CA FINAL

STRATEGIC FINANCIAL
MANAGEMENT

[QUESTION BANK]
VOLUME - I

PROF.RAHUL DANAIT

8070 400 700 online.jkshahclasses.com

CA – FINAL

1 Foreign Exchange Exposure and Risk

Management

. Module and Video Details

Module Video
Module Video Name
Name Number
1 Spot Rates
1 Introduction 2 Q.1
3 Currency Risk
4 Product and Price
Direct and 5 Direct and Indirect Quotes
2 Indirect
Quotes 6 Q.2
7 Q.3
8 Bid, Ask and Spread
Bid, Ask and
3 9 Q.4
Spread
10 Q.5
11 IDQ for Bid and Ask
IDQ For Bid 12 Q.6
4
and Ask 13 Q.7
14 Q.8
15 Cross Currency - Single Quote
16 Q.9
Cross Currency - Two Way Quotes-
17
Exporter
18 Cross Currency - Two Way Quotes- Importer
Cross 19 Q.10
5 Currency 20 Q.11
Rates 21 Q.12
22 Q.13
23 Q.14
24
25
Q.15
Q.16 :
26 Q.17

Strategic Financial Management 1 Forex

CA – FINAL

27 Forward Contracts
28 Q.18
29 Q.19
30 Q.20
31 Q.21
32 Q.22
33 Q.23

:
34 Q.24
Forward
6 35 Q.25
Contracts
36 Q.26
37 Q.27
38 Q.28
39 Q.29

:
40 Q.30
41 Q.31
42 Q.32
43 Q.33 A
44 Appreciation and Depreciation of Currency
Appreciation 45 Q.34
and 46 Q.35
7
Depreciation 47 Q.36

:
of Currency 48 Q.37
49 Q.38
50 Swap Points
51 Q.39
52 Q.40
53 Q.41
8 Swap Points
54 Q.42
55 Q.43
56 Q.44 * Nightmare ! !
57 Q.45

Strategic Financial Management 2 Forex

CA – FINAL

Exchange 58 Exchange Margins

9
Margins 59 Q.46
Special Cases in Forward Contract -
60
Introduction
Special Cases in Forward Contract - Base
Cancellation 61
10 Example
on Due Date
62 Cancellation on Due Date
63 Q.47
64 Q.48
Special Cases in Forward Contract -
65
Introduction
Special Cases in Forward Contract - Base
Cancellation 66
Example
11 Before Due
67 Cancellation Before Due Date
Date
68 Q.49
69 Q.50
70 Q.51 *
Special Cases in Forward Contract -
71
+
Net Introduction
to
FF Special Cases in Forward Contract - Base
72
Example
Extension on 73 Extension on Due Date
12
Due Date 74 Q.52
75 Q.53
76 Q.54 A
77 Q.55
78 Q.56
Special Cases in Forward Contract -
11 1- NFL 79
Introduction
Extension Special Cases in Forward Contract - Base
80
13 Before Due Example
Date 81 Extension Before Due Date
82 Q.57
83 Q.58

Strategic Financial Management 3 Forex

CA – FINAL

Special Cases in Forward Contract -

84
Introduction
Honor on Due Special Cases in Forward Contract - Base
14 85
Date Example
86 Execution On Due Date
87 Q.59
Special Cases in Forward Contract -
*
• of 88
Introduction
Special Cases in Forward Contract - Base
Execution 89
Example
15 Before Due
90 Execution Before Due Date – Steps
Date
91 Q.60
him 92 Q.61 *
93 Execution Before Due Date – Logic
Special Cases in Forward Contract -
94
Introduction
Special Cases in Forward Contract - Base
95
After Due Example
16 96 Rules of Automatic Cancellation – Steps
Date Cases
97 Q.62
98 Q.63

:
99 Rules of Automatic Cancellation – Logic
100 Money Market Hedging - For Exporter
101 Money Market Hedging - For Importer
102 Q.64
Money 103 Q.65
17 Market 104 Q.66
Hedging

:
105 Q.67
106 Q.68
107 Q.69
108 Q.70

Strategic Financial Management 4 Forex

CA – FINAL

109 Netting
18 Netting 110 Q.71
111 Q.72
112 Triangular Arbitrage
Triangular 113 Q.73
19
Arbitrage 114 Q.74
115 Q.75
116 Determination of Forward Rate
117 Q.76
118 Q.77
119 Q.78
120 Q.79
Interest Rate 121 Q.80
20 Parity 122 Q.81
Theorem 123 Q.82
124 Covered Interest Arbitrage *
125 Q.83
126 Q.84
127 Interest Rate Differential
128 Q.85
129 Determination of Forward Rate
Purchasing
21 Power Parity 130 Q.86
Theorem
131 Q.87
132 Nostro, Vostro and Loro
Nostro, 133 Exchange and Cash Position
22 Vostro and
Loro 134 Q.88
135 Q.89

Strategic Financial Management 5 Forex

CA – FINAL

different 136 Q.90 ,

µ concepts 137 Q.91

23 Miscellaneous 138 Q.92

p&& 139 Q.93

*
140 Q.94
141 Q.95
Additional 142 Q.96
and Recent
24 143 Q.97
Questions
from ICAI 144 Q.98
145 Q.99

Strategic Financial Management 6 Forex

CA – FINAL

SECTION A: PRACTICAL QUESTIONS

✓
Q1. The following spot rates are observed in the foreign currency market: -
Currency Foreign Currency per U.S.$
Britain Pound 00.62
Netherlands Guilder 1.90
Sweden Kroner 6.40
Switzerland Franc 1.50
Italy Lira 1300.00
Japan Yen 140.00
On the basis of this information, compute to the nearest second decimal
the number of:
(a) British Pounds that can be acquired for $100.
(b) Dollars that 50 Dutch guilders (a European Monetary Union legacy
currency) will buy.
(c) Swedish Krona that can be acquired for $40.
(d) Dollars that 200 Swiss Francs can buy.
(e) Italian Lira (an EMU legacy currency) that can be acquired for $10.
(f) Dollars that 1,000 Japanese Yen will buy.

Strategic Financial Management 7 Forex

CA – FINAL

Q2. Identify whether the following quotes offered by a Kolkata Bank, are in
r direct or indirect format, and provide the corresponding indirect or direct
quotes.
Currency Rate Quote
Rand (ZAR) 5.3400 Rupees per ZAR
Kroner (SEK) 0.1623 Kroner per Rupee
Pound (GBP) 72.7600 Rupees per Pound
Riyal (SAR) 0.0737 Riyal per Rupee

Q3. For the following information, you are required to specify the direct or
indirect format of quote, and to convert the rates into the other format.
Place of Quote
Product Price Rate Reciprocal
Quote Type
London Sterling Dollar 1.4300
Tokyo CHF Yen 87
Geneva UAE Dirham CHF 0.31
Singapore Malay SGD 0.4173
Ringgits

Q4. INR 130-132 per OMR is a direct quote. Another direct quote is ¥/£ 141
145. Spot:
(a) The country where the quote is made.
(b) The bid, ask and spread.
(c) For the Ask price
(i) Currency being bought by the bank.
(ii) Currency being bought by you.
(d) For the Bid price
(i) Currency being bought by the bank.
(ii) Currency being bought by you.

Strategic Financial Management 8 Forex

CA – FINAL

Q5. You propose visiting London. You go to your local bank. The exchange rate
quoted by the bank is Buying Rate ` 72.70; Selling Rate ` 73.25.
(a) Explain the Quote.
(b) Compute the Spread.
(c) How much would you pay for purchasing £ 250?
(d) If on your return from London, you have a balance of £ 23 in TCs,
how many rupees would you receive if the bank in India quotes
`73.65/73.92.

Q6. The rate quoted by a Chennai Banker is ` 70-72 per pound. Compute the
relevant pound per rupee rate.

Q7. Consider the following `/SG$ direct quote of ICICI Mumbai: 33.50-33.75
(a) What is the cost of buying SGD 7,500?
(b) How much would you receive by selling SGD 12,000?
(c) What is the cost of buying ` 1,00,000?
(d) How much would you receive by selling ` 50,000?

Q8. ABN-Amro Bank, Amsterdam, wants to purchase ` 15 million against US$

for funding their Vostro Account with Canara Bank, New Delhi. Assuming
the inter-bank rates of US$ is ` 51.3625/3700, what would be the rate
Canara Bank would quote to ABN-Amro Bank? Further, if the deal is
struck, what would be the equivalent US$ amount?

Q9. Suppose the exchange rate on Jan 2, 2012 between US Dollars and the
French Franc was FF5.9 = $1, and on the same day the exchange rate
between the dollar and the British pound was 1 Pound = $1.50. What was
the exchange rate between francs and pounds?

Q10. From the following quotes,

(i) $ 1.33-1.36 per €
(ii) $ 1.43-1.46 per GBP, derive Bid/Ask € rates for one unit of GBP.

Strategic Financial Management 9 Forex

CA – FINAL

Q11. You want to have your daughter’s marriage in Singapore. Your spending
budget is ` 10,00,000. The local currency required for all arrangements of
marriage is Singapore Dollar. You go to the bank which quotes the
following:
`/$ = 65-68. SGD/$ = 12-14.
How many SGD can you afford to buy?

Q12. XYZ Bank, Amsterdam, wants to purchase `25 million against £ for funding
their Nostro account and they have credited LORO account with Bank of
London, London.
Calculate the amount of £’s credited. Ongoing inter-bank rates are per $,
`61.3625/3700 and per £, $1.5260/70.

Q13. X Ltd. an Indian Company has bought goods worth ¥ 100 lakhs and has to
make payment in exporter’s home currency. The following exchanges are
available:
` 1 = $0.020 - $0.025
£1 = $1.40 - $1.48
¥1 = £0.0049 - £0.0069
You are required to calculate the Rupee cost of the deal today.

Q14. On January 28, 2013 an importer customer requested a Bank to remit

Singapore Dollar (SGD) 25,00,000 under an irrevocable Letter of Credit
(LC). However, due to unavoidable factors, the Bank could effect the
Remittances only on February 4, 2013. The inter-bank rates were as
follows:
January 28, 2013 February 4, 2013
US$ 1 `45.85/45.90 `45.91/45.97
GBP £1 US$ 1.7840/ 1.7850 US$ 1.7765/1.7775
GBP £1 SGD 3.1575/3.1590 SGD 3.1380/3.1390
The Bank wishes to retain an exchange margin of 0.125%.
Required:
How much does the customer stand to gain or lose due to delay?
(Note: Calculate the rate in multiples of 0.0001)
Strategic Financial Management 10 Forex
CA – FINAL

Q15. You sold Hong Kong Dollar 1,00,000 value spot to your customer at `5.70
& covered yourself in London market on the same day, when the exchange
rates were
US$1 = H.K.$ - 7.5880 – 7.5920
Local interbank market rates for US$ were
Spot US$1 = ` 42.70 – 42.85
Calculate cover rate & ascertain the profit or loss in the transaction. Ignore
brokerage.

Q16. Your forex dealer had entered into a cross currency deal and had sold US $
10,00,000 against Euro at US $ 1 = Euro 1.4400 for spot delivery. However
later during the day, the market became volatile and the dealer in
compliance with his management’s guidelines had to square up the
position when the quotations were –
Spot US $ 1 INR 31.4300/4500
1 Month Margin 25/20
2 Months Margin 45/35
Spot US $ 1 EURO 1.4400/4450
1 Month Forward 1.4425/4490
2 Months Forward 1.4460/4530
What will be the gain or loss in the transaction?

Q17. You, a foreign exchange dealer of your Bank, are informed that your bank has
sold a T.T. on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish
Kroner 1 = `6.5150. You are required to cover the transaction either in
London or New York Market. The rates on that date are as under: -
Mumbai – London `74.3000 `74.3200
Mumbai – New York `49.2500 `49.2625
London – Copenhagen DKK 11.4200 DKK 11.4350
New York – Copenhagen DKK 07.5670 DKK 07.5840
In which market will you cover the transaction, London or New York, and
what will be the exchange profit or loss on the transaction? Ignore
brokerages.

Strategic Financial Management 11 Forex

CA – FINAL

Q18. ABC Co. has taken a six-month loan from their foreign collaborators for
US$ 2 million. Interest payable on maturity is at LIBOR + 1%. Current 6–
month LIBOR is 2%. Spot rate is Spot USD : ` 50.25 – 50.75. 6–month
Forward USD: 50.15 – 50.70.

(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.

Q19. Sonu Electronics imported goods from Japan on July 1st 2009, of JP ¥ 1
million, to be paid on 31st, December 2009. The treasury manager
collected the following exchange rates on July 01, 2009 from the bank.

