IFM Notes Full Rudramurthy Sir

Rudramurthy B.
CRASH COURSE FOR IFM AND

PROJECT FINANCE WILL BE HELD
FROM 25TH MAY TO 31ST MAY
2011.
TIMINGS: 5 to 8pm.
FEES: Rs.1,500/- per subject.
COVERAGE; ALL PRACTICAL
AREAS.
GROUP DISCOUNT AVAILABLE
FOR SAME COLLEGE STUDENTS:
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the earliest as we take only 1 Batch. For
Registration and further details you can
contact Mr.Sagar @ 9845620530 Or
9535628295.
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INTERNATIONAL FINANCIAL MANAGEMENT
BASICS
• Extends the area of operations to outside the geographical boundaries of the

domestic country.
• Generally, Domestic Corporates face with only business and financial risks
only.
• Multinational Companies are exposed to currency risk.
QUOTES:
There are two types of Quotes:
1. Direct Quotes.
2. Indirect Quotes.
Direct Quote: One unit of foreign currency expressed in so many units of home
currency.
EX: 1$ = INR 40.

1P = INR 70.
1Kg of Sugar = INR 15.
1BG = INR 50,000.
Indirect Quote: One unit of home currency expressed in so many units of foreign
currency. (1/DQ)
EX: 1INR = $ 0.025

1INR = £ 0.0143
1INR = S 0.0667
1INR = BG 0.00005
Exceptions:
Certain Currencies are always quoted for 100units instead of 1unit.
EX: Japanese Yen.
South Korean Won
Indonesian Rupiah
Caution:
All over the world, direct quotes are followed, except in UK and Euro countries where
indirect quotes are followed.
Bid Rate: It is the Buying rate of the Authorized dealer i.e. the Selling rate for the
customer.
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Rudramurthy B.V
Offer Rate: It is the Selling rate of the Authorized dealer i.e. the Buying rate for the
customer.
Spread: It is the difference between Offer rate and Bid Rate.
Spread: (In %) = Spread in Rs × 100

Offer Rate
Computation of indirect quote for a two way direct quote:
Bid rate of Indirect Quote = 1 .

Offer rate of Direct Quote
Offer rate of Indirect Quote = 1 .

Bid rate of Direct Quote
Cross Rates:
Authorized dealers may have quotation only for some popularly traded foreign
currencies. If a customer needs a quotation for a currency other than these currencies,
CROSS RATES are used.
PROBLEM:
1. Suppose RM plans to invest in Martin ltd, a British corporation that is

currently selling for £50 per share. RM has $1,12,500 to invest at current
exchange rate of $2.25/1£
a) How many shares can RM purchase?
b) What is his net return if the price of Martin ltd at the end of the year is 60£ and
the exchange rate at that time is $2.00/1£
Solution
a)
RM has $112500 to invest = $ 112500 = 50000 £
2.25
RM can purchase = 5000 = 1000 shares

50
b)
His return in pounds would be 1000 × 60 £ = 60000 £
His return in dollars would be 60000 × 2 = $120000
Return in % (Pounds) = 60000 – 50000 = 20 %

50000
Return in % (Dollars) = 120000 – 112500 = 6.67 %
112500
This change in percentage is due to CURRENCY RISK
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Factors influencing Capital Budgeting

1. Estimated cash out flow
2. Estimated future cash inflow
3. Estimated life of the project
4. Discounting factor (Risk adjusted rate)
5. Spot rate and expected forward rate
6. Risk free rate in home country an foreign country
There are two approaches to evaluate international capital budgeting

a) Home currency approach
b) Foreign currency approach
Problem
2. Indian Pharma ltd an Indian based foreign MNC is evaluating an overseas
investment proposal, India Pharma ltd exporter of pharmaceutical products is
considering to build a plant in United States the project will entail an initial outlay
of $ 100 million and it is expected to give the following cash flow over its life of 4
years
Years Cash Flow (in million $)

1 30
2 40
3 50
4 60
The current spot exchange rate is Rs 45/$ the risk free rate of interest in India is
11 % and in US it is 6 %. India Pharma requires a rupee return of 15 % on the
above project. Calculate the NPV under both home currency and foreign currency
approach.
Solution
a) Home currency approach
Calculation of expected forward rate according to International Fischer effect
t
St = S0 1 + rhc
1 + rfc
Where St = forward rate for year t

S0 = spot rate
rhc = risk free rate in the home country
rfc = risk free rate in the foreign country
t = time period
S1 = 45 1 + 0.11 = 47.12
1 + 0.06
2
S2 = 45 1 + 0.11 = 49.35
1 + 0.06
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3
S3 = 45 1 + 0.11 = 51.67
1 + 0.06
4
S4 = 45 1 + 0.11 = 54.11
1 + 0.06
Calculation of NPV
Year Cash Flow (in ER Cash Flow (in DF @ 15% DCF
million $) million Rs)
0 (100) 45.00 (4500) 1.0000 (4500)
1 30 47.12 1413.60 0.8696 1229.22
2 40 49.35 1974.00 0.7561 1492.63
3 50 51.67 2583.50 0.6575 1698.69
4 60 54.11 3246.60 0.5718 1856.25
4717.70 1776.79
Since NPV is positive, the above foreign project shall be accepted
b) Foreign currency approach
(1 + risk adjusted rupee rate) = (1 + Rf rupee rate) × (1 + risk premium)
(1 + 0.15) = (1 + 0.11) (1 + rp)
(1 + rp) = 1.15/1.11 = 1.036
rp = 3.6 %
(1 + risk adjusted dollar rate) = (1 + Rf dollar rate) × (1 + risk premium)
(1 + risk adjusted dollar rate) = (1 + 0.06) × (1 + 0.036)
(1 + risk adjusted dollar rate) = 1.09816
risk adjusted dollar rate = 9.8 %
Calculation of NPV
Years Cash Flow in million $ DF @ 9.8 % DCF
0 (100) 1 -100
1 30 0.9107 27.3224
2 40 0.8295 33.1784
3 50 0.7554 37.7714
4 60 0.6880 41.2802
39.5524
39.5244 × 45 = 1779.86
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Home currency approach
1. Calculation of Expected Forward rate (ERF) using international Fischer effect

2. Convert cash flows in foreign currency to local currency using spot rate and
ERF
3. Calculate present value of cash flows in local currency (Risk adjusted local
country rate i.e. DF)
4. Evaluate the project by calculating its NPV, if NPV is positive accept or reject
the proposal
Foreign currency approach
1. Calculation of Risk premium rate

2. Calculation of risk adjusted foreign country rate
3. Calculation of cash flow using risk adjusted foreign country rate and
discounting factor
4. Evaluate the proposal using NPV
Problem
3. Barret Corporation presently has no existing business in France but is
considering the establishment of a subsidiary there. The following information is
given to assess this project
 The initial investment required is FF 60 million. The existing spot rate is $ 0.20;
the initial investment in dollars is $ 12 million. In addition to FF 60 million
initial investment on plant and equipment, FF 10 million is needed for working
capital and will be borrowed by the subsidiary from French bank. The French
subsidiary of Barret will pay interest only on the loan each year at an interest of
10%.
The loan principal is to be paid in 10 years
 The project will be terminated at the end of year 3, when subsidiary will be sold.
 The price, demand, and variable cost of the product in France are as follows:
Year Price (FF) Demand Variable Cost (FF)

1 600 40000 25
2 650 50000 30
3 700 60000 40
 The fixed costs are estimated to be FF 5 million per year.
 The exchange rate of the French Franc is expected to be $ 0.22 at the end of year
1, $0.25 at the end of year 2 and $ 0.28 at the end of year 3.
 The French government will impose a withholding tax of 10 % on earnings

remitted by the subsidiary. The U.S government will allow a tax credit on
remitted earnings and will not impose any additional taxes.
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 All cash flows received by the subsidiary are to be sent to the parent at the end
of each year. The subsidiary will use its working capital to support ongoing
operations.
 The plant and equipment are depreciated over 10 years, using straight-line
depreciation method. Since the plant and equipment are initially valued at FF 60
million, the annual depreciation expense is FF 6 million.
 In three years, the subsidiary is to be sold. Barret plans to let the acquiring firm
assume the existing French loan. The working capital will not be liquidated, but
will be used by the acquiring firm
 The required rate of return on this project is 15 %.
a) Determine the net present value of this project. Should Barret

accept this project?
b) Assume that Barret Co. provides the additional funds for

working capital so that the loan from the French government is not
necessary.
c) Would the NPV of this project from the parent’s perspective be

more sensitive to exchange rate movements if the subsidiary used French
financing to cover the working capital? Explain
d) Assume Barret Co. uses the original proposed financing

arrangement and that funds are blocked until the subsidiary is sold. The
funds to be remitted are reinvested at a rate of 8 % (after taxes) until the
end of year 3. How is the project’s NPV affected?
e) Assume that Barret Co. decided to implement the project, using

the original proposed financing arrangement; also assume that after one
year, a French firm offers Barret Co. a price of $ 30 million after taxes for
the subsidiary, and that Barret Co. original forecasts for years 2 and 3 have
not changed. Should Barret Co. divest the subsidiary? Explain
Solution
a)
To find cash flow transferred to parent co
FF in million
Particulars 1 2 3
Sales 24 32.5 42
- Variable Cost 1 1.5 2.4
Contribution 23 31 39.6
- Fixed Cost 5 5 5
EBITD 18 26 34.6
- Depreciation 6 6 6
EBIT after Depreciation 12 20 28.6
- Interest 1 1 1
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EBT (after interest and depreciation) 11 19 27.6

- tax - - -
EAT 11 19 27.6
+ depreciation 6 6 6
EATBD 17 25 33.6
+ Salvage value (60 – (6×3)) - - 42
Cash flow transferable to parent co 17 25 75.6
- withholding tax 1.7 2.5 7.56
Cash flow transferred to parent co 15. 22.5 68.04
3
Calculation of NPV
Years Cash flow (in Exchange rate Cash flow (in DF @ 15 % DCF
million FF ) million dollar)
0 (60) 0.20 (12) 1.0000 (12)
1 15.3 0.22 3.366 0.8696 2.9270
2 22.5 0.25 5.625 0.7561 4.2533
3 68.04 0.28 19.0512 0.6575 12.5265
7.7067
The above project shall be accepted since NPV is positive
b)
FF in million
Particulars 1 2 3
EBIT after Depreciation 12 20 28.6
- Interest - - -
- tax - - -
EAT 12 20 28.6
EATBD 18 26 34.6
+ Salvage value (60 – (6×3)) - - 42
Cash flow transferred to parent co 16. 23.4 68.94
2
Calculation of NPV
0 (70) 0.20 (14) 1.0000 (14)
1 16.2 0.22 3.564 0.8696 3.0991
2 23.4 0.25 5.85 0.7561 4.4234
3 68.94 0.28 19.3032 0.6575 12.6922
6.2147
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c) If Barret Corporation funds the working capital requirement of its subsidiary,

then it is exposed to French Franc 70 million, where as if the subsidiary
finances its working capital from French Bank then Barret Corporation is
exposed to a total capital of FF 60 million. Thus to minimize currency risk it is
advisable to borrow working capital required from French Bank. Higher the
exposure higher is the risk and visa versa.
d)
FF in million
Particulars 1 2 3
+ interest received at the end of year 2 1.36 - -
+ interest received at the end of year 3 1.46 2 -
8
Cash Flow 19.8 27 75.6
3
Calculation of NPV
0 (60) 0.20 (12) 1.0000 (12)
1 19.83 0.22 4.3626 0.8696 3.7936
2 27.00 0.25 6.75 0.7561 5.1040
3 75.60 0.28 21.168 0.6575 13.9183
10.8158
Note: - For calculating interest time value of money is ignored
e)
Particulars
Cash Flow(FF) 17
- withholding tax @ 10 % 1.7
Cash Flow after WT 15.3
Cash Flow after WT in Dollar (15.3 × 0.22) 3.366
+ Salvage Value 30
Cash Flow in Dollar 33.366
Discounted cash inflow (DF @ 15 %)
(33.366 ×0. 8696) 29.015
- Discounted cash outflow 12
NPV 17.015
It is better to sell the subsidiary at the end of year 1 as higher NPV of $17.015
million is achieved under this situation.
4. Yes corporation expects to receive cash dividend from a French joint venture
over the coming 3 years. The first dividend is expected to be paid on 31/12/02 and
is expected to be € 720000 the dividend is then expected to grow 10 % per year
over the following 2 years, the current exchange rate is $0.9180/€ the weighted
average cost of capital for Yes corporation is 12 %.
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a) What is present value of expected Euro dividend stream if the Euro is

expected to appreciate 4 % per annum against dollar?
b) What is the present value of expected Euro dividend stream if the Euro were to
depreciate at the rate of 3 % per annum against dollar?
Solution
a) Calculation of PV of dividends
Years 0 1 2 3
Expected dividend - 720000 792000 871200
WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118
Expected return (increase
by 4 % every year) 0.9180 0.9547 0.9929 1.0326
Present value of dividends - 613749 626900 640334 1880983
b) Calculation of PV of dividends
Years 0 1 2 3
Expected dividend - 720000 792000 871200
WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118
Expected return (decrease
by 3 % every year) 0.9180 0.8905 0.8637 0.8378
Present value of dividends - 572439 545350 519543 1637332
5. X Corporation presently has no existing business in New Zealand but is

considering the establishment of a subsidiary there. The following information is
given to assess this project
 The initial investment required is $ 50 million in NZ dollars. The existing spot

rate is 0.50 USD/ 1 NZD; the initial investment in USD is $ 25 million. In
addition to 50 million NZD initial investments on plant and equipments 20
million NZD is needed for working capital and will be borrowed by the
subsidiary from NZ bank. The NZ subsidiary of X will pay interest only on the
loan each year at an interest of 14%.
The loan principal is to be paid in 10 years
 The project will be terminated at the end of year 3, when subsidiary will be sold.
 The price, demand, and variable cost of the product in NZ are as follows:
Year Price (NZD) Demand Variable Cost (NZD)

1 500 40000 30
2 511 50000 35
3 530 60000 40
 The fixed costs are estimated to be 6 million NZD per year.
 The exchange rates of the NZD is expected to be $ 0.52 at the end of year 1,
$0.54 at the end of year 2 and $ 0.56 at the end of year 3.
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 The NZ government will impose an income tax of 30 % on income in addition it

will impose a withholding tax of 10 % on earnings remitted by the subsidiary.
The U.S government will allow a tax credit on remitted earnings and will not
impose any additional taxes.
 All cash flows received by the subsidiary are to be sent to the parent at the end
of each year. The subsidiary will use its working capital to support ongoing
operations.
 The plant and equipment are depreciated over 10 years, using straight-line
depreciation method. Since the plant and equipment are initially valued at 50
million NZD, the annual depreciation expense is 5 million NZD.
 In three years, the subsidiary is to be sold. X plans to let the acquiring firm
assume the existing NZ loan. The working capital will not be liquidated, but will
be used by the acquiring firm. When it sells the subsidiary X corporation
expected to receive 52 million NZD after subtracting capital gain tax, assume
that this amount is not subjected to a withholding tax
 X corporation requires 20 % ROI on this project
a) Determine the net present value of this project. Should X Corp.

accept this project?
b) Assume that X Corp. is also considering an alternative

financing arrangement in which the parent would invest an additional $ 10
million to cover working capital required so that subsidiary would avoid
the NZ bank loan. If this arrangement is used the selling price of the
subsidiary after subtracting any capital gains tax is expected to be 18
million NZD higher. Is this alternative financing arrangement more
feasible for the parent than original proposal?
c) From the parent’s perspective would the NPV of this project be

more sensitive to exchange rate movements. If the subsidiary uses NZ
financing to cover the working capital or if the parent invests more of its
own funds to cover the working capital explain.
d) Assume X Corp. uses the original proposed financing

arrangement and that funds are blocked until the subsidiary is sold. The
funds to be remitted are reinvested at a rate of 6 % (after taxes) until the
end of year 3. How is the project’s NPV affected?
e) What is the break-even salvage value of this project if X Corp.

