Foreign Exchange Risk Management

Transcription

1 C H A P T E R 2 Foreign Exchange Risk Management Coverage of FOREX in Past Examinations: Year May-2012 Nov-2011 May SFM (New) MAFA (Old) 8+10(Theory) = (With derivative)=19 Nov NA NA NA 4 Contents: 1. Introduction 2. Major foreign currency 3. Regulator of forex market in India 4. Types of Forex Market. 5. How transaction takes place in forex? 6. Bid, Ask and Spread 7. Exchange rate quotation (One way quote & Two way quote) 8. Interpretation of exchange rate -Quoted in form / -Quoted in compressed form -Few other cases 9. Types of transaction in Forex 10. Forward premium & Discount: 11. Direct quote & Indirect quote 12. Loss/gain due to Forward cover; Premium/Discount on currency 13. Swap point/forward margin/forward Spot differential. 14. Exchange margin 15. General concept question 16. Benefit of Early Payment 17. Cross Rates of Foreign Exchange 18. Hedging technique: -Hedging through Forward market -Hedging through Money (cash) Market Operation: -Leading/Lagging -Rupee Roll-Over-forward Contracts -Currency option (Refer derivative) -Currency future (Refer derivative) 19. Exchange rate determination Theory -Interest Rate Parity (IRPT) -Purchasing Power Parity OR Inflation rates parity 20. Nostro A/C ; Vostro A/C & LORO Account -Maintaining Exchange position and Nostro A/C -Transaction through demand draft (DD) May-2010 Nov June Nov CA Nagendra P a g e 2.1 May NA 8 (With derivative)

2 Strategic Financial Management -Transaction through Bills Receivable (B/R): 21. Cancellation of forward Contract: 22. Modification in forward contract: 23. Early Delivery of Currency 24. Arbitrage -Geographical Arbitrage -Cover interest Arbitrage 25. LC (Letter of Credit) Arrangement 26. Parallel Loan 27. Cash management between Holding and Subsidiary 28. Netting of foreign exchange 29. FOREX with Derivative Introduction In this chapter we will study how to minimize the loss /risk which will arise due to the adverse change in exchange rate of foreign currency. Normally, Payment will be receivable or payable at some future date and exchange rate will not be same at that day. As a result loss/gain will arise. The exchange rate is the relationship between two currencies at a given point of time. For example: $ 1 = 46 1 = 77 $1 = = Major Foreign Currency: One way quote Two way quote Country/territory (Sub Country) Currency ISO Code* Sign/symbol Fractional Unit 1. Kuwait Kuwaiti Dinar KWD fils 2. United Kingdom (UK) British pound GBP 100 penny 3. Eurozone Euro EUR 100 Cent [Total 28 country using Euro currency] 4. USA US dollar USD $ 100 Cent 5. Switzerland Swiss Franc CHF Fr 100 Rappen 6. India Indian Rupee INR 100 Paisa 7. Nepal Nepali Rupee NPR Rs 100 Paisa 8. Japan Japanese Yen JPY 100 Sen * ISO Code: Internationally Standardized three letter abbreviation *Note: Earlier Germany uses Deutsche mark (DEM or DM) (Also known as Mark or German Mark ) Currency. But Now Germany using Euro ( ) currency Earlier France was using French Franc (FRF) currency. But now France are using Euro ( ) currency In question we will still found DEM and FRM currency. Regulator of Forex Market in India All foreign exchange transaction made in India is being regulated either by RBI or FEDAI. In other word, we can say that a person doing transaction in foreign exchange has to follow RBI rule and FEDAI rule. Regulator of Forex Market RBI (Reserve Bank Of India) Established in accordance with the provisions of RBI Act 1934 Manage FEMA Act 1999 & maintain Foreign exchange market Website: FEDAI (Foreign Exchange Dealers Association) Established under Section-25 of Companies Act 1956 Regulate Inter-bank foreign exchange business Website: P a g e 2.2 CA. Nagendra

3 F O R E X Types of Forex Market: Forex Market Inter bank/wholesale Mkt. Retail Market Under inter Bank Market one Bank deal with other bank Exchange rate of Inter-bank market is known as Inter Bank rate. Only bank can deal at Inter Bank rate. Under retail Market Bank deal with Customer. Exchange rate of retail market is known as Merchant rate. A customer can buy or sell currency only at merchant rate. Merchant rate is derived from interbank rate by adding or deducting exchange margin. Forex Market is a world s largest market whose average daily turnover is around $ 4 trillion. 1 million = 10 Lacs 1 billion = 1000 million 1 trillion = 1000 billion How transaction takes place in FOREX Each party want to trade and deal in own currency but the invoice can be made in single currency. Hence the agreed currency would be the home currency, foreign currency or any other currency. Remember that, a person can t keep foreign currency with himself. If anyone receives foreign currency he has to sell it to forex dealer/bank and similarly if he has to pay foreign currency, he will buy foreign currency form forex dealer/bank. Option-I when invoice made in home currency USA Company($) Inflow at 3 Month Export to UK co. Invoice Amount: Option A: $ 10,000 (Credit period 3M) 1 UK Company ( ) Outflow at 3 Month 3 2B 2A UK co. make payment at 3 month time in $ Currency $ UK Bank Buy, sell $ Risk of currency fluctuation lies on UK company as UK Co has to convert into $ at 3 month time. When invoice is in $ : chain in steps, made in figure 1 2A 2B 3. (at end, USA co. get money in $) Analysis for USA co: when invoice is in home currency ($) No risk on USA co. No need to hedge foreign currency receipt and hence no need to study FOREX management. Analysis for UK co: when invoice is in foreign currency ($) Risk lies on UK co. UK Company need to hedge foreign currency payment. CA. Nagendra P a g e 2.3

