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Example You are required to find out the overall balance, showing clearly all the sub-balances

from the following data: (1) UC Corporation of the USA invests in India Rs.3,00,000 to modernise its India subsidiary. (2) A tourist from Egypt buys souvenirs worth Rs.3000 to carry with him. He also pays hotel and travel bills of Rs.5,000 to Delhi Tourist Agency. (3) The Indian subsidiary of UC Corporation remits, as usual, Rs.5,000 as dividends to its parent company in the USA. (4) This Indian subsidiary of UC Corporation sells a part of its production in other Asian countries for Rs.1,00,000. (5) The Indian subsidiary borrows a sum of Rs.2,00,000 (to be paid back in a year’s time) from the German money market to resolve its urgent liquidity problem. (6) An Indian company buys a machine for Rs.1,00,000 from Japan and 60 per cent payment is made immediately; the remaining amount is to be paid after 3 years. (7) An Indian subsidiary of French Company borrows Rs.50,000 from the Indian public to invest in its modernisation programme.

Solution Sources and Uses of Funds
S. No. 1. 2. (a) (b) 3. 4. 5. 6. (a) (b) Sources 3,00,000 3,000 5,000 1,00,000 2,00,000 40,000 6,48,000 Uses Nature Direct Foreign Investment Goods exported Services (invisible) rendered 5,000 Dividends paid Goods exported Short-term borrowing 1,00,000 Equipment imported Increase in claim to India (Portfolio) 1,05,000

BOP Statement Current Account Goods Account Exports : Rs. 1,03,000 (+) Imports : Rs. 1,00,000 (-) Balance : Rs. 3,000 (+)

Invisible Account Payment Received Payments Made

: :

Rs. 5,000 (+) Rs. 5,000 (-)




Current Account Balance: Rs. 3,000 (+) B. Capital Account Foreign Direct Investment Inflow Outflow Balance : : : Rs. 3,00,000 (+) Nil Rs. 3,00,000 (+)

Portfolio Investment Inflow Outflow Balance : : : Rs. 40,000 (+) Nil Rs. 40,000 (+)

Long-term Capital Balance: Rs.3,40,000 (+) (FDI + Portfolio) Short-term Capital Account Inflow : Rs. 2,00,0000 (+) Outflow : Nil Balance : Rs. 2,00,000 (+) Capital Accounts Balance: Rs.5,40,000 (+) Overall Balance: Rs. 5,43,000 (+)

4 .5.There is a net surplus of Rs. This means. 7 did not enter into the BOP Statement since this transaction does not involve any foreign country. Notes: The transaction No.000 in the balance of payments. The entire transaction has taken place in Indian rupees within India. there will be an increase of reserves by this amount.43.

5 . In operational terms. the monetary authority of the concerned country normally intervenes/steps in to bring out the desired balance by:  variation in the exchange rate.FOREIGN EXCHANGE MARKET INTRODUCTION The foreign exchange market is the market where the currency of one country is exchanged for that of another country and where the rate of exchange is determined. or  changes in official reserves. or  both. the demand for and supply of home currency should be equal. and  lending to and borrower from foreigners. demand for foreign currency (or the supply of home currency) should equal supply of foreign currency (or the demand for home currency). The genesis of Foreign Exchange (FE) market can be traced to the need for foreign currencies arising from:  international trade. In order to maintain an equilibrium in the FE market.  foreign investment. In the event of a disequilibrium situation.

Bank dealers often use brokers to stay anonymous since the identity of banks can influence short-term quotes. QUOTING IN THE FE MARKET Foreign exchange rates ale quoted either for immediate delivery (spot rate) or for delivery on a future date (forward rate). In practice. only a small number of countries have established fill convertibility of their currencies for all transactions.  Individual brokers or corporations. as also to execute the orders of government. Exchange markets primarily function through telephone and telex. Further. it may be mentioned hem that currencies with limited convertibility play a minor role in the FE market.PARTICIPANTS IN THE FE MARKET Major participants in the FE market are:  Large commercial banks (through their cambistes or dealers) operating either at retail level for individual exporters and corporations. 6 . And. delivery in spot market is made two days later. or at wholesale level in the interbank market.  Central banks of various countries that intervene in order to maintain or to influence the exchange rate of their currencies within a certain range.

This type of cp is made in the UK. It is direct when quoted as “so many units of local currency per unit of foreign currency”. an indirect quotation is the one where exchange rate is given in terms of variable units of foreign currency as equivalent to a fixed number of units of home currency. 100 is an indirect quotation. a quotation in the USA will be $ 0. 7 . Similarly. is a direct quotation for US dollars in India.55 = £ 1. Rs. On the other hand. For example. all quotations in India use the direct method of quotation. as indicated in Tables 1 to 3 below. in India US$ 2. Some currencies are quoted as so many rupees against one unit while others as so many rupees against 100 units.22 = FFr 1 whereas in France.A FE quotation is the price of a currency expressed in the units of another currency. The quotation can be other direct or indirect. it would be FFr 3. Since 2 August 1993.857 = Rs. in London a quotation may be made as $1. 35 = US$ 1. etc.3 = DM 1. For example. For example.

Deutschmark (DM) ringgit 7.Table 1 Foreign Currencies Quoted against their One Unit 1. Irish pound (I £) 22. Canadian dollar 13. Egyptian pound 17. Kuwaiti dinar Malaysian 24. Norvegian 26. European Currency 27. Bahrain dinar 12. Singapore dollar 3. Qatar riyal franc 20. Saudi riyal (SR) 21. Hong Kong (S$) dollar (HK$) 4. Austrian schilling (Sch) 10. French (FFr) mark 19. Swedish kroner (SKr) 15. 6. US Dollar ($) Unit (ECU) 18. Finish (FM) 11. Swiss franc (Sfr) 23. Australian dollar (A$) 2. Thai baht (Br) dollar (NZ$) 8. Dutch guilder (FI 16. Danish (DKr) kroner 14. New Zealand 25. Omani riyal 8 . Sterling pound (Can$) (£) 5. UAE Dirham kroner (NKr) 9.

i. Bangladesh taka 3. Burmese Kyat 4. Two-Way Quote A dealer usually quotes a two-way price for a given currency-the price at which he is buying (bid price) and the price at which he is selling (offer or ask price) the currency.Table 2 Foreign Currencies Quoted against their 100 Units 1. However. Sri Lankan rupee 2. Indonesian rupiah 3. Dealers do expect some profit in exchange operations and hence there is always some difference in buying and selling rates. the currency for which the bid or ask price is given is the unit of the item priced. In either case. Iranian rial 5. Pakistani rupee Foreign exchange rates are always quoted as a two-way price.e. Japanese yen 6. Spanish peseta Table 3: Asian Clearing Union Currencies Quoted against their 100 Units 1. Belgian franc (BFr) 2. All exchange rates by authorized dealers are quoted in terms of their capacity as buyer or seller. a rate at which the bank (dealer) is willing to buy foreign currency (buying rate) and a rate at which the bank sells foreign currency (selling rate). Italian lira 5. 9 . the maximum spread available to dealers may be restricted by their central bank. Kenyan shilling 4.

and sell dollars to an importer at US$ 1 = Rs 35. For example. 10 .In a bid quote of Rs 35/US$ 1. a dealer in New Delhi may quote: US$ 1 = Rs 35. which also means that he is willing to sell 35 m at the price of one dollar. All foreign exchange dealers are set to make profit out of each transaction. But when he sells foreign currency (the customer buying the currency). he implicitly quotes the rate at which rupees would be bought per dollar. he endeavours to take as many units of the local currency as he can against every unit of foreign currency he gives to the customer.0050. the dealer conveys that he will buy dollars at the price of Rs 35 per dollar. Therefore. he endeavours to give as few units of the local currency as he can against every one unit of the foreign currency he buys. Likewise. This means that he will buy dollars from an exporter at US$ 1 = Rs 35. when a dealer in India buys foreign currency (the customer selling the currency). Thus. whether it is a sale or purchase of foreign currency. the lower rate is the buy (bid) quote and the higher rate is the selling (ask) quote.0000. when the dealer quotes an offer price per dollar.0050.000 – 35.