Delhi ` / US$ Spot45.86 / 88

6 months forward 46.00 / 03

Tokyo JP ¥ / US $ Spot 108 / 108.50

6 months forward 110 / 110.60

In spite of fact that the forward quotation for JP ¥ was available through
cross currency rates, Mr. X, the treasury manager decided to purchase spot
US$ on due date and convert US$ into JP ¥ in Tokyo using 6 months
forward rate, entered into today itself.

However, on 31st 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.

Strategic Financial Management 12 Forex

CA – FINAL

Q20. A company operating in Japan has sold goods to an Indian company today,
the payment being due three months from the date of invoice. The invoice
amount is Yen 108 lakhs. At today’s spot rate, it is equivalent to `30 lakhs.
It is anticipated that the exchange rate will decline by 10% over the three
months period, and in order to protect the yen payments, the importer
proposes to take appropriate action in the foreign exchange market. The
three-month forward rate is presently quoted at 3.3 yen per ` You are
required to calculate the expected loss, and to show how it can be hedged
by a forward contract.

Q21. JKL Ltd, an Indian company has an export exposure of JPY 10,00,000
payable August 31, 2014. Japanese Yen (JPY) is not directly quoted against
Indian Rupee.
The current spot rates are:
INR/US$ `62.22
JPY/US$ JPY 102.34
It is estimated that the Japanese Yen will depreciate to 124 level and
Indian Rupee to depreciate against US$ to `65.
Forward Rates for August 2014 are: -
INR/US$ `66.50
JPY/US$ JPY 110.35
Required:-
(i) Calculate the expected loss, if the hedging is not done. How the
position will change, if the firm takes forward cover?
(ii) If the Spot Rates of August 31, 2014 are:
INR/US$ `66.25
JPY/US$ JPY 110.85
Is the decision to take forward cover justified?

Strategic Financial Management 13 Forex

CA – FINAL

Q22. In March 2003, the Multinational Industries makes the following assessment
of Dollar Rates per British Pound to prevail as on 01.09.2003 –
$/Pound Probability
1.6 0.15
1.7 0.2
1.8 0.25
1.9 0.2
2 0.2
(a) What is the expected Spot Rate for 01.09.03?
(b) If, as of March 2003, the 6 – month forward rate is $1.80, should the
firm sell forward its pound receivables due in September, 2003?

Q23. Alert Ltd. is planning to import a multi-purpose machine from Japan at a

cost of 3,400 lakhs yen. The company can avail loans at 18% interest per
annum with quarterly rests with which it can import the machine.
However, there is an offer from Tokyo branch of an India based bank
extending credit of 180 days at 2% per annum against opening of an
irrevocable letter of credit.
Other Information: Present exchange rate ` 100 = 340 Yen; 180 days
forward rate- `100 – 345 Yen.; Commission charges for letter of credit at
2% per 12 months.
Advise whether the offer from the foreign branch should be accepted?

Q24. AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are
as below:
U.S. $ 12.5 million
U.K. £ 6 million

Following exchange rate information are obtained:

$/` £/`
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150

Strategic Financial Management 14 Forex

CA – FINAL

Annual borrowing / deposit rates (Simple) are available

` 6.4% / 6.2%
$ 1.6% / 1.5%
£ 3.9% / 3.7%
The Indian operation is forecasting a cash deficit of ` 500 million.
It is assumed that interest rates are based on a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in ` for
each company under each of the following scenarios ignoring
transaction costs and taxes:
(a) Each company invests / finances its own cash balances /
deficits in local currency independently.
(b) Cash balances are pooled immediately in India and the net
balances are invested / borrowed for the 30 days period.
(ii) Which method do you think is preferable from the parent
company’s point of view?

Q25. 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, 2008. The present exchange rate is 1 US$ = `40.
It can purchase forward 1 US$ at `39. The company will have to make an
upfront premium of 2% of the forward amount purchased. The cost of
funds to the company is 10% per annum and corporate tax rate 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$.
(ii) If the exchange rate on September 30, 2008 is `38 per US$.

Q26. The treasury desk of a global bank incorporated in UK wants to invest GBP
200 million on 1st January, 2019 for a period of 6 months and has the
following options:
(1) The Equity Trading desk in Japan wants to invest the entire GBP 200
million in high dividend yielding Japanese securities that would earn
a dividend income of JPY 1,182 million. The dividends are declared
and paid on 29th June. Post dividend, the securities are expected to
quote at a 2% discount. The desk also plans to earn JPY 10 million
on a stock borrow lending activity because of this investment. The
securities are to be sold on June 29 with a T+1 settlement and the
amount remitted back to the Treasury in London.
Strategic Financial Management 15 Forex
CA – FINAL

(2) The Fixed Income desk of US proposed to invest the amount in 6

month G-secs that provides a return of 5% p.a.
The exchange rates are as follows:
Currency Pair 1-Jan-2019 30-June-2019
(Spot) (Forward)
GBP-JPY 148.0002 150.0000
GBP-USD 1.28000 1.30331
As a treasurer, advise the bank on the best investment option. What
would be your decision from a risk perspective. You may ignore
taxation.

Q27. X Ltd is supposed to make payment of $ 1,00,000 today when the spot rate
is ` 40-42. One month forward is available at $ 1 = ` 39-41 and the penal
interest for late payment would be at 12% p.a. Company’s cost of capital is
15%. You are required to advise the client whether to go for lagging or to
make the payment right away.

Q28. Z Ltd. Is importing goods worth USD 2 million, requires 90 days to make
the payment. The overseas supplier has offered a 60 days interest free
credit period and for additional credit for 30 days at interest of 8% per
annum.
The bankers of Z Ltd. Offer a 30 days loan at 10% per annum and their
quote for foreign exchange is as follows:
`
Spot 1 USD 56.50
60 days forward for 1 USD 57.10
90 days forward for 1 USD 57.50
You are required to evaluate the following options:
(i) Pay the Supplier in 60 days, or
(ii) Avail the Supplier’s offer of 90 days credit.

Strategic Financial Management 16 Forex

CA – FINAL

Q29. An Indian importer has to settle an import bill for $1,30,000. The exporter
has given the Indian importer two options: -
(i) Pay immediately without interest charges.
(ii) Pay after three months with interest at 5 per cent per annum.
The importer’s bank charges 15 per cent per annum on overdrafts. The
exchange rates in the market are as follows:
Spot Rate (`/$): 48.35/48.36
3-Months Forward Rate (`/$): 48.81/48.83
The importer seeks your advice. Give your advice.

Q30. An MNC company in USA has surplus funds to the tune of $ 10 million for 6
months. The Finance director of the company is interested in investing in
Euros for higher returns. There is a Double Taxation Avoidance Agreement
(DTAA) in force between USA and Germany. The company received the
following information from London:
€/$ 0.4040/41
6 month forward 0.3973/0.3976
Rate of interest for 6 month (p.a.) 5.95% - 6.15%
With holding tax applicable for interest income 22%
Tax as per DTAA 10%
If the company invests in € what is the gain for the company.

Q31. The following 2-way quotes appear in the foreign exchange market –
Spot Rate 2-Months Forward
` / US$ ` 46.00- 46.25 ` 47.00 – 47.50
Required –
(a) How many US Dollars should a firm sell to get ` 25 lakhs after
2 months?
(b) How many Rupees is the firm required to pay to obtain US
$ 2,00,000 in the spot market?
(c) 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?
Strategic Financial Management 17 Forex
CA – FINAL

Q32. 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 ` 225 ` 395 ` 510
Export sale price per unit Yen 650 US$ 10.23 Euro 11.99
Receipts from sale due in
90 days Yen 78,00,000 US$ 1,02,300 Euro 95,920
Foreign exchange rate information:
Year / ` US $ / ` Euro / `
Spot Market 2.417 – 2.437 0.0214 – 0.0217 0.0177 – 0.0180
3 Months Forward 2.397 – 2.427 0.0213 – 0.0216 0.0176 – 0.0178
3 Months Spot 2.423 – 2.459 0.02144 – 0.02156 0.0177 – 0.0179
Advice AKC Ltd - by calculating average contribution to sales ratio, advise
whether or not it should hedge its foreign currency risk.

Q33. India Imports Co. purchased USD 1,00,000 worth of machines from a firm
in New York, USA. The value of Rupee in terms of the Dollar has been
decreasing. The firm in New York offers 2/10 net 90 terms. The spot rate
for USD is `55; the 90 days forward rate is `56.
(a) Compute the Rupee cost of paying the account within 10 days.
(b) Compute the Rupee cost of buying a forward contract to liquidate
the account in 90 days.
(c) 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 each of
these components.

Strategic Financial Management 18 Forex

CA – FINAL

Q34. The Spot rate for `/AU$ is ` 29.45 and the three-month forward rate is
` 29.36.
(a) Which currency is appreciating and which is depreciating?
(b) Compute the annual percentage premium or discount.

Q35. Suppose that 1 French franc could be purchased in the foreign exchange
market for 20 US cents today. If the franc appreciates by 10% tomorrow
against the dollar, how many francs would a dollar buy tomorrow?

Q36. Excel Exporters are holding an Export Bill in US Dollars (USD) 1,00,000,
due 60 days hence. They are worried about the falling USD value which is
currently at ` 45.60 per USD. The concerned Export Consignment has been
priced on an Exchange Rate of ` 45.50 per USD. The firm’s bankers have
quoted a 60-day forward rate of ` 45.20.
Calculate:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed to.

Q37. Flur 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 exchange 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 transaction gain or loss in French
francs? If it were to weaken by 5%, what would happen? Make calculations
in francs per $.

Q38. The price of a bond just before a year of maturity is $5,000. It’s
redemption value is $5,250 at the end of the said period. Interest is $350
p.a. The Dollar appreciates by 2% during the said period. Calculate the rate
of return.

Strategic Financial Management 19 Forex

CA – FINAL

Q39. From the following data, calculate the fixed date forward buying & Selling
rates for the month of November:
(a) Spot 1$ = 44.5450 44.5475
Forward Sept = 2600 2800
Oct = 5400 5700
Nov = 7900 8400
(b) Spot 1$ = 44.4475 44.9500
Forward Sept = 2600 2400
Oct = 5400 5100
Nov = 7900 7400

Q40. An importer customer of your bank wishes to book a forward contract

with your bank on 3rd September for sale to him of SGD 5,00,000 to be
delivered on 30th October.
The spot rates on 3rd September are USD/` 49.3700/3800 and USD/SGD
1.7058/68. The swap points are:
USD/` USD/SGD
Spot/September 0300/0400 1st Month Forward 48/49
Spot/October 1100/1300 2nd Month Forward 96/97
Spot/November 1900/2200 3rd Month Forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000
Calculate the rate to be quoted to the importer by assuming an exchange
margin of paisa.

Q41. You have the following quotes from Bank A and Bank B –
Bank A Bank B
Spot USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 Months Swap Pts. 5/10
6 Months Swap Pts. 10/15

Spot GBP/USD 1.7645/60 GBP/USD 1.7640/50

3 Months Swap Pts. 25/20
6 Months Swap Pts. 35/25
Strategic Financial Management 20 Forex
CA – FINAL

Calculate –
(a) How much minimum CHF amount you have to pay for 1 Million
GBP spot?
(b) Considering quotes from Bank A only, for GBP/CHF, what are the
implied Swap Points for spot over 3 months?

Q42. Gibralater Limited has importer 5,000 bottles of shampoo at landed cost in
Mumbai, of US$ 20 each. The company has the choice for paying for the
goods immediately or in 3 months’ time. It has a clean overdraft limited
where 14% p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralater
Limited.
(i) Pay in 3 months’ time with interest @ 10% and cover risk forward
for 3 months.
(ii) Settle now at current spot rate and pay interest of the over draft for
3 months.
The rates are as follows:
Mumbai `/$ spot : 60.25 – 60.55
3 months swap : 35/25

Q43. Dada and Co. as imported goods for US$ 7,00,000. The amount is payable
after three months. The company has also exported goods for US$
4,50,000 and this amount is receivable in two months. For receivable
amount a forward contract is already taken at `48.90.
The market Rate for Rupee and Dollar are as under:
Spot `48.50/70
Two months `25/30 points
Three months `40/45 points
The company wants to cover the risk in the forward market. The cost of
Rupee Funds is 12%. Calculate the Net Profit after 3 months (in `)?

