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1. A corporate treasury operations in Sydney simultaneously calls Westpac Bank in Sydney, Barclays in
London and Deutsche Bank in Frankfurt. The three banks give the following quotes at the same time:
Westpac, Sydney
Barclays, London
Deutsch, Frankfurt
A$1.2223/
A$1.8410/
1.5100/
Explain, using A$1 million, how the corporate treasury could make a triangular arbitrage profit with the
three exchange rate quotes. [20 marks]
Ans.1
All along till recent past, bank dealers used to quote all currencies against the USD while trading
among them. Now with expansion of global economy growing percentage of currency trades do not
involve the dollar. Foreign exchanges traders and speculators continuously seek to exploit the
exchange rate inconsistencies in different money centers. The exploitation involves buying a currency
in one market and selling in another. Arbitrage is the purchase and sale of equity/currency/commodity
etc. in different market to exploit the price differential. In currency market professional Arbitragers
quickly transfer fund from one currency to another and exploit discrepancies between exchange rate
in different markets. The process of arbitration also works through the foreign exchange market to
bridge interest rates in national markets. Even small discrepancies between the exchange rates and
interest rates in different markets triggers arbitrage and eliminate discrepancies quickly.
To understand the triangular arbitrage we need to understand the rationale behind this arbitrage
advantage. Cross rates are the exchange rates of 1 currency with other currencies, and those
currencies with each other. Cross rates are equalized among all currencies through a process called
triangular arbitrage. If these cross rates didn't equalize with other cross rates it would present an
arbitrage opportunity in the foreign exchange spot market. The major factor which affects the
triangular arbitrage is transaction cost among cross country transaction. If this transaction cost is
lesser than the arbitrage advantage then only its net gain to the client. Triangular arbitrage is a
process that keeps cross-rates (such as euros per British pound) in line with exchange rates quoted
relative to the U.S. dollar. A trader can conduct a triangular arbitrage in many ways. In other words,
instead of exchanging just two currencies, the trader exchanges three (hence the term triangular
arbitrage). For example if USD is my home currency i will first purchase Euro form certain amount of
USD, then i will convert it to Pound by selling same amount of Euro. Consequently i will again
purchase USD from same amount of pound. If at the end of transaction, USD which i received is
greater than the USD which i invested at the time of commencement, the difference is my gain and
Vis-a-vis.
If such transactions can be done profitably, the trader can generate pure arbitrage profitsthat is,
earn risk-free profits. Obviously, in perfectly competitive financial markets, it is impossible to earn
arbitrage profits for very long. If the USD price of the Euro were not equal to the USD price of the
pound multiplied by the pound price of the Euro, arbitrage activity would immediately restore equality
between the quoted cross-rate and the cross-rate implied by two dollar quotes.(USD/Euro) =
(USD/Pound) * (Pound/Euro). In other words, the direct quote for the cross-rate should equal the
implied cross-rate, using the dollar as an intermediary currency.
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2. Calculate the cross rate between the Mexican peso (Ps) and the euro () from the following two spot
rates: Ps11.43/A$; 0.8404/A$. [5 marks]
Ans.2
The Cross rate is the exchange rate between two currencies implied by their exchange rates with
common third currency. For example in Japan all buy and sell transactions are routed through USD.
All deals other than a USD purchase or USD sale with respect to Yen would necessary involve
transaction involving USD. Thus If Japanese importer wishes to purchase Pound then he would have
to buy USD first and then they sell USD to buy Pound. The banker would obtain Pound/USD rate
from UK market and then apply the Yen/USD rate obtained from local market to arrive at exact Yen to
be given for purchase of Pound. Since the transaction involves two currencies we call such rate as
cross rates.
Thus a cross rate by definition involves transaction of any three currencies or more. When we have to
find the cross rates, we have to apply following formula.
(A/B)=(A/C)*(C/B)
After getting the cross rate If we consider the effect of premium charged by banker in form of
difference of Ask and Bid rate formula will be as follows,
Bid (A/B) =1/(Ask(B/A))
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3. Calculate the forward discount on the Australian dollar (the Australian dollar is the home currency) if
the spot rate is A$1.8200/ and the 6-month forward rate is A$1.8000/ [5 marks]
Ans.3
A forward transaction is an agreement made today to exchange one currency for another, with the
date of the exchange being a specified time in the future often one month, two months, or some
other definitive calendar interval. The rate at which the two currencies will be exchanged is set today.
