Example

You are required to find out the overall balance,

showing clearly all the sub-balances from the following
data:

(1) UC Corporation of the USA invests in India

Rs.3,00,000 to modernise its India subsidiary.
(2) A tourist from Egypt buys souvenirs worth
Rs.3000 to carry with him. He also pays hotel and
travel bills of Rs.5,000 to Delhi Tourist Agency.
(3) The Indian subsidiary of UC Corporation remits,
as usual, Rs.5,000 as dividends to its parent
company in the USA.
(4) This Indian subsidiary of UC Corporation sells a
part of its production in other Asian countries for
Rs.1,00,000.
(5) The Indian subsidiary borrows a sum of
Rs.2,00,000 (to be paid back in a year’s time)
from the German money market to resolve its
urgent liquidity problem.
(6) An Indian company buys a machine for
Rs.1,00,000 from Japan and 60 per cent payment
is made immediately; the remaining amount is to
be paid after 3 years.
(7) An Indian subsidiary of French Company borrows
Rs.50,000 from the Indian public to invest in its
modernisation programme.

1
Solution
Sources and Uses of Funds

S. No. Sources Uses Nature

1. 3,00,000 Direct Foreign Investment
2. (a) 3,000 Goods exported
(b) 5,000 Services (invisible) rendered
3. 5,000 Dividends paid
4. 1,00,000 Goods exported
5. 2,00,000 Short-term borrowing
6. (a) 1,00,000 Equipment imported
(b) 40,000 Increase in claim to India
(Portfolio)
6,48,000 1,05,000

BOP Statement
Current Account
Goods Account
Exports : Rs. 1,03,000 (+)
Imports : Rs. 1,00,000 (-)
Balance : Rs. 3,000 (+)

Invisible Account
Payment Received : Rs. 5,000 (+)
Payments Made : Rs. 5,000 (-)
2
 Balance : Nil

Current Account Balance: Rs. 3,000 (+)

B. Capital Account
Foreign Direct Investment

Inflow : Rs. 3,00,000 (+)

Outflow : Nil
Balance : Rs. 3,00,000 (+)

Portfolio Investment

Inflow : Rs. 40,000 (+)

Outflow : Nil
Balance : Rs. 40,000 (+)

Long-term Capital Balance: Rs.3,40,000 (+)

(FDI + Portfolio)

Short-term Capital Account

Inflow : Rs. 2,00,0000 (+)
Outflow : Nil
Balance : Rs. 2,00,000 (+)

Capital Accounts Balance: Rs.5,40,000 (+)

Overall Balance: Rs. 5,43,000 (+)

3
 There is a net surplus of Rs.5,43,000 in the balance
of payments. This means, there will be an increase of
reserves by this amount.

Notes: The transaction No. 7 did not enter into the

BOP Statement since this transaction does not involve
any foreign country. The entire transaction has taken
place in Indian rupees within India.

4
 FOREIGN EXCHANGE MARKET

INTRODUCTION
The foreign exchange market is the market where the
currency of one country is exchanged for that of
another country and where the rate of exchange is
determined. The genesis of Foreign Exchange (FE)
market can be traced to the need for foreign currencies
arising from:
 international trade;
 foreign investment; and
 lending to and borrower from foreigners.

In order to maintain an equilibrium in the FE market,

demand for foreign currency (or the supply of home
currency) should equal supply of foreign currency (or
the demand for home currency). In operational terms,
the demand for and supply of home currency should be
equal. In the event of a disequilibrium situation, the
monetary authority of the concerned country normally
intervenes/steps in to bring out the desired balance by:
 variation in the exchange rate; or
 changes in official reserves; or
 both.

5
PARTICIPANTS IN THE FE MARKET
Major participants in the FE market are:
 Large commercial banks (through their cambistes
or dealers) operating either at retail level for
individual exporters and corporations, or at
wholesale level in the interbank market;
 Central banks of various countries that intervene in
order to maintain or to influence the exchange rate
of their currencies within a certain range, as also to
execute the orders of government;
 Individual brokers or corporations. Bank dealers
often use brokers to stay anonymous since the
identity of banks can influence short-term quotes.

Exchange markets primarily function through

telephone and telex. Further, it may be mentioned hem
that currencies with limited convertibility play a minor
role in the FE market. And, only a small number of
countries have established fill convertibility of their
currencies for all transactions.

QUOTING IN THE FE MARKET

Foreign exchange rates ale quoted either for immediate
delivery (spot rate) or for delivery on a future date
(forward rate). In practice, delivery in spot market is
made two days later.

6
A FE quotation is the price of a currency expressed in
the units of another currency. The quotation can be
other direct or indirect. It is direct when quoted as “so
many units of local currency per unit of foreign
currency”. For example, Rs. 35 = US$ 1, is a direct
quotation for US dollars in India. Similarly, a quotation
in the USA will be $ 0.22 = FFr 1 whereas in France, it
would be FFr 3.3 = DM 1, etc.

On the other hand, an indirect quotation is the one

where exchange rate is given in terms of variable units
of foreign currency as equivalent to a fixed number of
units of home currency. For example, in India US$
2.857 = Rs. 100 is an indirect quotation. This type of cp
is made in the UK. For example, in London a quotation
may be made as $1.55 = £ 1.

Since 2 August 1993, all quotations in India use

the direct method of quotation. Some currencies are
quoted as so many rupees against one unit while others
as so many rupees against 100 units, as indicated in
Tables 1 to 3 below.

7
 Table 1 Foreign Currencies Quoted against their
One Unit

1. Australian dollar 10. Finish mark 19. Qatar riyal

(A$) (FM)
2. Austrian schilling 11. French franc 20. Saudi riyal (SR)
(Sch) (FFr)
21. Singapore dollar
3. Bahrain dinar 12. Hong Kong (S$)
dollar (HK$)
4. Canadian dollar 13. Irish pound (I £) 22. Sterling pound
(Can$) (£)

5. Danish kroner 14. Kuwaiti dinar 23. Swedish kroner

(DKr) (SKr)
15. Malaysian
6. Deutschmark (DM) ringgit 24. Swiss franc (Sfr)

7. Dutch guilder (FI 16. New Zealand 25. Thai baht (Br)
dollar (NZ$)
8. Egyptian pound 17. Norvegian 26. UAE Dirham
kroner (NKr)
9. European Currency 27. US Dollar ($)
Unit (ECU) 18. Omani riyal

8
 Table 2 Foreign Currencies Quoted against their
100 Units
1. Belgian franc (BFr) 3. Italian lira 5. Kenyan shilling
2. Indonesian rupiah 4. Japanese yen 6. Spanish peseta

Table 3: Asian Clearing Union Currencies Quoted

against their 100 Units
1. Bangladesh taka 3. Iranian rial 5. Sri Lankan
rupee
2. Burmese Kyat 4. Pakistani rupee

Foreign exchange rates are always quoted as a

two-way price, i.e. a rate at which the bank (dealer) is
willing to buy foreign currency (buying rate) and a rate
at which the bank sells foreign currency (selling rate).
Dealers do expect some profit in exchange operations
and hence there is always some difference in buying
and selling rates. However, the maximum spread
available to dealers may be restricted by their central
bank. All exchange rates by authorized dealers are
quoted in terms of their capacity as buyer or seller.

Two-Way Quote
A dealer usually quotes a two-way price for a given
currency-the price at which he is buying (bid price) and
the price at which he is selling (offer or ask price) the
currency. In either case, the currency for which the bid
or ask price is given is the unit of the item priced.

9
 In a bid quote of Rs 35/US$ 1, the dealer conveys
that he will buy dollars at the price of Rs 35 per dollar,
which also means that he is willing to sell 35 m at the
price of one dollar. Likewise, when the dealer quotes
an offer price per dollar, he implicitly quotes the rate at
which rupees would be bought per dollar.

All foreign exchange dealers are set to make profit

out of each transaction, whether it is a sale or purchase
of foreign currency. Therefore, when a dealer in India
buys foreign currency (the customer selling the
currency), he endeavours to give as few units of the
local currency as he can against every one unit of the
foreign currency he buys. But when he sells foreign
currency (the customer buying the currency), he
endeavours to take as many units of the local currency
as he can against every unit of foreign currency he
gives to the customer.

For example, a dealer in New Delhi may quote:

US$ 1 = Rs 35.000 – 35.0050.

This means that he will buy dollars from an

exporter at US$ 1 = Rs 35.0000, and sell dollars to an
importer at US$ 1 = Rs 35.0050. Thus, the lower rate is
the buy (bid) quote and the higher rate is the selling
(ask) quote.