4 Strategic Financial Management Option-II [When Invoice made in foreign currency] USA Company($) Inflow at 3 Month Export to UK co. Invoice Amount: Option A: 5,000 (Credit period 3M) 1 UK Company ( ) Outflow at 3 Month 3B 3A 2 $ USA Bank Buy, sell $ UK co. make payment at 3 month time in Currency Risk of currency fluctuation lies on USA company as USA Co has to convert into $ at 3 month time. When invoice is in : chain in steps, made in figure 1 2 3A 3B. (at end, USA co. get money in $) Analysis for USA co: when invoice is in foreign currency ( ) Risk lies on USA co. Need to hedge foreign currency receipt. Analysis for UK co: when invoice is in home currency ( ) No risk on UK co. No need to hedge home currency payment hence no need to study FOREX management. Option-III [When invoice made in other country currency] USA Company($) Inflow at 3 Month Export to UK co. Invoice Amount: Option A: 5,000 (Credit period 3M) 1 UK Company ( ) Outflow at 3 Month 4B 4A 3 2B 2A $ USA Bank Buy, sell $ UK co. make payment at 3 month time in Currency USA Bank Buy, sell Risk of currency fluctuation lies on both USA company & UK company as both Co has to convert one currency into another currency at 3 month time. When invoice is in : chain in steps, made in figure 1 2A 2B 3 4A 4B. (at end, USA co. get money in $) Analysis for USA co: when invoice is in foreign currency ( ) Risk lies on USA co. Need to hedge foreign currency receipt. Analysis for UK co: when invoice is in foreign currency ( ) Risk lies on UK co. also Need to hedge foreign currency payment. P a g e 2.4 CA. Nagendra

5 F O R E X Conclusion: From the above analysis it is clear that Hedging is done only when the invoice is being made in foreign currency. Hedging is not required when invoice is made in home currency. If question ask for any measures of hedging, it mean the currency payable or receivable is always foreign currency. Hence do not get confused to recognize which currency is foreign currency and which currency is home currency. Just identify the currency in which invoice is being made (i.e. currency in which amount payable or receivable), and conclude that invoice currency is always foreign currency. On basis of this currency identify the company who has to take corrective action to minimize loss. Bid, Ask & Spread Bid rate (Bank s buying rate): Bid rate is the rate at which bank buys left hand currency. Ask rate (Bank s selling rate): Ask rate is the rate at which bank sells left hand currency. Note: Ask rate will always be greater than bid rate (i.e. Ask rate > Bid rate) Spread: The difference between Ask and Bid rates is called the spread. Mathematically, Spread = Ask rate Bid rate % Spread = Exchange rate quotation 100 (i) One way quote: When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are same, it is the one way quote. Practically one way quote is not possible. For example: 1 = $ 1.50 It means bank will buy left hand currency (i.e. ) at $ 1.50 and also sale left hand currency (i.e. ) at $ (ii) Two way quote: When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are different, it is the two way quote. For example: 1 = $ $ 1.55 Bid rate Ask rate Buying rate selling rate Of bank of bank Bid rate is always less than Ask rate It means bank will buy left hand currency (i.e. ) at $ and bank will sale left hand currency (i.e. ) at $ 1.55 How to apply two way quote rate, for converting one currency into other currency? 1. Identify amount payable or receivable? For example: assume invoice amount is $ 1,00,000/- which will be payable in 3 month time. 2. Choose applicable Bid or Ask rate Take the given exchange rate and draw the following diagram and identify what will do bank for left hand currency (think left hand currency is apple. Here apple is so circle in figure). Bank will buy. Bid rate is applicable. Rate: 1 = $ Applicable Rate Buy Sale $ Bank Here amount payable is $ 1,00,000/-, means customer have to buy $ from bank. We made diagram on the basis of our requirement but think what will do bank for currency and not for $ currency because left hand currency given in rate is currency. Conclusion: Apply Bid rate i.e. $ 1.5 for conversion of $1,00, CA. Nagendra P a g e 2.5

6 Strategic Financial Management 3. Convert one currency into other using selected rate. Use unitary method to convert one currency into other. Here, 1 = $ 1.50 [pick only bid rate which is selected in step-2] $1.50 = 1 $1,00,000 =.5 = 66, Interpretation of exchange rate quoted in form / per In Practical world / means: Per In Academic word Normally interpret this one. Because 95% question s Exchange rate is quoted in this form. Example: 1. Exchange Rate: / / What does it mean? Normal interpretation: It means = or, It means: 1 = Which one we prefer? We have to apply our common sense on the basis of strength of the currency to decide this. Stronger currency have lower figure Here, Normal interpretation is correct. Because is stronger currency than. Hence, 1 = Example-2: Given exchange rate is / = 2.25/2.40 What does it mean? Normal interpretation: 1 = 2.25/2.40 Hence it means 1 = 2.25/2.40 In practical life we will find quotation, in this form up to 4 decimal places value is known as 1 Pip. Strength wise currency list for some important currency: (strongest to weakest currency sequence): 1. Kuwaiti Dinar-KWD Pound GBP ( ) Euro-EUR ( ) Swiss Franc (CHF) US Dollar-USD ($) Indian Rupee-INR ( ) 1 7. Japanese Yen-JPY ( ) 0.70 Example 3: Given Rate: ( per ): What does it mean? In this case we do not need any interpretation because question specifically written per. It mean: = Solve question assuming per even rate is illogical, because rate is specifically written as per and we know that specific provision overrides general. Alternatively one can use this rate as per logic i.e. per on the basis of strength. Both will be correct i.e. on the basis of strength and another, on the basis of specific information. P a g e 2.6 CA. Nagendra

