FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.6710.

67

Forward purchase contract cancelled 30,000

Remitted by TT 75,000
Draft on Zurich cancelled 30,000
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?

ANSWERS/ SOLUTIONS
Answers to Theoretical Questions
1. Please refer paragraph 10.
2. Please refer paragraph 4.
Answers to the Practical Questions
1. Here we can assume two cases (i) If investor is US investor then there will be no impact of
appreciation in $. (ii) If investor is from any other nation other than US say Indian then there
will be impact of $ appreciation on his returns.
First we shall compute return on bond which will be common for both investors.
(Price at end - Price at begining)+ Interest
Return =
Price at begining

(5250 − 5000) + 350

=
5000
250 + 350
= =0.12 say 12%
5000
(i) For US investor the return shall be 12% and there will be no impact of appreciation in $.
(ii) If $ appreciate by 2% then return for non-US investor shall be:
(1+0.12)(1+0.02) -1 =1.12X1.02 - 1 = 0.1424 i.e. 14.24%
2. Here Canara Bank shall buy US$ and credit ` to Vostro account of ABN-Amro Bank. Canara
Bank’s buying rate will be based on the Inter-bank Buying Rate (as this is the rate at which
Canara Bank can sell US$ in the Interbank market)
Accordingly, the Interbank Buying Rate of US$ will be ` 51.3625 (lower of two) i.e. (1/51.3625) =
$ 0.01947/`

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10.68 ADVANCED FINANCIAL MANAGEMENT

Equivalent of US$ for ` 15 million at this rate will be

15,000,000
= = US$ 2,92,041.86
51.3625
or = 15,000,000 x $ 0.01947 = US$ 2,92,050
3. To purchase Rupee, XYZ LTD Bank shall first sell £ and purchase $ and then sell $ to
purchase Rupee. Accordingly, rate (£/`)ask shall be used.
The available rates are as follows:
($/£)bid = $1.5260
($/£)ask = $1.5270
(`/$)bid = ` 61.3625
(`/$)ask = ` 61.3700
From above available rates we can compute required rate as follows:
(£/`)ask = (£/$)ask x ($/`)ask
= (1/1.5260) x (1/61.3625)
= £ 0.01068 or £ 0.0107
Thus, amount of £ to be credited
= ` 25,000,000 x £ 0.0107
= £ 267,500
2.50 (1 + 0.075)
4. Forward Rate = = Can$ 2.535/£
(1 + 0.060)

(i) If spot rate decline by 2%

Spot Rate = Can$ 2.50 x 1.02 = Can$ 2.55/£

£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239

£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.55) 1,96,078

Gain due to forward contract 1,161

(ii) If spot rate gains by 4%

Spot Rate = Can$ 2.50 x 0.96 = Can$ 2.40/£

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.6910.69

£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.40) 2,08,333
Loss due to forward contract 11,094

(iii) If spot rate remains unchanged

£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.50) 2,00,000
Loss due to forward contract 2,761

5. (i) Swap Points for 2 months and 15 days

Bid Ask
Swap Points for 2 months (a) 70 90
Swap Points for 3 months (b) 160 186
Swap Points for 30 days (c) = (b) – (a) 90 96
Swap Points for 15 days (d) = (c)/2 45 48
Swap Points for 2 months & 15 days (e) = (a) + (d) 115 138

(ii) Foreign Exchange Rates for 20th June 2016

Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 months & 15 days (b) 0.0115 0.0138
66.2640 67.6083

(iii) Annual Rate of Premium

Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rates for 66.2640 67.6083
20 th June 2016 (b)
Premium (c) 0.0115 0.0138
Total (d) = (a) + (b) 132.5165 135.2028
Average (d) / 2 66.2583 67.6014

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10.70 ADVANCED FINANCIAL MANAGEMENT

Premium 0.0115 12 0.0138 12

× × 100 × × 100
66.2583 2.5 67.6014 2.5
= 0.0833% = 0.0980%

6. Since the direct quote for ¥ and ` is not available it will be calculated by cross exchange rate
as follows:
`/$ x $/¥ = `/¥
62.22/102.34 = 0.6080
Spot rate on date of export 1¥ = ` 0.6080
Expected Rate of ¥ for August 2014 = ` 0.5242 (` 65/¥124)
Forward Rate of ¥ for August 2014 = ` 0.6026 (` 66.50/¥110.35)
(i) Calculation of expected loss without hedging

Value of export at the time of export (` 0.6080 x ¥10,000,000) ` 60,80,000

Estimated payment to be received on Aug. 2014 (` 0.5242 x ` 52,42,000
¥10,000,000)
Loss ` 8,38,000

Hedging of loss under Forward Cover

` Value of export at the time of export (` 0.6080 x ` 60,80,000

¥10,000,000)
Payment to be received under Forward Cover (` 0.6026 x ` 60,26,000
¥10,000,000)
Loss ` 54,000

By taking forward cover loss is reduced to ` 54,000.

(ii) Actual Rate of ¥ on August 2014 = ` 0.5977 (` 66.25/¥110.85)

Value of export at the time of export (` 0.6080 x ` 60,80,000

¥10,000,000)
Estimated payment to be received on Aug. 2014 (` 0.5977 x ` 59,77,000
¥10,000,000)
Loss ` 1,03,000

The decision to take forward cover is still justified.

