You are on page 1of 205

Accounting & Finance for Bankers

MODULE A
PRESENTATION
BY
Cma Sunil Kumar Mohan

cmaskmohan@gmail.com
9839736168
JAIIB-Accounting & Finance for Bankers
MODULE-A
BUSINESS MATHEMATICS and finance

1. Calculation of Simple and compound Interest


2. Calculation YTM
3. Capital Budgeting Techniques
4. Depreciation Methods
5. FX Exchange Arithmetic

5/13/18 S K MOHAN 2
Calculation of Interest
• Simple
• Compound
• Rule of 72
• Sinking fund method
• Annuities ordinary annuity and annuity due
• Amortization of debts (EMI)
• Perpetuities (infinite series of payment made at fixed
intervals )

5/13/18 S K MOHAN 3
Calculation of Simple and compound Interest-1
• Total repayment = Principle + interest
• Rate of Interest
– Simple Interest = Principle X time period X rate
– When interest earns interest , it is called Compounded interest
– Fixed Interest rate and floating interest rate
– Front end and back end interest
– Teaser rate of interest
• In how many years will take to double your money with
specific rate of interest is called RULE 72.
• An annuity is a series of payments made at fixed intervals .
types of annuities are :-
– Ordinary annuity and ( payment at the end of period)
– Annuity Due ( Payment at beginning of each period)
– Present value and Future value of both annuities are different
5/13/18 S K MOHAN 4
Simple Interest
• 'Simple' interest or 'flat rate' interest is the amount of interest paid
each year in a fixed percentage of the amount borrowed or lent at the
start.
• Formula for calculating simple interest :
Interest = Principal x Rate x Time (PRT), where:
• 'Interest' is the total amount of interest paid
'Principal' is the amount lent or borrowed
'Rate' is the percentage of the principal charged as interest each year.
'Time' is the time in years of the loan.
• Example :
• Principal: 'P' = Rs. 50,000, Interest rate: 'R' = 10% = 0.10, Repayment
time: T = 3 years. Find the amount of interest paid.
• Interest = PRT
= 50,000x0.10x3
= Rs. 15,000
5/13/18 S K MOHAN 5
• Simple Intt :-- P x R x T
• A sum of money amount to Rs.2,240 @ 4% simple interest in 3
years. Find the interest on the same sum for 6 months @ 3.5%
p.a.
• a. Rs. 35
• b. Rs. 40
• c. Rs. 45
• d. Rs. 50
• Ans – a
• A=P(1+rt)= 2240=P(1+4/100 X3)=28/25
• 2240/28*25=2000
• 3.5% of 2000= 70 and six month is rs.35/-

5/13/18 S K MOHAN 6
• At 5% per annum simple interest, Rahul borrowed Rs. 500.
What amount will he pay to clear the debt after 4 years ?
– A. 750
– B. 700
– C. 650
– D. 600
• Ans - D
• Explanation:
• We need to calculate the total amount to be paid by him
after 4 years, So it will be
• Principal + simple interest.
• So,=>500+500*5*4/100
• =>Rs.600
5/13/18 S K MOHAN 7
Compound Interest
• Compound interest is paid on the original principal and accumulated part of
interest.
• A=P(1+r)n
• P = the principal
A = the amount of money accumulated after n years
r = Annual the rate
n = number of years that interest is compounded
• Formula for calculating compound interest :
• A = P(1 +r/n)^nt, where
• P = the principal
A = the amount deposited
r = the rate (expressed as fraction, e.g. 6 per cent = 0.06)
n = number of times per year that interest is compounded
t = number of years invested
• Frequently compounding of Interest. If the interest is compounded :
Annually = P (1 + r)
Quarterly = P (1 + r/4)^4
Monthly = P (1 + r/12)^12
5/13/18 S K MOHAN 8
• What is the principal amount which earns Rs. 264 as compound
interest for the second year @ 10% p.a.?
– a. Rs. 2,000
– b. Rs. 2,200
– c. Rs. 2,400
– d. Rs. 2,600
• Ans - c
• Solution :
• A = P(1+r/100) n
– In the formula, A represents the final amount in the account after n years at interest rate 'r' with
starting amount 'p'.
– P 2nd year = 2640
– A 1st Year = 2640
• P 1st = (2640/110*100) = 2400
• Rs. 400 at 5% p.a. compound interest will amount to Rs. 441 in......
– a. 1 year
– b. 2 years
– c. 3 years
– d. 4 years
• 5/13/18
Ans – b S K MOHAN 9
• Find the compound interest on Rs 160000 for one year at the
rate of 20% per annum, if the interest is compounded
quarterly.
• Solution:
• Given:
• P = Rs 160,000
• R = 20 % p. a.
• n = 1 year
• We know that:
• A = P(1+R/400)4n
• A = 160000(1+20/400)4
• A = 160000(1.05)4
• A = Rs 19,4481
• Now, CI = A – P = Rs 19,448.1 – Rs 16,000 = Rs 3,4481
• Mewa Lal borrowed Rs 20000 from his friend Rooplal at 18%
per annum simple interest. He lent it to Rampal at the same
rate but compounded annually. Find his gain after 2 years.
• Solution:
• SI for Mewa Lal = P*R*T = 20000×18/100×2 = Rs 7,200
• Thus, he has to pay Rs 7,200 as interest after borrowing CI for
Mewa Lal = A – P
• = 20000(1+18/100)2 – 20,000
• = 20000(1.18)2 – 20,000
• = 27,848- 20,000
• = Rs 7,848
• He gained Rs 7,848 as interest after lending. His gain in the
whole transaction
• = Rs 7,848 – Rs 7,200 = Rs 648
• Rohit deposited Rs 8000 with a finance company for 3 years at
an interest of 15% per annum. What is the compound interest
that Rohit gets after 3 years?
• Solution:
• We know that amount A at the end of n years at the rate of R% per
annum is given by = A = P(1+R/100)n
• Given:
• P = Rs 8,000
• R = 15% p.a.
• n = 3 years.
• Now,
• A = 8000(1+15/100)3
• A = 8000(115/100)3
• A = Rs. 12,167
• And, CI = A – P = Rs 12,167 – Rs 8,000 = Rs 4,167
• In a laboratory, the count of bacteria in a certain experiment was increasing at
the rate of 2.5% per hour. Find the bacteria at the end of 2 hours if the count was
initially 5,06,000.
• Ans. Here, Principal (P) = 5,06,000, Rate of Interest (R) = 2.5%, Time = 2 hours
• After 2 hours, number of bacteria,
• Amount (A) =

• =

• =

• 5,31,616.25
• Hence, number of bacteria after two hours are 531616 (approx.).
• Qus. If the simple interest on a sum of money at 5% per annum for 3 years is Rs. 1200, find
the compound interest on the same sum for the same period at the same rate.

Sol. Clearly, Rate = 5% p.a., Time = 3 years, S.I.= Rs. 1200. ..

So principal=RS [100*1200]/3*5=RS 8000

Amount = Rs. 8000 x [1 +5/100]^3 - = Rs. 9261.

.. C.I. = Rs. (9261 - 8000) = Rs. 1261.


• The difference between the S.I. and C.I. on a certain sum of money for 2 years at 4% per
annum is Rs 20. Find the sum.
• Solution:
• Given:
• CI – SI = Rs 20
• [P(1+4/100)2−P]−P×4/100×2=20 P[(1.04)2−P]−0.08P=20
• 0.0816P – 0.08P = 20
• 0.0016P = 20
• P = 200.0016
• P = 12500
• Thus, the required sum is Rs 12500.
• ) The present population of a town is 25000. It grows at 4%, 5% and 8% during first year,
second year and third year respectively. Find its population after 3 years.
• Solution:
• Here,
• P = Initial population = 25000
• R1 = 4%
• R2 = 5%
• R3 = 8%
• n = Number of years = 3
• Therefore, Population after three years = P(1+R1/100)(1+R2/100)
(1+R/3100)
• = 25000(1+4100)(1+5100)(1+8100)
• = 25000 (1.04) (1.05) (1.08)
• = 29484
• Hence, the population after three years will be 29484.

• Aman started a factory with an initial
investment of its 100000. In the first year, he
incurred a loss of 5%. However, during the
second year, he earned a profit of 10% which is
the third year rose to 12%. Calculate his net
profit for the entire period of three years.
• Solution:
• Aman’s profit for three years = P(1−R1/100)(1+R2/100)(1+R3/100)
• = 100000(1−5/100)(1+10/100)(1+12/100)
• = 100000 (0.95) (1.10) (1.12)
• = 117040
• Therefore, Net profit = Rs 117,040 – Rs 100,000
• = Rs 17,040
• The cost of a T.V. set was quoted Rs 17000 at the
beginning of 2015. In the beginning of 2016 the
price was hiked by 5%. Because of decrease in
demand the cost was reduced by 4% in the
beginning of 2017. What was the cost of the T.V. set
in 2017?
• Solution:
• Cost of the TV = P(1+R/100)(1−R/100)
• => 17000(1+5/100)(1−4/100)
• = 17,000 (1.05) (0.96)
• = 17,136
• Thus, the cost of the TV in 2017 was Rs 17,136.
• Ashish started the business with an initial
investment of Rs 500000. In the first year he
incurred a loss of 4%. However during the
second year he earned a profit of 5% which in
third year rose to 10%. Calculate the net profit
for the entire period of 3 years.
• Solution:
• Profit for three years = P(1−R1/100)(1+R2/100)
(1+R3/100)
• => 500000(1−4/100)(1+5/100)(1+10/100)
• = 500,000 (0.96) (1.05) (1.10) = 554,400
• Thus, the net profit is Rs 554,400
• Illustration
• The population of an industrial town is increasing by 5 per cent
every year. If the present population is 1 million, estimate the
population five years hence. Also, estimate the population three
years ago.
• Solution
• Present population, P = 1 million, rate of increase = 5% per annum
• A = P(1+R/100)n
• Hence, the population after 5 years
• = 10,00,000 (1.05)5
• = 12,76,280
• P= A /(1+R/100)n
• Population three years ago = 10,00,000/ (1.05)3= 8,63,838
• Since the population three years ago, compounded at 5 per cent, is
equal to 1 million, today.
Calculation of Simple and compound Interest-1
• Mr. x borrowed a sum of Rs. 20000/- from Y at 12%
p.a. What is the amount of total interest payable in
two years?
• 1200
• 2400
• 4800
• 7200
• Non of above
• X borrowed Rs.10000/- from Y at 10% p.a. what is
total amount repayable by X to y in three years
» Rs.10000/-
» Rs.3000/-
» Rs.13000/-
– Rs.11000-
» NOA

5/13/18 S K MOHAN 20
• A sum of money doubles itself at compound
interest in 15 years it will become 8 time in
• A) 60 B)80 C)45 D ) 40

• According to rule of 72, to calculate the time


when the amount becomes double what formula
is used:
• a. Principal / time
• b. Interest rate / 72
• c. 72 / time
• d. 72/ interest rate
• e. Principal /72

5/13/18 S K MOHAN 21
Calculation of Simple and compound Interest-2
• Interest that is paid on the original principal amount and also
on the accumulated part of the interest , is called
» Yield on Maturity
» Annuities
» Compound interest
– interest
– NOA
• On an amount of Rs.50000/- lent on 8% interest. On which of the
following compounding periods, the interest amount will be
highest
– Half yearly compounding
– Yearly
– Quarterly
– Monthly
– Weekly
5/13/18 S K MOHAN 22
• What will be the compound interest on Rs. 25000 after 3
years at the rate of 12 % per annum?
– a. Rs 10123.20
b. Rs 10123.30
c. Rs 10123.40
d. Rs 10123.50
• Ans - a
• Explanation:
• A=P(1+r)n
• = (25000×(1+12/100)^3)
= 25000×(28/25)^3
= 35123.20
• So Compound interest will be 35123.20 - 25000
• = Rs 10123.20