7 F O R E X Interpretation of exchange rate Quoted in compressed form: Exapmle-1: Given exchange rate is: 1$ = /50 It means rate is: 1$ = / Example-2: Given exchange rate is 1$ = /12 It means rate is: 1$ = / Interpretation of exchange rate in few other cases: Suppose given exchange rate quotation is: Spot rate ( per ) : month forward rate ( per ) :.7829 It means spot rate is: = ( ) / ( ) =.78 8 /.7822 (Note: It doesn t mean that bid rate is and Ask rate is ( ) month forward rate is: = ( ) / ( ) =.7826 /.7832 Type of Transaction in Forex Normally, we use spot rate transaction for current settlement. And Forward transaction for future settlement. Type of Transaction Ready transaction Value tom transaction Spot transaction Forward transaction Transaction entered today for same day settlement. Transaction entered today for next working day settlement. Transaction entered today for (T + 2) working day settlement. Transaction entered today for Future day settlement. Diagrammatic representation: Indian importer Import of goods US supplier $ Payment in $ Bank Agreement Date: Today for all types of transaction Applicable rate: Ready rate, Value tom rate, Spot rate, forward rate as the case may be. Settlement Date: Ready Transaction: Immediate Value tom: Next Business Day Spot Transaction: T+2 Bus. Day Forward Transaction: Future day CA. Nagendra P a g e 2.7

8 Strategic Financial Management Note: In all transaction Exchange rate is decided today and settlement being made at different date. For different type of transaction different rate is applicable. The exchange rate for each transaction is not same. Normally, we use spot rate transaction for current settlement. And Forward transaction for future Settlement. Forward premium & Discount: If the currency is costlier in future as compare to spot it is said to be at a premium. If the currency is cheaper in future as compare to spot it is said to be at a discount. Concept example for calculation of premium (increase) and discount (decrease) : Ex-(1) 100 High Price %increase = 100 = 25% % Decrease = 100 = 20% 80 Low Price To calculate % increase, we take base of 80. To calculate %decrease, we take base of 100. Hence, % increase and % decrease will not be same because of different base used. Ex-(2) Today $ 1 = 50 Case-I Future date 1 $ = $ will be on Premium Premium amount = 5.55 % premium = 100 = 11.11% Case-II 1 $ = $ will be on discount Discount amount = 2.38 % Discount = 100 = 4.76% Ex-(3) All rates are same as Ex-2, but quoted in indirect form. Today 1 = 0.02 $ Case-I Future date 1 = $ will be on discount Discount = Apple % Discount = 100 = 10% Case-II 1 = $ will be on premium Premium amount = Apple % premium = 100 = 5% In case - I $ will be on premium and will be on discount. But Rate is different (i.e.11.11% & 10%) Inc case -II $ will be on Discount and will be on Premium But Rate is different (i.e. 4.76% & 5% P a g e 2.8 CA. Nagendra

9 F O R E X How we will calculate premium/discount on $ using Ex-3 s Indirect quote: Case-I: premium on dollar = 100 % premium = 11.11% Case-II: Discount on Dollar = 100 % Premium = 4.76% How to calculate forward premium or discount when spot rate and forward rate is given: First decide on which currency you have to calculate premium rate of discount rate. Check the quotation, whether it is direct quote or indirect quote for the decided currency. For Direct quote Annual Forward premium/discount = For Indirect quote Annual Forward premium/discount = If calculated value is +ve Means premium If calculated value is ve Means discount If calculated value is +ve Means premium If calculated value is ve Means discount How to calculate forward rate when forward premium & Discount given? Take spot rate. (say $1 = 45) Multiply by (1+premium rate) to the other currency (i.e. if premium is on $ then multiply in amount or vice versa). Or Multiply by (1- discount rate) to other currency (i.e. if discount is on $ then multiply in amount or vice versa). Direct quote & Indirect quote Direct quote: A direct quote is the home currency price for one unit foreign currency. Example: $1 = 48 is a direct quote for an Indian Indirect quote: An indirect quote is the foreign currency price for one unit of home currency. Example: 1 = $ is an indirect quote for an Indian. Note: To solve practical problem, we will think direct quote/indirect quote for any one currency and not for any country. $1 = 48 Direct quote for $ and Indirect quote for Converting direct quote into indirect quote: Conversion for one way quote Direct quote = OR Indirect quote = Example: Direct quote for $: $ 1 = 45 Indirect quote for $: 1 = $ CA. Nagendra P a g e 2.9

10 Strategic Financial Management Conversion for two way quote: Example: $1 = 45 / = / i.e. 1 = / Here, Because of Bid rate > Ask rate, above conversion is not correct. Hence Use following: Direct quote: $1 = 45 / Indirect quote: 1 = / i.e. 1 = / (Bid rate < Ask rate) Hedging through forward Market: For hedging (safeguard) future receipt or future payment one has to enter forward contract (i.e. today s contract for future delivery) at forward rate. At due date convert one currency into other currency at the agreed rate the rate at which forward contract is made, doesn t matter what is the actual rate on due date. Calculation of gain/loss Suppose a person has to buy 1 Kg Apple. Today 6 month 1 Apple = 40 Forward Contract for buying 1 Apple = 45 Expected loss = 6 Actual rate 1 Apple = 47 Actual loss if forward cover not taken = 7 Loss due to forward cover = 5 (In this case Actual rate/expected rate at 6 month time should not be given.) How expected loss can be hedged by forward cover? By entering forward cover expected loss can be reduce from 6 to 5. Expected rate 1Apple = 46 Loss due to forward cover if 6 month rate is 47 = 2 Gain Loss due to forward cover if 6 month rate is 46 = 1 Gain If Rate at 6 month time is given then calculate loss/gain using forward rate and 6 month time rate. Loss/gain due to Forward cover; Premium/Discount on currency Question No. - 1A (Nov Old-4 Marks) Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60 days hence. They are worried about the falling USD value which is currently at per USD. The concerned Export Consignment has been priced on an Exchange rate of 45.5 per USD. The Firm s Bankers have quoted a 6 -day forward rate of Calculate: (i) (ii) Rate of discount quoted by the Bank The probable loss of operating profit if the forward sale is agreed to. Ans: (i) Annual Discount = 5.38%; (ii) Probable loss = 30,000 P a g e 2.10 CA. Nagendra

