Questions on DSE 5.

2: International Finance

Questions on Foreign exchange market

Q1.
The exchange rates are quoted for maturity of one month, two months, three
months, etc. using swap points as shown below:
Currency pair Spot One month Two months Three months
forward forward forward
$/Euro 0.9158/50 30/40 60/85 100/90

Calculate the forward rates for one, two, and three months forward.
Solution:
Here spot rate is 0.9158/50 which implies spot buying rate is $0.9158 per euro
and spot selling rate is $0.9208 per euro since the last two digits of buying rate
are replaced by 50.
In order to determine, the forward rate, we shall see the relationship between
numerator and denominator of the forward period.
When Numerator<Denominator this is the case of premium,
and when Numerator>Denominator this is the case of discount.
Like, in the case of one month forward, numerator (30) is smaller than
denominator (40), then these points are to be added to the respective figures of
spot buying and selling rates. So, one month forward buying rate becomes 0.9188
(0.9158 + 0.0030) and one month selling rate becomes 0.92480 (0.9208 +.0040).
Here the forward rate figures are greater than spot rate figures therefore we Oct
say forward rate is at premium vis-à-vis spot rate.
Similarly, second month rate would be (0.9158+0.0060 = 0.9218 and 0.9208+
0.0085 = 0.9293) and
In the third month, there is a case of discount, and the rates would be (0.9158-
0.0100 = 0.9058 and 0.9208- 0.0090 = 0.9118)
Q2.
A foreign exchange trader gives the following quotes for the ₹vs. Dollar spot,
one month, two month and three months to a US based treasurer.
Spot rate (₹/$) 82.32 82.53
One-month forward 0.05 0.09
Two-months forward 0.07 0.03
Three months forward 0.08 0.06

Calculate the outright quotes for one, two and three months forward. Also
calculate spread and spread percentage (based on selling as well as buying price)
at these periods.
Solution:
Here we have given the trader quotation, buying rate (Bid rate) and selling rate
(Ask rate) at spot which is ₹82.32/1$ and ₹82.53/1$ respectively.
In order to determine one month forward rate we shall add the one month forward
rate to the spot rate
One month forward
Ask (Selling) = 82.53+0.09=82.62
Bid (Buying) = 82.32+0.05=82.37
Spread = Ask – Bid = 82.82-82.37 =0.25
𝑺𝒑𝒓𝒆𝒂𝒅
Ask(Selling) as a base = 𝑋 100
𝑨𝒔𝒌 𝑷𝒓𝒊𝒄𝒆

= (0.25 X 100/82.62) =0.3026

𝑺𝒑𝒓𝒆𝒂𝒅
Bid(Buying) as a base = 𝑋 100
𝑩𝒊𝒅 𝑷𝒓𝒊𝒄𝒆

= (0.25X100/82.37) = 0.3035
Two months forward
Ask (Selling) = 82.53+0.03=82.56
Bid (Buying) = 82.32+0.07=82.39
Spread = Ask – Bid = 82.56-82.39 =0.17
𝑺𝒑𝒓𝒆𝒂𝒅
Ask(Selling) as a base = 𝑋 100
𝑨𝒔𝒌 𝑷𝒓𝒊𝒄𝒆

= (0.17 X 100/82.56) =0.2059

𝑺𝒑𝒓𝒆𝒂𝒅
Bid(Buying) as a base = 𝑋 100
𝑩𝒊𝒅 𝑷𝒓𝒊𝒄𝒆

= (0.17X100/82.39) = 0.2063
Three months forward
Ask (Selling) = 82.53+0.06=82.59
Bid (Buying) = 82.32+0.08=82.40
Spread = Ask – Bid = 82.59-82.40 =0.19
𝑺𝒑𝒓𝒆𝒂𝒅
Ask(Selling) as a base = 𝑋 100
𝑨𝒔𝒌 𝑷𝒓𝒊𝒄𝒆

= (0.19 X 100/82.59) =0.2301

𝑺𝒑𝒓𝒆𝒂𝒅
Bid(Buying) as a base = 𝑋 100
𝑩𝒊𝒅 𝑷𝒓𝒊𝒄𝒆

= (0.19 X100/82.40) = 0.2306

Q3. Consider the data given below and calculate the arbitrage gain of a trader.
Spot exchange rate: ₹83/ $
3-month forward rate ₹82.85/$
3-month interest rates: Re: 6% p.a. Dollar: 8% p.a.

