SFM Pawan Sir
SFM Pawan Sir
Strategic
Financial Management
Volume
1
Edition
2022 - 23
CA FINAL SFM
STRATEGIC FINANCIAL
MANAGEMENT
Published By
STRATEGIC FINANCIAL MANAGEMENT
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DERIVATIVES
CONCEPTS Page No.
Option Contract………………………………………………………………... 1
Basics …………………………………………………………………………..… 1
Margin …………………………………………………………………………….. 18
QUESTIONS
Basic ………………………………………………………………………………. 27
CHAPTER – 02
QUESTIONS
Part III: Interest Rate Future (Euro Dollar Future) ………………… ... 16
CHAPTER – 03
Basics ……………………………………………………………………………… . 01
Cross Rates………………………………………………………………………… 04
Transaction Exposure…………………………………………………………. 19
Automatic Cancellation……………………………………….…………….. 31
Early Delivery…………………………………………………..………………. 32
Foreign Currency A/C …………………………………………….……….... 32
QUESTIONS
Basics……………………………………………………………..………………. 34
Residual……………………………………………………………………………. 183
CONTENTS
CHAPTER – 04
QUESTIONS
DERIVATIVES
CHAPTER – 01
DERIVATIVES
DERIVATIVES
1). BASICS
(1) Option contract is a contract in which option holder has right but
not obligation to buy or sell an underlying asset at predetermine
price (Exercise price or strike price) on maturity. An option
premium is to be paid in advance & such premium is transferred to
option writer by stock exchange.
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DERIVATIVES
EXAMPLE – 01
Required:-
(ii) Determine the Profit/Loss if the price on maturity is: - 250, 270,
290, 300, 320, 340, 350.
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EXAMPLE – 02
Required:-
(ii) Compute Profit/Loss for Mr. G if the price o n maturity is- ₹ 400,
420, 440, 480, 490, 500, 530.
In the money (ITM), At the money ( ATM ), Out of the money (OTM)
There are two parts of option premium :- Intrinsic value & Time
value (Volatility premium)
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EXAMPLE – 03
State whether each one of the following is In the money, At the money or
Out of the money.
EXAMPLE – 04
(i) Hedgers
- Existing Exposure
- To avoid risk
- Take Long or short position
(ii) Speculators
- No existing exposure
- For making profit on the basis of price expectation.
- Take long or short position
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(iii) Arbitrageurs
- No existing exposure
- For making profit on the basis of mispricing
- They are sophisticated investors & use skill to make profit
- Take long & short position simultaneously
- Loss is not possible
= ∑ Price x probability
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Or
EXAMPLE – 05
EXAMPLE – 06
In this topic, we calculate value of option & compare with market price of
option i.e. premium & decide whether option should be purchased or
not?
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DERIVATIVES
R−d
P =
u−d
E=500
Step – 3 : Binomial Tree
R =10%
Step – 4 : Calculate value of option Now we want to earn more than 500*1.1
Let's say it can be 500*1.2 & 500*0.8 after
- Value of call 1 year
500*1.2
Cup +Cd (1−P)
Co =
R
500
- Value of put
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DERIVATIVES
S (R − d)
500 (1.10 − 0.8) P=
S (u − d)
P=
500 (1.20 − 0.8)
R−d
1.10 − 0.8 P=
P= u−d
1.20 − 0.8
EXAMPLE – 07
Period = 1 year
Price on maturity
EXAMPLE – 08
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Period = 6 months
Price on maturity
EXAMPLE – 09
Period = 3 months
Price on maturity
EXAMPLE – 10
The stock of a company is currently quoted in the market at ₹150. The
price of the stock is expected to go up or down by 10% in next one year
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DERIVATIVES
and by 15% in the second year. The risk-free interest rate in the
economy is 6%.
Required:
Using two-step Binomial Model, find out the price of a 2-year American
put option on the company's stock with strike price of ₹ 170.
EXAMPLE – 11
Period = 1 year
Price on maturity
So + Po = Co + P.V, of EP
Where,
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EXAMPLE – 12
E
Co = So × n(d 1 ) − rt × n(d 2 )
e
Where,
E = Exercise Price
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exercise price
S σ2
Ln o + r + t
E 2
d1 =
σ t
d2 = d1 − σ t
EXAMPLE – 13
Time = 2 years
Rate = 6% p.a.
Calculate
(4) Butterfly
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DERIVATIVES
Straddles
− An Investor expects that wide Volatility in price of underlying asset
in future but he is not sure about movement i.e. price goes up &
goes down hence he creates straddles strategy.
− In straddles, we buy one call option & one put option at same
strike price, on same asset for same maturity period. (Long
straddles)
− If price will rise then we will exercise Call option & Put option will
lapse.
− If price will fall then we will exercise Put option & Call option will
lapse.
EXAMPLE – 14
(iii) Determine the Profit/Loss if the price on maturity is: -550, 600,
650, 700, 750, 800, 850
Strangles
− An investor expect wide volatility in price of share but he is not
sure about direction i.e. price rise or price fall, hence he creates
strangles strategy.
− In strangles, we buy one call option & one put option at different
strike price, on same asset for same maturity period.
− If price will rise then we will exercise call option & put option will
lapse.
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− If price will fall then we will exercise put option & call option will
lapse.
EXAMPLE – 15
Required:-
(iii) Compute the profit/Loss if the price on maturity is- ₹500, 550,
600, 650, 680, 700, 750, 800, 850.
EXAMPLE – 16
1,000 80 25
1,100 55 40
1,200 35 55
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Rate of change in option price with respect to each factor, keeping other
factors constant. This rate of change have been assigned in Greek Letter.
I). DELTA
(i) Delta means rate of change in option price with respect to stock
price. Since call is bullish & put is bearish hence call has positive
delta & put has negative delta.
(ii) If call option is deeply out of the money then delta of call closer to
zero. If call option is deeply in the money then delta of call closer to
1.
(iii) Suppose delta of call 0.4 & Delta of put – 0.6 means.
II). GAMMA
Delta does not move at same rate hence rate of changes in delta with
respect to rate of change in stock price is called Gamma.
III). THETA
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DERIVATIVES
Rate of change in option price with respect to rate & change in time is
called theta.
IV). VEGA
V). RHO
If rate of interest rises then price of call will go up & price of put will go
down.
Future contract is
- Standardized forward contract Standard Lots
- Traded at stock exchange
- With margin requirement
- No counter party default risk
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DERIVATIVES
- Contract to buy
- Upside betting
- Long position
(iv) Counter party default risk (iv) No counter party default risk
- It is difficult to manipulate.
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DERIVATIVES
NUMERICALS
(i) MARGIN
Important Notes
Initial Margin = µ + 3𝜎
µ = Average daily absolute change in price
𝜎 = Standard deviation in price
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DERIVATIVES
As per cost of carry model, Theoretical future price or fair value of future
is calculated as under
If
Suppose
Spot price = ₹ 500
Rate of Interest = 10% p.a.
Period = 1 year
Expected dividend = ₹ 40 at the year-end
(b) If actual price ₹ 550 :- Since actual future price is more than
theoretical future hence future is overpriced.
(c) If actual future price ₹ 505 :- Since actual future price is less
than theoretical future price hence future is under price.
EXAMPLE – 17
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EXAMPLE – 18
EXAMPLE – 19
EXAMPLE – 20
Dividend yield - 6%
CCRRI - 10%
EXAMPLE – 21
E XAMPLE – 22
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EXAMPLE – 23
EXAMPLE – 24
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EXAMPLE – 25
EXAMPLE – 26
EXAMPLE – 27
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20%
Hence Beta of stock = = 2
10%
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DERIVATIVES
Vp × BT − Bp
x=
F × M × Bf
x = No. of contracts
Bp = Beta of portfolio
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DERIVATIVES
Example – 28
(i) Margin
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DERIVATIVES
S.D. of Spot
Hedge Ratio = × r Spot & Market
S.D. of Future
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DERIVATIVES
OPTION
(I) BASICS
QUESTION – 01
The equity share of SSC Ltd. is quoted at ₹310. A three month call option is
available at a premium of ₹8 per share and a three month put option is available
at a premium of ₹ 7 per share.
Ascertain the net payoffs to the option holder of a call option and a put option,
considering that:
(ii) The share price on the exercise day is ₹300, 310, 320, 330 and 340.
Also, indicate the price range at which the call and the put options may be
gainfully exercised.
SOLUTION:-
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DERIVATIVES
The call option can be exercised gainfully for any price above ₹ 328 and put option
for any price below ₹ 313.
QUESTION – 02
Mr. A is holding 1,000 shares of face value of ₹ 100 each of M/s. ABC Ltd. He
wants to hold these shares for long term and have no intention to sell.
On 1st January 2020, M/s. XYZ Ltd. has made short sales of M/s. ABC Ltd.‟s
shares and approached Mr. A to lend his shares under Stock Lending Scheme with
following terms:
(i) Shares to be borrowed for 3 months from 1st January 2020 to 31st March
2020.
(iii) Bank Guarantee will be provided as collateral for the value as on 1st
January 2020.
Other Information :
(b) On 29th February 2020 M/s. ABC Ltd. declared dividend of 25%.
(c) Closing price of M/s. ABC Ltd.‟s shares quoted in Stock Exchange on
various dates are as follows :
(i) Earnings of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total earnings of Mr. A during 1st January 2020 to 31st March 2020 in both
the scenarios,
(iii) What is the profit or loss to M/s. XYZ by shorting the shares using through
Stock Lending Scheme in both the scenarios ?
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DERIVATIVES
SOLUTION:-
Scenario 1 Scenario 2
(i) Earnings of Mr. A through stock lending scheme
Lending fee
31-01-20 1020 × 1% and 980 × 1% 10.20 9.80
29-02-20 1040 × 1% and 960 × 1% 10.40 9.60
31-03-20 1050 × 1% and 940 × 1% 10.50 9.40
Earnings from lending per share (A) 31.10 28.80
Total No. of Shares 1,000 1,000
Total Earnings from lending 31,100 28,800
(ii) Total Earnings of Mr. A during 01-
01-2020 to 31-01-2020
Dividend income per share (B) 25.00 25.00
Total earnings per share (A) + (B) 56.10 53.80
Total No. of Shares 1,000 1,000
Total Earning 56,100 53,800
(iii) Profit or loss to M/s. XYZ
Gain on shortening the shares
(1,000 – 1,050) and (1,000 - 940) (50.00) 60.00
Lending fees paid (31.10) (28.80)
Bank guarantee charges @ 8% (20.00) (20.00)
Gain per share (101.10) 11.20
Total No. of shares 1,000 1,000
Total gain on shortening the shares (1,01,100) 11,200
QUESTION – 03
The equity share of VCC Ltd. is quoted at ₹ 210. A 3-month call option is available
at a premium of ₹ 6 per share and a 3-month put option is available at a premium
of ₹ 5 per share. Ascertain the net payoffs to the option holder of a call option and
a put option separately.
Also indicate the price range at which the call and the put options may be
gainfully exercised.
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SOLUTION:-
(₹)
Share price on exercise day 200 210 220 230 240
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 220 220
Out flow (premium) 6 6 6 6 6
Total Outflow 6 6 6 226 226
Less inflow (Sales proceeds) - - - 230 240
Net payoff -6 -6 -6 4 14
(₹)
Share price on exercise day 200 210 220 230 240
Option exercise Yes Yes No No No
Inflow (Strike price) 220 220 Nil Nil Nil
Less outflow (purchase price) 200 210 - - -
Less outflow (premium) 5 5 5 5 5
Net Payoff 15 5 -5 -5 -5
The call option can be exercised gainfully for any price above ₹ 226
(₹ 220 +₹ 6) and put option for any price below ₹ 215 (₹ 220 −₹ 5).
QUESTION – 04
Identify the profit or loss (ignoring dealing cost and interest) in each of the
following cases:
(a) A call option with an exercise price of ₹ 200 is bought for a premium of ₹ 89.
The price of underlying share is ₹ 276 at the expiry date.
(b) A put option with exercise price of ₹ 250 is bought for a premium of ₹42. The
price of underlying share is ₹189 at the expiry date.
(c) A put option with an exercise price of ₹ 300 is written for a premium of ₹ 57.
The price of the underlying share is ₹ 314 at the expiry date.
SOLUTION:-
(a) Call option is exercised, when price of share is more than ₹ 200. In this
question market price is ₹ 276, hence call option will be exercised.
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(−) Premium = ₹ 89
Loss = ₹ 13
(b) A put option is exercised, when price of share is less than ₹ 250. In this
question market price is ₹ 189, hence put option will be exercised.
(−) Premium = ₹ 42
Profit = ₹ 19
(c) In this question, we write put option at EP ₹ 300. A put option holder will
exercise his option when price of share is less than ₹ 300 but in this
question market price of share ₹ 314, hence put option holder will not
exercise his option.
QUESTION – 05
Equity share of PQR Ltd. is presently quoted at ₹ 320. The Market Price of the
share after 6 months has the following probability distribution:
You are required to find out expected value of option at maturity (i.e. 6 months)
SOLUTION:-
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30
*If the strike price goes beyond Rs. 300, option is not exercised at all.
Incase of put option, since share price is greater than strike price option value
would be zero.
QUESTION – 06
You as an investor had purchased a 4 month call option on the equity shares of X
Ltd. of ₹ 10, of which the current market price is ₹ 132 and the exercise price ₹
150. You expect the price to range between ₹ 120 to ₹ 190. The expected share
price of X Ltd. and related probability is given below:
COMPUTE:
(i) Expected Share price at the end of 4 months.
(ii) Value of Call Option at the end of 4 months, if the exercise price prevails.
(iii) In case the option is held to its maturity, what will be the expected value of
the call option?
SOLUTION:-
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(ii) If price after 4 m = 160.50, value of call = 160.50 − 150 = 10.50. Since
exercise price < market price, call will be exercised.
(iv) Expected pay off = Expected value of the option less option premium. Hence
option premium should be at the most ₹ 13 to make it worthwhile. At ₹ 14,
pay-off is zero and there is indifference,
QUESTION – 07
The Market Price of the share after 6 months has the following probability
distribution.
Options are available with a strike price of ₹200 and expiration 6 months from
now.
(i) What is the Expected value of market price per share?
SOLUTION:-
(170 × 0.05) + (190 × 0.20) + (200 × 0.40) + (220 × 0.20) + (240 × 0.15)
= 358.52
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BINOMIAL MODEL
QUESTION – 08
The current market price of an equity share of Penchant Ltd is ₹ 420. Within a
period of 3 months, the maximum and minimum price of it is expected to be ₹ 500
and ₹ 400 respectively. If the risk free rate of interest be 8% p.a., what should be
the value of a 3 months Call option under the “Risk Neutral” method at the strike
rate of ₹ 450?
SOLUTION:-
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DERIVATIVES
p= 0.2848
QUESTION – 09
Sumana wanted to buy shares of ElL which has a range of ₹ 411 to ₹ 592 a month
later. The present price per share is ₹ 421. Her broker informs her that the price of
this share can sore up to ₹ 522 within a month or so, so that she should buy a
one-month CALL of ElL. In order to be prudent in buying the call, the share price
should be more than or at least ₹ 522 the assurance of which could not be given
by her broker.
Though she understands the uncertainty of the market, she wants to know the
probability of attaining the share price ₹ 592 so that buying of a one-month CALL
of EIL at the execution price of ₹ 522 is justified. Advice her. Take the risk-free
interest to be 3.60% and e0.036 = 1.037.
SOLUTION:-
e rt −d
p =
u−d
e rt = e 0.036
d = 411/421 = 0.976
u = 592/421 = 1.406
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QUESTION – 10 (H.W.)
ABC Ltd. share price as on date is ₹ 200. 6 months from now it is expected that
the share price will be ₹ 178 or the price will be ₹ 214 per share. A call option of
the share can be exercised at the end of six months at exercise price of ₹ 205 per
share. The risk free interest rate is 10% p.a. (i.e. 5% for 6 months). Compute the
value of call option per share.
SOLUTION:-
Step 1: Given
S0 = ₹ 200
214
u = = 1.07
200
178
d = = 0.89
200
E = 205
R = 1.05
R −d 1.05 − 0.89
P = = = 0.889
u −d 1.07 − 0.89
Step 3: Binomial Tree
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QUESTION – 11
A two year tree for a share of stock in ABC Ltd., is as follows:
Consider a two years American call option on the stock of ABC Ltd., with a strike
price of ₹ 98. The current price of the stock is ₹ 100. Risk free return is 5 per cent
per annum with a continuous compounding and e0·05 = 1.05127. Assume two
time periods of one year each.
(ii) Expected pay offs at each nodes i.e. N1, N2 and N3 (round off upto 2 decimal
points).
SOLUTION:-
(i) Using the single period model, the probability of price moving up is
95
R−d 1.05127 − 0.10127
100
P= = 108 95 = = 0.779 say 0.78 i.e. 78%
u−d − 0.13
100 100
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Therefore, the probability of price moving down = 1 – 0.78 = 0.22 i.e. 22%
Node N2
0.78×18.64+0.22×4.60 15.55
= = ₹ 14.79
1.05127 1.05127
Node N3
0.78×4.60+0.22×0 3.588
= = ₹ 3.41
1.05127 1.05127
Node N1
0.78×14.79+0.22×3.41 12.286
= = ₹ 11.69
1.05127 1.05127
QUESTION – 12
Consider a two-year call option with a strike price of ₹ 50 on a stock the current
price of which is also ₹ 50. Assume that there are two-time periods of one year and
in each year the stock price can move up or down by equal percentage of 20%. The
risk-free interest rate is 6%. Using binominal option model, calculate the
probability of price moving up and down. Also draw a two-step binomial tree
showing prices and payoffs at each node.
SOLUTION:-
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DERIVATIVES
The two step Binominal tree showing price and pay off
The value of an American call option at nodes D, E and F will be equal to the value
of European option at these nodes and accordingly the call values at nodes D, E
and F will be 22, 0 and 0 using the single period binomial model the value of call
option at node B is
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DERIVATIVES
QUESTION – 13
Using the Binomial model, calculate the current fair value of a regular call option
on CAB Stock with the following characteristics: X = ₹ 28, Risk Free Rate = 5 %
p.a. (effective). You should also indicate the composition of the implied riskless
hedge portfolio at the valuation date.
SOLUTION:-
r = (1 + 0.05)1/2 = 1.0247
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DERIVATIVES
QUESTION – 14
AB Ltd.'s equity shares are presently selling at a price of ₹500 each. An investor is
interested in purchasing AB Ltd.'s shares. The investor expects that there is a 70%
chance that the price will go up to ₹650 or a 30% chance that it will go down to
₹450, three months from now. There is a call option on the shares of the firm that
can be exercised only at the end of three months at an exercise price of ₹550.
(i) If the investor wants a perfect hedge, what combination of the share and
option should he select?
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DERIVATIVES
(ii) Explain how the investor will be able to maintain identical position
regardless of the share price.
(iii) If the risk-free rate of return is 5% for the three months period, what is the
value of the option at the beginning of the period?
SOLUTION:-
(i) To compute perfect hedge we shall compute hedge ratio (∆) as follows:
C 1 −C 2 100−0 100
∆= = = = 0.50
S 1 −S 2 650−450 200
The investor should purchase 0.50 share for every 1 call option
Or, the investor should purchase 1 share for every 2 call option.
(ii) How the investor will be able to maintain his position if he purchase 0.50
share for 1 call option written.
(a) If price of share goes upto₹ 650 then value of purchased share will be :
₹ 225
(b) If price of share comes down to ₹ 450 then value of purchased share
will be :
(iii) The value of option, say, P at the beginning of the period shall be computed
as follows:
₹ 37.5 = 1.05
P = ₹ 35.71
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DERIVATIVES
70−35.71
Expected Rate of Return = × 100 = 96.02%
35.71
QUESTION – 15
Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are
currently selling at ₹ 600 each. He expects that price of share may go upto₹ 780 or
may go down to ₹ 480 in three months. The chances of occurring such variations
are 60% and 40% respectively. A call option on the shares of ABC Ltd. can be
exercised at the end of three months with a strike price of ₹ 630.
(i) What combination of share and option should Mr. Dayal select if he wants a
perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10% p.a.)?
SOLUTION:-
(i) To compute perfect hedge we shall compute Hedge Ratio (Δ) as follows:
C 1 −C 2 150−0 150
∆= = = = 0.50
S 1 −S 2 780−480 300
Mr. Dayal should purchase 0.50 share for every 1 call option.
If price of share comes out to be ₹780 then value of purchased share will be:
₹240
If price of share comes out to be ₹480 then value of purchased share will be:
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DERIVATIVES
P = ₹ 65.85
90−65.85
Expected Rate of Return = × 100 = 36.67%
65.85
QUESTION – 16
The following quotes are available for 3 months options in respect of a share of P
Ltd. which is currently traded at ₹ 310 :
Call option ₹ 30
Put option ₹ 20
An investor devises a strategy of buying a call and selling the share and a put
option.
(i) Draw his profit/loss profile if it is given that the rate of interest is 10% per
annum.
(ii) What would be the position if the strategy adopted is selling a call and
buying the put and the share? (e0.025 = 1.0253; e0.25 = 1.2840)
SOLUTION:-
P = C+ X e-rt– S
S + p = C + X e-rt
Here,
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DERIVATIVES
S = Spot price
X = Ex. Price
Since LHS is not equal to RHS and the difference is ₹ 330 - ₹ 322.68
= ₹ 7.40
From the put-call parity equation we can see that it is equivalent to;
(ii) If the investor would adopt by selling a call and buying the share and put
option, then the Put-Call Parity Equation would be equivalent to –C + S + P
= X e-rt.The result of net cash outflow (initial payoff) :
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DERIVATIVES
This strategy would not adopted, since the initial payoff is negative.
QUESTION – 17
From the following data for certain stock, find the value of a call option:
Exercise price = ₹ 75
Given
Number of S.D. from Mean, (z) Area of the left or right (one tail) 0.25
0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e0.12×0.5 = 1.062
In 1.0667 = 0.0646
SOLUTION:-
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DERIVATIVES
S
In +(r+σ2 /2)t
K
d1 =
σ t
d2 = d1−σ t
Where,
e = exponential term
In = natural logarithm
N(d1) = N (0.5820)
N(d2) = N (0.2992)
Value of option
75
= 80 N(d1) −
1.062 × N(d2)
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DERIVATIVES
75
Price = 80 × 0.7197 - × 0.6176
1.062
= 57.57 – 70.62 × 0.6176
Teaching Notes:
Values of N(d1) and N(d2) have been computed by interpolating the values of areas
under respective numbers of SD from Mean (Z) given in the question.
It may also be possible that in question paper areas under Z may be mentioned
otherwise e.g. Cumulative Area or Area under Two tails. In such situation the
areas of the respective Zs given in the question will be as follows:
Cumulative Area
Number of S.D. from Mean, (z) Area of the left and right (two tail)
0.25 0.8026
0.30 0.7642
0.55 0.5823
0.60 0.5485
QUESTION – 18
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DERIVATIVES
(Practice Manual)
SOLUTION:-
S σ2
In +(r+ )t
E 2
d1 =
σ t
185 0.18 2
In +(0.07+ )3
170 2
=
0.18 3
In 1.0882 +(0.07+0.0162 )3
=
0.18 3
0.08452 +0.2586
=
0.18 3
0.34312
=
0.31177
d1 = 1.1006
d2 = d1 - σ t
N(d2) = 0.7848
E
Value of option = Vs N(d1) − rt N(d2)
e
170
= 185 (0.8644) − 0.21 (0.7848)
e
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DERIVATIVES
170
= 159.914 −
1.2336 × 0.7848
= 159.91 – 108.15 = ₹ 51.76
QUESTION – 19
(a) To value a July, 2004 call option with strike price ₹ 15, trading on the
board options exchange on the same day for ₹ 2, the following are the
other parameter ₹ of the options:
(ii) The option expiration date is Friday july 23 rd 2004, there are 103
days to expiration days (year=365 days) and annualized treasury
bill rate corresponding to this option is 4.63%
(iii) The value using normal distribution on N(d1)= 0.5085 and N(d2)
was 0.3412
SOLUTION:-
15
= 6.926 – × 0.3412
1.0131
= ₹1.87
2 Premium amount (₹2) is more than value of call (₹1.87) hence it is
overpriced & should net be purchased.
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QUESTION – 20
The Ferguson system was trading at ₹ 134 on april 3, 2009 and call option
exercisable in three months‟ time had a strike price of ₹ 130.
(i) The annualized standard deviation in Ferguson system stock price over the
previous year was 60%
(ii) The annualized Treasury bill rate corresponding to this option life is 8%.
Requirements:
(i) Compute the value of a three month Call option on the stock of Ferguson
System using Black and Scholes Model.
(iii) If this call option is priced at ₹ 15 what investment strategy would you
adopt?
(iv) If this put option is available in the market at ₹ 14 what investment strategy
would you adopt?
N(−0.0177) = 0.4929
SOLUTION:-
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DERIVATIVES
T = 0.25 year
Vs
In E +[r+0.5σ 2 ]×t
d1 =
σ t
In(134/130)+[0.08+0.5×0.6 2 ]×0.25
=
0.6 0.25
In(1.0308)+0.065
=
0.3
0.0303 + 0.065
= = 0.3177
0.3
Thus,
Where,
= ₹ 19.08
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QUESTION – 21
The shares of TIC Ltd. are currently priced at ₹ 415 and call option
exercisable in three months‟ time has an exercise rate of ₹ 400. Risk free
interest rate is 5% p.a. and standard deviation (volatility) of share price is
22%.
(i) Based on the assumption that TIC Ltd. is not going to declare any
dividend over the next three months, is the option worth buying for ₹
25?
(iii) What would be the worth of put option if current price is considered ₹
380.
(iv) If TIC Ltd. share price at present is taken as ₹ 408 and a dividend of ₹
10 is expected to be paid in the two months time, then, calculate value
of the call option.
SOLUTION:-
415 1
In + .05 + (.22)2 .25 .03681 +.01855
400 2
d1 = = = .5032727
.22 .25 .11
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DERIVATIVES
415 1
In + .05+ (.22)2 .25 .03681 +.00645
400 2
d2 = = = .3932727
.22 .25 .11
400
Value of Option = 415 (.6928) − .05 .25 (.6529)
e
400
= 287.512 − (.6529)
1.012578
Step 1 : From table of area under normal curve find the area of variable
0.39 i.e. 0.6517.
Step 2 : From table of area under normal curve find the area of variable
0.40.
Step 3 : Find out the difference between above two variables and areas
under normal curve.
