ajnext.com · 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

STRATEGIC FINANCIAL

MANAGEMENT CA FINAL by A N SRIDHAR

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STRATEGIC FINANCIAL MANAGEMENT 2

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8

FOREIGN EXCHANGE - BASICS

THEORY

Foreign Currency Accounts

To facilitate dealings in foreign exchange, a bank in India may maintain accounts with banks abroad. Similarly, some foreign banks may maintain accounts with banks in India. There are mainly three types of accounts:

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, PNB may maintain an account with Citibank, New York. Obviously, the account would be in US dollar. All foreign exchange transactions are routed through Nostro accounts.

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

Let’s say that State Bank of India is having an account with Citibank, New York. When 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.

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CONCEPTS

Terms in Foreign Exchange

Direct Quote

Consider a foreign exchange quote of 1 £ = ₹ 96 / ₹ 96.50. Here we are expressing one standard unit of pound in terms of some units of Rupees. For an Indian, Pound is a foreign currency and Rupee is Domestic Currency. Therefore, we are expressing one standard unit of foreign currency in terms if some units of own currency. This is called the Direct Quote of Pound in terms of Rupee for an Indian. Similarly 1$ = £ 60 is a Direct Quote of $ for an Indian.

Bid Rate / Ask Rate

In the above quote £96 is called the Bid Rate and $96.50 is called the Ask Rate.

Note: The given quote is always with respect to the person (generally the Banker) who is giving the quote £ 96.50 is the Bid Rate i.e. the rate at which the Bank would buy the pounds and £96.50 is the ask rate i.e. the rate at which the Bank would sell the pounds.

For a customer, who wants to sell pounds, the rate applicable would be £96 because the bank is buying at this rate from the Customer. Similarly, if the customer wants to buy pounds the sell rate of the bank would be the applicable Ask Rate.

The reason behind Ask Rate always exceeding Bid Rate is that the Bank which is giving the Quote has an intension to make profit out of the Deal. In fact all Forex quotes follow this rule.

Spread

The Difference between Ask Rate and the Bid Rate is called the Spread. We can calculate spread in ‘%’ terms using the formula –

% Spread = (Ask – Bid)/Bid x 100

Note: The Average of Bid and Ask Rate is called the Mid Rate

Indirect Quote

A quote which is not a Direct Quote is called an Indirect Quote

Notation of Foreign Currency Quote

Every Forex Quote is generally expressed in A/B format. The currency that is expressed in standard unit is shown in the Denominator and the other currency in the Numerator. Therefore, we would express 1 £ = ₹96 /£ 96.50 as ₹/ £ quote.

Spot, Tom, Cash, Forward

By default, all foreign exchange transactions are considered settled on Spot basis.

a. Spot settlement refers to settlement in 2 Business days.

b. Tom settlement refers to settlement in 1 Business days.

c. Cash settlement refers to settlement on same day.

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Forward settlement refers to settlement beyond 2 Business days.

Inverse Quote

Consider a Forex Quote 1$ = £ 60. If we express this quote as 1 £ = $ 1/60 by exchanging the place of currencies then this is the inverse quote.

American Quote and a European Quote

An American Quote is that quote where we express a Standard unit of a foreign currency in terms of US Dollars. i.e. 1 FC = $ ______.

A European Quote is that quote, where we express a dollar in terms of some units of a foreign currency i.e. 1$ = FC____

How to use quote to find equivalent quantity of opposite currency?

Refer Class Discussion

Appreciation and Depreciation of a currency

A Currency is said to have appreciated, when we are able to buy more of the other currency than in the past and when one currency has appreciated it obviously means the other currency has depreciated.

Example: Jan 15 1$ = ₹64

Mar 15 1$ = ₹65

Between these two periods the dollar has appreciated.

When we say that the Currency has depreciated, then we know that we are able to buy less of the other currency than in the past.

Example: Jan 15 1$ = ₹66

Mar 15 1$ = ₹65

Between these two periods the dollar has depreciated.

Note:

To know the % appreciation/depreciation of a currency, we must have the quote of the currency expressed in standard units. When we are calculation the appreciation/depreciation, we generally use the Bid rates or the Mid-rates of the respective two quotes of two different periods. If the period relates to a past then we use the terms appreciated/depreciated and if it relates to future we use the terms ‘may appreciate’ or ‘may depreciate’.

Premium/Discount of a currency

When we compare a quote of a currency in the SPOT market with the FORWARD market, then we can comment on whether the currency that is expressed in standard unit is at a Premium or a Discount in the forward market. When the forward rate exceeds the spot rate, we say that

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the currency is at a premium in the forward market and when the forward rate is less than the spot rate, we say that the currency is at a discount in the forward market.

Premium of one currency indicates that the other currency is at discount. To calculate premium/discount, we use the following formula and we always express it in annual terms. We may either use Bid/Mid rates to calculate the same.

Premium/Discount =

Note: If the answer is positive, then the currency that is expressed in standard units is at a Premium. If the answer is negative, then the currency that is expressed in standard units is at a Discount.

To calculate Discount/Premium of other/opposite currency, we use Inverse Quotes.

Swap Points

The term swap refers to a pair of trades i.e. a buy and a sell position of equivalent amounts executed at the same time in two different markets (here one in the Spot Market and the other in the Forward Market).

Consider a customer is buying or selling currency. In this trade, the bank takes the opposite position as part of the contract. This being a currency position, it is subject to daily fluctuations in values and therefore the bank is exposed to risk.

If the buying/selling happens in the Spot Market, the bank immediately squares / covers the position in the Spot Market.

Whenever a forward quote is sought from a banker, the motive of the banker is to hedge an outstanding position in the forward market.

If a customer, buys/ sells foreign currency in the Forward Market , then the bank would have taken an opposite position i.e. Sell/ Buy matching the forward period. Now, the bank has an outstanding position in its books for that forward period. Since, bank cannot continue holding this position till the end of forward period, it rectifies this position by doing the following two trades –

1. Bank enters into a Swap Contract

If the customer has sold dollars, then the bank has taken a BUY position. If it does a swap contract, then it would square off its BUY position by selling in the forward market and simultaneously BUY the same quantity in the Spot Market. By doing this swap transaction, the Bank has shifted its BUY position in the forward market to a BUY position in the Spot Market. Now the exposure of BUY position is in the Spot folio.

2. Reversal in the SPOT market

To rectify the outstanding BUY in the Spot folio, the bank would Square the deal (i.e. SELL) in the Spot Market.

100n

12S

SF××

−

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Note: There is no active market that exists to directly reverse a forward trade, but an active market exists to do pair trades in the forward & spot together. Hence for all forward trades of customer, the Bank does a swap + reversal in the spot market.

These two trades involve some costs to the banker and they are quoted as SWAP points.

A Bank may choose not to do the above two procedures if they have an opposite request from another customer matching the same quantity and period.

These points would help in arriving at the implied forward rates. When the Swap points are quoted in the Ascending order, then we add them to the Spot Rates on the Bid and the Ask side to arrive at the respective implied Bid and Ask Forward Rate. When the Swap points are quoted in the Descending order, then we deduct them from the Spot Rates on the Bid and the Ask side to arrive at the respective implied Bid and Ask Forward Rate.

Swap Points Asc→Add

Swap Points Desc→Deduct

Before Adding or Deducting, we align the Decimals in swap points with respect to the given SPOT rates i.e. if SPOT has three decimals, convert the swap points to three decimals.

Cross Rates

Whenever we talk of involving more than two currencies, then we are talking of cross– rates. Cross- rates are calculated when we do not get a direct quote for a currency and it involves more than two currencies.

Refer class discussion

Nostro Account Reconciliation

Cash Position: Banks maintain accounts with counter – party banks always in foreign currency (Nostro Account). Banks depending on foreign exchange requirements have many such accounts in different currencies. It is not uncommon that the bank may have more than one account even in one currency. Balances available in the accounts reflect cash position. Cash position in foreign exchange, deals with all the transactions effecting Nostro account, funding of Nostro (in case of overdraft), utilization of surplus cash balance in Nostro and deployment of funds so as to ensure optimum utilization. Examples are delivery under forward contracts, inward /outward telex transfer. It is also called fund position. Currency Position: It deals with daily sale / purchase of foreign currency / transaction. It could be excess, less or equal. In that case we call it overbought (more purchase) Oversold (more sales) or Square (purchase matches sales) respectively. Open position needs to be covered suitably considering amalgamation of transactions. It is also called exchange position. Cash position and Currency position do not tally.

