International Finance W22

INTERNATIONAL FINANCE WINTER-2022
Q.1 Explain the following terms:

(a) Letter of credit
(b) Absolute and Relative PPP
(c) Direct Quote and Indirect Quote
(d) TT buying rate and TT selling rate
(e) Forward Purchase Contract and Forward Sale Contract
(f) Interest Rate Parity
(g) Bid Rate and Ask Rate
ANS: (a) Letter of credit: A letter of credit is a financial document issued by a bank
on behalf of a buyer, guaranteeing payment to a seller upon the fulfillment of
specified conditions. It serves as a payment mechanism in international trade,
providing assurance to the seller that they will receive payment for the goods or
services they deliver, as long as they meet the terms and conditions stated in the letter
of credit.
(b) Absolute and Relative PPP:
Absolute Purchasing Power Parity (PPP) is an economic theory that suggests that the
exchange rate between two currencies should adjust to ensure that the purchasing
power of a unit of currency is the same in different countries. In other words, the
prices of identical goods in different countries, when expressed in a common
currency, should be equal.
Relative Purchasing Power Parity is a modified version of absolute PPP that takes into
account the inflation differential between two countries. It suggests that the change in
exchange rates between two currencies should reflect the difference in the inflation
rates of the two countries.
(c) Direct Quote and Indirect Quote:
A direct quote is a foreign exchange rate expressed as the amount of domestic
currency required to buy one unit of a foreign currency. For example, if 1 USD equals
0.85 EUR, it means that the direct quote for USD/EUR is 0.85.
An indirect quote is a foreign exchange rate expressed as the amount of foreign
currency required to buy one unit of the domestic currency. Using the same example
as above, the indirect quote for EUR/USD would be 1.18, indicating that 1 EUR can
buy 1.18 USD.
(d) TT buying rate and TT selling rate:
TT (Telegraphic Transfer) buying rate is the exchange rate at which a bank or foreign
exchange dealer buys foreign currency from customers who want to convert their
domestic currency into foreign currency via a telegraphic transfer.
TT selling rate is the exchange rate at which a bank or foreign exchange dealer sells
foreign currency to customers who want to convert their foreign currency into
domestic currency via a telegraphic transfer.
(e) Forward Purchase Contract and Forward Sale Contract:
A forward purchase contract is an agreement between two parties to buy a specified
amount of a currency at a predetermined exchange rate on a future date. This allows
the buyer to protect themselves against potential exchange rate fluctuations.
A forward sale contract is an agreement between two parties to sell a specified amount
of a currency at a predetermined exchange rate on a future date. This allows the seller
to secure a future selling price and hedge against potential currency depreciation.
(f) Interest Rate Parity: Interest Rate Parity (IRP) is an economic concept that suggests
that the difference in interest rates between two countries should be equal to the
difference between the spot exchange rate and the forward exchange rate for those
currencies. According to IRP, if there is a deviation from this equality, arbitrage
opportunities would arise, and market forces would act to restore equilibrium.
(g) Bid Rate and Ask Rate:
Bid rate, also known as the buy rate, is the exchange rate at which a market maker or
dealer is willing to purchase a currency from a customer or trader.
Ask rate, also known as the sell rate or offer rate, is the exchange rate at which a
market maker or dealer is willing to sell a currency to a customer or trader. The ask
rate is typically higher than the bid rate, and the difference between the two is known
as the bid-ask spread, which represents the dealer's profit margin.
Q.2 (a) Who are the market participants in the foreign exchange market?
AMS: The foreign exchange market consists of various participants involved in the
buying, selling, and exchanging of currencies. The key market participants in the
foreign exchange market include:
Commercial Banks: Commercial banks play a crucial role in the foreign exchange
market. They act as intermediaries and facilitate currency transactions for their clients,
including individuals, corporations, and other financial institutions. Banks also engage
in proprietary trading of currencies to profit from exchange rate fluctuations.
Central Banks: Central banks, such as the Federal Reserve in the United States or the
European Central Bank, have a significant impact on the foreign exchange market.
They execute monetary policies and intervene in the market to stabilize their domestic
currency, manage foreign exchange reserves, and regulate the overall money supply.
Corporations and Businesses: Multinational corporations, importers, exporters, and
other businesses are active participants in the foreign exchange market. They engage
in currency transactions to facilitate international trade, manage foreign exchange risk,
and fulfill their payment obligations in different currencies.
Institutional Investors: Institutional investors, including pension funds, hedge funds,
mutual funds, and insurance companies, participate in the foreign exchange market for
investment purposes. They trade currencies to diversify their portfolios, speculate on
exchange rate movements, and seek potential profit opportunities.
Retail Traders: Individual retail traders, ranging from small investors to forex traders,
participate in the foreign exchange market through online forex brokers. These traders
engage in currency speculation, aiming to profit from short-term exchange rate
fluctuations.
Non-Bank Financial Institutions: Non-bank financial institutions, such as money
market funds, investment banks, and brokerage firms, actively participate in the
foreign exchange market. They provide liquidity, facilitate currency transactions, and
offer various foreign exchange products and services to their clients.
Governments and Sovereign Wealth Funds: Governments participate in the foreign
exchange market to manage their currency's value, regulate capital flows, and
influence economic conditions. Sovereign wealth funds, managed by governments,
also engage in foreign exchange transactions as part of their investment activities.
International Financial Institutions: International financial institutions, like the
International Monetary Fund (IMF), World Bank, and regional development banks,
participate in the foreign exchange market to execute currency operations, provide
financial assistance, and support global economic stability.
It's important to note that the foreign exchange market is decentralized and operates
24 hours a day across different financial centers worldwide. The participants
mentioned above contribute to the liquidity, volatility, and overall functioning of the
foreign exchange market.
(b) Explain the following terms in detail:
1. ADR & GDR 2. Nostro Accounts & Vostro Accounts
ANS: a. ADR & GDR: a. ADR (American Depositary Receipt): ADR is a negotiable
certificate issued by a U.S. bank representing a specific number of shares of a non-
U.S. company's stock. ADRs are created to facilitate the trading of foreign stocks in
U.S. markets, allowing U.S. investors to indirectly invest in foreign companies
without the need for direct ownership of foreign shares. ADRs are denominated in
U.S. dollars and trade on U.S. stock exchanges like regular stocks.
b. GDR (Global Depositary Receipt): GDR is a similar instrument to ADR but issued
in international markets outside the United States. GDRs are also negotiable
certificates that represent ownership of a specific number of shares in a foreign
company. They are denominated in a currency other than the issuer's domestic
currency and are traded on international stock exchanges. GDRs provide foreign
companies with access to global capital markets and enable international investors to
invest in non-U.S. companies.
Nostro Accounts & Vostro Accounts: a. Nostro Account: A Nostro account is a
foreign currency account maintained by a bank in another bank or financial institution
located in a foreign country. The term "nostro" is derived from Latin and means
"ours" in English. The purpose of a Nostro account is to facilitate international
transactions and hold funds in different currencies. For example, a U.S. bank may
have a Nostro account in a foreign bank to hold euros or other foreign currencies.
Nostro accounts are used for settlement, trade finance, and handling foreign exchange
transactions.
b. Vostro Account: A Vostro account is the mirror image of a Nostro account. It is an
account opened by a foreign bank or financial institution in a local bank to hold funds
in the local currency. The term "vostro" is also derived from Latin and means "yours"
in English. From the perspective of the local bank, the foreign bank's account is called
a Vostro account. The foreign bank uses the Vostro account to facilitate its operations
and provide services to its clients in the local market. For example, a foreign bank
may open a Vostro account in an Indian bank to handle transactions in Indian rupees.
Nostro and Vostro accounts are maintained to streamline cross-border transactions and
facilitate the settlement process between different banks. They enable banks to hold
funds in different currencies, settle international payments efficiently, and manage
their foreign exchange exposure.
It's important to note that the terms Nostro and Vostro are used in the context of
correspondent banking relationships, where banks maintain accounts with each other
to facilitate global financial transactions.
OR
(b) The spot rate for INR/USD is INR 45.6321/45.6380
Calculate forward rates for different periods using the following swap points:
1 month 30/25
2 months: 40/35
3 months: 25/35
ANS: To calculate the forward rates for different periods using the given swap points,
we need to add or subtract the swap points from the spot rate.
Forward rate for 1 month: Swap points: 30/25 (positive value indicates an addition)
Bid swap points: 30 Ask swap points: 25
Forward rate (bid) = Spot rate + Bid swap points Forward rate (bid) = 45.6321 +
0.0030 (30 swap points) Forward rate (bid) = 45.6351
Forward rate (ask) = Spot rate + Ask swap points Forward rate (ask) = 45.6380 +
0.0025 (25 swap points) Forward rate (ask) = 45.6405
Therefore, the forward rate for 1 month is INR 45.6351/45.6405.
