much will the 2@G inflow be when the receivable is settled? 'ow can the firm cover via money market? %s it better or worse than the forward hedge? ,uestion #o: (Eoney market hed5in5 leadin5 ) +or/ard 2 >elgian manufacturer of the crystal has received an order from a Japanese department store. (he buyer wishes to be invoiced in its home currency. (he >elgian firm agrees to this because it wishes to gain a foothold in a new market. (he order is for N50, million with payment due three months from delivery. (he >elgian firm confident about completing delivery - months from today. (he market rates today are as followsF >eFr ; A spot F - months F 9 months F (he interest rate areF Gomestic >e)rF )uro >e)rF Gomestic 7enF --.09,, ; --.0850 C0, ; C,, 9,, ; 050 - months 9.50/ - months 9/ - months C.0/ N ; A spot F +5+.0, ; +55.,, 5.0, ; 5.,, C.8, ; C.5, 9 monthsF 9.0,/ 9 months F 9.50/ 9 months F 0/

)uroyenF - months C.50/ 9 months F C.:0/ (he >elgian firm $ishes to know how it should cover its receivable. (he Japanese buyer may also be willing to pay on delivery if an appropriate discount is offered. )valuate the various alternatives. ,uestion #o: (2 'a55in5 )lectronic !orporation Ltd.# your customers# have imported 0#,,, cartridges at a landed cost in >ombay# of @S A5, each. (hey have the choice of paying for the goods immediately or in three months time. (hey have a clean overdraft limit with you where +8/ p.a. rate of interest is charged. !alculate which of the following methods would be cheaper to your customerF aO *ay in three months time with interest at +0/ and cover the e&change risk forward for three months. bO Settle now at a current spot rate and pay interest of the overdraft for three months. (he rates are as followsF >ombay Rs;A SpotF C+.50 - C+.00 - month swapF 50;-0 ,uestion #o: (8 Eoney Earket 3ed5in5 la55in5

2lpha ltd. is planning to import a multi-purpose machine from a @S based supplier at a cost of @SG +,,,,. (he company proposes to avail a 9 month3s loan from a bank in %ndia carrying interest at +5/ per annum calculated on .uarterly rests to pay the cost of the machine. (here is also an offer from the supplier to arrange for 9 month3s credit sub?ect to the following conditionsF aO 2n irrecoverable letter of credit is to be openedI and bO %nterest at L%>HR of 5/ per annum is to be paid at the end of the period. Hther information availableF Spot rate for @SG Forward rate for @SG S9 monthsO Rs.C8 Rs.C8.0,

L! !ommission payable tip front +/ $ould you advise the company to accept the offer the supplier for credit and if so# under what conditions? Show your workings. ,uestion #o: (; 1or/ard : EE3 : 'eadin5 2rt 2merican firm has a +8,-day payable of 2usA+,#,,#,,, to an 2ustralian supplier. (he market rates areF 2us A ; A spot F +.-C:0 I +8, day forward +.--C: @SA +8,-day interest rateF +,/ p.a. 2us A +8,-day interest rateF 8/ p.a. (he 2ustralian authorities have imposed a restriction on 2ustralian firms which prevents them from borrowing in the euro market. Similarly# non-residents cannot make moneymarket investment in 2ustralia. 2s a conse.uence# the domestic +8,-day interest rate in 2ustralia is 4.0/p.a. (he 2merican firm wants to evaluate the following four alternative hedging strategiesF aO >y Forward. bO >y 1oney market hedging cO >y Leading. dO >y Leading with a forward. ,uestion #o: (< #ettin5N +or/ardN EE3 (he $oolworth !orporation3s @S 2 is committed to the following transactions in 4, days F 1ake interest payment to french bank of FFr +,, Receive G)1 +9, for goods sold to Xerman retailer in +8, days Receives FFr +,, in payment for sales to a french. manufacturer. 1ake G)1 +9, payment to Xerman supplier for product. (he spot e&change rate today is G)1 +.9,,,;A. Hther foreign e&change and interest rate data areF 4,-day forward G1 +.9-,, +8,-day forward G1 +.90,, 4,-day interest rate G)1 4.0/ p.a. +8,-day interest rate G)1 8.50/ p.a. 4,-day interest rate @SG5.,/ p.a. +8,-day interest rate @SG 5.0/ p.a. Gemonstrate how the @S company can achieve certainty of value for its future payables and receivables. ,uestion #o: (= Currency s/ap 1cGonnoughs 'amburger !ompany wishes to lend A0,,#,,, to its Japanese subsidiary. 2t the same time# 7asufuku 'eavy %ndustries is interested in making a medium-term loan of appro&imately the same amount to its @.S. subsidiary. (he two parties are brought together by an investment bank for the purpose of making parallel loans.