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.7110.71

7. The bank (Dealer) covers itself by buying from the market at market selling rate.
Rupee – Dollar selling rate = ` 42.85
Dollar – Hong Kong Dollar = HK $ 7.5880
Rupee – Hong Kong cross rate = ` 42.85 / 7.5880
= ` 5.6471
Profit / Loss to the Bank
Amount received from customer (1 crore × 5.70) ` 5,70,00,000
Amount paid on cover deal (1 crore × 5.6471) ` 5,64,71,000
Profit to Bank ` 5,29,000
8. Amount realized on selling Danish Kroner 10,00,000 at ` 6.5150 per Kroner = ` 65,15,000.
Cover at London:
Bank buys Danish Kroner at London at the market selling rate.
Pound sterling required for the purchase (DKK 10,00,000 ÷ DKK 11.4200) = GBP 87,565.67
Bank buys locally GBP 87,565.67 for the above purchase at the market selling rate of
` 74.3200.
The rupee cost will be = ` 65,07,88
Profit (` 65,15,000 - ` 65,07,881) = ` 7,119
Cover at New York:
Bank buys Kroners at New York at the market selling rate.
Dollars required for the purchase of Danish Kroner (DKK10,00,000 ÷ 7.5670) = USD
1,32,152.77
Bank buys locally USD 1,32,152.77 for the above purchase at the market selling rate of
` 49.2625.
The rupee cost will be = ` 65,10,176.
Profit (` 65,15,000 - ` 65,10,176) = ` 4,824
The transaction would be covered through London which gets the maximum profit of
` 7,119 or lower cover cost at London Market by (` 65,10,176 - ` 65,07,881) = ` 2,295
9. On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = `45.90
Pound 1 = US$ 1.7850

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10.72 ADVANCED FINANCIAL MANAGEMENT

Pound 1 = SGD 3.1575

` 45.90 * 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = `25.9482
Add: Exchange margin (0.125%) ` 0.0324
` 25.9806
On February 4, 2013 the rates are
US $ = ` 45.97
Pound 1 = US$ 1.7775
Pound 1 = SGD 3.1380
` 45.97 * 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ` 26.0394
Add: Exchange margin (0.125%) ` 0.0325
` 26.0719
Hence, loss to the importer
= SGD 25,00,000 (`26.0719 – `25.9806)= `2,28,250
10. (i) Net exposure of each foreign currency in Rupees

Inflow Outflow Net Inflow Spread Net Exposure

(Millions) (Millions) (Millions) (Millions)
US$ 40 20 20 0.81 16.20
FFr 20 8 12 0.67 8.04
UK£ 30 20 10 0.41 4.10
Japan Yen 15 25 -10 -0.80 8.00

(ii) In Japanese Yen, the net exposure is payable, and the forward rate is quoted at a
discount, effectively offsetting the position. Likewise, in the remaining currencies, the
net exposures are in receivables, and the related currencies are at a premium,
offsetting the positions in their respective currencies.
11. (i) US $ required to get ` 25 lakhs after 2 months at the Rate of ` 47/$
` 25,00,000
∴ = US $ 53191.489
` 47

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(ii) ` required to get US$ 2,00,000 now at the rate of ` 46.25/$

∴ US $ 200,000 × ` 46.25 = ` 92,50,000
(iii) Encashing US $ 69000 Now Vs 2 month later
Proceed if we can encash in open mkt $ 69000 × `46 = ` 31,74,000
Opportunity gain
10 2
= 31,74,000 × × ` 52,900
100 12
Likely sum at end of 2 months 32,26,900
Proceeds if we can encash by forward rate :
$ 69000 × `47.00 32,43,000
It is better to encash the proceeds after 2 months and get opportunity gain.
12. (i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the applicable ` 57.10
forward rate for 1 USD
Payment Due USD 2,000,000
Outflow in Rupees (USD 2000000 × ` 57.10) ` 114,200,000
Add: Interest on loan for 30 days@10% p.a. ` 9,51,667
Total Outflow in ` ` 11,51,51,667

(ii) Availing supplier’s offer of 90 days credit

Amount Payable USD 2,000,000
Add: Interest on credit period for 30 days@8% p.a. USD 13,333
Total Outflow in USD USD 2,013,333
Applicable forward rate for 1 USD ` 57.50
Total Outflow in ` (USD 2,013,333 ×` 57.50) ` 115,766,648

Alternative 1 is better as it entails lower cash outflow.

13. The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy ` from USD 10,000,000 At Mumbai 48.30 × 10,000,000 `483,000,000
` 483,000,000
(ii) Convert these ` to GBP at London ( ) GBP 6,230,650.155
` 77.52

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10.74 ADVANCED FINANCIAL MANAGEMENT

(iii) Convert GBP to USD at New York GBP 6,230,650.155 × 1.6231 USD 10,112,968.26
There is net gain of USD 10,112968.26 less USD 10,000,000 i.e. USD 112,968.26
14. (i) Under the given circumstances, the USD is expected to quote at a premium in India
as the interest rate is higher in India.
(ii) Calculation of the forward rate:
1 + R h F1
=
1 + R f Eo

Where: Rh is home currency interest rate, Rf is foreign currency interest rate, F1 is end
of the period forward rate, and Eo is the spot rate.
1 + ( 0.10/2 ) F1
Therefore =
1 + ( 0.04 / 2 ) 55.50

1 + 0.05 F1
=
1 + 0.02 55.50
1.05
or × 55.50 =
F1
1.02
58.275
or = F1
1.02
or F1 = `57.13
(iii) Rate of premium:
57.13 - 55.50 12
× × 100 =
5.87%
55.50 6
15. (i) Calculation of expected spot rate for September, 2009:

$ for £ Probability Expected $/£

(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38
2.00 0.20 0.40
1.00 EV = 1.81

Therefore, the expected spot value of $ for £ for September, 2009 would be $ 1.81.

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.7510.75

(ii) If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximised by retaining its pounds receivable.
16.

USD/ ` on 3rd September 49.3800

Swap Point for October 0.1300
49.5100
USD/ SGD on 3rd September 1.7058
Swap Point for 2nd month Forward 0.0096
1.7154
SGD/ ` (49.5100/ 1.7154) 28.8621
Add: Exchange Margin 0.0500
28.9121

Thus, Cross Rate for SGD/ ` of 30th October shall be ` 28.9121.