Forward rate for 2 months: Swap points: 40/35 (positive value indicates an addition)
Bid swap points: 40 Ask swap points: 35
Forward rate (bid) = Spot rate + Bid swap points Forward rate (bid) = 45.6321 +
Forward rate (ask) = Spot rate + Ask swap points Forward rate (ask) = 45.6380 +
Therefore, the forward rate for 2 months is INR 45.6361/45.6415.
Forward rate for 3 months: Swap points: 25/35 (negative value indicates a subtraction)
Bid swap points: -25 Ask swap points: -35
Forward rate (bid) = Spot rate + Bid swap points Forward rate (bid) = 45.6321 -
Forward rate (ask) = Spot rate + Ask swap points Forward rate (ask) = 45.6380 -
Therefore, the forward rate for 3 months is INR 45.6296/45.6345.
Please note that forward rates are calculated based on the given swap points, and these
rates may not reflect the actual market rates at the time of calculation.
Q.3 (a) Briefly discuss the various types of international banking offices
ANS: Various types of international banking offices can be found globally. Here is a
brief discussion of some common types:
Branches: A branch is an extension of a bank's domestic operations established in a
foreign country. It operates under the same name and legal entity as the parent bank.
Branches provide a range of banking services, including deposits, loans, and other
financial services, to customers in the foreign market. They are subject to both local
and home country regulations.
Subsidiaries: A subsidiary is a separate legal entity incorporated in a foreign country
but owned by a parent bank. Subsidiaries are more independent than branches and
have their own board of directors and management. They are subject to local
regulations and operate with a certain degree of autonomy. Subsidiaries offer a full
range of banking services and are often subject to capital and regulatory requirements
of the host country.
Representative Offices: Representative offices are established by banks in foreign
countries to promote their services, build relationships, and conduct market research.
They are limited in their activities and typically cannot engage in core banking
operations or accept deposits. Representative offices serve as a liaison between the
parent bank and potential clients, providing information about the bank's products and
services.
Offshore Banking Units (OBUs): OBUs are located in offshore financial centers or
jurisdictions that offer favorable tax and regulatory environments. They are primarily
engaged in international banking activities, catering to non-resident customers and
facilitating cross-border transactions. OBUs provide services such as offshore
banking, wealth management, and international trade finance.
Correspondent Banking Offices: Correspondent banking offices act as intermediaries
between banks in different countries. They establish relationships and provide services
to facilitate cross-border transactions. Correspondent banks may offer services such as
clearing payments, facilitating trade finance, and conducting foreign exchange
transactions on behalf of their client banks.
International Banking Units (IBUs): IBUs are specialized units within a bank that
operate in specific countries or regions to serve international clients. They offer a
range of banking services tailored to meet the needs of multinational corporations,
institutional clients, and high-net-worth individuals. IBUs often benefit from
regulatory and tax incentives provided by the host country or jurisdiction.
Electronic Banking Centers: With the advancement of technology, banks have
established electronic banking centers to provide remote banking services to
customers worldwide. These centers utilize online banking platforms, mobile
applications, and other digital channels to offer services such as account management,
payments, and online trading to customers in different countries.
Each type of international banking office serves different purposes and operates under
specific regulations and guidelines. They play a vital role in facilitating cross-border
transactions, supporting international trade, and serving the financial needs of
customers in foreign markets.
(b) Write a detailed note on Interbank deals
ANS: Interbank deals, also known as interbank transactions or interbank trading, are
transactions that take place between banks in the financial markets. These deals
involve the buying and selling of financial instruments, such as currencies, securities,
and derivatives, among banks themselves. Here is a detailed note on interbank deals:
Nature of Interbank Deals: a. Wholesale Market: Interbank deals primarily take place
in the wholesale market, where banks trade with each other at large volumes and high
values. These deals are conducted to meet various purposes, including liquidity
management, risk management, and profit generation.
b. Over-the-Counter (OTC): Interbank deals are typically conducted over-the-counter,
meaning they occur directly between banks without the involvement of centralized
exchanges. This allows for flexibility in terms of pricing, negotiation, and
customization of deals to meet specific requirements.
c. Short-Term Transactions: Interbank deals often involve short-term transactions,
with maturities ranging from overnight to a few months. Banks engage in interbank
lending and borrowing to meet their short-term funding needs, manage liquidity, and
optimize their balance sheets.
Types of Interbank Deals: a. Interbank Lending: Banks lend to each other to address
temporary liquidity shortages. These loans are typically unsecured and have short
tenures. The interest rates for interbank lending, such as the London Interbank Offered
Rate (LIBOR), serve as benchmark rates for various financial products.
b. Foreign Exchange (FX) Trading: Banks engage in interbank deals to exchange one
currency for another. The interbank foreign exchange market is one of the most active
and liquid markets globally, with banks acting as market makers and participants. FX
interbank deals help banks manage currency exposures, facilitate international trade,
and provide liquidity to the market.
c. Money Market Instruments: Interbank deals involve the trading of money market
instruments like Treasury bills, commercial papers, certificates of deposit, and other
short-term debt instruments. Banks use these instruments for liquidity management,
investment purposes, and portfolio diversification.
d. Derivatives Trading: Banks engage in interbank deals involving derivatives such as
interest rate swaps, currency swaps, options, and futures. These deals allow banks to
hedge risks, speculate on future price movements, and manage their balance sheets
more effectively.
Market Participants: a. Commercial Banks: Commercial banks are the main
participants in interbank deals. They engage in these transactions to manage their
liquidity needs, fund their operations, and mitigate risks.
b. Central Banks: Central banks play a significant role in interbank deals, particularly
in managing monetary policy and maintaining stability in the financial system. They
may conduct open market operations and provide liquidity to banks through interbank
lending or repurchase agreements.
c. Investment Banks: Investment banks participate in interbank deals to trade on their
own behalf or on behalf of their clients. They engage in various financial market
activities, including foreign exchange trading, securities trading, and derivative
transactions.
Settlement and Clearing: Interbank deals are settled and cleared through central
counterparties (CCPs) or clearinghouses. These entities ensure efficient settlement,
mitigate counterparty risks, and provide a secure framework for transactions.
Regulatory Oversight: Interbank deals are subject to regulatory oversight by financial
authorities, including central banks and regulatory bodies. These authorities establish
rules and regulations to promote stability, transparency, and fair practices in interbank
transactions.
Interbank deals are critical for the functioning of the financial system. They provide
liquidity to banks, facilitate price discovery, and enable effective risk management.
The interbank market serves as a foundation for various financial activities and
contributes to the overall stability of the global financial system.
OR
Q.3 (a) Briefly define each of the major types of international bond market
instruments, noting their distinguishing characteristics.
ANS: The major types of international bond market instruments include the following:
Government Bonds: Government bonds, also known as sovereign bonds, are issued by
national governments to finance their budget deficits and fund public projects. These
bonds are considered low-risk investments as they are backed by the full faith and
credit of the issuing government. Government bonds typically have fixed interest
payments, known as coupon payments, and a predetermined maturity date.
Corporate Bonds: Corporate bonds are issued by corporations to raise capital for
business activities. They are used to fund expansions, acquisitions, and other corporate
initiatives. Corporate bonds carry higher credit risk compared to government bonds, as
the repayment depends on the financial strength and creditworthiness of the issuing
company. Corporate bonds can have varying interest rates, maturities, and structures.
Municipal Bonds: Municipal bonds, also known as munis, are issued by state and
local governments or their agencies to finance public projects, such as infrastructure
development or educational facilities. Municipal bonds offer tax advantages, as the
interest income is often exempt from federal income tax and, in some cases, state and
local taxes. These bonds can have fixed or variable interest rates and various
maturities.
Supranational Bonds: Supranational bonds are issued by international organizations
such as the World Bank, International Finance Corporation (IFC), or regional
development banks like the Asian Development Bank or the European Investment
Bank. These bonds are used to finance projects that promote economic development
and social welfare globally or within specific regions. Supranational bonds often carry
high credit ratings due to the backing of multiple member countries.
Mortgage-Backed Securities (MBS): Mortgage-backed securities are bonds that
represent an ownership interest in a pool of mortgage loans. These bonds are created
by financial institutions, which bundle individual mortgage loans into a security.
