SFM Pawan Sir

CA Final SFM
Strategic
Financial Management
SFM NEW SYLLABUS

(EXAM ORIENTED)
Volume
1
CA Pavan Karmele Sir

1. Derivatives
2. Interest Rate Risk Management
3. Foreign Exchange Exposure & Risk Management
4. International Financial Management
Edition
2022 - 23
CA FINAL SFM
STRATEGIC FINANCIAL
MANAGEMENT
EXAM ORIENTED BOOK (NEW SYLLABUS)
 Revised & Updated

 ICAI Study Material Coverage
 Includes Examination Question & Answer
 Video Lectures Available in Google Drive
Published By
STRATEGIC FINANCIAL MANAGEMENT
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CONTENTS
CHAPTER – 01
DERIVATIVES
CONCEPTS Page No.
Option Contract………………………………………………………………... 1
Basics …………………………………………………………………………..… 1
Valuation of option or option pricing………………………………….…. 6
Binomial Model ………………………………………………………............ 7
Two Period binomial Model …………………………………………………. 9
Put Call Parity Theorem …………………………………………………… … 10
Black Scholes Model (BSM) ………………………………………………… 11
Option strategies …………………………………………………………..….. 12
Straddles & Strangles ……………………………………………………..…. 13
Option Greeks …………………………………………………………….…….. 14
Part II : Forward & Future …………………………………………………… 16
Margin …………………………………………………………………………….. 18
Theoretical Future Price [Cost of Carry Model] ………………………. 19
Beta Management of Hedging Through Stock Index Future ……… 23
Commodity Future ……………………………………………………………. 25
QUESTIONS
Basic ………………………………………………………………………………. 27
Expected Value of Option …………………………………………… ……… 31
Option Pricing & Valuation ……………………….………….…………….. 34

Binomial Model ………………………………………………………….…….. 34
Two Period Binomial Model ………………………………………………… 37
Delta Hedging Binomial Model …………………………………….………. 41
Put Call Parity ………………………………………………………………….. 44
Block Scholes Model ………………………………………………………… .. 46
Option Strategies ……………………………………………………… ………. 58
Margin A/c ………………………………………………………………………. 68
Valuation of Future …………………………………………………… ……… 73
Beta Management ……………………………………………………………… 82
Commodity future ……………………………………………………………… 106

CONTENTS
CHAPTER – 02
Interest Rate Risk Management

CONCEPTS Page No.
Interest Rate Risk Management …………………………………………… 01
Part 1: Forward Rate Agreement ………………………………………….. 01
FRA for Hedging ……………………………………………………………….. 03
Part 2: Interest Rate Guarantee [FRAPTION]…………………………… 04
Part 3: Interest Rate Future (Euro Dollar Future) …………… ……… 04
Part 4: Financial Swap ………………………………..……………… …….. 04
Plain Vanilla Swap…………………………………………………………….. 04
Overnight Index Swap………………………………………………..………. 05
Two Parity Swap………………………………………………………………… 06
Swap Quotation (Structuring) ……………………………………………… 06
Swap Pricing &Valuation…………………………………………..… 06
Part 5: CAP, Floor & Collar………………………………………………… … 07
QUESTIONS
Part I: Forward Rate Agreement (FRA) ……………………………………. 08
Part II: Interest Rate Guarantee ……………………………………………. 14
Part III: Interest Rate Future (Euro Dollar Future) ………………… ... 16
Part IV: Financial Swap …………………………………………………… .… 20
Plain Vanilla Swap …………………………………………………… ……….. 20
Overnight Index Swap ………………………………………………………… 23

Two Party Swap ………………………………….…………………………….. 27
Swap Quotation ………………………………………………………........... 32
Swap Pricing & Valuation ………………………………..……… ..………… 35
Part V: CAP, Floor & Collar…………………………………………………… 37

CONTENTS
CHAPTER – 03
Foreign Exchange Exposure & Risk

Management
CONCEPTS Page No.
Foreign Exchange Risk Management ……………………………………… 01
Basics ……………………………………………………………………………… . 01
Exchange Rate …………………………………………………………..………. 01
Direct /Quote …………………………………………………………………….. 01
Indirect Quote ……………………..…………………………………………….. 02
Conversion of Currency ……………………………………………………… .. 02
BID – ASK RATES Bid – Ask Rates ………………..………………………. 03
Appreciation & Depreciation in Currency ………………………… ..…… 04
Calculation of Customer Rate or Merchant Rate ……………......…… 04
Cross Rates………………………………………………………………………… 04
Part I – Cross Rate Without Bid-Ask ………………………………………. 05
Part II – Cross Rate Without Bid-Ask ……………………………………… 06
Spot Market Arbitrage ………………………..……………………………….. 07
Triangular Arbitrage ………………………………………………….………… 08
Forward Contract ……………………………………………………………….. 08
Forward Contract for Importer …………………………………….……….. 08
Forward Cover for Importer ………………..………………………………... 09
Forward Premium or Discount ……………………………………………… 09

Calculation of Forward Rate With the Help of Swap Points … . …… 10
Cover Deal ……………………………………………………………………….. 11
Exchange Rate Determination …………………………………………….. 12
Interest Rate Parity (IRP) ……………………………………………………. 12
Covered Interest Arbitrage……………………………………… …………… 15
Purchasing Power Parity (PPP) ………………………….… ………………. 16
Absolute form of PPP …………………………………………………………. 16
Expectation form as relative form of PPP……………………………….. 16
International Fisher Effect (IFE) ……………………………….…………. 17
Foreign Currency Exposures…………………………………................. 19
Transaction Exposure…………………………………………………………. 19
Translation Exposure or Accounting Exposure ………….. …………... 19
Economic Exposure or Operating Exposure ……………... …………… 20
Internal Hedging ……………………………………………………………….. 21
External Hedging or Transaction Exposure …………………….… …… 23
Cancellation of Forward Contract …………………………… …………… 28
Cancellation & Extension of Forward Contract………………………. 29
Cancellation on Maturity …………………………………………………… 29
Cancellation Before Maturity ……………………………………………… 30
Extension of Forward Contract ……………………………… . …………. 30
Automatic Cancellation……………………………………….…………….. 31
Early Delivery…………………………………………………..………………. 32
Foreign Currency A/C …………………………………………….……….... 32
NOSTRO A/C ……………………………………………….…………………… 32
QUESTIONS
Basics……………………………………………………………..………………. 34
Spot Market ………………………..…………………………………………… 40
Forward Contract ……………………………………………………………… 44
Cover Deal ………………..…………………………………………………….. 64
Exchange Rate Determination …………………………………………….. 68
Interest Rate Parity ……………………………………………................. 68
Covered Interest Arbitrage …………………………………..……………… 75
Purchasing Power Parity ……………………………………..……………… 83
International Fisher Effect ………………………………….………………. 84
Currency Exposure ……………………………………………………………. 90
Leading & Laggings…………………………………………………………….. 90
Money Market Cover …………………………………………………………… 97
Currency Future ………………………………………………………………… 104
Currency Option ……………………………………………….……………….. 119
Invoicing …………………………………………………………………………… 129
Cancellation of Forward Contract …………..………..……………..……. 133
Cancellation & Extension of Forward Contract ……………………….. 133
Overdue Forward Contract …………………………………………………… 143
Early Delivery ……………………………………………………………………. 150
Foreign Currency A/c …………………………………………………………. 154

Currency of Borrowing ……………………………………………………….. 160
Currency of Invest …………………………………………………………… … 168
International Cash Management …………………………………………… 178
Currency Swap ………………………………………………………………….. 180
Economic Exposure ……………………………………………………………. 181
Residual……………………………………………………………………………. 183
CONTENTS
CHAPTER – 04
International Financial Management

CONCEPTS Page No.
International Financial Management ……………………… …………….. 01
International Capital Budgeting ………………………………… ..….……. 01
Raising Fund From Abroad (ADR, GDR) ……………………….………… 02
QUESTIONS
DERIVATIVES
CHAPTER – 01
DERIVATIVES
DERIVATIVES
 Derivative is a financial instrument which derives its value from an

underlying asset.
 Underlying asset means share, stock, bonds, currency, commodity,
stock index etc.
 Derivative is an instrument for betting.
 We will discuss this chapter in two parts.
Part I – Option Contract
Part II – Forward & Future Contract
PART I : OPTION CONTRACT
We will discuss option contract in three points

I – Basics
II – Valuation of Option
III – Option Strategy
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.
(2) There are two parties in option contract
Option Holder or Option Option Writer or Option

Buyer Seller
(i) Right but not obligation (i) Obligation but not right
(ii) An option premium to be (ii) Margin money is required

paid in advance. to be deposited at stock
exchange.
(iii) Unlimited profit & (iii) Unlimited loss &
maximum loss premium maximum profit is
www.pavansirsfmclasses.com Page 1
DERIVATIVES
amount. premium amount.
(iv) Loves volatility. (iv) Hates Volatility.
(3) There are two types of options

(a) Call Option
- Right to buy
- Expected to price rise
(b) Put Option

- Right to sell
- Expected to price fall
(4) Types of options on the basis of cash flows
(i) European Option :- European option can be exercised only

on maturity.
(ii) American Option :- American option can be exercised on or

before maturity. Premium amount of American option is more
than European
EXAMPLE – 01
Mr. E is interested in buying a share of I.T.C. He is however afraid that

the price of the share may move down. Hence, he does not purchase a
share but buys a call option on 1 share of I.T.C. at a strike price of ₹ 300
by paying an option premium of ₹ 35.
Required:-
(i) Determine the breakeven point price of Mr. E.
(ii) Determine the Profit/Loss if the price on maturity is: - 250, 270,
290, 300, 320, 340, 350.
(iii) Draw pay off for call option holder.
(iv) Draw pay off for call option writer.
DERIVATIVES
EXAMPLE – 02
Mr. G is hoping that the price of a share of ACC is going to fall. He

purchases a put option at an exercise price of ₹ 480. He pays a premium
of ₹ 40.
Required:-
(i) Determine the breakeven point to Mr. G
(ii) Compute Profit/Loss for Mr. G if the price o n maturity is- ₹ 400,
420, 440, 480, 490, 500, 530.
(iii) Draw pay off put option holder.
(iv) Draw pay off put option writer.
(5) In the money , At the money, Out of the Money, Intrinsic

value & Time value
In the money (ITM), At the money ( ATM ), Out of the money (OTM)
EP < CMP EP = CMP EP > CMP
Call ITM ATM OTM

Put OTM ATM ITM
There are two parts of option premium :- Intrinsic value & Time
value (Volatility premium)
Intrinsic value :- If option is in the money, then difference between

CMP & EP is called Intrinsic value. If option is out of the money &
At the money than Intrinsic value will be zero.
Time value or Volatility premium :- If option is in the money then

Time value = premium amount – Intrinsic value If option is Out of
the money & At the money then whole of the premium amount is
time value.
DERIVATIVES
EXAMPLE – 03
State whether each one of the following is In the money, At the money or
Out of the money.
Option Exercise price Stock price

Call 1360 1340 OTM
Call 1360 1360 ATM
Call 1360 1380 ITM
Call 1360 1400 ITM
Put 1360 1340 ITM
Put 1360 1360 ATM
Put 1360 1380 OTM
Put 1360 1400 OTM
EXAMPLE – 04
Consider the data relating to a stock contained in the following table.

Determine both the intrinsic value and the time value in each of the
cases.
Option Strike price Asset price Option premium IV TV

Call 90 100 15 10 5
Call 110 100 2 0 2
Put 200 100 135 100 35
Put 90 100 4 0 4
Put 150 125 30 25 5
Call 150 120 22 0 22
(6) Participants in Derivative Market
There are three participants or players in Derivative Market.
(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
DERIVATIVES
- They may loose
(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
(7) Short selling (Stock lending & Borrowing Scheme)
(i) Definition :- Short selling is a speculative activity is designed

to make profit on the basis of bearish price expectation.
(ii) Explanation :- In short selling, short seller borrow stock from

stock lender & sell it at current market price with a view to
buy later on at lower price & return to stock lender.
(iii) Sources of Return :-

- Price depreciation
- Interest on selling amount
(iv) Sources of Risk :-

- Price Appreciation
- Dividend (Short seller compensates dividend amount to
stock lender)
- Stock lending charges
(v) Legal Status :- Short selling is prohibited in some Countries.

In some Countries like US & India allow short selling with
some restriction.
In India stock Lending & Borrowing scheme (SLBS) of SEBI

regulates short selling activities.
(8) Expected value of option
- Expected price of share
= ∑ Price x probability
- Expected value of option
DERIVATIVES
= ∑ Gross payoff + probability
Or
∑ Intrinsic value x probability
EXAMPLE – 05
Option = Call option

Exercise Price = ₹ 500
Period = 3 months
Price of Maturity Probability
520 0.3
530 0.2
510 0.1
490 0.3
480 0.1
Calculate Expected value of option. & Expected Price of share
EXAMPLE – 06
Option = Put option

Period = 2 months
Price of Maturity Probability
170 0.15
180 0.10
200 0.05
220 0.30
160 0.40
Calculate Expected Value of option.
2). VALUATION OF OPTION OR OPTION PRICING
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?
- Premium Amt. > Value of option Overpriced Not buy
DERIVATIVES
- Premium Amt. < Value of option Underpriced Buy
There are three methods to calculate value of option.
(i) Binomial Model

- Risk neutral probability approach Imp
- Delta hedging or Risk free portfolio approach
- Replicating portfolio approach
(ii) Put call parity theorem (PCPT)
(iii) Black – Scholes Model (BSM)
(1). BINOMIAL MODEL
(i) Risk Neutral Probability Approach :- As per Binomial Model

(Name Suggested), Only two possible price of stock on maturity i.e.
- Maximum price or upper price of stock (us)
- Minimum price or lower price of stock (ds)
(ii) Following step are applied to calculate value of option
Step – 1 : Standard notation or given
Step – 2 : Calculate risk neutral probability
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
PuP +Pd (1−P) 500*0.8

Po =
R Derivation next page
DERIVATIVES
(iii) How to Calculate Risk Neutral Probability Derivation for understanding
500 × 1.10 = (500 × 1.20 × P)+(500 × 0.8)(1-P) SR=(us × P) + ds(1-P)
500 × 1.10 = (500 × 1.20 × P) +500 × 0.8-500 × SR= us × P + ds – dsP

0.08 × P
500 × 1.10 − 500 × 0.8 = 500 × 1.20 × P − 500 SR-ds = us × P – dsP

× 0.8 × P
500 × 1.10 - 500 × 0.8 = [(500 × 1.20) – 500 × SR – ds = P (us – ds)

0.08] P
500 × 1.10 − 500 × 0.8 SR − ds

P= P=
500 × 1.20 − 500 × 0.8 us − ds
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
Current market price = ₹ 500
Period = 1 year
Risk free rate = 10% p.a.
Price on maturity
Maximum price = ₹ 600
Minimum Price = ₹ 400
Calculate Value of call option as per binomial model.
EXAMPLE – 08
DERIVATIVES
Period = 6 months
Price on maturity
Upper price = ₹ 1300
Lower Price = ₹ 900
Calculate Value of Call option if
Risk free rate
Case 1- 8% p.a. compounded semi annually
Case 2 - 8% p.a. compounded annually
Case 3 - 8% p.a. compounded continuously
EXAMPLE – 09
Period = 3 months
Risk free rate = 12% p.a. effective
Price on maturity
Calculate Value of put option as per binomial model.
TWO PERIOD BINOMIAL MODEL
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
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
Risk free rate = 10% p.a.
Price on maturity
Calculate : Value of call option
(i) Using Delta hedging.
(ii) Using Risk Neutral Probability Approach
(iii) Using Replicating Portfolio Approach
(2). PUT CALL PARITY THEOREM
Put call parity theorem is a strategy of combination of European call &

put option at same exercise price on same asset for same maturity
period.
Equation of put call parity
So + Po = Co + P.V, of EP
Where,
DERIVATIVES
So = Current market price
Po = Value of put option/put premium
Co = Value of call option/call premium
This equation is derived with the help of following two parts.
Part I : Protective Put
Part II : Fiduciary Call
EXAMPLE – 12
The following table provides the prices of options on equity shares of X

Ltd. and Y Ltd. The risk free interest is 9%. You as a financial planner
are required to spot any mispricing in the quotations of option premium
and stock prices? Suppose, if you find any such mispricing then how you
can take advantage of this pricing position.
Share Time to Exercise Share Call Put

Exercise Price Price Price Price
X Ltd. 6 months 100 160 56 4
Y Ltd. 3 months 80 100 26 2
(3). BLACK SHOLES MODEL (BSM)
As per BSM, value of call option is calculated as under
E
Co = So × n(d 1 ) − rt × n(d 2 )
e
Where,
So = Current Market Price
E = Exercise Price
r = Rate of Interest [ Always Continuously Compounding ]
DERIVATIVES
n = Normal Distribution Table (Z Table)
d1 = Delta of call or probability of stock price is more than
exercise price
d2 = Probability of option exercise
S σ2
Ln o + r + t
E 2
d1 =
σ t
d2 = d1 − σ t
EXAMPLE – 13
Spot price = ₹ 165
Time = 2 years
Rate = 6% p.a.
Standard Deviation = 15% p.a.
Calculate
(i) Value of Call option.
(ii) Value of Put option
3). OPTION STRATEGIES
(1) Straddles & Strangles
(2) Straps & Strips
(3) Bull & Bearish
(4) Butterfly
DERIVATIVES
(1) STRADDLES & STRANGLES
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
An investor expects wide fluctuations in one share of R.I.L. but he is

unsure, where the movement will be, hence he buys one put and one call
at a strike price of ₹700 after paying a premium of ₹35 for put &₹45 for
call, having maturity of 2 months each.
Required:- BEP : Call=700+80= 780
Put= 700-80= 620
(i) Name the Strategy Straddles
Cost of Strategy = 35+45=80
(ii) Determine Break-Even points & compute the cost of strategy.
(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.
DERIVATIVES
− If price will fall then we will exercise put option & call option will
lapse.
− Cost of strangles strategy is less than cost of straddles strategy.
− In strangles, Call option is bought at higher EP & Put option is

lower EP.
EXAMPLE – 15
Mr. G is expecting wide fluctuations in stock of RIL. He buys one call

option at a strike price of ₹700 by paying ₹ 45, along with a put option at
a strike price of ₹650 by paying a premium of ₹20.
Required:-
(i) Name the strategy.
(ii) Compute the cost of strategy & Break Even Points.
(iii) Compute the profit/Loss if the price on maturity is- ₹500, 550,
600, 650, 680, 700, 750, 800, 850.
EXAMPLE – 16
Following are the options available for RIL for 3 months.
Exercise Price Call Option Put Option
1,000 80 25
1,100 55 40
1,200 35 55
Create Straddles and Strangles Strategy.
4). OPTION GREEKS
Price of option depends upon following factors.

(1) Stock price (So)
(2) Exercise price (E)
(3) Time (t)
DERIVATIVES
(4) Volatility (σ)

(5) Rate of Interest (R)
Among these factors, exercise price is constant, remaining factors may

change. Option price will change due to change in these factors. We wish
to carryout sensitivity analysis i.e.
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.
 If means if price of stock goes by ₹ 1 then price of call option

will go up by 40 paisa & price of put option will go down by
60 paisa .
 In Binomial
1 call is equivalent to 0.4 share long.
1 put is equivalent to 0.6 share short
 In BSM
Delta = N (d 1 )
 Hedge Ratio
Delta call 0.4 = Write call & buy 0.4 shares.
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
DERIVATIVES
Rate of change in option price with respect to rate & change in time is
called theta.
Option price will go down due to passage of time.
IV). VEGA
Rate of change in option price with respect to volatility is called vega.
Price of option will go up due to increase in volatility.
V). RHO
Rate of change in option price with respect to increase rate is called

“Rho”
If rate of interest rises then price of call will go up & price of put will go
down.
PART II : FORWARD & FUTURE
(1) Forward Contract
- Forward contract is a contract between two parties to buy or

sell an underlying asset at predetermine price (forward Rate)
in future delivery.
- In forward contract forward buyer is obligated to buy &

forward seller is obligated to sell such underlying asset.
- Forward contract is over the counter (OTC) contract.
(2) Future Contract
Future contract is
- Standardized forward contract Standard Lots
- Traded at stock exchange
- With margin requirement
- No counter party default risk
(3) There are Two parties in future contract
(a) Future Buyer
DERIVATIVES
- Contract to buy
- Upside betting
- Long position
(b) Future Seller

- Contract to sell
- Downside betting
- Short position
(4) Forward contract V/S Future contract
Forward Contract Future Contract
(i) Over the counter contract (i) Exchange traded
(ii) Customized (ii) Standardized
(iii) No margin requirement (iii) Margin requirement
(iv) Counter party default risk (iv) No counter party default risk
(v) Settlement only on maturity (v) Daily settlement in margin

balance (Mark to Market
settlement )
(vi) Less Liquidity (vi)High liquidity
(vii) Less regulations (vii)More regulations
(viii) Generally used by hedgers (viii)Generally used by speculators .
(5) Stock index future

- Stock index future means future contract on stock index i.e.
Nifty & Sensex etc.
- It could be on sector wise i.e. Bank nifty, IT index et c. Or it

could be on overall market i.e. Nifty, Senses etc.
- It is settled only in cash, No physical delivery is possible. It is

more liquid than stock future.
- It is difficult to manipulate.
DERIVATIVES
NUMERICALS
(I) Margin A/c
(II) Valuation of future
(III) Beta management or Hedging through future
(IV) Commodity future
(i) MARGIN
There are three types of margin
(i) Initial Margin :- Initial margin means margin amount is required

at the time of execution of contract
(ii) Maintenance Margin :- Maintenance margin is minimum margin

amount. If initial margin is below maintenance margin th en
investor has to bring out extra margin.
(iii) Variation Margin :- If initial margin is less than maintenance

margin then investor has to bring extra amount of margin & such
extra amount is called variation margin.
Important Notes
(i) Margin amount can be withdrawn if margin money is more than

initial margin. If question is silent then assume no withdraws.
(ii) Whenever contract is squared off then balance amount of margin is

refunded .
(iii) If initial margin is not given in question then it is calculated as

under.
Initial Margin = µ + 3𝜎
µ = Average daily absolute change in price
𝜎 = Standard deviation in price
DERIVATIVES
(ii) THEORETICAL FUTURE PRICE [COST OF CARRY MODEL]
As per cost of carry model, Theoretical future price or fair value of future
is calculated as under
F = Spot price + Interest saved – Dividend forgone
If
Actual future price > Value of future -: Future is overpriced
Actual future price < Value of future -: Future is Underpriced
Suppose
Spot price = ₹ 500
Rate of Interest = 10% p.a.
Period = 1 year
Expected dividend = ₹ 40 at the year-end
(a) Calculate theoretical future price
F = Spot price + Interest saved – Dividend forgone

= 500 + 50 – 40
= 510
Or,
F = S(1 + r)−D
F = 500(1.10)−40 = ₹ 510
(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
Spot Price = ₹ 500 (F.V. ₹ 100)

Period = 6 Months
Dividend Rate = 20%
DERIVATIVES
Calculate Theoretical Price of Future.
EXAMPLE – 18
Spot Price = ₹ 500 (F.V. ₹ 100)

Period = 6 Months
Dividend Yield = 5% p.a.
Calculate fair value of Future.
EXAMPLE – 19
Spot Price = ₹ 500

Period = 6 Months
Dividend Yield = 4% p.a. compounded annually.
Rate of Interest = 12% p.a. compounded annually.
Calculate fair value of Future.
EXAMPLE – 20
Consider the following:
Current value of index - 1400
Dividend yield - 6%
CCRRI - 10%
Find the value of a 3 month forward contract.
EXAMPLE – 21
Consider a 3 months maturity forward contract on a non-dividend paying

stock. The stock is available for ₹ 200. With compounded continuously
risk-free rate of interest (CCRRI) of 10% per annum, what is the value of
the forward contract?
E XAMPLE – 22
DERIVATIVES
Suppose that there is a future contract on a share presently trading at ₹

1,000. The life of future contract is 90 days and during this time the
company will pay dividends of ₹ 7.50 in 30 days, ₹ 8.50 in 60 days and ₹
9.00 in 90 days.
Assuming that the Compounded Continuously Risk free Rate of Interest

(CCRRI) is 12% p.a. you are required to find out:
(i) Fair Value of the contract if no arbitrage opportunity exists.
(ii) Value of Cost to Carry
[Given e -0.01 = 0.9905, e -0.02 = 0.9802, e -0.03 = 0.97045 and e 0.03 =

1.03045]
EXAMPLE – 23
Consider a 4 months forward contract on 500 shares with each share

priced at ₹ 75. Dividend @ ₹ 2.50 per share is expected to accrue to the
shares in a period of 3 months. The CCRRI is 10% per annum, what is
the value of the forward contract?
Arbitrage with future

(i) No dividend paying stock
(ii) Dividend paying stocks
EXAMPLE – 24
6 Months future price = ₹ 542
No dividend paying stock
(i) Calculate Theoretical price of future.
(ii) Calculate arbitrage gain.
DERIVATIVES
EXAMPLE – 25
No dividend paying stock
(i) Calculate Theoretical Price of future.
EXAMPLE – 26
Dividend per shares = ₹ 5
EXAMPLE – 27
Dividend per shares = ₹ 5
DERIVATIVES
(iii) BETA MANAGEMENT OR HEDGING THROUGH STOCK INDEX

FUTURE
(1) What is Beta?
Beta is measurement of systematic risk which represent
relationship between change in stock return & change in
market return.
Change in stock ′ s return

Beta =
change in market return
Suppose, change in stock return is = 20% & change in market

return is 10%
20%
Hence Beta of stock = = 2
10%
Higher Beta means higher volatility i.e. higher risk.
(2) What is portfolio Beta?
− Portfolio beta means weighted average beta of individual

stocks.
− Suppose, we invest in following stocks.
Stocks Investment Amount Beta

A 3,00,000 2
B 2,00,000 1.5
C 5,00,000 1
V P = 10,00,000
Method I :- Calculation of Beta of portfolio
3,00,000×2 + 2,00,000×1.5 +(5,00,000×1)

BP =
10,00,000
= 1.4
DERIVATIVES
Method II :- Beta of Portfolio
Stocks Amount Weights Beta W×B

A 3,00,000 0.30 2 0.6
B 2,00,000 0.20 1.5 0.3
C 5,00,000 0.50 1 0.5
10,00,000 1.00 BP 1.4
B p 1.4 means if index changes by 10% then value of portfolio will

change by 14%.
(3) Beta Management or Hedging Through Stock Index Future
− We know that beta is a relationship between stock & market.
− Suppose we hold stock of RIL at ₹ 5,00,000(Portfolio = ₹

5,00,000) & Beta = 1 & we expect that portfolio will rise but it
may possible that market will fall. We afraid from market
falling & we want to hedge the risk of decrease in value of
portfolio.
− In order to hedge risk, we have to decrease beta of portfolio &

we take short position on stock index future ( Downside
betting)
− Suppose market will fall in future then we loose on long

position of portfolio but, make profit on short position of
stock index future.
− No. of contracts to be bought or sold of stock index future is

calculated as under
Vp × BT − Bp
x=
F × M × Bf
x = No. of contracts
BT = Target Beta (If not given in question, assume “0”)[perfect

hedge]
Bp = Beta of portfolio
DERIVATIVES
F = Future price of stock index
m = Multiplier (Lot size)
BF = Beta of future (If not given in question , assume 1)
Example – 28
Consider a fund manager having a corpus of 500 lakhs as shown below:
₹ (in Lakhs) Beta

Bond 150 0.8
Equity 300 4
Cash 50 0
500
Nifty futures trade at 5750 (lot size 50)
The fund manager is expecting a market crash
(i) Find out the beta of the portfolio and interpret the same
(ii) How many nifty futures should be bought or sold to achieve a beta
of 0.5.
(iii) How many nifty futures should be bought or sold foe complete
hedging.
(iv) How many nifty futures should be bought or sold to achieve a beta
of 3.
(iv) COMMODITY FUTURE

Commodity future means future contra t on commodity like gold, steel,
oil etc.
(i) Margin
(ii) Theoretical future price
(iii) Beta management
DERIVATIVES
Theoretical Future Pricing of Commodity
As per cost of carry model, theoretical future price of Commodity is

calculated as under.
F = (Spot price + PVSC − PVCY) (1 + r)
F = Theoretical future price

PVSC = Present value of storage cost
PVCY = Present value of convenience yield
Hedge Ratio or Hedging Through Future
Spot price of Commodity & future price is Commodity are positive

correlated but not in same rate. In this situation we have to find out the
exact proportion & this is called “Hedge Ratio”.
Hedge ratio is calculated by “Least Square Method”.
S.D. of Spot
Hedge Ratio = × r Spot & Market
S.D. of Future
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:
(i) The strike price in both cases is ₹320; and
(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.
(Exam Nov - 2018)
SOLUTION:-
Net payoff for the holder of the call option

₹
Share price on exercise day 300 310 320 330 340
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 320 320
Outflow (Premium) 8 8 8 8 8
Total Outflow 8 8 8 328 328
Less inflow (Sales proceeds) - - - 330 340
Net payoff -8 -8 -8 2 12
Net payoff for the holder of the put option

₹
Option exercise Yes Yes No No No
Inflow (Strike price) 320 320 Nil Nil Nil
Less outflow (purchase price) 300 310 - - -
Less outflow (premium) 7 7 7 7 7
Net Payoff 13 3 -7 -7 -7
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.
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of

the stock quoted in Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 1st
January 2020.
Other Information :
(a) Cost of Bank Guarantee is 8% per annum.
(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 :
Date Share Price in Share Price in

Scenario – 1 Bullish Scenario – 2 Bullish
1st January 2020 1,000 1,000
31st January 2020 1,020 980
29th February 2020 1,040 960
31st March 2020 1,050 940
You are required to find out :
(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 ?
DERIVATIVES
(Exam January - 2021)
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.
(i) The strike price in both cases in ₹ 220; and
(ii) The share price on the exercise day is ₹ 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be
gainfully exercised.
(SM New Syllabus & PM)
DERIVATIVES
SOLUTION:-
Net payout for the holder of the call option
(₹)
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
Net payoff for the holder of the put option
(₹)
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.
DERIVATIVES
Gross Payoff (276 − 200) = ₹ 76
(−) 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.
Gross Payoff (250 - 189) = ₹ 61
(−) 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.
Profit = Premium received i.e. ₹ 57
(II) EXPECTED VALUE OF 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:
Market Price ₹ 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of ₹ 300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
(SM New Syllabus &PM)
SOLUTION:-
Expected value of option
(300 − 1800) × 0.1 12
(300 − 260) × 0.2 8
DERIVATIVES
(300 − 280) × 0.5 10
(300 − 320) × 0.1 Not Exercised*
(300 − 400) × 0.1 Not Exercised*
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:
Expected Price (₹) 120 140 160 180 190

Probability 0.05 0.20 0.50 0.10 0.15
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?
(MTP March – 2022, SM New Syllabus& PM)
SOLUTION:-
Price Pi Probability Price × prob If held till Call Call value

after 4 maturity value ×
m probability
120 0.05 6 Call lapses 0 0
140 0.20 28 Call lapses 0 0
160 0.50 80 Call exercised +10 5
180 0.10 18 Call exercised +30 3
190 0.15 28.5 Call exercised +40 6
Total 160.50 14
DERIVATIVES
(i) Expected share price after 4 months = ₹ 160.50
(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.
(iii) Expected value of the option = ₹ 14
(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.
Market Price 170 190 200 220 240

Probability 0.05 0.20 0.40 0.20 0.15
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?
(ii) What is expected value of call option?
(iii) What is the expected value of put option?
SOLUTION:-
(i) Expected market price per share
(170 × 0.05) + (190 × 0.20) + (200 × 0.40) + (220 × 0.20) + (240 × 0.15)
= 358.52
(ii) Expected value of call option
DERIVATIVES
Market Exercised or Gross payoff Probability GP × P

price not
170 No 0 0.05 0
190 No 0 0.20 0
200 No 0 0.40 0
220 Yes 20 0.20 4
240 Yes 40 0.15 6
Expected value of Call 10
(iii) Expected value of put option
Market Exercised or Gross payoff Probability GP × P

price not
170 Yes 30 0.05 1.50
190 Yes 10 0.20 2
200 No 0 0.40 0
220 No 0 0.20 0
240 No 0 0.15 0
Expected value of Put 3.50
(III) OPTION PRICING & VALUATION
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?
Given e0.02 = 1.0202
(SM New Syllabus& PM)
SOLUTION:-
Let the probability of attaining the maximum price be p
(500 − 420) × p+(400 − 420) × (1−p) = 420 × (e0.02−1)
DERIVATIVES
or, 80p− 20(1 − p) = 420 × 0.0202
or, 80p – 20 + 20p = 8.48
or, 100p = 28.48
p= 0.2848
0.2848 ×(500 450)

The value of Call Option in ₹ =
1.0202
0.2848 ×50 0.7152 0
= = 13.96
1.0202
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.
(SM New Syllabus& PM)
SOLUTION:-
e rt −d
p =
u−d
e rt = e 0.036
d = 411/421 = 0.976
u = 592/421 = 1.406
e 0.036 −0.976 1.037−0.976 0.061

p = = = = 0.1418
1.406−0.976 0.43 0.43
DERIVATIVES
Thus probability of rise in price 0.1418
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
Step 2: Risk Neutral Probability
R −d 1.05 − 0.89
P = = = 0.889
u −d 1.07 − 0.89
Step 3: Binomial Tree
DERIVATIVES
Step 4: Value of Call
Cup + Cd (1−P) 9 ×0.889 + 0(1 – 0.889)

C0 = =
R 1.05
= ₹ 7.62
TOW PERIOD BINOMIAL MODEL
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.
Using the Binomial Model, calculate:
(i) The probability of price moving up and down;
(ii) Expected pay offs at each nodes i.e. N1, N2 and N3 (round off upto 2 decimal
points).
(Exam Nov - 2020)
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
DERIVATIVES
Therefore, the probability of price moving down = 1 – 0.78 = 0.22 i.e. 22%
(ii) Expected pay-off at
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:-
Stock prices in the two step Binominal tree
DERIVATIVES
Using the single period model, the probability of price increase is
R−d 1.06−0.80 0.26

P= = = = 0.65
u−d 1.20−0.80 0.40
Therefore the p of price decrease = 1-0.65 = 0.35
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
Cup + Cd (1 − p) 22 × 0.65 + 0 × 0.35

C= = = 13.49
R 1.06
The value of option at node „A‟ is
DERIVATIVES
13.49 × 0.65 + 0 × 0.35

= 8.272
1.06
QUESTION – 13
Following is a two-period tree for a share of stock in CAB Ltd.:
(6 month) One Year
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:-
U = 33.00/30.00 = 36.30/33.00 = 1.10
d = 27.00/30.00 = 24.30/27.00 = 0.90
r = (1 + 0.05)1/2 = 1.0247
r−d 1.0247 −0.90

p= = = 0.1247/0.20 = 0.6235
u−d 1.10−0.90
Cuu = Max [0, 36.30 - 28] = 8.30
Cud = Max [0, 29.70 - 28] = 1.70
Cdd = Max [0, 24.30 - 28] =0
DERIVATIVES
0.6235 8.30 + (0.3765 )(1.70)

Cu =
1.025
5.175 + 0.064
= = 5.815/1.025 = ₹ 5.675
1.025
0.6235 1.70 + (0.3765 )(0.00) 1.05995
Cd = = = ₹ 1.0340
1.025 1.025
0.6235 5.675 + (0.3765 )(1.0340 ) 3.538 + 3895
C0 = = = ₹ 3.83
1.025 1.025
5 −0
h = = 0.8333
33 − 27
DELTA HEDGING BINOMIAL MODEL
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.
Calculate the following:
(i) If the investor wants a perfect hedge, what combination of the share and
option should he select?
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?
(iv) What is the expected return on the option?
(Exam Nov - 2019)
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 :
Sale proceeds of investments (0.50 ×₹ 650) ₹ 325
Loss on account of short position (₹ 650 - ₹ 550) ₹ 100
₹ 225
(b) If price of share comes down to ₹ 450 then value of purchased share
will be :
Sale proceeds of investment (0.50 ×₹ 450) ₹ 225
(iii) The value of option, say, P at the beginning of the period shall be computed
as follows:
(₹ 250 − P) 1.05 = ₹ 225
₹ 262.50 – 1.05P = ₹ 225
₹ 37.5 = 1.05
P = ₹ 35.71
DERIVATIVES
(iv) Expected Return on the Option
Expected Option Value = (₹ 650 −₹ 550) × 0.70 +₹ 0 × 0.30 = ₹ 70
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.)?
(iii) What is the expected rate of return on the option?
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.
(ii) Value of Option today
If price of share comes out to be ₹780 then value of purchased share will be:
Sale Proceeds of Investment (0.50 ×₹ 780) ₹390
Loss on account of Short Position (₹ 780 – ₹ 630) ₹150
₹240
If price of share comes out to be ₹480 then value of purchased share will be:
Sale Proceeds of Investment (0.50 ×₹ 480) ₹240
DERIVATIVES
Accordingly, Premium say P shall be computed as follows:
(₹ 300 – P) 1.025 = ₹240
P = ₹ 65.85
(iii) Expected Return on the Option
Expected Option Value = (₹ 780 – ₹ 630) × 0.60 +₹ 0 × 0.40 = ₹ 90
90−65.85
Expected Rate of Return = × 100 = 36.67%
65.85
PUT CALL PARITY
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 :
Strike price ₹ 300
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:-
(i) According to Put-Call Parity
P = C+ X e-rt– S
S + p = C + X e-rt
Here,
P = Put option price
DERIVATIVES
C = Call option price
S = Spot price
X = Ex. Price
Left Hand Side (LHS) = ₹ 310 +₹ 20 = ₹ 330
Right Hand Side (LHS) = ₹ 30 +₹ 300/[(0.10 × 3/12)] = ₹ 322.60
Since LHS is not equal to RHS and the difference is ₹ 330 - ₹ 322.68
= ₹ 7.40
There is an arbitrage opportunity and the investor is devising a strategy of

buying a call and selling the share and a put option.
From the put-call parity equation we can see that it is equivalent to;
C–S–P = X e-rt Or, (C – S − P) + X e-rt = 0
Arbitrage Profits per Share

Position Immediate Cash Flow Payable in 3 months
St≤ 300 St> 300
Sell Stock 310 −St −St
Deposit PV −292.60 300 300
(300)
Buy Call −30 0 St – 300
Sell Put +20 −(300 − St) 0
Total ₹ 7.40 0 0
St = Stock price at expiration
This strategy would be adopted, since the initial payoff is positive.
(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) :
Arbitrage Profits per Share

Position Immediate Cash Flow Payable in 3 months
St≤ 300 St> 300
Buy Stock −310 −St −St
Borrow PV (300) +292.60 −300 −300
DERIVATIVES
Sell Call +30 0 −(St – 300)

