Foreign Exchange Risk Management

Contents:
1. Introduction
2. Bid, Ask and Spread
3. Exchange rate quotation (One way quote & Two way quote)
4. Spot rate and forward rate
5. Swap point/Forward margin/Forward Spot differential.
6. Exchange margin
7. Direct quote & Indirect quote
8. How transaction takes place in FOREX?
9. Hedging:
- Forward cover
- Lead Payment
- Lagging
- Money (Cash) market operation
- Rupee roll over forward contract
- Currency option (Refer Derivative)
- Currency Future (Refer derivative)
10. IRPT (Interest rate parity theorem)
11. PPPT (Purchasing power parity theorem)/ Inflation rate parity theorem
12. Cross rate of foreign exchange
13. Arbitrage
14. Cancellation of forward contract
15. Modification in forward contract
16. Early delivery of currency.
17. Interest rate swap (Refer OTC derivative)
18. Nostro A/C and Vostro A/C
19. Maintaining Exchange position and Nostro A/C
20. Multinational Capital Budgeting (Refer Capital budgeting)
21. FOREX with other topic

Introduction
In this chapter we will study how to minimize the loss /risk which will arise due to the adverse
change in exchange rate of foreign currency. Normally, Payment will be receivable or payable at
some future date and exchange rate will not be same at that day. As a result loss/gain will arise.
The exchange rate is the relationship between two currencies at a given point of time.
For example: $1 =  46
One way quote
£ 1 =  70
$1 =  46 -  46.5
Two way quote
£ 1 =  70 -  70.5

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Bid, Ask & Spread
Bid rate (Bank’s buying rate): Bid rate is the rate at which bank buys left hand currency.

Ask rate (Bank’s selling rate): Ask rate is the rate at which bank sells left hand currency.

Note: Ask rate will always be greater than bid rate (i.e. Ask rate > Bid rate)

Spread: The difference between Ask and Bid rates is called the spread.

Mathematically, Spread = Ask rate – Bid rate

–
% Spread = 100

To remember: Think it is similar to Gross profit ratio = 100

Exchange rate quotation

(i) One way quote:
When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are same, it is the one way quote.

For example: £ 1 = $ 1.50

It means bank will buy left hand currency (i.e. £) at $ 1.50 and also sale left hand
currency (i.e. £) at $ 1.50.
(ii) Two way quote:
When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are different, it is the two way
quote.
For example: £ 1 = $ 1.50 - $ 1.55

Bid rate Ask rate

Buying rate selling rate

Of bank of bank
Bid rate is always less than Ask rate

It means bank will buy left hand currency (i.e. £) at $ 1.50.

And bank will sale left hand currency (i.e. £) at $ 1.55

How to apply two way quote rate, for converting one currency into other currency?
1. Identify amount payable or receivable?
For example: assume invoice amount is $ 1,00,000/- which will be payable in 3 month
time.
2. Choose applicable Bid or Ask rate
Take the given exchange rate and draw the following diagram and identify what will do
bank for left hand currency.

Bank
Rate: £ 1 = $ 1.50 – 1.55
Buy £ sale $

Here amount payable is $ 1,00,000/-, means customer have to buy $ from bank. We have
made diagram on the basis of our requirement. But we have to think, what will do bank

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for ‘£’ currency and not for ‘$’ currency because left hand currency given in rate is ‘£’
currency.
Conclusion: Apply Bid rate i.e. $ 1.5 for conversion of $1,00,000.
3. Identify whether multiply by 1.5 or divide by 1.5 for conversion
In which currency you are converting? Ans: in ‘£’ as per our example
See whether ‘£’ is greater in term of figure? Ans: no, smaller
Hence divide by rate chosen in step 2 i.e. 1.5.
Therefore, equivalent amount in £ = 1,00,000 = £ 66,666.67/-