11 Question No. -1B [Nov-2003-Old-10 Marks] F O R E X ABC Co. has taken a 6 month loan from their foreign collaborators for US Dollars 2 millions. Interest payable on maturity is at LIBOR plus 1.0%. Current 6-month LIBOR (London Interbank Offering rate) is 2%. Enquiries regarding exchange rates with their bank elicit the following information: Spot USD months forward (i) What would be their total commitment in Rupees, if they enter into a forward contract? (ii) Will you advise them to do so? Explain giving reasons. Ans: (i) Value of Commitment = 9,83,68,725 (ii)if own expectation- that dollar will depreciate more than quoted- do nothing; If firm has no specific view cover the exposure; it would be unwise to expect continuous depreciation of the dollar. The US Dollar is a stronger currency than the Indian Rupee based on past trends Hence it would be advisable to enter forward contract. Question No. - 1C [Study Mat.] Fleur du lac, a French co, has shipped goods to an American importer under a letter of credit arrangement, which calls for payment at the end of 90 days. The invoice is for $1, 24,000. Presently the exc hange rate is 5.70 French francs to the $ if the French franc were to strengthen by 5% by the end of 90 days, what would be the transactions gain or loss to exporter in French francs? If it were to weaken by 5%, what would happen? Ans: If Strengthen by 5%: Loss = 33,604 FRF If Weaken by 5%: Gain = 37,200 FRF Question No. - 1D [Nov-2003-old-6 Marks] A company operating in Japan has today effected sales to an Indian company, the payment being due 3 months from the date of invoice. The invoice amount is 108 lakhs yen. At today's spot rate, it is equivalent to 30 lakhs. It is anticipated that the exchange rate will decline by 10% over the 3 months period and in order to protect the yen payments, the importer proposes to take appropriate action in the foreign exchange market. The 3 months forward rate is presently quoted as 3.3 yen per rupee. You are required to calculate the expected loss and to show how it can be hedged by a forward contract. Ans: Expected exchange loss = 3.33 Lakh; If hedged by a forward contract expected loss = 2.73 Lakh; i.e. reduced by 0.6 lakh Question No. - 1E [Study Mat.] A UK company, is due to receive 5,00,000 Northland dollars in six month s time for goods supplied. The company secedes to hedge its currency exposure by using the forward market. The spot rate of exchange is 2.5 Northland dollars to the pound. The forward rate of exchange is Northland dollars to the pound. Calculate how much UK company actually gains or losses as a result of the hedging transaction if, at the end of the six months, the pound, in relation to the Northland dollar, has (i) gained 4%, (ii) lost 2% or (iii) remained stable. Ans: (i) Gain = 4,900; (ii) Loss = 6,874; (iii) Loss = 2,792. Question No. - 1F [May-2008-old-8 Marks] A company is considering hedging its foreign exchange risk. It has made a purchase on 1st. January, 2008 for which it has to make a payment of US $ 50,000 on September 30, The present exchange rate is 1 US $ = 40. It can purchase forward 1 US $ at 39. The company will have to make a upfront premium of 2% of the forward amount purchased. The cost of funds to the company is 10% per annum and the rate of Corporate tax is 50%. Ignore taxation. Consider the following situations and compute the Profit/Loss the company will make, if it hedges its foreign exchange risk: (i) If the exchange rate on September 30, 2008 is 42 per US $. (ii) If the exchange rate on September 30, 2008 is 38 per US $. Ans: (i) Due to forward cover, Gain = 1,08,075; (ii) Due to forward cover, Loss = 91,925 CA. Nagendra P a g e 2.11

12 Strategic Financial Management Question No. - 1G [Nov-2007-old-8 Marks] Following information relates to AKC Ltd. which manufactures some parts of an electronics device which are exported to USA, Japan and Europe on 90 days credit terms. Cost and Sales information: Japan USA Europe Variable cost per unit Export sale price per unit Yen 650 US$10.23 Euro Receipts from sale due in 90days Yen78,00,000 US$1,02,300 Euro 95,920 Foreign exchange rate information: Yen/ US$/ Euro/ Spot market months forward months spot Advice AKC Ltd. by calculating average contribution to sales ratio whether it should hedge it s foreign currency risk or not. Ans: (i) If foreign exchange risk is hedged, ratio = 19.56% (ii) If foreign exchange risk is not hedged, ratio = 19.17% Question No. -1H [RPT-May-2011] Arnie operating a garment store in US has imported garments from Indian exporter of invoice amount of 138,00,000 (equivalent to $ 3,00,000). The amount is payable in 3 months. It is expected that the exchange rate will decline by 5% over 3 months period. Arnie is interested to take appropriate action in foreign exchange market. The three month forward rate is quoted at You are required to calculate expected loss which Arnie would suffer due to this decline if risk is not hedged. If there is loss, then how he can hedge this risk. Ans: Expected loss = $15,789, By taking forward cover loss can reduce to $10,112 Question No. -1i [RTP-Nov-2010-Old] An Automobile company in Gujarat exports its goods to Singapore at a price of SG$ 500 per unit. The company also imports components from Italy and the cost of components for each unit is 2. The company s CEO executed an agreement for the supply of 20,000 units on January 01, 2010 and on the same date paid for the imported components. The company s variable cost of producing per unit is 1,250 and the allocable fixed costs of the company are 1,00,00,000. The exchange rates on 1 January 2010 were as follows Spot /SG$ 33.00/33.04 / 56.49/56.56 Mr. A, the treasury manager of company is observing the movements of exchange rates on a day to day basis and has expected that the rupee would appreciate against SG$ and would depreciate against. As per his estimates the following are expected rates for 30 th June 2010 Spot /SG$ 32.15/32.21 / 57.27/57.32 You are required to find out: (a) The change in profitability due to transaction exposure for the contract entered into. (b) How many units should the company increases its sales in order to maintain the current profit level for the proposed contract in the end of June Ans: (a) Profit will decrease by 115,40,000 (ii) Company would increase its sale from 20,000 to 23,434 units P a g e 2.12 CA. Nagendra