Buy Put −20 (300 − St) 0
Total − ₹ 7.40 0 0
This strategy would not adopted, since the initial payoff is negative.
BLACK SCHOLES MODEL
QUESTION – 17
From the following data for certain stock, find the value of a call option:
Price of stock now = ₹ 80
Exercise price = ₹ 75
Standard deviation of continuously compounded

annual return = 0.40
Maturity period = 6 months
Annual interest rate = 12%
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:-
Applying the Black Scholes Formula,
Value of the Call option now.
DERIVATIVES
The formula C = SN(d1) – Ke(-rt) N(d2)
S
In +(r+σ2 /2)t
K
d1 =
σ t
d2 = d1−σ t
Where,
C = Theoretical call premium
S = Current stock price
t = time until option expiration
K = option striking price
r = risk-free interest rate
N = Cumulative standard normal distribution
e = exponential term
σ = Standard deviation of continuously compounded annual return.
In = natural logarithm
In 1.0667 + 12%+0.08 0.5

d1 =
0.40 0.5
0.0646 + 0.2 0.5 0.1646

= = = 0.5820
0.40×0.7071 0.2828
d2 = 0.5820 – 0.2828 = 0.2992
N(d1) = N (0.5820)
N(d2) = N (0.2992)
Price = SN(d1) − Ke(-rt) N(d2)
= 80 × N(d1) – (75/1.062) × N(d2)
Value of option
75
= 80 N(d1) −
1.062 × N(d2)
DERIVATIVES
N(d1) = N(0.5820) = 0.7197
N(d2) = N(0.2992) = 0.6176
75
Price = 80 × 0.7197 - × 0.6176
1.062
= 57.57 – 70.62 × 0.6176
= 57.57 – 43.61 = ₹ 13.96
Teaching Notes:
Students may please note following important point:
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) Cumulative Area

0.25 0.5987
0.30 0.6179
0.55 0.7088
0.60 0.7257
Tow Tail 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
Following information is available for X Company‟s shares and Call option:
Current share price ₹ 185
DERIVATIVES
Option exercise price ₹ 170
Risk free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
Calculate the value of option using Black-Scholes formula.
(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
= 1.1006 – 0.031177 = 0.7888
N(d1) = 0.8644 (from table)
N(d2) = 0.7848
E
Value of option = Vs N(d1) − rt N(d2)
e
170
= 185 (0.8644) − 0.21 (0.7848)
e
DERIVATIVES
170
= 159.914 −
1.2336 × 0.7848
= 159.91 – 108.15 = ₹ 51.76
QUESTION – 19
On April 11th 2004, Ferguson system was trading at ₹ 13.62.
(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:
(i) The annualize standard deviation in Ferguson, system stock

price over the previous year was 81%.
(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
(b) Comment on the trading value as on July 23 rd 2004.
SOLUTION:-
1 Calculation of value of call option

E
Co = So × n(d1) - × n (d2)
erd
15
= 13.62 × 05085 − 0.0463 ×0.2822 × 0.3412
e
15
= 6.926 – 0.01306 × 0.3412
e
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.
DERIVATIVES
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.
The following are the other parameter of the option:
(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.
(ii) What would be the value of put?
(iii) If this call option is priced at ₹ 15 what investment strategy would you
adopt?
(iv) If this put option is available in the market at ₹ 14 what investment strategy
would you adopt?
Note: Extracted from the tables:
(a) Natural Logarithm:
(b) Ln(0.9701) = -0.0303
(c) Ln (1.0308) = 0.0303
(d) Value of e : e-0.02 = 0.9802, e-0.016 = 0.9841
(e) For N(X): where X > 0: N(0.3177) = 0.6246
(f) N(0.0177) =0.5071
Where X<0: N(−0.3177) = 0.3754
N(−0.0177) = 0.4929
SOLUTION:-
(i) Valuation of call option : (Using Black & Scholes Model)
DERIVATIVES
Vco = Vs N(d1) – E e-rt N (d2)
Where Vs = Current price of stock = ₹ 134
E = Exercise price = ₹ 130
r = Risk-free rate = 0.08
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
d2 = d1−σ t = 0.3177 – 0.30 = 0.0177
N (d1) = N (0.3177) = 0.6246
N (d2) = N (0.0177) = 0.5071
Thus,
Value of call option (Vco) : Vs N (d1) – E e-rt N (d2)
Where,
e-rt =e−0.08 ×9.25 = >e−0.02 = 0.9802
∴ (134 × 0.6246) – (130 × 0.98020 × 0.5071) = 83.70 – 64.62
= ₹ 19.08
(ii) Value of put (Vpo) = C + PV of E − So
= ₹ [19.08 + (130 × 0.9802) − 134]
= 19.08 + 127.43 – 134 = > 12.51 = ₹ 12.51
DERIVATIVES
Strategy : (iii) & (iv)
Option Actual option Fair option Valuation Decision

price (₹) price (₹)
(iii) Call 15 19.08 Under Buy call option
(iv) PDT 14 12.51 Over Sell put option
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?
(ii) Calculate value of aforesaid call option based on Block Scholes

valuation model if the current price is considered as ₹ 380.
(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:-
(i) Given : TIC ltd. Current Price ₹ 415
Exercise rate = 400

Risk free interest rate is = 5% p.a.
SD (Volatility) = 22% p.a.
Based on the above bit is calculated value of an option based on block
scholes model:
415 1
In + .05 + (.22)2 .25 .03681 +.01855
400 2
d1 = = = .5032727
.22 .25 .11
DERIVATIVES
415 1
In + .05+ (.22)2 .25 .03681 +.00645
400 2
d2 = = = .3932727
.22 .25 .11
N(d1) = N (.50327) = 1−.3072 =.6928
N(d2) = N (.39327) = 1−.3471 =.6529
400
Value of Option = 415 (.6928) − .05 .25 (.6529)
e
400
= 287.512 − (.6529)
1.012578
= 287.512 – 257.916 = ₹ 29.60

NB : N(0.39327) can also be find as under :
Step 1 : From table of area under normal curve find the area of variable
0.39 i.e. 0.6517.
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)
= 0.6517 + 0.0012 = 06529
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 :
DERIVATIVES
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
N(d2) = N (−0.407666) = .3418
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
Current market Value = ₹ 415
400
Present Value of Exercise Price = = 395.06
1.0125
Vp = − VS + VS + PV (E)
Vp = − 380 + 7.10 + 395.06 = 22.16 = ₹ 22.16
(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:
Present Value of Dividend (using continuous discounting)
= Dividend × e-rt
DERIVATIVES
= ₹ 10 × e−.05 × .1666
= ₹ 10 × e−.008333
= ₹ 9.917 (Please refer Exponential Table)
Adjust price of share is ₹ 408 – 9.917 = ₹ 398.083
This can be used in Block Scholes Model
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
N(d2) = N(0.125) = 0.5060
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:
Current share price = ₹415
Option exercise price = ₹400
DERIVATIVES
Risk free interest rate = 5%
Time of the expiry of option = three months
Standard deviation = 22%
Is the option worth buying for ₹25 using Black-Scholes formula?
SOLUTION:-
(i) Given : TIC ltd. Current Price ₹ 415
Exercise rate = 400

Risk free interest rate is = 5% p.a.
SD (Volatility) = 22% p.a.
Based on the above bit is calculated value of an option based on block
scholes model:
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
N(d1) = N (.50327) = 1−.3072 =.6928
N(d2) = N (.39327) = 1−.3471 =.6529
400
Value of Option = 415 (.6928) − .05 .25 (.6529)
e
400
= 287.512 − (.6529)
1.012578
= 287.512 – 257.916 = ₹ 29.60

NB : N(0.39327) can also be find as under :
0.39 i.e. 0.6517.
DERIVATIVES
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)
= 0.6517 + 0.0012 = 06529
Since market price of ₹25 is less than ₹27.60 (Block Scholes Valuation
Modal indicate that option is underpriced, hence worth buying.
(IV) OPTION STRATEGIES
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.
Coastal Corporation‟s stock is currently selling at ₹ 100. Determine profit or loss, if

the price of Coastal Corporation‟s stock:
(i) Remains at ₹ 100 after 3 months.
(ii) Falls at ₹ 70 after 3 months.
(iii) Rises to ₹ 138 after 3 months. Assume the size of option is 1,000 shares of
Coastal Corporation.
(RTP May - 2022)
DERIVATIVES
SOLUTION:-
(i) Total premium paid on purchasing a call and put option
= (₹ 6.50 per share × 1000) + (₹ 10 per share × 1000).
= ₹ 6,500 +₹ 10,000 = ₹ 16,500
In this case, Mr. P exercises neither the call option nor the put option as
both will result in a loss for him.
Ending value = −₹ 16,500 + zero gain = −₹ 16,500
i.e. Net loss = ₹ 16,500
(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.
Total premium paid = ₹ 16,500
Ending value = – ₹ 16,500 +₹ [(90 – 70) × 1000]
= – ₹ 16,500 +₹ 20,000 = ₹ 3,500
 Net gain = ₹ 3,500
(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.
Total premium paid = ₹ 16,500
Ending value = – ₹ 16,500 +₹ [(138 – 110) × 1000]
 Net Gain = – ₹ 16,500 +₹ 28,000 = ₹ 11,500
QUESTION – 24
Mr. X established the following strategy on the Delta Corporation‟s stock :
(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.
Delta Corporation‟s stock is currently selling at ₹ 500.
DERIVATIVES
CALCULATE profit or loss, if the price of Delta Corporation‟s stock:
(i) remains at ₹ 500 after 3 months.
(ii) falls at ₹ 350 after 3 months.
(iii) rises to ₹ 600.
Assume the option size is 100 shares of Delta Corporation.
(MTP April – 2022, SM & PM)
SOLUTION:-
= (₹30 per share × 100) + (₹5 per share × 100).

= 3,000 + 500 = ₹3,500
In this case, X exercises neither the call option nor the put option as both
will result in a loss for him.
Ending value = - ₹3,500 + zero gain = - ₹3,500
i.e Net loss = ₹3,500
Total premium paid = ₹3,500

Ending value = – ₹3,500 +₹ [(450 – 350) × 100]
= – ₹3,500 +₹ 10,000 = ₹6,500
∴ Net gain = ₹6,500
Total premium paid = ₹3,500

Ending value = -3,500 + [(600 – 550) × 100]
Net Gain = -3,500 + 5,000 = ₹1,500
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.
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. –
(i) Remains at ₹1000 after 3 months.
(ii) Falls to ₹700 after 3 months.
(iii)Raises to ₹1200 after 3 months.
Assume the size of option is 200 shares of TTK Ltd.
(Exam May - 2019)
SOLUTION:-
= (₹ 15 per share × 200) + (₹ 90 per share × 200).
= ₹ 3,000 +₹ 18,000 = ₹ 21000
In this case, Mr. John exercises neither the call option nor the put option as
both will result in a loss for him.
Ending value = – ₹ 21000 + zero gain = - ₹ 21000 i.e.
Net loss = ₹ 21000
Net Gain = (Exercise Price – Current Price) × No of Shares – Premium Paid
Total premium paid = ₹ 21000
Ending value = – ₹ 21000 +₹ [(900 – 700) × 200] = ₹ 19,000
 Net gain = ₹ 19,000
Total premium paid = ₹ 21000
DERIVATIVES
Ending value = – ₹ 21000 +₹ [(1200 – 1100) × 200] = −₹ 1000
Net Loss = ₹ 1,000
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.
(Exam May - 2018)
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:-
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:-
Cost of Call and Put Options
= (₹ 2 per share) × (100 share call) + (₹ 1 per share) × (100 share put)
= ₹ 2 × 100 + 1 × 100 = ₹ 300
(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
= (−₹ 300 cost of 2 option) + (₹ 4 per share gain on call) × 100
DERIVATIVES
= −₹ 300 + 100 Net Loss = −₹ 200
(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 cost of 2 options) + (₹ 4 per stock gain on put) × 100
= −₹ 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:
Market price of Stock or stock index ₹ 55
Market price of call ₹9
Market price of put ₹1
Calculate the expiration date cash flow, investment value, and net profit from:
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put
for expiration date stock prices of ₹ 50, ₹ 55, ₹ 60, ₹ 65, ₹ 70.
(Practice Manual)
SOLUTION:-
Expiration date cash flows
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
DERIVATIVES
Expiration date investment value
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
Expiration date net profits
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.
Assuming a lot size of 50 shares, determine the followings:
(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:-
Cost of Call and Put Options
DERIVATIVES
= (₹ 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 cost of 2 option) + (₹ 1 per share gain on call) × 50
= −₹ 150 + 50
Net Loss = −₹ 100
(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
= (-₹150 cost of 2 options) + (₹4 per stock gain on put) × 50 =

−₹150 + 200
Gain = ₹50
QUESTION – 31
Ram holding shares of Reliance Industries Ltd. which is currently selling at ₹

1,000. He is expecting that this price will further fall due to lower than expected
level of profits to be announced after one month. As on following option contract
are available in Reliance Shares.
Strike Price (₹) Option Premium (₹)

1030 Call 40
1010 Call 35
1000 Call 30
990 Put 35
970 Put 20
950 Put 8
930 Put 5
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:
Spot Price Stock Put Initial Total

after 1 month Value Payoff Cash Flow
S < 950 S 950 –S -8 942 – S
S > 950 S - -8 S-8
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.
However, this strategy will involve a cost of ₹ 8.
DERIVATIVES
FUTURE
(V) MARGIN A/C
QUESTION – 32
On 31/08/2021 Mr. R has taken a Long position of Two lots of Nifty Futures at
17300.
One lot of Nifty future is 50 units.
Initial Margin required is 10% of Contract Value.
Maintenance Margin required is 80% of Initial Margin.
The closing price of 5 days are given below –
Date Closing Price of Nifty

Future
01/09/2021 17340
02/09/2021 17180
03/09/2021 16990
06/09/2021 16900
07/09/2021 17120
You are required to-
(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?
(Exam December - 2021)
SOLUTION:-
(i) Contract Size (₹ 17,300 × 50 × 2) = ₹ 17,30,000
Initial Margin (10% of 17,30,000) = ₹ 1,73,000
Maintenance Margin (80% of 1,73,000) = ₹ 1,38,400
DERIVATIVES
Statement showing the daily balances in Margin A/c and margin call if any,
Day Change in Future Value Margin Call

(₹) A/c (₹) Money
(₹)
31/08/21 ----- 1,73,000 -----
01/09/21 (₹ 17,340 −₹ 17,300) × 50 × 2 = 4,000 1,77,000 -----
02/09/21 (₹ 17,180 −₹ 17,340) × 50 × 2 = −16,000 1,61,000 -----
03/09/21 (₹ 16,990 −₹ 17,180) × 50 × 2 = − 19,000 1,42,000 -----
06/09/21 (₹ 16,900 −₹ 16,990) × 50 × 2 = − 9,000 1,73,000 40,000
07/09/21 (₹ 17,120 −₹ 16,900) × 50 × 2 = 22,000 1,95,000 -----
(ii) Gain or Loss of Mr. R squared off position on 07/09/21
(₹)
Ending margin 1,95,000
Less: Initial margin 1,73,000
Profit 22,000
Less: Margin call 40,000
Net Loss (18,000)
(iii) Gain/Loss if MR. R has taken short position.
Day Change in Future Value Margin Call

(₹) A/c (₹) Money
(₹)
31/08/21 ----- 1,73,000 -----
01/09/21 (₹ 17,300 −₹ 17,340) × 50 × 2 = − 4,000 1,69,000 -----
02/09/21 (₹ 17,340 −₹ 17,180) × 50 × 2 = 16,000 1,85,000 -----
03/09/21 (₹ 17,180 −₹ 16,990) × 50 × 2 = 19,000 2,04,000 -----
06/09/21 (₹ 16,990 −₹ 16,900) × 50 × 2 = 9,000 2,13,000 -----
07/09/21 (₹ 16,900 −₹ 17,120) × 50 × 2 = − 22,000 1,91,000 -----
Profit or Loss on short position
(₹)
Ending margin 1,91,000
Less: Initial margin 1,73,000
Profit 18,000
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
Settlement Price (₹) 9380 9520 9100 8960 9140
You are required to calculate:
(i) Mark to market cash flows and daily closing balances on account of
(a) An investor who has taken a long position at 9170
(b) An investor who has taken a short position at 9170
(ii) Net Profit/Loss on each of the contract.
SOLUTION:-
(i) Contract Size (₹ 9,170 × 50) = ₹ 4,58,500

Initial Margin (8% of 4,58,500) = ₹ 36,680
Maintenance Margin (6% of 4,58,500) = ₹ 27,510
(a) For investor taken Long position:

Margin Call
Day Change in Future value (₹)
A/c (₹) Money (₹)
0 ----- 36,680
1 (₹ 9,380 - ₹ 9,170) ×50 = 10,500 47,180
2 (₹ 9,520 - ₹ 9,380) ×50 = 7,000 54,180
3 (₹ 9,100 - ₹ 9,520) × 50 = - 21,000 33,180
4 (₹ 8,960 - ₹ 9,100) × 50 = - 7,000 36,680 10,500
5 (₹ 9,140 - ₹ 8,960) × 50 = 9,000 45,680
(b) For investor taken Short position:

Margin Call
Day Change in Future value (₹)
0 ----- 36,680
1 (₹ 9,170 −₹ 9,380) × 50 = -10,500 36,680 10,500
DERIVATIVES
2 (₹ 9,380 −₹ 9,520) × 50 = -7,000 29,680

3 (₹ 9,520 −₹ 9,100) × 50 = 21,000 50,680
4 (₹ 9,100 −₹ 8,960) × 50 = 7,000 57,680
5 (₹ 8,960 −₹ 9,140) × 50 = -9,000 48,680
(ii) Calculation of Net Profit/Loss

(a) Long Position
(₹)
Ending margin 45,680
Less: Initial
Margin 36,680
Profit 9,000
Less: Margin Call 10,500
Net Loss 1,500
OR, Loss = (9,140 – 9,170) × 50 = (₹ 1,500)
(b) Short Position

(₹)
Ending margin 48,680
Less: Initial
Margin 36,680
Profit 12,000
Less: Margin Call 10,500
Net Profit 1,500
OR, Profit = (9,170 – 7,040) × 50 = ₹ 1,500
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:
Day High Low Closing
4-2-09 3306.40 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
DERIVATIVES
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abhishek bought one sensex futures contract on February, 04. The average daily
absolute change in the value of contract is ₹ 10,000 and standard deviation of
these changes is ₹ 2,000. The maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and
payment on margin calls, if any.
SOLUTION:-
Initial Margin = µ + 3σ
Where µ = Daily Absolute Change
σ = Standard Deviation
Accordingly
Initial Margin= ₹10,000 +₹6,000 = ₹16,000
Maintenance margin = ₹16,000 × 0.75 = ₹12,000
Day Changes in Future Values (₹) Margin Call

04/02/09 - 16000 -
05/02/09 50 × (3294.40 - 3296.50) = -105 15895 -
06/02/09 50 × (3230.40 - 3294.40)= -3200 12695 -
07/02/09 50 × (3212.30 - 3230.40)= -905 16000 4210
10/02/09 50 × (3267.50 - 3212.30)= 2760 18760 -
11/02/09 50 × (3263.80 - 3267.50)= -185 18575 -
12/02/09 50 × (3292 - 3263.80) =1410 19985 -
14/02/09 50 × (3309.30 - 3292)=865 20850 -
DERIVATIVES
17/02/09 50 × (3257.80 - 3309.30)=-2575 18275 -

18/02/09 50 × (3102.60 - 3257.80)=-7760 16000 5485
(VI) VALUATION OF FUTURE
QUESTION – 35
The following data relate to Anand Ltd.'s share price:
Current price per share ₹ 1,800
6 months future's price/share ₹ 1,950
Assuming it is possible to borrow money in the market for transactions in

securities at 12% per annum, you are required:
(i) to calculate the theoretical minimum price of a 6-months forward purchase;

and
(ii) to explain arbitrate opportunity.
SOLUTION:-
Anand Ltd
(i) Calculation of theoretical minimum price of a 6 months forward contract-

Theoretical minimum price = ₹ 1,800 + (₹ 1,800 × 12/100 × 6/12)
= ₹ 1,908
(ii) Arbitrage Opportunity-
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
The following data relate to R Ltd.'s share price:
Current price per share ₹ 1,900
DERIVATIVES
6 months future's price/share ₹ 2050
Assuming it is possible to borrow money in the market for transactions in

securities at 10% per annum,
(i) advise the justified theoretical price of a 6-months forward purchase; and
(ii) evaluate any arbitrage opportunity, if available.
(RTP May - 2021)
SOLUTION:-
(i) The justified theoretical price of a 6 months forward contract as per cost to
carry model is as follows:
Theoretical minimum price = ₹ 1,900 + (₹ 1,900 × 10/100 × 6/12)
= ₹ 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:-
Future‟s Price = Spot + cost of carry – Dividend
F = 220 + 220 × 0.15 × 0.25 – 0.25** × 10 = 225.75
** Entire 25% dividend is payable before expiry, which is ₹2.50.
Thus, we see that futures price by calculation is ₹ 225.75 which is quoted at ₹ 230
in the exchange.
DERIVATIVES
(i) Analysis:
Fair value of Futures less than Actual futures Price:
Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock

in the cash market.
Step I
He will buy PQR Stock at ₹ 220 by borrowing at 15% for 3 months. Therefore, his
outflows are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years
(220 × 0.15 × 0.25) 8.25
Total Outflows (A) 228.25
Step II
He will sell March 2000 futures at ₹ 230. Meanwhile he would receive dividend for
his stock.
Hence his inflows are 230.00
Sale proceeds of March 2000 futures 2.50
Total inflows (B) 232.50
Inflow – Outflow = Profit earned by Arbitrageur
= 232.50 – 228.25 = 4.25
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.
(SM New Syllabus)
SOLUTION:-
The appropriate value of the 3 months futures contract is –
DERIVATIVES
Fo = ₹ 300(1.008)3 = ₹ 307.26
Since the futures price exceeds its appropriate value it pays to do the following:-
Action Initial Cash flow at time T

Cash Flow (3 months)
Borrow ₹ 300 now and repay with +₹300 −₹300(1.008)3

interest after 3 months = −₹307.26
Buy a share −₹300 ST
Sell a futures contract (Fo = 312/-) 0 ₹312 – ST
Total ₹0 ₹4.74
Such an action would produce a risk less profit of ₹ 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:-
Calculation of spot price
The formula for calculating forward price is:

r
A = P (1+ )nt
n
Where
A = Forward price
P = Spot Price
r = rate of interest
n = no. of compounding
t = time
Using the above formula,
DERIVATIVES
208.18 = P (1 + 0.08/12)6
Or 208.18 = P × 1.0409
P = 208.18/1.0409 = 200
Hence, the spot price should be ₹ 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:
Month Dividend Paid p.a.

January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is continuously compounded daily, 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
Where S = Spot Price
DERIVATIVES
rf = Risk Free interest
D = Dividend Yield
t = Time Period
Accordingly, future price will be
= ₹ 2,200 e(0.08−0.0325)×4/12 = ₹2,200 e0.01583
= ₹ 2,200 × 1.01593 = ₹ 2235.05
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?
(ii) What arbitrage transaction is possible to gain out this mispricing?
(iii) Calculate the gains and losses if the index on 15thDecember closes at (a)
1260 (b) 1175.
Assume 365 days in a year for your calculations
(Exam November - 2019)
SOLUTION:-
91
(i) Current price of December future = ₹ 100[1195 + 1195(0.095 – 0.03) ]
365
= ₹ 100[1195 + 19.37]
= ₹ 1,21,437
Since the current market price of December-15 is ₹ 1,22,500 (₹ 100 × 1225)

it is overpriced.
(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
DERIVATIVES
Transaction Cash Flow

Buy(1195 × ₹ 100) = ₹ 1,19,500 worth of stocks − ₹ 1,19,500.00
Borrow ₹ 1,19,500 @ 9.50% for 91 days + ₹ 1,19,500.00
Sell a future contract @ 1225 0
Total 0
(a) If on December-15, the Index close at 1260

(₹)
Repay ₹ 1,19,500 @ 9.50% for 91 days − 1,22,330.35
Cancellation of future contract (1,22,500 – 1,26,500) − 3,500.00
Sell 1,19,500 worth of Stocks @ 1,260 +1,26,000.00
1260
× 1,19,500
1195
Dividend Earned @ 3% + 893.79

91
× 1,19,500 × 3%
365
Gain due to arbitrage + 1,063.44
(b) If on December-15, the index closes at 1175

(₹)
Repay ₹ 1,19,500 @ 9.50% for 91 days − 1,22,330.35
Cancellation of future contract (1,22,500 – 1,17,500) + 5,000.00
Sell 1,19,500 worth of Stocks @ 1,175 + 1,17,500.00
1,175
× 1,19,500
1,195
Dividend Earned @ 3% + 893.79

91
× 1,19,500 × 3%
365
Gain due to arbitrage + 1,063.44
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)]
= 13,800 + [828 – 331.20] = ₹ 14,296.80
Since presently index is trading at ₹ 14,340, hence it is overpriced.
To earn an abnormal rate of return, Mr. X shall take following steps:
1. Mr. X shall buy a portfolio which comprising of shares as index consisted of.
2. Mr. X shall go for short position on index future contract.
Now we shall calculate return to Mr. X under two given situations:
(i) Return of Mr. X, if index closes at ₹ 10,200
₹
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
(ii) Return of Mr. X if index closes at ₹ 15,600
₹
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
DERIVATIVES
871.20
6 months return = × 100 = 6.31%
13,800
Annualized return = 6.31 × 2 = 12.63%
QUESTION – 43
A future contract is available on R Ltd. that pays an annual dividend of ₹4 and

whose stock is currently priced at ₹125. Each future contract calls for delivery of
1,000 shares to stock in one year, daily marking to market. The corporate treasury
bill rate is 8%.
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?
(Ignore margin and taxation, if any)
(Exam Nov - 2019)
SOLUTION:-
(i) Future price = Spot + Cost of Carry – Dividend
= ₹ 125 + (₹ 125 × 0.08) – 4 = ₹ 131
Price of one future contract = 1,000 share ×₹ 131 = ₹ 1,31,000
(ii) Price decrease by 6%
Market Price = 125 × 94% = ₹ 117.50
Then, price of one future contract
= ₹ 117.50 + (₹ 117.50 × 0.08 ) – 4 = ₹ 122.90
= ₹ 122.90 × 1,000 = ₹ 1,22,900
(iii) If the investor has taken a long position, decrease in price will result in loss
for the investor.
DERIVATIVES
Amount of loss will be:
₹ 1,31,000 −₹ 1,22,900 = ₹ 8,100
(VII) BETA MANAGEMENT
QUESTION – 44
On April 1, 2015, an investor has a portfolio consisting of eight securities as

shown below:
Beta
Security Market Price No. of Shares Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The
investor fears a fall in the prices of the shares in the near future. Accordingly, he
approaches you for the advice to protect the interest of his portfolio.
You can make use of the following information:
(1) The current NIFTY value is 8500.
(2) NIFTY futures can be traded in units of 25 only.
(3) Futures for May are currently quoted at 8700 and Futures for June are
being quoted at 8850.
(i) The beta of his portfolio.
(ii) The theoretical value of the futures contract for contracts expiring in May
and June. Given (e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
(iii) The number of NIFTY contracts that he would have to sell if he desires to
hedge until June in each of the following cases:
(A) His total portfolio
DERIVATIVES
(B) 50% of his portfolio
(C) 120% of his portfolio
(SM New Syllabus&PM)
SOLUTION:-
(i) Beta of the Portfolio
Security Market No. of Value β Value × β

Price Shares
A 29.40 400 11760 0.59 6938.40
B 318.70 800 254960 1.32 336547.20
C 660.20 150 99030 0.87 86156.10
D 5.20 300 1560 0.35 546.00
E 281.90 400 112760 1.16 130801.60
F 275.40 750 206550 1.24 256122.00
G 514.60 300 154380 1.05 162099.00
H 170.50 900 153450 0.76 116622.00
994450 1095832.30
10,95,832.30
Portfolio Beta = = 1.102
9,94,450
(ii) Theoretical Value of Future Contract Expiring in May and June
F = Sert
2
FMay = 8,500× e0.20×(12) = 8500 × e0.0333
e0.0333shall be computed using Interpolation Formula as follows:
e0.03 = 1.03045
e0.04 = 1.04081
e0.01 = 0.01036
e0.0033 = 0.00342
e0.0067 = 0.00694
e0.0333 = 1.03045 + 0.00342 = 1.03387 or 1.04081 – 0.00694 = 1.03387
According the price of the May Contract
8500 × 1.03387 = ₹ 8788
Price of the June Contract
DERIVATIVES
3
FMay = 8,500 × e0.20×(12)
= 8,500 × e0.05
= 8500 ×1.05127 = 8935.80
(iii) No. of NIFTY Contracts required to sell to hedge until June
Value of position to be hedged

= ×β
Value of future contract
(A) Total portfolio
9,94,450
× 1.102 = 4.953 say 5 contracts
8,850×25
(B) 50% of Portfolio
9,94,450 × 0.50
× 1.102 = 2.47 say 3 contracts
8,850×25
(C) 120% of Portfolio
9,94,450 × 1.20
× 1.102 = 5.94 say 6 contracts
8,850×25
QUESTION – 45
Details about portfolio of shares of an investor is as below:
Shares No. of shares (Iakh) Price per share Beta
A Ltd. 3.00 ₹ 500 1.40
B Ltd. 4.00 ₹ 750 1.20
C Ltd. 2.00 ₹ 250 1.60
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
DERIVATIVES
(ii) Take appropriate position on Nifty Futures which are currently traded at
8125 and each Nifty points is worth ₹ 200.
You are required to determine:
(1) Portfolio beta,
(2) The value of risk free securities to be acquired,
(3) The number of shares of each company to be disposed off,
(4) The number of Nifty contracts to be bought/sold; and
(5) The value of portfolio beta for 2% rise in Nifty.
(SM New Syllabus&PM)
SOLUTION:-
Shares No. of shares Market price of × (2) % to 𝛃 (x) wx

(lakhs) (1) per share (2) (₹ lakhs) total (w)
A Ltd. 3.00 500.00 1500.00 0.30 1.40 0.42
B Ltd. 4.00 750.00 3000.00 0.60 1.20 0.72
C Ltd. 2.00 250.00 500.00 0.10 1.60 0.16
5000.00 1.00 1.30
(1) Portfolio Beta 1.30
(2) Required Beta 0.91
Let the proportion of risk free securities for target beta 0.91 = p
0.91 = 0 × p + 1.30 (1 – p)
p = 0.30 i.e. 30%
Shares to be disposed off to reduce beta (5000 × 30%) ₹ 1,500 lakh and Risk
Free securities to be acquired.
(3) Number of shares of each company to be disposed off
Share % to Proportionate Market price No. of shares

total (w) Amount (₹ lakhs) per share (lakhs)
A Ltd. 0.30 450.00 500.00 0.90
B Ltd. 0.60 900.00 750.00 1.20
C Ltd. 0.10 150.00 250.00 0.60
DERIVATIVES
(4) Number of Nifty Contract to be sold
1.30−0.91 ×500 lakh

= 120 Contracts
8,125×200
(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 following data relate to A Ltd.‟s Portfolio:
Shares X Ltd. Y Ltd. Z Ltd.
No. of shares (lakh) 6 8 4

Price per shares (₹) 1,000 1,500 500
Beta 1.50 1.30 1.70
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.
You are required to:
(a) Interpret the opinion of CEO, whether it is correct or not.
(b) Calculate the existing systematic risk of the portfolio,
(c) Advise the value of risk-free securities to be acquired,
DERIVATIVES
(d) Advise the number of shares of each company to be disposed off,
(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.
Note: Make calculations in ₹ lakh and upto 2 decimal points.
(RTP May - 2021)
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:
Shares No. of Market (1)×(2) % to 𝛃 (x) Wx

shares price of per (₹ lakhs) total (w)
(lakhs) (1) share (2) (₹)
X Ltd. 6.00 1,000.00 6,000.00 0.30 1.50 0.45
Y Ltd. 8.00 1,500.00 12,000.00 0.60 1.30 0.78
Z Ltd. 4.00 500.00 2,000.00 0.10 1.70 0.17
20,000.00 1.00 1.40
(b) Since the Beta of existing portfolio is 1.40, the systematic risk of the current
portfolio is 1.40.
(c) Required Beta 0.95
Let the proportion of risk-free securities for target beta 0.95 = p
0.95 = 0 × p + 1.40 (1 – p)
p = 0.32 i.e. 32%
Shares to be disposed off to reduce beta (20000 × 32%) ₹ 6,400 lakh and
Risk Free securities to be acquired for the same amount.
(d) Number of share of each company to be dispose off
Shares % to Proportionate Market Price No. of Shares

total (w) Amount (₹ lakhs) Per Share (₹) (Lakh)
X Ltd. 0.30 1920.00 1,000.00 1.92
DERIVATIVES
Y Ltd. 0.60 3840.00 1,500.00 2.56

Z Ltd. 0.10 640.00 500.00 1.28
(e) Since, the company is in long position in cash market it shall take short
position in Future Market.
Number of Nifty Contract to be sold
1.40−0.95 ×20,000 lakh

= 519 contracts
8,250×210
(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
On January 1, 2013 an investor has a portfolio of 5 shares as given below:
Security Price No. of Shares Beta

A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
D 734.70 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum.
(i) The beta of his portfolio.
(ii) The theoretical value of the NIFTY futures for February 2013.
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.
No. of days in a year be treated as 365.
Given: In (1.105) = 0.0998 and e(0.015858) = 1.01598
SOLUTION:-
(i) Calculation of Portfolio Beta
Security Price No. of Value Weightage Beta Weighted

of the wi Bi Beta
Stock Shares
A 349.30 5,000 17,46,500 0.093 1.15 0.107
B 480.50 7,000 33,63,500 0.178 0.40 0.071
C 593.52 8,000 47,48,160 0.252 0.90 0.227
D 734.70 10,000 73,47,000 0.390 0.95 0.370
E 824.85 2,000 16,49,700 0.087 0.85 0.074
1,88,54,860 0.849
Portfolio Beta = 0.849
(ii) Calculation of Theoretical Value of Future Contract
Cost of Capital = 10.5% p.a. Accordingly, the Continuously Compounded

Rate of Interest ln (1.105) = 0.0998
For February 2013 contract, t = 58/365 = 0.1589
Further F = Sert
F = ₹ 5,900 e(0.0998)(0.1589)
F = ₹ 5,900 e0.015858
F = ₹ 5,900 × 1.01598 = ₹ 5,994.28
Alternatively, it can also be taken as follows:
= ₹ 5900 e0.105 × 58/365
DERIVATIVES
= ₹ 5900 e0.01668
= ₹ 5900 × 1.01682 = ₹ 5,999.24
(iii) When total portfolio is to be hedged.
Value of spot position requiring hedging

= × Portfolio Beta
Value of future contract
1,88,54,860
= × 0.849 = 13.35 contracts say 13 or 14 contracts
5994.28×200
(iv) When total portfolio beta is to be reduced to 0.6:
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
Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company. He

expects to purchase a portfolio of shares in 90 days. However he is worried about
the expected price increase in shares in coming day and to hedge against this
potential price increase he decides to take a position on a 90-day forward contract
on the Index. The index is currently trading at 2290. Assuming that the
continuously compounded dividend yield is 1.75% and risk free rate of interest is
4.16%, you are required to determine:
(i) Calculate the justified forward price on this contract.
(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:-
(i) The Forward Price shall be = S0en(r – y)
DERIVATIVES
Where
S0 = Spot price
n = period
r = risk free rate of interest
y = dividend yield
Accordingly,
Forward Price = 2290 e90/365(0.0416 – 0.0175)
= 2290 e0.005942
= 2290(1.005960)
=2303.65
(ii) Gain/loss on Long Position after 28 days
= 2450 – 2290 e28/365(0.0416 – 0.0175)
= 2450 − 2290 e0.001849
=2450 − 2290(e0.001849)
= 2450 − 2290(1.001851)
= 2450 − 2294.24
= 155.76
(iii) Gain/loss on Long Position at maturity
= Sn – S0en(r – y)
= 2470.00 – 2303.65 = 166.35
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:
Time to expiration - 3 months (0.25 year)
DERIVATIVES
Borrowing rate - 15% p.a.
Annual dividend on the stock - 25% payable before 31.03.2011
Face Value of the Stock - ₹ 10
i. Based on the above information, what should be the futures price?
ii. Show the process of arbitrage
SOLUTION:-
i. Futures price = 220 + (220 × 0.15 × 0.25) – (0.25 × 10) = 225.75
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.
The arbitrager‟s inflows/outflows are as follows:
Sale proceeds of March 2011 futures ₹ 230.00

Dividend ₹ 2.50
Total (A) ₹ 232.50
Pays back the Bank ₹ 220.00
Cost of borrowing ₹ 8.25
Total (B) ₹ 228.25
Balance (A) – (B) ₹ 4.25
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.
DERIVATIVES
On next day Mr. ZZZ closed out his position when:
 Share price of X Inc. dropped by 2%
 Share price of A plc appreciated by 3%
 Index Future dropped by 1.5%
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.
You are required to find these value.
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 sale (short) position
2,200,000x – 4,000,000 = -1,000y
Cash Outlay (Out flow)
Purchase of 1,00,000 shares of X Inc. at a price of $22

(1,00,000 × 22) 2,200,000
Sale of 50,000 shares of A plc for $40 (50,000 × 40) -20,00,000
Short Position in Index Futures (1,000 × y) -1,000y
Net 2,00,000 – 1,000y
* Negative (-) sign indicates the indicates inflow due to sale (short) position
Cash Inflow
Sale of 1,00,000 shares of X Inc. (1,00,000 × 22 × 0.98) 21,56,000

Purchase of 50,000 shares of A plc (50,000 × 40 × 1.03) -20,60,000
Long Position in Index Futures (1,000 × y × 0.985) -985y
Net 96,000 – 985y
* Negative (-) sign indicates the indicates outflow due to purchase (long) position
DERIVATIVES
Position on Close Out
(2,00,000 – 1,000y) – (96,000 – 985y) = 1,14,500
y = 700
Thus number of future contract short is 700
Beta of X Inc. can be calculated as follows:
22,00,000x – 40,00,000 = -1,000 × 700
22,00,000x = 33,00,000
x = 1.5
Thus Beta of X Inc. shall be 1.5
QUESTION – 51
Following information is available for consideration:
BSE Index 25,000
Value of portfolio ₹ 50,50,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with 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.
Based on the above information calculate:
(i) Price of future contract.
(ii) Gain on short futures position if index turns out to be 22,500 in 3 months.
Note: Daily compounding (exponential) formula is not required to be used.
(RTP May – 2022, Exam July - 2021)
SOLUTION:-
DERIVATIVES
4
(i) Current future price of the index = 25000 + 25000 (0.09 − 0.06) 12
= 25000 + 250 = 25250
 Price of the future contract = ₹ 50 × 25,250 = ₹ 12,62,500
50,50,000
(ii) Hedge Ratio = × 1.5 = 6 contracts
12,62,500
Index after three months turns out to be 22500
1
Future price will be = 22500 + 22500 (0.09 − 0.06) ×
12
= 22556.25
Therefore, Gain from the short futures position is
= 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.
Lass = (1400 − 1378) × 200 + 1000
= (₹ 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
DERIVATIVES
Profit = 1400 − 1378 × 200 − 1000 = 3400
QUESTION – 53
BSE 5000
Value of portfolio ₹ 10,10,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity is
used to hedge the value of portfolio over next three months. One future contract is
for delivery of 50 times the index.
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in three
months.
SOLUTION:-
(i) Current future price of the index