10
Spread
Spread means the difference between a banks buying
(bid) and selling (offer or ask) rates in an exchange rate
quotation or an interest quotation. It fluctuates
according to the level of stability in the market, the
currency in question, and the volume of the business.
Thus, if there is a degree of volatility in an exchange
rate, and if business is thin and if (rumours persist
about the currency that) the current rate is rumoured to
be unsustainable, the dealer will protect himself by
widening the quote. That is, he will offer less currency
while selling but demand more when buying. The
spread represents the gross return to the dealer for the
risks inherent in making a market”. The spread can also
be expressed as a percentage. That is,

Ask price – Bid price x 100

Per cent spread = Ask price

For example, with dollar quoted at Rs 35.000 -

35.0050, the percentage spread equals 0.014.

35.0050 – 35.0000 x 100

Per cent spread = 35.0050
= 0.014.

Usually, in transactions among dealers, only the

last two digits are quoted, to save time and the rest is

11
understood. Thus, a dealer in New Delhi may quote a
spot price for the dollar which is US$ 1 = Rs 35.0050 -
35.0080 only by referring to the last two digits, i.e. 50-
80, instead of quoting the rate in its entirety.

The last digits are called points, e.g. in US dollar

terms, a point is 1/10,000 part of the unit. Or, one point
US$ 0.0001. A pip is one further decimal place to the
right, i.e. US$ 0.00001 and represents 1/100000 part of
a dollar.

Most quoted currencies are expressed to four

decimal places but the currencies with low value
relative to others are quoted up to two decimal places.
Italian Lira and Japanese yen are examples of such
currencies.

Cross Rates (Chain Rule)

Cross rate is the price of any currency other than the
home currency. In her words, it is the direct
relationship between two non-home currencies in a
foreign exchange market concerned with or used in
transactions in a country to which none of the
currencies belongs. Thus, in India, a cross rate is any
exchange rate which excludes rupees, for example,
US$/FFr, DM/BFr, etc.

12
If an importer has to remit French francs from India
with the knowledge that Rupee/FFr rates are not
normally quoted, would first buy dollars against the
rupees and the same dollars will be used overseas to
acquire French francs. If, say, rates in New Delhi am
US$ I = Rs 35.0010 — Rs 35.0080 and rates in Paris
market are US$ 1 = FFr 5.1025/50, he will get US$ 1
by paying Rs. 35.0080 and for one US$, he will get
FFr 5.1025. Thus, a sort of chain is formed as under:

FFr 5.1025 = US$1

US$ 1 = Rs. 35.0080

Therefore, FFr 1 = 35.0080/5.1025

or, FFr1 = Rs 6.8609

SETTLEMENTS
Cash
Cash rate or Ready rate is the rate when the exchange
of currencies takes places on the date of the deal. If
delivery is made on the day the contract is booked, it is
called a Telegraphic Transfer (TT) or cash or value-day
deal.

Tom
When the exchange of currencies takes place on the
next working day after the date of deal, it is called the
TOM (tomorrow) rate.

13
Spot
When the exchange of currencies takes place on the
second working day after the date of the deal, it is
called the spot rate. This time is allowed to banks to
process the necessary paperwork and transfer the funds.
Such transfers to and from banks will be effected when
their overseas currency accounts we either credited or
debited, depending on whether the bank is buying or
selling. The rate of the agreed deal on telephone is
called the contract dale; the value date is the one when
the deposit is credited or debited. Normally, a deal
done on Tuesday will b settled on Thursday and a deal
done on Friday will be settled on the following
Tuesday. A business day is defined as one in which
both banks are open for business in both settlement
countries. Most dealings now-a-days are done ‘spot”.

In the case of a US$/DM deal done on Tuesday,

settlement is normally expected on Thursday.
Settlement would not be affected by a US holiday on
the following Wednesday, but would be affected by a
German holiday on this Wednesday. In the latter case,
the spot date would be postponed until Friday, provided
that both centres were open on Friday. If Wednesday
were a normal day and Thursday a holiday in either the
USA or Germany, the spat day would be Friday, if both
centres were open on that day.

14
 In the case of a US$/DM deal done, say, in
London, the occurrence of bank holiday in the UK
during the spot period is entirely irrelevant. This is
because all bank account transfers are made in the
settlement country rather than the dealing centre.
Settlement of both sides of a foreign exchange deal
should be made on the same business day. Because of
time zone differences, settlement on any given business
day will take place earlier in the Far East, later in
Europe, mid later still in the USA. The principle that
the two sides of the deal should be completed on the
same day is referred to as the principle of compensated
value.

The only exception o the principle of compensated

value arises for deals in Middle East countries for
settlement on Friday. This is a holiday in most Middle
East countries. Even though a person buying the
Middle Eastern currency (say, Saudi riyals) may make
payment (say, in pound sterling) on Friday, the delivery
of riyals would take place on Saturday, provided it was
a business day in both the relevant countries:

For some currencies, such as US$/Can$ transactions, a

spot transaction is only one day by convention and
agreement among the market participants.

15
ADJUSTMENT OF DEMAND AND SUPPLY ON
THE SPOT MARKET: PROCESS OF
ARBITRAGE
Arbitrage can be defined as an operation that consists
in deriving a profit without risk from a differential
existing between different quoted rates. It may result
from two currencies (also known as geographical
arbitrage) or from three currencies (also known as
triangular arbitrage).

Example
An Arbitrage between Two Currencies

Suppose two traders A and B are quoting the following

rates:
Trader A (Paris) Trader B (New York)
FFr 5.5012/US$ US$ 0.1817/FFr

We assume that buying and selling rates for these

traders are the same. We find out the reciprocal rate of
the quote given by the trader B, which is FFr
55036/US$ (= 1/0.1817). A combiste buys, say, US$
10,000 from the trader A by paying FFr 55,012. Then
he sells these US dollars to the trader B and receives
FFr 55,036. In the process, he gains FFr 24 (= 55,036 -
55,012).

16
 Since, in practice, buying and selling rates are
likely to be different, so the quotation is likely to be as
follows:
Trader A Trader B
FFr 5.4500/US$ - FFr 5.50121US$ US$0.1785/FFr - US$ 0.18/FFr

These rates mean that the trader A would be

willing to buy one unit of US dollar by paying FFr 5.45
while he would sell one US dollar for FFr 5.5012. The
same holds true for the corresponding figures of the
trader B.

By observing these figures, it is clear that in order

to make an arbitrage gain, the selling rate of the trader
A has to be lower than the buying rate of the trader B.

But this process would tend to increase the selling

rate at the trader A because of the increase in demand
of US do and the reverse would happen at the trader B
because of increased supply of US dollars. This would
lead to an equilibrium after some time.

17
Example
An Arbitrage between Three Currencies

Now suppose both traders A and B are located at New

York and quoting as follows:
Trader A Trader B
$ 0.60/SF $ 0.60/SFr
$0.51/DM $0.52/DM

Since three currencies are involved hem, we find

cross rates between SFr and DM as well. These are:

SFr 0.85/DM (= 0.5110.64 at the trader A and SFr

0.867/DM (= 0.52/0.60) at the trader B. Thus, the
situation looks like as follows:
Trader A Trader B
$ 0.51/SFr $ 0.60/SFr
$0.51/DM $ 0.52/DM
SFr 0.85/DM SFr 0.867/DM
So what are the arbitrage possibilities?

There is no arbitrage gain possible between the US

dollar and Swiss franc. The following two arbitrages
ale, however, possible:
 Deutschmark against the US dollar is being quoted
higher at the trader B. So buy Deutschmarks from
the trader A and sell them to the trader B.

18
  A similar possibility of arbitrage gain exists
between the Swiss franc and Deutschmark: buy
Deutschmarks against Swiss francs from the trader
A and sell them to the trader B.

FORWARD RATE
If the exchange of currencies takes place after a certain
period from the date of the deal (more than two
working days), it is called the Forward Rate. A forward
exchange contract is a binding contract between a
customer and a dealer for the purchase or sale of a
specific quantity of stated foreign currency, at a rate of
exchange fixed at the time of making the contract (for
executing by delivery and payment at a future time
agreed upon when making the contract).

Forward rates are generally expressed by

indicating premium/discount on the spot rate for the
forward period. Premium on one country’s currency
implies discount on another country’s currency. For
instance, if a currency (say the US dollar) is at a
premium vis-à-vis another currency (say the Indian
rupee), it obviously implies that the Indian rupee is at a
discount vis-a-vis the US dollar.

The forward market is not located at any specified

place. Operations take place mostly by telephone/telex,
etc., through brokers. Generally, participants in the
19
market are banks which want to cover orders for their
clients.

Though the forward rate may be quoted by a trader

for any future date, the normal practice is to quote them
for 30 days (1 month), 60 days (2 months), 90 days (3
months) and 180 days (6 months).

Quotations for forward rates can be made in two

ways. They can be made in terms of the exact amount
of local currency at which the trader quoting the rates
will buy and sell a unit of foreign currency. This is
called the ‘outright rate’ and it is used by traders in
quoting to customers. The forward rates can also be
quoted in terms of points of premium or discount on the
spot rate, which is used in intetbank quotations. To find
the outright forward rates when premium or discount
on quotes of forward rates are given in terms of points,
the points are added to the spot price if the foreign
currency is trading at a forward premium; the points are
subtracted from the spot price if the foreign currency is
trading at a forward discount.