Step 4 : Using interpolation method find out the value of 0.00327. Which
is as follows :
0.0037
× 0.00327 = 0.0012
0.01
Stap5 : Add this value, computed above to the N(0.39). Thus N (039327)
Since market price of ₹25 is less than ₹27.60 (Block Scholes Valuation
Modal indicate that option is underpriced, hence worth buying.
(ii) If the current price is taken as ₹380 the computations are as follows :
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380 1
In + .05 + (.22)2 .25
400 2
d1 =
.22 .25
−0.05129 +0.1855
= = − 0.297636
.11
380 1
In + .05 − (.22)2 .25
400 2
d2 =
.22 .25
−0.05129 + .00645
= = − 0.407666
.11
E
V0 = VSN (d1) − rt N(d2)
e
N(d1) = N (−0.297363) = .3830
400
380 (.3830) − .05 (.25) × (.3418)
e
400
145.54 - (.3418) = 145.54 – 138.4397 = ₹ 7.10 10.52
1.012578
(iii) Value of call option = ₹ 7.10
400
Present Value of Exercise Price = = 395.06
1.0125
Vp = − VS + VS + PV (E)
(iv) Since dividend is expected to be paid in two months time we have to adjust
the share price and then use Block Scholes Model to value the option:
= Dividend × e-rt
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= ₹ 10 × e−.05 × .1666
= ₹ 10 × e−.008333
398 .083 1
In + .05 + (.22)2 .25
400 2
d1 =
.22 .25
−.00480 + .01855
= = .125
.11
398 .083 1
In + .05− (.22)2 .25
400 2
d2 =
.22 .25
−.00480 + .00645
= = .015
.11
N(d1) = N(0.125) = 0.5498
400
Value of option = 398.083 (0.5498) − (0.5060)
e 0.05 (0.25)
400
= 218.866 − 0.0125 (0.5060)
e
400
= 218.866 − (0.5060)
1.012578
= 218.866 – 199.8858 = ₹ 18.98
QUESTION – 22
Following information is available for TIC Company‟s shares and Call option:
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SOLUTION:-
415 1
In + .05 + (.22)2 .25 .03681 +.01855
400 2
d1 = = = .5032727
.22 .25 .11
415 1
In + .05+ (.22)2 .25 .03681 +.00645
400 2
d2 = = = .3932727
.22 .25 .11
400
Value of Option = 415 (.6928) − .05 .25 (.6529)
e
400
= 287.512 − (.6529)
1.012578
Step 1 : From table of area under normal curve find the area of variable
0.39 i.e. 0.6517.
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Step 2 : From table of area under normal curve find the area of variable
0.40.
Step 3 : Find out the difference between above two variables and areas
under normal curve.
Step 4 : Using interpolation method find out the value of 0.00327. Which
is as follows :
0.0037
× 0.00327 = 0.0012
0.01
Stap5 : Add this value, computed above to the N(0.39). Thus N (039327)
Since market price of ₹25 is less than ₹27.60 (Block Scholes Valuation
Modal indicate that option is underpriced, hence worth buying.
QUESTION – 23
Mr. P established the following spread on the Coastal Corporation‟s stock:
(i) Purchased one 3-month call option with a premium of ₹ 6.5 and an Exercise
price of ₹ 110.
(ii) Purchased one 3-month put option with a premium of ₹ 10 and an Exercise
price of ₹ 90.
(iii) Rises to ₹ 138 after 3 months. Assume the size of option is 1,000 shares of
Coastal Corporation.
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SOLUTION:-
In this case, Mr. P exercises neither the call option nor the put option as
both will result in a loss for him.
(ii) Since the price of the stock is below the exercise price of the call, the call will
not be exercised. Only put is valuable and is exercised.
(iii) In this situation, the put is worthless, since the price of the stock exceeds
the put‟s exercise price. Only call option is valuable and is exercised.
QUESTION – 24
(1) Purchased one 3-month call option with a premium of ₹ 30 and an exercise
price of ₹ 550.
(2) Purchased one 3-month put option with a premium of ₹ 5 and an exercise
price of ₹ 450.
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SOLUTION:-
(ii) Since the price of the stock is below the exercise price of the call, the call will
not be exercised. Only put is valuable and is exercised.
(iii) In this situation, the put is worthless, since the price of the stock exceeds
the put‟s exercise price. Only call option is valuable and is exercised.
QUESTION – 25
Mr. John established the following spread on the TTK Ltd.'s stock:
(i) Purchased one 3-month put option with a premium of ₹15 and an exercise
price of ₹ 900.
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DERIVATIVES
(ii) Purchased one 3-month call option with a premium of ₹ 90 and an exercise
price of₹1100.
TTK Ltd.'s stock is currently selling) at ₹1000. Calculate gain or loss, if the price of
stock of TTK Ltd. –
SOLUTION:-
In this case, Mr. John exercises neither the call option nor the put option as
both will result in a loss for him.
(ii) Since the price of the stock is below the exercise price of the call, the call will
not be exercised. Only put is valuable and is exercised.
(iii) In this situation, the put is worthless, since the price of the stock exceeds
the put‟s exercise price. Only call option is valuable and is exercised.
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DERIVATIVES
QUESTION – 26
Mr. KK purchased a 3-month call option for 100 shares in PQR Ltd. at a premium
of₹40 per share, with an exercise price of ₹560. He also purchased a 3-month put
option for 100 shares of the same company at a premium of ₹10 per share with an
exercise price of ₹460. The market price of the share on the date of Mr. KK's
purchase of options, is ₹500. Compute the profit or loss that Mr. KK would make
assuming that the market price falls to ₹360 at the end of 3 months.
SOLUTION:-
Since the market price at the end of 3 months falls to ₹ 360 which is below the
exercise price under the call option, the call option will not be exercised. Only put
option becomes viable.
(₹)
The gain will be :
Gain per share (₹ 460 −₹ 360) 100
Total gain per 100 shares 10,000
Cost or premium paid (₹ 40 × 100) + (₹ 10 × 100) 5,000
Net gain 5,000
QUESTION – 27
Mr. A purchased a 3 month call option for 100 shares in XYZ Ltd. at a premium of
₹ 30 per share, with an exercise price of ₹ 550. He also purchased a 3 month put
option for 100 shares of the same company at a premium of ₹ 5 per share with an
exercise price of ₹ 450. The market price of the share on the date of Mr. A‟s
purchase of options, is ₹ 500. Calculate the profit or loss that Mr. A would make
assuming that the market price falls to ₹ 350 at the end of 3 months.
SOLUTION:-
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DERIVATIVES
Since the market price at the end of 3 months falls to ₹ 350 which is below the
exercise price under the call option, the call option will not be exercised. Only put
option becomes viable.
₹
The gain will be:
Gain per share (₹ 450 – ₹ 350) 100
Total gain per 100 shares 10,000
Cost or premium paid (₹ 30 × 100) + (₹ 5 × 100) 3,500
Net gain 6,500
QUESTION – 28
The market received rumour about ABC corporation‟s tie-up with a multinational
company. This has induced the market price to move up. If the rumour is false,
the ABC corporation stock price will probably fall dramatically. To protect from
this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of ₹ 42 for ₹ 2 premium, and
paid Re.1 per share premium for a 3 months put with a striking price of ` 40.
(i) Determine the Investor‟s position if the tie up offer bids the price of ABC
Corporation‟s stock up to ₹ 43 in 3 months.
(ii) Determine the Investor‟s ending position, if the tie up program me fails and
the price of the stocks falls to ₹ 36 in 3 months.
SOLUTION:-
= (₹ 2 per share) × (100 share call) + (₹ 1 per share) × (100 share put)
(i) Price increases to ₹ 43. Since the market price is higher than the strike price
of the call, the investor will exercise it.
Ending position
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DERIVATIVES
(ii) The price of the stock falls to ₹ 36. Since the market price is lower than the
strike price, the investor may not exercise the call option.
Ending Position
= −₹ 300 + 400
Gain = ₹ 100
QUESTION – 29
A call and put exist on the same stock each of which is exercisable at ₹ 60. They
now trade for:
Calculate the expiration date cash flow, investment value, and net profit from:
for expiration date stock prices of ₹ 50, ₹ 55, ₹ 60, ₹ 65, ₹ 70.
(Practice Manual)
SOLUTION:-
Stock Price ₹ 50 ₹ 55 ₹ 60 ₹ 65 ₹ 70
Buy 1.0 call 0 0 0 -60 -60
Write 1.0 call 0 0 0 60 60
Buy 1.0 put 60 60 0 0 0
Write 1.0 put -60 -60 0 0 0
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Stock Price ₹ 50 ₹ 55 ₹ 60 ₹ 65 ₹ 70
Buy 1.0 call 0 0 0 5 10
Write 1.0 call 0 0 0 -5 -10
Buy 1.0 put 10 5 0 0 0
Write 1.0 put -10 -5 0 0 0
Stock Price ₹ 50 ₹ 55 ₹ 60 ₹ 65 ₹ 70
Buy 1.0 call -9 -9 -9 -4 1
Write 1.0 call 9 9 9 4 -1
Buy 1.0 put 9 4 -1 -1 -1
Write 1.0 put -9 -4 1 1 1
QUESTION – 30
Fresh Bakery Ltd.‟s share price has suddenly started moving both upward and
downward on a rumour that the company is going to have a collaboration
agreement with a multinational company in bakery business. If the rumour turns
to be true, then the stock price will go up but if the rumour turns to be false, then
the market price of the share will crash. To protect from this an investor has
purchased the following call and put option:
a) One 3 months call with a striking price of ₹ 52 for ₹ 2 premium per share.
b) One 3 months put with a striking price of ₹ 50 for ₹ 1 premium per share.
(i) The investor‟s position, if the collaboration agreement push the share price
to ₹ 53 in 3 months.
(ii) The investor‟s ending position, if the collaboration agreement fails and the
price crashes to ₹ 46 in 3 months time.
SOLUTION:-
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= (₹ 2 per share) × (50 share call) + (₹ 1 per share) × (50 share put)
= ₹ 2 × 50 + 1 × 50
= ₹ 150
(i) Price increases to ₹ 53. Since the market price is higher than the strike price
of the call, the investor will exercise it.
Ending position
= −₹ 150 + 50
(ii) The price of the stock falls to ₹46. Since the market price is lower than the
strike price, the investor may not exercise the call option.
Ending Position
Gain = ₹50
QUESTION – 31
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DERIVATIVES
Ram is interested in selling his stock holding as he cannot afford to lose more than
5% of its value.
Recommend a hedging strategy with option and show how his position will be
protected.
SOLUTION:-
Instead of selling the stock of Reliance Ltd., Ram must cover his Risk by buying or
long position in Put Option with appropriate strike price. Since Ram‟s risk appetite
is 5%, the most suitable strike price in Put Option shall be ₹ 950 (₹ 1000 – 5% of ₹
1000). If Ram does s, the overall position will be as follows:
Thus, from the above, it can be seen that the value of holding of Ram shall never
be less than ₹ 942 as Put Option will compensate for loss below spot price of ₹
950.
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FUTURE
QUESTION – 32
On 31/08/2021 Mr. R has taken a Long position of Two lots of Nifty Futures at
17300.
(i) Prepare a statement showing the daily balances in the margin account &
payment on margin calls, if any.
(ii) Compute the Gain or Loss of Mr. R, if contract squared off on 07/09/2021.
(iii) What would be the Gain or Loss if Mr. R, had taken the short position?
SOLUTION:-
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Statement showing the daily balances in Margin A/c and margin call if any,
(₹)
Ending margin 1,95,000
Less: Initial margin 1,73,000
Profit 22,000
Less: Margin call 40,000
Net Loss (18,000)
(₹)
Ending margin 1,91,000
Less: Initial margin 1,73,000
Profit 18,000
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DERIVATIVES
QUESTION – 33
The price of March Nifty Futures Contract on a particular day was 9170. The
minimum trading lot on Nifty Futures is 50. The initial margin is 8 and the
maintenance margin is 6%. The index closed at the following levels on next five
days:
Day 1 2 3 4 5
(i) Mark to market cash flows and daily closing balances on account of
SOLUTION:-
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QUESTION – 34
Sensex futures are traded at a multiple of 50. Consider the following quotations of
Sensex futures in the 10 trading days during February, 2009:
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DERIVATIVES
Abhishek bought one sensex futures contract on February, 04. The average daily
absolute change in the value of contract is ₹ 10,000 and standard deviation of
these changes is ₹ 2,000. The maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and
payment on margin calls, if any.
SOLUTION:-
Initial Margin = µ + 3σ
σ = Standard Deviation
Accordingly
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QUESTION – 35
SOLUTION:-
Anand Ltd
= ₹ 1,908
The arbitrageur can borrow money @ 12 % for 6 months and buy the shares
at ₹ 1,800. At the same time he can sell the shares in the futures market at
₹ 1,950. On the expiry date 6 months later, he could deliver the share and
collect ₹ 1,950 pay off ₹ 1,908 and record a profit of ₹ 42 (₹ 1,950 – ₹ 1,908)
QUESTION – 36
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(i) advise the justified theoretical price of a 6-months forward purchase; and
SOLUTION:-
(i) The justified theoretical price of a 6 months forward contract as per cost to
carry model is as follows:
= ₹ 1,995
(ii) Arbitrage Opportunity - Since current future price is ₹ 2050, yes there is an
opportunity for carrying arbitrage profit. The arbitrageur can borrow money
@ 10 % for 6 months and buy the shares at ₹ 1,900. At the same time he
can sell the shares in the futures market at ₹ 2,050. On the expiry date 6
months later, he could deliver the share and collect ₹ 2,050 pay off ₹ 1,995
and record a risk –less profit of ₹ 55 (₹ 2,050 – ₹ 1,995).
QUESTION – 37
Calculate the price of 3 months PQR futures, if PQR (FV ₹10) quotes ₹ 220 on NSE
and the three months future price quotes at ₹ 230 and the one month borrowing
rate is given as 15 percent per annum and the expected annual dividend is 25
percent, payable before expiry. Also examine arbitrage opportunities.
SOLUTION:-
Thus, we see that futures price by calculation is ₹ 225.75 which is quoted at ₹ 230
in the exchange.
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DERIVATIVES
(i) Analysis:
Step I
He will buy PQR Stock at ₹ 220 by borrowing at 15% for 3 months. Therefore, his
outflows are:
Step II
He will sell March 2000 futures at ₹ 230. Meanwhile he would receive dividend for
his stock.
QUESTION – 38
The share of X Ltd. is currently selling for ₹ 300. Risk free interest rate is 0.8% per
month. A three month futures contract is selling for ₹ 312. Develop an arbitrage
strategy and show what your riskless profit will be 3 months hence assuming that
X Ltd. will not pay any dividend in the next three months.
SOLUTION:-
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DERIVATIVES
Fo = ₹ 300(1.008)3 = ₹ 307.26
Since the futures price exceeds its appropriate value it pays to do the following:-
Total ₹0 ₹4.74
QUESTION – 39
The 6-months forward price of a security is ₹ 208.18. The borrowing rate is 8% per
annum payable with monthly rests. What should be the spot price?
SOLUTION:-
Where
A = Forward price
P = Spot Price
r = rate of interest
n = no. of compounding
t = time
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DERIVATIVES
208.18 = P (1 + 0.08/12)6
Or 208.18 = P × 1.0409
P = 208.18/1.0409 = 200
QUESTION – 40
On 31-8-2011, the value of stock index was ₹ 2,200. The risk free rate of return
has been 8% per annum. The dividend yield on this Stock Index is as under:
Assuming that interest is continuously compounded daily, find out the future
price of contract deliverable on 31-12-2011. Given: e0.01583 = 1.01593
SOLUTION:-
The duration of future contract is 4 months. The average yield during this period
will be:
3%+3%+4%+3%
= 3.25%
4
As per Cost to Carry model the future price will be
F = Se(rf-D)t
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D = Dividend Yield
t = Time Period
QUESTION – 41
The NSE-50 Index futures are traded with rupee value being ₹100 per index point.
On 15th September, the index closed at 1195, and December futures (last trading
day December 15) were trading at 1225. The historical dividend yield on the index
has been 3% per annum and the borrowing rate was 9.5% per annum.
(i) Determine whether on September 15, the December futures were under-
priced or overpriced?
(iii) Calculate the gains and losses if the index on 15thDecember closes at (a)
1260 (b) 1175.
SOLUTION:-
91
(i) Current price of December future = ₹ 100[1195 + 1195(0.095 – 0.03) ]
365
= ₹ 100[1195 + 19.37]
= ₹ 1,21,437
(ii) Since the actual future is overpriced, the cash and carry arbitrage is
possible i.e. sell the future contract and borrow to buy the stock.
(iii) September-15
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DERIVATIVES
QUESTION – 42
Suppose current price of an index is ₹ 13,800 and yield on index is 4.8% (p.a.). A 6
months future contract on index is trading at ₹ 14,340.
Assuming that risk free rate of interest is 12%. Show Mr. X (an arbitrageur) can
earn an abnormal rate of return irrespective of outcome after 6 months . You can
assume that after 6 months index closes at ₹ 10,200 and ₹ 15,600 and 50% of
stock included in index shall pay dividend in next 6 months. Also Calculate
implied risk free rate.
SOLUTION:-
The fair price of the index future contract can calculated as follows:
6
6 FC = 13,800 + [(13,800 × 0.12 × 12 – 13,800 × 4.8% × 0.50)]
1. Mr. X shall buy a portfolio which comprising of shares as index consisted of.
₹
Profit from short position of futures (₹ 14,340 −₹ 10,200) 4,140.00
Cash dividend on portfolio (₹ 13,800 × 4.8% × 0.5) 331.20
Loss on sale of portfolio (₹ 10,200 −₹ 13,800) (3,600.00)
871.20
₹
Loss from short position in futures. ((₹ 14,340 −₹ 15,600) (1,260.00)
Cash dividend on portfolio 331.20
Profit on sale of underlying portfolio (₹ 15,600 - ₹ 13,800) 1,800.00
871.20
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DERIVATIVES
871.20
6 months return = × 100 = 6.31%
13,800
Annualized return = 6.31 × 2 = 12.63%
QUESTION – 43
Required:
(i) Given the above information, what should the price of one future contract
be?
(ii) If the company stock price decreases by 6%, what will be the price of one
futures contract?
(iii) As a result of the company stock price decrease, will an investor that has
a long position in one futures contract of R Ltd. realizes a gain or loss ?
What will be the amount of his gain or loss?
SOLUTION:-
(iii) If the investor has taken a long position, decrease in price will result in loss
for the investor.
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QUESTION – 44
The cost of capital for the investor is 20% p.a. continuously compounded. The
investor fears a fall in the prices of the shares in the near future. Accordingly, he
approaches you for the advice to protect the interest of his portfolio.
(3) Futures for May are currently quoted at 8700 and Futures for June are
being quoted at 8850.
(ii) The theoretical value of the futures contract for contracts expiring in May
and June. Given (e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
(iii) The number of NIFTY contracts that he would have to sell if he desires to
hedge until June in each of the following cases:
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DERIVATIVES
SOLUTION:-
10,95,832.30
Portfolio Beta = = 1.102
9,94,450
F = Sert
2
FMay = 8,500× e0.20×(12) = 8500 × e0.0333
e0.03 = 1.03045
e0.04 = 1.04081
e0.01 = 0.01036
e0.0033 = 0.00342
e0.0067 = 0.00694
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DERIVATIVES
3
FMay = 8,500 × e0.20×(12)
= 8,500 × e0.05
9,94,450
× 1.102 = 4.953 say 5 contracts
8,850×25
9,94,450 × 0.50
× 1.102 = 2.47 say 3 contracts
8,850×25
9,94,450 × 1.20
× 1.102 = 5.94 say 6 contracts
8,850×25
QUESTION – 45
The investor thinks that the risk of portfolio is very high and wants to reduce the
portfolio beta to 0.91. He is considering two below mentioned alternative
strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
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DERIVATIVES
(ii) Take appropriate position on Nifty Futures which are currently traded at
8125 and each Nifty points is worth ₹ 200.
SOLUTION:-
Let the proportion of risk free securities for target beta 0.91 = p
0.91 = 0 × p + 1.30 (1 – p)
Shares to be disposed off to reduce beta (5000 × 30%) ₹ 1,500 lakh and Risk
Free securities to be acquired.
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DERIVATIVES
(5) 2% rises in Nifty is accompanied by 2% × 1.30 i.e. 2.6% rise for portfolio of
shares
₹ lakhs
Current Value of Portfolio of Shares 5000
Value of Portfolio after rise 5130
Mark-to-Market Margin paid (8125 × 0.020 ×₹ 200 × 120) 39
Value of the portfolio after rise of Nifty 5091
% change in value of portfolio (5091 – 5000)/ 5000 1.82%
% rise in the value of Nifty 2%
Beta 0.91
QUESTION – 46
The CEO is of opinion that the portfolio is carrying a very high risk as compared to
the market risk and hence interested to reduce the portfolio‟s systematic risk to
0.95. Treasury Manager has suggested two below mentioned alternative strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures, currently trading at 8250 and
each Nifty points multiplier is ₹ 210.
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DERIVATIVES
(e) Advise the position to be taken in Nifty Futures and determine the number
of Nifty contracts to be bought/sold; and
(f) Calculate the new systematic risk of portfolio if the company has taken
position in Nifty Futures and there is 2% rise in Nifty.
SOLUTION:-
(a) Yes, the apprehension of CEO is correct as the current portfolio is more
riskier than market as the beta (Systematic Risk) of market portfolio is as
computed as follows:
(b) Since the Beta of existing portfolio is 1.40, the systematic risk of the current
portfolio is 1.40.
0.95 = 0 × p + 1.40 (1 – p)
Shares to be disposed off to reduce beta (20000 × 32%) ₹ 6,400 lakh and
Risk Free securities to be acquired for the same amount.
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DERIVATIVES
(e) Since, the company is in long position in cash market it shall take short
position in Future Market.
(f) If there is 2% rises in Nifty there will be 2.80% (2% × 1.40) rise for portfolio
of shares
₹ Lakh
Current Value of Portfolio of Shares 20000
Value of Portfolio after rise 20560
Mark-to-Market Margin paid (8250 × 0.020 ×₹ 210 × 519) 179.83
Value of the portfolio after rise of Nifty 20380.17
% change in value of portfolio (20380.17 – 20000)/ 20000 1.90%
% rise in the value of Nifty 2%
New Systematic Risk (Beta) 0.95
QUESTION – 47
(ii) The theoretical value of the NIFTY futures for February 2013.
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DERIVATIVES
(iii) The number of contracts of NIFTY the investor needs to sell to get a full
hedge until February for his portfolio if the current value of NIFTY is 5900
and NIFTY futures have a minimum trade lot requirement of 200 units.
Assume that the futures are trading at their fair value.
(iv) The number of future contracts the investor should trade if he desires to
reduce the beta of his portfolios to 0.6.
SOLUTION:-
Further F = Sert
F = ₹ 5,900 e(0.0998)(0.1589)
F = ₹ 5,900 e0.015858
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DERIVATIVES
= ₹ 5900 e0.01668
P(βP −βP )
Number of contracts to be sold =
F
1,88,54,860(0.849−0.600)
= = 3.92 contracts say 4 contracts
5994.28×200
QUESTION – 48
(ii) Suppose after 28 days of the purchase of the contract the index value stands
at 2450 then determine gain/ loss on the above long position.
(iii) If at expiration of 90 days the Index Value is 2470 then what will be gain on
long position.
Note: Take 365 days in a year and value of e0.005942= 1.005960, e0.001849 =
1.001851.
SOLUTION:-
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DERIVATIVES
Where
S0 = Spot price
n = period
y = dividend yield
Accordingly,
= 2290 e0.005942
= 2290(1.005960)
=2303.65
=2450 − 2290(e0.001849)
= 2450 − 2290(1.001851)
= 2450 − 2294.24
= 155.76
= Sn – S0en(r – y)
QUESTION – 49
The price of ACC stock on 31 December 2010 was ₹ 220 and the futures price on
the same stock on the same date, i.e., 31 December 2010 for March 2011 was ₹
230. Other features of the contract and related information are as follows:
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DERIVATIVES
SOLUTION:-
ii. He will buy the ACC stock at ₹ 220 by borrowing the amount @ 15 % for a
period of 3 months and at the same time sell the March 2011 futures on
ACC stock. By 31st March 2011, he will receive the dividend of ₹ 2.50 per
share. On the expiry date of 31st March, he will deliver the ACC stock
against the March futures contract sales.
Thus, the arbitrage earns ₹ 4.25 per share without involving any risk.
QUESTION – 50
Mr. Careless was employed with ABC Portfolio Consultants. The work profile of Mr.
Careless involves advising the clients about taking position in Future Market to
obtain hedge in the position they are holding. Mr. ZZZ, their regular client
purchased 100,000 shares of X Inc. at a price of $22 and sold 50,000 shares of A
plc for $40 each having beta 2. Mr. Careless advised Mr. ZZZ to take short position
in Index Future trading at $1,000 each contract.
Though Mr. Careless noted the name of A plc along with its beta value during
discussion with Mr. ZZZ but forgot to record the beta value of X Inc.
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DERIVATIVES
Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due to the
position taken. Since record of Mr. Careless was incomplete he approached you to
help him to find the number of contract of Future contract he advised Mr. ZZZ to
be short to obtain a complete hedge and beta value of X Inc.
SOLUTION:-
Let the no. of contract in index future be y and Beta of X Inc. be x. Then,
1,00,000 × 22 × x −50,000 × 40 × 2
= -y*
1,000
* Negative (-) sign indicates the indicates inflow due to sale (short) position
Cash Inflow
* Negative (-) sign indicates the indicates outflow due to purchase (long) position
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DERIVATIVES
y = 700
22,00,000x = 33,00,000
x = 1.5
QUESTION – 51
We assume that a future contract on the BSE index with 4 months maturity is
used to hedge the value of portfolio over next 3 months. One future contract is for
delivery of 50 times the index.
(ii) Gain on short futures position if index turns out to be 22,500 in 3 months.
SOLUTION:-
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DERIVATIVES
4
(i) Current future price of the index = 25000 + 25000 (0.09 − 0.06) 12
50,50,000
(ii) Hedge Ratio = × 1.5 = 6 contracts
12,62,500
1
Future price will be = 22500 + 22500 (0.09 − 0.06) ×
12
= 22556.25
= 6 × (25250 – 22556.25) × 50
= ₹ 8,08,125
QUESTION – 52
An investor buys a NIFTY futures contract for ₹ 2,80,000 (lot size 200 futures). On
the settlement date, the NIFTY closes at 1,378. Find out his profit or loss, if he
pays ₹ 1,000 as brokerage. What would be the amount of profit or loss, if he has
sold the futures contract.