A forward contract between a bank and a customer calls for delivery, at a fixed future date, of a
specified amount of one currency against payment in another currency. The exchange rate specified
in the contract, called the Forward rate, is fixed at the time the parties enter into the contract.
Forward rate is specified by the bank by considering current interest cost on tax free bonds in the
country. It means, the forward rate is adjusted by including/reducing interest cost of that particular
duration to the spot rate.
Forward discount or Forward premium is relationship between forward and spot exchange rates. If
the forward price of the Pound in terms of Australian Dollars (that is, A$/) is higher than the spot
price of A$/, the Pound is said to be at a forward premium in terms of the Australian dollar.
Conversely, if the forward price of the euro in terms of dollars (A$/) is less than the spot price of A$/
, the pound is said to be at a forward discount in terms of the dollar. Please note, as with the terms
appreciation and depreciation, the terms forward premium and forward discount refer to the currency
that is in the denominator of the exchange rate. Because the forward premium and forward discount
are related to the interest rates on the two currencies, these premiums and discounts are often
expressed as annualized percentages. That is, the difference between the forward rate and the spot
rate is divided by the spot rate and then multiplied by the reciprocal of the fraction of the year over
which the forward contract is made. The result is then multiplied by 100 to convert it to a percentage.
% per annum forward premium or discount of an N day forward rate =
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4. How are foreign exchange transactions between international banks settled? Explain. [20 marks]
Ans.4
When a trade is agreed upon, banks communicate and transfer funds electronically through computer
networks. The most important interbank communications network is the Society of Worldwide
Interbank Financial Telecommunications (SWIFT), which began operations in Europe in 1973 and
is jointly owned by more than 2,000 member banks. The SWIFT network links more than 9,000
financial institutions in more than 200 countries. Banks use SWIFT to send and receive messages
pertaining to foreign exchange transactions, payment confirmations, documentation of international
trade, transactions in securities, and other financial matters. In particular, SWIFT is used to confirm
foreign exchange deals agreed upon on the phone. In 2010, SWIFTs global network processed close
to 4 trillion messages. After the verbal deal is electronically confirmed over SWIFT, the deal also has
to be settled. Citibank will transfer dollars to BNP Paribas in the United States, and Citibank will
receive euros from BNP Paribas in Europe. The transfer of dollars will be done through the Clearing
House Interbank Payments System (CHIPS), and the transfer of euros will be done through the
Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET). Fedwire
is a real-time gross settlement (RTGS) system operated by the Federal Reserve System of the United
States. Fedwire links the computers of more than 7,000 U.S. financial institutions that have deposits
with the Federal Reserve System. Transactions of Fedwire instantly move dollar balances between
financial institutions.
After completion of foreign exchange transaction with domestic bank, Domestic bank has to settle his
account with foreign bank with whom, domestic bank has transacted on behalf o his client. The
settlement of a foreign exchange trade requires the payment of one currency and the receipt of
another. However, the settlement procedures described previously do not guarantee that the final
transfer of one currency occurs if and only if the final transfer of the other currency occurs as well.
Because foreign currency transactions often involve the payment systems of two countries in different
time zones, simultaneous exchange of currencies
When commercial banks do not have their own banking operation in a major financial centre, they
establish a correspondent relationship with a local bank to conduct trade financing, foreign exchange
services, and other activities on their behalves. Correspondent relationships allow a bank to service
its multinational corporate clients without having to locate their banking personnel in many countries.
However, the correspondent bank may not be able to give the same level of services as it would if it
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Nostro Account: In Latin Nostro means Our account with you. Nostro account is the account
maintained by the bank in India with the bank abroad. For Example, State Bank of India may
maintain an account with Citibank, New York. Obviously, the account would be in USD. All foreign
exchange transactions are routed through Nostro account.
Vostro Account: In Latin, Vostro means Your account with us . A foreign bank, say Citibank,
New York, may open rupee account with State bank of India.
Loro account: Lets Say that State bank of India is having an account with Citibank, New York.
Syndicate bank of India likes to refer to this account while corresponding with Citibank, it would
refer to it as Loro account, meaning their account with you, in Latin.