uses original financing proposal and funds are not blocked?
f) Assume that X Corp. decided to implement the project, using

the original proposed financing arrangement; also assume that after one
year a NZ firm offers X Corp. a price of $ 27 million after taxes for the
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subsidiary, and that X Corp. original forecasts for years 2 and 3 have not
changed. Should X Corp. divest the subsidiary? Explain
Solution
a)
NZD in million
Particulars 1 2 3
Sales 20. 25.5 31.8
- Variable Cost 0 5 2.4
1.2 1.75
Contribution 18. 23.8 29.4
- Fixed Cost 8 6 6
6
EBITD 12. 17.8 23.4
- Depreciation 8 5 5
5
EBIT after Depreciation 7.8 12.8 18.4
- Interest 2.8 2.8 2.8
- tax 1.5 3 4.68
EAT 3.5 7 10.92
EATBD 8.5 12 15.92
5
EATBD after Withholding tax 7.6 10.8 14.33
+ Salvage value 5 - 52
-
Cash flow transferred to parent co 7.6 10.8 66.33
5
Calculation of NPV
million NZD ) million dollar)
0 (50) 0.50 (25) 1.0000 (25)
1 7.65 0.52 3.978 0.8333 3.3150
2 10.80 0.54 5.832 0.6944 4.0500
3 66.33 0.56 37.1448 0.5787 21.4958
3.8608
b)
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NZD in million
Particulars 1 2 3
EBIT after Depreciation 7.8 12.8 18.4
- Interest - - -
EBT (after interest and depreciation) 7.8 12.8 18.4
- tax 2.34 3.84 5.52
EAT 5.46 8.96 12.88
EATBD 10.4 13.9 17.88
- withholding tax 6 6 1.8
1.05 1.4
EATBD after Withholding tax 9.41 12.5 16.08
+ Salvage value - 6 70
-
Cash flow transferred to parent co 9.41 12.5 86.08
6
Calculation of NPV
0 (70) 0.50 (35) 1.0000 (35)
1 9.41 0.52 4.8932 0.8696 4.0777
2 12.56 0.54 6.7824 0.7561 4.7100
3 86.08 0.56 48.2048 0.6575 27.8963
1.684
The above project shall be accepted since NPV is positive the original proposal is
more feasible as NPV of original proposal is higher compared to new proposal.
c) If X Corp. funds the working capital requirement of its

subsidiary, then it is exposed to NZD 70 million, where as if the subsidiary
finances its working capital from NZ Bank then X Corp. is exposed to a total
capital of NZD 50 million. Thus to minimize currency risk it is advisable to
borrow working capital required from NZ Bank. Higher the exposure higher
is the risk and visa versa.
d)
NZD in million
Particulars 1 2 3
Cash flow transferable to parent co 10.46 13.9 87.88
6
+ interest received at the end of year 2 0.627 - -
+ interest received at the end of year 3 6 0.84 -
0.665
3
Cash Flow 11.75 14.8 87.88
3
Calculation of NPV
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0 (50) 0.50 (25) 1.0000 (25)
1 11.75 0.52 6.11 0.8333 5.0917
2 14.80 0.54 7.992 0.6944 5.5500
3 87.88 0.56 49.2128 0.5787 28.4796
14.1213
Note: - For calculating interest time value of money is ignored
e)
0 (50) 0.50 (25) 1.0000 (25)
1 7.65 0.52 6.11 0.8333 5.0917
2 10.80 0.54 7.992 0.6944 5.5500
3 14.33 + SV 0.56 30.4648 0.5787 17.6350
0
By reverse method we get (14.33 + SV) × 0.56 = 30.4648
Therefore SV = 40.07
f)
Particulars
Cash Flow(FF) 10.46
- withholding tax @ 10 % 1.05
Cash Flow after WT 9.41
Cash Flow after WT in Dollar (9.41 × 0.52) 4.89
+ Salvage Value 27
Cash Flow in Dollar 31.89
Discounted cash inflow (DF @ 15 %) (31.89
× 0. 8333) 26.58
- Discounted cash outflow 25
NPV 1.577
It is better not sell the subsidiary at the end of year 1 NPV of $1.577 million is
achieved under this situation which is less than the actual NPV of $ 3.8608 million.
Adjusted NPV
In this NPV method all cash flows are discounted at weighted average cost of
capital and it is assumed that uncertainty is involved in different cash flow schemes
are same.
Adjusted NPV method provides the flexibility of adopting the different
discount factors for different cash flow schemes. Higher the uncertainty involved
from a cash flow scheme, higher is the discount factor and vice versa.
Problem
6. A 10 million USD is invested in Thailand for a period of 5 years. It is financed
by 50 % debt and 50 % equity, normally the cost of debt would be 12 % for
project of this type in Thailand, the world bank is however willing to lend us 5
million USD at a subsidized rate of 10 %. The project is expected to generate 3
million USD operating cash flow every year for a period of 5 years and the
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Rudramurthy B.V
marginal tax rate is 40 %.Calculate adjusted NPV for the above project assuming
discount rate of 14.6%.
Solution
Cash Flow Scheme 1:
Operating cash flow 3 million every year to be discounted at the rate of 14.6 %.
Cash Flow Scheme 2: Savings in interest

Normal debt rate applicable in Thailand is 12 %, rate paid for debt borrowed
from World Bank is 10 % therefore savings in interest rate is 2 %.
Savings in interest = 5 million × 2 % = 0.1 million
The above savings in interest should be discounted at the general debt capital
rate of 12 %
Cash Flow Scheme 3: Tax benefit on account of payment of interest

Debt capital borrowed from World Bank 5 million, rate of interest 10 %
Annual interest = 5 million ×10 % = 0.5 million
Tax benefit = Annual interest × tax rate
= 0.5 million × 40 % = 0.2 million
Calculation of Adjusted NPV

Type of Cash Flow Cash Flow Period Discount Annuity DCF
($ in million) Rate Discount rate
Operating Cash 3 1-5 14.6 % 3.3841 10.1523
Flow
Savings in interest 0.1 1-5 12 % 3.605 0.3605
Tax benefit 0.2 1-5 12 % 3.605 0.721
11.234
∑ DCI = 11.234 million
- ∑ DCO = 10 million
ANPV = 1.234 million
The above project shall be accepted since ANPV is positive
7. C limited an Indian manufacturer of high quality sports goods and related

equipment, the company is planning to increase its exports in the coming years as
a part of its strategy it is thinking of establishing a subsidiary in France that could
manufacture and sell goods locally. The management has asked various
departments of the company to supply all relevant information for multinational
capital budgeting analysis, the relevant information is given below
Investment: - The total initial investment to finance plant and equipment is

estimated at 20 million French Franc that will be invested by the parent. Working
capital requirements estimated at FF 10 million will be borrowed by subsidiary
from a local financing institution at an interest rate of 8 % per annum, the
principal will be paid at the end of 5th year when the project is terminated while
the interest payments are it be paid by the subsidiary annually.
Depreciation: - The French government will allow the company to depreciate the
plant and equipment using straight-line method, the depreciation expense sill be
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Rudramurthy B.V
FF 4 million per year the live of the project is excepted to be 5 years. The forecast
price and sales schedule for the next 5 years are as given below
Year Price/unit Sales in France

1 FF 600 50000
2 FF 600 50000
3 FF 650 80000
4 FF 660 100000
5 FF 680 120000
The variable cost are FF 220/unit in year 1 and in year 2 it is expected to rise to
FF 300/unit and remain constant for years 3, 4 and 5. The fixed costs other then
depreciation are expected to be FF 1.5 million/year.
Exchange Rate: - The spot exchange rate of the French Franc is Rs 6.6 the
forecasted exchange rate for all future period is Rs 6.8
Remittance: - All profits after tax realized are to be transferred to the parent at the
end of each year. The French government plans to impose no restrictions on the
remittance of cash flows but will impose a 5 % withholding tax on funds remitted
by subsidiary to the parent as mentioned earlier.
French government taxes on income earned by subsidiary: - The Indian

government will allow a tax credit on taxes paid in France, the company requires a
10 % return on this project.
Advise the Indian company regarding the financial viability of the proposal,
should the project be setup in France or not.
Additional Considerations
1. Assume that all funds are blocked until the end of 5th year this funds can be
reinvested locally to yield 6 % annually after taxes, show the calculations
and comment on the result.
2. Assume the following exchange rate scenario and recalculate your results
Alternative 1
Year Exchange Rate
1 6.80
2 6.90
3 6.95
4 7.00
5 7.05
Alternative 2
Year Exchange Rate
1 6.55
2 6.50
3 6.40
4 6.38
5 6.35
Solution
Calculation of cash flow to parent company
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Particulars 1 2 3 4 5
Sales 30 30 52 66 81.6
- Variable Cost 11 11 24 30 36
Contribution 19 19 28 36 45.6
- Fixed Cost 1.5 1.5 1.5 1.5 1.5
EBITD 17.5 17.5 26.5 34.5 44.1
- Depreciation 4 4 4 4 4
EBIT 13.5 13.5 22.5 30.5 40.1
- Interest (10 × 8 %) 0.8 0.8 0.8 0.8 0.8
EBT 12.7 12.7 21.7 29.7 39.3
- Tax - - - - -
EAT 12.7 12.7 21.7 29.7 39.3
+ Depreciation 4 4 4 4 4
EATBD 16.7 16.7 25.7 33.7 43.3
+ Working Capital - - - - 10
- Repayment of loan - - - - 10
- Withholding Tax 0.84 0.84 1.29 1.69 2.17
Cash Flow
Transferred to 15.8 15.8 24.4 32.0 41.13
parent company 6 6 1 1
Calculation of NPV
Years Cash Flow Exchange Cash Flow DF @10% DCF
(FF in Rate (Rs in
million) million)
0 (20) 6.6 (132) 1 (132)
1 15.86 6.8 107.85 0.9091 98.04
2 15.86 6.8 107.85 0.8264 89.13
3 24.41 6.8 164.63 0.7513 123.69
4 32.01 6.8 217.67 0.6830 148.67
5 41.13 6.8 279.68 0.6209 173.66
502.22
Since NPV is positive, accept the project
Additional consideration
a)
Interest for 1st year = 16.7 × (1.06)4 = 21.08
Interest for 2nd year = 16.7 × (1.06)3 = 19.89
Interest for 3rd year = 25.7 × (1.06)2 = 28.88
Interest for 4th year = 33.7 × (1.06)1 = 35.72
Interest for 5th year = 43.3 × (1.06)0 = 43.30
Calculation of NPV
(FF in Rate (Rs in
million) million)
0 (20) 6.6 (132) 1 (132)
1 21.08 6.8 143.34 0.9091 130.31
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Rudramurthy B.V
2 19.89 6.8 135.25 0.8264 111.78

3 28.88 6.8 196.38 0.7513 147.55
4 35.72 6.8 242.90 0.6830 165.90
5 43.30 6.8 294.44 0.6209 182.82
606.36
b) Alternative 1
Calculation of NPV
(FF in Rate (Rs in
million) million)
0 (20) 6.60 (132) 1 (132)
1 15.86 6.80 107.85 0.9091 98.04
2 15.86 6.90 109.43 0.8264 90.44
3 24.21 6.95 169.65 0.7513 127.46
4 32.01 7.00 224.07 0.6830 153.04
5 41.13 7.05 289.97 0.6209 180.05
517.03
Alternative 2
Calculation of NPV
(FF in Rate (Rs in
million) million)
0 (20) 6.60 (132) 1 (132)
1 15.86 6.55 103.88 0.9091 94.44
2 15.86 6.50 103.09 0.8264 85.20
3 24.21 6.40 156.22 0.7513 117.37
4 32.01 6.38 204.22 0.6830 139.49
5 41.13 6.35 261.18 0.6209 162.17
466.67
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Rudramurthy B.V
PARITY CONDITIONS IN INTERNATIONAL FINANCE AND

CURRENCY FORECASTING
Meaning of arbitrage: - It is simultaneous purchase and sale of the same assets or

commodities on different markets to profit from price discrepancies.
Law of one price: - In competitive markets characterized by numerous buyers and

sellers, having low cost access to information exchange adjusted prices of identical
tradable goods and financial assets must be within transition costs of equality
worldwide.
International arbitrageurs who follow the principle of “Buy low and sell high”
enforce the above rule of law of one price.
Forward Premium and Discount: - A foreign currency is said to be at premium if

forward rate expressed is terms of home currency is greater than spot rate or else it is
said to be at discount.
Annualized % of forward = FR – SR × 360 .

Premium or Discount SR Forward contract period in days
The following five economic relationships arise due to the prevalence of “law or one
price” and international arbitraging opportunities.
1. PURCHASE POWER PARITY (PPP)
2. FISHER EFFECT (FE)
3. INTERNATIONAL FISHER EFFECT (IFE)
4. INTEREST RATE PARITY(IRP)
5. FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT
RATES (UFSR)
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Rudramurthy B.V
If inflation in US is expected to exceed inflation in India by 2 % for the

coming year then the US dollar should decline in value by 2 % relative to Rupee by
the same rate, the one year USD forward should sell at a 2 % discount relative to the
Indian Rupees. Similarly, 1-year interest rates in US should be about 2 % higher than
one-year interest rates on securities of comparable risk in India.
PURCHASING POWER PARITY [PPP]
If international arbitrage enforces the law of one price, then the exchange rate
between the home currency and domestic goods must be equal to the exchange rate
between home currency and foreign goods.
In other words, one unit of home currency should have the same purchasing
power worldwide. Ex: - If a pen costs Rs 50 in India and the same model pen costs $1
in US, then exchange rate shall be $1 = Rs 50.
For same purchasing power to remain constant world wide, the foreign
exchange rate must change approximately the same as difference between the
domestic and foreign rates of inflation.
Swedish economist ‘Gustav Cassel’ first stated purchasing power parity in a

rigorous manner in 1918. He used it as the basis for recommending a new set of
official exchange rates at the end of World War Ι.
Purchasing power parity in its absolute version states that price levels should
be same world wide when expressed in common currency. A unit of home currency
should have the same purchasing power worldwide. This theory is application of law
of one price to national price levels or else arbitrage opportunities would exist.
However, absolute PPP ignores the effects of transportation costs, tariffs quotas and
other restrictions and product differentiations in free trade.
The relative version of PPP states that the exchange rate between the home
currency and foreign currency will adjust to reflect changes in the price levels of two
countries. Ex: - If inflation in India is 5 % and in US is 2% then the rupee value of the
20
Rudramurthy B.V
USD must rise by about 3 % to equalize the Rupee price of goods in both the
countries.
If ih and if are inflations of home country and foreign country respectively, e0

is home currency value of 1 unit of foreign currency at the beginning of the period
and et is the spot exchange rate in period t, then
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
The value of et represents PPP rate.

Note: - the above formula works for direct quote. In case of indirect quote the formula
shall be
et = e0 (1 + if)t
(1 + ih)t
Ex: - The US (hc) and Switzerland (fc) are running annual inflation rates of 5 % and
3 % respectively and the spot rate is SFr 1 = $0.75 then calculate the PPP rate after
1,2 and 3 years
et = e0 (1 + ih)t
(1 + if)t
e1 = 0.75 (1 + 0.05)1 = $0.7646

(1 + 0.03)1
e2 = 0.75 (1 + 0.05)2 = $0.7794

(1 + 0.03)2
e3 = 0.75 (1 + 0.05)3 = $0.7945

(1 + 0.03)3
Thus according to PPP the exchange rate change during a period should be
equal to the inflation differential for the same time-period. In effect, PPP says that
currencies with high rates of inflation should devalue relative to currencies with lower
rate of inflation.
Inflation change of 2 % more in US should result in devaluation of USD by 2 %.

