INTERNATIONAL FINANCE (1)

SARVAGYA INSTITUTE OF COMMERCE 1
INTERNATIONAL FINANCE
FOREIGN EXCHANGE AND RISK MANAGEMENT (FOREX)
S.NO. TOPICS
1. INRODUCION / REGULATOR OF FOREIGN EXCHANGE MARKET IN
INDIA
2. TYPES OF FOREX MARKET
3. TYPES OF TRANSACTIONS
4. EXCHANGE RATE QUATATIONS (ONE WAY AND TWO WAY
QUOTE)
5. DIRECT QUOTE AND INDIRECT QUOTE
6. ASK RATE, BID RATE AND SPREAD
7. FORWARD PREMIUM OR DISCOUNT/ APPRECIATION OR
DEPRECIATION OF CURRENCY
8. CONCEPT OF SPOT RATE AND FORWARD RATE
9. COMPUTATION OF FORWARD RATES
 WITH THE HELP OF SWAP POINTS / MARGIN POINTS
 WITH THE HELP OF IRP (INTEREST RATE PARITY)
 WITH THE HELP OF PPP (PURCHASING POWER PARITY)
10. CONCEPT OF EXCHANGE MARGIN
11. HOW TO COMPUTE CROSS RATE
12. FORWARD HEDGING VS NO HEDGING TECHNIQUE
13. CANCELLATION OF FORWARD CONTRACT
 CANCELLATION ON DUE DATE
 CANCELLATION BEFORE DUE DATE
 CANCELLATION AFTER DUE DATE BUT WITHIN 15 DAYS
 AUTOMATIC CANCELLATION AFTER 15 DAYS
14. EXTENSION OF FORWARD CONTRACT
15. EARLY DELIVERY OF FORWARD CONTRACT
16. RUPEE ROLL – OVER OF FORWARD CONTRACT
17. OPTION FORWARD CONTRACTS
18. CALCULATION OF FORWARD RATE FOR BROKEN PERIOD
19. MMH (MONEY MARKET HEDGING)/ HEDGING THROUGH CASH
MARKET OPERATION
20. NETTING
21. INTEREST RATE PARITY
22. PURCHASING POWER PARITY THEORY
23. ARBITRAGE / COVERED INTEREST ARBITRAG
24. FISHER’S EFFECT
25. LEADING VS. LAGGING TECHNIQUE
26. COVER DEAL
27. INTERNATIONAL CAPITAL BUDGETING
28. INTERNATIONAL JOINT VENTURE
29. INTERNATIONAL CASH MANAGEMENT
30. NOSTRO, VESTRO AND LORO ACCOUNT
31. INTEREST RATE SWAP
32. CONCEPT OF WITH – HOLDING TAX
33. VARIOUS EXPOSURES IN FOREX MARKET
COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

CLASSES- CA FINAL, CWA FINAL, MBA, ACCA,CIMA,CFA
LIST OF IMPORTANT CURRENCIES

Country Unit name Symbol Currency name
Argentina Peso ARS Argentine Peso
Australia Dollar AUD Australian Dollar
Brazil Real BRL Brazilian Real
Canada Dollar CAD Canadian Dollar
China Yuan CNY Chinese Yuan
Czech Republic Koruna CZK Czech Koruna
Denmark Krone DKK Danish Krone
Hong Kong Dollar HKD Hong Kong Dollar
India Rupee ` Indian Rupee
Japan Yen JPY Japanese Yen
Malaysia Ringgit MYR Malaysian Ringgit
Mexico Peso MXN Mexican Peso
New Zealand Dollar NZD New Zealand Dollar
Russia Rouble RUB Russian Rouble
Singapore Dollar SGD Singapore Dollar
South Africa Rand ZAR South African Rand
Switzerland Franc CHF Swiss Franc
Taiwan Dollar TWD New Taiwan Dollar
United Kingdom Pound GBP British Pound
United States of Dollar USD American Dollar
America (USA)
Topic: 1 Introduction / Regulator of forex market in India

(a) If any transaction involves foreign currency, then such transaction is known as foreign exchange
transaction.
(b) If any transaction involves foreign currency, then this transaction is regulated by –
 RBI
 FEDAI (Foreign exchange dealers association of India)
(c) RBI established in accordance with the provisions of RBI Act, 1934. RBI manage FEMA act and
maintain foreign exchange market.
(d) FEDAI is established under section 25 of the company act. FEDAI regulate inter – bank foreign
currency business.
(e) The foreign exchange market is divided in 3 tiers as shown below:
Foreign banks
Bank
Customer
Notes:
(1) Foreign banks are banks which are licenced by the RBI to deal in foreign exchange.
(2) Only bank can enter into transactions of foreign currency with foreign bank.
(3) The rate at which transaction between foreign bank and bank taken place is known as Inter – bank rate.
(4) The rate at which transaction between bank and customer has taken place is known as Merchant rate.
(5) For any foreign exchange transaction always think from view point of bank.
(6) Think always view point of base currency / Commodity currency / Currency with 1 attached.
(7) Since bank is always in win – win position, hence bank always purchase foreign currency at lower rate
and sell foreign currency at higher rate.

Topic: 2 Types of forex market

(1) Wholesale market / Inter – bank market
 Under inter – bank market one bank can deal with another bank.
 Exchange rate of inter – bank market is known as inter – bank rate.
 Only bank can deal at inter – bank rate.
(2) Retail market

 Under retail market bank deal with customer.
 Exchange rate of retail market is known as merchant rate.
 A customer can buy or sale currency only at merchant rate.
 Merchant rate is derived from inter – bank rate by adding or deducting exchange margin.
Topic: 3 Types of transactions under forex market

(1) Cash transaction / Ready transaction – Transactions entered today for immediate settlement is known
as ready transaction. Ready rate is applicable for this transaction. This transaction can be entered by one
bank with another bank. In other words, we can say that this is a inter – bank market transaction.
(2) Value tom transaction – Transactions entered today for T + 1 business day settlement (i.e. next business
day settlement) is known as value tom transaction. Applicable rate for this transaction is value tom rate.
This transaction is possible in inter – bank market only.
(3) Spot transaction – Transactions entered today for T + 2 business day settlement is known as spot
transaction. Applicable rate for this transaction is spot rate.
(4) Forward transaction – Transactions entered today for settlement at a future date is known as forward
transaction. Applicable rate for this transaction is forward rate.
Topic: 4 Exchange rate quotations
One way quote Two – way quote

When buying rate (Bid rate) and When bid rate and ask rate are different then
selling rate (Ask rate) are same, this is known as two – way quote. Bid rate is
quotation is known as one way always less than ask rate because bank always
quote. purchase foreign currency at lower rate and
Example: Exchange rate = 1$ = `50 sale foreign currency at higher rate.
It means that 1 $ can be purchased Example: Exchange rate = 1$ = `50 / 50.50
or sold at `50 only. It means that bank will purchase 1 $ at `50
and sale 1 $ at `50.50.
HOW TO APPLY TWO – WAY QUOTE FOR CONVERTING ONE CURRENCY INTO ANOTHER
CURRENCY.
Following steps will be applied for conversion:

Step: 1 Identify amount payable / receivable.
Step: 2 Select applicable bid rate or ask rate by assuming that what will do bank for left hand currency i.e.
commodity currency.
Note: If bank has to purchase base currency then applicable rate is bid rate and if bank has to sell base
currency than applicable rate is ask rate. In other words we can say that bank always purchase foreign
currency at lower rate and sale foreign currency at higher rate.
Step: 3 Convert one currency into another currency by using selected rate.

Class example: 1 Calculate how many rupees Shri Ras Bihari Ji Ltd., a New Delhi 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
Solution:
(i) Firm receive Euro = 1,12,000
Applicable exchange rate = 1 Euro = `56.00 / 56.04
Since bank purchase Euro hence applicable rate is bid rate i.e. `56
Hence firm will receive = 1,12,000 * 56 = `62,72,000
(ii) Payment by firm = 2,00,000 ¥

Exchange rate: 100 ¥ = `44.00/ 44.10
Since bank sell ¥ hence applicable rate is ask rate i.e. `44.10
Payment by firm = 2,00,000 / 100 * 44.10 = `88,200
(iii) Firm receive = 3,00,000 $

Exchange rate: 1 $ = 40.00 / 40.05
Since bank purchase $ and hence applicable rate is bid rate i.e. `40.00
Hence firm receive = 3,00,000 * 40 = `1,20,00,000
(iv) Payment by firm = 4,00,000 SGD

Exchange rate: 1 SGD = `24.98 / 25.00
Since bank sell SGD hence applicable rate is ask rate i.e 1 SGD = `25
Hence firm pays = 4,00,000 * 25 = `1,00,00,000
Class example: 2 Calculate how many British pounds a London based firm will receive or pay for its
following four foreign currency transactions:
Given: 1$ = £0.50/0.51 1 Euro = £0.60/0.61
1 SGD = £0.39 /0.40 1 Yen = £0.0049 / 0.0050
Answer:
(i) Firm receive = £ 72,000
(i) Firm pays = 1,000 £
(iii) Firm receive = 1,50,000 £
(iv) Firm pays = 1,60,000 £
Class example: 3 Calculate how many US$ a New York based firm will receive or pay for its following
four foreign currency transactions:
(iii) The firm exported goods to UK and has just received £3,00,000.
Given: 1£ = $ 2.00/2.01 1 Euro = $ 1.20/1.21
1 SGD = $ 0.49/0.50 100 Yens = $ 0.89/0.90

Answer:
(i) Firm received = 1,44,000 $
(ii) Firm pays = 2,700 $
(iii) Firm received = 6,00,000 $
(iv) Firm pays = 2,00,000 $
Class example: 4 Calculate how many rupees a New Delhi based firm will receive or pay for its following
four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 90,000 from its French Associate Company.
Given:
1 Re = Euro 0.0178/0.0180
1 Re = Yens 2.50/2.51
1 Re. = $ 0.0249/0.0250
1 Re = SGD 0.040 / 0.041
Solution:
(i) Receive dividend = Euro 90,000
Applicable rate: Bank sell ` at 0.0180
Firm receive = 90,000 / 0.0180 = `50,00,000
(ii) Payment of interest = 2,00,000 ¥

Applicable rate = Bank is buying ` at 2.50
Payment = 2,00,000 / 2.50 = `80,000
(iii) Firm received = 3,00,000 $

Applicable rate = Bank selling ` at 0.0250
Firm receives = 3,00,000 / 0.0250 = `1,20,00,000
(iv) Payment by firm = 4,00,000 SGD

Applicable rate = Bank by ` at 0.040
Hence payment = 4,00,000 / 0.040 = `1,00,00,000
Topic: 5 Exchange rate interpretation – Exchange rate would be defined as the price of currency in
terms of another. Thus JPY 130.0250 per EUR means that 1 EUR = JPY 130.0250. Here Euro is known as
base currency and JPY is known as the price currency.
In general terms A/B, where
A = Price currency
B = Base currency
`/$ implies that 1 $ = `
$/£ implies that 1£ = $
Topic: 6 Direct quote and Indirect quote

(a) Direct quote is the home currency price for 1 unit of foreign currency. Means,
Direct quote: 1 unit of foreign currency = How many units of home currency
(b) Indirect quote is the foreign currency price for 1 unit of home currency. Means,
Indirect quote: 1 unit of home currency = How many units of foreign currency.
How to convert direct quote into indirect quote or vice – versa – Direct quote and indirect quote are
reciprocal of each other. Hence,
1
Direct quote =
Indirect quote
OR

1
Indirect quote =
Direct quote
Note: In two – way quote, when we calculate reciprocal then bid rate becomes ask rate and ask rate
becomes bid rate.
Class example: 5 Identify whether the following is a direct quote in USA. If not, find it.
(i) `46 = 1 $
(ii) 1 $ = S$ 1.60
(iii) 1 GBP = $ 0.639
Answer:
(i) No; 1 ` = 0.0217 $
(ii) No; 1 S$ = 0.6250
(iii) Yes
Class example: 6 A Mumbai banker has given the following quotes. Identify whether they are direct or
indirect. For each direct quote give the corresponding indirect quote and vice – versa.
Currency Rate Quote
SEK 6.16 `per Kroner
Euro 0.0148 € per `
SGD 0.0299 SGD per `
AED 13.85 ` per UAE Dirham
Solution:
Given quote Nature Other quote New rate
` per Kroner Direct Korner per ` 0.1623
€ per ` Indirect ` per € 67.5676
SGD per ` Indirect ` per SED 33.4448
` per UAE Dirhan Direct AED per ` 0.0722
Class example: 7 Convert the direct quotes into indirect quotes:

(a) 1$ = Rs.40.00 / 40.05
(b) 1£ = Rs.82.00/82.07
(c) 1Euro = Rs.56.00/ 56.18
Topic: 7 Bid rate, Ask rate and spread

 Bid rate is the rate at which bank buys base currency / left hand side currency.
 Ask rate is the rate at which bank sell base currency / left hand side currency.
 Ask rate will always be greater than bid rate.
 Spread is the difference between ask rate and bid rate.
Spread = Ask rate – Bid rate
Ask rate−Bid rate
% of Spread = X 100
Bid rate
Note: Sometimes, the ask rate may be given in incomplete fashion, and then it should be interpreted as
under:
`/$ = 47.30 / 70 implies 47.30 / 47.70
`/$ = 47.40 / 10 implies 47.40 / 48.10
$/£ = 1.3520 / 70 implies 1.3520 / 1.3570
$ /£ = 1.3260 / 10 implies 1.3260 / 1.3310
Class example: 8 Consider the following quotes.

Spot (Euro/Pound) = 1.6543/1.6557
Spot (Pound/NZ$) = 0.2786/0.2800
1. Calculate the % spread on the Euro/Pound Rate
2. Calculate the % spread on the Pound 1 NZ $ Rate

3. The maximum possible % spread on the cross rate between the Euro and the NZ $.
Topic: 8 Concept of exchange margin

Exchange margin is the extra amount or % charged by the bank over and above the rate quoted in inter –
bank market. With the help of exchange margin we can calculate merchant rate applicable for customers.
How to calculate exchange rate using exchange margin:
Rule: 1 Deduct margin from buying rate to get desired exchange rate.
Rule: 2 Add margin to selling rate to get desired exchange rate.
Class example: 9 Mr. A imported goods worth $ 1,00,000. Exchange rate on that date was 1$ = `40.80 /
40.90. If bank wants to earn margin of 0.8 %, then what rate should be quoted by the bank to customer.
SOLUTION:
Bank sell $ at ask rate 40.90
Add: Margin @ 0.80 % 0.3272
Applicable rate for customer 41.2272
Class example: 10 In the inter – bank market, we have the following quote:
` /$ = 59.20 / 59.40
TT buying commission = 0.8 %
TT selling commission = 0.90 %.
Calculate merchant / retail rates for customer.
SOLUTION:
Statement of retail rates for customer:
Bid Ask
Inter – bank rate 59.20 59.40
Adjustment of margin:
0.80 % (0.4736) -
0.90 % 0.5346
Applicable rate 58.7264 59.9346
Class example: 11 In the inter-bank market, the DM is quoting Rs.21.50. If the bank charges 0.125%
commission for IT selling and 0.15% for TT buying, what rate should it quote?
Answer: Applicable rate: 1 DM = `21.46775 / 21.52688
Topic: 9 Concept of spot rate and forward rate

Spot rate – Spot rate is the exchange rate at which we can buy or sell currency now. In other words spot
rate is the rate which prevails today.
Forward rate – Forward rate is the rate agreed today but settlement takes place at future date.
How to determine forward rate – Forward rate may be given in question directly or information is provided
for calculating it. If forward rate is directly given in question, then it is known as outright forward rate. If
forward rate is not given directly, then we should calculate forward rate as per the following method as
provided.
Method: 1 With the help of swap points / Margin points / Forward points
Forward rate = Spot rate ± Swap points
Rules for determining forward rate with the help of swap points –
Rule: 1 If swap points / forward points are in increasing order then add to spot rate to arrive forward rate.
Rule: 2 If swap points / forward points are in decreasing order then should be deducted from spot rate to
arrive forward rate.

Method: 2 With the application of IRPT (Interest rate parity theory):

1+Rq
Forward rate = Spot rate X
1+Rb
Rq = Rate of quote / price currency
Rb = Rate of base currency
Method: 3 with the application of PPPT (Purchasing power parity theory)
1+Iq
Forward rate / Expected spot rate = Spot rate X
1+Ib
Iq = Inflation rate of quote / price currency
Ib = Inflation rate of base currency
Class example: 12 The following quotes are available

Spot (DM/$): 1.5105/1.5120
Three-month swap points: 25/20
Six-month swap points: 30/25
Calculate the three-month and six-month forward rates.
Class example: 13 The 90 – day interest rate is quoted at 5 % in the US and 6% in UK. Current spot
rate is $ 2.02 / £. What will be the 90 – days forward rate. Assume 360 days in a year.
SOLUTION:
Spot rate = 1£ = 2.02 $
Interest rate in US = 5 % p.a. or 1.25 % for 90 days
Interest rate in UK = 6 % p.a. or 1.50 % for 90 days
1+Rq
Hence, Forward rate = Spot rate X
1+Rb
1.0125
Forward rate = 2.02 X = 2.0150
1.0150
Class example: 14 The current spot rate for the British pound is `81. The expected inflation rate is 4
% in India and 2.7 % in UK. What is the expected spot rate of British pound a year hence?
SOLUTION:
1+Iq
1+Ib
1.04
Forward rate / Expected spot rate = 81 X = 82.025
1.027
Class example: 15 The inflation rate in US is expected to be 2.7 % per year and the inflation rate in
Japan is expected to be 0.40 % per year. If the current spot rate is 114 Yen/$ , what will be the
expected spot rate in year 3?
SOLUTION:
1+Iq
1+Ib
1.004
For year 1 = 114 X = 111.4469
1.027
1.004
For year 2 = 111.4469 X = 108.9510
1.027
1.004
For year 3 = 108.9510 X = 106.5110
1.027

Class example: 16
Spot rate = € / $: 0.9450/0.9470
3 months swap points = 80 / 70
6 months swap points = 120 /110
Calculate 3 months and 6 months forward rates.
SOLUTION:
(a) Calculation of 3 – months forward rate:
Bid Ask
Spot rate 0.9450 0.9470
Less: 3 – months swap points 0.0080 0.0070
3 – months forward rate 0.9370 0.9400
(b) Calculation of 6 – months forward rate:

Bid Ask
Spot rate 0.9450 0.9470
Less: 6 – months swap points 0.0120 0.0110
6 – months forward rate 0.9330 0.9360
Class example: 17
Spot rate: `/$ = 58.60/ 58.90
1 month swap point = 50/60
3 months swap point = 90 /110
Calculate 1 month and 3 months forward rate.
Answer:
(a) 1 – Month forward rate = 59.10 / 59.50
(b) 3 – Month forward rate = 59.50 / 60.00
Topic: 10 Forward premium or discount/ Appreciation or depreciation in currency

Forward premium – If currency is costlier in future as compared to spot it is said to be at premium.
Forward discount – If currency is cheaper in future as compared to spot it is said to be at discount.
Calculation of Annualized forward premium / Discount on currency:

Currency terms = A/B
A = Price currency
B = Base currency
Forward rate−Spot rate 12

Annualized forward premium on currency B = X 100 X
Spot rate Period
Spot rate−Forward rate 12

Annualized forward premium on currency A = X100 X
Forward rate Period
Note: A negative answer would imply annualized discount rate.
Class example: 18 The exchange rate for Mexican peso was 0.1086 in December 2004, and 0.0913 in
November 2004, against dollar. Which currency has depreciated and by how much?
SOLUTION:
Nov. 04: 1 $ = 0.0913 Peso
Dec. 04: 1 $ = 0.1086 peso
Quote is: peso / $
𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒−𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
Hence for peso: X 100
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒

0.0913−0.1086
X 100
0.1086
−0.0173
X 100 = - 15.93 %
0.1086
Hence, Mexican Peso depreciated 15.93 % against $
Class example: 19 The dollar is currently trading at `40. If Rupee depreciates by 10%, what will be
the spot rate? If dollar appreciates by 10% what will be the spot rate?
SOLUTION:
Spot rate: 1 $ = `40
To find depreciation of `, we need to have a quote of `. Since, given quote is in $ and hence we need to
convert it. So, 1` = 1 / 40 = 0.025 $
If ` depreciate by 10 %, then new rate would be –
0.025 – 0.0025 = 0.0225
Hence, 1 $ = 1 / 0.0225 = `44.44
(b) If $ appreciates by 10 %, then we can apply 10 % directly to $ quote.
Hence, new rate would be: 40 + 10 % = 44
Hence, 1 $ = `44
Class example: 20
Spot rate: $ / £ = 1.3650
3 months forward rate $ / £ = 1.3710
Calculate annualized forward premium / discount on pound and dollar.
SOLUTION:
Quote: (A/B) = ($ / £)
𝐹−𝑆 12
(a) Annualized forward premium on pound = X 100 X
𝑆 𝑛
1.3710−1.3650 12
X 100 X
1.3650 3
0.006 12
X 100 X = 1.7582 %
1.3650 3
(b) Annualized forward premium on $ (Currency A)

𝑆−𝐹 12
X 100 X
𝐹 𝑛
1.3650−1.3710 12
X 100 X
1.3710 3
− 0.006 12
X 100 X = - 1.7505 % (Discount)
1.3710 3
Class example: 21
Spot rate: `/€ = 70.20
6 months forward rate = 68.10
Compute the annualized forward premium / discount on € and `.
Answer: Forward premium on € = - 5.9829 %
Forward premium on ` = 6.1674 %
Class example: 22
3 months forward rate (`/$) = 60
Based on 3 months forward rate, annualized forward discount on $ against ` = 5 %
Based on 6 months forward rate, annualized forward premium on ` against $ = 7 %
Compute 6 month forward rate (`/$).

Solution:
Calculation of spot rate using 3 months forward rate
𝐹−𝑆 12
X 100 X = - 5
𝑆 𝑛
60−𝑆 12
X 100 X =-5
𝑆 3
60−𝑆
X 400 = - 5
𝑆
24,000 – 400 S = - 5 S
395 S = 24,000
S = 60.7595
Calculation of 6 – months forward rate (Currency A)

𝑆−𝐹 12
X 100 X = 7
𝐹 𝑛
60.7595−𝐹 12
X 100 X =7
𝐹 6
60.7595−𝐹
X 200 = 7
𝐹
12,151.90 – 200 F = 7 F
207 F = 12,151.90
F = 58.7048
Class example: 23
6 months forward rate = $0.9750/€
Based on 6 months forward rate, the annualized forward premium on $ = 8 %
Based on 3 months forward rate, the annualized forward discount on € = 6 %
Calculate 3 months forward rate.
Topic: 11 Concept of cross rate

Cross rate is the exchange rate between two currencies where neither of the currencies are of the country in
which the exchange rate is quoted. In other words, whenever desired exchange rate will calculate with the
help of two or more another exchange rates then such rate is known as cross rate.
Class example: 24 Following exchange rates are quoted by bank:

Dollar – Euro exchange rate ($/€) = 1.5968
Dollar – Yen exchange rate (¥ / $) = 108.0030
Calculate Euro – Yen (¥ / €) cross rate.
Answer: 1¥ = 0.0058 €
SOLUTION:
1€ = 1.5968 $
So, 1 $ = 1/1.5968 € or 1 $ = 0.6263 €
1 $ = 0.6263 €
1 $ = 108.0030 ¥
So, 108.0030 ¥ = 0.6263 €

1 ¥ = 0.6263 / 108.0030
1 ¥ = 0.0058 €


Dollar – Euro exchange rate: 1 € = 1.5451 $
Dollar – Pound exchange rate: 1£ = 2.0975 $
Calculate Euro – pound (€ / £) cross rate.
Answer: 1£ = 1.3575 €

1 $ = 1.1641 / 1.1646 CAD
1 $ = 1.2948 / 1.2956 AUD
Calculate cross rate between AUD / CAD.
Answer: 1 CAD = 1.1118 / 1.1130 AUD
SOLUTION:
Interpretation of quotes:
(i) Bank buy 1 $ and sell 1.1641 CAD
Bank sell 1 $ and buy 1.1646 CAD
(ii) Bank buy 1 $ and sell 1.2948 AUD

Bank sell 1 $ and buy 1.2956 AUD
If bank buy I CAD against AUD If bank sell 1 CAD against AUD
Bank must sell AUD and purchase $ and Bank sell $ and buy AUD and buy $ and sell CAD
simultaneously sell $ and buy CAD 1 $ = 1.2956 AUD
Hence, applicable rates: 1 $ = 1.1641 CAD
1 $ = 1.2948 AUD 1.1641 CAD = 1.2956 AUD
1 $ = 1.1646 CAD 1 CAD = 1.2956 / 1.1641
So, 1.1646CAD = 1.2948 AUD 1 CAD = 1.1130 AUD
1 CAD = 1.2948 / 1.1646 = 1.1118 AUD
Class example: 27 Following rates are quoted by bank:

Rate between ¥ and $ (¥ / $) = 119.05 – 121.95
Rate between € and $ (€ / $) = 0.7920 – 0.7932
Calculate cross rate between ¥ and € (¥ / €)
Answer: 1€ = 150.0883 / 153.9773
Class example: 28 You are given the following exchange rates:

1 $ = 1.6000 / 1.6035 SF
1 £ = 1.9810 / 1.9850 $
Find out cross rate between 1£ = SF.
Answer: 1£ = 3.1696 / 3.1829 SF
SOLUTION:
Interpretation of quotes:
(i) Bank buy $ and sell SF at 1.6000
Bank sell $ and buy SF at 1.6035
(ii) Bank buy £ and sell $ at 1.9810

Bank sell £ and buy $ at 1.9850
Bank buy £ against SF Bank sell £ against SF
Buy £ and sell $ and Buy $ and sell SF Sell £ and buy $ and sell £ and SF
1 £ = 1.9810 $ or 1 $ = 1 / 1.9810 £ 1 £ = 1.9850 $ or 1 $ = 1/1.9850
1 $ = 1.6000 SF 1 $ = 1.6035 SF
1 / 1.9810 £ = 1.6000 SF
1 / 1.9850 £ = 1.6035 SF
1 £ = 1.6000 * 1.9810 = 3.1696 SF
1 £ = 1.6035 * 1.9850 = 3.1829

Class example: 29 A bank is quoting the following exchange rate against the dollar for the Swiss franc
and the AUD:
SF/$ = 1.5960 / 70
AUD / $ = 1.7225 / 35
An Australian firm asks the bank for an AUD / SF quote. What cross rate would the bank quote?
Answer: 1 SF = 1.0786 / 1.0799 AUD
Class example: 30 Assume a French trader who imports from London. He would like to buy Pound
against euro. The following market rates prevail:
EURO / $ = 1.18 / 1.19
Pound / $ = 0.69 / 0.70
At what rate the French would book his Pound?
Answer: 1£ = 1.7246 €
Class example: 31 Consider the following rates:
Spot `/$ 42.17/42.59
`/DM 24.61/25.10
3-m forward `/$ 43.15/43.60
`/DM 25.36/25.90
From these rates calculate the spot and forward DM/$ rates.
Answer: Spot rate – 1 $ = 1.6801 / 1.7306 DM
3 months forward rate – 1 $ = 1.6660 / 1.7192 DM
Class example: 32 You are given the following information

Spot DM/$: 1.5105/1.5130
Three-month swap: 25/35
Spot $/£: 1.6105/1.6120
Three-month swap: 35/25
Calculate the three-month DM/£ rate.
Answer: 1£ = 2.4314 / 2.4408 DM
Class example: 33 A bank has to submit a quote to a customer for buying DM against Rupees. The
customer have the option of taking delivery of `at the end of the second month. Given the following
spot and forward rates what rate should it quote?
`/$ Spot: 35.20/35.30
One-month forward: 15/25
Two-month forward: 20/30
DM/$ Spot: 1.51/1.52
One-month forward: 15/10
Two-month forward: 20/15.
Answer: 1 DM = `25.84
Topic: 12 Forward hedging Vs No hedging
Hedging means protect himself due to risk arise from exchange fluctuation. For hedging importer or
exporter has following alternatives:
(a) Forward cover or forward hedging
(b) Money market hedging / Cash market hedging
(c) Option hedging
(d) Future hedging
 Forward hedging means take an appropriate action to reduce risk against exchange fluctuation which
will arise in future in respect of payables or receivables.
 No hedging means no protection against future payables or receivables. Under this approach importer
or exporter wait till settlement date and settle transaction at applicable rate.
 Under forward cover Vs no cover following steps would be followed:

Step: 1 Book a forward contract today at applicable forward rate.
Step: 2 Calculate cash flows due to such forward cover.

Cash flow = Contract size * Forward rate
Step: 3 Calculate cash flow at spot rate prevails on due date (i.e. No cover)
Step: 4 Compare both cash flows and take decision.
HOW TO CALCULATE EXPECTED SPOT RATE:
Method: 1 Various expected spot Method: 3 If in the question appreciation /

rates and their probabilities are depreciation of exchange rate is given:
given:
In this situation apply appreciation /
In this situation we must calculate
depreciation directly to given exchange rate.
expected spot rate in the following
manner:
Expected spot rate = ∑ (Expected
rate1 * P1 + Expected rate2 * P2)
Method: 2 If in the question appreciation /

depreciation or increase / decrease in a particular
currency is given:
Step: 1 Must ensure that currency in which
appreciation/ depreciation is given is base currency, if
not than convert it.
Step: 2 Apply appreciation and depreciation as given.
Step: 3 Re – convert the quote in original terms.
Class example: 34 Loras corporation imported goods from New Zealand and needs 100,000 New Zealand
dollars 180 days from now. It is trying to determine whether to hedge this position. Loras has developed
the following probability distribution for the New Zealand dollar:
Possible value of New Zealand Dollar Probability
$ 0.40 5%
0.45 10 %
0.48 30 %
0.50 30 %
0.53 20 %
0.55 5%
The 180-day forward rate of the New Zealand dollar is $.52. The spot rate of the New Zealand
dollar is $.49. Decide that whether Loras Corporation go for forward hedging or not.
Answer: Benefit due to no hedging = $ 2,750
SOLUTION:
Alternative 1: Forward hedging
Amount payable 1,00,000
Applicable forward rate 0.52

Amount payable 52,000 $
Alternative 2:
Calculation of expected spot rate
Spot rate Probability Expected spot rate
0.40 0.05 0.02
0.45 0.10 0.045
0.48 0.30 0.144
0.50 0.30 0.15
0.53 0.20 0.106
0.55 0.05 0.0275
0.4925
Amount payable = 1,00,000 * 0.4925 = $ 49,250
Hence, Benefit due to no hedging = 52,000 – 49,250 = 2,750 $
Class example: 35 Suffolk Co. negotiated a forward contract to purchase 200,000 British pounds in 90
days. The 90-day forward rate was $1.40 per British pound. The pounds to be purchased were to be used to
purchase British supplies. On the day the pounds were delivered in accordance with the forward contract,
the spot rate of the British pound was $1.44. What was the real cost of hedging the payables for this U.S.
firm?
Answer: Cost of hedging: $ 8,000
SOLUTION:
Cost of forward market hedging (2,00,000 * 1.40) 2,80,000
Cost of remaining unhedged (2,00,000 * 1.44) 2,88,000
Cost of hedging 8,000
Class example: 36 You believe that IRP presently exists. The nominal annual interest rate in Mexico is
14%. The nominal annual interest rate in the U.S. is 3%. You expect that annual inflation will be about 4%
in Mexico and 5% in the U.S. The spot rate of the Mexican peso is $.10. You will receive 1 million pesos
in one year.
(a) Determine the amount of dollars that you will receive if you use a forward hedge.
(b) Determine the expected amount of dollars that you will receive if you do not hedge and believe in
purchasing power parity (PPP).
Answer: (i) $ 90,400
(ii) $ 1,00,960
Class example: 37 JKL Ltd, an Indian company has an export exposure of JPY 1,00,00,000 payable
August 31, 2014. Japanese Yen (JPY) is not directly quoted against Indian Rupee.
The current spot rates are:
INR / US $ `62.22
JPY / US $ JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to depreciate against US $
to `65.
Forward rates for August 2014 are:
INR / US $ `66.50
JPY / US $ 110.35
Required:
(i) Calculate the expected loss, if the hedging is not done. How the position will change, if the firm takes
forward cover?
(ii) If the spot rates on August 31, 2014 are:
INR / US $ `66.25
JPY / US $ JPY 110.85
Is the decision to take forward cover justified? [CA – May, 2014]
Answer:
(i) Loss Without hedging - `8,38,000

Loss due to forward cover - `54,000

(ii) Loss Without hedging - `1,03,000
SOLUTION:
Calculation of spot rate between `/ ¥ =
1 $ = `62.22
1 $ = ¥ 102.34
So, 102.34 ¥ = `62.22
1 ¥ = 62.22 / 102.34 = 0.6080
Expected rate between `/¥

1 $ = `65
1 $ = ¥ 124
So, 124 ¥ = `65
1 ¥= 65 / 124 = `0.5242
Forward rate between `/¥

1 $ = `66.50
1 $ = ¥ 110.35
110.35 ¥ = 66.50
1 ¥ = 66.50 / 110.35 = 0.6026
(i)
Calculation of expected loss, if no hedging:
Value of export at the time of export (1,00,00,000 * 0.6080) 60,80,000
Estimated payment to be received (1,00,00,000 * 0.5242) 52,42,000
Loss 8,38,000
Calculation of loss under forward cover:

Payment to be received under forward cover (1,00,00,000 * 0.6026) 60,26,000
Loss 54,000
Decision: Hence, by taking forward cover loss is reduced to `54,000.
(ii) Calculation of expected spot rate on August 31, 2014:

1 $ = `66.25
1 $ = ¥110.85
110.85 ¥ = 66.25
1 ¥ = 66.25 / 110.85 = 0.5977
Estimated payment to be received (1,00,00,000 * 0.5977) 59,77,000
Loss 1,03,000
The decision to take forward cover is still justified.
Topic: 13 Cancellation of forward contract – Whenever customer requested bank for not fulfilling his
obligation then it is known as cancellation of forward contract.
(a) Cancellation on due date – whenever bank book a forward contract with any customer then at the
same time bank also book counter contract with the market. If on the due date customer requests to bank
for cancellation of his forward contract even then bank also has to fulfil his counter obligation. For
fulfilling his counter obligation bank have to go in the market on the date of cancellation and purchase /
sale of foreign currency. Bank has to pay an additional amount for this new contract can be recovered from
customer and if there is any gain to bank then bank has to refund this gain to customer. Gain / loss to
customer can be calculated as under:
Spot rate for the new contract on the date cancellation xxx
Add/ Less: Margin xxx
xxx

Less: Original contract rate xxx

Loss or gain to customer xxx
(b) Cancellation before due date – Whenever bank book a forward contract with any customer then at the
same time bank also book counter contract with the market. If before the due date customer requests to
bank for cancellation of his forward contract even then bank also has to fulfil his counter contract on due
date. For this purpose, bank has to book a new contract with market for the remaining period of the
original contract. Gain / loss to customer can be calculated as under:
Forward rate of new contract xxx
Add/ Less: Margin xxx
xxx
Less: Original contract rate xxx
Gain / loss to customer xxx
(c) Cancellation of forward contract after due date but within 14 days – Whenever customer cancel his
contract after due date but within 14 days then bank will recover loss arising from cancellation of forward
contract from the customer. If there is any gain on cancellation then such gain will not be given to
customer.
This situation generally involve following steps:
Step: 1 Calculate swap difference on due date of original transaction:
Spot Rate applicable for settlement of original counter contract Xxx
Forward Rate applicable for booking a counter contract with market (xxx)
Swap difference xxx
Contract size xxx
Total swap cost Xxx
Note:
(i) Swap loss should be recovered from customer but if there is swap gain, then ignore swap gain.
(ii) Swap difference will always be calculated by using inter – bank rate because swap difference is
calculated when bank booked two contracts with market on same day at his own behalf.
Step: 2 Calculate gain / loss due to cancellation of contract

 Gain /Loss will calculate on the date of request by customer for cancellation/ extension.
 Gain / Loss will calculate using merchant rate.
 Gain / Loss will calculate by comparing original contract rate and spot rate applicable on the date
of request for cancellation / extension.
Applicable rate due to cancellation / extension of contract xxx
Original contract rate xxx
Loss / gain xxx
Contract size xxx
Total loss / gain xxx
Step: 3 Calculate interest charges for the period starting from due date of original contract to date of
request by customer.
 Interest is always calculated on actual cash flow.
Outflow rate xxx
Inflow rate xxx
Difference xxx
Contract size xxx
Total amount on which interest will be charged xxx
Step: 4 Now calculate total amount which is to be recovered from customer / Total cost
Swap cost xxx
Cancellation / extension charges xxx
Interest cost xxx
Interest benefits (xxx)
Total cost xxx

(d) Automatic cancellation on 15 th Day – In this situation bank does opposite action on spot basis.
Exchange loss if any is recovered from the customer but if there is any gain due to such cancellation the
entire gain will be retain by the bank itself.
This situation generally involve following steps:
Spot Rate applicable for settlement of original counter contract xxx
Swap difference xxx
Contract size xxx
Total swap cost xxx
Note:
(i) Swap loss should be recovered from customer but if there is swap gain, then ignore swap gain.
Step: 2 Calculate gain / loss due to cancellation of contract

 Gain /Loss will calculate on the date of request by customer for cancellation/ extension.
 Gain / Loss will calculate using merchant rate.
 Gain / Loss will calculate by comparing original contract rate and spot rate applicable on the date
of request for cancellation / extension.
Applicable rate due to cancellation / extension of contract xxx
Original contract rate xxx
Loss / gain xxx
Contract size xxx
Total loss / gain xxx
Step: 3 Calculate interest charges for the period starting from due date of original contract to date of
request by customer.
Outflow rate xxx
Inflow rate xxx
Difference xxx
Contract size xxx
Total amount on which interest will be charged xxx
Step: 4 Now calculate total amount which is to be recovered from customer / Total cost
Swap cost xxx
Cancellation / extension charges xxx
Interest cost xxx
Interest benefits (xxx)
Total cost xxx
Topic: 14 Extension of forward contract – Whenever customer approaches to bank for increasing the
time limit of contract, it is known as extension of forward contract.
(a) Extension on due date - An exporter finds that he is not able to export on the due date but expects to
do so in about two months. An importer is unable to pay on the due date but is confident of making
payment a month later. In both these cases, they may approach their bank with which they have entered
into forward contracts to postpone the due date of the contract. Such postponement of the date of delivery
under a forward contract is known as the extension of forward contract. When a forward contract is sought
to be extended. It shall be cancelled and rebooked for the new delivery period at the prevailing exchange
rates. FEDAI has clarified that it would not be necessary to load exchange margins when both the
cancellation and re-booking of forward contracts are undertaken simultaneously. However, it is observed
that banks do include margin for cancellation and rebooking as in any other case.

Flow chart for extension of forward contract
For extension of contract first we have Bank has to rebook a new contract
to cancel the original contract. At the with customer for the extended
time of cancellation bank has to fulfil period.
his counter contract by purchasing /
selling foreign currency in market.
Same contract with customer
for extended period. In other
Extension charges = Spot rate on the date of extension words, bank again booked a
(with margin, if any) – original contract rate new forward contract with
customer. New forward rate
should be calculated.
Early extension - When the request for extension is received earlier to the due date, it is known as early
extension. Due to such early extension, bank has to make a new forward contract for the remaining period
of original contract with the market. The difference between new forward rate and original contract rate is
known as extension charges which should be either recovered from customer or paid to customer. Bank
also decides a new forward rate for extended period.
Class example: 38 A customer with whom the bank had entered into 3 month’s forward purchase contract
for 50,000 $ at the rate of `50.25 comes to the bank on due date and requests cancellation of the contract.
Spot rate on the date of cancellation are:
1 $ = `50.85 / 51.00. What are the loss/ gain to the customer on cancellation?
Class example: 39 An exporter requests his bank to extend the forward contract for US $20,000 which is
due for maturity on 31st October, 2014 for a further period of 3 months. He agrees to pay the required
margin money for such extension of the contract.
Contracted rate – US $1= `62.32
The US $quoted on 31.10.2014:
Spot rate: - 61.5000/ 61.5200
3 months discount – 0.93 % / 0.87 %
Margin money from bank’s point of view for buying and selling rate is 0.45 % and 0.20 % respectively.
Compute:
(a) The cost of importer in respect of the extension of the forward contract, and
(b) The rate of new forward contract. [RTP – May, 2015]
SOLUTION:
Statement showing extension charges:
Applicable spot rate (Selling rate) 61.5200
Add: Margin @ 0.20 % 0.1230
Adjusted rate 61.64
Less: original rate 62.32
Gain per $ 0.68
Exposure amount 20,000
Total gain 13,600
Calculation of new forward rate:

Applicable spot rate 61.50
Less: Discount rate @ 0.93 % 0.5720
60.9280
Less: Margin @ 0.45 % 0.2742

New rate 60.65
Class example: 40 On 1.4.2007, Sangeet International (SI) concluded a contract for purchase of 10,00,000
blue ray discs from an American company at $ 1.48 per Disc, to be supplied over the next 3 months. SI is
required to make the payment immediately upon receipt of all the discs. To meet the obligation, SI had
booked a forward contract with its bankers to buy $ 3 months hence. The following are the exchange rates
on 1.4.2007 –
Spot rate: `41.30 – 70
3 months forward rate: `42.00 – 50
On 1.7.2007, the American company expressed its inability to supply the last installment of 3,00,000 Blue
Ray discs due to export restrictions in US and required SI to settle for the quantity supplied. Spot rate on
1.7.2007 was `40.90 – 41.20.
(a) Ascertain the total cash outgo for SI for purchase of 7,00,000 discs.
(b) Would total cash outgo undergo any change if the American company had informed on 1.6.2007, when
the following exchange rates were available –
Spot rate: `41.70 – 42.20
1 months forward: `42.10 – 42.50 [CWA – Study Material]
Solution:
(a) Bank booked forward sale Bank booked forward purchase
14,80,000 $ @ 42.50 Due date of contract

Spot rate: 41.30 / 41.70 4,44,000 $ contract will be cancelled
Spot rate: 40.90 / 41.20
Statement showing calculation of cash outflow:
(a) Amount paid for honored contract (i.e. for 7,00,000 discs) (10,36,000 *
42.50)
(7,00,000 * 1.48 * 42.50) 4,40,30,000
(b) Amount paid due to cancellation of contract (40.90 – 42.50) * 4,44,000 7,10,400
Total cash outflow 4,47,40,400
(b)
Bank booked forward sale Bank booked forward purchase
14,80,000 $ @ 42.50 1.7.2007 Due date of contract

Spot rate: 41.30 / 41.70 Cancellation
Spot rate: 41.70 / 42.20
1 months forward = 42.10 / 42.50
Customer cancel its contract before due date. Bank has booked 1 month forward sale contract with market.
Since market purchases $, Lower rate will (i.e. 42.10) apply. Hence cash outflow will be as under:
Statement showing calculation of cash outflow:
(a) Amount paid for honored contract (i.e. for 7,00,000 discs) (10,36,000 *
42.50)
(7,00,000 * 1.48 * 42.50) 4,40,30,000
(b) Amount paid due to cancellation of contract (42.10 – 42.50) * 4,44,000 1,77,600
Class example: 41 Ankita Papers Ltd (APL), on 1st July 2007 entered into a 3 Month forward contract for
buying GBP 1,00,000 for meeting an import obligation. The relevant rates on various dates are –
Date Nature of quote Quote
1.7.2007 Spot `81.50 – 81.85
3 – months forward `81.90 – 82.30
1.8.2007 Spot `82.10 – 82.40

2 – months forward `82.25 – 82.60

1.9.2007 Spot `81.70 – 82.05
1 month forward `82.00 – 82.30
2 months forward `82.40 – 82.70
1.10.2007 Spot `82.50 – 82.75
1 month forward `82.60 – 82.90
Explain the further course of action if APL—
(a) Honours the contract on
• 01.10.2007
• 01.09.2007; and meets the import obligation on the same date.
(b) Cancels the contract on —
• 01.08.2007
• 01.09.2007
• 01.10.2007; as the import obligation does not materialize.
(c) Rolls over the contract for --
• 2 Months on 01.09.2007
• 1 Month on 01.10.2007; as the import obligation gets postponed to 01.11.2007. Also determine the
cost / gain of that action. Ignore transaction costs. [CWA – Study Material]
Topic: 15 Early delivery of forward contract – When a customer requests early delivery of a forward
contract, i.e., delivery before its due date, the bank may accede to the request provided the customer agrees
to bear the loss, if any, that may accrue to the bank. At the time of early delivery, following procedure will
be adopted by bank:
In case of exporter – In case of Importer –

1. Take delivery from customer and sale 1. Purchase foreign currency from market
the foreign currency in the market immediately and sale to importer at contract rate.
immediately. Hence calculate inflow from Hence calculate outflow due to purchase from
sale in market. market.
2. Rebook a new forward purchase 2. Rebook a new forward sale contract with
contract with market for the remaining market for the remaining period of original
period of original contract. Hence calculate contract. Hence, calculate inflow from this
outflow. contract.
3. Difference between inflow and outflow 3. Difference between inflow and outflow either
either recovered from customer or paid to recovered from customer or paid to customer.
customer.
Following steps should be applied in case of early delivery:

Spot Rate applicable for settlement of original counter contract Xxx
Swap difference Xxx
Contract size Xxx
Total swap cost Xxx
Note:
(i) Swap loss should be recovered from customer and swap gain is refunded to customer.
Step: 2 Calculate interest cost

Calculate interest charges for the period starting from date of early delivery to due date of original
contract. .

Outflow rate Xxx

Inflow rate Xxx
Difference Xxx
Contract size Xxx
Total amount on which interest will be charged Xxx
RUPEE ROLL – OVER OF FORWARD CONTRACT

Rollover forward contracts are one where forward exchange contract is initially booked for the total
amount of loan etc. to be re-paid. As and when installment falls due, the same is paid by the customer at
the exchange rate fixed in forward exchange contract. The balance amount of the contract rolled over till
the date for the next installment. The process of extension continues till the loan amount has been re-paid.
A corporate can book with the Authorised Dealer a forward cover on roll-over basis as
necessitated by the maturity dates of the underlying transactions, market conditions and the need to reduce
the cost to the customer.
ADDITIONAL QUESTIONS RELATED TO CANCELLATION, EXTENSION, EARLY

DELIVERY OF FORWARD CONTRACTS
Q.1 On 15th November, ICICI bank booked a 3 months forward purchase contract of $ 20,000 for its export
customer. On that date exchange rate was as follows:
Spot rate: 1 $ = `49.3200 / 3325
3 months swap points = 1,000 / 1500
Margin = 0.10 % / 0.125 %
On the due date customer requests for cancellation of this contract. Exchange rate prevailing on that date is
as follows:
Spot rate: 1 $ = `47.5300 / 5400
3 months swap point = 500 / 1000
Margin = 0.10 % / 0.125 %
Calculate the amount recoverable from or payable to customer.
Answer: Amount payable to customer: `35,424

Q.2 On 1 April, the bank entered into a forward purchase contract of $ 1,00,000 at `44 due on 1st June.
st
On the same day bank covered its position by a forward sale at `45. On the due date the customer
requested for cancellation of the contract. The prevailing exchange rate on 1 st June were as under:
Spot inter – bank rate: 1 $ = `44.5500 / 6000
Margin = 0.15 %
Spot merchant rate = 1 $ = `44.43 / 44.67
Calculate the amount recoverable from or payable to the customer.
Answer: Amount recoverable from customer: `67,000
Q.3 In the previous question assumes that the customer made the request for cancellation of the contract on
1st May. The prevailing prices on 1st May are as under:
Spot inter – bank rate: 1 $ = `44.2000 / 3000
Forward June = 2,000 / 2500
Margin = 0.15 %
Forward June (Merchant rate): 1 $ = `44.34 / 44.62
Calculate the amount recoverable from the customer.
Answer: Amount recoverable from customer = `62,000
Q.4 On 15th January you booked a forward sale contract for French Francs 2,50,000 for your import
customer delivery 15th February at `6.95. on the due date the customer requests cancellation of the
contract. Assuming French Francs were quoted in the London foreign exchange market as under:
Spot rate: 1 $ = FF 5.0200 / 0300
And the US $ were quoted in the local inter – bank exchange market as under on the date of cancellation:
Spot rate: 1 $ = `34.7900 / 7975
Exchange margin required by you is 0.15 %. What will be the cancellation charges payable by the
customer, if any?