The traders know well whether the quotes in points

represent a premium or a discount on the spot rate. This
can be determined in a mechanical fashion. If the first
forward quote (the bid or buying figure) is smaller than
the second forward quote (the offer or the asking or

20
selling figure), then there is a premium. In such a
situation, points are added to the spot rate. Conversely,
if the first quote is greater than the second, then it is a
discount. If, however, both the figures are the same,
then the trader has to specify whether the forward rate
is at premium or discount. This procedure ensures that
the buy price is lower than the sell price, and the trader
profits from the spread between the two prices.

Example
Spot 1-month 3-month 6-month
(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms, these quotes would be expressed

as below:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot FFr 5.2321 per US$ FFr 5.2340 per US$ 0.0019
1-month FFr 5.2296 per US$ FFr 5.2320 per US$ 0.0024
3-months FFr 5.2281 per US$ FFr 5.2308 per US$ 0.0027
6-months FFr 5.2341 per US$ FFr 5.2366 per US$ 0.0025

It may be noted that in the case of forward deals of

1 month and 3 months, US dollar is at discount against
French franc while 6 months forward is at premium.
The first figure is greater than the second both in 1
month and 3 months forward quotes. Therefore, these
quotes ale at a discount and accordingly these points
have been subtracted from the spot rates to arrive at
21
outright rates. The reverse is the case for 6 months
forward.

Example
Let us take an example of a quotation for the US dollar
against rupees, given by a trader in New Delhi:
Spot 1-month 3-months 6-months

Rs. 32.1010 – Rs. 32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from the quotation will be as

follows:
Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs. 32.1010 per US$ Rs. 32.1100 per US$ 0.0090
1-month Rs 32.1235 per US$ Rs 32.1375 per USS 0.0140
3-months Rs 32.1310 per US$ Rs 32.1450 per US$ 0.0140
6-months Rs. 32.1385 per US$ Rs 32.1555 per US$ 0.0170

Here, we notice that the US dollar is at premium

for all the three forward periods.

Also, it should be noted that the spreads in forward

rates are always equal to the sum of the spread of the
spot rate and that of the corresponding forward points.
For example, the spread of 1 month forward is 0.0140
(= 0.0090 + 0.0050), and, so on.

Major Currencies Quoted in the Forward Market

22
The major currencies quoted on the forward market are
given below. They are generally in terms of the US
dollar.
 Deutschmark
 Swiss franc
 Pound sterling
 Belgian franc
 Dutch guilder
 Japanese yen
 Peseta
 Canadian dollar
 Australian dollar

Generally currencies ate quoted in terms of 1 month,

3 months, 6 months and one year forward. But
enterprises may obtain from banks quotations for
different periods.

Premium or Discount
Premium or discount of a currency in the forward
market on the spot rate (SR) is calculated as follows:
Premium or discount (per cent) =
[(Fwd rate - Spot rate)/Spot rate] x (12/n) x 100*

where n is the number of months forward.

If FR> SR, it implies premium.
<SR, it signals discount.

23
* To annualize the rate. 12/n is inserted to express in
percentage, 100 is introduced.

Arbitrage in Case of Forward Market (or Covered

Interest Arbitrage)
In the case of forward market, the arbitrage operates on
the differential of interest rates and the premium or
discount on exchange rates.

The rule is that if the interest rate differentia is

greater than the premium or discount, place the money
in the currency that has higher rate of interest or vice-
versa. Consider next two Examples.

Example
Exchange rate: Can$ 1.317 per US$ (Spot)
Can$ 1.2950 per USS (6-months
forward)
6-months interest rate:
US$ 10 per cent
Can$ 6 per cent

Work out the possibilities of arbitrage gain.

Solution
In this case, it is clear that. US$ is at discount on 6-
months forward market. The rate of annualized
discount is:

24
[(1.2950 - l.317)/l.317] x (12/6) x 1 = 3.34 per cent
Differential in the interest rate = 10 - 6 = 4 per cent

Here, the interest rate differential is greater than

the discount. So in order to derive an arbitrage gain,
mosey is to be placed in US$ money market since this
currency has a higher rate of interest.

The following steps are involved:

(i) Borrow Can$ l000 at 6 per cent p.a. for 6-
months.
(ii) Transform this sum into US$ at the spot rate to
obtain US$ 759.3 (= 1000/1.317);
(iii) Place these US dollars at 10 per cent p.a. for 6-
months in the money market to obtain US$
797.23 [= 759.3 x ( 1 + 0.1x 6/12)]
(iv) Sell US$ 79723 in the forward market in y at the
end of 6-months, Canadian $ 1032.4 (= 797.23 x
1.295);
(v) At the end of 6-months, refund the debt taken in
Canadian dollars plus interest, i.e. Canadian $
1030 [ = 1000 x (1 + 0.06 x 6/12)]

Net gain = Canadian $ 1032.4 — Canadian $1030 =

Canadian $2.4.

Thus, starting from zero, one is richer by Canadian

$2.4 at the end of 6 months period. Accordingly, on

25
borrowings of Canadian $ million, one will be richer by
(100,00,00 x $2.4/1000, i.e. Canadian $2400.

Example
Exchange rates: Can$ 0.665 per DM (Spot)
Can$ 0.670 per DM (3 months)
Interest rates: DM 7 per cent p.a.
Can$ 9 per cent p.a.

Calculate the arbitrage gain possible from the

above data.

Solution
In this ease, DM is at a premium against the Can$.
Premium = [(0.67 - 0.665)/0.665] x (12/3) x 100
= 3.01 per cent
Interest rate differential = 9 - 7 = 2 per cent.

Since the interest rate differential is smaller than

the premium, it will be profitable to place money in
Deutschmarks the currency whose 3-months interest is
lower.

The following operations are carried out:

(i) Borrow Can$ 1000 at 9 per cent for 3-months;
(ii) Change this sum into DM at the spot rate to
obtain DM 1503.7 (= 1000/0.665);

26
 (iii) Place DM 15037 in the money market for 3
months to obtain a Sum of DM 1530 [ = 1503.7
x (1 + 0.07 x 3/12)];
(iv) Sell DM at 3-months forward to obtain Can$
1025.1 (= 1530 x 0.67);
(v) Refund the debt taken in Can$ with the interest
due on it, i.e. Can$ 1022.5 [=1000 x (1 + 0.09 x
3/12)];
Net gain = 1025.1 — 1022.5 = Can$ 2.6

SPECULATION IN THE FORWARD MARKET

(a) Let us say that the US dollar is quoted as
follows:

Spot: FFr 5.60 per US$

6-months forward: FFr 5.65 per US$

If a speculator anticipates that the US dollar is going to

be FFr 5.7 in 6-months, he will take a long position in
that currency. He will buy US dollars at FFr 5.65, 6-
months forward. If his anticipation turns out to be true,
he will sell his US dollars at FFr 5.7 per unit and his
profit will be FFr 0.05 per US$ (= FR 5.7 — FFr 5.65).

This speculator could have bought on spot market

as well but his operation is much more risky and he
would have to block a part of this cash.

27
(b) Now, suppose that the speculator anticipates a
decrease in the value of the US dollar in next 6-months.
He thinks that it will be available for FFr 5.5 per US$.
Then he will take a short position in dollars by selling
them at 6-months forward. If his anticipation comes
tale, he will make a profit of FFr 0.15 per US$. On the
other hand, if the dollar rate in 6-months actually
climbs to FFr 5.75 per USS, he will end up incurring a
loss of FFr 0.1 per US$ ( =FFr 5.65 — FFr 5.75).

CONCLUSION
Exchange markets are influenced by numerous
economic factors such as imports and exports,
investments and disinvestments; by financial operations
such as lending and borrowing; by psychological
factors like anticipation of depreciation or appreciation
of currency; by socio-political factors like stability of
government, etc. The major players in the foreign
exchange market are big banks. Operations of
speculators and arbitragers also affect the markets.