Therefore e1 = $ 0.75 × 102 % = $ 0.765
Point ‘A’ on the parity line is an equilibrium point wherein 3 % change in inflation is
offset by 3 % appreciation in foreign currency, whereas Point ‘B’ is at disequilibrium
since 3 % change in inflation is offset just by 1 % appreciation in foreign currency.
21
Rudramurthy B.V
Real Exchange rate: -

The real exchange rate is the nominal exchange rate adjusted for changes in
the relative purchasing power of each currency since some base period
ét = et × Pf
Ph
By indexing these price levels to 100 as of the base period their ratio reflects
the change in the relative purchasing power of these currencies since time 0. Increase
in foreign price level and foreign currency depreciation have offsetting effects on the
real exchange rate and similarly home price level increases and foreign currency
appreciation offset each other.
An alternative way to represent the real exchange rate is to directly reflects the
change in relative purchasing powers of these currencies by adjusting the nominal
exchange rate for inflation in both countries since time 0 (base period).
ét = et × (1 + ih)t
(1 + if)t
Note: - et shall be in direct quote.
Empirical Evidence: -
The strictest version of PPP, that all goods and financial assets obey the law of
one price is demonstrably false. The risk and costs of shipping goods internationally
as well as government erected barriers to trade and capital flows, are at times high
enough to cause exchange adjusted prices to systematically differ between countries.
The general conclusion from empirical study of PPP is that theory holds up
well in long run, but not as well over shorter time-periods. Thus in long run the real
exchange rate tends to revert to its predicted value of e 0. That is if ét > e0, then the real
exchange rate should fall over time towards e0. Where as if ét < e0 the real exchange
rate should rise over time towards e0.
THE FISHER EFFECT: (∆ NIR = ∆ EXPECTED INFLATION)
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Rudramurthy B.V
The real interest rate shall be adjustable to reflect expected inflation to obtain
the nominal interest rate. According to Fisher effect the interest rate(r) is made of two
components
a) Real interest rate (a)
b) Expected inflation rate (i)
Therefore
(1 + Nominal interest rate) = (1 + real interest rate) (1 + expected inflation rate)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
However often approximated ‘r’ is calculated as equal to ‘a + i’.
Ex: If required real interest rate is 3 % and expected inflation rate is 10 %. Calculate
the nominal interest rate
(1 + r) = (1 + a) (1 + i)
(1 + r) = (1 + 0.03) (1 + 0.10)
(1 + r) = 1.133
r = 0.133 or 13.3 %
Alternatively
r = a + i + ai
r = 0.03 + 0.10 + (0.03) (0.10) = 0.133 or 13.3 %
According to FE the lender should not only be compensated for interest (3 %) but also
for depreciation in principal value by (10.3 %) for passage of time
“According to generalized version of FE the real returns are equalized across
the countries through arbitrage” i.e. ah = af. If expected real returns were higher in one
currency than the other, capital would flow from the second to the first currency.
In an equilibrium with no government interference, the nominal interest rate
differential will approximately equal the anticipated inflation differential between the
two currencies.
rh – rf = ih – if
∆ NIR = ∆ Inflation
Where rh and rf represents nominal interest rate at home country and foreign
country respectively, ih and if represents inflation at home country and foreign country
respectively.
In other words, according to FE,
(1 + rh)t = (1 + ih)t
(1 + rf)t (1 + if)t
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Rudramurthy B.V
THE INTERNATIONAL FISHER EFFECT [IFE]
It is the combination of Purchasing power parity (PPP) and generalized Fisher

Effect (FE) which gives way to International Fisher Effect (IEF)
According to PPP
∆ ER = ∆ IR
et = (1 + ih)t …………………………(1)
e0 (1 + if)t
According to FE
(1 + NIR) = (1 + RIR) (1 + IR)
(1 + r) = (1 + a) (1 + i)
Therefore ∆ NIR = ∆ Expected Inflation rate
(1 + rh)t = (1 + ih)t ……………………(2)

(1 + rf)t (1 + if)t
Equation 1 and 2 gives

et = (1 + rh)t
e0 (1 + rf)t
i.e. ∆ ER = ∆ NIR
Therefore
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Rudramurthy B.V
et = e0 (1 + rh)t
(1 + rf)t
According to IFE, the interest rate differential between any two countries is an
unbiased predictor of the future change in spot exchange rate. Hence currency with
higher interest rates will depreciate and those with low interest rates will appreciate.
Point ‘A’ on parity line is at equilibrium whereas point ‘B’ outside the parity
line is not at equilibrium.
INTEREST RATE PARITY THEORY [IRP]
According to IRP theory, the interest differential should be equal to the

forward differential i.e. the currency of the country with a lower interest rate should
be at a forward premium in terms of the currency of the country with higher interest
rate. If the above condition is satisfied, the forward rate is said to be at interest rate
parity and equilibrium prevails in money market.
Covered Interest Differential:

Interest parity ensures that the return on a hedged or covered foreign
investment will just equal the domestic interest rate on investment of identical risk or
else it gives rise to covered interest arbitrage. The process of covered interest
arbitrage continues until interest parity holds, unless there is government interference.
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Rudramurthy B.V
THE RELATIONSHIP BETWEEN THE FORWARD RATE AND FUTURE

SPOT RATE
An unbiased nature of forward rate is that the forward rate should reflect the
expected future spot rate on the date of settlement of the forward contract.
Ft = ē t
Where Ft = forward rate at time‘t’.
ēt = expected future spot rate
Equilibrium is achieved only when the forward differential equals the

expected change in the exchange rate.
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Rudramurthy B.V
PARITY CONDITIONS
I. PURCHASING POWER PARITY [PPP]
∆ ER = ∆ IR
et = (1 + ih)t
e0 (1 + if)t
et = e0 (1 + ih)t
(1 + if)t
II. FISHER EFFECT [FE]
∆ NIR = ∆ Expected Inflation rate
(1 + NIR) = (1 + RIR) (1 + IR)
(1 + r) = (1 + a) (1 + i)
(1 + r) = 1 + a + i + ai
r = a + i + ai
III. INTERNATIONAL FISHER EFFECT [IFE]
∆ ER = ∆ NIR
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Rudramurthy B.V
et = (1 + rh)t
e0 (1 + rf)t
et = e0 (1 + rh)t
(1 + rf)t
IV. INTEREST RATE PARITY [IRP]
Forward rate differential = Interest differential
Ft = (1 + rh)t
e0 (1 + rf)t
V. UNBIASED FORWARD RATES [UFR]
Ft = ē t
Ft – e0 = ēt –e0
e0 e0
Problems
1. Given the following date calculate any arbitrage possibility is available

Spot rate: Rs 42.0010 = $ 1
6 months forward rate: Rs 42.8020 = $1
Annualized interest rate on 6 months dollar = 8 %
Annualized interest rate on 6 months Rupees = 12 %
Solution
Calculation of forward differentials
= FR – SR × 360 .
SR Forward contract period in days
= 42.8020 – 42.0010 × 360

42.0010 180
= 3.8142 %
Calculation of interest differentials
Interest differential = Annualized Interest rate in India – Annualized interest rate in US
Interest differential = 12 % - 8 % = 4%
Since interest differential is grater than forward rate differential an arbitrager shall
prefer investment in that country where interest rate is higher. Thus, investment shall
be done in India and funds shall be borrowed from US.
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Rudramurthy B.V
Calculation of arbitrage profit

It is assumed that $ 100000 is borrowed from US bank at the rate of 8 % P.a.
Convert $ 100000 into Rupees using spot rate of $ 1 = Rs 42.0010
Therefore $ 100000 = 100000 × 42.0010 = Rs 4200100
Invest the above sum in India at the rate of 12 % P.a. for 6 months
Interest amount after 6 months = 4200100 × 12 % × 6/12 = Rs 252006
Total amount at maturity = 4200100 + 252006 = Rs 4452106
Convert the above Rupees to dollars
4452106 = $ 104016
42.8020
Loan amount to be refund along with interest = 100000 + (100000 × 0.08 × 6/12)
= $104000
Arbitrage profit = $104016 - $104000 = $16
Arbitrage profit (%) = 16 . × 100 = 0.016 %

100000

Spot rate: $ 1 = Rs 44.0030
6 months forward rate: $1 = Rs 45.0010
Annualized interest rate on 6 months Rupees = 12 %
Annualized interest rate on 6 months Dollars = 8 %
Solution
= FR – SR × 360 .
= 45.0010 – 44.0030 × 360

44.0030 180
= 4.536 %
Interest differential = Annualized Interest rate in India – Annualized interest rate in US
Since forward rate differential is grater than interest differential, invest in that
country’s currency which is expected to appreciate. Here in this case borrow in India
and invest in US.

It is assumed that Rs 100000 is borrowed from Indian bank at the rate of 12 % P.a.
Convert Rs 100000 into Dollars using spot rate of $ 1 = Rs 44.0030
Therefore $ 100000 = 100000 ÷ 44.0030 = $ 2273
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Rudramurthy B.V
Invest the above sum in US at the rate of 8 % P.a. for 6 months

Interest amount after 6 months = 2273 × 8 % × 6/12 = $ 90.92
Total amount at maturity = 2273 + 90.92 = $ 2363.92
Convert the above Dollars to Rupees
2363.92 × 45.0010 = Rs 106379
= Rs106000
Arbitrage profit = Rs106379 – Rs106000 = Rs 379
Arbitrage profit (%) = 379 . × 100 = 0.379 %

100000

Spot rate: ₣ 6 = $ 1 (₣ = French Franc)
6 months forward rate: ₣ 6.0020 = $1
Annualized interest rate on 6 months USD = 5 %
Annualized interest rate on 6 months FFR = 8 %
Solution
= FR – SR × 360 .
= 6.0020 – 6.0000 × 360

6.0000 180
= 0.067 %
Interest differential = Annualized Interest rate in France – Annualized interest rate in US
Since interest differential is grater than forward rate differential an arbitrager shall
prefer investment in that country where interest rate is higher. Thus, investment shall
be done in France and funds shall be borrowed from US.

It is assumed that $ 100000 is borrowed from US Bank at the rate of 5 % P.a.
Convert $ 100000 into French Franc using spot rate of $ 1 = ₣ 6
Therefore $ 100000 = 100000 × 6 = ₣ 600000
Invest the above sum in France at the rate of 8 % P.a. for 6 months
Interest amount after 6 months = 600000 × 8 % × 6/12 = ₣ 24000
Total amount at maturity = 600000 + 24000 = ₣ 624000
Convert the above French Franc to Dollars
624000 × 6.002 = $ 103965
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Rudramurthy B.V
= $102500
Arbitrage profit = $103965 – $102500 = $1465.34
Arbitrage profit (%) = 1465.34 . × 100 = 1.465 %

100000
4. Assume the buying rate for DM (Dutch Mark) spot in New York is $ 0.40
a) What would you expect the price of USD to be in Germany?
b) If the dollar to be quoted in Germany at DM 2.6 how is the market supposed
to react?
Solution
a) The price of USD in Germany is expected to be (1÷0.4) = 2.5 DM/$
b) Since dollar is cheaper in New York, Buy dollar at the rate of 2.5 DM/$ in
New York and sell the same in Germany at the rate of 2.6 DM/$ thus making
an arbitrage profit of DM 0.1/$.
5. You have called your foreign exchange trader and asked for quotation on the
spot, 1-month, 3-month and 6-month forward rate. The trader has responded with
the following
$ 0.2479/81, 3/5, 8/7, 13/10
a) What does this mean in terms of dollars per Euros?

b) If you wished to buy spot Euros, how much would you pay in Dollars?
c) If you wanted to purchase spot USD, how much would you have to pay in
Euro?
d) What is the premium or discount in the 1, 3, 6 month forward rate in annual
percentage?
Solution
a) Assume you are buying Euros

Particulars Buying Rate Offer Rate
Spot Rate 0.2479 0.2481
1 Month Forward Rate 0.2482 0.2486
Swap points: - Forward rates can be expressed by giving spot rates and their
respective swap points
E.g.1:- 3/5 in the above problem indicates premium swap point since bid swap point is
lesser than ask swap point/offer swap point.
E.g.2:- 8/7 in the above problem indicates discount swap point since bid swap point is
greater than ask swap point/offer swap point.
Forward rate = Spot rate + Premium Swap point or

Forward rate = Spot rate – Discount Swap point
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Rudramurthy B.V
b) €(4.0306/4.0339)/USD
Spot Euros can be bought at bankers offer rate of $ 0.2481/€
Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling
rate will be banker’s buying rate.
c) Purchase of spot USD can be made at banker’s offer rate of €4.0339/$
d) Calculation of Forward premium or discount
1-month Forward premium
= FR – SR × 360 .
= 0.2486 – 0.2481 × 360

0.2481 30
= 2.42 %
3-month Forward discount
= FR – SR × 360 .
= 0.2474 – 0.2481 × 360

0.2481 90
= 1.13 %
= FR – SR × 360 .
= 0.2471 – 0.2481 × 360

0.2481 180
= 0.806 %
6. An American firm purchases $ 4000 worth of perfume (₣ 20000) from a

French firm, the American distributor must make the payment in 90 days in
French Franc the following quotations and expectations exists for the French
Franc
Spot rate = $ 0.200, 90-day forward rate = $ 0.220, interest rate in US = 15 %,
interest rate in France = 10 %.
Your expectation of spot rate 90 days hence is $ 0.240
32
Rudramurthy B.V
a) What is the premium on the forward French Franc? What is the interest
rate differential between France and US? Is there an incentive for covered
interest arbitrage?
b) If there is a covered interest arbitrage how can an arbitrager take advantage

of given situation assume the arbitrager is willing to borrow $ 4000 or
French Franc (₣) 20000 and there are no transaction costs.
c) If transaction costs are $ 50 would an opportunity still exists for covered

interest arbitrage.
d) Calculate the cost covered interest arbitrage and suggest whether covered
interest arbitrage was required considering above cost of hedging.
Solution
a) Calculation of Forward premium on French Franc
= FR – SR × 360 .
= 0.2200 – 0.2000 × 360

0.2000 90
= 40 %
Calculation of interest differential

US interest rate per annum = 15 %
France interest rate per annum = 10 %
Interest rate differential = 5 %
There exists covered interest arbitrage opportunity since forward

differential and interest rate differential are not equal.
b) Since forward differential is grater than interest differential invest in that

country’s currency which is expected to appreciate thus borrow in US and
invest in France
1. Borrow $ 4000 in US at the rate of 15 % for 90 days.
2. Convert the above dollars into French Franc using spot rate.
= 4000/0.200 = ₣ 20000
3. Invest ₣ 20000 at the rate of 10 % for 90 days in France
Interest = 20000 × 0.10 × 90/360 = 500

Principal = 20000
Maturity Value = 20500
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Rudramurthy B.V
4. Convert the above amount to dollars using 90-day forward rate.
= 20500 × 0.2200 = 4510

5. Calculate loan repayment amount
Loan Interest = 4000 × 0.15 × 90/360 = 150

Principal amount = 4000
Loan repayment = 4150
6. Arbitrage profit = $ 4510 – $ 4150 = $ 360
c) Calculation of arbitrage profit after transaction cost
Arbitrage profit before transaction cost = $ 360

Less transaction cost = $ 050
Arbitrage Profit = $310
d) Calculation of arbitrage profit on uncovered interest arbitrage

= ₣ 20500 × 0.240 = $ 4920
Arbitrage profit = $ 4920 - $ 4150 = $ 770
Arbitrage profit after transaction cost = $ 770 - $ 50 = $ 720
Cost of hedging = Transaction cost + forgone profit
Cost of hedging = 50 + (770 – 360) = $ 460
7. Is covered interest arbitrage possible in the following situation? If so calculate

arbitrage profit
a) Spot rate Canadian dollar = 1.317/USD, Canada interest rate = 6 %

6-month forward rate = C$ 1.2950/USD, US interest rate = 10 %.
b) Spot rate 100 Yen = Rs 35.002, Indian interest rate = 12 %

6-month forward rate = Rs 35.9010/100 Yen, Japan interest rate = 7 %.
Solution
a)
Direct Quote = Nr = Home Country .
Dr Foreign Country
= FR – SR × 360 . × 100
= 1.3170 – 1.2950 × 360 × 100

1.3170 90
= 3.34 %
Interest rate differential = 10 – 6 = 4%
Strategy: - Interest rate differential > Forward rate differential

Invest in US and borrow in Canada
34
Rudramurthy B.V
1. Borrow Canadian $ 100000 in Canada at the rate of 6 % for 180

days
2. Convert the above Canadian dollars into USD using spot rate.
= 100000/1.317 = 75930 USD
3. Invest ₣ 20000 at the rate of 10 % for 90 days in France
Interest = 75930 × 0.10 × 6/12 = 3796.50

Principal = 75930 .
Maturity Value = 79726.50
4. Convert the above amount to dollars using 6-month forward rate.
= 79726 × 1.2950 = 103245.8C$
Loan Interest = 100000 × 0.6 × 6/12 = 3000

6. Arbitrage profit = C$ 103245.8 – C$ 103000 = C$ 245.8

Calculation of arbitrage profit in Percentage
= C$ 246 × 100 = 0.246 %
100000
b)
Calculation of Forward rate differential
= FR – SR × 360 . × 100
= 35.9010 – 35.002 × 360 × 100

35.002 90
= 5.14 %
Interest rate differential = 12 – 7 = 5%
Strategy: - Interest rate differential < Forward rate differential

Invest in Japan and borrow in India
1. Borrow Indian Rs 100000 in India at the rate of 12 % for 6 months
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Rudramurthy B.V
2. Convert the above Indian Rupees into Yen using spot rate.
= (100000 × 100)/35.002 = ¥ 285698
3. Invest ¥ 285698 at the rate of 7 % for 6 months in Japan
Interest = 285698 × 0.07 × 6/12 = 9999

Principal = 285698.
4. Convert the above amount to Rupees using 6-month forward rate.
= 295697 × 35.9010/100 = Rs 106158
Loan Interest = 100000 × 0.12 × 6/12 = 6000