Investors in MBS receive principal and interest payments from the underlying
mortgage loans. MBS can be issued by government-sponsored entities (GSEs) like
Fannie Mae and Freddie Mac, or private issuers.
Asset-Backed Securities (ABS): Asset-backed securities are bonds backed by a pool
of financial assets such as auto loans, credit card receivables, or student loans. These
bonds represent a share in the cash flows generated by the underlying assets. ABS
provide diversification and liquidity to investors and allow issuers to raise funds
against their existing assets.
Convertible Bonds: Convertible bonds are hybrid instruments that allow bondholders
to convert their bonds into a predetermined number of the issuer's common stock.
These bonds offer potential capital appreciation if the issuer's stock price increases.
Convertible bonds typically have lower coupon rates compared to regular bonds to
compensate for the conversion feature.
Zero-Coupon Bonds: Zero-coupon bonds, also known as discount bonds, are issued at
a discounted price and do not pay periodic coupon payments. Instead, investors
receive the face value of the bond at maturity. The difference between the purchase
price and face value represents the bond's interest. Zero-coupon bonds are suitable for
investors seeking long-term capital appreciation and are often used in retirement
planning.
These different types of international bond market instruments have distinct
characteristics in terms of issuer, risk profile, interest payments, maturities, and
underlying assets. Investors choose these instruments based on their risk appetite,
investment objectives, and market conditions.
(b) Write a note on Bretten Woods System. Also highlight the advantages and
disadvantages of gold standards.
ANS: Bretton Woods System:
The Bretton Woods System was a monetary system established in 1944 during the
Bretton Woods Conference in New Hampshire, United States. It aimed to provide
stability in international monetary relations after the turmoil of the Great Depression
and World War II. Here are the key features of the Bretton Woods System:
Fixed Exchange Rates: Under the Bretton Woods System, participating countries
fixed their exchange rates to the U.S. dollar, which was pegged to gold. This created a
fixed exchange rate regime and provided stability for international trade and
investment.
U.S. Dollar as Reserve Currency: The U.S. dollar was designated as the global reserve
currency. Central banks held their reserves in U.S. dollars, and the U.S. committed to
convert dollars into gold at a fixed rate of $35 per ounce.
International Monetary Fund (IMF): The IMF was established as an international
organization to oversee the monetary system and provide financial assistance to
member countries facing balance of payments problems. It aimed to promote
exchange rate stability and facilitate international cooperation.
Advantages of the Gold Standard:
Stability and Discipline: The gold standard provided a stable monetary system by
anchoring the value of currencies to a fixed quantity of gold. This helped prevent
excessive inflation and currency devaluations, promoting price stability and fiscal
discipline.
Global Consistency: The gold standard facilitated international trade and investment
by establishing a common measure of value across countries. It allowed for consistent
pricing and facilitated cross-border transactions without concerns of exchange rate
fluctuations.
Credibility and Trust: The gold standard instilled confidence and trust in the monetary
system. Countries adhering to the gold standard were seen as having a commitment to
sound economic policies and financial stability, which attracted foreign investment
and fostered economic growth.
Disadvantages of the Gold Standard:
Limited Monetary Policy Flexibility: Under the gold standard, countries had limited
flexibility in implementing monetary policies. The money supply was tied to the
amount of gold reserves, which restricted the ability to adjust interest rates and
stimulate the economy during downturns.
Economic Constraints: The gold standard imposed constraints on countries' economic
policies. In times of economic recessions, countries had to adhere to deflationary
measures to maintain the fixed exchange rates, which could exacerbate economic
downturns and increase unemployment.
Vulnerability to Speculation: The gold standard was vulnerable to speculative attacks
and currency crises. If a country's gold reserves were perceived as inadequate,
investors could sell the country's currency and demand gold, potentially leading to a
depletion of reserves and destabilizing the monetary system.
Limited Economic Expansion: The fixed exchange rates and limited money supply
growth under the gold standard could impede economic expansion. The inability to
adjust currency values based on economic fundamentals could hinder a country's
ability to achieve full employment and sustainable economic growth.
The Bretton Woods System provided a framework for international monetary
cooperation and stability for several decades but eventually collapsed in the early
1970s due to various economic challenges and imbalances. The advantages and
disadvantages of the gold standard highlight its potential benefits in terms of stability
and credibility but also its limitations in terms of economic flexibility and
vulnerability to economic shocks.
Q.4 (a) As an investor, what factors would you consider before investing in the
emerging stock market of a developing country?
ANS: As an investor considering investing in the emerging stock market of a
developing country, several factors should be carefully evaluated. Here are the key
factors to consider:
Economic and Political Stability: Assess the economic and political stability of the
country. Look at factors such as GDP growth, inflation rates, fiscal policies, political
stability, rule of law, and government regulations. Stable and favorable economic and
political conditions are crucial for sustained stock market performance.
Market Size and Potential: Evaluate the size and potential of the market. Look at the
country's population, consumer spending trends, urbanization rates, and overall
economic growth prospects. A large and growing market indicates potential
opportunities for businesses and can drive stock market growth.
Regulatory Environment: Understand the regulatory framework and investor
protection measures in the country. Examine the strength of securities regulations,
transparency, corporate governance practices, and the ease of doing business. A robust
regulatory environment provides confidence to investors and ensures fair market
practices.
Market Liquidity: Analyze the liquidity of the stock market. Consider factors such as
trading volumes, the number of listed companies, market depth, and the presence of
institutional investors. Adequate liquidity ensures ease of buying and selling stocks
without significant price impact.
Financial Reporting Standards: Assess the quality and transparency of financial
reporting standards. Look for adherence to international accounting standards, the
availability of audited financial statements, and the effectiveness of regulatory
oversight. Transparent and reliable financial reporting enhances investor confidence
and reduces the risk of fraud or manipulation.
Sector Analysis: Analyze the sectors that dominate the economy and the stock market.
Evaluate the growth potential, competitive landscape, and risks associated with each
sector. Diversification across sectors can help mitigate risks and capture broader
market opportunities.
Exchange Rate Risk: Consider the exchange rate risk associated with investing in a
developing country. Evaluate the stability of the local currency and its potential
impact on investment returns. Currency fluctuations can significantly impact
investment returns, especially for foreign investors.
Risk-Reward Profile: Assess the risk-reward profile of the country's stock market.
Evaluate historical market performance, volatility, and the potential for high returns.
Consider the level of risk tolerance suitable for your investment strategy and
objectives.
Market Access and Investment Restrictions: Understand any market access
restrictions or limitations on foreign investors. Evaluate the ease of investing,
repatriating funds, and any specific regulatory requirements for foreign investors.
Macroeconomic Indicators: Monitor key macroeconomic indicators such as interest
rates, inflation rates, employment data, and trade balances. These indicators provide
insights into the overall health of the economy and can influence stock market
performance.
Political and Geopolitical Risks: Assess political and geopolitical risks specific to the
country. Consider factors such as geopolitical tensions, government policies, social
instability, and potential changes in regulations that may impact investments.
Professional Advice: Seek professional advice from financial advisors or experts with
knowledge and experience in investing in emerging markets. They can provide
insights into country-specific risks, market dynamics, and investment strategies.
By considering these factors, investors can make informed decisions when evaluating
the potential of investing in the emerging stock market of a developing country and
better manage risks associated with such investments.
(b) Explain various types of Foreign Exchange exposures faced by a trader or
investor. Highlight the key differences between them
ANS: Traders and investors face various types of foreign exchange exposures when
engaging in international business or investment activities. These exposures arise from
potential changes in foreign exchange rates, which can impact the value of their
assets, liabilities, revenues, and expenses. Here are the key types of foreign exchange
exposures and their differences:
Transaction Exposure: Transaction exposure refers to the potential impact of exchange
rate fluctuations on individual transactions that are denominated in foreign currencies.
It arises when a trader or investor has pending transactions involving foreign currency
receipts or payments. The key differences include:
a. Timing: Transaction exposure focuses on the short-term impact of specific
transactions, typically occurring within a relatively short period.
b. Mitigation: Transaction exposure can be managed through hedging techniques such
as forward contracts or currency options to lock in the exchange rate for future
transactions.
Translation Exposure: Translation exposure, also known as accounting exposure,
arises when a trader or investor consolidates financial statements of foreign
subsidiaries or holds assets denominated in foreign currencies. It pertains to the
potential impact of exchange rate fluctuations on the reported financial statements.
The key differences include:
a. Time Horizon: Translation exposure focuses on the long-term impact of exchange
rate fluctuations on the financial statements of multinational companies.
b. Mitigation: Translation exposure can be managed through various accounting
techniques, such as using hedging instruments or adjusting financial statements based
on specific accounting standards.