17. Spot rate of ` 1 against yen = 108 lakhs yen/` 30 lakhs = 3.6 yen
3 months forward rate of Re. 1 against yen = 3.3 yen
Anticipated decline in Exchange rate = 10%.
Expected spot rate after 3 months = 3.6 yen – 10% of 3.6 = 3.6 yen – 0.36 yen = 3.24 yen
per rupee
` (in lakhs)
Present cost of 108 lakhs yen 30.00
Cost after 3 months: 108 lakhs yen/ 3.24 yen 33.33
Expected exchange loss 3.33
If the expected exchange rate risk is hedged by a Forward contract:
Present cost 30.00
Cost after 3 months if forward contract is taken 108 lakhs yen/ 3.3 yen 32.73
Expected loss 2.73
Suggestion: If the exchange rate risk is not covered with forward contract, the expected
exchange loss is ` 3.33 lakhs. This could be reduced to ` 2.73 lakhs if it is covered with
Forward contract. Hence, taking forward contract is suggested.
18. Firstly, the interest is calculated at 3% p.a. for 6 months. That is:

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10.76 ADVANCED FINANCIAL MANAGEMENT

USD 20,00,000 × 3/100 × 6/12 = USD 30,000

From the forward points quoted, it is seen that the second figure is less than the first, this
means that the currency is quoted at a discount.
(i) The value of the total commitment in Indian rupees is calculated as below:
Principal Amount of loan USD 20,00,000
Add: Interest USD 30,000
Amount due USD 20,30,000
Spot rate ` 48.5275
Forward Points (6 months) (–) 0.0700
Forward Rate ` 48.4575
Value of Commitment ` 9,83,68,725

(ii) It is seen from the forward rates that the market expectation is that the dollar will
depreciate. If the firm's own expectation is that the dollar will depreciate more than
what the bank has quoted, it may be worthwhile not to cover forward and keep the
exposure open.
If the firm has no specific view regarding future dollar price movements, it would be better to
cover the exposure. This would freeze the total commitment and insulate the firm from undue
market fluctuations. In other words, it will be advisable to cut the losses at this point of time.
Given the interest rate differentials and inflation rates between India and USA, it would be
unwise to expect continuous depreciation of the dollar. The US Dollar is a stronger currency
than the Indian Rupee based on past trends and it would be advisable to cover the exposure.
19. (i) Rate of discount quoted by the bank
(45.20 - 45.60) × 365 × 100
= = 5.33%
45.60 × 60
(ii) Probable loss of operating profit:
(45.20 – 45.50) × 1,00,000 = ` 30,000
20. Buy £ 62500 × 1.2806 = $ 80037.50
Sell £ 62500 × 1.2816 = $ 80100.00
Profit $ 62.50
Alternatively, if the market comes back together before December 15, the dealer could unwind
his position (by simultaneously buying £ 62,500 forward and selling a futures contract. Both
for delivery on December 15) and earn the same profit of $ 62.5.

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21. If importer pays now, he will have to buy US$ in Spot Market by availing overdraft facility.
Accordingly, the outflow under this option will be
`
Amount required to purchase $130000[$130000 X `48.36] 6286800
Add: Overdraft Interest for 3 months @15% p.a. 235755
6522555
If importer makes payment after 3 months then, he will have to pay interest for 3 months @
5% p.a. for 3 month along with the sum of import bill. Accordingly, he will have to buy $ in
forward market. The outflow under this option will be as follows:
$
Amount of Bill 130000
Add: Interest for 3 months @5% p.a. 1625
131625
Amount to be paid in Indian Rupee after 3 month under the forward purchase contract
` 6427249 (US$ 131625 X ` 48.83)
Since outflow of cash is least in (ii) option, it should be opted for.
22. (i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the applicable ` 63.15
forward rate for 1 USD
Payment Due USD 1 crore
Outflow in Rupees (USD 1 crore × ` 63.15) ` 63.15 crore
Add: Interest on loan for 30 days@9.5% p.a. ` 0.50 crore
Total Outflow in ` ` 63.65 crore
(ii) Availing supplier’s offer of 90 days credit
Amount Payable USD 1.00000 crore
Add: Interest on credit period for 30 days@7.75% p.a. USD 0.00646 crore
Total Outflow in USD USD 1.00646 crore
Applicable forward rate for 1 USD ` 63.45
Total Outflow in ` (USD 1.00646 crore ×` 63.45) ` 63.86 crore

Alternative 1 is better as it entails lower cash outflow.

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23.

(`)
Present Exchange Rate `65 = 1 US$
If company purchases US$ 60,000 forward premium is
60000 × 64 × 2% 76,800
Interest on `76,800 for 6 months at 12% 4,608
Total hedging cost 81,408
If exchange rate is `68
Then gain (`68 – `64) for US$ 60,000 2,40,000
Less: Hedging cost 81,408
Net gain 1,58,592
If US$ = `62
Then loss (`64 – `62) for US$ 60,000 1,20,000
Add: Hedging Cost 81,408
Total Loss 2,01,408
If US$ = `70
Then Gain (`70 – `64) for US$ 60,000 3,60,000
Less: Hedging Cost 81,408
Total Gain 2,78,592
If US$ = `65
Then Gain (` 65 – ` 64) for US$ 60,000 60,000
Less: Hedging Cost 81,408
Net Loss 21,408

24. If foreign exchange risk is hedged

Total
(` )
Sum due Yen 78,00,000 US$1,02,300 Euro 95,920
Unit input price Yen 650 US$10.23 Euro 11.99
Unit sold 12000 10000 8000
Variable cost per unit ` 225/- ` 395/- ` 510/-
Variable cost ` 27,00,000 ` 39,50,000 ` 40,80,000 ` 1,07,30,000

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.7910.79

Three months forward 2.427 0.0216 0.0178

rate for selling
Rupee value of receipts `32,13,844 ` 47,36,111 ` 53,88,764 ` 1,33,38,719
Contribution `5,13,844 ` 7,86,111 ` 13,08,764 ` 26,08,719
Average contribution to 19.56%
sale ratio
If risk is not hedged
Rupee value of receipt `31,72,021 ` 47,44,898 ` 53,58,659 ` 1,32,75,578
Total contribution ` 25,45,578
Average contribution to 19.17%
sale ratio

AKC Ltd. Is advised to hedge its foreign currency exchange risk.