6. Arbitrage profit = Rs 106158 – Rs 106000 = Rs 158

Calculation of arbitrage profit in Percentage
= Rs 158 × 100 = 0.158 %
100000
8. Spot quotation of Singapore $ is Rs 25. Interest rate in Singapore is 6 % and

interest rate in India is 10 %. What shall be the forward rate a year latter, also
calculate 270-day forward rate.
Solution
Calculation of 1-year forward rate using Interest rate parity theory
et = e0 (1 + rhc)t
(1 + rfc)t
et = 25 (1 + 0.10)1
(1 + 0.06)1
FR = Rs 25.94
Calculation of 270-day forward rate using Interest rate parity theory
et = e0 (1 + rhc)t t = 270/360 = 0.75

(1 + rfc)t
et = 25 (1 + 0.10)0.75
(1 + 0.06)0.75
FR = Rs 25.7046
9. Calculate Forward rate using the following data
36
Rudramurthy B.V
Particulars India USA

Cost of Dairy Milk Rs 40 $1
Inflation 10 % 6%
Solution
Spot rate $ 1 = Rs 40
FR = SR (1 + r) n CFV = PV (1 + r) n
FR = 40 (1 + 0.10)1 44 = PV (1 + 0.06)1
FR = Rs 44 PV = 44/1.06 = 41.509
Calculation of 1-year forward rate using Interest rate parity theory
et = e0 (1 + rhc)t
(1 + rfc)t
et = 40 (1 + 0.10)1
(1 + 0.06)1
FR = Rs 41.509
10. Following are rates quoted in Mumbai for British Pound Rs/BP = 52.60/70
and three month forward rate 20/70, interest rate in India is 8 %, interest rate in
London is 5 %. Verify weather there is any scope for Covered interest arbitrage if
you borrow in RS (India).
Solution
Spot rate: Rs/BP = 52.60/70 = 52.60/52.70
Forward rate: Rs/BP = 52.80/53.40
Strategy: Borrow in India and invest in London
1. Borrow Rs 100000 in India at the rate of 8 % for 3 months
2. Convert the above Indian Rupees into Pounds using spot rate.
= 100000/52.70 = £ 1898
3. Invest £ 1898 at the rate of 5 % for 3 months in UK
Interest = 1898 × 0.05 × 3/12 = 23.73

Principal = 1898 .
4. Convert the above amount to Rupees using 3-month forward rate.
= 295697 × 52.80 = Rs 101467
Loan Interest = 100000 × 0.08 × 3/12 = 2000
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Rudramurthy B.V

6. Arbitrage profit = Rs 101467 – Rs 102000 = - Rs 533

Strategy: Borrow in London and invest in India
1. Borrow £ 100000 at the rate of 5 % for 3 months
2. Convert the above London Pounds into Rupees using spot rate.
= 100000 × 52.60 = Rs 5260000
3. Invest Rs 5260000 at the rate of 8 % for 3 months in India
Interest = 5260000 × 0.08 × 3/12 = 105200

Principal = 5260000
4. Convert the above amount to Pounds using 3-month forward rate.
= 5365200 ÷ 52.40 = £ 100471.91
Loan Interest = 100000 × 0.05 × 3/12 = 1250

6. Arbitrage profit = Rs 100471.91 – Rs 101250 = - Rs 778.08
Note: - Covered Interest Arbitrage with two-way quote should be done using trial and
error method; both strategies can give loss because of “SPREAD”
11. Find cross rates from the following information

a) $/£ = 1.5240, ¥/£ = 235.20, ¥/$ =?
b) €/£ = 2.5150, €/T = 205.80, T/£ =?
c) $/£ = 1.5537/59, €/$ = 0.1982/92, €/£ =?
d) $/£ = 2.0015/30, $/SFR = 0.6965/70, £/SFR =?
Solution
a) ¥ = ¥ × £ = 235.20 × 1 . = 154.330
$ £ $ 1.5240
b) T = T × € = 1 . × 2.5150 = 0.0122
£ € £ 205.80
c) € = € × $ = (0.1982 × 1.5537) / (0.1992 × 1.5559). = 0.3079/0.3099

£ $ £
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Rudramurthy B.V
d) £ = £ × $ = [(2.0030)-1 × 0.6965]/ [(2.0015)-1 × 0.6970] = 0.3477 / 82

SFR $ SFR
12. A foreign exchange trader quotes for Belgium Franc spot, 1-month, 3-month
and 6-month forward rate to US based treasurer
$ 0.02478/80, 4/6, 9/8, 14/11
a) Calculate the outright quote for 1, 3, 6 month forward.
b) If treasurer wished to buy Belgium Franc 3-months forward, how much would
you pay in Dollars?
c) If you wanted to purchase USD 1-month forward, how much would you have
to pay in Belgium Franc?
d) Assuming Belgium Franc was brought what is the premium or discount in the
1, 3, 6 month forward rate in annual percentage?
e) What do the above quotations imply in respect of term structure of interest in
USA and Belgium?
Solution
a) Assume you are buying Euros
Particulars Buying Rate Offer Rate
Spot Rate 0.02478 0.02480
Swap points: - Forward rates can be expressed by giving spot rates and their
respective swap points
E.g.1:- 4/6 in the above problem indicates premium swap point since bid swap point is
lesser than ask swap point/offer swap point.
E.g.2:- 9/8 in the above problem indicates discount swap point since bid swap point is
greater than ask swap point/offer swap point.
Forward rate = Spot rate + Premium Swap point or

Forward rate = Spot rate – Discount Swap point
b) The treasurer can buy Belgium Franc 3-month forward at his bid rate of
$ 0.02469/Belgium Franc
Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling
rate will be banker’s buying rate.
c) $ 0.02482/86 for 1BFr

BFr = (1/0.02486 – 1/0.02482) per $
BFr = (40.2252-2901) per $
d) Calculation of Forward premium or discount
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Rudramurthy B.V
= FR – SR × 360 .
= 0.02482 – 0.02478 × 360

0.02478 30
= 1.94 %
= FR – SR × 360 .
= 0.02478 – 0.02469 × 360

0.02478 90
= 1.45 %
= FR – SR × 360 .
= 0.02478 – 0.02464 × 360

0.02478 180
= 1.13 %
e) Spot to 1-month forward

Since dollar is depreciating from spot to 1-month forward, interest rate
in US is higher compared to interest rate in Belgium.
Spot to 3-month forward

Since dollar is appreciating from spot to 3-month forward, interest rate
in Belgium is higher compared to interest rate in US
Spot to 6-month forward

Since dollar is appreciating from spot to 3-month forward, interest rate
in Belgium is higher compared to interest rate in US
13. Dutch Mark spot was quoted at $0.4/DM in New York, the price of Pound
Sterling was quoted at $1.8/£
a) What would you expect the price of Pound to be in Germany?
b) If the Pound were quoted in Frank Fort at DM 4.40/£ what would you do
to profit from the above situation
Solution
e) DM = DM × $ = 1 . × 1.8 = 4.5
£ $ £ 0.4
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Rudramurthy B.V
f) Buy 1 pound for DM 4.4 in Frank Fort and with the above pound buy $1.80 in
New York and with the above dollars buy DM 4.5 in Germany thus arbitrage
will make profit of DM 0.1 for an investment of DM 4.40
Arbitrage profit in (%) = 0.1/4.4 × 100 = 2.27 %

Selective Hedging
14. An Indian Company AB limited imports machinery worth of £ 2 million and is

to make the payment after 6 months the current rates are
Spot rate = Rs66.96/£
6-month forward rate =Rs67.50/£
a) What should AB limited do if they expect that in 6 months time the pound
will settle at Rs67.15/£?
b) What are the options available to the company in case of an expected
appreciation or depreciation in Rupee?
Solution
a) In the case of receivable exposure if FR (Forward Rate) > FSP (Forward
Spot Rate) hedge your position where as incase of payable position if FR >
FSP do not hedge your position.
In the above problem AB limited has payable exposure and since FR >
FSP, do not hedge your position
b) If Rupee appreciates (£ is depreciating) no hedging

If Rupee depreciates (£ is appreciating) hedging is required.
15. Brun Herbal products located in India is an old line producer of herbal teas
and medicines, their products are marketed throughout India and Europe
Brun Herbal generally invoices in rupees when it sells to foreign customers in
order to guard against exchange rate changes however company has received an
order from large wholesaler in France for ₣ 40 lakhs of its product. The condition
is that the delivery should be in 3 months time and order invoiced in French Franc.
The manager decides to contact firm’s bankers for suggestions about hedging the
exchange rate exposure.
The banker informs company that spot rate is 1 ₣ = Rs 6.60 thus invoice
amount should be Rs 26400000. The 90-day forward rate for Rs and ₣ and USD
are 1₣ = Rs 6.50 and 1$ = 42.0283. The banker offers to setup Forward hedge for
selling FFr receivable for Rupee based on cross forward exchange rates implicit in
forward rate against dollar, what would be your decision if you were manager of
Brun Herbal? Show the relevant calculations
Interest rates in India and France are 9 % Pa and 12 % Pa respectively.
Solution
Selective hedging (receivable position)
FSP > FR do not hedge
FSP < FR hedge
Calculation of expected future spot price according to IRP
Interest rate differential = Forward differential
Interest rate differential = 12% - 9% = 3 %
Forward rate for 90 days should be calculated
-3 % = x – 6.6 × 360 × 100
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Rudramurthy B.V
6.6 90
x – 6.6 = -3 × 6.6
4 × 100
x – 6.6 = -0.0495
x = 6.5505
i.e. 90-day forward for 1₣ = Rs 6.5505
Hence it would be advisable for the company not to hedge its risk by selling
French Franc forward. Expected spot price (1₣ = Rs 6.5505) is greater than
forward rate (1₣ = Rs 6.5)
16. In Frank Fort the French Franc is selling for DM 0.4343 spot and the 3-month
forward rate is DM 0.4300. The 3-month Euro DM inter bank rate is 5.75 % and
the Euro French inter bank rate is 9 %.
a) Are exchange rate and money market rate in equilibrium? Why?
b) Is there any way to take advantage of the situation? If so how?
c) What rate trends would appear in the market if a large number of
operators took the action indicated in (B) above?
Solution
a) Calculation of interest rate differential
3-month Euro-DM inter bank rate = 5.75 %
3-month Euro-FFr inter bank rate = 9 % .
Interest differential = 3.25 %
Calculation of Forward discount
= FR – SR × 360 .
= 0.4343 – 0.4300 × 360

0.4343 90
= 3.96 %
Since interest rate differential is not equal to forward rate differential there
exists no equilibrium between exchange rate and money market.
b) Since there is no equilibrium between exchange rates and money market there
exists arbitrage opportunity.
Strategy: - Borrow in France and invest in Germany.
1. Borrow ₣ 100000 at the rate of 9 % pa for 3 months
2. Convert the above French Franc into Dutch Mark using spot rate.
= 100000 × 0.4343 = DM 43430
3. Invest DM 43430 at the rate of 5.75 % for 3 months
Interest = 5260000 × 0.0575 × 3/12 = 624

Principal = 43430
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Rudramurthy B.V
4. Convert the above amount to French Franc using 3-month forward

rate.
= 5365200 ÷ 0.43 = ₣ 102451
Loan Interest = 100000 × 0.09 × 3/12 = 2250

6. Arbitrage profit = ₣ 102451 – ₣ 102250 = ₣ 201
c) Large number of operators by taking arbitrage opportunity as indicated in ‘b’

above brings back the equilibrium in exchange rate and money market there by
no further arbitrage opportunity exists.
17. A trader works for New York bank, the spot exchange rate against Canadian
dollar is USD 0.9968 and 1-month and 1-year forward rates are USD 0.9985 and
USD 1.0166 respectively. Twelve-month interest rate in USA and Canada may be
taken as 6.45 % and 4.46 % respectively.
a) What is the forward premium as annual percentage?
b) Which currency is at a premium? Why?
The trader becomes party to some insider information which suggests
the US interest rate will rise by 1 % pa during the next month. The
bank has a rule that in foreign exchange markets “Buy equals Sell” this
means that for any currency the total of long positions must be equal to
the total of short positions but this aggregation disregards maturity.
c) Indicate the mechanism of two operations by which you may trade in
expectation of profit for the bank. Should the insider information turns out
to be well founded
Solution
a) Calculation of Forward premium or discount
= FR – SR × 360 .
= 0.9985 – 0.9968 × 360

0.9968 30
= 2.05 %........................................................... (1)
1-year Forward premium
= FR – SR × 360 .
= 1.0166 – 0.9968 × 360
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Rudramurthy B.V
0.9968 90
= 1.99 %
b) Canadian dollar is at premium because 1-month forward and 1-year forward is

grater than spot rate
Current interest rate in US = 6.45 %

+ Expected increase based on insider information = 1 % .
= 7.45 %
Calculation of interest rate differential
Expected interest rate in US = 7.45 %

Interest rate in Canada = 4.46 %
Interest rate differential = 2.99 %........................ (2)
c) Interest rate differential = 2.99 % (from (2))

1-month forward differential in Canada = 2.05 (from (1))
Since interest rate differential is grater than forward differential
arbitrage opportunity exists
Strategy: -Borrow in Canada and invest in US.
1. Borrow C $ 100000 at the rate of 4.46 % for 1 month
2. Convert the above Canadian Dollars into USD using spot rate.
= 100000 × 0.99680 = $ 99680
3. Invest US $ 99680 at the rate of 7.45 % for 1 month in US
Interest = 99680 × 0.0645 × 1/12 = 618.85

Principal = 99680 .
4. Convert the above amount to C $ using 1-month forward rate.
= 100299 ÷ 0.9985 = C $100449.5
Loan Interest = 100000 × 0.0446 × 1/12 = 372

6. Arbitrage profit = C $ 100449.5 – C $ 100372 = C $ 77.5
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Rudramurthy B.V
18. Your company has to make USD 2 million payment in 3 months time, the
dollars are available now. You decide to invest them for 3 months and you are
given the following information.
 The US deposit rate is 8 % pa
 The sterling deposit rate is 9 % pa
 The spot expected rate is $ 1.81/£
 The 3-month forward rate is $ 1.78/£
a) Where should your company invest for better returns?
b) Assume that the US interest rates and the spot expected return
remain as above, what forward rate would yield an equilibrium situation?
c) Assuming that the US interest rate, Spot and forward rates
remains as in the original question, where would you invest if the sterling
deposit rate is 14 % pa?
d) With the originally stated spot and forward rates and the
same dollar deposit rate, what is the equilibrium sterling deposit rate?
Solution
a) Alternative 1: -
Invest USD 1 million in US at the rate of 8 % pa for 3 months
Interest income = 1 million × 8 % × 3/12 = US $20000
Alternative 2:-
Invest in London at the rate of 10 % pa for 3 months
1. Convert 1 million USD into equivalent pounds using spot rate.
= 1000000 ÷ 1.8 = £ 555556
2. Invest £ 555556 at the rate of 10 % pa for 3 month
Interest = 555556 × 0.10 × 3/12 = 13889

Principal = 555556.
3. Convert the above amount to USD using forward rate.
= 569445 × 1.78 = $1013612
4. Profit or gain = $ 1013612 – $ 1000000 = $ 13612

Conclusion: - Invest in US since gain is more when compared to London
b) Interest rate in US is 8 % pa
Interest rate for sterling deposit is 10 % pa
Interest rate differential = 10 % - 8 % = 2 %
Expected spot rate is
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Rudramurthy B.V
-2 % = x – 1.8 × 360 × 100

1.8 90
x – 1.8 = -2 × 1.8
4 × 100
x – 1.8 = -0.009
x = $ 1.79
Expected future spot rate = $ 1.79
c)
1) Invest £ 555556 at the rate of 14 % pa for 3 month
Interest = 555556 × 0.14 × 3/12 = 19444.5

Principal = 555556 .
2) Convert the above amount to USD using forward rate.
= 575000 × 1.78 = $ 1023500
3) Profit or gain = $ 1023500 – $ 1000000 = $ 23500

Conclusion: - Invest in London if the sterling deposit rate is 14 %
d) Calculation of equilibrium sterling rate
Calculation of Forward rate differential
= FR – SR × 360 . × 100
= 1.78 – 1.8 × 360 × 100

1.8 90
= 4.44 %
Interest in London = Interest in US + FRD
= 8 % + 4.4 %
= 12.44 %
Alternative method
£ 555556 + x % = $ 1020000
i.e. at what rate if we invest £ 555556 in London for 3 months after converting the
gain into USD should be $ 1020000 then only attain a sterling deposit rate
equilibrium
1020000 ÷ 1.78 = £ 573033
555556 + x % = 573033
x % = 573033 – 555556
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Rudramurthy B.V
x % = 17478
For £ 555556 ======== interest amount is £ 17478
For £ 100 = 100 × 17478 = 3.15 %