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The aggregate relationship between the amount of a currency bought and the amount of the same currency sold is known as ‘position‘ in the currency. It can be as under: Overbought position: If amount of foreign currency bought by a bank is more than the amount sold, the bank is said to have ‘overbought’ or ‘long’ or ‘plus’ position. Oversold position: If amount of foreign currency sold by a bank is more than the amount bought, the bank is said to have ‘oversold’ or ‘short’ or ‘minus’ position. Square position: If amount of foreign currency bought by a bank is equals the amount sold, the bank is said to have ‘square’ position. Similarly, if there is small difference in a currency bought and sold the bank is said to have ‘Near Square position. Purchases and Sales in Nostro A/c. As we know that Nostro A/c. is a foreign currency account maintained overseas. The purchase transactions are inflows into account and sale transactions are outflows from account. Purchase Transactions 1. Payment of inward remittance received through TT, MT, DD and payment of TCs, purchase of personal cheques drawn in foreign exchange. 2. Conversion of proceeds of instruments sent on collection basis. 3. Cancellation of outward TT, MT, DD, PO etc, 4. Purchase/ discount/negotiation of export bills. 5. Inter-bank Cash/Tom/Spot/Forward purchases. 6. Purchases in overseas foreign exchange markets 7. Cancellation of forward sale contract. Sale Transactions 1. Clean outward remittance in foreign currency by TT, MT, DD, PO. 2. Payment on account of remittance for import bills, 3. Inter-bank Cash/Tom/Spot/Forward sales, 4. Sales in overseas foreign exchange markets, 5. Cancellation of forward purchase contract. Effects of transactions in Cash and Exchange position A/c. 1. There are two accounts to be maintained - Cash Position and Exchange Position 2. Cash Position reflects effect of debit or credit to Nostro A/c maintained with counterparty bank which will be effected immediately - spot 3. Exchange position too effects debit or credit to Nostro A/c which will be effected either in spot or forward 4. All transactions should be drawn by or drawn on bank preparing reconciliation 5. Transactions already effected in the exchange account in past would not be re-effected. In other words, past transactions of exchange account would affect only cash account on realization or payment 6. While preparing reconciliation statement, due date is very relevant. 7. Invariably most transactions would be effected in Exchange account except for those which were already effected in the past Effects of transactions: a) TT - Telegraphic Transfer - Instant remittances used by customers to remit money to their

clients and suppliers. Since they are 'instant' remittances they would affect cash account every time. A bank would remit a TT (send money out on behalf of customers) or purchase a TT (receive money into the account on behalf of its customers) • Purchase a TT - would affect both Cash and Exchange position

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• TT Remittance - would affect both Cash and Exchange position b) DD or Draft - Delayed remittances of money. DDs are Negotiable instruments issued

against receipt of money from the customers. They are payable at a later due date and would be paid or realized only when presented. Therefore, issue of DD would affect only Exchange position and would affect Cash A/c only when they are presented or realized. Also, those DD drawn on other branches cannot be realized.

c) Issued a DD - Would affect only Exchange A/c and not Cash A/c since the purchaser (customer) is yet to present it for payment

d) DD purchased of past dates - Would affect Exchange A/c only since it would have been presented for payment and payment would have been made. Therefore, cash account would have been given effect.

e) Purchase of Export Bill drawn on some other branch - Here a bank would act as an agent and purchase other branch export bills but this would not affect cash account at all since it is not drawn on you. Therefore, only exchange account would be affected

f) Export Bill Realized - Drawn by other branches on you would be realized by you. • Affects Cash a/c only

g) Forward Sales - Sale of FC of customers of future due dates • Affects only Exchange A/c

h) Forward Purchase - Purchase of FC of customers of future due dates • Affects only Exchange A/c

i) Forward Contracts Cancelled - Since no cash is received or paid, will affect only Exchange A/c

Triangular Arbitrage

All along till recent past, bank dealers used to quote all currencies against the U.S. dollar when trading among them. Now, with the expansion of the global economy a growing percentage of currency trades do not involve the dollar. Foreign exchange 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 it in another. In the process of taking advantage of such opportunity, known as “arbitrage” the profit opportunity is eliminated. When profitable arbitrage opportunities disappear, we say that the no-arbitrage condition holds. The process of converting one currency to another, converting it again to a third currency and finally converting back to the first / original currency, especially in a short span of time, is called Triangular Arbitrage. This process provides the trader risk less profits arising out of above mentioned inconsistencies in foreign exchange quotes.

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PROBLEMS

1. Which is a direct quote for an Indian? 1CAD = INR52.252

1 MYR = SGD 0.37046

1INR = GBP0.01009

2. Suppose the direct quote for sterling in New York is 1.5450/55. What is the direct quote for dollars in London?

3. Answer the following after interpreting the Table I properly:

Source: Bloomberg

e. Direct quote of GBP for an Indian f. Direct quote of US Dollar for a Canadian g. Indirect quote of Euro for a Japanese h. Indirect quote of SGD for an Indian i. Direct quote of AUD for a Malaysian

4. State how you write these quotes in notation form. USD1 = INR48.72 / ₹48.94 INR1 = HKD 0.12174

1MYR = EUR 0.24926

1 KRW = AUD 0.11563

5. Write the spread in basis points 1 GBP = USD 1.5533/1.5539

1 USD = INR 63.2500/63.3600

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6. Calculate the spread in % 1 CAD = USD 0.8190/0.8199

1 EUR = INR 70.6383/70.6517

7. Considering the following quotes: Spot (Euro/Pound) = 1.6543/1.6557

Spot (Pound/NZ$) = 0.2786/0.2800

a. Calculate the % spread on the Euro/Pound Rate b. Calculate the % spread on the Pound/NZ$ Rate

8. Assuming you get the following rates per $ against S₣.

Day Quotes

1 1.6962/78

2 1.6990/1.7005

3 1.7027/42

a. The given quote is a direct quote for which citizen? b. How we express in notation form? c. On which day is it cheaper to buy US $ with respect to S₣? d. What is the spread on Day 2, in basis points? e. If I exchanged $2500 for S₣ 4256.75, which day I did the trade and what was the trade

– buy/sell?

f. On which day the spread is 16 bps? g. On which day it is cheaper to buy S₣? h. If I exchanged $1176.1247 with S₣2000, which day I did the trade and what was the

trade – buy/sell?

9. Write the inverse of ₹/$ 64.9725/64.9775 €/£ 1.1462/1.1468

10. The following rates appear in the foreign exchange market:

Spot rate 2 Month Forward

₹ /US $ ₹63.80/64.05 ₹64.50/65.00

a. How many dollars should a firm sell to get ₹5 Crore after 2 months?

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b. How many rupees is the firm required to pay to obtain US $ 2, 00,000 in the spot market?

c. Assume the firm has US $ 50,000. How many rupees does the firm obtain in exchange of US $?

11. The dollar is currently trading at ₹60. If dollar appreciates by 5%, what is the new spot rate? And if Rupee depreciates by 10%, what will be the new spot rate?

12. NRE Australia, a subsidiary of Indian company has called Standard Chartered Bank to get its opinion about the Japanese yen–Australian dollar exchange rate. The current rate is ¥67.72/A$, and the bank thinks the Australian dollar will weaken by 5% over the next year. What is the bank’s forecast of the future exchange rate?

13. XYZ Ltd. exports garments. It is expected to receive $100000 in 3 months’ time. Currently 1$ = ₹64. Market men indicate that dollar would depreciate by 6% in 3 months. What is the expected loss or gain to XYZ Ltd.

14. If the spot exchange rate of the yen relative to the dollar is ¥105.75, and the 90-day forward rate is ¥103.25/$, is the dollar at a forward premium or discount? Express the premium or discount as a percentage per annum for a 360-day year?

15. The following quotes of HKD /EUR are observed in the market:

Spot 1.2650/1.2675

3 Month forward 1.2695/1.2725

Find forward premium of relevant currency. Comment.