35. It fluctuates according to the level of stability in the market. Per cent spread = = 0. Ask price – Bid price x 100 Per cent spread = Ask price For example. in transactions among dealers.014.0050. to save time and the rest is 11 . and the volume of the business.0050 Usually. the percentage spread equals 0. he will offer less currency while selling but demand more when buying.0000 x 100 35.0050 – 35.014. The spread represents the gross return to the dealer for the risks inherent in making a market”. That is. the dealer will protect himself by widening the quote. That is.000 35. if there is a degree of volatility in an exchange rate. Thus. only the last two digits are quoted.Spread Spread means the difference between a banks buying (bid) and selling (offer or ask) rates in an exchange rate quotation or an interest quotation. the currency in question. and if business is thin and if (rumours persist about the currency that) the current rate is rumoured to be unsustainable. The spread can also be expressed as a percentage. with dollar quoted at Rs 35.

Thus. a point is 1/10. instead of quoting the rate in its entirety. The last digits are called points.00001 and represents 1/100000 part of a dollar.000 part of the unit.g.e. In her words. 5080. Most quoted currencies are expressed to four decimal places but the currencies with low value relative to others are quoted up to two decimal places. Cross Rates (Chain Rule) Cross rate is the price of any currency other than the home currency.understood. e. it is the direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. a dealer in New Delhi may quote a spot price for the dollar which is US$ 1 = Rs 35.0080 only by referring to the last two digits. for example.e. in US dollar terms. US$/FFr. in India. US$ 0. one point US$ 0. DM/BFr.0001. Thus. etc. Or. i. 12 . a cross rate is any exchange rate which excludes rupees. A pip is one further decimal place to the right. Italian Lira and Japanese yen are examples of such currencies.0050 35. i.

If delivery is made on the day the contract is booked. Thus.1025 or.1025 = US$1 US$ 1 = Rs. FFr 1 = 35. If.1025. 35. it is called the TOM (tomorrow) rate. would first buy dollars against the rupees and the same dollars will be used overseas to acquire French francs. it is called a Telegraphic Transfer (TT) or cash or value-day deal.0080 and rates in Paris market are US$ 1 = FFr 5. he will get US$ 1 by paying Rs. rates in New Delhi am US$ I = Rs 35. he will get FFr 5.0080 and for one US$. a sort of chain is formed as under: FFr 5. FFr1 = Rs 6. Tom When the exchange of currencies takes place on the next working day after the date of deal.0080/5.0080 Therefore.0010 — Rs 35. 13 .1025/50. say.If an importer has to remit French francs from India with the knowledge that Rupee/FFr rates are not normally quoted.8609 SETTLEMENTS Cash Cash rate or Ready rate is the rate when the exchange of currencies takes places on the date of the deal. 35.

the spat day would be Friday. A business day is defined as one in which both banks are open for business in both settlement countries. a deal done on Tuesday will b settled on Thursday and a deal done on Friday will be settled on the following Tuesday. This time is allowed to banks to process the necessary paperwork and transfer the funds. Most dealings now-a-days are done ‘spot”. Settlement would not be affected by a US holiday on the following Wednesday. Such transfers to and from banks will be effected when their overseas currency accounts we either credited or debited. If Wednesday were a normal day and Thursday a holiday in either the USA or Germany. the spot date would be postponed until Friday. 14 . if both centres were open on that day. In the case of a US$/DM deal done on Tuesday. In the latter case. provided that both centres were open on Friday. settlement is normally expected on Thursday. the value date is the one when the deposit is credited or debited. depending on whether the bank is buying or selling. but would be affected by a German holiday on this Wednesday. it is called the spot rate.Spot When the exchange of currencies takes place on the second working day after the date of the deal. The rate of the agreed deal on telephone is called the contract dale. Normally.

in London. such as US$/Can$ transactions. in pound sterling) on Friday. Settlement of both sides of a foreign exchange deal should be made on the same business day. The only exception o the principle of compensated value arises for deals in Middle East countries for settlement on Friday. the occurrence of bank holiday in the UK during the spot period is entirely irrelevant. Even though a person buying the Middle Eastern currency (say. This is because all bank account transfers are made in the settlement country rather than the dealing centre. provided it was a business day in both the relevant countries: For some currencies. later in Europe. 15 . The principle that the two sides of the deal should be completed on the same day is referred to as the principle of compensated value. settlement on any given business day will take place earlier in the Far East. Saudi riyals) may make payment (say.In the case of a US$/DM deal done. Because of time zone differences. mid later still in the USA. say. This is a holiday in most Middle East countries. the delivery of riyals would take place on Saturday. a spot transaction is only one day by convention and agreement among the market participants.

012. Example An Arbitrage between Two Currencies Suppose two traders A and B are quoting the following rates: Trader A (Paris) Trader B (New York) FFr 5. which is FFr 55036/US$ (= 1/0.ADJUSTMENT OF DEMAND AND SUPPLY ON THE SPOT MARKET: PROCESS OF ARBITRAGE Arbitrage can be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates.036. A combiste buys. say. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage).000 from the trader A by paying FFr 55.1817).1817/FFr We assume that buying and selling rates for these traders are the same. 16 . he gains FFr 24 (= 55.5012/US$ US$ 0. In the process. We find out the reciprocal rate of the quote given by the trader B. Then he sells these US dollars to the trader B and receives FFr 55.012).036 55. US$ 10.

so the quotation is likely to be as follows: Trader A FFr 5. But this process would tend to increase the selling rate at the trader A because of the increase in demand of US do and the reverse would happen at the trader B because of increased supply of US dollars.FFr 5.1785/FFr .45 while he would sell one US dollar for FFr 5. This would lead to an equilibrium after some time.50121US$ Trader B US$0.Since. 17 . buying and selling rates are likely to be different.US$ 0. it is clear that in order to make an arbitrage gain.18/FFr These rates mean that the trader A would be willing to buy one unit of US dollar by paying FFr 5.5012. in practice. The same holds true for the corresponding figures of the trader B.4500/US$ . By observing these figures. the selling rate of the trader A has to be lower than the buying rate of the trader B.

51/DM $0. Thus.51/DM $ 0.867/DM So what are the arbitrage possibilities? There is no arbitrage gain possible between the US dollar and Swiss franc.52/DM SFr 0. The following two arbitrages ale.5110.60/SFr $0.52/0.60/SFr $0. 18 .Example An Arbitrage between Three Currencies Now suppose both traders A and B are located at New York and quoting as follows: Trader A Trader B $ 0. the situation looks like as follows: Trader A Trader B $ 0.85/DM SFr 0.85/DM (= 0.51/SFr $ 0. possible:  Deutschmark against the US dollar is being quoted higher at the trader B. These are: SFr 0.60) at the trader B. So buy Deutschmarks from the trader A and sell them to the trader B. we find cross rates between SFr and DM as well.867/DM (= 0.52/DM Since three currencies are involved hem.60/SF $ 0. however.64 at the trader A and SFr 0.

at a rate of exchange fixed at the time of making the contract (for executing by delivery and payment at a future time agreed upon when making the contract). it obviously implies that the Indian rupee is at a discount vis-a-vis the US dollar. Operations take place mostly by telephone/telex. A forward exchange contract is a binding contract between a customer and a dealer for the purchase or sale of a specific quantity of stated foreign currency.. Premium on one country’s currency implies discount on another country’s currency. The forward market is not located at any specified place. through brokers. Generally. participants in the 19 . For instance. if a currency (say the US dollar) is at a premium vis-à-vis another currency (say the Indian rupee). Forward rates are generally expressed by indicating premium/discount on the spot rate for the forward period. FORWARD RATE If the exchange of currencies takes place after a certain period from the date of the deal (more than two working days). it is called the Forward Rate. A similar possibility of arbitrage gain exists between the Swiss franc and Deutschmark: buy Deutschmarks against Swiss francs from the trader A and sell them to the trader B. etc.

the points are subtracted from the spot price if the foreign currency is trading at a forward discount. They can be made in terms of the exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency. the normal practice is to quote them for 30 days (1 month). This can be determined in a mechanical fashion. the points are added to the spot price if the foreign currency is trading at a forward premium. Quotations for forward rates can be made in two ways. The traders know well whether the quotes in points represent a premium or a discount on the spot rate. 90 days (3 months) and 180 days (6 months). If the first forward quote (the bid or buying figure) is smaller than the second forward quote (the offer or the asking or 20 . Though the forward rate may be quoted by a trader for any future date.market are banks which want to cover orders for their clients. To find the outright forward rates when premium or discount on quotes of forward rates are given in terms of points. The forward rates can also be quoted in terms of points of premium or discount on the spot rate. This is called the ‘outright rate’ and it is used by traders in quoting to customers. 60 days (2 months). which is used in intetbank quotations.