Economic Exposure: Economic exposure, also known as operating exposure, refers to
the impact of exchange rate fluctuations on the overall competitiveness and
profitability of a trader or investor's business operations. It arises from changes in the
competitive position, pricing, and costs due to exchange rate movements. The key
differences include:
a. Scope: Economic exposure is broader and encompasses the strategic impact of
exchange rate fluctuations on the entire business operations and future cash flows.
b. Mitigation: Economic exposure can be managed through strategies such as
diversifying markets, adjusting pricing policies, sourcing inputs from different
countries, or entering into long-term contracts.
Contingent Exposure: Contingent exposure refers to potential foreign exchange risk
arising from contingent liabilities or assets, such as foreign currency-denominated
guarantees, warranties, or legal claims. It arises when a trader or investor has
contractual obligations or potential contingent events that are linked to foreign
currencies. The key differences include:
a. Uncertainty: Contingent exposure is associated with uncertain events that may or
may not occur in the future, but their potential impact on foreign exchange rates is
significant.
b. Mitigation: Contingent exposure can be managed by carefully assessing and
structuring contractual agreements to minimize foreign exchange risk or through
hedging strategies.
Each type of foreign exchange exposure requires a different approach to manage and
mitigate risk. While transaction exposure focuses on specific transactions, translation
exposure addresses the impact on financial statements, economic exposure considers
overall business operations, and contingent exposure deals with uncertain events
linked to foreign currencies. Understanding and managing these different types of
exposures is crucial for traders and investors to effectively navigate the complexities
of the global foreign exchange market.
OR
Q.4 (a) Explain the meaning of letter of credit. Explain its mechanism with the
help of an example
ANS: A letter of credit (LC), also known as a documentary credit, is a financial
instrument commonly used in international trade to provide payment security between
the buyer and seller. It serves as a guarantee from a bank to the seller that the buyer
will make payment upon the fulfillment of certain conditions.
The mechanism of a letter of credit involves the following steps:
Agreement between Buyer and Seller: The buyer and seller agree to use a letter of
credit as the payment method in their trade transaction. This agreement is usually
included in the sales contract.
Opening the Letter of Credit: The buyer approaches their bank, known as the issuing
bank, and requests the issuance of a letter of credit in favor of the seller. The issuing
bank may require collateral or a cash deposit from the buyer to secure the letter of
credit.
Application and Terms: The issuing bank reviews the buyer's application and, upon
approval, issues the letter of credit. The letter of credit contains specific terms and
conditions that must be fulfilled for the payment to be made. These terms may include
the required documents, the amount, the shipping date, and any other requirements
agreed upon by the buyer and seller.
Transmitting the Letter of Credit: The issuing bank sends the letter of credit to the
advising bank, which is usually located in the seller's country. The advising bank acts
as an intermediary between the issuing bank and the seller, informing the seller of the
existence and terms of the letter of credit.
Shipment and Documents: The seller ships the goods to the buyer and prepares the
required documents as specified in the letter of credit. These documents typically
include commercial invoices, bills of lading, packing lists, insurance certificates, and
any other documents specified in the letter of credit.
Presenting Documents: The seller submits the required documents to the advising
bank within the specified time frame. The advising bank examines the documents to
ensure they comply with the terms of the letter of credit.
Document Examination and Payment: The advising bank forwards the documents to
the issuing bank. The issuing bank reviews the documents and verifies their
compliance with the letter of credit terms. If the documents are in order, the issuing
bank makes payment to the seller as per the letter of credit instructions. If there are
discrepancies, the issuing bank may reject the documents or request amendments.
Payment to Seller: Upon receiving payment from the issuing bank, the advising bank
releases the funds to the seller. The seller receives payment for the goods sold,
ensuring secure and timely payment.
Example:
Let's say Company A in the United States wants to purchase goods from Company B
in China. They agree to use a letter of credit for the transaction. Company A, as the
buyer, approaches its bank, Bank X, and requests the issuance of a letter of credit in
favor of Company B.
Bank X issues the letter of credit, specifying the terms and conditions agreed upon by
Company A and Company B. The letter of credit is transmitted to Bank Y, the
advising bank in China. Company B is informed by Bank Y about the existence and
terms of the letter of credit.
Company B ships the goods to Company A and prepares the required documents,
including invoices, bills of lading, and packing lists. Company B presents these
documents to Bank Y within the specified time frame.
Bank Y reviews the documents and forwards them to Bank X. Bank X examines the
documents and verifies their compliance with the letter of credit terms. If the
documents are in order, Bank X makes the payment to Company B as specified in the
letter of credit.
Upon receiving payment from Bank X, Bank Y releases the funds to Company B,
completing the transaction. Company A receives the goods and ensures secure
payment to Company B through the letter of credit mechanism.
The letter of credit mechanism provides security to both the buyer and seller
(b) Explain cash management system in practice with reference to MNCs.
ANS: Cash management refers to the process of managing cash flows, liquidity, and
working capital within an organization. Multinational corporations (MNCs) operate
across multiple countries, currencies, and banking systems, which presents unique
challenges and requires an effective cash management system. Here are the key points
regarding cash management systems in practice for MNCs:
Cash Forecasting: MNCs need to develop robust cash forecasting techniques to
accurately predict cash inflows and outflows in different currencies and jurisdictions.
This involves analyzing historical data, considering market conditions, and
incorporating inputs from various business units and subsidiaries.
Centralized Treasury Function: MNCs often establish a centralized treasury function
responsible for managing cash flows across the organization. This helps in
consolidating cash positions, optimizing liquidity, and maintaining control over cash
management strategies.
Pooling Structures: MNCs utilize cash pooling structures to consolidate cash balances
from different entities and locations into a central account or regional accounts. Cash
pooling helps to optimize interest income/expense, reduce external borrowing costs,
and streamline cash management activities.
Cash Concentration Techniques: MNCs employ cash concentration techniques to
efficiently move funds from subsidiary accounts to centralized accounts. This can
involve physical cash transfers, electronic funds transfers, notional pooling, or other
liquidity management strategies.
Netting: MNCs often implement netting systems to offset intercompany payments and
receivables across different subsidiaries or business units. Netting allows for efficient
cash management, reduces external transactions, and minimizes foreign exchange
exposures.
Foreign Exchange Risk Management: MNCs face currency risk due to fluctuations in
exchange rates. To mitigate this risk, they implement hedging strategies, such as
forward contracts, currency options, or natural hedging techniques, to protect cash
flows and minimize the impact of currency movements.
Liquidity Management: MNCs focus on maintaining sufficient liquidity to meet short-
term obligations and unexpected contingencies. This involves optimizing working
capital, managing cash conversion cycles, and ensuring access to credit facilities or
short-term financing options.
Cash Flow Optimization: MNCs strive to optimize cash flows by managing payment
terms, negotiating favorable terms with suppliers and customers, and efficiently
managing inventory and receivables. This helps in improving working capital
efficiency and cash flow generation.
Cash Repatriation: MNCs need to navigate tax and regulatory considerations when
repatriating cash from foreign subsidiaries to the parent company's jurisdiction. They
must understand local regulations, tax implications, and available repatriation
mechanisms to ensure compliance and efficient cash repatriation.
Technology Solutions: MNCs leverage advanced treasury management systems
(TMS) and cash management platforms to automate cash management processes,
enhance visibility, and improve decision-making. These systems provide real-time
cash positions, cash flow forecasting tools, and integration with banking systems.
By implementing effective cash management systems, MNCs can optimize cash
flows, minimize liquidity risks, and enhance overall financial management across their
global operations. Efficient cash management enables MNCs to effectively allocate
resources, fund investments, and support growth strategies in different countries and
currencies.
Q.5 Consider the following case and answer the following questions: On 1st June,
M/s Reddy & Company, Export customer has booked with you a USD 1,00,000
forward Sale (i.e. your purchase) exchange contract delivery 31st August at Rs.
49.7500.
(a) Explain the Execution of forward contract in terms of Delivery of the
contract, Early Delivery and Extension of Forward contract
ANS: The execution of a forward contract involves the delivery of the contract, the
possibility of early delivery, and the extension of the forward contract. Let's examine
each of these aspects:
Delivery of the Contract:
On 1st June, M/s Reddy & Company, the export customer, has booked a forward sale
contract with the bank.
The contract specifies that the bank will purchase USD 1,00,000 from M/s Reddy &
Company on 31st August at a predetermined exchange rate of Rs. 49.7500.