5/13/18 S K MOHAN 23
Sinking Fund

• A sinking fund is an account earning compound


interest into which you make periodic deposits.
• Suppose that the account has an annual interest
rate of compounded times per year, so that is
the interest rate per compounding period.
• If you make a payment of at the end of each
period, then the future value after years, or
periods, will be
• FV=PMT { (1+i)n -1 }
• i
• Payment Formula for a Sinking Fund
• Suppose that an account has an annual rate of
compounded M times per year,
• so that i = R/M is the interest rate per
compounding period.
• If you want to accumulate a total of FV in the
account after T years, or N=MT periods, by
making payments PMT of at the end of each
period, then each payment must be .
• PMT= FV
• Sinking fund is created to accumulate the principle at
the end of term of loan period or end of life of assets
• schedule showing how a sinking fund accumulates to
the desired amount is called sinking fund schedule
• Sinking fund deposit is determined by the SIZE of the
payment to be made at the end of a particular period
• Sinking fund are used to pay –off debts, to redeem
bonds issues , to replace worn-out equipment , to buy
new equipment ,
• It is also one of the Depreciation method
• Formula for Sinking Fund ===
• F (future value) = A{ (1+i)n- 1}
• i
5/13/18 S K MOHAN 26
• Illustration
• 1. If you wish an annuity to grow to Rs. 17,000 over 5 years so
that you can replace your car, what monthly deposit would be
required if you could invest at 12 per cent compounded monthly?
• Formula for future value of annuity
• F (future value) = A{ (1+i)n- 1}
• i
• =0.12/12 =0.01% per month
• = 5 x 12 =60 Months
• 17,000= A [(1+0.01)60-1]
• 0.01
• A = 208.16
• The monthly payment should be Rs. 208.16
• How much must Mohan save each month in
order to buy a new car for Rs12,000 in three
years if the interest rate is 6% compounded
monthly?
• PMT= FV{( i )
• ( 1+i) n -1
• 12000 ( 0.06/ 12 )
• (1+.06/12) 36 -1
• =305.06
• Illustration
• Prakash Publishers buy a machine for Rs. 20,000. The rate of
depreciation is 10 per cent. Find the depreciated value of the machine
after 3 years. Also, find the amount of depreciation. What is the
average rate of depreciation?
• Solution
• Original value of machine = Rs. 20,000,
• Rate of depreciation, i = 10%
• Hence, the book value after 3 years = 20,000(1-0.1) 3
• = 20,000(0.9)3
• = 20,000 (0.729) = Rs. 14,580.
• Amount of depreciation in 3 years = Rs. 20,000 - Rs. 14,580 = Rs. 5,420
• Average rate of depreciation in 3 years
• (5,420/20,000) x (100/3) = 9.033%
• Qus :-An annuity consists of monthly repayments of Rs. 600 made over 20
years.
– (a) What is the present value of the annuity?
– (b) How much money is repaid?
– (c) What is the future value of the payments?
– (assume 14 per cent compounded monthly)
• Solution a
• r = 0.14/12 = 0.0117
• n= 20 x 12 = 240
• F= 600 [(1 +0.14/12)240-1/0.14/12]
• F = 48,250.10 (The present value of annuity)
• Solution b
• The amount repaid = 600 x 12 x 20 = 1,44,000
• Solution c
• F= 600 [(1 +0.14/12)240-1/0.14/12]
• = 7, 80,699.45
• The future value of the annuity is Rs. 7,80.699.45
Repayment of Debts
• Most popular method of paying Loans is EMI. It is called
Amortization Method .
• ENTIRE PERIOD OF PAYMENT IS CALLED TERM OF
ANNUITY AND
• EACH PERIOD OF PAYMENT (Month, quarter, year etc )is
called payment period
• equal monthly /quarterly installment of principle PLUS
interest applied during the period
• Equated monthly /quarterly installment covering both the
principle and interest
• Bullet repayment under the entire loan amount is repaid at
the end of the period
• Balloon repayment is that amount of repayment increased
slowly every month
5/13/18 S K MOHAN 31
Understanding Formula for EMI, Annuities

• Let us take case of a Car loan of Rs 1lac at 12%p.a. ,repayable in 180


installments (here p=1,00,000and r=12/100*12=.01)
– In the 1st month, bank will charge interest equal to p*r=Rs 1000 and so, the
outstanding amount will become Rs 1,01,000.
• What happens if the EMI is fixed at p*r, which is Rs 1000?
• This EMI will meet only the interest applied and so the principal will remain
unchanged at Rs 1,00,000.
• This process will continue and the loan will remain outstanding for ever.
Therefore, EMI has to be slightly more than p*r so that some amount can go
towards reducing the principal amount
• If EMI has to be more than p*r, we should multiply p*r by a fig which is more
than 1.
• This fig is (1+r)n
• (1+r)n -1.
• You will observe that denominator in less than numerator by 1 only. E.g.,
if numerator is 5.2310, the denominator will be 4.2310 . So, this fig is
always more than 1.
• Therefore, in a question, if periodic payment ,n and r are given, you can
calculate PV. FV is calculated by multiplying PV by (1+r)n.•
5/13/18 S K MOHAN 32
Formula FOR EMI

• E = P×r×(1 + r)n/((1 + r)n - 1)


• E = is EMI
• P = is Principle Loan Amount
• r = is rate of interest
• If calculated in monthly basis it should be = Rate of Annual
interest/12/100
• if its 10% annual ,then its 10/12/100=0.00833
• n = is tenure in number of months
• Example :
• For 100000 at 10% annual interest for a period of 12 months,
it comes to :
• 100000*0.00833*(1 + 0.00833)12/((1 + 0.00833)12 - 1) = 8792
5/13/18 S K MOHAN 33
Annuities
• An annuity is any series of equal payments that are made at
regular intervals.
• Types of annuities are :-
– Ordinary annuity and ( payment at the end of period)
– Annuity Due ( Payment at beginning of each period)
• The periods between payments in an annuity can be just
about anything -- years, months, weeks;
• It doesn't matter as long as the interval is consistent
• Present value and Future value of both annuities
are different
• The difference lies in the timing of each payment relative to
the period the payment covers.
5/13/18 S K MOHAN 34
• if you're the one making the payments, you're
better off with an ordinary annuity.
• If you're the one receiving the payments,
you're better off with an annuity due.
• The reason lies in a basic principle of finance
known as the "time value of money":
• Each payment of an ordinary annuity belongs
to the payment period preceding its date,
• while the payment of an annuity-due refers to
a payment period following its date.

5/13/18 S K MOHAN 35
• A more simplistic way of expressing the
distinction is to say that payments made under an
ordinary annuity occur at the end of the period
• while payments made under an annuity due
occur at the beginning of the period.

5/13/18 S K MOHAN 36
Calculating the Value of an Annuity Due

 An annuity due is calculated in reference to an


ordinary annuity.
 1st calculate either the present value (PV) or
future value (FV) of an ordinary annuity,
 multiply the result by a factor of (1 + i) as
shown below…
 Annuity Due = Annuity Ordinary x (1 + i)

5/13/18 S K MOHAN 37
• Present Value of an Annuity
calculate the PV of an ordinary annuity of 50 per year over 3 years at 7% as...
...

• and the present value of an annuity due under the same terms is calculated
as...
..

• the PV of the annuity due is greater than the PV of the ordinary annuity; by
9.18.

5/13/18 S K MOHAN 38
• Future Value of an Annuity
calculate the FV of an ordinary annuity of 25 per year
over 3 years at 9% as...

• future value of an annuity due under the same terms is


calculated as...


...and again the FV of the annuity due is greater than
the FV of the ordinary annuity; by 7.38.

5/13/18 S K MOHAN 39
• Example :
• 1. Calculate the present value on Jan 1, 2015 of an annuity of
5,000 paid at the end of each month of the calendar year 2015.
The annual interest rate is 12%.
• Solution
We have,
Periodic Payment R = 5,000
Number of Periods n = 12
Interest Rate i = 12%/12 = 1%
Present Value
PV = 5000 × (1-(1+1%)^(-12))/1%
= 5000 × (1-1.01^-12)/1%
= 5000 × (1-0.88745)/1%
= 5000 × 0.11255/1%
= 5000 × 11.255
= 56,275.40
5/13/18 S K MOHAN 40
• A certain amount was invested on Jan 1, 2015 such that it generated a
periodic payment of 10,000 at the beginning of each month of the
calendar year 2015. The interest rate on the investment was 13.2%.
Calculate the original investment and the interest earned.
• Solution
Periodic Payment R = 10,000
Number of Periods n = 12
Interest Rate i = 13.2%/12 = 1.1%
Original Investment = PV of annuity due on Jan 1, 2015
= 10,000 × (1-(1+1.1%)^(-12))/1.1% × (1+1.1%)
= 10,000 × (1-1.011^-12)/0.011 × 1.011
= 10,000 × (1-0.876973)/0.011 × 1.011
= 10,000 × 0.123027/0.011 × 1.011
= 10,000 × 11.184289 × 1.011
= 1,13,073.20
Interest Earned = 10,000 × 12 − 1,13,073.20

= 1,20,000 – 1,13,073.20 = 6926.80
5/13/18 S K MOHAN 41
SUMMARY OF ANNUITIES FORMULAS
• FUTURE VALUE OF INVESTMENT AT THE END OF PERIOD,
FVOA (Future Value of Ordinary Annuity) is applied.
• FVOA = (C ÷ R) x { (1 + R)^T - 1 }
• FUTURE VALUE OF INVESTMENT AT THE BEGINNING OF
PERIOD, FVAD (Future Value of Annuity Due) is applied.
– FVAD = (C ÷ R) x { (1 + R)^T - 1 } x (1 + R)
• PRESENT VALUE OF INVESTMENT AT THE END OF PERIOD,
PVOA (Present Value of Ordinary Annuity) is applied.
• PVOA = (C ÷ R) x { (1 + R)^T - 1 } ÷ (1 + R)^T
• PRESENT VALUE OF INVESTMENT AT THE BEGINNING OF
PERIOD, PVAD (Present Value of Annuity Due) is applied.
• PVAD = (C ÷ R) x { (1 + R)^T - 1 } x (1 + R) ÷ (1 + R)^T

5/13/18 S K MOHAN 42
Present Value

Present value describes how much a future sum of money is


worth today.
Three most influential components of present value are :
time,
expected rate of return,
the size of the future cash flow
The formula for present value is:
PV = CF/(1+r)n
Where:
CF = cash flow in future period
r = the periodic rate of return or interest (also called the
discount rate or the required rate of return)
n = number of periods
5/13/18 S K MOHAN 43
Example :
Assume that you would like to put money in an account today to
make sure your child has enough money in 10 years to buy a
car. If you would like to give your child 10,00,000 in 10 years,
and you know you can get 5% interest per year from a savings
account during that time, how much should you put in the
account now?

PV = 10,00,000 / (1+.05)10 = 6,13,913/-

Thus, 6,13,913 will be worth 10,00,000 in 10 years if you can


earn 5% each year. In other words, the present value of
10,00,000 in this scenario is 6,13,913.

5/13/18 S K MOHAN 44
• Future Value

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified
sum today. It refers to a method of calculating how much the present value (PV) of an asset or
cash will be worth at a specific time in the future. There are two ways to calculate FV:

1) For an asset with simple annual interest: = Original Investment x (1+(interest rate*number of years))
• .2) For an asset with interest compounded annually: = Original Investment x ((1+interest rate)^number
of years)

Example:

1) 10,000 invested for 5 years with simple annual interest of 10% would have a future value of

FV = 10000(1+(0.10*5))
= 10000(1+0.50)
= 10000*1.5
= 15000
2) 10,000 invested for 5 years at 10%, compounded annually has a future value of :

FV = 10000(1+0.10)^5)
= 10000(1.10)^5
= 10000*1.61051
= 16105.10

5/13/18 S K MOHAN 45
Calculation of Simple and compound Interest-3

• An annuity under which payments are made in the beginning of each


period are known as
– Annual annuity
– Special annuity
– Ordinary annuity
– Annuity due
– NOA
• An annuity under which payment are made at the end of each period
-
are known as ;
– Annual annuity
– Special annuity
– Ordinary annuity
– NOA

5/13/18 S K MOHAN 46
• When a debt is amortised by equal payment at equal payment
intervals, the debt becomes
» Annuity
» Future value of annuity
– Present value of annuity
– Discounted value of annuity
– NOA

• Total time during which the debt is amortised , is called


– Term of annuity
– Payment period of annuity
– Annuity duration
– Annuity period

5/13/18 S K MOHAN 47
• When amount is accumulated by means of equal periodic
contribution with the objective of using it for a specific
purpose , this is called
» Specific Reserve
» Special reserve
» Time deposit
» Sinking fund
» Annuity

• Which of the following can not be an objective


of creation of sinking fund :-
» Buy new equipment
– Pay off debts
– Redeem bond issues
– Replace worn out equipment
– NOA
5/13/18 S K MOHAN 48
• A=P (1 – r)n is used to calculate the following:
– a. simple interest on annual basis
– b. compounded interest with annual rest
– c. compounded interest with half-yearly rest
– d. compounded interest with quarterly rest
• The annuity is annuity due. It represents which of the
following:
I. cash flow is at the end of the given period
II. cash outflow only is at the given period
III. cash flow in the beginning of the given period
IV. cash inflow only in the beginning of the given period