2281 per US$ FFr 5.2341 per US$ Sell/Offer/Ask FFr 5. This procedure ensures that the buy price is lower than the sell price. Therefore. and the trader profits from the spread between the two prices. then it is a discount.2308 per US$ FFr 5. these quotes would be expressed as below: Maturity Spot 1-month 3-months 6-months Bid/Buy FFr 5.2321/2340 1-month 25/20 3-month 40/32 6-month 20/26 In outright terms. In such a situation.0025 It may be noted that in the case of forward deals of 1 month and 3 months.0027 0.2366 per US$ Spread 0.selling figure). Conversely. US dollar is at discount against French franc while 6 months forward is at premium. If. The first figure is greater than the second both in 1 month and 3 months forward quotes. points are added to the spot rate.2296 per US$ FFr 5. these quotes ale at a discount and accordingly these points have been subtracted from the spot rates to arrive at 21 .2340 per US$ FFr 5. both the figures are the same. Example Spot (FFr/US$) 5.0024 0. if the first quote is greater than the second. then the trader has to specify whether the forward rate is at premium or discount. however.2321 per US$ FFr 5. then there is a premium.0019 0.2320 per US$ FFr 5.

32.1235 per US$ Rs 32.0090 1-month 3-months 6-months 225/275 300/350 375/455 0. 32.1010 per US$ Rs 32.1010 – Rs.0090 + 0. 32.1100 per US$ Rs 32. and.1450 per US$ Rs 32.0140 0.0050 0. 32. The reverse is the case for 6 months forward.outright rates. given by a trader in New Delhi: Spot Rs. we notice that the US dollar is at premium for all the three forward periods.1555 per US$ Spread 0.0140 (= 0. For example.0170 Here. Also.0080 The outright rates from the quotation will be as follows: Maturity Spot 1-month 3-months 6-months Bid/Buy Rs. it should be noted that the spreads in forward rates are always equal to the sum of the spread of the spot rate and that of the corresponding forward points.1375 per USS Rs 32. Example Let us take an example of a quotation for the US dollar against rupees.0050 0.0050). Major Currencies Quoted in the Forward Market 22 .1385 per US$ Sell/Offer/Ask Rs.1100 Spread 0. 32.0140 0.0090 0. so on.1310 per US$ Rs. the spread of 1 month forward is 0.

The major currencies quoted on the forward market are given below.  Deutschmark  Swiss franc  Pound sterling  Belgian franc  Dutch guilder  Japanese yen  Peseta  Canadian dollar  Australian dollar Generally currencies ate quoted in terms of 1 month. If FR> SR. Premium or Discount Premium or discount of a currency in the forward market on the spot rate (SR) is calculated as follows: Premium or discount (per cent) = [(Fwd rate . They are generally in terms of the US dollar. it implies premium. 6 months and one year forward. 3 months. But enterprises may obtain from banks quotations for different periods. it signals discount. <SR. 23 .Spot rate)/Spot rate] x (12/n) x 100* where n is the number of months forward.

Consider next two Examples.2950 per USS (6-months forward) 6-months interest rate: US$ 10 per cent Can$ 6 per cent Work out the possibilities of arbitrage gain. Arbitrage in Case of Forward Market (or Covered Interest Arbitrage) In the case of forward market. it is clear that. 12/n is inserted to express in percentage. place the money in the currency that has higher rate of interest or viceversa. Example Exchange rate: Can$ 1. The rule is that if the interest rate differentia is greater than the premium or discount.317 per US$ (Spot) Can$ 1. US$ is at discount on 6months forward market. Solution In this case. the arbitrage operates on the differential of interest rates and the premium or discount on exchange rates. The rate of annualized discount is: 24 .* To annualize the rate. 100 is introduced.

317)/l.23 x 1.l. the interest rate differential is greater than the discount.295). (ii) Transform this sum into US$ at the spot rate to obtain US$ 759.4 at the end of 6 months period.06 x 6/12)] Net gain = Canadian $ 1032. Thus. for 6months. mosey is to be placed in US$ money market since this currency has a higher rate of interest.a.317] x (12/6) x 1 = 3. (iii) Place these US dollars at 10 per cent p.4 (= 797.1x 6/12)] (iv) Sell US$ 79723 in the forward market in y at the end of 6-months.a.e.4 — Canadian $1030 = Canadian $2. one is richer by Canadian $2.317). Canadian $ 1032.6 = 4 per cent Here.[(1.3 x ( 1 + 0. (v) At the end of 6-months.2950 .34 per cent Differential in the interest rate = 10 . Accordingly. i. for 6months in the money market to obtain US$ 797.23 [= 759. So in order to derive an arbitrage gain.4. on 25 . starting from zero.3 (= 1000/1. The following steps are involved: (i) Borrow Can$ l000 at 6 per cent p. Canadian $ 1030 [ = 1000 x (1 + 0. refund the debt taken in Canadian dollars plus interest.

The following operations are carried out: (i) Borrow Can$ 1000 at 9 per cent for 3-months.665 per DM (Spot) Can$ 0.665). one will be richer by (100.665)/0.67 . Since the interest rate differential is smaller than the premium. DM is at a premium against the Can$.7 (= 1000/0. 26 .00.00 x $2. (ii) Change this sum into DM at the spot rate to obtain DM 1503.a.4/1000. Solution In this ease.a. i. Premium = [(0.e.01 per cent Interest rate differential = 9 . Calculate the arbitrage gain possible from the above data.0.670 per DM (3 months) Interest rates: DM 7 per cent p.665] x (12/3) x 100 = 3. Can$ 9 per cent p.borrowings of Canadian $ million. it will be profitable to place money in Deutschmarks the currency whose 3-months interest is lower. Canadian $2400. Example Exchange rates: Can$ 0.7 = 2 per cent.

Can$ 1022.7 x (1 + 0.65.5 [=1000 x (1 + 0.6 SPECULATION IN THE FORWARD MARKET (a) Let us say that the US dollar is quoted as follows: Spot: FFr 5.65 per US$ If a speculator anticipates that the US dollar is going to be FFr 5. 6months forward. he will take a long position in that currency. (v) Refund the debt taken in Can$ with the interest due on it.60 per US$ 6-months forward: FFr 5. Net gain = 1025. i.05 per US$ (= FR 5.7 per unit and his profit will be FFr 0. (iv) Sell DM at 3-months forward to obtain Can$ 1025. 27 .7 — FFr 5.(iii) Place DM 15037 in the money market for 3 months to obtain a Sum of DM 1530 [ = 1503.7 in 6-months.67).65). he will sell his US dollars at FFr 5.09 x 3/12)].07 x 3/12)]. If his anticipation turns out to be true. This speculator could have bought on spot market as well but his operation is much more risky and he would have to block a part of this cash. He will buy US dollars at FFr 5.1 (= 1530 x 0.e.5 = Can$ 2.1 — 1022.

by socio-political factors like stability of government. On the other hand. Then he will take a short position in dollars by selling them at 6-months forward. etc. Operations of speculators and arbitragers also affect the markets. he will end up incurring a loss of FFr 0. he will make a profit of FFr 0.1 per US$ ( =FFr 5. The major players in the foreign exchange market are big banks. if the dollar rate in 6-months actually climbs to FFr 5.15 per US$.(b) Now.65 — FFr 5.5 per US$.75).6300/25 20/25 25/35 30/40 28 Rs/$ . He thinks that it will be available for FFr 5. CONCLUSION Exchange markets are influenced by numerous economic factors such as imports and exports. suppose that the speculator anticipates a decrease in the value of the US dollar in next 6-months. by psychological factors like anticipation of depreciation or appreciation of currency. investments and disinvestments. If his anticipation comes tale. Problem 1 Convert the following into outright rates and indicate their spreads: Spot 1-month 3-month 6-months 35. by financial operations such as lending and borrowing.75 per USS.