Answer: Cancellation charges = `10,000

Q.5 The bank entered into an agreement with its customer on 10th July for a forward purchase contract for
$ 4,000 to be delivered 10th September at the rate of `28.14 per $ covering itself by a forward sale at
`28.16. on 10th August, the customer requests the bank to settle the contract. Calculate the amount that
would be paid to the customer assuming the following rates in the inter – bank market on 10th August:
Spot rate: 1 $ = `28.1025 / 1075
Delivery September: 1 $ = `28.6475 / 6550
Interest on outlay of funds at 12 % and inflow of funds at 8 %.
Answer: Total recovery from customer = `2,212
Q.6 Bank entered into an agreement with its customer on 1st January, 2014 for a forward purchase contract
for $ 10,000 delivery 31st May, 2014.
Spot rate on 1st January, 2014: 1 $ = `62.00
Forward premium (May end): `2.00 / `2.03
On 31st March, 2014, customer requests the bank for settlement of its forward transaction. Following rates
are prevail in market on 31st March, 2014:
Forward premium (May end): `0.85 / 0.87
Interest on outlay of funds at 18 % and inflow of funds at 15 %. Calculate amount payable to customer /
recoverable from customer.
(a) Swap difference – `8,700
(b) Interest recovered - `900
(c) Total amount recovered – `9,600
Q.7 The bank entered into an agreement with Mr. A on 31st July for a forward purchase contract for GBP
8,000 to be delivered on 30th September at the rate of `56.28 per pound covering itself by a forward sale at
`56.32. On 31st August, the customer requests the bank to settle the contract of 8,000 GBP. Calculate the
amount that would be paid to the customer assuming the following rates in the inter – bank market on 31st
August:
Spot rate: 1 GBP = `56.2050 / 2150
Delivery September: 1 GBP = `55.2950 / 3100
Interest on outlay of funds at 12 % and inflow of funds at 9 %.
Answer: Net amount payable to customer = `7,154
Q.8 The bank had agreed on 1st January that it will sell on 1st April to customer Dirham 10,000 at `17.29.
on the same day bank covered its position by buying forward from the market due 1 st April at the rate of
`17.2775. On 1st March, the customer approaches the bank to sell Dirham 10,000 under the forward
contract earlier entered into. The rates prevailing in the inter – bank market on this date are:
Spot rate: 1 Dirham = `17.2350 / 2400
April: 1 Dirham = `17.1275 / 1300
Interest on outlay of funds at 18 % and inflow of funds at 12 %. What is the amount that would be
recovered from the customer on the transaction?
Answer: Net amount recovered from customer = `1,120
Q.9 A bank enters into a forward purchase TT covering an export bill for Swiss francs 1,00,000 at ₹
32.4000 due on 25th April and covered itself for same delivery in the local inter-bank market at ₹ 32.4200.
However on 25th March, exporter sought for cancellation of contract as the tenor of the bill is changed
In Singapore market, Swiss Francs were quoted against US dollars as under:
Spot: 1 $ = Sw. Fcs 1.5076 / 1.5120
One month forward: 1.5150 / 1.5160
Two month forward: 1.5250 / 1.5270
Three month forward: 1.5415 / 1.5445
And the inter – bank market US $ were quoted as under:
Spot rate: 1 $ = `49.4302 / 0.4455
Spot / April: 0.4100 / 0.4200
Spot / May: 0.4300 / 0.4400
Spot / June: 0.4500 / 0.4600

Calculate the cancellation charges payable by the customer if exchange margin required by the bank is
0.10% on buying and selling [CA – Nov. 2015]
Answer: Cancellation charges: `54,750
Q.10 A bank had booked a forward purchase contract with a customer for $ 2,50,000 at the rate of 1$ =
`33.50 delivery due on October 30. On September 30 customer approaches bank with a request to cancel
the forward purchase contract. What will be the cancellation charges of the bank, if following are the rates
in the interbank market on September, 30?
Spot rate: 1$ = `34.7400 / 35.0800
1 month forward: 8 -15 paise per US $
2 months forward: 31 – 41 paise per US $
3 months forward: 60 – 70 paise per US $
The bank is to load an exchange margin of 0.15 %.
Cancellation charges - `4,45,000

Q.11 Date of maturity of forward sale contract: September 30th 2002
Amount: $ 2,50,000
Contract rate: 1$ = `49.4500
On August 10, 02 the customer requests to extend the forward contract for October 31 st 2002. Interbank
market rates on August 10, 02:
Spot: 1$ = `48.1325 / 48.1675
Forward spot/ August 2200 / 2100
Spot / September 4700 / 4500
Spot / October 6900 / 6300
Compute extension charges payable / receivable. You are allowed to load an exchange margin of 0.08 %
on TT buying and 0.15 % on TT selling rate.
(a) Extension charges - `4,56,400
(b) New contract rate - `47.6088
th
Q.12 On 20 November, 2002 you booked a forward purchase contract for DEM 50,000 from your export
customer delivery 20th Feb. At `28.2500. On the due date the customer requests cancellation of the
contract. The rates prevailing on that day are:
Spot USD 1 = DEM 1.5150 / 1.5170
Spot USD 1 = `42.6125 / 2975
Exchange margin is 0.10%. Calculate gain or loss to customer, if any?
(a) Cross rate - `28.5792
(b) Applicable rate - `28.6078
(c) Total loss recovered from customer - `17,890
Q.13 The company had agreed on 20th February that it will buy on 20 th April from the banker USD 10,000
at `44.57. On 20th March, the company approaches the bank to buy USD 10,000 under the forward
contract earlier entered into. The rates prevailing in the market on this date are:
Spot rate: 1$ = `44.4725/ 4800
April: 1 $ = `44.2550/ 2625
Ignoring interest and fine out the amount that would be paid / received by the company on early delivery.
Answer: Swap loss - `2250
Q.14 An Importer booked a Forward Contract with his Bank on 10th April for USD 2,00,000 due on 10th
June @ ` 64.4000. The Bank covered its position in the market at ` 64.2800. The Exchange Rates for
Dollar in the Inter–Bank Market on 10th June and 20th June were:
10th June 20th June
Spot USD 1 `63.8000 / 8200 `63.6800 / 7200
Spot / June `63.9200 / 9500 `63.8000/8500
July `64.0500 / 0900 `63.9300 / 9900
August `64.3000 / 3500 `64.1800 / 2500
September `64.6000 / 6600 `64.4800 / 5600

Exchange Margin 0.10% and interest on Outlay of Funds @12%. The Importer requested on 20th June for
extension of contract with due date on 10th August. Rates rounded to 4 decimal in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate the following:
(i) Cancellation Rate (iv) Interest on Outlay of Funds, if any
(ii) Amount Payable on $ 2,00,000 (v) New Contract Rate
(iii) Swap Loss (vi) Total Cost [CA – May, 2015]
Answer: (i) Cancellation rate – 63.6175 (ii) Amount payable - `1,56,740 (iii) Swap loss – 30,000 (iv)
Interest cost – 320 (v) New contract rate – 64.3150 (vi) Total cost – 1,87,060
Q.15 On 1st January, the bank enters into a forward purchase contract with an export customer for $ 10,000
due on 1st March at an exchange rate of `35.60 and covers its position in the market at `35.65. The
customer defaults to execute the contract on the due date. On 15 th March the cancels the contract. The
following were the exchange rate prevalent:
On 1st March:
Inter – bank rate: 1 $ = `35.75 / 80
1 month forward (can be used for 15 days forward also) = 1 $ = 35.90 / 95
Merchant rate: 1 $ = `35.67 / 90
On 15th March:
Inter – bank rate: 1 $ = `36.10 / 15
Merchant rate: 1 $ = `36.05 / 20
Interest rate applicable = 12 % per annum.
Calculate amount recoverable from customer.
(a) Swap gain - `1,000 (ignore)
(b) Exchange loss - `6,000
(c) Interest recovered - `7
(d) Total amount recovered - `6,007
Q.16 An Import customer booked a forward contract with the bank on 10 th April for $ 20,000 due 10 th June
at `36.40. The bank covered its position in the market at `36.28. The exchange rates for dollar in the inter
– bank market on 10th June and 25th June were:
10th June 25th June
Spot 1 $ `35.80 / 82 `35.68 / 72
June `35.92 / 95 `35.80 / 85
July `36.05 / 09 `35.93 / 99
August `36.30 / 35 `36.18 / 25
September `36.60 / 66 `36.48 / 56
Exchange margin = 0.15 %
Interest on outlay of funds = 12 %
How will the bank react if the customer requests on 25 th June:
(a) To cancel the contract
(b) To execute the contract
(c) To execute the contract with due date to fall in August.
Swap loss - `3,000
Exchange difference - `15,400
Interest cost - `47
Total amount recovered from customer – `18,447
(a) Amount recovered on cancellation - `18,447
(b) Recovered from customer - `18,447 and applicable rate – `35.77
(c) Recovered from customer - `18,447 and new rate - `36.30
Q.17 Mr. A sold goods to USA worth $ 3,00,000 on 1.4.2015 receivable after 3 months from today. Mr. A
booked a forward contract with bank @ `45.4530 per $. On due date customer request for cancellation of
forward contract. Exchange rate prevail in market on due date were:
1 $ = `46.3025 / 35
Calculate gain / loss to customer due to cancellation.

Total Loss: `2,55,150

st
Q.18 Mr. A exported goods on 1 January, 2015 to Germany worth 40,000 € to be received after 4 months.
Mr. A booked a forward contract with bank. On due date customer requested for cancellation of contract.
Following are the exchange rates prevail on 1st January and 30th April, 2015:
On 1st January:
1 € = 67.4560 / 70
On 30th April:
1 € = 67.7235 / 55
Calculate gain or loss due to customer. Exchange margin is 0.10 %
Total loss - `16,128
Q.19 Mr. A imported goods from USA on 1st January, worth $ 1,00,000 payable on 31st May, 2015. For
hedging Mr. A book a forward contract with bank. Exchange rate on 1.1.2015 were as under:
1 $ = `62.7345 / 55
Interest rates were:
$ = 12 % per annum
` = 10 % per annum
On due date, Mr. A cancel the contract. Exchange rates on date of cancellation were:
1$ = 62.8532 / 42.
Exchange margin = 0.08 %.
Calculate gain or loss due to cancellation of contract.
(a) Quoted rate by bank initially - `62.2894
(b) Cancellation rate - `62.8029
(c) Amount payable to customer - `51,350
Q.20 An exporter booked a forward contract with his bank on 1.4.2015 for $ 50,000 due on 30.6.2015 at
`44.50 per $. Bank covered its position in the market at `44.80. Exchange rates in the inter – bank market
on 30.6.2015 and 10.7.2015 were as under:
Exchange rates on 30.6.2015:
Spot rate: 1 $ = 44.65 / 44.75
1 months swap point: 15 / 20 (Can be used for part of the month)
Spot rate: 1 $ = 44.60 / 44.75
Interest on fund @ 12 % per annum. The exporter requested on 10 th July for cancellation of contract. Bank
swaps necessary contracts.
Calculate the following:
(i) Swap cost / gain
(ii) Cancellation charges
(iii) Interest on funds
(iv) Total cost
(i) Swap gain - `2,500 (Ignore)
(ii) Cancellation charges – `12,500
(iii) interest payable to customer - `8
(iv) Total amount recovered from customer - `12,492
Q.21 Mr. A imported goods on 1.5.2015 from USA worth $ 50,000. Amount is payable after 4 months.
Mr. A booked a forward contract with his bank on 1.5.2015.
Exchange rate on 1.5.2015:
Spot rate: 1 $ = 45.4545 / 50
Swap points: July – 25 / 30
August – 35 / 40
Bank covered its position in the market at `45.4000. Following are the exchange rates available:
On 31.8.2015
Spot rate: 1 $ = 43.7500 / 80
1 month swap points: 15 /10
Spot rate: 1 $ = 44.7230 / 40

Exchange margin = 0.12 % and interest on fund 10 % per annum. Bank swaps by selling spot and buy 1
month forward. Customer requested for cancellation of contract on 12.9.2015.
Required:
(a) Swap cost
(b) Cancellation charges
(c) Interest charges
(d) Total amount receivable / payable to customer.
(a) Swap cost - `350
(b) Cancellation rate – 44.6693; Cancellation charges – `42,215
(c) Interest cost - `271
(d) Total amount recovered from customer - `42,836
Q.22 Mr. X sold goods worth € 1,20,000 on 1.4.2015 receivable after 3 months. Mr. X booked a forward
contract with his bank on 1.4.2015. Bank covered its position in the market at `70.3680 per €.
Exchange rate on 1.4.2015:
Spot rate: 1€ = 70.4350 / 70
On 10th July, 2015 Mr. X requested for cancellation of contract. On 30.6.2015, bank swaps by purchasing
spot and selling 1 month forward. Exchange margin 0.10 % and interest rate on funds @ 10 %.
Spot rate: 1€ = 70.2650 / 30
1 months swap point: 30 / 50
Spot rate on 10th July, 2015: 1 € = 70.3000 /15
Required:
(a) Swap cost
(b) Cancellation charges
(c) Interest on fund
(d) Total amount payable to / recoverable from customers.
(a) Swap cost - `600
(b) Cancellation charges - `564
(c) Interest payable to customer - `31
(d) Total amount recovered from customer - `1133
Topic: 16 Option forward contract

Option forward contracts are contracts which allow option (choice) about date of settlement during last
month of the contract.
12 Months
11 months 1 month
T=0
T = 1 Option period T = 2
(Customer can settle the transaction during the period t= 1 to t =2)
When to use option forward contract – When the customer is not certain about settlement date, then
customer must use option forward contract. In India, maximum period is 1 month.
How to price option forward contract:

 It is a simple forward rate, which will be used in normal forward contract.
 For calculation of forward rate we need spot rate, forward points and exchange margin.
 Option forward contract is priced considering the uncertainty involved in settlement from t= 1 to t
= 2.
 Bank follows worst case scenario approach.

Summary rule: Bank will quote such rate which is beneficial for bank. Either start of option period or end
of option period. The burden of uncertainty is on customer.
Class example: 42
1 USD = 49.8825 / 49.8975
Spot / May = 2500 / 2700
Spot / June = 5200 / 7700
Spot / July = 7700 / 8200
An exporter is likely to receive USD in July. What rate authorised dealer should quote for option forward
contract?
Solution:
Statement of applicable rate:
2 months 3 months
Spot rate 49.8825 49.8825
Add: Swap points 0.5200 0.7700
Forward rate 50.4025 50.6525
Hence, Forward rate for option contract = 50.4025.
Class example: 42
A Bank is quoting the following rates:
DM / $ Saudi riyal / $
Spot rate 1.5975 / 1.5980 Spot rate 3.7550 / 3.7560
2 month 20/10 2 month 20/40
3 month 25/15 3 month 30 /50
A firm wishes to buy Riyals against DM 3 month forward with an option over 3 rd month. What rate will
the bank quote?
Answer: Bank should sell riyals at 0.4251 DM
Topic No. 17: Money market hedging / Cash market hedging (MMH) – Whenever our exposure is for
foreign currency receivables or payables for a short period then we can hedge our receivables or payables
through money market hedging.
Case: A: Money market hedging for exporter – For an exporter under MMH we should apply following
steps:
Step: 1 Create foreign currency loan amount which is the discounted value of receivables. For this purpose
discount rate should be foreign currency borrowing rate.
Step: 2 Convert foreign currency loan into home currency amount by using spot rate.
Step: 3 Investment home currency amount at deposit rate.

Step: 4 On maturity amount realized from foreign currency debtors and repay foreign currency loan from
such value.
Step: 5 Realize from investment with interest

Hence, Inflow under MMH = Investment amount + Interest on investment.
Case: B Money market hedging for Importer – For an Importer under MMH we should apply following
steps:
Step: 1 Take home currency loan at spot rate for amount of investment.
Step: 2 Create foreign currency deposit / investment which is the discounted value of foreign currency
payable. The discount rate should be the deposit rate.
Step: 3 On maturity realized from investment and pay for foreign currency payables.
Step: 4 Repay home foreign currency loan with interest.

Hence, outflow = Loan amount + Interest on loan
Note:
(1) Interest rates given in the question is always quoted on per annum basis.
(2) if deposit and borrowing rates are not specifically mentioned then assume lower rate as deposit rate and
higher rate as borrowing rate.
Class example: 43 Assume the following information:

US interest rate = 16 %
British interest rate = 18 %
Spot rate of British pound = $ 1.50
180 – days forward rate of British pound = $1.48
Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be
better off using a forward hedge or a money market hedge? Substantiate your answer with estimated
revenue for each type of hedge. Assume 360 days in a year.
Answer: Alternative 1: Forward cover - $ 5,92,000; Alternative 2: MMH – 5,94,495.416 $

U.S. interest rate = 16 % p.a.
Malaysian interest rate = 12 %
Spot rate of Malaysian ringgit = $.404
90-day forward rate of Malaysian ringgit = $.400
Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to
hedge this payables position. Would it be better off using a forward hedge or a money market hedge?
Substantiate your answer with estimated costs for each type of hedge .
Answer: Alternative: 1 Forward cover – 1,20,000; Alternative: 2 – MMH – 1,22,376.70 $
Class example: 45 Assume that Carbondale Co. expects to receive S$500,000 in one year. The
existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is
$.62. Carbondale created a probability distribution for the future spot rate in one year as follows:
Future spot rate Probability
$ 0.61 20 %
$ 0.63 50 %
$ 0.67 30 %
Assume the following money market rates:
US Singapore
Deposit rate 8% 5%
Borrowing rate 9% 6%
Decide that which of the following hedging strategy is most appropriate for Carbondale Co.
(i) Forward hedging
(ii) Money market hedging
(iii) No hedging
Answer: Alternative: 1 Forward cover – 3,10,000; Alternative: 2 MMH – 3,05,660.38; Alternative: 3

No hedging – 3,19,000
Class example: 46 Columbus Surgical Inc. is based in US, has recently imported surgical raw material
from the UK and has been invoiced for £4,80,000, payable in 3 months. It has also exported surgical
goods to India and France.
The Indian customer has been invoiced for £1,38,000 payable in 3 months and the France customer
has been invoiced for €5,90,000 payable in 4 months.
Current spot rate and forward rates are as follows:
£ / US $
Spot rate: 0.9830 – 0.9850
Three months forward: 0.9520 – 0.9545

US $ / €
Spot rate: 1.8890 – 1.8920
Four months forward: 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.0 % - 12.0 % p.a.
France: 14.0 % - 16.0 % p.a.
USA: 11.50 % - 13.0 % p.a.
You as treasury manager are required to show how the company can hedge its foreign exchange
exposure using forward market and money market hedge and suggest and suggest which the best
hedging technique is.
Solution: Since Columbus has £ receipts and £ payments maturing at same time so net liability of £
3,42,000 (4,80,000 – 1,38,000) to be hedged.
(a) Forward hedging
Amount payable after 3 months £ 3,42,000
Total payment (3,42,000 / 0.9520) 3,59,244 $
(b) Money Market hedging:
Foreign currency receivables
Foreign currency liability 3,42,000 3,42,000
3months 10 = = 3,33,658 £
£ 3,42,000 1+ 𝑥3 1.025
12
Borrow in $
3,33,658
Borrowings: = 3,39,428 $
0.9830
Steps for MMH:

Step: 1Borrow $ 3,39,428 for 3 months @ 13 % p.a.
Step:2 Convert $ into £ at spot rate i.e. 0.9830

Hence £ = 3,39,428 * 0.9830 = 3,33,658 £
Step: 3 Invest £3,33,658 @ 10 % for 3 months.
Step: 4 Realize investment in Foreign currency and paid FC liabilities.
Step: 5 Repay $ loan with interest

Cash outflow = 3,39,428 + 3,39,428 *13 % * 3/12
= 3,39,428 + 11,031 = $ 3,50,459
For receivable after 4 months:

Option 1: Forward hedging
Amount receivable after 4 months € 5,90,000
Total receipt (5,90,000 * 1.9510) 11,51,090 $

Option 2: Money Market hedging:

Foreign currency loan
Foreign currency receivable 5,90,000 5,90,000
3months 16 = = € 5,60,144
€ 5,90,000 1+ 𝑥4
12
1.0533
Convert at spot rate and invest

5,60,144 € * 1.8890
= 10,58,112 $
Step: 1 Borrow 5,60,144 € @ 16 % for 4 months
Step: 2 Convert loan amount in $ at spot rate

Hence, $ = 5,60,144 * 1.8890 = $ 10,58,112
Step: 3 Invest $ 10,58,112 for 4 months @ 11.50 %.
Step: 5 realize from foreign currency debtors and repay foreign currency loan.
Step: 6 Realize from investment

10,58,112 + 10,58,112 * 11.5 % * 4/12
= 10,58,112 + 40,561 = 10,98,673 $.
Decision: Go for forward hedging.
Topic: 18 Choice of short – term borrowings or investment / investing excess cash to get
maximum return or profit
If a firm has surplus funds, it may invest in its home currency without currency risk. Instead, it may
invest in some foreign currency. This creates foreign currency receivables. Depending upon the sums
it may be required to cover the receivable forward or leave it uncovered. Finally, we should that
currency of investment for which home currency inflow is the highest.
Similarly, we should choose that currency of borrowing for which home currency outflow or
maturity is least.
On the other hand sometimes question requires investing in such currency in which we can get highest
return.
PART A: SHORT TERM INVESTMENTS:
Class example: 47 Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for
six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany.
Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is
DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she
invest to maximize the return?
Solution:
Alternative: 1 Invest in US
If treasurer invest $ 10,00,000 in US for 6 months, then maturity value in 6 months will be:
8 6
10,00,000 + 10,00,000 x x
100 12
10,00,000 + 40,000 = 10,40,000$
Alternative: 2 Invest in Germany

(i) Convert $ 10,00,000 in DM by using spot rate

1 $ = 1.60 DM
10,00,000 $ = 10,00,000 * 1.60 = 16,00,000 DM
(ii) Invest 16,00,000 DM in Germany for 6 months, then maturity value in 6 months will be:
6 6
DM 16,00,000 + 16,00,000 x x
100 12
DM 16,00,000 + 48,000 = DM 16,48,000
(iii) Convert 16,48,000 DM in $ by using forward rate

16,48,000
So, $ value = = $ 10,56,410.256
1.56
Decision: It is better to invest in Germany.
Class example: 48 Your bank’s London office has surplus funds to the extent of USD 5,00,000/- for a
period of 3 months. The cost of the funds to the bank is 4% p.a. It proposes to invest these funds in
London, New York or Frankfurt and obtain the best yield, without any exchange risk to the bank. The
following rates of interest are available at the three centres for investment of domestic funds there at
for a period of 3 months.
London – 5 % p.a.
New York – 8 % p.a.
Frankfurt – 3 % p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot rate 1.5350 / 90
1 month 15/ 18
2 month 30 /35
3 month 80 / 85
London on Frankfurt
Spot rate 1.8260 / 90
1 month 60/55
2 month 95 / 90
3 month 145 /140
At which centre, will be investment be made & what will be the net gain (to the nearest pound) to the
bank on the invested funds? [CA – Nov. 2013]
Solution:
Alternative 1: Invest in $
Step:1 Invest $ 5,00,000 at 8 % p.a. i.e. 2 % for 3 months. $ receivable after 3months.
= 5,00,000 (1.02) = $ 5,10,000.
5,10,000
Step: 2 Sell $ 3 month forward at 1.5390 + 0.0085 = 1.5475, so inflow after 3 months =
1.5475
= £3,29,563.81
Step: 3 Initially the bank has surplus fund of $ 5,00,000. At the current spot rate of 1.5390, it is
5,00,000
equivalent to = £ 3,24,886.29
1.5390
Given cost of fund i.e. 4 % p.a. or 1 % for 3 months
Outflow after 3 months = 3,24,886.29 * 1.01 = £3,28,135.15
So net gain = 3,29,563.81 – 3,28,135.15 = £1,428.66
Alternative 2: Invest in London

Step: 1 Convert $ 5,00,000 into £ spot getting £ 3,24,886.29.
Step: 2 Invest £ at 5 % p.a. i.e. 1.25 % for 3 months. So inflow after 3 months
= 3,24,886.29 – 3,28,135.15 = £812.22

Alternative: 3 Invest in €
Step: 1 Convert £ 3,24,886.29 into € spot getting
3,24,886.29 * 1.8260 = €5,93,242.37
Step: 2 Invest € 3 % p.a. i.e 0.75 % for 3 months. So inflow after 3 months
5,93,242.37 * 1.0075 = € 5,97,691.69
Step: 3Sell € 3 months future getting at 1.8290 – 0.140 = 1.8150, getting

5,97,691.69 / 1.8150 = £3,29,306.72
Net gain = 3,29,306.72 – 3,28,135.15 = £ 1,171.57
Conclusion: The firm should invest in NY i.e.$.
Class example: 49 An Indian firm has surplus fund of `500 lakhs for 6 months. Following interest
rates are given:
` = 10 % / 11 %
$ =6%/7%
¥ = 1.10 % / 1.50 %
Following exchange rates are provided:
Spot rate (` / $) = 57.20 / 57.90
6 months swap point = 90/110
Spot rate (` / ¥) = 0.4325 / 0.4380
6 months swap point = 140 / 170
Also the following currency forecast for the exchange rate likely to prevail after 6 months are
available.
Expected spot rate (`/$) = 58.30 / 58.95
Expected spot rate (` / ¥) = 0.4425 / 0.4480
Advise the firm as to which currency is to be choose for the currency and on what basis (i.e. forward
cover or uncovered)
Class example: 50 Suppose you are a treasurer of XYZ Plc in the UK. XYZ have two overseas
subsidiaries, one based in Amsterdam and one in Switzerland. The Dutch subsidiary has surplus Euros in
the amount of 7,25,000 which it does not need for the next three months but which will be needed at the
end of that period (91 days). The Swiss subsidiary has a surplus of Swiss Francs in the amount of 9,98,077
that again it will need on day 91. The XYZ Plc. In UK has a net balance of £75,000 that is not needed for
the foreseeable future. Given the rates below, what is the advantage of swapping Euros and Swiss Francs
into Sterling?
Spot rate:
£/€ 0.6858 / 0.6869
91 day Pts. 0.0037 / 0.0040
Spot rate:
CHF / £: 2.3295 / 2.3326
91 day Pts. 0.0242 / 0.0228
Interest rates for deposits:
Amount of currency 91 days interest rates (% per annum)
£ € CHF
0 – 1,00,000 1 ¼ 0
1,00,001 – 5,00,000 2 1½ ¼
5,00,001 – 10,00,000 4 2 ½
Over 10,00,000 5.375 3 1
PART B: SHORT TERM BORROWINGS

Class example: 51 The treasure at an Indian company requires `10 million for 6 months. He is exploring
various options of financing and has collected the following information:
`/$ `/£
Spot 46.90 / 95 65.35 / 40

6 months forward 70 / 90 paise 90 / 100 Paise

Expected spot rate after 6 months 47.50 / 55 66.90 / 95
Interest rates Per annum:
` = 12.00 %
$ = 4.00 %
£ = 5.00 %
You are required to advise the treasure in which currency to borrow, if he
(i) Covers the exchange risk in forward market
(ii) Keep the position open.
Class example: 52 An Indian company based at Mumbai needs short term funds of `50 million for a
period of 3 months. The company collected the following information from its banker:
`/$ `/£
Spot rate 48.50 / 55 74.05 / 10
3 months forward 45 / 50 85 / 90
3 months interest rates (p.a.)
` 9%
$ 4%
£ 6%
You are required to calculate the annualized effective cost of borrowing:
(a) If the company borrows in USD and
(i) Covers the exchange rate risk through forward market
(ii) Keeps the position open and spot rate after 3 months turns out to be `/ $ - 48.90 / 95.
(b) If the company borrows in pound and
(i) Covers the exchange rate risk through forward market
(ii) Keeps the position open and spot rate after 3 months turns out to be `/£ - 74.75 / 80.
Topic: 19 Netting
Netting means net position between parties. Whenever, one party has receivables as well as payables
then netting technique will apply to reduce the transaction cost. Netting is of two types:
(a) Bilateral netting – Netting between two parties only is known as bilateral netting.
(b) Multilateral netting – Netting between all parties are known as multilateral netting.
Note: If question is silent always use multilateral netting.

Note: For netting process if more than one currency is given then convert all other currencies into one
identified (selected) currency. This could be the currency of parent company or any other currency.
Topic: 20 Cover deal / cover rate / Profit or loss of dealer due to contract
Whenever, dealer (i.e. bank) booked a contract with customer, at the same time dealer also booked a
counter contract with the market. This counter contract is known as cover deal. The rate applicable for
the counter contract with the market is known as cover rate.
How to find out profit or loss of dealer due to cover = Cover rate – Contract rate with customer
Topic: 21 Leading and Lagging technique

Under leading technique settlement will be done before due date whereas under lagging technique
there is delay in settlement. Generally name of technique is given in the question but if not given then
apply following rules:
Foreign currency at premium Foreign currency at discount
Importer Lead Lag
Exporter Lag Lead

Topic: 21 Concept of Interest rate parity (IRP) and arbitrage process

As per IRP, interest rates across the world on a covered basis must be equal. Thus, whichever
currency has a lower interest rate, the currency of that country should be at a forward premium.
(A) Concept understanding:
Person of USA have two possible alternatives for investment:
A1 (Invest in USA)
t=0 t=1
100 $ $ 105
5%
8%
A2 (Invest in India)
t = 0 (exchange rate = 40) t=1
`4,000 (100 * 40) `4,320 (assume exchange rate = `40)
4,320 /40 = $ 108
In the above situation it is better for investor to invest in India for a year as it gives more $ in return in
comparison to invest in USA. However as per IRP theory the exchange rate will adjust in such a way that
there is no benefit to investor. In other words we can say that investor is indifferent between alternative 1
and alternative 2.
Hence, as per IRP exchange rate should be = 4,320 / 105 = `41.1429.
Summary:
(i) If IRP theory hold good = There is no arbitrage
(ii) If IRP theory does not hold good = Investor can earn arbitrage.
(B) How to compute forward rate with the help of interest rate parity theory (IRP)
1+Rq
Forward rate = Spot rate X
1+Rb
Rq = Rate of quote / price currency
Rb = Rate of base currency
(C) How to check arbitrage

 Arbitrage means risk less profit.
 Ideally buy low and sale high.
 While carrying out arbitrage equal amount is bought or sold.
 If money market interest differential is equal to forex market differential then IRP is valid and
hence arbitrage is not possible. In other words, if money market differential is not equal to forex
differential then arbitrage is possible and this is called covered interest arbitrage.
 If interest rate differential is higher than forex differential, then investor should go for deposit in
country where interest rate is higher.
 If interest rate differential is lower than forex differential, then investor should go for deposit in
country where interest rate is lower.
(D) Locational arbitrage – Locational arbitrage can occur when the spot rate of a given currency varies
among locations. Specifically, the ask rate at one location must be lower than the bid rate at another
location. The disparity in rates can occur since information is not always immediately available to all
banks. If a disparity does exist, locational arbitrage is possible.

Beal bank Yardely bank
Bid price of New Zealand $ $ 0.401 $ 0.398
Ask rate $ 0.404 $ 0.400
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational
arbitrage and compute the profit from this arbitrage if you has $ 10,00,000 to use.

Class example: 54
Assume the following information:
SBI bank BOB bank
Bid rate 1 $ = 45.05 1 $ = 45.08
Ask rate 1 $ = 45.07 1 $ = 45.09
Given this information is locational arbitrage possible? If so, explain the steps involved in locational
arbitrage and compute the profit from this arbitrage if you has `1,00,000 to use.
(E) Covered interest arbitrage
Class example: 55 Check arbitrage opportunity from the following information:
Spot rate 1 $ = `40
6 months forward rate 1 $ = `40.50
Indian interest rate 8%
USA interest rate 5%
Solution:
1+𝑅𝑎𝑡𝑒 𝑜𝑓 𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Step: 1 Calculate theoretical forward rate: SR x
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
1.04
= 40 x = 40.59
1.025
Quoted forward rate = 40.50
Since theoretical forward rate ≠ Quoted forward rate, so arbitrage is possible. For arbitrage, arbitrager
should borrow $ and invest in `.
Step: 2 Following is the process of arbitrage

(i) Borrow 10,000 $ @ 5 % per annum for 6 months.
(ii) Convert into ` by using spot rate
10,000 x 40 = `4,00,000
(iii) Invest `4,00,000 @ 8 % per annum for 6 months.
(iv) Buy forward purchase contract of $ at `40.50
(v) Realize from investment with interest

8 6
4,00,000 + 4,00,000 x x
100 12
4,00,000 + 16,000 = 4,16,000
(vi) Buy $ at agreed forward rate

4,16,000
$ Inflow = = $ 10,271.605
40.50
(vii) Repay loan with interest

5 6
$ Outflow = 10,000 + 10,000 x x
100 12
10,000 + 250 = $ 10,250
(viii) Arbitrage profit = 10,271.605 – 10,250 = 21.605 $
Class example: 56 Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate
is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K.
Assume that you can borrow as much as $1,500,000 or £1,000,000.
(i) Determine whether the interest rate parity is currently holding.
(ii) If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and
determine the arbitrage profit.
Solution: SR = 1£ = 1.50 $
1.02
Theoretical forward rate = 1.50 x = 1.5081
1.0145
Quoted forward rate = 1.52
Since, TFR ≠ quoted forward rate, thus IRP is not holding exactly.

For arbitrage borrow $ and invest in pound. Process of arbitrage is as under:

(i) Borrow 15,00,000 $ for 3 months @ 8 % per annum.
(ii) Purchase / Convert into £ by using spot rate
15,00,000
15,00,000 $ = = 10,00,000 £
1.50
(iii) Invest 10,00,000 £ for 3 months @ 5.80 % per annum.
(iv) Book forward sell contract of pound at 1.52
(v) Realize from investment with interest

5.80 3
£ Inflow = 10,00,000 + 10,00,000 x x
100 12
= 10,00,000 + 14,500 = 10,14,500
(vi) Sell £ at applicable forward rate
$ Inflow = 10,14,500 x 1.52 = 15,42,040 $
(vii) Repay loan with interest

8 3
$ Outflow = 15,00,000 + 15,00,000 x x
100 12
= 15,00,000 + 30,000 = $ 15,30,000
(viii) Arbitrage profit = 15,42,040 – 15,30,000 = 12,040 $
(F) Triangular arbitrage - As the name suggest triangular arbitrage involve 3 currencies. Under
triangular arbitrage start with currency A; then go to currency B (means sell currency A and buy
currency B); then go to currency C and finally come back to currency A.
In the process, if you end up with more A then you start with, triangular arbitrage is possible.
Class example: 57 Consider the following quotations:
Bank A: $ / £ = 1.4680 / 10
Bank B: € / £ = 1.3150 / 90
Bank C: $ / € = 0.6810 / 50
Show the process of arbitrage using $ 6,000.
Class example: 58 Consider the following quotations:
Bank A: CHF / AUD = 0.8210 / 50
Bank B: CHF / CAD = 0.7650 / 90
Bank C: AUD / CAD = 0.9650 / 0.9710
Show the arbitrage process of triangular arbitrage using CHF 80,000.
Class example: 59 The Dollar to Swiss Franc spot exchange rate is $0.8918/SF1.00, the Dollar to Pound
spot exchange rate is $1.6302/£1.00, and the SF to Pound spot exchange rate is SF1.7914/£1.00. Determine
the triangular arbitrage profit that is possible if you have $8,000,000.
Topic: 22 Purchasing power parity theory

As per the purchasing power parity theory goods market prices are used to determine the exchange rates
between two currencies. The exchange rate of 2 countries would be affected due to inflation rates in 2
countries. So we have to adjust inflation rate to find out expected spot rate. In other words, the expected
spot rate can be estimated using today’s spot rate and inflation differential of 2 countries.
1+Iq
Expected spot rate = Spot rate X
1+Ib
Iq = Inflation rate of quote / price currency
Ib = Inflation rate of base currency
Topic: 23 International capital budgeting

Whenever an entity of any one country wants to establish a project or business unit in another country then
entity has to decide whether project should be establish or not with the help of capital budgeting process. If

NPV of the project is positive then project should establish otherwise not. For calculation NPV we should
apply either of the following approach:
Approach 1: Home currency approach

Step: 1 Calculate foreign currency cash flows of each year.
Step: 2 Convert foreign currency cash flows into home currency cash flows by using exchange rates.
Step: 3 Compute home currency discount rate
Step: 4 Compute home currency NPV in its usual manner
Decision: If NPV of the project is positive, then accept the project.
Approach 2: Foreign currency approach

Step: 1 Calculate foreign currency cash flows of each year
Step: 2 Calculate foreign currency discount rate
Step: 3 Calculate foreign currency NPV of the project
Step: 4 Convert foreign currency NPV into home currency NPV by using spot rate.
Notes:
(i) Discount rate under both approach are different.
(ii) Discount rate should always be risk adjusted discount rate.
(iii) How to find out risk adjusted discount rate.
Risk adjusted discount rate = RF + Risk premium
OR
Risk adjusted discount rate = (1 + RADR) = (1 + RF) (1 + Risk premium)
(iv) Risk premium under both approaches are assumed to be same if question is silent.
(v) If exchange rates are missing use IRP theory or PPP theory to find out exchange rates.
Topic: 24 Concept of withholding tax

Whenever a foreign company invest in a home country then home country charges an additional tax over
and above the normal tax. Such tax is known as withholding tax. Withholding tax is applicable on surplus
profits or profits which are taken back by foreign company in his own country.
Topic: 25 International cash management

Cash management means manage surplus cash in such a manner that entity can get maximum return by
investing such surplus fund. Under cash management parent company may follow either decentralised cash
management system or centralised cash management system.
Decentralised cash management – If decentralised cash management system is followed then no set – off
of cash deficit is possible from any surplus cash available with another subsidiary. In other words, we
should calculate cash requirement for each subsidiary separately.
Centralised cash management – Under this system we can set – off deficit of a company with surplus of
any other company under the same management and cash requirement will calculate on net basis.
Topic: 26 International joint venture

Whenever any business is in form of joint venture then we should compute NPV of the project as per share
of joint venture. Each joint venture is liable to contribute in cash outflow and receive his share of inflow
from the project.

SOME ADVANCE PROBLEMS ON INTERNATIONAL CAPITAL BUDGETING / INTERNATIONAL

JOINT VENTURE/ CONCEPT OF WITHHOLDING TAX / APPLICATION OF DOUBLE TAXATION
AVOIDANCE AGREEMENT
Class example: 60 Opus Technologies Ltd., an Indian IT company is planning to make an investment
through a wholly owned subsidiary in a software project in China with a shelf life of two years. The
inflation in China is estimated as 8 percent. Operating cash flows are received at the year end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in a piece of land. The land
will be sold after the completion of project at estimated value of CN¥ 35,00,000. The project also requires
an office complex at cost of CN¥ 15,00,000 payable at the beginning of project. The complex will be
depreciated on straight-line basis over two years to a zero salvage value. This complex is expected to fetch
CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in Mauritius. Each GDR will have
5 common equity shares of the company as underlying security which are currently trading at `200 per
share (Face Value = ` 10) in the domestic market. The company has currently paid a dividend of 25%
which is expected to grow at 10% p.a. The total issue cost is estimated to be 1 percent of issue size. The
annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The price of unit is expected to
rise at the rate of inflation. Variable operating costs are 40 percent of sales. Current Fixed Operating costs
is CN¥ 22,00,000 per year which is expected to rise at the rate of inflation.
The tax rate applicable in China for business income and capital gain is 25 percent and as per GOI Policy
no further tax shall be payable in India. The current spot rate of CN¥ 1 is `9.50. The nominal interest rate
in India and China is 12% and 10% respectively and the international parity conditions hold.
You are required to
(a) Identify expected future cash flows in China and determine NPV of the project in CN¥.
(b) Determine whether Opus Technologies should go for the project or not, assuming that there neither
there is any restriction nor any charges/taxes payable on the transfer of funds from China to India.
[RTP – May, 2016]
Solution:
(i) Calculation of cost of capital:
No. of shares under each GDR = 5
Price per share = `200
Total value per GDR = 200 * 5 = 1,000
Value of one GDR (Net of cost) = 1,000 * 99 % = 990
Dividend per share: 10 * 25 % = 2.50
Dividend per GDR (D 0) = 2.50 * 5 = 12.50
D1 = 12.50 (1.10) = 13.75
P0 = D 1 / Ke – g
990 = 13.75 / Ke – 0.10
990 Ke – 99 = 13.75
Ke = 11.39 %
(ii) Calculation of expected exchange rate:

Spot rate: 1 CH¥ = `9.50
1.12
Year 1 = 9.50 X = `9.67
1.10
1.12
Year 2 = 9.67 X = `9.85
1.10
Calculation of cash flow:

Particulars Year 1 Year 2
Number of units sold 10,000 10,000
Selling price 540 583.20
(500 * 1.08) (540 * 1.08)
Sales revenue 54,00,000 58,32,000
Less: Variable operating cost @ 40 % 21,60,000 23,32,800
Fixed operating cost 23,76,000 25,66,080

(22,00,000 * (23,76,000 * 1.08)

1.08)
Depreciation 7,50,000 7,50,000
Profit before tax 1,14,000 1,83,120
Less: Tax 28,500 45,780
Profit after tax 85,500 1,37,340
Add: Depreciation 7,50,000 7,50,000
Cash flow 8,35,500 8,87,340
Calculation of terminal year cash flow:

Particulars Land Complex
Sale value 35,00,000 5,00,000
Less: Cost or WDV 30,00,000 Nil
Capital gain 5,00,000 5,00,000
Tax @ 25 % 1,25,000 1,25,000
Amount realized (Net of tax) 33,75,000 3,75,000
Statement of NPV of the project:
Annual cash flow 8,35,500 8,87,340
Terminal year cash flows (33,75,000 + - 37,50,000
3,75,000)
8,35,500 46,37,340
Present value factor @ 11.39 % 0.898 0.806
Present value 7,50,279 37,37,696
NPV = Total present value of cash inflow – Cash outflow

44,87,975 – 45,00,000 = (12,025)
Class example: 61 Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from
Aidscure Ltd., a company engaged in manufacturing of drugs to cure Dengue, to set up a manufacturing
unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a royalty @ US
$0.01 per bottle. The initial investment will be ` 200 crores for machinery and factory. The scrap value of
machinery and factory is estimated at the end of five (5) year to be ` 5 crores. The machinery is
depreciable @ 20% on the value net of salvage value using Straight Line Method. An initial working
capital to the tune of ` 50 crores shall be required and thereafter ` 5 crores each year.
As per GOI directions, it is estimated that the price per bottle will be ` 7.50 and production will be 24
crores bottles per year. The price in addition to inflation of respective years shall be increased by ` 1 each
year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxation Avoidance Agreement
between India and US. According to the agreement tax credit shall be given in US for the tax paid in India.
In both the countries, taxes shall be paid in the following year in which profit have arisen.
The Spot rate of $ is ` 57. The inflation in India is 6% (expected to decrease by 0.50% every year) and 5%
in US.
As per the policy of GOI, only 50% of the share can be remitted in the year in which they are earned and
remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from subsidiary point of view).
[Additional reading of ICAI]
Solution:
(i) Calculation of exchange rates:

1.06
Year 1: 57 X = 57.54
1.05
1.055
Year 2: 57.54 X = 57.81
1.05
1.05
Year 3: 57.81 X = 57.81
1.05
1.045
Year 4: 57.81 X = 57.53
1.05
1.04
Year 5: 57.53 X = 56.98
1.05
1.035
Year 6: 56.98 X = 56.17
1.05
(ii) Calculation of share in sales revenue:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Annual units (in crores) 24 24 24 24 24
Selling price 7.50 8.50 9.50 10.50 11.50
Inflation rate 6.00 % 5.50 % 5.00 % 4.50 % 4.00 %
Selling price including inflation 7.95 8.97 9.98 10.97 11.96
Sales revenue 190.80 215.28 239.52 263.28 287.04
Share in sales @ 55 % 104.94 118.40 131.74 144.80 157.87
(iii) Royalty payment:

Annual units 24 24 24 24 24
Royalty per bottle 0.01 0.01 0.01 0.01 0.01
Total royalty ($) 0.24 0.24 0.24 0.24 0.24
Exchange rate 57.54 57.81 57.81 57.53 56.98
Royalty (`) 13.81 13.87 13.87 13.81 13.68
(iv) Calculation of amount of tax:

Share in sales 104.94 118.40 131.74 144.80 157.87
Royalty 13.81 13.87 13.87 13.81 13.68
118.75 132.27 145.61 158.61 171.55
Less: Production cost @ 40 41.98 47.36 52.70 57.92 63.15
% of revenue (sales)
Depreciation 39.00 39.00 39.00 39.00 39.00
Profit before tax 37.77 45.91 53.91 61.69 69.40
Tax @ 30 % 11.33 13.77 16.17 18.51 20.82
Calculation of cash flows:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Profit before tax 37.77 45.91 53.91 61.69 69.40 -
Less: - 11.33 13.77 16.17 18.51 20.82
Profit after tax 37.77 34.58 40.14 45.52 50.89 (20.82)
Add: Depreciation 39.00 39.00 39.00 39.00 39.00
Cash flows 76.77 73.58 79.14 84.52 89.89 (20.82)
Less: Working capital 5.00 5.00 5.00 5.00 5.00
Net cash flows 71.77 68.58 74.14 79.52 84.89 (20.82)
Remittance in current year @ 50 35.89 34.29 37.07 39.76 42.45 -
%
Previous year remaining cash - 35.88 34.29 37.07 39.76 42.44
flows

Total remittance 35.89 70.17 71.36 76.83 82.21 21.62

Add: Terminal cash flow - - - - 40.00 40.00
Total cash flow 35.89 70.17 71.36 76.83 122.21 61.62
Calculation of terminal year cash flow:

Working capital released 75 -
Scrap value 5 -
Total 80.00 -
Remittance in current year @ 50 % 40.00 -
Previous year cash flow - 40.00
Calculation of present value of cash flows:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Total remittance 35.89 70.17 71.36 76.83 122.21 61.62
Exchange rate 57.54 57.81 57.81 57.53 56.98 56.17
Remittance in $ (A) 0.6237 1.2138 1.234 1.335 2.145 1.097
US tax @ 35 % - 0.218 0.425 0.432 0.467 0.751
Indian tax - 0.197 0.238 0.281 0.325 0.371
(11.33 /
57.54)
Net tax (B) - 0.021 0.187 0.151 0.142 0.38
Net cash flow (A – B ) 0.6237 1.1928 1.047 1.184 2.003 0.717
Present value factor 0.870 0.756 0.658 0.572 0.497 0.432
Present value of cash flow 0.543 0.902 0.689 0.677 0.995 0.310
Net present value = 4.116 - 4.386 = - 0.27 crores

Decision: Since NPV is negative, project should not be accepted.
Class example: 62 XYZ Ltd., a company based in India, manufactures very high quality modem furniture
and sells to a small number of retail outlets in India and Nepal. It is facing tough competition. Recent
studies on marketability of products have clearly indicated that the customer is now more interested in
variety and choice rather than exclusivity and exceptional quality. Since the cost of quality wood in India
is very high, the company is reviewing the proposal for import of woods in bulk from Nepalese supplier.
The estimate of net Indian (`) and Nepalese Currency (NC) cash flows for this proposal is shown below:
Net cash flow (in millions)
Year 0 1 2 3
NC -25.00 2.60 3.80 4.10
Indian (`) 0 2.869 4.200 4.600
The following information is relevant:
(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese customers are
invoiced in NC. NC cash flows are converted to Indian (`) at the forward rate and discounted at the Indian
rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively.
The current exchange rate is ` 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net present value (NPV) and
modified internal rate of return (MIRR) of the proposal. [CA – Nov. 2015]
Topic: 27 Nostro, Vestro and Loro account

(a) Nostro account – Nostro account is also called ours account with you. Nostro account is a current
account maintained by a domestic bank / dealer with a foreign bank in foreign currency.
SBI Switzerland bank

Current account in CHF currency called Nostro account

(b) Vostro account – Vostro account is called yours account with us. Vostro account is a current account
maintained by a foreign bank with domestic bank in ` currency.
SBI Switzerland bank

Current account in ` currency called Vostro account
(c) Loro account – Loro account is called our account with their money with you. Loro account is a current
account maintained by one domestic bank on behalf of other domestic bank in foreign bank in foreign
currency.
SBI Switzerland
Current account in CHF currency called Nostro account
Loro account
PNB
Maintaining forex position Vs. Fund position – Whenever we buy or sell foreign currency either on cash
basis, tom basis, spot basis or forward basis then forex position is created. The total of buy or sell is
counted and net amount is arrived at the end of every day. Position will be either over bought position or
oversold position. The bank has risk of adverse exchange rate movement in forex position. For avoiding
this risk bank has to create square up position on the same day with net amount.
Fund position (Nostro account) - This account will be affected due to forex transaction on cash basis only.
Topic: 28 Foreign exchange exposures

(a) Transaction exposure / Contractual exposure – under such type of exposure we have to show impact of
settling outstanding obligations entered into before change in exchange rate but to be settled after changing
exchange rate. Such exposure arises due to -
(i) Sale or purchase transaction
(ii) Receivable or payable transaction
(iii) Expenses or income transaction
(b) Operating exposure – Operating exposure denotes expected future cash flows arising from an
unexpected change in exchange rates. Such exposure can be affected by change in sales volume, sales
price, operating cost etc.
Class example: 63 Shanti exported 200 pieces of designer jewellery to USA at $ 200 each. To
manufacture and design this jewellery she imported raw material from Japan of the cost of JP¥ 6000 for
each piece.
The labour cost and variable overhead incurred in producing each piece of jewellery are `1,300 and `650
respectively.
Suppose Spot Rates are:
`/ US$ `65.00 – `66.00
JP¥/ US$ JP¥ 115 – JP¥ 120
Shanti is expecting that by the time the export remittance is received and payment of import is made the
expected Spot Rates are likely to be as follows:
`/ US$ `68.90 – `69.25
JP¥/ US$ JP¥ 105 – JP¥ 112
You are required to calculate the resultant transaction exposure. [Mock test paper]

Class example: 64 Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and
buys parts from U.S. companies. Suppose it has accounts receivable of $1.5 billion and accounts payable
of $740 million. It also borrowed $600 million. The current spot rate is $1.5128/£.
(a) What is Rolls-Royce's dollar transaction exposure in dollar terms? In pound terms?
(b) Suppose the pound appreciates to $1.7642/£. What is Rolls-Royce's gain or loss, in pound terms, on its
dollar transaction exposure?
Solution:
Statement showing calculation of transaction exposure:
Particulars $ in million
Receivables 1500
Less: Payables 740
Loans 600
Net transaction exposure 160
160
Transaction exposure in pound = = 105.79 M £
1.5128
160
(b) Value of transaction exposure at new rate = = 90.69 M £
1.7642
Hence, Loss due to transaction exposure = 105.79 – 90.69 = 15.10 million
Class example: 65 Find out the transaction gain / loss on the basis of the following data pertaining to
Indian foreign trade:
US $ (in millions) Japanese Yen (in milion) £ (in milion)
Import 1,250 650 800
Export 1,150 625 850
Spot rate `45 / $ `0.40 / ¥ `70 / £
Forward rate ` 47 / $ `0.41 / ¥ `68 / £
Solution:
Particulars $ ¥ £
Receivables 1150 625 850
Payables 1250 650 800
Net receivables / (payables) (100) (25) 50
Spot rate 45 0.40 70
Net amount using spot rate 4500 10 3500
Forward rate 47 0.41 68
Net amount using forward rate 4700 10.25 3400
Gain / (Loss) (200) (0.25) (100)
Class example: 66 An Indian exporter has obtained an order for supplying automotive brakes at the rate of
$ 100 per piece. The exporter will have to import parts worth $ 50 per piece. In addition, variable cost of `
200 will be incurred per piece. Explain the impact of transaction exposure if the exchange rate which is
currently `36 / $ moves to `40 / $.
Solution:
Gain or Loss due to present situation:
Revenue (100 * 36) 3,600
Less: Import cost 1800
Variable cost 200 2,000
Profit 1,600
Gain or Loss after change in exchange rates:
Revenue (100 * 40) 4,000
Less: Import cost (50 * 40) 2,000
Variable cost 200 2,200
Profit 1,800
Hence,
Profit due to transaction exposure = 1,800 – 1,600 = 200