Strategic Financial Management 21 Forex

CA – FINAL

Q44. Your bank’s London office has surplus funds to the extent of USD
5,00,000/- for a period of 3 months. The cost of the funds to the bank is
4% p.a. It proposes to invest these funds in London, New York or
Frankfurt and obtain the best yield, without any exchange risk to the bank.
The following rates of interest are available at the three centres for
investment of domestic funds there at for a period of 3 months.
London 5% p.a.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under :

London on New York

Spot 1.5350 / 90
1 Month 15 / 18
2 Month 30 / 35
3 Month 80 / 85

London on Frankfurt
Spot 1.8260 / 90
1 Month 60 / 55
2 Month 95 / 90
3 Month 145 / 140
At which centre, will be investment be made & what will be the net gain
(to the nearest pound) to the bank on the invested funds?

Q45. On April 3,2016 , a Bank quotes the following :

Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months swap points 70 90
3 months swap points 160 186
In a spot transaction, delivery is made after two days.
Assume spot date as April 5, 2016
Assume 1 swap point = 0.0001,

Strategic Financial Management 22 Forex

CA – FINAL

You are required to :

(a) Ascertain swap points for 2 months and 15 days. (For June 20, 2016)
(b) Determine foreign exchange rate for June 20, 2016, and
(c) Compute the annual rate of premium/discount of US$ on INR, on an
average rate.

Q46. Calculate the Merchant rates given the following interbank rates &
Margins:
£1 = `66.3250/4525
TT Buying rate margin 0.130%
TT Selling rate margin 0.030%

Q47. On 15th January 2015, you as a banker booked a forward cover for US$
2,50,000 for your import customer deliverable on 15th March, 2015 @
`65.3450. On due date, customer requests you to cancel the contract. On
this date quotation for US$ in the inter-bank market is as follows: -
Spot `65.2900/2975 per US$
Spot/April `3000/3100
Spot/May `6000/6100
Assuming that the flat charges for the cancellation is `100 and exchange
margin is 0.10%, then determine the cancellation charges payable by the
customer.

Q48. On 15th July 2018, you as a banker booked a forward cover for US$
2,00,000 for your export customer deliverable on 15th September, 2018 @
`64.4570. On due date, customer requests you to cancel the contract. On
this date quotation for US$ in the inter-bank market is as follows: -
Spot `64.3740/3975 per US$
Spot/April `2000/2100
Spot/May `5000/5100
Assuming that the flat charges for the cancellation is `200 and exchange
margin is 0.30%, then determine the cancellation charges payable by the
customer.

Strategic Financial Management 23 Forex

CA – FINAL

Q49. You as a banker has entered into a 3 month’s forward contract with your
customer to purchase AUD 1,00,000 at the rate of `47.2500. However after
2 months your customer comes to me and requests cancellation of the
contract. On this date quotation for AUD in the market as follows:
Spot `47.3000/3500 per AUD
1 month forward `47.4500/5200 per AUD
Determine the cancellation charges payable by the customer.

Q50. A customer with whom the Bank had entered into a 3 months forward
purchase contract for Swiss Francs 1,00,000 at the rate of ` 36.25 comes
to the Bank after two months and requests cancellation of the contract. On
that date, the rates are:
Spot INR – CHF 1 ` 36.30 ` 36.35
One month forward ` 36.45 ` 36.52
Determine the amount of Profit and Loss to the customer due to
cancellation of the contract.

Q51. A bank enters into a forward purchase TT covering an export bill for Swiss
Francs 1,00,000 at `32.4000 due 25th April and covered itself for same
delivery in the local inter bank market at `32.4200. However, on 25th
March, exporter sought for cancellation of the contract as the tenor of the
bill is changed.
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150/1.5160
Three month forward 1.5415/1.5445
And in the interbank market US Dollars were quoted as under:
Spot USD1 = ` 49.4302/.4455
Spot/April .4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600
Calculate the cancellation charges, payable by the customer if exchange
margin required by the bank is 0.10% on buying and selling.

Strategic Financial Management 24 Forex

CA – FINAL

Q52. Suppose you are a banker and one of your export customer has booked a
US$ 1,00,000 forward sale contract for 2 months with you at the rate of
`62.5200 and simultaneously you covered yourself in the interbank
market at 62.5900. However on due date, after 2 months your customer
comes to you and requests for cancellation of the contract and also
requests for extension of the contract by one month. On this date
quotation for US$ in the market was as follows:
Ask ,
Instead of Bid
°
trick
-

Spot `62.7200/62.6800 1cal

-

it is Ask - Bid
1 month forward `62.6400/62.7400
Determine the extension charges payable by the customer assuming
exchange margin of 0.10% on buying as well as selling.

Q53. On 30th June 2017 when a forward contract matured for execution you are
asked for an importer customer to extend the validity of the forward sale
contract for $ 10000 for a further period of 3 months.

Contracted rate $ 1 = ` 41.87

$ quotes on 30-6-2017
Spot ` 40.48/40.49
Premium July 0.1100/0.1300
Premium August 0.2300/ 0.2500
Premium September 0.3500 / 0.3750

Calculate the cost for your customer in respect of the extension to the
forward contract. Also calculate the new forward rate for the extended
period.

Bank’s margin 0.08% for Buying rate

0.25% for selling rate

Strategic Financial Management 25 Forex

CA – FINAL

Q54. X Ltd. has imported goods costing $ 1,00,000 from an American company
on 1/1/2017 payment to be made in 2 months time on 1/3/2017. The two
months forward rates available on 1/1/2017 are `43-45. X Ltd. enters into
2 months forward contract.
Now it is 1/3/2017 on which date following rates are available
Spot 1$ = `46 – 48
1 month forward 1$ = `46.10 – 47.20
The penal interest for late payment is 6% p.a. and the company’s cost of
capital is 18%. You are required to advice the company whether to settle
the deal today or go for lagging by extension of forward by 1 month.

Q55. An importer requests his bank to extend the forward contract for US$
20,000 which is due for maturity on 30th October, 2010, for a further
period of 3 months. He agrees to pay the required margin money for such
extension of the contract.
Contracted Rate – US$ 1 = `42.32
The US Dollar quoted on 30-10-2010: -
Spot – 41.5000/41.5200
3 months’ Premium – 0.87%/0.93%
Margin money for buying and selling rate is 0.075% and 0.20%
respectively Compute: -
(i) The cost of the importer in respect of the extension of the forward
contract, and
(ii) The rate of the new forward contract.

Strategic Financial Management 26 Forex

CA – FINAL

Q56. An exporter requests his bank to extend the forward contract for US$
20,000 which is due for maturity on 31st October, 2014, for a further
period of 3 months. He agrees to pay the required margin money for such
extension of the contract.
Contracted Rate – US$ 1 = `62.32
The US Dollar quoted on 31-10-2014: -
Spot – 61.5000/61.5200
3 months’ Discount – 0.93%/0.87%
Margin money for buying and selling rate is 0.45% and 0.20% respectively
Compute: -
(i) The cost of the exporter in respect of the extension of the forward
contract, and
(ii) The rate of the new forward contract.

Q57. Suppose you are a banker entered into a forward purchase contract for
US$ 50,000 on 5th March with an export customer for 3 months at the rate
of `59.6000. On the same day, you also covered yourself in the market at
`60.6025. However on 5th May, your customer comes to you and requests
extension of the contract to 5th July. On this date (5th May) quotation for
US$ in the market is as follows:
Spot `59.1300/1400 per US$
Spot/5th June `59.2300/2425 per US$
Spot/5th July `59.6300/6425 per US$
Assuming a margin of 0.10% on buying and selling, determine the
extension charges payable by the customer and the new rate quoted to the
customer.

Strategic Financial Management 27 Forex

CA – FINAL

Q58. Suppose you are a banker entered into a forward sale contract for US$
70,000 on 5th July with an import customer for 3 months at the rate of
`58.5200. On the same day, you also covered yourself in the market at
`58.5235. However on 5th September, your customer comes to you and
requests extension of the contract to 5th November. On this date (5th
September) quotation for US$ in the market is as follows:
Spot `58.2300/2400 per US$

Spot/5th October `58.3300/3425 per US$

Spot/5th November `58.7300/7425 per US$

Assuming a margin of 0.20% on buying and selling, determine the

extension charges payable by the customer and the new rate quoted to the
customer.

Q59. On 1st June 2017 the bank enters into a forward contract for 2 months for
selling $ 1,00,000 at `65.50. On 31st July 2017 the spot rate was
`65.750/65.8500. Calculate the amount to be debited in the customer’s
account.

Q60. On 1st October 2015, Mr. X an exporter enters into a forward contract with
a BNP Bank to sell US$ 1,00,000 on 31st December, 2015 at `65.40/$.
However, due to the request of the importer, Mr. X received amount on
28th November 2015. Mr. X requested the bank to take delivery of the
remittance on 30th November 2015 i.e. before due date. The inter-banking
rates on 28th November 2015 were as follows:
Spot `65.22/65.27

One Month Premium 10/15

If bank agrees to take early delivery then what will be net inflow to Mr. X
assuming that the prevailing prime lending rate is 18%?

Strategic Financial Management 28 Forex

CA – FINAL

Q61. On 19th January, Bank A entered into a forward contract with a customer
for a forward sale of US$ 7,000, delivery 20th March at `46.67. On the
same day, it covered its position by buying forward from the market due
19th March, at the rate of `46.655. On 19th February, the customer
approaches the bank and requests for early delivery of US$.
Rates prevailing in the interbank market on that date are as under:
Spot 46.5725/5800
March 46.3550/3650 ( 2013 FR)
Interest on outflow of funds is 16% and on inflow of funds is 12%. Flat
charges for early delivery are `100. What is the amount that would be
recovered from the customer on the transaction?
Note: Calculation should be made on months basis than on days basis.

Q62. On 10th July, an importer entered into a forward contract with the bank for
US$ 50,000 due on 10th September at an exchange rate of `66.8400. The
bank covered its position in the interbank market at `66.6800.
How the bank would react if the customer requests on 20th September:
I. To cancel the contract
II. To execute the contract
III. To extend the contract with the due date to fall on 10th November

The exchange rates for US$ in the interbank market were as below:
10th September 20th September
Spot USD 1 = `66.1500/1700 `65.9600/9900
September `66.2800/3200 `66.1200/1800
October `66.4100/4300 `66.2500/3300
November `66.5600/6100 `66.4000/4900
Exchange margin was 0.1% on buying and selling.
Interest on outlay of funds was 12% p.a.
You are required to show calculations to:
(i) Cancel the contract,
(ii) Execute the contract and
(iii) Extend the contract as above.

Strategic Financial Management 29 Forex

CA – FINAL

Q63. An importer booked a forward contract with his bank on 10th April for
USD 2,00,000 due on 10th June @ `64.4000. The bank covered its position
in the market at `64.2800.

The exchange rates for dollar in the interbank market on 10 th June and
20th June were:

10th June 20th June

Spot USD 1 = `63.8000/8200 `63.6800/7200

June `63.9200/9500 `63.8000/8500

July `64.0500/0900 `63.9300/9900

August `64.3000/3500 `64.1800/2500

September `64.6000/6600 `64.4800/5600

Exchange Margin 0.10% and interest on outlay of funds is @ 12%. The

importer requested on 20th June for extension of contract with due date on
10th August.

Rates rounded to 4 decimals in multiples of 0.0025.

On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
(i) Cancellation Rate
(ii) Amount Payable on $ 2,00,000
(iii) Swap Loss
(iv) Interest on Outlay of Funds, if any
(v) New Contract Rate
(vi) Total Cost

Strategic Financial Management 30 Forex

CA – FINAL

Q64. An Indian exporting firm, Rohit and Bros, want to cover itself against a
likely depreciation of pound sterling. The following data is given: -
Receivables of Rohit and Bros: £ 5,00,000
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?

Q65. 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 ($/£) 1.5865 – 1.5905
3-month Forward Rate ($/£) 1.6100 – 1.6140
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.