6350 0. the rates are: Spot Bid price (Rs) 35. Accordingly.2145 55. Thus.2200 Ask price (Rs) 55.6325 35.0025 1-month 35.6300 Ask price (Rs) 35.2160 55.2205 29 3-month 55.6330 35.2200 6-months 55.6320 35.9000/30 30/25 50/35 40/60 55/42 45/65 (a) Rupee Rate of Dollar An observation of the figures indicates that the first figure is lower than the second in all 3 forward quotes.6325 Spread (Rs) 0. it is clear that pound sterling is at discount in the forward market since points corresponding to the bid price are higher than those corresponding to the ask price.0030 3-month 35.2235 1-month 55. the forward points will be subtracted from the spot rate figures.6360 0.2200/35 40/30 23. implying dollar is being quoted at premium in the forward market.2193 .Rs/£ Rs/DM Solution 55. Thus.6365 0. Therefore. outright rates are: Spot Bid price (Rs) 55.0035 6-months 35.0035 (b) Rupee Rate of Pound Sterling While observing figures of forward quotations.2150 55. the points will be added to the corresponding spot rates.

9090 0.9095 0. for 10-month forward corresponding points will be subtracted from outright spot rates while points corresponding to 3-months and 6-months forward will be added.9040 23.066 per cent 35. outright rates are: Spot Bid price (Rs) 23.0035 3-month 23. which is calculated as follows: 35.9030 Spread (Rs) 0. Solution (i) 1-month forward: As already indicated dollar is quoted at a premium. Thus.0035 0.9000 Ask price (Rs) 23.0050 6-months 23.6300 x 12 x 100 Bid price premium = 35.9005 0.6320 – 35.8970 23.0030 1-month 23. So.6325 x 12 x 100 30 .6350 – 35.0045 0.0048 (c) Rupee Rate of Deutschmark Figures as given indicate that 1-month forward DM is at discount whereas 3-months and 6-months forward rates are at premium.0050 0.0050 Problem 2 Calculate premium or discount from the rupee-dollar rates given in the Problem 1 above.9045 23.Spread (Rs) 0.6300 1 = 0.

Ask price premium = 35.6325 x 12 x 100 Ask price premium = 35.028 per cent 35.6360 – 35.0224 per cent Problem 3 Are there any arbitrage gains possible from the data given below? Assume there are no transaction costs: 31 .0835 per cent 1 (ii) 3-months forward: Similarly. dollar premium on 3-months forward can be calculated as follows: 35.6300 x 12 x 100 Bid price premium = 35.6325 6 = 0.6325 = 0.6365 – 35. the premium on 6-months forward is also calculated: 35.6325 x 12 x 100 Ask price premium = 35.6300 3 = 0.6325 – 35.0393 per cent (iii) 6-months forward: In the like manner.6325 3 = 0.6300 6 = 0.6330 – 35.0168 per cent 35.6300 x 12 x 100 Bid price premium = 35.

5820 = £ 1 in New York Solution From the given data.89 x 1.47 (= 641.625 in London to get £ 641. 55. 35.5000 = £ 1 in London Rs.47 (= 1015. The arbitrageur would get Rs.625) (ii) Sell Rs.47 – 1000) 32 .89 in New York go get $ 1015.5) (iii) Sell £ 641.Rs. 35.625 (=100 x 35.5820) (iv) Net profit is $ 15. The following sequence will result into a gain: (i) Use $ 1000 to buy rupees in Delhi.625 = $ 1 in Delhi Rs. a triangular currency arbitrage is possible since the dollar/pound rate found by using the rates at London and Delhi is different from that of New York.89 (= 35625/55.35. 1.

 Covering through currency swaps. COVERING MARKET RISK IN THE FORWARD Covering a Transaction Exposure In order to cover himself against an exchange rate risk. The major techniques in this regard are:  Covering risk in the forward market. an importer wanting to cover himself 33 .  Covering in the options market. Conversely.  Covering in the money market  Advances in foreign currency. an exporter will sell his foreign exchange in the forward market.  Recourse to specialised organisations. the objective of the present discussion is to dwell on external techniques concerning the subject matter.EXTERNAL TECHNIQUES FOR COVERING EXCHANGE RATE RISK INTRODUCTION The preceding discussion has dealt with internal techniques to cover exchange rate risk. arising from an eventual depreciation of the currency in which he has invoiced his exports.  Covering in financial futures market.

without covering. after 3 months) was established at DM 1.1406.000 . Thus.100 (= 1.470. he would have received DM 1. for which he would receive payment of US$ 1 million in 3-months time. He would have received only DM 1. the cost of covering risk in the forward market against probable depreciation of the US dollar is DM 11. by covering himself in the forward market.000). Let us say that depreciation of the US dollar did take place and the rate on the date of payment (i. Therefore. will buy foreign exchange forward.470.4069/US$.4700/US$ The exporter sells his receivables at 3-months forward. for him.030 at the end of 3 months.003. he has reduced his risk 34 .000 (1.000 . Thus. Example 1 Suppose a German exporter Hartmann sells some machinery to an American company. the loss to the exporter would have been substantial.481.against the eventual appreciation of foreign currency. If the spot rate at the end of 3 months had remained as it is today.4810/US$ DM 1.900 and so loss would have been DM 74.900).1. In that case.e. The exchange rates are as follows: Spot 3-months forward DM 1. he would receive DM 1.481.406.481.

470.by becoming certain of his receiving DM 1.60/US$ 3-months forward FFr 5.000.8 x 10.000). he would have had to pay FFr 60.000 irrespective of the degree of depreciation of the US dollar. Example 2 Let us suppose.00 x 10.000 (= 5. But. If on the maturity date. Therefore. the rate was as on the date of contract. say FFr 6.000 US dollars in three months’ time. So. by covering himself in a forward market. this loss (or the cost of covering) was certain.000).6 x 10.000. he suffered a ‘loss’ of FFr 2. He will be paying FFr 58.000 (= 5. by covering in the forward market. he in a way gained as he would have otherwise been required to pay FFr 60. he would have had to pay. in that case only FFr 56. The cost of covering in the forward market is equal to the cost of premium or discount. a French importer is to pay 10. 35 .000). The exchange rates are being quoted as follows: Spot FFr 5. If the rate had appreciated to.000 (= 6.00/US$.80/US$ The importer covers himself by buying US dollars in the forward market.

000/56.000.6] x (12/3) x 100 = 14.0600/FFr The French company anticipates a. The exchange rates are as follows: Spot Rs 6.0 million. a translation loss = 1. 6. = [(5.8 – 5. the company will register.000 /6.28 per cent Covering a Consolidation Exposure The magnitude of exposure depends on the method of translation used by the parent company. The total translation exposure is estimated to be Indian Rs 1.Pre.434 French francs 36 .000/FFr 12-months Rs 6. If nothing is done to cover the exchange rate risk. at the end of the year. the anticipated rate is Rs. Example 3 Suppose a French multinational has an Indian subsidiary. the cost of covering = [(2.28 per cent And.3600 = 166.000.667 — 157.233 = 9.0000 — 1.000 /6.6)/5. depreciation of 6 per cent of the Indian m over the period of a year. That is.3600/FFr.000 x (12/3) x 100 = 14.

06).567) French francs. COVERING IN THE MONEY MARKET Covering a Transaction Exposure Example 4 Let us take the Example 1 of the German exporter Hartmann.FFr 1. Thus. If the anticipations turn out to be right.434 (FFr 200.001 (= 1212005/6. who wants to cover himself against a probable depreciation of the US dollar.36). The difference between the two is 9. potential loss has been compensated by a real gain.005/6. the company will buy rupees for FFr 190.005 The forward sale of Indian rupees gives French francs 203. He can do the following: 37 = X (Forward rate — Anticipated rate) = X [1/6. say X such that 9.3600)] = X [0.567 (= 1.212.001 .90.0600) – (1/6.434 or X = 1.00778] . the company can cover itself in the forward market by selling forward a certain sum of rupees.Now to avoid this potential loss.212.

 Place the marks in German money market.  Reimburse the loan taken in dollars with interest after 3-months.a. Borrow US dollars for 3-months.459.77.481 = 1.459.222 Conversion of dollars into Deutschmarks at the spot rate gives 985. Spot rate: DM 1.05 x 3/12)] = 14. Suppose the 3-months rates of interest are: Germany: 5 per cent p.a.06 x 3/12)] or = $1.353 marks 38 .  Convert these dollars into Deutschmarks on the spot.000.114 Deutschmarks The sum obtained by placing marks in 3-months money market is 1.222 x 1.481 = $ 1 USA: 6 per cent p. Borrowing dollars (D) should be such that D [1 + (0.000 D = $ 985.114 x [1 +(0.