13 F O R E X Question No. -1J [Nov-2009-New-12 Marks] M/s Omega Electronics Ltd. exports air conditioners to Germany by importing all the components from Singapore. The company is exporting 2,400 units at a price of Euro 500 per unit. The cost of imported components is S$ 800 per unit. The fixed cost and other variables cost per unit are Rs. 1,000 and Rs. 1,500 respectively. The cash flows in Foreign currencies are due in six months. The current exchange rates are as follows: /Euro 51.50/55 /S$ 27.20/25 After six months the exchange rates turn out as follows: /Euro 52.00/05 /S$ 27.70/75 (1) You are required to calculate loss/gain due to transaction exposure. (2) Based on the following additional information calculate the loss/gain due to transaction and operating exposure if the contracted price of air conditioners is Rs.25,000 : (i) the current exchange rate changes to /Euro 51.75/80 /S$ 27.10/15 (ii) Price elasticity of demand is estimated to be 1.5 (iii) Payments and receipts are to be settled at the end of six months. Swap point/forward margin/forward Spot differential. The difference between forward rate and spot rate is known as swap points/forward margin (not exchange margin) /forward premium (forward premium in value not in %. If it is in % then do as discussed earlier) How to calculate forward rate using swap point/forward margin? When we are given the Spot rate with forward margin / forward premium / forward swap / forward points for buying rate or selling rate (Bid or Ask), Check whether the forward margin for buying or selling is in increasing order OR in decreasing order, to find the forward rate. Swap Point Add to spot rate to arrive forward rate. Example 1: Spot Rate $1 = / 4900 Forward Premium.1100 /.1300 (increasing trend) Solution: Forward Rate: / i.e. Forward rate: $ 1 = / Example 2: Spot Rate $1 = / 70 3 Month Forward 20 / 70 (increasing trend) Solution: Forward Rate: / i.e. Forward rate: $ 1 = / Deduct from spot rate to arrive forward rate. Example1: Spot rate $1 = / 4900 Forward premium.1255 /.1200 (decreasing trend) Solution: Forward Rate: / (-).1255 (-) i.e. Forward rate: $ 1 = / Example 2: Spot rate $1 = / 70 3 Month Forward 30 / 25 (decreasing trend) Solution: Forward Rate: / (-).30 (-) i.e. Forward rate: $ 1 = / Notes for example-2: The point 7 given in spot rate is not swap point because it is not the difference in forward rate and spot rate. It is simply the quotation method as we quote telephone No /53 it means we are quoting two telephone no. (1) and (2) However point given in 3 month forward is not quotation method like telephone no. it is difference in forward rate and spot rate. CA. Nagendra P a g e 2.13

14 Strategic Financial Management Exchange margin Exchange margin is the extra amount or percentage charged by the bank over and above the rate quoted by bank. How to calculate Exchange rate (for both spot rate and forward rate) using exchange margin? When we are given the Spot rate / forward rate with margin for buying rate and margin for selling rate then effective rate will be calculated as: Deduct margin from buying rate to get desired exchange rate. Hence, Actual buying rate = Bid rate (1-exchange margin) Add margin to selling rate to get desired exchange rate. Hence, Actual selling rate = Ask rate (1+exchange margin) Example: Example: Given rate $1 = / Margin 0.08% for Buying rate Solution: Desired buying rate $1= ( ) = Example: Given rate $1 = / Margin.25% for selling rate Solution: Desired selling rate $1 = ( ) = Logic behind addition or deduction: Everyone wants to buy at low rate and wants to sell at high rate. Hence deduct margin from buying rate to arrive at low rate and add margin to selling rate to arrive at high rate. General concept question Question No. - 2A [June-2009-old-6 Marks] The following 2-way quotes appear in the foreign exchange market: Spot 2-months forward /US $ 46.00/ / Required: (i) How many US dollars should a firm sell to get 25 lakhs after 2 months? (ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot market? (iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee investment is 10% p.a. should the firm encash the US $ now or 2 months later? Ans: (i) US $ ; (ii) 92,50,000; (iii) Better to encash after 2 Month. Benefit of Early Payment Question No. - 3A [CWA-June Marks] Electronics Corp. Ltd. your customers, have imported 5, 000 cartridges at a landed cost in Bombay, of US $ 20 each. They have the choice of paying for the goods immediately or in three months time. They have a clean overdraft limit with you where 18% p.a. rate of interest is charged. Calculate which of the following methods would be cheaper to your customer. (a) (b) Pay in three months time with interest at 15% and cover the exchange risk forward for three months. Settle now at the current spot rate and pay interest to the overdraft for three months. The rates are as follows: Bombay /$ Spot: , 3 month swap: 25/35 Ans: (a) 33,09,625; (b) 32,96,975 P a g e 2.14 CA. Nagendra