Important Note: If exchange rate is quoted in form “/€”, it, normally, means price of 1 € currency
in  currency. But it is not always true. Sometime “/€” means pair of currency (It means either 
per € or € per). You have to apply your common sense on the basis of strength of the currency.
Stronger currency have lower figure.
For example: 1. Rate: /€ 60.00 – 60.25. It means: € 1 =  60.00 – 60.25
2. Rate: /€ 0.0165 – 0.0175 It means:  1 = € 0.0165 – 0.0175
 It doesn’t mean € 1 = 0.0165 – 0.0175
We know € is the stronger currency than . And stronger currency have lower figure. See example-1:
€ have lower figure and  have greater figure. See example-2:  have greater figure and € have
lower figure.
Example 3: Rate ( per €) 0.0165 – 0.0175
In this case you may solve question assuming:
(i) per € even rate is illogical, because rate is specifically written as  per € and we know
that specific provision overrides general. or
(ii) € per  on the basis of strength.
Both will get same mark in exam.
Strength wise currency list for some important currency: (strongest to weakest currency sequence):
1. Pound –GBP (£) 71
2. Euro-EUR (€) 61
3. Swiss Franc (CHF) 46
4. US Dollar-USD ($) 45
5. German Mark (DEM) 31
6. French Franc (FRF) 9
7. Indian Rupee-INR () 1
8. Japanese Yen-JPY (¥) 0.5
Spot Rate
Spot rate is the rate applicable for immediate settlement. In practice settlement actually takes place
within 2 business day.
Forward Rate:
Forward rate is the rate contracted today for future settlement. Forward rate are usually quoted
for fixed period of 30, 60, 90 or 180 days from the date of contract.
Forward premium & Discount:
If the currency is costlier in future as compare to spot it is said to be at a premium.
If the currency is cheaper in future as compare to spot it is said to be at a discount.
How to calculate forward rate when forward premium & Discount given?

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 Take spot rate. (say $1 =  45)
 Multiply by (1+premium rate of one currency in decimal) to the other currency (i.e. if premium is
on $ then multiply in  amount or vice versa). Or
 Multiply by (1- discount rate of one currency in decimal) to other currency (i.e. if discount is on $
then multiply in amount or vice versa).
How to calculate forward premium or discount when spot rate and forward rate is given:
 First decide on which currency you have to calculate premium rate of discount rate.
 check the quotation, whether it is direct quote or indirect quote for the decided currency.
 If it is direct quote, apply following formula:
Forward premium/discount =

 If it is indirect quote, apply following formula:

Forward premium/discount =

Swap point/Forward margin/Forward Spot differential.

The difference between forward rate and spot rate is known as swap points/forward margin (not
exchange margin)/forward premium (forward premium “in value” not in “%”. If it is in “%” then do as discussed earlier)

How to calculate forward rate using swap point/Forward margin?

 When we are given the Spot rate with forward margin / forward premium / forward swap /
forward points for buying rate or selling rate (Bid or Ask),
 Check whether the margin for buying or selling is in increasing order OR in decreasing order, to
find the forward rate.

Add to spot rate to arrive forward rate. Deduct from spot rate to arrive forward rate.

Example 1: Spot Rate $1 = 40.4800 / 4900 Example1: Spot rate $1 = 40. 4800 / 4900
Forward Premium .1100 / .1300 (increasing trend) Forward premium .1255 / .1200 (decreasing trend)

Solution: Forward Rate: 40.4800 / 40.4900 Solution: Forward Rate: 40.4800 / 40.4900
+ .1100 + .1300 (-) .1255 (-) .1200
40.5900 40.6200 40.3545 40.3700

i.e. Forward rate: $ 1 = 40.5900 / 40.6200 i.e. Forward rate: $ 1 = 40.3545 / 40.3700

Example 2: Spot Rate $1 =  52.60 / 70 Example 2: Spot rate $1 = 52.60 / 70

3 Month Forward 20 / 70 (increasing trend) 3 Month Forward 30 / 25 (decreasing trend)

Solution: Forward Rate: 52.60 / 52.70 Solution: Forward Rate: 52.60 / 52.70
+ . 20 + . 70 (-) .30 (-) .25
52.80 53.40 52.30 52.45

i.e. Forward rate: $ 1 = 52.80 / 53.40 i.e. Forward rate: $ 1 = 52.30 / 52.45

Notes for example-2: The point “70” given in spot rate is not swap point because it is not the difference in
forward rate and spot rate. It is simply the quotation method as we quote telephone No 24321152/53 it
means we are quoting two telephone no. (1) 24321152 and (2) 24321153. However point given in 3 month
forward is not quotation method like telephone no. it is difference in forward rate and spot rate.