4
= 5000 + 5000 (0.09 − 0.06)12 = 5000 + 50 = 5,050
∴Price of the future contract
= ₹ 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
Therefore, Gain from the short futures position is
= 6 × (5050 – 4511.25) × 50
= ₹ 1,61,625
DERIVATIVES
Note: Alternatively we can also use daily compounding (exponential)

formula.
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.
(i) The price of one Future Contract on 1st February 2020.
(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.
(iii) The maximum Contango/Backwardation.
(iv) The pay-off of the transaction.
Note: Carry out calculation on month basis.
(RTP November - 2020)
SOLUTION:-
(i) The price of one future contract
Let X be the Price of future contract. Accordingly,
₹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
DERIVATIVES
2400
And Y = = 2376.24
1.01
Hence Nifty Index on 1st February 2020 shall be approximately 2376.
(iii) To determine whether the market is in Contango/ Backwardation first we

shall compute Basis as follows:
Basis = Spot Price – Future Price
If Basis is negative the market is said to be in Contango and when it is

positive the market is said to be Backwardation.
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
A Mutual Fund is holding the following assets in ₹ Crores :
Investments in diversified equity shares 90.00
Cash and Bank Balances 10.00
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.
Substantiate your answer assuming the Fund Manager's apprehension will

materialize.
SOLUTION:-
Number of index future to be sold by the Fund Manager is:
DERIVATIVES
1.1 × 90,00,00,000
= 4,605
4,300 × 50
Justification of the answer:
Loss in the value of the portfolio if the index falls by 10% is
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%.
What is the overall profit or loss from this set of transaction?
SOLUTION:-
Cash Outlay
= 10000 ×₹ 25 – 400 ×₹ 1,100
= ₹ 2,50,000 – ₹ 4,40,000 = −₹ 1,90,000
Cash Inflow at Close Out
= 10000 ×₹ 25 × 0.96 − 400 ×₹ 1,100 × 0.975
= ₹ 2,40,000 – ₹ 4,29,000 = −₹ 1,89,000
Gain/Loss
= ₹ 1,90,000 – ₹ 1,89,000 = ₹ 1,000 (Gain)
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:-
Long position on HPCL (1,000 × 190) = ₹ 1,90,000
Short position on Nifty (300 × 972) = ₹ 2,91,600
Calculation of overall Profit or Loss
Loss on long position of HPCL (1,90,000 × 5%) = ₹ 9,500
Profit on short position of Nifty (2,91,600 × 4%) = ₹ 11,664
Overall profit = ₹ 2,164
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.
Justify your result in the following cases:
(i) When the Index zooms by 1%
(ii) When the Index plummets by 2%.
SOLUTION:-
Value of portfolio of Miss. K (₹ 2,738.70 × 10,000) = ₹ 2,73,87,000
Number of index future to be sold by Miss. K is:
1.2 × 2738.70 × 10,000

= = 108 contract
6,086 × 50
(i) Justification of the answer if index is zoomed by 1%:
Gain in the value of the portfolio

DERIVATIVES
₹ 2,73,87,000 × 1% × 1.2 = ₹ 3,28,644
Loss by short covering of index future is
0.01 × 6,086 × 50 × 108 = ₹ 3,28,644
(ii) Justification of the answer if index is plummets by 2&.
Loss in the value of the portfolio
₹ 2,73,87,000 × 2% × 1.2 = ₹ 6,57,288
Gain by short covering of index future is
0.02 × 6,086 × 50 × 108 = ₹ 6,57,288
This justifies the result.
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.
(SM New Syllabus& PM )
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

DERIVATIVES
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%.
What is the overall profit/loss to Ram?
SOLUTION:-
No. of the Future Contract to be obtained to get a complete hedge
10,000 ×₹ 22 × 1.5 − 5,000 × ₹ 40×2

=
₹ 1,000
₹ 3,30,000 −₹ 4,00,000
= = 70 contracts
₹ 1,000
Thus, by purchasing 70 Nifty future contracts to be long to obtain a complete

hedge.
Cash Outlay
= 10000 × ₹ 22 – 5000 × ₹ 40 + 70 × ₹ 1,000
= ₹ 2,20,000 – ₹ 2,00,000 + ₹ 70,000 = ₹ 90,000
Cash Inflow at Close Out
= 10000 ×₹ 22 × 0.98 – 5000 ×₹ 40 × 1.03 + 70 ×₹ 1,000 × 0.985
= ₹ 2,15,600 – ₹2,06,000 +₹68,950 = ₹78,550
Gain/ Loss
= ₹ 78,550 – ₹ 90,000 = −₹ 11,450 (Loss)

DERIVATIVES
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:
(i) Current portfolio beta.
(ii) Portfolio beta after 3 months if Mr. X on current date goes for long position
on ₹ 200 lakhs Nifty futures.
(Exam July - 2021)
SOLUTION:-
(i) Current Portfolio Beta
Current Beta for share portfolio = 1.6
Beta for cash =0
Current portfolio beta = 0.85 × 1.6 + 0 .15 × 0 = 1.36
(ii) Portfolio beta after 3 months:
Change in value of portfolio of share

Beta for portfolio of shares =
Change in value of market portfolio (index)
0.032
1.6 =
Change in value of market portfolio (index)
Change in value of market portfolio (Index) = (0.032 / 1.6) × 100 = 2%
Position taken on 200 lakh Nifty futures : Long
Value of index after 3 months = ₹ 200 lakh × (1.00 − 0.02)
= ₹ 196 lakh
Mark-to-market paid = ₹ 4 lakh
Cash balance after payment of mark-to-market = ₹ 26 lakh
Value of portfolio after 3 months = ₹ 170 lakh × (1 − 0.032) +₹ 26 lakh

DERIVATIVES
= ₹ 190.56 lakh
200 lakh−190.56 lakh

Change in value of portfolio = × 100 = 4.72%
200 lakh
Portfolio beta = 0.0472/0.02 = 2.36
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:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long
position on ₹ 100 lakhs Nifty futures.
SOLUTION:-
(i) Current Portfolio Beta
Current Beta for share portfolio = 1.6
Beta for cash =0
Current portfolio beta = 0.85 × 1.6 + 0 × 0.15 = 1.36
(ii) Portfolio beta after 3 months:
Beta for portfolio of shares

Change in value of portfolio of share
=
Change in value of market portfolio (Index)
0.032
1.6 =

DERIVATIVES
= (0.032 / 1.6) × 100 = 2%
Position taken on 100 lakh Nifty futures : Long
Value of index after 3 months = ₹ 100 lakh × (1.00 − 0.02)
= ₹ 98 lakh
Mark-to-market paid = ₹ 2 lakh
Cash balance after payment of mark-to-market = ₹ 13 lakh
Value of portfolio after 3 months = ₹85lakh× (1−0.032) +₹13lakh
= ₹ 95.28 lakh
₹100 lakh−₹95.28 lakh

Change in value of portfolio =
₹100 lakh
= 4.72%
Portfolio Beta = 0.0472/0.02 = 2.36
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.
The following information is available :
Value of the portfolio ₹ 1,16,00,000
BSE Sensex on 1st January 2022 58,580
(Anticipated on 1st September 2021)
BSE Sensex on 1st January 2022 56641.25
(Anticipated on 1st December 2021)
Dividend Yield of Index 6% p.a
181 day‟s treasury bills offers a rate of interest 9% p.a.
Beta of the portfolio 1.5
You are required to calculate

DERIVATIVES
(i) The present value of the Sensex as on 1st September 2021
(ii) Turned out value of the Sensex on 1st December 2021
(iii) The number of contracts to hedge the portfolio.
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
Thus, the present value of Sensex as on 1st September, 2021 is 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
Thus, turned out value of Sensex on 1st December, 2021 is 56,500
₹ 1,16,00,000 × 1.50
(iii) No. of Contract to the Hedge Portfolio =
58,580 × 50
= 5.95 Say 6 Contracts
(VIII) COMODITY FUTURE
QUESTION – 64
The following information is available about standard gold.
Spot Price (SP) ₹ 15,600 per 10 gms.
Future Price (FP) ₹ 17,100 for one year future contract

DERIVATIVES
Risk free interest Rate (R)f 8.5%
Present Value of Storage Cost ₹ 900 per year
From the above information you are requested to calculate the Present Value of
Convenience yield (PVC) of the standard gold.
SOLUTION:-
Calculation of PVC
F = (Spot Price + PVSC − PVC) (1 + r)
17,100 = (15,600 + 900 − PVC) (1.085)
17,100
= 16,500 – PVC
1.085
15,760 = 16,500 – PVC
PVC = 16,500 – 15,760
= ₹ 740
QUESTION – 65
The following information about copper scrap is given:
(i) Spot price : $10,000 per ton
(ii) Futures price : $10,800 for a one year contract
(iii) Interest rate : 12 %
(iv) PV (storage costs) : $500 per year
What is the PV (convenience yield) of copper scrap?
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

DERIVATIVES
Hence the present value of convenience yield is $857.14 per ton.
QUESTION – 66
A company is long on 10 MT of copper @ ₹ 474 per kg (spot) and intends to remain

so for the ensuing quarter. The standard deviation of changes of its spot and
future prices are 4% and 6% respectively, having correlation coefficient of 0.75.
What is its hedge ratio? What is the amount of the copper future it should short to
achieve a perfect hedge?
(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
ρ = coefficient of correlation between ΔS and ΔF
H = Hedge Ratio
ΔS = change in Spot price.
ΔF = change in Future price.
Accordingly
0.04
H = 0.75 × 0.06 = 0.5
No. of contract to be short = 10 × 0.5 = 5
Amount = 5000 ×₹ 474 = ₹ 23,70,000
QUESTION – 67
A company is long on 10 MT of copper @ ₹ 534 per kg (spot) and intends to remain

so for the ensuing quarter. The variance of change in its spot and future prices are

DERIVATIVES
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,
σS = Standard deviation of ∆S (Change in Spot Prices)
σF = Standard deviation of ∆F (Change in Future Prices)
ρ = Coefficient of correlation between ∆S and ∆F
H = Hedge Ratio
∆S = Change in spot price.
∆F = Change in Future price.
Accordingly
Standard deviation of ∆S = 16% = 4% and
Standard deviation of ∆F = 36% = 6% and
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.

DERIVATIVES
(iii) Since contact size of one contract is 1,000 Kg,
10,000 Kgs
No. of contract to be short = × 0.50 = 5 Contracts
1,000 Kgs
Amount = ₹ 5,000 × 534 = ₹ 26,70,000
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:-
To determine whether premium is justified we shall compute the value of option by

using any of the following models:
By use of Binomial Model
Decision Tree showing pay off
Year 0 3 Months Pay off
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.
The pay off if price goes up = 0.50 ×₹ 27300 – ₹ 1,300 = ₹ 12,350
The pay off if price goes down = 0.50 ×₹24,700 = ₹12,350

DERIVATIVES
₹ 12,350
Present Value of Pay-off = = ₹11,990
1.03
Current investment = ₹ 26,000 × 0.50 = ₹13,000
Value of Option = ₹ 13,000 – ₹11,990 = ₹ 1,010
Thus the price of option is justified.
Alternatively, by using Risk Neutral Model:
First of all we shall calculate probability of high demand (P) using risk neutral
method as follows:
3% = p × 5% + (1−p) × (-5%)
0.03 = 0.05 p − 0.05 + 0.05p
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
Thus, the price of option is justified.
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:
(i) To interpret the position of trader in the Cash Market.
(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.
(RTP Nov – 2020 & MTP May - 2019)

DERIVATIVES
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.
(iii) The gain on futures contract
= (₹ 59 – ₹ 58) × 22,000 kg. = ₹ 22,000
Revenue from the sale of Rice
= 22,000 ×₹ 57 = ₹ 12,54,000
Total Cash Flow = ₹ 12,54,000 + ₹ 22,000 = ₹ 12,76,000
₹ 12,76,000
Cash flow per kg. of Rice = = ₹ 58
22,000

INTEREST RATE RISK MANAGEMENT
CHAPTER – 02
Interest Rate Risk Management

We will discuss this chapter in following parts −
Part 1: Forward Rate Agreement (FRA)
Part 2: Interest Rate Guarantee
Part 3: Interest Rate Future (Euro Dollar Future)
Part 4: Financial swap
Part 5: Cap, Collar & Floor
Part 6: Swap Pricing & Valuation.
Part 1: Forward Rate Agreement

Forward Rate Agreement means Forward Contract on Interest Rate. It is Over
the Counter Contract.
Suppose City Bank Quotes FRA 3× 9 is 10%/12%. It means.
(1) Buy FRA 3 × 9 at 12%
 Contract to borrow after 3 months for 6 months @12% P.a.
 We afraid from Interest Rising , hence we take Long position on
Interest Rate at 12% ( upside betting)
(2) Sell FRA 3 × 9 at 10%

 Contract to Invest after 3 months for 6 months @10% P.a.
 We afraid from Interest Rate Falling , hence we take short position
on Interest Rate at 10% (downside betting)
There are two types of Numerical in FRA
(i) FRA for Hedging
(ii) FRA for Arbitrage
Page 1
www.pavansirsfmclasses.com
(I) FRA for Hedging
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
Dtm = Period of Forward Contract
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.
Page 2
(II) FRA for Arbitrageur
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
 If Actual FRA is less then theoretical FRA then

 Contract to borrow at forward rate
Or,
Buy FRA
Example – 03
3 Months LIBOR = 12% p.a.
Calculate 3 months FRA after 3 months.
Example – 04
Calculate 3 months FRA after 6 months.
Example – 05
Calculate 6 months FRA after 3 months .
Example – 06
(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%
Page 3
Part 2: Interest Rate Guarantee [FRAPTION]

Interest rate Guarantee (IRG) is a combination of option & FRA. In IRG FRA
Bank (Option Sales) has obligation to pay option buyer but FRA bank has no
right to receive difference amount. An option premium is to be paid in Advance.
It is also called FRAPTION.
Part 3: Interest Rate Future (Euro Dollar Future)

 Quotation = 100 − LIBOR
 Interest Rate Future means future Contract on Rate of Interest. It is
Exchange Traded.
 If we want to borrow in future, hence we afraid from interest rate rising &
we should take long position on interest rate. But in IRF, we have to take
position on interest rate bearing security. There is inverse relationship
between Rate of Interest & Interest Bearing Security [ If Rate of interest
rise then T. Bill Fall]
So If we borrow then we should take short position on T. Bill [Sell IRF]
Part 4: Financial Swap

(I) Plain Vanilla Swap
(II) Overnight Index Swap
(III) Two Party Swap
(IV) Swap Quotation
(V) Swap Pricing & Valuation
(I) Plain Vanilla Swap

(1) Suppose Ram expects that LIBOR will rise continuously in future. In
order to make profit, Ram will Issue fixed rate Bonds & use such
proceeds to Invest floating rate Bonds. In this situation Ram will receive
LIBOR &will pay fixed rate. In case of LIBOR will rise, then profit to Ram
But there is a problem in above transaction like operational Expenses
high & too much Legal requirement.
In this situation, Ram can enter into swap with Bank. In swap
arrangement, Ram will pay to Bank fixed Rate & Ram will receive from
Bank LIBOR.
Such type of swap arrangement is generic swap is called plain vanilla
swap. In plain vanilla swap, there are two legs.
Page 4
(i) Fixed Rate Leg

(ii) Floating Rate Leg
In plain Vanilla swap, there is a multiple time betting, involve Notional
principal with netting feature.
(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
(II) Overnight Index Swap

Overnight Index swap just like plain vanilla swap in which one party is fixed
Rate payer & other party is floating rate payer but MIBOR. MIBOR (Mumbai
Inter Bank offer Rate) is subject to daily compounding.
Page 5
(III) Two Parity Swap
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.
(IV) Swap Quotation (Structuring)

Concepts discuss with questions.
(V) Swap Pricing & Valuation

In Swap Pricing, we find out rate of interest of fixed leg & decide whether we
should enter into financial swap or not?
Periodical fixed rate of interest is calculated as under
dl = Discounting rate of last year
dn = Cumulative discounting factors
1 − dl
Periodical fixed rate =
dn
Page 6
Part 5: CAP, Floor & Collar
(i) Interest Rate CAP

If any person wants to borrow then he afraid from interest rate
rising. In order to protect risk from interest rate rising we can buy cap.
Interest rate cap is a right but not obligation to borrow certain amount at
specified Rate (Strike price) on Maturity date. An option premium is to be
paid in advance. (It is just like call option)
(ii) Interest Rate FLOOR

If any person wants to invest in future, he afraid from interest rate
falling. In order to protect risk from interest rate falling, we can buy
Interest rate floor. A floor is a right but not obligation to Invest a certain
sum at predetermine Rate [Strike price] on maturity date. An option
premium is to be paid in advance. [Just like put option]
(iii) Interest Rate COLLAR

If we buy Cap, it means we expect Rate of interest will rise & pay
premium. In order to Recover premium amount, we Can sell floor. If we
buy cap at Higher strike price & Sell floor at Lower Strike price then this
strategy is called “Interest Rate Collar”.
Page 7
Part I: Forward Rate Agreement (FRA)
QUESTION – 01
M/s. Parker & Co. is contemplating to borrow an amount of ₹ 60 crores for a

Period of 3 months in the coming 6 month's time from now. The current rate of
interest is 9% p.a., but it may go up in 6 month’s time. The company wants to
hedge itself against the likely increase in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30%

p.a.
What will be the Final settlement amount, if the actual rate of interest after 6
months happens to be
(i) 9.60% p.a. and
(ii) 8.80% p.a.?
(Exam May – 2013, SM & PM)
SOLUTION:-
Final settlement amount shall be computed by using formula:
dtm
N RR −FR ( DY )
= dtm
[1+RR ]
DY
Where,
N = The notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on

the contract settlement date;
FR = Agreed-upon Forward Rate; and
Dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could

be 360or 365 days.
Accordingly,
Page 8
If actual rate of interest after 6 months happens to be 9.60%

3
₹60Cr 0.096−0.093 ( )
12
= 3
[1+0.096 ]
12
₹60Cr (0.00075 )
= = ₹ 4,39,453
1.024
Thus banker will pay Parker & Co. a sum of ₹4,39,453

3
₹60Cr 0.088−0.093 ( )
12
= 3
[1+0.088 ]
12
₹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 treasurer of an insurance company expects to have a surplus of £5 million

6 months from now. She has decided to park the fund in a 3 months euro
sterling deposit. The current 3 months deposit rate 9%. A 6×9 £5 millions FRA
is being quoted at 8.75%. The treasurer sells an FRA to protect herself from
falling rates. Compute the effective rate of return on her investment if on day
182.
The 3months deposit rate is 9.5%
The rate is 8%
SOLUTION:-
Page 9
Final settlement amount is calculated as under:
N RR −FR (Dtm /Y)

Final settlement amount =
1+(RR ×Dtm /Y)
(a) If 3 Months Deposit Rate is 9.5%
Insurance company sell FRA at 8.75%. In this situation insurance

company will pay to FRA bank.
3
£ 50,00,000 0.095−0.0875 ×
12
Final settlement amount = 3
1+(0.095 × )
12
£ 9375
= = £ 9157.51
1.02375
(b) If Actual Rate is 8%
In this situation, FRA bank will pay to insurance company

3
£ 50,00,000 0.08−0.0875 ×
12
Final settlement amount = 3
1+(0.08 × )
12
£ 9375
= = £ 9191.18
1.02
QUESTION – 03
P Ltd. is contemplating to borrow an amount of ₹ 50 crores for a period of 3

months in the coming 6 months time for now. The current rate of interest is 8%
per annum but it my go up in 6 months time. The company wants to hedge
itself against the likely increase in interest rate.
The Company’s Bankers quoted an FRA (Forward Rate Agreement) at 8.30%

per annum.
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
(i) 8.60% p.a., or
(ii) 7.80% p.a.
Page 10
(Show your working on the basis of months)
SOLUTION:-
Final settlement amount shall be computed by using formula :
N RR −FR (dtm /DY )

=
[1+RR (dtm /DY )]
Where,
N = The notional principal amount of the agreement.
RR = Reference Rate for the maturity specified by the contract

prevailing on the contract settlement date;
FR = Agreed-upon Forward Rate; and
Dtm = Maturity of the forward rate, specified in Months
DY = Applicable basis of months
Accordingly,
₹ 50 crore 0.003 (0.25)

=
[1+0.086(3/12)]
₹ 50 crore 0.086−0.083 (3/12) 3,75,000

= = = ₹ 3,67,107
1.0215 1.0215
Thus , banker will pay a sum of ₹ 3,67,107 to P Ltd. and actual interest
rate for P Ltd. shall be as follows:
Interest on loan @ 8.60% for 3 months ₹ 1,07,50,000

Less : Amount Received from the bank ₹ 3,67,107
Net Amount ₹ 1,03,82,893
Effective Interest Rate 8.31%
(₹ 1,03,82,893/₹50 crore × 12/3 × 100)
Page 11
₹ 50 crore 0.0780 −0.0830 (3/12)

=
[1+0.0780 (3/12)]
₹ 50 crore −0.005 (0.25) −6,25,000

= = = − ₹ 6,13,046
1.0195 1.0195
Thus P Ltd. will pay banker a sum of ₹ 6,13,046 and actual interest
rate for P Ltd. shall be as follows :
Interest on loan @ 7.80% for 3 months ₹ 97,50,000

Add: Amount paid to bank ₹ 6,13,046
Net Amount ₹ 1,03,63,046
Effective Interest Rate 8.29%
(₹ 1,03,63,046/50 crore × 12/3 × 100)
QUESTION – 04
TM Fincorp has bought a 6 × 9 ₹ 100 crore Forward Rate Agreement (FRA) at

5.25%. On fixing date reference rate i.e. MIBOR turns out be as follows:
Period Rate (%)

3 Months 5.50
6 Months 5.70
9 Months 5.85
(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)
SOLUTION:-
(a) TM will make a profit of 25 basis points since a 6 × 9 FRA is a contract

on 3-month interest rate in 6 months, which turns out to be 5.50%
(higher than FRA price).
(b) The settlement amount shall be calculated by using the following

formula:
Page 12
N RR −FR (dtm /360)

1+RR (dtm /360)
Where,
N = Notional Principal Amount
RR = Reference Rate
FR = Agreed upon Forward Rate
Dtm = FRA period specified in days.
Accordingly:
100 Cr (5.50%−5.25%) 92∗ /360

= ₹ 6,30,032
1+0.0055 92 ∗ /360
Hence there is profit of ₹ 6,30,032 to TM Fincorp.
* Alternatively, it can also be taken as 90 days.
QUESTION – 05
The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY

3 Months 4.50% 0.25%
6 Months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is Nil.
1. What should be 3 months FRA rate at 3 months forward?
2. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is

quoting 6/12 USD FRA at 6.50 – 6.75%. Is any arbitrage opportunity
available?
Calculate profit in such case.
(Practice Manual)
SOLUTION:-
1. 3 Months Interest rate is 4.50% & 6 Months Interest rate is 5% p.a.
Page 13
Future Value 6 Months from now is a product of Future Value 3 Months

now & 3 Months Future Value from after 3 Months.
(1 + 0.05*6/12) = (1 + 0.045*3/12) × (1+ i3,6*3/12)
i3,6 = [(1 + 0.05* 6/12)/(1 + 0.045 *3/12) – 1] *12/3
i.e. 5.44% p.a.
2. 6 Months Interest rate is 5% p.a & 12 Month interest rate is 6.5%

p.a.
Future value 12 month from now is a product of Future value 6 Months

from now and 6 Months Future value from after 6 Months.
(1 + 0.065) = (1 + 0.05*6/12) × (1 + i6,6 *6/12)
i6,6 = [(1 + 0.065/1.025) – 1] *12/6
6 Months forward 6 month rate is 7.80% p.a.
The Bank is quoting 6/12 USD FRA at 6.50 – 6.75%
Therefore, there is an arbitrage Opportunity of earning interest @ 7.80%

p.a. & Paying @ 6.75%
Borrow for 6 months, buy an FRA & invest for 12 months
To get $ 1.065 at the end of 12 months for $ 1 invested today
To pay $ 1.060# at the end of 12 months for every $ 1 Borrowed

today
Net gain $ 0.005 i.e. risk less profit for every $ borrowed
# (1 + 0.05/2) (1 + .0675/2) = (1.05959) say 1.060
Part II: Interest Rate Guarantee
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:
Page 14
Year XYZ Ltd. ABC Ltd.

1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
*The difference in yield curve is due to 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
(a) 4.50% (b) 5.50%
(RTP November – 2020 & PM)
SOLUTION:-
(i) DEF Bank will fix interest rate for 2V3 FRA after 2 years as follows:
XYZ Ltd.
(1+r) (1+0.0420)2 = (1+0.0448)3
(1+r) (1.0420)2 = (1.0448)3
r = 5.04%
Bank will quote 5.04% for a 2V3 FRA.
ABC Ltd.
(1+r) (1+0.0548)2 = (1+0.0578)3
(1+r) (1.0548)2 = (1.0578)3
r = 6.38%
Bank will quote 6.38% for a 2V3 FRA.
Page 15
(ii)
4.50% 5.50%
Allow to Lapse Exercise
Interest ₹ 100 crores × 4.50% ₹ 4.50 crores -
₹ 100 crores × 5.04% - ₹ 5.04 crores
Premium (Cost ₹ 100 crores × 0.1% ₹ 0.10 crores ₹ 0.10 crores

of Option)
4.60 crores 5.14 crores
Part III: Interest Rate Future (Euro Dollar Future)
Question – 07
Electra space is consumer electronics wholesaler. The business of the firm is

highly seasonal in nature. In 6 months of a year, firm has a huge cash deposits
and especially near Christmas time and other 6 months firm cash crunch,
leading to borrowing of money to cover up its exposures for running the
business.
It is expected that firm shall borrow a sum of €50 million for the entire period
of slack season in about 3 months.
A Bank has given the following quotations:
Spot 5.50% - 5.75%
3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%
3 month €50,000 future contract maturing in a period of 3 months is quoted at

94.15 (5.85%).
(a) How a FRA, shall be useful if the actual interest rate after 3 months
turnout to be: (i) 4.5% (ii) 6.5%
Page 16
(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%
Actual Interest Rate 4.50% 6.50%
Loss/(Gain) 1.44% (0.56%)
FRA Payment/ (Receipts) €50m × 1.44% × ½ = €50m × 0.56% × ½ =

€3,60,000 (€1,40,000)
Interest after 6 months on = €50m × 4.5% × ½ = €50m × 6.5% × ½

€50 Million at actual rates = €11,25,000 = €16,25,000
Net Out Flow €14,85,000 €14,85,000
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.
Amount of Borrowing Duration of Loan

No. of Contracts = ×
Contract Size 3 Months
€50,000,000 6
= × = 2,000 Contracts
€50,000 3
Page 17
The final outcome in the given two scenarios shall be as follows:
If the rate turns out If the rate turns out

to be 4.50% to be 6.50%
Future Course Action:
Sell to open 94.15 94.15
Buy to close 95.50(100 – 4.5) 93.50(100 – 6.5)
Loss/(Gain) 1.35% (0.65%)
Cash Payment (Receipt) for €50,000 × 2,000 × €50,000 × 2,000 ×

Future Settlement 1.35% × 3/12 0.65% × 3/12
= €3,37,500 = (€1,62,500)
Interest for 6 months on €50 million × 4.5% × ½ €50 million× 6.5% × ½

€50 million at actual rates = €11,25,000 = €16,25,000
€14,62,500 €14,62,500
Thus, the firm locked itself in interest rate
€14,62,500 12
× 100 × = 5.85%
€50,000,000 6
Question – 08
Espaces plc is consumer electronics wholesaler. The business of the firm is

highly seasonal in nature. In 6 months of a year, firm has a huge cash deposits
and especially near Christmas time and other 6 months firm cash crunch,
leading to borrowing of money to cover up its exposures for running the
business.
It is expected that firm shall borrow a sum of £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):
Spot 5.50% - 5.75%
3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%
Page 18
3-month £50,000 future contract maturing in a period of 3 months is quoted at

94.15.
(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.
(RTP May - 2021)
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.
Amount of Borrowing Duration of Loan

No. of Contracts = +
Contract Size 3 Months
£ 25,000,000 6
= × 3 = 1000 Contracts
£ 50,000 3
(ii) The financial outcome in the given two scenarios shall be as follows:
If the interest rate turns If the interest rate turns

out to be 4.5% out to be 6.5%
Future Course
Action :
94.15 94.15
Sell to open
95.50 (100 − 4.5) 93.50 (100 − 6.5)
Buy to close
1.35% (0.65%)
Loss/ (Gain)
Cash Payment £ 50,000×1000×1.35%×3/12 £ 50,000×1000×0.65%×3/12

(Receipt) for Future = £1,68,750 = (£81,250)
Settlement
Page 19
Interest for 6 months

on £50 million at
£ 25 million × 4.5% × ½ £ 25 million × 6.5% × ½
actual rates = £ 5,62,500 = £ 8,12,500
£ 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%.
Part IV: Financial Swap
(i) Plain Vanilla Swap
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.
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period
from the effective date of swap to the settlement date comprises 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?
Generic swap is based on 30/360 days basis.
(SM, PM & Exam November - 2018)
SOLUTION:-
(i) Semi-annual fixed payment
Page 20
= (N) (AIC) (Period)
Where
N = Notional Principal amount = ₹ 5,00,000
AIC = All-in-cost = 8% = 0.08
180
= 5,00,000 × 0.08
360
= 5,00,000 × 0.08 (0.5)
= 5,00,000 × 0.04 = ₹ 20,000/-
(ii) Floating Rate Payment
dt
= N (LIBOR)
360
181
= 5,00,000 × 0.06
360
= 5,00,000 × 0.06 (0.503) or 5,00,000 × 0.06 (0.502777)
= 5,00,000 × 0.03018 or 0.30166 = ₹15,090 or 15,083
Both are correct
(iii) Net Amount
= (i) – (ii)
= ₹ 20,000 – ₹ 15,090 = ₹ 4,910
or = ₹ 20,000 – ₹ 15,083 = ₹ 4,917
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:
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period
from the effective date of swap to the settlement date comprises 181 days
Page 21
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.
(Exam July – 2021 & November - 2010)
SOLUTION:-
(i) Semi-annual fixed payment
= (N)(AIC) (Period)
Where N = Notional Principal amount = ₹ 8,00,000
AIC = All-in-cost = 6% 0.06
180
= 8,00,000 × 0.06
360
= 8,00,000 × 0.06 (0.5)
= 8,00,000 × 0.03 = ₹ 24,000
(ii) Floating Rate Payment
dt
= N (LIBOR)
360
181
= 8,00,000 × 0.05 ×
360
= ₹ 8,00,000 × 0.05 (0.503)
= ₹ 8,00,000 × 0.02515 = ₹ 20,120
(iii) Net Amount
= (i) – (ii)
= ₹ 24,000 - ₹ 20,120 = ₹ 3,880
Page 22
(ii) Overnight Index Swap
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.
Respective MIBOR rates for Tuesday to Monday were:
7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.15%.
If Derivative Bank received ₹ 317 net on settlement, calculate Fixed rate and
interest under both legs.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.
(Exam November – 2010, SM & PM)
SOLUTION:-
Day Principal (₹) MIBOR (%) Interest (₹)

Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Page 23
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.
8.70%, 9.10%, 9.12%, 8.95%, 8.98% and 9.10%.
If Punjab Bank received ₹507 net on settlement, calculate Fixed rate and
Notes:
(i) Sunday is a Holiday.
(ii) Workout in rounded rupees and avoid decimal working.
(iii) Consider a year consists of 365 days.
(Exam May - 2018)
SOLUTION:-
Day Principal MIBOR Interest

(₹) (%) (₹)
Tuesday 2,00,00,000 8.70 4,767
Wednesday 2,00,04,767 9.10 4,987
Thursday 2,00,09,754 9.12 5,000
Friday 2,00,14,754 8.95 4,908
Saturday & Sunday (*) 2,00,19,662 8.98 9,851
Monday 2,00,29,513 9.10 4,994
Total interest @ floating 34,507
Less: Net received 507
Expected interest @ fixed 34,000
Thus fixed rate of interest 0.0886428
Approx. 8.86%
(*) i.e. interest for two days.
Page 24
Question – 13
Derivative Bank entered into a swap arrangement 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, 19th August, 2019 and was to
commence on 20th August, 2019 and run a period of 7 days.
8.15%, 7.98%, 7.95%, 8.12%, 8.15%, 7.75%.
If Fixed Rate of Interest is 8%, then evaluate
(i) The nature of this swap arrangement.
(ii) The Net Settlement amount.
Note:
(1) Sunday is Holiday.
(2) Work in rounded rupees and avoid decimal working.
(3) Consider 365 days in a year.
(RTP November – 2021)
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:
Day Principal (₹) MIBOR Interest

(%) (₹)
Tuesday 10,00,00,000 8.15 22,329
Wednesday 10,00,22,329 7.98 21,868
Thursday 10,00,44,197 7.95 21,790
Friday 10,00,65,987 8.12 22,261
Saturday & Sunday (*) 10,00,88,248 8.15 44,697
Monday 10,01,32,945 7.75 21,261
Total Interest @ Floating Rate (A) 1,54,206
Total Interest @ Fixed Rate (B) 1,53,425
7
10,00,00,000 × 8.00% ×
365
Net Settlement Amount Paid 781
Page 25
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.
Respective MIBOR rates for Tuesday to Monday ware:
8.75%, 9.15%, 9.12%, 8.95%, 8.98% and 9.15%
If Bharat Bank Ltd. received ₹ 417 net on settlement, calculate fixed rate and
Notes:(i) Sunday is a holiday
(ii) Work in rounded rupee and avoid decimal working
(iii) Consider 365 days in a year.
SOLUTION:-
Day Principal (₹) MIBOR (%) Interest (₹)
Tuesday 1,00,00,000 8.75 2.397

Wednesday 1,00,02,397 9.15 2.507
Thursday 1,00,04,904 9.12 2.500
Friday 1,00,07,404 8.95 2.454
Saturday & Sunday (*) 1,00,09,858 8.98 2.925
Monday 1,00,14,783 9.15 2.511
Total Interest @ Floating 17.294
Less: Net Received 417
Expected Interest @ fixed 16,877
Thus Fixed Rate of Interest 0.0880015
Approx. 8.80%
(*) i.e. interested for two days.
(**) 1 crore × ‘X’/100 × 7/365 = 16.877
1,6,877 × 365 ×10

Hence, X = = 8.8%
1 Crore × 7
Page 26
(iii) Two Party Swap
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.
You are required to find out:
(i) Whether a swap can be arranged which may be beneficial to both the
firms?
(ii) What rate of interest will the firms end up paying?
(Exam Novemer - 2020)
SOLUTION:-
Though Company IB has an advantage in both the markets but it has

comparative more advantage in the INR floating-rate market. Company Zaki
has a comparative advantage in the JPY fixed interest rate market.
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%
Total Potential Gain = (INR interest differential) − (Yen rate differential)
Page 27
= (BPLR + 2.50% − BPLR + 0.50%) + (2% − 2.25%) = 1.75%
Less Banker's commission (To be shared equally) = 0.25%
Net gain (To be shared equally: 0.75% each) = 1.50%
(i) Yes, a beneficial swap can be arranged
(ii) Effective cost of borrowing = pays to lenders + pays to other party -

receives from other party + banker's commission
IB = BPLR + 0.50% + 1.125%* − (BPLR + 0.50%) + 0.125% = 1.25
(* has been arrived as 2% − 0.75% - 0.125%)
Zaki = 2.25% + BPLR + 0.50% − 1.125% + 0.125% = BPLR + 1.75%
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:
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1 = ¥120.
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.
(Exam May – 2011, SM & PM)
Page 28
SOLUTION:-
Opportunity gain of A Inc under Receipt Payment Net

currency swap
Interest to be remitted to B. Inc in $
2,00,000 × 9% = $18,000 ¥21,60,000
Converted into ($18,000 × ¥120)
Interest to be received from B. Inc in $ ¥14,40,000 -

converted into ¥ (6% × $2,00,000 ×
¥120)
- ¥12,00,000
Interest payable on ¥ loan
¥14,40,000 ¥33,60,000
¥19,20,000 -
Net Payment
¥33,60,000 ¥33,60,000
$equivalent paid
¥19,20,000 × (1/¥120) $16,000
Interest payable without swap in $ $18,000
Opportunity gain in $ $ 2,000
Opportunity gain of B inc under Receipt Payment Net

currency swap
Interest to be remitted to A. Inc in ($ $12,000
2,00,000 × 6%)
Interest to be received from A. Inc in $18,000

¥converted into $ =¥21,60,000/¥120
Interest payable on $ loan@10% - $20,000

$18,000 $32,000
Net Payment $14,000 -
$32,000 $32,000
¥ equivalent paid $14,000 × ¥120 ¥16,80,000
Interest payable without swap in ¥ ¥19,20,000

($2,00,000×¥120×8%)
Page 29
Opportunity gain in ¥ ¥ 2,40,000
Alternative Solution
Cash Flows of A Inc
(i) At the time of exchange of principal amount
Transactions Cash Flows

Borrowings $2,00,000 × ¥120 + ¥240,00,000
Swap - ¥240,00,000
Swap +$2,00,000
Net Amount +$2,00,000
(ii) At the time of exchange of principal amount

Interest to the lender ¥240,00,000×5% ¥12,00,000
Interest Receipt from B Inc. ¥2,00,000×120×6% ¥14,40,000
Net Saving (in $) ¥2,40,000/¥120 $2,000
Interest to B Inc. $2,00,000×9% -$18,000
Net Interest Cost -$16,000
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%.
Cash Flows of B Inc
(i) At the time of exchange of principal amount

Borrowings + $2,00,000
Swap − $2,00,000
Swap $2,00,000×¥120 +¥240,00,000
Net Amount +¥240,00,000
(ii) At the time of exchange of principal amount
Page 30

Interest to the lender $2,00,000×10% − $20,000
Interest Receipt from A Inc. +$18,000
Net Saving (in ¥) +$2,000×¥120 − ¥2,40,000
Interest to A Inc. $2,00,000×6%×¥120 − ¥14,40,000
Net Interest Cost − ¥16,80,000
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 is an American firm having its subsidiary in Japan and JI is a Japanese

firm having its subsidiary in USA: They face the following interest rates
IM JI
USD Floating rate LIBOR+0.5% LIBOR+2.5%
JPY Fixed rate 4% 4.25%
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.
You are required to find out
(i) Whether a beneficial swap can be arranged?
(ii) What rate of interest for both IM and JI?
(Exam May - 2019)
SOLUTION:-
(i) IM has overall strong position and hence is in a comparative

advantageous position in both rates. However, it has a comparative
advantage in floating-rate market.
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.
Page 31
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
Borrowing from Market LIBOR + 0.5%

Less: Benefit from Swap 0.5%
Net Interest LIBOR
JI
Borrowing from Market 4.25%
Less: Benefit from Swap 0.5%
Net Interest 3.75%
(iv) Swap Quotation
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)
Page 32
X Ltd. want to borrow at fixed rate but cost of fund is high.
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)
Page 33
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%.
Effective Cost = Outflows – Inflows
= 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.
i. What will be the "all in cost" funds to ABC Bank?
ii. Another possibility being considered is the issue of a hybrid instrument

which pays 7.5% for first three years and LIBOR – 1/4% for remaining
two years.
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.
In Flow Out Flow

LIBOR LIBOR + 0.25% + 7.5%
Net interest payment 7.75%
Cash flows per six months period
In Flow Out Flow

(LIBOR/2) × ₹ 200 (LIBOR/2) × ₹ 200 million + ₹ 2,50,000 + ₹
million 75,00,000
There for all in cost of funds = ₹ 77,50,000.
Page 34
Alternatively it can also be calculated as follows:
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.
First three years:
Bank pays on hybrid 7.5% p.a.