1cGonnoughs will lend A0,,#,,, to the @.S. subsidiary of 7asufuku for C years at +percent. *rincipal and interest are payable only at the end of the fourth year# with interest compounding annually. 7asufuku will lend the Japanese subsidiary of 1cGonnoughs :, million yen for C years at +, percent. 2gain the principal and interest Sannual compoundingO are payable at the end. (he current e&change rate is +C, yen to the dollar. 'owever# the dollar is e&pected to decline by 0 yen to the dollar per year over the ne&t C years. aO %f these e&pectations prove to be correct# what will be the dollar e.uivalent of principal and interest payments to 7asufuku at the end of C years? bO $hat total dollars will 1cGonnoughs receive at the end of C years from the payment of principal and interest on its loan by the @.S. subsidiary of 7osufuku? cO $hich party is better off with the parallel loan arrangement? $hat would happen if the yen did not change in value? .isposal o+ +or/ards by 0anks ,uestion #o:(A Early .eli:ery $mporter 2n %ndian company enters into a forward agreement with a >ank on +:th January for purchasing + lac @S Gollars. 2s on that date the fore& situation was as followsF Spot %=R ; A F -+ Jan 58 Feb
th th st

C9.0C,, ; 0C0, ::0 ; 850 5-0, ; 5C50

-, 1ar C,,, ; C+,, Hn +0th February# the company comes to know that it has to make early payment for his on 58th Feb and not on -,th 1arch. (he current rates on +0th February 5,,5 transaction date areF Spot %=R ; A F 58 Feb -, 1ar
th th

C9.0,50 ; 0,:0 90, ; :,, 5550 ; 55:0

5:th 2pr -4,, ; C,,, $hat are the charges payable by the company? ,uestion #o: -@ Early Early .eli:ery ) Exporter 2n %ndian company enters into a forward agreement with a >ank for selling +.:0 lac @S Gollars. 2s on that date the fore& situation on +4th January was as followsF Spot %=R ; A F -+st Jan 58th Feb C9.0C,,;0C0, ::0 ; 850 5-0, ; 5C50

-,th 1ar C,,, ; C+,, Hn +0th February# the company comes to know that it has to receive early remittance on 58th Feb and not on -,th 1arch. (he current rates on +0th February transaction date areF Spot %=R ; A F 58th Feb -,th 1ar C9.0,50 ; 0,:0 90, ; :,, 5550 ; 55:0

5:th 2pr -4,, ; C,,, $hat are the charges receivable;payable by the company? ,uestion #o: -1 Early .eli:ery) $mporter (he company had agreed on 5,th February that it will buy on 5,th 2pril from the banker @SG +,#,,, at Rs.CC.0:. Hn 5,th 1arch# the company approaches the bank to buy @SG +,#,,, tinder the forward contract earlier entered into. (he rates prevailing in

the market on this date areF Spot Rs.CC.C:50;C8,, 2pril Rs.CC.500,;5950 %gnoring interest and find out the amount that would be paid;received by the company on early delivery? ,uestion #o: -( Early .eli:ery)Exporter 2 company entered into an agreement with its banker on +.0th 1arch# for a forward sale contract for G)1 C#,,, delivery +st July# at the rate of Rs.58.+C per 1ark. Hn +0th 2pril# the company re.uested the bank to sell the Ybill for G)1 C#,,, tinder this contract. !alculate the amount payable;receivable to the company assuming the following rates on +0th 2prilF Spot G)1 + B Rs.58.+,50 ; +,:0 Geliver July 58.9C:0 ; 900, %gnore interest and the penal provisions under F)G2% rules. ,uestion #o: -Early Extension $mporter 2n %ndian company for purchasing + lac enters into a forward agreement with a >ank on +:th January @S Gollars. 2s on that date the fore& situation was as followsF Spot @SG ; %=R -+ Jan 58th Feb
th st