Exchange margin
Exchange margin is the extra amount or percentage charged by the bank over and above the rate
quoted by bank.

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How to calculate Exchange rate (for both spot rate and forward rate) using exchange margin?
When we are given the Spot rate / forward rate with margin for buying rate and margin for selling
rate then effective rate will be calculated as:

Deduct margin from buying rate to get
desired exchange rate. Hence,
Actual buying rate = Bid rate (1-exchange margin)
Example: Given rate $1 = . 40.4800 / 40.4900
Margin 0.08% for Buying rate
Add margin to selling rate to get desired
exchange rate. Hence,
Actual selling rate = Ask rate (1+exchange margin)
Example: Given rate $1 = . 40.8300 / 40.8650
Margin .25% for selling rate

Solution: Solution:
Desired buying rate $1=40.4800 (1-0.0008) Desired selling rate $1 = 40.8650 (1+0.0025)
= . 40.4476 = . 40.9672
Logic behind addition or deduction: Everyone wants to buy at low rate and wants to sell at high
rate. Hence deduct margin from buying rate to arrive at low rate and add margin to selling rate
to arrive at high rate.

Special situation for calculation of exchange rate:

Suppose given exchange rate quotation is:
Spot rate (€ per £) : 1.7820
1 month forward rate (€ per £) : 1.7829

It means spot rate is: 1£ = € (1.7820-0.0002) / (1.7820+0.0002)

= € 1.7818 / 1.7822
(Note: It doesn’t mean that bid rate is 1.7820 and Ask rate is (1.7820+0.0002)
1 month forward rate is: 1£ = € (1.7829-0.0003) / (1.7829+0.0003)
= € 1.7826 / 1.7832

Direct quote & Indirect quote

Indirect quote:
A direct quote is the home currency price for one unit foreign currency.
Example: $1 =  48 is a direct quote for an Indian (Or it is direct quote of $)
Indirect quote:
An indirect quote is the foreign currency price for one unit of home currency.
Example: . 1 = $ 0.0208 is an indirect quote for an Indian. (or it is indirect quote of $)
Converting direct quote into indirect quote:
Conversion for one way quote
Direct quote = OR Indirect quote =

Example: Direct quote: $ 1 =  45

Indirect Q. 1=$

Conversion for two way quote:

Example: $1 =  45 / 45.50 1= / i.e.  1 = 0.0222/0.0219
Here, Because of Bid rate > Ask rate, above conversion is not correct.

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Hence Use following:
Direct quote: $1 =  45 / 45.50

Indirect quote:  1 = / i.e. 1 = 0.0219 / 0.0222 (Bid rate < Ask rate)

How transaction takes place in forex

Each party want to trade and deal in own currency but the invoice can be made in single currency.
Hence the agreed currency would be the home currency, foreign currency or any other currency.

Export to UK co.
1
Invoice Amount:
Option A: $ 10,000
USA Company($) Option B: £ 5,000 UK Company (£)
Inflow at 3 Month Option C: € 7,000 Outflow at 3 Month
(Credit period 3M)

2B 2A
4B 4A 3
UK co. make payment at 3 month
$ £/€ time in ‘$’, ‘£’ or in ‘€’. $/€ £

USA Bank UK Bank

Buy £/€, Sell $ When invoice is in ‘£’ When invoice is in ‘$’ Buy £, sell $/€

Risk of currency fluctuation lies on Risk of currency fluctuation lies on

USA co. Because USA Co have to UK co. Because UK Co have to
convert £ into $ at 3 month time. convert £ into $ at 3 month time.