SOLUTION:-
280000
Price per nifty = = 1400
200
Investor buys nifty means take long position of nifty at 1400
If on settlement date, the nifty classes at 1878, then loss on long position of nifty.
= (₹ 5400)
If Investor has sold nifty i-e took short position of nifty at 1400
On settlement date, the nifty classes at 1378 then profit on short position of nifty
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QUESTION – 53
BSE 5000
We assume that a future contract on the BSE index with four months maturity is
used to hedge the value of portfolio over next three months. One future contract is
for delivery of 50 times the index.
(ii) The gain on short futures position if index turns out to be 4,500 in three
months.
SOLUTION:-
= ₹ 50 × 5,050 = ₹ 2,52,500
10,10,000
(ii) Hedge ratio = × 1.5 = 6 contracts
2,52,500
Index after there months turns out to be 4,500
1
Future price will be = 4,500 + 4,500 (0.09 − 0.06) × 12 = 4,511.25
= 6 × (5050 – 4511.25) × 50
= ₹ 1,61,625
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QUESTION – 54
Mr. SG sold five 4-Month Nifty Futures on 1st February 2020 for ₹ 9,00,000. At the
time of closing of trading on the last Thursday of May 2020 (expiry), Index turned
out to be 2100. The contract multiplier is 75.
(ii) Approximate Nifty Sensex on 1st February 2020 if the Price of Future
Contract on same date was theoretically correct. On the same day Risk Free
Rate of Interest and Dividend Yield on Index was 9% and 6% p.a.
respectively.
SOLUTION:-
₹9,00,000
5 =
X
X (Price One Future Contract) = ₹ 1,80,000
₹ 1,80,000
(ii) Current future price of the index = = 2400
75
Let Y be the current Nifty Index (on 1st February 2020) then
Accordingly,
4
Y + Y (0.09 – 0.06) = 2400
12
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DERIVATIVES
2400
And Y = = 2376.24
1.01
Hence Nifty Index on 1st February 2020 shall be approximately 2376.
Since current Spot Price is 2400 and Nifty Index is 2376, the Basis is
negative and hence there is Contango Market and maximum Contango shall
be 24 (2400 – 2376).
(iv) Pay off on the Future transaction shall be [(2400-2100) × 375] ₹ 112500 The
Future seller gains if the Spot Price is less than Futures Contract price as
position shall be reversed at same Spot price. Therefore, Mr. SG has gained
₹ 1,12,500/- on the Short position taken.
QUESTION – 55
100.00
The Beta of the equity shares portfolio is 1.1. The index future is selling at 4300
level. The Fund Manager apprehends that the index will fall at the most by 10%.
How many index futures he should short for perfect hedging? One index future
consists of 50 units.
SOLUTION:-
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1.1 × 90,00,00,000
= 4,605
4,300 × 50
11
₹ × 90 Cr. = ₹ 9.90 Cr.
100
Gain by short covering of index future is:
0.1×4,300×50×4,605
= ₹ 9.90 Cr.
1,00,00,000
This justifies the answer. Further, cash is not a part of the portfolio.
QUESTION – 56
Shyam buys 10,000 shares of X Ltd., @ ₹ 25 per share and obtains a complete
hedge of shorting 400 Nifty at ₹ 1,100 each. He closes out his position at the
closing price of the next day when the share of X Ltd., has fallen by 4% and Nifty
Future has dropped by 2.5%.
SOLUTION:-
Cash Outlay
Gain/Loss
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DERIVATIVES
QUESTION – 57
Mr. X buys 1,000 shares of HPCL at ₹190 each and obtains a complete hedge by
selling 300 Nifty at 972 each. He closes his position at the closing price of the next
day: at this point HPCL has dropped 5% and Nifty has dropped 4%. What is the
overall Profit/Loss of this set of transactions?
SOLUTION:-
QUESTION – 58
Miss K holds 10,000 shares of IBS Bank @ 2,738.70 when 1 month Index Future
was trading @ 6,086 the share has a Beta (β) of 1.2. How many Index Futures
should she short to perfectly hedge his position. A single Index Future is a lot of
50 indices.
SOLUTION:-
QUESTION – 59
Which position on the index future gives a speculator, a complete hedge against
the following transactions:
(i) The share of Right Limited is going to rise. He has a long position on the
cash market of ₹ 50 lakhs on the Right Limited. The beta of the Right
Limited is 1.25.
(ii) The share of Wrong Limited is going to depreciate. He has a short position
on the cash market of ₹ 25 lakhs on the Wrong Limited. The beta of the
Wrong Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short position on
the cash market of ₹ 20 lakhs of the Fair Limited. The beta of the Fair
Limited is 0.75.
SOLUTION:-
Sl. Company Trend (3) Amount Beta (₹) (6) [(4) Position
No. Name (2) (₹) (4) (5) × (5)] (7)
(1)
1 Right Ltd. Rise 50 lakh 1.25 62,50,000 Short
2 Wrong Ltd. Depreciat 25 lakh 0.90 22,50,000 Long
3 Fair Ltd. e 20 lakh 0.75 15,00,000 Long
Stagnant 25,00,000 Short
QUESTION – 60
Ram buys 10,000 shares of X Ltd. at a price of ₹ 22 per share whose beta value is
1.5 and sells 5,000 shares of A Ltd. at a price of ₹ 40 per share having a beta value
of 2. He obtains a complete hedge by Nifty futures at ₹ 1,000 each. He closes out
his position at the closing price of the next day when the share of X Ltd. dropped
by 2%, share of A Ltd. appreciated by 3% and Nifty futures dropped by 1.5%.
SOLUTION:-
₹ 3,30,000 −₹ 4,00,000
= = 70 contracts
₹ 1,000
Cash Outlay
Gain/ Loss
QUESTION – 61
Mr. X is having a portfolio of shares worth ₹ 170 lakhs at current price and cash ₹
30 lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares
dropped by 3.2%.
Determine:
(ii) Portfolio beta after 3 months if Mr. X on current date goes for long position
on ₹ 200 lakhs Nifty futures.
SOLUTION:-
0.032
1.6 =
Change in value of market portfolio (index)
= ₹ 196 lakh
= ₹ 190.56 lakh
QUESTION – 62
A trader is having in its portfolio shares worth ₹ 85 lakhs at current price and
cash ₹ 15 lakhs. The beta of share portfolio is 1.6. After 3 months the price of
shares dropped by 3.2%.
Determine:
(ii) Portfolio beta after 3 months if the trader on current date goes for long
position on ₹ 100 lakhs Nifty futures.
SOLUTION:-
0.032
1.6 =
Change in value of market portfolio (Index)
= ₹ 98 lakh
= ₹ 95.28 lakh
QUESTION – 63
A Future contract on BSE Index with 4 months maturity is used to hedge the
value of the portfolio over the next 3 months. One future contract for delivery is 50
times of the index.
SOLUTION:-
(i) Let X be the present value of the Sensex as the 1st September, 2021
4
58,580 = X + X [9% − 6%] × 12
X
58,580 = X + 100
X = 58,000
(ii) Let turned out value of Sensex on 1st December, 2021 is Y, then
1
56,641.25 = Y + Y [9% − 6%] × 12
Y
56,641.25 = Y + 400
Y = 56,500
₹ 1,16,00,000 × 1.50
(iii) No. of Contract to the Hedge Portfolio =
58,580 × 50
QUESTION – 64
From the above information you are requested to calculate the Present Value of
Convenience yield (PVC) of the standard gold.
SOLUTION:-
Calculation of PVC
17,100
= 16,500 – PVC
1.085
15,760 = 16,500 – PVC
= ₹ 740
QUESTION – 65
SOLUTION:-
Futures price
= Spot price + Present value of − Present value of
1+Risk −Free Rate 1
storage costs convenience yield
10,800
= 10,000 + 500 – Present value of convenience yield
1.12 1
QUESTION – 66
What is its hedge ratio? What is the amount of the copper future it should short to
achieve a perfect hedge?
(Practice Manual)
SOLUTION:-
The optional hedge ratio to minimize the variance of Hedger‟s position is given by:
σS
H = ρ σF
Where
σS = Standard deviation of ΔS
σF =Standard deviation of ΔF
H = Hedge Ratio
Accordingly
0.04
H = 0.75 × 0.06 = 0.5
QUESTION – 67
16% and 36% respectively, having correlation coefficient of 0.75. The contract size
of one contract is 1,000 kgs.
Required:
(i) Calculate the Optimal Hedge Ratio for perfect hedging in Future Market.
(ii) Advice the position to be taken in Future Market for perfect hedging.
(iii) Determine the number and the amount of the copper futures to achieve a
perfect hedge.
SOLUTION:-
(i) The optional hedge ratio to minimize the variance of Hedger‟s position is
given by:
σS
H = ρ σF
Where,
H = Hedge Ratio
Accordingly
0.04
H = 0.75 × 0.06 = 0.5
(ii) Since the company is long position in Spot (Cash) Market it shall take Short
Position in Future Market.
10,000 Kgs
No. of contract to be short = × 0.50 = 5 Contracts
1,000 Kgs
QUESTION – 68
A call option on gold with exercise price ₹26,000 per ten gram and three months to
expire is being traded at a premium of ₹1,010 per ten gram. It is expected that in
three months time the spot price might change to ₹27,300 or 24,700 per ten gram.
At present this option is at-the-money and the rate of interest with simple
compounding is 12% per annum. Is the current premium for the option justified?
Evaluate the option and comments.
(Practice Manual)
SOLUTION:-
27300 1300
2600
24700 0
1300 − 0
The Delta (Δ) Ratio = = 0.50
27300 − 24700
Replicating portfolio Buy 5 gram of gold and sell one call option.
₹ 12,350
Present Value of Pay-off = = ₹11,990
1.03
First of all we shall calculate probability of high demand (P) using risk neutral
method as follows:
3% = p × 5% + (1−p) × (-5%)
0.08
p= = 0.80
0.10
1300 × 0.8 + 0 × 0.2
The value of call option = = ₹1,009.71 say ₹1,010
1.03
QUESTION – 69
A Rice Trader has planned to sell 22000 kg of Rice after 3 months from now. The
spot price of the Rice is ₹ 60 per kg and 3 months Future on the same is trading at
₹ 59 per kg. Size of the contract is 1000 kg. The price is expected to fall as low as ₹
56 per kg, 3 months hence.
Required:
(ii) To advise the trader the trader should take in Future Market to mitigate its
risk of reduced profit.
(iii) To demonstrate effective realized price for its sale if he decides to make use
of future market and after 3 months, spot price is ₹ 57 per kg and future
contract price for closing the contract is ₹ 58 per kg.
SOLUTION:-
(i) Since trader has planned to sell after 3 months now it implies, he is in Long
Position in Cash or Spot Market.
(ii) Since the trader is in Long Position in Cash Market, he can mitigate its risk
of reduced profit by hedging his position by selling Rice Futures i.e. Short
Position in Future Market.
= 22,000 ×₹ 57 = ₹ 12,54,000
₹ 12,76,000
Cash flow per kg. of Rice = = ₹ 58
22,000
CHAPTER – 02
INTEREST RATE RISK MANAGEMENT
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In Hedging, we have to Calculate Net Settlement Amount between FRA Bank &
Customer. Net Settlement Amount is calculated as under
Dtm
N(RR −FR ) Y
Net Settlement Amount = Dtm
1+ RR ×
Y
N = National principal
RR = Reference Rate
FR = Forward Rate
Y = Days in a year
Example – 01
Mr. Ram wants to borrow ₹ 40,00,000 after 3 months for 6 months. Current
interest rate is 9% P.a. City bank quote FRA 3 × 9 is 10%/11%.
Ram buy FRA 3 × 9 @ 11% P.a. Calculated effect on FRA and Effective rate of
interest if after 3 months for 6 months is –
Case 1: 13% p.a.
Case 2: 8% p.a.
Example – 02
Mr. Shyam wants to invest ₹ 50,00,000 after 6 months for 3 months. City bank
quote FRA 6× 9 is 8%/10%. Ram sell FRA 6 × 9 @ 8% p.a.
Calculate effect on FRA and effective rate of interest if after 6 months for 9
months is –
Case 1: 5% p.a.
Case 2: 9% p.a.
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How to Calculate?
Bigger Factor
Theoretical FRA =
Smaller Factor
Action:
If Actual FRA is more than theoretical FRA then
Contract to Interest at forward Rate
Or,
Sell FRA
Example – 03
3 Months LIBOR = 12% p.a.
6 Months LIBOR = 15% p.a.
Calculate 3 months FRA after 3 months.
Example – 04
6 Months LIBOR = 9% p.a.
9 Months LIBOR = 12% p.a.
Calculate 3 months FRA after 6 months.
Example – 05
3 Months LIBOR = 15% p.a.
9 Months LIBOR = 12% p.a.
Calculate 6 months FRA after 3 months .
Example – 06
6 Months LIBOR = 12% p.a.
12 Months LIBOR = 10% p.a.
(i) Calculate 6 months FRA after 6 months.
(ii) Calculate Arbitrage gain in Actual FRA 6 × 12 is 10%/11%
(iii) Calculate Arbitrage gain if Actual FRA 6 × 12 is 5%/6%
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(2) Suppose, MR. Ram expects LIBOR will rise in future hence he entered
into plain vanilla swap with swap Bank where Ram will pay fixed Rate
i.e. 10% & Receive 3 months LIBOR for a period of 5 years & National
principal ₹ 50,00,000.
Suppose LIBOR on 1/1/2020 is 9%
In this situation, Ram will pay to swap Bank on 31/3/2020
Amount = ₹ 50,00,000 × 1% × 3/12
= ₹ 12,500
Suppose LIBOR on 1/4/2020 is 12%
In this situation swap Bank will pay to Ram on 30/6/2020.
Amount = ₹ 50,00,000 × 2% × 3/12
= ₹ 25,000
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Example – 07
A Ltd. B Ltd.
Fixed Rate 10% 12%
Floating Rate LIBOR + 4% LIBOR + 1%
A Ltd. wants to borrow at floating Rate & B Ltd wants to borrow at fixed Rate.
Design a swap between A Ltd & B Ltd So that Effective Cost should be less then
their Actual Borrowing.
Intermediary Commission = 50 Basis points
Example – 08
A Ltd B Ltd
Fixed Rate 10% 12%
Floating Rate LIBOR + 1% LIBOR + 4%
A Ltd wants to borrow at fixed rate & B Ltd Wants to borrow at floating Rate.
Design a financial swap & Intermediary Commission 50 Basis points.
1 − dl
Periodical fixed rate =
dn
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QUESTION – 01
What will be the Final settlement amount, if the actual rate of interest after 6
months happens to be
SOLUTION:-
dtm
N RR −FR ( DY )
= dtm
[1+RR ]
DY
Where,
Accordingly,
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₹60Cr (0.00075 )
= = ₹ 4,39,453
1.024
Thus banker will pay Parker & Co. a sum of ₹4,39,453
₹60Cr (−0.00125 )
= = - ₹7,33,855
1.022
Thus Parker & Co. will pay banker a sum of ₹7,33,855
Note: It might be possible that students may solve the question on basis of
days instead of months (as considered in above calculations). Further there
may be also possibility that the FRA days and Day Count convention may be
taken in various plausible combinations such as 90 days/360days,
90days/365days, 91days/360 days or 91 days/365days.
QUESTION – 02
The rate is 8%
SOLUTION:-
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£ 9375
= = £ 9157.51
1.02375
(b) If Actual Rate is 8%
£ 9375
= = £ 9191.18
1.02
QUESTION – 03
Compute the effect of FRA and actual rate of interest cost to the company, if
the actual rate of interest during consideration period happens to be
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SOLUTION:-
Where,
Accordingly,
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QUESTION – 04
SOLUTION:-
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Accordingly:
QUESTION – 05
(Practice Manual)
SOLUTION:-
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Net gain $ 0.005 i.e. risk less profit for every $ borrowed
Question – 06
Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA
(Forward Rate Agreement). They want to borrow a sum of ₹ 100 crores after 2
years for a period of 1 year. Bank has calculated Yield Curve of both companies
as follows:
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*The difference in yield curve is due to the lower credit rating of ABC Ltd.
compared to XYZ Ltd.
(i) You are required to calculate the rate of interest DEF Bank would quote
under 2V3 FRA, using the company’s yield information as quoted above.
(ii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of
the amount of loan, you are required to calculate the interest payable by
XYZ Ltd. if interest rate in 2 years turns out to be
SOLUTION:-
(i) DEF Bank will fix interest rate for 2V3 FRA after 2 years as follows:
XYZ Ltd.
r = 5.04%
ABC Ltd.
r = 6.38%
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(ii)
4.50% 5.50%
Allow to Lapse Exercise
Interest ₹ 100 crores × 4.50% ₹ 4.50 crores -
₹ 100 crores × 5.04% - ₹ 5.04 crores
Question – 07
It is expected that firm shall borrow a sum of €50 million for the entire period
of slack season in about 3 months.
(a) How a FRA, shall be useful if the actual interest rate after 3 months
turnout to be: (i) 4.5% (ii) 6.5%
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(b) How 3 months Future contract shall be useful for company if interest
rate turns out as mentioned in part (a) above.
SOLUTION:-
(a) By entering into an FRA. Firm shall effectively lock in interest rate for a
specified future in the given it is 6 months. Since, the period of 6 months
is starting in 3 months. The firm shall opt for 3 × 9 FRA locking
borrowing rate at 5.94%. In the given scenarios, the net outcome shall be
as follows:
If the rate turns out If the rate turns out
to be 4.50% to be 6.50%
FRA Rate 5.94% 5.94%
Thus, by entering into FRA, the firm has committed itself to a rate of
5.94% as follows:
€ 14,85,000 12
× 100 × = 5.94%
€50,000,000 6
(b) Since firm is borrower it will like to off-set interest cost by profit on
Future Contract.
Accordingly, if interest rate rises it will gain hence it should sell interest
rate futures.
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€14,62,500 €14,62,500
€14,62,500 12
× 100 × = 5.85%
€50,000,000 6
Question – 08
It is expected that firm shall borrow a sum of £25 million for the entire period
of slack season in about 3 months.
The banker of the firm has given the following quotations for Forward Rate
Agreement (FRA):
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(a) Advise the position to be taken in Future Market by the firm to hedge its
interest rate risk and demonstrate how 3 months Future contract shall
be useful for the firm, if later interest rate turns out to be (i) 4.5% and (ii)
6.5%
(b) Evaluate whether the interest cost to Espace plc shall be less had it
adopted the route of FRA instead of Future Contract.
Note:- Ignore the time value of money in settlement amount for future contract.
SOLUTION:-
(a) (i) Since firm is a borrower it will like to off-set interest cost by profit on
Future Contract. Accordingly, if interest rate rises it will gain hence it
should sell interest rate futures.
(ii) The financial outcome in the given two scenarios shall be as follows:
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£ 7,31,250 £ 7,31,250
£7,31,250 12
Thus, the firm locked itself in interest rate × 100 × = 5.85%
£25,000,000 6
(b) No, the interest cost shall not be less for Espace plc had it taken the
route of FRA, as the 3 × 9 FRA contract are available at 5.64% – 5.94%
i.e. borrowing rate of 5.94%. Hence, the interest cost under this option
shall be nearby by 5.94% which is more than interest rate under Future
contract rate of 5.85%.
Question – 09
Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six
month LIBOR flat. If the notional principal amount of swap is ₹ 5,00,000.
(ii) Find the first floating rate payment for (i) above if the six month period
from the effective date of swap to the settlement date comprises 181 days
and that the corresponding LIBOR was 6% on the effective date of swap.
In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer
would pay to the floating rate payer?
SOLUTION:-
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Where
180
= 5,00,000 × 0.08
360
dt
= N (LIBOR)
360
181
= 5,00,000 × 0.06
360
= (i) – (ii)
Question – 10
P Ltd., a dealer quotes 'All-in-cost' for a generic swap at 6% against six months
LIBOR flat. If the Notional principal amount of swap is ₹ 8,00,000:
(ii) Find the first floating rate payment for (i) above if the six month period
from the effective date of swap to the settlement date comprises 181 days
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and that the corresponding LIBOR was 5% on the effective date of swap.
(Consider up to three decimal places).
(iii) In question number (ii) above, if the settlement is on 'Net' basis, how
much the fixed rate payer would pay to the floating rate payer? Note:
Generic swap is based on 30/360 days basis.
SOLUTION:-
= (N)(AIC) (Period)
180
= 8,00,000 × 0.06
360
dt
= N (LIBOR)
360
181
= 8,00,000 × 0.05 ×
360
= (i) – (ii)
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Question – 11
Derivative Bank entered into a plain vanilla swap through on OIS (Overnight
Index Swap) on a principal of ₹ 10 crores and agreed to receive MIBOR
overnight floating rate for a fixed payment on the principal. The swap was
entered into on Monday, 2nd August, 2010 and was to commence on 3rd
August, 2010 and run for a period of 7 days.
If Derivative Bank received ₹ 317 net on settlement, calculate Fixed rate and
interest under both legs.
Notes:
SOLUTION:-
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Question – 12
Punjab Bank has entered into a plain vanilla swap through on Overnight Index
Swap (OIS) on a principal of ₹2 crore and agreed to receive MIBOR overnight
floating rate for a fixed payment on the principal. The swap was entered into on
Monday, 24th July, 2017 and was to commence on 25th July, 2017 and run
for a period of 7 days.
If Punjab Bank received ₹507 net on settlement, calculate Fixed rate and
interest under both legs.
Notes:
SOLUTION:-
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Question – 13
Note:
SOLUTION:-
(i) The given swap arrangement is Plain Vanilla Overnight Index Swap (OIS).
(ii) To compute the Net Settlement amount we shall compute Interest as per
floating rate as follows:
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Question – 14
Bharat Bank Ltd. has entered into a plain vanilla swap through on Overnight
Index Swap (OIS) on a principal of ₹ 1 crore and agreed to receive. MIBOR
overnight floating rate for a fixed payment on the principal. The swap was
entered into on Monday. 10th July 2017 and was to commence on and from
11th July 2017 and run for a period of 7 days.
If Bharat Bank Ltd. received ₹ 417 net on settlement, calculate fixed rate and
interest under both legs.
SOLUTION:-
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Question – 15
IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its
subsidiary in India and face the following interest rates:
Company IB Zaki
INR floating rate BPLR + 0.50% BPLR + 2.50%
JPY (Fixed rate) 2% 2.25%
Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow
JPY at a fixed rate. The amount of loan required by both the firms is same at
the current exchange rate. A financial institution may arrange a swap and
requires 25 basis points as its commission. Gain, if any, is to be shared by the
firms equally.
(i) Whether a swap can be arranged which may be beneficial to both the
firms?
SOLUTION:-
However, company IB wants to borrow in the JPY fixed interest rate market
and company Zaki wants to borrow in the INR floating-rate market. This gives
rise to the swap opportunity.
IB raises INR floating rate at BPLR + 0.50% and Zaki raises JPY at 2.25%
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Note: Candidates can also present the above Swap arrangement in a different
manner. In such case they should be awarded due marks provided solution be
ended up in correct answer.
Question – 16
A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for
a time horizon of one year. The prevalent interest rates are as follows:
A Inc 5% 9%
B Inc 8% 10%
They entered in a currency swap under which it is agreed that B Inc will pay A
Inc @ 1% over the ¥ Loan interest rate which the later will have to pay as a
result of the agreed currency swap whereas A Inc will reimburse interest to B
Inc only to the extent of 9%. Keeping the exchange rate invariant, quantify the
opportunity gain or loss component of the ultimate outcome, resulting from the
designed currency swap.
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SOLUTION:-
¥19,20,000 -
Net Payment
¥33,60,000 ¥33,60,000
$equivalent paid
¥19,20,000 × (1/¥120) $16,000
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Alternative Solution
A Inc. used $2,00,000 at the net cost of borrowing of $16,000 i.e. 8%. If
it had not opted for swap agreement the borrowing cost would have been
9%. Thus there is saving of 1%.
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B Inc. used ¥240,00,000 at the net cost of borrowing of ¥16,80,000 i.e. 7%.
If it had not opted for swap agreement the borrowing cost would have been
8%. Thus there is saving of 1%.
Question – 17
IM JI
IM wishes to borrow USD at floating rate and JI JY at fixed rate. The amount
required by both the companies is same at the current Exchange Rate. A
financial institution requires 75 basis points as commission for arranging
Swap. The companies agree to share the benefit/ loss equally.
SOLUTION:-
The differential between the U.S. dollar floating rates is 2.00% per
annum, and the differential between the JPY fixed rates is 0.25% per
annum. The difference between the differentials is 1.75% per annum.
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The total potential gain to all parties from the swap is therefore 1.75%
per annum, or 175 basis points. If the financial intermediary requires 75
basis points, each of IM and JI can be made 50 basis points better off.
(ii) Since the Net Benefit of 100 basis points to be shared equally among IM
and JI interest rate for them shall be as follows:
IM
JI
Borrowing from Market 4.25%
Less: Benefit from Swap 0.5%
Net Interest 3.75%
Question – 18
(a) X Ltd. wants to borrow fixed rate funds for 5 year. It can do so at an
interest rate of 13% p.a. Also floating rate funds are available at a spread
of 150 basis points over LIBOR. It approaches a swap bank which quotes
5-year fixed to floating swap at 20/30 basis points over 5-year treasuries
vs. LIBOR. How should the firm reduce the cost of its fixed rate funding
given that 5- year treasuries are yielding 10%.
(b) Another firm Y Ltd. had borrowed 7-year fixed rate funds 2 years ago at
14%. It is now expecting interest rates to fall and therefore wants to
convert its fixed rate liability into floating rate liability. Explain how Y
Ltd. can achieve this objective.
SOLUTION:-
(a)
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In order to reduce cost of fund, X Ltd. should borrow at floating rate &
convert it into floating rate with the help of swap. In which X Ltd. will pay fixed
(10.30%) to swap bank & receive floating from swap bank.
EC = L + 1.50% + 10.30% − L
= 11.8%
(b)
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Y Ltd. already borrow at fixed rate & want to convert it. Into floating rate with
the help of swap arrangement.
In Swap X Ltd. will be pay to swap bank LIBOR & receive from swap
bank 10.2%.