5. Many companies grant stocks and stock options to managers. Discuss the benefits and costs of using
this kind of incentive compensation scheme. [10 marks]
Ans. 5
Employee stock ownership occurs when the people who work for a corporation hold shares in that
corporation. In general, management experts believe that turning employees into shareholders
increases their loyalty to the company and leads to improved performance. Stock ownership also
offers employees the potential for significant financial rewards. For example, workers in several
fledgling high-technology companies have become millionaires by purchasing stock at the ground
floor and then watching the market price rise astronomically. Employee stock ownership takes a
number of different forms. Two of the most common forms are stock options and employee stock
ownership plans, or ESOPs. Different countries have their own set of guidelines and rules for ESOPs
under their Companies Act.
Stock options give employees the right to purchase a certain number of shares in the company at a
fixed price for a given period. The purchase price, also known as the strike price, is usually the
market value of the stock on the date that the options are granted. In most cases, employees must
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The most visible advantage of ESOP to employee for company is that, it strengthens its Balance
sheet on books at the end of financial period. If company issues stock to general public as an
Initial Public offer, It owes money to the general public (being a stakeholder) after granting a
shares. Further, when any executive is working for company he is being paid from the company in
form of salary. Salary is claimed in Profit & Loss account which reduces profit of the company and
saves the tax. On other side it will reduces the fund outflow because in lieu of Cash/Bank
company has granted equity shares to employee. Which will ultimately adds to companys
networth and makes the company stronger on books
The most commonly cited advantage in granting stock options to employees is that they increase
employee loyalty and commitment to the organization. Employees become owners with a financial
stake in the company's performance. Talented employees will be attracted to the company, and
will be inclined to stay in order to reap the future rewards. But stock options also offer tax
advantages to businesses.
Options are shown as worthless on company books until they are exercised. Even though stock
options are technically a form of deferred employee compensation, companies are not required to
record options pending as an expense. This helps growth companies to show a healthy bottom
line.
Once employees exercise their options, the company is allowed to take a tax deduction equal to
the difference between the strike price and the market price as compensation expense.
Critics of stock options claim that the disadvantages often outweigh the advantages. For one
thing, many employees cash out their shares immediately after exercising their option to buy.
These employees may want to diversify their personal holdings or lock in gains. In either case,
however, they do not remain shareholders very long, so any motivational value of the options is
lost. Some employees disappear with their newfound wealth as soon as they cash in their options,
looking for another quick score with a new growth company. Their loyalty lasts only until their
options mature.
Another common criticism of stock option plans is that they encourage excessive risk taking by
management. Unlike regular shareholders, employees who hold stock options share in the upside
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Another disclaim that the use of stock options as compensation actually places undue risk upon
unsuspecting employees. If large numbers of employees try to exercise their options in order to
take advantage of gains in the market price, it can collapse an unstable company's whole equity
structure. The company is required to issue new shares of stock when employees exercise their
options. This increases the number of shares outstanding and dilutes the value of stock held by
other investors. To forestall the dilution of value, the company has to either increase its earnings
or repurchase stock on the open market.
In general, ESOPs are likely to prove too costly for very small companies, those with
high employee turnover, or those that rely heavily on contract workers. ESOPs might also be
problematic for businesses that have uncertain cash flow, since companies are contractually
obligated to repurchase stock from employees when they retire or leave the company. Finally,
ESOPs are most appropriate for companies that are committed to allowing employees to
participate in the management of the business. Otherwise, an ESOP might tend to create
resentment among employees who become part-owners of the company and then are not treated
in accordance with their status.
There are several alternatives that solve some of the problems associated with traditional stock
options. For example, to ensure that the options act as a reward for employee performance, a
company might use premium-price options. These options feature an exercise price that is higher
than the market price at the time the option is granted, meaning that the option is worthless
unless the company's performance improves. Variable-price options are similar, except that the
exercise price moves in relation to the performance of the overall market or the stocks of an
industry group. To overcome the problem of employees cashing out their stock as soon as they
exercise their options, some companies establish guidelines requiring management to hold a
certain amount of stock in order to be eligible for future stock options.