5/13/18 S K MOHAN 49
Bonds
• What are bonds and what is relation between purchaser and issuer
• Who issues bonds
• Types of bonds
• Straight Bonds or Fixed rate bonds
• Zero Coupon Bonds
• Deep Discount Bonds
• Floating rate Bonds – linked with reference rate of interest e.g. LIBOR , MIBOR ,
• Convertible bonds
• Inflation –indexed Bonds
• Other index bonds - equity link etc
• High yield bond ( JUNK BON DS ) rated below investment grade
• Assets Backed Securities Bonds
• Subordinate bonds – lower priority at the time of liquidation
• Perpetual Bonds -- no maturity date
• Bearer bonds – indira vikas patra
• government bonds also called Treasury Bonds
• Bond Valuation
• Present value method of Bond valuation
• Bond value with Semi –annual Coupons (Interest)
5/13/18 S K MOHAN 50
Terms related to Bonds
• Face value -----
– Straight bonds
– face value of Zero Coupon bonds
• Coupon rate
• Maturity
• Term to Maturity
• Market Value
• Discount rate
• Yield
• Current Yield
• Yield To Maturity
5/13/18 S K MOHAN 51
YTM
• YTM is a annual return which an investors
gets ,if he holds the bonds till maturity .
• In other world it is an internal rate of interest
(IRR) which an investors received on bonds,
which he has purchased in current market
value holds it till maturity

5/13/18 S K MOHAN 52
Assumption at the time of calculation of YTM
• Bond once purchased will be held till maturity
• Cash flow will be received and there will be no default
• All cash flow are immediately reinvested (else where) at the
rate which is equal to the promised Y T M
• Important terms :-
• PVIF:-Present value interest factor;- it represent the discount
value of Rs. One for a period concerned of interest rate
• PVIFA:-Present value interest factor of annuity :-it represent the
present value of an ordinary annuity for the period concern and
interest rate
• Current Yield = coupon interest/ current market price
• Call option= Right to repay the bond before maturity date
• Put option=holder has right to force the issuer to repay the bond

5/13/18 S K MOHAN 53
Theorems for bonds value

Required rate of return is denote with symbol =Kd


1. When Kd= coupon rate result price is = par value
2.When Kd > Coupon rate result value of bond is < par value

3.When Kd<coupon rate value of bond is > par value


4.When Kd >coupon rate discount on bond declines as
maturity comes near
5.When Kd < coupon rate Premium on bonds reduces as
maturity comes near
6.Bond prices is inversely proportional to its yields maturity

7.If there is a deference between YTM and coupon rate of bond ,


the longer the term to maturity ,the greater will be the change in
the price with the change in YTM
5/13/18 S K MOHAN 54
• The face value of the bond is Rs. 1,000, coupon rate is
11 per cent, years to maturity is seven years. The
required rate of return is 13 per cent, and then the
present value of the bond is
– 110 x PVIFA (13 per cent, 7) + 1,000 (PVIF 13 per cent, 7)
110(4.423)+1,000 (0.425) = 911.53
• One year from now, when the maturity period will be
six years, the present value of the bond will be
– 110 x PVIFA (13 per cent, 6) + 1,000 (PVIF 13 per cent, 6)
110 (3.998) + 1,000 (0.480) = 919.78
• Similarly, when maturity period is 5, 4, 3, 2, 1 the
Bond value will become 929.87, 940.14, 952.71,
966.48, 982.35, respectively.
5/13/18 S K MOHAN 55
Bond Value

• A bond, whose par value is Rs. 1,000, bears a coupon


rate of 12 per cent and has a maturity period of 3 years.
The required rate of return on the bond is 10 per cent.
What is the value of this bond?
• Solution
• Annual interest payable = 1,000 * 12% = 120
Principal repayment at the end of 3 years = Rs. 1,000
The value of the bond
= 120 (PVIFA 10%, 3 yrs) + Rs. 1,000 (PVIF 10%, 3 yrs)
= 120 (2.487)+1,000 (0.751)
= 298.44 + 751
= Rs. 1,049.44
5/13/18 S K MOHAN 56
• A bond, whose par value is Rs. 1000, bears a coupon rate
of 12 per cent payable semi-annually and has a maturity
period of 3 years. The required rate of return on bond is
10 per cent. What is the value of this bond?
• Solution
• Semi-annual interest payable = 1,000 x 12 per cent/2= 60
Principal repayment at the end of 3 years = Rs. 1,000
• The value of the bond
= 60 (PVIFA 10%/2, 6 Period) + Rs. 1,000 (PVIF 10%/2, 6
Period) =
60 (5.0746) + 1,000 (0.746) = 304.48 + 746 = 1,050.48

5/13/18 S K MOHAN 57
• 12% , 4 years bonds of Rs.100 each were
purchased by Mr. Y for Rs.100 . If the market
interest rate decreases by 1% what will be the
market price
• Solution
• 12xPVIFA (11% for 4 years) + 100(PVIF 11%,4 )=
12X3.10245)+100x(0.65873) = 37.22 + 65.87 =
103.09

5/13/18 S K MOHAN 58
Problem on YTM

• Consider a Rs. 1,000 par value bond, whose


current market price is Rs. 850/-. The bond
carries a coupon rate of 8 per cent and has the
maturity period of nine years. What would be
the rate of return that an investor earns if he
purchases the bond and holds until maturity?

5/13/18 S K MOHAN 59
• Solution
• If kd is the yield to maturity then,
• 850 = 80 (PVIFA kd per cent, 9 yrs) + 1,000 (PVIF kd, 9 yrs)
• To calculate the value of kd, we have to try several values:
• = 80 (PVIFA 12 per cent, 9) + 1,000 (PVIF 12 per cent, 9)
• = 80x 5.328+ 1,000 x (0.361)
• = 426.24 + 361 =787.24
• Since, the above value is less than 850, we have to try with value less than 12
per cent. Let us try with kd =10 per cent
• = 80 (PVIFA 10 per cent, 9) + 1,000 (PVIF 10 per cent, 9) = 80
• x 5.759 + 1.000 * 0.424 = 884.72
• From the above it is clear that kd lies between 10% and 12%. Now we have to
use linear interpolation in the range of 10% and 12%. Using it, we find that kd is
equal to the following:
• (884.72-850) / (884.72-787.24)
• 34.72 / 97.48 = 10%.+
• .71=10.71%
• Therefore, the yield to maturity is 10.71%
5/13/18 S K MOHAN 60
• For two bonds X and Y having face value of Rs. 1.000, coupon rate of
10 per cent each, years to maturity is three and six years
respectively.
• Market value of bond X at YTM of 10 per cent is
– 100 PVIFA (10 per cent, 3) + 1.000 PVIF (10 per cent, 3) = 1,000
• Market Value of Bond Y at YTM of 10 per cent is
– 100 PVIFA (10 per cent, 6) + 1,000 PVIF (10 per cent, 6) = 1,000
• Now market value of bond X at YTM of 11 per cent is
– 100 PVIFA (11 per cent, 3) + 1,000 PVIF (11 per cent, 3) = 975
• And Market Value of Bond Y at YTM of 11 per cent is
– 100 PVIFA (11 per cent, 6) + 1,000 PVIF (11 per cent, 6) = 958
• Change in price for X on increasing YTM by 1 per cent is (1,000 -
975)/l,000 = 2.5 per cent
• Change in price for Y on increasing YTM by 1 per cent is (1,000 -
958)/1,000 = 4.2 per cent
5/13/18 S K MOHAN 61
• A bond of face value of Rs. 1,000 par value X bond with a coupon
rate of 12 per cent maturity period of six years and YTM of 10 per
cent. The market value of the bond will be Rs. 1,087.
– Consider another identical bond Y but with differing YTM of 20 per cent.
The market value of this bond will be Rs. 734.
• If the YTM increase by 20 per cent, i.e. YTM of bond X rises to 12
per cent (10 x 1.2) and bond Y rises to 24 per cent (i.e., 20 x 1.2)
then the market value of both bonds will change to:
– Bond X: 120 PVIFA (12 per cent, 6) + 1,000 PVIF (12 per cent. 6) =
Rs. 1,000
– Bond Y: 120 PVIFA (24 per cent, 6) + 1,000 PVIF (24 per cent, 6) =
638
– Market value of X bond with a lower YTM decreased by 8 per cent
– whereas in case of Y bond with an higher YTM the decrease is 13
per cent.
5/13/18 S K MOHAN 62
Yield to Maturity , Bonds Pricing
• Debt capital mainly consist of which of the following
» Bank borrowing
» Term loans and bank borrowing
» Bank term loan and debenture
– Bonds and debentures
– Bonds and bank term loan s

• The bonds or debenture holders , return for providing


debts capital to a company gets.
» Fixed dividends
» Variable dividend
» Commission
– Discount
– Coupon rate

5/13/18 S K MOHAN 63
• A bond carries a specific rate of interest which is known as
» Fixed dividend
» Variable dividend
» Commission
» Discount
» Coupon rate
• The amount represented by the bonds , that a company has to pay
back to the bonds holder at the end of term of bond , is called
– Premium on bonds
– Value of the bond
– Maturity value of the bonds
– Face value
– NOA

• The value at which a bond is traded on a stock exchange is called:


• face value
• net asset value
• net present value
• market value
• cost price

5/13/18 S K MOHAN 64
BONDS Valuation
• A bond with face value Rs’5000/-carrries a coupon rate of 12%
Market price of this bond is quoted at Rs.4500/- what is the current
yield of the bond
• 0.12*5000 =13.3%
• 4500
• Bond is a type of long term, interest bearing note payable on
maturity F
• When the require rate of return (kd) is greater than the coupon rate
bond price will trading at discount to face value T
• An secure bond is a debenture bond T
• A convertible bond is a bond that can be converted to cash at any
given time T
• The value which bond holder gets on maturity is called Redemption
value T
• When the expected rate of return(market discount rate)is lesser than
coupon rate bond price will rise T
5/13/18 S K MOHAN 65
• If a 7% coupon bond ( Rs.1000) is trading for Rs.
975.00, it has a current yield of ___ percent.
» 7.01
» 6.83
» 7.23
» 8.13
» 7.18

• A zero coupon bond has been issued for 10 years.


What is its duration.
– 10 years
– less than 10 years
– more than 10 years
– NOA.

5/13/18 S K MOHAN 66
DURATION OF BOND
• The holding period for which the interest rate risk
disappears, is known as the duration of the bond.
• There is a simple way of computing the desired
holding period (duration), which is as follows:
– 1. Determine the cash flows from holding the bond.
– 2. Determine the present value of these cash flows by
discounting the flows with discount rate (YTM).
– 3. Multiply each of the present values by respective
numbers of years left before the present value is
received.
– 4. Sum these products up and divide by the present
value to get the duration of the bond.
5/13/18 S K MOHAN 67
Problem

• 1. Calculate the Macaulay Duration, Modified


Duration of a bond for company A, if the
coupon rate is given to be 8 per cent, the YTM
is 6 per cent and the time to maturity is five
years. The face value of the bond is Rs.
1,00,000. The interest payments are made
annually. Also, calculate the percentage
change in price of the bond if the YTM falls by
100 basis points or 1 per cent from 6 per cent
to 5 per cent

5/13/18 S K MOHAN 68
5/13/18 S K MOHAN 69
470804.38/108424.72=4.3422234

5/13/18 S K MOHAN 70
Capital Budgeting

• Capital Budgeting is a process of planning


capital investment :- Expansion,
diversification, replacement, modernization
• NEED OF CAPITAL BUDGETING
– Volume of money invested is quite high
– Return are spread over uncertain long period
– Investment decision can not be reversed
– Project profitability is the basis of decision
– Probability of assets becoming obsolete is very high

5/13/18 S K MOHAN 71
Steps to capital budgeting

• Estimate Cash flows Outlays Inflows


• Estimate/Determine the appropriate cost of
capital.
• Define the Acceptance or Rejection Criterion
• Apply the Project Appraisal Techniques
• Rank Projects
• Accept/Reject Projects

5/13/18 S K MOHAN 72
• What is the difference between independent
and mutually exclusive projects?
• Projects are:
• independent, if the cash flows of one are
unaffected by the acceptance of the other. --
In other words A project whose acceptance (or
rejection) does not prevent the acceptance of
other projects under consideration
• mutually exclusive, if the cash flows of one
can be adversely impacted by the acceptance
of the other.
5/13/18 S K MOHAN 73
Capital
Capital Budgeting
Budgeting Techniques
Techniques

– Payback Period (PBP)


– Internal Rate of Return (IRR)
– Net Present Value (NPV)

5/13/18 S K MOHAN 74
Proposed
Proposed Project
Project Data
Data

MR.JRD is evaluating a new project for his firm,


he has determined that the after-tax cash flows for the project
will be
1. Rs.10,000;
2. Rs12,000;
3. Rs15,000;
4. Rs10,000; and
5. Rs7,000,
respectively, for each of the Years 1 through 5. maximum pay
back accepted by company is 3.5 years
The initial cash outlay will be Rs40,000.