C9.0C,, ; 0C0, ::0 ; 850 5-0, ; 5C50

-, 1ar C,,, ; C+,, Hn +0th February# the company comes to know that it has to settle its payable on -,th 1arch and not on 58th February. (he current rates on +0th February transaction date areF Spot %=R A 58 Feb -, 1ar
th th th

C9.0,50 ; 0,:0 90, ; :,, 5550 ; 55:0

5: 2pr -4,, ; C,,, $hat are the charges payables by the company? ,uestion #o: -2 Early Extension Exporter Hn +0th 1arch# K Ltd entered into a forward sale contract for @S dollars 0#,,, with its banker at the rate of Rs.C0.,0 delivery due on +0th June. Hn 0th 1ay# the company re.uests the bank to postpone the date to +0th July. !alculate the e&tension charges payable to the banker assuming the following rates in the market on 0th 1ay. Spot For ; June mid For ; July mid @SG + B Rs.C0.,, ; ,5 C0.,C ; ,9 C0.,C ; +,

For ; 2ug mid C0.+ ; +C ,uestion #o : -8 .ue date extension $mporter 2n importer bought @SG +#,,#,,, - months forward on Gecember 54 at a contract rate of Rs.CC.0,# delivery 1arch 54. Hn 1arch 54# the importer re.uests the bank to e&tend the contract to 2pril 54. Hn 1arch 54 the market rates areF %=R;@SG SpotF CC.8,;C0.,0 +-month swapF +,;+5. !alculate the charges payable / receivable to the banker. ,uestion #o: -; .ue date extension Exporter Xayle !ompany Ltd had booked a forward sale contract for @SG 5#,,#,,, at Rs.C0.55 a

bill for collection. 'owever# on the maturity date the company re.uested to e&tend contract by one monthF 2ssuming the on-going market rates for @S dollars are as underF Spot Hne month forward (wo month forward @SG + B Rs.C0.+450 ; 50:0 9,,; :,, 4,, ; +,,,

(hree month forward +5,, ; +-,, $hat will be the e&tension charges payable;receivable by the company ,uestion #o: -< Early cancellation $mporter Hn September+0 the Rs.;A rates were C+.+0;C+.C, spot and 85;40 - month swap points. 2 firm booked a - month forward purchase contract for A+0,#,,,. on =ovember +0 it wished to cancel the contract. 2t that time# the spot rate was C+.4,;C5.+, and one month swap rate was 5,;-,. 'ow much is collectable / payable by customer. ,uestion #o: -= Early Cancellation Exporter 2 customer with whom the bank had entered into a - months forward purchase contract for Sw.Fcs. +,#,,, at the rate of Rs.5:.50 comes to the bank after two months and re.uests cancellation of the contract. Hn this date# the rates and prevailing areF Spot Sw.Fcs + B Rs.5:.-, Q 5:.-0 + month forward 5:.C0 Q 5:.05 $hat is the loss;gain to the customer on cancellation? ,uestion #o: -A .ue date Cancellation $mporter Hn +0th January a company booked a forward purchase contract for French Francs 50,,,, from a banker# delivery +0th February at Rs.8.40. Hn the due date the customer re.uests cancellation of the contract. 2ssuming French Francs were .uoted in the London foreign e&change market as underF Spot Hne month @SG + B FFR 0.,5,, ; ,-,, -,0 ; -50

(wo month :+, ; :9, 2nd the @S dollars were .uoted in the local e&change market as under on the date of cancellation F Spot Spot ; 1arch @SG B + Rs.CC.:4,, ; :4:0 -, ; -0