= 14 + LIBOR – 10.2
= LIBOR + 3.8%
Question – 19
ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six
months LIBOR + 1/4% for ₹ 200 million for 5 years. The bank is able to swap
into a fixed rate at 7.5% versus six month LIBOR treating six months as exactly
half a year.
Given a three year swap rate of 8%, suggest the method by which the bank
should achieve fixed rate funding.
SOLUTION:-
(i) ABC Bank pay LIBOR + 0.25% p.a. for 5 years. The swap involves
payment of 7.5% p.a. and receipt of LIBOR.
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6
₹ 200 million × 7.75% × = ₹ 7.75 million or ₹ 77,50,000
12
(ii) ABC Bank issues hybrid and enters both the five year and three year
swaps.
There for the arrangement in (b) compared to (a) saves 0.75 p.a. over the
first three years and 0.5% p.a. over final two years.
Question – 20
A corporation enters into a $10 million notional principal interest rate swap.
The swap calls for a corporation to pay fixed rate and receive floating rate on
LIBOR. The payment will be made every 90 days for one year and will be based
on the adjustment factor 90/360. The term structure of LIBOR when the swap
is initiated is as follows:
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Note that at the initiation of the swap, the fixed rate is set at such a rate that
the value of the swap is zero.
SOLUTION:-
i. Let the fixed rate to be received by the bank be ‘R’ and the notional
principal be ‘P’.
The present value of the fixed leg we can get by multiplying (P × R) by the
discounting factor we can get from the LIBOR term structure.
= P × R × 0.9562
We know that on the date when interest rate is reset, the bond sells at
per value.
Now value of the swap at inception should be zero, hence we will equate
present value of fixed payments and present value of floating payments.
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ii. The first net payment is based on a fixed rate of 7.34% and a floating
rate of 7%:
The net is that the party paying fixed makes a payment of $ 8,500.
Question – 21
XYZ Inc. issues a £ 10 million floating rate loan on July 1, 2013 with resetting
of coupon rate every 6 months equal to LIBOR + 50 bp. XYZ is interested in a
collar strategy by selling a Floor and buying a Cap. XYZ buys the 3 year Cap
and sell 3 year Floor as per the following details on July 1, 2013:
Premium 0*
31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
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30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
(Practice Manual)
SOLUTION:-
Cap Receipt
Floor Pay-off
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16,26,094 365
× × 100 = 5.42%
1,00,00,000 1096
Question – 22
(i) Advise how borrower can hedge the risk arising out of expected rise in
the rate of interest when he is interested in pegging his interest cost at
8.50% p.a. and if option on Interest Rate is available at 0.75% p.a.
(ii) Assume that the premium negotiated by both the parties at the above-
mentioned rate which is to be paid on upfront basis and the actual rate
of interest on the respective due dates happens to as follows:
EVALUATE how the settlement will be executed on the respective interest due
dates.
(Exam Nov – 2017, SM, PM, RTP May – 2022 & MTP March – 22)
SOLUTION:-
(i) As borrower does not want to pay more than 8.5% p.a., on this loan
where the rate of interest is likely to rise beyond this, hence, he is
advised to hedge the risk by entering into an agreement to buy interest
rate caps with the following parameters:
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Question – 23
XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period
of 24 months. The company anticipates a rise in LIBOR, hence it proposes to
buy a Cap Option from its Bankers at the strike rate of 8.00%. The lump sum
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premium is 1.00% for the entire reset periods and the fixed rate of interest is
7.00% per annum. The actual position of LIBOR during the forthcoming reset
period is as under:
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap
Option.
For calculation, work out figures at each stage up to three decimal points and
amount nearest to £. It should be part of working notes.
SOLUTION:-
rp rp
P= 1
× A or ×A
1÷i − PVAF (3.5%,4)
i×(1+i)t
Where
P = Premium
A = Principal Amount
rp = Rate of Premium
t = Time
0.01
= 1 × £15,000,000
1/0.035 − 4
0.035 ×1.035
Or
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0.01
× £15,000,000
(0.966+0.933+0.901+0.871)
0.01 £150,000
= 1 × £15,000,000 or = £ 40,861
28.5714 − 3.671
0.04016
Please note above solution has been worked out on the basis of four decimal
points at each stage.
Thus, from above it can be seen that interest rate risk amount of £ 337,500
reduced by £ 214,917 by using of Cap option.
Note: It may be possible that student may compute upto three decimal points
or may use different basis. In such case their answer is likely to be different.
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
CHAPTER – 03
FOREIGN EXCHANGE EXPOSURE
AND RISK MANAGEMENT
(1) BASICS
1. EXCHANGE RATE
Exchange rate means price of one country’s currency is expressed in another
country’s currency.
$1 = ₹ 60
£1 = ₹ 82.50
€1 = ₹ 70.25
DIRECT QUOTE
Direct quote means one unit of foreign currency is worth how many units of
home currency.
₹/$ = 70.25
₹/€ = 83.50
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₹/£ = 92.75
USD/INR = 70.50
INDIRECT QUOTE
Indirect quote means one unit of home currency is worth how many units of
foreign currency.
$/₹ = 0.0143
€/₹ = 0.0119
£/₹ = 0.0108
INR/USD = 0.0138
2. CONVERSION OF CURRENCY
Example - 01
₹/$ = 70.50
$ 100000 =₹?
Example - 02
$/₹ = 0.0140
$ 50000 =?
Example - 03
$/£ = 1.5235
$ 40000 =£?
Example - 04
¥/₹ = 3.4245
₹ 5000 =¥?
Example - 05
USD/INR = 70.50
₹ 100000 =$?
Example - 06
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INR/GBP = 94.75
£ 40000 =₹?
Example - 07
₹/$ = 75.50/75.75
Mr. Ram import goods from US & $ 1,00,000 payable to US party. How much
rupees are required to buy $ 1,00,000.
Example - 08
$/£ = 1.50/1.55
A UK customer import goods from US & $ 10,000 payable to US party. How
much pounds are required to buy $ 10,000.
Example - 09
₹/£ = 90.25/45
Mr. Ram exported goods to UK & £ 40,000 receivable. How much rupees
received if sell £ 40,000 to bank.
Example - 10
¥/$ = 125/145
We want to buy ¥ 2,00,000. How much dollars are required.
Example - 11
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GBP/USD = 1.5525/75
We want to sell $ 80,000 then How much pounds are receivable from bank.
Example - 12
₹/$ = 70
If $ will appreciate by 10% what is new Exchange Rate.
Example - 13
₹/$ = 70
If ₹ will depreciate by 10% what is new Exchange Rate.
Example - 14
₹/$ = 70
If $ will depreciate by 10% then calculate New Exchange Rate.
Example - 15
₹/$ = 70
If ₹ will appreciate by 10% then calculate New Exchange Rate.
6. CROSS RATES
Exchange rates of all foreign currency against home currency may not be
available. In this situation, exchange rate is determined with the help of
cross multiplication is called “Cross Rate”
Cross rates are used to calculate arbitrage.
We will discuss cross rates in two parts.
Part I – Cross Rates Without Bid-Ask
Part II – Cross Rates With Bid-Ask
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Example - 16
₹/$ = 60
$/£ = 1.50
₹/£ =?
Example - 17
₹/£ = ₹ 90
$/£ = 1.50
₹/$ =?
Example - 18
¥/₹ = 3.45
₹/$ = 70
$/¥ =?
Example - 19
£/$ = 0.8045
$/₹ = 0.0167
₹/£ =?
Example - 20
¥/$ = 145
$/₹ = 0.165
¥/₹ =?
Example - 21
GBP/USD = 1.3575
USD/ INR = 70.7525
GBP/INR =?
Example - 22
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₹/$ = 60
$/€ = 1.25
€/£ = 1.40
₹/£ = ?
Example - 23
£/$ = 0.8045
₹/$ = 45.25
₹/€ = 72.50
€/£ = ?
Example - 24
₹/$ = 70.25/70.75
$/£ = 1.5045/1.5085
₹/£ =?
Example - 25
₹/£ = 90.45/91.25
₹/$ = 71.25/71.75
$/£ =?
Example - 26
¥/$ = 145/153
¥/£ = 182/185
£/$ =?
Example - 27
$/₹ = 0.0165/0.0168
₹/€ = 75.45/75.85
£/€ = 0.8525/0.8605
$/£ = ?
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Example - 28
GBP/USD = 1.5045/85
USD/JPY = 152/155
JPY/GBP =?
Example – 29
Example – 30
$/£ = 1.5025/1.5175 US
$/£ = 1.5075/1.5195 UK
Calculate Arbitrage Gain
Example – 31
In USA
₹/$ = 60
$/£ = 1.50
i. On the basis of above exchange rate, what should be price of £ in India.
ii. If £ is quoted in India at ₹ 80, calculate arbitrage.
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TRIANGULAR ARBITRAGE
Example – 32
Example – 33
Example – 34
Spot Rate
₹/$ = 70.50/71.25
3 Months Expected SR
₹/$ = 74.00
₹/$ = 72.50
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Example – 35
Spot Rate
₹/£ = 90.00/90.50
₹/£ = 87.50
₹/£ = 89.00
Example – 36
$/₹ = 0.01333
$/₹ = 0.01370
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Example – 37
Example – 38
Example – 39
Swap points are basically premium or discount in currency. If swap points are
in ascending order (10/15) then swap point are added to spot rate & if swap
points are in descending order then they are subtracted from spot rate to find
out forward rate.
Example – 40
Example – 41
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Example – 42
Example – 43
Example – 44
Example – 45
Example – 46
Local
₹/$ = 70/71
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International
HK$/$ = 12.50/12.75
F$ 1+R A $
=
S$ 1+R B
F = Forward Rate
S = Spot Rate
RA = Rate of Interest
RB = Rate of Interest
Example – 47
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USA = 8% p.a.
Calculate 3 months forward rate if
(i) Nothing is mentioned in question.
Example – 48
Example – 49
Example – 50
Example – 51
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Example – 52
3 Months FR
₹/$ = ₹ 72.50
Rate of Interest
India = 10% p.a. Compounded Continuously
US = 8% p.a. Compounded Continuously
Spot Rate = ?
Example – 53
Example – 54
Example – 55
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Example – 56
6 Months FR =?
FR =?
As per IRP, forward rate should be on the basis of interest rates but actual
forward rate may differ from theoretical forward rate i.e. forward rate calculated
as per IRP. In this situation there is a possibility of “ Covered Interest
Arbitrage.”
Example – 57
Example – 58
Example – 59
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USA = 5% p.a.
UK = 4% p.a.
You can borrow £ 1,00,000 or $ 1,25,750. Calculate arbitrage.
(2) Suppose price of 1 pen in USA is $ 10 & price of such pen in India ₹500.
As per PPP, Exchange rate between $ & ₹ should be
So demand of pen is USA will Increase due to Lower rate, hence demand
of dollar will Increase & $ will become strong .
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Suppose 1 pen in India is ₹500 & price of such pen in USA $ 10, hence
as per PPP Exchange Rate is
$ 10 = ₹ 500
$ 1 = ₹ 50
In Inflation Rate in India is 10% p.a. & USA is 8% p.a. then price of pen
in India & USA is Price of Pen
$ 10.80 = ₹ 550
550
$1 = = ₹ 50.92
10.80
Formula of PPP
Es 1 (1+i)A
=
So (1+i)B
Example – 60
SR ₹/$ ₹50.00
Inflation Rate
India = 10% p.a.
USA = 8% p.a.
Calculate 1 & 2 year Exchange Rate.
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Example – 61
Inflation Rate = 5%
Example – 62
Nominal Rate =?
Example – 63
Inflation rate = 5%
As per International fisher effect, Real rate of Interest of All countries is same
but. Nominal rate of Interest may be different because of inflation Rate.
1+r A 1+r B
=
1+i A 1+i B
Example – 64
Suppose
India USA
Real Rate 3% 3%
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
SR = ₹/$ = ₹70
Calculate:
1. Transaction Exposure
(iii) Whenever we import or export, we know how much foreign currency, but
we don’t know how much home currency required to buy foreign
currency.
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translated in home currency. Exchange rate can affect the value of asset
of foreign subsidiary. [Financial Statement] due to this reason, intrinsic
value of share can be affected.
(iii) Suppose, Mr. Ram exports goods USA. Invoicing in INR invoice amount ₹
60,00,000[10,000 units @ ₹ 600 per units]. In this situation transaction
exposure hedged because invoicing in Indian Rupees, but there is a
possibility of economic exposure. Current exchange rate is $1 = ₹ 60. It
means as party i.e. Mr. A has to buy ₹ 60,00,000 & $ required ₹
60,00,000/60 = $ 1,00,000. But if exchange rate change & $ 1 = ₹ 50. In
₹ 60,00,000
this situation Mr. A has to pay = $ 1,20,000 to buy ₹
50
60,00,000. It means cost of goods to Mr. A increase by $ 20,000 [in
percentage 20%]. Suppose price electricity of demand 1.5 means demand
of goods will decrease by (20 × 1.5) = 30% Hence sales for Mr. Ram will
decrease. It is an example of economic exposure.
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
INTERNAL HEDGING
Example – 65
SR ₹/$ = 70/71
(ii) Leading.
Example – 66
Payable = $ 1,00,000
SR ₹/$ = ₹ 70/71
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Example – 67
We export to USA & export proceeds $ 1,00,000 after 6 months. We can hedged
with the help of following two alternatives.
SR ₹/$ = ₹ 70/₹ 72
Example – 68
Payable = $ 3,00,000
Receivable = $ 2,00,000
₹/$ = 70.50/71.75
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Example – 69
Interest Rate
India = 15%/16%
USA = 12%/13%
SR ₹/$ = 70/71
Example – 70
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Interest Rate
India = 8%/10%
USA = 10%/12%
SR ₹/$ = 70/71
3. Currency Future:-
Example – 71
SR ₹/$ = 60
Currency future
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
Example – 72
SR ₹/$ = ₹70.50
Current future
1 month 3 months
Per contract
₹/$ ₹ 73.00 & Currency future rate is ₹ 74.25 Which option is better ?
Example – 73
SR $/₹ = 0.0142
Current future
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1 month 3 months
Example – 74
[Type - A]
SR ₹/$ = ₹70.50
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FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
3 months FR = ₹72.75
Price of $ on Maturity
Price Probability
70.10 0.3
71.50 0.2
72.25 0.5
Example – 75
[Type - B]
$ Payables = $ 100000
SR ₹/$ = ₹ 70.50/70.85
3 months FR = 72.50/72.75
Currency option
Premium
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Example – 76
Currency Option
Premium
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Example – 77
Ram had entered into forward to contract buy $ 1,00,000 on due date
01/04/2022 at ₹ 75.00. On maturity date 01/04/2022 contract cancelled.
Margin = 0.10%
Example – 78
Ram had entered into forward contract to sell $ 1,00,000 at ₹ 75.50 after 3
months on maturity, Contract cancelled.
Margin = 0.08%
Any difference between forward rate & spot rate is recoverable from customer
or payable to customer. If amount recoverable from customer then, it is called
cancellation charges.
Example – 79
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Inter-bank SR = ₹ 70.25/45
Margin = 0.10%
Example – 80
Inter-bank SR = 72.75/95
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Margin = 0.08%
Example – 81
Margin = 0.10%
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(iii) Calculate net cash outflow for the bank on cancellation date and
calculate interest on cash outlay from cancellation date to due date.
(i) Old contract with the customer is not cancelled it is executed at the old
rate on the early delivery date.
(iv) Calculate net inflow/outflow for the bank on the early delivery date.
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Example – 82
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(1) BASICS
QUESTION – 01
Given:
US$ 1 = ¥ 107.31
£1 = US$ 1.26
A$ 1 = US$ 0.70
(ii) Calculate the cross rate for Australian Dollar in Yen terms
(iii) Calculate the cross rate for Pounds in Australian Dollar terms
SOLUTION:-
(ii) Calculation the cross rate for Australian Dollar in Yen terms
A$1 =¥?
US$1 = ¥ 107.31
A$ 1 = US$ 0.70
¥ $ ¥
× =
$ A$ A$
¥
= 107.31 × 0.70
A$
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A$ 1 = ¥ 75.12
(iii) Calculation the cross rate for Pounds in Australian Dollar terms
₤1 = A$ ?
US $ 1 = A$ 1.4286
£1 = US$1.26
A$ $ A$
× =
$ £ £
A$
= 1.4286 × 1.26 = 1.80
£
£1 = A$ 1.80
QUESTION – 02
Mr. Mammen, an Indian investor invests in a listed bond in USA. If the price of
the bond at the beginning of the year is USD 100 and it is USD 103 at the end
of the year. The coupon rate is 3% payable annually.
(v) Will your answer differ if Mr. Mammen invests in the bond just before the
interest payable.
SOLUTION:-
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103−100 +3
=
100
3+3
= = 0.06 say 6%
100
(ii) If USD appreciates by 3%
(v) No, our answer will not differ even if Mr. Mammen invests in bond just
before the interest is payable.
QUESTION – 03
On January 28, 2013 an importer customer requested a Bank to remit
Singapore Dollar (SGD) 2,500,000 under an irrevocable Letter of Credit (LC).
However, due to unavoidable factors, the Bank could effect the remittances
only on February 4, 2013. The inter-bank market rates were as follows:
Required:
How much does the customer stand to gain or lose due to the delay?
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SOLUTION:-
On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.
US $ = ₹ 45.90
₹ 45.90 ∗ 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = ₹ 25.9482
₹ 25.9806
US $ = ₹ 45.97
₹ 45.90 ∗ 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ₹ 26.0394
₹ 26.0719
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QUESTION – 04
December 27, 2001 a customer requested a bank to remit DG 2,50,000 to
Holland in payment of import of diamonds under an irrevocable LC. However
due to bank strikes the bank could affect the remittance only on January 3,
2002. The interbank market rates were as follows:
December 27 January 3
The bank wishes to retain an exchange margin of 0.125%. How much does the
customer stand to gain or lose due to the delay?
SOLUTION:-
December 27
$/₹ = 0.031/0.0315
$/£ = 1.72520/1.7260
DG/£ = 3.9575/3.9590
₹/DG = ?
Buy $ and sell ₹, Buy £ and sell $ and Buy DG and sell £
₹ $ £
= × ×
$ £ DG
1 1
= × 1.7260 ×
0.031 3.9575
₹/DG = 14.069 + 0.125%
= 14.04
January 03
$/₹ = 0.0307/0.0312
$/£ = 1.7175/1.7185
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DG/£ = 3.9380/3.9390
₹/DG = ?
₹ $ £
= × ×
$ £ DG
1 1
= × 1.7185 ×
0.0307 3.9380
DG 1 = ₹ 14.21 + 0.125%
= ₹ 14.23
= ₹ 35,000
QUESTION – 05
The price of a bond just before a year of maturity is $ 5,000. Its redemption
value is $ 5,250 at the end of the said period. Interest is $ 350 p.a. The Dollar
appreciates by 2% during the said period. Calculate the rate of return.
SOLUTION:-
Here we can assume to cases (i) If investor is US investor than there will be no
impact of appreciation in $ (ii) If investor is from any other nation other than
US say India then there will be impact of $ appreciation on his returns.
First we shall compute return on bond which will be common for both
investors.
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(i) For US investor the return shall be 12% and there will be no impact of
appreciation in $.
QUESTION – 06
On the same date that the DM spot rate was quoted at $ 0.40 in New York, the
price of the pound Sterling was quoted at $ 1.80:
(i) What would you expect the price of the Pound to be Germany?
(ii) If the Pound was quoted in Frankfurt at DM 4.40/Pound, what would
you do to profit from situation.
SOLUTION:-
1
DM/£ = × 1.80 = DM 4.50
0.40
(ii) If £ was quoted in frank fort at DM 4.40 then buy £ from frank fort at
4.40 & sell in New York at 4.50.
QUESTION – 07
Followings are the spot exchange rates quoted at three different forex markets:
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The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction
costs, explain whether there is any arbitrage gain possible from the quoted spot
exchange rates.
SOLUTION:-
₹ 483,000,000
= GBP 6,230,650.155
₹ 77.52
(iii) Convert GBP to USD at New York
USD 112,968.26
QUESTION – 08
USD 10,000 is lying idle in your Bank Account. You are able to get the
following quotes from the dealers:
Dealer Quote
A EUR/USD 1.1539
B EUR/GBP 0.9094
C GBP/USD 1.2752
SOLUTION:-
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(10,000/1.1539) = € 8,666.26
There is net gain of US$ 10,049.97 less US$ 10,000 i.e. US$ 49.97 or US$
50.00.
QUESTION – 09
Followings are the spot exchange rates quoted at three different forex markets:
The arbitrageur has USD 1,00,00,000. Assuming that bank wishes to retain an
exchange margin of 0.125%, explain Whether there is any arbitrage gain
possible from the quoted spot exchange rates.
SOLUTION:-
USD/INR 59.35
59.42
59,44,83,064
Accordingly, USD acquired in exchange of INR is USD
59.42
1,00,04,763
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GBP/INR 102.50
102.37
GBP/USD 1.72
1.722
QUESTION – 10
Citi Bank quotes JPY/ USD 105.00 - 106.50 and Honk Kong Bank quotes
USD/JPY 0.0090- 0.0093.
(a) Are these quotes identical if not then how they are different?
(c) If there is an arbitrage opportunity, then show how would you make
profit from the given quotation in both cases if you are having JPY
1,00,000 or US$ 1,000.
SOLUTION:-
(a) No, while Citi Bank’s quote is a Direct Quote for JPY (i.e. for Japan) the
Hong Kong bank quote is a Direct Quote for USD (i.e. for USA).
(b) Since Citi Bank quote imply USD/JPY 0.0094 – 0.0095 and both rates
exceed those offered by Hong Kong Bank, there is an arbitrage
opportunity.
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QUESTION – 11
The following 2-way quotes appear in the foreign exchange market:
Required:
(i) How many US dollars should a firm sell to get ₹ 25 lakhs after 2 months?
(ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in
the spot market?
(iii) Assume the firm has US $ 69,000 in current account earning no interest.
ROI on Rupee investment is 10% p.a. Should the firm encase the US $
now or 2 months later?
SOLUTION:-
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₹ 25,00,000
= US $ 53191.489
₹ 47
(ii) ₹ required to get US$ 2,00,000 now at the rate of ₹ 46.25/$
Opportunity gain
10 2
= 31,34,000 × × ₹ 52,900
100 12
Likely sum at end of 2 months 32,26,900
QUESTION – 12
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm
sell forward its pound receivables due in September, 2009?
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SOLUTION:-
Therefore, the expected spot value of $ for £for September, 2009 would be $
1.81.
(ii) If the six-month forward rate is $ 1.80, the expected profits of the firm
can be maximised by retaining its pounds receivable.
QUESTION – 13
INR/US $ = ₹ 62.22
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee
to depreciate against US $ to ₹ 65.
INR/US $ = ₹ 66.50
Required:
(i) Calculate the expected loss, if the hedging is not done. How the position
will change, if the firm takes forward cover?
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INR/US $ = ₹ 66.25
SOLUTION:-
Since the direct quote for ¥ and ₹ is not available it will be calculated by cross
exchange rate as follows:
62.22/102.34 = 0.6080
Loss ₹ 8,38,000
Loss ₹ 54,000
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Loss ₹ 1,03.000
QUESTION – 14
SOLUTION:-
Spot rate of ₹ 1 against yen = 108 lakhs Yen/₹ 30 lakhs = 3.6. Yen
₹ (in lakhs)
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Suggestion: If the exchange rate risk in not covered with forward contract, the
expected exchange loss is ₹ 3.33 lakhs. This could be reduced to ₹ 2.73 lakhs if
it is covered with Forward contract. Hence, taking forward contract is
suggested.
QUESTION – 15
You are required to calculate the expected loss and show how it can be hedged
by a forward contract
SOLUTION:-
Spot rate of ₹ 1 against Yen = JPY 216 lakhs/₹ 50 lakhs = JPY 4.32
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₹ (in lakhs)
Present cost of JPY 216 lakhs 50.00
Cost after 3 months: JPY 216 lakhs/JPY 3.97 54.41
Expected exchange loss 4.41
₹ (in lakhs)
Present cost of JPY 216 lakhs 50.00
Suggestion: If the exchange rate risk is not covered with forward contract. The
expected exchange loss is ₹ 4.41 lakhs. This could be reduced to ₹ 2.43 lakhs if
it is covered with forward contract. Hence, taking forward contract is
suggested.
QUESTION – 16
Humata Ltd. a Japanese Corporation, has sold goods today to Peacock Ltd., an
Indian company for an amount of JPY 74 lakhs. The payment will be due in
three months from the date of invoice. At today’s spot rate, it is equivalent to
INR 50 lakhs. It is anticipated that the INR will decline by 10% over the 3 –
months period and in order to protect the Yen payments, Peacock decides to
take appropriate action in the foreign exchange market. The 3 – months
forward rate is presently quoted at JPY/INR 1.44.
SOLUTION:-
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₹ (in lakhs)
Present cost of JPY 74 lakhs 50.00
Cost after 3 months: JPY 74 lakhs/JPY 1.33 55.64
Expected exchange loss 5.64
₹ (in lakhs)
Present cost 50.00
Suggestion: If the exchange rate risk is not covered with forward contract the
expected exchange loss is ₹ 5.64 lakhs. This could be reduced to ₹ 1.39 Lakhs
if it is covered with forward contract. Hence, taking forward contract is
suggested.
QUESTION – 17
In the following situations, compute the profit/loss the company will make if it
hedges its foreign exchange risk with the exchange rate on 31st December,
2016 as:
(i) ₹ 68 per US $.
(ii) ₹ 62 per US $.
(iii) ₹ 70 per US $.
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(iv) ₹ 65 per US $.