Bank pays on five year swap 7.5% p.a.
Bank receives on three year swap 8% p.a.
Bank receives on five year swap LIBOR
Bank pays on three year swap LIBOR
Net interest payment 7% p.a.
Final two years:
Bank pays on hybrid LIBOR – 0.25%

Bank received on five year swap LIBOR
Bank pays on five year swap 7.5% p.a.
Net interest payment 7.25% p.a.
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.
(v) Swap Pricing & Valuation
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:
Days 90 180 270 360

Rate (%) 7.00 7.25 7.45 7.55
Page 35
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.
i. Determine the fixed rate on the swap.
ii. Calculate the first net payment on the swap.
SOLUTION:-
i. Let the fixed rate to be received by the bank be ‘R’ and the notional
principal be ‘P’.
At the first payment date, the fixed payments is = P × R × (90/360)
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.
Term Rate Discounting Factor

90 Days 7.00% 1/(1 + 0.07(90/360)) = 0.9828
180 Days 7.25% 1/(1 + 0.0725(180/360)) = 0.9650
270 Days 7.45% 1/(1 + 0.0745(270/360)) = 0.9471
360 Days 7.55% 1/(1 + 0.0755(360/360)) = 0.9298
The present value of fixed leg
= P × R × 0.25 (0.9828 + 0.9650 + 0.9471 + 0.9298)
= P × R × 0.9562
We know that on the date when interest rate is reset, the bond sells at
per value.
Hence, at time 0, the present value of floating rate payments is the

notional principal, P. but, given that there is no principal payment the
present value of principal repayment to be subtracted.
So, present value of floating payments is = P – P × 0.9298 = P × 0.0702
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.
P × R × 0.9562 = P × 0.0702 Or, R = 7.34%
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ii. The first net payment is based on a fixed rate of 7.34% and a floating
rate of 7%:
Fixed payment: $ 1,00,00,000(0.0734)(90/360) = $ 1,83,500
Floating payment: $ 1,00,00,000(0.07)(90/360) = $ 1,75,000
The net is that the party paying fixed makes a payment of $ 8,500.
Part V: CAP, Floor & Collar
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:
Notional Principal Amount $ 10 million
Reference Rate 6 months LIBOR
Strike Rate 4% for Floor and 7% for Cap
Premium 0*
*Since Premium paid for Cap = Premium received for Floor
Using the following data you are required to determine:
(i) Effective interest paid out at each reset date,
(ii) The average overall effective rate of interest p.a.
Reset Date LIBOR (%)
31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
Page 37
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
(Practice Manual)
SOLUTION:-
(i) The pay-off of each leg shall be computed as follows:
Cap Receipt
Max { 0, [Notional principal × (LIBOR on Reset date – Cap Strike Rate) ×

Number of days in the settlement period
365
}
Floor Pay-off
Max { 0, [Notional principal × (Floor Strike Rate – LIBOR on Reset date)

Nu mber of days in the settlement period
×
365
}
Statement showing effective interest on each re-set date
Reset Date LIBOR Days Interest Cap Floor Effective

(%) Payment ($) Receipts Pay-off Interest
LIBOR+0.50 ($) ($)
%
31-12-2013 6.00 184 3,27,671 0 0 3,27,671
30-06-2014 7.50 181 3,96,712 24,795 0 3,71,917
0 0
31-12-2014 5.00 184 2,77,260 0 2,77,260
30-06-2015 4.00 181 1,98,356 0 1,98,356
12,603
31-12-2015 3.75 184 1,89,041 0 2,01,644
0
30-06-2016 4.25 182 2,36,849 0 2,36,849
Total 1096 16,26,094
(ii) Average Annual Effective Interest Rate shall be computed as follows:
Page 38
16,26,094 365
× × 100 = 5.42%
1,00,00,000 1096
Question – 22
A textile manufacturer has taken floating interest rate loan of ₹ 40,00,000 on

1st April, 2012. The rate of interest at the inception of loan is 8.5% p.a. interest
is to be paid every year on 31st March, and the duration of loan is four years. In
the month of October 2012, the Central bank of the country release following
projections about the interest rates likely to prevail in future.
Dates Interest Rate

31st March, 2013 8.75%
31st March, 2014 10.00%
31st March, 2015 10.50%
31st March, 2016 7.75%
(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:
Dates Interest Rate

31st March, 2013 10.20%
31 March, 2014
st 11.50%
31st March, 2015 9.25%
31st March, 2016 8.25%
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:
Page 39
 National Principal: ₹ 40,00,000/-

 Strike rate: 8.5% p.a.
 Reference rate: the rate of interest applicable to this loan
 Calculation and settlement date: 31st March every year
 Duration of the caps: till 31st March 2016
 Premium for caps: negotiable between both the parties
To purchase the caps this borrower is required to pay the premium

upfront at the time of buying caps. The payment of such premium will
entitle him with right to receive the compensation from the seller of the
caps as soon as the rate of interest on this loan rises above 8.5%. The
compensation will be at the rate of the difference between the rate of
none of the cases the cost of this loan will rise above 8.5% calculated on
₹ 40,00,000/- This implies that in none of the cases the cost of this loan
will rise above 8.5%. This hedging benefit is received at the respective
interest due dates at the cost of premium.
(ii) To evaluate the position of the borrower on respective dates we shall

compute the interest cost as follows:
Dates Interest Exercise Compensation Net Cost

Rate (a) of Option (b) (a) – (b)
31st March, 2013 10.20% Yes 10.20% − 8.50% 8.50%
= 1.70%
31st March, 2014 11.50% Yes 11.50% − 8.50% 8.50%

= 3.00%
31st March, 2015 9.25% Yes 9.25% − 8.50% 8.50%

= 0.75%
31st March, 2016 8.25% No Nil 8.25%
Thus, from above it can be evaluated that the by paying an upfront

premium of ₹ 40,000 each year the borrower can ensure that its interest
rate cost does not exceed 8.50% p.a.
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
Page 40
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:
Reset Period LIBOR
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.
(Study Material & Practice Manual)
SOLUTION:-
First of all we shall calculate premium payable to bank as follows:
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
i = Fixed Rate of Interest
t = Time
0.01
= 1 × £15,000,000
1/0.035 − 4
0.035 ×1.035
Or
Page 41
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.
Now we see the net payment received from bank
Reset Additional interest Amount Premium paid Net Amt.

Period due to rise in interest received from to bank received from
rate bank bank
1 £ 75,000 £ 75,000 £ 40,861 £34,139
2 £ 112,500 £ 112,500 £ 40,861 £71,639
3 £ 150,000 £ 150,000 £ 40,861 £109,139
TOTAL £ 337,500 £ 337,500 £122,583 £ 214,917
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.
Page 42
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT
CHAPTER – 03
FOREIGN EXCHANGE EXPOSURE
AND RISK MANAGEMENT
FOREIGN EXCHANGE RISK MANAGEMENT

(1) Basics
(2) Spot Market Arbitrage
(3) Forward Contract
(4) Cover Deal
(5) Exchange Rate Determination
(6) Currency Exposure
(7) Cancellation of Forward Contract
(8) Foreign Currency A/C
(9) Currency of Borrowing
(10) Currency of Investment
(11) International Cash Management
(12) Currency Swap
(13) Economic Exposure
(14) Residual
(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
₹/£ = 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
INR/GBP = 94.75
£ 40000 =₹?
3. BID – ASK RATES

Foreign exchange is over the counter (OTC) market & regulated by RBI. RBI
has appointed a foreign exchange dealer to buy & sell currency. A dealer quote
Bid & Ask rates for a currency pair.
Suppose SBI Quotes
₹/$ = 70.25/70.75
It means
 SBI is ready to buy $ at ₹ 70.25 & it is called Bid rate.
 SBI is ready to sell $ at ₹ 70.75 & it is called Ask rate.
Difference between Ask rate & Bid rate is called Bid Ask spread i.e.
(70.75 – 70.25) = ₹ 0.50
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
GBP/USD = 1.5525/75
We want to sell $ 80,000 then How much pounds are receivable from bank.
4. APPRECIATION & DEPRECIATION IN CURRENCY
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.
5. CALCULATION OF CUSTOMER RATE OR MERCHANT RATE

If Inter Bank Rates are given, then commission or margin is added to Ask Rate
& Subtracted from bid rate to find out customer 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
PART I – CROSS RATES WITHOUT BID-ASK
Example - 16
₹/$ = 60
$/£ = 1.50
₹/£ =?
Example - 17
₹/£ = ₹ 90
$/£ = 1.50
₹/$ =?
Example - 18
¥/₹ = 3.45
₹/$ = 70
$/¥ =?
Example - 19
£/$ = 0.8045
$/₹ = 0.0167
₹/£ =?
Example - 20
¥/$ = 145
$/₹ = 0.165
¥/₹ =?
Example - 21
GBP/USD = 1.3575
USD/ INR = 70.7525
GBP/INR =?
Example - 22
₹/$ = 60
$/€ = 1.25
€/£ = 1.40
₹/£ = ?
Example - 23
£/$ = 0.8045
₹/$ = 45.25
₹/€ = 72.50
€/£ = ?
PART – II CROSS RATES WITH BID – ASK
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
$/£ = ?
Example - 28
GBP/USD = 1.5045/85
USD/JPY = 152/155
JPY/GBP =?
(2) SPOT MARKET ARBITRAGE

Arbitrage means risk free profit. In spot market arbitrage, we buy currency
where it is selling at lower rate & we sell currency where it is selling at higher
rate.
Suppose $ rate in India is ₹ 70 & in USA is ₹ 72.
In this situation we buy $ from India at ₹ 70 & sell in US at ₹ 72 arbitrage gain
= ₹ 2 per $
Example – 29
₹/$ = 60.50/60.75 India

₹/$ = 60.90/61.25 USA
Calculate Arbitrage Gain
Example – 30
$/£ = 1.5025/1.5175 US
$/£ = 1.5075/1.5195 UK
Calculate Arbitrage Gain
Example – 31
In USA
₹/$ = 60
$/£ = 1.50
i. On the basis of above exchange rate, what should be price of £ in India.
ii. If £ is quoted in India at ₹ 80, calculate arbitrage.
TRIANGULAR ARBITRAGE
Example – 32
₹/$ = ₹ 60.50 INDIA

$/£ = $ 1.5045 USA
£/₹ = £ 0.0125 UK
If you have ₹ 1,00,000 calculate arbitrage.
Example – 33
₹/$ = 60.50/60.75 INDIA

$/£ = 1.5075/1.5125 USA
£/₹ = 0.0125/0.0135 UK
If you have ₹ 1,00,000 calculate arbitrage gain.
(3) FORWARD CONTRACT

(i) Forward Cover for Importer
(ii) Forward Cover for Exporter
(i) FORWARD CONTRACT FOR IMPORTER
Example – 34
Spot Rate
₹/$ = 70.50/71.25
3 Months Expected SR
₹/$ = 74.00
3 Months Forward Rate
₹/$ = 72.50
(i) Calculate expected loss.
(ii) Whether Ram should enter into forward contract ?
(iii) If yes, saving in loss due to the forward contract ?
(ii) FORWARD COVER FOR EXPORTER
Example – 35
Spot Rate
₹/£ = 90.00/90.50
Expected Spot Rate
₹/£ = 87.50
3 Months Forward Rate (Bank)
₹/£ = 89.00
(i) Calculate expected loss.
(ii) Whether Ram should enter into forward contract?
(iii) If yes, saving in loss due to forward contract.
Example – 36
Spot Rate $/₹ = 0.01428
3 Months Expected Spot Rate
$/₹ = 0.01333
3 Months Forward Rate
$/₹ = 0.01370
i. Whether importer should enter into forward contract.
ii. If yes, calculate savings in loss due to forward contract.
FORWARD PREMIUM OR DISCOUNT
In forex, one currency may appreciate against another currency in forward

contract. If currency appreciate then it is at “Premium” & if currency
depreciates then we can say currency is at discount.
 Forward premium or discount is calculated as under.
Forward Rrate −Spot Rate 12

Forward premium/(Discount) = × 100 ×
Spot Rate n
Example – 37
Spot Rate ₹/$ = 70.25/70.85

2 Months FR ₹/$ = 71.45/71.75
6 Months FR ₹/$ = 69.25/69.95
Calculate forward premium/(Discount) in $.
Example – 38
Spot Rate ₹/$ = 70.45

3 Months FR ₹/$ = 71.25
Calculate Premium/Discount in
(i) $ (ii) ₹
Example – 39
$/£ = 1.5825 Spot

$/£ = 1.5975 3 Months FR
Calculate premium/discount in $.
CALCULATION OF FORWARD RATE WITH THE HELP OF SWAP POINTS
Swap points are basically premium or discount in currency. If swap points are
in ascending order (10/15) then swap point are added to spot rate & if swap
points are in descending order then they are subtracted from spot rate to find
out forward rate.
Example – 40
Spot Rate ₹/$ = 60.25/45

1 Months swap = 10/15
2 Months swap = 25/15
Calculate 1 Month & 2 Months FR.
Example – 41
Spot Rate ₹/$ = 70.4525/71.2525
1 Month Swap = 30/60

3 Months Swap = 40/70 paisa
Calculate 1 Month & 3 Month FR
Example – 42
Spot Rate ₹/$ = 70.75/45

3 Months Swap = 140/125
Calculate 3 Months FR
Example – 43
Spot Rate $/£ = 1.5275/1.5325

2 Months Swap = 0.35/0.45 cents
2 Months FR =?
Example – 44
Spot Rate ₹/$ = 70.75/71.25

2 Months Premium = 45/25
Calculate 2 Months FR.
Example – 45
Inter Bank Rate

Spot Rate ₹/$ =74.35/55
3 Months Swap = 60/70
Margin = 0.8%
Calculate 3 months FR (Customer’s Rate)
(4) COVER DEAL
Example – 46
You sold to your customer HK $ 10,00,000 at ₹ 7.25 & Covered yourself in

below market.
Local
₹/$ = 70/71
International
HK$/$ = 12.50/12.75
(i) Calculate cover rate.
(ii) Calculate profit/loss.
(5) EXCHANGE RATE DETERMINATION

Exchange rate of countries currency depends on following factors.
(i) Interest Rate [Interest Rate Parity]
(ii) Inflation Rate [Purchasing Power Parity]
(iii) Interest Rate & Inflation Rate [International Fisher Effect]
(i) Interest Rate Parity (IRP)
 As per IRP, exchange rate between two countries currency depends on

interest rate of their countries.
 Currency of a country having lower rate of interest will be stronger than
currency of country having higher rate of interest in future.
 IRP Equation
F$ 1+R A $
=
S$ 1+R B
F = Forward Rate
S = Spot Rate
RA = Rate of Interest
RB = Rate of Interest
Example – 47
Spot Rate ₹/$ = 70.25

Rate of Interest
India = 12% p.a.
USA = 8% p.a.
Calculate 3 months forward rate if
(i) Nothing is mentioned in question.
(ii) Rate of interest compounded annually or effective.
(iii) Rate of interest compounded continuously.
Example – 48
Spot Rate ₹/£ = 57.45

Rate of Interest
India = 10% p.a. Effective
UK = 8% p.a. Effective
Calculate 7 months FR
Example – 49
Spot Rate $/£ = 1.5075

Rate of Interest
US = 8% p.a. Effective
UK = 11% p.a. Effective
Calculate 9 months FR.
Example – 50
Spot Rate ¥/₹ = 0.3045

Interest Rate
Japan = 4% p.a. Compounded Quarterly
India = 10% p.a. Compounded Quarterly
Calculate 5 months FR
Example – 51
Spot Rate €/£ = 1.2545

6 Months FR
€/£ = 1.2775
Rate of interest
Europe = 8% p.a.
UK =?
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
Spot Rate ₹/£ = ₹ 90.45

3 Months FR
₹/£ = ₹ 92.75
Interest Rate
India = 12% Compounded Annually
UK =?
Example – 54
Spot Rate ₹/$ = ₹ 74.25

9 Months FR
₹/$ = ₹ 75.50
Rate of interest
India =?
USA = 8% p.a. Effective.
Example – 55
Spot Rate ₹/$ = 71.50

Rate of interest
India = 12% p.a.
USA = 10% p.a.
(i) Calculate 1 year FR
(ii) Calculate premium/discount in $
(iii) Calculate premium/ discount in ₹
Assuming IRP hold good.
Example – 56
Spot Rate ₹/$ = ₹ 70
6 Months FR =?
Discount in (₹) = 6% p.a.
FR =?
Covered Interest Arbitrage
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

1 Year FR ₹/$ = ₹ 61.50
Interest Rates
India = 12% p.a.
USA = 8% p.a.
Calculate arbitrage gain if you can borrow ₹ 60,00,000 or $ 1,00,000.
Example – 58

1 Year FR ₹/$ = ₹ 63.25
Rate of Interest
India = 12% p.a.
USA = 8% p.a.
You can borrow ₹ 60,00,000 or $ 1,00,000. Calculate arbitrage.
Example – 59
Spot Rate $/£ = 1.2575

6 Months FR
$/£ = 1.2650
Rate of Interest
USA = 5% p.a.
UK = 4% p.a.
You can borrow £ 1,00,000 or $ 1,25,750. Calculate arbitrage.
(ii) Purchasing Power Parity (PPP)
As per purchasing power parity , there are two theorem
I. Absolute form of PPP
II. Expectation form as relative form of PPP
I. Absolute Form of PPP
(1) As per PPP, Exchange rate of two countries currency depends on

demands of goods &services of their countries. It means demand of goods
creates demand of currency & currency will become strong in future.
(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
$10 = ₹500 Or, $1 = ₹50
(3) If actual Exchange is other than $1 = ₹50 than there is a possibility of

arbitrage.
Suppose Actual Exchange rate $1 = ₹40. In this situation an arbitrageur,

buy pen from US & pay ($10× ₹40) = ₹400 & sell such pen in India at
₹500. Arbitrage ₹100.
So demand of pen is USA will Increase due to Lower rate, hence demand
of dollar will Increase & $ will become strong .
Such process will continue till then $1 = ₹50.
So Exchange rate depends on demands of goods & services.
II. Expectation Form of PPP
 As per PPP, Currency of Country having Lower rate of Inflation will be

stronger than currency of country having higher rate of Inflation.
 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
India = ₹ 500 × 1.10 = ₹ 550

USA = $ 10 × 1.08 = $ 10.80
Exchange Rate after 1 year
$ 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.
III. International Fisher Effect (IFE)
Domestic Fisher Effect:-
 Domestic fisher effect explains relationship between Interest rate &

Inflation Rate.
 In order to understand International fisher effect, we have to discuss
Nominal Rate of Interest & Real rate of Interest.
 Real Rate of Interest means Excluding Inflation Rate.
 Nominal Rate of Interest means including inflation Rate.
Domestic Fisher Effect
Nominal Interest Rate = (1 + Real Interest Rate) (1 + i) – 1
(1+Nominal Interest Rate )

Real Interest Rate = −1
(1+i)
Example – 61
Real Rate of Interest = 10%
Inflation Rate = 5%
Calculate Nominal Rate of Interest
Example – 62
Real Rate of Interest = 8% p.a.
Inflation Rate = 6% p.a.
Nominal Rate =?
Example – 63
Nominal Rate of Interest = 15.5%
Inflation rate = 5%
Real Rate of Interest =?
International Fisher Effect:-
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%
Inflation Rate 8% 5% [PPP]
Nominal Rate 11.24% 8.15% [IRP]
SR = ₹/$ = ₹70
Calculate:
(i) FR as per Interest Rate Parity.
(ii) FR as per Purchasing Power Parity.
(6) FOREIGN CURRENCY EXPOSURES
We will discuss three types of currency exposure in forex.
1. Transaction Exposure
2. Translation Exposure or Accounting Exposure
3. Economic Exposure or Operating Exposure
(1) Transaction Exposure
(i) It is direct exposure.
(ii) It is faced by firm having foreign currency payables or receivables.
(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.
(iv) Transaction exposure can be hedged.
(2) Translation Exposure or Accounting Exposure
(i) It is notional exposure.
(ii) It is faced by firm having foreign branch or foreign subsidiary.
(iii) Whenever parent company prepares financial statement with foreign

subsidiary then financial statement of foreign subsidiary shall be
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.
(iv) Translation exposure need not to be hedged.
(3) Economic Exposure or Operating Exposure
(i) It is indirect exposure.
(ii) It is faced by all firm whether foreign currency payable/receivable or not.
(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.
(iv) Economic exposure can’t be hedged.
Techniques of Hedging of Translation Exposure Techniques
Internal Hedging External Hedging
1. Leading & Laggings 1. Forward Contract
2. Invoicing 2. Money Market Cover
3. Netting 3. Currency Future
4. Outsourcing or Matching 4. Currency Option
INTERNAL HEDGING
1. Leading & Laggings:- Leading means immediate payment & Laggings

means delay payment.
(i) Lead the payable if foreign currency will appreciate.
(ii) Lag the payable if foreign currency will depreciate.
(iii) Lead the receivable if foreign currency will depreciate.
(iv) Lag the receivable if foreign currency will appreciate.
Example – 65
Ram purchased goods from USA
Payable = $ 1,00,000 After 3 months
SR ₹/$ = 70/71
3 month FR ₹/$ = 72/73
Cash discount = 1% of immediate payment
₹ Loan = 14% p.a.
Which option is better
(i) Forward cover.
(ii) Leading.
Example – 66
Ram purchased goods from USA
Payable = $ 1,00,000
SR ₹/$ = ₹ 70/71
6 months FR ₹/$ = ₹ 68/69
₹ Loan = 10% p.a.
(i) Pay immediately without any interest.
(ii) Pay after 6 months @ 12% p.a.
2. Invoicing:- Whenever we import or export in foreign countries then try to

payment or receive payment in home currency i.e. Invoicing should be in home
currency.
If we invoicing in home currency then transaction exposures can be avoided

but economic exposure can’t be avoided.
Example – 67
We export to USA & export proceeds $ 1,00,000 after 6 months. We can hedged
with the help of following two alternatives.
(i) Invoicing in home currency at current Exchange rate
(ii) Forward cover
SR ₹/$ = ₹ 70/₹ 72
6 months FR ₹/$ = ₹ 68/₹ 70
Which option is better?
3. Netting:- If we have to pay foreign currency in future & receivable same

foreign currency at same time then we should not settle separately. Only net
amount should be settled & reduced Bid-Ask spreads.
Example – 68
Payable = $ 3,00,000
Receivable = $ 2,00,000
Exchange Rate (3 months FR)
₹/$ = 70.50/71.75
Calculate cash flows at the end of 3rd month
(i) Without Netting.
(ii) With Netting.
4. Outsourcing or Matching:- If we export to USA & receivable & then we

afraid of $ falling. In this situation we should create $ payable at same time by
outsourcing raw material or borrowing from US. On maturity net balance can
be hedged.
EXTERNAL HEDGING OR TRANSACTION EXPOSURE
1. Forward Contract:- In forward contract, we can buy or sell foreign currency

at contracted rate in future. It means, we are sure that how much domestic
currency required to buy foreign currency in future.
2. Money Market Cover of Money Market Hedged:-
(i) Money Market Cover For Importer
Example – 69
Import from USA & $ 1,03,000 payable after 3 months.
Interest Rate
India = 15%/16%
USA = 12%/13%
SR ₹/$ = 70/71
3 months FR ₹/$ = 72/73
(i) Money market cover.
(ii) Forward cover
(ii) Money Market Cover for Exporter
Example – 70
Export to USA & $ 1,06,000 receivable after 6 months
Interest Rate
India = 8%/10%
USA = 10%/12%
SR ₹/$ = 70/71
6 months FR ₹/$ = 68/69
(i) Money market cover.
(ii) Forward cover.
3. Currency Future:-
 Currency future means future contract on currency.

 If we afraid from exchange rate rising, take long position.
 If we afraid from exchange rate falling, take short position.
Example – 71
$ Payable = $ 1,00,000 After 3 months
SR ₹/$ = 60
3 months FR ₹/$ = 61.50
Currency future
3 months future rate ₹/$ = 61
On settlement date ₹/$ in forward market is ₹ 62 & in future market is ₹ 63.
Calculate cash outflows.
(i) Currency future.
(ii) Forward contract.
Example – 72
$ Payables after 3 months = $ 1,00,000
SR ₹/$ = ₹70.50
1 months FR ₹/$ = ₹71.25
3 months FR ₹/$ = ₹72.75
Current future
Contract size = $ 9,000
1 months Future rate = ₹71.50
3 months Future rate = ₹71.75
1 month 3 months
Rate of Interest 8% p.a. 10% p.a.
Initial margin ₹ 15,000 ₹ 20,000
Per contract
On due date (Settlement Date) spot rate
₹/$ ₹ 73.00 & Currency future rate is ₹ 74.25 Which option is better ?
(i) Currency future
(ii) Forward Cover
Example – 73
$ Payables = $ 1,00,000 (3 Months)
SR $/₹ = 0.0142
1 months FR $/₹ = 0.0140
3 months FR $/₹ = 0.0137
Current future
1 month future rate $/₹ = 0.0142
3 months future rate$/₹ = 0.0138
Contract size = ₹ 6,52,000
1 month 3 months
Rate of Interest 8% p.a. 10% p.a.
Initial margin ₹1000 ₹1500
On settlement date, spot rate
$/₹ is 0.0137 & Currency future rate is 0.0132
Which option is better ?
(i) Currency future
(ii) Forward Cover
4. Currency Option:- There are two types of options.
(i) Call Option:-
 Right to buy currency.

 Expectation price of currency will rise.
 Advance premium
(ii) Put Option:-
 Right to sell currency.

 Expectation price f currency will fall.
 Advance premium.
Example – 74
[Type - A]
$ Payables = $1,00,000 in 3 months
SR ₹/$ = ₹70.50
3 months FR = ₹72.75
3 months currency option
Strike price = ₹ 70.25
Premium Call option = ₹ 0.45 per $
Put option = ₹ 0.20 per $
Price of $ on Maturity
Price Probability
70.10 0.3
71.50 0.2
72.25 0.5
(i) Currency option.
(ii) Forward contract.
Example – 75
[Type - B]
$ Payables = $ 100000
SR ₹/$ = ₹ 70.50/70.85
3 months FR = 72.50/72.75
Currency option
Contract size = $ 9000
Strike price = ₹ 71.00
Premium
Call = ₹ 0.60 per $
Put = ₹ 0.45 per $
(ii) Forward cover.
Example – 76
$ Receivables = $ 1,00,000 in 3 months
SR $/₹ = $ 0.0142/$ 0.0143
3 months FR $/₹ = $0.0146/$0.0147
Currency Option
Strike price $/₹ $0.0145
Contract size = ₹ 620000
Premium
Call = $ 0.0008 per ₹
Put = $ 0.0005 per ₹
(ii) Forward cover.
(7) CANCELLATION OF FORWARD CONTRACT

(1) Cancellation & Extension of Forward Contract.
(2) Provision of Overdue Forward Contract.
(3) Early Delivery.
(1) Cancellation & Extension of Forward Contract.
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.
Inter-bank (SR) ₹/$ = ₹ 72.00/72.25
Margin = 0.10%
Calculate cancellation charges.
Example – 78
Ram had entered into forward contract to sell $ 1,00,000 at ₹ 75.50 after 3
months on maturity, Contract cancelled.
Inter-bank rates (SR) ₹/$ = 72.50/72.25
Margin = 0.08%
Calculate amount payable to or recoverable from customer.
(I) Cancellation on Maturity
Selling Contract of Bank:-
Bank sells currency at FR & buys currency at SR of due date.
Buying Contract of Bank:-
Banks buys currency at FR & sells at SR of due date.
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
Selling contract of bank for $ 1,00,000 after 3 months @ 72.50 on 31/03/2022
Exchange rate on cancellation date: 31/01/2022
Inter-bank SR = ₹ 70.25/45
1 month swap = 20/25
2 months swap = 35/40 (31/03/2022)
3 months swap = 65/80
Margin = 0.10%
Calculate amount payable are recoverable from customer.
(II) Cancellation Before Maturity
Selling Contract Bank:-
Banks sell currency at original FR & Buy currency at FR of due date,

available on cancellation date.
Buying Contract of Bank:-
Banks buy currency at original FR & Sells currency at FR of due date

available on cancellation date.
Any difference between above rates is payable to or receivables from customers.
(III) Extension of Forward Contract
In extension of forward contract, original forward contract shall be cancelled &

New forward contract shall be made for new due date.
Example – 80
 Selling contract of bank @ ₹ 75.50 on maturity customer request to bank

for extension of forward contract for 1 month.
 Exchange rate on due date.
Inter-bank SR = 72.75/95
Contract size = $ 1,00,000
Margin = 0.08%
(i) Calculate extension charges.
(ii) New forward rate.
Example – 81
 Selling contract of bank of $ 1,00,000 at 3 months FR @ ₹ 74.75 due

date 31/03/2022
 Contract extend on 28/02/2022 for 3 months
Exchange Rate : 28/02/2022
Inter-bank rate SR = ₹ 72.50/80
Margin = 0.10%
(1) Calculate extension.
(2) Calculate New FR.
(2) Automatic Cancellation
Provisions of automatic cancellation by RBI
(i) The rules for settlement are:
 Contract is automatically cancelled either on the date customer comes or

on the 3rd day after due date whichever is earlier.
 Calculate less on cancellation.
(ii) Calculate swap loss.
(iii) Calculate net cash outflow for the bank on cancellation date and
calculate interest on cash outlay from cancellation date to due date.
(3) Early Delivery
(i) Old contract with the customer is not cancelled it is executed at the old
rate on the early delivery date.
(ii) Bank has to enter into a swap.
(iii) Swap gain/loss shall be transferred to/charged from the customer.
(iv) Calculate net inflow/outflow for the bank on the early delivery date.
Bank will pay/charge interest on that.
Compare old contractual rate with spot rate of the swap.
(8) FOREIGN CURRENCY A/C
There are three types of foreign currency A/c
(1) NOSTRO A/C
(2) VOSTRO A/C
(3) LORO A/C
(1) NOSTRO A/C
There are two statement are prepared in NOSTRO A/C
(i) Cash position (NOSTRO A/C)
(ii) Exchange position
Example – 82
(i) Amount credited in NOSTRO A/C = $ 1,00,000
(ii) Spot sell $ 20,000 or remitted by TT
(iii) Forward selling contract cancelled $ 10,000
(iv) Spot buy $ 8,000 or T.T. purchased $ 8,000
(v) Forward buy $ 2,000
(vi) Bills purchased $ 7,000
(vii) Draft issued $ 3,000
(viii) Draft cancelled $ 3,000
(1) BASICS
QUESTION – 01
Given:
US$ 1 = ¥ 107.31
£1 = US$ 1.26
A$ 1 = US$ 0.70
(i) Calculate the cross rate for Pound in Yen terms
(ii) Calculate the cross rate for Australian Dollar in Yen terms
(iii) Calculate the cross rate for Pounds in Australian Dollar terms
SOLUTION:-
(i) Calculation the cross rate for Pounds in Yen terms

1£ =?¥
US$1 = ¥ 107.31
£1 = US$ 1.26
¥ $ ¥
× =
$ £ £
¥
= 107.31 × 1.26
£
£1 = ¥ 135.21
(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$
Page 34
A$ 1 = ¥ 75.12
(iii) Calculation the cross rate for Pounds in Australian Dollar terms
₤1 = A$ ?
A$1 = US$ 0.70
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.
Find the return on investment in terms of home country currency if:
(i) USD is Flat.
(ii) USD appreciates during the year by 3%.
(iii) USD depreciates during the year by 3%.
(iv) Indian Rupee appreciates during the year by 5%.
(v) Will your answer differ if Mr. Mammen invests in the bond just before the
interest payable.
(RTP May – 2022 & Exam July - 2021)
SOLUTION:-
(i) If USD is flat
Page 35
Price at end −Price at begining +Interest

Return =
Price at begining
103−100 +3
=
100
3+3
= = 0.06 say 6%
100
(ii) If USD appreciates by 3%
(1 + 0.06)(1 + 0.03) − 1 = 1.06 × 1.03 – 1 = 0.0918 i.e. 9.18%
(iii) If USD depreciates by 3%
(1 + 0.06)(1 − 0.03) – 1 = 1.06 × 0.97 – 1 = 0.0282 i.e. 2.82%
(iv) If Indian Rupee is appreciated by 5%
(1 + 0.06)(1 − 0.05) – 1 = 1.06 × 0.95 – 1 = 0.007 i.e. 0.7%.
(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:
January 28, 2013 February 4, 2013

US$ 1 = ₹ 45.85/45.90 ₹ 45.91/45.97
GBP £ 1 = US$ 1.7840/1.7850 US$ 1.7765/1.7775
GBP £ 1 = SGD 3.1575/3.1590 SGD 3. 1380/3.1390
The Bank wishes to retain an exchange margin of 0.125%
Required:
How much does the customer stand to gain or lose due to the delay?
(Note: Calculate the rate in multiples of 0.0001)
(Study Material, PM & Exam November - 2011)
Page 36
SOLUTION:-
On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = ₹ 45.90
Pound 1 = US$ 1.7850
Pound 1 = SGD 3.1575
₹ 45.90 ∗ 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = ₹ 25.9482
Add: Exchange margin (0.125%) ₹ 0.0324
₹ 25.9806
On February 4, 2013 the rates are
US $ = ₹ 45.97
Pound 1 = US$ 1.7775
Pound 1 = SGD 3.1380
₹ 45.90 ∗ 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ₹ 26.0394
Add: Exchange margin (0.125%) ₹ 0.0325
₹ 26.0719
Hence, loss to the importer
= SGD 25,00,000 (₹ 26.0719 – ₹ 25.9806) = ₹ 2,28,250
Page 37
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
Bombay $ /₹ 100: 3.15-3.10 3.12-3.07
London $/1 pound: 1.7250/60 1.7175/85
DG / pound: 3.9575/ 90 3.9380/90
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
Page 38
DG/£ = 3.9380/3.9390
₹/DG = ?
Buy $ and sell ₹, Sell $ and buy £, Sell £ and buy DG
₹ $ £
= × ×
$ £ DG
1 1
= × 1.7185 ×
0.0307 3.9380
DG 1 = ₹ 14.21 + 0.125%
= ₹ 14.23
Loss due to the delay = (₹ 14.23 – 14.09) × DG 2,50,000
= ₹ 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.
(Study Material, PM & Exam May – 2012)
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.
Price at end − Price at begining ) + Interest

Return =
Price at begining
5250 − 5000 + 350

=
5000
250 + 350
= = 0.12 say 12%
5000
Page 39
(i) For US investor the return shall be 12% and there will be no impact of
appreciation in $.
(ii) If $ appreciate by 2% then return for non-US investor shall be:
(1 + 0.12) (1 + 0.02) – 1 = 1.12 × 1.02 − 1 = 0.1424 i.e. 14.24%
(2) SPOT MARKET
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:-
$/DM = $ 0.40 (New York)
$/£ = $ 1.80 (New York)
(i) Price of £ in Germany
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.
Gain = 4.50 – 4.40 = DM 0.10 per £
QUESTION – 07
Followings are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
Page 40
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.
(Study Material & PM)
SOLUTION:-
The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy ₹ from USD 10,000,000 At Mumbai
48.30 × 10,000,000 = ₹ 483,000,000
(ii) Convert these ₹ to GBP at London
₹ 483,000,000
= GBP 6,230,650.155
₹ 77.52
(iii) Convert GBP to USD at New York
GBP 6,230,650.155 × 1.6231 = USD 10,112,968.26
There is net gain of USD 10,112,968.26 less USD 10,000,000 i.e.
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
Is there an opportunity of gain from these quotes?
(Exam November – 2020)
SOLUTION:-
The arbitrageur can proceed as started below to realize arbitrage gains.
Page 41
(i) Buy € from US$ 10,000 from Dealer A
(10,000/1.1539) = € 8,666.26
(ii) Convert these € to £ by selling to Dealer B
(€ 8,666.26 × 0.9094) = £ 7,881.09
(iii) Convert £ to US$ by selling to Dealer C
(£ 7,881.09 × 1.2752) = US$ 10,049.97
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:
USD/INR 59.25/59.35 in Mumbai
GBP/INR 102.50/103.00 in London
GBP/USD 1.70/1.72 in New York
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:-
The arbitrageur can proceed as stated below to realize arbitrage gains;
(i) Acquired USD by selling INR at Mumbai
USD/INR 59.35
Add: Exchange Margin @ 0.125% 0.07
59.42
59,44,83,064
Accordingly, USD acquired in exchange of INR is USD
59.42
1,00,04,763
Net gain (USD 1,00,04,763 – USD 1,00,00,000) USD 4,763
Page 42
(ii) Sell these GBP at London market and get INR
GBP/INR 102.50
Less: Exchange Margin @ 0.125% 0.13
102.37
INR on conversion of GBP (58,07,200 × 102.37) INR 59,44,83,064
(iii) Buy GBP at New York for USD, USD 1,00,00,000
GBP/USD 1.72
Add: Exchange Margin @ 0.125% 0.002
1.722
Accordingly, GBP acquired in exchange of USD 1,00,00,000 is GBP

58,07,200
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?
(b) Is there a possibility of arbitrage?
(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.
Page 43
(c) Let us how arbitrage profit can be made.
(i) Convert US$ 1,000 into JPY by buying from

Hong Kong Bank JPY 1,07,530
Sell these JPY to Citi Bank at JPY/USD 106.50

and convert in US$ US$ 1,009.67
Thus, arbitrage gain

(US$ 1,009.67 – US$ 1,000.00) US$ 9.67
(ii) Convert JPY 1,00,000 into USD by buying from