16. Digital exporters are holding an export bill in United States Dollar (USD) 5,00,000 due after 60 days. They are worried about the falling USD value, which is currently at ₹75.60 per USD. The concerned Export Consignment has been priced on an exchange rate of ₹75.50 per USD. The firm’s bankers have quoted a 60 day forward rate of ₹75.20. Calculate :

a. Rate of discount quoted by the Bank, assuming 365 days in a year. b. The probable loss of operating profit if the forward sale is agreed to. [NOV 2018-O]

17. The following quotes are provided per pound at Frankfurt:

Spot 1.8260/90

1 month 60/65

3 month 145/140

What are the implied forward rates?

18. On April 3, 2016, a Bank quotes the following : [Nov 2016]

Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945

2 months’ swap points 70 90

3 months’ swap points 160 186

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In a spot transaction, delivery is made after two days. Assume spot date as April 5, 2016; Assume 1 swap point = 0.0001. You are required to :

a. Ascertain swap points for 2 months and 15 days. (For June 20, 2016) b. Determine foreign exchange rate for June 20, 2016 and

19. An Indian customer who has imported equipment from Germany has approached its bank for booking a 6m forward EUR contract. The following rates are being quoted.

EUR/$spot 0.8147/0.8153

Six-month forward 59/58

₹/$ spot 64.9725/64.9750

Six-month forward 50/75

What rate will the bank quote if it needs a margin of 0.5%?

20. A bank sold Hong Kong Dollars 40,00,000 value spot to tis customer at ₹7.15 and covered itself in London Market on the same day, when the exchange rates were : [MAY 2013] [MAY 2014] [NOV 2014]

US$ = HK$ 7.9250/7.9290

Local interbank market rates for US$ were

Spot US$ 1 = ₹55.00/ 55.20 You are required to calculate rate and ascertain the gain or loss in the transaction. Ignore brokerage. You have to show the calculations for exchange rate up to four decimal points.

21. You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = 6.5150. You are required to cover the transaction either in London or New York market. The rates on that date are as under : [NOV 2013]

Mumbai - London INR 74.3000 INR 74.3200

Mumbai – New York INR 49.2500 INR 49.2625

London – Copenhagen DKK 11.4200 DKK 11.4350

New York – Copenhagen DKK 07.5670 DKK 07.5840

In which market will you cover the transaction, London or New York, and what will be the exchange profit or loss on the transaction? Ignore brokerages.

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22. You, a foreign exchange dealer operating from USA. You bought ₹50 million spot from a customer at the rate at 1₹ = $0.0135 and want to square the position. You have two options: Either square in Paris market or Zurich market. The rates on that date are as under:

:

Bid Ask

PARIS 1 € = ₹81.9489 1 € = ₹81.9505

1$ = €0.8795 1$ = €0.8802

ZURICH 1$ = S₣0.9934 1$ = S₣0.9936

1 S₣ = ₹71.7928 1 S₣ = ₹71.7935

In which market will you square the transaction, Paris or Zurich, and what will be the exchange profit or loss on the transaction? Ignore brokerages.

23. An Indian forex dealer had entered into a cross currency deal and had sold US$10,00,000 against EURO at US $ 1 = EURO 0.8145 for spot delivery.

However, later during the day, the market became volatile and the dealer in compliance with his management's guidelines had to cover - up the position when the quotations were:

Spot US $ 1 = INR 65/65.05

Spot US $ 1 = EURO 0.8200/0.8250

What will be the gain or loss in the transaction?

24. On January 28, 2005 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However due to bank strikes, the bank could effect the remittance only on February 4, 2005. The interbank market rates were as follows: [NOV 2011] [MAY 2014]

January 28 February 4

Bombay US $1 ₹ 45.85 / 45.90 ₹45.91 / 45.97

London Pound 1 US$ 1.7840/1.7850 US$ 1.7765/1.7775

Pound 1 SGD 3.1575/3.1590 SGD 3.1380/3.1390

The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand to gain or lose due to the delay? (Calculate rate in multiples of .0001)

25. An importer customer of your bank wishes to book a forward contract with your bank on 3rd September for sale to him of SGD 5,00,000 to be delivered on 30th October. The spot rates on 3rd September are $/₹ 49.3700/3800 and $/SGD 1.7058/68. The swap points are:

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$ / ₹ $ / SGD

Spot / September 0300 / 0400 1st Month Forward 48 / 49

Spot / October 1100 / 1300 2nd Month Forward 96 / 97

Spot / November 1900 / 2200 3rd Month Forward 138 / 140

Spot / December 2700 / 3100

Spot / January 3500 / 4000

Calculate the rate to be quoted to the importer by assuming an exchange margin of 5 paisa. [MAY 2018-O]

26. You are Bank of India, Mumbai. Commonwealth Bank of Australia (CBA) maintains a rupee account with you. HSBC Brazil has an Australian dollar account maintained with CBA. You and CBA maintain a Brazilian Real account with HSBC Brazil. Answer the following.

a. What is HSBC’s A$ account with CBA referred to as? b. How CBA would refer the A$ account of HSBC? c. What is your Real account with HSBC referred to as? d. How HSBC would refer the rupee account of CBA with you? e. What is your A$ account with CBA referred to as? f. How you would refer the CBA rupee account?

27. XYZ Bank, Amsterdam, wants to purchase ₹25 million against ₤. The purpose is that they want to fund rupee Nostro account of an Indian Bank, which is not available. Therefore, they have credited equivalent pounds in the Loro account with Bank of London. Calculate the amount of ₤’s credited. Ongoing inter-bank rates are per $, ₹ 61.3625/3700 & per ₤, $ 1.5260/70. [NOV 2013]

Followings are the spot exchange rates quoted at three different forex markets:

USD/INR 59.35 in Mumbai

GBP/INR 102.50 in London

GBP/USD 1.72 in New York

The arbitrageur has USD1,00,00,000. Assuming that bank wishes to retain an exchange margin of 0.0125%, explain whether there is any arbitrage gain possible from the quoted spot exchange rates.

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28. Assume your bank is maintaining a Nostro account in €with Deutsche Bank, Frankfurt:

Opening balance with 20,000

Opening position (overbought) 15,000

The following transactions were carried out.

Purchased a TT 1,50,000

Issued a draft 20,000

TT remittance outward 1,25,000

Purchase and export bill payable at Milan 2,75,000

Forward sales 2,75,000

Export bill realized 45,000

What steps would you take if you were required to maintain a credit balance of €70,000 in the Nostro account and keep a square position?

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Solution :

Exchange Position :

Particulars Purchase

€

Sale

€

Position

€

Cash Position:

Particulars Dr.

€

Cr.

€

Remarks:

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29. Assume your bank is maintaining a Nostro account in Swiss Francs with a bank:

Opening balance with 1,00,000

Opening position (overbought) 50,000

The following transactions were carried out.

Purchased a bill 80,000

Sold forward TT 60,000

Forward purchase contract cancelled 30,000

Remittance by TT 75,000

Draft on Zurich cancelled 30,000

What steps would you take if we require a credit balance of CHF 30,000 in the Nostro account and keep an overbought position of CHF 10,000? [NOV 2018] [CHF = S₣]

Solution:

Exchange Position:

Particulars Purchase

S₣

Sale

S₣

Position

S₣

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Cash Position:

Particulars Dr.

S₣

Cr.

S₣

Remarks:

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NOTES

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PROBLEMS FOR PRACTICE

1. Which are the direct quotes for an Indian? 1$ = ₹65 1$ = £0.65

₹1=$0.015 [Answer: only (a)]

2. You have just received a 1,000,000 GBP payment. You want to convert these pounds into dollars. You get a quote of USD/GBP 1.5457/61. What rate will you get? [Answer: Bid]

3. You have to buy Australian dollars to make a large payment. The quote is USD/AUD 0.5535/0.5537. What rate you will get? [Answer: Ask]

4. You need to make a SEK payment. You get a quote of SEK/USD 9.3854/9.3934. What rate you will get? [Answer: 1/Bid]

5. You have received a large JPY denominated dividend which you want to convert into dollars. The quote is JPY/USD 123.19/23. What rate you will get? [Answer: 1/Ask]

6. Decide what rate the client will get:

Trade to be performed Quote Competitor Quote

Rate?