In this case: Step 2A and 2B is not In this case: Step 4A and 4B is not
applicable. applicable

A: When invoice is in “$”: chain in steps, made in figure 12A2B3. (at end, USA co. get money in $)
B: When invoice is in “£”: chain in steps, made in figure 134A4B. (at end, USA co. get money in $)

C: When Invoice is in ‘€’: Risk lies on both UK co. and USA co. because both companies have to convert one
currency into other. UK co convert ‘£’ into ‘€’ and USA co convert ‘€’ into ‘$’. In this case all steps (i.e. 2A, 2B,
4A, 4B) are applicable.

Analysis for USA co: when invoice is in home currency ($)  No risk on USA co.  No need to hedge foreign
currency receipt and hence no need to study FOREX.

Analysis for UK co: when invoice is in home currency (£)  No risk on UK co.  No need to hedge foreign
currency receipt and hence no need to study FOREX.

Conclusion: If question ask for any measures of hedging, it mean the currency payable or receivable is always
foreign currency. Hence do not get confused to recognize which currency is foreign currency and which
currency is home currency. Just identify the currency in which invoice is being made (i.e. currency in
which amount payable or receivable), and conclude that invoice currency is always foreign currency.
On basis of this currency identify the company who has to take corrective action to minimize loss.

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Hedging through forward Market:
For hedging (safeguard) future receipt or future payment one has to enter forward contract (i.e. today’s contract
for future delivery) at forward rate.

At due date convert one currency into other currency at the agreed rate the rate at which forward contract is made,
doesn’t matter what is the actual rate on due date.

Calculation of gain/Loss due to forward hedge:

Suppose XYZ have to make payment $ 1,00,000/- at 6 month time.
Today 6 month

XYZ enters buying contract today for $ 1,00,000 @ 45

Actual rate 1$ =45.5
At 6 month time he buys $ from bank @  45, even at that date actual rate is  45.5.

For calculation of loss/gain think if Mr. XYZ not taken forward contract then at which rate he buy $?
He will buy $ (think $ is apple) @ 45.5 but due to forward contract he will buy $ @ 45 (at lower rate)
hence he will gain 1,00,000 (45.5 – 45) = 50,000/-

Lead Payment
Lead payment is a payment as on today for a transaction forgetting the credit period given by
supplier. Importer makes the lead payment when he feels that the loss due to currency fluctuation
will become higher than that of the benefit which he will get due to time value of money.

Notes: We know comparison can never be done between rickshaw wale and chartered accountant. Similarly,
Lead payment can never be comparable with Forward cover because under lead payment outflow
become today and under forward cover outflow become at some future date.
Hence, for making lead payment comparable with forward cover we make payment today taking loan
(for the period equal to forward cover) so that the outflow become at the time of repayment of loan.

[Refer Question No. -87]

Lagging
See page-15
Cross rate of foreign exchange
The cross rate is the currency exchange rate between two currencies, where neither of the
currencies are of the country in which the exchange rate is given.
Example of cross rate:
Exchange rate: £ 1 = € 1.21 in India.  Exchange rate: € 1 = ¥ 106 in India.
In both rate neither of the currencies is of India (i.e. ) hence it is cross rate, in India.

 How to calculate required exchange rate using cross rate?

Suppose an Indian importer have to make payment in ‘¥’ currency but ‘¥’ currency quote is not
available directly with.
One way quote:
Rate quoted by Indian bank is: (i) £ 1 = $ 1.55 (ii) £ 1 = 72 (iii) €1= $ 1.27 (iv) € 1 = ¥ 106
What is the applicable rate to Indian importer for payment in ¥ ?
We can calculate required rate /¥ using following relationship:
  £ €
= = = 0.5565
¥ £ € ¥