SOLUTION:-
(₹)
If exchange rate is ₹ 68
2,40,000
Then gain (₹ 68 – ₹ 64) for US$ 60,000
81,408
Less: Hedging cost
1,58,592
Net gain
If US$ = ₹ 62
1,20,000
Then loss (₹ 64 – ₹ 62) for US$ 60,000
81,408
Add: Hedging Cost
2,01,408
Total Loss
If US$ = ₹ 70
3,60,000
Then Gain (₹ 70 – ₹ 64) for US$ 60,000
81,408
Less: Hedging Cost
2,78,592
Total Gain
If US$ = ₹ 65
60,000
Then Gain (₹ 65 – ₹ 64) for US$ 60,000
81,408
Less: Hedging Cost
21,408
Net Loss
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QUESTION – 18
TT Ltd. is planning to hedge its foreign exchange risk. It has made a purchase
on 1st April 2021 for which it has to make a payment of US $ 1 Lakh on
30/09/2021. The present exchange rate is 1US $ = ₹ 73. It can purchase
forward 1US $ at ₹ 74. TT Ltd. will have to make an upfront premium @ 1% of
the forward amount purchased. The cost of the funds to the company is 10%
p.a. In the following situations, compute the Gain/(Loss) of the TT Ltd. will
make if they hedge with exchange rate on 30/09/2021 as:
(i) ₹ 76/US $
(ii) ₹ 70/US $
(iii) ₹ 79/US $
SOLUTION:
(₹)
1,00,000 × 74 × 1% 74,000
If exchange rate is ₹ 76
If US$ = ₹ 170
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If US$ = ₹ 79
QUESTION – 19
ZX Ltd. has made purchases worth USD 80,000 on 1st May 2020 for which it
has to make a payment on 1st November 2020. The present exchange rate is
INR/USD 75. The company can purchase forward dollars at INR/USD 74. The
company will have to make an upfront premium @ 1 per cent of the forward
amount purchased. The cost of funds to ZX Ltd. is 10 per cent per annum.
The company can hedge its position with the following expected rate of USD in
foreign exchange market on 1st May 2020:
You are required to advise the company for a suitable cover for risk.
SOLUTION:-
Expected Rate
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= ₹ 74.70
= ₹ 59,76,000
Advise: Since cash flow is less in case of unhedged position company should
opt for the same.
QUESTION – 20
Digital Exporter are holding an Export bill in United States Dollar (USD)
5,00,000 due after 60 days. They are worried about the falling USD value,
which is currently at ₹ 75.60 per USD. The concerned Export Consignment has
been priced on an Exchange rate of ₹ 75.50 per USD. The Firm’s Bankers have
quoted a 60-days forward rate of ₹ 75.20 Calculate:
(i) Rate of discount quoted by the Bank, assuming 365 days in a year.
(ii) The probable loss of operating profit if the forward sale is agreed to.
SOLUTION:-
(75.20−75.60)×365×100
= 3.22%
75.60×60
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QUESTION – 21
Excel Exporters are holding an Export bill in United States Dollar (USD)
1,00,000 due 60 days hence. They are worried about the falling USD value
which is currently at ₹ 45.60 per USD. The concerned Export Consignment has
been priced on an Exchange rate of ₹ 45.50 per USD. The Firm’s Bankers have
quoted a 60-day forward rate of ₹ 45.20.
Calculate:
(ii) The probable loss of operating profit if the forward sale is agreed to.
SOLUTION:-
(45.20−45.60)×365×100
= = 5.33%
45.60×60
(ii) Probable loss of operating profit:
QUESTION – 22
ABC Co. have taken a 6 month loan from their foreign collaborators for US
Dollars 2 millions. Interest payable on maturity is at LIBOR plus 1.0%. Current
6-month LIBOR is 2%.
Enquiries regarding exchange rates with their bank elicit the following
information:
(i) What would be their total commitment in Rupees, if they enter into a
forward contract?
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SOLUTION:-
From the forward points quoted, it is seen that the second figure is less than
the first, this means that the currency is quoted at a discount.
(ii) It is seen from the forward rates that the market expectation is that the
dollar will depreciate. If the firm's own expectation is that the dollar will
depreciate more than what the bank has quoted, it may be worthwhile
not to cover forward and keep the exposure open.
If the firm has no specific view regarding future dollar price movements, it
would be better to cover the exposure. This would freeze the total commitment
and insulate the firm from undue market fluctuations. In other words, it will be
advisable to cut the losses at this point of time.
Given the interest rate differentials and inflation rates between India and USA,
it would be unwise to expect continuous depreciation of the dollar. The US
Dollar is a stronger currency than the Indian Rupee based on past trends and
it would be advisable to cover the exposure.
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QUESTION – 23
SOLUTION:-
Total (₹)
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receipts
QUESTION – 24
You have following quotes from Bank A and Bank B:
Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 Months 5/10
6 Months 10/15
Calculate :
(i) How much minimum CHF amount you have to pay for 1 Million GBP
spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the
Implied Swap points for Spot over 3 months?
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SOLUTION:-
1. First to Buy USD against CHF at the cheaper rate i.e. from Bank A.
1 USD = CHF 1.4655
2. Then to Buy GBP against USD at a cheaper rate i.e. from Bank B 1
GBP = USD 1.7650
= CHF 2.5850
= CHF 2.5881
Hence
QUESTION – 25
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The spot rates on 3rd September are USD 49.3700/3800 and USD/SGD
1.7058/68. The swap points are:
USD/₹ USD/SGD
Spot/September 0300/0400 1st Month Forward 48/49
Spot/October 1100/1300 2nd Month Forward 96/97
Spot/November 1900/2200 3rd Month Forward 138/140
Spot/December 2700/3100
Spot/January 3500/4000
SOLUTION:-
QUESTION – 26
(Study Material)
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SOLUTION:-
Profit $ 62.50
Alternatively, if the market comes back together before December 15, the dealer
could unwind his position (by simultaneously buying £ 62,500 forward and
selling a futures contract. Both for delivery on December 15) and earn the
same profit of $ 62.5.
QUESTION – 27
The current spot exchange rate is $1.35/£ and the three-month forward rate is
$1.30/£. According to your analysis of the exchange rate, you are quite
confident that the spot exchange rate will be $1.32/£ after 3 months.
(i) Suppose you want to speculate in the forward market then what course
of action would be required and what is the expected dollar Profit (Loss)
from this speculation?
(ii) What would be your Profit (Loss) in Dollar terms on the position taken as
per your speculation if the spot exchange rate turns out to be $1.26/£.
SOLUTION:-
(i) If you believe the spot exchange rate will be $ 1.32/£ in three months,
you should buy £ 1,000,000 forward for $1.30/£ and sell at $ 1.32/£ 3
months hence.
(ii) If the spot exchange rate turns out to be $1.26/£ in three months, your
loss from the long position in Forward Market will be: -
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QUESTION – 28
(i) Ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) Determine foreign exchange rate for June 20, 2016, and
SOLUTION:-
Bid Ask
Swap Point for 2 month (a) 70 90
Swap Point for 3 month (b) 160 186
Swap Point for 30 days (c) = (b)−(a) 90 96
Swap Point for 15 days (c)/2 45 48
Swap Point for 2 month & 15 days (e) = (a)+(d) 115 138
Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 month & 15 days (b) 0.0115 0.0138
66.2640 67.6083
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Bid Ask
Spot Rate (a) 66.2525 67.5945
0.0115 12 0.0138 12
Premium × × 100 × × 100
66.2583 2.5 67.6014 2.5
= 0.0833% = 0.0980%
QUESTION – 29
You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at ₹ 5.70
& covered yourself in London market on the same day, when the exchange
rates were
Calculate cover rate and ascertain the profit or loss in the transaction. Ignore
brokerage.
SOLUTION:-
The bank (Dealer) covers itself by buying from the market at market selling
rate.
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= ₹ 5.6471
QUESTION – 30
A Bank sold Hong Kong Dollars 40,00,000 value spot to its customer at ₹ 7.15
and covered itself in London Market on the same day, when the exchange rates
were;
You are required to calculate rate and ascertain the gain or loss in the
transaction. Ignore brokerage.
You have to show the calculations for exchange rate up to four decimal points.
SOLUTION:-
The bank (Dealer) covered itself by buying from the London market at market
selling rate.
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Alternative Calculation
QUESTION – 31
English Bank Ltd. sold Hong Kong Dollar 10 Crores value spot to its customer
at ₹ 9.70 and covered itself in the London market on the same day, when the
exchange rates were US $ 1 = HK $ 7.7506 – 7.7546. Local inter-bank market
rates for US $ were Spot US $ 1 = ₹ 74.70 – 74.85. Calculate the cover rate and
ascertain the profit or loss on the transaction. Ignore brokerage.
SOLUTION:-
The bank (Dealer) covers itself by buying from the market at market selling
rate.
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QUESTION – 32
You, a foreign exchange dealer of your bank, are informed that your bank has
sold a T.T. on Copenhagen for Danish Kroner 10,00,000 at the rate of Danish
Kroner 1 = ₹ 6.5150. You are required to cover the transaction either in London
or New York market. The rates on that date are as under:
In which market will you cover the transaction, London or New York, and what
will be the exchange profit or loss on the transaction? Ignore brokerages.
SOLUTION:-
Cover at London:
Bank buys locally GBP 87,565.67 for the above purchase at the market selling
rate of ₹ 74.3200.
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Bank buys locally USD 1,32,152.77 for the above purchase at the market
selling rate of ₹ 49.2625.
QUESTION – 33
On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per
annum respectively. The UK £/US $ spot rate is 0.7570. What would be the
forward rate for US $ for delivery on 30th June?
SOLUTION:-
1 + in A
S1 = S0
1 + in B
1 + 0.075 ×3/12
S1 = £ 0.7570
1 +(0.035)×3/12
1.01875
= £ 0.7570
1.00875
= £ 0.7570 × 1.0099 = £ 0.7645
= UK £ 0.7645/US$
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QUESTION – 34
On 1st April, 3 months interest rate in the US and Germany are 6.5 per cent
and 4.5 per cent per annum respectively. The $/DM spot rate is 0.6560. What
would be the forward rate for DM for delivery on 30th June?
(Practice Manual)
SOLUTION:
USD DM
Spot 0.6560 1.000
Interest rate p.a. 6.5% 4.5%
Interest for 91 days 0.0106 0.0112
Amount after 91 days 0.6666 1.0112
Hence forward rate 0.6666 0.6592
1.0112
Or
91
0.6560 × 1+ 0.065×
365
Forward rate = 91
1+ 0.045×
365
= 0.6592
QUESTION – 35
The following table shows interest rates for the United States Dollar and
French Franc. The spot exchange rate is 7.05 Franc per Dollar. Complete the
missing entries:
(Practice Manual)
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SOLUTION:-
(1+r f ) S f/d
Or, =
1+r d F f/d
Where rf is the rate of interest of country F (say the foreign country), rd is rate
of interest of country D (say domestic country), S f/d is the spot rate between the
two countries F and D and Ff/d is the forward rate between the two countries F
and D.
3 months
1
Dollar interest rate = 11 % (annually compounded)
2
1
Franc interest rate = 19 % (annually compounded)
2
Then Forward France per Dollar rate would be
0.195
1+ 1 + 0.04875
4
= 7.05 0.115 = 7.05
1 + 1 + 0.02875
4
Further Forward discount per Franc per cent per year = Interest Differential i.e.
1 1
= 19 % − 11 % = 8%
2 2
Alternatively, more precisely it can also be computed as follows:
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1 + 0.115
One year forward rate = 0.142 = US Dollar 0.132 per Franc
1 + 0.195
0.142−0.132
Accordingly, the discount per annum will be = × 100
0.142
= 7.04%
6 months
Let r be the Franc interest rate (annually compounded) then as per IRP Theory.
r
1+
2
7.05 0.1225 = Franc 7.28 per Dollar
1 +
2
On solving the equation we get the value of r = 19.17% i.e. Franc interest rate
(annually compounded)
1 Year
As per Interest Rate Parity the relationship between the two countries rate and
1+Dollar interest rate 7.05
spot rate is i.e. =
1+0.20 7.52
Accordingly, the Dollar interest rate = 1.20 × 0.9374 – 1
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QUESTION – 36
The US dollar is selling in India at ₹ 55.50. If the interest rate for 6 months
borrowing in India is 10% per annum and the corresponding rate in USA is 4%.
(ii) What will be the expected 6-months forward rate for US dollar in India?
and
SOLUTION:-
1+R h F1
=
1+R f E0
1 + (0.10/2) F1
Therefore =
1 + (0.04/2) 55.50
1 + 0.05 F1
=
1 + 0.02 55.50
1.05
Or, × 55.50 = F1
1.02
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58.275
Or, = F1
1.02
Or, F1 = ₹ 57.13
57.13 −55.50 12
× × 100 = 5.87%
55.50 6
QUESTION – 37
The USD Dollar is selling in India at ₹ 72.50. If the interest rate for a 3 –
months borrowing in India is 6% per annum and the corresponding rate in
USA is 2.75%.
(ii) What will be the expected 3 – months forward rate for US dollar in India?
SOLUTION:-
1+R h F1
=
1+R f E0
1 + (0.06/4) F1
Therefore =
1 + (0.0275 /4) 72.50
1 + 0.015 F1
=
1 + 0.0069 72.50
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1.015
Or, × 72.50 = F1
1.0069
73.59
Or, = F1
1.0069
Or, F1 = ₹ 73.08
73.08 −72.50 12
× × 100 = 3.20%
72.50 3
QUESTION – 38
If the present interest rate for 6 months borrowings in India is 9% per annum
and the corresponding rate in USA is 2% per annum, and the US$ is selling in
India at ₹ 64.50/$.
Then:
(ii) Find out the expected 6-months forward rate for US$ in India.
SOLUTION:-
1+R h F1
=
1+R f E0
1+(0.09/2) F1
Therefore =
1+(0.02/2) 64.50
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1+0.045 F1
=
1+0.01 64.50
1.045
Or, × 64.50 = F1
1.01
67.4025
Or, = F1
1.01
Or, F1 = ₹ 66.74
66.74 − 64.50 12
× × 100 = 6.94%
64.50 6
QUESTION – 39
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage
of the situation, if he is willing to borrow ₹ 40,00,000 or US $83,312.
SOLUTION:-
= 3.36%
Since the negative Interest rate differential is greater than forward premium
there is a possibility of arbitrage inflow into India.
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2. Convert US$ 83,312 into Rupee and get the principal i.e. ₹ 40,00,000
= ₹ 2,40,000/-
= ₹ 42,40,000/-
= US$ 86,851.43
QUESTION – 40
What operations would be carried out to take the possible arbitrage gains?
SOLUTION:-
Since the interest rate differential is smaller than the premium, it will be
profitable to place money in Deutschmarks the currency whose 3-months
interest is lower.
= (1000/0.665) = 1503.76
(iii) Place DM 1503.76 in the money market for 3 months to obtain a sum of
DM
Principal: 1503.76
Total 1530.08
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Total 1022.50
QUESTION – 41
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To take the possible arbitrage gains, what operation would be carried out?
SOLUTION:-
Since the interest rate differential is smaller than the premium, it will be
profitable to place money in Deutschmarks the currency whose 3-months
interest is lower.
= (1000/0.666) = 1501.50
(iii) Place DM 1501.50 in the money market for 3 months to obtain a sum of
DM
Principal: 1501.50
Total 1529.65
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Total 1023.75
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Note: The students may use any quantity of currency to arrive at the arbitrage
gain since no specific amount is mentioned in the question.
QUESTION – 42
What operations would be carried out to earn the possible arbitrage gains?
SOLUTION:-
Since the interest rate differential is smaller than the premium, it will be
profitable to place money in Deutsch Marks the currency whose 3 months
interest is lower.
(iii) Place DM 1501.50 in the money market for 3 months to obtain a sum of
DM
A sum of DM –
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Principal DM1501.50
DM 1531.53
(v) Refund the debt taken in CAN $ with the interest due on it, i.e.
QUESTION – 43
Is there any arbitrage possibility? If yes, how a trader can take advantage of the
situation if he is willing to borrow USD 3 million.
SOLUTION:-
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Since the Interest rate differential is less than forward premium there is a
possibility of arbitrage outflow from India.
(i) Borrow equivalent amount of US$ 3000000 in India for 6 months at Spot
Rate
(ii)
Convert ₹ 20,55,00,000 into US$ and get the principal US$ 30,00,000
i.e.
Interest on Investments for 6 months – US$ 3000000 × US$ 60,000
0.02
Total amount at the end of 6 months = US$ (30,00,000 + US$ 30,60,000
60,000)
or
QUESTION – 44
Verify whether there is any scope for covered interest arbitrage if you borrow
rupees.
SOLUTION:-
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As the amount of Re. Received is less than the amount repaid there is no scope
for covered interest arbitrage.
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QUESTION – 45
The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The
current spot rate for USD in India is ₹ 46. What will be the expected rate after 1
year and after 4 years applying the Purchasing Power Parity Theory.
SOLUTION:-
(1+0.08)
2 ₹ 47.77 × 49.61
(1+0.04)
3 (1+0.08) 51.52
₹ 49.61 ×
(1+0.04)
(1+0.08)
4 ₹ 51.52 × 53.50
(1+0.04)
QUESTION – 46
The rate of inflation in USA is likely to be 3% per annum and in India it is likely
to be 6.5%. The current spot rate of US $ in India is ₹ 43.40. Find the expected
rate of US $ in India after one year and 3 years from now using purchasing
power parity theory.
SOLUTION:-
The differential inflation is 4%. Hence the rate will keep changing adversely by
4% every year. Assuming that the change is reflected at the end of each year,
the rates will be:
End of Year ₹ ₹/USD
1 ₹ 46.00 × 1.04 47.84
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Alternative Answer:
End of Year ₹ ₹/USD
1 (1+0.08) 47.77
₹ 46.00 ×
1+0.04
2 (1+0.08) 49.61
₹ 47.77 ×
1+0.04
3 (1+0.08) 51.52
₹ 49.61 ×
1+0.04
4 (1+0.08) 53.50
₹ 51.52 ×
1+0.04
QUESTION – 47
A US investor chose to invest in Sensex for a period of one year. The relevant
information is given below.
(iii) What should be the exchange rate if relevant purchasing power parity
holds good?
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SOLUTION:-
Sensex at To 3,256
Sensex at T1 3,765
US$ at T1 ₹ 43.90
(1+0.05)
Real Exchange Rate (Buying) = 43.85 = 42.24
(1+0.09)
42.50−42.24
Real Appreciation of ₹ = × 100 = 0.61%
42.50
(1+0.09)
Buying Rate = 42.50 = 42.12
(1+0.05)
(1+0.09)
Selling Rate = 42.60 = 44.22
(1+0.05)
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3,765−3,256
Nominal Return = × 100 = 15.63%
3,256
(1.1563 )
Real Return = –1 = 0.0608 or 6.08%
(1.09)
QUESTION – 48
(i) If Shoe Company were to hedge its foreign-exchange risk, what would it
do? What transactions are necessary?
(iii) What is the implied differential in interest rates between the two
countries? (Use interest-rate parity assumption).
(Practice Manual)
SOLUTION:-
(i) If Shoe Company were to hedge its foreign exchange risk, it would enter
into forward contract of selling deutsche marks 90 days forward. It would
sell 50,000 deutsche marks 90 days forward. Upon delivery of 50,000
DM 90 days hence, it would receive US $ 29,412 i.e. 50,000 DM/1.70. If
it were to receive US $ payment today it would receive US $ 29,240 i.e.
50,000 DM/1.71. Hence, Shoe Company will be better off by $ 172 if it
hedges its foreign exchange risk.
(ii) The deutsche mark is at a forward premium. This is because the 90 days
forward rate of deutsche marks per dollar is less than the current spot
rate of deutsche marks per dollar. This implies that deutsche mark is
expected to be strengthen i.e. Fewer deutsche mark will be required to
buy dollars.
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(iii) The interest rate parity assumption is that high interest rates on a
currency are offset by forward discount and low interest rate on a
currency is offset by forward premiums.
Further, the spot and forward exchange rates move in tandem, with the link
between them based on interest differential. The movement between two
currencies to take advantage of interest rates differential is a major
determinant of the spread between forward and spot rates. The forward
discount or premium is approximately equal to interest differential between the
currencies i.e.
1.70−1.71 365
Or, × = rDM − rUS $
1.71 90
Or, - 0.237 = 𝑟𝐷𝑀 − 𝑟𝑈𝑆$
QUESTION – 49
(ii) Assuming that the interest rates and the spot exchange rate
remain as above, what forward rate would yield an equilibrium
situation?
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(iii) Assuming that the US interest rate and the spot and forward rate
remain as in the original question. Where would you invest if the
sterling deposit rate were 14% per annum?
(iv) With the originally stated spot and forward rates and the same
dollar deposit rate, what is the equilibrium sterling deposit rate?
SOLUTION:-
US $ Deposits @ 8% p.a. or
Converted into Sterling Currency at the Spot Rate and invested in UK
Deposits.
Alternative 1
Particulars Value
Invest in $ deposits @ 8% p.a. for 3 months
Income = $ 10,00,000×8/100×3/12 $ 20,000
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x = 12.58%
QUESTION – 50
An Indian importer has to settle an import bill for $ 1,30,000. The exporter has
given the Indian exporter two options:
(ii) Pay after three months with interest at 5 percent per annum.
SOLUTION:-
If importer pays now, he will have to buy US$ in Spot Market by availing
overdraft facility. Accordingly, the outflow under this option will be
₹
Amount required to purchase $130000 [$130000 × ₹ 48.36] 62,86,800
Add: Overdraft Interest for 3 months @15% p.a. 2,35,755
65,22,555
If importer makes payment after 3 months then, he will have to pay interest for
3 months @ 5% p.a. for 3 month along with the sum of import bill. Accordingly,
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he will have to buy $ in forward market. The outflow under this option will be
as follows:
$
Amount of Bill 1,30,000
Add: Interest for 3 months @ 5% p.a. 1,625
1,31,625
Amount to be paid in Indian Rupee after 3 months under the forward purchase
contract ₹ 64,27,249 (US$ 1,31,625 × ₹ 48.83)
QUESTION – 51
Z Ltd. importing goods worth USD 2 million, requires 90 days to make the
payment. The overseas supplier has offered a 60 days interest free credit period
and for additional credit for 30 days an interest of 8% per annum.
The bankers of Z Ltd offer a 30 days loan at 10% per annum and their quote
for foreign exchange is as follows:
₹
Spot 1 USD 56.50
60 days forward for 1 USD 57.10
90 days forward for 1 USD 57.50
SOLUTION:-
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QUESTION – 52
DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms
are 60 days interest-free credit. For additional credit of 30 days, interest at the
rate of 7.75% p.a. will be charged.
The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a.
Their quote for the foreign exchange is as follows:
(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(Study Material, PM, MTP April – 2022 & Exam May - 2015)
SOLUTION:-
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QUESTION – 53
(i) Pay in 3 months’ time with interest @ 10% p.a. and cover risk forward for
3 months.
(ii) Settle now at a current spot rate and pay interest of the over draft for 3
months.
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SOLUTION:-
Option - I
Option - II
₹ 62,66,925
QUESTION – 54
India Imports Co., purchased USD 1,00,000 worth of machines from a firm in
New York, USA. The value of the rupee in terms of the Dollar has been
decreasing. The firm in New York offers 2/10, net 90 term. The spot rate for the
USD in ₹ 55; the 90 days forward rate is ₹ 56.
(i) Compute the Rupee cost of paying the account within the 10 days.
(ii) Compute the Rupee cost of buying a forward contract to liquidate the
account in 10 days.
(iii) The differential between part a and part b is the result of the time value
of money (the discount for prepayment) and protection from currency
value fluctuation. Determine the magnitude of each of these components.
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SOLUTION:-
= ₹ 2,10,000
QUESTION – 55
An Indian importer has to make payment of $100000 import bill to US party 3
months from now.
Spot rate $1 = ₹ 45.40 − 45.80
3 months forward rate = $1 = ₹ 46.10 – 46.75
The US party is willing to offer a cash discount of 2% for immediate payment.
The INR Loan borrowing rate is 14%.
Advise the importer whether he should enter into a forward contractor make
lead payment today?
SOLUTION:-
$ Payable = $ 1,00,000
Buy $ 1,00,000 at FR
= ₹ 46,75,000
= ₹ 44,88,400
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= ₹ 45,45,494
QUESTION – 56
An Indian Exporter is to receive € 200000 after 1 month. The customer is
requesting a total period of 3 months. The Indian exporter is planning to allow
additional 2 months to the foreign party at an interest of 6% p.a.
1 month FR € l = ₹ 56.70 − 57.20
3 month FR € 1 = ₹ 57.80 − 58.45
The rate of interest is Indian deposit rate is 14% p.a. for ₹ deposit made for 2
months.
Advise the exporter as to whether he should receive at the end of 1 month or at
end of 3 month.
SOLUTION:-
£ Receivable = £ 2,00,000
= ₹ 1,16,04,600
= £ 2,02,000
= £ 2,02,000 × 57.80
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Receive at the end of 3rd months is better due to the higher cash inflows.
QUESTION – 57
Columbus Surgicals Inc. is based in US, has recently imported surgical raw
materials from the UK and has been invoiced for £ 480,000, payable in 3
months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £ 138,000, payable in 3 months,
and the French customer has been invoiced for € 590,000, payable in 4
months.
£ / US$
US$ / €
You as Treasury Manager are required to show how the company can hedge its
foreign exchange exposure using Forward markets and Money markets hedge
and suggest which the best hedging technique is.
SOLUTION:-
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£ Exposure
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
€ Receipt
For money market hedge Columbus shall borrow in € and then translate
to US$ and deposit in US$
With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113
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In this case, more will be received in US$ under the forward hedge.
QUESTION – 58
Deposit Loan
$ 7% 9%
£ 5% 8%
Compute and show how a money market hedge can be put in place. Compare
and contrast the outcome with a forward contract.
SOLUTION:-
Create: $ Liability.
Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely, 1.5905
per £,
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QUESTION – 59
The supplier of the equipment has offered a discount of $5,000 if the payable is
settled at the current date. The manager is reviewing the following alternative
to settle the payable:
(c) Avail the cash discount of $ 5,000 by taking a bridge loan at 9% p.a.
from a Financial Institution.
You are required to suggest the best alternative to settle the payable.
SOLUTION:-
= ₹ 1,19,75,000
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= ₹ 1,19,70,628
(c) Leadings
= $ 2,45,000
= ₹ 1,15,88,500
QUESTION – 60
An Indian exporting firm, Rohit and Bros., would be covering itself against a
likely depreciation of pound sterling. The following data is given:
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SOLUTION:-
The only thing lefts Rohit and Bros to cover the risk in the money market. The
following steps are required to be taken:
(i) Borrow pound sterling for 3- months. The borrowing has to be such that
at the end of three months, the amount becomes £ 500,000. Say, the
amount borrowed is £ x. Therefore
3
x 1 + 0.05 ×
12 = 500,000 or x = £493,827
(ii) Convert the borrowed sum into rupees at the spot rate. This gives:
£ 493,827 × ₹ 56 = ₹ 27,654,312
(iii) The sum thus obtained is placed in the money market at 12 per cent to
obtain at the end of 3- months:
3
S = ₹ 27,654,312 × 1 + 0.12 ×
12 = ₹ 28,483,941
(iv) The sum of £ 500,000 received from the client at the end of 3- months is
used to refund the loan taken earlier.