On the delivery date, 31st August, the bank will deliver the agreed-upon amount of
USD 1,00,000 to M/s Reddy & Company, and in return, M/s Reddy & Company will
receive the agreed-upon amount in Indian Rupees at the specified exchange rate of Rs.
49.7500.
Early Delivery:
In some cases, either party may request early delivery of the contract, meaning that the
delivery occurs before the originally specified maturity date.
If M/s Reddy & Company wishes to receive the USD 1,00,000 earlier than the
contracted date of 31st August, they would need to negotiate with the bank.
The bank may agree to early delivery based on mutually agreed terms, such as
adjusting the exchange rate or charging additional fees.
Early delivery allows M/s Reddy & Company to receive the funds sooner, but it may
have implications for the bank's cash flow and risk management.
Extension of Forward Contract:
If M/s Reddy & Company wants to extend the maturity date of the forward contract
beyond 31st August, they would need to discuss this with the bank.
The bank will evaluate the request based on market conditions, their own risk
management policies, and the willingness of the counterparty.
If an extension is agreed upon, the bank and M/s Reddy & Company would negotiate
the new maturity date and potentially adjust the exchange rate to reflect the current
market conditions.
Extending the forward contract provides M/s Reddy & Company with the opportunity
to delay the exchange of currencies and potentially benefit from favorable exchange
rate movements. However, it also exposes them to the risk of adverse exchange rate
movements.
It's important to note that the specific terms and conditions of the forward contract,
including delivery, early delivery, and extension options, are mutually agreed upon by
the parties involved and may vary depending on their requirements, market
conditions, and the bank's policies.
(b) However on 28th July, the owner of the firm informed you that he wants the
remittance on 30th July as his importer has cleared the payment on 28th July.
Assume following quotes are available on 30th July: Spot USD 1 = Rs.
49.5000/5025 One month forward 2000/2025 If the bank agrees to take early
delivery, what will be the net inflow to M/s Reddy? Assume prime lending rate is
18%
ANS: To calculate the net inflow to M/s Reddy, we need to compare the two options:
sticking to the original forward contract or taking early delivery on 30th July based on
the available quotes. Let's calculate the net inflow for each scenario:
Original Forward Contract: Forward rate for the original contract = Rs. 49.7500/USD
Amount in USD = USD 1,00,000 Amount in INR = USD 1,00,000 × Rs.
49.7500/USD = Rs. 4,97,50,000
Taking Early Delivery: Spot rate on 30th July = Rs. 49.5000/49.5250/USD Amount in
USD = USD 1,00,000 Amount in INR = USD 1,00,000 × Rs. 49.5000/USD = Rs.
4,95,00,000
Difference in INR = Rs. 4,97,50,000 - Rs. 4,95,00,000 = Rs. 2,50,000
The net inflow to M/s Reddy, if they agree to take early delivery, will be Rs. 2,50,000.
Now, let's consider the impact of the prime lending rate of 18% mentioned in the
question. Assuming it is an annual rate, we can calculate the interest for the period
from 30th July to 31st August:
Interest = Rs. 2,50,000 × (18/100) × (32/365) = Rs. 8,246.58
Therefore, if M/s Reddy agrees to take early delivery, they will have a net inflow of
Rs. 2,50,000, but they will also incur an interest expense of approximately Rs.
8,246.58 due to the early remittance before the original delivery date.
OR
Q.5 (a) What are overdue forward contracts? What are the steps taken by a bank
if a customer requests late extension of such overdue contracts?
ANS: Overdue forward contracts refer to those contracts where the original delivery
date has passed, but the contract remains unfulfilled. In other words, the customer has
not made the payment or delivery of the foreign currency as per the terms of the
contract. This situation can arise due to various reasons, such as lack of funds,
unforeseen circumstances, or deliberate default.
If a customer requests late extension of such overdue contracts, the bank will follow a
standard process to evaluate the request and determine its feasibility. The steps that a
bank may take are as follows:
Evaluation of the Customer's Financial Condition: The bank will assess the customer's
financial condition to determine the reasons for the default and their ability to fulfill
the contract obligations. The bank may request additional financial information, such
as bank statements, credit reports, and income statements, to make an informed
decision.
Negotiation of Terms: If the bank finds the customer's request feasible, they may
negotiate the terms of the contract extension, such as the new delivery date, revised
exchange rate, and payment terms. The bank will also assess the potential risks
involved in extending the contract and adjust the terms accordingly.
Signing of the Contract Amendment: Once the negotiations are complete, the bank
will prepare a contract amendment, which outlines the revised terms of the contract
extension. The customer must sign the amendment to confirm their agreement to the
new terms.
Execution of the Contract Extension: After the contract amendment is signed, the
bank will execute the extension and notify the customer of the new delivery date. The
bank may also require the customer to provide additional collateral or security to
mitigate the risks involved in extending the contract.
Legal Action: If the bank finds the customer's financial condition unsatisfactory or if
they default on the extended contract, the bank may take legal action to recover their
dues. This may include filing a lawsuit, obtaining a judgment, or seizing the
customer's assets.
Overall, the steps taken by a bank when a customer requests late extension of overdue
forward contracts involve a careful evaluation of the customer's financial condition
and a negotiation of terms to minimize the risks involved in extending the contract.
The bank may also take legal action if necessary to recover their dues.
(b) However, on 31st August the customer informed you that it has not been
possible to deliver the USD as anticipated payment had not come from US. You
were therefore requested to cancel the Contract. And US Dollars were Quoted in
the Local Interbank Market as under: Spot USD 1 = Rs. 49.8225/8375 One
Month 1200/1100 Two Months 2700/2500 Three Months 4500/4300 What will be
the cancellation Charges, if any, payable by the customer? Exchange Margin
0.10% on buying as well as Selling
ANS: To calculate the cancellation charges payable by the customer, we need to
compare the spot rate on the cancellation date with the rate at which the customer
initially booked the forward contract. Let's calculate the cancellation charges:
Spot rate on 31st August = Rs. 49.8225/8375/USD Forward rate for the canceled
contract = Rs. 49.7500/USD
To determine if there are cancellation charges, we need to compare the spot rate with
the forward rate. Since the spot rate is higher than the forward rate, it means the
customer would benefit from canceling the contract.
Now, let's calculate the cancellation charges:
Amount in USD = USD 1,00,000 Amount in INR (as per the canceled contract) =
USD 1,00,000 × Rs. 49.7500/USD = Rs. 4,97,50,000
Amount in INR (as per the spot rate) = USD 1,00,000 × Rs. 49.8225/USD = Rs.
4,98,22,500
Cancellation charges = Amount in INR (as per the spot rate) - Amount in INR (as per
the canceled contract) = Rs. 4,98,22,500 - Rs. 4,97,50,000 = Rs. 72,500
Additionally, the exchange margin of 0.10% will be applicable on both buying and
selling.
Cancellation charges payable by the customer will be Rs. 72,500 plus the exchange
margin calculated on the INR equivalent of USD 1,00,000 at the prevailing rates.
It's important to note that the specific terms and conditions of the contract may vary,
and there may be other factors or charges involved in the cancellation process. It's
advisable for the customer to consult with the bank or financial institution where the
contract was booked to get accurate and detailed information regarding the
cancellation charges.
WINTER 2020
Q.3 (b) Calculate the profit or loss when C$9360000 are purchased at the rate of
C$1 = US$ 1.4510 and sold at the rate of C$1 = US$ 1.4620
ANS: The given information is:
Amount of CAD purchased = C$9360000 Buying rate = C$1 = US$1.4510 Selling
rate = C$1 = US$1.4620
To calculate the profit or loss, we need to convert CAD to USD.
Amount in USD at buying rate = C$9360000 * (1 USD / 1.4510 CAD) =
US$6441705.50
Amount in USD at selling rate = C$9360000 * (1 USD / 1.4620 CAD) =
US$6399459.28
Profit or Loss = Selling Amount - Buying Amount = US$6399459.28 -
US$6441705.50 = -US$42246.22
Since the result is negative, we can say that the investor incurred a loss of
US$42246.22 on this transaction.
Q.4 (b) Following data are available US$ 1 = ¥ 123.25 £1 = US$ 1.4560 A$1 = US$
0.5420 Find out cross rates for Pound and Yen, Australian Dollar and Yen,
Pound and Australian Dollar.
ANS: To find the cross rates, we can use the given exchange rates to calculate the
rates between the desired currency pairs.
1. Cross Rate for Pound (GBP) and Yen (JPY): Since we have the exchange rates
for USD/JPY and GBP/USD, we can calculate the cross rate for GBP/JPY.