Q66. The CFO of SKMC Ltd has been studying the exchange rates and interest
rates relevant to India and USA. SKMC has purchased materials from an
American Company at a cost of US $5.05 Million, payable in US $ in 3
months’ time. In order to maintain profit margins, the CFO wishes to
adopt, if possible, a risk-free strategy that will ensure that the cost of
goods sold to SKMC does not exceed `21 crores.
Exchange Rate Bid Rate[ ` /US $] Ask Rate[ `/US $]
Spot Rate 40.35 40.65
1 Month Forward 41.20 41.50
3 Months Forward 42.15 42.50
Strategic Financial Management 31 Forex
CA – FINAL

Interest Rates (available to SKMC Ltd) -

Period India USA
Deposit Borrowing Borrowing
Deposit Rate
Rate Rate Rate
1 Month 5% 12% 3% 8%
3 Months 6% 13% 4% 9%
Calculate whether it is possible for SKMC to achieve a cost directly
associated with this transaction of no more than `21 crores, by means of a
Forward Market Hedge, Money Market Hedge or Leading which is 0
available @ 3%. Transaction costs may be ignored.
☐
Q67. LMN exports its products throughout the world. It has today received from
a regular customer in France an order worth £ 3,50,000 at today’s spot
market exchange rate. It has also received from a new customer in Uganda
an order worth £ 1,50,000 at today’s spot rate. Both orders are to be paid
in the respective importer’s currency. Terms of trade are 60 day’s credit.
No discount if offered for early payment. Experience has shown that the
French customer may take upto 90 days to pay.
Foreign exchange rates (mid rates)
FF/$ $/£ Ugandan shillings/£
Spot 5.7485 1.4920 1.700
1 month forward 5.7622 1.4898 NA
2 month forward 5.7727 1.4886
3 month forward 5.7833 1.4873

Money market rates (% per annum)

Deposit rate Borrowing rate
UK Bank 5 8
Uganda 15 N/A
US Domestic Bank 3 6

Strategic Financial Management 32 Forex

CA – FINAL

These rates are fixed for a period of two to three months for immediate
deposits or borrowings. 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 $
2,25,000 to LMN in 3 months time, instead of Ugandan shillings in 60 days.
The customer is able to do this as a result of his government’s new
economic liberalization policies.
You are required:
(i) To calculate the sterling receipts that LMN can expect from its sales
to the French customer, assuming LMN hedges its risk using the
forward market.
(ii) To calculate the expected sterling receipts from the Ugandan
customer, assuming its offer of payment in $ is accepted. Assume
LMN hedges its risk using:
(a) The forward market
(b) The Money Market
And advise LMN on which method is most advantageous.
(iii) To advise LMN on whether the Uganda customer’s offer for payment
in US$ should be accepted. point
Theory

Q68. Expo is an importer/exporter of textile machinery. It is based in the UK

but trades extensively with countries through out Europe. It has a small
subsidiary based in Germany. The company is about to invoice a customer
in Germany DM. 7,50,000 payable in 3 months time. Expo’s treasurer is
considering two methods of hedging the exchange risk:
Method 1: Borrow DM for 3 months, convert the loan into sterling and
repay the loan out of eventual receipts.

Method 2: Enter into 3 month forward exchange contract with the

company’s bank to sell DM 7,50,000.
The spot exchange rate is DM 2.3834 to £1.
Strategic Financial Management 33 Forex
CA – FINAL

The three month forward rate of exchange is DM 2.3688 to £1.

Annual interest rate for 3 months borrowings and deposits are Germany
3% and UK 6%.
Requirements:
Advise the treasurer on which of the two methods is the most financially
advantageous for Expo include relevant calculation in your advice.

Q69. Columbus Surgicals Inc. is based in US, has recently imported surgical raw
materials from the UK and has been invoiced for £4,80,000, payable in 3
months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £1,38,000, payable in 3
months, and the French customer has been invoiced for €5,90,000,
payable in 4 months.
Current spot and forward rates are as follows: -
£/US$
Spot : 0.9830 – 0.9850
Three months forward : 0.9520 – 0.9545
US$/€
Spot : 1.8890 – 1.8920
Four months forward : 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.00% - 12.00% p.a.
France: 14.00% - 16.00% p.a.
USA: 11.50% - 13.00% p.a.
You as Treasury Manager are required to show how the company can
hedge its foreign exchange exposure using Forward Markets and Money
Markets hedge and suggest which the best hedging technique is.

Strategic Financial Management 34 Forex

CA – FINAL

Q70. A customer with whom the Bank had entered into 3 months forward
purchase contract for CHF 10,000 at the rate of `27.25 comes to the bank
after 2 months and requests cancellation of the contract. On this date the
rates prevailing are:

Spot 1CHF = `27.30/27.35

One month forward 1CHF = `27.45/27.52

What is the loss/gain to the customer:

(a) Under reverse forward

(b) On cancellation through money market operation if interest rates

are 12% and 6% in India and Switzerland respectively.

(c) If penalty for cancellation is `2,000.

(d) If nothing is done now and expected spot after a month is `27.54.

Q71. Truview Plc, a group of companies controlled from the United Kingdom
includes subsidiaries in India, Malaysia and the United States. As per the
CFO’s forecast that, at the end of the June 2010, the position of inter-
company indebtedness will be as follows:

 The Indian subsidiary will be owed `1,44,38,100 by the Malaysian

subsidiary and will owe to the US $1,06,007.

 The Malaysian subsidiary will be owed MYR 14,43,800 by the US

subsidiary and will owe it US$ 80,000.

Suppose you are head of Central Treasury Department of the group and
you are required to net off inter-company balances as far as possible and
to issue instructions for settlement of the net balances.

For this purpose, the relevant exchange rates may be assumed in terms of
£1 are US$ 1.415; MYR 10.215; `68.10

What are the net payments to be made in respect of the above balances?

Strategic Financial Management 35 Forex

CA – FINAL

Q72. A group of companies is controlled from the USA. This group has
subsidiaries in UK, Euroland and Japan. For convenience, these are
referred to as UK, EL and JP. As on 31st March, inter-company
indebtedness stood as under:
Debtor Creditor Amount (in mn)
UK EL EL 240
UK JP ¥12,000
JP EL EL 120
EL UK Sterling 75
EL JP ¥12,000
US Headquarters follow the multi-lateral netting policy, and adopt the
following exchange rates: US$ 1 = €0.90; Sterling 0.70; ¥120. Compute
and show net payments to be made by subsidiaries, after netting off.

Q73. Calculate Arbitrage Gains from `1 crore if the following quotes prevail:
Delhi 1£ = `81.20/81.90
London 1£ = $2.14/2.156
New York 1$ = `38.60/39.00

Q74. Following are the spot exchange rates quoted at three different forex
markets:
USD / INR 59.25 / 59.35 in Mumbai
GBP / INR 102.50 / 103.00 in London
GBP / USD 1.70 / 1.72 in New York
The arbitrageur has USD 1,00,00,000. Assuming that bank wishes to retain
an exchange margin of 0.125%, explain whether there is any arbitrage
gain possible from the quoted spot exchange rates.

Strategic Financial Management 36 Forex

CA – FINAL

Q75. Bharat Silk Limited, an established exporter of silk materials, has a surplus
of US$ 20 million as on 31st May, 2015. The banker of the company informs
the following exchange rates that are quoted at three different forex
markets:
GBP/INR 99.10 at London
INR/GBP 0.01 at London
USD/INR 64.10 at Mumbai
INR/US$ 0.02 at Mumbai
USD/GBP 0.65 at New York
GBP/USD 1.5530 at New York
Assuming that there are no transaction costs, advice the company how to
avail the arbitrage gain from the above quoted spot exchange rates.

Q76. On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5%
per annum respectively. The UK £/$ spot rate is 0.7570. What would be
the forward rate for US$ for delivery on 30th June?

Q77. Six month T-bills have a nominal rate of 7 percent, while default-free
Japanese bonds that mature in 6 months have a nominal rate of 5.5
percent. In the spot exchange market, 1 yen equals $0.09. If interest rate
parity holds, what is the 6 month forward exchange rate?

Q78. Suppose that on 1st January, 2017 the spot rate is £ 1 = $1.50 and the UK
and US interest rates are 6% and 8% p.a. respectively. What would you
expect the forward rate to be for the years 1, 2 and 3.

Strategic Financial Management 37 Forex

CA – FINAL

Q79. The United States Dollar is selling in India at `55.50. If the interest rate for
a 6 month borrowing in India is 10% per annum and the corresponding
rate in USA is 4%.
(a) Do you expect US $ to be at a discount or at premium in the Indian
Forward Market;
(b) What is the expected 6-month forward rate for US$ in India, and
(c) What is the rate of forward premium or discount?

Q80. Given Spot Exchange rate $1 = FF 7.05. Complete missing entries.

3 Months 6 Months 1 year
$ Int. Rate (Annual) 11.5% 12.25% ?
FF Int. Rate(Annual) 19.5% ? 20%
Forward Franc per $ ? ? 7.5200
Forward Dollar Premium % ? 6.3% ?

Q81. A UK company expects to receive Singapore dollars 4,00,000. The actual

.

due date falls exactly six months from now. Assume that Interest rate in
Singapore is 15%, while that in UK is 12%. Current Spot Rate is SGD 2.5 =
1 GBP. Evaluate the situation, if Sterling was to (a) gain 4%, (b) lose 2% or
(c) remain stable at present level. Assume that the forward exchange rate
reflects the interest rate parity analysis of forward rates. Should the
company take forward cover?

Q82. Singapore Dollar SG $ and Indian ` rates are available to you as under:
.

Spot rates `/SG$ = 20.725

90 day rates `/SG$ = 20.687
Singapore prime interest rate as on date is 9.5%.
Note: Use 360 days a year

Strategic Financial Management 38 Forex

CA – FINAL

Required:
(a) Explain what is implied about the Indian Interest rate
(b) Calculate and comment on the Indian interest rate if the forward
exchange rate was SG$/` = 0.04795.
(c) Calculate and comment on the 90 days forward rate on `/SG $ if
Indian interest rate was 8%.

Q83. Following are the rates quoted at Mumbai for British Pound (£):
Interest
Spot (£/`) 52.60/70 India London
Rates
3 m Forward 20/70 3 months 8% 5%
6 m Forward 50/75 6 months 10% 8%
Verify whether there is any scope for covered interest arbitrage, if you can
borrow in rupees.

Q84. Given the following information:

Exchange Rates – Canadian Dollar 0.665 per DM (spot)
Canadian Dollar 0.670 per DM (3 months)
Interest Rates - DM 7% p.a.
Canadian Dollar 9% p.a.
What operations would be carried out to take the possible arbitrage gains?

Q85. Shoe Company sells to a wholesaler in Germany. The purchase price of a

shipment is 50,000 Deutsche Marks with terms of 90 days. Upon payment,
Shoe Company will convert the DM to dollars. The present spot rate for
DM per dollar is 1.71, whereas the 90-day forward rate is 1.70.
You are required to calculate and explain:

Strategic Financial Management 39 Forex

CA – FINAL

(i) If Shoe Company were to hedge its foreign-exchange risk, what

would it do? What transactions are necessary?
(ii) Is the Deutsche Mark at a forward premium or a forward discount?
(iii) What is the implied differential in interest rates between the two
countries?
(Use Interest - Rate Parity Assumption)

Q86. The rate of inflation in India is 8% per annum and in the USA it is 4%. The
current Spot Rate for US$ in India is ` 46. What will be the expected rate
after 1 year and after 4 years applying the Purchasing Power Parity
Theorem?

Q87. On a given day, a Pen-Drive costs $ 22.84 in New York, SGD 69 in

Singapore and Rubles 3240 in Moscow.
(a) If the law of one price held, ascertain the exchange rate between the
three countries.
(b) The actual exchange rates on that day was US$ 1 = SGD 1.63; US$ 1 =
Rubles 250. Where would it be beneficial to buy the Pen-drive?

Q88. You as a dealer in foreign exchange have the following position in Swiss
Francs on 31st October, 2009:
Swiss Francs
Balance in the Nostro A/C Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold Forward TT 60,000
Forward Purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich contract cancelled 30,000

Strategic Financial Management 40 Forex

CA – FINAL

What steps would you take, if you are required to maintain a credit
balance of Swiss Francs 30,000 in the Nostro A/C and keep as overbought
position on Swiss Francs 10,000?

Q89. Suppose you are a dealer of ABC bank and on 20.10.2014 you found that
overdrawn by
your Nostro account with XYZ Bank in London is £65,000 and you had
1

overbought £35,000. During the day following transaction have taken

place:
£
DD Purchased 12,500
Purchased a Bill on London 40,000
Sold Forward TT 30,000
Forward Purchased Contract cancelled 15,000
Remitted by TT 37,500
Draft on London cancelled 15,000
What steps would you take, if you are required to maintain a credit
balance of £15,000 in the Nostro A/C and keep as overbought position on
£7,500.

Q90. 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 units. The cost of imported
components is S$ 800 per unit. The fixed cost and other variables cost per
unit are ` 1,000 and ` 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
` / $ SGD 27.20 / 25
After 6 months the exchange rates turn out as follows:
` / Euro 52.00 / 05
` / $ SGD 27.70 / 75

Strategic Financial Management 41 Forex

CA – FINAL

(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 ` 25,000 :
(a) The current exchange rate changes to:
` / Euro 51.75 / 80
`/$ 27.10 / 15
(b) Price elasticity of demand is estimated to be 1.5
(c) Payments and Receipts are to be settled at the end of six
months.