Problem 1
Convert the following into outright rates and indicate
their spreads:

Spot 1-month 3-month 6-months

Rs/$ 35.6300/25 20/25 25/35 30/40

28
Rs/£ 55.2200/35 40/30 50/35 55/42
Rs/DM 23.9000/30 30/25 40/60 45/65
Solution

(a) Rupee Rate of Dollar

An observation of the figures indicates that the first
figure is lower than the second in all 3 forward quotes,
implying dollar is being quoted at premium in the
forward market. Thus, the points will be added to the
corresponding spot rates. Accordingly, the rates are:

Spot 1-month 3-month 6-months

Bid price (Rs) 35.6300 35.6320 35.6325 35.6330
Ask price (Rs) 35.6325 35.6350 35.6360 35.6365
Spread (Rs) 0.0025 0.0030 0.0035 0.0035

(b) Rupee Rate of Pound Sterling

While observing figures of forward quotations, it is
clear that pound sterling is at discount in the forward
market since points corresponding to the bid price are
higher than those corresponding to the ask price.
Therefore, the forward points will be subtracted from
the spot rate figures. Thus, outright rates are:

Spot 1-month 3-month 6-months

Bid price (Rs) 55.2200 55.2160 55.2150 55.2145
Ask price (Rs) 55.2235 55.2205 55.2200 55.2193

29
Spread (Rs) 0.0035 0.0045 0.0050 0.0048

(c) Rupee Rate of Deutschmark

Figures as given indicate that 1-month forward DM is
at discount whereas 3-months and 6-months forward
rates are at premium. So, for 10-month forward
corresponding points will be subtracted from outright
spot rates while points corresponding to 3-months and
6-months forward will be added. Thus, outright rates
are:

Spot 1-month 3-month 6-months

Bid price (Rs) 23.9000 23.8970 23.9040 23.9045
Ask price (Rs) 23.9030 23.9005 23.9090 23.9095
Spread (Rs) 0.0030 0.0035 0.0050 0.0050

Problem 2
Calculate premium or discount from the rupee-dollar
rates given in the Problem 1 above.

Solution
(i) 1-month forward: As already indicated dollar is
quoted at a premium, which is calculated as follows:

35.6320 – 35.6300 x 12 x 100

Bid price premium = 35.6300 1
= 0.066 per cent

35.6350 – 35.6325 x 12 x 100

30
Ask price premium = 35.6325 1
= 0.0835 per cent

(ii) 3-months forward: Similarly, dollar premium on

3-months forward can be calculated as follows:

35.6325 – 35.6300 x 12 x 100

Bid price premium = 35.6300 3
= 0.028 per cent

35.6360 – 35.6325 x 12 x 100

Ask price premium = 35.6325 3
= 0.0393 per cent

(iii) 6-months forward: In the like manner, the

premium on 6-months forward is also calculated:

35.6330 – 35.6300 x 12 x 100

Bid price premium = 35.6300 6

= 0.0168 per cent

35.6365 – 35.6325 x 12 x 100
Ask price premium = 35.6325 6

= 0.0224 per cent

Problem 3
Are there any arbitrage gains possible from the data
given below? Assume there are no transaction costs:

31
 Rs. 55.5000 = £ 1 in London
Rs. 35.625 = $ 1 in Delhi
Rs. 1.5820 = £ 1 in New York

Solution
From the given data, a triangular currency arbitrage is
possible since the dollar/pound rate found by using the
rates at London and Delhi is different from that of New
York. The following sequence will result into a gain:

(i) Use $ 1000 to buy rupees in Delhi. The

arbitrageur would get Rs.35,625 (=100 x 35.625)
(ii) Sell Rs. 35,625 in London to get £ 641.89 (=
35625/55.5)
(iii) Sell £ 641.89 in New York go get $ 1015.47 (=
641.89 x 1.5820)
(iv) Net profit is $ 15.47 (= 1015.47 – 1000)

32
 EXTERNAL TECHNIQUES FOR COVERING
EXCHANGE RATE RISK

INTRODUCTION
The preceding discussion has dealt with internal
techniques to cover exchange rate risk; the objective of
the present discussion is to dwell on external
techniques concerning the subject matter. The major
techniques in this regard are:
 Covering risk in the forward market;
 Covering in the money market
 Advances in foreign currency;
 Covering in financial futures market;
 Covering in the options market;
 Covering through currency swaps;
 Recourse to specialised organisations.

COVERING RISK IN THE FORWARD

MARKET

Covering a Transaction Exposure

In order to cover himself against an exchange rate risk,
arising from an eventual depreciation of the currency in
which he has invoiced his exports, an exporter will sell
his foreign exchange in the forward market.
Conversely, an importer wanting to cover himself

33
against the eventual appreciation of foreign currency,
will buy foreign exchange forward.

Example 1
Suppose a German exporter Hartmann sells some
machinery to an American company, for which he
would receive payment of US$ 1 million in 3-months
time, The exchange rates are as follows:

Spot 3-months forward

DM 1.4810/US$ DM 1.4700/US$

The exporter sells his receivables at 3-months

forward. Thus, he would receive DM 1,470,030 at the
end of 3 months. If the spot rate at the end of 3 months
had remained as it is today, he would have received
DM 1,481,003. Thus, for him, the cost of covering risk
in the forward market against probable depreciation of
the US dollar is DM 11,000 (1,481,000 - 1,470,000).

Let us say that depreciation of the US dollar did

take place and the rate on the date of payment (i.e. after
3 months) was established at DM 1,4069/US$. In that
case, without covering, the loss to the exporter would
have been substantial. He would have received only
DM 1,406,900 and so loss would have been DM 74,100
(= 1,481,000 - 1406,900). Therefore, by covering
himself in the forward market, he has reduced his risk

34
by becoming certain of his receiving DM 1,470,000
irrespective of the degree of depreciation of the US
dollar.

Example 2
Let us suppose, a French importer is to pay 10,000 US
dollars in three months’ time. The exchange rates are
being quoted as follows:

Spot 3-months forward

FFr 5.60/US$ FFr 5.80/US$

The importer covers himself by buying US dollars

in the forward market. He will be paying FFr 58,000 (=
5.8 x 10,000). If on the maturity date, the rate was as on
the date of contract, he would have had to pay, in that
case only FFr 56,000 (= 5.6 x 10,000). So, by covering
in the forward market, he suffered a ‘loss’ of FFr 2,000.
But, this loss (or the cost of covering) was certain.

If the rate had appreciated to, say FFr 6.00/US$, he

would have had to pay FFr 60,000 (= 6.00 x 10,000).
Therefore, by covering himself in a forward market, he
in a way gained as he would have otherwise been
required to pay FFr 60,000.

The cost of covering in the forward market is equal

to the cost of premium or discount.

35
Pre. = [(5.8 – 5.6)/5.6] x (12/3) x 100 = 14.28 per cent
And, the cost of covering
= [(2,000/56,000 x (12/3) x 100 = 14.28 per cent

Covering a Consolidation Exposure

The magnitude of exposure depends on the method of
translation used by the parent company.

Example 3
Suppose a French multinational has an Indian
subsidiary. The total translation exposure is estimated
to be Indian Rs 1.0 million. The exchange rates are as
follows:

Spot 12-months
Rs 6.000/FFr Rs 6.0600/FFr

The French company anticipates a. depreciation of

6 per cent of the Indian m over the period of a year.
That is, the anticipated rate is Rs. 6.3600/FFr. If
nothing is done to cover the exchange rate risk, the
company will register, at the end of the year, a
translation loss

= 1,000,000 /6.0000 — 1,000,000 /6.3600

= 166,667 — 157,233
= 9,434 French francs

36
 Now to avoid this potential loss, the company can
cover itself in the forward market by selling forward a
certain sum of rupees, say X such that

9,434 = X (Forward rate — Anticipated rate)

= X [1/6.0600) – (1/6.3600)]
= X [0.00778]
or
X = 1,212,005

The forward sale of Indian rupees gives French

francs 203,001 (= 1212005/6.06). If the anticipations
turn out to be right, the company will buy rupees for
FFr 190,567 (= 1,212,005/6.36). The difference
between the two is 9,434 (FFr 200,001 - FFr 1,90,567)
French francs.

Thus, potential loss has been compensated by a

real gain.

COVERING IN THE MONEY MARKET

Covering a Transaction Exposure
Example 4
Let us take the Example 1 of the German exporter
Hartmann, who wants to cover himself against a
probable depreciation of the US dollar. He can do the
following:

37
  Borrow US dollars for 3-months;
 Convert these dollars into Deutschmarks on the
spot;
 Place the marks in German money market;
 Reimburse the loan taken in dollars with interest
after 3-months.

Suppose the 3-months rates of interest are:

Germany: 5 per cent p.a. USA: 6 per cent p.a.

Spot rate: DM 1.481 = $ 1

Borrowing dollars (D) should be such that

D [1 + (0.06 x 3/12)] = $1,000,000

or D = $ 985,222

Conversion of dollars into Deutschmarks at the

spot rate gives

985,222 x 1.481 = 1,459,114 Deutschmarks

The sum obtained by placing marks in 3-months money

market is

1,459,114 x [1 +(0.05 x 3/12)]

= 14,77,353 marks

38
 The sum received from the client in dollars at the
end of 3-months is $ 1.0 million. This is used to refund
the loan taken in dollars.