Citi Bank at JPY/USD 106.50 US$ 938.97
Sell these US$ to Hong Kong Bank at

JPY/USD 107.53 and convert in US$ JPY 1,00,967.44
Thus, arbitrage gain

(JPY 1,00,967.44 – JPY 1,00,000) JPY 967.44
(3) FORWARD CONTRACT
QUESTION – 11
The following 2-way quotes appear in the foreign exchange market:
Spot 2-months forward
RS/US $ ₹ 46.00/₹ 46.25 ₹ 47.00/₹ 47.50
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:-
Page 44
(i) US $ required to get ₹ 25 lakhs after 2 months at the Rate of ₹ 47/$
₹ 25,00,000
= US $ 53191.489
₹ 47
(ii) ₹ required to get US$ 2,00,000 now at the rate of ₹ 46.25/$
∴ US $ 200,000 × ₹ 46.25 = ₹ 92,50,000
(iii) Encasing US$ 69000 New Vs 2 month later
Proceed it we can encase in open mkt $ 69000 × ₹ 46 = ₹ 31,74,000
Opportunity gain
10 2
= 31,34,000 × × ₹ 52,900
100 12
Likely sum at end of 2 months 32,26,900
Proceeds if we can encase by forward rate :
$ 69000 × ₹ 47.00 32,43,000
It is better to encase the proceeds after 2 months and get opportunity

gain.
QUESTION – 12
In March, 2009, the Multinational Industries make the following assessment of

dollar rates per British pound to prevail as on 1.9.2009:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 01/09/2009?
(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?
Page 45
SOLUTION:-
(i) Calculation of expected spot rate for September, 2009:
$ for £ Probability Expected $/£

(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38
2.00 0.20 0.40
1.00 EV = 1.81
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
JKL Ltd., an Indian company has an export exposure of JPY 10,000,000

receivable August 31, 2014. Japanese Yen (JPY) is not directly quoted against
Indian Rupee.
The current spot rates are:
INR/US $ = ₹ 62.22
JPY/US$ = JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee
to depreciate against US $ to ₹ 65.
Forward rates for August 2014 are
INR/US $ = ₹ 66.50
Required:
(i) Calculate the expected loss, if the hedging is not done. How the position
will change, if the firm takes forward cover?
Page 46
(ii) If the spot rates on August 31, 2014 are:
INR/US $ = ₹ 66.25
Is the decision to take forward cover justified?
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
Spot rate on date of export 1 ¥ = ₹ 0.6080
Expected Rate of ¥ for August 2014 = ₹ 0.5242 (₹ 65/¥124)
Forward Rate of ¥ for August 2014 = ₹ 0.6026 (₹ 66.50/¥110.35)
(i) Calculation of expected loss without hedging
Value of export at the time of export

(₹ 0.6080 × ¥ 10,000,000) ₹ 60,80,000
Estimated payment to be received on Aug. 2014

(₹ 0.5242 × ¥ 10,000,000) ₹ 52,42,000
Loss ₹ 8,38,000
Hedging of loss under Forward Cover
₹ Value of export at the time of export

(₹ 0.6080 × ¥ 10,000,000) ₹ 60,80,000
Payment to be received under Forward Cover

(₹ 0.6026 × ¥ 10,000,000) ₹ 60,26,000
Loss ₹ 54,000
By taking forward cover loss is reduced to ₹ 54,000.
Page 47
(ii) Actual Rate of ¥ on August 2014 = ₹ 0.5977 (₹ 66.25/¥ 110.85)
Value of export at the time of export

(₹ 0.6080 × ¥ 10,000,000) ₹ 60,80,000
Estimated payment to be received on Aug. 2014

(₹ 0.5977 × ¥ 10,000,000) ₹ 59,77,000
Loss ₹ 1,03.000
The decision to take forward cover is still justified.
QUESTION – 14
A company operating in Japan has today effected sales to an Indian company,

the payment being due 3 months from the date of invoice. The invoice amount
is 108 lakhs yen. At today's spot rate, it is equivalent to ₹ 30 lakhs. It is
anticipated that the exchange rate will decline by 10% over the 3 months
period and in order to protect the yen payments, the importer proposes to take
appropriate action in the foreign exchange market. The 3 months forward rate
is presently quoted as 3.3 yen per rupee. You are required to calculate the
expected loss and to show how it can be hedged by a forward contract.
SOLUTION:-
Spot rate of ₹ 1 against yen = 108 lakhs Yen/₹ 30 lakhs = 3.6. Yen
3 month forward rate of Re. 1 against yen = 3.3 Yen
Anticipated decline in Exchange rate = 10%.
Expected spot rate after 3 month = 3.6 Yen – 10% of 3.6
= 3.6 Yen – 0.36 Yen
= 3.24 Yen per Rupee
₹ (in lakhs)
Present cost of 108 lakhs Yen 30.00
Cost after 3 month: 108 lakhs Yen/3.24 Yen 33.33
Expected exchange loss 3.33
Page 48
If the expected exchange rate risk is hedged by a forward contract:
Present cost 30.00
Cost after 3 months if forward contract is taken
108 lakhs Yen /3.3 Yen 32.73
Expected loss 2.73
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
A Japanese Company effected sales to X Ltd., an Indian Company, the payment

being due after 3 months. The invoice amount is JPY 216 lakhs, at today’s spot
rate it is equalent to ₹ 50 lakhs. It is anticipated that exchange rate will decline
by 8% over the 3 months period and in order to protect the JPY payments, the
importer proposes to take appropriate action in the foreign exchange market.
The 3 months forward rate is presently quoted as JPY 4.12 per rupee.
You are required to calculate the expected loss and show how it can be hedged
by a forward contract
(Exam December – 2021)
SOLUTION:-
Spot rate of ₹ 1 against Yen = JPY 216 lakhs/₹ 50 lakhs = JPY 4.32
3 months forward rate of Re. 1 against JPY = JPY 4.12
Anticipated decline in Exchange rate = 8%.
Expected spot rate after 3 months = JPY 4.32 – 8% of 4.32
= JPY 4.32 – JPY 0.35
= JPY 3.97 per rupee
Page 49
₹ (in lakhs)
Present cost of JPY 216 lakhs 50.00
Cost after 3 months: JPY 216 lakhs/JPY 3.97 54.41
₹ (in lakhs)
Cost after 3 months if forward contract is

taken JPY 216 lakhs/JPY 4.12 52.43
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.
(i) The expected loss to the importer and
(ii) Impact of hedging by a forward contract.
SOLUTION:-
Spot rate of ₹ 1 against Yen = JPY 74 lakhs/₹ 50 lakhs = JPY 1.48
3 months forward rate of Re. 1 against JPY = JPY 1.44
Anticipated decline in Exchange rate = 10%
Page 50
Expected spot rate after 3 months = JPY 1.48 – 10% of 1.48
= JPY 1.48 – JPY 0.15
= JPY 1.33 per rupee
₹ (in lakhs)
Cost after 3 months: JPY 74 lakhs/JPY 1.33 55.64
₹ (in lakhs)
Present cost 50.00
Cost after 3 months if forward contract is

taken JPY 74 lakhs/JPY 1.44 51.39
Expected loss 1.39
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
A company is considering hedging its foreign exchange risk. It has made a

purchase on 1st July, 2016 for which it has to make a payment of US$ 60,000
on December 31, 2016. The present exchange rate is 1 US $ = ₹ 65. It can
purchase forward 1 $ at ₹ 64. The company will have to make an upfront
premium @ 2% of the forward amount purchased. The cost of funds to the
company is 12% per annum.
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 $.
Page 51
(iv) ₹ 65 per US $.
(Study Material, PM & Exam November – 2016)
SOLUTION:-
(₹)
Present Exchange Rate ₹ 65 = 1 US$
If company purchases US$ 60,000 forward premium is 76,800

60000 × 64 × 2%
4,608
Interest on ₹ 76,800 for 6 months at 12%
81,408
Total hedging cost
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
Page 52
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 $
Note: Calculation to be done on monthly basis.
(Exam December – 2021)
SOLUTION:
(₹)
Present Exchange Rate ₹ 73 = 1 US$
If company purchase US$ 1,00,000 forward premium is
1,00,000 × 74 × 1% 74,000
Interest on ₹ 74,000 for 6 months at 10% 3,700
Total hedging cost 77,700
If exchange rate is ₹ 76
The gain (₹ 76 − ₹ 74) for US$ 1,00,000 2,00,000
Less: Hedging Cost 77,700
Net gain 1,22,300
If US$ = ₹ 170
Then loss (₹ 70 − ₹ 74) for US$ 1,00,000 4,00,000
Page 53
Add: Hedging Cost 77,700
Total Loss 4,77,700
If US$ = ₹ 79
Then Gain (₹ 79 − ₹ 74) for US$ 1,00,000 5,00,000
Less: Hedging Cost 77,700
Total Gain 4,22,300
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:
Exchange Rate Probability
(i) INR/USD 77 0.15
(ii) INR/USD 71 0.25
(iii) INR/USD 79 0.20
(iv) INR/USD 74 0.40
You are required to advise the company for a suitable cover for risk.
SOLUTION:-
(i) If ZX Ltd. does not take forward (Unhedged Position):
Expected Rate
= ₹ 77 × 0.15 + ₹ 71 × 0.25 + ₹ 79 × 0.20 + ₹ 74 × 0.40
Page 54
= ₹ 11.55 + ₹ 17.75 + ₹ 15.80 + ₹ 29.60
= ₹ 74.70
Expected amount payable = USD 80,000 × ₹ 74.70
= ₹ 59,76,000
(ii) If the ZX Ltd. hedge its position in the forward market:
Particulars Amount (₹)
If company purchase US$ 80,000 forward premium 59,200

is (80,000 × 74 × 1%)
Interest on ₹ 59,200 for 6 months at 10% 2,960
Total hedging cost (a) 62,160
Amount to be paid for US$ 80,000 @ ₹ 74.00 (b) 59,20,000
Total Cost (a) + (b) 59,82,160
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:-
(i) Rate of discount quoted by the bank
(75.20−75.60)×365×100
= 3.22%
75.60×60
Page 55
(ii) Probable loss of operating profit:
(75.20 – 75.50) × 5,00,000 = ₹ 1,50,000
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:
(i) Rate of discount quoted by the Bank
(ii) The probable loss of operating profit if the forward sale is agreed to.
SOLUTION:-
(i) Rate of discount quoted by the bank
(45.20−45.60)×365×100
= = 5.33%
45.60×60
(ii) Probable loss of operating profit:
(45.20 – 45.50) × 1,00,000 = ₹ 30,000
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:
Spot USD 1 ₹ 48.5275
6 months forward ₹ 48.4575
(i) What would be their total commitment in Rupees, if they enter into a
forward contract?
Page 56
(ii) Will you advise them to do so? Explain giving reasons.
SOLUTION:-
Firstly, the interest is calculated at 3% p.a. for 6 months. That is:
USD 20,00,000 × 3/100 × 6/12 = USD 30,000
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.
(i) The value of the total commitment in Indian rupees is calculated as

below:
Principal Amount of loan USD 20,00,000
Add: Interest USD 30,000
Amount due USD 20,30,000
Spot rate ₹ 48.5275
Forward Points (6 months) (–) 0.0700
Forward Rate ₹ 48.4575
Value of Commitment ₹ 9,83,68,725
(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.
Page 57
QUESTION – 23
Following information relates to AKC Ltd. which manufactures some parts of

an electronics device which are exported to USA, Japan and Europe on 90 days
credit terms.
Cost and Sales information:
Japan USA Europe

Variable cost per unit ₹225 ₹395 ₹510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in 90 Yen 78,00,000 US$1,02,300 Euro 95,920
days
Foreign exchange rate information:
Yen/₹ US$/₹ Euro/₹

Spot market 2.417-2.437 0.0214-0.0217 0.0177-0.0180
3 months forward 2.397-2.427 0.0213-0.0216 0.0176-0.0178
3 months spot 2.423-2.459 0.02144-0.02156 0.0177-0.0179
Advise AKC Ltd. by calculating average contribution to sales ratio whether it

should hedge its foreign currency risk or not.
(Study Material, PM & Exam Nov – 2019)
SOLUTION:-
If foreign exchange risk is hedged
Total (₹)
Sum due Yen 78,00,000 US$1,02,300 Euro 95,920
Unit input price Yen 650 US$10.23 Euro 11.99
Unit sold 12000 10000 8000
Variable cost per unit ₹ 225/- ₹395/ ₹ 510/-
Variable cost ₹ 27,00,000 ₹ 39,50,000 ₹ 40,80,000 ₹ 1,07,30,000
Three months forward 2.427 0.0216 0.0178

rate for selling
Rupee value of ₹32,13,844 ₹ 47,36,111 ₹ 53,88,764 ₹ 1,33,38,719
Page 58
receipts
Contribution ₹ 5,13,844 ₹ 7,86,111 ₹ 13,08,764 ₹ 26,08,719
Average contribution 19.56%

to sale ratio
If risk is not hedged
Rupee value of receipt ₹ 31,72,021 ₹ 47,44,898 ₹ 53,58,659 ₹ 1,32,75,578
Total contribution ₹ 25,45,578
Average contribution 19.17%

to sale ratio
AKC Ltd. Is advised to hedge its foreign currency exchange risk.
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
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50

3 Months 25/20
6 Months 35/25
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?
Page 59
SOLUTION:-
(i) To Buy 1 Million GBP Spot against CHF
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
By applying chain rule Buying rate would be
1 GBP = 1.7650 × 1.4655 CHF
1 GBP = CHF 2.5866
Amount payable CHF 2.5866 Million or CHF 25,86,600
(ii) Spot rate Bid rate GBP 1 = CHF 1.4650 × 1.7645
= CHF 2.5850
Offer rate GBP 1 = CHF 1.4655 × 1.7660
= CHF 2.5881
GBP / USD 3 months swap points are at discount
Outright 3 Months forward rate GBP 1 = USD 1.7620 / 1.7640
USD / CHF 3 months swap points are at premium
Outright 3 Months forward rate USD 1 = CHF 1.4655 / 1.4665
Hence
Outright 3 Months forward rate GBP 1 = CHF 2.5822 / 2.5869
Spot rate GBP 1 = CHF 2.5850 / 2.5881
Therefore 3-month swap points are at discount of 28/12.
QUESTION – 25
An importer customer of your bank wishes to book a forward contract with

your bank on 3rd September for sale to him of SGD 5,00,000 to be delivered on
30th October.
Page 60
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
Calculate the rate to be quoted to the importer by assuming an exchange

margin of 5 paisa.
SOLUTION:-
USD/₹ on 3rd September 49.3800

Swap Point for October 0.1300
49.5100
Add: Exchange Margin 0.0500
49.5600
USD/SGD on 3rd September 1.7058
Swap Point for 2nd month forward 0.0096
1.7154
Cross Rate for SGD/₹ of 30th October
USD/₹ selling rate = ₹ 49.5600
SGD/₹ buying rate = SGD 1.7154
SGD/₹ cross rate = ₹ 49.5600/1.7154 = ₹ 28.8912
QUESTION – 26
In International Monetary Market an international forward bid for December,

15 on pound sterling is $ 1.2816 at the same time that the price of IMM
sterling future for delivery on December, 15 is $ 1.2806. The contract size of
pound sterling is £ 62,500. How could the dealer use arbitrage in profit from
this situation and how much profit is earned?
(Study Material)
Page 61
SOLUTION:-
Buy £ 62500 × 1.2806 = $ 80037.50
Sell £ 62500 × 1.2816 = $ 80100.00
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/£.
Assume that you would like to buy or sell £1,000,000.
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.
Your expected profit will be: £1,000,000 × ($1.32 − $1.30) = $20,000
(ii) If the spot exchange rate turns out to be $1.26/£ in three months, your
loss from the long position in Forward Market will be: -
£ 1,000,000 × ($ 1.26 − $1.30) = $ 40,000
Page 62
QUESTION – 28
On April 3, 2016, a Bank quotes the following:
Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months’ swap points 70 90
3 months’ swap points 160 186
In a spot transaction, delivery is made after two days.
Assume spot date as April 5, 2016.
Assume 1 swap point = 0.0001,
(i) Ascertain swap points for 2 months and 15 days. (For June 20, 2016),
(ii) Determine foreign exchange rate for June 20, 2016, and
(iii) Compute the annual rate of premium/discount of US$ on INR, on an

average rate.
SOLUTION:-
(i) Swap Points for 2 month and 15 days
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
(ii) Foreign Exchange Rate for 20th June 2016
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
Page 63
(iii) Annual Rate of Premium
Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rate 66.2640 67.6083

for 20th June 2016 (b)
Premium (c) 0.0115

0.0138
Total (d) = (a) + (b)
132.5165 135.2028
Average (d)/2
66.2583 67.6014
0.0115 12 0.0138 12
Premium × × 100 × × 100
66.2583 2.5 67.6014 2.5
= 0.0833% = 0.0980%
(4) COVER DEAL
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
US$ 1 = H.K.$ 7.5880 7.5920
Local inter bank market rates for US$ were
Spot US$ 1 = ₹ 42.70 42.85
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.
Page 64
Rupee – Dollar selling rate = ₹ 42.85
Dollar – Hong Kong Dollar = HK $ 7.5880
Rupee – Hong Kong cross rate = ₹ 42.85 / 7.5880
= ₹ 5.6471
Profit / Loss to the Bank
Amount received from customer (1 crore × 5.70) ₹ 5,70,00,000
Amount paid on cover deal (1 crore × 5.6471) ₹ 5,64,71,000
Profit to Bank ₹ 5,29,000
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;
US$ = HK$ 7.9250 7.9290
Local inter-bank market rates for US$ were
Spot US$ 1 = ₹ 55.00 55.20
You are required to calculate rate and ascertain the gain or loss in the
transaction. Ignore brokerage.
You have to show the calculations for exchange rate up to four decimal points.
(Exam May – 2013)
SOLUTION:-
The bank (Dealer) covered itself by buying from the London market at market
selling rate.
Rupee – US Dollar selling rate = ₹ 55.20
US Dollar – Hong Kong Dollar = HK $ 7.9250
Rupee – Hong Kong cross rate (₹ 55.20 / 7.9250) = ₹ 6.9653
Gain / Loss to the Bank
Page 65
Amount received from customer (HK$ 40,00,000) × ₹ 7.15 ₹ 2,86,00,000

Amount paid on cover deal (HK$ 40,00,000 × ₹ 6.9653) ₹ 2,78,61,200
Gain to Bank ₹ 7,38,800
Alternative Calculation
Gain to bank = 40,00,000 (₹ 7.15 – ₹ 6.9653) = ₹ 7,38,800
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.
Figures are to be rounded off to 4 decimals.
SOLUTION:-
The bank (Dealer) covers itself by buying from the market at market selling
rate.
Dollar – Hong Kong Dollar = HK $ 7.7506
Rupee – Hong Kong cross rate = ₹ 74.85/7.7506
Cover Rate = ₹ 9.6573
Profit/Loss to the Bank
Amount received from customer (10 crore × 9.70) ₹ 97,00,00,000
Amount paid on cover deal (10 crore × 9.6573) ₹ 96,57,30,000
Profit to Bank ₹ 42,70,000
Page 66
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:
Mumbai – London ₹ 74.3000 ₹ 74.3200

Mumbai – New York ₹ 49.2500 ₹ 49.2625
London – Copenhagen DKK 11.4200 DKK 11.4350
New York – Copenhagen DKK 07.5670 DKK 07.5840
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:-
Amount realized on selling Danish Kroner 10,00,000 at ₹ 6.5150 per Kroner = ₹

65,15,000.
Cover at London:
Bank buys Danish Kroner at London at the market selling rate.
Pound sterling required for the purchase
(DKK 10,00,000 ÷ DKK 11.4200) = GBP 87,565.67
Bank buys locally GBP 87,565.67 for the above purchase at the market selling
rate of ₹ 74.3200.
The rupee cost will be = ₹ 65,07,88
Profit (₹ 65,15,000 − ₹ 65,07,881) = ₹ 7,119
Cover at New York:
Bank buys Kroners at New York at the market selling rate.
Dollars required for the purchase of Danish Kroner
(DKK10,00,000 ÷ 7.5670) = USD 1,32,152.77
Page 67
Bank buys locally USD 1,32,152.77 for the above purchase at the market
selling rate of ₹ 49.2625.
The rupee cost will be = ₹ 65,10,176.
Profit (₹ 65,15,000 − ₹ 65,10,176) = ₹ 4,824
The transaction would be covered through London which gets the

maximum profit of ₹ 7,119 or lower cover cost at London Market by
(₹ 65,10,176 − ₹ 65,07,881) = ₹ 2,295
(5) EXCHANGE RATE DETERMINATION
(I) INTEREST RATE PARITY
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:-
As per interest rate parity
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$
Page 68
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:
3 Months 6 Months 1 Year

Dollar interest rate
(annually compounded) 11 ½ % 12 ¼ % ?
Franc interest rate
(annually compounded) 19 ½ % ? 20%
Forward Franc per Dollar ? ? 7.5200
Forward discount per Franc
percent per year ? 6.3%
(Practice Manual)
Page 69
SOLUTION:-
Computation of Missing Entries in the Table: For computing the missing

entries in the table we will use Interest Rates Parity (IRP) theorem. This
theorem states that the exchange rate of two countries will be affected by their
interest rate differential. In other words, the currency of one country with a
lower interest rate should be at a forward premium in terms of currency of
country with higher interest rates and vice versa. This implies that the
exchange rate (forward and spot) differential will be equal to the interest rate
differential between the two countries i.e.
Interest rate differential = Exchange rate differential
(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
= Franc 7.19 per US Dollar
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:
Page 70
Spot per Franc Rate = 1/7.05 = US Dollar 0.142 per Franc
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
Forward discount on Franc % per year = − 6.3% or – 3.5% for 6 months
Hence 6 months forward rate = 7.05/(100% − 3.15%)
Forward Francs per Dollar = 7.28 Francs
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
Franc interest rate = 20% (annually compounded)
Forward Franc per Dollar = 7.5200
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
= 1.125 – 1 = 0.125 or 12.5%
The completed table will be as follows:
3 Months 6 Months 1 Year

Dollar interest rate
(annually compounded) 11 ½% 12 ¼% 12.50%
Page 71
Franc interest rate

(annually compounded) 19 ½% 19.17% 20%
Forward Franc per Dollar 7.19 7.28 7.5200
Forward discount per Franc
Percent per year 8% or 7.04% 6.3%
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%.
(i) Do you expect that US dollar will be at a premium or at discount in the

Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in India?
and
(iii) What will be the rate of forward premium or discount?
SOLUTION:-
(i) Under the given circumstance, the USD is expected to quote at a

premium in India as the interest rate is higher in India.
(ii) Calculation of the forward rate:
1+R h F1
=
1+R f E0
Where: Rh is home currency interest rate, Rf is foreign currency interest

rate, F1 is end of the period forward rate, and E0 is the spot rate.
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
Page 72
58.275
Or, = F1
1.02
Or, F1 = ₹ 57.13
(iii) Rate of premium:
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%.
(i) Do you expect that US dollar will be at a premium or at discount in the

Indian Forex Market?
(ii) What will be the expected 3 – months forward rate for US dollar in India?
(iii) What will be the rate of forward premium of discount?
SOLUTION:-
(i) Under the given circumstance, the USD is expected to quote at a

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
Page 73
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/$.
Then:
(i) Will US$ be at a premium or at a discount in the Indian forward market?
(ii) Find out the expected 6-months forward rate for US$ in India.
(iii) Find out the rate of forward premium/discount.
SOLUTION:-
(i) Under the given circumstances, the USD is expected to quote at a

1+R h F1
=
1+R f E0

1+(0.09/2) F1
Therefore =
1+(0.02/2) 64.50
Page 74
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
(II) COVERED INTEREST ARBITRAGE
QUESTION – 39
Spot rate 1 US $ = ₹ 48.0123
180 days Forward rate for 1 US $ = ₹ 48.8190
Annualized interest rate for 6 months – Rupee = 12%
Annualized interest rate for 6 months – US $ = 8%
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage
of the situation, if he is willing to borrow ₹ 40,00,000 or US $83,312.
SOLUTION:-
Spot Rate = ₹ 40,00,000 /US$83,312 = 48.0123
Forward Premium on US$ = [(48.8190 – 48.0123)/48.0123] × 12/6 × 100
= 3.36%
Interest rate differential = 12% − 8% = 4%
Since the negative Interest rate differential is greater than forward premium
there is a possibility of arbitrage inflow into India.
Page 75
The advantage of this situation can be taken in the following manner:
1. Borrow US$ 83,312 for 6 months
Amount to be repaid after 6 months
= US $ 83,312 (1 + 0.08 × 6/12) = US$86,644.48
2. Convert US$ 83,312 into Rupee and get the principal i.e. ₹ 40,00,000
Interest on Investment for 6 months = ₹ 40,00,000 × 0.06
= ₹ 2,40,000/-
Total amount at the end of 6 months = ₹ (40,00,000 + 2,40,000)
= ₹ 42,40,000/-
Converting the same at the forward rate = ₹ 42,40,000/₹ 48.8190
= US$ 86,851.43
Hence the gain is US $ (86,851.43 – 86,644.48) = US$ 206.95 OR
₹ 10,103 i.e., ($206.95 × ₹ 48.8190)
QUESTION – 40
Given the following information:
Exchange rate – Canadian dollar 0.665 per DM (spot)
Canadian dollar 0.670 per DM (3 months)
Interest rates – DM 7% p.a.
Canadian Dollar – 9% p.a.
What operations would be carried out to take the possible arbitrage gains?
(Study Material, PM & Exam May - 2011)
SOLUTION:-
In this case, DM is at a premium against the Can$.
Premium = [(0.67 – 0.665)/0.665] × (12/3) × 100 = 3.01 per cent

Page 76
Interest rate differential = 9% − 7% = 2 per cent.
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.
The following operations are carried out:
(i) Borrow Can$ 1000 at 9 per cent for 3-months;
(ii) Change this sum into DM at the spot rate to obtain DM
= (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
Add: Interest @ 7% for 3 months = 26.32
Total 1530.08
(iv) Sell DM at 3-months forward to obtain Can$
= (1530.08 × 0.67) = 1025.15
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Add: Interest @9% for 3 months 22.50
Total 1022.50
Net arbitrage gain = 1025.15 – 1022.50 = Can$ 2.65
QUESTION – 41
Exchange rate – Canadian dollar 0.666 per DM (Spot)
Canadian dollar 0.0671 per DM (3 Months)
Interest rates – DM 7.5% p.a.
Page 77
Canadian Dollar – 9.5% p.a.
To take the possible arbitrage gains, what operation would be carried out?
(Exam May – 2016 & 2018)
SOLUTION:-
In this case, DM is at a premium against the Can$.
Premium = [(0.671 – 0.666) /0.666] × (12/3) × 100 = 3.00 per cent
Interest rate differential = 9.5% − 7.5% = 2 per cent.
profitable to place money in Deutschmarks the currency whose 3-months
interest is lower.
The following operations are carried out:
(i) Borrow Can$ 1000 at 9.5 per cent for 3- months;
(ii) Change this sum into DM at the spot rate to obtain DM
= (1000/0.666) = 1501.50
DM
Principal: 1501.50
Add: Interest @ 7.5% for 3 months = 28.15
Total 1529.65
(iv) Sell DM at 3-months forward to obtain Can$
= (1529.65 × 0.671) = 1026.40
(v) Refund the debt taken in Can$ with the interest due on it, i.e.,
Can$
Principal 1000.00
Add: Interest @ 9.5% for 3 months 23.75
Total 1023.75
Page 78
Net arbitrage gain = 1026.40 – 1023.75 = Can$ 2.65
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
Exchange rate – Canadian Dollar 0.666 per DM (Spot)
Canadian Dollar 0.671 per DM (3 Months)
Interest rates – DM 8% p.a.
Canadian Dollar 10% p.a.
What operations would be carried out to earn the possible arbitrage gains?
SOLUTION:-
In this case, DM is at a premium against the Canadian $ premium
= [(0.671 – 0.666) /0.666] × 12/3 × 100 = 3.00 %.
Whereas interest rate differential = 10% – 8% = 2%
profitable to place money in Deutsch Marks the currency whose 3 months
interest is lower.
The following operations are carried out:-
(i) Borrow CAN $ 1000 at 10% for 3 months,
(ii) Change this sum into DM at the Spot Rate to obtain DM
= (CAN $1000/0.666) = 1501.50
DM
A sum of DM –
Page 79
Principal DM1501.50
Add: interest @ 8% for 3 months DM 30.03
DM 1531.53
(iv) Sell DM at 3 months forward to obtain
DM 1531.53 × 0.671 = CAN $ 1027.66
(v) Refund the debt taken in CAN $ with the interest due on it, i.e.
Principal – CAN $ 1000.00
Add: interest @ 10% for 3 months CAN $ 25.00
Total CAN $ 1025.00
∴ Net arbitrage gain = CAN $ 1027.66 – CAN $ 1025.00 = CAN $ 2.66
QUESTION – 43
Spot rate 1 US$ = ₹ 68.50
USD premium on a six month forward in 3%. The annualized interest in US is

4% and 9% in India.
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:-
Spot Rate = ₹ 68.50
Forward Rate = ₹ 68.50 × 1.03 = ₹ 70.56
Forward Premium on US$ = 3.00% × 12/6 = 6.00%
Interest rate differential = 9% − 4% = 5%
Page 80
Since the Interest rate differential is less than forward premium there is a
possibility of arbitrage outflow from India.
The advantage of this situation can be taken in the following manner:
(i) Borrow equivalent amount of US$ 3000000 in India for 6 months at Spot
Rate
₹ 68.50 × US$ 3000000 = ₹ 20,55,00,000
Amount to be repaid after 6 months
= ₹ 20,55,00,000 (1 + 0.09 × 6/12) = ₹ 21,47,47,500
(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)
Converting the same at the forward rate
= US$ 30,60,000 × ₹ 70.56 = ₹ 21,59,13,600
Hence the gain is ₹ (21,59,13,600 – 21,47,47,500) = ₹ 11,66,100
or
₹ 11,66,100/ ₹ 70.56 = US$ 16,526
QUESTION – 44
Following are the rates quoted at Bombay for British pound:
BP/₹ 52.60/70 Interest Rates India London

3 Months forward 20/70 3 Months 8% 5%
6 Months forward 50/75 6 Months 10% 8%
Verify whether there is any scope for covered interest arbitrage if you borrow
rupees.
SOLUTION:-
Page 81
Particulars Option I (3 months) Option II (6 months)

Amount borrowed 1,00,000 1,00,000
Pound obtained by 1,00,000/52.70 = 1,00,000/52.70 =
converting at spot rate 1897.53 1897.53
Invest pound for the 1.25% 4%
period
Amount of pound 1897.53 × 1.0125 = 1897.53 × 1.0 =
received at the end of the 1,921.25 1,973.43
period
Convert pounds to ₹ at 1,921.25 × 52.80 = 1,973.43 × 53.10 =
forward rate 1,01,442 1,04,789
Amount of Re. Loan to be 1,00,000 × 1.02 = 1,00,000 × 1.05 =
repaid 1,02,000 1,05,000
As the amount of Re. Received is less than the amount repaid there is no scope
for covered interest arbitrage.
Page 82
(III) PURCHASING POWER PARITY
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.
(Study Material, PM & Exam May - 2010)
SOLUTION:-
End of Year ₹ ₹/USD

(1+0.08)
1 ₹ 46.00 × 47.77
(1+0.04)
(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.
(PM & Exam November – 2017)
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:
1 ₹ 46.00 × 1.04 47.84
Page 83
2 ₹ 47.84 × 1.04 49.75

3 ₹ 49.75 × 1.04 51.74
4 ₹ 51.74 × 1.04 53.81
Alternative Answer:
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
(IV) INTERNATION FISHER EFFECT
QUESTION – 47
A US investor chose to invest in Sensex for a period of one year. The relevant
information is given below.
Size of investment ($) 20,00,000

Spot rate 1 year ago (₹/$) 42.50/60
Spot rate now (₹/$) 43.85/90
Sensex 1 year ago 3,256
Sensex now 3,765
Inflation in US 5%
Inflation in India 9%
(i) Compute the nominal rate of return to the US investor.
(ii) Compute the real depreciation /appreciation of Rupee.
(iii) What should be the exchange rate if relevant purchasing power parity
holds good?
(iv) What will be the real return to an Indian investor in Sensex?
(RTP May – 2022 & January – 2021)
Page 84
SOLUTION:-
(i) Nominal rate of return to the US investor
Size of investment ($) 20,00,000
Size of investment (₹) ($ 20,00,000 × 42.50) 8,50,00,000
Sensex at To 3,256
No. of units of Sensex that can be purchased at To

(₹ 8,50,00,000/3,256) 26,105
Sensex at T1 3,765
Sale of Sensex (26,105 × 3,765) 9,82,85,325
US$ at T1 ₹ 43.90
Equivalent Amount in US$ 22,38,846
Gain in US$ [22,38,846 – 20,00,000] 2,38,846
Nominal rate to US investor 11.94%
(ii) Real Appreciation/Depreciation of Rupees
(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
(iii) Exchange rate if relevant purchasing power parity holds
(1+0.09)
Buying Rate = 42.50 = 42.12
(1+0.05)
(1+0.09)
Selling Rate = 42.60 = 44.22
(1+0.05)
Exchange Rate = 44.12/44.22
Page 85
(iv) Real return to Indian Investor in Sensex
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
Shoe Company sells to a wholesaler in Germany. The purchase price of a

shipment is 50,000 deutsche marks with term of 90 days. Upon payment, Shoe
Company will convert the DM to dollars. The present spot rate for DM per
dollar is 1.71, whereas the 90-day forward rate is 1.70.
You are required to calculate and explain:
(i) If Shoe Company were to hedge its foreign-exchange risk, what would it
do? What transactions are necessary?
(ii) Is the deutsche mark at a forward premium or at a forward discount?
(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.
Page 86
(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.
F DM /US $ −S DM /US $ 365

× = rDM − rUS $
S DM /US $ 90
1.70−1.71 365
Or, × = rDM − rUS $
1.71 90
Or, - 0.237 = 𝑟𝐷𝑀 − 𝑟𝑈𝑆$
Therefore, the differential in interest rate is -2.37%,which means if interest rate

parity holds, interest rate in the US should be 2.37 higher than in Germany.
QUESTION – 49
Your Company has to make o US $1 million payment in three months’ time.