25. Receipts using a forward contract = $10,000,000/0.016129 = ` 620,001,240
Receipts using currency futures
The number of contracts needed is ($10,000,000/0.016118)/24,816,975 = 25

Initial margin payable is 25 contracts x ` 22,500 = ` 5,62,500

On April 1,2015Close at 0.016134
Receipts = US$10,000,000/0.016136 = ` 619,732,276
Variation Margin =
[(0.016134 – 0.016118) x 25 x 24,816,975/-]/0.016136
OR (0.000016x 25 x 24,816,975)/.016136 = 9926.79/0.016136 = ` 615,195

Less: Interest Cost – ` 5,62,500x 0.07 x 3/12 = ` 9,844

Net Receipts ` 620,337,627
Receipts under different methods of hedging

Forward contract ` 620,001,240

Futures ` 620,337,627
No hedge (US$ 10,000,000/0.016136) ` 619,732,276
The most advantageous option would have been to hedge with futures.

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26.
Spot Rate = `40,00,000 /US$83,312 = 48.0123
Forward Premium on US$ = [(48.8190 – 48.0123)/48.0123] x 12/6 x 100
= 3.36%

Interest rate differential = 12% - 8% = 4%

Since the negative Interest rate differential is greater than forward premium there is a
possibility of arbitrage inflow into India.
The advantage of this situation can be taken in the following manner:
1. Borrow US$ 83,312 for 6 months
Amount to be repaid after 6 months
= US $ 83,312 (1+0.08 x 6/12) = US$86,644.48
2. Convert US$ 83,312 into Rupee and get the principal i.e. `40,00,000
Interest on Investments for 6 months – `40,00,000/- x 0.06 = `2,40,000/-
Total amount at the end of 6 months = `(40,00,000 + 2,40,000) = `42,40,000/-
Converting the same at the forward rate
= `42,40,000/ `48.8190= US$ 86,851.43
Hence the gain is US $ (86,851.43 – 86,644.48) = US$ 206.95 OR
`10,103 i.e., ($206.95 x `48.8190)

27. In this case, DM is at a premium against the Can$.

Premium = [(0.67 – 0.665) /0.665] x (12/3) x 100 = 3.01 per cent
Interest rate differential = 9% - 7% = 2 per cent.
Since the interest rate differential is smaller than the premium, it will be profitable to place
money in Deutschmarks the currency whose 3-months interest is lower.
The following operations are carried out:
(i) Borrow Can$ 1000 at 9 per cent for 3- months;
(ii) Change this sum into DM at the spot rate to obtain DM
= (1000/0.665) = 1503.76

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.8110.81

(iii) Place DM 1503.76 in the money market for 3 months to obtain a sum of DM
Principal: 1503.76
Add: Interest @ 7% for 3 months = 26.32
Total 1530.08
(iv) Sell DM at 3-months forward to obtain Can$= (1530.08x0.67) = 1025.15
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Add: Interest @9% for 3 months 22.50
Total 1022.50
Net arbitrage gain = 1025.15 – 1022.50 = Can$ 2.65
28. The only thing lefts Rohit and Bros to cover the risk in the money market. The following steps
are required to be taken:
(i) Borrow pound sterling for 3- months. The borrowing has to be such that at the end of
three months, the amount becomes £ 500,000. Say, the amount borrowed is £ x.
Therefore

x 1 + 0.05 × 3  = 500,000 or x = £493,827

 12 

(ii) Convert the borrowed sum into rupees at the spot rate. This gives: £493,827 × ` 56 =
` 27,654,312
(iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the
end of 3- months:

S = ` 27,654,312 × 1 + 0.12 × 3  = ` 28,483,941

 12 

(iv) The sum of £500,000 received from the client at the end of 3- months is used to refund
the loan taken earlier.

From the calculations. It is clear that the money market operation has resulted into a
net gain of ` 483,941 (` 28,483,941 – ` 500,000 × 56).
If pound sterling has depreciated in the meantime. The gain would be even bigger.

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29. Identify: Foreign currency is an asset. Amount $ 3,50,000.

Create: $ Liability.
Borrow: In $. The borrowing rate is 9% per annum or 2.25% per quarter.
Amount to be borrowed: 3,50,000 / 1.0225 = $ 3,42,298.29
Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely, 1.5905 per £,
(Note: This is an indirect quote). Amount of £s received on conversion is 2,15,214.27
(3,42,298.29/1.5905).
Invest: £ 2,15,214.27 will be invested at 5% for 3 months and get £ 2,17,904.45
Settle: The liability of $3,42,298.29 at interest of 2.25 per cent quarter matures to $3,50,000
receivable from customer.
Using forward rate, amount receivable is = 3,50,000 / 1.6140 = £2,16,852.54
Amount received through money market hedge = £2,17,904.45
Gain = 2,17,904.45 – 2,16,852.54 = £1,051.91
So, money market hedge is beneficial for the exporter
30.