From the calculations. It is clear that the money market operation has
resulted into a net gain of ₹ 483,941 (₹ 28,483,941 – ₹ 500,000 × 56).
QUESTION – 61
H Ltd. is an Indian firm exporting handicrafts to North America. All the exports
are invoiced in US$. The firm is considering the use of money market or
forward market to cover the receivable of $ 50,000 expected to be realized in 3
months time and has the following information from its banker:
Exchange Rates
Spot ₹/$ 72.65/73
3 – months forward ₹/$ 72.95/73.40
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The borrowing rates in US and India are 6% and 12% p.a. and the deposit rates
are 4% and 9% p.a. respectively.
(ii) Assume the H Ltd. anticipates the spot exchange rate in 3 – months time
to be equal to the current 3 – months forward rate. After 3 – months the
spot exchange rate turned out to be ₹/$ : 73/73.42.
SOLUTION:-
For money market hedge Indian Firm shall borrow in US$ and then
translate them to Indian Rupee and shall make deposit in Indian Rupee.
= ₹ 36,47,500
In this case, more will be received under the money market hedge hence
it is better option.
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QUESTION – 62
EFD Ltd. is an export business house. The company prepares invoice in
customers' currency. Its debtors of US$. 10,000,000 is due on April 1, 2015.
3-Months ₹ 22,500 7%
On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate
is 0.016134.
(Study Material, PM, MTP April – 2022 & Exam May - 2015)
SOLUTION:-
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Variation Margin =
OR
Futures ₹ 620,337,627
The most advantageous option would have been to hedge with futures.
QUESTION – 63
XYZ Ltd. is an export oriented business house based in Mumbai. The Company
invoices in customers’ currency. Its receipt of US $ 1,00,000 is due on
September 1, 2009.
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On September 1, 2009 the spot rate US $Re. is 0.02133 and currency future
rate is 0.02134. Comment which of the following methods would be most
advantageous for XYZ Ltd.
(Practice Manual)
SOLUTION:-
47,23,639
Less: Interest Cost – 1,50,000 × 0.08 × 3/12
₹ 3,000
Net Receipts
₹ 47,20,639
Receipts under different methods of hedging
Forward contract
₹ 47,01,457
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Futures ₹ 47,20,639
No hedge
QUESTION – 64
Doom Ltd. is an export business house. The company prepares invoice in
customers' currency. Its debtors of US$ 48, 00,000 is due on April 1, 2020.
On April 1, 2020 the spot rate US$/INR is 0.013894 and currency future rate
is 0.013893. Recommend as to which of the following methods would be most
advantageous to Doom Ltd.
SOLUTION:-
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Variation Margin
OR
= ₹ 2,98,658
The most advantageous option would have been to hedge with futures as it is
slightly higher than Forward Option but comparing to no hedge option it is
better proposition.
QUESTION – 65
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On April 1, 2017 the spot rate US$/INR is 0.016136 and currency future rate
is 0.016134.
SOLUTION:-
(₹)
Receipts using a forward contract (20,000,000/0.016129) 1,24,00,02,480
Variation Margin
= [(0.016134 – 0.016118) × 40 × 31,021,218]/0.016136
OR (0.000016 × 40 × 31021218)/.016136
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= 755.2/0.016136 12,30,390
1,24,06,94,941
Less: Interest Cost – 20,00,000 × 0.08 × 3/12 40,000
Futures 1,24,06,54,941
No hedge
*The most advantageous option would have been to hedge with Future.
QUESTION – 66
On July, the spot rate US $/₹ is 0.0146 and currency future rate is 0.0147
comment which of the following methods would be most advantageous for DSE
Ltd.
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SOLUTION:-
(₹)
(i) Receipts using a forward contract (3,00,000/0.0147) = ₹ 2,04,08,163
Variation Margin
= [(0.0151 – 0.0147) × 31 × 640000/-]/0.0146
OR (0.0004 × 31 × 640000)/0.0146 = 7936/0.0146 5,43,562
2,10,91,507
iii) No hedge
US$ 3,00,000/0.0146 ₹ 2,05,47,945
The most advantageous option would have been to hedge with futures.
QUESTION – 67
Zaz plc, a UK Company is in the process of negotiating an order amounting
€2.8 million with a large German retailer on 6 month’s credit. If successful,
this will be first time for Zaz has exported goods into the highly competitive
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(a) Mr. Peter the Marketing head has suggested that in order to remove
transaction risk completely Zaz should invoice the German firm in
Sterling using the current €/£ average spot rate to calculate the invoice
amount.
(b) Mr. Wilson, CE is doubtful about Mr. Peter’s proposal and suggested an
alternative of invoicing the German firm in € and using a forward
exchange contract to hedge the transaction risk.
(c) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the
German first in €, but she is of opinion that Zaz should use sufficient 6
month sterling further contracts (to the nearest whole number) to hedge
the transaction risk.
(a) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3
above proposals.
SOLUTION:-
€ 2.8 million
Invoicing in £ will produce = = £ 2.340 million
1.1965
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€ 2.8 million
= £ 2.35 million
1.1965
(c) Proposal of Ms. Karen
= 37 × £62,500 = £23,12,500
€0.0070
After 6 months
€ 27,83,812
Sterling Receipts
€ 27,83,812
On sale of € as spot = = £ 2.3446 million
1.1873
(ii) Proposal of option (b) is preferable because the option (a) & (c) produces
least receipts. Further, in case of proposal (a) there must be a doubt as
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QUESTION – 68
(i) Invoice the German firm in Sterling using the current exchange rate to
calculate the invoice amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign
exchange contract to hedge the transaction risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future
contracts (to the nearly whole number) to hedge the transaction risk.
Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the
three proposals.
(b) In your opinion, which alternative would you consider to be the most
appropriate and the reason thereof.
SOLUTION:-
€ 4 million
Invoicing in £ will produce = = £ 3398471
1.1770
(b) Use of forward contract
€4million
Using Forward Market hedge Sterling receipt would be
1.1830
= £ 3382664
€4million
= = £ 3401360
1.1760
£3401360
Number of Contracts = = 54 Contracts (to the nearest
62,500
whole number)
€0.0025
= €8438
After 6 months
€ 4008438
Sterling Receipts
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€4008438
On sale of € at spot = = €3401305
1.1785
(ii) Proposal of option (c) is preferable because the option (a) & (b) produces
least receipts.
QUESTION – 69
Telereal Trillium, a UK Company is in the process of negotiating an order
amounting €5.5 million with a large German retailer on 6 month’s credit. If
successful, this will be first time for Telereal Trillium has exported goods into
the highly competitive German Market. The Telereal Trillium is considering
following 3 alternatives for managing the transaction risk before the order is
finalized.
(i) Mr. Grand, the Marketing head has suggested that in order to remove
transaction risk completely Telereal Trillium should invoice the German
firm in Sterling using the current €/£ average spot rate to calculate the
invoice amount.
(ii) Mr. John, CE is doubtful about Mr. Grand’s proposal and suggested an
alternative of invoicing the German firm in € and using a forward
exchange contract to hedge the transaction risk.
(iii) Ms. Royce, CFO is agreed with the proposal of Mr. John to invoice the
German first in €, but she is of opinion that Telereal Trillium should use
sufficient 6 month sterling future contracts (to the nearest whole
number) to hedge the transaction risk.
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(b) Interpret the proposal of Mr. Grand from non-financial point of view.
SOLUTION:-
€5.5 million
Invoicing in £ will produce = = £ 45, 87,156
1.1990
€5.5 million
= £ 46,08,295
1.1990
€0.0070
= €32,078
After 6 months
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€ 54, 67,922
Sterling Receipts
€54,67,922
On sale of € at spot = = £46, 05,342
1.1873
Proposal of option (ii) is preferable because the option (i) & (iii)
produces least receipts.
(b) Further, in case of proposal (i) there must be a doubt as to whether this
would be acceptable to German firm as it is described as a competitive
market and Telereal Trillium is moving into it first time.
QUESTION – 70
ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3 months.
The company decided to go for future contract to hedge against the risk. The
standard size of future contract available in the market is $1000. As on date
spot and futures $ contract are quoting at ₹ 44.00 &₹ 45.00 respectively.
Suppose after 3 months the company closes out its position futures are
quoting at ₹ 44.50 and spot rate is also quoting at ₹ 44.50. You are required to
calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.
SOLUTION:-
The company can hedge position by selling future contracts as it will receive
amount from outside.
$4,00,000
Number of Contracts = = 400 contracts
$1,000
= ₹ 1,80,00,000
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₹1,80,00,000
Effective Price realization = = ₹ 45 per US$
$4,00,000
QUESTION – 71
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the
following information is available:
U.K. US
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and
a premium of $ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
(d) No hedging.
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SOLUTION:-
* ($1.97 + $0.04)
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QUESTION – 72
Spot Rate - $ 1 = ₹ 71
Particulars US India
90 days Deposit Rate 2.50% 4.00%
90 days Borrowing Rate 4.00% 6.00%
Which of the following strategic would be the most preferable to Sun Limited :
(iv) No Hedging.
SOLUTION:-
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Expected Prem. Exercise Total Total price Prob. Pixi (5) × (6)
Spot rate /unit Option price for Pi (6) (7)
(1) (2) (3) per unit $5,00,000 ×
(4) (4) = (5)
72.50 0.10 No 72.60 3,63,00,000 0.25 90,75,000
73.00 0.10 No 73.10 3,65,50,000 0.50 1,82,75,000
74.50 0.10 Yes 74.10* 3,70,50,000 0.25 92,62,500
3,66,12,500
Add: Interest on Premium @ 6% (50,000 × 6% ) 3,000
3,66,15,500
* (₹ 74 + ₹ 0.10)
QUESTION – 73
A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of
the U.S. suppliers. The amount is payable in six months time. The relevant
spot and forward rates are:
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The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the
deposit rates are 5.5% and 4.5% respectively.
Currency options are available under which one option contract is for GBP
12,500. The option premium for GBP at a strike price of USD 1.70/GBP is USD
0.037 (call option) and USD 0.096 (put option) for 6 months period.
SOLUTION:-
In the given case, the exchange rates are indirect. These can be converted into
direct rates as follows:
1 1
GBP = to
USD 1.5617 USD 1.5673
USD = GBP 0.64033 - GBP 0.63804
1 1
GBP = to
USD 1.5455 USD 1.5609
USD = GBP 0.64704 - GBP 0.64066
Payoff in 3 alternatives
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1
PV @ 4.5% for 6 months i.e. = 0.9779951 USD 3,56,867
1.0225
Spot rate purchase GBP 0.64033
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GBP 2,27,923
The company should take currency option for hedging the risk.
Note: Even interest on Option Premium can also be considered in the above
solution.
QUESTION – 74
XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30 th
June. In order to hedge the risk involved in foreign currency transaction, the
firm is considering two alternative methods i.e. forward market cover and
currency option contract.
1.9516/1.9711. 1.9726./1.9923
For excess or balance of JY covered, the firm would use forward rate as future
spot rate. You are required to recommend cheaper hedging alternative for XYZ.
SOLUTION:-
1
3 – months Forward Rate = = ₹ 0.5070/JY
1.9726
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JY 5,00,000
Accordingly, outflow in INR ₹ 2,35,294
2.125
INR 2,35,294 ×0.098
Premium ₹ 11,815
1.9516
₹ 2,47,109
Since outflow of cash is least in case of Option same should be opted for.
Further if price of INR goes above JY 2.125/INR the outflow shall further
be reduced.
QUESTION – 75
An American firm is under obligation to pay interests of Can$ 1010000 and
Can$ 705000 on 31st July and 30th September respectively. The Firm is risk
averse and its policy is to hedge the risks involved in all foreign currency
transactions. The Finance Manager of the firm is thinking of hedging the risk
considering two methods i.e. fixed forward or option contracts.
It is now June 30. Following quotations regarding rates of exchange, US$ per
Can$, from the firm’s bank were obtained:
Price for a Can$ /US$ option on a U.S. stock exchange (cents per Can$,
payable on purchase of the option, contract size Can$ 50000) are as follows:
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(Study Material, PM, MTP March – 2022 & Exam Nov - 2013)
SOLUTION:-
Hedge the risk by buying Can$ in 1 and 3 months time will be:
Option Contracts
Company would like to take out 20 contracts for July and 14 contracts for
September respectively. Therefore costs, if the options were exercised, will be:
July September
Can $ US $ Can $ US $
Covered by Contracts 1000000 940000 700000 665000
Balance bought at spot rate 10000 9301 5000 4678
Option Costs:
Can $ 50000 × 20 × 0.0102 10200 ---
Can $ 50000 × 14 × 0.0164 --- 11480
Total cost in US $ of using Option
Contract 959501 681158
Decision: As the firm is stated as risk averse and the money due to be paid is
certain, a fixed forward contract, being the cheapest alternative in the both the
cases, would be recommended.
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QUESTION – 76
SOLUTION:-
(i) Straddle is a portfolio of a CALL & a PUT option with identical Strike
Price. A trader will be selling a Call option & a Put option with Strike
Price of USD per EURO.
At the expiry of three months Spot rate is 1.2900 i.e. higher than Strike
Price. Hence, buyer of the Call option will exercise the option, but buyer
of Put option will allow the option to lapse.
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(V) Invoicing
QUESTION – 77
XP Pharma Ltd., has acquired an export order for ₹ 10 million for formulations
to a European company. The Company has also planned to import bulk drugs
worth ₹ 5 million from a company in UK. The proceeds of exports will be
realized in 3 months from now and the payments for imports will be due after 6
months from now. The invoicing of these exports and imports can be done in
any currency i.e. Dollar, Euro or Pounds sterling at company's choice. The
following market quotes are available.
₹/$ 67.10/67.20 $ - 7%
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SOLUTION:-
QUESTION – 78
XYZ Ltd. has imported goods to the extent of US$ 8 Million. The payment terms
are as under:
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Advise which one of the following options would be better for XYZ Ltd.
(i) Pay immediately after utilizing cash available and for balance amount
take 90 days loan from bank.
(ii) Pay the supplier on 60th day and avail bank’s loan (after utilizing cash)
for 30 days.
(iii) Avail supplier offer of 90 days credit and utilize cash available.
Further presume that the cash available with XYZ Ltd. will fetch a return of 4%
p.a. in India till it is utilized.
Compute your working upto four decimals and cash flows in Crore.
SOLUTION:-
To evaluate which option would be better we shall compute the outflow under
each option as follows:
Particulars
Spot Rate ₹ 66.98
[US $ 8 million (1−0.01)] US$ 7.92 Million
Amount required in US$
[₹ 66.98 × US $ 7.92 million ]
₹ 53.0482 Crore
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(ii) Pay the supplier on 60th day and avail bank’s loan (after utilizing
cash) for 30 days.
Particulars
Applicable forward rate ₹ 67.16
Amount required in [₹ 67.16 × US$ 8 million] ₹ 53.7280 Crore
Loan required [₹ 53.7280 crore − ₹ 0.25 crore] ₹ 53.4780 Crore
Interest for 30 days @ 9% ₹ 0.4011 Crore
₹ 53.8791 Crore
Interest earned on cash for 60 days @ 4% ₹ 0.0017 Crore
Total Outflow ₹ 53.8774 Crore
(iii) Avail supplier offer of 90 days credit and utilize cash available
Particulars
Amount Payable US$ 8 Million
Interest for 30 days @ 8% US$ 0.0533 Million
Amount required in ₹ US$ 8.0533 Million
Applicable Forward Rate ₹ 68.03
Amount required in ₹ [₹ 68.03 × US$ 8.0533 million] ₹ 54.7866 Crore
Cash Available ₹ 0.2500 Crore
Interest earned on cash for 90 days @ 4% ₹ 0.0025 Crore
Total Outflow ₹ 54.5341
Decision: Cash outflow is least in case of Option (ii) same should be opted for.
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QUESTION – 79
An importer requests his bank to extend the forward contract for US$ 20,000
which is due for maturity on 30th October, 2010, for a further period of 3
months. He agrees to pay the required margin money for such extension of the
contract.
Margin money for buying and selling rate is 0.075% and 0.20% respectively.
Compute:
(i) The cost to the importer in respect of the extension of the forward
contract, and
SOLUTION:-
= ₹ 41.4689 or ₹ 41.47
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= ₹ 41.9061
= ₹ 41.9899 or ₹ 41.99
QUESTION – 80
A bank entered into a forward sale contract with a customer for US dollar
500,000 due Sep. 15, at the rate of US dollar 1 = ₹ 34.60. On Sep. 15,
customer requests the bank to cancel the contract.
What will be the cancellation charge if the following is the spot rate in the
interbank market?
SOLUTION:-
(34.50 – 0.08%)
QUESTION – 81
The rates ruling in the interbank market on Oct. 30, 2005 are as under:
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What will be the cancellation charges of the bank if Banks load 0.150% for
their exchange margin?
SOLUTION:-
(35.2050 + 0.150%)
QUESTION – 82
On 15th January 2015 you as a banker booked a forward contract for US$
2,50,000 for your import customer deliverable on 15th March 2015 at ₹
65.3450. On due date customer request you to cancel the contract. On this
date quotation for US$ in the inter-bank market is as follows:
Spot/April 3,000/3,100
Spot/May 6,000/6,100
Assuming that the flat charges for the cancellation is ₹ 100 and exchange
margin is 0.10%, then determine the cancellation charges payable by the
customer.
SOLUTION:-
Since this is sale contract the contract shall be cancelled at ready buying rate
on the date of cancellation as follows:
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Rounded to ₹ 65.2250
QUESTION – 83
You as a banker has entered into a 3 month’s forward contract with your
customer to purchase AUD 1,00,000 at the rate of ₹ 47.2500. However after 2
month’s your customer comes to you and requests cancellation of the contract.
On this date quotation for AUD in the market is as follows:
SOLUTION:-
The contract shall be cancelled at the 1 month forward sale rate of ₹ 47.5200
as follows:
QUESTION – 84
A customer with whom the bank had entered into 3 months forward purchase
contract for Swiss Francs 1,00,000 at the rate of ₹ 36.25 comes to the bank
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after two months and requests cancellation of the contract. On this date, the
rates are:
SOLUTION:-
Original contract for Swiss Franc 1,00,000 @ 36.25 – amount receivable by the
customer to cancel the purchase contract 1 month before the due date – the
contract will be cancelled at 1 month forward sale rate i.e. Swiss Francs 1 =
36.52 payable by the customer.
QUESTION – 85
A customer with whom the Bank had entered into 3 months’ forward purchase
contract for Swiss Francs 10,000 at the rate of ₹ 27.25 comes to the bank after
2 months and requests cancellation of the contract. On this date, the rates,
prevailing, are:
SOLUTION:-
The contract would be cancelled at the one month forward sale rate of ₹ 27.52.
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₹
Francs bought from customer under original forward contract at: 27.25
It is sold to him on cancellation at: 27.52
Net amount payable by customer per Franc 0.27
Note: The exchange commission and other service charges are ignored.
QUESTION – 86
Suppose you as a banker entered into a forward purchase contract for US$
50,000 on 5th March with an export customer for 3 months at the rate of ₹
59.6000. On the same day you also covered yourself in the market at ₹
60.6025. However on 5th May your customer comes to you and requests
extension of the contract to 5th July. On this date (5th May) quotation for US$
in the market is as follows:
SOLUTION:-
The forward purchase contract shall be cancelled at the for the forward
sale rate for delivery June.
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The forward contract shall be rebooked with the delivery 15th July as
follows:
QUESTION – 87
Suppose you are a banker and one of your export customer has booked a US$
1,00,000 forward sale contract for 2 months with you at the rate of ₹ 62.5200
and simultaneously you covered yourself in the interbank market at 62.5900.
However on due date, after 2 months you customer comes to you and requests
for cancellation of the contract and also requests for extension of the contract
by one month. On this date quotation for US$ in the market was as follows:
Spot ₹ 62.7200/62.6800
SOLUTION:-
Cancellation
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Thus total cancellation charges payable by the customer for US$ 1,00,000 is ₹
26,750.
Rebooking
QUESTION – 88
A bank enters into a forward purchase TT covering an export bill for Swiss
Francs 1,00,000 at ₹ 32.4000 due 25th April and covered itself for same
delivery in the local inter bank market at ₹ 32.4200. However, on 25th March,
exporter sought for cancellation of the contract as the tenor of the bill is
changed.
Spot/May .4300/.4400
Spot/June .4500/.4600
SOLUTION:-
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₹ 49.8655
₹ 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
QUESTION – 89
NP and Co. has imported goods for US $ 7,00,000. The amount is payable after
three months. The company has also exported goods for US $ 4,50,000 and
this amount is receivable in two months. For receivable amount a forward
contract is already taken at ₹ 48.90.
Spot ₹ 48.50/70
The company wants to cover the risk and it has two options as under :
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(B) To lag the receivables by one month and cover the risk only for the net
amount. No interest for delaying the receivables is earned. Evaluate both
the options if the cost of Rupee Funds is 12%. Which option is
preferable?
SOLUTION:-
(B) Assuming that since the forward contract for receivable was already
booked it shall be cancelled if we lag the receivables. Accordingly any
profit/ loss on cancellation of contract shall also be calculated and shall
be adjusted as follows:
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Since net payable amount is least in case of first option, hence the company
should cover payable and receivables in forward market.
Note: In the question it has not been clearly mentioned that whether quotes
given for 2 and 3 months (in points terms) are premium points or direct quotes.
Although above solution is based on the assumption that these are direct
quotes, but students can also consider them as premium points and solve the
question accordingly.
QUESTION – 90
An importer booked a forward contract with his bank on 10 th April for USD
2,00,000 due on 10th June @ ₹64.4000. The bank covered its position in the
market at ₹ 64.2800.
The exchange rates for dollar in the interbank market on 10 th June and 13th
June were:
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer
requested on 14th June for extension of contract with due date on 10th August.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
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SOLUTION:-
On 10th June the bank does a swap sale of $ at market buying rate of ₹
63.8000 and forward purchase for June at market selling rate of ₹
63.9500.
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QUESTION – 91
On 10th July, an importer entered into a forward contract with bank for US $
50,000 due on 10th September at an exchange rate of ₹66.8400. The bank
covered its position in the interbank market at ₹ 66.6800.
How the bank would react if the customer requests on 13th September:
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SOLUTION:-
In each of the case first the FEADI Rule of Automatic Cancellation shall be
applied and customer shall pay the charges consisted of following:
On 10th September the bank does a swap sale of $ at market buying rate
of ₹ 66.1500 and forward purchase for September at market selling rate
of ₹ 66.3200.
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₹ 33,58,526.00
QUESTION – 92
Y has to remit USD $ 1,00,000 for his son’s education on 4 th April 2018.
Accordingly, he has booked a forward contract with his bank on 4 th January @
63.8775. The bank has covered its position in the market @ ₹ 63.7575.
The exchange rates for USD $ in the inter-bank market on 4th April and 7th
April were:
Exchange margin of 0.10 percent and interest outlay of funds @ 12 percent are
applicable. The remitter, due to rescheduling of the semester, has requested on
7th April 2018 for extension of contract with due date on 7th June 2018.
Calculate:
SOLUTION:-
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On 4th April, the bank does a swap sale of $ at market buying rate of ₹
63.2775 and forward purchase for April at market selling rate of ₹
63.4275
On 4th April, the bank receives delivery under cover contract at ₹ 63.7575
and sell spot at ₹ 63.2775.
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QUESTION – 93
On 1st January 2019 Global Ltd., an exporter entered into a forward contract
with BBC Bank to sell US$ 2,00,000 on 31st March 2019 at ₹ 71.50/$.
However, due to the request of the importer, Global Ltd. received the amount
on 28 February 2019. Global Ltd. request the Bank of take delivery of the
remittance on 2nd March 2019. The Inter-banking rates on 28th February 2019
were as follows:
If Bank agrees to take early delivery then what will be the net inflow to Global
Ltd. assuming that the prevailing prime lending rate is 15%.
SOLUTION:-
On 28th February 2019 bank would purchase form the exporter US$ 200000 at
the agreed rate i.e. ₹ 71.50/$. However, bank will charge for this early delivery
consisting of Swap Difference and Interest on outlay of funds.
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It buys at ₹ 71.35
₹ 30,764
QUESTION – 94
On 19th January, Bank A entered into forward contract with a customer for a
forward sale of US $ 7,000, delivery 20th March at ₹ 46.67. On the same day, it
covered its position by buying forward from the market due 19 th March, at the
rate of ₹ 46.655. On 19th February, the customer approaches the bank and
requests for early delivery of US $. Rates prevailing in the interbank markets
on that date are as under:
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March 46.3550/3650
What is the amount that would be recovered form the customer on the
transaction?
SOLUTION:-
The bank would sell US $ to its customer at the agreed rate under the contract.
However, it would recover loss from the customer for early delivery.
On 19th February bank would buy US$ 7000 from market and shall sell to
customer. Further, Bank would enter into one month forward contract to sell
the US $ acquired under the cover deal.
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QUESTION – 95
On 1st October, 2020 Mr. Guru, and exporter, enters into a forward contract
with the Bank to sell USD 1,00,000 on 31st December 2020 at INR/USD 75.40.
However, at the request of the importer, Mr. Guru received the amount on 30 th
November, 2020. Mr. Guru requested the bank take delivery of the remittance
on 30th November, 2020 i.e. before due date.
(i) If bank agrees to take early delivery then what will be net inflow to Mr.
Guru assuming that the prevailing prime lending rate is 18% per annum.
(ii) If Mr. Guru can deploy these funds in USD, he gets return at the rate of
3% per annum. Which is better? Why?
SOLUTION:-
Working Notes:
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(ii) If Mr. Guru deploys these funds in US$, then inflow will be –
QUESTION – 96
You as a dealer in foreign exchange have the following position in Swiss Francs
on 31st October, 2009:
Swiss Francs
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000
Sold forward TT 60,000
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What steps would you take, if you are required to maintain a credit Balance of
Swiss Francs 30,000 in the Nostro A/c and keep as overbought position on
Swiss Francs 10,000?
SOLUTION:-
Exchange Position:
Credit Debit
Opening balance credit 1,00,000 ---
TT sales --- 75,000
1,00,000 75,000
Closing balance (credit) --- 25,000
1,00,000 1,00,000
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro
account to Sw. Fcs. 30,000.
This would bring down the oversold position on Sw. Fcs. as Nil.
Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to
buy forward Sw. Fcs. 10,000.