Class example: 67 An Indian exporter has an ongoing order from USA for 2,000 pieces per month at a
price of $ 100 per piece. To execute the order, the exporter has to import Yen 6,000 worth of material per
piece. Labour costs are `350 per Piece while other variable overheads add up to `700 per piece. The
exchange rates are currently `35/$ and Yen 120 / $. Assuming that the order will be executed after 3
months and payment is obtained immediately on shipment of goods, calculate the loss / gain due to
transaction exposure if the exchange rate change to `36 / $ and Yen 110 / $.
Solution:
Profit / Loss at existing situation:
Revenue (2,000 * 100 * 35) 70,00,000
Less: Import cost (2,000 * 6,000 * 35 / 120) 35,00,000
Labour cost (2,000 * 350) 7,00,000
Overheads (2,000 * 700) 14,00,000 56,00,000
Profit 14,00,000
Profit / Loss at revised situation:

Revenue (2,000 * 100 * 36) 72,00,000
Less: Import cost (2,000 * 6,000 * 36 / 110) 39,27,273
Labour cost (2,000 * 350) 7,00,000
Overheads (2,000 * 700) 14,00,000 60,27,273
Profit 11,72,727
Hence, Loss due to transaction exposure = 14,00,000 – 11,72,727 = 2,27,273

QUESTION BANK
Q.1 Assume you have a German customer who experts to London and would like to sell
pounds against Euros. The following market rates prevail:
Euro/$ 1.1875/1.1890
Pound/$ 0.6957/0.7008
If your customer wants a Cross Rate for Pound/Euro in Euro terms from you, what rate will you quote
assuming you want a spread of 0.0020 points.
Q.2 An Indian bank sells FF 1,000,000 spot to a customer at `6.40. At that point of time, the following
rates were being quoted.
FF/$ : 5.5880/5.5920
`/$ : 35.50/35.60
How much profit do you think the bank has made in the transaction?
Q. 3 As a dealer in the bank, you observed the following quotes in the market.
`/$ 42.18 42.60
`/£ 68.59 69.96
`/€ 46.25 47.17
Compute the cross rates for $/£ and $/€.
Q.4 From the following quotes of a bank, determine the rate at which Yen can be purchased with Rupees.
Rs./Pd. Sterling 75.31-33
Pd.Sterling/Doliar 1.563-65
Dollar/Yen 1.048/52 [Per 100 Yen]
Q.5 Q.14 Spot rate: 1 $ = 25.45 / 25.60

6 months forward swap points: 0.12/ .07
Find out forward rate.
Answer: Forward rate: 1 $ = 25.33 / 25.53
Q. 6 The following quotes are available:

Spot (DM/$) = 1.5105 / 1.5120
Three months swap points = 25/20
Six months swap points = 30/25
Calculate the three – months and six months outright forward rates.
Answer: 1£ = 2.4314 / 2.4408 DM
Q.7 An Indian customer who has imported equipment from Germany has approached its bank for booking
a forward DM contract. The delivery is expected at the end of the 6 th month from now. The following rates
are being quoted.
Spot (DM/$) = 1.584 / 1.585
Three – months forward = 0.030 / 0.029
Six – months forward = 0.059 / 0.058
Spot (Rs. / $) = 35.60 / 35.70
Three – months forward = 15/25
Six – months forward = 20/30
What rate will the bank quote if it needs a margin of 0.5 %?
Answer: 1 DM = `23.73
Q.8 On January 28, 2007 an importer customer requested a bank to remit SGD 25,00,000 under an
irrevocable LC. However, due to bank strike, the bank could effect the remittance only on February 4,
2007. The inter – bank market rates were as follows:
January 28 February 4
USD 1 INR 45.85/90 INR 45.91 / 97
GBP 1 USD 1.7840 / 50 USD 1.7765 / 75
GBP 1 SGD 3.1575 / 90 SGD 3.1380 / 90

The bank wishes to retain an exchange margin of 0.125 %. How much does the customer stand to gain or
loss due to the delay? [CA – May, 05]
QUESTIONS RELATED TO FORWARD COVER AND NO COVER AND BENEFITS FROM EARLY
PAYMENT
Q. 9 Excel exporters are holding an export bill in united states dollar (USD) 1,00,000 due 60 days, hence
they are worried about the falling USD value which is currently at `45.60 per USD. The concerned export
consignment has been priced on an exchange rate of `45.50 per USD. The firm’s bankers have quoted a 60
– days forward rate of `45.20.
Calculate:
(a) Rate of discount quoted by bank.
(b) The probable loss of operating profit if the forward sale is agreed to. [CA – Nov. 04]
SOLUTION:
Spot rate: 1 $ = `45.60
60 days forward rate: 1 $ = 45.20
(i) Rate of discount quoted by bank
𝐹𝑅−𝑆𝑅 365
x 100 x
𝑆𝑅 𝑛
45.20−45.60 365
x 100 x = 5.336 %
45.60 60
(ii) Probable loss of operating profit if forward sale is agreed:

Spot rate 45.50
Forward rate 45.20
Loss per $ 0.30
Contract size 1,00,000
Total loss 30,000
Q.10 An importer has to settle a bill for $ 1,35,000. The exporter has given the Indian company two
option:
(i) Pay immediately without any interest charge.
(ii) Pay after 3 months, with interest 6 % p.a.
The importer’s bank charges 16 % p.a. on overdrafts. If the exchange rates are as follows, what should the
company do?
Spot rate (` / $) = 48.35/ 48.36 3 months forward rate (` /$) = 48.81 / 48.83
[CWA – Dec. 02]
SOLUTION:
Option: 1 Pay immediately without any interest
Invoice value (1,35,000 * 48.36) 65,28,600
Add: Interest on overdraft facility (65,28,600 * 16 % * 3/12) 2,61,144
Total amount payable 67,89,744
Option: 2 Pay after 3 months with 6 % interest:

Invoice value $1,35,000
Add: Interest @ 6 % for 3 months (1,35,000 * 6 % * 3/12) $2,025
Total amount $1,37,025
Applicable rate 48.83
Total amount payable 66,90,931
Decision: It is advisable to settle the payable after 3 months. It will provide saving of `98,813.
Q.11 The following rates are appears in the foreign exchange market:
Spot rate: (`/ $) = `45.80 / 46.05
2 months forward rate (`/ $) = `46.50 / 47.00

(i) How many dollars should a firm sell to get `5 crores after 2 months?
(ii) How many rupees is the firm required to pay to obtain $ 2,00,000 in the spot market.
(iii) Assume the firm has $ 50,000. How many rupees does the firm obtain in exchange of $.
[CS – Dec. 03]
SOLUTION:
(i) 5,00,00,000 / 46.50 = 10,75,268.82 $
(ii) 2,00,000 * 46.05 = 92,10,000
(iii) 50,000 * 45.80 = 22,90,000
Q.12 Dishita Ltd. your customer has imported 5,000 cartridges at landed cost in Mumbai, of US $ 20 each.
The company has the choice for paying for the goods immediately or in 3 months time. It has a clean
overdraft limit with you where 14 % p.a. rate of interest is charged. Calculate which of the following
methods would be cheaper to your customer,
(i) Pay in 3 months time with interest @ 10 % and cover risk forward for 3 months.
(ii) Settle now at a current spot rate and pay interest of the overdraft for 3 months.
The rates are as follows:
Mumbai ` / $ spot rate: 43.25 / 43.55
3 months swap: 35 / 25 [CWA – June, 06]
SOLUTION:
Alternative: 1 Pay in 3 – month time with interest @ 10 %
Amount payable (5,000 * 20) $ 1,00,000
Add: Interest @ 10 % for 3 months $2,500
Total exposure $1,02,500
Cash outflow `44,38,250
Working note: Calculation of 3 – months forward rate:
Bid Ask
Spot rate 43.25 43.55
Less: Swap point 0.35 0.25
Forward rate 42.90 43.30
Alternative: 2 Settle now at current spot rate and pay interest

Cash outflow at spot rate (1,00,000 * 43.55) 43,55,000
Add: Overdraft interest (43,55,000 * 14 % * 3/12) 1,52,425
Total cash outflow 45,07,425
Decision: Since the cash outflow is lowest in alternative 1, hence it is suggested to pay in 3 months’ time.
Q.13 Management of Indian company is contemplating to import a machine from USA at a cost of $
15,000 at today’s spot rate of $ 0.0227272 per `. Finance manager opines that in the present foreign
exchange market scenario, the exchange rate may shoot up by 10 % after two months and accordingly he
proposes to defer import of machine. Management thinks that deferring import of machine will cause a
loss of `50,000 to the company in the coming two months. As the company secretary, you are asked to
express your views, giving reasons, as to whether the company should go in for purchase of machine right
now or defer purchase for two months. [CS – Dec. 06]
SOLUTION:
Spot rate: 1` = 0.0227272 $
Current cost of machine = $ 15,000
Current cost of machine in ` terms = 15,000 / 0.0227272 = 6,60,000
2 month’s forward rate = 0.0227272 * 1.10 = 0.02499992
Cost of machine after 2 months = 15,000 / 0.02499992 = 6,00,000

Saving due to foreign exchange fluctuations: 6,60,000 – 6,00,000 = 60,000

Loss due to deferring the import = 50,000
Net saving = 60,000 – 50,000 = 10,000
Q.14 In March, 2007 Yati Ltd. makes the following assessment of USD rates per GBP to prevail in June
2007.
USD / GBP 1.60 1.70 1.80 1.90 2.00
Probability 0.15 0.20 0.25 0.20 0.20
(a) What is the expected spot rate in June 2007?
(b) If, as of March 2007, the 3 month forward rate is USD 1.80, should the firm sell forward its GBP
receivables due in March, 2007? [CWA – June, 08]
Q.15 ABC Co. has taken a 6 month loan from their foreign collaborator for US Dollors 2 millions. Interest
payable on maturity is at LIBOR plus 1 %. Current 6 – month LIBOR is 2 %. Enquiries regarding
exchange rates with their bank elicit the following information:
Spot USD 1 = ` 48.5275
6 – months forward = ` 48.4575
(i) What would be their commitment in rupees, if they enter into a forward contract?
(ii) Will you advise them to do so? Explain giving reasons? [CA – Nov. 03]
Answer:
(i) Value of commitment - `9,83,68,725
(ii) - 0.2885 %. Not to take forward cover.
Q. 16 Fleur du lac, a French company, has shipped goods to an American importer under a letter of credit
arrangement, which calls for payment at the end of 90 days. The invoice is for 1,24,000 $. Presently the
exchange rate is 5.70 French francs to the $ if the French franc were to strengthen by 5 % by the end of 90
days, what would be the transactions gain or loss to exporter in French francs? If it were to weaken by 5 %,
what would happen? [Study material]
Answer:
(a) Transaction loss - `33,480
(b) Transaction gain - `37,200
Q. 17 A company operating in Japan has today effected sales to an Indian company, the payment being due
3 months from the date of invoice. The invoice amount is 108 lakhs yen. At today’s spot price, it is
equivalent to `30 lakhs. It is anticipated that the exchange rate will decline by 10 % over the 3 months
period and in order to protect the yen payments, the importer proposes to take appropriate action in the
foreign exchange market. The 3 months forward rate is presently quoted as 3.3 yen per rupee. You are
required to calculate the expected loss and to show how it can by hedged by a forward contract.
[CA – Nov. 03]
Answer:
(a) Expected loss – `3.33 lakhs
(b) Loss due to forward cover - `2.73 lakhs
Q.18 A UK company, is due to receive 5,00,000 Northland dollars in six month’s time for goods supplied.
The company secedes to hedge its currency exposure by using the forward market. The spot rate of
exchange is 2.5 Northland dollars to the pound. The forward rate of exchange is 2.5354 Northland dollars
to the pound. Calculate how much UK company actually gains or losses as a result of the hedging
transaction if at the end of the six months, the pound in relation to the Northland dollar, has (i) gained 4 %,
(ii) lost 2 % or (iii) remained stable. [Study material]
Answer:
(a) Gain due to hedging – 4,899.85
(b) Loss due to hedging – 6,874.09
(c) Loss due to hedging – 2,792.46

Q.19 A company is considering hedging its foreign exchange risk. It has made a purchase on 1 st January,
2008 for which it has to make a payment of US $ 50,000 on September 30, 2008. The present exchange
rate is 1 US $ = ` 40. It can purchase forward 1 US $ at ` 39. The company will have to make a upfront
premium of 2 % of the forward amount purchased. The cost of fund to the company is 10 % per annum
and the rate of corporate tax is 50 %. Ignore taxation. Consider the following situations and compute the
profit / loss the company will make, if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is `42 per US $.
(ii) If the exchange rate on September 30, 2008 is `38 per US $. [CA – May, 2008]
Answer:
(a) Net gain - `1,08,075
(b) Loss - `91,925
Q. 20 A operating a garment store in US has imported garments from Indian exporter of invoice amount of
`1,38,00,000 (equivalent to 3,00,000 $). The amount is payable in 3 months. It is expected that the
exchange rate will decline by 5 % over 3 months period. A is interested to take appropriate action in
foreign exchange market. The three month forward rate is quoted at `44.50. You are required to calculate
expected loss which A would suffer due to this decline if risk is not hedged. If there is loss, then how he
can hedge this risk. [RTP – May, 2011]
SOLUTION:
Invoice amount in ` = 1,38,00,000
$ equivalent value = $ 3,00,000
Spot rate: 1 $ = 1,38,00,000 / 3,00,000
1 $ = `46
Expected spot rate: 1 $ = 46 (1 – 0.05)
1 $ = 46 * 0.95 = 43.70
Statement of profit / loss without hedging:
Cost of `1,38,00,000 at present (1,38,00,000 / 46) $ 3,00,000
Cost of `1,38,00,000 if no cover (1,38,00,000 / 43.70) $ 3,15,789
Loss $ 15,789
Statement of profit / loss due to hedging
Present cost $ 3,00,000
Cost if forward cover is taken at 44.50 (1,38,00,000 / 44.50) $ 3,10,112
Loss 10,112
Q. 21 At the end of the of July, 2007, an Indian company has an export exposure of EUR 50,000 due at the
end of August 2007. EUR is not directly quoted against INR. The current spot rates are INR 46 / USD and
EUR 2.30 / USD. It is estimated that EUR will depreciate to EUR 2.5 level against USD and that INR will
depreciate against USD to INR 47. One month forward rate at the end of July 2007 are EUR 2.45 / USD
and INR 47.04 / USD.
(a) Calculate expected loss if hedging is not done. How the position will change with the company taking a
forward cover?
(b) If spot rate on 31st August 2007 are eventually EUR 2.52 / USD and INR 47.88 / USD is the decision to
take forward cover justified?
Answer:
(a) Expected loss if no hedging – `60,000
Loss due to forward cover - `40,000
Saving in loss = `20,000
(b) Expected loss if no hedging - `50,000
Saving in loss due to forward = `10,000

QUESTIONS RELATED TO EXTENSION/ CANCELLATION/ EARLY DELIVERY OF FORWARD

CONTRACT
Q. 22 A customer with whom the bank had entered into 3 month’s forward purchase contract for Swiss
Francs 10,000 at the rate of `27.25 comes to the bank after 2 months and requests cancellation of the
contract. On the date, the rates prevailing are:
Spot: CHF 1 = ` 27.30 / 27.35
One month forward: CHF 1 = ` 27.45 / 27.52
What is the loss / gain to the customer on cancellation? [CA – May, 02]
HINT: Total loss on cancellation recovered from customer: `2,700
Q. 23 A customer with whom the bank had entered into 3 month’s forward purchase contract for Swiss
Francs 1,00,000 at the rate of ` 36.25 comes to the bank after 2 months and requests cancellation of the
contract. On this date, the rates are:
Spot: CHF 1 = ` 36.30 / 36.35
One month forward: CHF 1 = ` 36.45 / 36.52
Determine the amount of profit or loss to the customer due to cancellation of the contract.
[CA – May, 04]
Answer: Applicable rate - `36.52
Total loss recovered from customer - `27,000
Q.24 NBA bank Ltd. transacted on August 19, 2010 the following:
(i) Sold $ 1,00,000 two months forward to Alpha Manufacturing Co. Ltd. at `44.50.
(ii) Purchase EURO 10,00,000 two months forward from Beta Trading Co. Ltd. at `47.20.
On October 19, 2010 both the customers approached the bank. Alpha Manufacturing Co. wants the
forward contract to be cancelled while Beta Trading Co. wants the contract to be extended by one month.
The following exchange rates prevailed on that day:
`/$ ` / EURO
Spot 44.60 / 65 47.75 / 85
One month forward 44.75 / 85 48.00 / 48.20
Based on the above information (ignore interest etc.), you are required to:
(i) Calculate the amount to be paid to or received from Alpha Manufacturing Co. due to the cancellation of
the forward contract.
(ii) Calculate the amount to be paid to or recovered from Beta Trading Co. due to the extension of the
forward contract. [CWA – Dec. 06]
Answer:
(a) Total gain - `10,000
(b) Loss due to extension - `6,50,000
Q.25 A bank entered into a forward sale contract with a customer for US $ 5,00,000 due September 15 at
the rate of 1 $ = ` 34.60. On September 15, customer requests the bank to cancel the contract. What will be
the cancellation charges if the following is the spot rate in the interbank market:
1 $ = ` 34.5000 / 34.5225. Exchange margin to be loaded by the bank is 0.080 %.
Answer: Total loss - `65,000
Q.26 A bank booked a forward purchase contract for $ 2,50,000 with a customer at the rate of 1$ = ` 34.50
due October 30th 2005. On the due date customer requests the bank to cancel the contract. The rates ruling
in the interbank market on October 30, 2005 are as under:
Spot rate: 1$ = 34.9025 / 35.2050. What will be the cancellation charges of the bank if bank load 0.150%
for their exchange margin.
Answer: Total loss - `1,90,000

Q.27 A customer with whom the bank had booked a forward purchase contract for $ 2,00,000 at `43.52.
However, on the maturity date your customer requested you to extend contract by one month. Assuming
the interbank market rates for US $ are as under:
Spot rate: 1$ = `43.6925 / 7075
1 month forward: 600 / 700
2 months forward: 900 / 1,000
3 months forward: 1200 / 1300
What will be the extension charges payable by your customer bearing in mind that you require an
exchange margin of 0.08 % for TT buying and 0.10 % for TT selling? Also determine the new forward
rate.
SOLUTION
Forward sale contract
Forward purchase contract Due date

$ 2,00,000 @ 43.52 Spot rate: 43.6925 / 43.7075
Since customer approaches for extension of contract by 1 month, so original contract is cancelled and bank
has to go in spot market for purchase of $ 2,00,000 at higher rate i.e. 43.7075.
Calculation of extension charges:

(A) Rate applicable due to extension:
Market selling rate 43.7075
Add: Margin @ 0.10 % 0.0437 43.75
(B) Original contract rate 43.52

Loss due to extension 0.23
Exposure amount 2,00,000
Total loss / extension charges 46,000
Forward purchase contract at bid rate:
Spot bid rate 43.6925
Add: Swap point 0.0600 43.7525
Less: Margin @ 0.08 % 0.0350
New forward rate 43.7175
Q.28 Date of maturity of forward purchase contract: April 30th 2002

Amount: $ 2,50,000
Contract rate: 1$ = `49.4500
Date of booking: 1 January, 2002
On March 1, 02 the customer requests to extend the forward contract for May 31 st 2002. Interbank market
rates on March 1, 02:
Spot: 1$ = `48.9325 / 48.9650
Forward spot/ March 2000 / 2100
Spot / April 4200 / 4500
Spot / May 6300 / 6700
Compute extension charges payable / receivable. You are allowed to load an exchange margin of 0.08 %
on TT buying and 0.15 % on TT selling rate.

SOLUTION:
1st March Forward sale contract
st
1 Jan.
Forward purchase contract spot rate Due date

$ 2,50,000 @ 49.4500 48.9325 / 48.9650 30th April
Since customer requests for extension up to 31st May but bank has to fulfil contract on 30 th April. Bank has
to book a forward contract with market due on 30th April at ask rate.
Statement showing extension charges:
(A) Spot rate on date of extension 48.9650
Add: Swap points 0.4500
49.4150
Add: Margin @ 0.15 % 0.0741 49.4891
Less: Original contract rate 49.4500
Loss per $ 0.0391
Total loss / extension charges 9,775

Spot rate on extension (bid rate since bank purchase) 48.9325
Add: Swap points 0.6300
49.5625
Less: Margin @ 0.08 % 0.0397
New forward rate 49.5228
Q.29 On 30th June 2009 when a forward contract matured for execution you are asked by an importer
customer to extend the validity of the forward sale contract for US $ 10,000 for a further period of three
months.
Contracted rate: 1$ = `41.87
The US$ quoted on 30.6.2009:
Spot rate: 1$ = `40.4800 / 40.4900
Premium July: 0.1100 / 0.1300
Premium August: 0.2300 / 0.2500
Premium September: 0.3500 / 0.3750
Calculate the cost for your customer in respect of the extension of the forward contract. Rupee values to be
rounded off to the nearest rupee. Margin 0.080 % for buying and 0.25 % for selling rate.
[RTP – May, 2010]
Answer:
(a) Applicable rate - `40.4476 or 40.45
(b) Total loss - `14,200
(c) New contract rate - `40.9672 or 40.97
Q.30 Your import customer requested you to him Danish Kroners (DKR) 12,50,000 six months forward at
`7.0200. However, after two months, customer requests cancellation of the contract. The rates prevailing
on that day are:
Spot: USD 1 = DKR 6.2800 / 2900
4 months forward 900 / 850
Spot USD 1 = `42.6125 / 6200
4 months forward 42.6800 / 6925
Exchange margin is 0.10%. Calculate gain or loss to customer, if any?
Answer: Applicable cross rate (Buy DKR and sell `)

1 DKR = 6.8783

Applicable rate for cancellation - `6.8714

Total loss - `1,85,750
Q.31 A company entered into an agreement with its banker on 15th March, for a forward sale contract for
DEM 4,000 delivered on 1st July at the rate of 28.14 per mark. On 15th April, the company requested the
bank to sell the bill for DEM 4,000 under this contract. Calculate the amount payable/ receivable to the
company assuming the following rates on 15 th April:
Spot rate: 1 DEM = `28.1025 / 1075
Delivery July: 28.6475/6550
Ignore interest and the penal provisions under FEDAI rules.
Answer: Swap gain - `2,160
Q. 32 A person has to make payment of USD 3,00,000. Payment is to be done in three equal yearly
instalments. Assuming the following rates are available:
A. Today 1 year forward rate: 42 / 42.50
B. At the end of 1st year Spot rate: 43 / 43.10
1 year forward rate: 43.4/ 43.50
C. At the end of 2nd year Spot rate: 44 / 44.10
1 year forward rate: 44.50 / 44.60
D. At the end of 3rd year Spot rate: 45/ 45.10
Find the amount he has to pay in rupees in the following three cases:
(i) No hedging
(ii) Rupee roll over forward
(iii) Three separate forward contracts, one today, 1 year and 2 years from today.
Answer:
(i) No hedging - `43,10,000; `44,10,000; `45,10,000
(ii) Rupee roll over - `41,50,000; `43,00,000; `44,60,000
(iii) Forward cover – `42,50,000; `43,50,000; `44,60,000
Q. 33 A Ltd. Exports edible oils to Middle – East and African countries. In June the company exported an
assignment worth $ 5 million to Jambia. The payment for the same is expected to realize during the month
of September. For the company has entered into an option forward contract for delivery of $ 5 million over
the month of September. The market quotes on June 30 at the time of entering into the contract were as
follows:
June 30 Spot `/$ 47.05 / 08
1 month 23/25
Forward rate 2 month 47/49
3 month 70/72
On September 1, the company approached the bank for extension of the contract by another two months,
that is for delivery during the month of November. The market quotes on September 01 were as follows:
Spot rate `/$ 47.58/ 60
1 month 18/20
Forward rate 2 month 37/39
3 month 55/57
On November 01, the company approached the bank to cancel the forward contract. The exchange rates as
on November 01, were as follow:
Spot `/$ 47.97 / 99
Forward 1 month 16/18
2 month 33/35
You are required to calculate:
(a) The forward rate to be quoted to A Ltd.
(b) The exchange rate to be quoted be the bank on September 01 for the extension of the contract.
(c) The amount of cash flows due to extension of the contract.

(d) The exchange rate at which the forward contract to be cancelled on November 01.
(e) The amount of cash flows due to cancellation of the contract. [CWA – June, 2010]
Answer:
(a) Applicable rate - `47.52
(b) Exchange rate quoted on extension - `47.95
(c) Extension charges - `14,00,000
(d) Exchange rate on cancellation of contract – 48.17
(e) Cash flow due to cancellation - `11,00,000
QUESTIONS RELATED TO MONEY MARKET HEDGE AND FORWARD COVER:
Q. 34 MN a UK company, has a substantial portfolio of its trade with American and German companies. It
has recently invoiced a US customer the sum of $ 50,00,000, receivable in one year’s time. MN finance
director is considering two methods of hedging the exchange risk:
Method: 1- Borrowing present value of $ 5 million now for one year, converting the amount into sterling
and repaying the loan out of eventual receipts.
Method: 2- Entering into a 12 month forward exchange contract with the company’s bank to sell the $ 5
million.
The spot rate of exchange is £ 1= US $ 1.6355. The 12 month forward rate of exchange is £ 1= US $
1.6125. Interest rate for 12 months are USA 3.5 % and UK 4 %. You are required to calculate the net
proceeds in sterling under both methods and advise the company. [CWA – June. 04]
SOLUTION:
Method 1:
Borrow P.V. of 50,00,000 $ = 50,00,000 /1.035 = 48,30,918$
Convert into sterling at spot rate = 48,30,918 / 1.6355 = 29,53,787 ₤
Deposit ₤ @ 4% for 1 year
4
Total inflow after 1 year = 29,53,787 + (29,53,787  ) = 29,53,787 + 1,18,151 = 30,71,938₤
100
Method 2: Forward Hedging
Total Inflows = 50,00,000/1.6125 = 31,00,775 ₤
Decision: Go for forward hedging
Q. 35 The finance director of M Ltd. has been studying exchange rates and interest rates relevant in India
and USA. M Ltd. has purchased goods from the US Co. at a cost of $ 40.50 lakhs payable in $ in 3 months
time. In order to maintain profit margins the finance director wishes to adopt, if possible a risk – free
strategy that will ensure that the cost of goods to M Ltd. is no more than `18 crores:
` / $ spot: ` 41 / 43
` / $ (1 month forward) ` 42 / 44
` / $ (3 months forward) ` 43 / 46
Interest rate available of M Ltd.:
India (rates in %) USA (rates in %)
Deposit Borrowing Deposit Borrowing
1 month 9.00 12.0 4.0 7.0
3 months 9.00 13.0 5.0 8.0
Calculate whether is it possible for M Ltd. to achieve a cost directly associated with transaction not more
than `18 crore, by means of a forward market hedge or money market hedge. Ignore transaction costs.
[CWA – June, 06]
SOLUTION:
Option 1: MMH
FC Receivables:
FC. Liability
Discounted value of liability
40,50,000 $ 40,50,000 40,50,000
.05 = = 40,00,000 $
3M 1+ ×3 1.0125
12

Loan amount:
40,00,000 $ 43
Step 1: Borrow `17,20,00.000 for 3 months @ 13% p.a.

Step 2: Purchase $ at spot rate i.e. 1$ = 43
Hence $ = 17,20,00,000 /43 = 40,00,000 $
Step 3: Invest 40,00,000$ @ 5% p.a. for 3 months
Step 4: Realize investment in FC and paid FC liability
Step 5: Reply home currency loan with interest
Cash outflow after 3 months : 17,20,00,000 + (17,20,00,000 13% 3/12) = 17,75,90,000 `
Amount payable in 3 month time = 40,50,000$
3 month forward rate: 1 $ = 46`
Total Cash outflow after 3 months = 40,50,000 46 = 18,63,00,000
Decision: Since cash outflow is less in close of MMH, Hence it is suggested to choose MMH
Q. 36 The Chief Finance Officer (CFO) of Yati Ltd. hass been studying the exchange rates and interest
rates relevant to India and USA. Yati Ltd. purchased materials from an American company at a cost of US
$ 5.05 millions, payable in US $ in 3 months time. In order to maintain profits margins, the CFO wishes to
adopt, if possible, a risk free strategy that will ensure that the cost of the goods to Yati Ltd. does not
exceed `21 crores.
Exchange rates Bid rate (` / US $ 1) Ask rate (` / US $ 1)
Spot rate 40.35 40.65
1 month forward 41.20 41.50
3 months forward 42.15 42.50
Interest rates (available to Yati Ltd.):
India (rates in %) USA (rates in %)
Deposit Borrowing Deposit Borrowing
1 month 5.0 12.0 3.0 8.0
3 months 6.0 13.0 4.0 9.0
Calculate whether it is possible for Yati Ltd. to achieve a cost directly associated with this transaction of
no more than ` 21 crores, by means of a forward hedge or money market hedge. Transaction costs may be
ignored. [CA - RTP]
SOLUTION:
Option 1: MMH
FC Receivables:
FC. Liability 50,50,000 50,50,000
50,50,000 $ .04 = = 50,00,000
3M 1+
12
×3 1.01
Borrow in HC:
50,00,000  40.65= 20,32,50,000
Step 1: Borrow `20,32,50,000 for 3 months @ 13% p.a.
Step 2: Convert borrowed amount in $ at spot rate to be invested
20,32,50,000
In FC = 50,00,000 $
40.65
Step 3: Invest 50,00,000$ for 3 months at 4% rate
Step 4: Realize investment after 3 months and paid FC liability
Step 5: Reply home currency loan with interest
13 3
Hence, Total cash outflow under, MMH = 20,32,50,000 + 20,32,50,000  
100 12
= 20,32,50,000 + 66,05,625 = 20,98,55,625


Payment in $ after 3 month period = 50,50,000$
Forward rate: 1 $ = 42.50 `
Cash outflow = 50,50,000 42.50 = 21,46,25,000
Decision: GO for MMH.
Q. 37 An exporter is a UK based company. Invoice amount is $ 3,50,000. Credit period is three months.
Exchange rates in London Rate of interest in money market
Particulars Exchange rates Currency Deposit Loan
Spot rate ($ / £) 1.5865 – 1.5905 $ 7% 9%
3 month forward rate ($ / £) 1.6100 – 1.6140 £ 5% 8%
Compute and show how a money market hedge can be put in place. Compare and contrast the outcome
with a forward contract. [CA – Nov. 08]
SOLUTION:
Option 1: MMH
FC payables:
FC. Receivables 3M 3,50,000 3,50,000
3,50,000 $ .09 = = 3,42,298.29 $
1+ ×3 1.0225
12
Deposit 2,15,214.27 ₤ for 3 Convert 3,42,298.28 $ in ₤ at Spot

months at 5% rate = 3,42,298.29/1.5905 =
2,15,214.27 ₤
Step 1: Borrow P.V. of 3,50,000 $ = 3,50,000/1.0225 = 3,42,298.29 $

Step 2: Convert in to ₤ at spot rate = 3,42,298.29/1.5905 = 2,15,214.27 ₤
Step 3: Deposit 2,15,214.27₤. for 3 months at 5%
Step 4: on maturity realize from debtors and paid FC loan.
Step 5: Amount received from deposit with interest
Hence, inflow = 2,14,215.27 + 2,690.18 = 2,17,904.45

Invoice amount = 3,50,000 $
3 month forward rate 1₤ = 1.6100/1.6140
Hence, inflow = 3,50,000 /1.6140 = 2,16,852.54 $
Decision: Go for money market hedge.
Q.38 F Ltd. is a medium size UK company with export and import trade with the USA. The following
transactions are due within next 6 months.
Sale of finished goods, cash receipt due in three months $ 1,97,000
Purchase of finished goods, cash payment due in 6 months $ 2,93,000
Exchange rates (London market):
$/£
Spot £ 1 = $ 1.7106 / 1.7140
Three months forward £ 1 = $ 1.7024 / 1.7063
Six months forward £ 1 = $ 1.6967 / 1.7006

Calculate the net sterling pound receipts and payments that F Ltd. might expect for both its three and six
months transactions if the company hedges foreign exchange risk on (1) Forward foreign exchange market
(2) On money market operation basis. You may assume following interests rates:
Borrowing Lending
Pound 12.50 % 9.50 %
$ 9% 6%
SOLUTION:
(A) 3 Months receivables
Alternative: 1 Forward cover
Amount receivable in 3 months $ 1,97000
Applicable forward rate (Per £) 1.7063 $
Amount received due to forward cover (1,97,000 / 1.7063) 1,15,454
Alternative: 2 Money market hedge
FC payables:
FC. Receivables 3M 1,97,000 1,97,000
1,97,000 $ .09 = = 1,92,665 $
1+ ×3 1.0225
12
Deposit 1,12,407 ₤ for 3 Convert 1,92,665 $ in ₤ at Spot

months at 9.5% rate = 1,92,665 / 1.7140 = 1,12,407
₤
Hence, Inflow = 1,12,407 + [1,12,407 * 9.50 % * 3/12]

1,12,407 +2,670 = 1,15,077 £
Decision: Go for forward hedging.

(B) 6 – Months receivables:
Amount receivable in 6 months 2,93,000
Applicable rate (Per £) 1.6967
Amount payable (2,93,000 / 1.6967) 1,72,688.16
MMH
FC Receivables:
FC. Liability 2,93,000 2,93,000
2,93,000 $ .06 = = 2,84,466.02
1+ ×6 1.03
12
Borrow in HC:
2,84,466.02 / 1.7106 = 1,66,296.05£
Hence, cash outflow = 1,66,296.05 + 10,393.50 = 1,76,689.55
Q. 39 An Indian company has availed the services of two London based interior decorators and are
required to pay GBP 50,000 in 3 months. From the following information, advice the course of action to
minimize rupee outflow –
Foreign exchange rates (` / GBP) Money market rates (p.a.)
Bid Ask Deposit Borrowings

Spot ` 81.60 ` 81.90 GBP 6% 9%

3 – month forward ` 82.70 ` 83.00 ` 8% 12 %
Answer:
(a) Cash flow under MMH - `41,55,516
(b) Cash flow under forward cover - `41,50,000
Q.40 An Indian exporting firm, Rohit and Bros. would be cover itself against a likely depreciation of
pound sterling. The following data is given:
Receivables of Rohit Bros. £ 5,00,000
Spot rate 1 £ = `56
Payment date 3 months
3 months interest rate India: 12 % per annum
UK: 5 % per annum
What should the exporter do? [CA – Nov. 2008]
Answer: Cash flow under MMH - `2,84,83,950.59
Q.41 Wenden Co. is a Dutch – based company which has the following expected transactions.
One month: Expected receipt of £ 2,40,000
One month: Expected payment of £ 1,40,000
Three months: Expected receipts of £ 3,00,000
The finance manager has collected the following information:
Spot rate (1€ = £) : 1.7820 ± 0.0002
One month forward rate (1€ = £) : 1.7829 ± 0.0003
Three months forward rate (1€ = £) : 1.7846 ± 0.0004
Borrowing Deposit
One year euro interest rate 4.9 % 4.6 %
One year sterling interest rate 5.4 % 5.1 %
Assume it is now 1st April.
Required:
(a) Calculate the expected Euro receipts in one month and in three months using the forward market.
(b) Calculate the expected Euro receipts in three months using money market hedge and recommend
whether a forward market hedge or a money market hedge should be used. [CA – RTP, May, 2010]
Answer:
(a) Receipts using forward contract: 1 month - € 56,079; 3 months - € 1,68,067
(b) Receipt under MMH - € 1,67,999.10
QUESTIONS RELATED TO NEETING

Q. 42 The following payments and receipts are to be settled between a parent company in USA and its
three subsidiaries located in Canada, Germany and UK. All amounts are is $:
USA CANADA GERMANY UK
Pay Receipt Pay Receipt Pay Receipt Pay Receipt
USA - - 30 20 35 10 60 40
CANADA 20 30 - - 10 25 40 30
GERMANY 10 35 25 10 - - 30 20
UK 40 60 30 40 20 30 - -
Case1: How bilateral netting would be carried out?
Case 2: How multilateral netting would be carried out?

Solution:
$ 20
USA
$ 30 CANADA
$ 60 $ 15
$35 $40
$ 10 $ 40 $ 30
GERMANY UK
$ 25
$ 30 $ 20
BILATERAL NETTING
USA
$ 10 CANADA
$ 25 $ 20
$10
GERMANY UK
$ 15
$ 10
MULTILATERAL NETTING
USA
$ 15 CANADA
30 + 35 + 60 – 20 – 10 -40
= $ 55 $40 20 + 10 + 40 – 30 – 25 – 30 = -15
GERMANY UK
10 – 35 + 30 – 20 + 25 – 10 = 0 - 40 + 30 – 30 + 20 + 40 – 60 = - 40
Q.43 The following payments and receipts (in million) are to be settled between a parent and its two
subsidiaries:
Payment Receipts
Amount to whom Amount from whom
UK Parent USD 75 USA STG 200 USA
EURO 60 GERMANY STG 100 GERMANY
GERMANY EURO 150 USA USD 125 USA

STG 100 UK EURO 60 UK

USA STG 200 UK EURO 150 GERMANY
USD 125 GERMANY USD 75 UK
Exchange rate:
1STG = EURO 1.5; 1 STG = 1.25 USD; 1 EURO = 8.333 USD
Solution:
60
60 € or = 40 £
1.50
UK GERMANY
100£
200 £
$75 or
75
= 60 £
1.25
125
$125 = = 100 £
1.25
USA
150
150 € = = 100 £
1.50
Multilateral netting
UK
GERMANY
60£
100 – 60+ 200 - 40
= 200 140 £ 40 – 100 + 100 – 100 = -60
USA
60 – 200 + 100 – 100 = - 140
Q.44 Trueview Plc., a group of companies controlled from the United Kingdom includes subsidiaries
in India, Malaysia and United States. As per the CFO’s forecast that, at the end of the June 2010 the
position of inter – company indebtedness will be as follows:
(i) The Indian subsidiary will be owed Rs. 1,44,38,100 by the Malaysian subsidiary and will to owe the US
subsidiary $ 1,06,007.
(ii) The Malaysian subsidiary will be owed MYR 14,43,800 by the US subsidiary and will owe it $ 80,000.
Suppose you are head of central treasury department of the group and you are required to net – off inter –
company balances as far as possible and to issue instructions for settlement of the net balances. For this
purpose, the relevant exchanges rates may be assumed in terms of £ 1 are $ 1.415; MYR 10.215; Rs. 68.10.
What are the net payments to be made in respect of the above balances? [RTP – Nov. 2010]

Solution:
QUESTIONS RELATED TO LEADING AND LAGGING

Q.45 An Indian importer has to make payment of $ 1,00,000 import bill to US party 3 months from now.
Spot rate 1 $ = ` 45.40 / 45.80. 3 months forward rate: 1 $ = ` 46.10 / 46.75.
The US party is willing to offer a cash discount of 2 % for immediate payment. The INR loan borrowing
rate is 14 %. Advise the importer whether he should enter into a forward contract or make lead payment
today?
Solution:
Alternative: 1 Forward cover:
Invoice value $ 1,00,000
Cash outflow after 3 months `46,75,000
Alternative: 2 Lead payment

Invoice value $ 1,00,000
Less: Discount @ 2 % 2,000
Net amount payable $ 98,000
Applicable spot rate 45.80
Cash outflow (Through borrowing) 44,88,400
14 3 1,57,094
Add: Interest @ 14 % for 3 months (44,88,000 x x )
100 12
Cash outflow after 3 months 46,45,494
Decision: Leading option should be preferred.
Q.46 An Indian importer has to settle a bill for $ 1,35,000. The exporter has given the Indian company two
options:
(i) Pay immediately without any interest charge,
(ii) Pay after 3 months, with interest 6 % p.a.
The importer’s bank charges 16 % p.a. on overdrafts. If the exchange rates are as follows, what should the
company do?
Spot rate: 1$ = `48.35 / 48.36
3 months forward rate: 1$ = `48.81 / 48.83
Answer:
Pay immediately - `67,89,744
Pay after 3 months - `66,90,930.75
Q.47 An Indian firm has imported a machine from USA, the invoice is $ 1,00,000/-. The payment is to be
made in 2 months time. The USD rates are quoted in the market as follows:
2 month forward 1$ = `45.30/ 45.36
3 month forward 1$ = `44.80/ 44.85
The importer firm is considering the ‘lagging. The exporter firm will charge interest at the rate of 9% p.a.
if the payment is delayed after it becomes due. Your cost of capital is 12%. Opine.
Answer:
Alternative: 1 – Pay after 2 months - `45,81,360
Alternative: 2 – Pay after 3 months - `45,18,637.50

Q. 48 CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a foreign
supplier in Netherland for the first time and need to pay € 2,50,000 to the supplier in six month’s time. You
as financial manager are concerned that the cost of these supplies may rise in Pound Sterling terms and has
decided to hedge the currency risk of this account payable. The following information has been provided
by the company’s bank:
Spot rate (€ per £): 1.998 ± 0.002
Six months forward rate (€ per £): 1.979 ± 0.004
Money market rates available to CQS plc:
Borrowing Deposit
One year pound sterling interest rates 6.1 % 5.4 %
One year Euro interest rates 4.0 % 3.5 %
Assuming CQS plc has no surplus cash at the present time. You are required to evaluate whether a money
market hedge, a forward hedge or a lead payment should be used to hedge the foreign account payable.
[CA – RTP – May, 2010]
Solution:
Calculation of spot rate:
Bid Ask
Rate as given 1.998 1.998
Adjustment (0.002) 0.002
Spot rate 1.996 2.000
Calculation of forward rate:
Bid Ask
Rate as given 1.979 1.979
Adjustment (0.004) 0.004
Amount payable € 2,50,000
2,50,000 1,26,582.28
Cash flow due to forward cover ( )
1.975
Alternative: 2 Lead payment

Today’s payment € 2,50,000
Spot rate 1.996
2,50,000 1,25,250.50
Amount to be borrowed today for payment
1.996
Cash outflow at t = 6 months:
Repayment of loan 1,25,250.50
Add: Interest @ 6.10 % for 6 months 3,820.14
Net cash outflow 1,29,070.64
Q. 49 NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three months. The
company has also exported goods for US $ 4,50,000 and this amount is receivable in two month. For
receivable amount a forward contract is already taken at `48.90.
The market rates for ` and Dollar areas under:
Spot ` 48.50 / 70
Two month 25 / 30 point
Three month 40/45 point
The company wants to cover the risk and it has two options as under:
(a) To cover payables in the forward market and
(b) To lag the receivables by one month and cover the risk only for net amount. No interest for delaying
the receivables is earned.
Evaluate both the options if the cost of Rupee fund is 12 %. Which option is preferable?
[CA - May, 2012]
Solution:
Option: 1 To cover payables and receivables in forward market:

Amount payable after 3 months $ 7,00,000

Applicable forward rate (48.70 + 0.45) 49.15
Total amount payable (7,00,000 * 49.15) 3,44,05,000
(B) Amount receivable after 2 months $ 4,50,000

Contracted forward rate 48.90
Amount receivable after 2 months (4,50,000 * 48.90) 2,20,05,000
Assuming cash inflow received after 2 months will be deposited for 1 2,20,050
month @ 12 % per annum and hence interest received for 1 month will be
Total cash flow after 3 months 2,22,25,050
Hence, net cash outflow = 3,44,05,000 – 2,22,25,050 = 1,21,79,950
Option: 2 Lag the receivable by one month

Since the forward contract was already booked it shall be cancelled if we lag the receivables. Accordingly,
and profit / loss on cancellation of contract shall also be calculated.
Forward purchase contract Rate: 48.50 / 48.70

$ 4,50,000 @ `48.90 swap point: 25 / 30
Calculation of forward rate:

Bid Ask
Spot rate 48.50 48.70
Add: Swap points 0.25 0.30
Calculation of gain / loss on cancellation:

Applicable rate due to cancellation of contract (Market ask rate) 49.00
Original contract rate 48.90
Loss due to cancellation 0.10
Total loss on cancellation 45,000
Cash flow after netting:

Amount payable $ 7,00,000
Amount receivable $ 4,50,000
Net amount payable 2,50,000
Applicable rate (48.70 + 0.45) 49.15
Amount payable (2,50,000 * 49.15) 1,22,87,500
Statement of net cash flow under option: 2

Net amount payable 1,22,87,500
Loss on cancellation of forward contract 45,000
Decision: Since net outflow under option 1 is lower, option 1 shall be preferred.
QUESTIONS RELATED TO COVER RATE / COVER DEAL/ PROFIT OR LOSS OF DEALERS
Q. 50 A dealer sold 1 lakh Hong Kong Dollar @ `6.37 and cover himself in London market on the same
day when the existing rate were:
US$ 1 = HK $ 7.5780 / 7.5810
Local bank rate for US $ were:

Spot rate US $ 1 = `47.20 / ` 47.40

Calculate cover rate and ascertain profit or loss in the deal. [CA – June, 09]
Solution:
.
Forward purchase contract
1 $ = HK $ 7.5780 / 7.5810
1 $ = `47.20 / 47.40

HK$ 1,00,000 @ `6.37
Since bank has to book forward purchase contract with market to cover itself, applicable rate should be ask
rate.
1 HK $ = ` [sell HK $ and buy `]
Sell HK $ and buy $ at 7.5780
Sell $ and buy ` at `47.40
So, 7.5780 HK $ = `47.40
47.40
1 HK $ = = 6.2549
7.5780
Statement showing gain / loss of dealer:

Applicable rate of sale contract 6.37
Applicable rate of purchase contract 6.2549
Gain per HK $ 0.1151
Total gain 11,510
Q.51 You sold HK $ 10 million value spot to your customer at ` 5.70 and covered in London market on
the same day, when the exchange rates were 1 $ = HK $ 7.5880 / 7.5920. Local interbank market rates for
US $ were spot: 1 $ = `42.70 / 42.85.
Calculate cover rate and ascertain profit or loss in the transaction. Ignore brokerage.
Solution:
.
1 $ = HK $ 7.5880 / 7.5920
1 $ = `42.70 / 42.85

$ 10 million @ `5.70
Since bank has to book forward purchase contract with market to cover itself, applicable rate should be the
ask rate.
1 HK $ = `
Market sell HK $ and buy `
Sell HK $ and buy $ at 7.5880 (i.e 1 $ = 7.5880 HK$)
Sell $ and buy ` at `42.85 (1 $ = `42.85)
7.5880 HK $ = `42.85
42.85
1 HK $ = = 5.6471 or 5.65
7.5880
Statement showing gain / loss of dealer:

Gain per HK $ 0.05
Contract size 1,00,00,000
Total gain 5,00,000
Q. 52 A bank sold Hong Kong Dollars 40,00,000 value spot to its customer at `7.15 and covered itself in
London Market on the same day, when the exchange rates were:

1 $ = HK $ = 7.9250 / 7.9290
Local interbank market rates for US $ were:
Spot rate: 1 $ = `55.00 / 55.20.
You are required to calculate rate and ascertain the gain or loss in the transaction. Ignore brokerage. You
have to show the calculations for exchange rate up to four decimal points. [CA- May, 2013]
Solution:
.
1 $ = HK $ 7.9250 / 7.9290
1 $ = `55.00 / 55.20

HK$ 40,00,000 @ `7.15
Since bank has to book forward purchase contract with market to cover itself, applicable rate should be the
ask rate.
1 HK $ = ` i.e Sell HK $ and buy `
Sell HK $ and buy $ at 7.9250
Sell $ and buy ` at 55.20
7.9250 HK $ = `55.20
55.20
1 HK $ = = 6.9653
7.9250
Statement showing profit / loss of dealer:

Gain to bank 0.1847
Total gain 7,38,800
QUESTIONS RELATED TO INTEREST RATE SWAP
Q. 53 Company ABC and XYZ have been offered the following rates per annum on a Rs. 200 lakhs five
year loan:
Company Floating rate Fixed rate
ABC Libor + .1 % 12 %
XYZ Libor + 0.6 % 13.4 %
Company ABC requires a floating rate loan; Company XYZ requires a fixed rate loan. Design a swap that
will net a bank acting as intermediary 0.1 % per annum and be equally attractive the both companies. Find
out the advantageous interest rate for the two companies.
SOLUTION:
Step: 1 Identify absolute advantage party.
Company ABC‘s benefit in fixed market = 1.40
Company ABC’s benefit in floating market = 0.50
Hence company ABC is the absolute advantage party.
Step: 2 Decide the market for both parties. First decide market of absolute advantage party and the other
party’s market get automatically decided.
ABC Company should go in fixed market and XYZ Company should go in floating market.

Step: 3 Structure of IRS can be shown as under:

L + 0.60
12 %
Company ABC Company XYZ
Fixed @ 12 % Floating @ L + 0.60

12 %
Bank Swap dealer Bank

L + 0.60
Step: 4 Statement of gain / loss due to interest rate swap and allocation of swap gain:
ABC XYZ
(A) Cost due to IRS:
ABC pays L + 0.60 -
XYZ Pays 12
(B) Cost without IRS L + 0.10 13.40
Gain / (loss due to IRS) (0.50) 1.40
Net gain 0.90
Less: Dealer’s margin 0.10
Net gain 0.80
Share of each party 0.40 0.40
Step: 5 Statement of effective rate:

ABC XYZ
Cost without IRS L + 0.10 13.40
Less: Share in gain due to IRS (0.40) (0.40)
Effective rate L – 0.30 13.00
Q. 54 ABC Ltd. is a financial institution which enjoys very good credit rating. It lends at floating rates and
borrows at fixed and it has risk of floating rates fall. XYZ is a manufacturing company enters into a fixed
price contract to purchase machinery. It has higher funding costs, whether fixed or floating. It has risk of
losses if funded on a floating rate basis. The relative borrowing costs of ABC Ltd. and XYZ Ltd. are as
follows:
Company Floating rate Fixed rate
ABC Ltd. (Financial institution) Libor 8%
XYZ Ltd. (Manufacturing company) Libor + 1 % 10%
Differential borrowing cost 1 2
What is the saving for both the companies?
SOLUTION:
Step: 1 Identify the absolute advantage party
Advantage of ABC in fixed market = 2
Advantage of ABC in floating market = 1
Step: 2 Decide the market for both parties. First decide market of absolute advantage party and the other
party’s market get automatically decided.
ABC Company should go in fixed market and XYZ Company should go in floating market.