End of Year ` `/USD

1 (1+ 0.08) 47.77
`46.00 x
(1+ 0.04)
2 (1+ 0.08) 49.61
`47.77 x
(1+ 0.04)
3 (1+ 0.08) 51.52
`49.61 x
(1+ 0.04)
4 (1+ 0.08) 53.50
`51.52 x
(1+ 0.04)

31. As per interest rate parity

 1 + in A 
S1 = S0  
 1 + in B 

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.8310.83

 1 + (0.075) × 3 
S1 = £0.7570  12 
 1 + (0.035) × 3 
 12 

 1.01875 
= £0.7570  
 1.00875 
= £0.7570 × 1.0099 = £0.7645
= UK £0.7645 / US$
32. (i) The contract is to be cancelled on 30-10-2010 at the spot buying rate of US$ 1
= ` 41.5000
Less: Margin Money 0.075% = ` 0.0311
= ` 41.4689 or ` 41.47
US$ 20,000 @ ` 41.47 = ` 8,29,400

US$ 20,000 @ ` 42.32 = ` 8,46,400

The difference in favour of the Bank/Cost to the importer ` 17,000
(ii) The Rate of New Forward Contract
Spot Selling Rate US$ 1 = ` 41.5200
Add: Premium @ 0.93% = ` 0.3861
= ` 41.9061
Add: Margin Money 0.20% = ` 0.0838
= ` 41.9899 or ` 41.99
33. (i) Forward Cover
1
3-month Forward Rate = = ` 0.5070/JY
1.9726
Accordingly, INR required for JY 5,00,000 (5,00,000 X ` 0.5070) ` 2,53,500
(ii) Option Cover
To purchase JY 5,00,000, XYZ LTD shall enter into a Put Option @ JY 2.125/INR

Accordingly, outflow in INR  JY 5,00,000  ` 2,35,294

 2.125 

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 2.84
10.84 ADVANCED FINANCIAL MANAGEMENT

Premium  INR 2,35,294 × 0.098  ` 11,815

 1.9516 

` 2,47,109
Since outflow of cash is least in case of Option same should be opted for. Further if
price of INR goes above JY 2.125/INR the outflow shall further be reduced.
34. The company can hedge position by selling future contracts as it will receive amount from
outside.

Number of Contracts = $4,00,000 = 400 contracts

$1,000

Gain by trading in futures = (` 45 – ` 44.50) 4,00,000= ` 2,00,000

Net Inflow after after 3 months = ` 44.50 x ` 4,00,000+ 2,00,000 = ` 1,80,00,000
` 1,80,00,000
Effective Price realization = = ` 45 Per US$
$ 4,00,000
35. Option - I
$20 x 5000 = $ 1,00,000
Repayment in 3 months time = $1,00,000 x (1 + 0.10/4) = $ 1,02,500
3-months outright forward rate = ` 59.90/ ` 60.30
Repayment obligation in ` ($1,02,500 X ` 60.30) = ` 61,80,750
Option - II
Overdraft ($1,00,000 x ` 60.55) ` 60,55,000
Interest on Overdraft (` 60,55,000 x 0.14/4) ` 2,11,925
` 62,66,925
Option I should be preferred as it has lower outflow.
36. Forward Market Cover
Hedge the risk by buying Can$ in 1 and 3 months time will be:
July - 1010000 X 0.9501 = US $ 959601
Sept. - 705000 X 0.9556 = US $ 673698
Option Contracts
July Payment = 1010000/ 50,000 = 20.20
September Payment = 705000/ 50,000 = 14.10

© The Institute of Chartered Accountants of India

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.8510.85

Company would like to take out 20 contracts for July and 14 contracts for September
respectively. Therefore costs, if the options were exercised, will be:

July Sept.

Can $ US $ Can $ US $

Covered by Contracts 1000000 940000 700000 665000

Balance bought at spot rate 10000 9501 5000 4778
Option Costs:

Can $ 50000 x 20 x 0.0102 10200 ---

Can $ 50000 x 14 x 0.0164 --- 11480

Total cost in US $ of using Option Contract 959701 681258

Decision: As the firm is stated as risk averse and the money due to be paid is certain, a fixed
forward contract, being the cheapest alternative in the both the cases, would be
recommended.
37. (i) Receipt under three proposals
(a) Proposal of Mr. Peter
€ 2.8 million
Invoicing in £ will produce = = £ 2.340 million
1.1965
(b) Proposal of Mr. Wilson
Forward Rate = € 1.1970-0.0055 = 1.1915
€ 2.8 million
Using Forward Market hedge Sterling receipt would be =
1.1915
£ 2.35 million
(c) Proposal of Ms. Karen
The equivalent sterling of the order placed based on future price (€1.1943)
€ 2.8 million
= = £ 2,344,470 (rounded off)
1.1943
£2,344,470
Number of Contracts = = 37 Contracts (to the nearest whole number)
62,500

Thus, € amount hedged by future contract will be = 37 × £ 62,500 = £ 23,12,500

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 2.86
10.86 ADVANCED FINANCIAL MANAGEMENT

Buy Future at € 1.1943

Sell Future at € 1.1873
€ 0.0070
Total loss on Future Contracts = 37 × £ 62,500 × € 0.0070 = € 16,188
After 6 months
Amount Received € 28,00,000
Less: Loss on Future Contracts € 16,188
€ 27,83,812
Sterling Receipts
€ 27,83,812
On sale of € at spot = = £ 2.3446 million
1.1873
(ii) Proposal of option (b) is preferable because the option (a) & (c) produces least
receipts. Further, in case of proposal (a) there must be a doubt as to whether this
would be acceptable to German firm as it is described as a competitive market and
Zaz is moving into it first time.
38. £ Exposure
Since Columbus has a £ receipt (£ 138,000) and payment of (£ 480,000) maturing at the
same time i.e. 3 months, it can match them against each other leaving a net liability of £
342,000 to be hedged.
(i) Forward market hedge
Buy 3 months' forward contract accordingly, amount payable after 3 months will be
£ 342,000 / 0.9520 = US$ 359,244
(ii) Money market hedge
To pay £ after 3 months' Columbus shall requires to borrow in US$ and translate to £
and then deposit in £.
For payment of £ 342,000 in 3 months (@2.5% interest) amount required to be
deposited now (£ 342,000 ÷ 1.025) = £ 333,658
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
Loan repayable after 3 months (@3.25% interest) will be = US$ 350,460
In this case the money market hedge is a cheaper option.