The 30-days interest rates are: US$: 6 per annum and.353 = 3. the cost of covering in the money market is = 1.000. he should have a quantity of dollars. Thus.6 = $1 39 . emphasis should be also on the ease of covering.0 million. FFr: 8 per annum Spot rate: FFr 5.The sum received from the client in dollars at the end of 3-months is $ 1.477.481 — 1. This is used to refund the loan taken in dollars. differential in interest rates is equal to premium or discount.647 marks Note: If the markets are in equilibrium or are efficient.000 x 1. the cost of covering either in the forward market or in the money market will same as in an efficient market.000 and fears an appreciation of the dollar.000 on the due date. Example 5 Taking the Example 2 of the French importer who is to pay $ 10. one should actually carry out calculations to know where the cost of covering is less. that would become $ 10. say S. Since the markets are rarely in equilibrium.

005)  To buy these dollars.092 — 56. borrow from the spot market a sum of French francs. equal to 55.000 x (0.000 after one month: S (1 + 0.720 (= 9.000).06 x 1/12) or S = $9.000/1.092 francs. It may be noted that this cost is equal to the interest differential: = 56.08—0.  Refund the loan in French francs after 30 days by paying 55.000 40 .000.Steps involved are:  Buy S dollars and place them in the money market so as to obtain $ 10. So the cost of covering in the money market is FFr 92 (= 56.950 x 5.6). the amount of the borrowing on that market would be equal to the exposure position.720 x [ + (008 x 1/12)] 56.950 (= 10.06) x (l/12) = 93 francs Covering a Translation Exposure If a company wants to cover in the money market. = 10.  Pay to the seller the sum of US$ 10.

000/6).000. The loss would be sizeable if the rupee underwent an appreciation instead of a depreciation.Example 6 Taking example 8 of the Indian subsidiary of the French multinational. the following operations will have to be done.  Convert these rupees into French francs at the spot rate to obtain FFr 166. after one year (= 1. 1.0 million for a year on the Indian market.667 (= 1. which would give FFr 180.12 million [= 1 + (l x 0.  Place the francs in the French money market. the company will make a gain or loss. Depending on the evolution of the Indian rupee.66. 41 . We assume that interest rates are 12 per cent on Indian rupee and 8 per cent on French franc.667 x 1.08)  Reimburse the loan with interest after one year in rupees.  Borrow Rs 1. that is a sum of Rs.12)].

the costs of covering in the two markets am identical. 1. that is. This means a net gain of FFr 3.36). On the other hand. Comparison between Risk Covering in Forward and Money Markets (a) When a risk is covered in the forward market. it figures in the balance sheet and results into an increase in debt ratio. interest differential for covering in the money market.If unfavourable movement is stronger anticipated.176. than Say the exchange rate at the year end is Rs 6.12 niillio/6. The financial structure of the balance sheet is not affected. It is equal to:   premium or discount for covering in the forward market. (b) If interest differential is equal to the premium or discount on exchange rates.101 ( Rs. the refund would be equal to FFr 176.3/FFr as anticipated. the company will have a net gain. 42 . the transaction does not appear in the balance sheet. if the risk is covered in the money market. if interest parity exists.101).899 = (180 .

importers may avail advances. it has been assumed that purchase and sale of foreign currency in the forward market as well as obtaining loans in the money market is always possible and there are no constraints. Exporting enterprises surrender the foreign exchange to the bank at the spot rate. advances are a protection against exchange risk as well. This enables them to get cash in the national currency. to cover for US$ 1 million. there are exchange controls). advances constitute a means of tem financing. FOREIGN CURRENCY ADVANCES Advances can be obtained by exporting enterprises. for an exporter. if the markets are not efficient (say. The cost of covering should be the same in the forward market as well provided the markets are efficient. The operator would opt for forward market or money market. For them. Likewise. say. for example. from the financial institutions to guard against possible fluctuations in exchange rate.For the German exporter. The exchange rate risk is thus neutralized Advances in foreign exchange are even more beneficial if the rate of interest on the 43 . In the above discussion. the cost will be US$ 2. the cost of covering is likely to be different. But. In addition. depending on where the cost is less.500 if the interest differential is 1 per cent on the 3-months money market.

in France. And on maturity in order to refund the advances. e. However.g. butter. The currency futures were launched for the first time in 1972 on the International Money Market 44 . They help settle on spot the dues of the suppliers and thus enable the importer to avail discounts from suppliers. COVERING FUTURES IN FOREIGN EXCHANGE (OR FINANCIAL FORWARD) CONTRACT MARKET Initially. advance cannot be availed of until and unless the exported goods have passed through custom authorities. Foreign currency advances cannot cover the exchange risk for importers. the exchange rate risk continues to exist between the date of contract and the date when the goods pass customs clearance.foreign currency happens to be lower than that on credits in national currency. As a result. futures markets were engaged in merchandise business only. For example. eggs. cereals. monetary authorities in certain countries may impose certain restrictions on such advances. the importer has to arrange the requisite amount of foreign exchange from the exchange market. These advances are given on a fixed rate for a fixed period. raw material and so on.

etc. For example. So if the contract is of the value DM 125.01/100 = DM 12.000 x 0.(IMM) of Chicago. The smallest variation (also called ‘tick’) is 0. A currency futures contract is a commitment to buy or to sell a specified quantity of a currency on a future date. Sydney. Table 2 indicates the quotation for Deutschmark on a particular day.  Fluctuations differ according to currencies. For illustration purposes Table 1 contains the values of major currency futures contracts. Futures Markets and Contracts Currency futures markets are now functioning at Chicago New York. Tokyo. at the pre-determined/decided price existing on the date of the contract. These contracts have the following characteristics:  Transactions are traded in standard lots.000. The most important of them is the IMM of Chicago.50. 45 . Singapore. London. (presently a division of the Chicago Mercantile Exchange).  Quotations are made in terms of US$ per unit of another currency.01 per cent. traded on IMM Chicago. the value of minimal fluctuation is 125.

September and December. March June.0.6547 Latest 0. say.500.6564 0.0011 .500 500.Table 1: Transaction Lots of Major Currencies on Futures Contract at IMM Currency Australian dollar Canadian dollar Pound sterling French franc Deutschmark Japanese yen Swiss franc Amount 10.6536 0.0.6581 ChangeHigh + 0.000 100.000 125.000 125.6520 0.000 and is made with the Clearing House. 46 . This deposit is of the order of US$ 1.6581 148  Maturity periods are also standardised.6539 0.000 12.6507 74.000 62.  A guarantee deposit is required to be made for selling or buying of a contract.433 0.0005 0.6546 2.023 .6564 Low Estimated Volume 0.000 Table 2: Deutschmark Futures Quotation in Relation to US$ on IMM (Contract amount: DM 125.000) Open March June September 0.

the Clearing House calculates the situation of each operator. Operating Procedure of Futures Markets First of all. an enterprise A buys a currency futures contract through a broker X from another enterprise B ass with/related to broker Y. Thus. assuming there were no transaction costs. For instance. it proceeds to call for maintenance margins from the operator who has registered a loss and 47 . The broker will deposit this sum with the Clearing House. They are very close to forward rates of the same currency for the same maturity date. both enterprises deal directly with the Clearing House. Once the engagement has been made. the interested enterprise is required to make a guarantee deposit with a broker who is a mediator between the enterprise (or the player in the market) and the Clearing House. As the rate of the contract evolves. Everyday. In fact. there would be a profit to the operator without risk.Futures rates differ from spot rates for the same reasons as forward rates. it would be easy to buy in the forward market if the currency was cheaper and sell futures contracts in the same currency at the same time. if forward rates were much different from futures rates of the same maturity.

conversely. In other words. credits the account of the other party who has registered a gain. They are closed by a reverse operation: the buyers resell the contracts and the sellers repurchase the contracts. with a similar settlement date. 48 . sale of a currency future contract protects against a depreciation of the currency of contract. A company that has exported and is to receive its dues in pound sterling will sell future contracts in pound sterling corresponding to the value of exports. If the enterprise A wants to sell its contract. Most of the contracts (98 per cent) on the futures market are not delivered. Purchase of a currency future protects against an appreciation of the currency of contract. Principle of Covering the Risk The principle is to compensate a loss of opportunity on the s market by a gain of almost the same amount on the futures market. the same is executed by him through his broker who finds another buyer. The enterprise A will have made a gain or loss depending on the evolution of the rate of futures. Similarly. one should take a reverse position on the futures market vis-à-vis the position that one has on the spot market.

that is 28P dollars [=(0588 — 0. The DM March future contracts are quoted at US$ 0.A company that has imported and is to pay in Deutschmarks will buy DM future contracts to protect against an appreciation of Deutschmark.000]. Example 7 An American company has exported in January of the current year to a German client.587— 0. The American company wants to cover itself against the risk of a depreciation of DM.559) x 8 x 125. The spot rate in January is US$ 0.000.0 million are due in March.560) x 49 . This gain is equal to the loss of opportunity on the spot market.0 million (= 8 x 125.559 dollar per DM.  During all this period up to the maturity date. In March. this company repurchases (or closes) the contract at a rate of 0. each of DM 125. The total amount covered is DM 1.  In January the American company deposits the guarantee with the Clearing House and sells 8 DM future contracts. The payments of DM 1.0000 dollars [= (0.000).587 per DM. the American company will pay maintenance margins if DM rises and conversely will have its account credited if DM slips.588 per DM. It makes a gain of 28.