Buy 5 GBP versus USD USD/GBP 1.5471/73

USD/GBP 1.5472/75

Sell10 USD versus JPY JPY/USD 125.06/12

JPY/USD 125.01/05

Sell 7 NOK versus USD NOK/USD 7.5946/78

NOK/USD 7.5950/80

Buy 1 USD versus CAD CAD/USD 1.5626/32

CAD/USD 1.5620/25

Sell 5 EUR versus SEK EUR/SEK 9.1268/9.1318

EUR/SEK 9.1260/9.1300

[Answer: 1.5473, 125.06, 7.5978, 1.5625, 9.1268]

7. What is the spread in the following quote? 1$ = €0.9448/€0.9452

[Answer: 0.042%]

8. What is the spread in basis points in the following quote? 1£ = $1.4834/$1.4846

[Answer: 12 bps]

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9. What is the appreciation/depreciation of £ between the two periods shown below? Jan 2015 1£ = $1.4834

Mar 2015 1£ = $1.4907

[Answer: 0.492%]

10. What is the appreciation/depreciation of $ between the two periods shown below? Jan 2015 1£ = $1.4834

Mar 2015 1£ = $1.4907

[Answer: –0.49%]

11. Suppose the direct quote for sterling in New York is 1.1110/5. What is the direct quote for dollars in London? How much it would cost to buy £500,000 in New York?

[Answer: 1$ = £0.8997/£0.9001; $555,570]

12. The $/€ exchange rate is €1 = $0.95, and the €/SFr exchange rate is SFr 1 = € 0.71. What is the $/SFr exchange rate?

[Answer: 1 SFr = $0.6745]

13. The following rates appear in the foreign exchange market: Spot rate 2 Month Forward

₹ /US $ ₹66/66.25 ₹67/67.50

a. How many dollars should a firm sell to get ₹50 lakhs after 2 months?

b. How many rupees is the firm required to pay to obtain US $ 3, 00,000 in the spot market?

c. Assume the firm has US $ 1,19,000. How many rupees does the firm obtain in exchange of US $?

[Answer: Refer similar problem solved in the class]

14. The spot and 90-day forward rates for the pound are $1.1376 and $1.1350, respectively. What is the forward premium or discount on the pound?

[Answer: –0.91%]

15. Calculate the implied forward rates of the following: 1 USD = NOK 7.1040/ NOK 7.1050 Swap points 95/85

1 USD = GBP 1.5675/ GBP 1.5685 Swap points 150/142

1 USD = JPY 123.4000/ JPY 123.5000 Swap points 1050/1340

[Answer: 7.0945/7.0965, 1.5524/1.5543, 123.5050/123.6340]

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16. Calculate the 30-day, 90-day, and 180-day forward discounts for the British pound. Here are the relevant rates for the pound:

Spot: £1 = $1.8220

30-day forward: £1 = $1.8180

90-day forward: £1 = $1.8086

180-day forward: £1 = $1.7949

[Answer: –2.63%, –2.94%, –2.97%]

17. A bank purchased 500000 GBPs from a customer at INR 98.8730 today. Immediately the bank reversed its exposure in the US and Indian markets when the spot rates were:

US market 1.5641/1.5649

India market 63.2110/63.2140

What was the net gain or loss for the bank?

[Answer: INR 2350 - Loss]

18. Determine if there is a spot arbitrage opportunity among each of the following two sets of spot rates. Next, show how an investor can take advantage of it, if there is one. Assume that the dollar is your home currency. Use $1 million.

$/Pound = $1.65

$/DM = $ 0.554

DM/Pound = DM 3

[Answer: Gain = $7200]

19. Consider the following INR/SGD direct quote of ICICI Mumbai: 26.50 – 75: a. What is the cost of buying INR 55,000? b. How much would you receive by selling INR 92,000? c. What is the cost of buying SGD 7,450? d. What is your receipt if you sell SGD18,340? [Answer: Gain = SGD 2075.48, SGD 3439.25, INR 199287.5, INR 486010]

20. As at 27 December 2012, the exchange rate between Euro and US dollar is €0.75 per US$. Exchange rate between US$ and Swiss Franc is 1.09 US$ per Swiss Franc. Find the exchange rate between Euro and Swiss Franc in € per Swiss Franc. [Answer: 0.8175]

21. You are in UK and $/£ exchange rate is 1.540- 1.560 and ¥/£ is 149.06 – 149.50. Calculate the $/¥ exchange rate. [Answer: 0.0103/0.0104]

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22. Calculate the cross rate of EUR/SEK 0.9772 EUR/USD

9.3622 USD/SEK

[Answer: 9.1487 ]

23. Calculate the cross rate of EUR/GBP 0.9772 EUR/USD

1.5465 USD/GBP

[Answer: 0.6318 ]

24. Calculate the cross rate of AUD/NZD 0.5535 USD/AUD

0.4841 USD/NZD

[Answer: 1.1433 ]

25. Calculate the cross rate of NOK/EUR USD/EUR 0.9785/0.9789

NOK/USD 7.5853/7.5865

[Answer: 7.4222/7.4264]

26. Calculate the cross rate of JPY/CAD CAD/USD 1.5675/1.5685

JPY/USD 125.11/125.17

[Answer: 79.76/79.85]

27. Assume an FX trader bought $1 million worth of Swiss Francs at 1.4996 at the open because she thought Francs would strengthen over that day. However, her outlook for the day was wrong, and she closed out her position by buying back the dollars at 1.5040. What was her loss in dollar terms? [Answer: Loss of $2925.53]

28. Sterling opens at 1.5409 against dollar and closes at 1.5425. If a dealer sold 1 million GBP and bought USD at the open and the reversed the trade at the close, what is the loss or gain in $? [Answer: Loss of $1600]

29. Dollar-yen opens at 124.05 and closes at 123.50. If a dealer sold $ 1 million at the open and reversed the position at the close, what is the loss or gain in $? [Answer: Gain of $4453]

30. CHF/USD opens at 1.5030 and closes at 1.5035. If a dealer sold 10 million CHF at the open and bought them back at the close, what will be profit or loss in CHF? [Answer: Gain of CHF 3327]

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31. Assume the following information: Value of Canadian dollar in U.S. dollars $0.90

Value of New Zealand dollar in U.S. dollars $0.30

Value of Canadian dollar in New Zealand dollars NZ$3.02

Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? [Answer: Gain of $6667; By repeated arbitrage, the value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall.]

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9

FOREIGN EXCHANGE – PARITY THEOREMS

THEORY

The Purchasing Power Parity theory

The theory of purchasing power parity (PPP) in its simplest form says that the exchange rate must reflect uniformity of prices in terms of a single currency across nations. In other words, prices that are quoting in different countries in different currencies should be same when one converts all prices in terms of a single currency. This can happen only if the proportion of price change is reflected correctly by exchange rate difference. PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar.

The PPP theory has an absolute version and a relative version. The absolute version of the PPP theory maintains that the equilibrium exchange rate between domestic and foreign currencies equals the ratio between domestic and foreign prices. To illustrate, assume that one Indian rupee can buy two pens and that one dollar can buy eighty pens. In that case, to maintain absolute parity, if we quote dollar in terms of rupees, it should read as $1 = 40. In short, what this means is that a bundle of goods should cost the same in India and the United States once you take the exchange rate into account.

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so.

The relative version of the PPP doctrine indicates that in the long run, exchange rates reflect the relative purchasing power of currencies. In other words, it relates equilibrium changes in the exchange rate to changes in the ratio of domestic and foreign prices.

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( )( )tf

th

0

t

i1i1

pp

++

=

Where, pt = price in terms of foreign currency in period t; p0 = price in terms of foreign currency in period 0;

Ih = domestic inflation rate; and If = foreign inflation rate.

Interest Rate Parity Theorem

According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-à-vis the currency of another country will be exactly offset by the interest rate differential between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa. Two assumption central to interest rates parity are capital mobility & perfect substitutability of domestic and foreign assets. For example, the parity condition implies that the expected return on a currency’s assets will equal the expected return on foreign currency assets, due to equilibrium in foreign exchange market resulting from changes in the exchange rate between two countries.

In an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential. When this condition is met, the forward rate is said to be at interest rate parity, and equilibrium prevails in the money markets. Interest parity ensures than the return on hedged (or “covered”) foreign investment will just equal the domestic interest rate on investment of identical risk, thereby eliminating the possibility of having a money machine. When this Condition holds, the covered interest differential – the difference between the domestic interest rate and the hedged foreign rate – is zero.