 Hence, required rate: ¥1 =  0.5565

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Two way quote:
Rate quoted by bank is: (i) £ 1 = ¥ 130 – 131 (ii) £ 1 = 72 – 72.5
Convert into indirect quote: (i) ¥1 = £ – (ii) 1 = £ –
Calculate required rate using following relationship:
  £  £
= – = – = 0.5496 – 0.5577
¥ £ ¥ £ ¥

for Bid for Ask

 Hence, required rate: ¥1 = 0.5496 – 0.5577

Hedging through Money (cash) Market Operation:

A. Amount Receivable in foreign currency:

Export to USA

Invoice for
$ 10,000/-
Indian Company Credit period 3M USA Company
Inflow at 3 Month Outflow at 3 Month

1
3 4
2
1

 $

Indian B – 1 Indian B – 2 USA Bank

Rate: 10-12% SR: 1$=40-41 Rate; 5%-6%

1. Borrow less amount today from the USA bank for 3 month at borrowing rate of USA.

= $ 10,000 / (1+0.06 X 3/12) = $ 9,852

1. Convert $ 9,852 into ‘Rupee’ @ spot rate.

$9,852 =  9,852 X 40 =  3,94,080

2. Invest  3,94,080 in India for 3 month at Deposit rate of India.

Deposit amount after 3 month =  3,94,080 X (1+0.10X3/12) =  4,03,932

2. Borrowing amount with interest will become Invoice amount at 3 month time which will pay
by USA company to USA Bank.

Hence, Amount receivable under money market operation at 3 month time is equal to  4,03,932/-

3. Concept: Why borrowed money from foreign bank to be deposit in home country bank? Why
not keep with him self today?
4. If we not deposit money in home country bank today, then the inflow become today’s time
and it is not comparable with forward contract or with other hedging option. Hence deposit
today in home country bank by taking loan in foreign currency.

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B. Amount Payable in foreign currency:

Import from USA

Invoice for
$ 10,000/-
Indian Company Credit period 3M USA Company
Outflow at 3 Month Inflow at 3 Month

1
3 4
2
1

$ 

Indian B – 1 Indian B – 2 USA Bank

Rate: 10-12% SR: 1$=40-41 Rate; 5%-6%

5. Deposit less amount today in the USA bank for 3 month at deposit rate of USA.

= $ 10,000/ (1 + 0.05 X 3/12) = $ 9,876

6. Convert $ 9,876 into ‘Rupee’ @ spot rate.

$ 9,876 =  9,876 X 41 =  4,04,916

7. Borrow  4,04,916 in India for 3 month at borrowing rate of India.

Borrowing amount after 3 month =  4,04,916 X (1+0.12X3/12) =  4,17,063

8. Deposit amount with interest will become Invoice amount at 3 month time which will receive
by USA company from USA Bank.

Hence, Amount payable under money market operation at 3 month time is equal to  4,17,063/-

Concept: Why borrow money from home country bank to deposit fewer amounts in foreign bank?
Why not from own pocket at today time?
If we not borrow money from home country bank, then the outflow become today’s time
and it is not comparable with forward contract or with other hedging option. Hence deposit
today by taking loan.

IRPT (Interest rate parity theorem)

 Interest Rate prevailing in two countries affects the exchange rate between the currencies of
those countries.
 According to this theory, difference between interest rate of two countries must be equal to the
difference between the forward and spot Exchange rate
 IRPT mathematically express the relationship between SR, FR, and interest rate of two countries.

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At interest rate parity theorem,
 
(i) =

(ii)

 If FR, SR and Interest rate of both countries are based on IRPT then arbitrage gain (risk free profit) is
not possible.
 The currency with the Higher Interest Rates will sell at a discount in the forward market against
a currency with the lower interest rate.
Similarly currency with lower interest rate will sell at a premium in the forward market against
the currency with the higher interest rate

PPPT (Purchasing Power parity theorem):

Purchasing power parity theorem (also known as inflation rate parity theorem) is same as Interest
rate Parity theorem. If we replace the Interest rate by Inflation rate in above parity formula, then it
will become Purchasing power parity.
At purchasing power parity theorem/inflation rate parity theorem,
 
(i) =


(ii)

Arbitrage
 Arbitrage is an act to earn risk free profit. The act may be:
(i) Sale at high rate & purchase at low rate; (ii) borrowing at low rate & investing at high rate
 Arbitrage is not possible in Forex market if ‘Exchange rates’ and ‘interest rates’ are based on
IRPT.