Q91. Following are the details of Cash Inflows and Outflows in foreign currency
denominations of MNP Co. an Indian export firm, which have no foreign
subsidiaries:
Forward
Currency Inflow Outflow Spot Rate
Rate
US$ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
UK £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of
Rupees.
(ii) Are any of the exposure positions offsetting to some extent?

Q92. The risk free rate of interest in USA is 8% p.a. and in UK is 5% p.a. The spot
exchange rate is 1$ = £0.75.
Assuming that interest is compounded continuously then at which
forward rate of 2 years there will be no opportunity for arbitrage.
Further show, how an investor could make riskless profit if two year
forward price is 1$ = £0.85.
Given e-0.06 = 0.9418, e-0.16 = 0.8521, e0.16 = 1.1735, e-0.10 = 0.9048.

Strategic Financial Management 42 Forex

CA – FINAL

Q93. An Indian company obtains the following quotes (`/$)

Spot: 35.90/36.10
3-Months forward rate: 36.00/36.25
6-Months forward rate: 36.10/36.40
The company needs $ funds for six months. Determine whether the
company should borrow in $ or `. Interest rates are:
3-Months interest rate: `: 12%; $: 6%
6-Months interest rate: `: 11.50%; $: 5.5%
Also determine what should be the rate of interest after 3-months to make
the company indifferent between 3-months borrowing and 6-months
borrowing in the case of:
(i) Rupee borrowing
(ii) Dollar borrowing
Note: For the purpose of calculation you can take the units of dollar and
rupee as 100 each.

Q94. Place the following strategies by different persons in the Exposure

Management Strategies Matrix.
Strategy 1: Kuljeet a wholesaler of imported items imports toys from
China to sell them in the domestic market to retailers. Being a sole trader,
he is always so much involved in the promotion of his trade in domestic
market and negotiation with foreign suppliers that he never pays attention
to hedge his payable in foreign currency and leaves his position unhedged.
Strategy 2: Moni, is in the business of exporting and importing
brasswares to USA and European countries. In order to capture the market
he invoices the customers in their home currency. Lavi enters into forward
contracts to sell the foreign exchange only if he expects some profit out of
it other-wise he leaves his position open.

Strategic Financial Management 43 Forex

CA – FINAL

Strategy 3: TSC Ltd. is in the business of software development. The

company has both receivables and payables in foreign currency. The
Treasury Manager of TSC Ltd. not only enters into forward contracts to
hedge the exposure but carries out cancellation and extension of forward
contracts on regular basis to earn profit out of the same. As a result,
management has started looking Treasury Department as Profit Centre.
Strategy 4: DNB Publishers Ltd. in addition to publishing books are also in
the business of importing and exporting of books. As a matter of policy the
movement the company invoices the customer or receives invoice from
the supplier immediately covers its position in the Forward or Future
markets and hence never leave the exposure open even for a single day.

Q95. NP and Co. as imported goods for US$ 7,00,000. The amount is payable
after three months. The company has also exported goods for US$
4,50,000 and this amount is receivable in two months. For receivable
amount a forward contract is already taken at `48.90.
The market Rate for Rupee and Dollar are as under:

Spot `48.50/70

Two months `25/30 points

Three months `40/45 points

The company wants to cover the risk and it has two options as under:
(A) To cover payables in the forward market and
(B) To lag the receivables by one month and cover the risk only for the
net amount. No interest for delaying the receivables in earned.
Evaluate both the options if the cost of Rupee Funds is 12%. Which
option is preferable?

Strategic Financial Management 44 Forex

CA – FINAL

Q96. A German subsidiary of an US based MNC has to mobilize 1,00,000 Euro’s

working capital for the next 12 months;. It has the following options :

Loan from German Bank : @ 5% p.a.

Loan from US Parent Bank : @ 4%
Loan from Swiss Bank : @ 3%

Banks in Germany charge an additional 0.25% p.a towards loan servicing.

Loans from outside Germany attract withholding tax of 8% on interest
payments. If the interest rates given above are market determined,
examine which loan is the most attractive using interest rate differential.

Q97. H Ltd, is an Indian firm exporting handicrafts to North America. All the
exports are invoiced in US$. The firm is considering the use of money
market or forward market to cover the receivable of $50,000 expected to
be realized in 3 months’ time and has the following information from its
banker:

Exchange Rates

Spot `/$ 72.65/73

3-m forward `/$ 72.95/73.40

The borrowing rate in US and India are 6% and 12% p.a. and the deposit
rates are 4% and 9% p.a. respectively.
(i) Which option is better for H Ltd.
(ii) Assume that H Ltd. anticipates the spot exchange rate in 3-months
time to be equal to the current 3 months forward rate. After
3-months the spot exchange rate turned out to be `/$ : 73/73.42.
What is the foreign exchange exposure and risk of H Ltd?

Strategic Financial Management 45 Forex

CA – FINAL

Q98. Citi Bank quotes JPY/ USD 105.00 – 106.50 and Honk Kong Bank quotes
USD/JPY 0.0090 – 0.0093.
(a) Are these quotes identical if not then how they are different?
(b) Is there a possibility of arbitrage?
(c) If there is an arbitrage opportunity, then show how would you
make profit from the given quotation in both cases if you are
having JPY 1,00,000 or US$ 1,000.

Q99. (a) Given:

US$ 1 = ¥ 107.31
£ 1 = US$ 1.26
A$ 1 = US$ 0.70
(i) Calculate the cross rate for Pound in Yen terms
(ii) Calculate the cross rate for Australian Dollar in Yen terms
(iii) Calculate the cross rate for Pounds in Australian Dollar terms
(b) The current spot exchange rate is $1.35/£ and the three-month
forward rate is $1.30/£. According to your analysis of the exchange
rate, you are quite confident that the spot exchange rate will be
$1.32/£ after 3 months.
(i) Suppose you want to speculate in the forward market then
what course of action would be required and what is the
expected dollar Profit (Loss) from this speculation?
(ii) What would be your Profit (Loss) in Dollar terms on the
position taken as per your speculation if the spot exchange
rate turns out to be $1.26/£.
Assume that you would like to buy or sell £1,000,000.

Strategic Financial Management 46 Forex

CA – FINAL

SECTION B: THEORY

1. Write Short Note On Nostro, Vostro and Loro Accounts.

In interbank transactions, foreign exchange is transferred from one account to

another account and from one centre to another centre. Therefore, the banks
maintain three types of current accounts in order to facilitate quick transfer of
funds in different currencies. These accounts are Nostro, Vostro and Loro
accounts meaning “our”, “your” and “their”. A bank’s foreign currency account
maintained by the bank in a foreign country and in the home currency of that
country is known as Nostro Account or “our account with you”.
For example, An Indian bank’s Swiss franc account with a bank in Switzerland.
Vostro account is the local currency account maintained by a foreign
bank/branch. It is also called “your account with us”.
For example, Indian rupee account maintained by a bank in Switzerland with a
bank in India. The Loro account is an account wherein a bank remits funds in
foreign currency to another bank for credit to an account of a third bank.

Exchange Position

It is referred to total of purchases or sale of commitment of a bank to purchase

or sale foreign exchange whether actual delivery has taken place or not. In other
words all transactions for which bank has agreed with counter party are entered
into exchange position on the date of the contract.

Cash Position

It is outstanding balance (debit or credit) in bank’s Nostro account. Since all

foreign exchange dealings of bank are routed through Nostro account it is
credited for all purchases and debited for sale by bank.

Strategic Financial Management 47 Forex

CA – FINAL

It should however be noted that all dealings whether delivery has taken place or
not effects the Exchange Position but Cash Position is effected only when actual
delivery has taken place.

Therefore, all transactions effecting Cash position will affect Exchange Position
not vice versa.

2. Explain Each Of The Following Terms In Brief :

(A) American and European Term

(B) Direct and Indirect Quote
(C) Bid, Offer and Spread
(D) Cross Rates
(E) Pips
(F) Forward Exchange Rate Quotation
(G) Forward Point Determination
(H) Broken Period Forward Rate
(I) Merchant Rates

(A) American Term and European Term

Quotes in American terms are the rates quoted in amounts of U.S. dollar per unit
of foreign currency. While rates quoted in amounts of foreign currency per U.S.
dollar are known as quotes in European terms.

For example, U.S. dollar 0.2 per unit of Indian rupee is an American quote while
INR 44.92 per unit of U.S. dollar is a European quote.

Most foreign currencies in the world are quoted in terms of the number of units
of foreign currency needed to buy one U.S. dollar i.e. the European term.

Strategic Financial Management 48 Forex

CA – FINAL

(B) Direct and Indirect Quote

As indicated earlier, a currency quotation is the price of a currency in terms of

another currency.

For example, $1 = `48.00, means that one dollar can be exchanged for `48.00.
Alternatively; we may pay `48.00 to buy one dollar. A foreign exchange quotation
can be either a direct quotation and or an indirect quotation, depending upon the
home currency of the person concerned.

A direct quote is the home currency price of one unit foreign currency. Thus, in
the aforesaid example, the quote $1 = `48.00 is a direct-quote for an Indian.

An indirect quote is the foreign currency price of one unit of the home currency.
The quote Re.1

=$0.0208 is an indirect quote for an Indian.

($1/` 48.00 =$0.0208 approximately)

Direct and indirect quotes are reciprocals of each other, which can be
mathematically expressed as follows.

Direct quote = 1/indirect quote and vice versa

(C) Bid, Offer and Spread

A foreign exchange quotes are two-way quotes, expressed as a 'bid' and an offer'
(or ask) price. Bid is the price at which the dealer is willing to buy another
currency. The offer is the rate at which he is willing to sell another currency.
Thus a bid in one currency is simultaneously an offer in another currency. For
example, a dealer may quote Indian rupees as `48.80 – 48.90 vis-a-vis dollar.
That means that he is willing to buy dollars at `48.80/$ (sell rupees and buy
dollars), while he will sell dollar at ` 48.90/$ (buy rupees and sell dollars).

Strategic Financial Management 49 Forex

CA – FINAL

The difference between the bid and the offer is called the spread. The offer is
always higher than the bid as inter-bank dealers make money by buying at the
bid and selling at the offer.

Bid–Offer
% Spread = ×100
Bid

It must be clearly understood that while a dealer buys a currency, he at the same
time is selling another currency.

When a dealer wants to buy a currency, he/she will ask the other dealer a quote
for say a million dollars. The second dealer does not know whether the first
dealer is interested in buying or selling one million dollars. The second dealer
would then give a two way quote (a bid/offer quote).

When the first dealer is happy with the ‘ask’ price given by the second dealer,
he/she would convey “ONE MINE”, which means “I am buying one million
dollars from you”. If the first dealer had actually wanted to sell one million
dollars and had asked a quote, and he is happy with the ‘bid’ price given by the
second dealer, he/she would convey “ONE YOURS”, which means “I am selling
one million dollars to you”.

(D) Cross Rates

It is the exchange rate which is expressed by a pair of currency in which none of

the currencies is the official currency of the country in which it is quoted. For
example, if the currency exchange rate between a Canadian dollar and a British
pound is quoted in Indian newspapers, then this would be called a cross rate
since none of the currencies of this pair is of Indian rupee.

Broadly, it can be stated that the exchange rates expressed by any currency pair
that does not involve the U.S. dollar are called cross rates. This means that the
exchange rate of the currency pair of Canadian dollar and British pound will be
called a cross rate irrespective of the country in which it is being quoted as it
does not have U.S. dollar as one of the currencies.

Strategic Financial Management 50 Forex

CA – FINAL

(E) Pips

This is another technical term used in the market. PIP is the Price Interest Point.
It is the smallest unit by which a currency quotation can change. E.g., USD/INR
quoted to a customer is INR 61.75. The minimum value this rate can change is
either INR 61.74 or INR 61.76. In other words, for USD/INR quote, the pip value
is 0.01. Pip in foreign currency quotation is similar to the tick size in share
quotations. However, in Indian interbank market, USD-INR rate is quoted upto 4
decimal point. Hence minimum value change will be to the tune of 0.0001. Spot
EUR/USD is quoted at a bid price of 1.0213 and an ask price of 1.0219. The
difference is USD 0.0006 equal to 6 “pips”.