000]. Comparison between Covering on the Forward Market and the Futures Market Both the forward market and the futures market serve the same objective of covering the foreign exchange risk. the number of futures contracts should be either 8 or 9. in the case of 8 contracts. there may be some uncovered loss and some costs of transactions which have been ignored here. However. In case it is 9. Note: To simplify the calculations. For instance. 50 .56 dollar per DM. there arc some significant differences in their modus-operandi. The spot rate on the date of closure or repurchase of the contact is 0. if the sum to be covered was DM 1. then. In reality.000. And.1. the amount covered may be less or more than the sum involved in a transaction.125 rather than DM 1.1 million.1 million. Also. we would be covering DM 1. the rates have been so chosen as to compensate the loss of opportunity in totality. we would be covering DM 1 million. Thus. Table 3 provides a comparative summary of forward market and futures market. the amount to be covered may not always be in exact multiples of standard futures contract lots.

Pads. Nowadays. at Amsterdam. London. interested investors/enterprises can deal in options to buy or sell common equity. Vancouver. bonds. The first organized market in options in currencies was opened in Philadelphia in 1982. 51 . etc. Singapore. etc.Table 3: Comparison between Covering on Forward Market and Future Market Futures Market Standardized contracts Guarantee deposit Clearing house Quotation on market Commission or brokerage Forward Market Tailor-made risk coverage No guarantee deposit Contract with a bank Quotation by a bank Quoted rate (Spread between buying and selling rates) COVERING IN THE FOREIGN EXCHANGE OPTIONS MARKET An option gives its holder a right (but not an obligation) to buy or sell an asset in future at a price that is agreed upon today. for example. Montreal. New York. Chicago. Many other markets have since developed. commodities and currencies.

Put Option The holder of a put option acquires a right but not an obligation to sell a certain quantity of foreign currency at a predetermined strike price. It is taken recourse to by companies to cover the exchange rate risk. These are bought or sold at a premium. it is the holder (buyer or owner) of an option who has a choice to use or abandon the exercise of the option whereas the seller of an option should be ready to sell 52 . which is paid to the writer of the option. Call Option The holder of a call option acquires a right but not an obligation to buy a certain quantity of foreign currency at a predetermined price (also called exercise or strike price). There exist two types of options: call and put options.It is an instrument that permits its holder (buyer or owner) to take advantage of a favourable evolution of exchange rate. usually in local currency per unit of foreign currency. Thus. A writer (or seller) of a call option has an obligation to sell a certain amount of foreign currency at a predetermined price. The writer of a put option has an obligation to buy a certain amount of foreign currency at a predetermined price.

The option which a holder enjoys could be the one where he can exercise his right any time during the life of the option. or on. This type of option is referred to as of American style. Premium on Options The premium paid for buying a put or call option depends upon several factors and is comparable to an insurance premium. a call option on.  Volatility of price movements. then he has also a right to sell Indian rupees at a specified dollar rate. US dollar is also simultaneously a put option on the other currency of transaction.(in case of call) or buy (in case of put) the amount agreed upon. The latter has no choice of his own. if the holder has a right to buy US dollars against Indian rupees at a predecided price. the maturity date. The other type is of European style where the holder can exercise his right only on expiration of. The major factors in this regard are:  The difference between the exercise price and spot price. 53 . Indian rupees For.  The maturity periods. say. It should be noted that unlike stock options. say.

 Risk free interest rate in the.  Volatility of the spot currency rate. domestic country.  Risk free interest rate in the foreign country. etc. This is because the holder stands to lose when he exercises the call option. A put option becomes less valuable with the rise in spot price and vice-versa. the higher will be the option premium and vice-versa. Determinants of Option Value These are:  Spot rate. the call option tends to lose value. the holder tends to gain on exercising the option. Strike price: Strike price is the price at which the deal will take place when an option (call or put) is exercised.  Expiration date (time to expiration). Spot rate: The effect of this variable on the option price is quite evident. A put option moves in direct relation with the strike price and with the rise in strike price. 54 .  Strike price. With the rise in strike price. the higher the spot rate. A call option tends to vary inversely with the strike price. Interest rates. In the case of a call option.

20/FFr He is considering call option for the purpose as he will be required to buy foreign exchange (i. He decides to cover himself in the ‘option market’. The data are: Exchange rate: FFr 500/US$ or US$ 0. Example 8 A French imparter has bought an equipment from a US firm for US$ 1 million on 1 March in the current year to be paid for in 3 months. i.e. both call and put options gain value.000 (= 1 million x 0.Time to expiration: With the increase in the time to expiration.05/US$ Maturity date: 1 June Premium: 3 per cent The buyer of the call option.000 x 5). the importer pays the premium amount of US$ 30. 55 . will have a higher time value.e.03) or FFr 150. US dollars).00) (= 30. The importer fears an appreciation of the US dollar. This is because the option with a longer time to expiration. other things being held constant. The characteristics of call option are: Strike price: FFr 5.

75/US$. 2nd Possibility: The US currency has undergone a depreciation and on 1 June.000) French francs = 5. In this situation.75/US$.20 million French francs Thus.05 per US dollar.000 + 150. 56 . He will pay thus.On 1 June. his net price is FFr 4.0 million + 0. there are three possibilities: 1st Possibility: The US currency has appreciated and the spat rate is FFr 5. In this situation.05 x 1. Total cost = (5. his net price is FFr 5.0 million).9/US$ instead of FFr 4.75/US$. the holder of the call option will exercise his option and buy US dollars at the strike price of FFr 5.20/US$ instead of FFr 5. it is at FFr 4. he abandons his call option and buys dollars from the market at FFr 4. FFr 5. His total payment is thus: (4.5/US$.5/US$.75 x 1.15 million) French francs = 4.05 million (= 5.90 million French francs Thus.050.

Sum paid (million FFrs) 5. that is. 1.20 million French francs.000 + 150.1: Sum to be Paid under the Call Option 57 .05 5. He pays: (5. The graphic representation of the call option is given in Fig.05/US$.2 5. he can afford to be indifferent to either the market option or the call option.1 5.20 million. whatever be the level of appreciation of the US dollar.20 Z N 5.3 Exchange rate (FFr/$) Fig.000) French francs = 5. Here. He will pay the same price whether he resorts to one or the other.3rd Possibility: The US dollar is at FFr 5. the same amount as in the first possibility. This means he has never to pay more than FFr 5.050.

if the German currency depreciates.22/DM.75). The strike price is decided to be Rs. Sum paid (million Rs) 22. he 58 . The operation is graphically represented in Fig.435 Z N 21 22 23 24 25 26 Exchange rate (Rs/DM) Fig.22.Example 9 An Indian importer is to pay DM 1.435/DM (= 22.0 million on 1 March in the current year. Fearing a depreciation of the US dollar. 2: Sum to be Paid under the Call Option Example 10 A French exporter is to receive US$ 1.0 million on 1 September in the current year.02 x 21. In the case of appreciation of the Deutschmark. having sold his product in January. the net price to be paid by the importer is going to be Rs.00 + 0. 2. the importer will abandon his call option. He buys a call option by paying 2 per cent premium on the current price. He wants to make sure that he does not pay too high in case the Deutschmark appreciates. The current rate is Rs.21. Conversely.75/DM.