Thus, the cost of covering in the money market is

= 1,000,000 x 1.481 — 1,477,353
= 3,647 marks

Note: If the markets are in equilibrium or are efficient,

the cost of covering either in the forward market or in
the money market will same as in an efficient market,
differential in interest rates is equal to premium or
discount. Since the markets are rarely in equilibrium,
one should actually carry out calculations to know
where the cost of covering is less; emphasis should be
also on the ease of covering.

Example 5
Taking the Example 2 of the French importer who is to
pay $ 10,000 and fears an appreciation of the dollar, he
should have a quantity of dollars, say S, that would
become $ 10,000 on the due date. The 30-days interest
rates are:

US$: 6 per annum and, FFr: 8 per annum

Spot rate: FFr 5.6 = $1

39
 Steps involved are:
 Buy S dollars and place them in the money market
so as to obtain $ 10,000 after one month:

S (1 + 0.06 x 1/12) = 10,000

or
S = $9,950 (= 10,000/1.005)

 To buy these dollars, borrow from the spot market

a sum of French francs, equal to 55,720 (= 9,950 x
5.6).
 Refund the loan in French francs after 30 days by
paying 55,720 x [ + (008 x 1/12)] 56,092 francs.
 Pay to the seller the sum of US$ 10,000.

So the cost of covering in the money market is FFr

92 (= 56,092 — 56,000). It may be noted that this cost
is equal to the interest differential:
= 56,000 x (0.08—0.06) x (l/12)
= 93 francs

Covering a Translation Exposure

If a company wants to cover in the money market, the
amount of the borrowing on that market would be equal
to the exposure position.

40
Example 6
Taking example 8 of the Indian subsidiary of the
French multinational, the following operations will
have to be done. We assume that interest rates are 12
per cent on Indian rupee and 8 per cent on French
franc.

 Borrow Rs 1.0 million for a year on the Indian

market;
 Convert these rupees into French francs at the spot
rate to obtain FFr 166,667
(= 1,000,000/6);
 Place the francs in the French money market,
which would give FFr 180, after one year (=
1,66,667 x 1.08)
 Reimburse the loan with interest after one year in
rupees, that is a sum of Rs. 1.12 million [= 1 + (l x
0.12)].

Depending on the evolution of the Indian rupee, the

company will make a gain or loss. The loss would be
sizeable if the rupee underwent an appreciation instead
of a depreciation.

41
 If unfavourable movement is stronger than
anticipated, the company will have a net gain.

Say the exchange rate at the year end is Rs 6.3/FFr as

anticipated, the refund would be equal to FFr 176,101
( Rs. 1.12 niillio/6.36). This means a net gain of FFr
3,899 = (180 - 176,101).

Comparison between Risk Covering in Forward

and Money Markets

(a) When a risk is covered in the forward market,

the transaction does not appear in the balance
sheet. The financial structure of the balance sheet
is not affected. On the other hand, if the risk is
covered in the money market, it figures in the
balance sheet and results into an increase in debt
ratio.

(b) If interest differential is equal to the premium

or discount on exchange rates, that is, if interest
parity exists, the costs of covering in the two
markets am identical. It is equal to:

 premium or discount for covering in the forward

market;
 interest differential for covering in the money market.

42
 For the German exporter, to cover for US$ 1 million,
for example, the cost will be US$ 2,500 if the interest
differential is 1 per cent on the 3-months money
market. The cost of covering should be the same in the
forward market as well provided the markets are
efficient. But, if the markets are not efficient (say, there
are exchange controls), the cost of covering is likely to
be different. The operator would opt for forward market
or money market, depending on where the cost is less.

In the above discussion, it has been assumed that

purchase and sale of foreign currency in the forward
market as well as obtaining loans in the money market
is always possible and there are no constraints.

FOREIGN CURRENCY ADVANCES

Advances can be obtained by exporting enterprises. For
them, advances constitute a means of tem financing. In
addition, for an exporter, advances are a protection
against exchange risk as well. Likewise, importers may
avail advances, say, from the financial institutions to
guard against possible fluctuations in exchange rate.

Exporting enterprises surrender the foreign

exchange to the bank at the spot rate. This enables them
to get cash in the national currency. The exchange rate
risk is thus neutralized Advances in foreign exchange
are even more beneficial if the rate of interest on the

43
foreign currency happens to be lower than that on
credits in national currency. However, monetary
authorities in certain countries may impose certain
restrictions on such advances. For example, in France,
advance cannot be availed of until and unless the
exported goods have passed through custom
authorities. As a result, the exchange rate risk continues
to exist between the date of contract and the date when
the goods pass customs clearance.

Foreign currency advances cannot cover the

exchange risk for importers. These advances are given
on a fixed rate for a fixed period. They help settle on
spot the dues of the suppliers and thus enable the
importer to avail discounts from suppliers. And on
maturity in order to refund the advances, the importer
has to arrange the requisite amount of foreign exchange
from the exchange market.

COVERING IN FOREIGN EXCHANGE

FUTURES

(OR FINANCIAL FORWARD) CONTRACT

MARKET
Initially, futures markets were engaged in merchandise
business only, e.g. eggs, butter, cereals, raw material
and so on. The currency futures were launched for the
first time in 1972 on the International Money Market

44
(IMM) of Chicago, (presently a division of the Chicago
Mercantile Exchange).

Futures Markets and Contracts

Currency futures markets are now functioning at
Chicago New York, London, Singapore, Tokyo,
Sydney, etc. The most important of them is the IMM of
Chicago.

A currency futures contract is a commitment to

buy or to sell a specified quantity of a currency on a
future date, at the pre-determined/decided price existing
on the date of the contract. These contracts have the
following characteristics:

 Transactions are traded in standard lots. For

illustration purposes Table 1 contains the values of
major currency futures contracts, traded on IMM
Chicago.
 Quotations are made in terms of US$ per unit of
another currency. For example, Table 2 indicates
the quotation for Deutschmark on a particular day.
 Fluctuations differ according to currencies. The
smallest variation (also called ‘tick’) is 0.01 per
cent. So if the contract is of the value DM 125,000,
the value of minimal fluctuation is 125,000 x
0.01/100 = DM 12.50.

45
Table 1: Transaction Lots of Major Currencies on
Futures Contract at IMM

Currency Amount
Australian dollar 10,000
Canadian dollar 100,000
Pound sterling 62,500
French franc 500,000
Deutschmark 125,000
Japanese yen 12,500,000
Swiss franc 125,000

Table 2: Deutschmark Futures Quotation in

Relation to US$ on IMM
(Contract amount: DM 125,000)

Open Latest ChangeHigh Low Estimated

Volume
March 0.6520 0.6536 + 0.0011 0,6539 0.6507 74,433
June 0.6547 0.6564 - 0.0005 0.6564 0.6546 2,023
September - 0.6581 - - - 0.6581 148

 Maturity periods are also standardised, say, March

June, September and December.
 A guarantee deposit is required to be made for
selling or buying of a contract. This deposit is of
the order of US$ 1,000 and is made with the
Clearing House.

46
 Futures rates differ from spot rates for the same
reasons as forward rates. They are very close to
forward rates of the same currency for the same
maturity date.

In fact, if forward rates were much different from

futures rates of the same maturity, it would be easy to
buy in the forward market if the currency was cheaper
and sell futures contracts in the same currency at the
same time. Thus, there would be a profit to the operator
without risk, assuming there were no transaction costs.

Operating Procedure of Futures Markets

First of all, the interested enterprise is required to make
a guarantee deposit with a broker who is a mediator
between the enterprise (or the player in the market) and
the Clearing House. The broker will deposit this sum
with the Clearing House. For instance, an enterprise A
buys a currency futures contract through a broker X
from another enterprise B ass with/related to broker Y.
Once the engagement has been made, both enterprises
deal directly with the Clearing House.

Everyday, the Clearing House calculates the

situation of each operator. As the rate of the contract
evolves, it proceeds to call for maintenance margins
from the operator who has registered a loss and

47
conversely, credits the account of the other party who
has registered a gain.

If the enterprise A wants to sell its contract, the

same is executed by him through his broker who finds
another buyer. The enterprise A will have made a gain
or loss depending on the evolution of the rate of
futures. Most of the contracts (98 per cent) on the
futures market are not delivered. They are closed by a
reverse operation: the buyers resell the contracts and
the sellers repurchase the contracts.

Principle of Covering the Risk

The principle is to compensate a loss of opportunity on
the s market by a gain of almost the same amount on
the futures market. In other words, one should take a
reverse position on the futures market vis-à-vis the
position that one has on the spot market.

Purchase of a currency future protects against an

appreciation of the currency of contract. Similarly, sale
of a currency future contract protects against a
depreciation of the currency of contract.

A company that has exported and is to receive its

dues in pound sterling will sell future contracts in
pound sterling corresponding to the value of exports,
with a similar settlement date.

48
 A company that has imported and is to pay in
Deutschmarks will buy DM future contracts to protect
against an appreciation of Deutschmark.