L + 1.00
Company ABC Company XYZ
8%
Fixed Floating @ L + 1.00
@8%
Bank Bank
ABC XYZ
ABC pays L + 1.00 -
XYZ Pays 8
(B) Cost without IRS L 10
Gain / (loss due to IRS) (1) 2
Net gain 1.00
Less: Dealer’s margin -
Net gain 1.00

ABC XYZ
Cost without IRS L 10
Effective rate L – 0.50 9.50
Q. 55 Company A has outstanding debt on which it currently pays fixed rate of interest at 9.5 %. The
company intends to refinance the debt with a floating rate of interest. The best floating rate it can obtain is
Libor + 2 %. However, it does not want to pay more than Libor. Another company B is looking for a loan
at a fixed rate of interest to finance its exports. The best rate it can obtain is 13.5 % bit it cannot afford to
pay more than 12 %. However, one bank has agreed to offer finance at a floating rate of Libor + 2 %. Citi
bank is in the process of arranging an interest rate swap between these two companies.
(i) With a schematic diagram, show how the swap deal can be structured.
(ii) What are the interest saving by each company?
(iii) How much would Citi bank receive? [CWA – Dec. 05]
SOLUTION:
(i) Structure of interest rate swap
L + 2.00
9.50 %
Company A Company XYZ
Fixed @ Floating @ L + 2
9.50 % 12 %

L
(ii) Calculation of interest saving by each party:
Company A Company B
(A) Cost due to swap:

Paid to swap dealer L 12

Received from swap dealer 9.50 L+2
Paid to bank 9.50 L+2
Net cost due to swap L 12
(B) Cost without swap L+2 13.50
Saving of party 2 1.50
Statement of gain earned by city bank:

Received from A L
Paid to A (9.50)
Received from B 12
Paid to B L+2%
Gain of city bank 0.50
Q. 56 Yorkshire Industries a British industries firm with a US Subsidiary seeks to refinance some of its
existing British pound debt to include floating rate obligations. The best floating rate if can obtain in
London is LIBOR + 2.0%, but cannot afford more than L. Its current debts are as follows:
(i.) $ 10 Million owed to Citibank at 9.5% (fixed annually); and
(ii) £ 5 Million owed to Midland Bank at 9.5% (fixed) annually.
Huron River Salt Company wishes to Finance exports to Britain with £ 3 million of pound rate in London
for less than 13.5% interest because of its lack of credit history in the U.K. however, Lloyds Bank is
willing to extend a floating rate British pound Loan at LIBOR + 2%. Huron, however, cannot afford to pay
more than 12%. How can Yorkshire and Huron help one another via an interest rate swap? Assume that
Yorkshire is in a strong bargaining position and can negotiable the best deal possible, but Huron will not
pay over 12%, Assume further that transaction costs are 0.5% and exchange rates do not change. Illustrate
the effective post-swap interest rates of each party with boxes and arrows. What are the interest savings by
each party over the six months period of the swap? [CWA – June, 07]
SOLUTION:
(i) Structure of interest rate swap
L + 2.00
9.50 %
Yorkshire Huron
Fixed @ Floating @ L + 2
9.50 % 12 %

L
(ii) Calculation of interest saving by each party:

Yorkshire Huron
Paid to swap dealer L 12
Received from swap dealer 9.50 L+2
Paid to bank 9.50 L+2
Net cost due to swap L 12
(B) Cost without swap L+2 13.50
Saving of party 2 1.50
Statement of gain earned by swap dealer:

Received from A L
Paid to A (9.50)
Received from B 12

Paid to B L+2%
Q. 57 MUMBAI LTD. is an Indian Company; they are in the process of raising a US dollar loan and are
negotiating the rates with City Bank. The Company has been offered a fixed rate of 7% p. a. with a proviso
that should they opt for a floating rate, the interest rate is likely to be linked to the Bench mark rate of 60
basis points over the 10 years US T Bill rate, with interest re fixation on a three monthly basis. The
expectations of Mumbai Ltd are that the dollar interest rates with fall, and are inclined to have a flexible
mechanism built into their interest rates. On enquiry they find that they could go for a swap arrangement
with Chennai India Ltd. Who have been offered a floating rate of 120 basis points over 10-year US T Bill
Rate, as against a fixed rate of 8.20% Describe the swap on the assumption that the swap differential is
shared between Mumbai Ltd and Chennai India Ltd. in the preparation of 2:1. [CWA – June, 08]
SOLUTION:
Available interest rates are as follows:
Mumbai Ltd. Chennai Ltd.
Fixed rate 7% 8.20 %
Floating rate Bench mark + 60 BP Bench mark + 120 BP
Step: 1 Identify absolute advantage party

Advantage of Mumbai Ltd. in fixed market = 1.20
Advantage of Mumbai Ltd. in floating market = 60 BP or 0.60
Hence absolute advantage party = Mumbai Ltd.
Step: 2 Decide market for both party.

Mumbai Ltd. should go in fixed market and Chennai Ltd. should go in floating market.
Bench mark + 1.20

7%
Fixed Floating @
@7% Bench mark + 1.20
Bank Bank
Mumbai Ltd. pays Bench mark + 1.20 -
Chennai Ltd. Pays 7
(B) Cost without IRS Bench mark + 0.60 8.20
Gain / (loss) due to IRS (0.60) 1.20
Net gain 0.60
Less: Dealer’s margin -
Net gain 0.60

Cost without IRS Bench mark + 0.60 8.20
Effective rate Bench mark + 0.20 8.00

Q.58 X Company Ltd. And Y Company Ltd. Both wish to raise US 40 M Dollar’s Loan for five years, X
Company Ltd. has the choice of issuing fixed rate debt at 7.50% or floating rate debt at LIBOR+25 basis
point. On the other, Y Company Ltd. which has a lower credit rating can issue fixed rate debt of the same
maturity at 8.45% or floating rate at LIBOR + 37 basis points. X Company Ltd. prefers to issue floating
rate debt and Y Company Ltd. prefers fixed rate debt with a lower coupon. City Bank is in the process of
arranging an interest rate swap between these two companies.
X Company Ltd. negotiates to pay the Bank a fixed a floating rate of LIBOR flat while the Bank agrees to
pay X Company Ltd. a fixed rate of 7.60%. Y Company Ltd. agrees to pay Bank a fixed rate of 7.75%
while the Bank pays Y Company Ltd a floating rate of LIBOR flat.
Required:
(i) With a schematic diagram, show how the swap deal can be structured.
(ii) What are interests saving by each company?
(iii) How much would City bank receive? [CWA – June, 09]
SOLUTION:
Available interest rates are as follows:
Company X Company Y
Fixed rate 7.50 % 8.45 %
Floating rate L + 0.25 L + 0.37
Step: 1 Identify absolute advantage party
Advantage of company X in fixed market = 0.95
Advantage of company X in floating market = 0.12
Hence, absolute advantage party = Company X
Step: 2 Identify the market of loan for both party and then enter into swap contract.
Company X should go in fixed market whereas company Y should go in floating market.
Step: 3 Structure of interest rate swap

L
7.60 %
Company X Company Y
Fixed @ Floating @ L + 0.37

7.50 % 7.75 %
Bank City bank Bank

L
Calculation of interest saving by each party:

Company X Company Y
Paid to swap dealer L 7.75
Received from swap dealer 7.60 L
Paid to bank 7.50 L + 0.37
Net cost due to swap L – 0.10 8.12
(B) Cost without swap L + 0.25 8.45
Saving of party 0.35 0.33
Statement of gain earned by swap dealer:

Received from X L
Paid to X (7.60)
Received from Y 7.75
Paid to Y (L)

Q.59 Soni Ltd. and Tony Ltd. face the following interest rate:
Particulars Soni Ltd. Tony Ltd.
US Dollar (Floating rate) Libor + 0.25 % Libor + 2.25 %
Japanese Yen (Fixed rate) 1.75 % 2%
Toni Ltd. Wants to borrow US Dollar at a floating rate of interest and Soni Ltd. wants to borrow Japanese
Yen at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 100 basis
points spread. If the swap is equally attractive to Soni Ltd. Toni Ltd. What rate of interest will they end up
paying? [CS – June, 06]
SOLUTION:
Advantage of Soni Ltd. in fixed rate loan = 0.25
Advantage of Soni Ltd. in floating rate loan = 2.00
Hence, absolute advantage party is Soni Ltd.
Step: 2 Decide market for each party. Decide market for the absolute advantage party and other party’s
market will automatically decide.
Soni Ltd. borrow floating rate loan and Tony Ltd. borrow fixed rate loan.

2%
L + 0.25
Soni Ltd. Tony Ltd.
Fixed @ Borrow @ 2 %
L + 0.25 % L + 0.25
Bank Financial Bank

institution
2%
Sony Ltd. Tony Ltd.
Soni Ltd. pays 2% -
Tony Ltd. Pays - L + 0.25
(B) Cost without IRS 1.75 % L + 2.25
Net gain 1.75
Net gain 0.75
Sony Ltd. Tony Ltd.
Cost without IRS 1.75 L + 2.25
Effective rate 1.375 L + 1.875
Q.60 Celina Ltd. wishes to borrow US Dollars at a fixed rate of interest. Priyanka Ltd. wishes to borrow
Japanese Yen at a fixed rate of interest. The amounts required by the two companies are roughly the same
at current exchange rate. The companies have been quoted the following interest rates:
Name of company Yen Dollar
Celina Ltd. 4.0 % 8.6 %
Priyanka Ltd. 5.5 % 9%
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap
equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.

[CS – June, 05]

SOLUTION:
Advantage of Celina Ltd. in Yen loan = 1.50
Advantage of Celina Ltd. in $ loan = 0.40
Step: 2 Decide market for each party. Decide market for the absolute advantage party and other party’s
market will automatically decide.
Celina Ltd. borrow Yen loan and Priyanka Ltd. borrow $ loan.
9%
4%
Celina Ltd. Priyanka Ltd.
Yen loan $ loan @ 9 %

4% 4%
Financial
Bank Bank
9% institution
Tony Ltd.
Celina Ltd. pays 9%
Priyanka Ltd. Pays 4%
(B) Cost without IRS 8.60 5.50
Net gain 1.10
Net gain 0.60
Celina Ltd. Priyanka Ltd.
Cost without IRS 8.60 5.50
Effective rate 8.30 5.20
INTEREST RATE PARITY / PURCHASING POWER PARITY / INTEREST COVERED

ARBRITRAGE
Q.61 It is given that Dollar 6 month T-Bills rate = 7 % and Risk Free 6-month Japanese bonds = 5.5%;
Spot exchange rate is 1 Yen = $ 0.009. What is the 6-months forward exchange rate? [Nov. 2008]
Q.62 The united State Dollar is selling in India at `45.50. if the interest rate of a 6 months borrowing in
India is 8% per annum and the corresponding rate in USA is 2%.
(a) Do you accept United State Dollar to be at a premium or at discount in the Indian forward market;
(b) What is the expected 6-months forward rate for United State Dollar in India; and
(c) What is the rate of forward premium or discount? [CA FINAL]
Q.63 The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5 %. The
current spot rate of US $ in India in `43.40. Find the expected rate of US $ in India after one year and 3
years from now using purchasing power parity theory. [CA - Nov 2008]
Solution:
Inflation rate in USA = 3 %

Inflation rate in India = 6.5 %

Spot rate = 1$ = ` 43.40
(i) Expected rate after one year:
Expected rate = SR * 1 + iq / 1 + ib
43.40 * 1.065 / 1.03 = 44.8748
(ii) Calculation of expected rate after 3 years:
Expected rate = SR * 1 + iq / 1 + ib
Year 1 43.40 * 1.065 / 1.03 44.8748
Year 2 44.8748 * 1.065 / 1.03 46.3997
Year 3 46.3997 * 1.065 / 1.03 47.9764
Q.64 The rate of inflation in India is 8 % per annum and in USA it is 4 %. The current spot rate of USD in
India is `46. What will be the expected rate after 1 year and after 4 years applying purchasing power parity
theory? [CA – May, 2010]
Solution:
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Expected spot rate =SR x
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
1.08
Year 1: 46 X = 47.77
1.04
1.08
Year 2: 47.77 X = 49.61
1.04
1.08
Year 3: 49.61 X = 51.52
1.04
1.08
Year 4: 51.52 X = 53.50
1.04
Q.65 On April,1, 3 months interest rate in UK £ and US $ are 7.5 % and 3.5 % per annum respectively.
The £/$ spot rate is 0.7570. What would be the forward rate for $ for delivery on 30 th June?
[CA – Nov. 2008]
Solution:
Interest rate in UK = 7.5 %
Interest rate in US = 3.5 %
Spot rate = 1 $ = 0.7570£
Forward rate = SR * 1 + iq / 1 + ib
0.7570 * 1.01875 / 1.00875 = 0.7645
Q.66 The expected annual inflation in Mexico is 5 %. The expected inflation for the US is 1.5 %. If the
spot rate for the peso is 3.4 peso/$, estimate the expected 1 year future spot rate.
Solution:
Spot rate = 1 $ = 3.40 Peso
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑃𝑒𝑠𝑜
Expected spot rate = SR X
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 $
1.05
3.40 X = 3.52
1.015
Q.67 On 1st April, 3 month’s interest rate in the US and Germany are 6.5 % and 4.5 % per annum
respectively. The $/ DM spot rate is 0.6560. What would be the forward for DM for delivery on 30 th June?
[CA – Nov. 2002]
Solution:
Spot rate: 1 DM = $ 0.6560
1.0162
Expected spot rate after 3 months = 0.6560 X = 0.6592
1.0113

Q.68 An Indian company is planning to invest in US. The US inflation rate is expected to be 3 % and that
of India is expected to be 8 % annually. If the spot rate currently is `45 per $, what spot rate can you
expect after 5 years. [CWA – June, 2005]
Solution:
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Calculation of expected spot rate after 5 years = SR X
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
1.08
Year 1: 45 X = 47.18
1.03
1.08
Year 2: 47.18 X = 49.47
1.03
1.08
Year 3: 49.47 X = 51.87
1.03
1.08
Year 4: 51.87 X = 54.39
1.03
1.08
Year 5: 54.39 X = 57.03
1.03
Q.69 Spot rate: $ .02090/ `

6 months forward rate: $ 0.02105/ `
6 months T – bill rate in India = 5.50 % p.a.
US 6 months T – bill rate will be =?
Solution:
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Forward rate = SR X
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

0.02105 = 0.02090 X
1.0275
0.02090 (1 + Interest rate of price currency) = 0.02163

0.02163
1 + Interest rate of price currency =
0.02090
1 + Interest rate = 1.0349
Interest rate = 1.0349 – 1 = 0.0349 or 3.49 %
3.49
Annualized interest rate = x 12 = 6.98 %
6
Q.70 Exchange rates:

Spot rate: 1 DM = 0.665 Can. $
3 months forward rate: 1 DM = 0.670 Can $
Interest rate: DM = 7 %; Can $ = 9 %.
What operations would be carried out to take the possible arbitrage gain? [CA – May, 2006]
Solution:
1+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Step: 1 Calculate theoretical forward rate for 3 months: SR X
Q.71 Spot rate: 1 $ = `47.7123

180 days forward rate: 1 $ = 48.6690
Interest rate in India = 12 % p.a.
Interest rate in US = 8 % p.a.
An arbitrageur takes loan of `40,00,000 from Indian bank for 6 months and goes for arbitrage. What is his
gain or loss? (Take 1 year = 360 days). [RTP – Nov. 2008]
Q. 72 Consider the following:

Spot rate: $ 0.75 / DM
1 year forward rate: $ 0.77 / DM

Interest rate (DM) = 7 % p.a.

Interest rate ($) = 9 % p.a.
(i) Assuming no transaction cost or taxes exist, do covered arbitrage profits exist in the above situation?
Explain
(ii) Suppose now that transaction costs in the foreign exchange market equal 0.25 % per transaction. Do
unexploited covered arbitrage profit opportunities still exist? [CWA – Dec. 2005/ CA – Nov. 2010]
Q. 73 The annual interest rate is 5 % in the US and 8 % in UK. The spot exchange rate is STG / USD =
1.50 and forward exchange rate, with one year maturity is STG / USD = 1.48. In view of the fact that the
arbitrager can borrow $ 10,00,000 at current spot rate, what would be the arbitrager profit or loss?
[CWA – Dec. 2004]
Q.74 Following are the rates quoted at Mumbai for British Pound
Spot rate: 1 BP = `52.60 / 70
3 months forward rate: 20 /30
6 months forward rate: 50 /75
Interest rates are as under:
` £
3 months 8% 5%
6 months 10 % 8%
Verify whether there is any scope of covered interest arbitrage if you borrow rupees.
[CA – Study Material]
Q. 75 Spot rate 1 $ = `48.0123
180 days forward rate for 1 $ = `48.8190
Annualized interest rate for 6 months (`) = 12 %
Annualized interest rate for 6 months ($) = 8 %
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is
willing to borrow `40,00,000 or $ 83,312. [CA – Nov. 2006]
Q.76 Given Spot Exchange rate $ = FF 7.05. Complete missing entries.

3 months 6 months 1 years
$ int. Rate (Annuity) 11.5% 12.25% E
FF Int. Rate (Annuity) 19.5% C 20%
Forward Franc per $ A D 7.52
Forward Dollar Premium % B 6.3% F
[CA – Nov. 2000]
Q.77 Syntex Ltd. has to make a US $ 5 million payment in three months’ time. The required amount in
dollars in available with Syntex Ltd. The management of the company decides to invest them for three
months and following information is available in this context:
The US $ deposit rate is 9% per annum.
The Sterling pound deposit rate is 11% per annum.
The Spot exchange rate is $ 1.82/pound.
The three month forward rate is $1.80 /pound
Answer the following Questions –
(a) Where should the company invest for better returns?
(b) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would
yield an equilibrium situation?
(c) Assuming that the US interest rate and the spot and forward rates remain as above, where should the
company invest if the sterling pound deposit rate were 15% per annum?
(d) With the originally stated spot and forward rates and the same dollars deposit rate, what is the
equilibrium sterling pound deposit rate? [RTP – CA, May, 2005]
Q.78 Decide whether on opportunity for currency arbitrage exists for the following quotes in each case:
JPY / USD: 110.25 / 111.10
NLG / USD: 1.6520 / 1.6530
JPY / NLG: 68.30 / 69.00

Q.79 In London, a dealer quotes:

1 GBP = 3.5250 / 55 CHF
1 GBP = 180.80 / 181.30 JPY
(i) What do you expect the 1 CHF = JPY rate to be in Geneva?
(ii) Suppose that in Geneva you get 1 CHF = 51.1530 / 51.2550 JPY. Is there an arbitrage opportunity?
Q.80 Following are the spot exchange rates quoted at three different forex markets:
1 $ = `48.30 in Mumbai
1 GBP = `77.52 in London
1 GBP = 1.6231 in New York
The arbitrageur has $ 1,00,00,000. Assuming that there are no transaction costs, explain whether there is
any arbitrage gain possible from the quoted spot exchange rates. [CA – Nov. 2008]
QUESTIONS RELATED TO INTERNATIONAL CAPITAL BUDGETING / CASH

MANAGEMENT / TREATMENT OF WITHHOLDING TAX / JOINT VENTURE
Q.81 ABC Ltd. is considering a project in US, which will involve an initial investment of US $
1,10,00,000. The project will have 5 years of life. Current spot exchange rate is `48 per US $. The risk free
rate in US is 8 % and the same in India is 12 %. Cash inflows from the project are as follows:
Year Cash inflows
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is
14 %. [CA – Nov. 06]
Solution: Foreign currency approach

Risk – free rate in US = 8 %
Risk – free rate in India = 12 %
RADR in India = 14 %
(1 + RADR ) = (1 + R f) (1 + Risk premium)
1.14 = (1.12) (1 + Risk premium)
1.14
1 + Risk premium = = 1.0179
1.12
Risk premium = 1.0179 – 1 = 1.79 %
So, RADR for US = (1 + RADR) = (1 + R f) (1 + Risk premium)
= (1.08) (1.0179)
RADR = 9.93 %
Statement showing NPV of the project:
Year Cash flow ($) Present value factor @ Present value
9.93 %
1 20,00,000 0.910 18,20,000
2 25,00,000 0.827 20,67,500
3 30,00,000 0.753 22,59,000
4 40,00,000 0.685 27,40,000
5 50,00,000 0.623 31,15,000
1,20,01,500
Less: Cash outflow 1,10,00,000
NPV in foreign currency 10,01,500
HC NPV = 10,01,500 * 48 = 4,80,72,000
Decision: Project should be accepted.
Q.82 XYZ Inc. currently exports 500 calculators per month to UAE @ $ 60 per piece. The variable cost
per unit is $ 40. There is a proposal to establish a manufacturing plant in UAE, for which the company

decided to make an equity investment of $ 1 million, half of which would represent working capital and
the balance is fixed assets. The company would sell the plant to a local entrepreneur for a sum of $ 1
million at the end of 5 th year and the Government of UAE would repay the company $ 5,00,000 for
working capital. XYZ Inc. will sell its calculators at $ 50 per unit in the UAE. The total cost of local
managers and material would be $ 15 per calculator. Other materials would be purchased from parent
company at $ 10 per unit and the parent company would receive a direct contribution to overhead variable
costs $ 5 per unit sold. The company expects to sell 12,000 calculators per annum. The fixed assets are to
be depreciated on a straight line basis over a 5 year period. The company will have to pay income tax at 50
% on profits. The current exchange rate is 10 UAE dinars per $ and is expected to stay the same for the
next five years. There is no restriction on cash flow repatriation.
(i) Determine the NPV of the project at 10 %.
(ii) XYZ Inc. has been informed that if it decides to reject the project, it would lose its entire export sales
to UAE. How does this affect decision of XYZ? [CWA – Study Material]
Solution:
(i) Calculation of cash outflow:
Cost of fixed assets $ 5,00,000
Working capital $ 5,00,000
Cash outflow $ 10,00,000
Calculation of cash inflows:
Sales revenue (12,000 * 50) $6,00,000
Less: Variable cost (15 + 10 - 5) * 12,000 $2,40,000
Depreciation (5,00,000 / 5) $1,00,000
PBT $2,60,000
Less: Tax @ 50 % $1,30,000
PAT $ 1,30,000
Add: Depreciation $1,00,000
Cash inflow $ 2,30,000
Cumulative present value factor 3.791
Present value of cash inflows 8,71,930
Calculation of terminal year cash inflows:

Sale value of assets 10,00,000
Less: Tax @ 50 % on STCG (10,00,000 - 0) * 50 % 5,00,000
Net amount 5,00,000
Add: Working capital 5,00,000
Total cash inflows 10,00,000
Present value factor 0.621
Present value of cash inflow 6,21,000
Statement of NPV:
Present value of annual cash inflow 8,71,930
Present value of terminal cash inflow 6,21,000
Total cash inflows 14,92,930
Less: Cash outflow 10,00,000
NPV 4,92,930
(ii) If company reject the project:
Sales (500 * 12 * 60) 3,60,000
Less: Variable cost (500 * 12 * 40) 2,40,000
PBT 1,20,000
Less: Tax @ 50 % 60,000
PAT 60,000
Cumulative present value factor 3.791
Present value of cash inflows 2,27,460
Therefore, rejection of project would lead to loss of $ 2,27,460.

Q.83 A Ltd. an India based MNC is evaluating an overseas investment proposal. It is considering a project
building a plant in United Kingdom. The proposal would initially cost 50 million pound and is expected to
generate the following cash flows, over its 4 years life:
Years Cash flows in million (£)
1 20
2 30
3 20
4 10
The current spot rate = 1£ = `70. Risk free rate in India = 10 % in United Kingdom is 6 %. The
companies cost of capital is 20 %. Will the project be undertaken?
Solution:
Calculation of various exchange rates:
Spot rate: 1£ = `70
1.10
1 year forward rate = 70 X = 72.64
1.06
1.10
2 year forward rate = 72.64 X = 75.38
1.06
1.10
1.06
1.10
1.06
Alternative: 1 Home currency approach:

Year Cash flow (£) Exchange rate Home currency Present value Present value
cash flow factor @ 20 %
1 20 72.64 1,452.80 0.833 1,210.18
2 30 75.38 2261.40 0.694 1,569.41
3 20 78.22 1,564.40 0.579 905.79
4 10 81.17 811.70 0.482 391.24
Present value of cash inflow 4,076.62
Less: cash outflow 3,500.00
NPV 576.62
Alternative: 2 Foreign currency approach
(1 + RADR) = (1 + Rf) (1 + Risk premium)
1.20 = (1.10) (1+ Risk premium)
1.20
1 + Risk Premium =
1.10
Risk premium = 9.09 %
Risk premium is assumed is same and hence RADR
(1 + RADR) = (1 + Rf) (1 + Risk premium)
1 + RADR = (1.06) (1.0909)
RADR = 15.63 %
Year Cash flow Present value factor @ Present value
15.63 %
1 20 0.865 17.30
2 30 0.748 22.44
3 20 0.647 12.94
4 10 0.559 5.59
58.27
Less Cash outflow 50.00
NPV 8.27
Home currency NPV= 8.27 * 70 = 578.90

Q. 84 An American firm is evaluating an investment proposal in Holland. The project cost is 1.3 million
NLG (Netherlands guilders). The interest rate in Holland and USA are respectively 6 % and 5 %. The spot
rate in NLG = 0.5 $. Cost of capital in USA = 16 % and the NLG discount rate is 17.1 %. The cash flows
for 5 years project are as follows:
Years Cash flow (in’000 NLG)
1 400
2 450
3 510
4 575
5 650
Evaluate under both approaches and advise whether the project should be taken up.
Solution:
Spot rate: 1 NLG = 0.50 $
1.05
Year 1 = 0.50 X = $ 0.4953
1.06
1.05
Year 2 = 0.4953 X = 0.4906
1.06
1.05
Year 3 = 0.4906 X = 0.4860
1.06
1.05
Year 4 = 0.4860 X = 0.4814
1.06
1.05
Year 5 = 0.4814 X = 0.4769
1.06
Home currency approach:

Year Cash flow in NLG Exchange rate Cash flow Present value Present value
in $ factor at 16 %
1 400 0.4953 198.12 0.862 170.78
2 450 0.4906 220.77 0.743 164.03
3 510 0.4860 247.86 0.641 158.88
4 575 0.4814 276.81 0.552 152.80
5 650 0.4769 309.99 0.476 147.56
794.05
Less: Cash outflow (1,300 * 0.50) 650.00
NPV 144.05
Foreign currency approach:

Year Cash flow Present value factor @ Present value
17.10
1 400 0.854 341.60
2 450 0.729 328.05
3 510 0.623 317.73
4 575 0.532 305.90
5 650 0.454 295.10
1,588.38
Less: Cash outflow 1,300.00
NPV 288.38
NPV in home currency = 288.38 * 0.50 = 144.19
Q.85 XY Limited is engaged in large retail business in India. It is contemplating for the expansion into a
country of Africa by acquiring a group of stores having the same line of operation as that of India. The
exchange rate for the currency of the proposed African country is extremely volatile. Rate of inflation is
presently 40 % in a year. Inflation in India is currently 10 % a year. Management of XY Limited expects

these rates likely to continue for the foreseeable future. Estimated projected cash flows, in real terms, in
India as well as African country for the first three years of the project are as follows –
Particulars Year 0 Year 1 Year 2 Year 3
Cash flow in India (` 000) - 50,000 - 1,500 - 2,000 - 2,500
Cash flows in African Rands (000) - 2,00,000 50,000 70,000 90,000
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It
evaluates all investments using normal cash flows and a nominal discount rate. The present exchange rate
is African Rand 6 to `1.
You are required to calculate the Net present value of the proposed investment considering the following –
(i) African Rand cash flows are converted into ` and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20 % to reflect it’s high risk.
[CA – May, 2013]
Solution:
Calculation of various exchange rates:
Spot rate: 1` = 6
1.40
Year: 1 = 6 X = 7.6364
1.10
1.40
Year: 2 = 7.6364 X = 9.7191
1.10
1.40
Year: 3 = 9.7191 X = 12.3698
1.10
Calculation of Nominal cash flows (`000):

Year Cash flow (Real) Inflation factor Cash flow (nominal)
0 - 50,000 1 - 50,000
1 - 1,500 1.10 - 1,650
2 - 2,000 1.21 - 2,420
3 - 2,500 1.331 - 3,327.50
Calculation of nominal cash flows (Rand ‘000)

Year Cash flow (Real) Inflation factor Cash flow (Nominal)
0 - 2,00,000 1 - 2,00,000
1 50,000 1.40 70,000
2 70,000 1.96 1,37,200
3 90,000 2.744 2,46,960
Conversion of Rand cash flows in ` cash flows:

Year Rand cash flows Exchange rate Cash flows (`)
0 - 2,00,000 6 - 33,333
1 70,000 7.6364 9,167
2 1,37,200 9.7191 14,117
3 2,46,960 12.3698 19,965
Calculation of present value of annual cash flows:

Year Cash flows (India) Cash flows Total cash Present Present value
(Africa) flows value
converted in ` factor
1 - 1,650 9,167 7,517 0.833 6,262
2 - 2,420 14,117 11,697 0.694 8,118
3 - 3,327.50 19,965 16,637.50 0.579 9,633
24,013
16,637.50
Terminal value = = 83,187.50
0.20
Present value of terminal value = 83,187.50 * 0.579 = 48,166
Statement of NPV:
Present value of annual cash inflow 24,103

Present value of terminal value 48,166

Total present value of cash inflow 72,179
Less: Cash outflow 83,333
NPV (11,154)
Q.86 A USA based company is planning to set up a software development unit in India. Software
development at the Indian unit will be bought back by the US parent at a transfer price of US $ 10
millions. The unit will remain in existence in India for one year; the software is expected to get developed
within this time frame. The US based company will be subject to corporate tax of 30 % and a with –
holding tax of 10 % in India and will not be eligible for tax credit in the US.
The software developed will be sold in the US market for US $ 12.0 millions. Other estimates are as
follows –
Rent for fully furnished unit with necessary hard ware in india `15,00,000
Man power cost (80 software professional will be working for 10 hours each day) `400 per man
hour
Administrative and other costs `12,00,000
Advise the US company on financial viability of the project. The ` - $ rate is `48 / $.
[CA – Nov. 2007]
Solution:
Sales (1,00,00,000 * 48) 48,00,00,000
Less: Costs
Rent 15,00,000
Man power (80 * 10 * 400 * 365) 11,68,00,000
Administrative cost 12,00,000 11,95,00,000
Profit before tax 36,05,00,000
Less: tax @ 30 % 10,81,50,000
Surplus profit 25,23,50,000
Less: Withholding tax @ 10 % 2,52,35,000
Amount to be repatriate 22,71,15,000
Exchange rate `48
Amount repatriated in $ terms $47,31,562.50
Hence, cost of developing the software:
1,00,00,000 – 47,31,562.50 = 52,68,437.50
Since the software can be sold for $ 1,20,00,000, this project is viable.
Q.87 A US based plastic manufacturer is considering a proposal to produce of high quality plastic glasses
in India. The necessary equipment to manufacture the glasses would cost `1,00,000 in India and it would
last 5 years. The tax relevant rate of depreciation is 25 % on written – down value method. The expected
salvage value is `10,000. The glasses will be sold at 4 each. Fixed cost will be `25,000 each year and
variable cost `2 per glass. The manufacturer estimates it will sell 75,000 glasses per year; tax rate in India
is 35 %. The US manufacturer assumes 20 % cost of capital for such a project. Additional working capital
requirement will be `50,000.
The US manufacturer will be allowed 100 % repatriation each year with a withholding tax rate of 10 %.
Should the proposal of setting up a manufacturing unit in India be accepted by the US manufacturer? Spot
and expected exchange rates are as follows:
Spot rate `50 / $
Year end 1 `50
Year end 2 `50
Year end 3 `52
Year end 4 `52
Year end 5 `52
Q. 88 OJ Ltd. is a supplier of leather goods to retailers in the UK and other Western European countries.
The company is considering entering into a Joint venture with a manufacturer in South America. The two
companies will each own 50 % of the limited liability company JV (SA) and will share profits equally. £
4,50,000 of the initial capital is being provided by OJ Ltd. and the equivalent in South America dollars

(SA$) is being provided by the foreign partner. Manager of the joint venture expects the following net
operating cash flows, which are in nominal terms:
Year SA $ (000) Forward rate of exchange to the £ sterling
1 4,250 10
2 6,500 15
3 8,350 21
For tax reasons JV (SA) the company to be formed specifically for the joint venture, will be registered in
South America. Ignore taxation in your calculation.
Requirements:
Assume you are financial adviser retained by OJ Limited to advice on the proposed joint venture. Calculate
the NPV of the project under the two assumptions explained below. Use a discount rate of 16 % for both
assumptions.
Assumption: 1 The South America country has exchange control which prohibit the payment of dividends
above 50 % of the annual cash flows for the first three years of the project. The accumulated balance can
be repatriated at the end of the third year.
Assumption: 2 The government of South America country is considering removing exchange controls and
restriction on repatriation of profits. If this happens all cash flows will be distributed as dividends to the
partner companies at the end of each year. [Supplement study material]
Q. 89 AMK Ltd. an Indian based company has subsidiaries in US and UK. Forecasts of surplus funds for
the next 30 days from two subsidiaries are as below:
U.S. $ 12.5 millions
U.K. £ 6 millions
Following exchange rate information are obtained:
$/` £/`
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
Annual borrowing / deposit rates (Simple) are available.
` 6.4 % / 6.2 %
$ 1.6 % / 1.5 %
£ 3.9 % / 3.7 %
The Indian operation is forecasting a cash deficit of `500 million. It is assumed that interest rates are based
on a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in ` for each company under each of the
following scenarios ignoring transaction costs and taxes:
(a) Each company invests / finances its own cash balances / deficits in local currency independently.
(b) Cash balances are pooled immediately in India and the net balances are invested / borrowed for the 30
days period.
(ii) Which method do you think is preferable from the parent company’s point of view?
[CA – May, 2007]
Q. 90 An American multinational corporation has subsidies whose cash positions for the month of
September, 2002 are given below:
Swiss subsidiary: Cash surplus of SF 1,50,00,000
Canadian subsidiary: Cash deficit of Can $ 2,50,00,000
UK subsidiary: Cash deficit of 30,00,000 (UK pound)
What are the cash requirements, if –
(i) Decentralized cash management is adopted?
(ii) Centralized cash management is adopted?
[Exchange rate: SF 1.48 / $; Can $ 1.58 / $; $ 1.50 / £] [CWA – Dec. 2002]
Solution: (a) Decentralized cash management is adopted:

US $
Canadian subsidiary : Cash deficit (2,50,00,000 / 1.58) 1,58,22,785
UK subsidiary: Cash deficit (30,00,000 * 1.50) 45,00,000
Total cash requirements 2,03,22,785

(b) Centralized cash management:

US $
Swiss subsidiary: Cash surplus (1,50,00,000 / 1.48) (1,01,35,135)
Canadian subsidiary : Cash deficit (2,50,00,000 / 1.58) 1,58,22,785
UK subsidiary: Cash deficit (30,00,000 * 1.50) 45,00,000
Total cash requirement 1,01,87,650
Q.91 An American small car manufacturing company wants to established a project in China, after
surveying the country for demand for small cars. Initial outlay is $ 120 millions. Annual cash flows (in
Chinese yuan) for next 5 years are – 200 millions, 350 millions, 300 millions, 250 millions, 150 millions.
At the end of five years, the project would be wound up. Considering China’s stringent exchange
restrictions and its average cost of capital, the desired return is 15 % in USD terms. In respect of project
investment by foreign companies, the Chinese laws restrict repatriation to 10 % of the project investment
for each of the first 3 years. The foreign company’s share in the cash flows in excess of 10 % of the project
investment should be invested in 6 % tax free Government of China bonds. The bonds will mature at the
end of the 3rd year.
The spot rate is USD 0.1250 per yuan. The Yuan is expected to appreciated by 10 % every year
for the next 2 years and depreciates 3 % every year thereafter. Evaluate the project from the American
company’s perspective, would there be any change, if the 50 % of the project is financed by a Chinese
engineering firm? [CWA – Study Material]
Solution: Calculation of exchange rates for the next 5 years:

Year Spot rate (Beginning) Appreciation / Depreciation Closing rate (USD / Yuan)
1 0.1250 10 % 0.1250 * 1.10 = 0.1375
2 0.1375 10 % 0.1375 * 1.10 = 0.1513
3 0.1513 (3 %) 0.1513 * 0.97 = 0.1468
4 0.1468 (3%) 0.1468 * 0.97 = 0.1424
5 0.1424 (3%) 0.1424 * 97 = 0.1381
Amount of investment = 120 million / 0.1250 = 960 million Yuan

Calculation of cash inflows:
1 2 3 4 5
Net cash flows (A) 200 350 300 250 150
Maximum amount 96 96 96 NA NA
repatriable (10 % of
project cost) (B)
Amount repatriated 96 96 96 250 150
(lower of A or B)
Amount to be invested 104 254 204 - -
in Govt. of china bonds
Proceeds on maturity of - - 590.094 - -
bonds
Net inflows 96 96 680.094 250 150
Net inflows in $ 13.20 (96 * 14.525 99.838 35.60 20.715
0.1375)
Present value factor @ 0.870 0.756 0.658 0.572 0.497
15 %
Present value 11.484 10.9809 65.6934 20.3632 10.2954
NPV = Total of present value of cash inflows – Cash outflows
118.8169 – 120.00 = (1.1831)
Inflow from proceeds on maturity of Government bonds:

Year Opening investments Additional investments Interest on opening Closing
balance @ 6 % p.a. investments
1 - 104.00 - 104.00
2 104.00 254 6.240 364.24

3 364.24 204 21.854 590.094
Amount repatriated in the next 5 years (with a JV partner)

1 2 3 4 5
Net cash flows (A) 200 350 300 250 150
Cash flow attributable 100 175 150 125 75
to American company
Maximum amount 96 96 96 NA NA
repatriable (10 % of
project cost) (B)
Amount repatriated 96 96 96 125 75
(lower of A or B)
Amount to be invested 4 79 54 - -
in Govt. of china bonds
Proceeds on maturity of - - 142.234 - -
bonds
Net inflows 96 96 236.234 125 75
Net inflows in $ 13.20 (96 * 14.525 34.679 17.8 10.358
0.1375)
Present value factor @ 0.870 0.756 0.658 0.572 0.497
15 %
Present value 11.484 10.9809 22.8188 10.1816 5.1479
NPV = Total of present value of cash inflows – Cash outflows
60.6132 – 60.00 = 0.6132
Inflow from proceeds on maturity of Government bonds:
Year Opening investments Additional investments Interest on opening Closing
balance @ 6 % p.a. investments
1 - 4.00 - 4.00
2 4.00 79.00 0.240 83.240
3 83.240 54.00 4.994 142.234
Q.92 D Ltd. an Indian company is evaluating an investment in Hong Kong. The project costs 300 million
Hong Kong Dollars. It is expected to generate an income of 100 million HKD a year in real terms for the
next 4 years (project duration). Expected inflation rate in Honk Kong is 6 % p.a. interest rate in India is 7
% p.a. while in Hong Kong is 10 % p.a. The risk premium for the project is 6 % in absolute terms, over the
risk free rate. The project beta is 1.25. Spot rate per HKD is `5.75. Evaluate the project in `, if the
investment in the project is out of retained earnings. [CWA – Study material]
Q. 93 XYZ Ltd. is considering a project in Luxemburg, which will involve an initial investment of €
1,30,00,000. The project will have 5 years of life. Current spot exchange rate is `58 per €. The risk free
rate in Germany is 8 % and the same in India is 12 %. Cash inflow from the project are as follows:
Year Cash inflow
1 € 30,00,000
2 € 25,00,000
3 € 35,00,000
4 € 40,00,000
5 € 60,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is
14 %. [CA – RTP – Nov. 2008]
Solution: Calculation of discount rate

(1 + RADR) = (1 + Risk free) (1 + Risk premium)
1.14 = (1.12) (1 + Risk premium)
1.14
1 + Risk premium =
1.12
Risk premium = 1.79 %

So, (1 + RADR) = (1.08) (1.0179)

RADR = 9.93 %
Statement of NPV:
Year Cash flow Present value factor Present value
@ 9.93 %
1 30,00,000 0.910 27,30,000
2 25,00,000 0.827 20,67,500
3 35,00,000 0.753 26,35,500
4 40,00,000 0.685 27,40,000
5 60,00,000 0.623 37,38,000
1,39,11,000
Less: Outflow 1,30,00,000
NPV 9,11,000
Q.94 An Indian company is planning to set up a subsidiary in US. The initial project cost is estimated to be
US $ 40 million; working capital required is estimated to be $ 4 million. The finance manager of company
estimated the data as follows:
Variable cost of production (per unit sold) $ 2.50
Fixed cost per annum $ 3 million
Selling price $ 10
Production capacity 5 million units
Expected life of plant 5 years
Method of depreciation SLM
Salvage value at the end of 5 years Nil
The subsidiary of the Indian company is subject to 40 % corporate tax rate in the US and the required rate
of return if such type of project is 12 %. The current exchange rate is ` 48 / $ and the rupee is expected to
depreciate by 3 % per annum for next 5 years. The subsidiary company shall be allowed to repatriate 70 %
of the CFAT every year along with the accumulated arrears of blocked funds at the end of 5 years, the
withholding taxes are 10 %. The blocked fund will be invested in the USA money market by the
subsidiary, earning 4 % (free of taxes) per year. Determine the feasibility of having a subsidiary company
in the USA, assuming no tax liability in India on earnings received by the parent company from the US
subsidiary. [CA – RTP – Nov. 2008]
Solution:
Calculation of exchange rate over a period of 5 years:
1
Year 0: 1 $ = `48 or 1`= = 0.02083
48
Year 1: 0.02083 (1 – 0.03) = 0.02021 or 49.48
Year 2: 0.02021 (1 – 0.03) = 0.01960 or 51.02
Year 3: 0.01960 (1 – 0.03) = 0.01901 or 52.60
Year 4: 0.01901 (1 – 0.03) = 0.01844 or 54.23
Year 5: 0.01844 (1 – 0.03) = 0.01789 or 55.90
Calculation of cash outflow:

Initial project cost $ 40 million
Working capital $ 4 million
44 million
Exchange rate 48
Cash outflow (`) 2,112
Calculation of cash inflow:
Sales 50 50 50 50 50
Less: Variable cost 12.50 12.50 12.50 12.50 12.50
Fixed cost 3.00 3.00 3.00 3.00 3.00
Depreciation 8.00 8.00 8.00 8.00 8.00

PBT 26.50 26.50 26.50 26.50 26.50

Less: Tax @ 40 % 10.60 10.60 10.60 10.60 10.60
PAT 15.90 15.90 15.90 15.90 15.90
Add: Depreciation 8.00 8.00 8.00 8.00 8.00
Cash flow 23.90 23.90 23.90 23.90 23.90
Less: retention @ 30 % 7.17 7.17 7.17 7.17 7.17
Repatriate amount 16.73 16.73 16.73 16.73 16.73
Less: Withholding tax @ 10 1.673 1.673 1.673 1.673 1.673
%
Net amount 15.057 15.057 15.057 15.057 15.057
Exchange rate 49.48 51.02 52.60 54.23 55.90
` cash flow 745.02 768.21 792.00 816.54 841.69
Present value factor @ 12 % 0.893 0.797 0.712 0.636 0.567
Present value 665.30 612.26 563.90 519.32 477.24
Total of present value = 2,838.02
Calculation of accumulated blocked fund at the end of year 5:

Year Opening balance Addition Interest Closing balance
1 Nil 7.17 - 7.17
2 7.17 7.17 0.29 14.63
3 14.63 7.17 0.59 22.39
4 22.39 7.17 0.90 30.46
5 30.46 7.17 1.22 38.85
Terminal year cash flow:

Amount received from investment 38.85
Add: Working capital released 4.00
42.85
Less: Withholding tax @ 10 % 4.29
38.56
Applicable exchange rate 55.90
` cash flow 2,155.50
Present value factor 0.567
Present value of cash flow 1,222.17
Statement of NPV:
Present value of cash inflow 2,838.02
Present value of terminal cash flow 1,222.17
Total cash inflow 4,060.19
Less: Cash outflow 2,112.00
NPV 1,948.19
Decision: Since NPV of the project is positive, hence project is viable.
Q. 95 An MNC company in USA has surplus funds to the tune of $ 10 million for six months. The finance
director of the company is interested in investing in DM for higher returns. There is a Double tax
avoidance agreement (DTAA) in force between USA and Germany. The company received the following
information from London:
€ / $ spot rate 0.4040 / 41
6 months forward 67 / 65
Rate of interest for 6 months (p.a.) 5.95 % - 6.15 %
Withholding tax applicable for interest income 22 %
Tax as per DTAA 10 %
If the company invests in £, what is the gain for the company? [CA – RTP – June, 2009]
QUESTIONS RELATED TO NOSTRO ACCOUNTS

Q. 96 You as a dealer in foreign exchange have the following position in Swiss France on 31 st October,
2007:
Particulars Swiss Francs in thousand
Balance in Nostro account credit 100
Opening position overbought 50
Purchased a bill on Zurich 80
Sold forward 60
Forward purchases cancelled 30
Remitted by TT 75
Draft on Zurich cancelled 30
Expected closing balance in Nostro credit 30
Expected closing overbought 10
[CA – Nov. 2005]
Solution: Foreign exchange position
Particulars Purchases Sale Overall position
Opening balance 50,000 (O/B)
Bills purchased 80,000 - 1,30,000 (O/B)
Sold forward - 60,000 70,000 (O/B)
Forward purchased cancelled - 30,000 40,000 (O/B)
Remittance by TT (assuming - 75,000 35,000 (O/B)
outward)
Draft cancelled 30,000 - 5,000 (O/B)
Buy Swiss France on cash 5,000 - Nil
basis
Buy Swiss France on forward 10,000 - 10,000 (O/B)
basis
Nostro a/c (Fund position)
Particulars Debit Credit Balance
Opening position 1,00,000 (Cr.)
Remitted by TT 75,000 - 25,000 (Cr.)
Buy Swiss France on cash basis - 5,000 30,000 (Cr.)
Q. 97 A dealer has the following position in Frankfurt. What must he do to make it square?
His account in Frankfurt is overdrawn DEM 3,75,000. He has purchased cheques which are in course of
post and not yet credited to his account totalling DEM 3,28,000. He has forward contracts outstanding as
follows:
Sales DEM 1,63,86,000
Purchases DEM 1,46,06,250
He has issued draft not yet presented for payment for DEM 12,20,080. He has long bills purchased in hand
not due for DEM 28,85,640.
Q. 98 You as a dealer have the following position in pound – sterling:
Opening balance in Barclays bank international London GBP 20,000 O/D
Opening currency position overbought 5,000
Purchased a telegraphic transfer 50,000
Issued a draft on London 20,000
TT remittance outward 25,000
Purchased bills on London 75,000
Forward sales 75,000
Export bills realized 45,000
What steps would you take if you are required to maintain a credit balance of GBP 10,000 in Nostro
account and square your exchange position?