The dollars are available now. You decide to invest them for three months and
you are given the following information:
(a) The US deposit rate is 8% per annum
(b) The sterling deposit rate is 10% per annum
(c) The spot exchange rate is $1.80/pound
(d) The three month forward rate is $1.78/pound.
(i) Where should your company invest for better results?
(ii) Assuming that the interest rates and the spot exchange rate
remain as above, what forward rate would yield an equilibrium
situation?
Page 87
(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:-
(i) Invest for better results
Since the US $ are available now, amount can be invested in
 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
Sr. Particulars Value

No.
1. Convert Dollars into Pounds at Spot Rate (US $
10,00,000 ÷ 1.80) £5,55,556
2. Invest £5,55,556 in Sterling Deposits at the rate of

10% p.a. for 3 months interest on £5,55,556 @ £13,889
10% for 3 months = £5,55,556 10%×3/12
3. Total Cash Inflow at the end of 3 months [(2)+(3)] £5,69,445
4. Amount earned in US $ = [(4) × 1.78 (Forward

Rate)] US $ 10,13,612
5. Gain in US $ [10,13,612-10,00,000] US $ 13,612
Gain in Alternative 1 is higher. Hence, company should invest in US Deposits.
Page 88
(ii) Equilibrium Forward Rate 3 Months Forward; (for 1 £)
= Spot Rate × [(1 + US Interest Rate for 3 months)/(1 + Sterling Interest

Rate for 3 months)]
= $ 1.8 × [(1 + 8%/4) / (1 +10%/4)]
= $ 1.7912/£ [Interest Rate Parity method]
Equilibrium 3 months forward rate = $ 1.7912/£
(iii) Investment if Sterling Deposit: Rate is 14%
Sr. Particulars Amount

No.
1. Amount invested in sterling deposit rate £5,55,556
2. Interest income @ 14% for 3 months £5,55,556 × £19,444

14% × 3/12
3. Total cash inflow at the end of 3 months [(2)+(3)] £5,75,000
4. Amount earned in US $ = [(4) × 1.78 (forward rate)] US $ 10,23,500
5. Gain in US $ [10,23,500 – 10,00,000] US $ 23,500
Conclusion: Gain is highest of all the considered alternatives, therefore

amount should be invested in sterling deposits @ 14%.
(iv) Equilibrium Sterling Deposit Rate Franc Interest Rate [6 Months] =

Assuming Sterling Interest Rate = x, applying the same in Interest Rate
Parity Formula for determining Forward Rate -
(1+US Rate for 3 Months )

£1 = Spot Rate ×
(1+Sterling Interest Rate for 3 Months )
1£ = $ 1.80 × (1 + 8%/4)/(1 + x/4)
1£ = $ 1.80 × (1 + 0.02)/(1 + x/4)
$1.78 = $ 1.80 × (1 + 0.02)/(1 + x/4)
1 + x/4 = $ 1.80 × 1.02/$ 1.78
Page 89
x/4 = 1.03146 − 1 = 0.03146 or 3.146%
x = 12.58%
Equilibrium Sterling Interest Rate = 12.58%
(6) CURRENCY EXPOSURE
(I) Leading & Laggings
QUESTION – 50
An Indian importer has to settle an import bill for $ 1,30,000. The exporter has
given the Indian exporter two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 percent per annum.
The importer's bank charges 15 percent per annum on overdrafts. The

exchange rates in the market are as follows:
Spot rate (₹ /$) : 48.35 /48.36
3-Months forward rate (₹/$) : 48.81 /48.83
The importer seeks your advice. Give your advice.
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,
Page 90
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)
Since outflow of cash is least in (ii) option, it should be opted for.
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
You are required to evaluate the following options:
(i) Pay the supplier in 60 days, or
(ii) Avail the supplier's offer of 90 days credit.
SOLUTION:-
(i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the ₹ 57.10

applicable forward rate for 1 USD
Payment Due USD 2,000,000
Page 91
Outflow in Rupees (USD 2000000 × ₹ 57.10) ₹ 114,200,000
Add: Interest on loan for 30 days @10% p.a. ₹ 9,51,667
Total Outflow in ₹ ₹ 11,51,51,667
(ii) Availing supplier’s offer or 90 days credit
Amount Payable USD 2,000,000
Add: Interest on credit period for 30 days @ 8% p.a. USD 13,333
Total Outflow in USD USD 2,013,333
Applicable forward rate for 1 USD ₹ 57.50

Total Outflow in ₹ (USD 2,013,333 × ₹ 57.50) ₹ 115,766,648
Alternative 1 is better as it entails lower cash outflow.
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:
Spot rate INR/US$ 62.50
60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45
Which one of the following options would be better?
(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier's offer of 90 days credit.
(Study Material, PM, MTP April – 2022 & Exam May - 2015)
SOLUTION:-
Page 92
(i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days the

applicable forward rate for 1 USD ₹ 63.15
Payment Due USD 1 crore
Outflow in Rupees (USD 1 crore × ₹ 63.15) ₹ 63.15 crore
Add: Interest on loan for 30 days @ 9.5% p.a. ₹ 0.50 crore
Total Outflow in ₹ ₹ 63.65 crore
(ii) Availing supplier’s offer of 90 days credit
Amount Payable USD 1.00000 crore
Add: Interest on credit period for 30 [email protected]% USD 0.00646 crore

p.a.
Total Outflow in USD USD 1.00646 crore
Applicable forward rate for 1 USD ₹ 63.45

Total Outflow in ₹ (USD 1.00646 crore × ₹ 63.45)
₹ 63.86 crore
Alternative 1 is better as it entails cash outflow.
QUESTION – 53
Gibralater Limited has imported 5000 bottles of shampoo at landed cost in

Mumbai, of US $ 20 each. The company has the choice for paying for the goods
immediately or in 3 months’ time. It has a clean overdraft limited where 14%
p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralter Limited.
(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.
Page 93
The rates are as follows:
Mumbai ₹ /$ spot : 60.25-60.55
3 months swap points : 35/25
SOLUTION:-
Option - I
$20 × 5000 = $ 1,00,000
Repayment in 3 months time = $1,00,000 × (1 + 0.10/4) = $ 1,02,500
3-months outright forward rate = ₹ 59.90/₹ 60.30
Repayment obligation in ₹ ($1,02,500 × ₹ 60.30) = ₹ 61,80,750
Option - II
Overdraft ($1,00,000 × ₹ 60.55) ₹ 60,55,000
Interest on Overdraft (₹ 60,55,000 × 0.14/4) ₹ 2,11,925
₹ 62,66,925
Option I should be preferred as it has lower outflow.
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.
Page 94
SOLUTION:-
(i) (98,000) (₹ 55) = ₹ 53,90,000
(ii) (100,000) (₹ 56) = ₹ 56,00,000
Differences = ₹ 56,00,000 – ₹ 53,90,000
= ₹ 2,10,000
(iii) Time value of money = (100,000 – 98,000) (₹ 56) = ₹ 1,12,000
Protection from devaluation = (98,000) (₹ 56 – ₹ 55) = ₹ 9,80,000
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:-
Option – 1: Forward Cover
$ Payable = $ 1,00,000
Buy $ 1,00,000 at FR
Cash outflows = $ 1,00,000 × 46.75
= ₹ 46,75,000
Option – 2: Lead Payment
$ Payable = ($ 1,00,000 – 2% of $ 1,00,000) = $ 98,000
Buy $ 98,000 at SR = $ 98,000 × 45.80
= ₹ 44,88,400
Page 95
Borrow ₹ 44,88,400 @ 14% p.a. for 3 months
Cash outflows = ₹ 44,88,400 (1.035)
= ₹ 45,45,494
Lead payment is better due to the lower cash outflows.
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:-
Option – 1: At the end of 1 month
£ Receivable = £ 2,00,000
Sell £ 2,00,000 at 1 month FR
£ 2,00,000 × 56.70 = ₹ 1,13,40,000
Invest ₹ 1,13,40,000 @ 14% p.a. for 2 months
Cash inflows = ₹ 1,13,40,000 (1.0233)
= ₹ 1,16,04,600
Option – 2: At the end of 3rd month
£ Receivable = £ 2,00,000 (1.01)
= £ 2,02,000
Sell £ 2,02,000 at 3 months FR
= £ 2,02,000 × 57.80
Page 96
Cash inflows = ₹ 1,16,75,600
Receive at the end of 3rd months is better due to the higher cash inflows.
(II) Money Market Cover
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.
Current spot and forward rates are as follows:
£ / US$
Spot: 0.9830 – 0.9850
Three months forward: 0.9520 – 0.9545
US$ / €
Spot: 1.8890 – 1.8920
Four months forward: 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.0% – 12.0% p.a.
France: 14.0% – 16.0% p.a.
USA: 11.5% – 13.0% p.a.
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:-
Page 97
£ Exposure
Since Columbus has a £ receipt (£ 138,000) and payment of (£ 480,000)

maturing at the same time i.e. 3 months, it can match them against each other
leaving a net liability of £ 342,000 to be hedged.
(i) Forward market hedge
Buy 3 months' forward contract accordingly, amount payable after 3

months will be £ 342,000 / 0.9520 = US$ 359,244
(ii) Money market hedge
To pay £ after 3 months' Columbus shall requires to borrow in US$ and

translate to £ and then deposit in £.
For payment of £ 342,000 in 3 months (@2.5% interest) amount required

to be deposited now (£ 342,000 ÷ 1.025) = £ 333,658
With spot rate of 0.9830 the US$ loan needed will be = US$ 339,429
Loan repayable after 3 months (@3.25% interest) will be = US$ 350,460
In this case the money market hedge is a cheaper option.
€ Receipt
Amount to be hedged = € 590,000
(i) Forward market hedge
Sell 4 months' forward contract accordingly, amount

receivable after 4 months will be (€ 590,000 ×1.9510) = US$ 1,151,090
(ii) Money market hedge
For money market hedge Columbus shall borrow in € and then translate
to US$ and deposit in US$
For receipt of € 590,000 in 4 months (@ 5.33% interest)

amount required to be borrowed now (€590,000 ÷ 1.0533) = € 560,144
With spot rate of 1.8890 the US$ deposit will be = US$ 1,058,113
Deposit amount will increase over 4 months
(@3.83% interest) will be = US$ 1,098,639
Page 98
In this case, more will be received in US$ under the forward hedge.
QUESTION – 58
An exporter is a UK based company. Invoice amount is $3,50,000. Credit

period is three months. Exchange rates in London are :
Spot Rate ($/£) 1.5865 – 1.5905
3-month Forward Rate ($/£) 1.6100 – 1.6140
Rates of interest in Money Market:
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:-
Identify: Foreign currency is an asset. Amount $ 3,50,000.
Create: $ Liability.
Borrow: In $. The borrowing rate is 9% per annum or 2.25% per quarter.
Amount to be borrowed: 3,50,000 / 1.0225 = $ 3,42,298.29
Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely, 1.5905
per £,
(Note: This is an indirect quote). Amount of £s received on conversion is

2,15,214.27 (3,42,298.29/1.5905).
Invest: £ 2,15,214.27 will be invested at 5% for 3 months and get £

2,17,904.45
Settle: The liability of $3,42,298.29 at interest of 2.25 per cent quarter

matures to $3,50,000 receivable from customer.
Using forward rate, amount receivable is = 3,50,000 / 1.6140 = £2,16,852.54
Amount received through money market hedge = £2,17,904.45
Page 99
Gain = 2,17,904.45 – 2,16,852.54 = £1,051.91
So, money market hedge is beneficial for the exporter
QUESTION – 59
ABC Ltd. has imported specialty computer equipment worth US $ 2,50,000

from o company in US. The amount due for the imports is payable after 3
months, the treasury manager of ABC Ltd. has collected the following market
quotes:
Exchange rates:
Spot ₹ /$ 47.15/47.30 Forward 3 months swap 55/60
Interest rates (p.a.):

Dollar (3 months) 6% / 6.50%. Rupee (3 months) 10.00%/11.00%
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:
(a) Cover through forward market.
(b) Cover through money market.
(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:-
(a) Forward Cover
Buy $ 2,50,000 at 3 months FR
Cash Outflows = $ 2,50,000 × 47.90
= ₹ 1,19,75,000
(b) Money Market Hedge
Page 100
 Amount to be invested in us money market @ 6% p.a. for 3 months

$ 2,50,000
3 = $ 2,46,305.42
1+(0.06× )
12
 Buy $ 2,46,305.42 at SR = $ 2,46,305.42 × 47.30
= ₹ 1,16,50,246
 Borrow ₹ 1,16,50,246 from India money market @ 11% p.a. for 3
months
Cash Outflows = 1,16,50,246 + [(1 × (0.11 × 3/12)]
= ₹ 1,19,70,628
(c) Leadings
 $ payable after discount = $ 2,50,000 - $ 5,000
= $ 2,45,000
 Rupees required to buy $ 2,45,000 at SR = ($ 2,45,000 × 47.30)
= ₹ 1,15,88,500
 Borrow ₹ 1,15,88,500 @ 9% p.a. for 3 months
Cash Outflows = ₹ 1,15,88,500 × [(1 × (0.09 × 3/12)]

= ₹ 1,18,49,241
Option (c) is the best due to lower cash outflows.
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:
Receivables of Rohit and Bros : £500,000
Spot rate : ₹ 56.00/£
Payment date : 3-months
3 months interest rate : India : 12 per cent per annum
: UK : 5 per cent per annum
Page 101
What should the exporter do?
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).
If pound sterling has depreciated in the meantime. The gain would be

even bigger.
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
Page 102
The borrowing rates in US and India are 6% and 12% p.a. and the deposit rates
are 4% and 9% p.a. respectively.
(i) Which option is better for H Ltd?
(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.
What is the foreign exchange exposure and risk of H Ltd.?
SOLUTION:-
(i) Money market hedge
For money market hedge Indian Firm shall borrow in US$ and then
translate them to Indian Rupee and shall make deposit in Indian Rupee.
For receipt of US$ 50,000 in 3 months (@ 1.5% interest) amount required

to be borrowed now (US$ 50,000 ÷ 1.015) = US$ 49,261.08
With spot rate of 72.65 the Rupee deposit will be = ₹ 35,78,817.46
Deposit amount will increase over 3 months (@2.25% interest) will be

= ₹ 36,59,340.85
Forward market hedge
Sell 3 months' forward contract accordingly, amount receivable after 3

months will be (US$ 50,000 × 72.95)
= ₹ 36,47,500
In this case, more will be received under the money market hedge hence
it is better option.
(ii) Exchange Exposure to H Ltd.
Expected Realization as per Forward Rate (US$ 50,000 × 72.95) ₹ 36,47,500

Actual Realization as per actual Spot Rate (US$ 50,000 × 73.00) ₹ 36,50,000
Gain ₹ 2,500
Page 103
(III) Currency Future
QUESTION – 62
EFD Ltd. is an export business house. The company prepares invoice in
customers' currency. Its debtors of US$. 10,000,000 is due on April 1, 2015.
Market information as at January 1, 2015 is:
Exchange rates US$/INR Currency Futures US$/INR
Spot 0.016667 Contract size: ₹ 24,816,975
1-month forward 0.016529 1-month 0.016519
3-months forward 0.016129 3-month 0.016118
Initial Margin Interest rates in India
1-Month ₹ 17,500 6.5%
3-Months ₹ 22,500 7%
On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate
is 0.016134.
Which of the following methods would be most advantageous to EFD Ltd?
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk
(Study Material, PM, MTP April – 2022 & Exam May - 2015)
SOLUTION:-
Receipts using a forward contract = $10,000,000/0.016129 = ₹ 620,001,240
Receipts using currency futures
The number of contracts needed is ($10,000,000/0.016118)/24,816,975 = 25
Page 104
Initial margin payable is 25 contracts × ₹ 22,500 = ₹ 5,62,500
On April 1,2015Close at 0.016134
Receipts = US$10,000,000/0.016136 = ₹ 619,732,276
Variation Margin =
[(0.016134 – 0.016118) × 25 × 24,816,975/-]/0.016136
OR
(0.000016 × 25 × 24,816,975)/.016136= 9926.79/0.016136 = ₹ 615,195
Less: Interest Cost – ₹ 5,62,500 × 0.07 × 3/12 = ₹ 9,844
Net Receipts ₹ 620,337,627
Receipts under different methods of hedging
Forward contract ₹ 620,001,240
Futures ₹ 620,337,627
No hedge (US$ 10,000,000/0.016136) ₹ 619,732,276
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.
Market information as at June 1, 2009 is:
Exchange Rates Currency Futures
US $/₹ US $/₹ Contract size ₹4,72,000
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118
3 Months Forward 0.02127
Initial Margin Interest Rates in India
Page 105
June ₹ 10,000 7.50%
September ₹ 15,000 8.00%
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.
(a) Using forward contract
(b) Using currency futures
(c) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of

the futures contract.
(Practice Manual)
SOLUTION:-
Receipts using a forward contract (1,00,000/0.02127) = ₹ 47,01,457
The number of contracts needed is (1,00,000/0.02118)/4,72,000 =

10
Initial margin payable is 10 × ₹ 15,000 = ₹ 1,50,000
On September 1 Close at 0.02134

= 46,88,233
Receipts = US$1,00,000/0.02133
Variation Margin = [(0.02134 – 0.02118) × 10 × 472000/-]/0.02133
OR (0.00016 × 10 × 472000)/.02133 = 755.2/0.02133

35,406
47,23,639
Less: Interest Cost – 1,50,000 × 0.08 × 3/12
₹ 3,000
Net Receipts
₹ 47,20,639
Forward contract
₹ 47,01,457
Page 106
Futures ₹ 47,20,639
No hedge
US$ 1,00,000/0.02133 ₹ 46,88,233
The most advantageous option would have been to hedge with

futures.
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.
Market information as at January 1, 2020 is:
Exchange Rate US$/INR Currency Futures US$/INR

Spot 0.014285 Contract Size ₹ 2,88,16,368
1 – month forward 0.014184 1 – month 0.014178
3 – months forward 0.013889 3 – month 0.013881
Initial Margin Interest Rate in India

1 – Month ₹ 27,500 5.5%
3 – Months ₹ 32,500 9%
is 0.013893. Recommend as to which of the following methods would be most
advantageous to Doom Ltd.
Note: Round off calculation upto zero decimal points.
(RTP May - 2021)
SOLUTION:-
Receipts using a forward contract = $ 48,00,000/0.013889 = ₹ 34,55,97,235
Page 107
The number of contracts needed is ($ 48,00, 000/0.013881)/= 12

28,816,368
Initial margin payable is 12 contracts × ₹ 32,500 = ₹ 3,90,000
On April 1, 2020 Close at 0.013893
Receipts = US$ 48,00,000/0.013894 = ₹ 34,54,72,866
Variation Margin
[(0.013893 – 0.013881) × 12 × 28,816,368]/0.013894
OR
(0.000012 × 12 × 28,816,368)/0.013894 = 4149.5570/0.013894
= ₹ 2,98,658
Less: Interest Cost – ₹ 3,90,000 × 0.09 × 3/12 = ₹ 8,775
Net Receipts ₹ 34,57,62,749
Forward contract ₹ 34,55,97,235
Future Contract ₹ 34,57,62,749
No Hedge (US$ 48,00,000/ 0.013894) ₹ 34,54,72,866
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
JKL Ltd. is an export business house. The company prepares invoice in

customer’s currency.
Its debtors of US$. 2,00,00,000 is due on April 1,2017.
Page 108
Market information as at January 1, 2017 is :
Exchange Rate US$/INR Currency Futures US$/INR

Spot 0.016667 Contract Size: 31,021,218
1 – month forward 0.016529 1 – month 0.016519
3 – months forward 0.016129 3 – month 0.016118
Initial Interest rates in

Margin India
1 – Month ₹ 32,500 7%
3 – Months ₹ 50,000 8%
is 0.016134.
Which of the following methods would be most advantageous to JKL Ltd.?
SOLUTION:-
(₹)
Receipts using a forward contract (20,000,000/0.016129) 1,24,00,02,480
The number of contracts needed is

(20,000,000/0.016118)/31,021,218 = 40
On April 1 Close at 0.016136
Receipts = US$20,000,000/0.016136 1,23,94,64,551
Variation Margin
= [(0.016134 – 0.016118) × 40 × 31,021,218]/0.016136
OR (0.000016 × 40 × 31021218)/.016136
Page 109
= 755.2/0.016136 12,30,390
1,24,06,94,941
Less: Interest Cost – 20,00,000 × 0.08 × 3/12 40,000
Net Receipts 1,24,06,54,941
Forward contract 1,24,00,02,480
Futures 1,24,06,54,941
No hedge
US$ 20,000,000/0.016136 1,23,94,64,551
*The most advantageous option would have been to hedge with Future.
QUESTION – 66
DSE Ltd. is an export oriented business in Kolkata. DSE Ltd. invoices in

customer currency. Its receipts of US $ 3,00,000 is due on July 1st, 2019.
Market information as at April 1st, 2019
Exchange Rate Currency Futures

US $/₹ US $/₹
Spot 0.0154 April 0.0155 Contract Size
1 Month Forward 0.0150 July 0.0151 = ₹ 6,40,000/-
3 Months Forward 0.0147
Initial Margin Interest Rates in

India
April ₹ 13,000 9%
July ₹ 24,000 8.5%
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.
(i) Using forward contract.
Page 110
(ii) Using currency futures.
(iii) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of

the futures contract.
(Exam May - 2019)
SOLUTION:-
(₹)
(i) Receipts using a forward contract (3,00,000/0.0147) = ₹ 2,04,08,163
(ii) Receipts using currency futures
The number of contracts needed is

(3,00,000/0.0151)/6,40,000 = 31.04 say 31
On July 1 Close at 0.0147
Receipts = US$3,00,000/0.0146 = ₹ 2,05,47,945
Variation Margin
= [(0.0151 – 0.0147) × 31 × 640000/-]/0.0146
OR (0.0004 × 31 × 640000)/0.0146 = 7936/0.0146 5,43,562
2,10,91,507
Less: Interest Cost – 7,44,000 × 0.085 × 3/12 15,810
Net Receipts ₹ 2,10,75,697
iii) No hedge
US$ 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
Page 111
German Market. The Zaz is considering following 3 alternatives for managing

the transaction risk before the order is finalized.
(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.
Following data is available
Spot Rate € 1.1960 − €1.1970/£
6 months forward points 0.60 – 0.55 Euro Cents.
6 month further contract is currently trading at € 1.1943/£
6 month future contract size is £62,500
After 6 month Spot rate and future rate € 1.1873/£
You are required to
(a) Calculate (to the nearest £) the £ receipt for Zaz plc, under each of 3
above proposals.
(b) In your opinion which alternative you consider to be most appropriate.
SOLUTION:-
(i) Receipt under three proposals
(a) Proposal of Mr. Peter
€ 2.8 million
Invoicing in £ will produce = = £ 2.340 million
1.1965
Page 112
(b) Proposal of Mr. Wilson
Forward Rate = €1.1970 − 0.0055 = 1.1915
Using forward market hedge sterling receipt would be
€ 2.8 million
= £ 2.35 million
1.1965
(c) Proposal of Ms. Karen
The equivalent sterling of the order placed based on future price

€ 2.8 million
(€1.1943) = = £ 2,344,470 (rounded off)
1.1943
€ 2,344,470
Number of contract = = 37 Contract (to the nearest whole
62,500
number)
Thus, € amount hedged by future contract will be
= 37 × £62,500 = £23,12,500
Buy Future at €1.1943
Sell Future at €1.1873
€0.0070
Total loss on Future Contracts = 37 × £ 62,500 × € 0.0070 = € 16,188
After 6 months
Amount Received €28,00,000
Less: Loss on Future Contracts € 16,188
€ 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
Page 113
to whether this would be acceptable to German firm as it is described as

a competitive market and Zaz is moving into it first time.
QUESTION – 68
Nitrogen Ltd, a UK company is in the process of negotiating an order

amounting to €4 million with a large German retailer on 6 months credit. If
successful, this will be the first time that Nitrogen Ltd has exported goods into
the highly competitive German market. The following three alternatives are
being considered for managing the transaction risk before the order is finalized.
(i) Invoice the German firm in Sterling using the current exchange rate to
calculate the invoice amount.
(ii) Alternative of invoicing the German firm in € and using a forward foreign
(iii) Invoice the German first in € and use sufficient 6 months sterling future
contracts (to the nearly whole number) to hedge the transaction risk.
Following data is available:
Spot Rate € 1.1750 - €1.1770/£
6 months forward premium 0.55-0.60 Euro Cents
6 months future contract is currently trading at €1.1760/£
6 months future contract size is £62500
Spot rate and 6 months future rate €1.1785/£
Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the
three proposals.
(b) In your opinion, which alternative would you consider to be the most
appropriate and the reason thereof.
SOLUTION:-
(i) Receipt under three proposals
(a) Invoice in Sterling

Page 114
€ 4 million
Invoicing in £ will produce = = £ 3398471
1.1770
(b) Use of forward contract
Forward Rate = €1.1770 + 0.0055 = 1.1830
€4million
Using Forward Market hedge Sterling receipt would be
1.1830
= £ 3382664
(c) Use of Future Contract

(€1.1760)
€4million
= = £ 3401360
1.1760
£3401360
Number of Contracts = = 54 Contracts (to the nearest
62,500
whole number)
Thus, € amount hedged by future contract will be = 54 × £62,500

= £3375000
€0.0025
Total profit on Future Contracts = 54 × £62,500 × €0.0025
= €8438
After 6 months
Amount Received €4000000
Add: Profit on Future Contracts € 8438
€ 4008438
Sterling Receipts
Page 115
€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
(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.
Following data is available
Spot Rate € 1.1980 - €1.1990/£
6 months forward points 0.60 – 0.55 Euro Cents.
6 month future contract is currently trading at € 1.1943/£
6 month future contract size is £70,500
After 6 month Spot rate and future rate € 1.1873/£
You are required to
(a) Advise the alternative you consider to be most appropriate.
Page 116
(b) Interpret the proposal of Mr. Grand from non-financial point of view.
Note: Calculate (to the nearest £) the £ receipt.
(RTP May - 2021)
SOLUTION:-
(a) (i) Receipt under three proposals
(a) Proposal of Mr. Grand
€5.5 million
Invoicing in £ will produce = = £ 45, 87,156
1.1990
(b) Proposal of Mr. John
Forward Rate = €1.1990 − 0.0055 = 1.1935
Using Forward Market hedge Sterling receipt would be
€5.5 million
= £ 46,08,295
1.1990
(c) Proposal of Ms. Royce

€5.5 million
(€1.1943) = = £ 46, 05,208 (rounded off)
1.1990
£46,05,208
Number of Contracts = = 65 Contracts (to the nearest
70,500
whole number)
Thus, € amount hedged by future contract will be = 65 × £70,500

= £45,82,500
€0.0070
Total loss on Future Contracts = 65 × £70,500 × €0.0070
= €32,078
After 6 months
Page 117
Amount Received €55, 00,000
Less: Loss on Future Contracts € 32,078
€ 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
$1,000
Gain by trading in futures = (₹ 45 – ₹ 44.50) 4,00,000 = ₹ 2,00,000
Net Inflow after 3 months = ₹ 44.50 × ₹ 4,00,000 + 2,00,000
= ₹ 1,80,00,000
Page 118
₹1,80,00,000
Effective Price realization = = ₹ 45 per US$
$4,00,000
(IV) Currency Option
QUESTION – 71
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the
following information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
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:
Future rate Probability
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(a) A forward contract;
(b) A money market hedge;
(c) An option contract;
(d) No hedging.
Show calculations in each case
Page 119
(Study Material, PM & Exam November - 2015)
SOLUTION:-
(a) Forward contract: Dollar needed in 180 days
= £3,00,000 × $ 1.96 = $5,88,000/-
(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in

180 days
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081
Amount of $ needed to convert into £ = 2,87,081 × 2 = $ 5,74,162
Interest and principal on $ loan after 180 days
= $5,74,162 × 1.055 = $ 6,05,741
(c) Call Option:
Expected Prem. Exercise Total Total Prob. Pi xi

Spot rate /unit Option price price for Pi
in 180 per unit £
days 3,00,000
xi
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200
2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
5,94,900
Add: Interest on Premium @ 5.5% (12,000 × 5.5%) 660
5,95,560
* ($1.97 + $0.04)
(d) No hedge option:
Expected Future Dollar needed Prob. Pi Pi Xi

spot rate Xi
1.91 5,73,000 0.25 1,43,250
1.95 5,85,000 0.60 3,51,000
2.05 6,15,000 0.15 92,250
5,86,500
Page 120
The probability distribution of outcomes for no hedge strategy appears to

be most preferable because least number of $ are needed under this
option to arrange £3,00,000.
QUESTION – 72
Sun Limited, an Indian company will need $ 5,00,000 in 90 days. In this

connection, following information is given below:
Spot Rate - $ 1 = ₹ 71
90 days forward rate of $ 1 as of today = ₹ 73
Interest Rates are as follows:
Particulars US India
90 days Deposit Rate 2.50% 4.00%
90 days Borrowing Rate 4.00% 6.00%
A call option on $ that expires in 90 days has an exercise price of ₹ 74 and a

premium of Re. 0.10. Sun Limited has forecasted the spot rates for 90 days as
below:
Future Rate Probability

₹ 72.50 25%
₹ 73.00 50%
₹ 74.50 25%
Which of the following strategic would be the most preferable to Sun Limited :
(i) A Forward Contract;
(ii) A Money Market Hedge;
(iii) An Option Contract;
(iv) No Hedging.
Show your calculation in each case.
(Exam May – 2019)
SOLUTION:-
Page 121
(i) Forward contract:
Rupees needed in 90 days = $ 5,00,000 × ₹ 73 = ₹ 3,65,00,000
(ii) Money market hedge:
Amount in $ to be invested = 5,00,000/1.0250 = ₹ 4,87,805
Amount of ₹ needed to convert into $ = 4,87,805 × 71 = ₹ 3,46,34,155
Interest and principal on ₹ loan after 90 days
= ₹ 3,46,34,155 × 1.06 = ₹ 3,67,12,204
(iii) Call option:
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)
(iv) No hedge option:
Expected Future ₹ Needed Xi Prob.Pi Pi xi

Spot Rate
72.50 3,62,50,000 0.25 90,62,500
73.00 3,65,00,000 0.50 1,82,50,000
74.50 3,72,50,000 0.25 93,12,500
3,66,25,000
Decision: Forward Contract Strategy is most preferable strategy because it

requires the least amount to arrange $5,00,000.
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:
Page 122
Spot rate USD 1.5617−1.5673
6 months’ forward rate USD 1.5455 –1.5609
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.
The company has 3 choices:
(i) Forward cover
(ii) Money market cover, and
(iii) Currency option
Which of the alternatives is preferable by the company?
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
6 months’ forward rate
1 1
GBP = to
USD 1.5455 USD 1.5609
USD = GBP 0.64704 - GBP 0.64066
Payoff in 3 alternatives
(i) Forward Cover
Amount payable USD 3,64,897
Forward rate GBP 0.64704
Page 123
Payable in GBP GBP 2,36,103
(ii) Money Market Cover
1
PV @ 4.5% for 6 months i.e. = 0.9779951 USD 3,56,867
1.0225
Spot rate purchase GBP 0.64033
Borrow GBP 3,56,867 × 0.64033 GBP 2,28,512
Interest for 6 months @ 7 % 7,998
Payable after 6 months GBP 2,36,510
(iii) Currency options
Unit in Options contract GBP 12,500
Value in USD at strike rate of 1.70
(GBP 12,500 × 1.70) USD 21,250
Number of contracts USD 3,64,897/ USD 21,250 17.17
Exposure covered USD 21,250 × 17 USD 3,61,250
Exposure to be covered by Forward
(USD 3,64,897 – USD 3,61,250) USD 3,647
Options premium 17 × GBP 12,500 × 0.096 USD 20,400
Premium in GBP (USD 20,400 × 0.64033) GBP 13,063
Total payment in currency option
Payment under option (17 × 12,500) GBP 2,12,500
Premium payable GBP 13,063
Payment for forward cover (USD 3,647 × 0.64704) GBP 2,360
Page 124
GBP 2,27,923
Thus total payment in:
(i) Forward Cover 2,36,103 GBP
(ii) Money Market 2,36,510 GBP
(iii) Currency Option 2,27,923 GBP
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.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.9516/1.9711. 1.9726./1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future
spot rate. You are required to recommend cheaper hedging alternative for XYZ.
SOLUTION:-
(i) Forward Cover
1
3 – months Forward Rate = = ₹ 0.5070/JY
1.9726
Page 125
Accordingly, INR required for JY 5,00,000 (5,00,000 × ₹ 0.5070) ₹

2,53,500
(ii) Option Cover
To purchase JY 5,00,000, XYZ shall enter into a Put Option @ JY

2.125/INR
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:
Spot 1 Month Forward 3 Months Forward

0.9284-0.9288 0.9301 0.9356
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:
Strike Price Calls Puts

(USD/Can$) July Sept. July Sept.
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
Page 126
According to the suggestion of finance manager if options are to be used, one

month option should be bought at a strike price of 94 cents and three month
option at a strike price of 95 cents and for the remainder uncovered by the
options the firm would bear the risk itself. For this, it would use forward rate
as the best estimate of spot. Transaction costs are ignored.
Recommend, which of the above two methods would be appropriate for

the American firm to hedge its foreign exchange risk on the two interest
payments.
(Study Material, PM, MTP March – 2022 & Exam Nov - 2013)
SOLUTION:-
Forward Market Cover
Hedge the risk by buying Can$ in 1 and 3 months time will be:
July - 1010000 × 0.9301 = US $ 939401
Sept. - 705000 × 0.9356 = US $ 659598
Option Contracts
July Payment = 1010000/ 50,000 = 20.20
September Payment = 705000/ 50,000 = 14.10
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.
Page 127
QUESTION – 76
On 19th April following are the spot rates
Spot EURO/USD 1.20000 USD/INR 44.8000
Following are the quotes of European Options:
Currency Pair Call/Put Strike Price Premium Expiry date

EUR/USD Call 1.2000 $ 0.035 July 19
EUR/USD Put 1.2000 $ 0.04 July 19
USD/INR Call 44.8000 ₹ 0.12 Sep. 19
USD/INR Put 44.8000 ₹ 0.04 Sep. 19
(i) A trader sells an at-the-money spot straddle expiring at three months
(July 19). Calculate gain or loss if three months later the spot rate is
EUR/USD 1.2900.
(ii) Which strategy gives a profit to the dealer if five months later (Sep. 19)
expected spot rate is USD/INR 45.00. Also calculate profit for a
transaction USD 1.5 million.
(Practice Manual)
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.
He will receive premium of $ 0.035 + $ 0.040 = $ 0.075
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.
Profit or Loss to a trader is
Premium received $0.075
Loss on call option exercised 1.2900 – 1.2000 $0.090
Net Loss of $ 0.015 per EURO
(ii) Strategy i.e. either Call or Put
Price is expected to go up then buy call option is beneficial.
Page 128
On 19th April to pay Premium US$ 15,00,000

@ ₹ 0.12 i.e. INR 1,80,000
On 19th September exercise call option to gain

US$15,00,000 @ ₹ 0.20 INR 3,00,000
Net Gain or Profit INR 1,20,000
Or Sell of Put option will be beneficial.
On 19th April to receive Premium US$ 15,00,000

@ ₹ 0.04 i.e. INR 60,000
On 19th September option buyer shall not exercise

the option hence no loss INR –
Net Gain or Profit INR 60,000
(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.
Spot Rate Annualized Premium
₹/$ 67.10/67.20 $ - 7%
₹ /Euro 63.15/63.20 Euro - 6%
₹ /Pound 88.65/88.75 Pound - 5%
Advice XP Pharma Ltd. about invoicing in which currency.
(Calculation should be upto three decimal places).
(Exam July – 2021)
Page 129
SOLUTION:-
(i) Proceeds of Exports in INR = ₹ 10 Million
Position of Inflow under three currencies will be as follows:
Currency Invoice at Spot Rate Expected Rate after Conversion in

3-months INR after 3-
months
$ ₹ 100,00,000/ ₹ 67.10 ₹ 67.10 (1 + 0.07/4) = ₹ 68.27 × $
= $ 149031.297 ₹ 68.27 149031.297
= ₹ 1,01,74,367
€ ₹ 100,00,000/ ₹ 63.15 ₹ 63.15 (1 + 0.06/4) = ₹ 64.10 × €
= € 1,58,353.127 ₹ 64.10 1,58,353.127
= ₹ 1,01,50,435
£ ₹ 100,00,000/ ₹ 88.65 ₹ 88.65 (1 + 0.05/4) = ₹ 89.76 × £
= £ 1,12,803.158 ₹ 89.76 1,12,803.158
= ₹ 1,01,25,211
(ii) Payment of Import in INR = ₹ 5 Million
Position of outflow under three currencies will be as follows:
Currency Invoice at Spot Rate Expected Rate after Conversion in

6-months INR after 6-
months
$ ₹ 50,00,000/ ₹ 67.20 = ₹ 67.20 (1 + 0.07/2) ₹ 69.55 × $
$ 74404.762 = ₹ 69.55 74404.762
= ₹ 51,74,851
€ ₹ 50,00,000/ ₹ 63.20 ₹ 63.20 (1 + 0.06/2) ₹ 65.10 × €
= € 79,113.924 = ₹ 65.10 79,113.924
= ₹ 51,50,316
£ ₹ 50,00,000/ ₹ 88.75 ₹ 88.75 (1 + 0.05/2) ₹ 90.97 × £
= £ 56,338.028 = ₹ 90.97 56,338.028
= ₹ 51,25,070
Advice: Since cash inflow is highest (1,01,74,367) in case of $ hence invoicing

for Export should be in $. However, cash outflow is least (51,25,070) in case of
£ the invoicing for import should be in £.
QUESTION – 78
XYZ Ltd. has imported goods to the extent of US$ 8 Million. The payment terms
are as under:
Page 130
(a) 1% discount if full amount is paid immediately; or
(b) 60 days interest free credit. However, in case of a further delay up to 30

days, interest at the rate of 8% p.a. will be charged for additional days
after 60 days. M/s XYZ Ltd. has ₹ 25 Lakh available and for remaining it
has an offer from bank for a loan up to 90 days @ 9.0% p.a.
The quotes for foreign exchange are as follows:
Spot Rate INR/ US$ (buying) ₹ 66.98
60 days Forward Rate INR/ US$ (buying) ₹ 67.16
90 days Forward Rate INR/ US$ (buying) ₹ 68.03
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.
Assume year has 360 days. Ignore Taxation.
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:
(i) Pay Immediately availing discount
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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Amount required in ₹ ₹ 0.2500 Crore

Cash Available ₹ 52.7982 Crore
Loan required ₹ 1.1880 Crore
Interest for 90 days @ 9% ₹ 53.9862 Crore
Total Outflow
(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.
Page 132
(7) CANCELLATION OF FORWARD CONTRACT
(i) Cancellation & Extension of Forward Contract
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.
Contracted Rate – US$ 1= ₹ 42.32
The US Dollar quoted on 30-10-2010:- Spot – 41.5000/41.5200
3 months’ Premium -0.87% /0.93%
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
(ii) The rate of new forward contract.
SOLUTION:-
(i) The contract is to be cancelled on 30-10-2010 at the spot buying rate of

US$ 1 = ₹ 41.5000
Less: Margin Money 0.075% = ₹ 0.0311
= ₹ 41.4689 or ₹ 41.47
US$ 20,000 @ ₹ 41.47 = ₹ 8,29,400
US$ 20,000 @ ₹ 42.32 = ₹ 8,46,400
The difference in favor of the Bank/Cost to the importer ₹ 17,000
(ii) The Rate of New Forward Contract
Spot Selling Rate US$ 1 = ₹ 41.5200
Page 133
Add: Premium @ 0.93% = ₹ 0.3861
= ₹ 41.9061
Add: Margin Money 0.20% = ₹ 0.0838
= ₹ 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?
US dollar 1 = ₹ 34.5000 − 34.5225
Exchange margin to be loaded by the bank is 0.080%
SOLUTION:-
Calculation of cancellation charges
Selling rate of bank = ₹ 34.60
Buying rate of bank = ₹ 34.47
(34.50 – 0.08%)
Gain to bank = ₹ 0.13 per $
(×) Contract Size = $ 5,00,000
Cancellation charges = ₹ 65,000
QUESTION – 81
A bank booked a forward purchase contract for US dollar 250,000 with o

customer at the rate of US dollar 1 = ₹ 34.50 due Oct. 30th 2005. On the due
date customer requests the bank to cancel the contract.
The rates ruling in the interbank market on Oct. 30, 2005 are as under:
Page 134
Spot US dollar 1: ₹ 34.9025 − 35.2050
What will be the cancellation charges of the bank if Banks load 0.150% for
their exchange margin?
SOLUTION:-
Calculation of cancellation charges
Selling rate of bank = ₹ 34.50
Buying rate of bank = ₹ 35.26
(35.2050 + 0.150%)
Gain to bank = ₹ 0.76 per $
(×) Contract Size = $ 2,50,000
Cancellation charges = ₹ 1,90,000
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 ₹ 65.2900/2975 per US$
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:-
Bank will buy from customer at the agreed rate of ₹ 65.40.
Since this is sale contract the contract shall be cancelled at ready buying rate
on the date of cancellation as follows:
Page 135
Spot buying rate on 15th March 2015 ₹ 65.2900

Less: Exchange Margin ₹ 0.0653
₹ 65.2247
Rounded to ₹ 65.2250
Dollar sold to customer at ₹ 65.3450

Dollar bought from customer ₹ 65.2250
Net amount payable by the customer per US$ ₹ 0.1200
Amount payable by the customer
Flat Charges ₹ 100.00

Cancellation Charges (₹ 0.12 × 2,50,000) ₹ 30,000.00
₹ 30,100.00
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:
Spot ₹ 47.3000/3,500 per AUD
1 month forward ₹ 47.4500/5,200 per AUD
Determine the cancellation charges payable by the customer.
SOLUTION:-
The contract shall be cancelled at the 1 month forward sale rate of ₹ 47.5200
as follows:
AUD bought from customer under original forward contract at ₹ 47.2500

On cancellation it is sold to him at ₹ 47.5200
Net amount payable by customer per AUD ₹ 00.2700
Thus total cancellation charges payable by the customer ₹ 27,000
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
Page 136
after two months and requests cancellation of the contract. On this date, the
rates are:
Spot CHF 1 = ₹ 36.30 36.35

One month forward 36.45 36.52
Determine the amount of profit or loss to the customer due to cancellation of

the contract.
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.
Hence, Swap profit/loss to the customer:
₹ 36.52 Payable by the customer

₹ 36.25 Receivable by the customer
₹ 0.27 Net payable by the customer i.e. loss
Therefore, total loss to the customer is
Swiss Francs 1,00,000 × ₹ 0.27 = ₹ 27,000
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:
Spot CHF 1 = ₹ 27.30 27.35
One month forward ₹ 27.45 27.52
What is the loss/gain to the customer on cancellation?
SOLUTION:-
The contract would be cancelled at the one month forward sale rate of ₹ 27.52.
Page 137
₹
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
At ₹ 0.27 per Franc, exchange difference for CHF 10,000 is ₹ 2,700.
Loss to the Customer:
Exchange difference (Loss) ₹ 2,700
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:
Spot ₹ 59.1300/1400 per US$
Spot/5th June ₹ 59.2300/2425 per US$
Spot/5th July ₹ 59.6300/6425 per US$
Assuming a margin 0.10% on buying and selling, determine the extension

charges payable by the customer and the new rate quoted to the customer.
SOLUTION:-
(i) Cancellation of Original Contract
The forward purchase contract shall be cancelled at the for the forward
sale rate for delivery June.
Interbank forward selling rate ₹ 59.2425

Add: Exchange Margin ₹ 0.0592
Net amount payable by customer per US$ ₹ 59.3017
Rounded off, the rate applicable is ₹ 59.3000
Buying US$ under original contract at original rate ₹ 59.6000
Selling rate to cancel the contract ₹ 59.3000
Page 138
Difference per US$ ₹ 00.3000
Exchange difference for US$ 50,000 payable to the customer is ₹ 15,000.
(ii) Rate for booking new contract
The forward contract shall be rebooked with the delivery 15th July as
follows:
Forward buying rate (5thJuly) ₹ 59.6300

Less: Exchange Margin ₹ 0.0596
Rounded off to ₹ 59.5700
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
1 month forward ₹ 62.6400/62.7400
Determine the extension charges payable by the customer assuming exchange

margin of 0.10% on buying as well as selling.
SOLUTION:-
Cancellation
First the original contract shall be cancelled as follows:
US$/₹ Spot Selling Rate ₹ 62.7200

Add: Margin @ 0.10% ₹ 0.06272
Rounded off ₹ 62.7825
Bank buys US$ under original contract at ₹ 62.5200
Bank Sells at ₹ 62.7825
₹ 0.2675
Page 139
Thus total cancellation charges payable by the customer for US$ 1,00,000 is ₹
26,750.
Rebooking
Forward US$/₹ Buying Rate ₹ 62.6400

Less: Margin @ 0.10% ₹ 0.06264
Net amount payable by customer per US ₹ 62.57736
Rounded off ₹ 62.5775
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.
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150/ 1.5160
Two months forward 1.5250 / 1.5270
Three months forward 1.5415/ 1.5445
and in the interbank market US dollars were quoted as under:
Spot USD 1 = ₹ 49.4302/.4455
Spot / April 4100/.4200
Spot/May .4300/.4400
Spot/June .4500/.4600
Calculate the cancellation charges, payable by the customer if exchange

margin required by the bank is 0.10% on buying and selling.
SOLUTION:-
First the contract will be cancelled at TT Selling Rate
Page 140
USD/ Rupee Spot Selling Rate ₹ 49.4455
Add: Premium for April ₹ 0.4200
₹ 49.8655
Add: Exchange Margin @ 0.10% ₹ 0.04987
₹ 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (₹ 49.91537/1.5150) ₹ 32.9474
Rounded Off ₹ 32.9475
Bank buys Sw. Fcs. Under original contract ₹ 32.4000
Bank Sells under Cancellation ₹ 32.9475
Difference payable by customer ₹ 00.5475
Exchange difference of Sw. Fcs. 1,00,000 payable

by customer ₹ 54,750
(Sw. Fcs. 1,00,000 × ₹ 0.5475)
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.
The market rates for Rupee and Dollar are as under:
Spot ₹ 48.50/70
Two months 25/30 points
Three months 40/45 points
The company wants to cover the risk and it has two options as under :
(A) To cover payables in the forward market and
Page 141
(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:-
(A) To cover payable and receivable in forward Market
Amount payable after 3 months $7,00,000
Thus Payable Amount (₹) (A) ₹ 3,39,15,000
Amount receivable after 2 months $ 4,50,000
Thus Receivable Amount (₹) (B) ₹ 2,20,05,000
Interest @ 12% p.a. for 1 month (C) ₹ 2,20,050
Net Amount Payable in (₹) (A) – (B) – (C) ₹ 1,16,89,950
(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:
Amount Payable ($) $7,00,000

Amount receivable after 3 months $ 4,50,000
Net Amount payable $2,50,000
Applicable Rate ₹ 48.45
Amount payable in (₹) (A) ₹ 1,21,12,500
Profit on cancellation of Forward cost
Page 142
(48.90 – 48.30) × 4,50,000 (B) ₹ 2,70,000
Thus net amount payable in (₹) (A) + (B) ₹ 1,18,42,500
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.
(ii) Overdue Forward Contract
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:
10th June 13th June
Spot USD 1= ₹ 63.8000/8200 ₹ 63.6800/7200
Spot/June ₹ 63.9200/9500 ₹ 63.8000/8500
July ₹ 64.0500/0900 ₹ 63.9300/9900
August ₹ 64.3000/3500 ₹ 64.1800/2500
September ₹ 64.6000/6600 ₹ 64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer
requested on 14th June for extension of contract with due date on 10th August.
Rates rounded to 4 decimal in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate:
Page 143
(i) Cancellation rate

(ii) Amount payable on $ 2,00,000
(iii) Swap loss
(iv) Interest on outlay of funds, if any
(v) New contract rate
(vi) Total Cost
SOLUTION:-
(i) Cancellation Rate:
The forward sale contract shall be cancelled at Spot TT Purchase for $

prevailing on the date of cancellation as follows:
$/ ₹ Market Buying Rate ₹ 63.6800

Less: Exchange Margin @ 0.10% ₹ 0.0636
₹ 63.6163
Bank sells $ 2,00,000 @ ₹ 64.4000 ₹ 1,28,80,000

Bank buys $ 2,00,000 @ ₹ 63.6175 ₹ 1,27,23,500
Amount payable by customer ₹ 1,56,500
(iii) Swap Loss
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.
Bank buys at ₹ 63.9500

Bank sells at ₹ 63.8000
Amount payable by customer ₹ 0.1500
Swap Loss for $ 2,00,000 in ₹ = ₹ 30,000
(iv) Interest on Outlay of Funds
On 10th June, the bank receives delivery under cover contract at ₹

64.2800 and sell spot at ₹ 63.8000.