Example 7
An American company has exported in January of the
current year to a German client. The payments of DM
1.0 million are due in March. The American company
wants to cover itself against the risk of a depreciation
of DM. The DM March future contracts are quoted at
US$ 0.587 per DM. The spot rate in January is US$
0.588 per DM.

 In January the American company deposits the

guarantee with the Clearing House and sells 8 DM
future contracts, each of DM 125,000. The total
amount covered is DM 1.0 million (= 8 x 125,000).
 During all this period up to the maturity date, the
American company will pay maintenance margins
if DM rises and conversely will have its account
credited if DM slips. In March, this company
repurchases (or closes) the contract at a rate of
0.559 dollar per DM. It makes a gain of 28,0000
dollars [= (0.587— 0.559) x 8 x 125,000]. This
gain is equal to the loss of opportunity on the spot
market, that is 28P dollars [=(0588 — 0.560) x

49
 1,000,000]. The spot rate on the date of closure or
repurchase of the contact is 0.56 dollar per DM.

Note: To simplify the calculations, the rates have been

so chosen as to compensate the loss of opportunity in
totality. In reality, there may be some uncovered loss
and some costs of transactions which have been
ignored here.

Also, the amount to be covered may not always be in

exact multiples of standard futures contract lots. Thus,
the amount covered may be less or more than the sum
involved in a transaction. For instance, if the sum to be
covered was DM 1.1 million, then, the number of
futures contracts should be either 8 or 9. In case it is 9,
we would be covering DM 1.125 rather than DM 1.1
million. And, in the case of 8 contracts, we would be
covering DM 1 million.

Comparison between Covering on the Forward

Market and the Futures Market
Both the forward market and the futures market serve
the same objective of covering the foreign exchange
risk. However, there arc some significant differences in
their modus-operandi. Table 3 provides a comparative
summary of forward market and futures market.

50
 Table 3: Comparison between Covering on
Forward Market and
Future Market

Futures Market Forward Market

Standardized contracts Tailor-made risk coverage
Guarantee deposit No guarantee deposit
Clearing house Contract with a bank
Quotation on market Quotation by a bank
Commission or brokerage Quoted rate (Spread between
buying and selling rates)

COVERING IN THE FOREIGN EXCHANGE

OPTIONS MARKET
An option gives its holder a right (but not an
obligation) to buy or sell an asset in future at a price
that is agreed upon today. Nowadays, interested
investors/enterprises can deal in options to buy or sell
common equity, bonds, commodities and currencies,
etc.

The first organized market in options in currencies

was opened in Philadelphia in 1982. Many other
markets have since developed, for example, at
Amsterdam. London, Pads, Montreal, Vancouver, New
York, Chicago, Singapore, etc.

51
 It is an instrument that permits its holder (buyer or
owner) to take advantage of a favourable evolution of
exchange rate. It is taken recourse to by companies to
cover the exchange rate risk.

There exist two types of options: call and put

options. These are bought or sold at a premium, which
is paid to the writer of the option, usually in local
currency per unit of foreign currency.

Call Option
The holder of a call option acquires a right but not an
obligation to buy a certain quantity of foreign currency
at a predetermined price (also called exercise or strike
price). A writer (or seller) of a call option has an
obligation to sell a certain amount of foreign currency
at a predetermined price.

Put Option
The holder of a put option acquires a right but not an
obligation to sell a certain quantity of foreign currency
at a predetermined strike price. The writer of a put
option has an obligation to buy a certain amount of
foreign currency at a predetermined price. Thus, it is
the holder (buyer or owner) of an option who has a
choice to use or abandon the exercise of the option
whereas the seller of an option should be ready to sell

52
(in case of call) or buy (in case of put) the amount
agreed upon. The latter has no choice of his own.

It should be noted that unlike stock options, a call

option on, say, US dollar is also simultaneously a put
option on the other currency of transaction, say, Indian
rupees For, if the holder has a right to buy US dollars
against Indian rupees at a predecided price, then he has
also a right to sell Indian rupees at a specified dollar
rate.

The option which a holder enjoys could be the one

where he can exercise his right any time during the life
of the option. This type of option is referred to as of
American style. The other type is of European style
where the holder can exercise his right only on
expiration of, or on, the maturity date.

Premium on Options
The premium paid for buying a put or call option
depends upon several factors and is comparable to an
insurance premium. The major factors in this regard
are:
 The difference between the exercise price and spot
price;
 The maturity periods;
 Volatility of price movements;

53
  Interest rates, etc.

Determinants of Option Value

These are:
 Spot rate;
 Strike price;
 Expiration date (time to expiration);
 Risk free interest rate in the, domestic country;
 Risk free interest rate in the foreign country;
 Volatility of the spot currency rate.

Spot rate: The effect of this variable on the option

price is quite evident. In the case of a call option, the
higher the spot rate, the higher will be the option
premium and vice-versa. A put option becomes less
valuable with the rise in spot price and vice-versa.

Strike price: Strike price is the price at which the deal

will take place when an option (call or put) is
exercised. A call option tends to vary inversely with the
strike price. With the rise in strike price, the call option
tends to lose value. This is because the holder stands to
lose when he exercises the call option. A put option
moves in direct relation with the strike price and with
the rise in strike price, the holder tends to gain on
exercising the option.

54
Time to expiration: With the increase in the time to
expiration, both call and put options gain value. This is
because the option with a longer time to expiration,
other things being held constant, will have a higher
time value.

Example 8
A French imparter has bought an equipment from a US
firm for US$ 1 million on 1 March in the current year
to be paid for in 3 months. The importer fears an
appreciation of the US dollar. He decides to cover
himself in the ‘option market’. The data are:

Exchange rate: FFr 500/US$ or US$ 0.20/FFr

He is considering call option for the purpose as he

will be required to buy foreign exchange (i.e. US
dollars). The characteristics of call option are:

Strike price: FFr 5.05/US$

Maturity date: 1 June
Premium: 3 per cent

The buyer of the call option, i.e. the importer pays

the premium amount of US$ 30,000 (= 1 million x
0.03) or FFr 150,00) (= 30,000 x 5).

55
 On 1 June, there are three possibilities:

1st Possibility: The US currency has appreciated and

the spat rate is FFr 5.5/US$. In this situation, the holder
of the call option will exercise his option and buy US
dollars at the strike price of FFr 5.05 per US dollar. He
will pay thus, FFr 5.05 million (= 5.05 x 1.0 million).

Total cost = (5,050,000 + 150,000) French francs

= 5.20 million French francs

Thus, his net price is FFr 5.20/US$ instead of FFr

5.5/US$.

2nd Possibility: The US currency has undergone a

depreciation and on 1 June, it is at FFr 4.75/US$.

In this situation, he abandons his call option and

buys dollars from the market at FFr 4.75/US$. His total
payment is thus:

(4.75 x 1.0 million + 0.15 million) French francs

= 4.90 million French francs

Thus, his net price is FFr 4.9/US$ instead of FFr

4.75/US$.

56
3rd Possibility: The US dollar is at FFr 5.05/US$.
Here, he can afford to be indifferent to either the
market option or the call option. He will pay the same
price whether he resorts to one or the other. He pays:

(5,050,000 + 150,000) French francs

= 5.20 million French francs, that is, the same

amount as in the first possibility.

This means he has never to pay more than FFr 5.20

million, whatever be the level of appreciation of the US
dollar.

The graphic representation of the call option is given in

Fig. 1.
Sum paid
(million FFrs)

5.20

Z
N
5.05 5.1 5.2 5.3 Exchange rate (FFr/$)

Fig.1: Sum to be Paid under the Call Option

57
Example 9
An Indian importer is to pay DM 1.0 million on 1
September in the current year. He wants to make sure
that he does not pay too high in case the Deutschmark
appreciates. He buys a call option by paying 2 per cent
premium on the current price. The current rate is
Rs.21.75/DM. The strike price is decided to be
Rs.22/DM.

In the case of appreciation of the Deutschmark, the

net price to be paid by the importer is going to be
Rs.22.435/DM (= 22.00 + 0.02 x 21.75). Conversely, if
the German currency depreciates, the importer will
abandon his call option. The operation is graphically
represented in Fig. 2.
Sum paid
(million Rs)

22.435

Z
N
21 22 23 24 25 26 Exchange rate (Rs/DM)

Fig. 2: Sum to be Paid under the Call Option

Example 10
A French exporter is to receive US$ 1.0 million on 1
March in the current year, having sold his product in
January. Fearing a depreciation of the US dollar, he

58
decides to cover his risk through a put option. The data
are:

Spot rate: FFr 5.0/US$

Premium: 3 per cent
Date of maturity: 1 March
Exercise or strike price: FFr 4.95/US$.

1st Possibility: The US currency has depreciated to FFr

4.70/US$. He exercises his put option and sells dollars
at FFr 4.95/US$. He, thus receives:

(4.95 x 1 – 0.03 x 5.0) million French francs

= 4.8 million French francs

If he had not covered his risk through the put

option, he would have received only 4.7 million French
francs.