8 million French francs If he had not covered his risk through the put option.95/US$. He. He exercises his put option and sells dollars at FFr 4. Either way.2 – 0.95 x 1 – 0. In this case.70/US$. The data are: Spot rate: FFr 5.03 x 5. 2nd Possibility: The US dollar has appreciated to. 1st Possibility: The US currency has depreciated to FFr 4.95/US$.7 million French francs. he would have received only 4.decides to cover his risk through a put option. he will receive a sum of 59 . thus receives: (4. He thus receives: FFr (5. say FFr 5.0/US$ Premium: 3 per cent Date of maturity: 1 March Exercise or strike price: FFr 4. 3rd Possibility: The rate on 1 March is FFr 4. or selling in the open market.2/US$.0) million French francs = 4. He abandons his put option and sells his dollars in the open exchange market.95/US$.05 million.15) million = FFr 5. he need not worry about either making use of his option.

Sum received (million FFrs) 4.95 brings a greater advantage to him and a price less than FFr4.15) million French francs = 4. irrespective of the degree of depreciation of the US dollar.8 4. Any price above the strike price of FFR 4. 3: Sum to be Received under the Put Option In view of the above.8 million.8 million French francs Thus. it is apparent that the enterprise/operator needs to be more vigilant/watchful towards trends in exchange rate while covering in the 60 . he is assured of getting at lease FFr 4.2 Exchange rate (FFr/$) Fig.95 – 0. The graphical representation of the operation is shown in Fig.95 does not affect his receipts which do not fall below FFr 4.95 5.0 5.8 million.(4. 3.9 4.1 5.

he would pay only Rs 35.60 per dollar.90. For example. Covering against Exchange Risk by Purchasing Tunnel with a Zero Premium Since premium represents a non-negligible cost. One would choose between the two depending upon the anticipations of future rates. An Indian importer buys a 1-month tunnel with zero premium. then he would have to pay the actual market price.option market unlike covering in the exchange market where everything is certain. he would have to pay Rs 35. But.00 per dollar. if the rate is Rs 34. on the other hand. This means that if after a month’s time the dollar rate is Indian Rs 35. If the dollar price is established somewhere within the range.70. Besides the tunnels of narrow range. banks propose to their clients the option with zero premium called tunnel. let us consider the data of the Table 4. of narrow range. The importance of tunnels lies in the fact that one dc not have to pay premium but at the same time they do not allow the operator to get the fill advantage of a favourable evolution of rates. 61 . but protection is available only within certain limits. there are tunnels of wider range too.

75-36.00-35.60 34.Table 4 Tunnel with Zero Premium Maturity Narrow range Wider range 1-month 35.00-36.80-36. They are equally used by foreign currency lenders.25-36.50 Importance of Options Options are used by: • exporters. They are equally used by the foreign currency borrowers.30 6-months 35.25 3-months 35. it is an important instrument for hedging for foreign 62 .35 33.50-36.00 34. Put options are used by exporters who have invoiced in foreign currency and fear a depreciation of that currency. • investors. CURRENCY SWAPS Swap is essentially an exchange of two transactions. • companies bidding for global contracts. • banks and financial institutions. Call options are used by companies that have to pay for their imports in foreign currency but fear an appreciation of the currency of invoice. • importers.

$ 1m American Company DM 1. Suppose an American company wants to borrow Deutschmarks at a variable rate. the spot rate being DM 1. Figure 4 illustrates the swap.4m American Company $ 1m Bank Bank Bank Fig 4: Swap between a Company and its Bank 63 . there is an exchange of the principal: the American company pays to its bank 1 million dollars and receives 1. On the date of the contract.exchange transactions in which two streams of payments am exchanged. The company is well placed on the American market.4/US$.4 million Deutschmarks.4m Variable rate American Company Fixed rate DM 1. It borrows US$ 1 million on the American market at a fixed rate and enters into a swap deal with its bank. the company will pay a variable rate on the Deutschmarks while the bank will pay it a fixed rate on dollars. Them will also be a re-exchange of the principal on the maturity date. During the contract period.

The exchange rates are quoted as follows: Spot: FEr 3. internal as well as external. Nowadays a number of techniques are available such as hedging in forward rate market. special attention was paid to the possibility of a currency devaluation.3876/DM 6-months forward: FFr 3.0 million in 6 months. currency futures. named Charles.Currency swaps are comparable to a forward exchange transaction with a difference that the differential of rates is calculated periodically instead of being settled just once at the end of the contract. options and swaps. In periods of fixed rate regime. CONCLUSION Volatility of exchange rates makes it necessary for companies engaged in international operations to take measures for covering against exchange rate risk. In floating rate regime. is to receive DM 1. Several techniques are used. it comes important to anticipate evolution of rates and adopt appropriate strategies for covering risks.3368/DM 64 . this feature renders the swaps more efficient and more flexible than covering in the forward market for long periods. Problem 1 A French exporter. money market.

(a) There is a fear of depreciating of DM in the near future. What should Charles do? (b) What would you suggest to Charles in case an appreciation of DM is likely to take place? Solution (a) Since the rates given above indicate that DM is at a forward discount, Charles will do well to cover himself in the forward market. When a currency is selling at discount in the forward market, there is a possibility that it would undergo a depreciation. So it is safe to cover the receivables of that currency in the forward market. Thus, Charles will sell his DM 1.0 million in the forward market and receive FFr3.3368 million at the end of 6-months. If the spot rate at the end of 6-months was the same as the spot rate today, the cost of covering (or the loss) for Charles would be FFr 50800 (= FFr 3.3876 million – FFr 3.3368 million). The depreciation of DM indicted by the forward rate is the following: 3.3876 – 3.3368 x 100 = 3.3876 = 1.4966 or 1.5 per cent

So, if DM depreciated more than 1.5 per cent between now and 6-months hence, Charles would make a loss bigger than FFr 50,800 in case he decided not to cover in the forward market. (b) In case of a likely appreciation of DM, Charles need not do anything. Any appreciation in the currency of receivables (DM in the present case) would be profitable to the receiver. Problem 2 An Indian company C & Co. imports equipment worth $1.0 million and is to pay after 3 months. On the day of the contract, the rates are: Spot: Rs.35.00/$ 3-months forward: Rs.36.25/$ (a) There is an anticipation of a further fall of rupee. What can C & Co. do? (b) What would C & Co. do if it knows with a high probability that, in 3-months, dollar will settle at Rs.36.00/$. Solution (a) Since there is an anticipation of a further fall in the value of rupee (or in other words an appreciation of dollar), it would be wise to cover the payables in the forward market.

Thus, C & Co. will have to pay at the end of three months Rs.36.25 million. So, the net cost of covering the payables in the forward market is Rs.1.25 million (= Rs.36.25 million – Rs.35 million). If the rupee had fallen to Rs.37.10/$ ( a depreciation of 6 per cent) and if C & Co. had not covered itself in the forward market, the loss to it would have been Rs.2.10 million. (b) If C & Co. knows with a high degree of certainty that the rupee is likely to settle at Rs.36.00/$ in 3-months, it would be advised not to cover in the forward market. It would pay Rs.36 million at the end of 3-months, the sum which is less than Rs.36.25 million. Problem 3 An Indian exporting firm, Rohit and Bros, would like to cover itself against a likely depreciation of pound sterling. The following data is given: Receivables of Rohit and Bros: £ 500,000 Spot rate: 56.00/£ Payment date: 3-months
3-months interest rate: India: 12 per cent per annum

UK: 5 per cent per annum What should the exporter do?

941 – 500. The following steps are required to be taken: (i) Borrow pound sterling for 3-months.05 x 12 = 500. it is clear that the money market operation has resulted into a net gain of Rs.493.000 x 56).654. Say. The borrowing has to be such that at the end of three months.483.483.312 (iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the end of 3months: 3 S = 27.312 x 1 + 0.941 The sum of £ 500.000.654.941 (= 28. the only thing that Rohit and Bros can do is to cover itself in the money market. 3 D 1 + 0. 28. the amount becomes £ 500. 68 . the amount borrowed is £ D.827 x 56 = Rs.000 received from the client at the end of 3-months is used to refund the loan taken earlier. Therefore.827 (ii) Convert the borrowed sum into rupee at the spot rate.Solution Since no other date is available. This gives: Rs.483. From the calculations.27.000 or D = £493.12 x 12 (iv) = Rs.

the gain would be even bigger.668. He can take the following steps: (i) Buy S dollars at the spot rate and place them in the money market so as to obtain $ 100. the UK importer has to work out possibility that exist for him to cover himself in the money market.000 in a month’s time. He fears an appreciation of the dollar.If pound sterling has depreciated in the meantime. What can he do with the knowledge of the following data? 1-m interest rate: US$: 4 per cent UK £ : 5 per cent Spot rate: $ 1.000 or S = $99.04 x 12 = 100. Problem 4 A UK importer has to pay $100. 69 . That is. 1 S 1 + 0.553/£ Solution Since only the money market data are available.000 in month’s time.

the dollar had appreciated and the payable was not hedged.013.3 . the loss would have been greater.416. Use this sum to pay the payable due. The borrowing B is. 99668 B =1. which means a loss of about £ 650.416.05 x 12 = £ 64. The cost of covering in the money market works out to £ 53.000. The refunded amount would be: R = 64149 1 1 + 0. the equivalent amount of pound sterling is required to be borrowed. Even 1 per cent depreciation of pound sterling ($ 1.5537 = £ 64.5382/£) would require a payment of £ 65.000 = 64. Problem 5 70 .5537 In case.3 (iv) In the meaning the sum of S dollars placed in the money market would mature to $ 100.149 (iii) Refund the sterling loan after one month.81 100.1.(ii) In order to buy S dollars.