555556
Annualized sterling deposit rate is 3.15 % × 4 = 12.6 %
19. Calculate the nominal interest rates using Fisher effect from the following data
given below
Real interest rate = 8 %
Inflation rate = 3.5 %
Solution
r = a + i + ai
Where r = nominal interest rate, a = real interest, i = inflation rate
r = 8 % + 3.5 % + (8 × 3.5)
r = 0.1178 or r = 11.78 %
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Rudramurthy B.V
Foreign Exchange Risk Management
Exposure: - Exposure refers to the level of commitment and degree to which a

company is affected by exchange rate movements.
Types of Exposure
1. Accounting Exposure/Translation Exposure
2. Economic Exposure
a) Operating Exposure
b) Transaction Exposure
Accounting Exposure: - It is also called as translation exposure where in the

measurement of exposure is retrospective in nature. It is based on the past activities
and it measures the effect of exchange rate changes on published financial statements,
it effects both income statement and balance sheet statement.
Economic Exposure: - Operating exposure and transaction exposure together

constitutes a firm’s economic exposure. It is the extent to which the value of the firm
measured by its present value of expected cash flow changes with changes in
exchange rate movements (i.e. NPV).
Operating Exposure: - It measures the extent to which currency exposure can

alter a company’s future operating cash flows the measurement of operating
exposure is prospective in nature and it is based on future activities of the firm it
affects revenues and costs associated with future sales.
Transaction Exposure: - It arises due to changes in the value of outstanding

foreign currency denominated contracts. The measurement of transaction
exposure is both retrospective and prospective in nature because it is based on
activities that occurred in the past but will be settled in the future.
Methods of Accounting Exposure (Translation Exposure)
1. Current and Non Current Method
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Rudramurthy B.V
Under this method all current assets and current liabilities of foreign
affiliated are translated into home currency at the current exchange rate while
the non current assets and non current liabilities are translated at historical
rate.
2. Monetary and Non Monetary method
According to this method all monetary assets and monetary liabilities
are translated at current rates where as non monetary assets and non monetary
liabilities are translated at historical rates.
Monetary items are those items which represent a claim to receive or
an obligation to pay a fixed amount of foreign currency units.
Eg: - Cash, accounts receivable (Debtors + Bills Receivable), accounts
payable (Creditors + Bills Payable), other current liabilities, long term debts
etc.
Non Monetary items are those items that do not represent a claim to
receive or an obligation to pay a fixed amount of foreign currency units.
Eg: - Stock, fixed assets, equity shares, preference shares etc.
3. Temporal Method
It is a modified version of monetary and non monetary method the
only difference between monetary and non monetary method is valuation of
stock.
Under monetary and non monetary method, stock is considered as non
monetary assets and it is valued at historical rate where as under temporal
method stock is valued at historical rate if it is shown at cost price or valued at
current rate if it is shown at market price.
4. Current Rate Method
Under this method all balance sheet items are translated at current
exchange rate except for shareholders equity (Share Capital + Reserve &
Surplus) which is translated at historical rate.
Exchange Rate under Accounting Exposure Method
Items Current/ Non- Monetary/Non- Temporal Current Rate

current Method monetary Method Method Method
Cash CR CR CR CR
Receivables CR CR CR CR
Inventory CR HR HR /CR CR
Fixed Assets HR HR HR CR
Payables CR CR CR CR
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Rudramurthy B.V
Long term HR CR CR CR
Debt
Net worth HR HR HR HR
CR = Current Rate, HR = Historical Rate
Problems
1. Assume that a foreign subsidiary of US multinational has the following
Particulars Amount
Cash FC 100
Account Receivable FC 150
Inventory FC 200
Fixed Assets FC 250
Current Liabilities FC 100
Long term Debt FC 300
Net worth FC 300
Assume historical exchange rate is $2 = FC 1, current exchange rate is

$1= FC 1 and inventory is carried at market price. Calculate the gain or loss
under different translation methods.
Solution
Monetary &
Current &
Particulars FC Non Temporal Current Rate
Non Current
Monetary
Cash 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100
Account
150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150
Receivables
Assets
Inventory 200 200 ×1 = $200 200 ×2 = $400 200 ×1 = $200 200 ×1 = $200
Fixed Assets 250 250 ×2 = $500 250 ×2 = $500 250 ×2 = $500 250 ×2 = $250
CTA a/c balance - $350 - $50 $300
Total 700 $1300 $1150 $1000 $1000
Current Liabilities 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100
Long term Debt 300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300
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Liabilities
Net worth 300 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600
CTA a/c balance - - $150 - -
Total 700 $1300 $1150 $1000 $1000
2. Farm products is Canadian affiliate of US manufacturing company, its balance

sheet in thousands of Canadian dollar for 01/01/2007 is shown below
Liabilities CAN$ Assets CAN$

Cash 100000
Current Liabilities 60000
Account Receivables 220000
Long term Debt 160000
Inventory 320000
Capital Stock (Net worth) 620000
Net Plant & Machinery 200000
Total 840000 Total 840000
The Expected return as on 01/01/2007 was CAN$ 1.6 per USD determine
Farm product accounting exposure on 01/01/2008 using current rate method and
monetary and non-monetary method.
Calculate Farm product contribution to its parents accounting loss if the

expected return on 31/12/2007 was CAN$ 1.8 per USD. Assume all account to
remain as they were in beginning of the year.
Solution
Monetary & Non
Particulars CAN$ Current Rate
Monetary
Cash 100000 ÷ 1.8 = $ 55556 ÷ 1.8 = $ 55556
Account
220000 ÷ 1.8 = $ 122223 ÷ 1.8 = $ 122223
Receivables
Assets
Inventory 320000 ÷ 1.8 = $ 177778 ÷ 1.6 = $ 200000

Net Plant &
200000 ÷ 1.8 = $ 111111 ÷ 1.6 = $ 125000
Machinery
CTA a/c balance - $ 43054 $ 6943
Total $ 509722 $ 509722
Current Liabilities 60000 ÷ 1.8 = 33333 ÷ 1.8 = 33333

Long term Debt 160000 ÷ 1.8 = 88889 ÷ 1.8 = 88889
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Liabilities
Net worth 620000 ÷ 1.6 = 387500 ÷ 1.6 = 387500
CTA a/c balance - - -
Total $ 509722 $ 509722
Calculation of Accounting Exposure under Current rate method

Accounting Exposure = (Exposed assets – Exposed liabilities) except CTA a/c
Accounting Exposure = $ 466666.67 - $ 122222.22
AE = $ 344444.45
Calculation of Accounting Exposure under Monetary & Non monetary method
Accounting Exposure = (Exposed assets – Exposed liabilities) except CTA a/c
Accounting Exposure = $ 177778 - $ 122222
AE = $ 55556
Note: -
⇒ Exposed assets are those assets which are exposed to exchange
rate fluctuations (Valued at current rate).
⇒ Exposed liabilities are those liabilities which are exposed to
exchange rate fluctuations (Valued at current rate).
Transaction Exposure
Transaction exposure form the possibility of incurring future exchange gains
or losses on transaction already entered in and denominated in foreign currency.
3. Suppose Boing airlines sell A-747 to Garuda, the Indonesian airlines in

Rupaiah (RP) at a price of RP 140 billion. To help to reduce the impact on
Indonesian balance of payment Boing agrees to buy parts from various Indonesian
companies worth RP 55 billion
a) If the spot rate is $ 0.004/RP what is Boing’s net Rupaiah transaction
exposure?
b) If the Rupaiah depreciates $ 0.0035/RP what is Boing’s transaction
loss?
Solution
a) Boing’s net Rupaiah transaction exposure = (RP 140 - RP 55) billion
= RP 85 billion (receivable exposure)
Net transaction exposure in $ = RP 85 billion × $ 0.004
NTE = $ 0.34 billion receivable exposure
b) Transaction loss = RP 85 billion × (0.004 – 0.0035)
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Transaction loss = RP 85 billion × 0.0005

Transaction loss = $ 0.0425 billion
HEDGING
Hedging is a particular currency exposure, means establishing an offsetting
currency position so as to lock in the home currency value for the currency exposure
and eliminate currency fluctuation risk.
Problems
1. In March multinational industry incorporation assesses the September spot
rate for Sterling at the following rates
$ 1.30/£ with probability 0.15
a) What is the expected spot rate for September?
b) If 6-month forward rate is $1.40 should the firm sell forward its pound
500000 receivable
c) During receivable what factors are likely to affect multinational
industry hedging decision
Solution
a) Calculation of expected spot rate for the month of September
Expected Spot Rate (X) Probability (P) X×P
$ 1.30 0.15 0.195

$ 1.35 0.20 0.270
$ 1.40 0.25 0.350
$ 1.45 0.20 0.290
$ 1.50 0.20 0.300
Total $1.405/£
Expected spot rate for the month of September is $1.405/£

b) Cash inflow by hedging
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Rudramurthy B.V
£ 500000 × $1.40 = $ 700000

Cash inflow by not hedging
£ 500000 × $1.405 = $ 702500
Strategy: Do not hedge
Cost of hedging: $ 2500
c) During Receivable factors that likely affect multinational industry
hedging are
 Risk bearing capacity of firm
 Accuracy of Estimation
Exposure Netting: - It refers to offsetting exposure in one currency with exposure in
the same or another currency whose exchange rates are expected to move in a way
such that loss or gain on first exposed position will be offset by gain or loss in the
second exposed position
Eg: - If A limited has $ 10000 receivable position and $ 6000 payable position both
for 3 months exposure netting can be done and it is enough if A limited hedges for
$ 4000 receivable positions
Centralized v/s Decentralized Hedging
Centralized hedging refers to total corporate exposure hedged as a totality

instead of each individual hedging where specific exposure are hedged at branch
levels which is referred to as decentralized hedging.
Centralized hedging reduces cost of hedging because of netting however
centralized hedging requires strong real time information qualified and trained
employees to operate real time system etc.
Thus before deciding for centralized or decentralized hedging a detailed cost

benefit analysis should be undertaken i.e. if the cost of implementation, then go for
centralized hedging or else decentralized hedging is a better option.
Methods for managing Translation Exposure (Accounting Exposure)
1) Adjusted fund flows: - It involves altering either the amount of

currencies or both cash flows of parent or subsidiary to reduce the firm’s local
currency exposure
If local currency devaluation is expected then exports are priced in
hard currency (Foreign currency) and imports are priced in soft currency
(Local currency).
Other techniques like investing in hard currency replacing hard

currency borrowing with soft currency loans etc are also considered.
2) Entering into forward contracts: - It demands a formal market in the

respective local currency. Forward contract creates an offsetting asset or
liability in the foreign currency, the gain or loss on the transaction exposure is
offset by a corresponding loss or gain in forward market.
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Rudramurthy B.V
If a firm cannot find a forward market for currency in which it has

exposure it can hedge such risk through a forward contract on a related
currency whose relationship is estimated by examining historical currency
fluctuations between actual and related currency.
3) Exposure netting: - It refers to offsetting exposure in one currency

with exposure in the same or another currency whose exchange rates are
expected to move in a way such that loss or gain on first exposed position will
be offset by gain or loss in the second exposed position.
Managing Transaction Exposure

Transaction exposure can be managed by using
 Price adjustment
 Forward market
 Money market
 Currency option
 Borrowing or lending in foreign currency etc.
Forward market hedge v/s money market hedge
In a forward market hedge a company that is long (buy) on foreign currency
will sell foreign currency forward where as a company that is short (sell) on foreign
currency will buy the foreign currency forward. In this way the company can fix the
home currency value of future foreign currency cash flow.
Hedging with forward contract eliminates the downside risks at the expense of
foregoing upside potentials (cost of hedging).
Money market hedge is alternative to forward market hedge which involves
simultaneous borrowing and lending activities in two different currencies to lock in
home currency value of a future foreign currency cash flow. The effective rate on
forward contract will equal the actual forward rate if interest parity holds.
Problems
2. Pepsi Company would like to hedge its CAN $ 40 million payable to ‘A’
limited, a Canadian aluminum producer which is due in 90 days suppose it
faces the following exchange and interest rates.
Spot rate $ 0.7307/12 per CAN $
Forward rate (90 days) $ 0.7320/41 per CAN $
CAN $ 90 day interest rate (annualized) 4.71 % - 4.64 %
US $ 90 day interest rate (annualized) 5.50 % - 5.35 %
Which hedging alternative would you recommend? The first rate is the
borrowing rated and second rated is the lending rate.
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Rudramurthy B.V
Solution
Forward Market Hedge
Payable position CAN $ 40 million after 3 months
Spot rate $ 0.7307 - $ 0.7312 per CAN $
Forward rate $ 0.7320 - $ 0.7341 per CAN $
Forward market payable = CAN $ 40 million × $ 0.7341
Forward market payable = $ 29.364 million
Money Market Hedge
US Canada
Borrow CAN $ 39.5413 million = PV of C $ 40 million

at spot rate of $ 0.7312 = 40 million × 1 .
i.e. C $ 39.5413 × $0.7312 (1 + 0.0116)
= USD 28.9123
= C $ 39.5413 million
FV of USD 28.9126 C $ 40 million (payable in 90 days)

= 28.9126 × (1 + 0.01375) i.e. Future value
= $ 29.3101 (Payable)
Explanation
 Pepsi Company has a payable exposure of CAN $ 40 million after 3
months.
 The Present Value (PV) of C $ 40 million should be invested as on today
in a Canada bank so that along with interest it will mature at C $ 40
million after 3 months.
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Rudramurthy B.V
Invest rate in Canada is 4.64 % per annum

For 3 months = 4.64 % × 3/12 = 1.16 %
PV = FV × 1 . = 40 million × 1 . = C $ 39.5413 million
n
(1 + r) (1 + 0.0116)
 USD equivalent of C $ 39.5413 million shall be borrowed form a US bank
as on today
= C $ 39.5413 × $ 0.7312
= $ 28.9126
Note: - for conversion spot rate shall be considered since it is conversion
as on today. To buy C $ offer rate of banker shall be considered
($0.7312/C$)
 Loan borrowed form US bank ($ 28.9126 million) should be repaid along
with interest after 3 months
Interest rate = 5.5 % pa
For 3 months = 5.5 % × 3/12 = 1.375 %
Maturity value of the loan = $ 28.9126 × (1 + 0.01375)
Money market hedge payable = $ 29.3101
Conclusion: - Money Market hedge shall be preferred for the above problem
3. DC corporation is a US based software consultant specialized in financial
software for several fortune 500 it has an office in India, UK, Europe and
Australia. In 2002 DC corporation required £ 100000 in 180 days and had 4
options before it
⇒ Forward Market Hedge
⇒ Money Market Hedge
⇒ Option Hedge
⇒ No Hedge
Its analyst developed the following information which was used to asses
the alternative solution
Current spot rate of £ is $ 1.50 and 180-day forward rate of £ is $ 1.48
Interest rates were as follows
Particulars UK US
180 day deposit rate 4.5 % 4.5 %
180 day borrowing rate 5.1 % 5.1 %
The company also had the following information available to it
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Rudramurthy B.V
A call option on £ that expires in 180 days has an exercise price of 1.5 and
a premium of $ 0.02. The future spot rate in 180 days are forecasted as follows
Possible outcome Probability
$ 1.44 20 %
$ 1.46 60 %
$ 1.53 20 %
An analysis of hedging technique should be made and advice DC
corporation on the best alternative for hedging
Solution
DC Corporation has payable position £ 100000 in 180 days
To meet the above payment DC Corporation has to buy bounds at prevailing
forward rate
180-day forward rate $ 1.48/£
Forward market hedge = £ 100000 × 1.48 = $148000
Money Market Hedge
US UK
Borrow £ 95694 at spot rate of = PV of £ 100000

$ 1.5 = 100000 × 1 .
i.e. 95694 × $ 1.5 (1 + 0.045)
= $ 143541
= £ 95694
FV of USD 143541 £ 100000 (payable in 180 days)

= 143541 × (1 + 0.051) i.e. Future value
= $ 150861 (Payable)
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Rudramurthy B.V
No Hedge
Calculation of Expected future spot price
Possible outcome (X) Probability (P) X×P
$ 1.44 0.2 0.288

$ 1.46 0.6 0.876
$ 1.53 0.2 0.306
Expected future spot rate $ 1.47
Expected future payable = £ 100000 × 1.47 = $ 147000

Option Hedge
Strike price = $ 1.5
Premium = $ 0.02
Possible outcome Option Probability Premium Payoff
$ 1.44 Not Exercise 0.2 $ 0.02 - $ 0.02