Solution:
Step1: Calculate forward discount/ premium
Discount = (82.85 – 83.00)/ 83 x (12/3) x 100 = 0.722 percent
Interest rate differential = 8 – 6 = 2 per cent
In this case the interest rate differential is higher than premium or discount, then
borrow that currency which has lower interest rate and place that currency in
money market which has higher interest rate.
(On the other hand, if the interest rate differential is smaller than premium or
discount, then borrow that currency which has higher interest rate and place that
currency in money market which has lower interest rate.)
Step 2 Following the above rule, Borrow ₹1000 at 6% p.a. for 3 months.
Step 3. Convert ₹into dollars, using spot rate
We will have (1000/83) = 12.0481 dollars
Step 4: Invest 12.0481 dollars at the rate of 8% p.a.
After three months, we will have
12.0481 ( 1 + 0.08 x 3/12) = 12.2891 dollars
Step 5: Convert dollars back into rupee using forward rate
We will have
12.2891 x 82.85 = ₹1018.1488
Step 6 : Refund loan of ₹1000 with interest on it. Refunded amount will be
₹1000 ( 1+0.06 x3/12) = ₹1015
Net gain in the process ₹1018.1488– ₹1015 = ₹3.1488
This is a gain on transaction of ₹1000 . In actual practice , one conducts arbitrage
in large amount so the gain will accordingly increase
 Questions on currency risk management- Futures
Q1.
An Indian importer will be paying USD 40,000 on Oct 31st, since the payment of
USD will be after 3-months the importer is facing transaction exposure for USD
against INR. He wanted to enter a future contract for USD against INR. The spot
exchange rate as on 1st August is ₹83.6680 in USD and future which will be
delivered on Oct 31st, is trading at ₹83.6685. How many contracts would the
importer buy to immune the position and also what is the pay off? If on Oct 31st ,
the Oct futures contract is traded at ₹83.6825 and the spot exchange rate is
₹83.6800/$. The Rupee Future has a contract size of $1,000.
Solution:
Rate 1st August (a) 31st Oct (b) Profit /$=(b)-(a) Total Profit Hedged/not
Spot ₹83.6680/$ ₹83.6800/$ =0.012 0.012X40,000 = 480 No Hedging (loss)
3M future ₹83.6685/$ ₹83.6825/$ =0.014 0.014X40,000= 560 Hedged by futures (profit)
1st August
Spot Rate = ₹83.6680/$
3 months’ future rate = ₹83.6685/$
31th Oct
Spot Rate = ₹83.6800/$
Payment Amount = $40,000
If not hedge, the transaction exposure is
= ₹83.6680 – ₹83.6800
= ₹0.012
Total = ₹480
Size of contract = $1,000
Number of contracts needed to purchase = $40,000/$1,000 = 40 (Future Contract)
As on August 1st
3 months future contract = ₹83.6685/$
As on Oct 31st, the price of 31st Oct future is ₹83.6825/$
Note: Gain on future contract = $40,000 (₹53.6825 – ₹53.6685) = ₹560
So, the gain on future contract is ₹560 and net gain is ₹80.
Questions on Portfolio Diversification
Q1.
An Indian investor invests in U.S Bonds with a face value of $10000. The bonds
have a market price of $ 10500 by the year end and brings $700 as interest during
the year. Dollar appreciates by 3%. Simultaneously he invests in German bonds
with a face value of 30000 euro fetching 3000 as interest and the market price of
bonds going upto 30500 during the year. Euro depreciates by 2% during this
period. Calculate the Portfolio Return for the indian investor.
25% invested in US Bonds and 75% invested in European Bonds

Solution:
Return from International Investment
S1 − S0 + I
1 + 𝐑𝐡𝐜 = (1 + ) × (1 + ⅇ)
S0
Where
Rhc = Fluctuation adjusted Return in Home Country (without weights)
S0 = Face Value at T0
S1 = Market Value at T1
I = Income from dividend/interest
e = The exchange rate changes
FV MP(t=1) Intt Return Appreciation Fluctuation Weights Wtd
/Depreciation adjusted Return
Return
USD 10000 10500 700 1.12000 3% 0.15360 25% 0.03840
Euro 30000 30500 3000 1.11667 -2% 0.09433 75% 0.07075
0.10915

10500 − 10000 + 700

1 + 𝐑𝐡𝐜 = (1 + ) × (1 + 0.03)
10000

1 + 𝐑𝐡𝐜 = (1.12) × (1.03)

𝐑 𝐡𝐜 = (1.12) × (1.03)- 1 = 0.15360
Weighted RHC = 0.15360 X 0.25 = 0.0384
Weighted RHC = 0.09422 X 0.75 = 0.0707
Total portfolio return = 0.0384 +0.0707 = 0.1091
Total portfolio return = 10.91%
Q2.
An Indian investor invests in Japanese and British securities in proportions of
60% and 40% respectively. The relevant details of securities are given below:
Particulars Japanese security British security
Expected Return(%) 16 10
Risk(in terms of Variances)(%) 9 4
Coefficient of Correlation -0.8
between Securities
Find out Portfolio risk and Portfolio Return.
Solution:
i. Portfolio Return= E(R) = w1R1 + w2Rq + ...+ wnRn
= 0.6(16)+0.4(10) = 13.6%

ii. Portfolio Risk= 𝜎𝑝 = √𝑤12 𝜎12 + 𝑤22 𝜎12 + 2𝑤1 𝑤2 (𝑟12 𝜎1 𝜎2 )

𝜎𝑝 = √0.36(9) + 0.16(4) + 2(0.6)(0.4)(−0.8)(3)(2)

𝜎𝑝 = 1.255%