(F) Forward Exchange Rate Quotation

Forward contract or outright forward contractor merely outright is an

agreement between two counterparts to exchange currencies on a future date at
a rate fixed in the contract. Ideally, the way in which exchange rate for a forward
date [forward exchange rate] is quoted should be the same as that for spot date
e.g. if the spot rate is 61.53/54, then the [say six months] forward rate quoting
should look like say 61.93/98. However, the market convention is different.
Forward rate is not quoted as so and so exchange rate like this but always
quoted with spot rate and the forward margin separately. In other words,
forward quote is not a foreign exchange rate quotation but is quoted as a
difference between spot & forward rates.

The reader or user has to calculate the forward applicable rate by loading the
forward margin into the spot rate. Thus e.g. in the above case, the foreign
exchange dealer will quote the six month forward rate as 40/44. He will even
presume that the on-going spot rate is known to the counterparty and may not
even mention. Even if he were to mention, he will mention only 53/54, because
the ‘big figure’ [in this case, “61”] is supposed to be known to the counterparty
without ambiguity. Since the rate fluctuation is very high, the dealer has no time

Strategic Financial Management 51 Forex

CA – FINAL

to quote rates in very detailed English sentences and these conventions have
come into practice! The numbers 40 & 44 are arrived at as the differential
between 61.93 – 61.53 and 61.98 – 62.54 respectively.

These numbers 40 & 44 are called forward margins representing the factor by
which the forward rate is different from the spot rate i.e. the margin to be
‘loaded’ onto the spot rate. Though looks silly, it is worth reiterating that this
margin is not the profit margin of the trader!

If the price on a future date is higher, then the currency is said to be at forward
premium and then the number represents the forward premium for that
forward period. If the price on a future date is lower, then the currency is said to
be at forward discount and then the number represents the forward discount for
that forward period. In the above example, US dollar is at a premium and the
forward premium of USD for six months is 40/44 paise for buying and selling
rate respectively in the interbank market.

Generally, the margin is quoted in annualized percentage terms. E.g. in this case,
extrapolating the premium of six months to twelve months, it can be said that US
dollar is likely to have a premium of 80 paise per year [40 paise per six months
2] which means on a base rate of 61.53, the annualized premium
[=0.8*2*100/61.53] is 2.60% p.a.

In market parlance, forward premium is quoted in percentage terms and this is

the basis of calculation.

Actually, the forward market in foreign exchange is an interest rate market and
is not a foreign exchange market. Because it compares interest rate of one
currency with that of another over a period of time.

In fact some banks include FX forward traders under their interest rate segment
rather than FX segment.

Strategic Financial Management 52 Forex

CA – FINAL

(G) Forward point Determination

The number of ‘basis points’ from the spot rate to arrive at the forward rate in
the above discussions is also referred to as forward points. The points are added
to the spot rate when the [foreign] currency is at a premium and deducted from
the spot rate when the [foreign] currency is at a discount, to arrive at the
forward rate.

This is when the rates are quoted in direct method. In case of indirect rate
quotations, the process will be exactly the opposite. The forward point may be
positive or negative and marked accordingly or specifically mentioned so. The
forward points represent the interest rate differential between the two
currencies. E.g. if the spot exchange rate is GBP 1 = 1.6000 – 1.6010 USD and if
the outright forward points are 5-8, then the outright forward exchange rate
quote is GBP 1 = $ 1.6005 – 1.6018.

The number of forward points between the spot and forward is influenced by
the present and forward interest rates, the ‘length’ of the forward and other
market factors. Forward point is not a rate but a difference in the rate! Between
two currencies, the currency which carries lower interest rate is always at a
premium versus the other currency.

This is the same as stating that if a currency has a relatively higher ‘yield’, then
it will cost less in the forward market and a currency having lower yield will
cost more in the forward market. If there is an aberration to this, arbitration
opportunity arises, which itself will push the prices to equilibrium.

If the forward points are mentioned simply as 5/8, then a doubt arises as to
whether it is at premium, and hence has to be added or at discount and hence to
be deducted. The spot market always has the lowest bid- ask spread and the
spread will steadily widen as the duration lengthens.

This is because the uncertainty and the liquidity concerns increase as we go

forward in time. If we add 5/8 to the left and right side, the spread will widen
and hence fits into the argument.
Strategic Financial Management 53 Forex
CA – FINAL

Hence a quote such as 5/8 or 43/45 with increasing numbers from left to right
means the foreign currency is at premium. This looks like a workaround to
calculate but the reader can visualize the logic.

Forward points are equivalent to pips in the spot market which we discussed
earlier. They are quoted to an accuracy of 1/100thof one point. E.g. if EUR/USD
rates for spot and forward are 1.1323 & 1.1328, then the forward point is 5
because one pip or point is worth 0.0001 in EUR/USD.

(H) Broken Period Forward Rate

Interbank exchange rates are wholesale rates which are applicable to

transaction among banks and in the interbank market. They are for large
standard amounts with standardized due dates i.e. end of January, end of
February and so on.
However, in customer transactions, the amounts are not only smaller & for odd
amounts, but the due date could be also a non standardized one. There could be
an export bill for euro 12,345.67 getting realized on 10th January or
23rd February and so on.
Thus the forward rate that is available in the interbank market [in the form of
forward points for February, for March and so on] cannot be applied as such for
customer transactions. The broken period concept becomes relevant in such
situations.
On 1st January, if the spot rate for US Dollar is 62 and if the forward margin for
two months is 10 paise [premium], then the forward rate can be calculated as
` 62.10 per USD and any customer transaction exchange rate can be calculated
using this as the base rate.

Thus if the bank wishes to keep a margin of say 3 paise, it will quote a rate of
` 62.13 for an importer and quote a rate of ` 62.07 for an exporter for an end
February realizing bill. However, this logic is valid only for a bill to be realized
[for an exporter] or a bill to be paid [for an importer] on 28thFebruary because
the underlying forward rate was for two months on 1stJanuary i.e. the date of

Strategic Financial Management 54 Forex

CA – FINAL

28thFebruary. However, in customer transactions, the event [of converting FC

into INR or vice versa] does not always happen on the exact standard dates.
Thus if the bill is getting paid or is to be retired on 23rdFebruary, then the
forward points are to be calculated for such odd number of days starting from
1stJanuary.
It will be presumed [though there is no logical answer, in practice, it turns out
to be adequately accurate], that the forward points ‘grow’ uniformly throughout
and arithmetical proportionate for the applicable date is arrived at. E.g. in the
above instance, on 1stJanuary, the premium for a customer transaction
expected to happen on 23rd February is calculated as =10*53/59 = 8.98 paise
[53 & 59 are broken & full periods] and hence the exchange rate will be 62.0898.
As market convention, this will be rounded off to 62.09. The merchant forward
rate for a customer transaction expected to happen on 23rdFebruary will be this
margin loaded onto spot rate. Thus if the margin is 3 paise, the rate for an
exporter will be 62.06 & for an importer, the rate will be 62.12. This logic will be
applied even while calculating exchange rate for a third currency though the
calculation will be a bit lengthier.

(I) Merchant Rates

It is always interesting to know who ‘fixes’ the exchange rates as quoted to

customers and to realize that nobody fixes but the market decides the exchange
rate based on demand and supply and other relevant factors. RBI often clarifies
that it does not fix the exchange rates, though in the same breath, RBI also
clarifies that it monitors the ‘volatility’ of Indian rupee exchange rate. In other
words, RBI does not control the exchange rates but it controls the volatile
movement of INR exchange rate by intervention i.e. by deliberately altering the
demand and supply of the foreign currency say USD.

It does it by either buying USD from the interbank market or pumping in USD
into the market. This wholesale interbank market rate is the basis for banks’
exchange rates quoted to customers.

Strategic Financial Management 55 Forex

CA – FINAL

In foreign exchange market, banks consider customers as ‘merchants’ for

historical reasons. It may look ridiculous to call an NRI who has remitted dollars
to India as a merchant but exchange rates applied to all types of customers
including that for converting inward remittance in USD to INR are called
merchant rates as against the rates quoted to each other by banks in the
interbank market, which are called interbank rates. Why this term is important
here is because there are guidelines issued by FEDAI [Foreign Exchange Dealers
Association of India] to banks on these merchant rates as there is customer
service element involved in these.
Till 1998, FEDAI prescribed what ‘margins’ are to be loaded by banks onto the
on-going interbank exchange rate for quoting to customers i.e. to arrive at the
merchant rates. This was because; most customer affecting costs like interest
rates were then controlled by regulators.
As a part of liberalization, banks got the freedom to quote their own rates. Since
then, banks decide themselves what should be the margin depending on the
bank’s ‘position’. The only rule that is still existing in the FEDAI rule book is
rule 5A.8 which states that “Settlement of all merchant transactions shall be
effected on the principle of rounding off the Rupee amounts to the nearest whole
Rupee i.e., without paise”.
This means if an exporter or an individual has received USD 1234 and if the
applicable exchange rate is 61.32, then the amount to be credited to customer’s
account is ` 75669 and not ` 75668.88, less charges if any.

This rule will be similarly applicable for import or outward remittance

transactions also. This rule is more a matter of common sense and does not have
any meaningful impact on customer transactions. In fact in some of the banking
software, amount is always rounded off.
After the discontinuation of gold standard in 1971 by USA, the foreign exchange
market was in turmoil. Initially, RBI had kept sterling as the intervention
currency pegging the rupee exchange rate for historical reasons and due to
political legacy. Effective 1975, rupee was delinked from sterling and was linked
to a basket of currencies. It should be noted that the concept of RBI/FEDAI
advising the fixed exchange rate was discontinued long ago.

Strategic Financial Management 56 Forex

CA – FINAL

The sterling schedule was abolished from the beginning of 1984. FEDAI issued
detailed guidelines to banks on how to calculate exchange rates under the new
freedom, the minimum & maximum profit margin and the maximum spread
between the buying and selling rates. All these are now redundant now. There
were arguments for and against giving freedom to banks for loading margins by
banks themselves on the on-going interbank rate. However the liberalization
wave overruled the skeptics.

The International Division of any bank calculates the merchant rates for variety
of transactions like import bill, export bill, inward & outward remittance etc. and
advises the same in the morning with standard spread loaded to all branches. It
is called card rate. For a walk-in customer, for transactions of small value [what
is small varies with the bank], this is applied.

However, for regular customers and for transactions of high value, always a
better rate is sought from the dealing room. Card rates advised in the margin are
generally not changed unless there is too much volatility.

3. Explain the Various Methods of Exchange Rate Forecasting.

The foreign exchange market has changed dramatically over the past few years.
The amounts traded each day in the foreign exchange market are now huge. In
this increasingly challenging and competitive market, investors and traders need
tools to select and analyze the right data from the vast amounts of data available
to them to help them make good decisions. Corporates need to do the exchange
rate forecasting for taking decisions regarding hedging, short-term financing,
short- term investment, capital budgeting, earnings assessments and long-term
financing.

Techniques of Exchange Rate Forecasting: There are numerous methods

available for forecasting exchange rates. They can be categorized into four
general groups- technical, fundamental, market-based, and mixed.

Strategic Financial Management 57 Forex

CA – FINAL

(a) Technical Forecasting:

It involves the use of historical data to predict future values. For example time
series models. Speculators may find the models useful for predicting day-to-day
movements. However, since the models typically focus on the near future and
rarely provide point or range estimates, they are of limited use to MNCs.

(b) Fundamental Forecasting:

It is based on the fundamental relationships between economic variables and

exchange rates. For example subjective assessments, quantitative measurements
based on regression models and sensitivity analyses.

In general, fundamental forecasting is limited by:

 The uncertain timing of the impact of the factors,
 The need to forecast factors that have an immediate impact on exchange
rates,
 The omission of factors that are not easily quantifiable, and
 Changes in the sensitivity of currency movements to each factor over time.

(c) Market-Based Forecasting:

It uses market indicators to develop forecasts. The current spot/forward rates are
often used, since speculators will ensure that the current rates reflect the market
expectation of the future exchange rate.

(d) Mixed Forecasting:

It refers to the use of a combination of forecasting techniques. The actual forecast is

a weighted average of the various forecasts developed.

Strategic Financial Management 58 Forex

CA – FINAL

4. Write Short Notes on :

(A) Interest Rate Parity

(B) Purchasing Power Parity
(C) International Fisher Effect

There are three theories of exchange rate determination- Interest rate parity,
Purchasing power parity and International Fisher effect.

(A) Interest Rate Parity (IRP)

Interest rate parity is a theory which states that ‘the size of the forward premium
(or discount) should be equal to the interest rate differential between the two
countries of concern”. When interest rate parity exists, covered interest arbitrage
(means foreign exchange risk is covered) is not feasible, because any interest rate
advantage in the foreign country will be offset by the discount on the forward rate.
Thus, the act of covered interest arbitrage would generate a return that is no higher
than what would be generated by a domestic investment.