(FSP < SP)
$ 1.46 Not Exercise 0.6 $ 0.02 - $ 0.02
(FSP < SP)
$ 1.53 Exercise 0.2 $ 0.02 $ 0.01
(FSP > SP)
The probability of exercising the call option is 0.2(20 %); the probability of not
exercising the call option is 0.8 (80 %)
Calculation of probable option price
Possible Expected price Expected

Premium Probability
outcome including premium price
$ 1.44 $ 0.02 $ 1.44 0.2 0.292

$ 1.46 $ 0.02 $ 1.46 0.6 0.888
$ 1.53 $ 0.02 $ 1.53 0.2 0.310
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Rudramurthy B.V
$ 1.49
Option hedge = £ 100000 × 1.5 = 150000

Since FSP < SP, DC Corporation will exercise the contract
Decision
Alternative Cash Outflow ($)
Forward Market Hedge $ 148000

Money Market Hedge $ 150861
No Hedge $ 147000
Option Hedge $ 150000
DC Corporation shall not hedge as the no hedge option is the lowest value in
all the set of alternatives
4. P Company is a US based multinational Pharmaceutical company is evaluating
an export sale of its extremely effective cholesterol reduction drug. The purchase
would be for 750 million Indonesian Rupaiah, which current spot rate of
RP 8800/$ translates into a little more than $ 85000 although not a big sale, the
policy of P Company dictates that sale must be settled at least for a minimum
gross margin which results at $ 78000 on the above sale
The current 90-day forward rate is 9800 RP/$. Although this appears to be
unattractive, P Company has to contact several major banks before even finding
the forward quote on the RP the consequences of currency forecasters at the
movement however is that the Rupaiah is holding out relative study. The possible
rate of RP is RP 9400 over the coming 90 days analyze the prospective sale and
make the hedging recommendation.
Solution
Given
Spot rate = RP 8800/$
90-day forward rate = RP 9800/$
Expected future spot rate = RP 9400/$
Since P Company has receivable exposure of RP 750 million
Hedging Strategy: - Forward market hedge
P Company should go to forward market and short the Indonesian Rupaiah.
90-day forward market rate is RP 9800/$
Therefore cash inflow = 75000000/98000 = $ 76530
The company’s policy is not to sell below $ 78000 but if the company sell
today then they will get $ 85227.27 using the spot rate of RP 8800/$.
P Company has a expectation of future spot rate of RP 9400/$ then the
company need not go for hedging option as it will give the cash inflow of $ 79787.23
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Rudramurthy B.V
750000000/9400 = $ 79787.23
Decision: - By taking ‘not hedging option’, company can receive $ 79787.23 which is
more than their minimum expectation of $ 78000. Hence company can opt for not
hedging. But the company’s business is not to make profit by doing currency business
they are in pharmaceutical business if they do not hedge or if they expose their
receivables open they will get $ 79787.23 but expected future spot price may not
become true then company loose their minimum expectation of $ 78000
5. Hindustan Lever Uniliver’s Subsidiary in India, procures much of its toiletries
product line form Japanese Company. Due to shortage of working capital in India
payment terms by Indian importers are typically 180 days or longer. Hindustan
Lever wishes to hedge 8.5 million Japanese Yen payable.
Although options are not available on the Indian Rupee, forward rates are
available against Yen. Additionally a common practice in India is for companies
like Hindustan Lever to work with a currency agent who will in this case lock in
current spot exchange rate in exchange for 4.85 % fee.
Using the following exchange rate and interest rate data, recommend a
hedging strategy
Spot rate ¥/$ = ¥ 120.60/$
Spot rate Rs/$ = Rs 47.75/$
180-day forward rate ¥/Rs = ¥ 2.4000/Rs
Expected spot rate in 180 days = ¥ 2.6000/Rs
180-day Yen investment rate = 1.5 %
180-day Rupee investment rate = 8.0 %
Hindustan Lever’s cost of capital =12 %
Solution
Given
Spot rate ¥/$ = ¥ 120.60/$
Spot rate Rs/$ = Rs 47.75/$
Hence ¥/Rs = 120.6/47.75 = 2.5257
180-day forward rate ¥/Rs = ¥ 2.4000/Rs
Expected spot rate in 180 days = ¥ 2.6000/Rs
180-day Yen investment rate = 1.5 %
180-day Rupee investment rate = 8.0 %
Hindustan Lever’s cost of capital =12 %
Agent exchange rate commission is 4.85 %
No Hedge
= ¥ 8.5 million/Rs 2.6 = Rs 3.2692 million
Buy 8.5 million Yen in forward market at the spot rate of ¥ 2.4 /Rs
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Rudramurthy B.V
¥ 8.5 million/Rs 2.4 = Rs 3.5417 million

Money Market Hedge
India Japan
Borrow ¥ 8.4367 million at spot = PV of ¥ 8.5 million

rate of Rs 2.5257 = 8.5 × 1 .
(1 + 0.045)
i.e. ¥ 8.4367 ÷ Rs 2.5257
= Rs 3.3403 million = ¥ 8.4367 million
FV of Rs 3.3403 million ¥ 8.5 million (payable after 6 months)

= 3.3403 × (1 + 0.06) i.e. Future value
= Rs 3.3403 million (Payable)
Currency agent hedge
Exposure ¥ 8.5 million
Agent hedge = ¥ 8.5 million/2.5257 = Rs 3.3654 million
Agent commission = 4.85 % × 3.3654 million
= Rs 0.1632 million (today’s value)
FV of the above commission is
= 0.1632 × (1.06) = Rs 0.1730 million
Total outflow = (3.3654 + 0.1730) = Rs 3.5384 million
Decision
Alternative Cash Outflow ($)
No Hedge Rs 3.2692 million

Forward Market Hedge Rs 3.5417 million
Money Market Hedge Rs 3.5384 million
Agent Hedge Rs 3.5384 million
No hedge shall be preferred as it gives least cash outflow of Rs 3.2692 million

6. Dayton Company has concluded the target sale deal with a UK Company by
name Crown. The total payment due from crown for 90-days is £ 30 lakhs the
borrowing rate in UK is 14 % pa given the following exchange rate and interest
rate what transaction exposure hedge is now in Dayton’s best interest?
Spot rate = $1.7620/£
Expected spot rate in 90 days = $1.7850/£
90-days forward rate = $ 1.7550/£
90-days dollar deposit rate = 6 % pa
90-days dollar borrowing rate = 8 % pa
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Rudramurthy B.V
90-days pound deposit rate = 8 % pa

90-days pound borrowing rate = 14 % pa
Dayton’s weighted average cost of capital = 12 %
Dayton has also collected data on 2 specific options
Option Type Strike Price Premium
90-day put option on pound $ 1.75/£ 1.5 %

90-day put option on pound $1.71/£ 1.0 %
Solution
Money Market Hedge
India Japan
Borrow £ 2898551 into = PV of £ 3000000 at 14 % pa

equivalent dollar at spot rate = 3000000 × 1 .
$ 1.7620/£ (1 + 0.045)
= £ 2898551 × 1.7620
= $ 5107246 = £ 2898551
FV of $ 5107246 is Borrow £ 3000000 in UK

= $ 5107246 × (1 + 0.03)
= $ 5260463
No Hedge
Expected spot rate in 90 days is $ 1.7850/£
£ 3000000 × 1.7850 = $ 5355000
90 days forward rate is $ 1.7550/£
£ 3000000 × 1.7550 = $ 5265000
Option Hedge
Particulars A B
Strike price $ 1.75/£ $ 1.71/£
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Rudramurthy B.V
Premium 1.5 % 1.0 %

Receivable exposure £ 3000000 £ 3000000
Spot rate $ 1.7620/£ $ 1.7620/£
Option premium 3000000 × 1.762 × 1.5 % 3000000 × 1.762 × 1.5 %
= $ 79290 = $ 79290
FV of option premium $ 79290 × 1.03 = $ 81669 $ 79290 × 1.03 = $ 81669
Option exercised 3000000 × 1.75 = $ 5250000 3000000 × 1.75 = $ 5250000

- FV of option premium - $ 81669 - $ 81669
$ 5168331 $ 5075554
Calculation of minimum and maximum values

Considering certain cash flows (Except No Hedge Option) the best alternative
is forward market hedge. It gives a receivable of $ 5265000 after 90 days. To accept
option hedging the minimum future spot price should be
Particulars A B
Forward market hedge $ 5265000 $ 5265000

+ Future value of option $ 81669 $ 54446
premium
$ 5346669 $ 5319446
Minimum future spot price $ 5346669 ÷ 3000000 $ 5319446 ÷ 3000000
= $ 1.782 = $ 1.7736
If FSP > 1.782 for option A and 1.773 for option B then option hedge shall be
preferred over forward market hedge.
7. Nike International needs to order supplies 2 months ahead of delivery date. It
is considering an order from Japanese that requires a payment of ¥ 12.5 million
payable as of the delivery date. Nike has two option or choice
a. Purchase 2 call option contracts each option contract size is ¥ 6250000
b. Purchase one future contract representing ¥ 12.5 million
c. The future price of yen has historically exhibited a slight discount form
the existing spot rate however the firm likes to use currency option to hedge in
Japanese Yen for transaction 2 months in advance. Nike would prefer hedging
since it is uncomfortable to leave position open giving historical volatility of
Yen.
The current Yen spot rate is $ 0.0072 there are 2 call options available, call A
with an excise price of 5 % above spot price with premium of 2 % the price to be paid
per Yen if the option is exercised. Call B with an excise price of 10 % above spot
price with premium of 1.5 % the price to be paid per Yen if the option is exercised.
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Rudramurthy B.V
The 2-month future price of Yen is $ 0.006912 as an analyst you have been
asked to answer insight of how to hedge assume the spot rate remain unchanged after
2 months.
a) Calculate option exercise price and premium for both the call options
b) If Nike decides to use call option to hedge Yen which call option should it use.
c) If Nike decides to allow Yen to be un-hedged, will it benefit? If so calculate
trade-off.
d) Which is the optimal choice for the company, call A or call B or future
contract if the spot price on expiry becomes $ 0.00781?
Solution
a) Calculation of Option exercise price and premium
Particulars A B
Spot price $ 0.0072 $ 0.0072

Exercise price 0.0072 × 1.05 0.0072 × 1.10
= 0.00756 = 0.00792
Payable exposure ¥ 12500000 ¥ 12500000
Option premium 12500000 × 0.00756 × 2 % 12500000 × 0.00792 × 1.5 %
= $ 1890 = $ 1485
b)
Particulars A B
Exercise price 0.0072 × 1.05 0.0072 × 1.10

= 0.00756 = 0.00792
Payable exposure ¥ 12500000 ¥ 12500000
Option premium 12500000 × 0.00756 × 2 % 12500000 × 0.00792 × 1.5 %
= $ 1890 = $ 1485
Option exercised 12500000 × 0.00756 12500000 × 0.00792

= $ 94500 = $ 99000
+ Option premium $1890 $ 1485
$ 96390 $ 100485
Interpretation: - Option A shall be preferred
c) No hedge
= 12500000 × 0.0072
= $ 90000
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Rudramurthy B.V
2-month future price of the Yen is assumed to be $ 0.006912 then the payable
exposure will be
= 12500000 × 0.006912
= $ 86400
d) If the spot price on expiry is $ 0.00781 call option A shall be preferred since
FSP > SP
Particulars A B
Future spot price $ 0.00781 $ 0.00781

Exercise price = 0.00756 = 0.00792
Exercise or Lapse Exercise (FSP >SP) Lapse (FSP < SP)
Option premium = $ 1890 = $ 1485
Option exercised / Lapsed 12500000 × 0.00756 12500000 × 0.00781

= $ 94500 = $ 97625
+ Option premium $1890 $ 1485
Payable exposure $ 96390 $ 99110

including premium
Interpretation: - Option A shall be preferred

8. A call option in Canadian dollar is available with strike price of $ 0.60 and he
purchased by a speculator at $ 0.06/unit. Contract size is 50000 units, C $ spot rate
is $ 0.65 at the time option is exercise. What is the net profit to the speculator?
What spot rate will earn the speculator BEP (Break Even Point) and at what rate
will the seller earn profit?
Solution
Type of option = Call option
Strike price = $ 0.60
Premium = $ 0.06
Contract Size = 50000 units
FSP =$ 0.65
Call option is exercised when FSP > SP
= ($ 0.65 – 0.60) × 50000
= $2500
Cash flow
= 2500 – [0.06 × 50000] = $ 2500 - $2000 = $ 500
Break Even Point (BEP) for call holder (Buyer)
= Strike price + Premium
= 0.60 + 0.06 = 0.66
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Seller makes profit if FSP < 0.66

9. P international has sold Australian put option at a price of $ 0.01/unit with
strike price of $ 0.76/unit. If the following rates prevail, determine net profit or net
loss
$ 0.72, $ 0.74, $ 0.76, $ 0.78, $0.79
Solution
Profit Profit/Loss for

Writer’s
FSP SP Exercise/Lapse before Premium holders including
profit/Loss
premium premium
0.7
6
0.72 0.7 Exercise 0.04 0.01 0.03 -0.03
6
0.74 Exercise 0.01 0.01 0.01 -0.01
0.7
0.76 Exercise/Lapse 0.01 0.01 -0.01 0.01
6
0.78 Lapse - 0.01 -0.01 0.01
0.7
0.79 6 Lapse - 0.01 -0.01 0.01
0.7
6
10. An Indian importer is required to pay US $ 10 lakh on June 30, 2000. The
import of goods took place on April 1, 2000. Following further details are
furnished
Spot rate on April 1, 2000 = Rs 44.25/37
3-month forward rate = Rs 44.54/73
Strike price of option (3 months) = Rs 44.50
Option premium = 0.25
What will happen to importer if he takes the following?
a) Forward cover
b) Option cover
The spot prices on June 30, 2000 are
1) 45.0/1
2) 44.00/12
Solution
a) Forward market cover
Payable exposure = $ 1000000 Spot rate = 44.25/44.37
3-month forward rate = 44.54/44.73
Payable exposure after 3 months
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= 1000000 × 44.73 (consider offer rate while buying)

= 44730000
b) Option cover
1) When future spot rate is 45.00/45.10
Payable exposure = $1000000
FSP = Rs 45.00
SP = Rs 44.50
Premium = 0.25
Payable exposure = (1000000 × 44.50) + premium paid
Payable exposure = (1000000 × 44.50) + (1000000 × 0.25) = Rs 44750000
2) When future spot rate is 44.00/44.15
Payable exposure = $1000000
FSP = Rs 44.00
SP = Rs 44.50
Premium = 0.25
Payable exposure = (1000000 × 44.15) + premium paid
Payable exposure = (1000000 × 44.50) + (1000000 × 0.25) = Rs 44400000
Interpretation
Alternative Payable Exposure
Forward cover Rs 44730000

Call option FSP 45.0/1 Rs 44750000
Call option FSP 44.00/15 Rs 44400000
If FSP is 45.0/1 forward cover shall be preferred

If FSP is 44.00/44.15 option cover shall be preferred
11. City Corporation sell a call option in DM (contract size is DM 600000) at a
premium of $ 0.04 per DM. If the exercise price is $ 0.71 and spot price on the
day of expiration is $ 0.73 what is profit/loss on above call option sold by City
Corporation?
Solution
Calculation of Pay-off for the holder
Writer of call option (City Corporation)
SP = $ 0.71
FSP = $ 0.73
Call option is exercised by the holder since FSP > SP
Profit/loss = ($ 0.71 - $0.73) × 500000
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Rudramurthy B.V
= -0.02 × 500000 = -$ 10000

Therefore pay-off for writer = $10000
12. During the month of June, European pound sterling are quoting the following
quotes in terms of USD
Call option premium Strike price
0.06 1.61
0.03 1.65
0.01 1.60
Determine the conditions under which profit can be made by

a) Option buyer
b) Option writer
Solution
Calculation of profit/loss for option buyer
FSP 1.61 1.65 1.66

Premium 0.06 0.03 0.01
BEP 1.67 1.68 1.67
Option buyer will make profit when FSP > SP + premium

⇒ For SP of 1.61, option buyer will make profit if FSP > 1.67
An option writer makes profit when FSP < SP + premium
⇒ For SP of 1.61, option writer will make profit if FSP < 1.67
13. Calculate the following rates into outright rates
Particulars Spot 1-month 3-month 6-month
Rs / $ 35.6300/25 20/25 25/35 30/40
Rs / £ 55.2200/35 40/30 50/35 55/42
Rs / DM 23.9000/30 30/25 40/60 45/65
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Rudramurthy B.V
Solution
Rs / $ 35.6300/35.6325 35.6320/35.6350 35.6325/35.6360 35.6330/35.6365
Rs / £ 55.2200/55.2235 55.2160/55.2205 55.2150/55.2200 55.2145/55.2193
Rs / DM 23.9000/23.9030 23.8970/23.9005 23.9040/23.9090 23.9045/23.9095
14. Calculate outright rates and spread percentage
USD / INR 43.1010/1100 225/275 300/330 375/455
Solution
USD / INR 43.1010/43.1100 43.1235/43.1375 43.1310/43.1430 43.1385/43.1555