Page 144
Outlay for $ 2,00,000 in ₹ 96,000
Interest on ₹ 96,000 @ 12% for 3 days ₹ 96
(v) New Contract Rate
The contract will be extended at current rate
$/ ₹ Market forward selling Rate for August ₹ 64.2500

₹ 64.3143
(vi) Total Cost
Cancellation Charges ₹ 1,56,500.00

Swap Loss ₹ 30,000.00
Interest ₹ 96.00
₹ 1,86,596.00
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:
(i) To cancel the contract?

(ii) To execute the contract?
(iii) To extend the contract with due date to fall on 10th November?
The exchange rates for US$ in the interbank market were as below:
10th September 13th September
Spot US$1=66.1500/1700 65.9600/9900
Spot/September 66.2800/3200 66.1200/1800
Spot/October 66.4100/4300 66.2500/3300
Spot/November 66.5600/6100 66.4000/4900
Page 145
Exchange margin was 0.1% on buying and selling.
Interest on outlay of funds was 12% p.a.
You are required to show the calculations to:
(i) Cancel the Contract,

(ii) Execute the Contract, and
(iii) Extend the Contract as above.
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:
(a) Exchange Difference
(b) Swap Loss
(c) Interest on Outlay Funds
(a) Exchange Difference
(1) Cancellation Rate:
The forward sale contract shall be cancelled at Spot TT Purchase

for $ prevailing on the date of cancellation as follows:
$/₹ Market Buying Rate ₹ 65.9600

₹ 65.8940
(2) Amount payable on $ 50,000
Bank sells $50,000 @ ₹ 66.8400 ₹ 33,42,000

Bank buys $50,000 @ ₹ 65.8950
Amount payable by customer ₹ 32,94,750
₹ 47,250
(b) Swap Loss
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.
Page 146

Swap Loss for $ 50,000 in ₹ = ₹ 8,500
(c) Interest on Outlay of Funds
On 10thSeptember, the bank receives delivery under cover contract at ₹

66.6800 and sell spot at ₹ 66.1500.

Outlay for $ 50,000 in ₹ 26,500
(d) Total Cost
Cancellation Charges ₹ 47,250.00

Swap Loss ₹ 8,500.00
Interest ₹ 26.00
₹ 55,776.00
(e) New Contract Rate
The contract will be extended at current rate
$/₹ Market forward selling Rate for November ₹66.4900

₹66.5565
(i) Charges for Cancellation of Contract = ₹ 55,776.00
(ii) Charges for Execution of Contract
Charges for Cancellation of Contract ₹ 55,776.00
Spot Selling US$ 50,000 on 13th September at ₹ ₹ 33,02,750.00

65.9900 + 0.0660 (Exchange Margin) = ₹
66.0560 rounded to ₹ 66.0550
Page 147
₹ 33,58,526.00
(iii) Charges for Extension of Contract
Charges for Cancellation of Contract 55776

New Forward Rate ₹ 66.5575
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:
4th April ₹ 7th April ₹

Spot USD 1 = 63.2775/63.2975 63.1575/63.1975
Spot/April 63.3975/63.4275 63.2775/63.3275
May 63.5275/63.5675 63.4075/63.7650
June 63.7775/63.8250 63.6575/63.7275
July 64.0700/64.1325 63.9575/64.0675
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.
Rates must be rounded to 4 decimal place in multiples of 0.0025.
Calculate:
(i) Cancellation Rate;
(ii) Amount payable on $ 1,00,000;
(iii) Swap loss;
(iv) Interest on outlay of funds, if any;
(v) New Contract Rate; and
(vi) Total cost
SOLUTION:-
Page 148
(i) Cancellation Rate:
The forward sale contract shall be cancelled at Spot TT Purchase for $

prevailing on the date of cancellation as follows:
$/ ₹ Market Buying Rate ₹ 63.1575

₹ 63.0943
Bank sells $ 1,00,000 @ ₹ 63.8775 ₹ 63,87,750

Bank buys $ 1,00,000 @ ₹ 63.0950 ₹ 63,09,500
Amount payable by customer ₹ 78,250
(iii) Swap Loss
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

Swap loss for $ 1,00,000 in ₹ = ₹ 15,000
(iv) Interest on Outlay of Funds
On 4th April, the bank receives delivery under cover contract at ₹ 63.7575
and sell spot at ₹ 63.2775.

Outlay for $ 1,00,000 in ₹ 48,000
(v) New Contract Rate
Page 149
The contact will be extended at current rate
$/₹ Market forward selling rate for June ₹ 63.7275

Add: Exchange margin @ 0.10% ₹ 0.0637
₹ 63.7912
(vi) Total Cost
Cancellation charges ₹ 78,250.00

Swap Loss ₹ 15,000.00
Interest ₹ 47.00
₹ 93,297.00
(iii) Early Delivery
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:
Spot Rate ₹ 71.20/1.25

One month premium 5/10
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%.
Assume 365 days in a year.
(Exam May – 2019)
SOLUTION:-
On 28th February 2019 bank would purchase form the exporter US$ 200000 at
the agreed rate i.e. ₹ 71.50/$. However, bank will charge for this early delivery
consisting of Swap Difference and Interest on outlay of funds.
(i) Swap Difference
Page 150
It buys at ₹ 71.35
Swap loss per US$ ₹ 0.15
Swap loss for $ 200000 is ₹ 30,000
(ii) Interest on Outlay of funds
On February Bank sell $ in Market ₹ 71.20
Bank buys from customer ₹ 71.50
Outlay per US $ ₹ 0.30
Outlay of funds for US$ 200000 ₹ 60,000
Interest of outlay of funds on ₹ 60,000 for 31 days (1st March 2019 to

31st March 2019) at 15% p.a. i.e. Interbank forward selling rate 764
(iii) Charges for early delivery
Swap Loss ₹ 30,000
Interest on Outlay of Funds ₹ 764
₹ 30,764
(iv) Net Inflow to Global Ltd.
Proceed of US $ 200000 @ ₹ 71.50 ₹ 1,43,00,000
Less: Charges for early delivery ₹ 30,764
Net Inflow ₹ 1,42,69,236
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 $. Rates prevailing in the interbank markets
on that date are as under:
Page 151
Spot (₹/$) 46.5725/5800
March 46.3550/3650
Interest on outflow of funds is 16 % and on inflow of funds is 12 %.
Flat charges for early delivery are ₹ 100.
What is the amount that would be recovered form the customer on the
transaction?
Note: Calculation should be made on months basis than on days basis.
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.
(i) Swap Difference
Swap loss per US $ 0.225
Swap loss for US $ 7000 ₹ 1,575
(ii) Interest on Outlay of Funds
On 19th February, Bank sell to customer ₹ 46.67
It buys from spot Market ₹ 46.58
Inflow of funds per US $ ₹ 0.09
Inflow of funds for US $ 7000 is ₹ 630
Interest on ₹ 630 at 12% for one month ₹ 6.30
Page 152
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.
The inter-bank rate on 30th November, 2020 was as follows:
Spot INR/USD 75.22 - 75.27
One Month Premium 10/15
Assume 365 days in a year.
(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?
(Exam July – 2021)
SOLUTION:-
(i) If Bank agrees to take early delivery-
Working Notes:
(1) Swap Difference
(a) Bank sells at spot rate on 30th November 2020 ₹ 75.22

(b) Bank buys at forward rate of 31st December ₹ 75.42
2020 (75.27 + 0.15)
Swap loss per US$(a − b) - ₹ 0.20
Swap loss for US$ 1,00,000 (1,00,000 × - 0.20) ₹ 20,000
(2) Interest on Outlay Funds
(a) On 30th November Bank sell at ₹ 75.22

(b) It buy from customer at ₹ 75.40
Outlay of Funds per US$ (b − a) ₹ 0.18
Interest on Outlay fund for US$ 1,00,000 for 31 days ₹ 275.18
(US$ 1,00,000 × 00.18 × 31/365 × 18%)
Page 153
(3) Charges for early delivery
Swap loss ₹ 20,000.00

Interest on Outlay fund for US$ 1,00,000 for 31 ₹ 275.18
days
Total charges of early delivery ₹ 20,275.18
Net Inflow to Mr. Guru
Amount received on sale (₹ 75.40 × 1,00,000) ₹ 75,40,000

Less: Charges for early delivery payable to bank ₹ 20,275.18
Net Inflow to Mr. Guru ₹ 75,19,724.82
(ii) If Mr. Guru deploys these funds in US$, then inflow will be –
Receipt of US$ on 30th November 2020 US$ 1,00,000

∗
31
Add: Interest for 31 days 1,00,000 × 3% × US$ 254.79
365
US$ available on 31st December 2020 for sale US$ 1,00,257.79
Sale of US$ 1,00,000 to bank as per agreed rate (₹ ₹ 75,40,000.00

75.40)
Sale of US$ 254.79 @ ₹ 75.32 i.e. Forward Rate ₹ 19,190.78
Amount of Inflows ₹ 75,59,190.78
Advice: Since cash inflow will be higher in deployment of funds option

the same should be chosen.
(8) FOREIGN CURRENCY A/C
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
Page 154
Forward purchase contract cancelled 30,000

Remitted by TT 75,000
Draft on Zurich cancelled 30,000
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?
(Study Material &n MTP March - 2022)
SOLUTION:-
Exchange Position:
Particulars Purchase Sw. Sale Sw. Fcs.

Fcs.
Opening Balance Overbought 50,000
Bill on Zurich 80,000
Forward Sales 60,000
Cancellation of Forward Contract 30,000
TT Sales 75,000
Draft on Zurich cancelled 30,000 ---
1,60,000 1,65,000
Closing Balance Oversold 5,000 ---
1,65,000 1,65,000
Cash Position (Nostro A/c)
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.
Page 155
QUESTION – 97
A dealer in foreign exchange has the following position in Swiss Francs on 31 st

January, 2018 ;
(Swiss Francs)
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 70,000
Draft on Zurich cancelled 40,000
Examine what steps would the dealer take, if he is 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
Particulars Purchase Sw. Sale Sw.

Fcs. Fcs.
Opening Balance Overbrought 50,000
Bill on Zurich 70,000
Forward Sales – TT 49,000
Cancellation of Forward Contract 41,000
TT Sale 75,000
Draft on Zurich Cancelled 40,000 ---
1,60,000 1,65,000
Closing Balance Oversold 5,000 ---
1,65,000 1,65,000
Page 156
Credit Debit
Opening balance credit 1,00,000 ---
TT sales --- 75,000
1,00,000 75,000
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
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:
Particulars Purchase £ Sale £

Opening balance overbought 35,000 ---
DD purchased 12,500 ---
Purchased a bill on London 40,000 ---
Sold forward TT --- 30,000
Page 157
Forward purchase contract cancelled --- 15,000

TT Remittance 37,500
Draft on London cancelled 15,000 ---
1,02,500 82,500
Closing balance overbought --- 20,000
1,02,500 1,02,500
Credit £ Debit £
Opening balance credit 65,000 ---
TT Remittance --- 37,500
65,000 37,500
65,000 65,000
To maintain Cash Balance in Nostro Account at £ 7500 you have to sell £

20000 in Spot which will bring Overbought exchange position to Nil. Since
bank require Overbought position of £ 7500 it has to buy the same in forward
market.
QUESTION – 99
ABN-Amro Bank, Amsterdam, wants to purchase ₹ 15 million against US$ for

funding their Nostro account with Canara Bank, New Delhi. Assuming the
inter-bank, rates of US$ is ₹ 51.3625/3700, what would be the rate Canara
Bank would quote to ABN-Amro Bank? Further, if the deal is struck, what
would be the equivalent US$ amount.
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/₹
Equivalent US$ for ₹ 15 million at this rate will be
Page 158
15,000,000
= = US$ 2,92,041.86
51.3625
Or = 15,000,000 × $ 0.01947 = US$ 2,92,050
QUESTION – 100
XYZ Bank, Amsterdam, wants to purchase ₹ 25 million against £ for funding

their Nostro account and they have credited LORO account with Bank of
London, London.
Calculate the amount of £’s credited. Ongoing inter-bank rates are per $, ₹
61.3625/3700 & per £, $ 1.5260/70.
SOLUTION:-
To purchase Rupee, XYZ Bank shall first sell £ and purchase $ and then sell $
to purchase Rupee. Accordingly, following rate shall be used:
(£/₹)ask
The available rates are as follows:
($/£)bid = $1.5260
($/£)ask = $1.5270
(₹/$)bid = ₹ 61.3625
(₹/$)ask = ₹ 61.3700
From above available rates we can compute required rate as follows:
(£/₹)ask = (£/$)ask × ($/₹)ask
= (1/1.5260) × (1/61.3625)
= £ 0.01068 or £ 0.0107
Thus, amount of £ to be credited
= ₹ 25,000,000 × £ 0.0107
= £ 267,500
Page 159
(9) CURRENCY OF BORROWING
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:
Present exchange rate ₹ 100 = 340 yen
180 day’s forward rate ₹ 100 = 345 yen
Commission charges for letter of credit at 2 percent per 12 months.
Advice the company whether the offer from the foreign branch should be
accepted.
(Study Material, PM & Exam January – 2021)
SOLUTION:-
Option I (To finance the purchases by availing loan at 18% per annum):
Cost of equipment ₹ in lakhs
3400 lakh yen at ₹ 100 = 340 yen 1,000.00
Add: Interest at 4.5% I Quarter 45.00
Add: Interest at 4.5% II Quarter (on ₹ 1045 lakhs) 47.03
Total outflow in Rupees 1,092.03
Alternatively, interest may also be calculated on compounded

basis, i.e.,
₹ 1000 × [1.045]² ₹ 1092.03
Option II (To accept the offer from foreign branch):
Page 160
Cost of letter of credit
At 1 % on 3400 lakhs yen at ₹ 100 = 340 yen ₹ 10.00 lakhs
Add: Interest for 2 Quarters ₹ 0.90 lakhs
(A) ₹ 10.90 lakhs
Payment at the end of 180 days:
Cost 3400.00 lakhs yen

Interest at 2% p.a. [3400 × 2/100 × 180/365] 33.53 lakhs yen
3433.53 lakhs yen

Conversion at ₹ 100 = 345 yen [3433.53 / 345 × 100] (B) ₹ 995.23 lakhs
Total Cost: (A) + (B) ₹ 1006.13 lakhs
Advise: Option 2 is cheaper by (1092.03 – 1006.13) lakh or ₹ 85.90 lakh.

Hence, the offer may be accepted.
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:
Spot Rate INR/USD 68.5275
6 months Forward rate INR/USD 68.4575
6 months LIBOR for USD 2%
6 months LIBOR for INR 6%
You are required to :
(i) Calculate Rupee requirements if forward cover is taken.
(ii) Advise the company on the forward cover.
What will be your opinion if spot rate of INR/USD is 68.4275 ?
(Exam January – 2021)
Page 161
SOLUTION:-
(i) Rupee requirement if forward cover is taken:
6 Months Forward Rate 68.4575
6
Interest amount (20,00,000 × 3%* × ) US$ 30,000
12
Principal amount US$ 20,00,000
US$ 20,30,000
Rupee Requirement = INR 68.4575 × US$ 20,30,000 = INR 13,89,68,725

* LIBOR + 1%
(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)
Thus, still the company should take forward cover.
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%
Page 162
 The 6 month LIBOR is expected to be 1.05%.
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.
As a finance manger, given the above information and taking the
1 GBP = INR 90:
(i) Calculate the overall cost both in percentage and rupee terms on an
annual basis.
(ii) What is the cost of hedging in rupee terms ?
(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 ?
Ignore time value and taxes and calculate to two decimals.
(Exam May – 2019)
SOLUTION:-
(i) Calculation of Overall Cost
Upfront Fee (GBP 10 M @ 1.20%) ₹ 1,20,000
Interest Payment (GBP 10 M × 3.55% × 3.4) ₹ 12,07,000
Hedging Cost (GBP 10 M × 4% × 3.4) ₹ 13,60,000
Total ₹ 26,87,000
Or ₹ 2.687 million
Overall cost in % terms on Annual Basis
2.687 million 1
= ×
(1,00,00,000−1,20,000) 3.4
2.687 1
= × × 100 = 8%
9.88 3.4
Page 163
Overall cost in rupees terms @ GBP 1
2.687
= ₹ 90 × × 100 = ₹ 711.26 lakhs
3.4
OR
Overall cost in % terms on Annual Basis
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
Calculation of overall cost
Interest & Margin (A) = 3.55%
Hedging cost (B) = 4%
7.55%
Onetime fee = 1.20%
Average loan maturity = 3.4 years
Per annum cost 1.2/3.4 (C) = 0.35%
Annual overall cost in % terms (A + B + C) = 7.9%
Overall Cost in Rupee terms@ GBP 1 = 10,000,000 × 7.90% × 90
= ₹ 71,100,000
(ii) Cost of Hedging in terms of Rupees
₹ 13,60,000 × 90 = ₹ 12,24,00,000 = ₹ 12.24 crores in Total
Page 164
OR
GBP10,000,000 × 90 × 4% = ₹ 3,60,00,000 on Annual Basis
(iii) If K Ltd. pursues an aggressive approach then Gain/Loss in INR

Depreciation/ Appreciation shall be computed as follows:
(a) If INR depreciates by 10%
Re. loss per GBP = 90 × 10% =₹9
Total Losses GBP10M = ₹ 90 Million
Less: Cost of Hedging = ₹ 36 Million
Net Loss = ₹ 54 million
(b) If INR appreciates by 10%
₹ Gains per GBP = ₹ 90 × 10% =₹9
Total Gain on Repayment of loan = 90 Million
Add: Saving in Cost of Hedging = 36 Million
Net Gain = 126 Million
QUESTION – 104
An Indian company obtains the following quotes (₹/$)
Spot ; 35.90/36.10
3 Months forward rate: 36.00/36.25
6 Months forward rate: 36.10/36.40
The company needs $ funds for six months, Determine whether the company
should borrow in $ or ₹. Interest rates are:
3 Months interest rate: ₹: 12%, $: 6%
6 Months interest rate: ₹: 11.50%, $: 5.5%
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:
Page 165
(i) Rupee borrowing
(ii) Dollar borrowing
Note: For the purpose of calculation you can take the units of dollar and rupee
as 100 each.
SOLUTION:-
(i) If company borrows in $ then outflow would be as follows:
Let company borrows $ 100 $ 100.00

Add: Interest for 6 months @ 5.5% $ 2.75
Amount Repayable after 6 months $ 102.75
Applicable 6 month forward rate 36.40
Amount of Cash outflow in Indian Rupees ₹ 3,740.10
If company borrows equivalent amount in Indian Rupee, then outflow

would be as follows:
Equivalent ₹ amount ₹ 36.10 × 100 ₹ 3,610.00

Add: Interest @ 11.50% ₹ 207.58
₹ 3817.58
Since cash outflow is more in ` borrowing then borrowing should be

made in $.
(ii)
a. Let ‘ir’ be the interest rate of ₹ borrowing make indifferent between 3

months borrowings and 6 months borrowing then
(1 + 0.03) (1 + ir) = (1 + 0.0575)
ir = 2.67% or 10.68% (on annualized basis)
b. Let ‘id’ be the interest rate of $ borrowing after 3 months to make

indifference between 3 months borrowings and 6 months borrowings.
Then,
(1 + 0.015) (1 + id) = (1 + 0.0275)
id = 1.232% or 4.93% (on annualized basis)
Page 166
QUESTION – 105
A German subsidiary of an US based MNC has to mobilize 1,00,000 Euro’s

working capital for the next 12 months. It has the following options:
Loan from German Bank : @ 5% p.a.
Loan from US Parent Bank : @ 4% p.a.
Loan from Swiss Bank : @ 3% p.a.
Banks in Germany charge an additional 0.25% p.a. towards loan servicing.

Loans from outside Germany attract withholding tax of 8% on interest
payments. If the interest rates given above are market determined, examine
which loan is the most attractive using interest rate differential.
SOLUTION:-
Net Cost under each of the options is as follows:
(i) Loan from German Bank
Cost = 5% + 0.25% = 5.25%
(ii) Loan from US Parent Bank
4% 4.35%
Effective rate of interest
1−0.08
1.05 0.96%
Premium on US$ − 1
1.04
Net Cost 5.31%
(iii) Loan from Swiss Bank
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
Page 167
(10) CURRENCY OF INVESTMENT
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.
New York 8% p.a.
Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York
Spot 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:-
(i) If investment is made at London
Page 168
Convert US$ 5,00,000 at Spot Rate (5,00,000/1.5390) = £ 3,24,886
Add: £ Interest for 3 months on £ 324,886 @ 5% =£ 4,061
= £ 3,28,947
Less: Amount Invested $ 5,00,000
Interest accrued thereon $ 5,000
= $ 5,05,000
Equivalent amount of £ required to pay the

above sum ($ 5,05,000/1.5430*) = £ 3,27,285
Arbitrage Profit =£ 1,662
(ii) If investment is made at New York
Gain $ 5,00,000 (8% − 4%) × 3/12 = $ 5,000
Equivalent amount in £ 3 months ($ 5,000/ 1.5475) £ 3,231
(iii) If investment is made at Frankfurt
Convert US$ 500,000 at Spot Rate (Cross Rate)

1.8260/1.5390 = € 1.1865
Euro equivalent US$ 500,000 = € 5,93,250
Add: Interest for 3 months @ 3% = € 4,449
= € 5,97,699
3 month Forward Rate of selling € (1/1.8150) = £ 0.5510
Sell € in Forward Market € 5,97,699 × £ 0.5510 = £ 3,29,332
Less: Amounted invested and interest thereon = £ 3,27,285
Arbitrage Profit = £ 2,047
Since out of three options the maximum profit is in case investment is made in
New York. Hence it should be opted.
* Due to conservative outlook.
Page 169
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.
Sydney -------------- 7.5% p.a.
New York -------------- 8% p.a.
Tokyo -------------- 4% p.a.
The market rates in Australia for US Dollars and Yen are as under:
Sydney on New York.
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?
(Exam May - 2019)
SOLUTION:-
(i) If investment is made at Sydney
Convert US$ 7,00,000 at Spot Rate (7,00,000/0.7300) = A$ 9,58,904
Add: A$ Interest for 2 months on A$ 9,58,904 @ 7.5% = A$ 11,986
Page 170
= A$ 9,70,890
Less: Amount Invested $ 7,00,000
Interest accrued thereon $ 7,000
= $ 7,07,000
Equivalent amount of £ required to pay the above sum

($ 7,07,000/0.7125*) = A$ 9,92,281
Arbitrage Loss = A$ 21,391
Or Equivalent Amount in US$(21391 × 0.7125) = $ 15,241
(ii) If investment is made at New York
Gain $ 7,00,000 (8% - 6%) × 2/12 = $ 2,333.33
Or
Equivalent amount in £ 3 months ($ 2,333/ 0.7330) = A$ 3,183
(iii) If investment is made at Tokyo
Convert US$ 700,000 at Spot Rate (Cross Rate)

79.0900/0.7300 = ¥ 108.34
Yen equivalent US$ 700,000 = ¥ 7,58,38,000
Add: Interest for 2 months @ 4% = ¥ 5,05,587
= ¥ 7,63,43,587
3 month Forward Rate of selling ¥ (1/79.1950) = A$ 0.0126
Sell ¥ in Forward Market ¥ 7,63,43,587 x A$ 0.0126 = A$ 9,61,929
Less: Amounted invested and interest thereon = A$ 9,92,281
Arbitrage Loss = A$ 30,352
Or Equivalent Loss in $(30352×0.7125) = $ 21,626
Out of three options the profit is in case of investment is made in New

York. Hence it should be opted.
* Due to conservative outlook.
Page 171
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?
Spot Rate (€) £0.6858− 0.6869
91 day Pts 0.0037 0.0040
Spot Rate(£) CHF 2.3295− 2.3326
91 day Pts 0.0242 0.0228
Interest rates for the Deposits
Amount of Currency 91 Days Interest Rate % p.a.

£ € CHF
0 – 1,00,000 1 ¼ 0
1,00,001 – 5,00,000 2 1½ ¼
5,00,001 – 10,00,000 4 2 ½
Over 10,00,000 5.375 3 1
(Practice Manual)
SOLUTION:-
Individuals Basis
Interest Amt. after Conversion in £

91 days
Holland £502,414.71
€ 725,000 × 0.02 × 91/360 = € 3,665.28 € 728,665.28 (728,665.28 × 0.6895)
Switzerland CHF CHF £432,651.51

CHF 998,077 × 0.005 × 1,261.46 999,338.46 (999,338.46 ÷ 2.3098)
91/360 =
Page 172
UK £ 189.58 £ 75,189.58 £ 75,189.58

£ 75,000 × 0.01 × 91/360 =
£ 1,010,255.80
Total GBP at 91 days
Swap to Starling
Sell € 7,25,000 (Spot at 0.6858) buy £ £ 4,97,205.00
Sell CHF 9,98,077(Spot at 2.3326) buy £ £ 4,27,881.76
Independent GBP amount £ 75,000.00
£ 1,000,086.76
Interest (£ 1,000,086.76 × 0.05375 × 91/360) £ 13,587.98

Total GBP at 91 days £ 1,013,674.74
Less: Total GBP at 91 days as per individual basis £ 1,010,255.80
Net Gain £ 3,418.94
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).
Holding Company £ 150,000

Swiss Subsidiary CHF 1,996,154
Dutch Subsidiary € 1,450,000
Exchange Rate as on date are as follows:
Spot Rate (€) £0.6858 - 0.6869
91 day Pts 0.0037 0.0040
Spot Rate (£) CHF 2.3295 − 2.3326
91 day Pts 0.0242 0.0228
Page 173
91-Day Interest rates on p.a. basis on the Deposits in Money Market are as
follows:
Amount of Currency £ € CHF

0 – 200,000 1.00 0.25 Nil
200,001 – 1,000,000 2.00 1.50 0.25
1,000,001 – 2,000,000 4.00 2.00 0.50
Over 2,000,000 5.38 3.00 1.00
You have been approached by your banker wherein the above-mentioned

surplus was lying, requesting you to swap the surplus lying with other two
subsidiaries and place them in deposit with them.
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.
Note: Consider 360 days a year.
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:
Interest Amt. after Conversion in £

91 days
Holland
€ 1,450,000 × 0.02 × € 7,330.56 € 1,457,330.56 £1,004,829.42
91/360 = (1,457,330.56 × 0.6895)
Switzerland CHF CHF

CHF 1,996,15 × 0.005 2,522.92 1,998,676.92 £865,303.02
× 91/360 = (1,998,676.92÷2.3098)
UK
£ 150,000 × 0.01 £ 379.17 £ 150,379.17 £ 150,379.17
× 91/360 =
Total GBP at 91 days £ 2,020,511.61
Swap to Sterling
Sell € 1,450,000 (Spot at 0.6858) buy £ £ 994,410.00

Sell CHF 1,996,154 (Spot at 2.3326) buy £ £ 855,763.53
Page 174
Independent GBP amount £ 150,000.00

£ 2,000,173.53
Amount accrued on Individual Basis (Principal + Interest) £ 2,020,511.61
Interest Required £ 20,338.08
Required Interest Rate on Per Annum Basis 4.023%
20,338.08 360
× × 100
2,000,173.53 91
Thus, the minimum rate that should be offered is 4.023%.
QUESTION – 110
The Treasury desk of a global bank incorporated in UK wants to invest GBP

200 Million on 1st January, 2019 for a period of 6 months and has the following
options:
(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.
The exchange rates are as follows:
Currency Pair 1st January, 2019 30th Jun, 2019

(Spot) (Forward)
GBP – JPY 148.0002 150.0000
GBP – USD 1.28000 1.30331
As a treasure, advise the bank on the best investment option. What

would be your decision from a risk perspective? You may ignore taxation.
SOLUTION:-
(i) Yield from investment in equity trading index in Japan
Page 175
Conversion of GBP 200 million in JPY (148.0002)

JPY29600.04 Million
Dividend income JPY 1182.00 Million

Stock lending JPY 10.00 Million
Investment value at end JPY 29008.0392 Million
Amount available at end JPY 30200.0392 Million
Forward rate of 30.06.2019 JPY 150/GBP
Amount to be remitted back to London GBP 201.3336 Million
Gain = GBP 201.3336 – GBP 200 GBP 1.3336 Million
(ii) Fixed income desk for US
Conversion of GBP 200 million in USD(1.28000) USD 256.00 Million

Add: Interest @ 5% p.a. for 6 months USD 6.40 Million
Amount available at end USD 262.40 Million
Forward rate of 30.06.2019 USD 1.30331/ GBP
Amount to be remitted back to London GBP 201.3335 Million
Gain = GBP 201.3335 – GBP 200 GBP 1.3335 Million
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.
However, from risk perspective, the investment in fixed income desk of US is

more beneficial as the chance of variation in fixed income securities is less as
compared to Equity Desk.
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 -
Page 176
Discount on initial investment at the end 2% -

Interest - 5 per cent per
annum
Exchange Rate (1st April, 2020) JPY/INR 1.58 USD/INR 0.014
Exchange Rate (30th September, 2020) JPY/INR 1.57 USD/INR 0.013
You, as an Investment Manager, is required to suggest the best course of

option.
SOLUTION:-
Investment in JPY (in billions)
Particulars Currency INR ER Currency JPY
Available amount 200 1.58 316
Dividend Income 25
Stock Lending Income 11.9276
Investment value at the end after discount @ 2% 309.68
Amount available at the end 346.6076
Conversion as on 30-09-2020 1.57 ₹ 220.7692
Gain ₹ 20.7692
Investment in USD (in billions)
Particulars Currency INR ER Currency USD
Available amount 200 0.014 2.80
Interest for 6 months @ 5% p.a. 0.07
Amount available at the end 2.87
Conversion as on 30-09-2020 0.013 ₹ 220.7692
Gain ₹ 20.7692
The equivalent amount is same in both the options so ICL is indifferent.
Page 177
However, USD is more stable, and Treasury Bills are risk free, so investment in
Treasury Bills (USD) is suggested.
(11) INTERNATIONAL CASH MANAGEMENT
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.S. $12.5 million
U.K. £ 6 million
Following exchange rate information is obtained:
$/₹ £/₹
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
Annual borrowing/deposit rates (Simple) are available.
₹ 6.4%/6.2%
$ 1.6%/1.5%
£ 3.9%/3.7%
The Indian operation is forecasting a cash deficit of ₹500 million.
It is assumed that interest rates are based on a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in ₹ for each
company under each of the following scenarios ignoring transaction costs
and taxes:
(a) Each company invests/finances its own cash balances/deficits in

local currency independently.
(b) Cash balances are pooled immediately in India and the net
balances are invested/borrowed for the 30 days period.
Page 178
(ii) Which method do you think is preferable from the parent company’s
point of view?
(Practice Manual)
SOLUTION:-
Cash Balances: (‘000)
Acting independently
Capital Interest ₹ in 30 days

India -5,00,000 -2,666.67 -5,02,667
U.S. 12,500 15.63 5,76,757
U.K. 6,000 18.50 4,01,233
4,75,323
Cash Balance:-
Immediate cash pooling
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
Immediate cash pooling is preferable as it maximizes interest earnings
Note: If the company decides to invest pooled amount of ₹ 4,84,080/- @ 6.2%

p.a. for 30 days an interest of ₹ 2,501/- will accrue.
Page 179
(12) CURRENCY SWAP
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:-
(a) The following swap arrangement can be entered by Drilldip.
(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.
(b) With the swap
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.
Page 180
Without the swap
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
Net result is a net receipt of US$ 29.04 million.
Decision: Since the net receipt is higher in swap option the company
should opt for the same.
(13) ECONOMIC EXPOSURE
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
After six months the exchange rates turn out as follows:
₹/Euro 52.00/05
₹/S$ 27.70/75
(A) You are required to calculate loss/gain due to transaction exposure.
(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 :
(i) the current exchange rate changes to
Page 181
₹/Euro 51.75/80
₹/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5
(iii) Payments and receipts are to be settled at the end of six months.
SOLUTION:-
(i) Profit at current exchange rates
2400 [€ 500 × ₹ 51.50 – (S$ 800 × ₹ 27.25 + ₹ 1,000 + ₹ 1,500)]
2400 [₹ 25,750 − ₹ 24,300] = ₹ 34,80,000
Profit after change in exchange rates
2400[€500 × ₹ 52 – (S$ 800 × ₹ 27.75 + ₹ 1000 + ₹ 1500)]
2400[₹ 26,000 − ₹ 24,700] = ₹ 31,20,000
LOSS DUE TO TRANSACTION EXPOSURE
₹ 34,80,000 – ₹ 31,20,000 = ₹ 3,60,000
(ii) Profit based on new exchange rates
2400[₹ 25,000 − (800 × ₹ 27.15 + ₹ 1,000 + ₹ 1,500)]
2400[₹ 25,000 − ₹ 24,220] = ₹ 18,72,000
Profit after change in exchange rates at the end of six months
2400 [₹ 25,000 − (800 × ₹ 27.75 + ₹ 1,000 + ₹ 1,500)]
2400 [₹ 25,000 − ₹ 24,700] = ₹ 7,20,000
Decline in profit due to transaction exposure
₹ 18,72,000 − ₹ 7,20,000 = ₹ 11,52,000
₹ 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
€ 485.44 − € 483.09 = € 2.35 or (-) 0.48%
Price elasticity of demand = 1.5
Increase in demand due to fall in price 0.48 × 1.5 = 0.72%
Size of increased order = 2400 × 1.0072 = 2417 units
Profit = 2417 [ ₹ 25,000 – (800 × ₹ 27.75 + ₹ 1,000 + ₹ 1,500)]
= 2417 [₹ 25,000 − ₹ 24,700] = ₹ 7,25,100
Therefore, decrease in profit due to operating exposure
₹ 18,72,000 – ₹ 7,25,100 = ₹ 11,46,900
Alternatively, if it is assumed that Fixed Cost shall not be changed with

change in units then answer will be as follows:
Fixed Cost = 2400[₹ 1,000] = ₹ 24,00,000
Profit = 2417 [₹ 25,000 – (800 × ₹ 27.75 + ₹ 1,500)] – ₹ 24,00,000
= 2417 (₹ 1,300) – ₹ 24,00,000 = ₹ 7,42,100
Therefore, decrease in profit due to operating exposure
₹ 18,72,000 – ₹ 7,42,100 = ₹ 11,29,900
(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.
Page 183
Accordingly, Mr. X invested a sum of ₹ 1.58 crore on 1.1.20 × 1 in standard &

poor index. On 1.1.20 × 2 Mr. X sold his investment. The other relevant data is
given below:
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
(i) The return for a US investor.
(ii) Holding period return to Mr. X.
(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:-
(i) Return of a US investor
Ending Price −Initial Price