Interest rate parity plays a fundamental role in foreign exchange markets, enforcing an essential link between short-term interest rates, spot exchange rates and forward exchange rates.

No arbitrage condition can be stated as follows:

f

h

f

h

i1i1

r1r1

++

=++

The interest rate parity says that high interest rates on a currency are offset by forward discounts and that low interest rates are offset by forward premium.

SSFrr fh

−=−

More precisely,

fh rr100n360

SSF

−=××−

The interest rate parity theory holds that the difference between a forward rate and a spot rate equals the difference between a domestic interest rate and a foreign interest rate:

Where, F = forward rate, S = spot rate, if = domestic interest rate; and if = foreign interest rate.

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Covered interest arbitrage

Interest rate parity theorem says that forward rates reflect the differential over spot rates, equivalent to the difference between the interest rates prevailing in the home and the foreign country But, whenever, the difference between forward and spot is out of sync with the difference between interest rates prevailing in the two countries, arbitrage is possible.

A typical covered interest arbitrage transaction involves borrowing in one currency and converting into another (second) currency first; the proceeds obtained after conversion are then deposited in the second currency for a certain period over during which the forward spot differential is not equivalent to interest rate differential. The deal is closed after the arbitrage period, by re-converting the foreign currency proceeds and earning the difference as profit. Net gain is usually the interest rate differential minus the discount or premium on the sale of foreign currency in the forward market. Thus, this type of capital outflow occurs when the interest rate differential exceeds the forward discount.

Thus, covered interest arbitrage is the movement of short-term funds between countries to take advantage of interest differentials with exchange risk covered by forward contracts. Uncovered Interest Arbitrage

This refers to exploiting the interest differentials between the two countries for the purpose of making riskless profit but without taking forward cover ahead of performing the arbitrage transaction. These transactions are highly risky as the actual forward rate at the time of converting the investment proceeds might significantly differ from the expected forward rate.

CONCEPTS

The Fischer effect (FE)

The Fischer effect, named after the economist Irving Fischer, assumes that the nominal interest rate in each country is equal to a real interest rate plus an expected rate of inflation. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. According to the Fisher Effect, countries with higher inflation rates have higher interest rates.

It is stated as:

1 + Nominal rate = (1 + Real Rate) (1 + Expected inflation rate)

1 + r = (1 + a)(1 + i)

Or for most cases, Nominal Rate = Real Rate + Inflation

According to Fisher, since real rates are same in all countries,

f

h

f

h

r1r1

i1i1

++

=++

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The International Fischer effect (IFE)

The international Fischer effect states that the spot rate adjusts to the interest rate differential between two countries. A future spot rate of a currency with a higher interest rate would depreciate in the long run; a future spot rate of a currency with a lower interest rate would appreciate in the long run. For example, if the interest rate over the next year is 4 percent in the United States and 10 percent in India, the Indian rupee would depreciate against the dollar by 6 percent.

We can define the International Fischer effect using the below given equation. The Spot rate of one currency with respect to another currency will change in accordance with the differential in interest rates between two countries.

International Fischer effect (IFE) suggests that a currency’s value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency’s value if it occurs.

The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.

Inter-relations between the above five theorems:

f

hte

r1r1

SS

++

=

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PROBLEMS

1. The annual interest rate is 6% in the United States and 4% in the UK. The spot exchange rate is £/$ - 1.50 and forward exchange rate, with one-year maturity, is £/$ = 1.60. Using these facts explain the principles surrounding Interest Rate Parity Theorem. [NOV 2008]*

2. It is given that Dollar 6-month T-bills = 7%; Risk-free 6-month Japanese bonds = 5.5%; Spot exchange rate is 1 yen = $0.009. What is the 6-month forward exchange rate?

3. The US dollar is selling in India at ₹ 55.50. If the interest rate for a 6 months borrowing in India is 10% per annum and the corresponding rate in USA is 4% : [Nov 2012]

e. Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?

f. What will be the expected 6 months forward rate for US dollar in India? And g. What will be the rate of forward premium or discount?

4. Following information is given : [NOV 2010] [MAY 2016][MAY 2018] Exchange rate –

Canadian dollar 0.666 per DM (spot)

Canadian Dollar 0.671 per DM (3 months)

Interest rate –

DM - 7.5% p.a.

Canadian Dollar – 9.5% p.a.

To take the possible arbitrage gains, what operations would be carried out?

5. Spot Rate is1 US$ = ₹68.50. USD premium on a six month forward is 3%. The annualized interest in US is 4% and 9% in India. Is there any arbitrage possibility?

If yes, how a trader can take advantage of the situation if he is willing to borrow USD 3 million. [NOV 2018 – O]

6. Suppose currently rates are: Spot 1$ = FF 6.25

3m 1$ = FF 6.28

US interest rates are 5.6% per annum and France interest rates are 8.8% per annum and if $ 1 million or FF 6.25 million can be borrowed explore covered interest arbitrage and estimate profit in $ and FF separately.

7. Suppose currently rates are: Spot 1$ = €0.80

3m 1$ = €0.7813

US interest rates are 5.6% per annum and German interest rates are 5.4% per annum and if $ 1 million or €0.8 million can be borrowed, explore covered interest arbitrage.

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8. The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%. The current spot rate of US $ in India is ₹43.40. Find the expected rate of US $ in India after one year and 3 years from now using purchasing power parity theory. [NOV 2008] [MAY 2010]*

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NOTES

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NOTES

1.

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PROBLEMS FOR PRACTICE

1. If the Swiss franc is $0.68 on the spot market and the 180-day forward rate is $0.70, what is the annualized interest rate in the United States over the next six months? The annualized interest rate in Switzerland is 2%.

[Answer: 7.94%]

2. The interest rate in the United States is 8%; in Japan the comparable rate is 2%. The spot rate for the yen is $0.007692. If interest rate parity holds, what is the 90-day forward rate on the Japanese yen?

[Answer: $0.0078]

3. The following information is given: Spot 1$ = ₹64.0123 180 days forward = 1$ = ₹64.9120 ₹ rate = 12% p.a., $ rate = 8% p.a. Use 1000 units any currency to demonstrate arbitrage if any.

[Answer: Refer class notes]

4. Suppose Amit Inc. has $10,000,000 to invest, and it faces the following data: USD interest rate, 8.0% p.a.; GBP interest rate, 12.0% p.a.; spot exchange rate, $1.60/£; and 1-year forward exchange rate, $1.53/£. Is covered interest arbitrage possible? [Answer: Yes, borrow pound and gains of £9411.76]

5. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is 5.6 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or €800,000. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.

[Answer: Arbitrage profit would be = $23758]

6. The inflation rate in Great Britain is expected to be 4% per year, and the inflation rate in Switzerland is expected to be 6% per year. If the current spot rate is £1 = SF 12.50, what is the expected spot rate in two years?

[Answer: SF 12.99]

7. Assume the following information: Spot rate of Canadian dollar $0.80

90-day forward rate of Canadian dollar $0.79

90-day Canadian interest rate 4%

90-day U.S. interest rate 2.5%

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Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) [Answer: 2.7%]

8. Assume the following information: Spot rate of Mexican peso = $.100

180-day forward rate of Mexican peso = $.098

180-day Mexican interest rate = 6%

180-day U.S. interest rate = 5%

Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest? [Answer: MXP 71429]

9. The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? [Answer: For US Investors – feasible, since arbitrage yield = 14.48%]

10. Suppose currently rates are: Spot 1£ = SF1.2676

6m 1£ = SF1.2658

UK interest rates are 3% per annum and Swiss interest rates are 1% per annum and if $ £ million or SF 1267600 can be borrowed, explore covered interest arbitrage.

[Answer: Refer Class Notes]

11. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent.

a. According to IRP, what should the forward rate premium or discount of the euro be?

b. If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

[Answer: Euro will be at discount, rate = -1.89%, F = $1.079]

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10

FOREIGN EXCHANGE – HEDGING EXPOSURES ETC.

THEORY

Exposure and types of exposures

Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange. Exposure is different from risk. Exposure tells you “what is at risk?” Exposure refers to the degree to which a company is affected by exchange rate changes.

Transactions are said to be exposed to foreign exchange risk if following 2 conditions are met:

1. They are denominated in foreign currencies and 2. They are translated at the current exchange rate. Four basic types of exchange exposure are translation exposure, transaction exposure, operating exposure and economic exposure.