Arbitrage

Geographical Arbitrage Cover Interest Arbitrage

Situation:
Information of different rate (either one
way quote or two way quote) for various
markets are given.
How to Solve question?
1. Assume a person have some money in
any of the currency.
2. Sale at high rate in one market and
Purchase at low rate in another
market.
Arbitrage gain = sale value – purchase Value
When arbitrage is possible?
1. Arbitrage is possible if there are
mismatch in cross rates of various
markets.
Situation:
Information of FR, SR and interest rate of two
countries are given.
How to solve question?
1. Assume a person have nothing today.
2. Borrow at low rate in one country for
specific period and invest at high rate in
another country for same period.
Bring the deposit amount with interest in
first country and repay the borrowing taken
earlier.
Arbitrage gain = Deposit amt – borrowing amt.
When arbitrage is possible?
1. Arbitrage is possible if there are mismatch in FR,
SR and Interest rates.

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Note:
- In one way quote, arbitrage gain is possible
from only one route. If gain in one rout,
there must be loss in another route.
- In two way quote there may be loss in both
routes.
Note:
- We can use short cut to find out the high rate and
low rate if given quote is single quote.
- If given rate is two way quote then check for
arbitrage possibility for all the routs in trial and
error method.

Short cut for finding the countries to be invested or to be borrowed when one way quote is
given (For Cover interest arbitrage)

 Calculate Premium/Discount on any currency using following formula

Premium/discount = [Say calculated premium on one currency is 4%]
 Compare this 4% with interest rate differential of two countries and decide the country in which
deposit should be made and country from which borrowing should be made.

Situation - I
Interest rate differential
= Int. rate of country ‘A’ (say 10%) – Int. rate of Country ‘B’ (say 4%) = 6%

Because this rate is high Because this rate is low Why not 4%?
Hence for arbitrage gain take borrowing from country ‘B’ and invest in country ‘A’.

Situation-II
Interest rate differential
= Int. rate of country ‘A’ (say 8%) – Int. rate of country ‘B’ (say 5%) = 3%

Because this rate is low Because this rate is high Why not 4%?
Hence for arbitrage gain take borrowing from country ‘A’ and invest in country ‘B’.

Cancellation of forward Contract:

Suppose a person enters forward contract on date “A” (i.e. today) for delivery on 3 month time. Due
to some reason contract cannot be performed and hence he approaches for cancellation. We are
discussing the position for 4 different situations.
3 month
2 month

Date
A B C D E
Today before due date
B
Due date After due date
B
Due date + 15 days
B

Originally entered F. Contract for due date

3 4
1 2

Situation-1: Customer approaches to cancel forward contract before due date (on date ‘B’):
Bank enters sale contract, if original contract was for purchase (i.e. opposite contract), OR
Bank enters Purchase contract if original contract was for Sale (i.e. opposite contract),

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for due date exchange rate i.e. 1 month forward rate on date ‘B’.

Bank’s gain Customer’s gain

Gain to bank = Loss to customer or Loss to bank = Gain to customer

Gain/Loss to bank = Sale value under original contract – Purchase value under opposite contract
OR,
= sale value under opposite contract – Purchase value under original contract

Situation-2: Customer approaches to cancel forward contract on due date (i.e. on date ‘C’):
To cancel forward contract on date ‘C’, bank enters opposite contract at spot rate on date
‘C’.
Bank’s gain Customer’s gain
Gain/Loss to both parties = same as above situation - ‘1’

Situation-3: Customer approaches to cancel forward contract after due date (i.e. on date ‘D’):
Bank enters opposite contract at spot rate on date ‘D’.