5/13/18 S K MOHAN 75
Independent Project
 For this project, assume that it is independent of any other
potential projects that JRD may undertake.

• Independent -- A project whose acceptance (or


rejection) does not prevent the acceptance of
other projects under consideration.

5/13/18 S K MOHAN 76
Payback
Payback Period
Period (PBP)
(PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time required for the


cumulative expected cash flows from an investment
project to equal the initial cash outflow.

5/13/18 S K MOHAN 77
Payback Solution (
Year Cash out Flow Cash inflow Cumulative cash inflow

0 40000 (B)
1 10000 10000
2 12000 22000
3 (A) 15000 37000 ©
4 10000 (D) 47000
5 70000 54000

PBP = a + ( b - c ) / d
= 3 + (40 - 37) / 10= 3 + (3) / 10 = 3.3
Years
5/13/18 S K MOHAN 78
Payback Solution Alternative
year Cash Cumulative Cash Flows
flow
0 --40000 -40000
1 10000 -30000
2 12000 -18000
3 15000 -3000
4 10000 +7000
5 7000 +14000

PBP = 3 + ( 3K ) / 10K = 3.3 Years


Note: Take absolute value of last negative
cumulative cash flow value.

5/13/18 S K MOHAN 79
PBP Acceptance Criterion

The management of JRD has set a maximum


PBP of 3.5 years for projects of this type.
Should this project be accepted?

Yes! The firm will receive back the initial cash


outlay in less than 3.5 years. [3.3 Years < 3.5 Year
Max.]

5/13/18 S K MOHAN 80
Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value


of the future net cash flows from an investment
project with the project’s initial cash outflow. It is
calculated on the basis of trial and error method

CF1 CF2 CFn


ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

5/13/18 S K MOHAN 81
IRR Solution
RS.40,000 =
Rs.10,000 + Rs.12,000 +
(1+IRR)1 (1+IRR)2
Rs.15,000 + Rs.10,000 + Rs.7,000
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the


discounted cash flows to equal Rs.40,000.
5/13/18 S K MOHAN 82
IRR Solution (Try 10%)
Rs40,000 = Rs10,000(PVIF10%,1) + Rs12,000(PVIF10%,,2) +
Rs15,000(PVIF10%,,3) + Rs10,000(PVIF10%,4) + Rs
7,000(PVIF10%,5)
Rs40,000 = Rs10,000(.909) + Rs12,000(.826) +
Rs15,000(.751) + Rs10,000(.683) + Rs 7,000(.621)
Rs40,000 = Rs9,090 + Rs9,912 + Rs11,265 +
Rs6,830 + Rs4,347 = Rs41,444 [Rate
is too low!!]

5/13/18 S K MOHAN 83
IRR Solution (Try 15%)

Rs40,000 = 10,000(PVIF15%,1) + 12,000(PVIF15%,2) +


15,000(PVIF15%,,3) + 10,000(PVIF15%,,4) +
7,000(PVIF15%,,5)
Rs40,000 = 10,000(.870) + 12,000(.756) + 15000(.658) +
10,000(.572) + 7,000(.497)
Rs40,000 = 8,700 + 9,072 + 9,870 + 5,720 + 3,479 =
Rs36,841 [Rate is too high!!]

5/13/18 S K MOHAN 84
IRR Solution (Interpolate)

15%-10% X {41444-40000}
41444-36841

== 0.05X1444 = 0.0157
4603
IRR Will be =0.10+0.0157=0.1157 i.e. 11.57%

5/13/18 S K MOHAN 85
IRR Acceptance Criterion

The management of JRD has determined


that the hurdle rate is 13% for projects of
this type.
Should this project be accepted?

No! The firm will receive 11.57% for each


Rs. invested in this project at a cost of 13%.
[ IRR < Hurdle Rate/Cost of project ]
5/13/18 S K MOHAN 86
• 1. Company A is considering a new piece of
equipment. It will cost Rs. 6,000 and will
produce a cash flow of Rs. 1,000 every year for
the next 12 years (the first cash flow will be
exactly one year from today). Cash Flows look
like the following:

5/13/18 S K MOHAN 87
• (a) What is the NPV if the appropriate discount rate is 10%?
• You can either discount each individual cash flow or recognize that the
• Rs. 1,000 cash flows are just a twelve year annuity. So,
• PV = a/i[l -1/(1 +i)n]
• PV= 1,000/0.1 [1 - 1/(1.1)12] = PV = Rs. 6,814
• Adding this to the original investment gives an NPV of
• NPV = Rs. 6,814 - Rs. 6,000 = NPV =Rs. 814
• (b) What is the NPV if the appropriate discount rate is 12%?
• PV= 1,000/0.12 [1 -1/(1.12)12] = PV = Rs. 6,194
• Adding this to the original investment gives an NPV of
• NPV = Rs. 6,194-Rs. 6,000 = NPV=Rs. 194
• (c) What is the NPV if the appropriate discount rate is 15%?
• PV= 1,000/0.15 [1-1/(1.15)12] = PV = Rs. 5,421
• Adding this to the original investment gives an NPV of
• NPV = Rs. 5,421-Rs. 6,000
5/13/18 S K MOHAN 88
Net Present Value (NPV)

NPV is the present value of an


investment project’s net cash flows
minus the project’s initial cash
outflow.

CF1 CF2 CFn


NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
5/13/18 S K MOHAN 89
NPV
NPV Solution
Solution

JRD has determined that the appropriate discount rate (k) for this
project is 13%.

Rs.10,000 Rs12,000 Rs15,000


NPV = + + +
(1.13)1 (1.13)2 (1.13)3

Rs10,000 Rs7,000 -Rs40,000


+
(1.13) 4
(1.13)5

5/13/18 S K MOHAN 90
NPV
NPV Solution
Solution
NPV = Rs.10,000(PVIF13%,1) + Rs12,000(PVIF13%,2) +
Rs15,000(PVIF13%,3) + Rs10,000(PVIF13%,4) + Rs
7,000(PVIF13%,5) - Rs40,000
NPV = Rs10,000(.885) + Rs12,000(.783) +
Rs15,000(.693) + Rs10,000(.613) + Rs 7,000(.543) -
Rs40,000
NPV = Rs8,850 + Rs9,396 + Rs10,395 + Rs6,130
+ Rs3,801 - Rs40,000
=- Rs1,428

5/13/18 S K MOHAN 91
NPV Acceptance Criterion
The management of JRD has determined
that the required rate is 13% for projects
of this type.
Should this project be accepted?

No! The NPV is negative. This means that the


project is reducing shareholder wealth. [Reject
as NPV < 0 ]
5/13/18 S K MOHAN 92
• The discount factor at 12% rate of interest p.a. is 0.893, 0.797, 0.712,
0.636 for 1st year, 2nd year, 3rd year and 4th year respectively. If the cash
inflow from the project is Rs. 10000 in each of these years, calculate the
present value of cash inflows.
I. Rs. 40000
II. Rs. 36260
III. Rs. 32980
IV. Rs. 30380

• The discount factor at 12% rate of interest p.a. is 0.893, 0.797, 0.712,
0.636 for 1st year, 2nd year, 3rd year and 4th year. If the initial investment
is Rs. 30000 and cash inflow from the project is Rs. 10000 in each year.
Whether the project can be taken up for investment or not.

i. investment can be made as the cash inflow is Rs. 40000 in 4 years and cash outflow
is Rs. 30000.
ii. The investment can be made as the present value of cash inflow is positive.
iii. The investment cannot be made because NPV is negative
iv. NOA
5/13/18 S K MOHAN 93
DEPRECIATION

• Meaning Depreciation is a reduction in the book


value of all fixed assets excepting land used in
business

• all fixed assets


• all fluctuating assets
• both fixed and current assets
• all assets used in business.

• Need for depreciation


» To know correct profit
» Show correct financial position
» Make provision for replacement of assets
» To ascertain the real cost of production
» To comply with legal requirements
5/13/18 S K MOHAN 94
Causes of Depreciation

• I. Internal Causes
• Wear and tear
• Disuse : When a machine is kept continuously idle, it becomes potentially less useful

• Maintenance: The value of machine deteriorates rapidly because of lack of proper


maintenance.
• Depletion: It refers to the physical deterioration by the exhaustion of natural resources eg.,
mines, quarries, oil wells etc.

• II. External Causes


• Obsolescence: The old asset will become obsolete (useless) due to new inventions, improved
techniques and technological advancement
•.
• Effluxion of time: When assets are exposed to forces of nature, like weather, wind, rain, etc., the
value of such assets may decrease even if they are not put into any use.

• Time Factor: Lease, copy-right, patents are acquired for a fixed period of time. On the expiry of the
fixed period of time, the assets cease to exist.
5/13/18 S K MOHAN 95
Factors of depreciation

• Original Cost of asset


• Residual value
• Life of an asset

5/13/18 S K MOHAN 96
METHODS OF Calculating DEPRECIATION
• 1. Straight line method or fixed installment method.
• 2. Written down value method or diminishing balance
method
• 3. Annuity method.
• 4. Depreciation Fund method.
• 5. Insurance Policy method.
• 6. Revaluation method.
• 7. Sum of year’s Digit Method

• all assets used in business.


5/13/18 S K MOHAN 97
Straight line method or fixed installment method
• Under this method, the same amount of depreciation is charged
every year throughout the life of the asset. The amount and rate
of depreciation is calculated as under
• Amount of depreciation = Total cost –– Scrap value
————————————
• Estimated Life

• Rate of depreciation = Amount of Depreciation


• = ———————————— x 100
• Original Cost

5/13/18 S K MOHAN 98
Illustration

• A company purchased Machinery for Rs.1,00,000. Its installation


costs amounted to Rs.10,000. It’s estimated life is 5 years and the
scrap value is Rs.5,000. Calculate the amount and rate of
depreciation
• Solution:
• Total cost = Purchase Price + Installation Charges
• Rs.1,00,000 + Rs.10,000 = Rs. 1,10,000
• Amount of depreciation = Total cost –– Scrap value
Estimated Life
1,10,000 –– Rs.5,000 = 105000 = 21000
5 5
• Rate of depreciation = Amount of depreciation x 100
• Original cost
• 21000 X 100 = 19.09%
• 110000
5/13/18 S K MOHAN 99
Written Down Value Method or Diminishing Balance
Method or Reducing Balance Method
• Under this method, depreciation is charged at a fixed
percentage each year on the reducing balance (i.e., cost
less depreciation) of asset.
• The amount of depreciation goes on decreasing every
year.
• For example,
• if the asset is purchased for Rs.1,00,000 and
depreciation is to be charged at 10% p.a. on reducing
balance method, then Depreciation for the
• 1st year = 10% on Rs.1,00,000, ie., Rs.10,000
• 2nd year = 10% on Rs.90,000 (Rs.1,00,000 –– Rs.10,000) = Rs. 9,000
• 3rd year = 10% on Rs.81,000 (Rs.90,000 - Rs.9,000) = Rs.8,100 and so on.

5/13/18 S K MOHAN 100


Annuity Method

• The annuity method considers that the business


besides loosing the original cost of the asset in
terms of depreciation and also looses interest on
the amount used for buying the asset.
• This is based on the assumption that the amount
invested in the asset would have earned in case
the same amount would have been invested in
some other form of investment.
• The annual amount of depreciation is determined
with the help of annuity table. This method is
used to calculate depreciation amount on lease
5/13/18 S K MOHAN 101
Depreciation Fund Method or Sinking Fund Method

• Under this method, funds are made available for the


replacement of asset at the end of its useful life.
• The depreciation remains the same year after year and is
charged to Profit and Loss account every year through the
creation of depreciation fund.
• The amount of annual depreciation is invested in good
securities bearing interest at a specified rate.
• The aggregate amount of interest and annual provision is
invested every year.
• When the asset is completely written off or is to be
replaced, the securities are sold and the amount so realised
by selling securities is used to replace the old asset
5/13/18 S K MOHAN 102
• Q.In sinking fund method of depreciation
accounting
– A fund is created at the beginning to which
depreciation is charged annually.
– Since acquiring an asset results in sunk costs
depreciation of the asset is called so.
• Depreciation charged annually is transferred to a fund
which is invested in growth and income generating
securities to take care of the replacement of the asset.
• None of the above.