Q.99 XYZ Bank, Amsterdam, wants to purchase ` 25 million against £ for funding their Nostro account
and they have credited LORO account with Bank of London, London. Calculate the amount of £’s
credited. Ongoing inter-bank rates are per $, 61.3625/3700 & per £, $ 1.5260/70.
Solution:
Exchange rates:
1 $ = `61.3625 / `61.3700
1 £ = 1.5260 / 1.5270 $
Since customer bank wants to purchase ` against £, hence from bank point of view we should find out
exchange rate at which bank sell ` against £.
Bank buy $ and sell ` at `61.3625.
Bank sell $ and buy `at `61.3700.
Bank buy £ and sell $ at 1.5260.
Bank sell £ and buy $ at 1.5270.
For required quote, we should go through following route:

(i) Bank buy $ and sell ` at `61.3625
(ii) Bank buy £ and sell $ at 1.5260 or 1 $ = 1/ 1.5260 £
1$ = `61.3625
1 $ = 1/1.5260 £
`61.3625 = 1/1.5260 £
1` = 1/1.5260 * 1/61.3625 £
0.6553 * 0.0163
1` = 0.01068 £
Hence for selling `25 million against £
0.01068 * 2,50,00,000 = 2,67,000£
TRANSACTION EXPOSURE / NET EXPOSURE / OPERATING EXPOSURE
Q.100 An automobile company in Gujarat exports its goods to Singapore at a price of SG $ 500 per unit.
The company also imports components from Italy and the cost of components for each unit is € 200. The
company’s CEO executed an agreement for the supply of 20,000 units on January 1, 2010 and on the same
date paid for the imported components. The company’s variable cost of production per unit is `1,250 and
the allocable fixed costs of the company are `1,00,00,000. The exchange rates as on 1st January, 2010 were
as follows:
Spot ` /SG $ = 33.00 / 33.04
` / € = 56.49 / 56.56
Mr. A, the treasury manager of company is observing the movement of exchange rates on a day to day
basis and has expected that the rupee would appreciate against SG $ and would depreciate against €. As
per his estimates the following are expected rates for 30th June, 2010.
Spot: ` / SG $ 32.15 / 32.21
` /€ 57.27 / 57.32
Required: find out
(i) The change in profitability due to transaction exposure for the contract entered into.
(ii) How many units should the company increases its sales in order to maintain the current profit level for
the proposed contract in the end of June, 2010. [CA – Nov. 2010]
Solution: Company’s existing profit:

Sales (20,000 * 500 * 33) 33,00,00,000
Less: Raw material cost (20,000 * 200 * 56.56) 22,62,40,000
Variable cost (20,000 * 1250) 2,50,00,000
Fixed costs 1,00,00,000 26,12,40,000
Profit 6,87,60,000
Company’s revised profit due to exchange fluctuation:

Sales (20,000 * 500 * 32.15) 32,15,00,000
Less: Raw material cost (20,000 * 200 * 56.56) 22,62,40,000

Variable cost (20,000 * 1250) 2,50,00,000

Fixed costs 1,00,00,000 26,12,40,000
Revised profit 6,02,60,000
Reduction in profit due to transaction exposure = 6,87,60,000 – 6,02,60,000 = 85,00,000
(ii) Calculation of contribution per unit:

Selling price (500 * 32.15) 16,075
Less: Variable cost
Raw material (200 * 56.56) 11,312
Variable cost 1,250
Contribution per unit 3,513
Target increase in profit 85,00,000
Target increase in quantity sold (85,00,000 / 3,513) 2,420 units
Q.101 Following are the details of cash inflows and outflows in foreign currency denominations of MNP
Co. an Indian export firm, which have no foreign subsidiaries:
Currency Inflow Outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
UK £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of Rupees.
(ii) Are any of the exposure position offsetting to some extent? [CA – Nov. 06]
Q.102 M/s Omega Electronics Ltd exports air-conditioners to Germany by importing the components from
Singapore. The company is exporting 2400 units at a price of Euro 500 per unit. The cost of imported
components is S$ 800 per unit, The fixed cost and other variable cost per unit are `1000 and `1500
respectively. The cash-flows in foreign currencies are due in six months. The current exchange rates are as
follows:
`/Euro 51.50/55
`/S$ 27.20/25
After six months the exchange rates turn out as follows:
`/Euro 52.00/05
`/S$ 27.70/75
(1) You are to calculate the gain/loss due to transaction exposure.
(2) Based on the following additional information calculate the loss/gain due to transaction and operating
exposure if the contracted price of the air conditioner is `25000:
(i) The current exchange rate is :
`/Euro 51.75/80
`/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5.
(iii) Payments and receipts are to be settled in six-months. [CA – Nov. 09]
OTHERS
Q.103 A firm is contemplating import of a consignment from the USA for a value of US $ 10,000. The
firm requires 90 days to make payment. The supplier has offered 60 days interest – free credit and is
willing to offer additional 30 days credit at an interest rate of 6 % per annum. The bankers of t he firm offer
a short loan for 30 days at 9 % per annum. The banker’s quotation for foreign exchange is:
60 days forward 1 $ = `46.20
90 days forward 1 $ = ` 46.35
You are required to advise the firm as to whether it should:
(i) Pay the supplier in 60 days, or
(ii) Avail the supplier’s offer of 90 days credit. Show your calculations. [RTP – May, 06]

Q.104 On 1st March, 2008 A, Inc. a US company bought certain products from Tapland. The currency of
Tapland is Tapa. The price agreed was Tapa 9,00,000 payable on 31st May, 2008. The spot price on 1st
March, 2008 was 10 Tapa per $. The expected future spot rate was 8 Tapa per $ and the 3 months forward
rate is 9 Tapa per $. The US and Tapland annual interest rate are 12 % and 8 % respectively. The tax rate
for both countries is 40 %. A Inc. is considering three alternatives to deal with the risk of exchange rate
fluctuations.
(i) To enter the forward market to buy Tapa 9,00,000 at 3 months forward rate.
(ii) To borrow appropriate amount in $ to buy Tapa at current spot rate and to invest the Tapa purchased
for 3 months.
(iii) To wait until May, 2008 and buy Tapas at whatever spot rate prevailing at that time.
Which alternative the A Inc. should follow in order to minimize its cost of future payment of Tapas.
[RTP – Nov. 08]
Q.105 Yati Ltd. is planning to import a multi – purpose machine from Japan at a cost of 3,400lakhs Yen.
The company can avail loans at 18 % per annum with quarterly rests with which it can import the machine.
However, there is an offer from Tokyo branch of an India based bank extending credit of 180 days at 2 %
p.a. against opening of an irrevocable letter of credit.
Other information:
Present exchange rate: ` 100 = 340 Yen
180 days forward rate: ` 100 = 345 Yen.
Commission charges for letter of credit at 2 % per 12 months. Advise whether the offer from the foreign
branch should be accepted? [CA – Nov. 96]
Q.106 A company operating in a country having dollar as its unit of currency has today invoiced sales to
an Indian company, the payment being due three months from the date of invoice. The invoice amount is $
13,750 and at today’s spot rate of $ 0.0275 per `1, is equivalent to `5,00,000. It is anticipated that the
exchange rate will decline by 5 % over the three months period and in order to protect the dollar proceeds,
the importer proposes to take appropriate action through foreign exchange market. The three month
forward rate is quoted as $ 0.0273 per `1. You are required to calculate the expected loss and to show, how
it can be hedged by forward contract. [CA – May, 98]
Q.107 Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000 against
EURO at US $ 1 = EURO 1.4400 for spot delivery. However, later during the day, the market became
volatile and the dealer in compliance with his management’s guidelines had to square – up the position
when quotations were:
Spot US $ 1 INR 31.4300/ 4500
1 month margin 25 /20
2 months margin 45/35
Spot US $ 1 EURO 1.4400/ 4450
1 month forward 1.4425 / 4490
2 months forward 1.4460 / 4530
What will be the gain or loss in the transaction? [CA – June, 2009]
Q.108 An Indian importer has to settle an import bill for $ 1,30,000. The exporter has given the Indian
exporter two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 % per annum.
The importer’s bank charges 15 % per annum on overdrafts. The exchange rates in the market are as
follows:
Spot rate (` /$): 48.35 / 48.36
3 months forward rate (` /$): 48.81 / 48.83
The importer seeks your advice. Give your advice. [CA – Nov. 2011]
Q.109 Following information is given:

Exchange rate - Canadian dollar 0.666 per DM (spot)
Canadian dollar 0.671 per DM (3 months)
Interest rates - DM 7.5% p.a.

Canadian Dollar 9.5% p.a.

To take the possible arbitrage gains, what operations would be carried out? [CA – May, 2016]
Q.110 ABC Ltd. of UK has exported goods worth CAN$ 5,00,000 receivable in 6 months. The exporter
wants to hedge the receipt in the forward market. The following information is available.
Spot Exchange Rate CAN $2.5/£
Interest rate in UK 12%
Interest rate in Canada 15%
The forward rates truly reflect the interest rate differential.
Find out the gain/loss to UK exporter if CAN$ spot rates (i) declines 2%, (ii) gains 4% or (iii) remains
unchanged over next 6 months. [CA – May, 2016]

DERAVITIVES
S.NO. TOPICS COVERED
1. FOREX MARKET DERIVATIVES
 CURRENCY FORWARD
 CURRENCY OPTIONS
 CURRENCY FUTURES
2. CAPITAL MARKET DERIVATIVES
 STOCK OPTIONS
 INDEX OPTIONS
 STOCK FUTURES
 INDEX FUTURES
 COMMIDITY FUTURES
3. INTEREST RATE SWAP
4. FORWARD RATE AGREEMENT
5. INTEREST RATE FUTURES
6. CAP OPTIONS
7. FLOOR OPTIONS
8. COLLAR OPTIONS
9. VALUATION OF STOCK FUTURE
10. VALUATION OF CURRENCY FUTURE
11. VALUATION OF COMMODITY FUTURE
12. VALUATION OF CURRENCY SWAP
13. VALUATION OF INTEREST RATE SWAP
14. VARIOUS OPTIONS STRATIGES
 STRAP
 STRIP
 LONG CALL
 LONG PUT
 SHORT CALL
 SHORT PUT
 PROTECTIVE PUTS
 BULL SPREAD
 BEAR SPREADS
 BUTTERLY
 STRADALES
 STRANGLES
 COVERED CALL
15. OPTION PRICING MODELS
 BINOMIAL METHOD
 BALCK – SCHOLES OPTION PRICING METHOD
 RISK NUTURAL METHOD
 PORTFOLIO REPLACTING APPROACH
16. PUT – CALL PARITY THEORY
17. OPTIONS GREEKS
 DELTA
 GAMMA
 THEATA
 VEGA
 RHO

TOPIC: 1 FORWARD RATE AGREEMENT
(1) Meaning of forward rate agreement – Forward rate agreement is a contract to borrow or invest a
specified amount of money at a specified rate of interest for a specified period in future. Under such type
of agreement principal amount is called notional principal and it is agreed only for interest calculation.
For example: Mr. A wants to borrow `500 lakhs for 6 months period after 3 months from today. If he
contracts for such amount at a specified interest rate today which will prevail in future, then such
agreement is known as forward rate agreement.
After 3 months Loan for 6 months
T=0 T=1 T= 2
Today
(Agreement day)
(2) Forward rate agreement is an over the counter product (OTC), where the counter party is always bank.
(3) Forward rate agreement is a single settlement derivative. It can be settled in advance or at the expiry of
the contract period.
(4) Participants of forward rate agreement – There are three types of participants in market:
 Hedger – Participants who wishes to hedge against future interest rate risks by setting the future
interest rate today.
 Speculator – Participants who want to make profits based on their expectations on the future
interest rates.
 Arbitrager – Participants who try to take advantage of the different prices of FRAs.
(5) Buying FRA or selling FRA – For deciding buying of FRA or selling of FRA we always talk with
respect to fixed interest rate payment / receipts.
 Buying FRA – Pay fixed interest rate and receives floating interest rate. Borrower should buy
FRA to get protection from rising interest rate.
 Selling FRA – Receive fixed interest rate and pay floating interest rate. Depositor / Lender should
sell FRA to get protection from the falling of interest rate.
 Buying FRA means contracting to borrow a certain amount.
 Selling FRA means contracting
(6) FRA quotes style –

 Prices of FRAs are quoted as the same way as the money market rate i.e. as an annualized %.
 FRA are written as 3 -9, 3X9, 3Vs 9 etc. The difference between two figures is known as
contract period.
 FRA interpretation – 3 Vs 9 FRA means a contract which will start 3 months from today and
would run for a period of 6 months. Both 3 and 9 are counted from today i.e. t = 0.
TYPE: 1Problem: HOW TO CALCULATE SETTLEMENT AMOUNT UNDER FRA

FRAs are cash settled derivatives. Under forward rate agreement settlement amount will calculate in either
of the following two ways as specified by the question.
 At settlement date:
Notional principal X Interest rate differential X t/12
Settlement amount =
1+(Index rate X t/12)
 At contract expiry date:

Settlement amount = Notional principal X Interest rate differential X T/12
 If question is silent then FRA are always settled on settlement date i.e. at t = 1.
 FRA should be settled at present value of difference.

T=0 T=1 T= 2
Today (Settlement date) (Contract expiry date)
(Agreement day)
Class example: 1 Nestle rolls over a 25 million $ loan priced at LIBOR 3 on a three – month basis. The
company feels that interest rates are rising and that rates will be higher at the next roll – over date in three
months. Suppose the current LIBOR 3 is 5.4375 %.
(a) Explain how Nestle can use an FRA at 6 % to reduce its interest rate risk on this loan?
(b) In three months, interest rates have risen to 6.25 %. How much will Nestle receive / pay on its FRA?
Solution:
(a) Nestle can buy a FRA priced at 6 % to lock its interest rate. Whatever happens to LIBOR 3 at the
rollover date Nestle will pay LIBOR 3 of 6 % in three months’ time.
(b) If actual rate is 6.25 %, Nestle will receive due to FRA

Settlement amount =
2,50,00,000 X (6.25 % − 6 %) X 3/12

1 + (6.5 X 3/12)
15,625
= = 15,384.994 $
1.0156
Class example: 2 A lender plans to invest $ 100 million for 150 days, 60 days from today (i.e. if today is
0, the loan will be initiated on day 60 and will mature on day 210). The implied forward rate over 150
days, and hence the rate on a 150 – day FRA is 2.50 %. Consider 360 days in a year.
(a) If interest rate on day 60 is 2.80 %, how much lender will have to pay / receive if the FRA is settled on
day 60? How much if it is settled on day 210?
(b) If the interest rate on day 60 is 2.20 %, how much will the lender have to pay / receive if the FRA is
settled on day 60? How much if it is settled on day 210?
Solution:
(a) Interest rate is higher than the rate of FRA, so the lender must pay the borrower.
(i) Settled on day 60:
Settlement amount =
10,00,00,000 X (2.50 %−2.80 %) X 150/360

Settlement amount =
1+(2.80 X 150/360)
1,25,000
Settlement amount = = 1,23,554.41 $
1.0117
(ii) Settled on 210 day
Settlement amount = Notional principal X Interest rate differential X t/12

Settlement amount = 10,00,00,000 * (2.80 % - 2.50 %) * 150 / 360
= 1,25,000 $
(b) Interest rate is lower than FRA, so lender will receive under FRA.
(i) Settled on 60 day:
Settlement amount =

10,00,00,000X (2.50 %−2.20 %)X 150/360

Settlement amount =
1+(2.20 X 150/360)
1,25,000
Settlement amount = = 1,23,860.48 $
1.0092
(ii) Settled on 210 day

= 10,00,00,000 * (2.50 % - 2.20 %) * 150 / 360 = $ 1,25,000
Class example: 3 Yati Industries has decided to borrow `2,00,00,000 for 3 months, after 3 months from
today. As the treasurer, you are concerned that interest rates will rise over the next three months. To reduce
the company’s interest rate exposure, you decide to purchase a 3X6 FRA whereby you pay the dealer’s
quoted fixed rate of 5.85 % in exchange for receiving 3 – month LIBOR at the settlement date. Assume
that there are 90 days between month 3 and month 6. Assume 360 days in a year.
(i) Assuming that 3 – month LIBOR is 6 % on the rate determination day and the contract specified that
settlement will takes place at contract expiry day, calculate settlement amount.
(ii) If contract specified that settlement will be in advance, then calculate settlement amount.
Solution:
(i) Since reference rate is higher than quoted rate and hence Yati Industries will receive:
= 2,00,00,000 * (6.00 % - 5.85 %) * 90/360 = 7,500
(ii) If contract specified settlement in advance, then calculate settlement amount

Settlement amount =
2,00,00,000 X (6.00 %−5.85 %) X 90/360

Settlement amount =
1+(6% X 90/360)
7,500
Settlement amount = = 7,389.16
1.015
Class example: 4 These are the current euro FRA quotations:

FRA Bid Ask
3X6 3.42 % 3.46 %
3X9 3.30 % 3.34 %
6X12 3.36 % 3.40 %
(a) A company knows it will have to issue 1 million euros 6 months debt in 6 months and wants to hedge
against interest rate movements. What should it do?
(b) After 6 months the spot rate is 4 %. Calculate settlement amount and decide who will make payment
under FRA?
(a) Company should buy 6 X 12 FRA at the rate of 3.40 %.
10,00,000 X (4.00 %−3.40 %) X 6/12

(b) Settlement amount =
1+(4 X 6/12)
3,000
Settlement amount = = 2,941.17
1.02
TYPE: 2 HOW TO CALCULATE EFFECTIVE COST UNDER FRA/ HEDGING THROUGH FRA
Through FRA borrower or depositor can lock its interest rate and get protection against movement in
interest rates. This technique, under which borrower or depositor can lock its rate is known as hedging
through FRA.

Following steps should be followed for calculation of effective cost of borrowing:

Step: 1 Calculate settlement amount at t =1 i.e. settlement date as under:
Settlement amount =
Step: 2 Identify amount to be borrowed at t = 1after adjusting settlement amount calculated in step: 1.
Step: 3 Repayment of loan with interest at agreed rate at t = 2 i.e. contract expiry date.
Repayment = Amount borrowed + Amount borrowed * agreed rate of interest * T / 12
Step: 4 Calculate effective cost of borrowing as under:

Repayment of amount −Fund enjoyed 12
Effective cost = X 100 X
Fund enjoyed Period
Class example: 5 X Limited has contracted to borrow `500 lakhs after 6 months for 3 months period at a
spread of 100 basis point over the 3 month LIBOR. 6 X 9 FRA is quoted at 8 % / 9 %. Find out the annual
cost of borrowing when hedged through FRA if 3 months LIBOR after 6 months happens to be –
(a) 11 % (b) 7 %
Solution:
(a) FRA rate: 9 %
Borrowing rate: L + 1 %
Step: 1 Calculate settlement amount at t = 1

Settlement amount =
500 lakhs X (11 %−9 %) X 3/12

Settlement amount =
1+(11X 3/12)
2.50
Settlement amount = = 2.43 lakhs
1.0275
Step: 2 Calculate amount to be borrowed at t =1

500 lakhs – 2.43 lakhs = 497.57 lakhs
Step: 3 Loan repayment in 3 month with interest of L + 1 % i.e. 12 %

Repayment = 497.57 + 497.57 * 12 % * 3/12
= 497.57 + 14.93 = 512.50 lakhs
Step: 4 Calculate effective cost

Fund enjoyed Period
512.50 −500 12
Effective cost = X 100 X = 10 %
500 3
(b) FRA rate = 9 %

Borrowing rate = L + 1
Step: 1 Calculate settlement amount at t = 1
Settlement amount =
500 lakhs X (7 %−9 %) X 3/12

Settlement amount =
1+(7X 3/12)
500 X 2% X 3/12
Settlement amount = = 2.50 / 1.0175 = 2.46 lakhs
1.0175
Step: 2 Calculate amount to be borrowed at t = 1

500 lakhs + 2.46 lakhs = 502.46 lakhs
Step: 3 Repayment of loan with interest after 3 months

502.46 + 502.46 * 8 % * 3/12
= 502.46 + 10.05 = 512.51 lakhs
Step: 4 Calculate effective cost of borrowing

Fund enjoyed Period
512.50 −500 12
Effective cost = X 100 X = 10 %
500 3
Class example: 6 A company’s financial projections show an expected cash deficit in two months’ time of
`8 million, which will last for approximately three months. It is now 1st November 2014. The treasurer is
concerned that interest rates may rise before 1st January 2015. The treasurer can look into an interest rate
today, for a future loan. A 2 – 5 FRA at 4.70 % / 5 % is agreed. Show how company hedged through FRA
by calculating effective cost if in two months’ time the market rate is –
(a) 7 % (b) 4 %
Solution:
(a) If market rate is 7 %
Step: 1 Calculate settlement amount

Settlement amount =
8 M X (7 %−5 %) X 3/12
Settlement amount = = 0.0399 / 1.0175 = 0.0392 M
1+(7X 3/12)
Step: 2 Borrowed required amount for 3 months at 7 %

Borrowed amount = 8 – 0.0392 = 7.9608
Step: 3 Repayment of loan with interest

Repayment = 7.9608 + 7.9608 * 7 % * 3/12
= 7.9608 + 0.1393 = 8.1001

Fund enjoyed Period
8.1001 −8 12
Effective cost = X 100 X =5%
8 3
(b) If market rate is 4 %
Step: 1 Calculate settlement amount

Settlement amount =
8 M X (4 %−5 %) X 3/12
Settlement amount = = 0.0399 / 1.0175 = 0.0197 M
1+(4X 3/12)
Step: 2 Borrow required amount for 3 months at 4 %

8 M + 0.0197 M = 8.0197
Step: 3 Repayment of loan with interest

Repayment = 8.0197 + 8.0197 * 4 % * 3 /12
= 8.0197 + 0.0802 = 8.0999


Fund enjoyed Period
8.0999 −8 12
Effective cost = X 100 X =5%
8 3
TYPE: 3 PRICING OF FRA

Price of a FRA refers to the forward rate that should prevail in order to prevent arbitrage. In other words,
price of FRA should be calculated in such manner that there is no arbitrage.
We can understand the pricing of FRA with the help of following example:
Class Example: 7 A company’s yield curve has been calculated as:

Year Individual yield curve (%)
1 3.96
2 4.25
3 4.56
Calculate rate for a 12 X 24 FRA.
Solution: Company will have to pay interest of 3.96 % if it wants to borrow money for 1 year, 4.25 % if it
wants to borrow for 2 years etc. An alternative to borrow for 2 years at 4.25 % throughout is to borrow for
1 year initially at 3.96 % and then to borrow for another year in 1 years’ time at an unknown rate. This
unknown rate is to decide in such a manner that there will be no arbitrage. It means whatever is the
alternative choose by the company interest cost remains same.
4.25 %
A1
A2 3.96 % r =?
Let amount borrowed for 2 years is `100 at 4.25 % p.a., then total repayment under alternative 1
100 (1.0425)2 = 108.6806
Amount borrowed under alternative 2 where borrow for 1 year at 3.96 % and for another year at r % then r
is to be decided in such manner that total repayment must be 108.6806. Hence,
100 (1.0396) (1 + r) = 108.6806
103.96 (1 + r) = 108.6806
1 + r = 108.6806 / 103.96
1 + r = 1.0454
r = 1.0454 – 1 = 0.0454 or 4.54 %
Class example: 8 Given the following term structure of LIBOR:

Period LIBOR
1 month 6%
2 months 7%
3 months 7.20 %
6 months 8%
9 months 10 %
Calculate the price of 1 X2 FRA, 1 X 6 FRA, 3 X 9 FRA and 6 X 9 FRA.
Solution:
Price of 1X 2 FRA
7 % p.a. (1.17 %)
A1
A2 6 % (0.50 %) r =?
1.0117 = (1.005) (1 + r)

1 + r = 1.0117 / 1.005
1+ r = 1.0067
r = 1.0067 – 1
r = 0.0067
Hence price (p.a.) = 0.0067 * 100 * 12 = 8.04 %
Price of 1 X 6 FRA
8 % p.a. (4 %)
A1
A2 6 % (0.50 %) r =?
1.04 = (1.005) (1 + r)
1 + r = 1.04 / 1.005
1 + r = 1.0348
r = 1.0348 – 1
r = 0.0348
Hence Price (p.a.) = 0.0348 * 100 * 12 / 5 = 8.35 %
Price of 3 X 9 FRA
10 % p.a. (7.50 %)
A1
A2 7.20 % (1.80 %) r =?
1.075 = (1.018) (1 + r)
1 + r = 1.075 / 1.018
1 + r = 1.056
r = 1.056 – 1 = 0.056
Hence, Price (p.a.) = 0.056 * 100 * 12 / 6 = 11.20 %
Price of 6 X 9 FRA
10 % p.a. (7.50 %)
A1
A2 8 % (4 %) r =?
1.075 = (1.04) (1 + r)
1 + r = 1.075 / 1.04
1 + r = 1.0337
r = 1.0337 – 1 = 0.0337
Hence, price (p.a.) = 0.0337 * 100 * 12 / 3 = 13.48 %
TYPE: 4 ARBITRAGE THROUG FRA

Class example: 9 Consider the following term of structure:
6 – Months LIBOR 5%
12 – Months LIBOR 5.75 %
The 6X 12 FRA is quoted at 7%/8%
Required:
(a) What should be the price of 6X 12 FRA?
(b) Show the process of arbitrage (Assume $ 1,00,000)

Solution:
(i) Price of FRA:
5.75 %
A1
6 Months
A2 5 % (2.50 %) r =?
1.0575 = (1.025) (1 + r)
1 + r = 1.0575 / 1.025 = 1.0317
r = 1.0317 – 1 = 0.0317
Price of FRA = 0.0317 * 100 * 12 / 6 = 6.34 %
(ii) Process of Arbitrage:
Borrow alternative
5.75 %
A1
Quoted = 7 % / 8 %
A2 5 % (2.50 %) r =? 6.34 %
Deposit alternative
Step: 1 Borrow $ 1,00,000 for 12 months @ 5.75 % per annum. Hence cash outflow after 12 months
1,00,000 (1.0575) = $ 1,0,750
Step: 2 Invest $ 1,00,000 for 6 months @ 5 % per annum and agree to deposit for further 6 months @ 7 %
per annum.
Cash inflow = $ 1,00,000 (1.025) (1.035) = $1,06,087.50
Step: 3 Arbitrage profit = $ 1,06,087.50 – 1,05,750 = $ 337.50
Class example: 10 Consider the following term structure:

3 – Months T- bill rate 6%
6 – Months T – bill rate 7%
3 X 6 FRA is quoted in market at 9 %
Required:
(a) What should the price of 3X 6 FRA?
(b) Show the process of arbitrage (Assume `1,00,000)
Hint: (i) Price of FRA = 7.88 %

(ii) Process of arbitrage: Inflow = 1,03,783.75; Outflow = 1,03,500
Arbitrage profit = 283.75
Class example: 11 Assume that the 3 months and 9 months interbank rates (LIBOR) are the following:
Bid Ask
3 months 3.50 % 3.60 %
9 months 4.10 % 4.25 %
(a) Calculate the highest and lowest FRA (3X9) rates.
(b) Assume the market FRA rate is 4.20 %. Would there be the possibility of an arbitrage?
(c) How would the arbitrage be structured?

TYPE: 5 VALUATION OF FRA / MARKET VALUE OF FRA
Class example: 12 A corporate treasurer, wishes to hedge against an increase in future borrowing cost due
to a possible rise in short – term interest rates. She proposes to hedge against this risk by entering into a
long 6 X 12 FRA. The current term structure for LIBOR is as follows:
Term Interest rates
30 days 5.10 %
90 days 5.25 %
180 days 5.70 %
360 days 5.95 %
(a) Indicate when this 6 X 12 FRA expires and identify which term of the LIBOR this FRA is based on.
(b) Calculate the rate; the treasurer would receive on a 6 X 12 FRA.
(c) Suppose the treasurer went long this FRA. Now, 45 days later, interest rates have risen and the LIBOR
term structure is as follows:
135 days 5.90 %
315 days 6.15 %
Calculate the market value of this FRA based on a notional principal of $1,00,00,000.
(d) At expiration, the 180 – day LIBOR is 6.25 %. Calculate the pay – off on the FRA.
Solution:
(a) 6 X 12 FRA means
Contract starts after 180 days from today and expires after 360 days from today.
Hence, terms of LIBOR: 180 days – 5.70 %
360 days – 5.95 %
(b) Calculate the rate, the treasurer would receive on a 6 X 12 FRA.
5.95 %
A1
T=0 T = 180 T = 360

A2 5.70 % (2.85 %) r =?
1.0595 = (1.0285) (1 + r)
1 + r = 1.0595 / 1.0285
1 + r = 1.0301
r = 1.0301 – 1 = 0.0301
Hence, price = 0.0301 * 100 * 360 / 180 = 6.02 %
(c) Situation after 45 days
6.15 % (5.38 %)
A1
135 days 315 days
T=0 T = 45 T = 180 T = 360

A2 r =?
5.90 % (2.21 %)
1.0538 = (1.0221) (1 + r)
1 + r = 1.0538 / 1.0221
1 + r = 1.0310
r = 1.0310 – 1 = 0.0310
Hence price = 0.0310 * 100 * 360 / 180 = 6.20 %
Hence market value of FRA = [6.20 % - 6.02 %] * 1,00,00,000 * 180 / 360

= 9,000

(d) Settlement amount =
1,00,00,000 X (6.25 %−6.02 %) X 180/360

Settlement amount = = 11,500 / 1.03125 = 11,151.5152 $
1+(6.25X 180/360)
Class example: 13 A financial manager needs to hedge against a possible decrease in short term interest
rates. He decides to hedge his risk exposure by going short on an FRA that expires in 90 days and is based
on 90 day LIBOR. The current term structure for LIBOR is as follows:
Term Interest rates
30 days 5.83 %
90 days 6.00 %
180 days 6.14 %
360 days 6.51 %
(a) Identify the type of FRA used by the financial manager using the appropriate terminology.
(b) Calculate the rate the manager would receive on this FRA.
(c) It is now 30 days since the manager took a short position in the FRA. Interest rates have shifted down,
and the new term structure for LIBOR is as follows:
60 days 5.50 %
150 days 5.62 %
Calculate the market value of this FRA based on a notional principal of $ 1,50,00,000.
TYPE: 6 SPECULATIONS WITH FRA

Class example: 14 A “three against nine” FRA has an agreement rate of 4.75 %. You believe six month
LIBOR in three months will be 5.125 %. You decided to take speculative position in a FRA with a $
10,00,000 notional value. There are 183 days in the FRA period. Determine whether you should buy or sell
the FRA and what is your expected profit will be if your forecast is correct about the six – month LIBOR
rate. Consider 360 days.
Solution: Since the agreement rate is less than year forecast, you should buy a FRA. If your forecast is
correct your expected profit will be as under:
10,00,000 X (5.125 % −4.75 % ) X 183/360
Profit =
1+5.125 X183/360
= 1906.25 / 1.0261
= $ 1,857.76
QUESTION BANK RELATED TO FRA
Q. 1 Ford has a $20 million Eurodollar deposit maturing in two months that it plans to roll over for a
further six months. The company's treasurer feels that interest rates will be lower in two months time when
rolling over the deposit. Suppose the current LIBOR6 is 7.875%.
(a) Explain how Ford can use an FRA at 7.65% from Banque Paribas to lock in a guaranteed six month
deposit rate when it rolls over its deposit in two months.
(b) After two months, LIBOR6 has fallen to 7.5%. How much will Ford receive/pay on its FRA?
(c) In two months, LIBOR6 has risen to 8%. How much will Ford receive/pay on its FRA?
Q.2 Suppose that in order to hedge interest rate risk on your borrowing, you enter into an FRA that will
guarantee a 6% effective annual interest rate for 1 year on $500,000.00. On the date you borrow the
$500,000.00, the actual interest rate is 5%. Determine the dollar settlement of the FRA assuming:
(a) Settlement occurs on the date the loan is initiated.
(b) Settlement occurs on the date the loan is repaid.
Q.3 Consider the following data:

3 Months LIBOR 8%
9 Months LIBOR 10 %

3X9 FRA 15 % / 16 %
(a) What should be the price of 3X 9 FRA?
(b) Show the process of arbitrage using $ 1,000.
Q. 4 Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate
Agreement). They want to borrow a sum of ` 100 crores after 2 years for a period of 1 year. Bank has
calculated Yield Curve of both companies as follows:
Year XYZ Ltd. ABC Ltd.*
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
* The difference in yield curve is due to lower credit rating of ABC Ltd. compared to XYZ Ltd.
(i) You are required to calculate the rate of interest DEF bank would quote under 2V3 FRA, using the
company’s yield information as quoted above.
(ii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of the amount of loan, you are
required to calculate the interest payable by XYZ Ltd. if interest in 2 years turns out to be
(a) 4.50%
(b) 5.50% [RTP – Nov. 2014]
Q. 5 Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature.
In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6 months
firm cash crunch, leading to borrowing of money to cover up its exposures for running the business.
It is expected that firm shall borrow a sum of € 50 million for the entire period of slack season in
about 3 months.
A bank has given the following quotations:
Spot rate: 5.50 % - 5.75 %
3 X 6 FRA 5.59 % - 5.82 %
3 X 9 FRA 5.64 % - 5.94 %
3 months € 50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85 %). You are
required to determine:
(i) How a FRA, shall be useful if the actual interest rate after 6 months turnout to be:
(a) 4.50 % (b) 6.50 %
(ii) How 3 months future contract shall be useful for company if interest rate turns out as mentioned in part
(i) above. [CA – RTP, May, 2014]
Q.6 The following market data is available –

Spot USD / JPY – 116.00.
Deposit rates p.a. USD JPY
3 months 4.50 % 0.25 %
6 months 5.00 % 0.25 %
Forward rate agreement (FRA) for YEN is Nil.
(i) What should be 3 months FRA rate at 3 months forward?
(ii) The 6 and 12 months LIBOR are 5 % and 6.50 % respectively. A Bank is quoting 6/12 USD FRA at
6.50 – 6.75 %. Is any arbitrage opportunity available? Calculate profit in such cases. [CA – May, 2010]
Q.7 M/s Parker and Company is contemplating to borrow an amount of `60 crores for a period of 3 months
in the coming 6 month’s time from now. The current rate of interest is 9 % p.a. but it may go up in 6
month’s time. The company wants to hedge itself against the likely increase in interest rate. The
company’s Bankers quoted an FRA at 9.30 % p.a.
What will be the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest
after 6 months happens to be (i) 9.60 % p.a. and (ii) 8.80 % p.a. [CA – May, 2013]
Q. 8 AB Tech plans to borrow $ 10 million in 30 days at 90 day LIBOR plus 100 basis points. To lock in a
borrowing rate of 7 %, it purchases an FRA at a rate of 6 %. This contract would be referred to as a 1X4
FRA because it expires in one month (30 days) and the underlying $ matures four months (120 days) from
now. Thirty days later, LIBOR is 7.5 %. Demonstrate that AB Tech’s effective borrowing rate is 7 % if
LIBOR in 30 days is 7.5 %.

Q. 9 TM Fincorp has bought a 6X9 ` 100 crore Forward Rate Agreement (FRA) at 5.25%. On fixing date
reference rate i.e. MIBOR turns out be as follows:
Period Rate (%)
3 months 5.50 %
6 months 5.70 %
9 months 5.85 %
You are required to determine:
(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year) [CA – RTP – Nov. 2012]
TOPIC: 2 INTEREST RATE SWAP

(1) Meaning – An interest rate swap (IRS ) is a contractual agreement entered into between two
counterparties under which they agree to exchange fixed for variable interest rates (mostly LIBOR )
periodically, for an agreed period of time based upon a notional amount of principal. The principal amount
is notional because there is no need to exchange actual amounts of principal. Equally, however, a notional
amount of principal is required in order to compute the actual cash amounts that will be periodically
exchanged.
In other words we can say Interest rate swap is a contract between two parties where parties are
agreed for exchange of interest. One party receive one type of interest and pays another type of
interest.
Under interest rate swap principal amount never exchanged. It is only agreed for interest
calculation and hence principal amount is always called notional principal.
(2) Swap structure: Swap structure can be shown as below:
Pay fixed interest rate

Company A Company B
Receive floating interest rate
(3) Interest rate swap is multiple settlement derivatives. Multiple settlements mean interest is to be
exchanged on every re – set date. Re – set date means date of payment of interest.
(4) Interest rate swap contracts are over the counter products where counter party can be bank or other
corporate.
(5) Parties of interest rate swap – Interest rate swap involve buyer of interest rate swap and seller of
interest rate swap. Under interest rate swap we always talk with respect of fixed interest rate payer /
receiver.
 Buyer of interest rate swap means who pay fixed interest rate and receive floating interest rate.
 Seller of interest rate swap means who receive fixed interest and pay floating interest rate.
(6) The basic object behind the interest rate swap contracts are hedging of interest rate risk. In other words
we can say that due to entering into swap contract both parties are able to reduce their interest rate risk.
TYPE: 1 THERE IS NO SWAP DEALER INVOLVES AND ALSO THERE IS NO SWAP

PAYMENT IS GIVEN
Following steps should be followed:

Step: 1 Identify absolute advantage party and calculate comparative advantage for such party under both
market. The party having advantage in both the market is known as absolute advantage party.
Step: 2 Identify the market for each party. Select the market for absolute advantage party where
comparative gain is higher and the other party’s market will automatically decide.

Step: 3 Step: 3 Now they can enter into a swap with each other and prepare the flow chart of swap.
Step: 4 Prepare statement showing gain or loss due to swap and its allocation between parties.
Particulars A Limited B Limited
Cost due to IRS:
A Ltd. pay to B Ltd. Xxx
B Ltd. pay to A Ltd. xxx
Cost without IRS:

A Ltd. pay Xxx
B Ltd. pay xxx
Gain / (Loss) due to IRS (xxx) xxx
Net gain due to IRS xxx
Share of each party Xxx xxx
Step: 5 Prepare a statement showing effective cost of borrowing for each party:
Particulars A Limited B Limited
Paid to bank xxx xxx
Paid to other party due to swap xxx xxx
Receive from other party due to swap xxx xxx
Share in loss xxx xxx
Share in gain xxx xxx
Effective cost xxx xxx
Class example: 15 Cat Limited and Dog Limited both want to borrow £150 million for 8 years. Cat
Limited would like to borrow on a fixed rate basis whereas Dog Limited prefers to borrow at floating rates.
Following data are provided to you:
Name of company Fixed Floating
Cat Limited 10 % L+2%
Dog Limited 8% L+1%
Design a swap between both the parties by assuming that swap gain will be distributed equally by the
parties.
Solution:
Step: 1 Identify absolute advantage party if any and calculate comparative advantage for such party.
Absolute advantage party means party who can obtain cheaper loan under both market.
Here Dog Limited is absolute advantage party:
Dog Limited’s advantage in fixed market: 2 %
Dog Limited’s advantage in floating market: 1 %
Hence,
Dog Limited should borrow fixed rate loan
Cat Limited should borrow floating rate loan.

Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap
Due to swap dog Ltd. pay to Cat Ltd. L + 2 %
Dog Limited Cat Limited

Due to swap Cat Ltd. pay 8 % to
Dog Ltd.
Obtain loan at 8 % from obtain loan at L + 2 %
bank from bank
Bank Bank
Step: 4 Prepare a statement showing gain / loss due to swap and its allocation:
Particulars Dog Limited Cat Limited
Cost due to IRS:
Dog Ltd. pay to Cat Ltd. L+2% -
Cat Ltd. pay to Dog Ltd. - 8%
Cost without IRS:

Dog Ltd. pay L+1%
Cat Ltd. pay 10 %
Gain / (Loss) due to IRS (1 %) 2%
Net gain due to IRS 1%
Share of each party 0.50 % 0.50 %
Particulars Dog Limited Cat Limited
Paid to bank 8% L+2%
Paid to other party due to swap L+2% 8%
Receive from other party due to swap (8 %) (L + 2 %)
Share in loss (0.50) 0.50
Share in gain (1 %) 1%
Effective cost L + 0.50 % 9.50 %
Class example: 16 Company A wishes to raise $10m and to pay interest at a floating rate, as it would like
to be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or
at a floating rate of 1% above LIBOR.
Company B also wishes to raise $10m. They would prefer to issue fixed rate debt because they want
certainty about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR +
2% floating, as it has a lower credit rating than company A.
Required:
Calculate the effective swap rate for each company – assume savings are split equally.
Solution:
Before solving the problem we can summarize the problem as under:
Company A B
Fixed rate 10 % 13 %
Floating rate L+1% L+2%
Here, Company A is absolute advantage party

Company A’s advantage in fixed market = 3 %

Company A’s advantage in floating market = 1 %
Hence,
Company A should borrow fixed rate loan
Company B should borrow floating rate loan
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap:
Due to swap A pays B L + 2 %
Company A Company B
Due to swap B pays A 10 %
Loan obtain @ 10 % from Loan obtain @ L + 2 %

bank
Bank Bank
Step: 4 Prepare a statement showing gain / loss due to swap and its allocation:
Particulars Company A Company B
Cost due to IRS:
Company A pays B L+2% -
Company B pays A - 10 %
Cost without IRS:

Company A pays L+1%
Company B pays - 13 %
Gain / (Loss) due to IRS (1 %) 3%
Net gain 2%
Share of each party 1% 1%
Paid to bank 10 % L+2%
Paid to other party due to swap L+2% 10 %
Receive from other party due to swap (10 %) (L + 2 %)
Share in loss (0.50 %) 0.50
Share in gain (1.50 % ) 1.50
Effective cost L 12 %
TYPE: 2 IF SWAP DEALER INVOLVES BUT SWAP PAYMENTS ARE NOT GIVEN
Class example: 17 Companies A and B faces the following interest rates:
US $ (Floating) L + 0.50 % L+1%
Canadian (Fixed) 5% 6.50 %
Assume that A wants to borrow US $ at a floating rate of interest and B wants to borrow Canadian dollars
at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 50 basis point
spread. If the swap is equally attractive to A and B, what rates of interest will A and B end up paying?
[RTP – May, 2005]

Solution:
Here, Company A is absolute advantage party
Company A’s advantage in fixed market (Canadian $) = 1.5 %
Company A’s advantage in floating market (US $) = 0.50 %
Hence,
Company A should borrow fixed rate loan
Company B should borrow floating rate loan
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap:
Company B
Company A Swap dealer
Loan at L + 1 %
Loan @ 5 % fixed
Bank Bank
Class example: 18 Alpha and Beta companies can borrow for a five – year term at the following rates:
Alpha Beta
Fixed rate borrowing cost 10.5 % 12.0 %
Floating rate borrowing cost L L+1%
Alpha desires floating rate debt and Beta desires fixed rate debt. Develop an interest rate swap in which
both Alpha and Beta have an equal cost saving. No sap bank is involved in this transaction.
Answer:
Effective cost for Alpha = L – 0.25 %
Effective cost for Beta = 11.75 %
Class example: 19 Company A is a AAA rated firm desiring to issue five – year FRNs. It finds that it can
issue FRNs at six – month LIBOR + 0.125 % or three – month LIBOR + 0.125 %. Given its asset
structure, three months LIBOR is the preferred index. Company B is an A – rated firm that also desires to
issue 5 year FRNs. It finds it can issue at six – month LIBOR + 1 % or at three – months LIBOR + 0.625
%. Given its asset structure, six months LIBOR is the preferred index. Assume a notional principal of $
1,50,00,000. Design a floating for floating rate swap where the swap bank receives 0.125 % and the
counter parties share the remaining savings equally.
Answer:
Effective cost for Company A: L
Effective cost for Company B: L + 0.875
TYPE: 3 IF SWAP PAYMENTS ARE GIVEN IN THE QUESTION

Class example: 20 Bank A is a AAA – rated international bank located in U.K. and wishes to raise $
1,00,00,000 to finance floating rate Eurodollar loans. Bank A can issue 5 – years fixed rate Eurodollars
bonds at 10 %. Alternatively, Bank A can raise money by issuing 5 – years floating notes at LIBOR.
Firm B is a BBB – rated US company. It needs $ 1,00,00,000 for 5 – years. Firm B is considering issuing 5
– years fixed rate Eurodollar bonds at 11.75 %. Alternatively, firm B can raise money by issuing 5 – year
floating rate note at L + 0.50 %. Firm B is preferred to borrow at a fixed rate.
A swap bank offers to Bank A: You pay L – 0.125 % per year and we will pay you 10.375 % for 5 years.
Swap bank makes offer to company B: You pay us 10.50 % and we will pay you L – 0.25 %.
Required:
(i) With the help of a diagram, show how the swap deal can be structured?
(ii) What are the savings earned by each party?

(iii) how much swap bank received?
Solution: Borrowing opportunities are as under:

Fixed Floating
Bank A 10 % L
Company B 11.75 % L + 0.50 %
Step: 1 Identify the absolute advantage party. The party for which it is cheaper to borrow amount in both
market.
Bank A’s advantage in fixed market = 1.75 %
Bank A’s advantage in floating market = 0.50 %
Step: 2 Select the market for the absolute advantage party where comparative gain is higher and the other
party’s market will automatically decide.
Hence,
Bank A should borrow fixed rate loan
Company B should borrows floating rate loan
Step: 3 Now they can enter into a swap with each other through swap banker. Structure of swap will be as
under:
L - 0.125 % L – 0.25 %
Company B
Bank A Swap dealer
10.375 % 10.50 %
Obtain loan at Obtain loan at

10 % fixed L + 0.50 %
Bank Bank
Step: 4 Calculate interest saving for each party as under:

Particulars Bank A Company B
(A) Net cost due to IRS:
Paid to banker 10 % L + 0.50 %
Paid to swap dealer L – 0.125 % 10.50 %
Received from swap dealer 10.375 % L – 0.25
Net cost due to swap L – 0.50 % 11.25 %
(B) Cost without IRS L 11.75 %
Savings (A - B) 0.50 % 0.50 %
Step: 5 Calculate gain of swap dealer:
Paid to Bank A 10.375 %
Received from Bank A L – 0.125 %
Paid to company B L – 0.25 %
Received from company B 10.50 %
Gain of swap dealer 0.25 %
TYPE: 4 CALCULATION OF CASF FLOWS DUE TO SWAP

Class example: 21 Company A pays `75,000 as interest payment at the end of one year. Company B pays
the current LIBOR + 50 basis points on a `10,00,000 loan at the end of the year. Suppose that the two
companies enter into an interest rate swap. Suppose that in one year the current LIBOR rate is 6.45 %.
Find which company is making payment at the end of year and its amount.
Answer: A will make payment to B `5,500

Solution:
Swap structure:
Fixed @ 7.5 %
A Limited B Limited
Receive L + 0.50
At the end of the year company A will make payment to company B

10,00,000 (7.50 % - 6.95 %) = `5,500
Class example: 22 A Limited and B Limited enter into a swap deal on March 15, 2006. A Limited agrees
to pay fixed interest @ 5 % p.a. on the principal of `100 lakhs to B every six months and B Limited to pay
a floating rate of L + 0.70 % to A Limited. The interest obligations of the parties are to be calculated with
reference to the interest rates effective on the first day of the interest period. The deal is for a period of 2
years. The deal specifies for the exchange of differential cash flows. LIBOR rate for 2006, 2007 and 2008
are 4.20 %, 4.60 % and 4.30 %.
Answer: Cash flows for A Limited:
- 5,000; - 5,000; 15,000; 15,000
Solution:
Fixed @ 5 %
A Limited B Limited
Receive L + 0.70
Statement of cash flow from A Limited point of view:

Re – set date Fixed interest Floating interest Net cash flows
payment received
15.3.06 100 * 5 % * 6/12 = 100 * 4.90 % * 6/12 = - 5,000
2,50,000 2,45,000
15.9.06 100 * 5 % * 6/12 = 100 * 4.90 % * 6/12 = - 5,000
2,50,000 2,45,000
15.3.07 100 * 5 % * 6/12 = 100 * 5.10 % * 6/12 = 15,000
2,50,000 2,65,000
15.9.07 100 * 5 % * 6/12 = 100 * 5.10 % * 6/12 = 15,000
2,50,000 2,65,000
Class example: 23 A three – year swap initiated on 1st April, 2006 between P Limited and Q Limited. By
the swap arranged, P Limited agrees to pay 10 % fixed to Q Limited on `100 lakhs every half year. In
return, Q Limited agrees to pay floating rate LIBOR to P Limited every half year. Suppose the 6 – month
annual LIBOR rates are as below:
Date LIBOR
1.4.2006 10.4 %
1.10.2006 11.20 %
1.4.2007 11.40 %
1.10.2007 10.6 %
1.4.2008 9.60 %
1.10.2008 9.00 %
Calculate cash flows under the swap arrangement from the view point of P Limited.
Answer: 20,000; 60,000; 70,000; 30,000; (20,000); (50,000)
Class example: 24 On 1.1.2010 A and B enter into a interest rate swap having following features:
Notional principal $ 500 million
Term of the swap 1 year
Payment frequency 3 months

Fixed rate 10 %
Floating rate 3 – months LIBOR
The swap is shown below:

3 – Months L on $ 500 million
A B
10 % on $ 500 million
The 3 – Months LIBOR at the beginning of each quarter happen to be:

Date 3 – Months LIBOR
1.1.2010 11 %
1.4.2010 8%
1.7.2010 7%
1.10.2010 13 %
Calculate net cash flows at the end of each quarter.
Answer:
1st quarter: B will receive $ 1.25 million
2nd quarter: A will receive $ 2.50 million
3rd quarter: A will receive $ 3.75 million
4th quarter: B will receive $ 3.75 million
Solution:
1st Quarter:
Relevant LIBOR: 11 %; Fixed rate: 10 %
B will receive 11 % - 10 % i.e. 1 %
Amount = 500 (11 % - 10 %) * 3/12 = $ 1.25 million
2nd Quarter:
A will receive (10 % - 8 %) = 2 %
Amount = 500 (10 % - 8 %) * 3/12 = $ 2.50 Million
3rd Quarter:
A will receive 3 % (10 % - 7 %)
Amount = 500 (10 % - 7 %) * 3/12 = $ 3.75 million
4th Quarter:
B will receive (13 % - 10 %)
Amount = 500 (13 % - 10 %) * 3/12 = $ 3.75 Million
TYPE: 5 PRICING OF INTEREST RATE SWAP

Pricing a swap means determining the fixed interest rate of the swap (swap rate) such that the value of the
swap is zero at time t = 0. The price of a swap should be in such a manner that value of fixed leg = value of
floating leg. Pricing of swap here means calculation of fixed rate of swap. In general price of any
instrument can be calculated in such a manner that there is no arbitrage.
Formula for calculating periodic swap price is as under:
1−𝐷𝑙
Periodic swap price = X 100
∑𝐷
DL = Last discount factor
∑ D = Sum of the discounting factors
Value of floating leg: Present value of next coupon payment + Present value of principal value
(Since we only know next coupon payment)

Rule: At every re – set date the value of floating leg is always equal to its par value. It can be explained as
under:
Example: Loan of ` 1,00,000 at floating rate LIBOR. Payment frequency is annual. Current LIBOR is 8 %.
Cash flow after 1 year will be: 1,00,000 + 8 % = 1,08,000
The present value of `1,08,000 today, discounting at market rate which is the LIBOR
1,08,000
Hence Present value = = 1,00,000
1.08
Hence it is always equal to par value at every re – set date.
Value of fixed leg: Present value of all future coupon payments + Present value of principal value
Hence we can derive the formula for periodic swap price is as under:
Let us assume a 3 – year’s annual payment frequency swap on notional amount of `1,00,000
Value of swap = Value of fixed leg = Value of floating leg

Let Coupon rate = C
Present value of all coupon payment = C [D 1 + D 2+ D3]
Present value of principal amount = 1,00,000 * D 3
Value of swap = 1,00,000 *C [D 1 + D2+ D 3] + 1,00,000 * D 3 = 1,00,000

1,00,000 [C ∑D] + D 3 = 1,00,000
[C ∑D] + D 3 = 1
C ∑D = 1 - D3
1 − D3 1− Last discount factor
C= or X 100
∑D ∑𝐷
Class example: 25 Consider a one – year swap with semi – annual payments on day 180 and day 360. The
underlying is 180 – day MIBOR. The annualized 180 – day MIBOR is 9 % and 360 – day MIBOR is 10
%. What is the fixed rate (price) of swap?
Solution:
1− Last discount factor
Price of swap = X 100
∑𝐷
Period Discount rate Periodic discount rate Discount factor

180 days 9% 4.50 % 0.957
360 days 10 % 10 % 0.909
1.866
1− 0.909
𝑋 100 = 0.0488 or 4.88 %
1.866
Hence swap price (annualized) = 4.88 * 2 = 9.76 %
Class example: 26 Suppose the LIBOR discount factors are given in the table below. Consider a 3 – year
swap with semi – annual payments whose floating payments are found using the LIBOR rate compiled a
semester before the payment is made. The notional amount of the swap is 10,000.
LIBOR discount factor 0.9748 0.9492 0.9227 0.8960 0.8687 0.8413
Time (Months) 6 12 18 24 30 36
(a) Calculate price of swap
(b) Calculate net payment made by the fixed rate side in 18 months if the 6 – months LIBOR interest rate
compiled in 12 months is 2.30 %.
SOLUTION:
Period Discount factor

6 months 0.9748
12 months 0.9492
18 months 0.9227
24 months 0.8960
30 months 0.8687

36 months 0.8413
5.4527
Price of swap = X 100
∑𝐷
1− 0.8413
X 100
5.4527
0.1587
X 100 = 0.0290 or 2.90 %
5.4527
Annualized swap price = 2.90 * 2 = 5.80 %
(b) Payment by fixed rate payer: 10,000 (2.90 % - 2.30 %) = 60
Class example: 27 Given the following term structure of LIBOR –

Period LIBOR p.a.
12 months 8%
24 months 9%
36 months 10 %
48 months 12 %
60 months 13 %
Calculate the swap price.
SOLUTION:
Period LIBOR (per annum) Periodic LIBOR Discount factor
12 months 8% 8% 0.9259
24 months 9% 18 % 0.8475
36 months 10 % 30 % 0.7692
48 months 12 % 48 % 0.6757
60 months 13 % 65 % 0.6061
3.8244
Price of swap = 𝑋 100
∑𝐷
1− 0.6061
X 100
3.8244
0.3939
X 100 = 10.30 %
3.8244
Class example: 28 Consider 1 year quarterly payment frequency swap with a notional principal of `100
million. The term structure of LIBOR is:
Period LIBOR
3 – Months 6.00 %
6 – Months 6.40 %
9 – Months 6.80 %
12 – Months 7.00 %
(i) Calculate the swap price.
(ii) Calculate the first net payment.
Solution:
Period LIBOR (per annum) Periodic LIBOR Discount factor
3 months 6% 1.50 % 0.9852
6 months 6.40 % 3.20 % 0.9690
9 months 6.80 % 5.10 % 0.9515
12 months 7.00 % 7.00 % 0.9346
3.8403
Price of swap = 𝑋 100
∑𝐷
1− 0.9346
X 100
3.8403

0.0654
X 100 = 1.70 %
3.8403
Annual swap price = 1.70 * 4 = 6.80 %
(b) First net payment = 100 (6.80 % - 6.00 %) * 3/12 = 0.20 million
TYPE: 6 VALUATION OF SWAP

(1) Value of swap can be defined as the difference value of fixed leg and value of floating leg.
Value of swap = Value of fixed leg – Value of floating leg
(2) Initially value of swap is zero. However, as the time passes, rates changes in market and hence swap
comes to have a non – zero value.
(3) Valuation of swap can be categorized in 2 parts.