Bank’s gain Customer’s gain

Gain/Loss to both parties = same as above situation - ‘1’

Situation-4: Customer doesn’t approaches to cancel forward contract. Hence automatic

cancellation on due date + 15 days (on date ‘E’):
Bank enters opposite contract at spot rate on date ‘E’.
Bank’s gain Customer’s gain

Gain/Loss to both parties = same as above situation - ‘1’

Modification in forward contract:

Situation-I:
Some time customer enters forward contract to buy/sale the foreign currency but due to some
reason (like defective goods) later on customer need less amount than contracted amount.
Suppose customer originally entered forward purchase contract for $ 96,000 with bank but later on
they need only $ 50,000 and not 96,000. What he will do.
Solution:
- Cancel the original forward contract on due date by entering the opposite contract.
- Purchase $ 50,000 at spot rate prevailing on that date (i.e. due date)

Situation-II:
Some time customer enters forward contract to buy/sale the foreign currency but due to some
reason (like defective goods) later on customer want to extend contract for some further period. What he
will do.
Solution:
- Cancel earlier forward contract by entering opposite contract.
- Make fresh forward contract for the desired period.

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Early delivery of currency
Some time customer approaches the bank with early delivery of foreign currency before the forward
contract period expires and at that time the spot rate is higher than that of original forward contract.
In this case how the transaction will settled?

Understand this with following example:

Suppose, a customer has originally entered a 6 month forward contract to Sale $ 5,00,000 currency
at a rate of 40. After 3 month time customer received $ 500,000 from US company and hence he
approached bank with $ 5,00,000 to exchange in Rupee (when spot rate is 41.28-41.33 and 3
month forward rate is 41.80-41.89) against forward contract. How much amount will be payable to
customer?
Today 3 month 6 month

Original contract @ 40

Spot rate 41.28 - 41.33 Swap charges

3 M FR 40.80 - 41.89

To settle this transaction bank will do two things:

(i) Bank Purchase $ 5,00,000 at spot rate 41.28 but pay in two part as below:

40 1.28
Pay today as per earlier contract rate pay at due date with interest
i.e. 40 5,00,000 = 200 lakh Reducing swap charges

(i) Bank will collect swap charges with reference to spot purchase & forward sale.
Swap charges = (forward sale – spot purchase) 5,00,000
= (41.89 – 41.28) 5,00,000 = 3,05,000

At due date payment with interest reducing swap charges is equal to:
(1.28 5,00,000) - 3,05,000 = 3,47,800

Customer will get two payment one at 3 month time 200 lakh and one at 6 month time 3,47,800
[Refer Question No. -51]

Rupee roll-over forward contract:

Forward rate for the period more than 6 month is not available. In this case rupee role over contract
is used to hedge the future payment or receipt.

When whole amount in foreign currency is receivable or payable at the time more than 6 month.

Amt receivable/Payable
$1,00,000 at 2Y
0Y 6m 1Y 1.5 Y 2Y

1 2 3 4
5
1. Originally enter 6m forward contract @ 6m FR on 0 Y to sell/buy $1,00,000/-

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2. At 6m time, cancel forward contract by entering opposite contract (because payment not receivable/payable
at 6m ) @ SR on 6 Month.

- Calculate amount receivable/payable due to cancelation.

- Again enter 6m forward contract @ 6m FR on 6m to sell/Buy $ 1,00,000/-

3. At 1Y, cancel forward contract by entering opposite contract (because payment not receivable/payable at 1Y)

@ SR on 1 Year.
- Calculate amount receivable/payable due to cancelation.
- Again enter 6m forward contract @ 6m FR on 1 Y to sell/Buy $ 1,00,000/-

4. At 1.5Y, cancel forward contract by entering opposite contract (because payment not receivable/payable at 1.5Y)
@ SR on 1.5 Year.
- Calculate amount receivable/payable due to cancelation.
- Again enter 6m forward contract @ 6m FR on 1.5 Y to sell/Buy $ 1,00,000/-

5. At 2Y, sell/Buy $1,00,000 @ committed 6m FR of 1.5Y time.

- Calculate final amount receivable/payable.