5/13/18 S K MOHAN 103


Choose the correct answer :

1. Depreciation arises due to


» a) wear and tear of the asset
» b) fall in the market value of asset
» c) fall in the value of money

2. Under straight line method, rate of depreciation is calculated


on
– a) Original cost b) Written down value c) Cost less scrap value

3. Under diminishing balance method, depreciation


– a) decreases every year b) increases every year c) constant every year
4. The term depletion is used for
– a) Intangible assets b) Fixed assets c) Natural resources
5. If selling price is more than the book value of the asset on the
date of sale, it is
• a) a loss b) an income c) a profit
5/13/18 S K MOHAN 104
Insurance Policy Method
• According to this method, an Insurance policy is
taken for the amount of the asset to be replaced.
• The amount of the policy is such that it is
sufficient to replace the asset when it is worn out.
• A sum equal to the amount of depreciation is paid
as premium every year.
• The amount goes on accumulating at a certain
rate of interest and is received on maturity.
• The amount so received is used for the purchase
of new asset, replacing the old one.
5/13/18 S K MOHAN 105
Revaluation Method:

• Under this method, the assets like loose tools


are revalued at the end of the accounting
period
• same is compared with the value of the asset
at the beginning of the year.
• The difference is considered as depreciation.

5/13/18 S K MOHAN 106


• Machinery worth Rs.82000 is purchased and the
firm spent Rs.8000 on its installation. Its effective
commercial life is estimated as 10 years and scrap
value Rs.10000.What will be written down value at
the end of 3rd year, under straight line method?.
• Solution
• The amount of annual depreciation would be
Rs.8000 p.a.
• == (82000+8000-10000, divided by 10).
• For 3 years it will be Rs.24000 (8000 x 3).
• The WDV would be Rs.66000 (90000-24000).
5/13/18 S K MOHAN 107
• In the previous question, if the method would have been
written down value method, what would be the amount of
depreciation for 3 years and WDV of the machinery?
• Answer—
• For 1st year the amount of depreciation would be Rs.8000,
• for 2nd yearRs.7200 (80000-8000 x 10%)
• and for 3rd yearRs.6480 (72000-7200 x 10%).
• The total depreciation for three years would be
• Rs.21680.
• There would be saving of Rs.2320 (24000-21680) on account
of change in the method of depreciation. To that extent
profit would increase along with the WDV of the fixed asset.

5/13/18 S K MOHAN 108


• A firm purchased machinery worth Rs_76000 on
January 01, 2003 and its life is expected to
• be 8 years, with scrap value at the end
Rs.12000. What is amount of depreciation.
• Solution—
• Depreciation = (Cost-Scrap value) / no. of years
of expected economic life
• = 76000-12000 / 8 = Rs.8000 per annum

5/13/18 S K MOHAN 109


• A firm purchased certain machinery on January 01, 2013 for Rs.1 lac. It added
more machinery on July 01, 2013 for Rs.50000. 1/2 of the machinery
purchased on January 01, 2013 was sold for Rs.25000 on Dec 31, 2014. The
rate of depreciation is to be assumed 20%and the annual closing of accounts
as on Dec 31. Find the value of machinery as on Dec 31, 201 4.
• Solution :
• WDV of 1st machine as on Dec 31, 2014 would be Rs.30000 as under:
• Original value = 1,00,000
• 2 years' depreciation @ 20% = 40000
• Hence, WDV = 60,000
• Sale of I /2 of machinery : Rs.25000
• Loss on sale of machinery= 30000-25000 = 5000
• Hence WDV = 60000-30000= 30000
• WDV of 2nd machinery :
• Original value = 50,000—depreciation of 1-1/2 year i.e.
• Rs.5000 + 10000 = 15000.
• WDV = 50000 —15000 = 35000
• Total WDV : 30000 + 35000 = 65000
5/13/18 S K MOHAN 110
SUM OF THE YEARS' DIGITS

• To calculate depreciation charges using the sum of the years' digits method, take the expected life of an asset (in
years) count back to one and add the figures together.
• This is a method of calculating depreciation of an asset that assumes a higher depreciation
charge and a greater tax benefit in the early years of an asset's life.
• Illustration
• 10 years useful life = 1 0+ 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 55
• In the first year, the asset would be depreciated 10/55 in value [the fraction 10/55 is equal to
18.18%]
• the first year,
• Second year 9/55 [ 16.36%]
• 8/55 [ 14.54%] the third year, and so on. Going back to our
• Illustration from the straight-line discussion: a Rs. 5,000 computer with a Rs. 200 salvage value
and 3 years useful life would be calculated as follows:
• 3 years useful life = 3 + 2 + 1 Sum of the years = 6
• Taking Rs. 5,000 - Rs. 200, we have a depreciable base of Rs. 4,800.
• In the first year, the computer would be depreciated by 3/6, i.e [50%], the second year, by 2/6
[33.33%] and the third and final year by the remaining 1/6 [16.67%].
• This would have translated into depreciation charges of Rs. 2,400 the first year, Rs. 1,599.84 the
second year, and Rs. 800.16 the third year.
• The straight -line Illustration would have simply charged Rs. 1,600 each year, distributed evenly
over the three years useful life.
5/13/18 S K MOHAN 111
Recording Depreciation
• Depreciation is directly charged against the asset by debiting Depreciation
account and crediting the Asset account. Depreciation account is closed by
transferring to Profit and Loss account at the end of the year. The entries will
be as under:
• 1) For the amount of depreciation to be provided at the end of the
• year:
• Depreciation A/c….. Dr. with the amount
• To Asset A/c. of depreciation

• For transferring the amount of depreciation at the end of the year.



• Profit and Loss A/c….. Dr. with the amount
• To Depreciation A/c. of depreciation
• transferred

• Asset Account will be shown at cost less depreciation i.e., written down value
at the end of the year in the Balance sheet.
5/13/18 S K MOHAN 112
Illustration : 2

• Raheem & Co. purchased a fixed asset on


1.4.2000 for Rs.2,50,000. Depreciation is to be
provided @10% annually according to the
Straight line method. The books are closed on
31st March every year.
• Pass the necessary journal entries, prepare Fixed
asset Account and Depreciation Account for the
first three years.

5/13/18 S K MOHAN 113


5/13/18 S K MOHAN 114
5/13/18 S K MOHAN 115
• Accounting Entries under the Sinking Fund
Method The following accounting entries are
recorded in the books: (A) At the end of the first
year
• (i) Depreciation a/c Dr. (For Providing
Depreciation)
• To Sinking Fund a/c
• (ii) Sinking Fund Investment a/c Dr. (For
Investment of Fund in Securities)
• To Bank a/c

5/13/18 S K MOHAN 116


• FX Exchange Arithmetic

5/13/18 S K MOHAN 117


What is Foreign Exchange

• Foreign Exchange is a mechanism by which the


currency of one country gets converted into the
currency of an other country

5/13/18 SKMOHAN 118


What is Foreign Exchange?

 Sec 2 (n) of FEMA provides the definition of Foreign Exchange:-


 Foreign Exchange simply means “foreign currency “.
 It also means deposit , credits and balance payable in Foreign currency
 It means draft / travelers cheques / LC /Bill of exchange drawn in FC by
Banks out side India
 It also means draft / travelers cheques / LC /Bill of exchange expressed in
Indian rupees but payable in FC
 FX includes all claims payable abroad . It consists of chaques ,
bills , deposits payable outside India. It also consists of funds held
in FC with Banks abroad
 Thus foreign money and near money instruments denominated in foreign
currency are called Foreign Exchange.
 Foreign Currencies balances kept abroad;
 TT / DD / MT / International postal order, FTC and (Bill of Exchange, Credit
Cards and foreign currency, currency payable abroad). etc
 Deposit ,Credits and balance payable in FC.
5/13/18 SKMOHAN 119
EXAMPLES OF FX

 A postal order issued by New York Post office in US $


 A Credit Card ,International Debit card issued by the Bank outside
India to draw F Ex or Rupee in India
 Balance in FCNR (B) or RFC or EEFC account
 Deposit Balance in NRE account in F Currency
 Vostro account Maintained By Foreign Bank in India.
 Nostro account maintained by Indian Bank outside India
 Draft Drawn by the IOB Hong Kong payable in Delhi In Indian
Rupee
 TC drawn in Foreign Currency

5/13/18 SKMOHAN 120


CHARACTERISTIC FEATURES OF
Foreign Exchange
• Scarcity Character
• Commodity Character

5/13/18 SKMOHAN 121


Who Control Foreign Exchange

5/13/18 SKMOHAN 122


How These Deptt. Function

5/13/18 SKMOHAN 123


Powers of RBI over Authorised persons

• Chapter IV Sn 13 provides that in case an


authorized person contravenes the directions
or fails to submit any report, RBI is
empowered by FEMA to impose penalty up to
Rs 10,000.
• In case the contravention continues it can
• imposes an additional penalty of Rs 2000/-
per day for the period of such continuation

5/13/18 SKMOHAN 124


Different categories of branches of an authorized dealer
 Category A : These branches are not only permitted to
handle all types of business but also maintain and
operate bank’s NOSTRO Account at Foreign Centre.
 Category B : These branches are permitted to handle
all types of foreign exchange transactions But not
maintain Nostro account and However they are
permitted to operate bank’s NOSTRO Accounts. At
foreign centre
 Category C : Not permitted to independently handle
foreign exchange transactions. These branches can
route their FX transactions through their designated
AD branches
5/13/18 SKMOHAN 125
FEMA 1999Effective from 01.06.2000
 This act extends to whole of India and also to all offices outside
India which are controlled by persons resident in India.
 The act contains 49 sections divided into 7 chapters
 Chapter 2 (sec3 To -9)deals with the restrictions imposed on
various type of fx transaction
 Sec 10 to 12 of the Act authorizes RBI to appoint different banks,
companies etc., as “Authorized Persons” to deal in foreign
exchange
 Chapter 3 (13 to 15) deals with offences and penalties
 Sec.46 of the Act empowers Govt. of India to make Rules on
any matter to carry out the provisions of this Act.
 Sec.47 of the Act authorizes the RBI to make regulations to
carry out the provisions and rules made there under.

5/13/18 SKMOHAN 126


Account to be open by AD
• NOSTRO ACCOUNT ( our account with you)
• VOSTRO ACCOUNT ( Your account with us )
• Vostro account is also called NON –RESIDENT Bank ACCOUNT as it is
maintained by a bank not resident in India)

• LORO ACCOUNT ( their Nostro account with you Or Third party


account )

• MIRROR ACCOUNT: or shadow account


• Escrow Account It is also called trust and
retention account ( Financing infrastructure projects , or payment
from third country e.g Nigeria payment is made from UK )

5/13/18 SKMOHAN 127


1. As per FEDAI rule 2 an usance export bill purchased remaining unpaid is required to be
crystallized
 (a) within 30 days from date of purchase,
 (b) on the 30th day after due date,
 (c) As per the policy decision taken by the bank
 (d) a or b whichever is earlier.
2. Authorized Dealers are appointed by
 (a) GOI (b) RBI (c) FEDAI (d) SEBI (e) NOA
3. Authorized Person" does not include the following
 (a) Authorized Dealer
 (b) Authorized Money Changer
 (c) Off-shore Banking unit
 (d) a+b+c (e) NOA

4. Directives to Authorized Persons are given by RBI through the following series of
circulars,
◦ (a) A.D. (MA) (b) A.D. (Dim) (c) A.P. (DIR) (d) A.P. (MA) (e) NOA
5. Non-Exchange Dealing branches are classified as category branches.
 (a) A (b) B (c) C (d) B or C (e) NOA

6. ADs are not permitted to do any commercial transaction in foreign exchange on


◦ (a) Sundays (b) Saturdays (c) evening hours (d) afternoon hours (e) NOA

5/13/18 SKMOHAN 128


Fill in the Blank

1. The term Foreign exchange is used , to denote FC


as well as the exchange of one currency into
another
2. The exchange rates of major currencies fluctuate
every ----- second
3. The Forex markets are dynamic and round the clock
markets. True/False
4. Forex markets are not affected by government
policies. True/False
5. A large part of the total global forex turnover
results from global commodities trade. True/False
5/13/18 SKMOHAN 129
What is Need Of Control

• Conserve Foreign exchange Recourse for


purchase of essential material and services from
Cross the Board.

• For That government require .