(a) Valuation of swap at re – set date – Under this, we have to calculate value of fixed leg only. No need to
calculate value of floating leg as we know that at every re – set date the value of floating leg is equal to its
par value.
(b) Valuation of swap other than re – set date – Under this, for valuation of swap we have to compute both
values i.e. value of fixed leg as well as value of floating leg and the difference between these two legs are
known as value of swap.
 Whenever holder of swap has a long position in fixed rate bond and a short position in floating
rate bond then value of swap will be as under:
Value of swap = Value of fixed leg – Value of floating leg
 Whenever holder of swap has a short position in fixed rate bond and long position is floating rate
bond then value of swap will be as under:
Value of swap = Value of floating leg – Value of fixed leg
Note: If under the valuation of swap LIBOR rates are continuous compounding rates, then for calculation
of value of leg we should apply following formula:
Present value of future cash flows = Cash flow * e -rt
Where,
r = Rate of interest
t = time period (always expressed on per annum basis)
e = exponential value
Note: If any value is in power of of e i.e. e x, then it can be replaced by 1 + x.

FLOW CHART OF SWAP VALUATION
Re- set date Other than re –

valuation set date
Value of swap = value of Fixed leg – value of floating leg
Value of floating leg = Par value Value of floating leg = Present value
of next coupon payment + Present
Value of fixed leg = Present value of value of notional principal
future cash flows Value of fixed leg = Present value of
all interest payment + Present value
of notional principal
Class example: 29 Cavin Cally Limited a large export house from India entered into a five – year interest
rate swap with the ICICI bank, under which it has contracted to pay 8 % and receive six – month LIBOR
semi – annually, on a notional principal amount of $ 25 million. This deal was set – up on April 1, 2003.
On April 01, 2005, after the swap payments were settled, the treasurer of Cavin Cally suggested that the
swap be cancelled as the rates in the market have dropped considerably. He approached the bank, which
agreed to cancel the deal at 6 %, which is also the current rate for the 3 years swap deal for fixed Vs.
LIBOR.
You are required to find out the following:
(a) If the deal was to be cancelled on April 1, 05, what amount of money would be required to be paid? By
whom?
(b) instead of cancelling the existing deal, if a new deal was made and allowed to run for 3 years (till the
maturity of the original deal), what would be the cash flow on the fixed leg of the new deal? (Assume that
each period is exactly 6 months).
Class example: 30 Consider the following information relating to a swap deal with a notional amount of $
500 million entered by a client with a swap bank:
Remaining terms of maturity 4 years and 9 months
Reset frequency Semi – annually
Interest rate of the fixed leg 4%
Interest rate of floating rate LIBOR
LIBOR applicable to the current half – year 3.25 %
Present market quote for a 5 year swap 5 – year US T – bill note yield + 30 basis points
Current yield on 5 – year US T note 3.10 %
Current 3 – month LIBOR 2.95 %
Considering that the client pays the fixed leg, you are required to find out value of the swap for the client.

Solution: Value of swap = Value of floating leg – Value of fixed leg

(a) Value of floating leg:
3.25 %
3 months
Last re – set date Valuation date Payment date
Cash flow after 3 months: [500 * 3.25 % * 6/12] + 500

= 8.125 + 500 = 508.125
Market interest rate today = 2.95 % p.a.
508.125
Present value of floating leg = 2.95
1+ ∗3
12
508.125 / 1.0074 = 504.39
(b) Value of fixed leg:

3 months 10 M
9 months 10 M
15 months 10 M
21 months 10 M
27 months 10 M
33 months 10 M
39 months 10 M
45 months 10 M
51 months 10 M
57 months 10 M
Present value of future interest payment:
10 * 8.280 (1.70 % for 9 years) + 500 * 0.859
82.80 + 429.50 = 512.30
Present value of cash flow after 3 months = 512.30 + 10 = 522.30
Hence, present value of cash flow today:

522.30
3.40 = 522.30 / 1.0085
1+ 𝑋3
12
= 517.89
Value of swap = 504.39 – 517.89 = - 13.50 million
Class example: 31 Suppose that a financial institution pays six – months LIBOR and receive 8 % per
annum (with semi – annual compounding) on a swap with a notional principal of $ 100 and the remaining
payment dates are in 3, 9 and 15 months. The swap has a remaining life of 15 months. The LIBOR rates
with continues compounding for 3 – month, 9 – month, and 15 – month maturities are 10 %, 10.50 % and
11 % respectively. The 6 – month LIBOR rate at the last payment date was 10.20 % (with semi – annual
compounding). What is the value of swap?
Solution:
(a) Value of fixed leg:
4 X e -0.10 * .25 + 4 X e -0.105 * 0.75 + 104 X e – 0.11* 1.25
4 X e – 0.025 + 4 X e – 0.07875 + 104 X e – 0.1375
1 1 1
4X +4X + 104 X
1.025 1.07875 1.1375
3.902 + 3.708 + 91.429 = 99.039

(b) Value of floating leg:

105.10 X e – 0.10 * 0.25
105.10 X e – 0.025
1
105.10 X = 102.537
1.025
Value of swap = 99.039 – 102.537 = - 3.498 $
Class example: 32 Under the terms of an interest rate swap, a financial institution has agreed to pay 10%
per annum and to receive 3-month LIBOR in return on a motional principal of $100 million with payments
being exchanged every 3 months. The swap has a remaining life of 14 months. The average of the bid and
offer fixed rates currently being swapped for 3-month LIBOR is 11.82% per annum for all maturities being
continues compounding. The 3-month LIBOR rate 1 month ago was 11.8% per annum. What is the value
of the swap?
Solution:
2M 3M 3M 3M 3M
2.5 2.5 2.5 2.5 2.5 + 100
(a) Value of fixed leg:

2.5 X e – 0.1182*2/12 + 2.5 X e – 0.1182 * 5/12 + 2.5 X e – 0.1182 * 8/12 + 2.5 X e – 0.1182 * 11/12 + 102.5 X e -0.1182 * 14/12
2.5 X e – 0.0197 + 2.5 X e – 0.0492 + 2.5 X e – 0.0788 + 2.5 X e – 0.1083 + 102.5 X e – 0.1379
2.5 2.5 2.5 2.5 102.5
+ + + +
1.0197 1.0492 1.0788 1.1083 1.379
2.45 + 2.38 + 2.32 + 2.26 + 90.08 = 99.49
(b) Value of floating leg:

102.95 X e – 0.1182 * 2/12
102.95 X e – 0.0197
102.95
= 100.961
1.0197
Hence, Value of swap = 100.961 – 99.49 = 1.471
Class example: 33 A $ 100 million interest rate swap has a remaining life of 10 months. Under the terms
of the swap, six – month LIBOR is exchanged for 12 % per annum compounded semi – annually. The
average of the bid – offer rate being exchanged for six – month LIBOR in swap of all maturities is
currently 10 % per annum with continues compounding. The six – month LIBOR rate was 9.60 % per
annum two months ago. What is the current value of the swap to the party paying floating?
Class example: 34 An interest rate swap was entered into at a fixed rate of 13 % against LIBOR both
annual. The swap has 5.25 years to go. The current 5 – year swap rate is 10 %. The 3 – month LIBOR is 7
% and the one year LIBOR at the last reset date 9 months ago was 11 %. Compute the swap’s value.
TYPE: 7 INTEREST RATE SWAP FOR INVESTMENT

Whenever interest rate swap contract are for investment purpose, then due to such interest rate swap both
the parties will get more benefit in form of interest on investment. Hence interest rate for investment must
be higher in comparison to no interest rate swap rate.
Step: 1 Identify the absolute advantage party. Absolute advantage party means party having higher
investment return in both market.

Step: 2 Calculate comparative advantages for the absolute advantage party and select the market which
provide higher return and the other party’s investment market gets automatically decided.
Step: 3 Design a swap between them as per the requirement of question.
Step: 4 Prepare a statement showing gain or loss due to swap and its allocation between parties of swap.
Step: 5 Calculate effective rate of return on investment for both the parties
TYPE: 8 INTERET RATE SWAP CONTRACT WITH OPTIONS

Under interest rate swap with option contract, two types of options are available with parties:
(a) Cap / Call option – This option contract fixed highest interest rate. If interest rate goes beyond the cap
rate option will exercise by the option buyer and if interest rate is below from cap rate, then option buyer
does not exercise the option. This option is beneficial for borrower.
(b) Floor / Put option – This option contract fixes minimum interest rate. If market interest rate rises then
option will not exercise by the option buyer and if market interest rate decreases in comparison to floor
rate, then option will be exercise by the option buyer.
QUESTION BANK RELATED TO SWAP

Q. 10 Companies A and B have been offered the following rates per annum on a $ million five – year loan:
Company Fixed Floating
A 5% LIBOR + 0.10 %
B 6.4 % LIBOR + 0.60 %
Company A requires a floating rate loan; Company B requires a fixed rate loan. Design a swap that will
net a bank, acting as intermediary 0.10 % per annum and that will appear equally attractive to both
companies.
Answer:
Effective rate for A – LIBOR – 0.30 %
Effective rate for B – 6.0 %
Q. 11 Company X wishes to borrow U.S. $ at a fixed rate of interest. Company Y wishes to borrow
Japanese Yen at a fixed rate of interest. The amounts required by the two companies are roughly the same
at the current exchange rate. Interest rate for companies are as under:
Yen $
X 5.0 % 9.60 %
Y 6.50 % 10.0 %
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap
equally attractive to the companies.
Answer:
Effective rate for X – 9.30 %
Effective rate for Y – 6.20 %
Q.12 Companies X and Y have been offered the following rates per annum on a $ 5 million to years
investment:
Company Fixed Floating
X 8.0 % LIBOR
Y 8.80 % LIBOR
Company X requires a fixed rate investment; Company Y requires a floating rate investment. Design a
swap that will net a bank, acting as intermediary, 0.20 % per annum and will appear equally attractive to X
and Y.
Answer:
Effective rate for X – 8.30 %
Effective rate for Y – LIBOR + 0.30 %

Q.13 Electronic Limited enjoys a high rating in Indian market due to its Indian money market due to its
strong financials and track record. Tim software Ltd. is a new but a growing company. Electronic and Tim
software Ltd. can obtain loans at the rate given below:
CD (Company deposit) with fixed Mumbai inter – bank money
rate market with variable rate
Electronic Ltd. T + 0.50 MIBOR + 0.10
Tim software Ltd. T + 2.10 MIBOR + 0.60
Here T means the risk free 15 years Government bonds.
Electronic Ltd. wants to take a loan at variable rate, while Tim software Ltd. wants to take loan at fixed
rate. The two companies approached a bank to design a suitable swap.
(a) If the bank wants to have a profit of 0.20 % to be contributed from Tim software’s share of swap
benefit, what would be the two agreements that the bank will enter with these two companies.
(b) What are the likely costs of debts to the two companies? [RTP – Nov. 2008]
Q. 14 Mary Martin, the treasurer of Cañon Candy Company believes interest rates are going to rise, so she
wants to swap her future floating rate interest payments for fixed rates. At present she is paying LIBOR +
2% per annum on $5,000,000 of debt for the next two years, with payments due semi-annually. LIBOR is
currently 4.00% per annum. Ms. Martin has just made an interest payment today, so the next payment is
due six months from today. Ms. Martin finds that she can swap her current floating rate payments for fixed
payments of 7.00% per annum. She has to pay fixed and received only LIBOR.
(a) If LIBOR rises at the rate of 50 basis points per six month period, starting tomorrow, how much does
Ms. Martin save or cost her company by making this swap?
(b) If LIBOR falls at the rate of 25 basis points per six month period, starting tomorrow, how much does
Ms. Martin save or cost her company by making this swap?
Q. 15 Companies X and Y enter into a 2 – year plain vanilla interest rate swap. The swap cash flows are
exchanged semi - annually, and the reference rate is 6 – month LIBOR. The fixed rate of the swap is 3.784
% and the notional principal is $ 100 million. The various LIBOR rates are as under:
Beginning of the period LIBOR
1 3.00 %
2 3.50 %
3 4.00 %
4 4.50 %
5 5.00 %
Calculate cash flow for company X, the fixed payer of this swap. [FRM – Study Material]
Q. 16 Derivative bank entered into a plain vanilla swap through on OIS (Overnight index swap) on a
principal of `10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on the
principal. The swap was entered into on Monday, 2 nd August, 2010 and was to commence on 3 rd August,
2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75 %, 8.15 %, 8.12 %,7.95 %, 7.98 %,8.15 %.
If derivative bank received `317 net on settlement, calculate fixed rate.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working. [RTP – May, 2012]
Q. 17 Euroloan bank has a differential advantage in issuing variable – rate loans, but wishes to avoid the
income risk associated with such loan. Currently bank has a portfolio € 2,50,00,000 loans with PLR + 150
basis points, reset monthly PLR is currently 4 %. IB an investment bank has arranged for Eurolaon to swap
into a fixed interest payment of 6.50 % on notional amount of loan for its variable interest income. If
Euroloan agrees to this, what amount of interest is received and given in the first month? Further, assume
that PLR increased by 200 bp. [RTP – Nov. 2011]
Q. 18 A Ltd. is considering a ` 50 crores 3 year interest rate swap. The company is interested in borrowing
at floating rate however, due to its good credit rating, it has a comparative over lower rated companies in
fixed rate market. It can borrow at fixed rate of 6.25% or floating rate MIBOR+0.75%. Presently, MIBOR

is 5.25% but is expected to change in 6 months due to political situation in the country. X Ltd. an
intermediary bank agreed to arrange a swap. The bank will offset the swap risk with a counter party (B.
Ltd.) a comparative lower credit rated company, which could borrow at a fixed rate of 7.25% and floating
rate of MIBOR + 1.25%. X Ltd. would charge ` 12,00,000 per year as its fee from each party. Mr. Fin the
CFO, of A Ltd. desires that A Ltd. should receive 60% of any arbitrage saving (before payment of fees)
from the swap as A Ltd. enjoying high credit rating. Any fees paid to the bank are tax allowable. The
applicable tax rate is 30%.
You are required to:
(a) Evaluate whether the proposal is beneficial for both parties or not.
(b) Assuming that MIBOR was to increase to 5.75% immediately after political crisis over and shall
remain constant for the period of swap. Evaluate the present value of savings from the swap for A Ltd.,
assuming that interest payment are made semi - annually in arrears. [RTP – Nov. 2011]
Q. 19 The following details are related to the borrowing requirements of two companies ABC Ltd. and
DEF Ltd.
Company Requirement Fixed rate offered Floating rates offere
ABC Ltd. Fixed rupee rate 4.50 % PLR + 2 %
DEF Ltd. Floating rupee rate 5.00 % PLR + 3.00 %
Both Companies are in need of Rs. 2,50,00,000 for a period of 5 years. The interest rates on the floating
rate loans are reset annually. The current PLR for various period maturities are as follows:
Maturity (Years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375
DEF Ltd. has bought an interest rate Cap at 5.625% at an upfront premium payment of 0.25%.
(a) You are required to exhibit how these two companies can reduce their borrowing cost by adopting swap
assuming that gains resulting from swap shall be share equity among them.
(b) Further calculate cost of funding to these two companies assuming that expectation theory holds good
for the 4 years. [CA – RTP, May, 2011]
Q. 20 Suppose a dealer Rupam quotes ‘All – in – cost’ for a generic swap at 8 % against 6 month LIBOR.
If the notional principal amount of swap is `5,00,000.
(i) Calculate Semi – annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of swap
to the settlement date comprises 91 days and that the corresponding LIBOR was 6 % on the effective date
of swap.
(iii) In (ii) above, if settlement is on ‘net basis’, how much the fixed rate payer would pay to the floating
rate payer?
(iv) Generic swap is based on 30 /360 days basis.
Q. 21 Sandip Ltd.is planning to expand its cotton apparel division, by setting up 100 looms and installing
adequate machinery in Gujrat. It expect the total cost of the project, including cost of the land to be `3
crores, repayable at the end of the third year.
Fixed interest rate 11.00 %
Floating interest rate MIBOR + 2.50 %
Susmita consumer goods Ltd. (SCGL) is also an expansion mode. It also requires `3 crores, repayable at
the end of the third year.
Fixed interest rate 10.00 %
Floating interest rate MIBOR + 1.00 %
Sandip anticipates a contraction in economy and therefore a reduction in interest rate, and therefore wants
to opt for floating rate. SCGL is worried about rising inflation and wants to freeze its interest rate by
option choosing fixed interest rate option. Both these companies enter into a swap arrangement. If interest
payments are to be made half – yearly based on interest prevailing at the beginning of the 6 month period.
MIBOR today is 10 % and rate at the beginning of the next five half years are 9.00 %, 9.50 %, 11.00 %,
10.00 % and 8.00 %. Ascertain the cash flows. [CWA – Study material]

Q. 22 TMC Corporation entered into € 3.50 million notional principal interest rate swap agreement. As per
the agreement TMC is to pay a fixed rate and to receive a floating rate of LIBOR. The payment will be
made at the interval of 90 days for one year and it will be based on the adjustment factor 90/ 360. The term
structure of LIBOR on the date of agreement is as follows:
Days Rate (%)
90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate fixed rate on the swap and first net payment on the swap.
[RTP – Nov. 2010]
Q. 23 Drilldip Inc. a US based company has a won a contract in India for drilling oil filed. The project will
require an initial investment of ` 500 crore. The oil field along with equipments will be sold to Indian
Government for ` 740 crore in one year time. Since the Indian Government will pay for the amount in
Indian Rupee (`) the company is worried about exposure due exchange rate volatility.
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US$ = ` 50 in one year, then
should the company should opt for this option or should it just do nothing. The spot rate after one year is
expected to be 1US$ = ` 54. Further you may also assume that the Drilldip can also take a US$ loan at 8%
p.a. [CA – RTP – Nov. 2013]
TOPIC: CURRENCY SWAP

(i) Currency swap is an over – the – counter product of forex market.
(ii) Currency swap is a multiple settlement derivatives. Under currency swap settlement is done on every re
– set date.
(iii) Under currency swap principal and interest both are exchanged.
(iv) Currency swap provides hedge against two types of risk:

 Currency risk
 Interest risk
(v) Following are the steps for currency swap:

Step: 1 Initial exchange of currencies at t = 0 at spot rate.
Step: 2 Exchange the interest during the entire life of contract.
Step: 3 Re – exchange of principal at expiry date at spot rate agreed at t = 0
Q. 24 A Inc. and B Inc. intend to borrow $ 2,00,000 and $ 2,00,000 in ¥ respectively for a time horizon of
one year. The prevalent interest rates are as follows:
Company ¥ $
A Inc. 5% 9%
B Inc. 8% 10 %
The prevalent exchange rate is $ 1 = ¥ 120.
They entered into a currency swap under which it is agreed that B Inc. will pay A Inc. @ 1 % over the ¥
loan interest rate which the later will have to pay as a result of the agreed currency swap whereas A Inc.
will reimburse interest to B Inc. only to the extent of 9 % keeping the exchange rate invariant, quantify the
opportunity gain or loss component of the ultimate outcome, resulting from the designed currency swap.
[CA – RTP - Nov. 2013]
Q. 25 Consider a currency swap in which the domestic party pays a fixed rate in the foreign currency, the
British Pound, and the counter party pays a fixed rate in US $. The principals are $ 50 million and £ 30

million. The fixed rates are 5.60 % in dollars and 6.25 % in pounds. Both sets of payments are made on the
basis of 30 days per month and 365 days per year, and the payments are made semi – annually.
(a) Determine the initial exchange of cash that occur at the start of the swap.
(b) Determine the semi – annual payments.
(c) Determine the final exchange of cash that occurs at the end of the swap.
SOLUTION:
(i) Calculation of Initial exchange of principal:
$ 50 Million
Domestic Counter party
party
£30 million
Since domestic party pays fixed interest rate in £. Hence it must have receive £ at initial exchange. This
automatically means it has paid $ 50 million.
(ii) Calculation of semi – annual payments
£ Interest = 30 * 6.25 % * 180 / 365

Domestic = 0.925 M £ Counter party
party
$ Interest = 50 * 5.60 %* 180 / 365
= 1.381 M
(iii) Final exchange of principal amount:
£30 million
Domestic Counter party
party
$ 50 Million
Q. 26 A Canadian corporation with a French subsidiary cash flows of € 10 million a year. It wants to use a
current swap to lock in the rate at which it converts to Canadian dollars. The current exchange rate is CAN
$ 0.825 / €. The fixed rate on a currency swap in Euros is 4 % and the fixed rate on a currency swap in
Canadian dollar is 5 %.
(a) Determine the notional principal in Euros and Canadian dollars for a swap with annual payments that
will achieve the corporation’s objective.
(b) Determine the overall periodic cash flow from the subsidiary operations and the swap.
Q. 27 Mcdonnoughs Hamburger company wishes to lend $ 5,00,000 to its Japanese subsidiary. At the
same time, Yasufuku Heavy Industries is interested in making a medium term loan of approximatel y the
same `1amount to its U.S. subsidiary. The two parties are brought together by an investment bank for the
purpose of making parallel loans. Mcdonnoughs will lend $ 5,00,000 to the U.S. subsidiary of Yasufuku
for 4 years at 13 %. Principal and interest are payable only at the end of the fourth year with interest
compounding annually. Yasufuku will lend the Japanese subsidiary if Mcdonnoughs 70 milion Yen for 4
years at 10 %. Again the principal and interest (annual compounding) are payable at the end. The current
exchange rate is 140 Yen to the $. However, the dollar is expected to decline by 5 Yen to the dollar per
year over the next 4 years.
(a) If these expectations prove to be correct, what will be the dollar equivalent of principal and interest
payments to Yasufuku at the end of 4 years?
(b) What total dollars will Mcdonnoughs will receive at the end of 4 years from the payment of principal
and interest on its loan by the U.S. subsidiary of Yasufuku?
(c) Which party is better off with the parallel loan arrangement? What would happen if the Yen did not
change in value? [CA – Study Material]

Q. 28 A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates
€25,000,000 a year, received in equivalent semi-annual installments of €12,500,000. The British company
wishes to convert the euro cash flows to pounds twice a year. It plans to engage in a currency swap in
order to lock in the exchange rate at which it can convert the euros to pounds. The current exchange rate
is €1.5/£. The fixed rate on a plain vanilla currency swap in pounds is 7.5 percent per year, and the
fixed rate on a plain vanilla currency swap in euros is 6.5 percent per year.
(a) Determine the notional principals in euros and pounds for a swap with semi-annual payments that will
help achieve the objective.
(b) Determine the semi-annual cash flows from this swap. [CFA - Exam]
Q. 29 A company based in Germany has a Czech subsidiary.

• The subsidiary generates 25,000,000 CZK a year, received in equivalent semi - annual instalments of
12,500,000 CZK.
• The British company wishes to convert the CZK cash flows to EUR twice a year.
• It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the
CZK to EUR.
• The current exchange rate is CZK 27/EUR.
• The fixed rate on a plain vanilla currency swap in EUR is 7.5 percent per year, and the fixed rate on a
plain vanilla currency swap in EUR is 6.5 percent per year.
(a)Determine the notional principals in euros and pounds for a swap with semi - annual payments that will
help to achieve the objective.
(b)Determine the semi - annual cash flows from this swap.
TOPIC: FUTURES
(1) Meaning of futures – Future contracts are forwards except they are always traded on exchange
whereas forwards are always traded as OTC (Over the counter).
Party A Party B
Enter into an agreement to buy 100 shares
of reliance for `2,500 each. Settlement will take

place in future.
Under future contract both the parties have rights as well as obligation. This can be explained as under:
Party Right Obligation
A To receive 100 shares of reliance To pay `2,500 per share
B To receive `2,500 per share To deliver 100 shares of reliance
In other words, futures are –

(i) Futures are financial derivatives.
(ii) They are traded on the exchange.
(iii) Under futures buy or sell a specified amount or quantity at an agreed price.
(iv) Agreement is to be entered today for the settlement at specified future date.
(2) Difference between futures and forwards – Future contracts are same as forward contracts because
both futures and forwards involves a contract to buy or sell a asset at some letter date at a price per –
determined today. However, the following differences exist between futures and forward –
Futures Forwards
1. Futures are exchange traded 1. Forwards are over the counter
2. Futures are standardized contract (i.e. lot size, 2. Forwards are customized contracts
maturity date is fixed)
3. Margin requirement 3. No margin requirement
4.Daily mark to market features 4. No mark – to – market features

5. High liquidity 5. Low liquidity

6. Highly regulated 6. Less regulations
7. Futures are cash settled contracts 7. Forwards are physically settled
(3) Meaning of buying and selling futures –
Buying futures means Selling futures means

taking delivery of giving delivery of
underlying. underlying.
(4) Margin requirement under future contracts – The person dealing in derivative transaction has to
deposit an initial margin as specified. This margin is adjusted for daily gain or loss. His transaction is daily
settled at market price known as mark – to – market. The adjusted margin is then compared with
maintenance margin and made margin call and withdrawn accordingly.
Following rules should be followed for margin:

(i) If adjusted margin is less then initial margin but more than maintenance margin, no further adjustment
is to be done.
(ii) If adjusted margin is greater than initial margin, he can withdraw the excess amount as allowed.
(iii) If adjusted margin is below the maintenance margin then he will bring further amount to make his
margin balance equal to the initial margin.
Flow chart of process of margin:

Excess amount can be withdrawn
Initial margin
Maintenance margin By depositing margin, so that margin balance

should be equal to the initial margin
Note: Generally initial and maintenance margin will be given. If it is not given, we are required to use the
following formula.
Initial margin = µ + 3σ
Maintenance margin = 75 % of initial margin
Here,
µ = mean of daily absolute change in the value of future contract.
σ = Standard deviation of the daily absolute change in the value of the future contract.
The formula is based on the property of normal distribution whereby a variable cannot deviate from its
mean by more than 3 standard deviation.
How to prepare statement showing margin call and closing balance of margin account:
Day Settlement Opening Mark to Adjusted Margin Margin Closing
price balance of market margin call withdrawal balance of

margin margin margin account

account
1 Xxx xxx Xxx Xxx xxx xxx Xxx
2 Xxx xxx xxx Xxx xxx xxx Xxx
Class example: 35 The settlement price of an index future contract on a particular day was 1,760. The
multiple associated with the contract is 100. The maximum amount by which the contract can realistically
change is 50 points per day. The initial margin is, therefore set at 50 X 100 = `5,000. The maintenance
margin is set at `4,000. The settlement prices on the following four days are as follows:
Day Settlement price
1 1,800
2 1,752
3 1,780
4 1,824
Required:
Calculate the mark – to – market cash flows, the daily closing balances and net profit (loss) in the accounts
of,
(a) An investor who has gone long at 1,760.
(b) An investor who has gone short at 1,760.
Solution:
(a) Statement showing closing balance of margin account: (Investor has gone long at 1,760)
Day Settlement Opening Mark – to – Adjusted Margin Closing
price balance market balance call balance
1 1,800 5,000 4,000 9,000 - 9,000
2 1,752 9,000 (4,800) 4,200 - 4,200
3 1,780 4,200 2,800 7,000 - 7,000
4 1,824 7,000 4,400 11,400 - 11,400
(b) Statement showing closing balance of margin account: (Investor has short at 1,760)
Day Settlement Opening Mark – to – Adjusted Margin Closing
price balance market balance call balance
1 1,800 5,000 (4,000) 1,000 4,000 5,000
2 1,752 5,000 4,800 9,800 - 9,800
3 1,780 9,800 (2,800) 7,000 - 7,000
4 1,824 7,000 (4,400) 2,600 2,400 5,000
Class example: 36 A trader has gone long on 5 Brent crude futures for December settlement at $ 26.32 per
barrel. The minimum contract size for Brent futures contract is 1,00,000 barrel. The initial margin is $
50,000 and the maintenance margin is $ 30,000. The future closes at the following prices on the next 10
trading days:
Day 1 2 3 4 5 6 7 8 9 10
Settlement 26.19 26.30 26.45 26.48 26.34 26.21 25.98 25.87 25.90 25.95
price ($)
The trader will take out the profit out of the margin account whenever he gets the opportunity to do so.
(a) Prepare the margin account showing all the cash flows.
(b) Find the profit / loss for the trader after 10 trading days.
Solution: Initial Margin for 5 contracts = 5 X 50,000 = $ 2,50,000

Maintenance margin for 5 contracts = 5 X 30,000 = $ 1,50,000
Statement showing closing balance of margin account

Day Settlement Opening Mark – to Adjusted Margin Withdrawn Closing balance
price balance market margin call of margin account
1 26.19 2,50,000 (65,000) 1,85,000 - - 1,85,000

2 26.30 1,85,000 55,000 2,40,000 - - 2,40,000

3 26.45 2,40,000 75,000 3,15,000 - 65,000 2,50,000
4 26.48 2,50,000 15,000 2,65,000 - 15,000 2,50,000
5 26.34 2,50,000 (70,000) 1,80,000 - - 1,80,000
6 26.21 1,80,000 (65,000) 1,15,000 1,35,000 - 2,50,000
7 25.98 2,50,000 (1,15,000) 1,35,000 1,15,000 - 2,50,000
8 25.87 2,50,000 (55,000) 1,95,000 - - 1,95,000
9 25.90 1,95,000 15,000 2,10,000 - - 2,10,000
10 25.95 2,10,000 25,000 2,35,000 - - 2,35,000
Class example: 37 On June 05, 2005 you bought 5 gold futures at a price of $ 297.50 per ounce. The size
of gold future is 100 ounce per contract, initial margin is $ 2,000 per contract and maintenance margin is $
1,500 per contract. Closing prices of gold futures for 10 trading days are:
Date June June June 07 June June June June June June June
05 06 10 11 12 13 14 17 18
Price 298.20 297.10 294.40 293.90 292.70 287.00 287.00 287.80 288.50 289.10
($)
On June 19, 2005 you square – off the position at a price of $ 289.70. Yo You are required to prepare the
margin account showing all the cash flows and calculate profit / loss after squaring – off the contract. (You
can assume any amount above the initial margin to be withdrawn).
Class example: 38 A Sensex futures are traded at a multiple of 50. Consider the following quotations of
Sensex futures in the 10 trading days during February, 2009:
Day High Low Closing
4.2.2009 3306.40 3290.00 3296.50
5.2.2009 3298.00 3262.50 3294.40
6.2.2009 3256.20 3227.00 3230.40
7.2.2009 3233.00 3201.50 3212.30
10.2.2009 3281.50 3256.00 3267.50
11.2.2009 3283.50 3260.00 3263.80
12.2.2009 3315.00 3286.30 3292.00
14.2.2009 3315.00 3257.10 3309.30
17.2.2009 3278.00 3249.50 3257.80
18.2.2009 3118.00 3091.40 3102.60
Abhishek bought one sensex futures contract on February, 04. The average daily absolute change in the
value of contract is ` 10,000 and standard deviation of these changes is ` 2,000. The maintenance margin
is 75% of initial margin. You are required to determine the daily balances in the margin account and
payment on margin calls, if any. [RTP – May, 2013]
(5) Currency futures

Currency futures were introduced in India in 2008.
Underlying currency of the currency future contract – The currency in which contract size is given is
known as underlying currency.
Currency further is available for 1 month, 2 months, …….. 12 months. This means expiry date of the
contract is fixed by the exchange and that is last working day of the month.
Currency future contracts are cash settled contracts. Physical settlement is not allowed.
How to use currency future for hedging:
Three critical dates for currency future contract:
T=0 T=1 T=2

Date on which contract Date on which future Contract expiry date
bought or sold contract will be settled
(Transaction settlement date)

Creation of hedging strategy:
Either OR
Buy at t = 0 and sell at t = 1 sell at t = 0 and buy at t =1
How to decide whether we should buy currency future at t = 0 or sell it at t = 0 – Do the same thing what
you have done in case of forward contract.
Which period future contract is to be settled – Next nearest expiry currency future contract from t = 1 (that
is expiry date of transaction)
STEPS FOR CURRENCY FUTURE HEDGING: Following are the steps to be followed under
currency future –
Step: 1 Identify the underlying currency of the future contract. Underlying currency is the currency in
which contract size is given.
Step: 2 Calculate numbers of future contracts to be taken for hedging purpose

𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑚𝑜𝑢𝑛𝑡
No. of contracts =
𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒/ 𝑙𝑜𝑡 𝑠𝑖𝑧𝑒
Note: Number of future contracts should be in rounding off.
Step: 3 Create a hedging strategy to hedge the risk.
Step: 4 On settlement date calculate hedge efficiency (if required) by comparing spot market result and
future market result.
OR
Step: 4 On settlement date calculate final cash flow due to currency future contract as under:
Cash flow due to spot market transaction Xx
Add/ Less: Cash flow due to future contract Xxx
Net amount Xxx
Step: 5 Calculate effective costs per unit due to currency future

Net amount
Effective cost per unit of currency =
exposure amount
Class example: 38 A Japanese company plans to set up a plant in UK. The plant is to be imported from
USA at a cost of $ 50 million. Japanese company will settle the dollar liability on December 15. The
current market quotes are:
Spot rate ($ / ¥) = 0.6545
December ¥ future = 0.6441
3 month $ / ¥ forward rate = 0.6432
Explain how the company can hedge currency risk. Also, calculate the effective cost in ¥ if the following
rates materialize on December 15:
Spot rate ($ / ¥) = 0.6400
December ¥ futures = 0.6389
(Assume standard size of a future contract is ¥ 12.50 million)
Class example: 39 A corporate is expecting to receive Yen 50 million after 3 months. It decides to hedge
the foreign exchange risk using the future markets. The standard size of Yen future contract is Yen 12.50
million. Currently, both spot and future Yen are quoting $ 0.00892. If after 3 months, when the corporate
close out, the futures are quoting $ 0.00885 and the spot price of the Yen is also $ 0.00885. Calculate the
effective realization for the corporate while selling the receivables.

Solution:
No. of future contracts = 50 / 12.50 = 4 contracts
Hedging strategy: Sell 4 Yen future contracts at t = 0.
T=0 T=1
Sell Yen future at 0.00892 Buy Yen future at 0.00885
Statement showing final settlement amount at t = 1

Amount realized from sell of Yen in spot market (5,00,00,000 *0.00885) 4,42,500
Add: Gain in future market (0.00892 – 0.00885) * 4 * 1,25,00,000 3,500
Net realization 4,46,000
Hence effective cost per unit = 4,46,000 / 5,00,00,000 = $ 0.00892 per Yen
Class example: 40 A germen company is planning to set up a plant in India. The whole plant will be
imported from USA at a cost of $ 2 million. German company will be settling the dollar liability on
December, 10. The current market quotes are:
$ / € spot rate = 0.8949
December € future = 0.8876
3 – month $ / € Forward rate = 0.8850
Explain how the company can hedge currency risk. Also, calculate the effective cost in € if the following
rates materialize on December, 10:
$ / € spot rate = 0.8760
December € futures = 0.8695
Assume that the standard size of a future contract is € 1,25,000.
Class example: 41 A US importing firm has a payable of euro 1 million on December 11 th. Today is
September 8 and the firm wants to hedge against appreciation of the euro. The following are the rates
prevailing today:
$ / € spot rate = 0.8950
The standard size of the contract is 1,25,000 euro.
If the following are the rates that prevail on December, 11:
Case A: $ / € spot rate = 0.8972
Case B: $ / € spot rate =0.8942

Calculate effective cost of purchase of euro.
(6) Pricing of future contracts / How to calculate theoretical future price – The spot price of a
commodity is known and standing today. Future price is known today but standing on future. The link
between these two is Rf i.e. either compound S or discounting F. This model is also known as cost of carry
model. We can apply cost of carry model in either of the following two forms:
Type: 1 Future value type
F = Spot price + Interest + future value of other factors
Type: 2 Present value type

Present value of F = S + Present value of other factors
Note: According to text book we should apply following formula for calculating theoretical value
F = S.ert
Here,
F = Theoretical price of future contract

S = Spot rate
r = Rate of interest p.a.
t = Time period
e = exponential value
where ex can be substituted by 1+ x
Following are the cases to find out theoretical future price:
Case A: Securities providing no income (Non – dividend paying shares or stock)

F = S.ert
Class example: 42
Spot rate `60
Maturity period of future contract 3 months
Risk – free rate of interest 8 % p.a.
Calculate theoretical future price.
SOLUTION:
F = S X e rt
60 X e0.08 * 3/12
60 X e0.02
60 X 1.02 = 61.20
Case B: Securities providing known income

Following steps should be followed:
Step: 1 Calculate present value of cash income (cash income Y)
Cash income. e-rt
Step: 2 Calculate adjusted spot price

Adjusted S = Spot price – Present value of cash income
Step: 3 Now compute theoretical future price

F = Adjusted S. ert
Class example: 43
Spot price `40
Period for future contract 6 months
Lot size 100 shares
Risk – free rate of return 12 % p.a.
Dividend payment (3 months from now) `2.5 per share
Calculate future price.
SOLUTION:
Step:1 Calculate present value of dividend income
2.50 X e – 0.12* 3/12
2.50 X e – 0.03
1
2.50 X = 2.43
1.03
Total amount of dividend = 2.43 * 100 = 243
Step: 2 Calculate adjusted S

Adjusted S = Spot rate – Present value of dividend
(40 X 100) – 243 = 4,000 – 243 = 3,757
Step: 3 Now calculate theoretical future price
F = Adjusted S X ert
3757 X e 0.12 * 6/12
3757 X e 0.06

3757 X 1.06 = 3,982.42

Class example: 44
Spot price `120
Contract size 50 shares
Dividend income after 4 months `3 per share
Calculate future price for 8 months contract.
Solution:
Step: 1 Calculate present value of dividend income
Dividend income X e – rt
3 X e – 0.10 * 4/12
3 X e – 0.033
1
3X = 2.90
1.033
Total income = 2.90 * 50 = 145.20

Adjusted S = Spot price – Present value of dividend income
(120 * 50) – 145.20
6,000 – 145.20 = 5,854.80
Step: 3 Calculate theoretical future price

F = Adjusted S X ert
F = 5,854.80 X e 0.10 * 8/12
F = 5,854.80 * 1.067 = 6,245.12
Class example: 45
Spot price `1,100
Risk – free rate 15 % p.a.
Dividend income:
After 3 months `4
After 6 months `6
After 9 months `8
Calculate theoretical future price for 1 year contract .
SOLUTION:
Step: 1 Calculate present value of dividend income
4 X e – 0.15 * 3/12 + 6 X e – 0.15 * 6/12 + 8 X e – 0.15 * 9/12
4 X e – 0.0375 + 6 X e – 0.075 + 8 X e – 0.1125
1 1 1
4X +6X +8X
1.0375 1.075 1.1125
3.856 + 5.58 + 7.19 = 16.626

Adjusted S = spot rate – present value of dividend
1,100 – 16.626 = 1,083.374
Step: 3 Calculate future price
F = Adjusted S X e rt
F = 1083.374X e 0.15 * 12/12
F = 1083.374 * 1.15 = 1245.8801
Case C: Securities providing a known dividend yield

F = S. e(r - y)* t/12

y = Dividend yield
Note:
(i) If time period of contract and period of income is same then above formula will apply directly.
(ii) If time period of contract and period of income is different than apply case B.
(iii) If dividend rate is given then apply on face value.
(iv) If dividend yield is given then apply on spot price (market price).
Class example: 46 From the following information calculate 1 month theoretical future price:
Spot price `500
Risk – free interest rate 15 % p.a.
Dividend yield 3 % p.a.
SOLUTION:
F = S X e (r - y) * t/12
F = 500 X e (15 % - 3 %) * 1/12
F = 500 X e 0.12 * 1/12
F = 500 X e0.01
F = 500 X 1.01 = 505
Class example: 47 From the following information calculate 3 – months theoretical future price
Spot price `500
Dividend yield 4%
SOLUTION:
F = S X e (r - y) * t/12
F = 500 X e (8 % - 4 %) * 3/12
F = 500 X e 0.04 * 3/12
F = 500 X e0.01
F = 500 X 1.01 = 505
Class example: 48 Calculate 4 – months theoretical future price.

Spot price `600
Risk – free rate of return 18 %
Dividend yield (to be received after 1 month) 6%
Class example:49 Calculate 2 month theoretical price from the following data:
Spot price `500
Risk – free rate 15 % p.a.
Dividend rate (dividend is expected to be received after 1 month) 25 %
Face value `100
Case D: Commodities having come storage cost

If storage cost is involved then storage cost can be considered as negative cash income. In such situation
following steps will apply.
Step: 1 Calculate present value of storage cost

Present value of storage cost = Storage cost. e -rt
Step: 2 Calculate adjusted spot price

Adjusted spot price = spot price + present value of storage cost

Step: 3 Now calculate theoretical future price as under

F = Adjusted S.e rt
Concept of convenience yield – A Convenience yield, a common concept in the valuation of commodity
futures. Convenience yield is the benefit from storage of the physical commodity. Storage may provide
profit opportunities in case of temporary shortages in the commodity. When shortage occur, the spot price
for the commodity is high, generating a convenience yield.
Case: E Future price of commodity when convenience yield is given in % terms

F = Spot price. e(r - c)* t
Where c = Convenience yield in % terms
Case F: Future price of commodity when convenience yield is given in amount terms
Step: 1 Calculate present value of convenience yield
Present value of CY = CY.e-rt

Adjusted S = Spot price – Present value of CY
Step: 3 Calculate future price

F = Adjusted S. ert
Case: G Future price of commodity when storage cost and convenience yield both are given
Step: 1 Calculate present value of storage cost
Step: 2 Calculate present value of convenience yield
Step: 3 Calculate adjusted S in the following manner

Adjusted S = Spot price + Present value of storage cost – Present value of convenience yield
Step: 4 Calculate Future price in the following manner

F = Adjusted S.e rt
Case: H Pricing of currency future – The pricing of currency future is exactly similar to pricing of stock
future in case of dividend yield form but the currency does not give any dividend, therefore we would
replace it with interest rate.
F = S + S. (Quote currency interest rate – Base currency interest rate) * T/12
Class example: 49A Suppose three month LIBOR on the USD is 1.28% and on the Euro is 2.52%. The
spot rate is 1 USD 0.9250 Euro. What should be the three month forward rate between USD and Euro?
Class example: 50 J Limited trades in paper boards and manufacture carton boxes. Following information
is available in the future market on paper board –
Single layer paper Double layer paper board
board
Spot price `500 per Kg. `720 per Kg.
Carrying cost (` per quintal per quarter) payable `150 `200
at the end of each quarter
Cash rebate for high volume purchase (receivable `10 per Kg. `15 per Kg.
after 4 months)
6 – months future contract rate for 1 tonne `5,20,000 `7,40,000
Risk free interest rate is 9 % per annum. Calculate future price for 6 months period.
Class example: 51
9 – Months future price of a commodity = `635
Risk – free rate of return = 8 % p.a. compounded quarterly
Calculate spot price.

Class example: 52
6 – Months future price: `165
Spot price: `160
Storage cost: `8 at the end of every month.
Risk – free rate of return: 12 % p.a. compounded monthly
Calculate present value of CY.
Class example: 53
Spot price: `430
Risk – free rate of return: 1.50 % per month
Storage cost: 0.90 % per month
Monetary benefits: 0.60 % per month
Convenience yield: 0.80 per month
All these rates are compounded continuously. Find the price of 3 months future. Given e 0.03 = 1.03045
(7) Commodity futures – A future contract is an agreement for buying or selling a commodity for a
predetermined delivery period at a specific future price is known as commodity future. Suppose a farmer is
expecting a crop of wheat to be ready in 2 months, time, but is worried that the price of wheat may decline
in this period. In order to minimize a risk, he can enter to future contract to sell his crop in 2 months’ time
at a price determined now. This way he is able to hedge his risk arising from a possible adverse change in
the price of his commodity.
How to compute net gain / loss due to commodity futures:

(A) Gain or loss in spot market
Difference between cash flows due to spot market dealing Xxx
(B) Gain / Loss in future market
(i) Difference between buying and selling rate xxx
(ii) No. of future contracts xxx
(iii) Size of each contract xxx
Gain / loss due to future contract (i * ii* iii) Xxx
Net profit (A + B) Xxx
How to compute effective rate:

Cash flow due to transaction in spot market Xxx
Add/Less: cash flow due to future market Xxx
Net cash flow Xxx
Total quantity Xxx
Effective rate per unit (Net cash flow / total quantity) Xxx
Class example: 54 In March, a wheat farmer is planning to plant 1,00,000 bushels of wheat, which will be
ready for harvesting by late August and delivery in September. The farmer knows from past years that the
total cost of planting and harvesting the crops is about to $ 6.30 per bushel. At that time, September wheat
futures are trading at $ 6.70 per bushel and the wheat farmer wishes to lock in this selling price. Each
wheat future contract covering 5,000 bushels. By mid – August, his wheat crops are ready for harvesting.
However, the price of wheat have since fallen and the price has dropped to $ 6.20 per bushel.
Correspondingly, prices of September wheat future have also fallen and are now trading at $ 6.33 per
bushel. Calculate net profit / loss to wheat farmer.
SOLUTION:
(A) Gain or loss in spot market:
Amount realized from sale (1,00,000 * 6.20) $ 6,20,000
Less: Planting and harvesting cost $ 6,30,000
Loss in spot market $10,000
(B) Gain / loss in future market:
Rate at t = 0 (Selling rate) 6.70
Rate at t = 1 (Buying rate) 6.33

Profit $ 0.37
No of future contracts (1,00,000 / 5,000) 20
Size of each contract 5,000
Profit due to future market (5,000 * 20 * 0.37) $ 37,000
Net profit $ 27,000
Class example: 55 In June a farmer expects to harvest at least 10,000 bushels of soybeans during
September. By hedging, he can lock in a price for his soybeans in June and protect himself against the
possibility of falling prices. In June following prices are available:
Spot rate for new crop soybeans = $ 6 per bushel
November future price = $ 6.25 per bushel
Contract size is 5,000 bushels of soybeans. At the beginning of September when farmer wants to sell his
crop, the prices are as under:
Spot rate = $ 5.72 per bushel
November soybeans future = $ 5.95 per bushel
Calculate effective selling price for the farmer.
Solution:
Cash inflow due to sale in spot market (10,000 * 5.72) 57,200
Cash inflow due to future:
Selling rate 6.25
Buying rate 5.95
Profit 0.30
Contract size (2,000 * 5) 10,000
Cash inflow due to future 3,000
Total cash inflows 60,200
Total quantity 10,000
Effective rate (60,200 / 10,000) 6.02
Class example: 56 It is June 8 and a company knows that it will need to purchase 20,000 barrels of crude
oil at some time in October or November. Oil future contracts are currently traded for delivery every
month and contract size is 1,000 barrels. The company therefore decides to use the December contract for
hedging. The future price on June 8 is $ 68.00 per barrel. The company finds that it is ready to purchase
the crude oil on November 10. It therefore closes out its future contract on that date. The spot price and
future price on November 10 are $ 70.00 per barrel and $ 69.10 per barrel.
(8) Hedge ratio concept – One more important decision to develop a hedging strategy is to determine the
optimal future position to follow, popularly known as optimal hedge ratio. In other words, in order to
minimize the risk, the hedger must take a future position i.e. the number of future contracts.
How to calculate hedge ratio:
σy
Hedge ratio = x r (between spot price and future price)
𝜎𝑥
Class example: 57 A company knows that it will buy 2 million gallon fuel of jet in six months. The
standard deviation of the change in price per gallon of fuel over a six months period is calculated as 0.020.
The company chooses to hedge by buying future contract on heating oil. The standard deviation of the
change in the future price over a three months period is 0.025 and the coefficient of correlation between
the three months change in the price of jet fuel and the three months change in future price is 0.50.
Calculate the optimum hedge ratio and number of Contracts Company should buy to hedge the risk.
(Contract size: 42,000 gallaons)
Class example: 58 An aviation company, kingfisher wants to purchase 4 million gallons of fuel in 1
month and decides to use similar oil futures for hedging. The future price and spot price of 10 successive
months are given below:
Month 1 2 3 4 5 6 7 8 9 10
Future 60.23 60.56 60.90 60.70 60.78 61.00 61.15 61.02 61.19 61.45

price
Spot 60.76 60.80 60.84 60.72 60.80 60.90 61.00 60.88 61.22 61.32
price
(a) Calculate minimum variance hedge ratio?
(b) What will be the optimal number of contracts for hedging?
(Assume size of future oil contracts = 50,000 gallons)
Class example:59 Bharat Oil Corporation (BOC) imports crude oil for its requirements on a regular basis.
Its requirements are estimated at 100 tonnees per month.
Of late, there has been a surge in the prices of oil. The current price (month of June) of crude oil is ` 5,500
per barrel. The firm expects the price to rise in coming months to ` 5,800 by August. It wants to hedge
against the rising prices for its requirements of the month of August.
Multi Commodity Exchange (MCX) in India offers a futures contract in crude oil. The contract size is 100
barrels and August contract is currently traded at ` 5,668 per barrel.
(a) How can BOC hedge its exposure against the rising price of crude oil?
(b) If Bharat Oil Corporation hede its exposure at MCX, how many contracts it must book?
(c) Analyse the position of BOC if in the month of August (i) the spot price is ` 5,750 and futures price is
` 5,788, (ii) the spot price is ` 5,417 and futures market were matched?
Ignore marking-to-the-market and initial margin on futures contracts. [CWA – RTP, June 2013]
(9) Arbitrage through futures – Whenever quoted future price is not equal to theoretical future price,
then there will be opportunity of arbitrage. By taking appropriate action an arbitrager can earn profit due to
mispriced future. There may be two situations for arbitrage:
Case A: Where F > (S + C) i.e. Quoted future price is more than theoretical future price
Step: 1 Sell future contract (i.e. Create short position)
Step: 2 Borrow sufficient amount and buy underlying at today’s spot price.
Step: 3 Repay loan with interest at contract expiry

Outflow = Loan amount + Interest
Step: 4 Calculate cash inflow due to future contract
Step: 5 Calculate arbitrage profit from the contract

Arbitrage profit = Inflow – Outflow
Case B: Where F< (S + C) i.e. quoted future price is less than theoretical future price
Step: 1 Buy future contract today (i.e. create long position)
Step: 2 Sell the underlying today and invest the proceeds for future period.
Step: 3 At contract expiry amount realized from investment with interest

Cash inflow = Value of investment + Interest
Step:4 Buy as per future contract and calculate cash outflow due to future contract.
Step: 5 Calculate arbitrage profit from the process

Arbitrage profit = Inflow – Outflow
Arbitrage problems can be categorized in following parts:

(a) Arbitrage of currency futures
(b) Arbitrage of stock futures
(c) Arbitrage of index future
(d) Arbitrage of commodity futures

Class example: 60 Consider a stock, currently trading at $80 (assuming no dividend). The interest rate is
1% per month (compounded monthly).
(a) What should be the “price” of a 3 month future on this stock?
(b) If a 6 month future is trading at $90, can you make arbitrage profit? How?
(c) If a 1 year future is trading at $90, can you make arbitrage profit? How?
Class example: 61 The following data available from the financial markets:
Spot exchange rate (` per $) 49.7500
90 – days futures 51.4000
` interest rate 12 %
$ interest rate 8%
Based on these data, find out the fair price of the future contract. Is there any arbitrage opportunity? If yes,
how can the arbitrage be executed?
Class example: 62
Spot price of gold per gram $ 10
Storage cost 2 % of its value to store a gram for one year
Annual interest rate 7%
1 year future price $ 11
Solution:
Theoretical future price = S + C
10 + 10 * 9 % = 10.90 $
Since quoted future price > Theoretical price, hence we should create short position on gold future.
Step: 1 Borrow $ 10 to buy the gold at spot rate and sell gold future. At t= 0 net investment must be zero.
Borrow at risk free interest rate of 7 % $ 10
Buy gold at spot rate ($ 10)
Sell gold future at $ 11 -
Net investment 0
Step: 2 At Maturity
Repay loan with interest (10 + 7 %) 10.70
Pay storage cost 0.20
Received from gold future 11
Arbitrage profit $ 0.10
Class example: 63
Spot price of index `650
1 year future price `665
Risk – free – interest rate 5%
Dividend yield 3%
Show the process of arbitrage.
SOLUTION:
F = S X e rt
650 X e (0.05 – 0.03) * 1
650 X e 0.02
650 X 1.02 = 663
Step: 2 Since quoted future price i.e. 665 > TFP, hence for arbitrage we should sell futures.
Step: 3 Process of arbitrage
At t =0
Borrow fund at Rf 650
Buy index (650)

Sell future at 665 0

Net cash flow today 0
At t = 1 (Maturity)
Activity Cash flow
Collect dividend (650 * 3 %) 19.50
Repay loan with interest (650 + 5 %) (682.50)
Settle future contract 665
Arbitrage profit 2
Class example: 64
Stock price 400
3 months future price 450
Risk – free interest rate 6%
Dividend yield 1%
SOLUTION:
F = S X e rt
F = 400 X e (0.06 – 0.01) * 3/12
F = 400 X e0.05 * 3/12
F = 400 X e0.0125
F = 400 X 1.0125 = 405
Step: 2 Since quoted future price i.e. 450 is greater than theoretical future price hence for arbitrage we
should create short position of stock future.
At t =0
Activity Cash flow
Borrow fund at risk – free rate 400
Buy stock at spot rate (400)
Sell stock future at 450 0
Net cash flow 0
At t = 1
Activity Cash flow
Settle stock future 450
Receive dividend (400 * 1 % * 3/12) 1
Repay borrowed amount with interest (400 * 6 % * 3/12) (406)
Arbitrage profit 45
Alternative solution:
Since with dividend yield p.a. is not given, so we can assume that full 1 % dividend is to be paid by the
company on stock.
Step: 1 Calculate theoretical future price as per cost of carry model

Future price = Spot price + Interest saved – Dividend foregone
400 + 400 * 6 % * 3/ 12 – 400 * 1 %
400 + 6 – 4 = 402
Step: 2 Since Quoted future price is greater than theoretical future price and hence for arbitrage we should
sell stock future.