Spot 2pril 9, ; 90 $hat will be the charges payable by the company# if any or otherwise? ,uestion #o: 2@ .ue date Cancellation Exporter F6 Ltd had booked a forward sale contract for Geutsche 1ark 0,#,,, delivery 5, th =ovember at Rs.58.40. (he company on the due date re.uested cancellation of forward e&change contract. 2ssuming Geutsche 1arks were .uoted in the Frankfurt market as underF Spot Hne month forward @SG B + G)1 +.0+0, ; 0+:, +50 ; ++0

(wo month forward 58, ; 5:, 2nd the @S dollars were .uoted in the local market as underF Spot @SG B + Rs.CC.9+50 ; 95,, Spot ; Gecember -C ; -9 $hat will be the cancellation charges# if any# payable or receivable by F6 Ltd? .ealers desk

,uestion #o: 21 Cash position : Exchan5e position 7ou as a dealer in foreign e&change have the following position in Swiss francs on -+st Hctober 5,,CF *articulars >alance in =ostro account credit Hpening position overbought *urchased a bill on Zurich Sold forward (( Forward purchases cancelled Remitted by (( Graft on Zurich cancelled )&pected closing balance in =ostro !redit Swiss Francis in thousands +,, 0, 8, 9, -, :0 -, -,

)&pected closing Hverbought position +, $hat steps would you take# if you were re.uired to maintain the balance stated in the above table? ,uestion #o: 2( Cash position : Exchan5e position 7ou as a dealer have the following position in pound-sterlingF Hpening balance in >arclays >ank %nternational London X>* 5,#,,, HG Hpening currency position overbought 0#,,, *urchased a telegraphic transfer 0,#,,, %ssued a draft on London 5,#,,, (( remittance outward 50#,,, *urchased bills on London :0#,,, Forward sales :0#,,, )&port bills reali<ed C0#,,, $hat steps would you take if you are re.uired to maintain a credit balance of X>* +,#,,, in nostro account and s.uare your e&change position? ,uestion #o : 2.ealers Pro+it 7ou sold 'KA +, 1illion value spot to your customer at Rs.0.:, and covered in London market on the same day# when the e&change rates were A B 'KA :.088, Q :.045, Local interbank market rates for @SA were Spot A B Rs.C5.:, Q C5.80 !alculate cover rate and ascertain the profit or loss in the transaction. %gnore brokerage. !axation and $nternational +inance ,uestion : 22 !ax 3a:ens R Ltd has manufacturing subsidiaries in three overseas countries Country Subsidiary + Subsidiary 5 1ars Jupiter Corporate tax C,/ -0/ Proposed #et di:idend +,,,,,, +9,,,,,

Subsidiary - Venus 5,/ 8,,,,,, (he %ndian corporate ta& is -,/. (here are no ta&es in the ta& haven country. >ilateral ta& agreement e&ist between %ndia and the countries where each of the subsidiaries is located# which allow a ta& credit against %ndian corporate ta& liability up to a ma&imum of the %ndian ta& liability. (his ta& credit may be assumed to be available even when dividends are channeled via a ta& haven. %ndian corporate ta&ation on overseas earnings may be assumed to be based upon the total dividends remitted to %ndia grossed up by one minus ta& rate from each overseas country". Re.uired F )valuate whether or not R Ltd would benefit from using a ta& haven holding

company through which dividends would be channeled. ,uestion : 28 'ocal purchase or o:erseas branch trans+er Givision $# which is part of the 67Z group# is based in country 2 and has the capacity to manufacture +,,,,, units of products > each year. (he variable cost of producing a unit of > is A+0. and the division can sell 80,,, units e&ternally per annum at A50 per unit. Givision G is part of the same group and is based in country L. G purchases C,,,, units of product > each year from F an entity outside the group"# which is also in country L. G pays A e.uivalent of A 5, per unit. %f division G were to purchase product > from division $# division $ would set a transfer price of A55. Xiven that there are no seling costs involved in the transferring units to division G# this woukd give $ the same contribution on internal and e&ternal sales. Givision $ gives priority to G and so te orders from some e&ternal customers would not be met. Re.uired F Getermine from whom G has to purchase > in each of the following circumstancesF +. (a& rate in country 2 F -,/ I country L F C,/ 5. (a& rate in country 2 F 9,/ I country L F +0/ Eiscellaneous ,uestion #o: 2; Cost o+ strike