• to Know the Balance of trade and balance of
Payment

5/13/18 SKMOHAN 130


What is Balance of Trade
Difference between Total value of Export good
and total value of Import in Goods (Visible) in
a particular period
Value of Goods Exported
Less Value of Goods Imported
For purpose of Balance of Trade
 Value of export are valued on FOB basis
 And Import are valued on CIF bases

5/13/18 SKMOHAN 131


Balance of Payment
• Capital account Transaction
• Current account Transaction

5/13/18 SKMOHAN 132


CAPITAL ACCOUNT

The transactions which alter the assets and liability


(including contingent Liabilities) outside India of a
person resident in India or assets and liabilities in
India of a person resident outside India ( u/s2(e) FEMA)
 CAPITAL ACCOUNT == Receipt on capital transaction
 Less Payment on capital Transaction
 Example :-
◦ resident borrows foreign exchange from outside India
◦ A resident issued guarantee in favour of a non-resident
◦ Resident buy /sells immovable property situated outside India
◦ Resident invest in securities /shares issued in Foreign currency (outside
India)
◦ Non resident keeps his deposit with a bank in India
◦ Non resident invest in immovable assets in India

5/13/18 SKMOHAN 133


Current account Transaction

• Which is not a capital account transaction is called


current account transaction
• It effects the Revenue a/c only
 Which do not result in change in assets and liability position
of the person receiving and making payment
 Current account transaction =
Balance of Trade +Net of Invisible import and
export transaction
Remittance for living expenses of parents/spouse/children
living abroad, remittance in connection with travel,
education, medical expenses etc

5/13/18 SKMOHAN 134


1. A transaction which alters the asset or liability position
outside India of a person resident in India is called a _____
transaction.
2. A person resident in India acquires an immovable property
in London. It is a --- transaction.
3. A person resident in U.K. invests in immovable property in
India. It is a----- transaction.
4. A bank accepts a FCNR deposit of US$ 1000 from a non-
resident. It is a === transaction.
5. Payment of interest on non-resident deposits by a bank is
---------transaction.
6. Release of foreign exchange for travel, medical expenses,
study or for gift is classified as _____ transaction.
 ( ans 1 to 4 Capital account and 5& 6 are current account )
5/13/18 SKMOHAN 135
Some Information related to Foreign Currency

5/13/18 SKMOHAN 136


Characteristic of Fx Market
 No Exact Location
 OTC market :- over the counter market means direct deal without
intervention of any one .
 Twenty four hours market
 Very Volatile Fx rate fluctuate almost every 4 second
 ADs are market makers
 Five days operation except some middle east /Islamic countries
 Major players Multinational companies , International
banks ( largest market is LONDON followed by New York,
Tokyo, Zurich ,Frankfurt)

5/13/18 SKMOHAN 137


FOREIGN EXCHANGE MARKETS

5/13/18 SKMOHAN 138


VALUE DATE IN FOREX TRANSACTIONS

5/13/18 SKMOHAN 139


5/13/18 SKMOHAN 140
What is EXCHANGE RATES
• The rate at which an AD buys and sells the currency is
called Exchange rate.
• It means the rate at which one currency is converted
into another currency is called exchange rate .
• In other words it denotes the price or the ratio or the
value at which one currency is exchanged for another
• Exchange rate is very dynamic
• The foreign exchange market is round-the-clock
market due to different time zones
• Major participants- central banks, commercial banks,
forex brokers, corporations, individuals
5/13/18 SKMOHAN 141
The exchange rates are quoted in two ways.

• Direct Method
• Indirect Method

5/13/18 SKMOHAN 142


Direct Method
• the home currency is quoted per unit of foreign
currency or it can also be defined as a quote
where the home currency is the variable unit..

• e.g 1 USD = Rs. 65.23


How to show Purchase rate and sale rate
AD would buy 1USD = Rs. 65.30 and sell at 1 USD =
Rs. 65.45 in order to make profit.

5/13/18 SKMOHAN 143


Indirect Method
• the Home Currency unit remains constant and
the foreign currency is the variable unit.
e.g.Rs. 100 = USD 1.153

India was following indirect method of quotation


till 01.08.1993.

5/13/18 SKMOHAN 144


Types of Rates

5/13/18 SKMOHAN 145


Price or Rate of Fx exchange

 Buying Rate / Bid rate


 Selling Rate/ offer rate
 WE TREAT BUYING AND SELLING TRANSACTION ONLY WHEN
THE AD IS REQUIRED TO CONVERT FX. EXCHANGE TO RUPEE
OR vice versa
Difference between two transaction is called
MARGIN
 The mean of Bid rate and offer rate is called middle rate
 Selling Rate – buying rate = spread /margin/profit / BASIS POINT
SPREAD
 E.g. 1usd = Rs.48.3050/3060 ( the basis point spread is 10basis points)
 All inward remittance / receipt of Fx exchange when
converted to rupee involve Buying Transaction
 While all outward remittance /payments of Fx exchange
involve sales transaction
5/13/18 SKMOHAN 146
Purchase and sales
• We say purchase , we imply that
• The bank has purchased and
• It has purchased Fx currency
• Similarly when we say SALE , it imply that
• The bank has sold
• It has sold Fx currency

• in Purchase transaction bank acquires Fx


Currency and part with home currency
• In sale transaction the Bank part with the
Fx currency and acquires home currency
5/13/18 SKMOHAN 147
1. Mr. Ravi presents a foreign draft for $20000 for credit of
his SB account . Is it a buying or selling transaction
2. Mr. X wants a Fx draft for $ 1000 to subscribe a foreign
magazine . What type of transaction is for AD.
3. DUNLOP India has lodged an export bill for USD 100000
. Which is realized and credited into our nostro account .
AD wants to vouch the same and credit the amount in the
account of DUNLOP India. Is it buying or selling
transaction
4. AD wants to issue travelers cheque of pound sterling
5000 to Mr. Jain who is going on foreign tour . Is it a
buying or selling transaction

5/13/18 SKMOHAN 148


Purchase and Sale
• The purchase or sale of foreign currency is to be
viewed from the point of view of the AD.
• For an Authorised Dealer foreign exchange is like
a commodity and like in any other trade the
objective is to make profit while buying or selling a
foreign currency.

• The buying and selling are not effected at the same


rate.
• e.g AD would buy 1USD = Rs. 65.35 and sell at 1
USD = Rs. 65.45 in order to make profit.
• The maxim is ‘Buy Low & Sell High’.
• Where indirect method of quotation is followed, the
maxim would be ‘Buy High and Sell Low’.
5/13/18 SKMOHAN 149
PURCHASE/ BID RATE

1. Clean Inward remittances (MT, TT, DD) where cover has TTB
already been provided in NOSTRO
1. Realization of instruments sent on collection. TTB
1. Cancellation of DD/MT/TT etc., Payment of FCNR deposit TTB
1. Cancellation of Forward Sale contract. TTB
1. Purchase/discounting of bills and other instruments BB
i. Where bank has to claim cover after payment.
ii. Where drawing bank at one centre remits cover for credit
to a different centre.
1. Foreign currency notes and Travellers cheques It is a
specific
*** AT THE DISCRETION OF THE AUTHORISED DEALER version
of B B
rate ***
• Other than Bill, T C , Currency purchase of other transaction as per FADAI we have
to deduct 0.15% or 0.125% from TTB

5/13/18 SKMOHAN 150


SALE/ OFFER RATE/ Ask rate
1. Issuance of TT/DD/MT etc. and no document are TTS
handled by AD
1. Cancellation of purchase like: TTS
i. Bill purchased/discounted returned unpaid.
ii. Bill purchased/discounted transferred to collection
account.
iii. Refund of earlier inward remittance converted to
rupees.

1. Cancellation of forward purchase contract TTS

1. Import Bills payment. , Advance payment of Import BS


transaction ,Where documents are handled by AD
1. Sale of foreign currency notes and Travelers cheques. ***
2. TC rate = TTS + maximum margin of 0.50%
3. Currency Note selling rate = TC rate +maximum margin
of .50% in TC rate
5/13/18 SKMOHAN 151
Different Rates
 Card rates these are buying and selling rates computed by the ADs during the
start of business hours it is used for small transaction for handling of small value
transaction It is a indicative rates .
 Notional rate: Weekly average of daily rates for different currencies advised by
FEDAI on every Friday. This is used on liability transaction ( deposit ) {in other
words it is a assumed rate which is used to express the rupee value of Foreign
currency deposit }
 . Inter-Bank Rates: / based rate called a two-way quote
 one is for purchase and second is for sale
• The first rate is called the BID rate and the second is the Ask
rate
 Merchant rate :- actual quoted to public /customer based on bases of market
rate
 Cross rate if the rate of Foreign currency is given in term of another foreign
currency it is called a cross rate
 Fine rate:- rate quoted to good customers with thinner spread
 REER:-Real effective exchange rate used for Basket of currencies

5/13/18 SKMOHAN 152


• a) Cross rate
• If a person wants to remit Euros from India, and as a banker, and for
argument sake, rupees/Euros are not normally quoted and therefore, we
have to first buy dollars against the rupees and the same dollars will be
disposed off overseas to acquire the Euros.
• (b) Chain rule
Calculation of the cross rate is based on a commonsense approach. However,
it can be reduced to a rule known as the chain rule with similar steps.
• (c) Value date
The value date is a date on which the exchange of currencies actually takes
place.
• (v) Premium: When a currency is costlier in forward or say, for a future value
date, it is said to be at a premium. In the case of the direct method of
quotations, the premium is added to both the selling and buying rate.
• (vi) Discount: If currency is cheaper in the forward or for a future value date,
it is said to be at a discount. In the case of a direct quotation, the discount is
(deducted) subtracted from both the rates, i.e. buying and selling rates.
TT buying rate In Rs.
Dollar /Rupee market spot buying rate ----
Less Exchange margin -----
TT buying Rate -----
Rounding of to nearest multiple of 0.0025( after loading Exchange margin only )
On the 15th Sept. IOB received a mail transfer from New York correspondent for
USD 10000payable to his customer Bank’s account with the correspondent has
been credited with the amount
Assuming Rupee /Usd are quoted in local interbank market as under
Spot USD 1 = 39.2500/2700
Spot/ Oct = 2200/2300
Bank require exchange margin 0.080% rupee nearest to whole value
Rate applicable TT buying rate 39.2500
Less exchange margin 0.080% of 39.2500 0.03140
39.21860
Rounding off 39.2175
customer will get 10000 X 39.2175 3,92,175

5/13/18 SKMOHAN 154


For calculation of BB rate

Forward margin is normally available for a period of


calendar month not for number of days

forward margin may be on premium or on discount

Premium is to be added to the spot rate

and discount should be deducted from spot rate


Rule of loading forward margin in BB rate
calculate BB rate
If Forward margin is at premium round off the transit period
add usance period to lower month
if the forward margin is at discount round off the forward
margin to the higher month

5/13/18 SKMOHAN 155


• Premium When currency is costlier in
forward /future value date . It is added in
buying and selling rates
• Discount When currency is cheaper in
forward /future value date . It is deducted
from both buying and selling rate

5/13/18 SKMOHAN 156


calculation of BB rate Rs.

Dollar /Rupee market spot buying rate -----

If Premium -----
Add premium
( Transit and usance period rounded of to lower
month
If Discount ------
Less Forward Discount
( Transit and usance rounded to higher month
Less exchange margin -----

Bills buying rate -----

Rounded off to nearest multiple of 0.0025

5/13/18 SKMOHAN 157


• on 25th July a customer presented to the bank
at sight documents for USD 100000 under LC .
The LC provides for reimbursement by
negotiating bank’s own demand draft on
opening bank at NEW YORK
• Rupee / usd rate
• Spot 1usd = 39.6525/6650
• Spot /august = 6000/5700
• Spot /September = 1.000/0.9700
• transit period is 25 days bank require exchange
margin of 0.15% calculate the rate and amount
to be payable in Rupee
5/13/18 SKMOHAN 158
Dollar is at discount and transit period is 25 days

Dollar /Rupee market spot buying rate 39.65250

Less discount for one month 00.60000

forward rate 39.05250

Less exchange margin 0.15% 0.05859

Bills buying rate 38.99391

Rounding off 38.9950

Amount paybale to customer 38,99,500


100000X 38.9950

5/13/18 SKMOHAN 159


• on 8th sept , an exporter tenders a demand bill for Usd 100000
drawn on New York .The ruling rates for Usd in the inter bank
market are as under
Spot Usd 1=Rs.39.3000/3500
Spot /sept. .6000/7000
Oct. .8000/9000
Nov 1.000/1000
Transit period is 25 days The bank requires an exchange margin of 0.10% .
Interest on export finance is 10% p.a.
Customer opts for retain of 15% proceeds in US dollars
You are required to compute
The rate at which the bill will be purchased by the Bank
The rupee amount payable to the customer
Interest to be recovered from him
5/13/18 SKMOHAN 160
Since the currency is at premium .the transit period will be
rounded off to lower month ( i.e. nil) and rate to the customer will
be based on spot rates
Dollar /rupee spot buying rate 39.3000
less exchange margin 0.10% on 39.3000 0.0393

39.2607
Round off to the nearest multiple of 0.0025 , the rate quoted to
the customer would be Rs.39.2600
Customer account will be credited with USD 85000 x39.2600 =
33,37,100
Interest charges on 33,37,100 @10% for 25 days is Rs.22,857