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QUESTION – 97
(Swiss Francs)
Remitted by TT 75,000
SOLUTION:-
Exchange Position
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Credit Debit
Opening balance credit 1,00,000 ---
TT sales --- 75,000
1,00,000 75,000
Closing balance (credit) --- 25,000
1,00,000 1,00,000
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro account
to Sw. Fcs. 30,000.
This would bring down the oversold position on Sw. Fcs. as Nil.
Since the bank requires an overbought position of Sw. Fcs. 10,000, it has to buy
forward Sw. Fcs. 10,000.
QUESTION – 98
Suppose you are a dealer of ABC bank and on 20/10/2014 you found that
balance in your Nostro account with XYZ bank in London is £ 65,000 and you
had overbought £ 35,000. During the day following transaction have taken
place:
£
DD purchased 12,500
Purchased a bill on London 40,000
Sold forward TT 30,000
Forward purchase contract cancelled 15,000
Remitted by TT 37,500
Draft on London cancelled 15,000
What steps would you take, if you are required to maintain a credit balance of
£ 15,000 in the Nostro A/c and keep as overbought position on £ 7,500?
(Study Material)
SOLUTION:-
Exchange Position:
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Credit £ Debit £
Opening balance credit 65,000 ---
TT Remittance --- 37,500
65,000 37,500
Closing balance (credit) --- 27,500
65,000 65,000
QUESTION – 99
SOLUTION:-
Here Canara Bank shall buy US$ and credit ₹ to Vostro account of ABN-Amro
Bank Canara Bank’s buying rate will be based on the inter-bank buying Rate (
as this is the rate at which Canara Bank can sell US$ in the inter-bank
market)
Accordingly, the inter-bank Buying Rate of US$ will be ₹ 51.3625 (lower of two)
i.e. (1/51.3625) = $ 0.01947/₹
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15,000,000
= = US$ 2,92,041.86
51.3625
Or = 15,000,000 × $ 0.01947 = US$ 2,92,050
QUESTION – 100
Calculate the amount of £’s credited. Ongoing inter-bank rates are per $, ₹
61.3625/3700 & per £, $ 1.5260/70.
SOLUTION:-
To purchase Rupee, XYZ Bank shall first sell £ and purchase $ and then sell $
to purchase Rupee. Accordingly, following rate shall be used:
(£/₹)ask
($/£)bid = $1.5260
($/£)ask = $1.5270
(₹/$)bid = ₹ 61.3625
(₹/$)ask = ₹ 61.3700
= (1/1.5260) × (1/61.3625)
= £ 0.01068 or £ 0.0107
= ₹ 25,000,000 × £ 0.0107
= £ 267,500
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QUESTION – 101
Sun Ltd. is planning to import equipment from Japan at a cost of 3,400 lakh
yen. The company may avail loans at 18 percent per annum with quarterly
rests with which it can import the equipment. The company has also an offer
from Osaka branch of an India based bank extending credit of 180 days at 2
percent per annum against opening of an irrecoverable letter of credit.
Additional information:
Advice the company whether the offer from the foreign branch should be
accepted.
SOLUTION:-
Option I (To finance the purchases by availing loan at 18% per annum):
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QUESTION – 102
XYZ has taken a six-month loan from its foreign collaborator for USD 2
millions. Interest is payable on maturity @ LIBOR plus 1%. The following
information is available:
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SOLUTION:-
6
Interest amount (20,00,000 × 3%* × ) US$ 30,000
12
US$ 20,30,000
(ii) Forward Rate as per Interest Rate Parity after 6 months is expected to be:
(1.03)
= 68.5275 × = 69.8845/US$
(1.01)
The company should take forward cover because as per Interest Rate
Parity, the rate after 6 months is expected to be higher than forward rate.
However, if spot rate is 68.4275, the expected rate as per Interest Rate
Parity shall be:
(1.03)
= 68.4275 × = 69.7825/US$
(1.01)
QUESTION – 103
K Ltd. currently operates from 4 different building and wants to consolidate its
operations into one building which is expected to cost ₹ 90 crores. The Board of
K Ltd, had approved the above plan and to fund the above cost, agreed to avail
an External Commercial Borrowing (ECB) of GBP 10 m from G Bank Ltd. on
the following condition:
The Loan will be availed on 1st April, 2019 with interest payable on half
yearly rest.
Average Loan Maturity life will be 3.4 years with an overall tenure of 5
years.
Upfront Fee of 1.20%.
Interest Cost is GBP 6 months LIBOR + Margin of 2.50%
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K Ltd. also entered into a GBP – INR hedge at 1 GBP = INR 90 to cover the
exposure on account of the above ECB Loan and the cost of the hedge is
coming to 4.00% p.a.
(i) Calculate the overall cost both in percentage and rupee terms on an
annual basis.
(iii) If K Ltd. wants to pursue an aggressive approach, what would be the net
gain/loss for K Ltd. if the INR depreciate/appreciates against GBP by
10% at the end of the 5 years assuming that the loan is repaid in GBP at
the end of 5 years ?
SOLUTION:-
Total ₹ 26,87,000
Or ₹ 2.687 million
2.687 million 1
= ×
(1,00,00,000−1,20,000) 3.4
2.687 1
= × × 100 = 8%
9.88 3.4
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2.687
= ₹ 90 × × 100 = ₹ 711.26 lakhs
3.4
OR
2.687 million 1
= ×
(1,00,00,000) 3.4
2.687 1
= × × 100 = 7.9%
1.00 3.4
Overall const in rupee terms @ GBP 1
= 10,000,000 × 7.90% × 90
= ₹ 71,100,000
OR
7.55%
= ₹ 71,100,000
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OR
QUESTION – 104
Spot ; 35.90/36.10
The company needs $ funds for six months, Determine whether the company
should borrow in $ or ₹. Interest rates are:
Also determine what should be the rate of interest after 3 – months to make the
company indifferent between 3- months borrowings end 6- months borrowings
in the case of:
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Note: For the purpose of calculation you can take the units of dollar and rupee
as 100 each.
SOLUTION:-
(ii)
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QUESTION – 105
SOLUTION:-
4% 4.35%
Effective rate of interest
1−0.08
1.05 0.96%
Premium on US$ − 1
1.04
Net Cost 5.31%
3% 3.26%
Effective rate of interest
1−0.08
1.05 1.94%
Premium on US$ − 1
1.03
Net Cost 5.20%
Thus, loan from Swiss Bank is the best option as the Total Outflow including
interest is less i.e. € 1,05,200
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QUESTION – 106
Your bank’s London office has surplus funds to the extent of USD 5,00,000/-
for a period of 3 months. The cost of the funds to the bank is 4% p.a. It
proposes to invest these funds in London, New York or Frankfurt and obtain
the best yield, without any exchange risk to the bank. The following rates of
interest are available at the three centres for investment of domestic funds
there at for a period of 3 months.
London 5 % p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
Spot 1.5350/90
1 month 15/18
2 months 30/35
3 months 80/85
London on Frankfurt
Spot 1.8260/90
1 month 60/55
2 months 95/90
3 months 145/140
At which centre, will be investment be made & what will be the net gain (to the
nearest pound) to the bank on the invested funds?
(Study Material, PM, RTP Nov – 2021 & Exam Nov - 2013)
SOLUTION:-
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= £ 3,28,947
= $ 5,05,000
= € 5,97,699
Since out of three options the maximum profit is in case investment is made in
New York. Hence it should be opted.
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QUESTION – 107
KGF Bank’s Sydney branch has surplus of USD $ 7,00,000 for a period of 2
months. Cost of funds to the bank is 6% p.a. They propose to invest these
funds in Sydney. New York or Tokyo and obtain the best yield, without any
exchange risk to the bank. The following rates of interest are available at the
three centers for investment of domestic funds there for a period of 2 Months.
The market rates in Australia for US Dollars and Yen are as under:
Spot 0.7100/0.7300
1 Month 10/20
2 Months 25/30
Sydney on Tokyo:
Spot 79.0900/79.2000
1 Month 40/30
2 Months 55/50
At which center, will the investment be made & what will be the net gain to the
bank on the invested funds?
SOLUTION:-
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= A$ 9,70,890
= $ 7,07,000
Or
= ¥ 7,63,43,587
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QUESTION – 108
Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas
subsidiaries, one based in Amsterdam and one in Switzerland. The Dutch
subsidiary has surplus Euros in the amount of 725,000 which it does not need
for the next three months but which will be needed at the end of that period
(91 days). The Swiss subsidiary has a surplus of Swiss Francs in the amount of
998,077 that, again, it will need on day 91. The XYZ plc in UK has a net
balance of £75,000 that is not needed for the foreseeable future.
Given the rates below, what is the advantage of swapping Euros and Swiss
Francs into Sterling?
(Practice Manual)
SOLUTION:-
Individuals Basis
Holland £502,414.71
€ 725,000 × 0.02 × 91/360 = € 3,665.28 € 728,665.28 (728,665.28 × 0.6895)
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Swap to Starling
£ 1,000,086.76
QUESTION – 109
Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas
subsidiaries, one is based in Amsterdam and another in Switzerland. The
surplus position of funds in hand is as follows which it does not need for the
next three months but will be needed at the end of that period (91 days).
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91-Day Interest rates on p.a. basis on the Deposits in Money Market are as
follows:
Determine the minimum interest rate per annum (upto 3 decimal points) that
should be offered by the bank to your organization so that your organization is
ready to undertake such swap arrangement.
SOLUTION:-
XYZ plc shall be ready to undertake this swap arrangement only if it receives
the interest on the surplus funds if invested on individual basis as follows:
UK
£ 150,000 × 0.01 £ 379.17 £ 150,379.17 £ 150,379.17
× 91/360 =
Swap to Sterling
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QUESTION – 110
(1) The equity trading desk in Japan wants to invest the entire GBP 200
million in high dividend yielding Japanese securities that would earn a
dividend income of JPY 1,182 million. The dividends are declared and
paid on 29th June. Post dividend, the securities are expected to quote at
a 2% discount. The desk also plans to earn JPY 10 million on a stock
borrow lending activity because of this investment. The securities are to
be sold on June 29th with a T+1 settlement and the amount remitted
back to the Treasury in London.
(2) The fixed income desk of US proposed to invest the amount in 6 months
G-Secs that provides a return of 5% p.a.
SOLUTION:-
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Decision:
The equivalent amount at the end of 6 months shall be almost same in both
the options. The bank can go for any of the options.
QUESTION – 111
ICL an Indian MNC is executing a plant in Sri Lanka. It has raised ₹ 400
billion. Half of the amount will be required after six months’ time. ICL is
looking an opportunity to invest this amount on 1 st April, 2020 for a period of
six months. It is considering two underlying proposals:
Market Japan US
Nature of Investment Index Fund (JPY) Treasury Bills
(USD)
Dividend (in billions) 25 -
Income from stock lending (in billions) 11.9276 -
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SOLUTION:-
Dividend Income 25
Gain ₹ 20.7692
Gain ₹ 20.7692
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However, USD is more stable, and Treasury Bills are risk free, so investment in
Treasury Bills (USD) is suggested.
QUESTION – 112
AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K.
Forecasts of surplus funds for the next 30 days from two subsidiaries are as
below:
U.K. £ 6 million
$/₹ £/₹
₹ 6.4%/6.2%
$ 1.6%/1.5%
£ 3.9%/3.7%
(i) Calculate the cash balance at the end of 30 days period in ₹ for each
company under each of the following scenarios ignoring transaction costs
and taxes:
(b) Cash balances are pooled immediately in India and the net
balances are invested/borrowed for the 30 days period.
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(ii) Which method do you think is preferable from the parent company’s
point of view?
(Practice Manual)
SOLUTION:-
Acting independently
Cash Balance:-
India − 5,00,000
12,500
U.S. = 5,81,395
0.0215
6,000
U.S. = 4,02,685
0.0149
4,84,080
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QUESTION – 113
Drilldip Inc. a US based company has a won a contract in India for drilling oil
field. The project will require an initial investment of ₹ 500 crore. The oil field
along with equipments will be sold to Indian Government for ₹ 740 crore in one
year time. Since the Indian Government will pay for the amount in Indian
Rupee (₹) the company is worried about exposure due exchange rate volatility.
(a) Construct a swap that will help the Drilldip to reduce the exchange rate
risk.
(b) Assuming that Indian Government offers a swap at spot rate which is
1US$ = ₹ 50 in one year, then should the company should opt for this
option or should it just donothing. The spot rate after one year is
expected to be 1US$ = ₹ 54. Further you may also assume that the
Drilldip can also take a US$ loan at 8% p.a.
SOLUTION:-
(i) Swap a US$ loan today at an agreed rate with any party to obtain Indian
Rupees (₹) to make initial investment.
(ii) After one year swap back the Indian Rupees with US$ at the agreed rate.
In such case the company is exposed only on the profit earned from the
project.
Year 0 Year 1
(Million US$) (Million US$)
Buy ₹ 500 crore at spot rate of 1US$ = ₹ 50 (100.00) ……
Swap ₹ 500 crore back at agreed rate of ₹ 50 …… 100.00
Sell ₹ 240 crore at 1US$ = ₹ 54 …… 44.44
Interest on US$ loan @ 8% for one year …… (8.00)
(100.00) 136.44
Net result is a net receipt of US$ 36.44 million.
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Year 0 Year 1
(Million US$) (Million US$)
Buy ₹ 500 crore at spot rate of 1US$ = ₹ 50 (100.00) ---
Sell ₹ 740 crore at 1US$ = ₹ 54 --- 137.04
Interest on US$ loan @8% for one year --- (8.00)
(100.00) 129.04
Decision: Since the net receipt is higher in swap option the company
should opt for the same.
QUESTION – 114
M/s Omega Electronics Ltd. exports air conditioners to Germany by importing
all the components from Singapore. The company is exporting 2,400 units at a
price of Euro 500 per unit. The cost of imported components is S$ 800 per
unit. The fixed cost and other variables cost per unit are ₹ 1,000 and ₹ 1,500
respectively. The cash flows in Foreign currencies are due in six months. The
current exchange rates are as follows:
₹/Euro 51.50/55
₹/S$ 27.20/25
₹/Euro 52.00/05
₹/S$ 27.70/75
(B) Based on the following additional information calculate the loss/gain due
to transaction and operating exposure if the contracted price of air
conditioners is ₹ 25,000 :
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₹/Euro 51.75/80
₹/S$ 27.10/15
(iii) Payments and receipts are to be settled at the end of six months.
SOLUTION:-
₹ 25,000
Current price of each unit in € = = € 485.44
₹ 51.50
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₹ 25,000
Price after change in exchange rate = = € 483.09
₹ 51.75
Change in Price due to change in Exch. Rate
(14) RESIDUAL
QUESTION – 115
With relaxation of norms in India for investment in international market upto $
2,50,000 Mr. X to hedge himself against the risk of declining Indian economy
and weakening of Indian Rupee during last few years, decided to diversify in
the international Market.
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1.1.20 × 1 1.1.20 × 2
Index of stock market in India 7,395 ?
Standard & Poor index 2,028 1,919
Exchange Rate (₹/$) 62.00/62.25 67.25/67.50
(iii) The value of index of stock market in India as on 1.1.20 × 2 at which Mr.
X would be indifferent between investment in Standard & Poor index and
India stock market.
SOLUTION:-
1919−2028
= × 100 = -5.37%
2028
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16152242−15800000 2.23%
Rate of return × 100
15800000
QUESTION – 116
M/s. Sky products Ltd., of Mumbai, an exporter of sea foods has submitted a
60 days bill for EUR 5,00,000 drawn under an irrevocable Letter of Credit for
negotiation. The company has desired to keep 50% of the bill amount under
the Exchange Earners Foreign Currency Account (EEFC). The rates for₹/USD
and USD/EUR in inter-bank market are quoted as follows:
₹/ USD USD/EUR
Spot 67.8000 − 67.8100 1.0775 − 1.8000
1 month forward 10/11 Paise 0.20/0.25 Cents
2 months forward 21/22 Paise 0.40/0.45 Cents
3 months forward 32/33 Paise 0.70/0.75 Cents
SOLUTION:-
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(i) Transit and usance period is 80 days. It will be rounded off to the lower
of months and @ months forward bid rate is to be taken
₹/USD ₹ 67.8000
Add: Premium for 2 months ₹ 0.2100
₹ 68.0100
Less: Exchange margin @ 0.1% ₹ 0.0680
Bid rate for USD ₹ 67.9420
USD/EUR
USD 1.0775
Add: Premium
USD 0.0040
USD 1.0815
₹/EUR Rate (67.942 × 1.0815) ₹ 73.4793
Amount of Export Bill EUR 5,00,000
Less: EEFC EUR 2,50,000
EUR 2,50,000
Exchange Rate ₹ 73.4793
QUESTION – 117
ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6
months. The exporter wants to hedge the receipt in the forward market. The
following information is available:
The forward rates truly reflect the interest rates differential. Find out the
gain/loss to UK exporter if Can $ spot rates (i) declines 2%, (ii) gains 4% or (iii)
remains unchanged over next 6 months.
SOLUTION:-
2.50 (1+0.075)
Forward Rate = = Can$ 2.535/£
(1+0.060)
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£
£ receipt as per forward rate (Can $ 5,00,000/Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/Can$ 2.55) 1,96,078
Gain due to forward contract 1,161
£
£ receipt as per forward rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.40) 2,08,333
Loss due to forward contract 11,094
£
£ receipt as per forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.50) 2,00,000
Loss due to forward contract 2,761
QUESTION – 118
Following are the details of cash inflows and outflows in foreign currency
denominations of MNP Co. an Indian export firm, which have no foreign
subsidiaries:
(i) Determine the net exposure of each foreign currency in terms of Rupees.
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SOLUTION:-
(ii) The exposure of Japanese yen position is being offset by a better forward
rate
QUESTION – 119
Your forex dealer had entered into a cross currency deal and had sold US $
10,00,000 against EURO at US $ 1 = EURO 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in
compliance with his management’s guidelines had to square – up the position
when the quotations were:
SOLUTION:-
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US $ 1 = EURO 1.4400
US $ 1 = INR 31.45
31.45
Cross Currency = = ₹ 21.8403
1.440
Loss in Transaction (21.8403 × EURO 5,000) = ₹ 1,09,201.50
QUESTION – 120
Airlines Company entered into an agreement with Airbus for buying latest
plans for a total value of F.F. (French Francs) 1,000 Million payable after 6
months. The current spot exchange rate is INR (Indian Rupees) 6.60/FF. The
Airlines Company cannot predict the exchange rate in the future. Can the
Airlines Company hedge its Foreign Exchange risk? Explain by examples.
(Practice Manual)
SOLUTION:-
Airlines Company can hedge its foreign exchange risk by the following ways:
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(i) Hedging through Forward Contract: The Company can take full
forward cover against foreign exchange exposure and entirely hedge its
risk. It can contract with a bank to buy French franc forward at an
agreed exchange rate e.g. suppose the 6 months forward rate is INR
6.77/FF. The liability is fixed and the airlines can concentrate on
operation. Cost of forward contract
6.60−6.77 360
= ×
6.60 days
(ii) Foreign Currency Option: Foreign currency option is the right (not an
obligation) to buy or sell a currency at an agreed exchange rate (exercise
price) on or before an agreed maturity period. The right to buy is called a
call option and right to sell is put option. Suppose, the airlines wants to
purchase a 6 months put option. The call option exercise rate (say) is INR
6.70. The Airlines will be required to pay a premium for purchasing the
option say 5% of the value of call option INR 6700 × 0.05 = INR 335
Suppose at the end of 6 months the exchange rate stay at INR 6.8/FF
Airlines will exercise its put option hence it will buy FF at INR 6.7
Thus Airlines will be able to hedge against the changes in the exchange
rate. The problem with money market is that all markets are not open
and all countries are not fully convertible.
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QUESTION – 121
Since hedging of Foreign Exchange Risk was part of company’s strategic policy
and no contract for hedging in SKW was available at any in-shore market, it
approached an off-shore Non Deliverable Forward (NDF) Market for hedging the
same risk.
After 1 month (1st March 2020) the dealer agreed for SKW 1185/ USD as rate
for settlement and on the same day the Spot Rates in the above markets were
as follows:
Analyze the position of company under each of the following cases, comparing
with Spot Position of 1st February:
(i) Do Nothing.
(ii) Opting for NDF Contract. Note: Both Rs./ SKW Rate and final payment
(to be computed in Rs. Lakh) to be rounded off upto 4 decimal points. (10
Marks)
SOLUTION:-
(i) Do Nothing
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We shall compute the cross rates in spot market on both days and shall
compare the amount payable in INR on these two days.
= ₹ 0.0634
= ₹ 0.0638
Since company needs SKW after one month it will take long position in
SKW at quoted rate of SKW 1190/USD and after one-month it will
reverse its position at fixing rate of SKW 1187/USD. The profit/loss
position will be as follows:
Buy SKW 1190 million and sell USD (1190 million/1190) USD 10,00,000
Sell SKW 1190 million and buy USD at fixing rate (1190 USD 10,04,219
million/1185)
Profit USD 4,219
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Final position
Decision: Since exchange loss is less in case of NDF same can be opted
for.
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CHAPTER – 04
INTERNATIONAL FINANCIAL MANAGEMENT
Example – 01
1 = $ 3,00,000
2 = $ 5,00,000
3 = $ 6,00,000
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D1
2. Cost of Equity = +g
P0
QUESTION – 01
ABC Ltd. is considering a project in US, which will involve an initial investment
of US $ 1,10,00,000. The project will have 5 years of life. Current spot
exchange rate is ₹ 48 per US $. The risk free rate in US is 8% and the same in
India is 12%. Cash inflow from the project is as follows :
Calculate the NPV of the project using foreign currency approach. Required
rate of return on this project is 14%.
SOLUTION:
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Calculation of NPV
= ₹ 48.624 Million
QUESTION – 02
(ii) What will be the impact if there is a withholding tax of 10% applicable on
the project.
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SOLUTION:
Calculation of NPV
= ₹ 109.44 Million
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Thus, if there is a withholding tax of 10% then the project will not be
viable.
QUESTION – 03
(i) You are required to find out the investment worth of the project by
Given :
t 1 2 3 4 5
PVIF (8%, t) 0.92593 0.85734 0.79383 0.75503 0.68058
PVIF (7%, t) 0.93457 0.87344 0.81630 0.76290 0.71299
(Exam December - 2021)
SOLUTION:
Working Notes :
End of ₹ ₹/KR
Year
1 1.06 0.373
0.37 ×
1.052
2 1.06 0.376
0.373 ×
1.052
3 1.06 0.380
0.376 ×
1.052
4 1.06 0.384
0.379 ×
1.052
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5 1.06 0.388
0.382 ×
1.052
*Alternatively if students have used the PVIF (8%, 4) as given in the question
paper then answer NPV would be 1.2188 instead of 1.1573
Calculation of NPV
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Decision: NPV is positive in the approach so, project will worth investment.
QUESTION – 04
The exchange rate for the currency of the proposed African country is
extremely volatile. Rate of inflation is presently 40% a year. Inflation in India is
currently 10% a year. Management of XY Limited expects these rates likely to
continue for the foreseeable future.
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each
year indefinitely. It evaluates all investments using nominal cash flows and a
nominal discounting rate. The present exchange rate is African Rand 6 to ₹ 1.
You are required to calculate the net present value of the proposed investment
considering the following:
(i) African Rand cash flows are converted into rupees and discounted at a
risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to
reflect it’s high risk.
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SOLUTION:
Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
Cast Flows in ₹ ’000
Real -50000 -1500 -2000 -2500
Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian ₹ ’000 (2) -33333 9167 14117 19965
Net Cast Flow in ₹ ’000 (1) + (2) -83333 7517 11697 16637
PVF@20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633
16637
NPV of Terminal Value = × 0.579 = 48164 (₹ ’000)
0.20
Total NPV of the Project = -59320 (₹ ‘000) + 48164 (₹ ’000) = -11156 (₹ ’000)
QUESTION – 05
XYZ Ltd., a company based in India, manufactures very high quality modem
furniture and sells to a small number of retail outlets in India and Nepal. It is
facing tough competition. Recent studies on marketability of products have
clearly indicated that the customers are now more interested in variety and
choice rather than exclusivity and exceptional quality. Since the cost of quality
wood in India is very high, the company is reviewing the proposal for import of
woods in bulk from Nepalese supplier.
The estimate of net Indian (₹) and Nepalese Currency (NC) cash flows in
Nominal terms for this proposal is shown below:
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(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All
Nepalese customers are invoiced in NC. NC cash flows are converted to
Indian (₹) at the forward rate and discounted at the Indian rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a.
respectively. The current exchange rate is ₹ 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net
present value (NPV) and modified internal rate of return (MIRR) of the proposal.
You may use following values with respect to discount factor for ₹ 1 @9%.
SOLUTION:
Working Notes:
End of NC NC/ ₹
Year
1+0.09
1 NC1.60 × 1.615
(1+0.08)
1+0.09
2 NC1.615 × 1.630
(1+0.08)
1+0.09
3 NC1.630 × 1.645
(1+0.08)
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(₹ Million)
Year Cash Flow Cash Flow Total PVF @ 9% PV
in India in Nepal
0 --- -15.625 -15.625 1.000 -15.625
1 2.869 1.61 4.479 0.917 4.107
2 4.200 2.33 6.53 0.842 5.498
3 4600 2.49 7.09 0.772 5.473
Year
0 1 2 3
Cass Flow (₹ Million) -15.625 4.479 6.53 7.09
Year 1 Cash Year 1 Cash Inflow reinvested for 2 5.32
years (1.188 × 4.479)
Year 2 Cash Inflow reinvested for 1 7.12
years (1.090 × 6.53) 19.53
n TerminalCashFlow
MIRR =
Initial Outlay
3 19.53
= −1 = 0.0772 say 7.72%
15.625
QUESTION – 06
DD Ltd. a company based in India manufactures good quality of leather bags
and sells to retail outlets in India and USA. The cost of quality leather in India
is very high, the company is reviewing the proposal of importing of leather in
bulk from USA supplier. The estimate of net US $ and Indian ₹ Currency Cash
Flows in nominal terms for this proposal is given below:
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Other information:
You are required to Calculate Net Present Value and recommend the decision.