© The Institute of Chartered Accountants of India

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.8710.87

€ Receipt
Amount to be hedged = € 590,000
(i) Forward market hedge
Sell 4 months' forward contract accordingly, amount
receivable after 4 months will be (€ 590,000 x1.9510) = US$ 1,151,090
(ii) Money market hedge
For money market hedge Columbus shall borrow in
€ and then translate to US$ and deposit in US$
For receipt of € 590,000 in 4 months (@ 5.33% interest)
amount required to be borrowed now (€590,000 ÷ 1.0533) = € 560,144
With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113
Deposit amount will increase over 4 months
(@3.83% interest) will be = US$ 1,098,639
In this case, more will be received in US$ under the forward hedge.
39. (a) Forward contract: Dollar needed in 180 days = £3,00,000 x $ 1.96 = $5,88,000/-
(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in 180 days
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081
Amount of $ needed to convert into £ = 2,87,081 x 2 = $ 5,74,162
Interest and principal on $ loan after 180 days = $5,74,162 x 1.055 = $ 6,05,741
(c) Call option:
Expected Prem./ Exercise Total Total price Prob. Pi pixi
Spot rate in unit Option price per for
180 days unit £3,00,000xi
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200
2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
5,94,900
Add: Interest on Premium @ 5.5% (12,000 x 5.5%) 660
5,95,560
* ($1.97 + $0.04)

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 2.88
10.88 ADVANCED FINANCIAL MANAGEMENT

(d) No hedge option:

Expected Future Dollar needed Prob. Pi Pi xi

spot rate Xi
1.91 5,73,000 0.25 1,43,250
1.95 5,85,000 0.60 3,51,000
2.05 6,15,000 0.15 92,250
5,86,500

The probability distribution of outcomes for no hedge strategy appears to be most

preferable because least number of $ are needed under this option to arrange
£3,00,000.
40. In the given case, the exchange rates are indirect. These can be converted into direct rates
as follows:
Spot rate

GBP = 1 1
to
USD 1.5617 USD 1.5673

USD = GBP 0.64033 - GBP 0.63804

6 months’ forward rate

GBP = 1 1
to
USD 1.5455 USD 1.5609

USD = GBP 0.64704 - GBP 0.64066

Payoff in 3 alternatives
i. Forward Cover
Amount payable USD 3,64,897
Forward rate GBP 0.64704
Payable in GBP GBP 2,36,103
ii. Money market Cover
Amount payable USD 3,64,897
1 USD 3,56,867
PV @ 4.5% for 6 months i.e. = 0.9779951
1.0225

Spot rate purchase GBP 0.64033

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.8910.89

Borrow GBP 3,56,867 x 0.64033 GBP 2,28,512

Interest for 6 months @ 7 % 7,998
-
Payable after 6 months GBP 2,36,510

iii. Currency options

Amount payable USD 3,64,897
Unit in Options contract GBP 12,500
Value in USD at strike rate of 1.70 (GBP 12,500 x 1.70) USD 21,250
Number of contracts USD 3,64,897/ USD 21,250 17.17
Exposure covered USD 21,250 x 17 USD 3,61,250
Exposure to be covered by Forward (USD 3,64,897 – USD USD 3,647
3,61,250)
Options premium 17 x GBP 12,500 x 0.096 USD 20,400
Premium in GBP (USD 20,400 x 0.64033) GBP 13,063
Total payment in currency option
Payment under option (17 x 12,500) GBP 2,12,500

Premium payable GBP 13,063

Payment for forward cover (USD 3,647 x 0.64704) GBP 2,360
GBP 2,27,923
Thus total payment in:
(i) Forward Cover 2,36,103 GBP

(ii) Money Market 2,36,510 GBP

(iii) Currency Option 2,27,923 GBP
The company should take currency option for hedging the risk.
Note: Even interest on Option Premium can also be considered in the above solution.

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 2.90
10.90 ADVANCED FINANCIAL MANAGEMENT

41. (i) Receipt under three proposals

(a) Invoicing in Sterling
€ 4 million
Invoicing in £ will produce = = £3398471
1.1770
(b) Use of Forward Contract
Forward Rate = €1.1770 + 0.0060 = 1.1830
€ 4 million
Using Forward Market hedge Sterling receipt would be
1.1830
= £ 3381234
(c) Use of Future Contract
The equivalent sterling of the order placed based on future price (€1.1760)
€ 4.00 million
= = £ 3401360
1.1760
£3401360
Number of Contracts = = 54 Contracts (to the nearest whole
62,500
number)
Thus, € amount hedged by future contract will be = 54 × £62,500
= £3375000
Buy Future at €1.1760
Sell Future at €1.1785
€0.0025
Total profit on Future Contracts = 54 × £62,500 × €0.0025 = €8438
After 6 months
Amount Received € 4000000
Add: Profit on Future Contracts € 8438
€ 4008438
Sterling Receipts
€ 4008438
On sale of € at spot = = €3401305
1.1785
(ii) Proposal of option (c) is preferable because the option (a) & (b) produces least
receipts.