43.1100 – 43.1010 43.1375 – 43.1235 43.1430 – 43.1310 43.1555 – 43.1385
Spread in 43.11 43.1375 43.1430 43.1555
%
= 0.0208 % = 0.0325 % = 0.0278 % = 0.0394 %
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International Portfolio Diversification

Problems
1. X limited is thinking to invest in two different risky assets in an index of US
equity market and German equity market. The two equities are characterized
by the following expected return and expected risk
Particulars Expected return Expected risk
US Equity index 14 % 15 %
German Equity index 18 % 20 %
Correlation co-efficient between US and German market is 0.34

If the weights of investment are 0.4 for US Equity index and 0.6 for
German equity index, calculate
a. Expected return of above portfolio
b. Covariance between US and German Equity index
c. Risk of the above international portfolio
Solution
a. Calculation of expected return on portfolio
Portfolio Weight (W) Expected return (R) W×R
US Equity index 0.4 14 % 5.6 %

German Equity index 0.6 18 % 10.8 %
Expected return on portfolio 16.4 %
b. Calculation of covariance
COVUG = σU × σG × rUG
COVUG = 15 × 20 ×0.34
COVUG = 102
c. Calculation of risk of the portfolio
σP2 = σU2 WU2+ σG2 WG2 + 2 COVUG WU WG
σP2 = (15)2 (0.4)2 + (20)2 (0.6)2 + 2 × 0.4 ×0.6 ×102
σP2 = 228.96
σP = 15.13
2. Boing Company and Uniliver company are from US and UK, an investor is
evaluating a two asset portfolio of the following two securities
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Rudramurthy B.V
Particulars Expected return Standard Deviation
Boing Company 18.6 % 22.8 %
Uniliver Company 16 % 24 %
Co-efficient of correlation 0.6
a. What is the expected return and the risk of the portfolio if they are
equally weighed?
b. If the weights are changed to 0.7 for Boing and 0.3 for Uniliver, what
is the Expected return and risk
Solution
a. Calculation of expected return on portfolio of equal weights
Boing Company 0.5 18.6 % 9.3 %

Uniliver Company 0.5 16 % 8%
Calculation of risk of the portfolio of equal weights

σP2 = σB2 WB2+ σU2 WU2 + 2 rBU σB σU WB WU
σP2 = (22.8)2 (0.5)2 + (24)2 (0.5)2 + 2 × 0.6 × 24 × 22.8 × 0.5 × 0.5
σP2 = 438.12
σP = 20.93 %
b. Calculation of expected return on portfolio of 0.7 and 0.3 for Boing

and Uniliver respectively
Boing Company 0.7 18.6 % 13.02 %

Uniliver Company 0.3 16 % 8%
Calculation of risk of the portfolio of 0.7 and 0.3 for Boing and Uniliver respectively
σP2 = σB2 WB2+ σU2 WU2 + 2 rBU σB σU WB WU
σP2 = (22.8)2 (0.7)2 + (24)2 (0.3)2 + 2 × 0.6 × 24 × 22.8 × 0.7 × 0.3
σP2 = 444.45
σP = 21.08 %
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3. An investor is evaluating a two asset portfolio of the following two securities
Particulars Expected return Standard Deviation
Anglo Equity 12.5 % 26.4 %
American Equity 10.8 % 22.5 %
The correlation co-efficient between the two equity funds is 0.72.

What is expected return and risk for the following portfolio weights
a. 75 % Anglo 25 % American
b. 50 % Anglo 50 % American
c. 25 % Anglo 75 % American
Which of the above portfolio is preferable and on what basis?
Solution
a. 75 % Anglo 25 % American
Expected return on portfolio
ERP = WAN × EAN + WAM × EAM
ERP = (0.75) (12.5) + (0.25) (10.8)
ERP = 12.075 %
Risk of the portfolio
σP2 = σAN2 WAN2+ σAM2 WAM2 + 2 rAN,AM σAN σAM WAN WAM
σP2 = (26.4)2 (0.75)2 + (22.5)2 (0.25)2 + 2 × 0.72 × 26.4 × 22.5 × 0.75 × 0.25
σP2 = 584.06
σP = 24.17 %
b. 50 % Anglo 50 % American
ERP = (0.5) (12.5) + (0.5) (10.8)
ERP = 11.65 %
σP2 = (26.4)2 (0.5)2 + (22.5)2 (0.5)2 + 2 × 0.72 × 26.4 × 22.5 × 0.5 × 0.5
σP2 = 514.64
σP = 22.69 %
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Rudramurthy B.V
c. 25 % Anglo 75 % American
ERP = (0.25) (12.5) + (0.75) (10.8)
ERP = 11.225 %
σP2 = (26.4)2 (0.25)2 + (22.5)2 (0.75)2 + 2 × 0.72 × 26.4 × 22.5 × 0.25 × 0.75
σP2 = 488.71
σP = 22.11 %
Interpretation
Option ‘a’ shall be preferred based on return as it gives higher return and
option ‘c’ shall be preferred based on risks as it gives lower risks
Risk reward ratio
a. Risk / Return = 24.17 ÷ 12.075 = 2.0017
b. Risk / Return = 22.69 ÷ 11.650 = 1.9476
c. Risk / Return = 22.11 ÷ 11.225 = 1.9679
Option ‘b’ shall be preferred based on both risk and return i.e. an investor can
get a maximum return with minimum risk levels only if the weights of the two
securities are equal.
4. Assume the US dollar rate of return, standard deviation Risk free rate of return
and β value for three Baltic republic are given as follows
Country Mean Return Standard deviation Risk Free return β
Estonia 1.12 % 15 % 0.42 % 1.65

Latvia 0.75 % 22.8 % 0.42 % 1.53
Lithuania 1.60 % 13.5 % 0.42 % 1.00
Calculate Sharpe, Treynor, Jenson measure
TRYENOR measure
TM = R p – R f
βp
TME = 1.12 – 0.42 = 0.42 TMLi = 1.6 – 0.42 = 1.18
1.65 1.00
TMLa = 0.75 – 0.42 = 0.22

1.53
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Rudramurthy B.V
TRYENOR measure
SM = R p – R f
σp
SME = 1.12 – 0.42 = 0.0438
16
SMLa = 0.75 – 0.42 = 0.0145

22.8
SMLi = 1.6 – 0.42 = 0.0874

13.5
JENSEN measure
JM = R p – SML
JM = R p – [R f + β (ER m – R f)]
JMA = 1.12 – [0.42 + 1.65(1.6 – 0.42)] = -1.247
JMB = 0.75 – [0.42 + 1.53(1.6 – 0.42)] = -1.4754
JMC = 1.60 – [0.42 + 1.00(1.6 – 0.42)] = 0
75
Rudramurthy B.V
International Cost of Capital and Capital Structure

International cost of capital is much cheaper than domestic weighted average
cost of capital (WACC) because company can increase finance through global market
where it will get at cheaper rate
Problems
1. MS Oil Company’s cost of debt is 7 %. The risk free rate of interest is 3 %.
The expected return on the market portfolio is 8 %. After depletion allowances
MS oil’s effective tax rate is 25 % its optimal capital structure is 60 % debt
and 40 % equity.
a. If MS Oil’s beta is estimated at 1.1, what is WACC?
b. If MS Oil’s beta is estimated at 0.8, significantly lower because of
continuing profit prospects in the global energy sector, what is
WACC?
Solution
a. When beta is 1.1
Post tax cost of debt = Pre tax cost of debt (1 – tax)
KD = 7 % (1 – 0.25)
KD = 7 % × 0.75 = 5.25 %
Calculation of cost of equity
KE = RF + [ERM – RF] β
KE = 3 % + [8 – 3] 1.1
KE = 3 % + 5.5 %
KE = 8.5 %
Calculation of weighted average cost of capital
WACC = WD KD + WE KE
WACC = 0.6 × 5.25 + 0.4 × 8.5
WACC = 6.55 %
b. When beta is 0.8
KD = 7 % (1 – 0.25) = 5.25 %
Calculation of cost of equity
KE = 3 % + [8 – 3] 0.8 = 7 %
Calculation of weighted average cost of capital
WACC = 0.6 × 5.25 + 0.4 × 7
WACC = 5.95 %
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2. Using the following data calculate

a. Cost of Equity
b. Cost of Debt
c. Weighted average cost of capital (WACC)
RF = 4 %, KD = 7 %, Tax = 30 %, β = 1.3, ERM = 9 %, D/(D + E) = 50 %
Solution
a. Calculation of cost of equity
KE = 4 % + [9 – 4] 1.3 = 10.5 %
b. Calculation of post tax cost of debt
KD = 7 % (1 – 0.3) = 4.9 %
c. Calculation of weighted average cost of capital (WACC)
WACC = 0.5 × 4.9 + 0.5 × 10.5
WACC = 7.7 %
Cost of Capital across Countries
Just like technology or resource differences, there exist differences in the cost
of capital across countries. Such differences can be advantages to MNCs in the
following ways
 Increased competitive advantage results to the MNC as a result of using low
cost of capital obtained from international financial markets compared to
domestic firms in the foreign country. This in turn, results in lower costs that
can be translated into higher market shares.
 MNCs have the ability to adjust international operations to capitalize on cost
of capital differences among countries, something not possible for domestic
companies.
 Country differences in the use of debt or equity can be understood and
capitalized by MNC
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Swaps
A swap is an agreement between two companies to exchange cash flows so as
to gain the difference.
Types of Swaps
1. Interest Rate Swaps
2. Currency Swaps
An interest rate swap is a swap where in a company borrows fixed rate of
interest (Comparative advantage in fixed rate interest) and ends up paying in floating
rate (wishes to pay floating rate of interest) by entering into swap agreement with
other company with opposite cash flows.
LIBOR (London Inter Bank Offer Rate)
It is the rate of interest at which bank deposits money with other banks in the
euro currency markets generally 1-month, 3-month, 6-month and 1-year LIBOR’s are
used.
Advantages of Swap
1. A swap agreement can be used to transform a floating rate of loan into fixed
rate of loan and vice versa.
2. A swap agreement can also be used to transform an asset turning fixed rate of
interest into an asset turning floating rate of interest.
Comparative Advantage Theory
 The popularity of swaps comes into picture only because of
Comparative Advantage Theory.
 According to this theory a company should borrow or invest for that
rate of interest in which it has comparative advantage.
 But however it wants to satisfy its wish of opposite rate, it should enter
into swap agreement.
 Critics of Comparative Advantage Theory argue that the benefit of
swap will not exist in reality because of arbitragers operating in market.
 Comparative Advantage Theory makes an assumption that floating rate
of interest remains unchanged throughout the period of swap agreement.
However in reality floating rate might change due to change in the
creditworthiness of the company.
Currency Swap
It involves exchange of principal and interest payment of receipts and
payments in one currency with that of another currency.
Advantages of currency swap
 Transformation of liabilities.
 Transformation of assets.
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Problems
1. Company A and company B have been offered the following rates pa on a
$ 20 million 5 year loan
Company Fixed rate Floating rate
A 12 % LIBOR + 0.1 %
B 13.4 % LIBOR + 0.6 %
Company A requires floating rate loan and company B requires a fixed

rate loan. Design a swap agreement that will net a bank acting as intermediary
0.1 % pa and that will appear equally attractive to both the companies
Solution
A 12 % LIBOR + 0.1 %
B 13.4 % LIBOR + 0.6 %
Interest rate differential 1.4 % 0.5 %
Calculation of profit or gain on swap

Swap gain = 1.4 % - 0.5 % = 0.9 %
Less banker commission = 0.1 %
Net swap gain = 0.8 %
Swap gains are shared equally by A and B respectively
Net swap gain to Company A = 0.4 %
Net swap gain to Company B = 0.4 %
Net Cash outflow for A = LIBOR + (0.1 – 0.4) = LIBOR – 0.3 %
Net Cash outflow for B = 13.4 % - 0.4 % = 13 %
Intermediary Gain = 0.1 %
Company Comparative advantage Actual Borrowing rate
A Fixed rate Floating rate
B Floating rate Fixed rate
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2. Company ‘A’ wishes to borrow 10 million at a fixed rate for 5 years and has
been offered 11 % fixed or 6-month LIBOR + 1 %. Company B wishes to
borrow 10 million at a floating rate for 5 years and has been offered 10 %
fixed or 6-month LIBOR + 0.5 %. How do they enter into a Swap agreement
in which each benefit equally? What risk did this arrangement generate?
Solution
A 11 % 6-M LIBOR + 1 %
B 10 % 6-M LIBOR + 0.5 %
Interest rate differential 1% 0.5 %
Calculation of profit or gain on swap

Swap gain = 1.0 % - 0.5 % = 0.5 %
Swap gains are shared equally by A and B respectively
Net swap gain to Company A = 0.25 %
Net swap gain to Company B = 0.25 %
Net Cash outflow for A = 11 % - 0.25 % = 10.75 %
Net Cash outflow for B = 6-M LIBOR + (0.5 – 0.25) = 6-M LIBOR + 0.25 %
Company Comparative advantage Actual Borrowing rate
A Floating rate Fixed rate
B Fixed rate Floating rate
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Spot Rate: It is the rate paid for delivery within 2 business days after the date of
transaction, in other words it is the current exchange rate between 2 or more
currencies.
Forward Rate: It is rate quoted for delivery of foreign currency on a future day which
is established at the time of entering into the contract. Forward rates are usually
quoted for fixed periods of 30, 60, 90 and so on days.
Cross Rate: An exchange rate between two countries that is derived from the
exchange rate of those currencies with a 3rd known currency is known as cross rate of
exchange.
Derivative: A derivative may be a commodity derivative or financial derivative whose

value is derived from an underlying asset.
Forward: A forward contract is a tailor made contract whose terms are negotiated
between the buyer and the seller which are not traded on organized exchanges and are
useful to hedge forward receivables and payables where the exact date of such
transactions is not fixed or known.
Future: A future contract where quantity, date and delivery conditions are
standardized. The futures contracts are traded on organized exchanges which are
settled with the differences
Option: An option gives its owner the right to buy or sell an underlying asset on or
before a given date at a fixed price but with no obligation to buy or sell the same for a
fixed premium.
Swap: A swap is a contract between two counter parties to exchange two streams of
payments for an agreed period to time swaps may either be interest rate or currency
swaps
Interest rate swap: It is an arrangement between parties or through the help of an

intermediary where fixed rate interest cash flows are exchanged for floating rate
interest cash flows or vice versa so as to benefit form exchange
Currency swaps: It is an arrangement between parties through an intermediary

wherein receipts or payments in one currency is exchanged for receipts or payments
in another currency so as to benefit from such transactions
Currency future: A currency future is the price of a particular currency for settlement
at a specified future date. Currency futures are traded on future exchanges where the
contracts are freely transferable.
Call option: Call option gives the option holder the right to buy an asset at a fixed
price during a certain period without any obligation to buy.
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Put option: Put option gives the option holder the right to buy an asset at a fixed price
during a certain period without any obligation to buy.
Covered call: A covered call involves writing a call option or an asset along with
buying the asset. It is a covered call since potential obligation to deliver the stock is
covered by underlying stock in the portfolio.
Uncovered call: An uncovered call or naked call refers to a speculative position not
covered by an asset where the potentials of gains/losses are unlimited.
Dirty float: Dirty float refers to partly managed floating exchange rate wherein the
central bank intervenes to smoothen the fluctuation or to manage the value of the
domestic currency.
Clean float: Clean float it is left to the market forces of demand and supply to
determine the exchange rate.
Arbitrage: Arbitrage is the simultaneous purchase and sale of the same asset or
commodities on different markets to profit form price discrepancies.
Law of one price: In completive market characterized by numerous buyers and sellers
having low cost access to information exchange adjusted prices of identical tradable
goods and financial assets must be within transaction costs of equality world wide.
Difference between risk and exposure: Risk is the measure of uncertainty of expected
return meeting with actual return. Risk is a pact of exposure where higher the
exposure, higher is the degree of risk.
Comparative advantage theory of swaps: Swap contracts are entered in order to

benefit form the comparative advantage where parties entering into swap agreement
have in one interest rate say fixed rate over the other rate say floating rate.
Hard currency: A hard currency is a currency which is widely and popularly traded in
the market. It is also that currency which is expected to appreciate in future.
Soft currency: A soft currency lacks liquidity and is expected to depreciate in future.
Difference between speculation and hedging: Speculation involves taking an

uncovered call position to have exposed to unlimited profits and losses whereas
hedging is process of covered position which removes risk of future appreciation/
depreciation of currency.
Marked to market: It is a system of calculating profits or losses on a daily basis and

the same is credited or debited to customer’s account at the end of each trading day.
Currency option: The right to buy/sell an underlying asset being a currency for a
premium without obligation to buy/sell.
Distinguish between absolute and relative PPP: Absolute PPP ignores the effect of
transportation cost, tariff, quotas and other restrictions and product differentiation in
free trade which is considered by relative PPP.
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Participants in foreign exchange markets: Banker and other intermediary, importer,

exporter etc.
Floor: A contract that protects the holder against the fall in prices below a certain
point or lower limit.
Dollarization: The complete replacement of local currency with the US dollar. It helps
in providing economic stability.
Currency collar (Range Forward): It is an arrangement wherein the currency move

outside an agreed upon range is protected.
Agency cost: Cost of conflicting interest between subsidiary company and parent
company’s interest.
Devaluation of currency: It refers to drop in the foreign exchange value of a currency.
International Financial Management