The Covered Interest Rate Parity equation is given by:

F
1  rD   1  rF 
S

Where,
(r + rD)= Amount that an investor would get after a unit period by investing a
F
rupee in the domestic market at rD rate of interest and 1  rF  is the amount
S
that an investor by investing in the foreign market at rF that the investment of
one rupee yield same return in the domestic as well as in the foreign market.

S1
The Uncovered Interest Rate Parity equation is given by: r  rD  1  rF 
S

Strategic Financial Management 59 Forex

CA – FINAL

Where,
S1 = Expected future spot rate when the receipts denominated in foreign
currency is converted into domestic currency.
Thus, it can be said that Covered Interest Arbitrage has an advantage as there is
an incentive to invest in the higher-interest currency to the point where the
discount of that currency in the forward market is less than the interest
differentials. If the discount on the forward market of the currency with the
higher interest rate becomes larger than the interest differential, then it pays to
invest in the lower-interest currency and take advantage of the excessive
forward premium on this currency.

(B) Purchasing Power Parity (PPP)

Why is a dollar worth ` 48.80, JPY 122.18, etc. at some point in time? One
possible answer is that these exchange rates reflect the relative purchasing
powers of the currencies, i.e. the basket of goods that can be purchased with a
dollar in the US will cost ` 48.80 in India and ¥ 122.18 in Japan.
Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’
relationship. There are two forms of PPP theory:-
The ABSOLUTE FORM, also called the ‘Law of One Price’ suggests that “prices of
similar products of two different countries should be equal when measured in a
common currency”. If a discrepancy in prices as measured by a common
currency exists, the demand should shift so that these prices should converge.
An alternative version of the absolute form that accounts for the possibility of
market imperfections such as transportation costs, tariffs, and quotas embeds
the sectoral constant. It suggests that ‘because of these market imperfections,
prices of similar products of different countries will not necessarily be the same
when measured in a common currency.’ However, it states that the rate of
change in the prices of products should be somewhat similar when measured in
a common currency, as long as the transportation costs and trade barriers are
unchanged.
PD
In Equilibrium Form: S  
PE

Strategic Financial Management 60 Forex

CA – FINAL

Where,
S(`/$) = spot rate
PD = is the price level in India, the domestic market.
PF = is the price level in the foreign market, the US in this case.
α = Sectoral price and sectoral shares constant.

For example, A cricket bat sells for ` 1000 in India. The transportation cost of
one bat from Ludhiana to New York costs ` 100 and the import duty levied by
the US on cricket bats is ` 200 per bat. Then the sectoral constant for adjustment
would be 1000/1300 = 0.7692.

It becomes extremely messy if one were to deal with millions of products and
millions of constants. One way to overcome this is to use a weighted basket of
goods in the two countries represented by an index such as Consumer Price
Index. However, even this could break down because the basket of goods
consumed in a country like Finland would vary with the consumption pattern in
a country such as Malaysia making the aggregation an extremely complicated
exercise.

The RELATIVE FORM of the Purchasing Power Parity tries to overcome the
problems of market imperfections and consumption patterns between different
countries. A simple explanation of the Relative Purchase Power Parity is given
below:

Assume the current exchange rate between INR and USD is ` 50/$1. The
inflation rates are 12% in India and 4% in the US. Therefore, a basket of
goods in India, let us say costing now ` 50 will cost one year hence
` 50  1.12 = ` 56.00.A similar basket of goods in the US will cost USD 1.04 one
year from now. If PPP holds, the exchange rate between USD and INR, one year
hence, would be ` 56.00 = $1.04. This means, the exchange rate would be
` 53.8462/ $1, one year from now.

Strategic Financial Management 61 Forex

CA – FINAL

This can also be worked backwards to say what should have been the exchange
rate one year before, taking into account the inflation rates during last year and
the current spot rate.

Expected spot rate = Current Spot Rate x expected difference in inflation rates

E  S1   S0 
1  1d 
1  1f 

Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
According to Relative PPP, any differential exchange rate to the one propounded
by the theory is the ‘real appreciation’ or ‘real depreciation’ of one currency over
the other. For example, if the exchange rate between INR and USD one year ago
was ` 45.00. If the rates of inflation in India and USA during the last one year
were 10% and 2% respectively, the spot exchange rate between the two
currencies today should be
S0 = 45.00  (1+10%)/(1+2%) = ` 48.53

However, if the actual exchange rate today is ` 50.00, then the real appreciation
of the USD against INR is ` 1.47, which is 1.47/45.00 = 3.27%.

And this appreciation of the USD against INR is explained by factors other than
inflation.

PPP is more closely approximated in the long run than in the short run, and
when disturbances are purely monetary in character.

Strategic Financial Management 62 Forex

CA – FINAL

(C) International Fisher Effect (IFE)

International Fisher Effect theory uses interest rate rather than inflation rate
differentials to explain why exchange rates change over time, but it is closely
related to the Purchasing Power Parity (PPP) theory because interest rates are
often highly correlated with inflation rates.
According to the International Fisher Effect, ‘nominal risk-free interest rates
contain a real rate of return and anticipated inflation’. This means if investors of
all countries require the same real return, interest rate differentials between
countries may be the result of differential in expected inflation.
The IFE theory suggests that foreign currencies with relatively high interest
rates will depreciate because the high nominal interest rates reflect expected
inflation. The nominal interest rate would also incorporate the default risk of an
investment.
The IFE equation can be given by:
rD – PD = rF – PF
or
PD – PF = ΔS = rD –rF

The above equation states that if there are no barriers to capital flows the
investment will flow in such a manner that the real rate of return on investment
will equalize. In fact, the equation represents the interaction between real
sector, monetary sector and foreign exchange market.
If the IFE holds, then a strategy of borrowing in one country and investing the
funds in another country should not provide a positive return on average. The
reason is that exchange rates should adjust to offset interest rate differentials on
the average. As we know that purchasing power has not held over certain
periods, and since the International Fisher Effect is based on Purchasing Power

Strategic Financial Management 63 Forex

CA – FINAL

Parity (PPP). It does not consistently hold either, because there are factors other
than inflation that affect exchange rates, the exchange rates do not adjust in
accordance with the inflation differential.

5. What Is a Foreign Exchange Market and Mention:

(A) What are the four Levels of Market

Participants?
(B) What are the four Categories of Market
Participants?

The foreign exchange market is the market in which individuals, firms and banks
buy and sell foreign currencies or foreign exchange. The purpose of the foreign
exchange market is to permit transfers of purchasing power denominated in one
currency to another i.e. to trade one currency for another. For example, a Japanese
exporter sells automobiles to a US dealer for dollars, and a US manufacturer sells
machine tools to Japanese company for yen. Ultimately, however, the US Company
will be interested in receiving dollars, whereas the Japanese exporter will want yen.
Because it would be inconvenient for the individual buyers and sellers of foreign
exchange to seek out one another, a foreign exchange market has developed to act
as an intermediary.
Transfer of purchasing power is necessary because international trade and capital
transactions usually involve parties living in countries with different national
currencies. Each party wants to trade and deal in his own currency but since the
trade can be invoiced only in a single currency, the parties mutually agree on a
currency beforehand. The currency agreed could also be any convenient third
country currency such as the US dollar. For, if an Indian exporter sells machinery to
a UK importer, the exporter could invoice in pound, rupees or any other convenient
currency like the US dollar.
But why do individuals, firms and banks want to exchange one national currency
for another? The demand for foreign currencies arises when tourists visit another
country and need to exchange their national currency for the currency of the
country they are visiting or when a domestic firm wants to import from other
nations or when an individual wants to invest abroad and so on. On the other hand,
a nation's supply of foreign currencies arises from foreign tourist expenditures in
the nation, from export earnings, from receiving foreign investments, and so on.

Strategic Financial Management 64 Forex

CA – FINAL

For example, suppose a US firm exporting to the UK is paid in pounds sterling (the
UK currency). The US exporter will exchange the pounds for dollars at a
commercial bank. The commercial bank will then sell these pounds for dollars to a
US resident who is going to visit the UK or to a United States firm that wants to
import from the UK and pay in pounds, or to a US investor who wants to invest
in the UK and needs the pounds to make the investment.
Thus, a nation's commercial banks operate as clearing houses for the foreign
exchange demanded and supplied in the course of foreign transactions by the
nation's residents. Hence, four levels of transactor or participants can be identified
in foreign exchange markets. At the first level, are tourists, importers, exporters,
investors, etc. These are the immediate users and suppliers of foreign currencies. At
the next or second level are the commercial banks which act as clearing houses
between users and earners of foreign exchange. At the third level are foreign
exchange brokers through whom the nation's commercial banks even out their
foreign exchange inflows and outflows among themselves. Finally, at the fourth and
highest level is the nation's central bank which acts as the lender or buyer of last
resort when the nation's total foreign exchange earnings and expenditures are
unequal. The central bank then either draws down its foreign exchange reserves or
adds to them.
Market Participants
The participants in the foreign exchange market can be categorized as follows:

(i) Non-bank Entities

Many multinational companies exchange currencies to meet their import or

export commitments or hedge their transactions against fluctuations in exchange
rate. Even at the individual level, there is an exchange of currency as per the needs
of the individual.

(ii) Banks:

Banks also exchange currencies as per the requirements of their clients.

Strategic Financial Management 65 Forex

CA – FINAL

(iii) Speculators:

This category includes commercial and investment banks, multinational companies

and hedge funds that buy and sell currencies with a view to earn profit due to
fluctuations in the exchange rates.

(iv) Arbitrageurs:

This category includes those investors who make profit from price differential
existing in two markets by simultaneously operating in two different markets.

(v) Governments:

The governments participate in the foreign exchange market through the central
banks. They constantly monitor the market and help in stabilizing the exchange
rates.

6. Explain Foreign Exchange Exposure. What are the three

types of Exposures? Explain each in detail.

“An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow

whose magnitude is not certain at the moment. The magnitude depends on the
value of variables such as Foreign Exchange rates and Interest rates.”

In other words, exposure refers to those parts of a company’s business that would
be affected if exchange rate changes. Foreign exchange exposures arise from many
different activities.

For example, travellers going to visit another country have the risk that if that
country's currency appreciates against their own their trip will be more expensive.

Strategic Financial Management 66 Forex

CA – FINAL

An exporter who sells his product in foreign currency has the risk that if the value
of that foreign currency falls then the revenues in the exporter's home currency
will be lower.
An importer who buys goods priced in foreign currency has the risk that the
foreign currency will appreciate thereby making the local currency cost greater
than expected.
Fund Managers and companies who own foreign assets are exposed to fall in the
currencies where they own the assets. This is because if they were to sell those
assets their exchange rate would have a negative effect on the home currency
value.
Other foreign exchange exposures are less obvious and relate to the exporting and
importing in ones local currency but where exchange rate movements are affecting
the negotiated price.

Types of Exposures

The foreign exchange exposure may be classified under three broad categories:

Types of Exposures

Translation exposure Operating exposure

Accounting-based changes Change in expected cash
in consolidated financial flows arising because of an
statements caused by a unexpected change in
change in exchange rates exchange rates

Transaction exposure
Impact of setting outstanding obligations
entered into before change in exchange
rates but to be settled after the change in
exchange rates

Strategic Financial Management 67 Forex

CA – FINAL

Transaction Exposure

It measures the effect of an exchange rate change on outstanding obligations that

existed before exchange rates changed but were settled after the exchange rate
changes. Thus, it deals with cash flows that result from existing contractual
obligations.
Example: If an Indian exporter has a receivable of $100,000 due in six months
hence and if the dollar depreciates relative, to the rupee a cash loss occurs.
Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs.

The above example illustrates that whenever a firm has foreign currency
denominated receivables or payables, it is subject to transaction exposure and their
settlements will affect the firm’s cash flow position.

It measures the changes in the value of outstanding financial obligation incurred

prior to a change in exchange rates but not due to be settled until after the
exchange rates change.

Thus, it deals with the changes in the cashflow which arise from existing
contractual obligation.

In fact, the transaction exposures are the most common ones amongst all the
exposures. Let’s take an example of a company which exports to US, and the export
receivables are also denominated in USD. While doing budgeting the company had
assumed USDINR rate of 62 per USD. By the time the exchange inward remittance
arrives. USDINR could move down to 57 leading to wiping off of commercial profit
for exporter. Such transaction exposures arise whenever a business has foreign
currency denominated receipts or payments. The risk is an adverse movement of
the exchange rate from the time the transaction is budgeted till the time the
exposure is extinguished by sale or purchase of the foreign currency against the
domestic currency.