#a% 'n December ()* a customer requested a bank to remit D+ (,---- to .olland in payment of import of diamonds under an irrevocable /+. .owever due to bank strikes* the bank could effect the remittance only on 0anuary 1. 2he market rates were as follows3
.ecember (< >ombay London A ; +,, Rs. F -.+, Q -.+0 A ; *ound F +.:50, ; 9, Panuary -.,: Q -.+5 +.:+:0 ; 80

GX ; *ound -.40:0 ; 4, -.4-8, ; 4, (he bank wishes to retain an e&change margin of ,.+50/. 'ow much does the customer stand to gain or lose due to the delay?

#b% 'n 0anuary (4* a customer requested a bank to realise 5ingapore 6(., Million in receipt under an irrevocable /+ for their e&ports through 5ingapore corridor. .owever due to bank strikes* the bank could complete the formalities only on February 7* 2he market rates were as follows3
.ecember (< >ombay %=R A London A ; *ound C0.84 ; 4, +.:8C, ; 0, Panuary C0.4+ ; 4: +.::90 ; :0

Singapore A ; *ound -.+0:0 ; 4, -.+-8, ; 4, (he bank wishes to consider an e&change margin of ,.+50/. 'ow much does the customer stand to gain or lose due to the delay? !omputational rates can be e&tended up to C decimal locations. ,uestion #o: 2< 0ond yield and +orei5n exchan5e %n September +440 interest rates were 0.8 percent in the @nited States and +,.9 percent in %taly. (he spot e&change rate was L+959;A. Suppose that + year later interest rates are 8 percent in both countries# while the value of the lira has fallen to L+8,,;A. aO Floria (osca from Rome invested in an %talian 5-year <ero coupon bond in September +440 and sold it in September +449. $hat was her return? bO >en?amin *inkerton from =ew 7ork also invested in the %talian 5-year bond in

September+440 and sold it in September +449.$hat was his return in dollars? cO Suppose that 1r.*inkierton had correctly forecasted the price at which he sold his bond and that he hedged his investment against currency risk? 'ow could he have done so? $hat would have been his return in dollars. ,uestion : 2= !rans+er price and exchan5e rates 2 subsidiary in @K sells product * to a @S subsidiary. Getais are as follows F (ransfer price A5+ !ost incurred in @K subsidiary L4 (he @S subsidiary incurs additional cost of A- to convert product * for sale in the @S market at a selling price of A54 per unit. Gue to weakening of the dollar against the pound# the e&change rate is now +L B A +.8,. Re.uiredF !alculate the effect of the change in e&change rate on the profit per unit of each subsidiary if the agreed transfer price was fi&ed in terms of F +. Gollars 5. *ound sterling ,uestion 2A: E++ecti:e rate o+ protection and domestic resource cost (he following details are available in respect of a pro?ectF Value of tradable inputs at domestic prices :,, crores Value of non-tradable inputs at domestic prices +8, crores Value of tradable inputs at world prices 09, crores Sales realisation at domestic prices +,,, crores Sales realisation at world prices 8,, crores !alculateF +. )ffective rate of *rotection for the pro?ect. 5. %f the e&change rate of rupee per @SA is -0# what is the domestic resource cost of the pro?ect. ,uestion #o : 8@ Expected 1or/ard %n 1arch 2 1=! makes the following assessment of A rates per X>* to prevail as on September F 7 M0P +.9, +.:, +.8, +.4, Probability ,.+0 ,.5, ,.50 ,.5,

5.,, ,.5, +. $hat is the e&pected spot rate for September? 5. %f in the 1arch the 9 month forward rate is A +.8,# should the firm sell forward its X>* receivable due in September ?