At t = 0
Activity Cash flow
Sell future at 450 0
Borrow fund at risk – free rate 400
Buy stock at spot rate (400)
Net cash flow 0
At t = 3 months
Activity Cash flow
Repay loan with interest (400 * 6 % * 3/12) (406)
Receive dividend (400 * 1 %) 4
Settle future contract 450
Net cash flow / Arbitrage profit 48
Class example: 65
Stock price 800
6 – months future price 810
Risk – free rate 10 %
Dividend yield 4 % p.a.
Solution:
F = S X e (r - y) * 6/12
F = 800 X e (.10 – 0.04) * 6/12
F = 800 X e 0.03
F = 800 X 1.03 = 824
Step: 2 Since Quoted future price is less than theoretical future price so for arbitrage we should buy stock
future.
Step: 3 Process of arbitrage:

At t = 0
Activity Cash flow
Buy stock future at 810 0
Short sell of stock (borrow stock and sell in spot 800
market)
Invest the fund at risk – free rate of interest (800)
Net cash flow 0
At t = 6 months
Activity Cash flow
Mature investment with interest (800 * )
Class example: 66 Current future price for delivery of gold in 60 days is $ 375 per troy oz. The current
spot price of gold is $ 365 per troy oz. Storing gold costs $ 12 per oz. per year and the storage costs are
paid when the gold is taken out of storage. Risk – free rate of interest is 6 % per year. Consider 360 days in
a year.
Answer:
Theoretical future price = 370.65
Arbitrage strategy – sell gold future
Arbitrage profit – 4.35

Class example: 67 Following data are available on March 15 th:

IBM stock price $ 125
September 15 Future price $ 123
Risk – free rate 7%
Dividend in IBM (Paid on the first day of February, May, August and $ 2.50
November)
Show the process of arbitrage. Consider 360 days.
Answer:
Theoretical future price – 124.39 $
Arbitrage profit – 1.38
Class example: 68 Following data are available on January 10, 2002
Spot exchange rate (`/$) 46.3500
Future exchange rate (` /$) : Quoted on June 9, 2002 46.7900
6 – months Indian interest rate 7 % p.a.
6 – months US interest rate 6 % p.a.
Show the process of arbitrage. Consider 360 days.
SOLUTION:
S + S (interest rate of quote currency – interest rate of base currency) * t/12
46.35 + 46.35 (0.07 – 0.06) * 150 / 360
46.35 + 0.1931 = 46.5431
Step: 2 Since quoted future price is more than theoretical future price. Hence, for arbitrage we should sell $
future contract.
Step: 3 Process of arbitrage:
At t = 10th January
Activity Cash flows
Borrow fund at risk free rate of 7 % 46.3500
Purchase $ at spot rate and invest at 6 % (46.3500)
Sell $ future at 46.7900 0
Net cash flow 0
At t = 9th June
Activity Cash flow
Realise from investment and settle at future rate 47.9598
(1 + 6 % * 150 / 360 = 1.025 $ )
Repay loan with interest (46.35 + 7 % * 150 / 47.7019
360)
Arbitrage gain 0.2579
Class example: 69 On August 8, 2002, the following yields and price existed:
Spot exchange rate ($ / DM) 0.6262
December 9, 2002 future price ($ / DM) 0.6249
German interest rate 8.50 % p.a.
US interest rate 7 % p.a.
Time to maturity 130 days
From the above data, show an arbitrage opportunity.
(10) Beta management – There are 3 methods of Beta Management

Method: 1 Stock trading
Under this method we can increase or reduce beta through shifting from one stock to another stock. For
this purpose, we should apply following steps:
Step: 1 Calculate current portfolio beta
𝑊𝐵
βP =
∑𝑊

Where W = Value of stock in portfolio
Step: 2 Now assume that amount x will be shifted from one stock to another.
Step: 3 Now calculate value of x by making an equation of desired beta.
Step: 4 After calculating value of x we can compute desired beta after calculating new portfolio.
Class example: 70 Consider the following portfolio:

Stock Market value Beta
A 200 lakhs 2.50
B 100 lakhs 1.50
C 150 lakhs 1.80
D 200 lakhs 0.80
Calculate:
(a) Current portfolio beta
(b) Portfolio manager wants to reduce beta of portfolio to 1.20. For this purpose he has decided to shift
some amount from stock A to stock D. Calculate such amount.
SOLUTION:
(a) Calculation of portfolio beta:
Stock Market value (W) Beta W*B
A 200 2.50 500
B 100 1.50 150
C 150 1.80 270
D 200 0.80 160
650 1080
𝑊𝐵
βP =
∑𝑊
1080
βP = = 1.66
650
(b) Let amount shifted from stock A to stock B be x and hence we have,
(200−𝑥)2.50+100∗1.50+150∗1.80+(200−𝑥).80
= 1.20
650
500 – 2.50 x + 150 + 270 + 160 + 0.80 x = 780
1.70 x = 300
300
x= = 176.471 lakhs
1.70
Hence revised portfolio beta will be:
Stock Market value (W) Beta W*B
A 23.529 2.50 58.8225
B 100 1.50 150
C 150 1.80 270
D 376.471 0.80 301.1768
650 780
𝑊𝐵
βP =
∑𝑊
780
βP = = 1.20
650

A 100 lakhs 1.80
B 300 lakhs 2.00
C 150 lakhs 1.30
D 200 lakhs 1.75

E 80 lakhs 0.80
(i) Calculate current portfolio beta.
(ii) Portfolio manager wants to increase beta of portfolio to 1.70. For this purpose he has decided to shift
some amount from Stock D to stock B. Calculate such amount.
Method: 2 Risk – free investment or borrowing
Under this method we can reduce or increase beta in the following manner:
(a) If we want to reduce beta = Additional investment should be made in risk – free securities
(b) If we want to increase beta = Borrow some amount at risk – free rate and invest in risky securities.
A 200 lakhs 2.50
B 300 lakhs 1.80
C 500 lakhs 1.60
D 100 lakhs 0.40
(i) Calculate current portfolio beta.
(ii) The portfolio manager expects market to fall. He wishes to reduce the beta to 1.50. for this purpose he
has decided to shift some amount from A to D. Calculate such amount.
(iii) How would achieve the objective in (ii) by investing some amount at R f.
Method: 3 Through index future and hedging
(i) Hedging is the process of taking opposite position in order to reduce loss caused by price fluctuation.
The basic objective behind hedging is to reduce the loss and not to earn profit.
(ii) Position to be taken for hedging purpose –
(a) If investor has long position in spot market, then hedging must be done taking a short position in future
market.
(b) If investor has short position in spot market, then hedging must be done taking a long position in future
market.
(iii) An Investor may hedge his portfolio in the following manner –
(a) Complete hedging = Current value of portfolio x existing beta
(b) Partial hedging = Current value of portfolio x existing beta x % of hedge

Notes:
(i) Whenever question is silent always assume complete hedging.
(ii) If hedge ratio is not given in the question, then we can compute hedge ratio with the help of following
formula:
Standard deviation of portfolio
Hedge ratio = x Correlation between portfolio and futures
Standard deviation of futures
(iii) Calculate desired beta with the help of hedge ratio:

Desired beta = 1 – Hedge ratio
(iv) How to calculate number of contracts to be bought and sold

(𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑏𝑒𝑡𝑎−𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑏𝑒𝑡𝑎)∗𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
=
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑖𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
Value of one index future = Lot size * index price

𝑊𝐵
(v) Calculation of existing portfolio beta = βP =
∑𝑊
Weights should be based on market price of stocks.
(vi) Application of βp to find out % change in market or % change in security

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
βp =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡

Class example: 72 X had taken a long position on ICICI bank stock for `100. Beta of ICICI Limited is 2.
X is afraid of fall in prices of stock of ICICI. He wants to hedge his position by using NIFTY future. If
prices of ICICI stock fall 10 % on maturity
Class example: 73 Ram holds a diversified equity portfolio of ` 150 Crores with beta 1.5. Shyam holds
his entire money in stock X of same value with a beta of 0.9. Both are planning to hedge their holdings
using futures. The following futures are available:
(i) Nifty Index Futures @ 4550 (Each lot = 50 units)
(ii) Futures of stock X @ 1520 (Each lot = 100 units)
How Ram & Shyam would perfectly hedge their portfolios using the above futures? Examine all possible
options and find the number of contracts required to hedge, gain or loss overall on hedging if it is expected
that markets would fall by 10% from the current level. Today spot Nifty is at 4500 and stock X is quoting
at ` 1500. [CWA – RTP – June, 2015]
Class example: 74 An investor buys the stocks of Hindustan Lever Ltd. (HLL) worth ` 20 lakh due to its
very strong fundamentals. However, the market in general is considered to remain weak for about the next
three months. The beta of HLL is 1.2 and the current value of NIFTY is 2250 and 3-m futures is selling at
2310. Answer the following:
1. How can the investor hedge himself against the expected fall in the market?
2. Analyse his position (a) if the market falls by 10% in 3 months and HLL drops to ` 178 from ` 200 (b)
if the market registers a rise of 6% and HLL rises to ` 215 from ` 200.
3. Given the standard deviations of the market as 12% and HLL as 18%, what is the risk of unhedged
portfolio? [CWA – RTP June, 2013]

Equity 200 lakhs with a beta of 3
Bond 150 lakhs with a beta of 0.40
Cash 50 lakhs with a beta of 0
Index future price = 4,000
Lot size = 100
(i) Calculate beta of the entire portfolio.
(ii) How many NIFTY future contracts should be bought or sold for complete hedge.
(iii) If market falls by 5 %, prove that you are hedged.
QUESTIONS RELATED TO FUTURES
Q. 30 For imports from UK, Philadelphia Ltd. of USA owes £ 6,50,000 to London Ltd. payable on May,
2010. It is now 12 February, 2010.
The following future contracts (Contract size £ 62,500) are available on the Philadelphia exchange.
Expiry Current futures rate
March 1.4900 $ / DM 1
June 1.4960 $ / DM 1
(a) Illustrate how Philadelphia Ltd. can use future contracts to reduce the transaction risk, if on 20 th May
the spot rate is 1.5030 $ / £ 1 and June futures are trading at 1.5120 $ / £ 1. The spot rate on 12th February
is 1.4850 $ / £ 1.
(b) Calculate the ‘Hedge efficiency’ and comment on it. [CWA – June, 2004]
Hints:
 Number of future contracts – 10
 Hedging strategy – Buy 10 £ future contracts
 Hedge efficiency – 85.47 %
Q. 31 XYZ is an export oriented business house based in Mumbai. The company invoices in customer’s
currency. Its receipt of US $ 1,00,000 is due on September 1, 2010.
Market information as at June 1, 2010:
Exchange rates: US $ / `

Spot 0.02140
1 month forward 0.02136
3 month forward 0.02127
Currency futures: US $ / `
June 0.02126
September 0.02118
Contract size: `4,72,000
Month Initial margin Interest rates in India
June `10,000 7.50 %
September `15,000 8.00 %
On September 1, 2010 the spot rate US $ / ` is 0.02133 and currency future rate is 0.02134. Comment
which of the following method would be most advantageous for XYZ Ltd.
(a) Using forward contract
(b) Using currency futures
(c) No hedging [CA – Nov. 2006]
Hints:
 Forward cover – 47,01,457
 Currency future: Number of contracts – 10; Hedging strategy – Buy 10 ` future; Gain due to
future contract – 35,406; Cash flow under currency future – 47,20,639
 No hedging – 46,88,233
Q. 32 The Corporate treasurer of a US company multinational receives a fax on 21 st February from its
European subsidiary. The subsidiary will transfer € 10 million to the parent company on 16 th August. The
corporate treasurer decides to hedge the position using currency futures. The available spot and future rate
of the Euro on the 21st February are:
Spot rate: US $ 1.0600 / €
September future: US $ 1.1000 / €
December future: US $ 1.1600 / €
(a) What expiry month will be chosen for the future by the corporate treasurer?
(b) Will the corporate treasurer go long or short on the Euro future?
(c) If the corporate treasurer plans to hedge through futures in the European currency market, will he buy
or sell dollar futures?
(d) What is the unhedged and hedged outcome on 16th August, if the spot and future rate on the 16th of
August are as follows:
Spot rate: US $ 1.0100 / €
September future: US $ 1.0200 / €
December future: US $ 1.1200 / €
Hints:
 (a) September future
 (b) Short on Euro future
 (c) Buy dollar future
 (d) Cash flow due to hedging – 1,09,00,000
Q. 33 January 1, 2009 Mr. A wants to enroll for CFA course for which $ 1,100 is payable on 15 th
September, 2009. The current spot rate 1 $ = `40.56. Use currency future for hedging. Lot size is $ 1,000.
The price of currency future on 1.1.09 is –
August 2009 – 1 $ = `40.20
September 2009 – 1 $ = `40.80
October 2009 – 1 $ = `40.90
Calculate hedge efficiency in the following situations.
Case: 1 On 15th September 2009 prices are as under:
September future price: 1 $ = 45.30

(b) Calculate cost per$ for Mr. A

Case: 2 On 15th September 2009 prices are as under:
September future price: 1$ = `37.25
Hints:
(a) Case A
 Number of future contract – 1
 Strategy – Buy September $ future contract
 Hedge efficiency – 92.14 %
(b) Case B:
 Loss due to future contract – 3,550
 Cash flow due to hedging – 44,250
 Cost per $ = 40.2273
Q. 34 Nitrogen Ltd. a UK company is in the process of negotiating an order amounting to € 4 million with
a large German retailer on 6 months credit. If successful, this will be the first time that Nitrogen Ltd. has
exported goods into the highly competitive German market. The following three alternatives are being
considered for managing the transaction risk before the order is finalized.
(i) Invoice the German firm in sterling using the current exchange rate to calculate the invoice amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign exchange contract to hedge
the transaction risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future contracts (to the nearly whole
number) to hedge the transaction risk.
Following data is available:
Spot rate € 1.1750 - € 1.1770 / £
6 months forward premium 0.60 – 0.55 Euro cents
6 months further contract is currently trading at € 1.1760 / £
6 months future contract size is £62,500
Spot rate and 6 months future rate € 1.1785 / £
Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd. under each of the three proposals.
(b) In your opinion, which alternative would you consider to be the most appropriate and the reason
therefore? [CA – Nov. 2011]
Hints:
 £ 33,98,471
 Forward hedging - £ 34,14,426
 Currency future – Number of contracts – 54; Strategy – Buy £ future; Profit due to currency
future – 7,159.52 and Cash flow under future – 34,01,304.52
Q. 35 Ram buys 10,000 shares of X Ltd. at `22 and obtains a complete hedge of shorting 400 Nifty at
`1,100 each. He closes out his position at the closing price of next day at which point the shares of X Ltd.
has dropped 2 % and the Nifty future has dropped 1.5 %. What is the overall profit / loss of this set of
transaction? [CA – May, 2005]
Hints:
 Loss due to spot market - `4,400
 Profit due to future market - `6,600
 Overall profit - `2,200
Q. 36 The following information is related to stock of A Ltd. A Ltd. has a beta of 0.50 with Nifty. Each
Nifty contract is equal to 100 units. A Ltd. now quotes at `250 and the Nifty future is 4,000 index points.
You are long on 1,200 shares of A Ltd. in the spot market.
(i) How many future contracts will you have to take?
(ii) Suppose the price in the spot market drops by 10 %, how are you protected? [CS – Dec. 2007]

Hints:
 Value of hedge position – long position of `1,50,000
 Number of future contracts – 0.375 contracts
 Loss in spot market – `30,000
 Gain in future market – `30,000
Q. 37 The settlement price of Sensex future contract on a particular day was `4,600. The initial margin was
set at `10,000, while the maintenance margin was fixed at `8,000. The multiplier of each contract is 50.
The settlement prices on the following five days were as follows:
Day Settlement price (`)
1 4700
2 4500
3 4650
4 4750
5 4700
Calculate the mark to market cash flows and the daily closing balances in the accounts of -
(a) An investor who has gone long, and
(b) An investor who has gone short at 4600
Calculate net profit (loss) on each of the contracts. [CWA – Dec. 2005]
Hints:
(a) Long position:
 Mark – to – Market – 5,000; (10,000); 7,500; 5,000; (2,500)
 Margin call (2nd day) – 5,000
 Closing balance – 15,000; 10,000; 17,500; 22,500; 20,000
 Net profit / loss – 5,000
(b) Short position:
 Mark – to – Market – (5,000); 10,000; (7,500); (5,000); 2,500
 Margin call – 1st day – 5,000 and 4th day – 2,500
 Closing balance – 10,000; 20,000; 12,500; 10,000; 12,500
Q. 38 On August 2, Mr. T buys 5 contracts of December Reliance futures at 840. Each contract covers 50
shares. Initial margin was set at `2,400 per contract while maintenance margin was fixed at `2,000 per
contract. Daily settlement prices are as follows:
August 2 818
August 3 866
August 4 830
August 5 846
Mr. T meet all margin calls. Whenever he is allowed to withdraw money from the margin account, he
withdraws half the maximum amount allowed.
Compute for each day –
(i) Margin call
(ii) Profit / loss on the contract
(iii) The balance in the account at the end of the day. [CWA – June, 2006]
Hints:
 Margin call – August 2nd – 5,500 and August 4 th – 3,000
 Profit / loss – 1,500
 Closing balance – 12,000; 18,000; 12,000; 14,000
Q. 39 Which position on the index future gives a speculator, a complete hedge against the following
transactions:
(i) The share of Right Ltd. is going to rise. He has a long position on the cash market of `50 lakhs on the
right Ltd. The beta of the right Ltd. is 1.25.

(ii) The share of Wrong Ltd. is going to depreciate. He has a short position on the cash market of `25 lakhs
on the Wrong Limited. Beta of the Wrong Limited is 0.90.
(iii) The share if Fair Limited is going to stagnant. He has a short position on the cash market of 20 lakhs
of the Fair Limited. The beta of the Fair Limited is 0.75. [CA – Nov.2004]
Hints:
 Short position of `62.50 lakhs
 Long position of `22.50 lakhs
 Long position of `15 lakhs
Q. 40 The following data relates to ABC Ltd.’s share prices:

Current price of share `180
Price per share in the future market – 6 months `195
It is possible to borrow money in market for securities transactions at the rate of 12 % per annum.
Required:
(a) Calculate the theoretical minimum price of a 6 months forward contract.
(b) Explain if any arbitrage opportunities exist. [CA – May, 2004]
Hints:
 Theoretical future price - `190.80
 Arbitrage strategy – sell stock future
 Arbitrage gain - `4.20
Q. 41 Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on NSE and the three
months future price quotes at `230 and the one month borrowing rate is given as 15 % and the expected
annual dividend rate is 25 % per annum payable before expiry. Also examine arbitrage opportunities.
[CA – Nov. 2008 / PM (39)]
Hints:
 Arbitrage strategy – sell future contract
 Arbitrage gain - `4.25
Q. 42
BSE index 5000
Value of portfolio `10,10,000
Risk – free interest rate 9 % p.a.
Dividend yield on index 6 % p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity is used to hedge the value of
portfolio over the next three months. One future contract is for delivery of 50 times the index. Based on the
above information calculate:
(a) Price of future contract
(b) The gain on short future position if index turns out to be 4500 in three months. [CA – Nov. 2007]
Q. 43 A trader is having in its portfolio shares worth `85 lakhs at current price and cash `15 lakhs. The
beta if share portfolio is 1.60. after 3 months the price of shares dropped by 3.20 %. Determine –
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on `100 lakhs Nifty
futures. [CA – Nov. 2013/ PM (35)]
Hints:
 Current portfolio beta – 1.36
 Revised value of portfolio – 95.28 lakhs
 % change in portfolio – 4.72 %

 Portfolio beta after 3 months – 2.36
Q.44 Ram buys 10,000 shares of X Ltd. at a price of `22 per share whose beta value is 1.50 and sells 5,000
shares of A Ltd. at a price of `40 per share having a beta value of 2. He obtains a complete hedge by Nifty
futures at `1,000 each. He closes out his future position at the closing price of the next day when the share
of X Ltd. dropped by 2 %, share of A Ltd. appreciated by 3 % and Nifty futures dropped by 1.50 %. What
is the overall profit / loss to Ram? [CA – Nov. 2013]
Hints:
 For shares of X Limited – Short position in future market of `3,30,000
 For shares of A Limited – Long position in future market of `4,00,000
 Net position on NIFTY - `70,000 (Long position)
 Loss on shares of X Limited - `4,400
 Loss on shares of A Limited - `6,000
 Loss on NIFTY - `1,050
 Total loss - `11,450
Q.45 A portfolio manager owns 3 stocks:

Stock Shares owned Stock price (`) Beta
1 1 lakhs 400 1.10
2 2 lakhs 300 1.20
3 3 lakhs 100 1.30
The spot Nifty index is at 1,350 and futures price is 1,352 to use index futures to (a) decrease the
portfolio beta to 0.80 and (b) Increase the portfolio beta to 1.50. Assume the index factor is `100. Find out
the number of contracts to be bought or sold of stock index futures. [RTP – May, 2005]
Hints:
 Beta of portfolio – 1.19
 Number of future contracts to be sold – 375
 Number of future contracts to be purchased – 298
Q.46 A sold one January Nifty futures contract for ` 3,40,000 on January, 15. For this he had paid an
initial margin of ` 34,000 to his broker. Each nifty future contract is for the delivery of 200 Nifty’s. On
January 25, the index was closed on 1850. How much profit / loss A has made? [RTP – May, 2005]
Hints:
 Loss due to transaction – 30,000
Q.47 A company is long on 10 MT of copper @ `474 per Kg. (Spot) and intends to remain so for the
ensuing quarter. The standard deviation of changes of its spot and future prices are 4 % and 6 %
respectively, having correlation coefficient of 0.75. What is its hedge ratio? What is the amount of the
copper future it should short to achieve a perfect hedge?
[CA – RTP – Nov. 2013/ CA – May, 2012]
Hints:
 Hedge ratio – 0.50
 Value of short position - `23,70,000
Q.48 A mutual fund is holding the following assets in `Crores:

Investment in diversified equity shares 90.00
Cash and bank balance 10.00
100.00

The beta of the portfolio is 1.10. The index future is selling at 4300 level. The fund manager apprehends
that the index will fall at the most by 10 %. How many index futures he should short for perfect hedging so
that the portfolio beta is reduced to 1.00? one index future consists of 50 units. Substantiate your answer
assuming the fund manager’s apprehension will materialize. [CA – RTP – Nov. 2013/ PM (34)]
Q. 49 A wheat trader has planned to sell 440000 kgs of wheat after 6 months from now. The spot price of
wheat is ` 19 per kg and 6 months future on same is trading at ` 18.50 per kg (Contract Size= 2000 kg).
The price is expected to fall to as low as ` 17.00 per kg 6 month hence. What trader can do to mitigate its
risk of reduced profit? If he decides to make use of future market what would be effective realized price
for its sale when after 6 months is spot price is ` 17.50 per kg and future contract price for 6 months is `
17.55. [CA – RTP – May, 2013]
Hints:
 Trader should create short position on wheat future
 Number of future contracts – 220 contracts
 Gain due to future hedging – `4,18,000
 Total cash flow due to hedging - `81,18,000
 Effective realization rate - `18.45
Q. 50 Suppose that there is a future contract on a share presently trading at ` 1000. The life of future
contract is 90 days and during this time the company will pay dividends of ` 7.50 in 30 days, ` 8.50 in 60
days and ` 9.00 in 90 days. Assuming that the Compounded Continuously Risk free Rate of Interest
(CCRRI) is 12% p.a. you are required to find out:
(a) Fair Value of the contract if no arbitrage opportunity exists.
(b) Value of Cost to Carry.
[Given e -0.01 = 0.9905, e-0.02 = 0.9802, e-0.03 = 0.97045 and e0.03 = 1.03045]
[CA – RTP – Nov. 2012]
Hints:
 Fair value if not arbitrage opportunity exist – 1005.21
 Value of cost of carry - `5.21
Q. 51 On 31.7.2011, the value of stock index is `2,600. The risk free rate of return is 9 % p.a. The
dividend yield on this stock index is as follows:
Month Dividend paid
January 2%
February 5%
Mach 2%
April 2%
May 5%
June 2%
July 2%
August 5%
September 2%
October 2%
November 5%
December 2%
Assuming that interest is continuously compounded daily, then what will be future price of contract
deliverable on 31.12.2011. Given e0.02417 = 1.02446. [CA – RTP – May, 2012]
Hints:
 Average dividend yield – 3.20 %
 Future price - `2,663.60

Q. 52 Mr. V decides to sell short 10,000 shares of ABC Plc. When it was selling at yearly high of £ 5.60.
His broker requested him to deposit a margin requirement of 45 % and commission of £ 1550 while Mr. V
was short the share, the ABC paid a dividend of £ 0.25 per share. At the end of one year Mr. V buys 1,000
shares of ABC Plc. at £ 4.50 to close out position and was charged a commission of £ 1,450. You are
required to calculate the return on investment of Mr. V. [CA – RTP – Nov. 2011]
Hints:
 Profit on transaction - `5,500
 Amount of investment - `26,750
 Rate of return – 20.56 %
Q. 53 The following information is available about standard gold.

Spot price `15,600 per 10 gms.
Future price `17,100 for one year future contract
Risk free interest rate 8.5 %
Present value of storage cost `900 per year
From the above information you are requested to calculate the present value of convenience yield (PVC)
of the standard gold. [CA – RTP – May, 2011]
Hints:
 Present value of Convenience yield - `739.63
Q.54 ABC Technologic is expecting to receive a sum of US $ 4,00,000 after 3 months. The company
decided to go for future contract to hedge against the risk. The standard size of future contract available in
the market is $ 1000. As on date spot and future $ contract are quoting at `44.00 and `45.00 respectively.
Suppose after 3 months the company closes out its position futures are quoting at `44.50 and spot rate is
also quoting at `44.50. you are required to calculate effective realization for the company while selling the
receivable. Also calculate how company has been benefitted by using the future option.
[CA – RTP – May, 2011]
Hints:
 Company should create short position on $ future at `45.00
 Number of future contracts – 400 contracts
 Gain due to future contract - `2,00,000
 Net cash flow due to future contract - `1,80,00,000
 Effective rate - `45.00
Q. 55 Assume that the risk-free interest rate is 9% per annum with continuous compounding and that the
dividend yield on a stock index varies throughout the year. In February, May, August, and November,
dividends are paid at a yield of 5% per annum. In other months, dividends are paid at a yield of 2%per
annum. Suppose that the value of the index on July 31 is 1,300. What is the futures price for a contract
deliverable in December 31 of the same year?
Hints:
 Theoretical future price – 1331.46
Q. 56 The spot price of silver is $15 per ounce. The storage costs are $0.24 per ounce per year payable
quarterly in advance. Assuming that interest rates are 10% per annum for all maturities, calculate the
futures price of silver for delivery in 9 months.
Hints:
 Theoretical future price - $ 16.931
Q. 57 Consider a 6 – month gold future contract of 100 gm. If the spot price is `600 per gram and that it
costs `3 per gram for the 6 – monthly period to store gold and that the cost is incurred at the end of 2
months. If the risk – free rate of interest is 12 % per annum continuous compounded, compute the future
price?

Hints:
 Total value – `63,911.70
Q. 58 The stock of Y Limited, a non – dividend paying stock, is today selling at `72. You wish to enter
into a future contract on this stock maturing in 6 months time. (i) If the risk – free rate of return is 12 % per
annum continuously compounded what would the future price to be? (ii) If the price of future contract is
`75, what action would you take? (iii) In case it is priced at `77 will your decision change?
Hints:
 Arbitrage profit in case A - `1.32
 Arbitrage profit in case B - `0.68
Q. 59 Calculate the price of a 6 months future contract on a share that is currently priced at `75. The share
is expected to pay a dividend four months from today. The continuously compounded risk free rate is 12 %
per annum. The contract size is 100. If the contract value is `7,400 what action would follow? In case it is
`7,800 what would you do?
Hints:
 Theoretical future price - `7,746
 Arbitrage profit in case of case A – 346
 Arbitrage profit in case of case B - `54
Q. 60 Gold futures have been opened up in India recently. A 3 – month gold future is available at `540 per
gram. Suppose the current price of gold is `530 per gram and that it costs `3 per gram in arrears for the 3 –
monthly period to store gold. (i) If the futures are rightly priced what is the continuously compounded risk
free rate?
Hints:
 Risk – free rate – 5.28 %
Q. 61 On 31.8.2011, the value of stock index is `2,200. The risk free rate of return is 8 % p.a. The
dividend yield on this stock index is as follows:
Month Dividend paid
January 3%
February 4%
Mach 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is continuously compounded daily, then what will be future price of contract
deliverable on 31.12.2011? Given e 0.01583 = 1.01593. [CA – May, 2012]
Hints:
 Theoretical future price – 2,234.83

Q. 62 The six months forward price of a security is `208.18. The rate of borrowing is 8 % per annum
payable at monthly rates. What will be the spot price? [CA – Nov. 2011/ PM (36)]
Hints:
 Spot price - `200.17
Q. 63 The following information about copper scrap is given:

Spot price $ 10,000 per ton
Future price $ 10,800 for a one year contract
Interest rate 12 %
Present value of storage cost $ 500 per year
What is the present value of convenience yield of copper scrap? [Practice manual]
Hints:
 Present value of convenience yield – 857.14
Q. 64 The share of X Limited is currently selling for `300. Risk free interest rate is 0.80 % per month. A
three months futures contract is selling for `312. Develop an arbitrage strategy and show what your
riskless profit will be 3 month hence assuming that X Limited will not pay any dividend in the next three
months. [Practice manual]
Hints:
 Theoretical future price – 307.26
 Arbitrage profit – 4.74
Q. 65 The following data relate to Anand’s Limited’s share price:

Current price per share `1,800
6 months future price per share `1,950
Assuming it is possible to borrow money in the market for transactions in securities at 15 % per annum,
you are required:
(a) To calculate the theoretical minimum price of a 6 – months forward purchase; and
(b) To explain arbitrage opportunity. [Practice manual]
Hints:
 Theoretical future price – 1935
 Arbitrage profit - 15
Q.66 EFD Ltd. is an export business house. The company prepares invoice in customers' currency. Its
debtors of US$. 10,000,000 is due on April 1, 2015. Market information as at January 1, 2015 is:
Exchange rates: US $ / INR Currency future US $ / INR
Spot 0.016667 Contract size: `2,48,16,975
1 – month forward 0.016529 1 – month 0.016519
3 – months forward 0.016129 3 – months 0.016118
Initial margin Interest rates in India

1 – month `17,500 6.50 %
3 – months `22,500 7%
On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134. Which of the
following methods would be most advantageous to EFD Ltd?
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk [CA – May, 2015]
Hints:
 Forward contract – 62,00,01,240

 Currency future – Number of future contract – 25; strategy – Buy ` future; gain due to future
contract – 6,15,195; Cash flow due to currency future – 62,03,37,627
 No hedging – 61,97,32,276
Q.67 On April 1, 2015, an investor has a portfolio consisting of eight securities as shown below:
Security Market price No. of shares Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The investor fears a fall in the
prices of the shares in the near future. Accordingly, he approaches you for the advice to protect the interest
of his portfolio.
You can make use of the following information:
(i) The current NIFTY value is 8500.
(ii) NIFTY futures can be traded in units of 25 only.
(iii) Futures for May are currently quoted at 8700 and Futures for June are being quoted at 8850.
You are required to calculate:
(i) The beta of his portfolio.
(ii) The theoretical value of the futures contract for contracts expiring in May and June. Given
(e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
(iii) The number of NIFTY contracts that he would have to sell if he desires to hedge until June in each of
the following cases:
(A) His total portfolio
(B) 50% of his portfolio
(C) 120% of his portfolio [CA – Nov. 2015]
Hints:
 Portfolio beta – 1.102
 Theoretical value of May future – 8788
 Theoretical value of June future – 8935.80
 Number of NIFTY contracts: (a) 5 contracts; (b) 3 contracts; (c) 6 contracts

OPTIONS:
(1) INTRODUCTION – In this type of derivative instrument only one party will have right and the other
party will have only obligation. The party which buys the right is called option buyer and pays
compensation at the inception of the contract to the option seller (also called option writer). The
compensation paid by the option buyer is called option premium.
(2) TYPES OF OPTION INSTRUMENT – There are two types of option instruments
Call option: The one which gives Put option: The one which gives
the buyer of the option the right to the buyer of the option the right to
buy the underlying sell the underlying.
(3) IMPORTANT TERMS FOR OPTION CONTRACTS –

 Option buyer – The one who buys the right and pay premium.
 Option seller – The one who sells the right, take obligation and receive premium.
 Option price / Premium – It is a compensation payable by buyer option to seller of option at the
time of buying the option.
 Strike price / Exercise price – This is the price at which underlying can be bought or sold by the
option buyer in case of call or put respectively.
(4) STYLE OF OPTION CONTRACTS – There are two style of option contract
American style of option: The European style of option: The

right can be exercised on any right can be exercised on the
day during the life of contract. expiry day.
(5) CONCEPT OF OPTION PREMIUM – Option premium is the compensation paid by buyer to seller
for option contract.
Intrinsic value - This is calculated by Time value – This is the balancing figure.
comparing spot price of the underlying TV = Option premium – Intrinsic value
with the strike price. This will keep on
changing during the life of the contract.
Notes:
 Intrinsic value can have either positive or zero value. It cannot be negative.
 Time value will always be positive except on the last day (where it will be zero). Time value
cannot be negative.
 Theoretically time value should be maximum at inception of the contract and it should decline
gradually over the life of the contract.

(6) CALCULATION OF PAY – OFF AND PROFIT –

 Pay – off of an option refers to the cash flow on maturity.
 Profit on the other hand refers to the entire calculation of gain or loss based on pay – off and
initial premium paid or received.
Class example: 76 A trader purchased a 3 months put option on the stock of SBI at a strike price of
`2,500. The put premium was `320. The following table provides a probability distribution of the stock
prices 3 months from now:
Share price (`) Probability
2,000 0.10
2,200 0.30
2,500 0.20
2,700 0.30
3,000 0.10
Calculate expected pay – off and profit for the trader.
Class example: 77 A trader purchased a call option with a strike price of `550. Premium paid on purchase
of call option is `280. At expiry following probability distribution of various prices are given:
Price Probability
450 0.20
500 0.10
550 0.15
600 0.45
650 0.10
Calculate expected pay – off and net profit.
Class example: 78 A trader purchased 2 call options and sold 3 put options.
Premium: Call option - `25; Put option - `35
Strike price: Call - `450; Put - `400. At expiry following prices prevails: `390 - `440 at interval of 10,
470, 500 and 530. Calculate expected pay – off and net profit.
(7) CONCEPT OF ITM, ATM OR OTM – These can be calculated by comparing spot price of the
underlying with strike price of the underlying.
ITM In – the money
ATM At – the money
OTM Out – of the money
(8) CURRENCY OPTIONS AND HEDGING THROUGH CURRENCY OPTION –

 Currency option can be OTC (Over the counter) product or exchange traded.
 Currency options are of two types
Currency call option – This gives Currency put option – This gives right
right to the option buyer to buy the to the option buyer to sell the
underlying currency at the strike price. underlying currency at the strike price.
Following are the steps for currency hedging:

Step: 1 Identify underlying currency and priced currency
 The currency in which contract size is given is considered as underlying currency.
 If lot size is not given, then underlying currency cannot be identified then identify price currency
and another currency will automatically consider as underlying.
 Price currency is the currency in which option price / premium is given.

Step: 2 Calculate number of contracts to be taken for hedging purpose

𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑚𝑜𝑢𝑛𝑡
Number of contracts =
𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒
Note:
 Exposure amount and contract size must be in same currency.
 Number of contract must be rounded off.
 If number of contracts are in fraction then for the fractional part (converted in exposure amount)
must be covered if question is silent.
Step: 3 Decide option to be taken i.e. call option or put option

Option to be taken must be decided as per the underlying currency.
Step: 4 Calculate cash flow under currency option hedging

Cash flow due to option contract (no. of option contract * contract size * strike xxx
price)
Cash flow due to remaining exposure value (Either forward cover or no hedging) xxx
Cash flow due to premium xxx
Total cash flow xxx
Note:
If under option hedging various spot rates with their probabilities are provided then cash flow due to option
contract will calculate in the following manner:
Spot price Strike price Exercise of Cash flow Probability Expected cash
lapse flow
xxx xxx Xxx xxx xxx xxx
xxx xxx Xxx xxx xxx xxx
(9) COMPUTATION OF THEORITICAL/ FAIR PRICE OF OPTION AND ARBITRAGE

THROUGH OPTIONS:
Arbitrage through call option: Arbitrage through put option:

Step: 1 Calculate current value of Step:1 Calculate theoretical value of
call option put option
Value = Current price – S*e-rt Value = S*e-rt – Current price
S = Exercise price
r = risk – free rate of return Step: 2 Compare theoretical price of
t = Time period (expressed on per option with quoted price of option
annum basis) and decide course of action.
Step: 2 Compare theoretical price of
Step: 3 prepare statement showing
option with quoted price and decide process of arbitrage at t = 0 and t =
course of action.
maturity.
Step: 3 Prepare statement showing
process of arbitrage at t= 0 and t=
maturity.
Class example:79 Given the following:

Strike price `180
Current price per share `200
Risk – free rate of interest (Continuous compounding) 10 % p.a.
(i) Calculate theoretical minimum price of a European call option expiring after one year.
(ii) If price of the call option is `30, then how can an arbitrageur make profit.

Class example: 80 Given the following data:

Strike price `400
Current stock price `370
Time until expiration 6 months
Risk – free interest rate (Continuous compounding) 5 % p.a.
(i) Calculate the theoretical minimum price of a European put option.
(ii) If European put option price is `10, then how can an arbitrageur make profit.
Class example:81 Given the following data:

Strike price `40
Risk – free interest rate (Continuous compounding) 6 % per annum
(i) Calculate the theoretical minimum price of call option?
(ii) If price of call option is 1.05, then how can an arbitrageur make profit?
Class example: 82 A one month European put option on a non – dividend paying stock is currently selling
for `2.50. The stock price is `47. The strike price is `50 and risk – free interest rate is 6 % per annum
continuous compounding. What opportunities are there for an arbitrageur?
Class example: 83 A four month European call option on a dividend paying stock is currently selling for
`5. The stock price is `64. The strike price is `60 and a dividend of `0.80 is expected in one month. The
risk – free interest rate is 12 % per annum continuous compounding. What opportunities are there for an
arbitrageur?

Strike price `200
Risk – free interest rate (Not continuous compounding) 5 % per annum
(i) Calculate the theoretical minimum price of European put option?
(ii) If price of put option is `5, then how can an arbitrageur make profit?

Strike price `90
Time until expiration 1 year
Risk – free interest rate (Not continuous compounding) 10 % per annum
(i) Calculate the theoretical minimum price of European call option expiring after one year.
(ii) If price of call option is `15, then how can an arbitrageur make profit?
(10) OPTIONS PRICING METHODS/ VALUATION OF OPTIONS
METHOD: 1 RISK – NEUTRAL METHOD:

When there are two expected price of share at expiration date:
 One price is more than exercise price and the second price is less than exercise price.
(a) Calculate the probability of high price of shares at expiration date as:
𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒 (1 + 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒) − 𝐿𝑜𝑤 𝑝𝑟𝑖𝑐𝑒
𝐻𝑖𝑔ℎ 𝑝𝑟𝑖𝑐𝑒 − 𝐿𝑜𝑤 𝑝𝑟𝑖𝑐𝑒
The probability of low price of share = 1 – Probability of high price
OR
Calculation of probability of high price of shares at expiration date, if interest rate is continuously
compounded:
Spot price * e rt – Low price / High price – Low price
The probability of low price of share = 1 – probability of high price

(b) Find expiration date value of option = Sum of (value of option * Probability)
Expiration date value

(c) Find the current value as:
(1+Periodic interest rate)
Note: The above method of finding probability of high price is known as risk neutral method.
Class example: 86 The current market price of an equity share of Penchant Ltd is `420. Within a period of
3 months, the maximum and minimum price of it is expected to be ` 500 and ` 400 respectively. If the risk
free rate of interest be 8% p.a., what should be the value of a 3 months Call option under the “Risk
Neutral” method at the strike rate of ` 450? Given e0.02 = 1.0202. [PM - 46]
Class example: 87 A share price is currently priced `40. It is known that at the end of one month it will be
either `36 or `46. The risk – free interest rate is 12 % per annum continuous compounding. Find the value
of a one month European call option with a strike price of `39 with the help of risk neutralization model.
Class example: 88 A share price is currently `50. It is known that at the end of four month it will be either
`38 or `42. The risk – free interest rate is 8 % per annum continuous compounding. Find the value of a
four – month European call option with a strike price of `58 with the help of risk neutralization method?
METHOD: 2 PORTFOLIO REPLICATING METHOD:

Class example: 89 The current market price of the equity shares of Andhra Bank Ltd. is `190 per share. It
may be either ` 250 or `140 after a year. A call option with a strike price of `180 (time 1 year) is available.
The rate of interest applicable to the investor is 9%. Anand wants to create a replicating portfolio in order
to maintain his pay off on the call option for 100 shares. Find out (i) Hedge ratio, (ii) Amount of
borrowing, (iii) Fair value of the call and (iv) His cash flow position after a year.
[CWA – RTP – Dec. 2011]
Class example: 90 Suppose Ann's stock price is currently $25. In the next six months it will either fall to
$15 or rise to $40. What is the current value of a six-month call option with an exercise price of $20? The
Six-month risk-free interest rate is 5% (periodic rate).
Class example: 91 Suppose Carol's stock price is currently $20. In the next six months it will either fall to
$10 or rise to $40. What is the current value of a six-month call option with an exercise price of $12? The
six-month risk-free interest rate (periodic rate) is 5%.
METHOD: 3 BINOMIAL PRICING MODEL/ BINOMIAL TREE METHOD FOR

CALCULATING OPTION PRICE
 In a risk free world the expected return is equal to risk – free return.
 Risk neutral probability is required for this approach. The probability is called risk neutral because
it remains same trial after trial. This means every period will have similar probability for upward
and downward.
 Each period µ (% of upward movement) and d (% of downward movement) will be the same.
 How to calculate risk neutral probability
P is upward movement probability (1 - P) is the downward

𝑅−𝑑
P= movement probability
µ−d

 The value of R, µ and d would be:
If directly given: If not given directly:

R = 1 + r % (Periodic risk free R = e rt
rate) t = one trial period
µ = 1 + % increase in stock price µ = eσ√t
d = 1 - % decrease in stock price 1
d=
µ
 Under this approach we needs to follow following steps:

Step: 1 Construct Binomial tree for stock price movement.
Step: 2 Construct Binomial tree for option price movement.
Step: 3 Calculate risk neutral probability
Step: 4 Calculate cash flow of option at the last trial period (compare spot price with strike price)
Step: 5 Now move from right to left using option cash flow tree and calculate expected values at each
node.
Expected value = (C u * P + Cd * 1 – P)
Step: 5 Calculate value of option / option price in the following manner:

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒
Ce =
1+𝑟
 Forms of problem under Binomial model:
Type: 1 Single period non – dividend paying stock

Type: 2 Single period dividend paying stock
Type: 3 Multi period Binomial models
Type: 4 American options
Class example: 92 A stock is currently selling for `50. The stock price could go up by 10 % or fall by 5 %
each month. The risk free rate of interest is 12 % p.a. Calculate the price of European call option on the
stock with an exercise price of `50 and a maturity of 2 months.
Solution:
R=1+r%
= 1 + 0.01 = 1.01
u = 1 + 10 % = 1.10
d = 1 – 5 % = 0.95
𝑅−𝑑 1.01−0.95 0.06
P= = = = 0.40
𝑢−𝑑 1.10−0.95 0.15
So, probability of upward movement = 0.40
Probability of downward movement = 0.60

Stock price movement: 60.50
55
10 %
52.25
5%
47.50 45.125
Option cash flow: Spot Exercise Cash flow

60.50 55 10.50
0.40
0.40 0.60
52.25 55 2.25
0.40
0.60
0.60
B 45.125 55 Nil
Value at node A: (i.e. t = 1)

(10.50∗0.40)+(2.25∗0.60) 4.20+1.35
= = 5.495
1.01 1.01
Value at node B: (i.e. t= 1)

(2.25∗0.40)+(0∗0.60)
= 0.891
1.01
(5.495∗0.40)+(0.891∗0.60) 2.198+0.5346
So, value of call option today = = = `2.71
1.01 1.01
Class example: 93 A stock is currently selling for `50. One month from today stock price could go up by
10 % or fall by 50 %. If the risk – free interest rate is 12 % p.a., calculate the price of a European call
option on the stock with an exercise price of `48 and a maturity of one month.
Solution:
R=1+r%
= 1 + 0.01 = 1.01
u = 1 + 10 % = 1.10
d = 1 – 50 % = 0.50
𝑅−𝑑 1.01−0.50 0.51

P= = = = 0.85
𝑢−𝑑 1.10−0.50 0.60

Stock price movement: Option cash flow
55 Spot exercise CF
55 48 7
10 % 0.85
55 2.25
50 %
0.15
25
25 48 Nil
(7∗0.85)+(0∗0.15)
Value of option = = `5.89
1.01
each month. Risk – free interest rate is 12 % per annum. Calculate the price of a European put option on
the stock with an exercise price of `55 and a maturity of two months.
Solution:
R=1+r% 𝑅−𝑑 1.01−0.95 0.06
P= = = = 0.40
= 1 + 0.01 = 1.01 𝑢−𝑑 1.10−0.95 0.15
u = 1 + 10 % = 1.10
d = 1 – 5 % = 0.95
55
10 %
52.25
5%
47.50 45.125

60.50 55 Nil
0.40
0.40 0.60
52.25 55 2.75
0.40
0.60
0.60
B 45.125 55 9.875


(0∗0.40)+(2.75∗0.60)
= 1.64
1.01
(2.75∗0.40)+(9.875∗0.60)
= 6.96
1.01
(1.64∗0.40)+(6.96∗0.60) 0.656+4.176
So, value of put option today = = = `4.78
1.01 1.01
each month. The risk – free interest rate is 12 % per annum. Calculate the price of an American put option
on the stock with an exercise price of `55 and a maturity of 2 months.
Solution:
R=1+r% 𝑅−𝑑 1.01−0.95 0.06
P= = = = 0.40
= 1 + 0.01 = 1.01 𝑢−𝑑 1.10−0.95 0.15
u = 1 + 10 % = 1.10
d = 1 – 5 % = 0.95
55
10 %
52.25
5%
47.50 45.125

60.50 55 Nil
0.40
0.40 0.60
52.25 55 2.25
0.40
0.60
0.60
B 45.125 55 9.875

(0∗0.40)+(2.75∗0.60)
= 1.64
1.01
Since this is American option so it can be exercised at t = 1 month
At this time cash flow will be:
Spot price of stock = `55
Exercise price of stock = `55
So, CF = Nil

Hence, value at node A: Maximum of (0; 1.64) = 1.64

(2.75∗0.40)+(9.875∗0.60)
= 6.96
1.01
Since this is American option so it can be exercised at t = 1 month
At this time cash flow will be:
Spot price of stock = `47.50
Exercise price of stock = `55
So, CF = 7.50
Hence, value at node A: Maximum of (6.96; 7.50) = 7.50
(1.64∗0.40)+(7.50∗0.60) 0.656+4.50
So, value of put option today = = = `5.10
1.01 1.01
Class example: 96 Suppose A’s stock price is currently `25. In the next 6 months it will either fall to `15
or rise to `40. What is the current value of a six – month call option with an exercise price of `20. The risk
– free interest rate is 10 % per annum.
Solution:
R = 1 + r = 1.05
u = 1 + % increase
1 + 60 % = 1.60
40−25
% increase = x 100 = 60 %
25
d = 1 – 40 % = 0.60
25−15
% Decrease = x 100 = 40 %
25
𝑅−𝑑 1.05−0.60 0.45
P= = = = 0.45
𝑢−𝑑 1.60−0.60 1
So, Probability of upward movement = 0.45

Stock price movement: Option cash flow
40 Spot exercise CF
40 20 20
10 % 0.45
55 2.25
50 % 0.55
15
15 20 Nil
20∗0.45+0∗0.55
Hence, value of call option = = `8.57
1.05
Class example: 97 Sumana wanted to buy shares of ElL which has a range of ` 411 to ` 592 a month later.
The present price per share is ` 421. Her broker informs her that the price of this share can sore up to ` 522
within a month or so, so that she should buy a one month CALL of ElL. In order to be prudent in buying
the call, the share price should be more than or at least ` 522 the assurance of which could not be given by
her broker. Though she understands the uncertainty of the market, she wants to know the probability of
attaining the share price ` 592 so that buying of a one month CALL of EIL at the execution price of ` 522
is justified. Advice her. Take the risk free interest to be 3.60% and e0.036 = 1.037. [PM - 42]

Solution:
R = e rt = e 0.036 = 1.037
u = 1 + % increase
= 1 + 40.62 % = 1.4062
592−421
% increase = x 100 = 40.62 %
421
d = 1 - % Decrease
= 1 - .0238 = 0.9762
421−411
% Decrease = x 100 = 2.38 %
421
𝑅−𝑑 1.037−0.9762 0.0608
P= = = = 0.1414
𝑢−𝑑 1.4062−0.9762 0.43
Class example: 98 Consider a two year American call option with a strike price of ` 50 on a stock the
current price of which is also ` 50. Assume that there are two time periods of one year and in each year the
stock price can move up or down by equal percentage of 20%. The risk free interest rate is 6%. Using
binominal option model, calculate the probability of price moving up and down. Also draw a two-step
binomial tree showing prices and payoffs at each node. [PM - 45]
Class example: 99 For a two period binomial model, you are given:
(i) Each period is one year.
(ii) The current price for a non – dividend paying stock is `20.
(iii) u = 1.2840, where u is one plus the rate of capital gain on the stock per period if the stock price goes
up.
(iv) d = 0.8607, where d is one plus rate of capital loss on the stock per period if the stock price goes down.
(v) The continuously compounded risk –free interest rate is 5 %.
Calculate the price of an American call option on the stock with a strike price of `22
Class example:100 The volatility of a non – dividend paying stock whose price is `78, is 30 %. The risk –
free rate is 3 % per annum (continuously compounded) for all maturities. Calculate values for u, d and P
when a two month time step is used. What is the value of a four – month European call option with a strike
price of `80 given by a two – step binomial tree?
Class example:101 A stock index is currently 1500. Its volatility is 18 %. The risk –free rate is 4 % per
annum (continuously compounded) for all maturities and the dividend yield on the index is 2.50 %.
Calculate value of u, d and P when a six month time step is used. What is the value of 12 – month
American put option with a strike price of 1480 given by a two – step binomial tree?
PERFECTLY HEDGED SITUATION THROUGH BINOMIAL METHOD:

(i) Binomial method offers perfectly hedged situation for option writer. It is important to note that no other
method offers perfectly hedged situation. An option writer (Seller of the option) has written a call and
receive premium. At expiration date, if the market price goes up then he has to pay value of option to
buyer of call. It creates risk on his part.
(ii) To avoid this risk he may buy certain number of shares from the market. It is calculated through hedge
ratio.
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑎𝑛𝑑 𝑙𝑜𝑤 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒
Hedge ratio =
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
He will get the number of shares to be purchased to eliminate the risk.
(iii) The expiration date value of hedged position is calculated for high – low price of shares.
Value of hedge = Value of number of shares held – Value of call (payable to buyer of call)
(iv) It is assumed that own fund invested to buy shares along with risk – free rate of interest is equal to
value of hedge at expiration date.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 ℎ𝑒𝑑𝑔𝑒
Own fund invested =
(1+𝑟)
(v) Purchase cost of share = Own fund invested + value of option (Premium initially recovered from buyer
of option)
And hence, we can then calculate value of option at start.