15 F O R E X Question No. - 3B [Nov Marks] [CWA-Dec Marks] [As CWA-Dec Marks] An import house in India has bought goods from Switzerland for CHF 10, 00,000. The exporter has given the Indian company two options: Pay immediately the bill for CHF 10,00,000. Pay after 3 months, with 5%p.a. The importer bank charges 14% on overdrafts. If the exchange rates are as follows, what should the company do? Spot ( /CHF): 30.00/ months ( /CHF): 31.10/31.60 Ans: Immediate payment = 315,67,500; pay at 3 month = 319,95,000 Question No. - 3C [Study Mat.] U.S. Co., purchased,, Mark s worth of machines from a firm in Dortmund, Germany the value of the dollar in terms of the mark has been decreasing. The firm in Dortmund offers 2/10, net 90 terms. The spot rate for one mark is dollar 0.55; the 90 days forward rate is $0.56. (a) Compute the $ cost of paying the account within 10 days. (b) Compute the $ cost of buying a forward contract to liquidate the account in 90 days. (c) The differential between part (a) and part (b) is the result of the time value of money (the discount for prepayment) and protection from currency value fluctuation. Determine the magnitude of these components. Ans: (a) $ 53,900; (b) $56,000; (c) Time value of money = $1120; protection from devaluation = $980 Question No. - 3D A firm is contemplating import of a consignment from the USA for a value of US dollars 10,000. The firm requires 90 days to make payment. The supplier has offered 60 days interest free credit and is willing to offer additional 30 days credit at an interest rate of 6% p.a. The bankers of the firm offer a short loan for 30 days at 9% p.a. The bankers quotation for foreign exchange is: Spot USD 1 = days forward 1 USD = days forward 1 USD = You are required to advice the firm as to whether it should pay the supplier in 60 days or avail the supplier s offer of 90 days credit. Show your calculations. Ans: pay in 60 days = 465,465; pay in 90 days = 465,818 Cross Rates of Foreign Exchange The cross rate is the currency exchange rate between two currencies, where neither of the currencies are of the country in which the exchange rate is quoted. Example of cross rate: Exchange rate: 1 = 1.21 in India. Exchange rate: 1 = 106 in India. In both rate neither of the currencies is of India (i.e. ) hence it is cross rate, in India. How to calculate required exchange rate using cross rate? Suppose an Indian importer have to make payment in currency but currency quote is not available directly with. CA. Nagendra P a g e 2.15

16 Strategic Financial Management Option-I [If quoted rate is one way quote] Rate quoted by Indian bank is: (i) 1 = $ 1.55 (ii) 1 = 72 (iii) = $.27 (iv) = 6 What is the applicable rate to Indian importer for payment in? We can calculate required rate / using following relationship: = = = Hence, required rate: 1 = Option-II [If quoted rate is two way quote] Rate quoted by bank is: (i) 1 = (ii) 1 = OR, 1 = OR, 1 = Calculate required rate using following relationship: = = = for Bid for Ask Hence, required rate: 1 = Question No. - 4A [RTP-Nov-2009-old] You sold million value spot to your customer at = and covered yourself in Singapore market on the same day when the exchange rate was as under: Spot US$ =.7373/.7375 Local inter bank US$ 1 = / (Brokerage paid 2,000) Calculate the cross rate nearest to the fourth decimal and ascertain profit or loss in the transaction to the nearest rupee. Ans: Cross rate = ; Profit = 81,500 Question No. - 4B [Nov marks] [Study Mat.] [As RTP-June-2009-Old] X Ltd. an Indian company has an export exposure of 10 million (100 lakhs) yen, value September end. Yen is not directly quoted against Rupee. The current spot rates are USD/INR = and USD/JPY = It is estimated that Yen will depreciate to 144 level and Rupee to depreciate against dollar to 43. Forward rate for September 1998 USD/Yen = and USD/INR = You are required to: (i) to calculate the expected loss if hedging is not done. How the position will change with company taking forward cover? (ii) If the spot rate on 30th September, 1998 was eventually USD/Yen = and USD/INR = 42.78, is the decision to take forward cover justified? Ans: (i) Expected loss = Lacs; if forward cover taken loss can be reduced to lacs, (ii)receipt under Forward cover = Lacs; decision to purchase forward cover is justified Question No. - 4C [Nov old-4marks] [As RTP-June-2009-old] [CS-June-09-4 Marks] You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at 5.70 & covered yourself in London market on the same day, when the exchange rates were US$ 1 = H.K.$ Local inter bank market rates for US$ were Spot US$ 1 = Calculate cover rate & ascertain the profit or loss in the transaction ignores brokerage. Ans: Cover rate HK$ 1 = ; Gain = 5,29,260; P a g e 2.16 CA. Nagendra

17 Question No. - 4D [CWA-Dec Marks] F O R E X Your bank wants to calculate Rupee. TT selling rate of exchange for DM since a deposit of DM 1,00,000 in a Foreign Currency Non Resident A/C has matured, when: EURO 1 = DM (locked in rate) EURO 1 = US$ /43 US $ 1 = 48.51/53 What is the Rupee TT selling rate for DM currency? Ans: Rupee TT selling rate = Question No. - 4E [Nov Marks] [May-2005-old-8marks] [As Study Mat.] On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the remittance only on February 4, The interbank market rates were as follows: January, 28 February 4 Bombay US$1 = 45.85/ /45.97 London Pound 1 = US$ / / Pound 1 = SGD / / The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of.0001) Ans: Loss to customer due to strike = 2,28,250 Question No. -4F [RTP-Nov-2010-Old] Somu Electronics imported goods from japan on july 1 st 2009, of 1 Million, to be paid on 31 st, December Mr. X, the treasury manager collected the following exchange rates on July 01, 2009 from the bank. Delhi /$ Spot 45.86/88 6 months forward 46.00/03 Tokyo /$ Spot 108/ month forward 110/ In spite of fact that the forward quotation for was available through cross currency rates, Mr. X, the treasury manager purchased spot $ and converted $ into in Tokyo using 6 months forward rate. However, on 31 st December, 2009 /$ spot rate turned out to be 46.24/26. You are required to calculate the loss or gain in the strategy adopted by Mr. X by comparing the notional cash flow involved in the forward cover for yen with the actual cash flow of the transaction. Ans: Loss = 2,091 [Hint: Cash flow of forward purchasing = ; Cash flow of forward purchasing $ in spot market and converting into ] CA. Nagendra P a g e 2.17