Transaction exposure

Transaction exposure measures the changes in value of exposure between the time that an obligation is incurred and the time that it is settled, during which period the relevant foreign exchange rate has changed. Translation exposure is the account-based changes in consolidated financial statements caused by exchange rate changes. In short, transaction exposure refers to exposures (i.e. those transactions whose value change owing to foreign exchange fluctuations) arising out of routine business foreign exchange transactions. It measures domestic value of foreign currency outstanding obligations changed when they were settled.

Translation exposure

Translation exposure measures the effect of an exchange rate change on published financial statements of a firm. It arises out of conversion of the results of foreign operations from the

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foreign currency to the home currency. They are just paper exchange gains or losses; they are retrospective in nature and are short-term in nature.

Operating Exposure

Operating Exposure arises because currency fluctuations combined with price level changes can affect the amounts receivable and introduce risk. They give rise to real exchange gains or losses; they are prospective in nature and long-term in nature. This exposure arises because of impact of exchange rate changes on future cash flows; the currency change may be in either the home currency or the foreign currency and owing to this change we witness a change in prices of inputs or change in the quantities of output. Consequently, the profit margin would change owing to influence of currency movements and change in input and output variables.

Operating Exposure begins, the moment a firm starts to invest in a market subject to foreign competition or in sourcing goods or inputs abroad. Operating exposure depends on whether unexpected changes in exchange rates cause unanticipated changes in sales volume, sales price, or operating costs. Firms are not subject to operating exposure if the exchange rate changes are matched by the inflation rate differential between countries, firms’ competitive positions will not be altered by exchange rate changes.

Operating exposure therefore depends upon:

a. Change in nominal exchange rate

b. Change in selling (output) price

c. Change in output quantity

d. Change in operating costs i.e. quantities and prices of inputs

Operating exposure can be understood to be caused by two effects:

1. Conversion Effect (Static) - Without any changes at all in selling price (P), or number of units sold (Q), the impact on operating cash flows owing to change in the value of domestic currency proceeds arising out of change in foreign currency. This is pure transaction exposure.

2. Competitive Effect (Dynamic) – The change in competitive position that may arise because of change in prices of output done purely by the firm to cover the increase in input cost, which has arisen because foreign currency has changed. This is the price impact and quantity impact resulting out of exchange rate changes.

Exposure management

The exposure management strategy involves four steps:

1. Forecasting the degree of exposure in each major currency in which the multinational company operates.

2. Developing a reporting system to monitor exposure and exchange rate movements to assist in protecting the MNC from risk.

3. Assigning responsibility for hedging exposure and determining whether to centralize or decentralize exposure management.

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4. Selecting appropriate hedging tools including diversification of the MNCs operations, a balance sheet hedge, and exposure netting.

Strategies for Exposure Management

Exposure management strategies are developed keeping in mind the company’s attitude towards risk, financial strength, nature of business, vulnerability to adverse movement etc. It is important to understand that there is no single strategy which is appropriate to all businesses. The strategies for exposure management can be classified based on risk-reward and would indicate how aggressive the company is as regards exposure management.

Low Risk: Low Reward

This is not the best strategy as far as benefits go but is the simplest way to approach / manage exposure. All exposures are hedged in the forward market as soon as they occur without considering whether it is the best choice. Under this strategy the company knows its cash flow receipts with certainty and the costs associated with it is known. For the company, this strategy hardly involves any time or effort. This strategy is adopted by those companies who believe that active management of exposure is not really their business.

Low Risk: Reasonable Reward

This strategy involves some management time and effort and hedging is adopted only when the company feels hedge would be better than remaining without hedge. The risk of leaving the exposures open at times could prove risky to the company. The rewards on the other hand are more as company puts lot of serious efforts to quantify the future expectations and then decides to hedge. Moreover, the rewards depend upon the accuracy of the prediction.

High Risk: Low Reward

When the company leaves movement of foreign currencies to the act of god and decides not to hedge any exposure, it obviously takes very high risk. Since the exposures are always left open, rewards are uncertain. Cash flows are not stable, but the advantage is management does not spend even a minute to manage their exposures.

High Risk: High Reward

This strategy involves active trading in the currency market through continuous cancellations and re-bookings of forward contracts. This requires good knowledge and market inputs and is the most aggressive method of managing exposure. Frequent booking and cancellations to get the best rate for the exposures increases transaction costs and generally adopted by large companies.

Hedging transaction exposures

Whenever a company is committed to a foreign currency denominated transaction, we have a case of transaction exposure. Since the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered

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into and the time it is settled in cash will lead to a change in the local currency amount of the cash inflow or outflow.

Exposure to movements in foreign exchange rates and currency market volatility cannot be an advantage to a corporate treasurer. Because he is risk averse. His priority is to reduce or eliminate currency exposure. Hedging aims at eliminating or reducing these exposures. The main objective of hedging is minimization of uncertainty. Hedging does not attempt to increase profits or minimize losses. Rather, it manages uncertainty.

The primary costs of hedging all foreign exchange risks relate to the fact that a firm will miss out on any positive swings in exchange rate fluctuations, but the benefits are that it will avoid the costs of any negative swings in exchange rate fluctuations. Firms that choose to follow such a strategy are likely to accept the idea of offsetting effects, i.e., in the long run, losses or less than maximum gains will be offset by gains or less than maximum losses.

There are four instruments multinational companies predominantly use for hedging their foreign exchange exposures (transaction exposure to be precise): Forwards, futures, options, and swaps.

Forwards are custom-made contracts to buy or sell foreign exchange in the future at a specific price. Maturity and size of contracts can be determined individually to almost exactly hedge the desired position.

Futures are ready-made contracts to buy or sell foreign exchange in the future at a specific price. Futures are nothing but standardized forward contracts. Futures involve margin payments and mark to market unlike forwards. A firm may buy foreign currency futures to hedge payables and may sell foreign currency futures to hedge receivables. The gain or loss on futures would hedge the loss or gain in the underlying forex position.

Options are contracts that offer the right, but not the obligation, to buy or sell foreign exchange in the future at a specific price. Options allow hedging of contingent risks. A currency option hedge involves the use of currency call or put options to hedge transaction exposure. Using options, the firm will be insulated from adverse exchange rate movements but may benefit from favourable movements. A firm may buy CALL options on payable currency to hedge payables and may buy PUT options on receivable currency to hedge receivables. However, the firm must assess whether the advantages are worth the premium paid for the option.

Swaps are contracts which involve two counter parties exchanging over an agreed period, two streams of payments in different currencies. Currency swaps involve an exchange of cash flows in two different currencies over an agreed period. These payments are each calculated using a different interest rate. At the end of the period, exchange takes place of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

The general rules to follow when choosing between currency options and forward contracts for hedging purposes are summarized as follows:

1. When the quantity of a foreign currency cash outflow is known, buy the currency forward; when the quantity is unknown, buy a call option on the currency.

2. When the quantity of a foreign currency cash inflow is known, sell the currency forward; when the quantity is unknown, buy a put option on the currency.

3. When the quantity of a foreign currency cash flow is partially known and partially uncertain, use a forward contract to hedge the known portion and an option to hedge the maximum value of the uncertain remainder.

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Transaction exposures can also be managed by any of the following means:

4. Money market hedge 5. Risk shifting 6. Managing pricing 7. Exposure netting 8. Risk sharing 9. Cross hedging 10. Using caps, floors or collars 11. Using swaptions

Exposure Netting

Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. The process of adjustment of receivables and payables at a given point of time is called netting. This is beneficial to a firm because when we sell receivables, we get a lower price and when we buy payables, we have to pay a higher price. So, it makes sense to use receivables to settle payables in part or whole and vice versa.

In practice, exposure netting involves one of three possibilities:

1. A firm can offset a long position in a currency with a short position in that same currency. 2. If the exchange rate movements of two currencies are positively correlated, then the firm

can offset a long position in one currency with a short position in the other.