5/13/18 SKMOHAN 161


Selling rate

Dollar /Rupee market spot selling rate ------

Add Exchange margin for TT selling rate -----

TT selling Rate ------

Add exchange margin for bills selling rate ----

Bills selling rate ----

Rounded off to nearest multiple of0.0025 and quoted


to customer

5/13/18 SKMOHAN 162


 on 12 th feb an importer receive a bill for usd 10000 . He asks
his bank to retire the bill to the debit of his account . Interbank
rate for dollar is
Spot 1 USD = 38.7050/7200
Spot/ march = 5000/4500
 Bank retain margin 0.15% for TT selling rate and 0.20% on BS
rate what amount will be debited the importer ‘s account
 Solution
 Figures in Rs.
Dollar / rupee market spot selling rate 38.7200
Add exchange margin for TTS0.15% of 38.7200 0.05808
 tt selling rate 38.77808
Add exchange margin at 00.20% on 38.77808 0.07756
 bills selling rate 38.85564
 Rounding off 38.8550
 Customer have to pay 10000 X 38.8550 = Rs.388550
5/13/18 SKMOHAN 163
 A customer requests IOB to issue DD on New York for USD 25000. Assuming the
on going spot rates in the local market in the local market for USD are as under
 Spot usd = rs.39.3575/3825
 1 month forward rs.39.7825/8250
 Bank requires an exchange margin of 0.15%
 What rate will be quoted to the customer and what is the rupee amount
payable by him
 Solution
Bank has to quote its TT selling rate based on the market
selling rate
Dollar/rupee market spot selling = 39.3825
 Add exchange margin at 0.15 % on Rs. 39.3825 = 0.05907
 39.4415
Rounding of 39.4425
The amount payable by the customer for usd 25000 at
Rs.39.4425 per dollar is Rs. 9,86,063
5/13/18 SKMOHAN 164
Examples of buying and selling rate

• A traveler tender traveller cheque of USD 5000


for encashment exchange rate is 1usd =
Rs.49.30/50. how much AD will pay to customer.
• Mr. Man Mohan Singh , a NRI sends DD for
GBP2000 to be credited in his account . Rate 1GBP
=68.20/.50 . Find the amount to be credited in his
account .
• Miss Katrina wants DD of DEM100 for
subscribing the journal Rate 1DEM= 35.40/60
How much she have to pay

5/13/18 SKMOHAN 165


EXERCISE ON SELECTION OF RATES
1. An authorised dealer receives a TT from its correspondent
bank for credit to the account of its customer. The exchange
rate to be applied is
◦ (a) TT Selling Rate, (b) Bills Buying Rate, (c) Rate prescribed by the
correspondent, (d) TT Buying Rate.
2. A customer brings a DD for US$ 1000 drawn by Banker Trust, New
York drawn on your branch & requests you to give credit to his
account. You will apply
 (a) DD Buying Rate (b) Notional Rate (c) TT Selling Rate (d) TT
Buying Rate.
3. Mr. Ashok deposits his personal cheque for GBP 1000 to be
credited to his NRE account. The rate to be applied is
(a) TT Buying Rate, (b) Separate rate to be worked out from TT
Selling Rate (c) Personal cheque cannot be purchased,
(d) Separate rate worked out from TT Buying Rate.

5/13/18 SKMOHAN 166


1. The exchange rate of a foreign currency is
determined by
◦ (a) RBI (b) AD (c) FEDAI (d) IBA (e) market forces of
demand and supply
2. The inter-bank foreign exchange rates for US$ are
Rs. 45.10/20. A customer requests for encashment
of FC demand draft for US $ 5000. if there are other
no charges or commission, what amount will the
customer be receiving?
 a. Rs. 226000
 b. Rs. 225500
 c. Rs. 225000
 d. Rs. 220000

5/13/18 SKMOHAN 167


• Inter bank rate is USD 1 = Rs.48.05/10. Your bank
has to take up following USD transactions. Choose
appropriate rate (
a) Purchase of an export bill from exporter
b) Payment of an import bill by importer
c) Payment of inward TT remittance favoring customer.
Cover received.
d) Remittance of examination fees to USA on behalf of a
remitter customer
e) Crediting proceeds of Export Collection Bill realized
• Ans:-.a-(48.05) Bills Buying Rate, b-(48.10) Bills
Selling Rate, c-(48.05) TT Buying Rate, .d-(48.10) TT
Selling Rate, e- (48.05) TT Buying Rate,
5/13/18 SKMOHAN 168
QUS .
Calculate rates of exchange for the undernoted transactions when your bank is
quoting following card rates for USD (Jan, 2015). Please note that you are
required to make the above card rates favorable for your customers by 5 ps. per $
for every transaction
Buying Rates Selling Rates
 TT BB TT BS
 45.10 45.00 45.80 45.90
(i) Converting rupees from NRESB A/c for preparing FCNR (B) deposit for USD
10,000.
(ii) Purchasing of an export bill for USD-10,000.
(iii) Crediting rupee proceeds of inward remittance after getting funds in NOSTRO
a/c USD-5000.
(. iv) Remittance of USD-5000 outside India for a permissible current a/c
transaction
(v) Retirement of an import bill on collection USD-5000


ANS (i) Rs.45.75 (TT Selling), (ii) Rs.45.05 (Bills Buying), (iii) Rs.45.15 (TT Buying), (iv)
Rs.45.75 (TT Selling), (v) Rs.45.85 (Bills Selling
5/13/18 SKMOHAN 169
1. Forward differential is known as:
 a. swap rate
 b. arbitrage rate
 c. forward rate
 d. spot rate
2. An exporter presented sight bills valuing US $ 50000 for purchase on
31.3.2015. What rate will you quote and what amount will be paid to the
customer taking into account the following assumptions:
 Exchange margin is 0.15%
 Inter-bank spot rate 1 USD = 43.5525 / 5650
 April forward discount 0.6000 / 0.5700

Solution : The bank will quote bills buying rate i.e. = 43.55250
Less : discount for one month = 0.60000
One month forward rate = 42.95250
Less : 0.15% exchange margin on 42.9525 = 0.06443
Bills buying rate = 42.88807
Amount payable to exporter in Rupees = 2144404.
5/13/18 SKMOHAN 170
Cross rates:
 A cross rate is the currency exchange rate between
two currencies when neither are official currencies of the
country in which the exchange rate quote is given.
 Foreign exchange traders use the term to refer
to currency quotes that do not involve the U.S. dollar,
regardless of what country the quote is provided in

 In India, the inter-bank transaction always has USD as


one leg. If we have to arrive at the INR equivalent of any
other currency, we have to apply cross rates. The
calculation involves two stages.
 1. USD / INR
 2. USD / other Foreign Currency

5/13/18 SKMOHAN 171


How to calculate Cross Rate?:
The math is simple algebra: [a/b] x [b/c] = a/c
Substitute currency pairs for the fractions shown above, and you get,
for instance,
GBP/AUD x AUD/JPY = GBP/JPY.
This is the implied (or theoretical) value of the GBP/JPY, based on
the value of the other two pairs.
 The actual value of the GBP/JPY will vary around this implied value,
as the following calculation shows.
Here are Friday's actual closing BID prices for the 3 currency pairs in this example

GBP/AUD = 1.73449,
AUD/JPY = 0.85535

GBP/JPY = 1.48417. Now, let's do the math:


GBP/AUD x AUD/JPY = GBP/JPY
1.73449 x 0.85535 = 1.4836,
which is not exactly the same as the actual market price. Here's why. During market hours (Sunday afternoon
to Friday afternoon, EST), all prices are LIVE, and small departures from the mathematical relationships can
exist momentarily
5/13/18 SKMOHAN 172
• EXAMPLE: Derive the rate for EUR/AUD
• EUR/USD =1.3798/1.3858
• USD/AUD =1.0432/1.0502
• Bid Ask
• The EUR/AUD Bid rate= Multiply the term currency bid by the base
currency
• ask = 1.3798 x 1.0432 = 1.4394
• this is the rate at which the market buys EUR and sells AUD
• The EU/AUD Ask rate=
• Multiply the term currency ask by the base currency bid
• = 1.3858 x 1.0502 = 1.4553
• this is the rate at which the market sells EUR
and buys AUD
• Derive the rate for GBP/EUR
• GBP/USD = 1.9850/1.9950 GBP is base, /USD is terms
• EUR/USD= 1.3460/1.3520 EUR is base, /USD is terms The GBP/EUR
• Bid rate
• = divide the base currency bid by the terms currency ask =
• 1.9850 / 1.3520 = 1.4682
• this is the rate at which the market buys GBP and sells EUR at 1.4682
EUR per GBP.
• The GBP/EUR Ask rate=
• divide the base currency ask by the terms currency bid =
• 1.9950 / 1.3460 = 1.4821
• this is the rate at which the market sells GBP
and buys EUR at 1.4821 EUR per GBP
Cross Rate
calculation of TT buying rate on the basis of cross rate

Dollar / Rupee market spot buying rate ----

Less Exchange margin ------

TT buying rate ------ (1)

Dollar Fx currency market spot rate selling rate ----- (2)

TT buying rate for Fx currency = 1 divided by 2 ------

Rounding of to nearest multiple of 0.0025

5/13/18 SKMOHAN 175


Bills buying rate
calculation of Bills buying rate on the basis of cross rate
Dollar / Rupee market spot buying rate ----
If Premium
Add premium( Transit and usance period rounded of to lower month
If Discount
Less Forward Discount ( Transit and usance rounded to higher month
Less exchange margin
BB rate for Dollar --- (1)
Fx currency / Dollar market spot selling rate --
If Premium
Add premium( Transit and usance period rounded of to higher month
If Discount
Less Forward Discount ( Transit and usance rounded to lower month
--- (2)
BB rate for Fx currency = 1 divided by 2 -----
Rounded off to nearest multiple of 0.0025
5/13/18 SKMOHAN 176
Example

• IOB has issued a demand draft on Montreal for Canadian dollar


50000 at CAD = Rs.32.4850 however , after a few days the
purchaser of draft requested the bank to cancel the draft and
repay the rupee equivalent to him
• Assuming the Canadian dollar were quoted in Singapore Fx
exchange market as under :-
• USD 1=CAD 1.2541/2561
• And in the interbank market
• 1 USD = Rs.39.5275/5350 ,
• how much the customer will gain or loss on cancellation of the
draft ? Exchange margin on TT buying is 0.08%

5/13/18 SKMOHAN 177


Solution
The bank cancel the DD at TT Buying rate
USD /rupee market buying rate =39.5275
Less exchange margin at 0.08% on Rs.39.5275 = 0.0316
TT buying Rate 39.4959
USD /CAD market selling rate 1.2561
CAD TT buying rate (39.4959 /1.2561 31.4433

Rounding up to 0.0025 == 31.4425

Amount paid by the customer on purchase of DD for CAD 50000 at 16,24,250


32.4850
Amount received by the customer 50000X31.4425 = 15,72,125

Loss to the customer 52125

5/13/18 SKMOHAN 178


Example

 An exporter received an advance remittance of


Danish kroner 100000 by way of TT .He likes to
remain 15% of the remittance in Fx currency in
the interbank market dollar was quoted at
 Spot 1 usd = Rs.39.3500/3600
 1 month forward 1100/1200
 Singapore market Danish kroner was quoted as
under spot USD 1= DKR6.9220/6.9280
 Bank require an exchange margin of 0.08% what
rate will be quoted to the customer / what is the
rupee amount payable to him
5/13/18 SKMOHAN 179
solution

Bank has to quote TT buying rate to the customer

Dollar / Rupee market spot buying rate 39.3500

Less Exchange margin0.08% of 39.3500 0.03148

TT buying rate for dollar 39.31852

Dollar /Danish kroner spot selling rate DKR 6.92800

TT buying rate for Kroner 39.31852/ 6.9280 5.6753

Rounded to 0.0025 5.6750

Amount paid to customer DRK 85000X 5.6750 482375


5/13/18 SKMOHAN 180
Selling rate
Dollar /Rupee market spot rate ---
Add exchange margin Rs.---
TT selling rate for dollar Rs.---- (1)
add exchange margin for bills selling rate Rs.---
Bill selling rate of dollar Rs.--- ( 2)

Dollar / Fx currency buying rate Fx C----(3)


For TT S rate for Fx currency 1 is divided by 3 ---
Bills selling fx currency 2 is divided by 3 ---
Rounding of to nearest multiple of 0.0025

5/13/18 SKMOHAN 181


Example
• on 17th July usd is quoted in the interbank market as follow
– spot 1usd = Rs.38.6025/6100
– Spot /July 500/600
– August 1500/1600
• At Singapore market Malaysian Ringit are quoted as follow
• spot Usd 1 = MYR 3.8012/59
• 1month 24/26
– 2 month 48/50
• bank require the margin of 0.10% on TT selling rate and 0.15% on Bills
selling rate
• 1. Mr. Sk Kapoor requested for a bank draft for MYR 5000
• 2. M/s SMCO ltd desire an import bill for MYR 15000
• calculate the exchange rate to be quoted by the bank in each case