Strategic Financial Management 68 Forex

CA – FINAL

Translation Exposure

Also known as accounting exposure, it refers to gains or losses caused by the

translation of foreign currency assets and liabilities into the currency of the parent
company for consolidation purposes.

Translation exposure, also called as accounting exposure, is the potential for

accounting derived changes in owner’s equity to occur because of the need to
“translate” foreign currency financial statements of foreign subsidiaries into a
single reporting currency to prepare worldwide consolidated financial statements.

Translation exposures arise due to the need to “translate” foreign currency assets
and liabilities into the home currency for the purpose of finalizing the accounts for
any given period. A typical example of translation exposure is the treatment of
foreign currency loans.

Consider that a company has taken a medium term loan to finance the import of
capital goods worth dollars 1 million. When the import materialized, the exchange
rate was, say, USD/INRR-55. The imported fixed asset was, therefore, capitalized in
the books of the company at ` 550 lacs through the following accounting entry:

Debit fixed assets ` 550 lacs

Credit dollar loan ` 550 lacs

In the ordinary course, and assuming no change in the exchange rate, the company
would have provided depreciation on the asset valued at ` 550 lacs, for finalizing
its account for the year in which the asset was purchased.

However, what happens if at the time of finalization of the accounts the exchange
rate has moved to say USD/INR-58. Now the dollar loan will have to be “translated”
at ` 58, involving a “translation loss” of a ` 30 lacs. It shall have to be capitalized by
increasing the book value of the asset, thus making the figure ` 580 lacs and
consequently higher depreciation will have to be provided, thus reducing the net
profit.

Strategic Financial Management 69 Forex

CA – FINAL

It will be readily seen that both transaction and translation exposures affect the
bottom line of a company. The effect could be positive as well if the movement is
favourable – i.e., in the cited examples, in case the USD would have appreciated in
case of Transaction Exposure example, or the USD would have depreciated in case
of Translation Exposure, for example, against the rupee.

An important observation is that the translation exposure, of course, becomes a

transaction exposure at some stage: the dollar loan has to be repaid by undertaking
the transaction of purchasing dollars.

Economic Exposure

It refers to the extent to which the economic value of a company can decline due to
changes in exchange rate. It is the overall impact of exchange rate changes on the
value of the firm. The essence of economic exposure is that exchange rate changes
significantly alter the cost of a firm’s inputs and the prices of its outputs and
thereby influence its competitive position substantially.

7. Write In Brief on Various Currency Risk Hedging Instruments.

There are a range of hedging instruments that can be used to reduce risk. Broadly
these techniques can be divided into

(A) Internal Techniques: These techniques explicitly do not involve transaction

costs and can be used to completely or partially offset the exposure. These
techniques can be further classified as follows:

(i) Invoicing in Domestic Currency:

Companies engaged in exporting and importing, whether of goods or services, are

concerned with decisions relating to the currency in which goods and services are
invoked. Trading in a foreign currency gives rise to transaction exposure. Although

Strategic Financial Management 70 Forex

CA – FINAL

trading purely in a company's home currency has the advantage of simplicity, it

fails to take account of the fact that the currency in which goods are invoiced has
become an essential aspect of the overall marketing package given to the customer.
Sellers will usually wish to sell in their own currency or the currency in which they
incur cost. This avoids foreign exchange exposure. But buyers' preferences may be
for other currencies. Many markets, such as oil or aluminum, in effect require that
sales be made in the same currency as that quoted by major competitors, which
may not be the seller's own currency. In a buyer's market, sellers tend increasingly
to invoice in the buyer's ideal currency. The closer the seller can approximate the
buyer's aims, the greater chance he or she has to make the sale.

Should the seller elect to invoice in foreign currency, perhaps because the
prospective customer prefers it that way or because sellers tend to follow
market leader, then the seller should choose only a major currency in which
there is an active forward market for maturities at least as long as the payment
period. Currencies, which are of limited convertibility, chronically weak, or with
only a limited forward market, should not be considered.

The seller’s ideal currency is either his own, or one which is stable relative to it.
But often the seller is forced to choose the market leader’s currency. Whatever
the chosen currency, it should certainly be one with a deep forward market. For
the buyer, the ideal currency is usually its own or one that is stable relative to it,
or it may be a currency of which the purchaser has reserves.

(ii) Leading and Lagging:

Leading and Lagging refer to adjustments in the times of payments in foreign

currencies. Leading is the payment before due date while lagging is delaying
payment past the due date. These techniques are aimed at taking advantage of
expected devaluation and/or revaluation of relevant currencies. Lead and lag
payments are of special importance in the event that forward contracts remain
inconclusive. For example, Subsidiary b in B country owes money to subsidiary a
in country A with payment due in three months’ time, and with the debt
denominated in US dollar. On the other side, country B’s currency is expected to

Strategic Financial Management 71 Forex

CA – FINAL

devalue within three months against US dollar, vis-à-vis country A’s currency.
Under these circumstances, if company b leads -pays early - it will have to part
with less of country B’s currency to buy US dollars to make payment to company
A. Therefore, lead is attractive for the company.

When we take reverse the example-revaluation expectation- it could be attractive

for lagging.

(iii) Netting:

Netting involves associated companies, which trade with each other. The
technique is simple. Group companies merely settle inter affiliate indebtedness for
the net amount owing. Gross intra-group trade, receivables and payables are netted
out. The simplest scheme is known as bilateral netting and involves pairs of
companies. Each pair of associates nets out their own individual positions with
each other and cash flows are reduced by the lower of each company's purchases
from or sales to its netting partner. Bilateral netting involves no attempt to bring in
the net positions of other group companies.

Netting basically reduces the number of inter company payments and receipts
which pass over the foreign exchanges. Fairly straightforward to operate, the main
practical problem in bilateral netting is usually the decision about which currency
to use for settlement.

Netting reduces banking costs and increases central control of inter company
settlements. The reduced number and amount of payments yield savings in terms
of buy/sell spreads in the spot and forward markets and reduced bank charges.

(iv) Matching:

Although netting and matching are terms, which are frequently used
interchangeably, there are distinctions. Netting is a term applied to potential flows
within a group of companies whereas matching can be applied to both intra-group
and to third-party balancing.

Strategic Financial Management 72 Forex

CA – FINAL

Matching is a mechanism whereby a company matches its foreign currency inflows

with its foreign currency outflows in respect of amount and approximate timing.
Receipts in a particular currency are used to make payments in that currency
thereby reducing the need for a group of companies to go through the foreign
exchange markets to the unmatched portion of foreign currency cash flows.

The prerequisite for a matching operation is a two-way cash flow in the same
foreign currency within a group of companies; this gives rise to a potential for
natural matching. This should be distinguished from parallel matching, in which the
matching is achieved with receipt and payment in different currencies but these
currencies are expected to move closely together, near enough in parallel.

Both Netting and Matching presuppose that there are enabling Exchange Control
regulations. For example, an MNC subsidiary in India cannot net its receivable(s)
and payable(s) from/to its associated entities. Receivables have to be received
separately and payables have to be paid separately.

(v) Price Variation:

Price variation involves increasing selling prices to counter the adverse effects of
exchange rate change. This tactic raises the question as to why the company has
not already raised prices if it is able to do so. In some countries, price increases are
the only legally available tactic of exposure management.

Let us now concentrate to price variation on inter company trade. Transfer pricing
is the term used to refer to the pricing of goods and services, which change hands
within a group of companies. As an exposure management technique, transfer price
variation refers to the arbitrary pricing of inter company sales of goods and
services at a higher or lower price than the fair price, arm’s length price. This fair
price will be the market price if there is an existing market or, if there is not, the
price which would be charged to a third party customer. Taxation authorities,
customs and excise departments and exchange control regulations in most
countries require that the arm’s length pricing be used.

Strategic Financial Management 73 Forex

CA – FINAL

(vi) Asset and Liability Management:

This technique can be used to manage balance sheet, income statement or cash
flow exposures. Concentration on cash flow exposure makes economic sense but
emphasis on pure translation exposure is misplaced. Hence our focus here is on
asset liability management as a cash flow exposure management technique.

In essence, asset and liability management can involve aggressive or defensive

postures. In the aggressive attitude, the firm simply increases exposed cash
inflows denominated in currencies expected to be strong or increases exposed
cash outflows denominated in weak currencies. By contrast, the defensive
approach involves matching cash inflows and outflows according to their
currency of denomination, irrespective of whether they are in strong or weak
currencies.

(B) External Techniques: Under this category range of various financial

products are used which can be categorized as follows:

(i) Money Market Hedging:

At its simplest, a money market hedge is an agreement to exchange a certain

amount of one currency for a fixed amount of another currency, at a particular
date. For example, suppose a business owner in India expects to receive 1
Million USD in six months. This Owner could create an agreement now (today)
to exchange 1Million USD for INR at roughly the current exchange rate. Thus, if
the USD dropped in value by the time the business owner got the payment, he
would still be able to exchange the payment for the original quantity of U.S.
dollars specified.

Advantages and Disadvantages of Money Market Hedge: Following are the

advantages and disadvantages of this technique of hedging.

Strategic Financial Management 74 Forex

CA – FINAL

Advantages
(a) Fixes the future rate, thus eliminating downside risk exposure
(b) Flexibility with regard to the amount to be covered
(c) Money market hedges may be feasible as a way of hedging for currencies
where forward contracts are not available.

Disadvantages include:
(a) More complicated to organise than a forward contract
(b) Fixes the future rate - no opportunity to benefit from favourable movements
in exchange rates.

(ii) Derivative Instruments:

A derivatives transaction is a bilateral contract or payment exchange agreement

whose value depends on - derives from - the value of an underlying asset, reference
rate or index. Today, derivatives transactions cover a broad rang of underlying -
interest rates, exchange rates, commodities, equities and other indices.

In addition to privately negotiated, global transactions, derivatives also include

standardized futures and options on futures that are actively traded on organized
exchanges and securities such as call warrants.

The term derivative is also used to refer to a wide variety of other instruments.
These have payoff characteristics, which reflect the fact that they include
derivatives products as part of their make- up.

Transaction risk can also be hedged using a range of financial derivatives products
which include: Forwards, futures, options, swaps, etc. These instruments are
discussed in detailed manner in following pages.

Strategic Financial Management 75 Forex

CA – FINAL

8. Explain the Risk Hedging Strategies

A company’s attitude towards risk, financial strength, nature of business,

vulnerability to adverse movements, etc shapes its exposure management
strategies. There can be no single strategy which is appropriate to all businesses.
Four separate strategy options are feasible for exposure management.
High Risk

All
Exposures Active
Left Trading
Unhedged

Low Reward High Reward

All Selective
Exposures Hedging
Hedged

Low Risk

Exposure Management Strategies

Low Risk: Low Reward

This option involves automatic hedging of exposures in the forward market as soon
as they arise, irrespective of the attractiveness or otherwise of the forward rate.
The merits of this approach are that yields and costs of the transaction are known
and there is little risk of cash flow destabilization. Again, this option doesn't require
any investment of management time or effort. The negative side is that automatic
hedging at whatever rates are available is hardly likely to result into optimum

Strategic Financial Management 76 Forex

CA – FINAL

costs. At least some management seems to prefer this strategy on the grounds that
an active management of exposures is not really their business. In the floating rate
era, currencies outside their home countries, in terms of their exchange rate, have
assumed the characteristics of commodities. And business whose costs depend
significantly on commodity prices can hardly afford not to take views on the price
of the commodity. Hence this does not seem to be an optimum strategy.

Low Risk: Reasonable Reward

This strategy requires selective hedging of exposures whenever forward rates are
attractive but keeping exposures open whenever they are not. Successful pursuit of
this strategy requires quantification of expectations about the future and the
rewards would depend upon the accuracy of the prediction. This option is similar
to an investment strategy of a combination of bonds and equities with the
proportion of the two components depending on the attractiveness of prices. In
foreign exchange exposure terms, hedged positions are similar to bonds (known
costs or yields) and unhedged ones to equities (uncertain returns).

High Risk: Low Reward

Perhaps the worst strategy is to leave all exposures unhedged. The risk of
destabilization of cash flows is very high. The merit is zero investment of
managerial time or effort.

High Risk: High Reward

This strategy involves active trading in the currency market through continuous
cancellations and re-bookings of forward contracts. With exchange controls relaxed
in India in recent times, a few of the larger companies are adopting this strategy. In
effect, this requires the trading function to become a profit centre. This strategy, if it
has to be adopted, should be done in full consciousness of the risks.


Strategic Financial Management 77 Forex