© The Institute of Chartered Accountants of India

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.9110.91

42. Option I (To finance the purchases by availing loan at 18% per annum):

Cost of equipment ` in lakhs

3400 lakh yen at `100 = 340 yen 1,000.00
Add: Interest at 4.5% I Quarter 45.00
Add: Interest at 4.5% II Quarter (on `1045 lakhs) 47.03
Total outflow in Rupees 1,092.03
Alternatively, interest may also be calculated on compounded basis, i.e.,
`1000 × [1.045]² `1092.03

Option II (To accept the offer from foreign branch):

Cost of letter of credit

At 1 % on 3400 lakhs yen at `100 = 340 yen ` 10.00 lakhs
Add: Interest for 2 Quarters ` 0.90 lakhs
(A) ` 10.90 lakhs
Payment at the end of 180 days:
Cost 3400.00 lakhs yen
Interest at 2% p.a. [3400 × 2/100 × 180/365] 33.53 lakhs yen
3433.53 lakhs yen
Conversion at `100 = 345 yen [3433.53 / 345 ×100] (B) ` 995.23 lakhs
Total Cost: (A) + (B) ` 1006.13 lakhs

Advise: Option 2 is cheaper by (1092.03 – 1006.13) lakh or ` 85.90 lakh. Hence, the offer
may be accepted.
43. (A) To cover payable and receivable in forward Market
Amount payable after 3 months $7,00,000
Forward Rate ` 48.45
Thus Payable Amount (`) (A) ` 3,39,15,000
Amount receivable after 2 months $ 4,50,000
Forward Rate ` 48.90
Thus Receivable Amount (`) (B) ` 2,20,05,000
Interest @ 12% p.a. for 1 month (C) ` 2,20,050
Net Amount Payable in (`) (A) – (B) – (C) ` 1,16,89,950

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 2.92
10.92 ADVANCED FINANCIAL MANAGEMENT

(B) Assuming that since the forward contract for receivable was already booked it shall be
cancelled if we lag the receivables. Accordingly, any profit/ loss on cancellation of
contract shall also be calculated and shall be adjusted as follows:
Amount Payable ($) $7,00,000
Amount receivable after 3 months $ 4,50,000
Net Amount payable $2,50,000
Applicable Rate ` 48.45
Amount payable in (`) (A) ` 1,21,12,500
Profit on cancellation of Forward cost ` 2,70,000
(48.90 – 48.30) × 4,50,000 (B)
Thus, net amount payable in (`) (A) + (B) ` 1,18,42,500
Since net payable amount is least in case of first option, hence the company should cover
payable and receivables in forward market.
Note: In the question it has not been clearly mentioned that whether quotes given for 2 and
3 months (in points terms) are premium points or direct quotes. Although above solution is
based on the assumption that these are direct quotes, but students can also consider them
as premium points and solve the question accordingly.
44. The contract would be cancelled at the one-month forward sale rate of ` 27.52.

`
Francs bought from customer under original forward contract at: 27.25
It is sold to him on cancellation at: 27.52
Net amount payable by customer per Franc 0.27

At ` 0.27 per Franc, exchange difference for CHF 10,000 is ` 2,700.

Loss to the Customer:
Exchange difference (Loss) ` 2,700
Note: The exchange commission and other service charges are ignored.
45. First the contract will be cancelled at TT Selling Rate
USD/ Rupee Spot Selling Rate ` 49.4455
Add: Premium for April ` 0.4200
` 49.8655

© The Institute of Chartered Accountants of India

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.9310.93

Add: Exchange Margin @ 0.10% ` 0.04987

` 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (`49.91537/1.5150) ` 32.9474
Rounded Off ` 32.9475
Bank buys Sw. Fcs. Under original contract ` 32.4000
Bank Sells under Cancellation ` 32.9475
Difference payable by customer ` 00.5475
Exchange difference of Sw. Fcs. 1,00,000 payable by customer ` 54,750
(Sw. Fcs. 1,00,000 x ` 0.5475)
46. The amount of EURO bought by selling US$
US$ 10,00,000 * EURO 1.4400 = EURO 14,40,000
The amount of EURO sold for buying USD 10,00,000 * 1.4450 = EURO 14,45,000
Net Loss in the Transaction = EURO 5,000
To acquire EURO 5,000 from the market @
(a) USD 1 = EURO 1.4400 &
(b) USD1 = INR 31.4500
Cross Currency buying rate of EUR/INR is ` 31.4500 / 1.440 i.e. ` 21.8403
Loss in the Transaction ` 21.8403 * 5000 = ` 1,09,201.50
Alternatively, if delivery to be affected then computation of loss shall be as follows:
EURO to be surrendered to acquire $ 10,00,000 = EURO 14,45,000
EURO to be received after selling $ 10,00,000 = EURO 14,40,000
Loss = EURO 5,000
To acquire EURO 5,000 from market @
US $ 1 = EURO 1.4400
US $ 1 = INR 31.45
31.45
Cross Currency = = ` 21.8403
1.440
Loss in Transaction (21.8403 x EURO 5,000) = ` 1,09,201.50

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 2.94
10.94 ADVANCED FINANCIAL MANAGEMENT

47. (i) To Buy 1 Million GBP Spot against CHF

1. First to Buy USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655
2. Then to Buy GBP against USD at a cheaper rate i.e. from Bank B 1 GBP
= USD 1.7650
By applying chain rule Buying rate would be
1 GBP = 1.7650 * 1.4655 CHF
1 GBP = CHF 2.5866
Amount payable CHF 2.5866 Million or CHF 25,86,600
(ii) Spot rate Bid rate GBP 1 = CHF 1.4650 * 1.7645 = CHF 2.5850
Offer rate GBP 1 = CHF 1.4655 * 1.7660 = CHF 2.5881
GBP / USD 3 months swap points are at discount
Outright 3 Months forward rate GBP 1 = USD 1.7620 / 1.7640
USD / CHF 3 months swap points are at premium
Outright 3 Months forward rate USD 1 = CHF 1.4655 / 1.4665
Hence
Outright 3 Months forward rate GBP 1 = CHF 2.5822 / 2.5869
Spot rate GBP 1 = CHF 2.5850 / 2.5881
Therefore 3-month swap points are at discount of 28/12.
48. (i) Profit at current exchange rates
2400 [€ 500 × ` 51.50 – (S$ 800 × ` 27.25 + ` 1,000 + ` 1,500)]
2400 [` 25,750 - ` 24,300] = ` 34,80,000
Profit after change in exchange rates
2400[€500× ` 52 – (S$ 800 × ` 27.75 + ` 1000 + ` 1500)]
2400[` 26,000 - ` 24,700] = ` 31,20,000
LOSS DUE TO TRANSACTION EXPOSURE
` 34,80,000 – ` 31,20,000 = ` 3,60,000
(ii) Profit based on new exchange rates
2400[` 25,000 - (800 × ` 27.15 + ` 1,000 + ` 1,500)]