USD/JPY = 123.25 GBP/USD = 1.4560
To find GBP/JPY, we multiply the exchange rates:
GBP/JPY = GBP/USD * USD/JPY = 1.4560 * 123.25 = 179.175
Therefore, the cross rate for Pound (GBP) and Yen (JPY) is 179.175.
2. Cross Rate for Australian Dollar (AUD) and Yen (JPY): Similarly, we can use
the exchange rates for USD/JPY and AUD/USD to calculate the cross rate for
AUD/JPY.
USD/JPY = 123.25 AUD/USD = 0.5420
To find AUD/JPY, we multiply the exchange rates:
AUD/JPY = AUD/USD * USD/JPY = 0.5420 * 123.25 = 66.8495
Therefore, the cross rate for Australian Dollar (AUD) and Yen (JPY) is 66.8495.
3. Cross Rate for Pound (GBP) and Australian Dollar (AUD): Using the given
exchange rates for GBP/USD and AUD/USD, we can calculate the cross rate
for GBP/AUD.
GBP/USD = 1.4560 AUD/USD = 0.5420
To find GBP/AUD, we divide the exchange rates:
GBP/AUD = GBP/USD / AUD/USD = 1.4560 / 0.5420 = 2.6878
Therefore, the cross rate for Pound (GBP) and Australian Dollar (AUD) is 2.6878.
In summary, the cross rates are:
 Pound (GBP) and Yen (JPY): 179.175
 Australian Dollar (AUD) and Yen (JPY): 66.8495
 Pound (GBP) and Australian Dollar (AUD): 2.6878
Q.7 Suppose that a US computer company has a wholly owned British
subsidiary. Albion Computers PLC that manufactures and sells personal
computers in the UK market. Albion computers imports microprocessors from
Intel, which sells them for $512 per unit. At the current exchange rate of $1.60
per pound. Each Intel microprocessors costs £320. Albion computer hires British
workers and sources all the other inputs locally. Albion faces a 50% income tax
in the UK. The company expects to sell 50000 units of personal computers per
year at a selling price of £1000 per unit. The unit variable cost is £650 which
comprises £320 for the imported input and £330 for the locally sourced inputs.
The pound price of imported inputs will change as the exchange rates changes,
which can affect the selling price in UK. Albion incurs fixed overhead cost of £4
Million for rents and Depreciation allowance is £1 Million.
ANS: To analyze the financial performance of Albion Computers PLC, we need to
calculate the relevant costs, revenues, and taxes. Let's break down the information
provided and calculate the key figures:
1. Cost of Imported Inputs: The cost of each Intel microprocessor is £320, and
Albion imports them at an exchange rate of $1.60 per pound. Therefore, the
cost of imported inputs in USD per unit is: Cost in USD = £320 * (1 / $1.60) =
$200
2. Unit Variable Cost: The unit variable cost includes the cost of imported inputs
(£320) and the cost of locally sourced inputs (£330). Therefore, the unit
variable cost is: Unit Variable Cost = £320 + £330 = £650
3. Total Variable Cost: The total variable cost is the unit variable cost multiplied
by the number of units sold: Total Variable Cost = £650 * 50,000 units =
£32,500,000
4. Revenue: The selling price per unit is £1,000, and Albion expects to sell 50,000
units. Therefore, the total revenue is: Revenue = £1,000 * 50,000 units =
£50,000,000
5. Gross Profit: Gross Profit is calculated by subtracting the total variable cost
from the revenue: Gross Profit = Revenue - Total Variable Cost = £50,000,000
- £32,500,000 = £17,500,000
6. Fixed Overhead Cost: The fixed overhead cost is £4,000,000.
7. Operating Profit: Operating Profit is calculated by subtracting the fixed
overhead cost from the gross profit: Operating Profit = Gross Profit - Fixed
Overhead Cost = £17,500,000 - £4,000,000 = £13,500,000
8. Income Tax: Albion Computers faces a 50% income tax rate in the UK.
Therefore, the income tax expense is: Income Tax = 50% * Operating Profit =
0.5 * £13,500,000 = £6,750,000
9. Net Profit: Net Profit is calculated by subtracting the income tax from the
operating profit: Net Profit = Operating Profit - Income Tax = £13,500,000 -
£6,750,000 = £6,750,000
In summary, based on the given information, Albion Computers PLC is projected to
generate a net profit of £6,750,000 per year.
Q.7 (b) Calculate operating cash flow in Dollar if the price of imported input
change as the rate of £1 = $1.40. Other details remain same.
ANS: To calculate the operating cash flow in dollars, we need to consider the changes
in the exchange rate and how it affects the cost of imported inputs and the revenue.
Let's calculate the operating cash flow:
with an exchange rate of £1 = $1.40, the cost of imported inputs in dollars per
unit is: Cost in USD = £320 * $1.40 = $448
£32,500,000
£50,000,000
- £32,500,000 = £17,500,000
Overhead Cost = £17,500,000 - £4,000,000 = £13,500,000
6. Income Tax: Albion Computers faces a 50% income tax rate in the UK.
Therefore, the income tax expense is: Income Tax = 50% * Operating Profit =
0.5 * £13,500,000 = £6,750,000
7. Net Profit: Net Profit is calculated by subtracting the income tax from the
operating profit: Net Profit = Operating Profit - Income Tax = £13,500,000 -
£6,750,000 = £6,750,000
To convert the net profit from pounds to dollars, we need to use the exchange rate of
£1 = $1.40: Net Profit in USD = £6,750,000 * $1.40 = $9,450,000
Therefore, the operating cash flow in dollars, considering the change in the exchange
rate, is $9,450,000.
OR
Q.7 (a) Calculate operating cash flow in Dollar if the price of imported input
changes as the rate of £1=$1.40 as well as selling price per unit is £1143 per unit.
in the exchange rate, the price of imported inputs, and the selling price per unit. Let's
calculate the operating cash flow:
(£448) and the cost of locally sourced inputs (£330). Therefore, the unit
variable cost is: Unit Variable Cost = £448 + £330 = £778
£38,900,000
£57,150,000
- £38,900,000 = £18,250,000
Overhead Cost = £18,250,000 - £4,000,000 = £14,250,000
To convert the operating profit from pounds to dollars, we need to use the exchange
rate of £1 = $1.40: Operating Profit in USD = £14,250,000 * $1.40 = $19,950,000
Therefore, the operating cash flow in dollars, considering the changes in the exchange
rate and selling price per unit, is $19,950,000.
Q.7 (b) Calculate operating cash flow in Dollar if the price of imported input
changes as the rate of £1=$1.40, selling price per unit is £1080 and total selling
units are 40000 units. Assume that price of locally sourced inputs increase at the
rate of 8%.
in the exchange rate, the price of imported inputs, the selling price per unit, and the
increase in the price of locally sourced inputs. Let's calculate the operating cash flow:
(£448) and the cost of locally sourced inputs. Since the price of locally sourced
inputs increases at a rate of 8%, we can calculate the increased cost as follows:
Increased Cost of Locally Sourced Inputs = £330 + (8% * £330) = £356.40
Therefore, the unit variable cost is: Unit Variable Cost = £448 + £356.40 = £804.40
by the number of units sold: Total Variable Cost = £804.40 * 40,000 units =
£32,176,000
£43,200,000
- £32,176,000 = £11,024,000
Overhead Cost = £11,024,000 - £4,000,000 = £7,024,000
To convert the operating profit from pounds to dollars, we need to use the exchange
rate of £1 = $1.40: Operating Profit in USD = £7,024,000 * $1.40 = $9,834,400
Therefore, the operating cash flow in dollars, considering the changes in the exchange
rate, selling price per unit, and the increase in the price of locally sourced inputs, is
$9,834,400.
SUMMER 2020
Q.3 (a) Calculate how many rupees ABC Ltd., Gujarat based firm, will receive or
pay for its following four foreign currency transactions: (i) The firm receives
dividend amounting to Euro 1,12,000 from its French Associate Company. (ii)
The firm pays interest amounting to 2,00,000 Yens for its borrowings from a
Japanese Bank. (iii) The firm exported goods to USA and has just received USD
3,00,000. (iv) The firm has imported goods from Singapore amounting to
Singapore Dollars (SGD) 4,00,000. Given: 1$ = Rs.40.00/40.05 1 Euro =
Rs.56.00/56.04 1 SGD = Rs.24.98/25.00 100 Yens = Rs.44.00/44.10
ANS: To calculate the amount in rupees that ABC Ltd. will receive or pay for each
foreign currency transaction, we need to use the given exchange rates. Let's calculate:
(i) Euro to Rupees: Amount in Rupees = Euro 1,12,000 * Rs. 56.04 (buying rate) =
Rs. 62,78,080
ABC Ltd. will receive Rs. 62,78,080 from its French Associate Company.