6. It has been shown that foreign companies listed in the U.S. stock exchanges are valued more than
those from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed
foreign firms are valued more than those which are not. Also explain why not every foreign firm wants
to list stocks in the United States. [20 marks]
Ans. 6
To understand the answer to the above mentioned phenomenon, first we need to understand the
Cross Listing of Shares.
Cross listing of shares is when a firm lists its equity shares on one or more foreign stock
exchange in addition to its domestic exchange. Examples include: American Depositary
Receipt (ADR), European Depositary Receipt (EDR), International Depository Receipt (IDR)
and Global Registered Shares (GRS). Generally such a company's primary listing is on a stock
exchange in its country of incorporation, and its secondary listing(s) is on an exchange in another
country. Cross-listing is especially common for companies that started out in a small market but grew
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Liquidity :
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Market Integration
Markets are integrated when securities of similar risk have the same expected returns, whatever
the market in which they trade. A firm located in a country that is not fully integrated in the world
capital markets typically faces a higher cost of capital because the firms equity risk has to be
borne mostly by investors in its own country. If the firm finds a way to make it less costly for
foreign investors to hold its shares, these investors share some of the firms risk, and therefore,
the cost of capital falls. Investment barriers segment domestic capital markets from global capital
markets. Investment barriers are usually grouped into direct and indirect barriers. Direct
barriers comprise regulatory frictions from foreign exchange controls, foreign ownership
restrictions, taxes, and trading costs. By cross-listing in a foreign market, a firm makes its shares
more accessible to foreign investors, which can be viewed as a liberalization of the domestic
equity market. In some cases, the government literally relaxes restrictions for cross-listing stocks
in order to facilitate cross-border arbitrage between the stock prices in the local and foreign
markets. For example, even though Chile imposed capital flow and dividend repatriation
restrictions on foreign investors in the mid 1990s (that is, foreigners could not repatriate capital or
dividends for at least 1 year after the initial investment), these restrictions were lifted for the many
Chilean companies cross-listing in the United States during that time. The opposite occurs as
well. When Brazil introduced a 2% tax on foreign bond and stock purchases in 2009 to dampen
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7. Read the mini case below and answer the question that follows:
MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD.
Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line
producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United
Kingdom and in many parts of continental Europe as well.
Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in
order to guard against adverse exchange rate changes. Nevertheless, it has just received an order
from a large wholesaler in central France for 320,000 of its products, conditional upon delivery being
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Ans.10
To understand the solution of above mentioned case we need to understand certain terms,
A forward transaction is an agreement made today to exchange one currency for another, with the
date of the exchange being a specified time in the future often one month, two months, or some
other definitive calendar interval. The rate at which the two currencies will be exchanged is set today.
A forward contract between a bank and a customer calls for delivery, at a fixed future date, of a
specified amount of one currency against payment in another currency. The exchange rate specified
in the contract, called the Forward rate, is fixed at the time the parties enter into the contract.
Forward rate is specified by the bank by considering current interest cost on tax free bonds in the
country. It means, the forward rate is adjusted by including/reducing interest cost of that particular
duration to the spot rate.
If you owe someone foreign currency at some date in the future, you can buy the foreign currency
forward by contracting to have a bank deliver a specific amount of foreign currency to you on the
date that you need it. At that time, you must pay the bank an amount of domestic currency equal to
the forward rate (domestic currency per foreign currency) multiplied by the amount of foreign
currency. Because the total amount you would owe the bank is determined today, it does not depend
in any way on the actual value of the future exchange rate. Thus, using a forward contract eliminates
transaction exchange risk.
Similarly, if you are scheduled to receive some foreign currency on a specific date in the future, you
can sell it forward and entirely eliminate the foreign exchange risk. You contract to have the bank
buy from you the amount of foreign currency you will receive in the future on that date in the future.
Your forward contract establishes today the amount of domestic currency that you will receive in the
future, which is equal to the forward exchange rate (domestic currency per foreign currency)
multiplied by the amount of foreign currency you will be selling. The amount of domestic currency that
you receive in the future consequently does not depend in any way on the future spot exchange rate.
Notice that in both cases, you have completely hedged your transaction exchange risk. Basically, you
eliminate your risk by acquiring a foreign currency asset or liability that exactly offsets the foreign
currency liability or asset that is given to you by your business.
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