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.9510.95

2400[` 25,000 - ` 24,220] = ` 18,72,000

Profit after change in exchange rates at the end of six months
2400 [` 25,000 - (800 × ` 27.75 + ` 1,000 + ` 1,500)]
2400 [` 25,000 - ` 24,700] = ` 7,20,000
Decline in profit due to transaction exposure
` 18,72,000 - ` 7,20,000 = ` 11,52,000
` 25,000
Current price of each unit in € = = € 485.44
` 51.50
` 25,000
Price after change in Exch. Rate = = € 483.09
` 51.75
Change in Price due to change in Exch. Rate
€ 485.44 - € 483.09 = € 2.35 or (-) 0.48%
Price elasticity of demand = 1.5
Increase in demand due to fall in price 0.48 × 1.5 = 0.72%
Size of increased order = 2400 ×1.0072 = 2417 units

Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,000 + ` 1,500)]

= 2417 [ ` 25,000 - ` 24,700] = ` 7,25,100
Therefore, decrease in profit due to operating exposure
` 18,72,000 – ` 7,25,100 = ` 11,46,900
Alternatively, if it is assumed that Fixed Cost shall not be changed with change in units
then answer will be as follows:
Fixed Cost = 2400[` 1,000] = ` 24,00,000
Profit = 2417 [ ` 25,000 – (800 × ` 27.75 + ` 1,500)] – ` 24,00,000
= 2417 ( ` 1,300) – ` 24,00,000 = ` 7,42,100
Therefore, decrease in profit due to operating exposure ` 18,72,000 – ` 7,42,100
= ` 11,29,900
49. (i) If investment is made at London
Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) = £ 3,24,886
Add: £ Interest for 3 months on £ 324,886 @ 5% =£ 4,061

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 2.96
10.96 ADVANCED FINANCIAL MANAGEMENT

= £ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
= $ 5,05,000
Equivalent amount of £ required to pay the
above sum ($ 5,05,000/1.5430*) = £ 3,27,285
Arbitrage Profit =£ 1,662
(ii) If investment is made at New York
Gain $ 5,00,000 (8% - 4%) x 3/12 = $ 5,000
Equivalent amount in £ 3 months ($ 5,000/ 1.5475) £ 3,231
(iii) If investment is made at Frankfurt
Convert US$ 500,000 at Spot Rate (Cross Rate) 1.8260/1.5390= € 1.1865
Euro equivalent US$ 500,000 = € 5,93,250
Add: Interest for 3 months @ 3% =€ 4,449
= € 5,97,699
3 month Forward Rate of selling € (1/1.8150) = £ 0.5510
Sell € in Forward Market € 5,97,699 x £ 0.5510 = £ 3,29,332
Less: Amounted invested and interest thereon = £ 3,27,285
Arbitrage Profit = £ 2,047
Since out of three options the maximum profit is in case investment is made in New
York. Hence it should be opted.
* Due to conservative outlook.
50. (a) The following swap arrangement can be entered by Drilldip.
(i) Swap a US$ loan today at an agreed rate with any party to obtain Indian
Rupees (`) to make initial investment.
(ii) After one year swap back the Indian Rupees with US$ at the agreed rate.
In such case the company is exposed only on the profit earned from the
project.

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 2.9710.97

(b) With the swap

Year 0 Year 1
(Million US$) (Million US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Swap ` 500 crore back at agreed rate of ` 50 ---- 100.00
Sell ` 240 crore at 1US$ = ` 54 ---- 44.44
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 136.44

Net result is a net receipt of US$ 36.44 million.

Without the swap

Year 0 Year 1(Million

(Million US$) US$)
Buy ` 500 crore at spot rate of 1US$ = ` 50 (100.00) ----
Sell ` 740 crore at 1US$ = ` 54 ---- 137.04
Interest on US$ loan @8% for one year ---- (8.00)
(100.00) 129.04

Net result is a net receipt of US$ 29.04 million.

Decision: Since the net receipt is higher in swap option the company should opt for
the same.
51. Exchange Position:

Particulars Purchase Sw. Sale Sw.

Fcs. Fcs.
Opening Balance Overbought 50,000
Bill on Zurich 80,000
Forward Sales – TT 60,000
Cancellation of Forward Contract 30,000
TT Sales 75,000
Draft on Zurich cancelled 30,000 —
1,60,000 1,65,000
Closing Balance Oversold 5,000 —
1,65,000 1,65,000

© The Institute of Chartered Accountants of India

 2.98
10.98 ADVANCED FINANCIAL MANAGEMENT

Cash Position (Nostro A/c)

Credit Debit
Opening balance credit 1,00,000 —
TT sales — 75,000
1,00,000 75,000
Closing balance (credit) — 25,000
1,00,000 1,00,000

The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account to
Sw. Fcs. 30,000.
This would bring down the oversold position on Sw. Fcs. as Nil.
Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy forward Sw. Fcs.
10,000.

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India
© The Institute of Chartered Accountants of India