Following steps should be applied under this situation:

Step: 1 Calculate value of option at expiration date at high price as well as low price of share.
Step: 2 Calculate hedge ratio as under to identify number of shares purchased for perfect hedging
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛
Hedge ratio =
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒
Step: 3 Calculate hedge position at the expiration date by comparing value of shares and value of options.
Step: 4 Calculate own fund invested which should be equal to present value of hedge position at expiration
date.
Step: 5 Calculate value of option at the time of writing of call by satisfying following equation:
Purchase cost of shares at current price = Own fund invested + value of option
Class example:102 Suppose there are only two possible future states of the world. In state 1 the stock
price rises by 50%. In state 2, the stock price drops by 25%. The current stock price S(0) = $50. If a call
option has an exercise price of $50 and the risk-free rate (r) for the period is 5%: (a) Calculate the call
option hedge ratios; (b) Use the binomial option pricing model to value the call option.
Solution: For calculation of hedge ratio first we have to calculate value of option at expiration date:
Spot price Exercise price Value of option
75 50 25
37.50 50 0
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛 25−0 25
Hedge ratio = = =
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 75−37.50 37.50
The writer of a call for 1 share should buy 0.667 shares for perfect hedging.
Calculation of hedge position at the expiration date:

Spot price Value of 0.667 shares Value of option Hedge position
75 25 25 50 – 25 = 25
75 * = 50
37.50
37.50 25 0 25 – 0 = 25
37.5 * = 25
37.50
Value of option:
(33.35 - P) 1.05 = 25
35.02 – 1.05 P = 25
1.05 P = 10.02
10.02
P= = 9.54
1.05
Class example:103 Quickset company’s equity shares are currently selling at a price of `400 each. An
investor is interested in purchasing Quickset’s shares. The investor expects that there is a 70 % chance that
the price will go up to `550 or a 30 % chance that it will go down to `350, three months from now. There
is a call option on the shares of Quickset that can be exercised only at three months at an exercise price of
`450.
(i) If the investor wants a perfect hedge, what combination of the share and option should be selected?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price.
(iii) If the risk – free rate of return is 5 % for 3 months (periodic rate), what is the value of the option at the
beginning of the period?
(iv) What is the expected return on the option? [CWA – Dec. 2005]
Solution:
(i) Calculate value of option at expiration date:
550 450 100
350 450 0

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛 100−0 100

Hedge ratio = = = = 0.50
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 550−350 200
The writer of 1 call required to purchase 0.50 shares for perfect hedge.
(ii) If we want to know that whether investor will be able to maintain identical position regardless of the
share price, then we need to calculate value of hedge position in the following manner:
Calculation of hedge position at the expiration date:
Spot price Value of 0.50 shares Value of option Hedge position
550 550 * 0.50 = 275 100 175
350 350 * 0.50 = 175 0 175
The position remains unchanged.
(iii) Value of option:
(200 - P) 1.05 = 175
210 – 1.05 P = 175
1.05 P = 35
35
P= = `33.33
1.05
Class example: 104 The equity shares of ENDALOCO Limited are currently selling at a price of `500
each. An investor is interested in purchasing the shares of Endaloco Limited. The investor expects that
there is 80 % chance that the price will go up to `650 or a 20 % chance that it will go down to `450, three
months from now. There is a call option on the shares of Endaloco Limited that can be exercised only at
the end of three months at an exercise price of `550. The risk –free rate is 12 % per annum.
(i) If the investor wants a perfect hedge, what combination of the share and option should he select?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price?
(iii) How much the investor should pay for buying this call option today?
(iv) What is the expected return on the option? [CWA – Dec. 2007]
Solution:
Class example: 105 Mr. Dayal is interested in purchasing equity shares of ABC Limited which are
currently selling at `600 each. He expects that price of share may go up to `780 or may go down to `480
in three months. The chances of occurring such variation are 60 % and 40 % respectively. A call option on
the shares of ABC Limited can be exercised at the end of three months with a strike price of `630.
(i) What combination of shares and options should Mr. Dayal select if he wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10 % p.a.)?
(iii) What is the expected return on the option? [CA – Nov. 2015]
Solution:
(i) Calculation of value of option
780 630 150
480 630 0
To compute perfect hedge we shall compute hedge ratio
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛
Hedge ratio =
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒
150−0 150
= = = 0.50
780−480 300
Mr. Dayal should purchase 0.50 shares for every 1 call option.
Hedge position on expiration date
Spot price Value of 0.50 Value of option Hedge position
shares
780 390 150 240
480 240 0 240
(ii) Amount of premium / Value of option can be calculated as under:

(300 – P) 1.025 = 240

307.50 – 1.025 P = 240

67.50
P= = `65.85
1.025
(iii) Expected return on option:

Expected value = 150 * 0.60 + 0 * 0.40 = 90
90−65.85
Return = x 100 = 36.67 %
65.85
Class example: 106 The equity share of Maruti Ltd. is currently selling at ` 100. Find the value of 6
months maturity put option, strike price ` 101, risk free rate of interest 12% p.a. Over 3 month’s period, it
is expected to go up by 10% or go down by 10%. Over next 3 months period, it is expected to go up by 8%
or go down by 6%. [CWA – RTP – June, 2015]
METHOD: 4 BLACK – SCHOLES MODEL OF OPTION PRICING

Assumptions of Black – Scholes Model of option pricing:
 Perfect competition in market.
 Option must be European option.
 Risk – free interest rate must be continuous compounded rate which is known and constant.
 Annualized volatility of the stock (σ) is known and constant.
 Stock price is log normally distributed means that normal log of the stock price followed normal
distribution i.e. Log es = Ln
Formula for European call option: Ce = S.N(d1) – X.e-rt N (d2)

S = Spot price of the underlying
X = Strike price of the underlying
X.e-rt = Present value of strike price
r = Risk free interest rate on per annum basis
t = Time period of option (Option life). Option life should always be expressed on per annum basis.
Steps for BSOPM

Step: 1 Calculate value of d 1 and d2 as under:
S σ2
Ln ( )+(r+ )T
x 2
d1 =
σ√T
d2 = d1 - σ√T
Step: 2 Now calculate N (d1) and N (d2)
N (d1) and N (d2) represent cumulative standard normal distribution table.
Step: 3 Plug values in BSOPM.
Class example:107 Following information is available for X Company’s shares and Call option
Current share price `185
Option exercise price `170
Risk – free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
[CWA – RTP - Dec. 2014]
Class example: 108 A stock is currently trading for ` 28. The riskless interest rate is 6 per cent per annum
continuously compounded. Estimate the value of European call option with a strike price of ` 30 and a
time of expiration of 3 months. The standard deviation of the stock‘s annual return is 0.44. Apply Black-
Scholes model. [CWA – RTP, June, 2015]

Class example: 109 Compute a call option price by applying the Black – Scholes option pricing model on
the following values:
Strike price `45
Time remaining to expiration 183 days
Expected price volatility 25
Risk – free rate 10 %
[CWA – RTP – Dec. 2013]
Class example: 110 A six month Call option on Nagarjuna Fertilizer with a strike price of `43 sells for `8.
A put option on the same stock and same strike price sells for `2. option on this stock is available with a
strike price of `40 and an expiration date in six months. If the risk-free rate equals 10% at what price
shares of Nagaijuna Fertilizer should trade to prevent arbitrage? [CWA – RTP – Dec. 2014]
Class example: 111 Sulekha Ltd. has both European call and put options traded on NSE. Both options
have an expiration date 6 months and exercise price of ` 30. The call and put are currently selling for ` 10
and ` 4 respectively. If the risk-free rate of interest is 6% p.a., what would be the stock price of Sulekha
Ltd? [Given PVIF (6%, 0.5 Years = 0.9709] [CWA – RTP – Dec. 2013]
Class example: 112 The FERGUSON SYSTEMS was trading at ` 134 on April 3, 2009 and call option
exercisable in three months’ time had a strike price of `130.
The following are the other parameters of the option:
The annualized standard deviation in Ferguson Systems stock price over the previous year was 60%
The annualized Treasury Bill rate corresponding to this option life is 8%
Requirements:
(i) Compute the value of a three month CALL option on the stock of Ferguson system using Black and
Scholes model.
(ii) What would be the value of PUT?
(iii) If this CALL option is Priced at `15 what investment strategy would you adopt?
(iv) If this PUT option is available in the market at `14 what investment strategy would you adopt?
Note: Extracted from the tables:
(1) Natural logarithms: In (0.9701) = -0.0303
In (1.0308) = 0.0303
(2) Value of ex: e-0.02 = 0.9802, e-0.016 = 0.9841
(3) For N (X): where X ≥ 0: N (0.3177) = 0.6246
N (0.0177) = 0.5071
Where X ≤ 0: N (-0.3177) = 0.3754
N (-0.0177) = 0.4929 [CWA – RTP – Dec. 2013]
Class example: 113 What is the value of the following call option according to the Black Scholes option
pricing model?
Stock price `27
Exercise price `25
Time to expiration 6 months
Risk – free rate 6%
Stock return variance 0.11
[CWA – RTP – June, 2012]
Class example: 114 The shares of ITC Ltd., are currently priced at `415 and call option exercisable in
three months’ time has an exercise rate of ` 400. Risk free interest rate is 5% p.a. and standard deviation
(volatility) of share price is 22%. Based on the assumption that ITC Ltd., is not going to declare any
dividend over the next three months, is the option worth buying for ` 25?
(i) Calculate value of aforesaid call option based on Black Scholes valuation model if the current price is
considered as ` 380.
(ii) What would be the worth of put option if current price is considered `380.

(iii) If ITC Ltd., share price at present is taken as `408 and a dividend of `10 is expected to be paid in the
two months’ time, then calculate value of the call option. [CWA – RTP – June, 2012]
Class example: 115 Vishnu is interested in purchasing a European call option on Colgate Ltd. a non-
dividend paying stock, with a strike price of `100 and two years until expiration. Colgate Ltd. is currently
trading
at `100 per share and the annual variance of its continuously compounded rate of return is 0.04. The
treasury bill that matures in two years yield a continuously compounded interest rate of 5% per annum.
(a) Use the Black Scholes Model to calculate the price of the call option that Vishnu is interested in
buying?
(b) What does the put call parity imply about the price of the put, with strike price of `100 and two years
until expiration? [CWA – RTP - Dec. 2011]
Class example: 116 From the following data for certain stock, find the value of a call option:
Price of stock now `80
Exercise price `75
Standard deviation of continuously compounded 0.40
Maturity period 6 months
Annual interest rate 12 %
Given:
Number of SD from mean (z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e0.12 * 0.5 = 1.062
Ln 1.0667 = 0.0646 [PM - 52]
OPTION PRICING WHILE APPLYING INTEREST DIFFERENTIALS:

Class example: 117 From the following data calculate price of a call option expiring after one year:
(i) Spot exchange rate: `50 per $
(ii) Exercise / strike price: `60 per $
(iii) Risk – free interest rate for `- 10 % per annum.
(iv) Risk – free interest rate for $ - 15 % per annum.
(v) Expected range of (Maximum and Minimum) spot rate on maturity of option after one year = `70 - `40
per $.
Class example: 118 From the following data calculate price of a call option expiring after one year:
(i) Spot exchange rate: `60 per pound
(ii) Exercise / strike price: `64 per pound
(iii) Risk – free interest rate for ` - 15 % per annum
(iv) Risk – free interest rate for £ - 20 % per annum
(v) Expected spot rate on maturity of option after one year: `76.25 - `45 per pound.
(11) PUT – CALL PARITY THEORY – Put – call parity define relationship between the price of an
European call option and price of an European put option, when they have same strike price and maturity
date.
The relationship between put option and call option can be expressed as under:
Value of call + Present value of exercise price = Value of put + Current stock price
Class example:119 Consider a European call option and a European put option on a non – dividend
paying stock. You are given:
(i) Current price of the stock is `60
(ii) Call option currently sells for 0.15 more than put option.
(iii) Both the call option and put option have a strike price of 70
(iv) Both the call option and put option will expire in 4 years.

Calculate risk – free interest rate.
Class example: 120 You are given the following information:

(i) Current price to buy one share of XYZ stock is `500.
(ii) The stock does not pay dividends.
(iii) The risk – free interest rate compounded continuously is 6 %.
(iv) A European call option on one share of XYZ with a strike price of K, that expires in one year costs at
`66.59.
(v) A European put option on one share of XYZ with a strike price of K, that expires in one year costs
`18.64.
Determine the strike price K.
(12) IMPORTANT OPTION STRATEGIES

(1) Long call strategy:
 Buy Call option
 Popular for bullish investors
 Maximum loss – Amount of premium paid
 Profit – Unlimited
(2) Long put strategy:

 Buy put option
 Popular for bearish investors
 Maximum loss – unlimited
 Profit – Strike price – price of underlying – premium
(3) Short call strategy:

 Sell call option
 Type of investor – Bearish
 Maximum loss – Unlimited
 Maximum profit – Premium amount
(4) Short put strategy:

 Sell put option
 Type of investor – Bullish
 Maximum loss – Unlimited
 Maximum profit – Premium received
(5) Straddle and strangles strategy:

Straddle – Buying a call and a put with same strike price and same maturity period.
Strangle – Buy a call and a put with different strike prices and same maturity period.
These strategies must be use when investor expect that there is a strong movement in prices but not sure
about the direction.
(6) Strip and strap strategy:

Strip – Buy 1 call and 2 put of same underlying, same strike price and same expiration date.
Strap – Buy 2 call and 1 put of same underlying, same strike price and same expiration date.
(7) Butterfly strategy:

 These strategies involve position in option with 3 different strike prices.
 It can be created through buy a call at low strike price, buy a call with high strike price and sell 2
call at strike price equal to average of low and high price
Class example: 121 Current spot price - `61

Following are the call option quotation in the market:
Strike price Premium

55 10
60 7
65 5
Calculate pay – off for the investor as per Butterfly strategy if stock price on expiry 51 – 71 at a interval of
2.
INTEREST RATE OPTIONS:

(1) CAP option -
(i) It is a financial derivative which gives the buyer right to decide about the interest rate on every re – set
date. This instrument provides protection to the borrower and at the same time it allows benefits, if interest
rate falls. The buyer of the option has to pay premium for buying the cap option.
(ii) It is an over – the – counter product.
(iii) Key terms used for CAP option:

(a) Notional principal – It is an amount agreed for interest calculation. It is never exchanged.
(b) CAP rate / Strike rate – It is the rate of interest at which buyer of CAP pays fixed interest.
(c) Index rate / Benchmark rate / Spot rate – It is the rate of interest at which buyer of the CAP will receive
interest.
(d) Option life – Option life means life of contract which is agreed between the parties.
(iv) It is a multiple settlement derivative.
(v) On every re – set date there will be two possibilities:
CASE: A – Index rate > CAP rate

CASE: B – Index rate < CAP rate
Exercise the option
Do not Exercise the option
(2) Floor Option

(i) The buyer of the floor option gets protection if interest rate falls and at the same time it allows benefit if
interest rate goes up. For this purpose, buyer pays premium to option seller. This instrument works as risk
hedging instrument for the lender or depositor.
(ii) It is an over – the – counter product.
(iii) Key terms of the instrument -

(a) Notional principal – It is an amount agreed for interest calculation. It is never exchanged.
(b) Floor rate / Strike rate – It is the rate of interest at which buyer of Floor receive fixed interest.
(c) Index rate / Benchmark rate / Spot rate – It is the rate of interest which prevails in market.
(d) Option life – Option life means life of contract which is agreed between the parties.
(iv) It is a multi – settlement derivative.

(v) On every re –set date, there will be two possibilities:
CASE: A – Index rate > Floor rate CASE: B – Index rate < Floor rate
Do not exercise the option Exercise the floor option
(3) Collar option –

(i) When a person is buying and selling CAP and FLOOR then this situation is known as collar option.
Under collar strategy either:
 Buying CAP and selling FLOOR or
 Buying FLOOR and selling CAP
(ii) Both options must have same expiry period.
(iii) This instrument can be created for borrower as well as depositor in the following manner:
(a) For Borrower – Buy CAP and sell FLOOR
(b) For Lender / Depositor – Buy FLOOR and sell CAP
(iv) It is an over – the counter product.
(iv) It is a multiple settlement derivative.
QUESTION BANK FOR OPTIONS

Q.68 XYZ Ltd. a US firm need British Pound (BP) 3,00,000 in 180 days. In this connection, the following
information is available:
Spot rate 1 BP = $ 2.00
180 days forward rate of BP as of today = $ 1.96
Interest:
UK US
180 days deposit rate 4.5 % 5.0 %
180 days borrowing rate 5.0 % 5.50 %
A call option on BP that expires 180 days has an exercise price of $ 1.97 and a premium of $ 0.04. XYZ
has forecast spot rates 180 days hence as follows:
Rate Probability
$ 1.91 25 %
$ 1.95 60 %
$ 2.05 15 %
Which of the following strategies would be most preferable to XYZ.
(a) Forward (b) Money market hedge (c) option hedging (d) No hedging .
[CA – May, 07]
Q. 69 Best of Luck Ltd, London will have to make a payment of $3,64,897 in six month’s time. It is
currently 1st October. The company is considering the various choices it has in order to hedge its
transaction exposure.
Exchange rates:
Spot rate $ 1.5617 – 1.5773
Six – month forward rate $ 1.5455- 1.5609
Money market rates:
Borrow (%) Deposit (%)
US 6 4.5
UK 7 5.5
Foreign currency option prices (1 unit is £12,500):
Exercise price Call option (March) Put option (March)

$1.70 $0.037 $0.096

By making the appropriate calculations and ignoring time value of money (in case of Premia) decide which
of the following hedging alternatives is the most attractive to Best of Luck Ltd:
(a) Forward market
(b) Cash (Money) market;
(c) Currency options. [RTP – May, 05]
Q. 70 Carlhams corporation Ltd. in UK will need to make a payment of $ 2,50,000 in six months time. It is
currently 1st January. The company is considering various choices it has, in order to hedge its transaction
exposure. Following market information is available:
Exchange rates Country Money market rates
Borrow % Deposit %
£ spot rate $ 1.5617 – 1.5773 USA ($) 6 4.50
Six months £ forward rate $ 1.5445 – 1.5609 UK 7 5.50
Foreign currency option prices:
Exercise price Call option (June) Put option (June)
$1.70 $0.037 $0.096
Contract size (1 unit is £ 12,500)
Evaluate the hedging alternatives with necessary calculations and decide which of the same is the most
attractive to Carlhams corporation Ltd. [CWA – June, 2007]
Q.71 An American firm is under obligation to pay interest of Can $ 10,10,000 and Can $ 7,05,000 on 31 st
July and 30th September respectively. The firm is risk averse and its policy is to hedge the risks involved in
all foreign currency transactions. The finance manager of the firm is thinking of hedging the risk
considering two methods i.e. fixed forward or option contracts.
Spot rate 1 months forward 3 months forward
0.9284 – 0.9288 0.9301 0.9356
Price for a Can $ / US $ option on a US stock exchange (Cents per Can $, payable on purchase of the
option, contract size Can $ 50,000) are as follows:
Strike price (US $ / Can $) Calls Puts
July September July September
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the suggestion of finance manager if options are to be used, one month option should be
bought at a strike price of 94 cents and three months option at a strike price of 95 cents and for the
remainder uncovered by the option the firm would bear the risk itself. For this, it would use forward rate as
the best estimate of spot. Transaction costs are ignored. Recommend, which of the above two methods
would be appropriate for the American firm to hedge its foreign exchange risk on the two interest
payments. [CA – Nov. 2013]
Q.72 Zenith Ltd. (ZL) places an order to buy machinery with an American company. As per the agreement
Zenith Ltd. will be paying $ 2,00,000 after 180 days. The company Zenith Ltd. consider to use (a) A
forward hedge; (b) A money market hedge; (c) An option hedge or (d) no hedge. The consultant of Zenith
Ltd. collects and develops the following data / information as desired by the company, which can be used
to assess the alternative approaches for hedging.
(i) Spot rate of dollar as of today is `47 / $.
(ii) 180 days forward rate of dollar as of today is `47.50 / $.
(iii) Interest rates are as follows:
India US
180 days deposit (per annum) 7.50 % 3%
180 days borrowing rate (per annum) 8.00 % 4%
Assume 360 days in a year
(iv) Future spot rate in 180 days as estimated by the consultant is `47.75 / $.

(v) A call option on the dollar, which expires in 180 days has an exercise price of `47/ $ and premium
`0.52/ $.
(vi) A Put option on the dollar, which expires in 180 days has an exercise price of `47.50 and premium of
`0.40/ $.
Required: Carry out a comparative analysis of various outcomes (rupee cost of import) / alternatives and
decide which of the alternative is the best for Zenith Ltd. [CWA – Dec. 2005]
Q.73 Fresno Corporation Ltd. a US company will need £ 2,00,000 in 180 days. It considers using ( a) A
forward; (b) A money market hedge; (c) Option hedge or (d) No hedge. Its analysts develop the following
information, which can be used to assess the alternative approaches to hedging:
(i) Spot rate of pound as of today = $ 1.50.
(ii) 180 days forward rate of pound as of today = $ 1.47.
(iii) Interest rates are as follows:
UK US
180 days deposit (per annum) 4.50 % 4.50 %
180 days borrowing rate (per annum) 5% 5.0 %
Assume 360 days in a year.
(iv) A call option on pounds that expires in 180 days has an exercise price of $ 1.48 and a premium of $
0.03.
(v) Fresno Corporation forecasted the future spot rate in 180 days as follows:
Possible outcome $ 1.43 $ 1.46 $ 1.52
Probability 20 % 70 % 10 %
Evaluate each alternative with necessary calculation and give your recommendations. Ignore transaction
cost or taxes. [CWA – Dec. 2007]
Q.74 A Ltd. of UK has imported some chemical worth of USD 3,64,897 from one of the US suppliers. The
amount is payable in six months time. The relevant spot and forward rates are –
Spot rate USD 1.5617 – 1.5673
6 months forward rate USD 1.5455 – 1.5609
The borrowing rates in UK and US are 7 % and 6 % respectively and the deposit rates are 5.50 % and 4.50
% respectively. Currency option is available under which one option contract is for GBP 12,500. The
option premium for GBP at a strike price of USD 1.70 / GBP is USD 0.037 (call option) and USD 0.096
(put option) for 6 months period. The company has 3 choices – (a) Forward cover (b) Money market cover
and (c) currency option. Which of the alternative is preferable by the company? [CA – May, 2010]
Q. 75 An Importer is to pay 1 million US $ in two months. The importer wants to cover exchange risk with
call option. The data are given below:
Spot rate, forward rate and strike price are `43.00 / $.
Premium = 3 %
Discuss various possibilities that may occur to the importer.
Expected spot rate = `44 or `42. [CA - RTP]
Q.76 ABC Co. excepts to receive S$ 5,00,000 in one year. The existing spot rate of Singapore dollar is $
0.60. The one year forward rate of the Singapore dollar is $ 0.62. ABC created a probability distribution
for the future spot rate in one year as follows:
Future spot rate Probability
$ 0.61 20 %
0.63 50 %
0.67 30 %
Assume that one year put options on Singapore dollars are available, with an exercise price of $ 0.63 and a
premium of $ 0.04 per unit. One year call option on Singapore dollars are available with an exercise price
of 0.60 and a premium of $0.03 per unit. Assume the following money market rates are available:
US Singapore
Deposit rate 8% 5%
Borrowing rate 9% 6%

Determine whether a forward hedge, money market hedge or a currency option hedge would be most
appropriate. Then compare the most appropriate hedge to an un – hedged strategy and decide whether
ABC should hedge its receivables position.
Q. 77 Suppose that a 1-year cap has a cap rate of 8% and a notional amount of ` 100 crore. The frequency
of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for the
next four quarters is as shown below.
Quarters 3 months MIBOR (%)
1 8.70 %
2 8.00 %
3 7.80 %
4 8.20 %
You are required to compute payoff for each quarter. [CA –RTP – Nov. 2013]
Q. 78 Suppose that a 1 year floor has a floor rate of 4 % and a notional principal of `200 crore. The
frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month
MIBOR for the next four quarters is as shown below.
Quarters 3 months MIBOR (%)
1 4.70 %
2 4.40 %
3 3.80 %
4 340 %
You are required to compute payoff for each quarter. [CA –RTP – Nov. 2013]
Q. 79 XYZ Inc. issues a £10 million floating rate loan on July 1, 2013 with resetting of coupon rate every
6 months equal to LIBOR + 50 basis points. XYZ is interested in a collar strategy by selling a floor and
buying a cap. XYZ buys the 3 years cap and sell 3 years floor as per the following details on July 1, 2013:
Notional principal $ 10 million
Reference rate 6 month LIBOR
Strike rate 4 % for Floor and 7 % for Cap
Premium 0^
^ Since premium paid for Cap = Premium received for Floor
Using the following data you are required to determine:
(i) Effective interest paid out at each reset date,
(ii) The average overall effective rate of interest p.a.
Reset date LIBOR (%)
31.12.3013 6.00
30.6.2014 7.00
31.3.2014 5.00
30.6.2015 3.75
31.12.2015 3.25
30.6.2016 4.25
[RTP – May, 2014]
Q.80 A British airline company has decided to take a 3 – year floating rate loan of British $ 1,000 million
to finance its acquisition. The loan is indexed to 6 month British $ LIBOR with a spread of 75 basis points.
The company has identified the following caps and floors quoted by a bank.
Particulars Cap Floor
3 – years 3 – years 3 – years 3 – years
Underlying interest rate 6 months US $ 6 months US $ 6 months US $ 6 months US $
LIBOR LIBOR LIBOR LIBOR
Strike rate 3.00 % 3.75 % 3.25 % 3.75 %
Premium 2.0 % 1.50 % 1.25 % 2.00 %
Face value $ 1,000 million $ 1,000 million $ 1,000 million $ 1,000 million
You are required to show how the company can hedge its interest rate exposure by using an interest rate
collar strategy. Also calculate the effective cost of the loan showing all the relevant cash flow if the 6

month US $ LIBOR at the 6 reset dates turn out to be 3.85 %, 4.10 %, 3.50 %, 3.30 %, 3.10 % and 3.00 %.
Use a discount rate of 4 % to amortize the premium. [CWA – Study Material]
Q. 81 A put and a call option each have an expiration date 6 months hence and an exercise price of `10.
The interest rate for the 6 month period is 3 %.
(a) If the put has a market price of `2 and share is worth `9 per share, what is the value of the call?
(b) If the put has a market price of `1 and the call `4, what is the value of per share?
(c) If the call has a market value of `5 and market price of the share is `12 per share, what is the value of
put? [CWA – Study Material /CA – RTP, May, 2005]
Q. 82 You are given three call options on a stock at exercise price of `30, `35 and `40 with expiration date
in three months and the premium of `4, `2 and `1 respectively. Show how the option can be used to create
a butterfly spread. Construct a table with different market prices and show how profit changes with stock
prices ranging from `20 to `50 by taking interval of `2. [CA – RTP, May, 2005]
Q. 83 Mr. Khan established the following spread on the Delta Corporation’s stock:
(i) Purchased one 3-month call option with a premium of `20 and an exercise price of `550.
(ii) Purchased one 3-month put option with a premium of `10 and an exercise price of `450.
Delta Corporation’s stock is currently selling at `500. Determine profit or loss, if the price of Delta
Corporation’s:
(i) Remains at `500 after 3 months.
(ii) Falls at `350 after 3 months.
(iii) Rises to `600.
Assume the size option is 100 shares of Delta Corporation. [CWA – Study Material]
Q. 84 A call and put exist on the same stock each of which is exercisable at `60. They now trade for –
Market price of stock or stock index - `55
Market price of call - `9
Market price of put - `1
Calculate the separation date cash flow, investment value and net profit from –
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put
For expiration date stock prices of `50, `55, `60, `65 and `70. [CA – May, 2010]
Q. 85 The equity share of VCC Ltd. is quoted at `210. A – 3 month call option is available at a premium of
`6 per share and A – 3 month put option is available at a premium of `5 per share. Ascertain the net pay
off to the option holder of a call option and a put option given that –
(i) Strike price in both cases is `220 and
(ii) The share price on the exercise day is `200, `210, `220, `230 and `240.
Also indicate the price range at which the call option and the put options may be gainfully exercised.
[CA – May, 2009]
Q.86 Mr. A purchased from CIT a 3 year collar with:
 A cap rate of 6 %
 A floor rate of 4 %
 Notional principal - `1,00,00,000
 Reset date – Quarterly
 3 months LIBOR rate as the reference
 Collar would be structured on a zero cost basis.
(a) If 3 month LIBOR is 7 % on a reset date, then what will be the pay off from collar option?
(b) If 3 months LIBOR is 3 % on a reset date, then what will be the pay off from collar option?

Q.87 Mr. A purchased a 3 month call option for 100 shares in XYZ Limited at a premium of `30 per share,
with an exercise price of `550. He also purchased a 3 month put option for 100 shares of the same
company at a premium of `5 per share with an exercise price of `450. The market price of the share on the
date of Mr. A’s purchase of option is `500. Calculate the profit and loss that Mr. A would make assuming
that the market price falls to `350 at the end of 3 months. [Practice manual]
Q.88 XYZ Ltd. borrows £ 20 million of 6 months LIBOR + 0.25 % for a period of two years. T, Treasury
manager of XYZ, anticipates a rise in LIBOR, hence proposed to buy a cap option from ABC Bank at
strike rate of 7 %. The lump sum premium is 1 % for the whole of the three reset period and the fixed rate
of interest is 6 % p.a. The actual position of LIBOR during the forthcoming reset period is as follows:
Reset period LIBOR
1 8.00 %
2 8.50 %
3 9.00 %
You are required to show how far interest rate risk is hedged through cap option. [CA – May, 2013]
Q.89 The market received rumor about ABC Corporation’s tie-up with a multinational company. This has
induced the market price to move up. If the rumor is false, the ABC corporation stock price will probably
fall dramatically. To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of `42 for `2 premium, and paid `1 per share
premium for a 3 months put with a striking price of 40.
(i) Determine the investor’s position in the tie up offer bids the price of ABC Corporation’s stock up to
`43 in 3 months.
(ii) Determine the Investor’s ending position, if the tie up programme fails and the price of the stock falls
to `36 in 3 months. (FM, May 2006; Marks 7)
Hint:
(a) If spot price is `43 – Loss of `2
(b) If spot price is `36 – Profit of `1
Q.90 D Investment Ltd. deals in equity derivatives. Their current portfolio comprises of the following
instruments:
(i) Infosys `5,600 call expiry June 2004, 2000 units bought at `97 each.
(ii) Infosys `5,700 call expiry June 2004, 3600 units bought at `131 each.
(iii) Infosys `5,400 Put expiry June 2004, 4000 units bought at `81 each.
What will the profit or loss to D investment Ltd. in the following situations?
(a) Infosys closes on the expiry day at `6041.
(b) Infosys closes on the expiry day at `5812.
(c) Infosys closes on the expiry day at `5085. [CWA – June, 2004]
Hint:
(a) If spot price is `6,041 – 6,88,000; 7,56,000; (3,24,000)
(b) If spot price is `5,812 – 2,30,000; (68,400); (3,24,000)
(c) If spot price is `5,085 – (1,94,000); (4,71,600); 9,36,000
Q. 91 Identify profit or loss in each of the following cases:

(i) A call option with an exercise price of `200 bought for a premium of `89. The price of underlying share
is `276 at the expiry date.
(ii) A put option with exercise price of `250 is bought for a premium of `42. The price of underlying share
is `189 at the expiry date.
(iii) A put option with an exercise price of `300 is written for a premium of `57. The price of the
underlying share is `314 at the expiry date. [CS – June, 07]
Hint:
(i) Loss of `13
(ii) Profit of `19

(iii) Profit of `57
Q.92 Calculate profit or loss from the following transactions:

(i) Mr. X writes a call option to purchase share at an exercise price of `60 for a premium of `12 per share.
The share price rises to `62 by the time the option expires.
(ii) Mr. Y buys put option at an exercise price of `80 for a premium of `8.50 per share. The share price
falls to `60 by the time the option expires.
(iii) Mr. Z writes a put option at an exercise price of `80 for a premium of `11 per share. The price of the
share rises to `96 by the time the option expires.
(iv) Mr. XY writes a put option with an exercise price of `70 for a premium of `8 per share. The price falls
to `48 by the time the option expires. [CWA – Dec. 04]
Hint:
(i) Profit of `10
(ii) Profit of `11.50
(iii) Profit of `11.00
(iv) Loss of `14
Q.93 Mr. A enters into following transaction in an option contract in derivative market to buy a call option.
On 2nd September, 2010, Mr. A buys 400 call options on BSE sensex September, 2010 which is expiring
on 26th September, 2010 at a strike price of `3,500. The premium is `10 per call payable to the seller Mr.
B. If on the contract expiry date, the prevailing sensex is `3,300, the what is the gain or loss to Mr.A from
this contract. Would your answer differ if on the contract expiry date, the prevailing sensex is `3,600.
Q.94 Rax Investment Ltd. deals in equity derivatives. Their current portfolio comprises of the following
investment:
(i) Infosys `1,400 call expire December 2010: 200 units bought at `50 each (cost)
(ii) Infosys `1,425 call expire December 2010: 3000 units bought at `33 each (cost)
(iii) Infosys `1,350 Put expire December 2010: 4000 units bought at `22 each (cost)
What will be the profit or loss to Rax Investment Ltd. in the following situation?
(i) Infosys closes on the expiry day at `1550.
(ii) Infosys closes on the expiry day at `1460.
(iii) Infosys closes on the expiry day at `1,280. [CWA – Dec. 2008]
Hint:
 If spot price is 1550 – 20,000; 2,76,000; (88,000)
 If spot price is 1460 – 2,000; 6,000; (88,000)
 If spot price is 1280 – (10,000); (99,000); 1,92,000
Q.95 An investor purchased Reliance November Future (600 shares Tick size) at `542 and write a `580
November call option at a premium of `6 (600 share tick size). As on November 20 spot price rises and so
the future price and call premium. Future price rises to `575 and call premium rises to `12. Find out profit
/ loss of the investor, if he / she settle the transaction on that date and at stated prices. Brokerage is 0.05 %
for the transaction value of future and strike price net of call premium for option.
[CWA – Dec. 04]
Hint:
 Net loss on trading of derivatives - `15,522.30
Q.96 The market received runmour about ABC Corporation’s tie – up with a multinational company. This
has induced the market price to move up. If the runmour is false, the ABC Corporation stock price will
probably fall dramatically. To protect from this an investor has bought the call and put options. He
purchased one 3 months call with a strike price of `48 for `2 premium, and paid `4 per share premium for
a 3 months put with a striking price of `52.

(i) Determine the investor’s position if the tie – up offer bids the price of ABC Corporation’s stock up to
`56 in 3 months.
(ii) Determine the investor’s ending position, if the tie – up program fails and the price of the stock falls to
`39 in 3 months. [CA – May, 06]
Hint:
Q. 97 The shares of Bangalore Corporation Limited are selling at `105 each. C wants to chip in with
buying a three months call option at a premium of `10 per option. The exercise price is `110. Five possible
prices per share on the expiration date ranging from `100 to `140, with intervals of `10 are taken into
consideration by him. What is C’s payoff as call option holder on expiration?
[CWA – June, 2006]
Hints:
 Pay – off from call option – Nil; Nil; 10; 20; 30
 Net profit from call option – (10); (10); 0; 10; 20
Q.98 An investor purchased Reliance November futures (600 tick size) at `1,150 and write a `1,190
November call option at a premium of `10 (600 shares tick size). As on November 25, spot price rises and
so the future price and the call premium. Future price rises to `1,180 and call premium rises to `16.
Brokerage is 0.045 % for the transaction value of futures and strike price net of call premium for option.
Find out the profit / loss for the investor, if he / she settle the transaction on that date and at stated prices.
[CWA – Dec. 2006]
Hints:
 Profit / loss of the trader - `13,135.32
Q.99 XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30th June. In order to
hedge the risk involved in foreign currency transaction, the firm is considering two alternative methods i.e.
forward market cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.9516/1.9711. 1.9726./1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate. You are required
to recommend cheaper hedging alternative for XYZ. [CA – Nov. 2015]
Hint:
 Forward cover - `2,53,473
 Currency option contract - `2,47,109

NATURAL LOGARITHMS
X Ln (x) X Ln (x) X Ln (x) x Ln (x) X Ln (x)
0.01 -4.6052 0.51 -0.6733 1.01 0.0100 1.51 0.4121 2.10 0.7419
0.02 -3.9120 0.52 -0.6539 1.02 0.0198 1.52 0.4187 2.20 0.7885
0.03 -3.5066 0.53 -0.6349 1.03 0.0296 1.53 0.4253 2.30 0.8329
0.04 -3.2189 0.54 -0.6162 1.04 0.0392 1.54 0.4318 2.40 0.8755
0.05 -2.9957 0.55 -0.5978 1.05 0.0488 1.55 0.4383 2.50 0.9163
0.06 -2.8134 0.56 -0.5798 1.06 0.0583 1.56 0.4447 2.60 0.9555
0.07 -2.6593 0.57 -0.5621 1.07 0.0677 1.57 0.4511 2.70 0.9933
0.08 -2.5257 0.58 -0.5447 1.08 0.0770 1.58 0.4574 2.80 1.0296
0.09 -2.4079 0.59 -0.5276 1.09 0.0862 1.59 0.4637 2.90 1.0647
0.10 -2.3026 0.60 -0.5108 1.10 0.0953 1.60 0.4700 3.00 1.0986
0.11 -2.2073 0.61 -0.4943 1.11 0.1044 1.61 0.4762 3.10 1.1314
0.12 -2.1203 0.62 -0.4780 1.12 0.1133 1.62 0.4824 3.20 1.1632
0.13 -2.0402 0.63 -0.4620 1.13 0.1222 1.63 0.4886 3.30 1.1939
0.14 -1.9661 0.64 -0.4463 1.14 0.1310 1.64 0.4947 3.40 1.2238
0.15 -1.8971 0.65 -0.4308 1.15 0.1398 1.65 0.5008 3.50 1.2528
0.16 -1.8326 0.66 -0.4155 1.16 0.1484 1.66 0.5068 3.60 1.2809
0.17 -1.7720 0.67 -0.4005 1.17 0.1570 1.67 0.5128 3.70 1.3083
0.18 -1.7148 0.68 -0.3857 1.18 0.1655 1.68 0.5188 3.80 1.3350
0.19 -1.6607 0.69 -0.3711 1.19 0.1740 1.69 0.5247 3.90 1.3610
0.20 -1.6094 0.70 -0.3567 1.20 0.1823 1.70 0.5306 4.00 1.3863
0.21 -1.5606 0.71 -0.3425 1.21 0.1906 1.71 0.5365 4.10 1.4110
0.22 -1.5141 0.72 -0.3285 1.22 0.1989 1.72 0.5423 4.20 1.4351
0.23 -1.4697 0.73 -0.3147 1.23 0.2070 1.73 0.5481 4.30 1.4586
0.24 -1.4271 0.74 -0.3011 1.24 0.2151 1.74 0.5539 4.40 1.4816
0.25 -1.3863 0.75 -0.2877 1.25 0.2231 1.75 0.5596 4.50 1.5041
0.26 -1.3471 0.76 -0.2744 1.26 0.2311 1.76 0.5653 4.60 1.5261
0.27 -1.3093 0.77 -0.2614 1.27 0.2390 1.77 0.5710 4.70 1.5476
0.28 -1.2730 0.78 -0.2485 1.28 0.2469 1.78 0.5766 4.80 1.5686
0.29 -1.2379 0.79 -0.2357 1.29 0.2546 1.79 0.5822 4.90 1.5892
0.30 -1.2040 0.80 -0.2231 1.30 0.2624 1.80 0.5878 5.00 1.6094
0.31 -1.1712 0.81 -0.2107 1.31 0.2700 1.81 0.5933 5.50 1.7047
0.32 -1.1394 0.82 -0.1985 1.32 0.2776 1.82 0.5988 6.00 1.7918
0.33 -1.1087 0.83 -0.1863 1.33 0.2852 1.83 0.6043 6.50 1.8718
0.34 -1.0788 0.84 -0.1744 1.34 0.2927 1.84 0.6098 7.00 1.9459
0.35 -1.0498 0.85 -0.1625 1.35 0.3001 1.85 0.6152 7.50 2.0149
0.36 -1.0217 0.86 -0.1508 1.36 0.3075 1.86 0.6206 8.00 2.0794
0.37 -0.9943 0.87 -0.1393 1.37 0.3148 1.87 0.6259 8.50 2.1401
0.38 -0.9676 0.88 -0.1278 1.38 0.3221 1.88 0.6313 9.00 2.1972
0.39 -0.9416 0.89 -0.1165 1.39 0.3293 1.89 0.6366 9.50 2.2513
0.40 -0.9163 0.90 -0.1054 1.40 0.3365 1.90 0.6419 10.00 2.3026
0.41 -0.8916 0.91 -0.0943 1.41 0.3436 1.91 0.6471 11.00 2.3979
0.42 -0.8675 0.92 -0.0834 1.42 0.3507 1.92 0.6523 12.00 2.4849
0.43 -0.8440 0.93 -0.0726 1.43 0.3577 1.93 0.6575 13.00 2.5649
0.44 -0.8210 0.94 -0.0619 1.44 0.3646 1.94 0.6627 14.00 2.6391
0.45 -0.7985 0.95 -0.0513 1.45 0.3716 1.95 0.6678 15.00 2.7081
0.46 -0.7765 0.96 -0.0408 1.46 0.3784 1.96 0.6729 16.00 2.7726
0.47 -0.7550 0.97 -0.0305 1.47 0.3853 1.97 0.6780 17.00 2.8332
0.48 -0.7340 0.98 -0.0202 1.48 0.3920 1.98 0.6831 18.00 2.8904
0.49 -0.7133 0.99 -0.0101 1.49 0.3988 1.99 0.6881 19.00 2.9444
0.50 -0.6931 1.00 0.0000 1.50 0.4055 2.00 0.6931 20.00 2.9957

AREA UNDER NORMAL CURVE

Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
value
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.495
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
3.1 0.4990 0.4991 0.4991 0.4991 0.4992 0.4992 0.4992 0.4992 0.4993 0.4993
3.2 0.4993 0.4993 0.4994 0.4994 0.4994 0.4994 0.4994 0.4995 0.4995 0.4995
3.3 0.4995 0.4995 0.4995 0.4996 0.4996 0.4996 0.4996 0.4996 0.4996 0.4997
3.4 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4998
3.5 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998
3.6 0.4998 0.4998 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.7 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.8 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.9 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000
4.0 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000


INTERNATIONAL FINANCE (1)

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INTERNATIONAL FINANCE (1)

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SARVAGYA INSTITUTE OF COMMERCE 1

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

LIST OF IMPORTANT CURRENCIES

Topic: 1 Introduction / Regulator of forex market in India

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Topic: 2 Types of forex market

(2) Retail market

Topic: 3 Types of transactions under forex market

One way quote Two – way quote

Following steps will be applied for conversion:

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

(ii) Payment by firm = 2,00,000 ¥

(iii) Firm receive = 3,00,000 $

(iv) Payment by firm = 4,00,000 SGD

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

(ii) Payment of interest = 2,00,000 ¥

(iii) Firm received = 3,00,000 $

(iv) Payment by firm = 4,00,000 SGD

Topic: 6 Direct quote and Indirect quote

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Class example: 7 Convert the direct quotes into indirect quotes:

Topic: 7 Bid rate, Ask rate and spread

Class example: 8 Consider the following quotes.

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Topic: 8 Concept of exchange margin

Rule: 2 Add margin to selling rate to get desired exchange rate.

Topic: 9 Concept of spot rate and forward rate

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Method: 2 With the application of IRPT (Interest rate parity theory):

Method: 3 with the application of PPPT (Purchasing power parity theory)

Class example: 12 The following quotes are available

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

(b) Calculation of 6 – months forward rate:

Topic: 10 Forward premium or discount/ Appreciation or depreciation in currency

Calculation of Annualized forward premium / Discount on currency:

Forward rate−Spot rate 12

Spot rate−Forward rate 12

Note: A negative answer would imply annualized discount rate.

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

(b) Annualized forward premium on $ (Currency A)

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Calculation of 6 – months forward rate (Currency A)

Topic: 11 Concept of cross rate

Class example: 24 Following exchange rates are quoted by bank:

So, 108.0030 ¥ = 0.6263 €

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Class example: 25 Following exchange rates are quoted by bank:

Class example: 26 Following exchange rates are quoted by bank:

(ii) Bank buy 1 $ and sell 1.2948 AUD

Class example: 27 Following rates are quoted by bank:

Class example: 28 You are given the following exchange rates:

(ii) Bank buy £ and sell $ at 1.9810

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Class example: 32 You are given the following information

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Step: 1 Book a forward contract today at applicable forward rate.

Step: 2 Calculate cash flows due to such forward cover.

Step: 4 Compare both cash flows and take decision.

HOW TO CALCULATE EXPECTED SPOT RATE:

Method: 1 Various expected spot Method: 3 If in the question appreciation /

Method: 2 If in the question appreciation /

Step: 3 Re – convert the quote in original terms.

COMPILED BY ADHISH BHANSALI (M.COM./ FCA) Mo. No. 9829279730

Amount payable 52,000 $