(ii) Yen to Rupees: Amount in Rupees = 2,00,000 Yens * Rs. 44.10 (buying rate) =
Rs. 88,20,000
ABC Ltd. will pay Rs. 88,20,000 as interest to the Japanese Bank.
(iii) USD to Rupees: Amount in Rupees = USD 3,00,000 * Rs. 40.05 (selling rate) =
Rs. 1,20,15,000
ABC Ltd. will receive Rs. 1,20,15,000 for exporting goods to the USA.
(iv) SGD to Rupees: Amount in Rupees = SGD 4,00,000 * Rs. 24.98 (selling rate) =
Rs. 99,92,000
ABC Ltd. will pay Rs. 99,92,000 for importing goods from Singapore.
Therefore, ABC Ltd. will receive Rs. 62,78,080 from the dividend, pay Rs. 88,20,000
as interest, receive Rs. 1,20,15,000 for exporting goods, and pay Rs. 99,92,000 for
importing goods.
OR
Q3 (b) There are three currencies INR (Indian Rs.) USD (US Dollar) and SGD
(Singapore Dollar). From the following details of Currencies find the cross
currency rates. 1 USD = Rs.40.00 1USD = 1.40 SGD 1 SGD = Rs.? Find the
currency rate between Singapore Dollar and Indian Rupees
ANS: o find the currency rate between the Singapore Dollar (SGD) and the Indian
Rupees (INR), we can use the given exchange rates for USD and SGD.
Given: 1 USD = Rs. 40.00 1 USD = 1.40 SGD
To find the rate between SGD and INR, we can set up a proportion:
1 USD / 1.40 SGD = Rs. 40.00 / x
Cross-multiplying:
1 USD * x = 1.40 SGD * Rs. 40.00
x = (1.40 SGD * Rs. 40.00) / 1 USD
x = 56.00 SGD
Therefore, the currency rate between the Singapore Dollar (SGD) and the Indian
Rupees (INR) is 56.00 SGD.
Q4 (b) A person gets an interest free loan of $3,00,000. Repayment is to be done
in three equal – half – yearly installment. Assume following rates: A. Today - Six-
month forward rate 40/40.50 B. @ end of 6 months - Spot: 42/42.10 Forward:
42.40/42.50 C. @ end of 1 year - Spot: 43/43.10 Forward: 43.50/43.60 D. @ end of
1.5 year - Spot: 45/45.10 Q. Find the amount he has to pay in Rs.
In following 3 condition. 1) No hedging 2) Rupee roll over 3) Separate contract.
ANS: To calculate the amount the person has to pay in rupees under different
conditions, we need to consider the exchange rates at each installment and the method
of repayment. Let's calculate the amount in rupees for each condition:
1. No hedging: In this case, the person does not engage in any hedging strategy
and pays the installments based on the prevailing exchange rate at each
repayment date.
First installment: Amount to be paid = $3,00,000
Conversion rate at today's spot rate: 1 USD = Rs. 40.50 Amount in rupees = $3,00,000
* Rs. 40.50 = Rs. 1,21,50,000
Second installment: Amount to be paid = $3,00,000
Conversion rate at the end of 6 months forward rate: 1 USD = Rs. 42.40 Amount in
rupees = $3,00,000 * Rs. 42.40 = Rs. 1,27,20,000
Third installment: Amount to be paid = $3,00,000
Conversion rate at the end of 1 year forward rate: 1 USD = Rs. 43.50 Amount in
rupees = $3,00,000 * Rs. 43.50 = Rs. 1,30,50,000
Total amount to be paid in rupees = Rs. 1,21,50,000 + Rs. 1,27,20,000 + Rs.
1,30,50,000 = Rs. 3,79,20,000
2. Rupee roll over: In this case, the person enters into a rupee roll-over agreement
where the loan amount is converted to rupees at each repayment date based on
the prevailing forward rate.
First installment: Amount to be paid = $3,00,000
Conversion rate at today's six-month forward rate: 1 USD = Rs. 40.50 Amount in
rupees = $3,00,000 * Rs. 40.50 = Rs. 1,21,50,000
Second installment: Amount to be paid = $3,00,000
Conversion rate at the end of 6 months forward rate: 1 USD = Rs. 42.40 Amount in
rupees = $3,00,000 * Rs. 42.40 = Rs. 1,27,20,000
Third installment: Amount to be paid = $3,00,000
Conversion rate at the end of 1 year forward rate: 1 USD = Rs. 43.60 Amount in
rupees = $3,00,000 * Rs. 43.60 = Rs. 1,30,80,000
Total amount to be paid in rupees = Rs. 1,21,50,000 + Rs. 1,27,20,000 + Rs.
1,30,80,000 = Rs. 3,79,50,000
3. Separate contract: In this case, the person enters into separate forward contracts
for each repayment date to hedge the currency risk.
First
Q.5 CASE STUDY: Find the translation Gain/ loss on the basis of following data:
Liabilities Amount (Rs. Million) Assets Amount (Rs. Million) Current liabilities
400 Cash 100 Share capital 1,000 Marketable securities 100 Bonds 600 Debtors
200 Retained earnings 400 Inventory 300 Land & Building 600 Plant &
machinery 800 Furniture & Fixtures 300 Historical rate = Rs.40/ $ Current rate=
Rs.46/$ Find translation gain/loss by
(a) Current-non current method 07 (b) Temporal method
ANS: To calculate the translation gain/loss using the current-noncurrent method and
the temporal method, we need to compare the assets and liabilities at the historical
exchange rate and the current exchange rate. Let's calculate:
(a) Current-Noncurrent Method: Under this method, current items (cash, debtors,
inventory, marketable securities) are translated at the current exchange rate, while
non-current items (land & building, plant & machinery, furniture & fixtures) are
translated at the historical exchange rate.
Liabilities: Current liabilities: 400 million * Rs. 46/$ = Rs. 18,400 million
Share capital: 1,000 million * Rs. 40/$ = Rs. 40,000 million
Retained earnings: 400 million * Rs. 40/$ = Rs. 16,000 million
Total liabilities at the current rate: Rs. 18,400 million + Rs. 40,000 million + Rs.
16,000 million = Rs. 74,400 million
Assets: Cash: 100 million * Rs. 46/$ = Rs. 4,600 million
Marketable securities: 100 million * Rs. 46/$ = Rs. 4,600 million
Bonds: 600 million * Rs. 40/$ = Rs. 24,000 million
Debtors: 200 million * Rs. 46/$ = Rs. 9,200 million
Inventory: 300 million * Rs. 46/$ = Rs. 13,800 million
Land & building: 600 million * Rs. 40/$ = Rs. 24,000 million
Plant & machinery: 800 million * Rs. 40/$ = Rs. 32,000 million
Furniture & fixtures: 300 million * Rs. 40/$ = Rs. 12,000 million
Total assets at the current rate: Rs. 4,600 million + Rs. 4,600 million + Rs. 24,000
million + Rs. 9,200 million + Rs. 13,800 million + Rs. 24,000 million + Rs. 32,000
million + Rs. 12,000 million = Rs. 1,24,200 million
Translation gain/loss: Total assets at the current rate - Total liabilities at the current
rate Translation gain/loss = Rs. 1,24,200 million - Rs. 74,400 million = Rs. 49,800
million
Therefore, the translation gain/loss using the current-noncurrent method is Rs. 49,800
million.
(b) Temporal Method: Under this method, all items are translated at the historical
exchange rate, except for monetary items (cash, debtors, marketable securities) and
long-term liabilities (bonds) which are translated at the current exchange rate.
Monetary items: Cash: 100 million * Rs. 46/$ = Rs. 4,600 million
Long-term liabilities: Bonds: 600 million * Rs. 46/$ = Rs. 27,600 million
All other items are translated at the historical exchange rate:
Total assets: Rs. 4,600 million
OR
Q5 (a) Find translation gain/loss by Current rate method 07 (b) Monetary/ non-
monetary method
ANS:
(a) Current Rate Method: Under the current rate method, all items are translated at the
current exchange rate.
Liabilities: Current liabilities: 400 million * Rs. 46/$ = Rs. 18,400 million
Share capital: 1,000 million * Rs. 46/$ = Rs. 46,000 million
Retained earnings: 400 million * Rs. 46/$ = Rs. 18,400 million
Total liabilities at the current rate: Rs. 18,400 million + Rs. 46,000 million + Rs.