18 Strategic Financial Management Hedging through Money (cash) Market Operation: A. Amount Receivable in foreign currency: Ind Co. cannot receive payment today. It cannot use forward rate. It has to hedge transaction using spot rate but it will receive fund after 3M. Export to USA Indian Company Inflow at 3 Month 1 Invoice for $ 10,000/- Credit period 3M USA Company Outflow at 3 Month 4 3 $ 5 2 3M today $ Indian B 1 Rate: 10-12% Indian B 2 SR: 1$=40-41 USA Bank Rate; 5%-6% 2 Borrow less amount today from the USA bank for 3 month at borrowing rate of USA. = $ 10,000 / ( X 3/12) = $ 9, Convert $ 9,852 into spot rate. $9,852 = 9,852 X 40 = 3,94,080 Invest 3,94,080 in India for 3 month at Deposit rate of India. Deposit amount after 3 month = 3,94,080 X (1+0.10X3/12) = 4,03,932 Borrowing amount with interest will become Invoice amount at 3 month time which will pay by USA 5 Company to USA Bank. Hence, Amount receivable under money market operation at 3 month time is equal to 4,03,932/- Concept: Why borrowed money from foreign bank to be deposit in home country bank? Why not keep with him today? We know comparison cannot be done between rickshaw wale and chartered accountant. Similarly, today payment cannot be comparable with Future payment. If we do not deposit money in home country bank today, then the inflow become today s time and it is not comparable with forward contract or with other hedging option. Hence deposit today in home country bank by taking loan in foreign currency. P a g e 2.18 CA. Nagendra

19 F O R E X B. Amount payable in foreign currency: Ind Co. not makes payment today. It cannot use forward rate. It has to hedge using spot rate but make payment after 3M. Import from USA Indian Company Inflow at 3 Month 1 Invoice for $ 10,000/- Credit period 3M USA Company Outflow at 3 Month 2 3M 3 $ 4 5 today $ Indian B 1 Rate: 10-12% Indian B 2 SR: 1$=40-41 USA Bank Rate; 5%-6% Borrow money from home country. (How much money we will borrow?) Convert into $ at spot rate. (Which amount we will convert?) Deposit $ into foreign bank at deposit rate of foreing country We cannot calculate the required amount if we follow above sequence. Hence do back calculation. Deposit less amount today in the USA bank for 3 month at deposit rate of USA. 4 = $ 10,000/ ( X 3/12) = $ 9,876 3 Convert $ 9,876 into spot rate. $ 9,876 = 9,876 X 41 = 4,04, Borrow 4,04,916 in India for 3 month at borrowing rate of India. Borrowing amount after 3 month = 4,04,916 X (1+0.12X3/12) = 4,17,063 Deposit amount with interest will become Invoice amount at 3 month time which will receive by USA company from USA Bank. Hence, Amount payable under money market operation at 3 month time is equal to 4,17,063/- Concept: Why borrowed money from home country bank to be deposit in foreign bank? Why not from own pocket at today time? If we not borrow money from home country bank, then the outflow become today s time and it is not comparable with forward contract or with other hedging option. Hence deposit today by taking loan. CA. Nagendra P a g e 2.19

20 Strategic Financial Management Hedging through Forward market & Money Market Operation Question No. - 5A [Study Mat.] [As CWA-June Mks] The finance director of P Ltd., has been studying exchange rates and interest rates relevant to India and USA. P Ltd. has purchased goods from the US Co. at a cost of $51 lakhs payable in dollars in three months time. In order to maintain profit margins the finance director wishes to adopt, if possible, a risk -free strategy that will ensure that the cost of the goods to P Ltd. is no more than 22 Crores. Exchange rates ( /Dollars) Spot month forward months forward Interest rate (available to P Ltd): India USA Deposit rate (%) Borrowing rate (%) Deposit rate (%) Borrowing rate(%) 1 month months Calculate whether it is possible for P.Ltd to achieve a cost directly associated with this transaction of no more than 22 Crores by means of a forward hedge, or money market hedge. Ans: payment under forward hedge = crore; Payment under Money market hedge = crore Question No.-5B [Nov-2008-New-6 Marks] [Nov-2009-old-7 Marks] [CS-June Marks] [RTP-Nov-2009] An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three months. Exchange rates in London are: Spot Rate ($/ ) month Forward Rate ($/ ) Rates of interest in Money Market: Deposit Loan $ 7% 9% 5% 8% Compute and show how a money market hedge can be put in place. Compare and contrast the outcome with a forward contract. Ans: Receipt under money Market hedge = 2, 17,902; Receipt under forward hedge = 2, 16,852 Question No. - 5C F Ltd. is a medium-sized UK company with export and import trade with the USA. The following transaction are due within the next six months. Sale of finished goods, cash receipt due in three months $1,97,000 Purchase of finished goods cash payment due in six months $2,93,000 Exchange rates (London Market) $/ Spot 1 = $ Three months forward 1 = $ Six months forward 1 = $ Calculate the net sterling pounds receipts and payments that F Ltd. might expect for both its three and six months transactions if the company hedges foreign exchange risk on (1) forward foreign exchange market (2) on money market operation basis. You may assume following interest rates: P a g e 2.20 CA. Nagendra