Total amount receivable/payable under Rupee roll over:

A. When cost of debt/discount rate is not given:
Amount receivable/payable = Amt at 6m + Amt at 1Y + Amt at 1.5Y + Amt at 2Y.

B. when cost of debt/discount rate is given:

Option – 1:
Total amount receivable/payable under Rupee roll over at today’s money term:
Amt at 6m Amt at 1Y Amt at 1.5Y Amt at 2Y
Present value of receivable/payable = + + +
(1+PIR) 1 (1+PIR) 2 (1+PIR) 3 (1+PIR) 4
OR
Amt at 6m Amt at 1Y Amt at 1.5Y Amt at 2Y
+ + +
PVIF(R, 1) PVIF(R, 2) PVIF(R, 3) PVIF(R, 4)

Option – 2:
Total amount receivable/payable under Rupee roll over at future’s money term i.e. after 2Y:
Amt at 6m Amt at 1Y Amt at 1.5Y Amt at 2Y
Future value of receivable/payable = + + +
(1+PIR)3 (1+PIR)2 (1+PIR)1 (1+PIR)0

Nostro A/C and Vostro A/C

Nostro A/C: Nostro Account is an account maintained by an Indian bank/dealer with a foreign bank
in foreign currency. For example, Account of SBI Bank (an Indian bank) in London (UK) with London
bank in pound (£) currency.

Vostro A/C: Vostro A/C is an account maintained by a foreign bank in India with Indian bank in
Rupee currency. For example account of London bank in India with SBI in Rupee () Currency.

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Maintaining Exchange position and Nostro A/C [Nov-05] [RTP-Nov-08]
General information:
- Currency of Switzerland is Swiss Franc (CHF)
- “Zurich” is a city of Switzerland
- Telegraphic Transfer or Telex Transfer , often abbreviated to TT, is an electronic means of
transferring funds overseas

Exchange position: Exchange position (for CHF currency) of an Indian bank/dealer will affect by:
- Purchase/sale of foreign currency, (the purchase/sale of currency may be spot or forward)
- Issue/cancellation of demand draft,
- Purchase/sale of Bills receivable,
- Remittance of foreign currency [Remember that Indian bank do not remit foreign currency (say CHF) in Nostro account from
India. All receipt in Swiss franc (CHF) and all payment/remittances in CHF will be made through Nostro account maintained with Switzer land

bank]

Cash Position (Nostro A/C): Nostro A/C of an Indian bank/dealer maintained with Switzerland bank
will affect by:
- Spot Purchase/Sale of foreign currency (CHF) (Forward Purchase/Sale of CHF do not affect Nostro A/C because
there is no delivery of currency as on today)

- Receipt/payment in CHF.
Note: Spot purchase/Sales of CHF affects both exchange position as well as Nostro A/C (Cash Position).
However, forward purchase/sale affects only the exchange position.
[Refer Question No – 44]

Lagging:
Lagging means delaying the payment beyond the due date allowed by supplier.

Example: Indian importer has to make payment for $ 5,000 at 3 month time to US supplier. If
payment is delayed, supplier charges interest @ 6% p.a.
3 month forward rate: 1$ = 45.30- 45.36
6 month forward rate: 1$ =  43.20-43.50
Indian company is considering the lagging if it is beneficial. Cost of capital of Indian company is 12%.

1. If Indian importer make payments at due date i.e. at 3 month time:

Outflow in Rupee at 3 month = 5,000 45.36 = 2,26,800

2. In Indian importer make payment at 6 month time (i.e. lagging):

Outflow in Dollar at 6 month= 5,000 = $ 5,075 [charge int. for 3M only)
Outflow in Rupee at 6 month= 5,075 43.50 = 2,20,762.5

0 Year 3 month 6 month

2,20,762.5

= 2,14,332

Outflow under lagging will be 214332 and under normal credit period will be 2,26,800.
Hence lagging is beneficial for importer.

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