18,400 million = Rs. 82,800 million
Assets: Cash: 100 million * Rs. 46/$ = Rs. 4,600 million
Bonds: 600 million * Rs. 46/$ = Rs. 27,600 million
Inventory: 300 million * Rs. 46/$ = Rs. 13,800 million
Total assets at the current rate: Rs. 4,600 million + Rs. 4,600 million + Rs. 27,600
million + Rs. 9,200 million + Rs. 13,800 million + Rs. 27,600 million + Rs. 36,800
million + Rs. 13,800 million = Rs. 1,38,400 million
Translation gain/loss: Total assets at the current rate - Total liabilities at the current
rate Translation gain/loss = Rs. 1,38,400 million - Rs. 82,800 million = Rs. 55,600
million
Therefore, the translation gain/loss using the current rate method is Rs. 55,600
million.
(b) Monetary/Non-monetary Method: Under the monetary/non-monetary method,
monetary items (cash, debtors, marketable securities) are translated at the current
exchange rate, while non-monetary items (inventory, land & building, plant &
machinery, furniture & fixtures) are translated at the historical exchange rate.
Monetary items: Cash: 100 million * Rs. 46/$ = Rs. 4,600 million
Non-monetary items: Inventory: 300 million * Rs. 40/$ = Rs. 12,000 million
Total assets: Rs. 4,600 million + Rs. 9,200 million + Rs. 4,600 million + Rs. 12,000
million + Rs. 24,000 million + Rs. 32,000 million + Rs. 12,000 million = Rs. 98,400
million
Total liabilities: Rs. 82,800 million
WINTER 2021
OR
Q2 (b) If the treasurer of XYZ Ltd. has an extra cash reserve of $100,000,000 to
invest for six months. The six-month interest rate is 8% per annum in the U.S.
and 7% per annum in Germany. Currently, the spot exchange rate is €1.01 per
dollar and the six-month forward exchange rate is €0.99 per dollar. The
treasurer of XYZ Ltd. does not wish to bear any exchange risk. Where should
he/she invest to maximize the return?
ANS: To determine the optimal investment choice for the treasurer of XYZ Ltd., we
need to compare the returns on investment in the U.S. and Germany, taking into
account the interest rates and exchange rates.
Investment in the U.S.: Principal amount = $100,000,000 Interest rate = 8% per
annum Time period = 6 months
Interest earned in the U.S. = Principal amount * Interest rate * Time period =
$100,000,000 * 8% * (6/12) = $4,000,000
Investment in Germany: Principal amount = €100,000,000 (equivalent to
$100,000,000 * €1.01) Interest rate = 7% per annum Time period = 6 months
Interest earned in Germany = Principal amount * Interest rate * Time period =
€100,000,000 * 7% * (6/12) = €3,500,000
To determine the returns in dollars, we need to convert the interest earned in Germany
back to dollars using the forward exchange rate:
Interest earned in Germany (in dollars) = €3,500,000 * (1/$0.99) = $3,535,353.54
Comparing the returns: Return from the U.S. investment = $4,000,000 Return from
the German investment = $3,535,353.54
Since the return from the U.S. investment is higher, the treasurer of XYZ Ltd. should
invest the extra cash reserve of $100,000,000 in the U.S. to maximize the return.
It's important to note that this analysis assumes no other factors such as transaction
costs, liquidity considerations, or any other specific investment constraints. It's always
advisable to consult with a financial professional for a comprehensive evaluation of
investment decisions.
OR
Q4 (b) Cray Research sold a super computer to the Max Planck Institute in
Germany on credit and invoiced €10 million payable in six months. Currently,
the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor
for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months.
Solve following problems A). What is the expected gain/loss from the forward
hedging? B). If you were the financial manager of Cray Research, would you
recommend hedging this euro receivable? Why or why not?\
ANS: A) To calculate the expected gain/loss from forward hedging, we need to
compare the amount received in dollars through the forward exchange rate with the
amount that would be received in dollars through the spot exchange rate.
Amount receivable in euros = €10 million Forward exchange rate = $1.10/€
Expected amount receivable in dollars through forward exchange = Amount
receivable in euros * Forward exchange rate = €10,000,000 * $1.10/€ = $11,000,000
Spot exchange rate prediction in six months = $1.05/€
Expected amount receivable in dollars through spot exchange = Amount receivable in
euros * Spot exchange rate = €10,000,000 * $1.05/€ = $10,500,000
Expected gain/loss from forward hedging = Expected amount receivable in dollars
through forward exchange - Expected amount receivable in dollars through spot
exchange = $11,000,000 - $10,500,000 = $500,000
Therefore, the expected gain from forward hedging is $500,000.
B) As the financial manager of Cray Research, whether to recommend hedging the
euro receivable depends on the company's risk tolerance, objectives, and expectations
of future exchange rate movements.
If the financial manager expects the euro to depreciate against the dollar (as indicated
by the spot exchange rate prediction of $1.05/€), hedging the receivable through the
forward contract at $1.10/€ would provide a gain of $500,000 and protect the
company from potential exchange rate losses.
However, if the financial manager expects the euro to appreciate or remain stable,
they may choose not to hedge the receivable. By not hedging, the company would
have the opportunity to benefit from a potential increase in the euro-dollar exchange
rate and receive more dollars.
Ultimately, the decision to hedge or not to hedge should be based on a thorough
assessment of the company's risk appetite, market outlook, and financial goals.
SUMMER 2022
OR
Q.3 (a) Calculate the 1 year forward and 3 years forward rate for the spot rate
of USD 1 = INR 70.2450, assuming annual interest rate for currency INR as 6.5%
and the same for currency USD as 2.25%.
ANS: To calculate the 1-year forward rate and 3-year forward rate, we can use the
formula for calculating forward exchange rates using interest rate differentials. The
formula is as follows:
Forward Rate = Spot Rate * (1 + r1) / (1 + r2)
Where:
 Spot Rate is the current exchange rate
 r1 is the interest rate of the foreign currency (INR in this case)
 r2 is the interest rate of the domestic currency (USD in this case)
Given: Spot Rate: USD 1 = INR 70.2450 Interest rate for INR: 6.5% Interest rate for
USD: 2.25%
1. Calculate the 1-year forward rate: r1 (INR interest rate) = 6.5% r2 (USD
interest rate) = 2.25%
Forward Rate (1 year) = 70.2450 * (1 + 0.065) / (1 + 0.0225) = 70.2450 * 1.065 /
1.0225 = 73.4387
Therefore, the 1-year forward rate is USD 1 = INR 73.4387.
2. Calculate the 3-year forward rate: r1 (INR interest rate) = 6.5% * 3 (since it's a
3-year forward rate) = 19.5% r2 (USD interest rate) = 2.25% * 3 (since it's a 3-
year forward rate) = 6.75%
Forward Rate (3 years) = 70.2450 * (1 + 0.195) / (1 + 0.0675) = 70.2450 * 1.195 /
1.0675 = 78.4658
Therefore, the 3-year forward rate is USD 1 = INR 78.4658.
Please note that forward rates are based on interest rate differentials and are subject to
market fluctuations and changes in interest rates.
(b) You are required to identify the exchange rate of INR in terms of CHF, if it is
known that USD 1 = INR 70.5650 and CHF 1 = USD 1.0250. Also, analyze the
change and calculate new exchange rate of INR to CHR if the exchange rate of USD
to CHF changes to CHF 1 = USD 1.0350 after certain period of time.
ANS:
To find the exchange rate of INR in terms of CHF, we can use the given exchange
rates between USD, INR, and CHF.
Given: USD 1 = INR 70.5650 CHF 1 = USD 1.0250
1. Calculate the exchange rate of INR to CHF using the given rates: INR to USD
= 1 / (USD 1 / INR 70.5650) = INR 70.5650
INR to CHF = INR to USD * CHF 1 = INR 70.5650 * CHF 1.0250 = INR 72.2716
Therefore, the exchange rate of INR to CHF is INR 72.2716.
2. Analyze the change and calculate the new exchange rate of INR to CHF if the
exchange rate of USD to CHF changes to CHF 1 = USD 1.0350:
INR to USD = 1 / (USD 1 / INR 70.5650) = INR 70.5650
INR to CHF = INR to USD * CHF 1 = INR 70.5650 * CHF 1.0350 = INR 72.9806
Therefore, the new exchange rate of INR to CHF, after the change in the exchange
rate of USD to CHF, is INR 72.9806.
Please note that exchange rates are subject to market fluctuations and can change over
time. The calculations provided are based on the given exchange rates and may not
reflect the current or future rates accurately.

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INTERNATIONAL FINANCE WINTER-2022

Q.1 Explain the following terms:

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