2nd Possibility: The US dollar has appreciated to, say

FFr 5.2/US$. He abandons his put option and sells his
dollars in the open exchange market. He thus receives:
FFr (5.2 – 0.15) million = FFr 5.05 million.

3rd Possibility: The rate on 1 March is FFr 4.95/US$.

In this case, he need not worry about either making use
of his option, or selling in the open market. Either way,
he will receive a sum of

59
 (4.95 – 0.15) million French francs
= 4.8 million French francs

Thus, irrespective of the degree of depreciation of

the US dollar, he is assured of getting at lease FFr 4.8
million.

Any price above the strike price of FFR 4.95

brings a greater advantage to him and a price less than
FFr4.95 does not affect his receipts which do not fall
below FFr 4.8 million.

The graphical representation of the operation is

shown in Fig. 3.
Sum received
(million FFrs)

4.8

4.9 4.95 5.0 5.1 5.2 Exchange rate (FFr/$)

Fig. 3: Sum to be Received under the Put Option

In view of the above, it is apparent that the

enterprise/operator needs to be more vigilant/watchful
towards trends in exchange rate while covering in the

60
option market unlike covering in the exchange market
where everything is certain.

Covering against Exchange Risk by Purchasing

Tunnel with a Zero Premium
Since premium represents a non-negligible cost, banks
propose to their clients the option with zero premium
called tunnel, but protection is available only within
certain limits. For example, let us consider the data of
the Table 4. An Indian importer buys a 1-month tunnel
with zero premium, of narrow range. This means that if
after a month’s time the dollar rate is Indian Rs 35.70,
he would pay only Rs 35.60 per dollar. But, on the
other hand, if the rate is Rs 34.90, he would have to pay
Rs 35.00 per dollar. If the dollar price is established
somewhere within the range, then he would have to pay
the actual market price.

Besides the tunnels of narrow range, there are

tunnels of wider range too. One would choose between
the two depending upon the anticipations of future
rates.

The importance of tunnels lies in the fact that one

dc not have to pay premium but at the same time they
do not allow the operator to get the fill advantage of a
favourable evolution of rates.

61
 Table 4 Tunnel with Zero Premium
Maturity Narrow range Wider range
1-month 35.00-35.60 34.25-36.25
3-months 35.50-36.00 34.00-36.30
6-months 35.75-36.35 33.80-36.50

Importance of Options
Options are used by:
• exporters;
• importers;
• investors;
• banks and financial institutions;
• companies bidding for global contracts.

Call options are used by companies that have to pay for

their imports in foreign currency but fear an
appreciation of the currency of invoice. They are
equally used by the foreign currency borrowers.

Put options are used by exporters who have

invoiced in foreign currency and fear a depreciation of
that currency. They are equally used by foreign
currency lenders.

CURRENCY SWAPS
Swap is essentially an exchange of two transactions; it
is an important instrument for hedging for foreign

62
exchange transactions in which two streams of
payments am exchanged.

Suppose an American company wants to borrow

Deutschmarks at a variable rate. The company is well
placed on the American market. It borrows US$ 1
million on the American market at a fixed rate and
enters into a swap deal with its bank. On the date of the
contract, there is an exchange of the principal: the
American company pays to its bank 1 million dollars
and receives 1.4 million Deutschmarks, the spot rate
being DM 1.4/US$. During the contract period, the
company will pay a variable rate on the Deutschmarks
while the bank will pay it a fixed rate on dollars. Them
will also be a re-exchange of the principal on the
maturity date. Figure 4 illustrates the swap.
$ 1m
American Company Bank
DM 1.4m

Variable rate
American Company Bank
Fixed rate

DM 1.4m
American Company Bank
$ 1m

Fig 4: Swap between a Company and its Bank

63
 Currency swaps are comparable to a forward
exchange transaction with a difference that the
differential of rates is calculated periodically instead of
being settled just once at the end of the contract; this
feature renders the swaps more efficient and more
flexible than covering in the forward market for long
periods.

CONCLUSION
Volatility of exchange rates makes it necessary for
companies engaged in international operations to take
measures for covering against exchange rate risk.
Several techniques are used, internal as well as
external. In periods of fixed rate regime, special
attention was paid to the possibility of a currency
devaluation. In floating rate regime, it comes important
to anticipate evolution of rates and adopt appropriate
strategies for covering risks. Nowadays a number of
techniques are available such as hedging in forward
rate market, money market, currency futures, options
and swaps.

Problem 1
A French exporter, named Charles, is to receive DM
1.0 million in 6 months. The exchange rates are quoted
as follows:
Spot: FEr 3.3876/DM
6-months forward: FFr 3.3368/DM

64
 (a) There is a fear of depreciating of DM in the
near future. What should Charles do?
(b) What would you suggest to Charles in case an
appreciation of DM is likely to take place?

Solution
(a) Since the rates given above indicate that DM is at
a forward discount, Charles will do well to cover
himself in the forward market. When a currency is
selling at discount in the forward market, there is a
possibility that it would undergo a depreciation. So
it is safe to cover the receivables of that currency
in the forward market.

Thus, Charles will sell his DM 1.0 million in the

forward market and receive FFr3.3368 million at
the end of 6-months.
If the spot rate at the end of 6-months was the
same as the spot rate today, the cost of covering
(or the loss) for Charles would be FFr 50800 (=
FFr 3.3876 million – FFr 3.3368 million).

The depreciation of DM indicted by the forward

rate is the following:
3.3876 – 3.3368 x 100
= 3.3876
= 1.4966 or 1.5 per cent

65
 So, if DM depreciated more than 1.5 per cent
between now and 6-months hence, Charles would make
a loss bigger than FFr 50,800 in case he decided not to
cover in the forward market.

(b) In case of a likely appreciation of DM,

Charles need not do anything. Any appreciation in
the currency of receivables (DM in the present
case) would be profitable to the receiver.

Problem 2
An Indian company C & Co. imports equipment worth
$1.0 million and is to pay after 3 months. On the day of
the contract, the rates are:
Spot: Rs.35.00/$
3-months forward: Rs.36.25/$

(a) There is an anticipation of a further fall of

rupee. What can C & Co. do?
(b) What would C & Co. do if it knows with a
high probability that, in 3-months, dollar will settle
at Rs.36.00/$.

Solution
(a) Since there is an anticipation of a further fall
in the value of rupee (or in other words an
appreciation of dollar), it would be wise to cover
the payables in the forward market.

66
Thus, C & Co. will have to pay at the end of three
months Rs.36.25 million. So, the net cost of covering
the payables in the forward market is Rs.1.25 million
(= Rs.36.25 million – Rs.35 million).

If the rupee had fallen to Rs.37.10/$ ( a

depreciation of 6 per cent) and if C & Co. had not
covered itself in the forward market, the loss to it
would have been Rs.2.10 million.

(b) If C & Co. knows with a high degree of

certainty that the rupee is likely to settle at
Rs.36.00/$ in 3-months, it would be advised not to
cover in the forward market. It would pay Rs.36
million at the end of 3-months, the sum which is
less than Rs.36.25 million.

Problem 3
An Indian exporting firm, Rohit and Bros, would like
to cover itself against a likely depreciation of pound
sterling. The following data is given:

Receivables of Rohit and Bros: £ 500,000

Spot rate: 56.00/£
Payment date: 3-months
3-months interest rate: India: 12 per cent per annum
UK: 5 per cent per annum
What should the exporter do?

67
Solution
Since no other date is available, the only thing that
Rohit and Bros can do is to cover itself in the money
market. The following steps are required to be taken:

(i) Borrow pound sterling for 3-months. The

borrowing has to be such that at the end of
three months, the amount becomes £ 500,000.
Say, the amount borrowed is £ D. Therefore,
3
D 1 + 0.05 x 12 = 500,000 or D = £493,827

(ii) Convert the borrowed sum into rupee at the

spot rate. This gives: Rs.493,827 x 56 =
Rs.27,654,312
(iii) The sum thus obtained is placed in the money
market at 12 per cent to obtain at the end of 3-
months:
3
S = 27,654,312 x 1 + 0.12 x 12 = Rs. 28,483,941

(iv)The sum of £ 500,000 received from the client

at the end of 3-months is used to refund the
loan taken earlier.
From the calculations, it is clear that the money
market operation has resulted into a net gain of
Rs.483,941 (= 28,483,941 – 500,000 x 56).

68
 If pound sterling has depreciated in the meantime,
the gain would be even bigger.

Problem 4
A UK importer has to pay $100,000 in month’s time.
He fears an appreciation of the dollar. What can he do
with the knowledge of the following data?