21 F O R E X Borrowing Lending Pound 12.50%p.a. 9.50% p.a. $ 9%p.a. 6% p.a. Ans: Receipt Forward = 1,15,454.49; Receipt money market = 1,15,076.33; Payment Forward = 1,72,688.16; Payment money market = 1,76, Question No. - 5D [Study Mat.] [As RTP-Nov-2008-old] [Must Revise] On 1 st March 2009, the B Ltd. bought from a foreign firm electronic equipment that will require the payment of LC 9, 00, 000 on 31 st May The spot rate on 1 st March 2009, is LC 10 per dollar; the expected future spot rate is LC 8 per dollar; and the 90 days forward rate is LC 9 per dollar. The US interest rate is 12%, and the foreign interest rate is 8%. The tax rate for both countries is 40%. The B Ltd. is considering three alternatives to deal with the risk of exchange rate fluctuations. (a) To enter the forward market to buy LC 9,00,000 at the 90 days forward rate in effect on 31 st May (b) To borrow an amount in dollars to buy the LC at the current spot rate. This money is to be invested in government securities of the foreign country; with the interest income, it will equal LC 9, 00,000 on 31 st May (c) To wait until 31 st May 2009, and buy LCs at whatever spot rate prevails at that time. Which alternatives should the B Ltd. follow in order to minimize its cost of meeting the future payment in LCs? Explain. Ans: (a) Forward Mkt. = $ 96, ; (b) Money Mkt. = $ 9,534; (c) wait until = $, 3,5 Question No. - 5E [Nov-2008-New-6 Marks] [RTP-Nov-2009] An Indian exporting firm, Rohit and Bros., would be 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? Ans: Amount receivable = 284,83,941; Net gain = 4,83,941 Question No. - 5F Best of Luck Ltd., London will have make a payment of $ 3,64,897 in six month s time. It is currently The company is considering the various choice it has in order to hedge its transaction exposure. Exchange rates Spot rate $ six-month forward rate $ st October. Money market rates: Borrow(%) Deposit(%) US UK By making the appropriate calculations decide which of the following hedging alternatives is the most attractive to Best of Luck Ltd. (a) Forward market, (b) Cash (Money) market. Ans: (a) Pmt. under Forward Mkt. = ; Pmt. under Money Mkt. = 2,36,510.11; CA. Nagendra P a g e 2.21

22 Strategic Financial Management Question No. - 5G [CWA-June Mks] MN, a UK company, has a substantial portfolio of its trade with American and German companies. It has recently invoiced a US customer the sum of $ 50,00,000, receivable in one year s time. MN finance director is considering two methods of hedging the exchange risk: Method 1: Borrowing present value of $ 5 million now for one year, converting the amount into sterling, and repaying the loan out of eventual receipts. Method 2: Entering into a 12-month forward exchange contract with the company s bank to sell the $5 million. The spot rate of exchange is 1 = US $ , The 12-month forward rate exchange is 1 = US $ , Interest rates for 12 months are USA 3.5%; UK 4%. You are required to calculate the net proceeds in sterling under both methods and advise the company. Ans: Rcpt. under Method 1 = ; Rcpt. Under Method 2 = Question No. - 5H Expo is an importer/exporter of textile machinery. It is based in the UK but trades extensively with countries throughout Europe. It has a small subsidiary based in Germany. The company is about to invoice a customer in Germany DM 7, 5, payable in three month s time. Expo s treasurer is considering two me thods of hedging the exchange risk; Method 1: Borrow DM 7, 50,000 for three months, convert the loan into sterling and repay the loan out of eventual receipts. Method 2: enter into a three month forward exchange contract with the company s bank to sell DM 7,5,. The spot rate of exchange is DM to the 1. The three month forward rate of exchange is DM to the 1. Annual interest rates for three months borrowing are: Germany 3%, UK 6%. Which of the two methods are the most financially advantageous for Expo? Ans: Rcpt. Under method 1 = ; under Method 2 = 316,616. [In absence of deposit rate we use borrowing rate as deposit rate.] Question No.- 5I [RTP-May-2010-New/Old] Wenden Co is a Dutch-based company which has the following expected transactions. One month: Expected receipt of 2,40,000 One month: Expected payment of 1,40,000 Three months: Expected receipts of 3,00,000 The finance manager has collected the following information: Spot rate ( per ) : ± One month forward rate ( per ) : ± Three months forward rate ( per ) : ± Money market rates for Wenden Co: Borrowing Deposit One year Euro interest rate: 4.9% 4.6 One year Sterling interest rate: 5.4% 5.1 Assume that it is now 1 April. Required: (a) Calculate the expected Euro receipts in one month and in three months using the forward market. (b) Calculate the expected Euro receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used. Ans: (a) Expected euro receipt: in 1 m = 56, 79, in 3 m =,68, 67. (b) Expected euro receipt in 3 m = 67,999. P a g e 2.22 CA. Nagendra

23 F O R E X Question No. - 5J LMN exports its products throughout the world. It has today received from a new customer in Uganda an order worth, 5, at today s spot rate. The order is to be paid in the importer s currency. Terms of trade are 6 days credit. No discount is offered for early payment. Foreign exchange rates (mid rates) US$/ Uganda shillings/ Spot ,700 1 month forward N/A 2 month forward month forward Money market rates (% per annum) Deposit UK bank 5 8 Uganda bank 15 N/A US domestic bank 3 6 Borrowing LMN converts all foreign currency receipts into sterling immediately on receipt. Wherever possible, the company uses forward exchange contracts to hedge its currency risks. In view of the lack of forward markets in Uganda, the Ugandan customer has offered to pay $US 2, 25,000 to LMN in three months time, instead of Ugandan shillings in 6 days. The customer is able to do this as a result of his government s new economic liberalization policies. You are required: to calculate the expected sterling receipts from the Ugandan customer, assuming its offer of payment in US$ is accepted. Assume LMN hedges its risk using (1) The forward market, or (2) The money market, and advise LMN on which method is most advantageous; to advise LMN on whether the Ugandan customer s offer of payment in US$ should be accepted. Ans: Receipt under1 = 1,51,281; Receipt under 2 = 1,50,433 Leading/Lagging Leading: Lead payment is a payment as on today for a transaction forgetting the credit period given by supplier. Importer makes the lead payment when he feels that the loss due to currency fluctuation will become higher than that of the benefit which he will get due to time value of money. Notes: We know comparison can never be done between rickshaw wale and chartered accountant. Similarly, Lead payment can never be comparable with Forward cover because under lead payment outflow become today and under forward cover outflow become at some future date. Hence, for making lead payment comparable with forward cover we make payment today taking loan (for the period equal to forward cover) so that the outflow become at the time of repayment of loan. CA. Nagendra P a g e 2.23