To avoid this loss. 6993 = X (Forward rate . the company will do well to buy pound sterling forward (or sell rupee forward) such that the difference is equal to the anticipated loss. Say. Then.200/£.3200/£ A 4 per cent depreciation of the rupee is expected. In that risk. The rates are as follows: Spot: One-year forward: Rs. the company will suffer a translation loss equal to: 10 million 10 million £ 55 . 57.56.10 million.Anticipated rate) 71 .2 = £ 6993. it sells Rs.An Indian subsidiary of a UK multinational has a translation exposure or Rs. How can the exchange risk be hedged? Solution The anticipated rate after expected depreciation would be: Rs. X.57. Suppose.55. no action is taken to hedge the risk.0000/£ Rs.

017482517] 72 . = X [0. with less amount of pounds sterling.555. the company will buy the Rs.974 This amount of rupees will give the following amount of pound sterling in the forward market: 25.50 . That is. if the anticipated depreciation of the rupee (or appreciation of pound sterling) does take place.2 = £ 447. X back.599.974 56.974 57.599.017755680 – 0.45 However.99 The difference between the two (£ 454.3200 = £ 454.2000 or 6993 or X = Rs.1 1 = X 56.3200 .545.599. 25.545.555. for 25.57.99) is equal to the loss (£ 6959.51) that would have accrued without hedging.£ 447.

5 million x 1. Interest rates are 8 and 11 per cent for the franc and the rupee respectively. If the anticipated depreciation of 6 per cent does take place. (2) Place FFr 0.25 million FFr.25 million in the money market for a year at 8 per cent. This would give FFr 0.5 million at 11 per cent and convert them into French francs at spot rate to obtain: Rs.27 million after a year.6.1. 73 .1. (3) The sum thus obtained is converted into rupees.11) = Rs.36/FFr.Problem 6 Total translation exposure of a company is Rs. The rupee is likely to depreciate by 6 per cent. Solution Since only the interest rate data is available. This exposure is in French francs.5 million/6 = 0.27 million x 6.6 per FFr.(1. the hedging operation is to be done in the money market.36) = Rs. How is hedging to be done? Spot rate is Rs. the amount in rupees at the end of the year would be Rs. The refund amount works out to Rs. 1.7172 million. (0. the rate would settle at Rs. So.665 million.1. The following steps are involved: (1) Borrow Rs. (4) Refund the rupee loan with interest.5 million.1.

the total number of future contracts to be sold is 60 (= 30 million/0.185/FFr and the future contract is likely to be quoted at $0. Problem A French company imports in January an equipment from the USA for $6 million.208. 1. To guard against the depreciation of the French franc. 74 . This also means that the French franc would depreciate.Thus. The payment is US dollars.7172 million – Rs. Thus.5).178/FFr. the importer can sell French franc future contracts. since the value of one futures contract is FFr 500. What is the hedging efficiency? Solution The US dollar is likely to appreciate against the French francs. The gain in French franc would be FFr 8.1. What should the French importer do? Assume further spot rate on settlement date is $0.52.665 million). The amount involved is $6 million or FFr 30 million (= 6 million/0.2).2/FFr. The spot rate is $0.000. the hedging operation would result into a net gain of Rs.200 (= Rs. The FFr future contract for June is quoted at $0.19/FFr.

000 = $ 360. The pound 75 .185/FFr and the futures contract is being quoted at $0.185) million = FFr 2.945.432 – 1.945. It is equal to 1.178/FFr.946. During the period JanuaryJune.The French importer deposits the security amount with the Clearing House.185 = FFr 1.946/2.5 million receivable due in September against the exports made in June. Net loss = FFr 2.486. On the due date in June the contract is closed (or repurchased). Note: The loss is not fully covered as spot rate deteriorated more than the future rate. Say. However.000 = FFr 360. The importer makes a loss: FFr (6/0.000/0. the spot rate on the due date is $0.432. Hedge efficiency can be defined as the ratio between the gain made on the future market and the loss payable due to rate movement on spot market. it makes a gain equal to $ (0. Problem 8 A British exporter has $2. on the future market.432432 million.945 = FFr 486.432 x 100 = 80 per cent.2 – 6/0.19 – 0.432.945. the importer will pay margins if the FFr rises and have its account credited if the FFr slips.178) x 60 x 500.

6250] = £71. He can reduce this loss by hedging with future contracts.500 x 1. he makes a loss of 2.75 Since the contracts are available only in integral numbers. Sterling future rate: $1.5530 = 25. Let us say the following rates are being quoted on 15 September (the date of payment): Spot rate: $1.000/62. Pound sterling September future contract $ 1.326.5600/£ What can the exporter do? Solution If the British currency is going to appreciate between June and September. 76 .sterling is heading for appreciation. the exporter will suffer a loss on the data of payment.5530/£. So.500.6275/£ When the exporter receives his dues.000 [1/1.6250/£ September. Say.500. the number of contracts to be purchased is: 2. The amount of sterling future is £ 62.5530 – 1/1. The June data are as follows: Spot rate: $1.500. he buys 26 of them. so the exporter can either buy 25 or 26 contracts.

The company would like to hedge in the options market.500 = $109.On the other hand. has its receivables of DM 1.688 109. The rupee has tendency to appreciate. The current rate is Rs. Problem 9 The company ABC & Co.2020/DM.33 per cent. the gain would have been: £ (1. Note: In case the exporter had decided to hedge with 25 futures contracts.6250 = £ 67.326 – 67.500/71. The data are as follows: Strike price: RS. So. hedge efficiency would have been: 64.500. Premium: 2 per cent 77 .688/1.904.326 = 91 per cent.0 million due in 3-months.6275 – 1. he makes a gain on the futures contracts.326 x 100 = 94.24.500 x 1/1.23.826.50/DM. And.6250 = £64. the net loss is: £ (71.5600) x 26 x 62.904/71.500) = £3. The gain is: $(1. The hedge efficiency = 67.5600) x 25 x 62.6275 – 1.

Net loss: Rs.000. Thus.22. The loss without hedging would have been: Rs. put option is 78 .23.2600/DM.692. it will receive a sum of: Rs.040) = Rs. it would be wise to buy a put option on DM. 23.23.5 – 484.015. is going to lose if the rupee appreciates between now and 3-months hence when payments of its receivables will be due. (24.186. ( = Rs.000 – Rs.1.24.000 x 23. Naturally. which is Rs. 484.50/DM.23.1. The following possibilities may be considered: (i) Rupee does appreciate and its value settles at Rs.5100) million = Rs.000.2020 – 22. in this situation.016 million.040. The company will make use of its option to sell DM received at the strike price of Rs.Which type of option is involved? How is this option to be used? Solution Since the company ABC & Co. (ii) Rupee depreciates in a small measure and is quoting on the due date at Rs.5100/DM.960 or Rs. The company would pay the premium amount immediately.

1. Thus.23. the value corresponding to the strike rate minus the premium amount).01596 + 0.015. the company will always receive a minimum sum of Rs. the company is neutral between the choices of using and abandoning the option at a rate equal to the strike price.23. the net sum is still less than Rs. Note: Irrespective of the level of appreciation of the rupee.23.960. The company will receive a net sum of Rs.50/DM. Here.775.960 (that is.000 x 24. Therefore. that is Rs.2600 – 484.abandoned.040 = Rs. it is to be noted that the depreciation of the rupee has not been able to compensate the premium amount paid for buying the put option.202)/DM or Rs. 79 .02 x 24.