1-m interest rate: US$: 4 per cent

UK £ : 5 per cent
Spot rate: $ 1.553/£

Solution
Since only the money market data are available, the UK
importer has to work out possibility that exist for him
to cover himself in the money market. He can take the
following steps:

(i) Buy S dollars at the spot rate and place them in

the money market so as to obtain $ 100,000 in a
month’s time. That is,
1
S 1 + 0.04 x 12 = 100,000

or
S = $99,668.

69
 (ii) In order to buy S dollars, the equivalent amount
of pound sterling is required to be borrowed.
The borrowing B is,
99668
B =1.5537 = £ 64,149

(iii) Refund the sterling loan after one month. The

refunded amount would be:
1
R = 64149 1 + 0.05 x 12 = £ 64,416.3

(iv) In the meaning the sum of S dollars placed in the

money market would mature to $ 100,000. Use
this sum to pay the payable due.

The cost of covering in the money market works out to

£ 53.81
100,000
= 64,416.3 - 1.5537

In case, the dollar had appreciated and the payable

was not hedged, the loss would have been greater.
Even 1 per cent depreciation of pound sterling ($
1.5382/£) would require a payment of £ 65,013,
which means a loss of about £ 650.

Problem 5

70
 An Indian subsidiary of a UK multinational has a
translation exposure or Rs.10 million. The rates are
as follows:

Spot: Rs.55.0000/£
One-year forward: Rs.56.3200/£

A 4 per cent depreciation of the rupee is expected.

How can the exchange risk be hedged?

Solution
The anticipated rate after expected depreciation would
be: Rs. 57.200/£.

Suppose, no action is taken to hedge the risk. In

that risk, the company will suffer a translation loss
equal to:

10 million 10 million
£ 55 - 57.2

= £ 6993.

To avoid this loss, the company will do well to buy

pound sterling forward (or sell rupee forward) such that
the difference is equal to the anticipated loss. Say, it
sells Rs. X. Then,
6993 = X (Forward rate - Anticipated rate)

71
 1 1
= X 56.3200 - 57.2000
or
6993 = X [0.017755680 – 0.017482517]
or
X = Rs. 25,599,974

This amount of rupees will give the following

amount of pound sterling in the forward market:

25,599,974
56.3200 = £ 454,545.45

However, if the anticipated depreciation of the

rupee (or appreciation of pound sterling) does take
place, the company will buy the Rs. X back, with less
amount of pounds sterling. That is, for

25,599,974
57.2 = £ 447,555.99

The difference between the two (£ 454,545.50 - £

447,555.99) is equal to the loss (£ 6959.51) that would
have accrued without hedging.

72
Problem 6
Total translation exposure of a company is Rs. 1.5
million. This exposure is in French francs. Interest rates
are 8 and 11 per cent for the franc and the rupee
respectively. How is hedging to be done? Spot rate is
Rs.6 per FFr. The rupee is likely to depreciate by 6 per
cent.

Solution
Since only the interest rate data is available, the
hedging operation is to be done in the money market.
The following steps are involved:

(1) Borrow Rs.1.5 million at 11 per cent and

convert them into French francs at spot rate to
obtain: Rs.1.5 million/6 = 0.25 million FFr.
(2) Place FFr 0.25 million in the money
market for a year at 8 per cent. This would
give FFr 0.27 million after a year.
(3) The sum thus obtained is converted into
rupees. If the anticipated depreciation of 6 per
cent does take place, the rate would settle at
Rs.6.36/FFr. So, the amount in rupees at the
end of the year would be Rs. (0.27 million x
6.36) = Rs.1.7172 million.
(4) Refund the rupee loan with interest. The
refund amount works out to Rs.(1.5 million x
1.11) = Rs.1.665 million.

73
 Thus, the hedging operation would result into a net
gain of Rs.52,200 (= Rs. 1.7172 million – Rs.1.665
million). The gain in French franc would be FFr 8,208.

Problem
A French company imports in January an equipment
from the USA for $6 million. The payment is US
dollars. The spot rate is $0.2/FFr. The FFr future
contract for June is quoted at $0.19/FFr. What should
the French importer do? Assume further spot rate on
settlement date is $0.185/FFr and the future contract is
likely to be quoted at $0.178/FFr. What is the hedging
efficiency?

Solution
The US dollar is likely to appreciate against the French
francs. This also means that the French franc would
depreciate.

To guard against the depreciation of the French

franc, the importer can sell French franc future
contracts. The amount involved is $6 million or FFr 30
million (= 6 million/0.2). Thus, the total number of
future contracts to be sold is 60 (= 30 million/0.5),
since the value of one futures contract is FFr 500,000.

74
 The French importer deposits the security amount
with the Clearing House. During the period January-
June, the importer will pay margins if the FFr rises and
have its account credited if the FFr slips. On the due
date in June the contract is closed (or repurchased).
Say, the spot rate on the due date is $0.185/FFr and the
futures contract is being quoted at $0.178/FFr.

The importer makes a loss: FFr (6/0.2 – 6/0.185)

million = FFr 2.432432 million. However, on the future
market, it makes a gain equal to $ (0.19 – 0.178) x 60 x
500,000 = $ 360,000 = FFr 360,000/0.185 = FFr
1,945,946.

Net loss = FFr 2,432,432 – 1,945,945

= FFr 486,486.

Note: The loss is not fully covered as spot rate

deteriorated more than the future rate. Hedge efficiency
can be defined as the ratio between the gain made on
the future market and the loss payable due to rate
movement on spot market. It is equal to
1,945,946/2,432,432 x 100 = 80 per cent.

Problem 8
A British exporter has $2.5 million receivable due in
September against the exports made in June. The pound

75
sterling is heading for appreciation. The June data are
as follows:

Spot rate: $1.5530/£; Pound sterling September future contract

$ 1.5600/£

What can the exporter do?

Solution
If the British currency is going to appreciate between
June and September, the exporter will suffer a loss on
the data of payment. He can reduce this loss by hedging
with future contracts. The amount of sterling future is £
62,500. So, the number of contracts to be purchased is:

2,500,000/62,500 x 1.5530 = 25.75

Since the contracts are available only in integral

numbers, so the exporter can either buy 25 or 26
contracts. Say, he buys 26 of them. Let us say the
following rates are being quoted on 15 September (the
date of payment):
Spot rate: $1.6250/£
September, Sterling future rate: $1.6275/£
When the exporter receives his dues, he makes a
loss of 2,500,000 [1/1.5530 – 1/1.6250] = £71,326.

76
 On the other hand, he makes a gain on the futures
contracts. The gain is: $(1.6275 – 1.5600) x 26 x
62,500 = $109,688

109,688/1.6250 = £ 67,500.

So, the net loss is:

£ (71,326 – 67,500) = £3,826.

The hedge efficiency = 67,500/71,326 x 100 = 94.33

per cent.

Note: In case the exporter had decided to hedge with

25 futures contracts, the gain would have been:

£ (1.6275 – 1.5600) x 25 x 62,500 x 1/1.6250 =

£64,904. And, hedge efficiency would have been:
64,904/71,326 = 91 per cent.

Problem 9
The company ABC & Co. has its receivables of DM
1.0 million due in 3-months. The rupee has tendency to
appreciate. The current rate is Rs.24.2020/DM. The
company would like to hedge in the options market.
The data are as follows:
Strike price: RS.23.50/DM; Premium: 2 per cent

77
Which type of option is involved? How is this option to
be used?

Solution
Since the company ABC & Co. is going to lose if the
rupee appreciates between now and 3-months hence
when payments of its receivables will be due, it would
be wise to buy a put option on DM. The company
would pay the premium amount immediately, which is
Rs. 484,040.

The following possibilities may be considered:

(i) Rupee does appreciate and its value settles at
Rs.22.5100/DM. The company will make use
of its option to sell DM received at the strike
price of Rs.23.50/DM. Thus, it will receive a
sum of: Rs. (1,000,000 x 23.5 – 484,040) =
Rs. 23,015,960 or Rs.23.016 million.

Net loss: Rs.24,202,000 – Rs.23,015,960 =

Rs.1,186,040.
The loss without hedging would have been:
Rs. (24.2020 – 22.5100) million =
Rs.1,692,000.

(ii) Rupee depreciates in a small measure and is

quoting on the due date at Rs.24.2600/DM.
Naturally, in this situation, put option is

78
 abandoned. The company will receive a net
sum of Rs.1,000,000 x 24.2600 – 484,040 =
Rs.23,775,960.

Here, it is to be noted that the depreciation of

the rupee has not been able to compensate the
premium amount paid for buying the put
option. Therefore, the net sum is still less than
Rs.24,202,000.

Note: Irrespective of the level of appreciation of the

rupee, the company will always receive a minimum
sum of Rs.23,015,960 (that is, the value corresponding
to the strike rate minus the premium amount). Thus, the
company is neutral between the choices of using and
abandoning the option at a rate equal to the strike price,
that is Rs.(23.01596 + 0.02 x 24.202)/DM or
Rs.23.50/DM.

79