3. If the currency movements are negatively correlated, then short (or long) position can be used to offset each other.

Multi-National Corporations (MNC) will have divisions/subsidiaries in different countries. Each of the subsidiary or division will have cash positions, receivables and payables in the same currencies or different currencies. The composition of payables and receivables can be in any combination. In netting, all cash transactions are settled through single point. Receivables and payables are netted out and net cash flows are settled among the group subsidiaries. Netting with other corporate entities is also possible. When netting of bilateral obligations is between two parties, we call it as bilateral netting. Bilateral netting would be of less use where there is a more complex structure of internal sales involving say four affiliates of an organization. The alternative then is multilateral netting. Multilateral netting is an arrangement whereby three or more counterparties agree to aggregate and net their foreign exchange payments, generally through a clearinghouse structure. Such an arrangement will result in only a single payment or receipt in each traded currency to be made by each of the counterparties on any given day. On a multilateral basis, there is greater scope for reducing cost of hedging and number of transactions.

Advantages of Netting

1. Netting reduces intercompany cash flows

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2. Streamlines reconciliation between group companies 3. Provides mechanism for inter-company borrowing 4. Reduces inter-company balances on the balance sheet 5. Enforces a strict payment schedule that’s easy to follow. 6. Quickly resolves mismatches on Intercompany bookings. 7. Makes regular balance reconciliation fast and efficient. 8. Optimizes use of funds within group 9. Ensures effective payment processes for group companies 10. Reduces number of funds transfer payments 11. Centralizes foreign exchange management at netting center 12. Improves forex spreads 13. Allows leading and lagging

Global Depository Receipts (GDR)

“Global Depositary Receipts mean any instrument in the form of a depositary receipt created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company.”

An Indian company places its equity shares in the custody of a domestic (Indian) bank, which is the Domestic Custodian Bank (DCB) – The Company authorizes an Overseas Depository Bank (ODB) to issue GDRs (book building adopted for price discovery) against issue of the company’s equity shares or Foreign Currency Convertible Bonds. The ODB can be any bank in the country where the Indian company plans to make the issue – On the company’s orders, the DCB instructs the ODB to issue the GDRs to investors. GDRs are issued at a certain predetermined ratio to the company’s shares or bonds. A GDR is evidence of a Global Depository Share. The holder of one GDS will in reality be holding one or two or even ten equity shares or bonds of the Indian company.

The holder of a GDR does not have voting rights. The proceeds are collected in foreign currency thus enabling the issuer to utilize the same for meeting the foreign exchange component of project cost, repayment of foreign currency loans, meeting overseas commitments and for similar other purposes. Dividends are paid in Indian rupees due to which the foreign exchange risk or currency risk is placed totally on the investor. The GDRs are usually listed at the London or Luxembourg Stock Exchange as also traded at two other places besides the place of listing e.g. on the OTC market in London. As the cost of floating an GDR issue is quite high, GDR issue is only justifiable if the amount of finance to be raised is quite large. When an investor redeems his GDRs, the appropriate number of underlying equity shares or bonds is accordingly released. GDRs are negotiable instruments. Holders are eligible for dividends, bonus shares, rights issues, and can also exercise their voting rights through the ODB.

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American Depository Receipts (ADR)

An American Depository Receipt (ADR) is a security issued in the United States that represents shares of a foreign stock allowing that stock to be traded in the U.S. Foreign companies use ADRs which are issued in US Dollars, to expand the pool of potential U S Investors. ADRs are negotiable instruments issued by an Indian (or any non-US) company on an American stock or electronic exchange like New York Stock Exchange or the NASDAQ.

Owning an ADR or American Depository Receipt is not the same thing as owning the stock of a foreign company even though it does entitle the owner to dividends and capital gains. ADRs offer advantages to U.S. investors compared to owning the actual stock in a foreign company. Investing in an ADR reduces some of the risks associated with the outright ownership of foreign stock. Issuers need to meet U.S. regulatory standards, and the ADR market is typically more liquid. There are also some tax advantages in owning ADRs rather than foreign stock. The advantages of ADRs still outweigh the disadvantages, but holders need to be aware that owning an ADR is not the same as owning stock in a foreign company.

An Indian company places its equity shares in the custody of a domestic (Indian) bank, which is the Domestic Custodian Bank (DCB). The company authorizes an Overseas Depository Bank (ODB) to issue ADRs against issue of the company’s equity shares or Foreign Currency Convertible Bonds. The ODB can be any bank in the country where the Indian company plans to make the issue. On the company’s orders, the DCB instructs the ODB to issue the ADRs to investors. ADRs are issued at a certain predetermined ratio to the company’s shares or bonds. An ADR is evidence of an American Depository Share. The holder of one ADS will in reality be holding one or two or even ten equity shares or bonds of the Indian company. When an investor redeems his ADRs, the appropriate number of underlying equity shares or bonds is accordingly released. ADRs are negotiable instruments. Holders are eligible for dividends, bonus shares, rights issues, and can also exercise their voting rights through the ODB.

Companies planning to make an ADR issue must comply with stringent rules, set by the US Securities Exchange Commission (SEC). These rules pertain to the following issues: -

1. Shareholder wealth maximization as a primary goal 2. High standards of corporate governance 3. Professionally managed boards, and a disciplined approach to business 4. Focus on core competency 5. Aiming to achieve global competitiveness 6. High level of disclosure 7. Adherence to US Generally Accepted Accounting Principles (GAAP). Major benefits to the issuing company

1. Companies find ADRs attractive since the US market is huge and provides liquidity. They have access to a huge capital base at cheaper rates. Since the US dollar is the denominated currency, there is no exchange risk.

2. Advantages of ADR’s to Indian companies

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3. ADR’s offer unique opportunity to raise capital in the US markets exposing non-US companies to more investors.

4. They can provide a buffer to a company’s shares against a sharp fall in domestic markets by spreading the company’s investor base to stable US markets.

5. The company gets more visibility in the US markets and helps the company to seek more business orders from US clients. Thus, it helps their global image and business income.

6. The company need not pay premium for raising funds through FCCB and other instruments as it is already known well to the US investors.

Advantages & Disadvantages of GDR

Advantages

a. For companies

1. Foreign exchange risk is on the investor and not the company. 2. GDR provides access to foreign capital markets. 3. GDR can help expand the global presence of the company which helps in getting

international attention and coverage.

4. GDR are liquid in nature as they are based on demand and supply which can be regulated. 5. GDR enhances the image of company’s products/ services or financial instruments in a

market place outside their home country

6. GDR issue helps a company to acquire a foreign company. 7. GDR increases the shareholders base of the company. b. For Investors

1. GDR’s are usually quoted in $ and interest and dividends are paid in $. GDR helps investor to directly purchase and hold securities in Indian company

2. GDR’s are liquid and are interchangeable with securities 3. GDR’s are negotiable 4. With GDR, the non-residents can invest in shares of the foreign company. 5. Foreign Institutional investors can buy the shares of company issuing GDR in their country

even if they are restricted to buy shares of foreign company.

6. GDR’s overcome foreign investment restrictions Disadvantages

1. GDR’s immediately dilute earnings 2. Normally GDR’s are priced at discount to local market price 3. In India GDR issues have an uneven track record of international investors (i.e) not all GDR

issues are successful

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Foreign Currency Convertible Bonds (FCCB)

FCCB is a bond subscribed for by non-resident in ‘foreign currency’ and convertible into equity shares of the issuer company in any manner whether in whole or in part. "Foreign Currency Convertible Bonds" means bonds issued in accordance with this scheme and subscribed by a non- resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrants attached to debt instruments;

Advantages of FCCB

1. Convertible nature of the bond 2. Companies prefer bonds as it delays dilution of equity and avoids current dilution of

earnings per share.

3. Easily marketable and enjoys option of conversion into equity if resulting to capital appreciation

Disadvantages of FCCB

1. Exchange risk is more in FCCB as interest on bonds would be payable in foreign currency 2. FCCB mean creation of more debt and a forex outgo. 3. In the case of convertible bonds, though the interest rate is low, there is exchange risk on

interest payment as well as repayment if bonds are not convertible into equity shares

Euro Convertible Bond

A convertible bond is a bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. A convertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock. A Euro convertible bond is a bond issued by a company in a market other than its country of operation. Thus, a bond issued by an Indian Company in the foreign market with an option to convert them into pre-determined number of equity shares is a Euro Convertible Bond. These bonds generally carry a small percent of interest but offer a potential to subscribers (investors) to earn premium on conversion.