5/13/18 SKMOHAN 182


1st we have to calculate the selling rate for USD
Dollar / rupee market spot selling rate 38.6100
Add exchange margin 0.0386
TT selling rate for dollar 38.6486
Add exchange margin at 0.15% on 38.6486 0.0580
Bills selling rate for dollar 38.7066
1. Tt selling rate for MYR
dollar /rupee selling rate 38.6486
dollar / MYR spot buying rate Usd 1 = MYR 3.8012
MYR / rupee TT selling rate 38.6486/3.8012 Rs.10.1675
bank will quote a rate of 10.1675 for issue of DD
Bills selling rate for MYR
dollar /rupee bills selling rate 38.7066
dollar / MYR spot buying rate 38.8012
MYR / rupee bills selling rate 38.7066/3.8012 10.1827
rounded of to nearest 0.025 Rs. 10.1825for Import bill
5/13/18 SKMOHAN 183
Example of a Chain Rule (1 )

• All foreign exchange calculations have to be worked with care and


accuracy and several rules have to be kept in mind
• Chain rule- is used to attain comparison or ratio between two
quantities which are linked together through another or other
quantities.
• Equation in the form of a chain is derived.
• Per cent and per mille- Per 100 units/per 1000 units

• Query: If we have to remit French Francs to France from India how do


we go about it? (We have to arrive at cross rates between FRF and
INR.)
• Mumbai interbank market:
– US $ 1 = Rs. 41.2550/2650
• London Market
– US $ 1 = FRF 6.0500/6.0550

5/13/18 SKMOHAN 184


Chain rule (2)
• At what rate can one buy FRF against rupees?
• How many Rs----- = FRF 1?
• FRF 6.0500 = US $ 1
• US $ 1 = 41.2650, therefore,
• FRF 6.0500 = US $ 1 = Rs. 41.2650
• Hence, FRF 1 = 41.2650/6.0500
• Or FRF 1 = Rs. 6.8206

5/13/18 SKMOHAN 185


Forward Contracts
 Definition:
 Contract between two parties, one of them a Banker.
 To buy or sell a fixed amount of Foreign Currency.
 On a specified future date or within a specified period
 Pre-determined rate of exchange.

 Forward contracts can be booked on the basis of the ongoing spot
rate. It can be used to hedge any exposure in forex. Customer
should have a limit sanctioned.
 Forward contract can be booked on declaration basis also by
exporters with good track record.
 Types of Forward Contracts:
 Fixed Forward
 Option Forward.
 In Option forward contracts, the option period cannot exceed one
calendar month.
5/13/18 SKMOHAN 186
1. An AD enters into an agreement to take delivery of foreign exchange at a specified
rate on a specified time. This agreement is called a .
– (a) Forward Sale Contract (b) Forward Purchase Contract (c) Future Contract (d) Swap
Contract (e) NOA
2. In option contract, the option period shall not exceed .
– (a) six months (b) twelve months (c) nine months (d) one month (e) NOA
3. If the date of delivery in case of forward contract falls on a holiday, the delivery has
to be effected on the .
– (a) succeeding day (b) preceding day (c) succeeding working day (d) preceding working day
(e) a day to be mutually agreed.
4. When a foreign exchange for forward transaction is at premium, it means the
currency will be_____ in future.
• (a) dearer (b) cheaper (c) same rate (d) more in supply (e) NOA
5. For computing a forward quotation for a currency which is in premium, the
premium margin is to be_________ in case of direct quote.
– (a) added for both selling and buying rate (b) deducted for both selling and buying rate (c)
added to selling rate and deducted from buying rate (d) deducted from buying rate and added to
selling rate (e) NOA
6. If US Dollar is in premium, it is beneficial to .
– (a) exporters (b) importers (c) Authorised Dealers (d) Indian Tourists going abroad (e) b+c
7. For import bills received on collection basis the AD may be required to book
contract.
– (a) Forward purchase contract (b) Forward sale contract (c) Future contract (d) No contract
can be booked for a collection bill (e) NOASKMOHAN
5/13/18 187
calculation of forward buying rate Rs.

Dollar /Rupee market spot buying rate -----

If Premium -----
Add premium
( for forward period ,Transit and usance period
rounded of to lower month
If Discount ------
Less Forward Discount
(for forward period ,Transit and usance rounded to
higher month
Less exchange margin -----

Forward Buying Rate -----

Rounded off to nearest multiple of 0.0025

5/13/18 SKMOHAN 188


calculation of forward selling rate Rs.

Dollar /Rupee market spot selling rate -----

If Premium -----
Add premium( for forward period ,

If Discount ------
Less Forward Discount (for forward period ,

Add s exchange margin for TT selling rate -----

Forward TT selling rate ----1

Add exchange margin bills selling rate


Forward bills selling rate ----2

5/13/18 SKMOHAN 189


Forward premium (or discount) in percent per annum

(Forward Rate -Spot Rate)/ X 12 X 100


Spot Rate n

Where ‗n‘ is the number of months till maturity of the forward contract

suppose that the forward rate (60 days) for the Rupee is 49.05/$ whereas the spot rate for
it is 48.20/$ . The forward premium on Indian Rupee will be

49.05-48.20 X 6 X 100 10.58 % Premium


48.20 1

on the other hand, the forward rate for the Rupee is 47.80/$, the forward discount on it
will be

47.80-48.20 X 6 X 100 4.97 % discount


48.20 1

5/13/18 SKMOHAN 190


Interpretation of interbank quotation
• Base currency is the currency which is being bought
and sold and the other currency is incidental.
• Forwards are quoted as follows on 15th January
– Spot/1 month 16/18
– Spot/ 2 months 34/36
– Spot/ 3 months 53/56
• If forward differentials are in the ascending order (1 st
figure is lower than the 2nd) the base currency is at
premium
• If rates are quoted in this manner one month
forward margin is valid for one month from 15 th jan
to 14th Feb i.e last date of delivery two months
forward margin is valid from 15 th feb to 14th March
so on
5/13/18 SKMOHAN 191
• Forwards are quoted as follows on 10 th January rates are given
as
– Spot usd 1 = 49.5000/5200
– Spot Feb 3000/3200
– Spot march 3500/3700
– in 1st statement is spot rate for USD buying 49.5000 and
selling 49.5200
– 2nd and 3rd gives forward margin during the month of Feb
and March respectively. Feb rate is valid from 1st feb to last
date of Feb while March rate is valid from 1st march to 31st
march

– REMEMBER
– Forward margin is given in ascending order --- premium add
to spot rate ( AA =Ascending order ADD)
– Descending order deduct from spot rate ( DD = Descending
= deduct )
5/13/18 SKMOHAN 192
• You have received on 15th jan a TT from
your New York correspondent for USD
10000 for credit to your customer account .
The interbank rate is as follow
• Spot usd 1 = Rs.49.3500/.3700
• spot feb .2500/.2600
• You are require exchange margin @
0.080% calculate the rate to be applied
and the rupee amount to be credited to the
customer’s account

5/13/18 SKMOHAN 193


As nostro account already credited rate to be applied is
TT buying rate

Calculate TT B rate
inter bank buying rate 48.3500
deduct exchange margin of 0.080 of 48.3500 0.0386
48.31132

Amount to be rounded off to nearest rupee 0.0025 48.3125


which comes to

a/c to be credited with 10000X 48.3125 = 483125

5/13/18 SKMOHAN 194


Forward Contracts
• Types of Forward Contracts:
• Fixed Forward and
• Option Forward.
• In Option forward contracts, the option period cannot exceed one calendar
month.
• Definition:
• Contract between two parties, one of them a Banker.
• To buy or sell a fixed amount of Foreign Currency.
• On a specified future date or within a specified period
• Pre-determined rate of exchange.

• Forward contracts can be booked on the basis of the ongoing spot rate. It can be
used to hedge any exposure in forex. Customer should have a limit sanctioned.
• Forward contract can be booked on declaration basis also by exporters with good
track record.

5/13/18 S K MOHAN 195
5/13/18 S K MOHAN 196
Forward Points

• Forward Points: The forward premium or


discount, expressed in percentage points, is
called Forward Points, e.g. a forward premium
of 0.0150 is referred to as premium of 150
points.

5/13/18 S K MOHAN 197


Forward point
• Let us suppose that the spot rate of US$/Euro is
• Spot Euro 1 =US$ 1.3180
• the exchange rate three months forward is 3 months Euro 1 = US$ 1.3330
• The difference of 150 points referred to is the forward point.
• Calculating forward points
• We can calculate the approximate forward points for a given forward period with the help
of the following information
• Spot rate 1.5000
• Interest rate different 3%
• Forward period 90 day
• number of days of the year for calculation 360 days
• Formula for
• spot rate X intt. Rate different X Forward period
• 100 X number of days in the year
• 1.500X3X90 = 0.01125
• 100X360
5/13/18 S K MOHAN 198
1. In "Tom Contracts" the delivery of foreign exchange should take place

– (a) within two days (b) next day (c) within 3 days (d) next working day (e) NOA
2. Currency position does not include one of the following.
– (a) Encashment of foreign currency notes (b) Booking forward contract (c)
Delivery under forward purchase contract (d) Sale of foreign currency notes
(e) NOA
3. Arbitrage is a process of simultaneous buying and selling of foreign
exchange for the sake of making profit from the difference of .
– (a) An exchange rate at two centers (b) Forward margin at two centers (c)
Interest rates at two centers (d) a+b+c (e) NOA

4. Buying Spot & Selling Forward simultaneously is called deal.


– (a) Swap (b) Arbitrage (c) Speculative (d) Cover (e) NOA

5/13/18 S K MOHAN 199


1. An AD enters into an agreement to take delivery of
foreign exchange at a specified rate on a specified
time. This agreement is called a
1. (a) Forward Sale Contract (b) Forward Purchase Contract (c) Future
Contract (d) Swap Contract (e) NOA

2. If US Dollar is in premium, it is beneficial to .


– (a) exporters (b) importers (c) Authorised Dealers (d)
Indian Tourists going abroad (e) b+c
3. For import bills received on collection basis the AD
may be required to book contract.
– (a) Forward purchase contract (b) Forward sale contract (c)
Future contract (d) No contract can be booked for a
collection bill (e) NOA
5/13/18 S K MOHAN 200
• The spot Euro 1=US$ 1.4250/70. The forward premium is 30-
25 for one month, 70-65 for 2 months, 110-105 for 3 months.
What rate will be charged for 2 months forward sale by Bank.
• a. 1.4335
• b. 1.4300
• c. 1.4200
• d. 1.4205
• The home currency price of one unit of foreign currency is
called:
• a. selling rate
• b. buying rate
• c. direct rate
• d. indirect rate

5/13/18 S K MOHAN 201


• . Forward Rate = Spot Rate + Premium or –
Discount
• If the value of the currency is more than being
quoted for Spot, then it is said to be at a
premium.
• If the currency is cheaper at a later date than
Spot, then it is called at a Discount.
• The forward premium and discount are generally
based on the interest rate differentials of the
two currencies involved.

5/13/18 S K MOHAN 202


ARBITRAGE
• It consist of purchase of one currency in one centre
and almost simultaneously sale of same currency in
another centre with an objective to make profit due to
exchange difference prevalent in these two
centers .
• Exchange Arbitrage are of three type :-
• Arbitrage in space – price very in different place buying and
selling of currency it is also called Simple /direct / two point arbitrage
• Arbitrage in time :-WHEN THE FORWARD MARGIN FOR
ONE PARTICULAR CURRENCY IS FOR PARTICULAR PERIOD
HAVING DEFFFERENCE THAN BUYING AND SELLING IS CALLED
ARBITRAGE IN TIME
• Arbitrage in interest rate WHEN SHORT TERM INTEREST
RATES ON DEPOSIT VARY IN TWO PLACES
5/13/18 SKMOHAN 203
Arbitrage

• Arbitrage opportunities available to forex traders are known as the inter


market arbitrage. Forex traders regular make arbitrage profit though
interest rate differential in two countries. This is known as “interest rate
arbitrage”.
• Interest rate arbitrage works like this:
• Spot rate £1 = €1.6140. Interest rate for coming 12 months is 5.5% for
Pound Sterling and 3.75% for Euro.
• Suppose a bank quotes a 3 month forward rate as £1 = €1.5970.
• Now let us see whether there exist an arbitrage opportunity or not.

• For example, a trader borrows £100,000 for 3 months. He has to pay


£101,375 after 3- months. He converts £100,000 to € at the spot rate. He
receives €161400.
• Invests €161400 at 3.75% interest rate for 3 months. He earns € 162913.
He converts euro proceeding to Pound sterling at the 3 month forward
rate of £1 = €1.5970.
• He earns £102,012. He returns £101,375and makes a arbitrage profit of
£636.
5/13/18 S K MOHAN 204
THANKs
wish you best of luck