Present value factor @ 9% are as under:
SOLUTION:
Year ₹/USD
1 (1+0.08) 73.32
₹ 74.00 ×
(1+0.09)
2 (1+0.08) 72.65
₹ 73.32 ×
(1+0.09)
3 (1+0.08) 71.98
₹ 72.65 ×
(1+0.09)
0 1 2 3
Cash Flow is US$ (Lakh) (25) 5 7 8
74.00 73.32 72.65 71.98
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QUESTION – 07
A multinational company is planning to set up a subsidiary company in India
(where hitherto it was exporting) in view of growing demand for its product and
competition from other MNCs. The initial project cost (consisting of Plant and
Machinery including installation) is estimated to be US$ 500 million. The net
working capital requirements are estimated at US$ 50 million. The company
follows straight line method of depreciation. Presently, the company is
exporting two million units every year at a unit price of US$ 80, its variable
cost per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and
other data in respect of proposed project:
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share
of allocated fixed cost will be US $ 3 million p.a. based on principle of
ability to share;
(iv) Expected useful life of the proposed plant is five years with no salvage
value;
(v) Existing working capital investment for production & sale of two million
units through exports was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million
units in case the company does not open subsidiary company in India, in
view of the presence of competing MNCs that are in the process of setting
up their subsidiaries in India;
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Assuming that there will be no variation in the exchange rate of two currencies
and all profits will be repatriated, as there will be no withholding tax, estimate
Net Present Value (NPV) of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
SOLUTION:
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00
$ Million
Sales Revenue (5 Million × $ 80) 400.00
Less Costs:
Variable Cost (5 Million × $ 80) 100.00
Fixed Cost 30.00
Depreciation ($ 500 Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Deprecation 100.00
CFAT (1-5 Years) 210.50
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(b) Cash flow at the end of the 5 years (Release of Working Capital)
35.00
$ Million
Sales Revenue (1.5 Million × $80) 120.00
Less: Variable Cost (1.5 Million × $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 Years) 39.00
$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 Years) 171.50
QUESTION – 08
TG Ltd., a multinational company is planning to set up a subsidiary company
in India (where hitherto it was exporting) in view of growing demand for its
product and competition from other MNCs. The initial project cost (consisting
of plant and machinery including installation) is estimated to be US $ 500
million. The net working capital requirements are estimated at US $ 100
million. The company follows straight line method of depreciation. Presently,
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the company is exporting 2 million units every year at a unit price of US $ 100,
its variable cost per unit being US $ 50.
The Chief Financial Officer has estimated the following operating cost and
other data in respect of the proposed project:
(c) Production and Sales capacity of the proposed project in India will be 5
million units.
(d) Expected useful life of the proposed plant is 5 years with no salvage
value.
(e) Existing working capital investment for production and sale of 2 million
units through exports was US $ 20 million.
(f) Export of the product in the coming year will decrease to 1.5 million
units in case the company does not open subsidiary company in India, in
view of the presence of competing MNCs that are in the process of setting
up their subsidiaries in India.
Assume that there will be no variation in the exchange rate of two countries, all
profits will be repatriated and there will be no withholding tax.
Estimate the Net Present Value (NPV) of the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for 5 years are as under:
Year: 1 2 3 4 5
PVIF: 0.8929 0.7972 0.7118 0.6355 0.5674
(c) Discuss briefly the key decisions which fall within the scope of financial
strategy.
SOLUTION:
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11,600+10,000
Rm = × 100 = 15.88%
1,36,000
Security
15.49+15.10+14.33+13.55
= = 14.62%
4
QUESTION – 09
A US company wants to setup a manufacturing plant in India which requires
an initial outlay of ₹ 8 Million. It is expected to have a useful life of 5 years with
a salvage of ₹ 2 Million. The company follows straight line method of
depreciation. To support additional level of activity, investment would require
one time additional working capital of ₹ 1 Million.
Since the cost of production lower in India, the variable cost of production
would be ₹ 30 per unit. Additional fixed cost per annum is estimated at ₹ 0.5
Million. The company is projecting its annual sales to 80000 units at the price
of ₹ 100 per unit. Applicable tax rate to the company is 34% and its cost of
capital is 8%.
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Assuming that all profit will be repatriated every year and there will be no
withholding taxes, estimate the net present value of the proposed project in
India and evaluate its feasibility.
SOLUTION:
Working Notes:
Particulars Amount
Initial Quality ₹ 80,00,000
Additional Working Capital ₹ 10,00,000
Total ₹ 90,00,000
Exchange Rate ₹ 72/US$
Initial Investment in US$
US$ 1,25,000
Year ₹/USD
1 (1+0.09) 72.67
₹ 72.00 ×
1+0.08
2 (1+0.09) 73.34
₹ 72.67×
1+0.08
3 (1+0.09) 74.02
₹ 73.34 ×
1+0.08
4 (1+0.09) 74.71
₹ 74.02 ×
1+0.08
5 (1+0.09) 75.40
₹ 74.71 ×
1+0.08
(iii) Annual Cash Inflows
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(₹ 80,00,000− ₹ 20,00,000)
Depreciation 12,00,000
5
Profit Before Tax (PBT) 39,00,000
25,74,000
37,74,000
(v) Release of working capital in US$ at the end (₹ 10,00,000/₹ 75.40) = US$
13,262.60
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QUESTION – 10
The CFO of the Company has estimated the following operating cost and other
data in respect of proposed project:
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share
of allocated fixed cost will be US $ 3 million p.a. based on principle of
ability to share;
(iii) Expected useful life of the proposed plant is five years with no salvage
value;
(v) Existing working capital investment for production and sale of two
million units through exports was US $ 25 million;
(vi) Export of the product in the coming year will decrease to 1.5 million
units, provided the company does not set up subsidiary company in
India, in view of the presence of competing other US based companies
that are in the process of setting up their subsidiaries in India;
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Assuming that there will be no variation in the exchange rate of two currencies
and all profits will be repatriated as there will be no withholding tax, Estimate
Net Present Value of the proposed project in India and give your advice. Present
Value Interest Factors (PVIF) @ 12% for five years is as below :
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674
SOLUTION:
$ Million
Cost of Plant and Machinery 490.00
Working Capital 60.00
Release of existing Working Capital (25.00)
525.00
II. (1) Incremental Cash Inflow after Tax (CFAT) generated by investment in
India for 5 years
$ Million
Sales Revenue (5 Million × $90) 450.00
Less: Costs
Variable Cost (5 Million × $30) 150.00
Fixed Cost 30.00
Depreciation ($490 Million/5) 98.00
EBIT 172.00
Taxes @ 35% 60.20
EAT 111.80
Add: Depreciation 98.00
CFAT (1-5 years) 209.80
(2) Cash flow at the end of the 5 years (Release of Working Capital) $35.00
Million
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$ Million
Sales Revenue (1.5 Million × $90) 135.00
Less: Variable Cost (1.5 Million × $50) 75.00
Contribution before tax 60.00
Tax @ 35% 21.00
CFAT (1-5 years) 39.00
$ Million
Through setting up subsidiary in India 209.80
Through Export in India 39.00
CFAT (1-5 years) 170.80
QUESTION – 11
The US based company will be subject to corporate tax of 30 per cent and a
withholding tax of 10 per cent in India and will not be eligible for tax credit in
the US. The software developed will be sold in the US market for US $ 12.0
millions. Other estimates are as follows:
Rent for fully furnished unit with necessary hardware in India ₹ 15,00,000
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Advise the US Company on the financial viability of the project. The rupee-
dollar rate is ₹48/$.
(SM New Syllabus, PM, RTP Nov – 2021 & Exam May - 2017)
SOLUTION:
Proforma profit and loss account of the Indian software development unit
₹ ₹
Revenue 48,00,00,000
Less Costs:
Rent 15,00,000
Manpower (₹ 400 × 80 × 10 × 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Tax 10,81,50,000
Earning after tax 25,23,50,000
Less: Withholding tax (TDS) 2,52,35,000
Repatriation amount (in rupees) 22,71,15,000
Repatriation amount (in dollars)
$ 4.7 million
Advise: The cost of development software in India for the US based company is
$ 5.268 million. As the USA based Company is expected to sell the software in
the US at $ 12.0 million, it is advised to develop the software in India.
Alternatively, if is assumed that since foreign subsidiary has paid taxes it will
not pay withholding taxes then solution will be as under:
₹ ₹
Revenue 48,00,00,000
Less Costs:
Rent 15,00,000
Manpower(₹ 400 × 80 × 10 × 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Tax 10,81,50,000
Earning after tax 25,23,50,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in rupees) $ 5,257,292
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Advise: The cost of development software in India for the US based company is
$4.743 million. As the USA based Company is expected to sell the software in
the US at $12.0 million, it is advised to develop the software in India.
₹ ₹
Revenue 48,00,00,000
Less Costs:
Rent 15,00,000
Manpower (₹ 400 × 80 × 10 × 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earning before tax 36,05,00,000
Less: Withholding tax 3,60,50,000
Earning after Withholding tax @10% 32,44,50,000
Less: Corporation Tax net of withholding tax 7,21,00,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in rupees) $ 5,257,292
Advise: The cost of development software in India for the US based company is
$4.743 million. As the USA based Company is expected to sell the software in
the US at $12.0 million, it is advised to develop the software in India.
QUESTION – 12
At the current rate of exchange dollar cost of local production equals to USD 6
per unit. Dollar is expected to decline by 10% or 15%. The change in local cost
of production and probability from the expected current level will be as follows:
Decline in
Reduction in local cost
value of USD Probability
of production (USD/unit)
(%)
0 - 0.4
10 0.30 0.4
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The plant at the current rate of exchange will have a depreciation of USD 1
million annually. Assume local Tax rate as 30%.
(i) Annual Cash Flow After Tax (CFAT) under all the different scenarios of
exchange rate.
SOLUTION:
US $ 32,26,000(1.03)
Expected Value of inflow in perpetuity =
0.11−0.03
33,22,780
= = US$ 4,15,34,750
0.08
US $
Value of Inflows 4,15,34,750
Less: Initial Outlay 2,50,00,000
NPV of project 1,65,34,750
QUESTION – 13
Odessa Limited has proposed to expand its operations for which it requires
funds of $ 15 million, net of issue expenses which amount to 2% of the issue
size. It proposed to raise the funds though a GDR issue. It considers the
following factors in pricing the issue:
(iii) Underlying shares are priced at 10% discount to the market price
You are required to compute the number of GDR's to be issued and cost of
GDR to Odessa Limited, if 20% dividend is expected to be paid with a growth
rate of 20%.
SOLUTION:
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$15million
Gross Issue = = $15.306 million
0.98
Issue Price per GDR in ₹ (300 × 3 × 90%) ₹ 810
$15.306 million
= 1.1338 million
$13.50
6.00
Ke = + 0.20 = 20.76
793.80
QUESTION – 14
M/s. Raghu Ltd. is interested in expanding its operation and planning to install
manufacturing plant at US. It requires 8.82 million USD (net of issue
expenses/ floatation cost) to fund the proposed project. GDRs are proposed to
be issued to finance this project. The estimated floatation cost of GDRs is 2%.
Additional information:
(i) Expected market price of share at the time of issue of GDR is ₹ 360 (Face
Value ₹ 100)
(iii) The issue shall be priced at 10% discount to the market price.
(v) Dividend is expected to be paid at the rate of 20% with growth rate of
12%.
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(RTP May – 2022, MTP April – 2022 & Exam July - 2021)
SOLUTION:
8.82
Gross Issue = = $ 9.00 million
0.98
Issue Price per GDR in ₹ (360 × 2 × 90%) ₹ 648
$9.00 million
= 1.00 million
$9
(b) Cost of GDR
40.00
Ke = + 0.12 = 18.30%
635.04
(2) If the company receives an offer from US Bank willing to provide an
equivalent amount of loan with interest rate of 12%, it should accept the
offer.
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QUESTION – 15
Right Limited has proposed to expand its operations for which it requires funds
of $ 30 million, net of issue expenses which amount to 4% of the issue size. It
proposed to raise the funds though a GDR issue. It considers the following
factors in pricing the issue:
(i) The expected domestic market price of the share is ₹ 300 (Face Value of ₹
10 each share)
(iii) Underlying shares are priced at 20% discount to the market price
You are required to compute the number of GDR's to be issued and cost of
GDR to Right Limited, if 20% dividend is expected to be paid with a growth rate
of 20%.
SOLUTION:
$30 million
Gross Issue = = $31.25 million
0.96
$31.25 million
= 2.2794 million
$13.71
8
Ke = + 0.20 = 20.87%
921.60
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QUESTION – 16
(i) Expected market price of share at the time of issue of GDR is ₹ 250 (Face
Value being ₹ 100)
(ii) 2 shares shall underlay each GDR and shall be priced at 4% discount to
market price.
SOLUTION:
₹ 10 million
Gross Issue = = $10.2041 million
0.98
Issue Price per GDR in ₹ (250 × 2 × 96%) ₹ 480
$ 10.2041 million
= 1.360547 million
$ 7.50
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30
Ke = + 0.12 = 18.378%
470.40
QUESTION – 17
Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from
Aidscure Ltd., a company engaged in manufacturing of drugs to cure Dengue,
to set up a manufacturing unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of
revenues plus a royalty @ US $0.01 per bottle. The initial investment will be ₹
200 crores for machinery and factory. The scrap value of machinery and
factory is estimated at the end of five (5) year to be ₹ 5 crores. The machinery is
depreciable @ 20% on the value net of salvage value using Straight Line
Method. An initial working capital tothe tune of ₹ 50 crores shall be required
and thereafter ₹ 5 crores each year.
As per GOI directions, it is estimated that the price per bottle will be ₹ 7.50 and
production will be 24 crores bottles per year. The price in addition to inflation
of respective years shall be increased by ₹ 1 each year. The production cost
shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double
Taxation Avoidance Agreement between India and US. According to the
agreement tax credit shall be given in US for the tax paid in India. In both the
countries, taxes shall be paid in the following year in which profit have arisen.
As per the policy of GOI, only 50% of the share can be remitted in the year in
which they are earned and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it
expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from
subsidiary point of view).
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SOLUTION:
Working Notes:
Year 0 1 2 3 4 5 6
Exchange Rate 57 57.54 57.82 57.82 57.54 56.99 56.18
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Price per bottle (₹) 7.50 8.50 9.50 10.50 11.50
Price fluctuation inflation 6.00% 5.50% 5.00% 4.50% 4.00%
rate
Inflated price (₹) 7.95 8.97 9.98 10.97 11.96
Inflated Sales Revenue (₹ 190.80 215.28 239.52 263.28 287.04
Crore)
Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Royalty in $ 0.01 0.01 0.01 0.01 0.01
Total Royalty ($ Crore) 0.24 0.24 0.24 0.24 0.24
Exchange Rate 57.54 57.82 57.82 57.54 56.99
Total Royalty (₹ Crore) 13.81 13.88 13.88 13.81 13.68
Year 1 2 3 4 5
Sales Share 104.94 118.40 131.74 144.80 157.87
Total Royalty 13.81 13.88 13.88 13.81 13.68
Total Income 118.75 132.28 145.61 158.61 171.55
Less: Expenses
Production Cost
(Sales share × 40%) 41.98 47.36 52.69 57.92 63.15
Depreciation (195 × 20%) 39.00 39.00 39.00 39.00 39.00
PBT 37.77 45.92 53.92 61.69 69.40
Tax on Profit @30% 11.33 13.78 16.18 18.51 20.82
Net Profit 26.44 3214 37.74 43.18 48.58
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Year 0 1 2 3 4 5 6
Sales
Share 0.00 104.94 118.40 131.74 144.80 157.87 0.00
Total
Royalty 0.00 13.81 13.88 13.88 13.81 13.68 0.00
Production
Cost 0.00 -41.98 -47.36 -52.69 -57.92 -63.15 0.00
Initial
Outlay -200.00 0.00 0.00 0.00 0.00 0.00 0.00
Working
Capital -50.00 -5.00 -5.00 -5.00 -5.00 70.00 0.00
Scrap
Value 0.00 0.00 0.00 0.00 0.00 -5.00 0.00
Tax on
Profit 0.00 0.00 -11.33 -13.78 -16.18 -18.51 -20.82
Free Cash
Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
Year 0 1 2 3 4 5 6
Free Cash
Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
50% of
Current Year
Cash Flow 0.00 35.89 34.29 37.07 39.76 82.45 0.00
Previous year
remaining
cash flow 0.00 0.00 35.88 34.30 37.08 39.75 82.44
Total
Remittance -250.00 35.88 70.17 71.37 76.84 122.20 61.62
Year 0 1 2 3 4 5 6
Total Remittance
(₹ Crore) -250.00 35.88 70.17 71.37 76.84 122.20 61.62
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Indian Tax ($mn) 0.00 0.00 1.96 2.38 2.82 3.25 3.71
Net /Tax ($mn) 0.00 0.00 0.22 1.87 1.51 1.42 3.79
Net Cash Flow
($mn) -43.86 6.24 11.92 10.47 11.84 20.02 7.18
Decision: Since NPV of the project is negative, Perfect inc. should not invest in
the project.
Expected spot rate = Current Spot Rate × expected difference in inflation rates
(1+ I d )
E S1 = S0 ×
(1+ 1 f )
Where
QUESTION – 18
Its Entertainment Ltd., an Indian Amusement Company is happy with the
success of its Water Park in India. The company wants to repeat its success in
Nepal also where it is planning to establish a Grand Water Park with world
class amenities. The company is also encouraged by a marketing research
report on which it has just spent ₹ 20,00,000 lacs.
The estimated cost of construction would be Nepali Rupee (NPR) 450 crores
and it would be completed in one years time. Half of the construction cost will
be paid in the beginning and rest at the end of year. In addition, working
capital requirement would be NPR 65 crores from the year end one. The after
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tax realizable value of fixed assets after four years of operation is expected to be
NPR 250 crores. Under the Foreign Capital Encouragement Policy of Nepal,
company is allowed to claim 20% depreciation allowance per year on reducing
balance basis subject to maximum capital limit of NPR 200 crore. The company
can raise loan for theme park in Nepal @ 9%.
The water park will have a maximum capacity of 20,000 visitors per day. On an
average, it is expected to achieve 70% capacity for first operational four years.
The entry ticket is expected to be NPR 220 per person. In addition to entry
tickets revenue, the company could earn revenue from sale of food and
beverages and fancy gift items. The average sales expected to be NPR 150 per
visitor for food and beverages and NPR 50 per visitor for fancy gift items. The
sales margin on food and beverages and fancy gift items is 20% and 50%
respectively. The park would open for 360 days a year.
The annual staffing cost would be NPR 65 crores per annum. The annual
insurance cost would be NPR 5 crores. The other running and maintenance
costs are expected to be NPR 25 crores in the first year of operation which is
expected to increase NPR4 crores every year. The company would apportion
existing overheads to the tune of NPR 5 crores to the park.
All costs and receipts (excluding construction costs, assets realizable value and
other running and maintenance costs) mentioned above are at current prices
(i.e. 0 point of time) which are expected to increase by 5% per year.
The current spot rate is NPR 1.60 per ₹. The tax rate in India is 30% and in
Nepal it is 20%.
The current WACC of the company is 12%. The average market return is 11%
and interest rate on treasury bond is 8%. The company’s current equity beta is
0.45. The company’s funding ratio for the Water Park would be 55% equity and
45% debt.
Being a tourist Place, the amusement industry in Nepal is competitive and very
different from its Indian counterpart. The company has gathered the relevant
information about its nearest competitor in Nepal. The competitor’s market
value of the equity is NPR 1850 crores and the debt is NPR 510 crores and the
equity beta is 1.35.
State whether Its Entertainment Ltd. should undertake Water Park project in
Nepal or not.
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SOLUTION:-
Working Notes:
Assuming debt to be risk free i.e. beta is zero, the beta of competitor is
un-geared as follows:
E
Asset Beta = Equity Beta ×
E+D (1−t)
1850
= 1.35 × = 1.106
1850 +510 (1−0.20)
55
1. 106 = Equity Beta ×
55 + 45 (1−0.30)
Cost of Equity = Risk free return + β (Market Return − Risk free return)
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Year 0 1 2 3 4 5
PVAF 1.000 0.905 0.819 0.741 0.670 0.607
Year 1 2 3 4
Opening Balance (NPR Crore) 200.00 160.00 128.00 102.40
Less: Depreciation (NPR Crore) 40.00 32.00 25.60 20.48
Closing Balance (NPR Crore) 160.00 128.00 102.40 81.92
Year 0 1 2 3 4 5
Expected Annual
visitors 5040000 5040000 5040000 5040000
Entry ticket
price per visitor
(NPR) 242.55 254.68 267.41 280.78
Profit from sale
of Food and
Beverages per
visitor (NPR) 33.08 34.73 36.47 38.29
Profit from sale
of Fancy Gift
Items per visitor
(NPR) 27.56 28.94 30.39 31.91
Revenue per
visitor (NPR) 303.19 318.35 334.26 350.98
Total Revenue
(NPR crores) 152.81 160.45 168.47 176.89
Less: Annual
Staffing Cost
(NPR crores) 71.66 75.25 79.01 82.96
Annual
Insurance Costs
(NPR crores) 5.51 5.79 6.08 6.38
Other running
and
maintenance
costs (NPR
crores) 25.00 29.00 33.00 37.00
Depreciation
Allowances (NPR
crores) 40.00 32.00 25.60 20.48
Total Expenses
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QUESTION – 19
Opus Technologies Ltd., an Indian IT company is planning to make an
investment through a wholly owned subsidiary in a software project in China
with a shelf life of two years. The inflation in China is estimated as 8 percent.
Operating cash flows are received at the year end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be
inland. The land will be sold after the completion of project at estimated value
of CN¥ 35,00,000. The project also requires an office complex at cost of CN¥
15,00,000 payable at the beginning of project. The complex will be depreciation
straight-line basis over two years to a zero salvage value. This complex is
expected to fetch CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in
Mauritius. Each GDR will have 5 common equity shares of the company as
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underlying security which are currently trading at ₹ 200 per share (Face Value
= ₹ 10) in the domestic market. The company has currently paid the dividend of
25%which is expected to grow at 10% p.a. The total issue cost is estimated to
be 1 percent of issue size.
The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per
unit. The price of unit is expected to rise at the rate of inflation. Variable
operating costs are 40 percent of sales. Fixed operating costs will be CN¥
22,00,000 per year and expected to rise at the rate of inflation.
The tax rate applicable in China for income and capital gain is 25 percent and
as per GOI Policy no further tax shall be payable in India. The current spot rate
of CN¥ 1 is ₹ 9.50. The nominal interest rate in India and China is 12% and
10%respectively and the international parity conditions hold
(i) Identify expected future cash flows in China and determine NPV of the
project in CN¥.
(ii) Determine whether Opus Technologies should go for the project or not
assuming that there neither there is restriction on the transfer of funds
from China to India nor any charges/taxes payable on the transfer of
funds.
SOLUTION:-
Working Notes:
2.75
Ke = + 0.10 = 0.1139 i.e. 11.39 %
198
2. Calculation of Expected Exchange Rate as per Interest Rate Parity
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2 (1+0.12)2
9.50 × = 9.85
(1+0.10)2
CN¥
Sale value at the end of project 35,00,000.00
Cost of Land 30,00,000.00
Capital Gain 5,00,000.00
Tax paid 1,25,000.00
Amount realized net of tax 33,75,000.00
CN¥
Sale value at the end of project 5,00,000.00
WDV 0.00
Capital Gain 5,00,000.00
Tax paid 1,25,000.00
Amount realized net of tax (A) 3,75,000.00
Year 1 2
Annual Units 10,000 10,000
Price per bottle (CN¥) 540.00 583.20
Annual Revenue (CN¥) 54,00,000.00 58,32,000.00
Less: Expenses
Variables operating cost (CN¥) 21,60,000.00 23,32,800.00
Depreciation (CN¥) 7,50,000.00 7,50,000.00
Fixed Cost per annum (CN¥) 23,76,000.00 25,66,080.00
PBT (CN¥) 1,14,000.00 1,83,120.00
Tax on Profit (CN¥) 28,500.00 45,780.00
Net Profit (CN¥) 85,500.00 1,37,340.00
Add: Depreciation (CN¥) 7,50,000.00 7,50,000.00
Cash Flow 8,35,500.00 8,87,340.00
Year 0 1 2
Initial Investment -45,00,000.00
Annual Cash Inflows 8,35,500.00 8,87,340.00
Realization on the
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(a) Assuming that inflow funds are transferred in the year in which
same are generated i.e. first year and second year.
Year 0 1 2
Cash Flows (CN¥) -45,00,000.00 8,35,500.00 46,37,340.00
Exchange Rate (₹/ CN¥) 9.50 9.67 9.82
Cash Flows (₹) -4,27,50,000.00 80,79,285.00 4,56,77,799.00
PVF @ 12% 1.00 0.893 0.797
-4,27,50,000.00 72,14,802.00 3,64,05,206.00
NPV 8,70,008.00
b. Assuming that inflow funds are transferred at the end of the project
i.e. second year.
Year 1 2
Cash Flows (CN¥) -45,00,000-00 54,72,840.00
Exchange Rate (Rs./ CN¥) 9.50 9.85
Cash Flows (Rs.) -4,27,50,000.00 5,39,07,474.00
PVF 1.00 0.797
-4,27,50,000.00 4,29,64,257.00
NPV 2,14,257.00
Though in terms of CN¥ the NPV of the project is negative but in Rs. it has
positive NPV due to weakening of Rs. in comparison of CN¥. Thus Opus can
accept the project.
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TABLES
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Entries represent Pr(Z ≤ z). The value of z to the first decimal is given in the left
column. The second decimal is given in the top row.
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Student’s T Distribution
Level of Significance for One Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
1 3.078 6.314 12.706 31.821 63.657 636.619
2 1.886 2.920 4.303 6.965 9.925 31.599
3 1.638 2.353 3.182 4.541 5.841 12.294
4 1.533 2.132 2.776 3.747 4.604 8.610
5 1.476 2.015 2.571 3.365 4.032 6.869
6 1.440 1.943 2.447 3.140 3.707 5.959
7 1.415 1.895 2.365 2.998 3.499 5.408
8 1.397 1.560 2.306 2.896 3.355 5.041
9 1.383 1.833 2.262 2.821 3.250 4.781
10 1.372 1.812 2.228 2.764 3.169 4.587
11 1.363 1.796 2.201 2.718 3.106 4.437
12 1.356 1.782 2.179 2.681 3.055 4.318
13 1.350 1.771 2.160 2.650 3.012 4.221
14 1.345 1.761 2.145 2.624 2.977 4.140
15 1.341 1.753 2.131 2.602 2.947 4.073
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Exam Oriented Book
CA Pavan Sir
Address: Pavan Sir SFM Classes, H. No. 22, Divya colony Near Maruti Residency,
Amlidih, Raipur (c.g.) 492001