= × 100
Initial Price
1919−2028
= × 100 = -5.37%
2028
(ii) Return of Mr. X
Initial Investment (₹) 1.58 Crore

Applicable exchange rate on 1.1.20 × 1 ₹ 62.25
Equivalent US$ US$ 2,53,815.26
Purchase price of standard & poor index 2028
No. of standard & poor indices purchased 125.16
Ending price of standard & poor index 1919
Proceeds realized in US$ on sale of standard & poor US$ 2,40,182.04
index
Applicable exchange rate on 1.1.20 × 2 ₹ 67.25
Proceeds realized in INR on sale of standard & poor ₹ 1,61,52,242
index
Page 184
16152242−15800000 2.23%
Rate of return × 100
15800000
(iii) Rate of return had the amount been invested in India
Initial investment (₹) 1.58 Crore

Purchase price of Indian Index 7395
No. of Indian Indices purchased 2136.58
Let ending price of Indian index X
Then to be indifferent with return in 2136 .58 × X − 1.58
× 100 = 2.23
International market 1.58
Price of Indian Index to be indifferent 7559.90 say 7560
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
Transit Period is 20 days. Interest on post shipment credit is 8% p.a.
Exchange Margin is 0.1%. Assume 365 days in a year.
(i) Exchange rate quoted to the company
(ii) Cash inflow to the company
(iii) Interest amount to be paid to bank by the company.
SOLUTION:-
Page 185
(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
(ii) Cash Inflow ₹ 1,83,69,825
(iii) Interest for 80 days @ 8% ₹ 3,22,101
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:
Spot Exchange Rate Can $ 2.5/£
Interest Rate in UK 12%
Interest Rate In Canada 15%
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)
Page 186
(i) If spot rate decline by 2%
Spot Rate = Can$ 2.50 × 1.02 = Can$ 2.55/£
£
£ 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
(ii) If spot rate gains by 4%
Spot Rate = Can$ 2.50 ×0.96 = Can$ 2.40/£
£
£ 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
(iii) if Spot rate remains unchanged
£
£ 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:
Currency Inflow Outflow Spot Rate Forward Rate

US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of Rupees.
(ii) Are any of the exposure positions offsetting to some extent?
Page 187
SOLUTION:-
(i) Net exposure of each foreign currency in Rupees
Inflow Outflow Net Inflow Spread Net

(Millions) (Millions) (Millions) Exposure
(Millions)
US$ 40 20 20 0.81 16.20
FFr 20 8 12 0.67 8.04
UK£ 30 20 10 0.41 4.10
Japan Yen 15 25 -10 -0.80 8.00
(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:
Spot US $ 1 INR 31.4300/4500
1 month margin 25/20
2 months margin 45/35
Spot US $ 1 EURO 1.4400/4450
1 month forward 1.4425/4490
2 months forward 1.4460/4530
What will be the gain or loss in the transaction?
SOLUTION:-
The amount of EURO bought by selling US$
US$ 10,00,000 × EURO 1.4400 = EURO 14,40,000
The amount of EURO sold for buying
Page 188
USD 10,00,000 × 1.4450 = EURO 14,45,000
Net Loss in the Transaction = EURO 5,000
To acquire EURO 5,000 from the market @
(a) USD 1 = EURO 1.4400 &
(b) USD1 = INR 31.4500
Cross Currency buying rate of EUR/INR is ₹ 31.4500 / 1.440 i.e. ₹ 21.8403
Loss in the Transaction ₹ 21.8403 × 5000 = ₹ 1,09,201.50
Alternatively, if delivery to be affected then computation of loss shall be as

follows:
EURO to be surrendered to acquire $ 10,00,000 = EURO 14,45,000
EURO to be received after selling $ 10,00,000 = EURO 14,40,000
Loss = EURO 5,000
To acquire EURO 5,000 from market @
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:
Page 189
(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
Maximum final cost = 6700 + 335 = INR 7035
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
Suppose exchange rate at the end of 6 months is INR 6.35, Airlines

should not exercise its option. In the open market it need to pay only INR
6.35 (instead of INR 6.70) to buy one FF. However, it has already paid the
option premium.
(iii) Money Market Operations: Airlines can borrow in Indian Rupee an

amount and get it converted in FFs at Spot Rate. This amount can be
invested in France for 6 months so that this amount along with interest
due on it becomes equal to FFs 1000 million and is used for making the
payment. The loan in Indian Rupee can be repaid back after 6 months
along with the interest due thereon. If interest rate parity holds, the
difference in the forward rate and the spot rate is the reflection of the
difference in the interest rates in two countries.
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.
Page 190
QUESTION – 121
On 1st February 2020, XYZ Ltd. a laptop manufacturer imported a particular

type of Memory Chips from SKH Semiconductor of South Korea. The payment
is due in one month from the date of Invoice, amounting to 1190 Million South
Korean Won (SKW). Following Spot Exchange Rates (1 st February) are quoted in
two different markets:
USD/ INR 75.00/ 75.50 in Mumbai
USD/ SKW 1190.00/ 1190.75 in New York
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.
In NDF Market a dealer quoted one-month USD/ SKW at 1190.00/1190.50 for

notional amount of USD 100,000 to be settled at reference rate declared by
Bank of Korea.
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:
USD/ INR 75.50/ 75.75 in Mumbai
USD/ SKW 1188.00/ 1188.50 in New York
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)
(MTP April 2021)
SOLUTION:-
(i) Do Nothing
Page 191
We shall compute the cross rates in spot market on both days and shall
compare the amount payable in INR on these two days.
On 1st February 2020
Dollar – SKW = SKW 1190.00
Rupee – SKW cross rate = ₹ 75.50/1190.00
= ₹ 0.0634
Amount payable to importer as per above rate (1190 millions × ₹ 0.0634)

₹ 754.4600 lakh
Dollar – SKW = SKW 1188.00
Rupee – SKW cross rate = ₹ 75.75/1188.00
= ₹ 0.0638
Amount payable to importer as per above rate (1190 millions × 0.0638) ₹

759.2200 lakh.
Thus, Exchange rate loss
= (₹ 759.2200 lakh - ₹ 754.4600 lakh) ₹ 4.7600 lakh
(ii) Hedging in NDF
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
Page 192
Final position
Amount payable in spot market (as computed earlier) ₹ 759.2200 Lakh

Less: Profit form NDF market USD 4219 × 75.50 ₹ 3.1853 Lakh
₹ 756.0347 lakh
Thus, Exchange rate loss = (₹ 756.0347 lakh - ₹ 754.4600 lakh) ₹ 1.5747

lakh.
Decision: Since exchange loss is less in case of NDF same can be opted
for.
Page 193
INTERNATIONAL FINANCIAL MANAGEMENT
CHAPTER – 04
International Financial Management

(I) International Capital Budgeting
(II) Raising Fund From Abroad (ADR, GDR)
(I) International Capital Budgeting
International capital budgeting means long term investment in foreign country.

Decision is taken on the basis of positive NPV.
There are two approaches to calculate NPV
(i) Domestic currency approach.
(ii) Foreign currency approach.
Example – 01
Indian company evaluating a project in US
Cost of project = $ 10,00,000
Cash inflows year
1 = $ 3,00,000
2 = $ 5,00,000
3 = $ 6,00,000
Current spot rate ₹/$ = 75
Risk free rate in India = 6% p.a.
Risk free rate in USA = 2% p.a.
Required rate of return by Indian shareholders in ₹ term 16% p.a.
Page 1
Evaluate the project using
(i) Domestic (Home) currency approach.
(ii) Foreign currency approach.
(II) Raising Fund From Abroad (ADR, GDR)
ADR/GDR means equity shares issued in foreign countries. It means if an

Indian company wants to issue shares on US stock exchange, we call it ADR. If
issue anywhere, it is called GDR.
Net Amount to be Raised

1. Number of ADR to be issued =
Net Proceeds per ADR
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 :
Year Cash in flow

1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required
rate of return on this project is 14%.
SOLUTION:
(1 + 0.12) (1 + Risk Premium) = (1 + 0.14)
Or, 1 + Risk Premium = 1.14/1.12 = 1.0179
Page 2
Therefore, Risk adjusted dollar rate is = 1.0179 × 1.08 = 1.099 – 1 = 0.099
Calculation of NPV
Year Cash Flow (Million) PV Factor @ 9.9% P.V.

US$
1 2.00 0.910 1.820
2 2.50 0.828 2.070
3 3.00 0.753 2.259
4 4.00 0.686 2.744
5 5.00 0.624 3.120
12.013
Less: Investment 11.000
NPV 1.013
Therefore, Rupee NPV of the project is = ₹ (48 × 1.013) Million
= ₹ 48.624 Million
QUESTION – 02
X Ltd., an Indian company, is considering a proposal to make an investment of

USD 1,65,00,000 in Latin America. The project will have a life of 5 years. The
current spot exchange rate is INR/USD 72. All investments and revenues will
occur in USD. The USD and INR risk free rates are 8% and 12% respectively.
The following cash flow is expected from the project.
Year Cash Inflows (USD)

1 30,00,000
2 37,50,000
3 45,00,000
4 60,00,000
5 75,00,000
Assume required rate of return on the project as 14%.
(i) The viability of the project using foreign currency approach.
(ii) What will be the impact if there is a withholding tax of 10% applicable on
the project.
Page 3
SOLUTION:
(i) Viability of the Project
(1 + 0.12) (1 + Risk Premium) = (1 + 0.14)

Or, 1 + Risk Premium = 1.14/1.12 = 1.0179
Therefore, Risk adjusted dollar rate is = 1.0179×1.08 = 1.099 – 1
= 0.099
Calculation of NPV
Year Cash flow (Million) US$ PV Factor at 9.9% P.V.

1 3.00 0.910 2.730
2 3.75 0.828 3.105
3 4.50 0.753 3.389
4 6.00 0.686 4.116
5 7.50 0.624 4.680
18.02
NPV 1.52
Therefore, Rupee NPV of the project is = ₹ 72 × US$ 1.52 Million
= ₹ 109.44 Million
Project is viable as the NPV is positive.
(ii) If there is a withholding tax of 10%
Total PV of Cash Inflows US$ 18.02 Million
Less: Withholding Tax @ 10% US$ 1.802 Million
PV of Cash Inflow after Withholding Tax US$ 16.218 Million
Less: Initial Investment US$ 16.50 Million
NPV (US$ 0.282 Million)
Therefore, Rupee NPV of the project is = ₹ 72 × (US$ 0.282 Million)

= − ₹ 20.304 Million
Page 4
Thus, if there is a withholding tax of 10% then the project will not be
viable.
QUESTION – 03
DK Ltd. is considering as investment proposal in Sri Lanka involving an initial

investment of LKR 25 billion. The current spot exchange rate is INR/LKR 0.37.
The risk free rate in India is 6% and the same is Sri Lanka is 5.02%. The
project will generate a cash flow of LKR 5 billion in the first year. The cash flow
will increase by LKR 1 billion each year for the next 4 years. The project will
bind up on completion of 5 years with no salvage value.
The required rate of return for the project is 8%
(i) You are required to find out the investment worth of the project by
(a) Home Currency Approach

(b) Foreign Currency Approach
(ii) Compare the outcome under both the approaches.
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
SOLUTION:
Working Notes :
Calculation of Forward Exchange Rates
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
Page 5
5 1.06 0.388
0.382 ×
1.052
(i) Home Currency Approach
Year Cash ₹/LKR Cash PVF @ PV

Flow Flow 8% Billion
Billon Billon ₹ ₹
LKR
1 5 0.373 1.865 0.92593 1.7269
2 6 0.376 2.256 0.85734 1.9342
3 7 0.380 2.660 0.79383 2.1116
4 8 0.384 3.072 0.73503 2.2580
5 9 0.388 3.492 0.68058 2.3766
10.4073
Less:
Investment 25 0.37 9.2500
NPV 1.1573
*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
(ii) Foreign Currency Approach
(1 + 0.06) (1 + Risk Premium) =1.08
1 + Risk Premium = 1.08/1.06 = 1.01887
Therefore, Risk adjusted LKR Rate = 1.01887× 1.0502 – 1 = 0.07
Calculation of NPV
Year Cash Flow (Billon PVF @ 7% PV (Billion

LKR) LKR)
1 5 0.93457 4.6729
2 6 0.87344 5.2406
3 7 0.81630 5.7141
4 8 0.76290 6.1032
5 9 0.71299 6.4169
28.1477
NPV 3.1477
Page 6
Thus, Rupee NPV of the project = 0.37 × 3.1477 = 1.1646 billion
Decision: NPV is positive in the approach so, project will worth investment.
QUESTION – 04
XY Limited is engaged in large retail business in India. It is contemplating for

expansion into a country of Africa by acquiring a group of stores having the
same line of operation as that of India.
The exchange rate for the currency of the proposed African country is
extremely volatile. Rate of inflation is presently 40% a year. Inflation in India is
currently 10% a year. Management of XY Limited expects these rates likely to
continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African

country for the first three years of the project are as follows:
Year – 0 Year – 1 Year – 2 Year – 3

Cash flows in Indian ₹ (000) −50,000 −1,500 −2,000 −2,500
Cash flows in African Rands

(000) −2,00,000 +50,000 +70,000 +90,000
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each
year indefinitely. It evaluates all investments using 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.
(iii) Ignore taxation.
Year – 1 Year - 2 Year - 3
PVIF @ 20% .833 .694 .579
(SM New Syllabus, PM & Exam May - 2013)
Page 7
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
NPV of 3 years = -59320 (₹ ‘000)
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:
Year Net Cash Flow (in millions)

0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (₹) 0 2.869 4.200 4.600
Page 8
The following information is relevant:
(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All
Nepalese customers are invoiced in NC. NC cash flows are converted to
Indian (₹) at the forward rate and discounted at the Indian rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a.
respectively. The current exchange rate is ₹ 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net
present value (NPV) and modified internal rate of return (MIRR) of the proposal.
You may use following values with respect to discount factor for ₹ 1 @9%.
Present Value Future Value

Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1
(SM New Syllabus, PM & Exam November - 2015)
SOLUTION:
Working Notes:
(i) Computation of Forward Rates
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)
(ii) NC Cash Flows converted in Indian Rupees
Year NC (Million) Conversion Rate ₹ (Million)

0 -25.00 1.600 -15.625
1 2.60 1.615 1.61
2 3.80 1.630 2.33
Page 9
3 4.10 1.645 2.49
Net Present Value
(₹ 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
Modified Internal Rate of Return
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:
Page 10
Net Cash Flow (in Lakh)

Year 0 1 2 3
In US $ (25) 5 7 8
In ₹ 0 60 80 90
If not imported cost of leather to be purchased 400 450 500 600
in India (in ₹)
Other information:
(i) DD Ltd. evaluates all investments by using discount rate of 9% p.a.
(ii) All US customers are invoiced in US $. US $ Cash flows converted into `

at the forward rate and discounted at Indian Rate.
(iii) Inflation in USA and India are expected to be 9% and 8% respectively.
(iv) The current exchange rate 1 US $ = ₹ 74
You are required to Calculate Net Present Value and recommend the decision.
Present value factor @ 9% are as under:
1 Year 2 Year 3 Year

0.917 0.842 0.772
SOLUTION:
Expected Forward Exchange Rates
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)
NPV of the proposal if leather is imported from US
0 1 2 3
Cash Flow is US$ (Lakh) (25) 5 7 8
74.00 73.32 72.65 71.98
Page 11
Expected Forward Rates ₹/ US$ (1,850.00) 366.60 508.55 575.84

Cash Flows in ₹ Lakh (400.00) (450.00) (500.00) (600.00)
Cost of leather if not imported --- 60.00 80.00 90.00
Cash Flows in ₹ Lakh (2,250.00) (23.40) 88.55 65.84
Total Cash Flow ₹ Lakh 1.00 0.917 0.842 0.772
PVF @ 9% (2,250.00) (21.46) 74.56 50.83
PV in ₹ Lakh
NPV (2.146.07)
Decision: Proposal should not be accepted as NPV is negative.
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:
(i) Variable operating cost will be US $ 20 per unit of production;
(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) Production capacity of the proposed project in India will be 5 million

units;
(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;
Page 12
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
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
(SM New Syllabus, PM & Exam May – 2014)
SOLUTION:
Financial Analysis whether to set up the manufacturing units in India or not

may be carried using NPV technique as follows:
(i) Incremental Cash Outflows
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00
(ii) Incremental Cash Inflow after Tax (CFAT)
(a) Generated by investment in India for 5 years
$ 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
Page 13
(b) Cash flow at the end of the 5 years (Release of Working Capital)
35.00
(c) Cash generation by exports (Opportunity Cost)
$ 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
(d) Additional CFAT attributable to Foreign Investment
$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 Years) 171.50
(iii) Determination NPV
Year CFAT PVF@12% PV ($ Million)

($Million)
1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590
638.0822
Less : Initial Outflow 535.0000
103.0822
Since NPV is positive the proposal should be accepted.
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,
Page 14
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:
(a) Variable operating cost will be US $ 25 per unit of production.
(b) Additional cash fixed cost will be US $ 40 million per annum.
(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.
(g) Applicable Corporate Income Tax rate is 30%.
(h) Required rate of return for such project is 12%.
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
(Compute your working to 4 decimals)
(c) Discuss briefly the key decisions which fall within the scope of financial
strategy.
SOLUTION:
Page 15
(a) Calculation of expected return on market portfolio (Rm)
Investment Cost (₹) Dividends (₹) Capital Gains (₹)

Shares A 16,000 1600 400
Shares B 20,000 1600 1000
Shares C 32,000 1600 12,000
PSU Bonds 68,000 6800 -3,400
1,36,000 11,600 10,000
11,600+10,000
Rm = × 100 = 15.88%
1,36,000
Calculation of expected rate of return on individual security.
Security
Shares A 12 + 0.9 (15.88 – 12.0) = 15.49%
Shares B 12 + 0.8 (15.88 – 12.0) = 15.10%
Shares C 12 + 0.6 (15.88 – 12.0) = 14.33%
PSU Bonds 12 + 0.4 (15.88 – 12.0) = 13.55%
Calculation of the average return of the portfolio:
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%.
Page 16
Inflation rates in US and India are expected to be 8% and 9% respectively. The

current exchange rate is ₹ 72 per US Dollar.
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.
PVF @ 8% for the five years are as under:
Rate 1 Year 2 Year 3 Year 4 Year 5 Year

8% 0.926 0.857 0.794 0.735 0.681
SOLUTION:
Working Notes:
(i) Initial Investment in US$
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
(ii) Expected Exchange Rates
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
Page 17
Particulars Amount (₹)
Sales (80000 × ₹ 100) 80,00,000
Less: Variable Cost (80000 × ₹ 30) 24,00,000
Additional Fixed Cost 5,00,000
(₹ 80,00,000− ₹ 20,00,000)
Depreciation 12,00,000
5
Profit Before Tax (PBT) 39,00,000
Less: Tax @ 34% 13,26,000
25,74,000
Add: Depreciation 12,00,000
37,74,000
(iv) Amount repatriated each year in US$
Year In ₹ Expected In US$

Exchange Rate
(₹/US$)
1 Annual Cash Flow 37,74,000 72.67 51,933.40
2 ---do--- 37,74,000 73.34 51,458.96
3 ---do--- 37,74,000 74.02 50,986.22
4 ---do--- 37,74,000 74.71 50,513.33
5 ---do--- 37,74,000 75.40 50,053.05
(v) Release of working capital in US$ at the end (₹ 10,00,000/₹ 75.40) = US$
13,262.60
(vi) Salvage value of project in US$ (₹ 20,00,000/₹ 75.40) = US$ 26,525.20
NPV of the proposed project
Particulars Period Cash Flows PVF @ PV ($)

($) 8%
Initial Outlay 0 (1,25,000.00) 1.000 (1,25,000.00)
Annual Cash Flow 1 51,933.40 0.926 48,090.33
---do--- 2 51,458.96 0.857 44,100.33
---do--- 3 50,986.22 0.794 40,483.06
---do--- 4 50,513.33 0.735 37,127.30
Page 18
---do--- 5 50,053.05 0.681 34,086.13

Release of working 5 13,262.60 0.681 9,031.83
capital
Salvage value of the 5 26,525.20 0.681 18,063.66
project
1,05,982.64
Since the NPV of the project is positive, it is feasible.
QUESTION – 10
A US based company is planning to set up a subsidiary company in India

(where so far it was exporting) in view of growing demand for its product and
competition from other US based companies. The initial project cost consisting
of plant and machinery including installation is estimated to be US$ 490
million. The net working capital requirements are estimated at US$ 60 million.
The company follows straight line method of depreciation. Currently, the
company is exporting two million units every year at a unit price of US$ 90, its
variable cost per unit being US$ 50.
The CFO of the Company has estimated the following operating cost and other
data in respect of proposed project:
(i) Variable operating cost will be US $ 30 per unit of production;
(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;
(iv) Production capacity of the proposed project in India will be 5 million

units;
(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;
(vii) Applicable Corporate Income Tax rate is 35%, and
Page 19
(viii) Required rate of return for such project is 12%.
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
(Exam July - 2021)
SOLUTION:
Financial Analysis whether to set up the manufacturing units in India or not

may be carried using NPV technique as follows:
I. Incremental Cash Outflows
$ 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
Page 20
(3) Cash generation by exports (Opportunity Cost)
$ 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
(4) Additional CFAT:
$ Million
Through setting up subsidiary in India 209.80
Through Export in India 39.00
CFAT (1-5 years) 170.80
III. Determine of NPV
Year CFAT ($ Million) PVF @ 12% PV ($ Million)

1-5 170.80 3.6048 615.6998
5 35 0.5674 19.8590
635.558
Less: Initial Outflow 525.0000
NPV 110.5588
Advice: Since NPV is positive the proposal should be accepted.
QUESTION – 11
A USA based company is planning to set up a software development unit in

India. Software developed at the Indian unit will be bought back by the US
parent at a transfer price of US $10 millions. The unit will remain in existence
in India for one year; the software is expected to get developed within this time
frame.
The US based company will be subject to corporate tax of 30 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
Man power cost (80 software professional will be working

for 10 hours each day) ₹ 400 per man hour
Page 21
Administrative and other costs ₹ 12,00,000
Advise the US Company on the financial viability of the project. The rupee-
dollar rate is ₹48/$.
Note: Assume 365 days a year.
(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
Less: Tax 10,81,50,000
Earning after tax 25,23,50,000
Repatriation amount (in rupees) $ 5,257,292
Page 22
$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.
Alternatively, if it assumed that first the withholding tax @ 10% is being

paid and then its credit is taken in the payment of corporate tax then
solution will be as follows:
₹ ₹
Revenue 48,00,00,000
Less Costs:
Rent 15,00,000
Manpower (₹ 400 × 80 × 10 × 365) 11,68,00,000
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) $ 5,257,292
$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
A proposed foreign investment involves creation of a plant with an annual

output of 1 million units. The entire production will be exported at a selling
price of USD 10 per unit.
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
Page 23
15 0.15 Additional reduction 0.2
The plant at the current rate of exchange will have a depreciation of USD 1
million annually. Assume local Tax rate as 30%.
You are required to find out:
(i) Annual Cash Flow After Tax (CFAT) under all the different scenarios of
exchange rate.
(ii) Expected value of CFAT assuming no repatriation of profits.
(iii) Viability of the investment proposal assuming an initial investment of

USD 25 million on plant and working capital with a required rate of
return of 11% on investment and on the basis of CFAT arrived under
option (ii). The CFAT will grow @ 3% per annum in perpetuity.
SOLUTION:
(i) Calculation of Annual CFAT

Scenario 1 Scenario 2 Scenario 3
Annual Sales (in units) (A) 10,00,000 10,00,000 10,00,000
US $ US $ US $
Selling price p.u. 10.00 10.00 10.00
Cost p.u. 6.00 5.70 5.55
Profit p.u. (B) 4.00 4.30 4.45
Total Profit (A × B) 40,00,000 43,00,000 44,50,000
Less: Depreciation 10,00,000 9,00,000 8,50,000
PBT 30,00,000 34,00,000 36,00,000
Less: Tax @30% 9,00,000 10,20,000 10,80,000
PAT 21,00,000 23,80,000 25,20,000
Add: Depreciation 10,00,000 9,00,000 8,50,000
Expected CFAT (US$) 31,00,000 32,80,000 33,70,000
(ii) Expected Value of CFAT

= US$ 31,00,000 × 0.4 + US$ 32,80,000 × 0.4 + US$ 33,70,000 × 0.2
= US$ 32,26,000
(iii) Viability of proposal :

Expected CFAT = US $ 32,26,000
Expected Growth Rate = 3%
Page 24
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
Since NPV is positive, project is viable.
(II) Raising Fund From Abroad (ADR,GDR)
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:
(i) The expected domestic market price of the share is ₹ 300
(ii) 3 shares underly each GDR
(iii) Underlying shares are priced at 10% discount to the market price
(iv) Expected exchange rate is ₹ 60/$
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%.
(Practice Manual & Exam Nov - 2014)
SOLUTION:
Net Issue Size = $15 million
Page 25
$15million
Gross Issue = = $15.306 million
0.98
Issue Price per GDR in ₹ (300 × 3 × 90%) ₹ 810
Issue Price per GDR in $ (₹ 810/ ₹ 60) $13.50
Dividend Per GDR (D1) = ₹ 2* × 3 = ₹6
* Assumed to be on based on Face Value of ₹ 10 each share.
Net Proceeds Per GDR = ₹ 810 × 0.98 = ₹ 793.80
(a) Number of GDR to be issued
$15.306 million
= 1.1338 million
$13.50
(b) Cost of GDR to Odessa Ltd.
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)
(ii) Each GDR will represent two underlying Shares.
(iii) The issue shall be priced at 10% discount to the market price.
(iv) Expected exchange rate is INR/USD 72.
(v) Dividend is expected to be paid at the rate of 20% with growth rate of
12%.
Page 26
(1) You, as a financial consultant, are required to compute the

number of GDRs to be issued and cost of the GDR.
(2) What is your suggestion if the company receives an offer from a

US Bank willing to provide an equivalent loan with an interest rate
of 12%?
(3) How much company can save by choosing the option as

recommended by you?
(RTP May – 2022, MTP April – 2022 & Exam July - 2021)
SOLUTION:
Net Issue Size = $ 8.82 million
8.82
Gross Issue = = $ 9.00 million
0.98
Issue Price per GDR in $ (₹ 648/ ₹ 72) $ 9.00
Dividend Per GDR (D1) = ₹ 20 × 2 = ₹ 40
(1) (a) Number of GDR to be issued
$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.
(3) If the offer is accepted there will be net saving of 6.30%.
Page 27
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)
(ii) 4 shares underlay each GDR
(iii) Underlying shares are priced at 20% discount to the market price
(iv) Expected exchange rate is ₹ 70/$
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%.
(RTP May - 2021)
SOLUTION:
Net Issues Size = $30 million
$30 million
0.96
Dividend per GDR (D1) (₹ 2 × 4) ₹8
Net Proceeds per GDR (₹ 960 × 0.96) ₹ 921.60
(a) Number of GDR to be issued
$31.25 million
= 2.2794 million
$13.71
(b) Cost of GDR to Right Ltd.
8
Ke = + 0.20 = 20.87%
921.60
Page 28
QUESTION – 16
Omega Ltd. is interested in expanding its operation and planning to install

manufacturing plant at US. For the proposed project, it requires a fund of $10
mil lion (net of issue expenses or floatation cost). The estimated floatation cost
is 2%. To finance this project, it proposes to issue GDRs.
As a financial consultant, you are requested to compute the number of GDRs

to be issued and cost of the GDR with the help of following additional
information:
(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.
(iii) Expected exchange rate ₹ 64/$
(iv) Dividend expected to be paid is 15% with growth rate 12%.
(Exam May - 2018)
SOLUTION:
Net Issue Size = $10 million
₹ 10 million
0.98
Dividend Per GDR (D1) = ₹ 15 × 2 = ₹ 30
(i) Number of GDR to be issued
$ 10.2041 million
= 1.360547 million
$ 7.50
Page 29
(ii) Cost of GDR to Omega Ltd.
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.
The Spot rate of $ is ₹ 57. The inflation in India is 6% (expected to decrease by

0.50%every year) and 5% in US.
As per the policy of GOI, only 50% of the share can be remitted in the year in
which they are earned and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it
expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from
subsidiary point of view).
Page 30
SOLUTION:
Working Notes:
(i) Estimated Exchange Rate (Using PPP Theory)
Year 0 1 2 3 4 5 6
Exchange Rate 57 57.54 57.82 57.82 57.54 56.99 56.18
(ii) Share in sales
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)
(iii) Royalty Payment
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
(iv) Tax Liability
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
Page 31
(v) Free Cash Flow
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
(vi) Remittance of Cash Flows
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
NPV of Project under Appraisal
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
Exchange Rate 57.00 57.54 57.82 57.82 57.54 56.99 56.18
Remittance ($mn) -43.86 6.24 12.14 12.34 13.35 21.44 10.97

US Tax @ 35%
($mn) 0.00 0.00 2.18 4.25 4.32 4.67 7.50
Page 32
Indian Tax ($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
PVF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432

Present Value
($mn) -43.86 5.43 9.01 6.89 6.77 9.95 3.10
Net Present Value ($mn) -2.71
Decision: Since NPV of the project is negative, Perfect inc. should not invest in
the project.
* Estimated exchange rates have been calculated by using the following

formula:
Expected spot rate = Current Spot Rate × expected difference in inflation rates
(1+ I d )
E S1 = S0 ×
(1+ 1 f )
Where
E S1 is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
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
Page 33
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.
Page 34
SOLUTION:-
Working Notes:
(1) Calculation of Cost of Funds/ Discount Rate
Competing Company's Information

Equity Market Value 1850.00
Debt Market Value 510.00
Equity Beta 1.35
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)
Equity beta for Its Entertainment Ltd. in Nepal
Assets beta in Nepal 1.106

Ratio of funding in Nepal
Equity 55.00%
Debt 45.00%
55
1. 106 = Equity Beta ×
55 + 45 (1−0.30)
Equity Beta = 1.74
Cost of Equity as per CAPM
Market Return 11.00%
Risk free return 8.00%
Cost of Equity = Risk free return + β (Market Return − Risk free return)
= 8.00% + 1.74(11.00% - 8.00%) = 13.22%
WACC = 13.22% × 0.55 + 9%(1− 0.20) × 0.45 = 10.51%
2. Present Value Factors at the discount rate of 10.51%
Page 35
Year 0 1 2 3 4 5
PVAF 1.000 0.905 0.819 0.741 0.670 0.607
3. Calculation of Capital Allowances
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
Calculation of Present of Free Cash Flow
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
Page 36
(NPR crores) 142.18 142.03 143.69 146.82
PBT (NPR crores) 10.63 18.41 24.78 30.07

Tax on Profit
(NPR crores) 2.13 3.68 4.96 6.01
Net Profit (NPR
crores) 8.51 14.73 19.83 24.06
Add:
Depreciation
Allowances (NPR
crores) 40 32 25.6 20.48
Park
Construction
Cost (NPR
crores) -225 -225
After tax assets
realization value
(NPR crores) 250
Working capital
(NPR crores) -65.00 -3.25 -3.41 -3.58 75.25
Net cash Flow
(NPR crores) -225.00 -290.00 45.26 43.32 41.84 369.78
PVF at discount
rate 1.00 0.90 0.82 0.74 0.67 0.61
Present Values
(NPR crores) -225.00 -262.40 37.06 32.10 28.06 224.35
Net Present Value (NPR crores) -165.86
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
Page 37
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
You are required to
(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:
1. Calculation of Cost of Capital (GDR)
Current Dividend (D0) 2.50

Expected Dividend (D1) 2.75
Net Proceeds (Rs. 200 per share -1%) 198.00
Growth Rate 10.00%
2.75
Ke = + 0.10 = 0.1139 i.e. 11.39 %
198
2. Calculation of Expected Exchange Rate as per Interest Rate Parity
Year Expected Rate

1 (1+0.12)
9.50 × = 9.67
(1+0.10)
Page 38
2 (1+0.12)2
9.50 × = 9.85
(1+0.10)2
3. Realization on the disposal of Land net of Tax
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
4. Realization on the disposal of Office Complex
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
5. Computation of Annual Cash Inflows
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
(i) Computation of NPV of the project in (CN¥)
Year 0 1 2
Initial Investment -45,00,000.00
Annual Cash Inflows 8,35,500.00 8,87,340.00
Realization on the
Page 39
disposal of Land net of 33,75,000.00

Tax
Realization on the
disposal of Office 3,75,000.00
Complex
Total -45,00,000.00 8,35,500.00 46,37,340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -45,00,000.00 7,50,279.00 37,37,696.00
NPV -12,025
(ii) Evaluation of Project from Opus Point of View
(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.
Page 40
TABLES
TABLES
Page 1
TABLES
Page 2
TABLES
Page 3
TABLES
Page 4
TABLES
Standard Normal Distribution Table
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.
Values of z for selected values of Pr(Z ≤ z)

z 0.842 1.036 1.282 1.645 1.960 2.326 2.576
Pr(Z ≤ z) 0.800 0.850 0.900 0.950 0.975 0.990 0.995
Page 5
TABLES
Normal Probability Distribution Table
Page 6
TABLES
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
16 1.337 1.746 2.120 2.583 2.921 4.015

17 1.333 1.740 2.110 2.567 2.898 3.965
18 1.330 1.734 2.101 2.552 2.878 3.922
19 1.328 1.729 2.093 2.539 2.861 3.883
20 1.325 1.725 2.086 2.528 2.845 3.850
21 1.323 1.721 2.080 2.518 2.831 3.819
22 1.321 1.717 2.074 2.508 2.819 3.792
23 1.319 1.714 2.069 2.500 2.807 3.768
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725
26 1.315 1.706 2.056 2.479 2.779 3.707
27 1.314 1.703 2.052 2.473 2.771 3.690
28 1.313 1.701 2.048 2.467 2.763 3.674
29 1.311 1.699 2.045 2.462 2.756 3.666
30 1.310 1.697 2.042 2.457 2.750 3.646
40 1.303 1.684 2.021 2.423 2.704 3.551
60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
0 1.282 1.645 1.9600 2.326 2.576 3.291
Page 7
TABLES
Continuous Compounding, Discrete Cash Flows
r = 1%
Page 8
WORKING NOTE
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Exam Oriented Book
CA Pavan Sir
About CA Pavan Sir
CA PAVAN KARMELE is a qualified Chartered Accountant is a

fellow member of ICAI. He is Post graduate in Master of Commerce with
specialization in Finance from Sagar University, Graduated from Dr.
Harishingh Gour University. He is known for conceptual clarity. He has 12
years of experience in teaching in the field of Financial Management for CA
and CS aspirants at Inter and FINAL level. He has profound interest in
spreading quality education. He has taught more than 10,000+ students.
He has conducted face to face classes at Raipur, Chhattisgarh and also
provide Pendrive and Google Drive video lectures classes all over the
India CA/CS aspirants. His way of teaching is so being loved and
appreciated by students from all over India.
OUR WHATSAPP & TELEGRAM CHANNEL
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CA Final SFM

SFM NEW SYLLABUS

CA Pavan Karmele Sir

2. Interest Rate Risk Management

3. Foreign Exchange Exposure & Risk Management

4. International Financial Management

EXAM ORIENTED BOOK (NEW SYLLABUS)

 Revised & Updated

COPYRIGHT © 2020 PAVAN SIR SFM CLASSES

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Contact Us for Technical and General Help

Printed by Pavan Sir SFM Classes

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Valuation of option or option pricing………………………………….…. 6

Binomial Model ………………………………………………………............ 7

Two Period binomial Model …………………………………………………. 9

Put Call Parity Theorem …………………………………………………… … 10

Black Scholes Model (BSM) ………………………………………………… 11

Option strategies …………………………………………………………..….. 12

Straddles & Strangles ……………………………………………………..…. 13

Option Greeks …………………………………………………………….…….. 14

Part II : Forward & Future …………………………………………………… 16

Theoretical Future Price [Cost of Carry Model] ………………………. 19

Beta Management of Hedging Through Stock Index Future ……… 23

Commodity Future ……………………………………………………………. 25

Expected Value of Option …………………………………………… ……… 31

Option Pricing & Valuation ……………………….………….…………….. 34

Two Period Binomial Model ………………………………………………… 37

Delta Hedging Binomial Model …………………………………….………. 41

Put Call Parity ………………………………………………………………….. 44

Block Scholes Model ………………………………………………………… .. 46

Option Strategies ……………………………………………………… ………. 58

Margin A/c ………………………………………………………………………. 68

Valuation of Future …………………………………………………… ……… 73

Beta Management ……………………………………………………………… 82

Commodity future ……………………………………………………………… 106

Interest Rate Risk Management

Part 1: Forward Rate Agreement ………………………………………….. 01

FRA for Hedging ……………………………………………………………….. 03

Part 2: Interest Rate Guarantee [FRAPTION]…………………………… 04

Part 3: Interest Rate Future (Euro Dollar Future) …………… ……… 04

Part 4: Financial Swap ………………………………..……………… …….. 04

Plain Vanilla Swap…………………………………………………………….. 04

Overnight Index Swap………………………………………………..………. 05

Two Parity Swap………………………………………………………………… 06

Swap Quotation (Structuring) ……………………………………………… 06

Swap Pricing &Valuation…………………………………………..… 06

Part 5: CAP, Floor & Collar………………………………………………… … 07

Part I: Forward Rate Agreement (FRA) ……………………………………. 08

Part II: Interest Rate Guarantee ……………………………………………. 14

Part IV: Financial Swap …………………………………………………… .… 20

Plain Vanilla Swap …………………………………………………… ……….. 20

Overnight Index Swap ………………………………………………………… 23

Swap Quotation ………………………………………………………........... 32

Swap Pricing & Valuation ………………………………..……… ..………… 35

Part V: CAP, Floor & Collar…………………………………………………… 37

Foreign Exchange Exposure & Risk

Foreign Exchange Risk Management ……………………………………… 01

Exchange Rate …………………………………………………………..………. 01

Direct /Quote …………………………………………………………………….. 01

Indirect Quote ……………………..…………………………………………….. 02

Conversion of Currency ……………………………………………………… .. 02