These bonds have two types of options. A call option that would provide the issuer to call back the bonds when the underlying stock price has risen substantially, literally forcing the investors to opt for conversion. The bonds can also give investors an option to opt for conversion by selling the bond, if the bond has a put option. Certain countries do not permit issue of ECBs by its companies since it will add to the external debt of the country.

LIBOR and Significance

LIBOR is the average interest rate offered by a specific group of multinational banks in London (selected by the British Bankers Association for their degree of expertise and scale of activities) for short-term loans of a stated maturity and is used as a base index for setting rates of many floating rate financial instruments, especially in the Euro currency and Euro bond markets.

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LIBOR is now administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the US dollar (USD), Euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF). The LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates being calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the “current LIBOR rate.”

LIBOR is the cornerstone in the pricing of money market issues and other short-term debt issues by both government and corporate borrowers. Interest rates are frequently quoted as some spread over LIBOR and they then float with the LIBOR Rate. It is the base rate for most international financial transactions and financial products such as options and swaps. Banks too use LIBOR as the base rate for setting interest rate on loans, savings and mortgages.

Foreign Currency Instruments

Euro Bond

Eurobonds, or external bonds, are international bonds that are denominated in a currency other than that of the issuer. Despite their name, euro bonds aren’t necessarily denominated in Euros and can take many different forms. An American firm issues a rupee-denominated bond in US, for the purpose of investing in India. This is an example of a Euro bond issue. These so-called Eurobonds have become increasingly popular with the rise in globalization. It provides diversification benefit to US investors.

Foreign Bond

A foreign bond is a debt security issued by a foreign entity in a domestic market, denominated in the domestic currency. An example would be an Indian company issuing a dollar-based bond in the U.S. (popularly called Yankee bonds), to invest in the US. Foreign bonds issued in other countries are labelled in a similar fashion such as Panda bonds (China), Dim Sum (Hong Kong), Samurai (Japan), Bull Dog (UK) and Matilda bonds (Australia).

Investors of foreign bonds typically reside within the country of issuance with the proceeds used to finance domestic-based capital projects. Primary reasons to invest in a foreign bond is the higher yield that it typically provides relative to a domestic bond, and diversification. Risks include the general risks associated with all bonds such as interest rate risk and inflation risk in addition to currency risk, political and sovereign risks.

FCCB

FCCB are convertible bonds denominated in Foreign Currency issued and sold in a foreign country. They are convertible into equity shares of the company listed in the issuer’s country. Some convertible bonds have detachable warrants involving acquisition rights. Some have automatic convertibility into a specified number of shares.

GDR

Global Depository Receipt (GDR) are certificates issued by international bank, which can be subject of worldwide circulation on capital markets. GDR's are emitted by banks, which purchase shares of foreign companies and deposit it on the accounts. Global Depository Receipt facilitates

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trade of shares, especially those from emerging markets. Prices of GDR's are often close to values of related shares.

ADR

American Depository Receipt (ADR) are certificates issued by international bank, which can trade in American capital markets. They represent ownership in the shares of a non-U.S. company that trades in U.S. financial markets. ADRs carry prices in US dollars, pay dividends in US dollars, and can be traded like the shares of US-based companies.

Euro Commercial Papers (ECP)

Euro Commercial Paper (ECP) is an unsecured, short-term debt instrument that is denominated in a currency differing from the domestic currency of the market where it is issued. The ECP works to be an attractive short-term financing tool for firms that wish to reduce forex market risk.

The following are the characteristics of Euro Commercial Papers:

• ECP are generally issued at a discount or on an interest-bearing basis, in the form of a promissory note.

• The time period for the maturity of an ECP ranges from a few days to a year.

• It is flexible alternative for short term borrowing, cheaper than bank finance and are traded in the secondary market.

FRN (floating-rate note)

A floating-rate note, also known as a floater or FRN, is a debt instrument with a variable interest rate. A floating rate note’s interest rate is usually tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the Fed funds or the prime rate. Financial institutions and governments mainly issue floaters, and they typically have a two- to five-year term to maturity.

Fully Hedged Bonds

In the case of foreign bonds currency risk is present, On the other hand, fully hedged bonds eliminate that risk by selling streams of interest and principal in the forward market.

Euro Notes

Like Promissory Notes, Euro Notes are used for obtaining short term funds. They are denominated in any currency other than the currency of the country where they are issued. The documentation facilities are minimum. It is one of the low-cost funding route. Investor too prefer them in view of short maturity.

Complexities in foreign projects

Complexities in multinational capital budgeting are –

1. Involves exchange risk as cash flows have to be converted into currency of parent organization.

2. Parent cash flow would be different from project cash flows 3. Profit remitted by subsidiary to the parent may be subjected to tax both in the home country

and host country.

4. Change in the rate of inflation could cost a shift in the competitive environment and affect cash flows.

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5. Restrictions on remittances by subsidiary to parent in the host country are a big threat. 6. Increased political risk will reduce the possibility of expected cash flow. 7. Concessions and benefits provided by host country might increase the profitability of the

foreign project.

8. Estimating the terminal value in multinational capital budgeting is difficult since buyers in the parent companies have divergent views on acquisition of the project.

Adjusted Present Value Method (APV)

Broadly adjusted present value (APV) of a project equals the net present value of the project under all-equity financing plus the net present value of any financing side effects less present value of bankruptcy costs. The NPV of financing side effects equals the after-tax present value of cash flows resulting from the firms’ debt.

APV = NPV of project assuming it is all equity financed + NPV of financing effects

When we use Weighted Average Cost of Capital (WACC) as the discount rate to evaluate projects, we ignore the fact that, in many cases, the capital structure of the project may change over time. In other cases, the tax rate faced by the firm may be expected to change over time (as firm goes from loss to profit, or special tax subsidies expire etc.). In other cases, the firm may be able to obtain subsidized financing from a government agency for the project. In all of these circumstances, these types of things mean that the WACC for the project will change, and may even change each year of the project’s life. Incorporating these types of factors into an NPV-WACC calculation is possible, but very complicated. The normal assumption is that the WACC is the same for each cash flow and each year of the project.

Therefore, APV method segregates the calculation into equity-only component and debt components. The first step in calculating an APV is to calculate a base NPV using the cost of equity as the discount rate.

Once the base NPV has been calculated, the next step is to calculate the NPV of each set of cash flows that results from financing. Essentially in this part we add on the extra value created from using debt in the capital structure. The most obvious of these are the tax effects of using debt rather than equity. These can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the tax effects (e.g. future tax rates, whether the company as a whole will be profitable and paying tax). As we add debt to the firm, the default risk of the firm increases, and when default happens the firm goes bankrupt. Therefore, to avoid default that may arise from taking debt, the firm incurs costs called as bankruptcy costs. In practice the quantification of bankruptcy costs is always a challenge. This step of the adjusted present value approach poses the most significant estimation problem, since neither the probability of bankruptcy nor the bankruptcy cost can be estimated directly.

Thus, the benefit of APV is that it breaks the problem down into the value of the project itself (if equity financed) and the value of the financing (whereas the effect of financing is taken account of in the WACC when calculating regular NPV) and promptly subtracts costs of any risk arising out of taking additional debt. Though APV seems preferable from a managerial point of view as it shows directly the sources of value created by a project (i.e. how much is from running the actual project, how much is from the financing arrangements, how much value is created by a

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government subsidy etc.), WACC is still, by far, the most common project valuation approach used by firms.

Leading and Lagging

Leading and lagging are adopted by company subsidiaries for optimizing cash flow movements where timing of payments is adjusted based on expectations of future currency movements.

On the foreign currency payment front, leading is the payment of an obligation before due date when there is apprehension that in future foreign currency will be dearer, while lagging is delaying the payment of an obligation past due date, where the company plans to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.

On the foreign currency receipt front, leading is the speeding up collections on receivables before due date when there is apprehension that in future foreign currency will be cheaper, while lagging is permitting clients to pay past due date, where the company plans to take advantage of expected appreciation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.

At the level of an individual transaction this is a specific protection measure; but at the corporate level this requires forecasting of currency movements, centralization of information on transactions, and evolving guidelines for subsidiaries. This technique helps the firm to reduce foreign exchange exposure thereby reducing the risk or it helps the firm increase the available working capital. In most cases in an uncertain environment firms accelerate payments of hard currency (appreciating currency) and delay payments of

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