It is concerned with application of functions of management to financing
activity, investing activity, dividend decision and liquidity of a business keeping in
mind the global perspective and crossing the geographical boundaries of the country.
Activities of IFM
1. Financing activity: How to raise the fund and from what source (debt or
equity)
2. Investing activity: Where to invest (application of funds collected through
financing activity)
3. Dividend decision: It decides how much of profit to be distributed to share
holders as dividend and how much of profits to be retained
4. Liquidity decision or asset management decision: It studies the proportion of
current assets and fixed assets in the total asset of the firm. Higher the
proportion of current asset in the total asset of the firm, higher is the liquidity
and vice versa.
Ex of IFM
Borrowing money from USA (financing decision) and employing the same in
Japan (Investing decision).
Importance of IFM
1. Increasing boundaries of business
2. Growing financial instruments markets and systems
3. Changing political economy
4. Globalization
5. Changing socio-economic conditions
Differences from domestic FM
1. Exchange rate
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2. Wider boundary of business

3. Wider exposure and risk
4. International taxation
5. International capital markets
6. Political treaties between countries
7. International capital budgeting
8. International working capital management decisions
Challenges of IFM
1. Fluctuations in exchange rate
2. Expanding geographical boundaries
3. Growing financial and monetary developments
4. Fiscal polices and monetary developments
5. Changing capital markets
Theories of IFM
1. Comparative advantage theory
2. Relative advantage theory
3. Imperfect market theory (Supplying of resources not restricted by exports and
imports)
4. Product life cycle theory
Factors that affect exchange rates
1. Demand for a currency
2. Supply for a currency
3. Inflation rates
4. Interest rates
5. Income level
6. Government control
Multinational Company (MNC)
A multinational company (MNC) or a transnational company is a company
which has gone global. It keeps in mind a global scenario and views the entire world
as one single market by extending the boundaries of its operation in more than one
country. Foreign operation of a company which has substantial interest on revenue
and decision making is also considered as MNC.
Ex: - Sony, Samsung, General Motors, Ford etc
Goals or objectives of MNC
 Maximize shareholder’s wealth
 To increase its cash flow by tapping the available money in the overseas
market.
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 To recognize additional foreign opportunities

 Availability of cheap and abundance of funds
 Availability of cheap and talented labor
 Creation of place, form and possession utility
 To move with advancement of technology
 To help the firm invest its capital in potential investment avenues
 To minimize time and distance across the globe
 To enjoy the benefits of large scale business operations
 Expansion and diversification
The Balance of Payment (BOP)
The Balance of Payment (BOP) of a country is a systematic accounting record
of all economic transactions during a given period of time (generally one year)
between the residents of the country and residents of foreign country. In short BOP is
a statement which records a country’s international economic transaction with that of
rest of the world for a specific period of time.
Importance of BOP (uses)
1. It indicates the pressure on a country’s foreign exchange rate.
2. Changes in BOP signal the imposition or removal of controls over payment of
dividends, interest, license fee etc.
3. BOP helps to forecast a country’s market potential.
4. Decides a country’s monetary policy.
Economic transaction include
1. One real transfer: unilateral gift in kind
2. One financial transfer: unilateral financial gift
3. Two real transfer: barter transaction
4. Two financial transfer: exchange of financial items
5. One real transfer & one financial transfer: sale or purchase of goods or
services for cash or credit
Accounting principles in BOP
 BOP statement follows rules of double entry system of book keeping
i.e. for every debt entry there is a corresponding credit entry.
 Leaving aside errors & omissions BOP must always balance i.e. total
debits = total credits.
Components of BOP
1. Current account
2. Capital account
3. Reserves account
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4. Errors and omissions

If credits are more than debits then we call it as surplus BOP, if credits are less
than debits we call it as surplus BOP and if credit is equal to debit then we call it as
balanced BOP.
Format of Balance of Payment
Particulars Credit Debit Net
A.CURRENT ACCOUNT
1. Merchandise (goods) BOT XXX XXX
XXX
2. Invisibles (a + b + c) XXX XXX
XXX
a) Services XXX XXX
XXX
b) Transfers XXX XXX
XXX
c) Incomes (Investment incomes) XXX XXX
Total Current Account (1 + 2) XXX XXX XXX
B. CAPITAL ACCOUNT
1. Foreign investment XXX XXX XXX
2. Loans XXX XXX XXX
3. Banking capital XXX XXX XXX
4. Rupee debt services XXX XXX XXX
Total Capital Account (1 + 2 + 3 + 4) XXX XXX XXX
C. ERRORS & OMISSIONS XXX XXX XXX
Overall Balance XXX XXX XXX
D. OFFICIAL RESERVES ACCOUNT

1. IMF
XXX XXX XXX
2. Foreign Balance reserve (increase or
XXX XXX XXX
decrease)
Rules and guidance notes on recording

 Imports are debt entry where as exports are credit entry
 Increase in foreign asset or decrease in foreign liability is a debit entry
whereas increase in foreign liability or decrease in foreign asset is a credit
entry i.e. Increase in FA & Decrease in FL is a Debit
Decrease in FA & Increase in FL is a Credit
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 Merchandise imports and exports of goods and services are recorded in current
account whereas transactions related to financial assets or liabilities are
recorded in capital account.
 Capital outflow is a debit entry whereas capital inflow is a credit entry
(netting)
 Financial transfers and real transfers are recorded in current account.
 Income form investment to be recorded in current account.
International monetary system
International monetary system is defined as the institutional frame work within
which international payment are made, movement of capital accommodated and
exchange rates among currencies are determined.
In short it is a complex whole of agreement, rules, institutions, mechanism and
policies regarding
1. Exchange rates
2. International payments
3. Flow of capital
Stages of International Monetary System
1. Bimetallism (Before 1875)
It is a double standard system of free coin age for both silver and gold.
Both silver and gold were used as international means of payment and the
exchange rate among countries currency were determined by either gold or
silver reserves
2. Classical Gold Standards (1875 – 1914) 39 years
Classical gold standards system as an international monetary system
lasted for about 40 years. During this period London became the center of
international financial system reflecting Britain’s advanced economy and its
predominant position in international trade.
Under the gold standards, the exchange rate between any two
currencies was determined by their gold content.
Ex: If 1 Kg of gold is 1000 £ and 1 kg of gold is 1500 $ then the exchange rate
between £ and $ is £ 1 = $ 1.5
3. Inter-war period (1915 – 1944) 29 years
World war first ended the classical gold standards in August 1914, as
all major countries suspend redemption of bank notes in gold countries, lacked
the political will to abide by the “rules of the game” and so automatic
adjustment mechanism of gold standards was unable to work. The event of
great depression 1929 accompanying financial crisis added for further
downfall of classical gold standards.
Paper standard came into being when gold standard was abandoned.
4. Breton Hood conference system (1945 – 1972) 27 years
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Only July 1944 representative of 44 nations gathered at Breton Hood

to discuss and design the post war international monetary system.
It paved way for establishment of International Monetary Fund (IMF)
and its sister institution World Bank.
US dollar was held as the only currency that was fully convertible to
gold. Countries held gold and US dollars as the means of international
payments.
5. Flexible exchange rate system (1973 – till date)
International Monetary Fund (IMF) members met at Jamaica and
agreed for a new set of rules for international monetary system. The agreement
include
 Flexible exchange rate where central bank was allowed to
intervene in exchange market to cut down the volatility.
 Gold reserves were abandoned and half of the gold holding was
returned to members and other half was sold and proceed was used
to help poor nations.
 Non oil exporting countries and less developed countries were
given grater access to IMF funds.
Current Scenario
G5 countries meet at Plaza in New York in 1985 and G7 countries economic
summit in Paris in 1987 made developed countries to more closely consult and co-
ordinate their macro-economic policy and to achieve greater exchange rate stability.
The exchange rates were determined by market force.
International Project Appraisal (Factors determining international capital
budgeting)
A company can go global by any of the following means
1) Export trade
2) Establishment of subsidiary in the foreign country
3) Joint venture in foreign country
4) Establishing branch in foreign country
5) Agencies and franchise relationship
The following features distinguish a domestic project with that of international project
appraisal (factors)
1. Exchange rate risk
Cash inflows form a foreign project will be in terms of foreign
currency and there is exchange rate risk involved while converting the same
to local currency.
2. Capital market segmentation
A precise cost of capital cannot be ascertained while appraising an
international foreign project since cost of capital in home country varies with
that of the host countries.
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3. International taxation
Host country charges tax on income earned through a foreign project
and even with holding tax is also charged on remittances made to parent
company.
Due considerations shall be given to tax credits allowed by home
countries for payments of taxes in host countries.
4. Political risk or country risk
Changes in government policies of host country, entry and exit
barriers, fluctuation in tax rate, penalties and subsidies, nationalization
policy of host country etc determine the level of international project
acceptability.
5. Inflation
Rates of inflation between home country and host country act as a
factor for international project appraisal.
6. Salvage value
Salvage value offered by the host country at the time of repurchasing
the project determines a factor for international project appraisal.
Country Risk Analysis
There is great interest developed in recent years among private and official
lending institution in the systematic evaluation of country’s risk.
Need
Whether a country will be able to get loans at reasonable cost?

Whether a country will be able to attract foreign capital?
Factors to be considered in country-risk analysis
Political Risk Factors

According to Hans, it is said that “Political risk is 50 % of the country’s
risk analysis but it is inseparable from economic risk”.
The following factors indicate political risk
a) Political Stability: - Changes in government, level of violence in
country, internal and external conflicts etc determine political risk of
each nation.
b) Attitude of host government: - The host government may impose
restrictions on transfer of funds by subsidiary to parent company by
charging the corporate tax, with-holding tax etc.
c) War: - Safety of local employees hired by MNCs and the project cash
inflows are subject to volatility because of war.
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d) Business Cycle: - The period of Business Cycle in which a country is

operating decides the risk factor. In periods of trough, risk factor is
more and in periods of boom risk factor is less
e) Priorities: - The host government may support the MNC and be
friendly with the subsidiaries of parent company which determines the
risk levels.
Economic Risk Factors
The following factors indicate economic risk of a country
a) Rate of inflation: - It determines economic instability, government’s
mismanagement, purchasing power of consumers etc
b) Current and potential state of country: -
An MNC which exports to a country or sets up a subsidiary
there is concerned with present and future dement of its product.
Levels of external debt, foreign exchange reserve, BOP, GDP
growth rate etc determines the country’s state or position.
c) Exchange rate: - It signifies the influence of the demand for a country’s
export which in turn affects the country’s product and income level.
d) Resource base: - It includes natural resources, human resources and
other intangible resources available in a country which measures the
economic risk level.
e) Adjustment to external shock: - Countries with greater adaptability to
external shocks have lesser economic risk compared to other countries
whose level of adaptability is low.
Techniques to assess country risk
1) Debt related factors
 Borrowing capacity of the country
 Debt servicing capacity.
 Liquidity and solvency problem
Indicators of debt servicing
Debt/GDP
Debt/foreign exchange receipt
Interest payment/foreign exchange receipt
2) Balance of payment
It represents difference between national income and national
expenditure. It indicates the rate at which a country is building its foreign assets
or foreign liabilities.
Indicators of BOP
a) Current account balance
b) Capital account balance
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c) Reserve balance
3) Economic performance
It can be measured in terms of country’s rate of growth and rate of inflation
Indicators of Economic performance
a) GDP/GNP
b) Gross domestic savings/GNP
c) Gross domestic investment/GDP
4) Political instability
Direct effect: - It includes political protest like strikes, lock outs etc
Indirect effect: - Adverse consequences on growth, inflation, foreign exchange
reserve etc
5) Checklist approach
a) Identification of country risk factors
b) Assign weights
c) Prepare rating scale
d) Calculation of product (wt × rating scale)
e) Calculate country risk score
International Cost of Capital
It is the return what a total capital (domestic as well as international) expects
from a project.
International Capital Structure
It is the means of financing a project using an ideal mix of various sources of
capital like debt, equity and preference shares so as to maximize the value of firm and
minimize the overall cost of capital.
Differences in cost of capital for an MNC and domestic firm can be because of
the following factors
(1) Size of the firm
(2) Foreign exchange risk
(3) Access to international capital market
(4) International diversification effect
(5) Country risk
1. Political risk
2. Economic risk
Multinational Taxation
The objective of multinational taxation is to minimize the total tax burden on
multinational projects.
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Different countries charges tax based on either the source of income generated
from a particular place or based on residential status or a combination of both.
Double Taxation
An income earned in a foreign country may be charged to tax both in foreign
country as well as home country. This concept of charging tax twice for the same
income is called double taxation.
As provided in natural law, same income shall not be charged to tax twice.
Thus double taxation relief might be awarded based on section 90 (bilateral
agreement) and section 91 (unilateral agreement) of Indian Income Tax Act of 1961.
1) Bilateral agreement under section 90
Two different countries can come to an agreement not to charge tax on

same income earned in any one of the two countries by resident or non
residents of these countries.
Based on double taxation agreements if tax is charged in host country
either no tax shall be charged in home country or part of income shall be
charged with tax in both countries.
2) Unilateral agreement under section 91
Where bilateral agreements are not there, income earned in such

countries shall be given tax credit under section 91 of Indian Income Tax Act
of 1961.
Factors considered in multinational tax management
a) Bilateral agreement
b) Tax holiday
c) Deductions available under chapter (6) of Indian Income Tax Act of
1961.
d) Exemption under section 10 of Indian Income Tax Act of 1961.
e) Mutual benefits
Multinational Cash Management
It involves estimation of various cash inflows from both domestic as well as

international projects and optimum utilization of funds.
Objectives
a) To maximize foreign exchange risk exposure
b) To minimize political risk
c) To minimize country risk
d) To minimize transaction costs
e) To minimize cash requirement of multinational firm
Techniques of optimize cash flow
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1) Accelerating cash inflows

2) Managing blocked funds
3) Leading and lagging strategy
4) Netting
5) Minimization of tax using international transfer pricing
Multinational Inventory Management
A multinational firm might maintain inventory and re-order level far in excess
of the economic order quantity. The following reasons shall be attributable for the
same.
1) Anticipating devaluation
If devaluation of local currency is expected in near future, after
devaluation imported inventory will cost more in local currency. Hence higher
level of inventory is maintained but however a trade off on higher holding cost
and high local interest rate is to be made.
2) Anticipating price freeze
When local government enforces price freeze following devaluation,
the organization establishes price of an imported item at a high level with
actual sales made at discount. In the event of devaluation sales continue at the
posted price but discounts are withdrawn
3) Purchase of forward contract
Future purchases can be hedged with exchange rate fluctuations by
entering into a forward by contract.
Managing of Multinational Receivables
Multinational accounts receivable are created by two types of transactions

1. Sales to related subsidiaries
2. Sales to unrelated buyers
 Independent customers (unrelated buyers)
It involves decisions regarding selection of currency and terms of payment.

Seller prefers to price the commodity in stronger currency where buyer prefers weaker
currency.
Receivables from sales in weaker currency should be collected as soon as
possible whereas receivables from sales in a stronger currency should be delayed
 Self liquidating bills
If the sale deed has the bills accepted by the buyer and endorsement of the
seller, it can be rediscounted with the banker and net investment in receivable can be
brought down to zero.
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Financing by exporting government
Government bodies in many countries facilitate inventory financing by

extending export credit or by guaranteeing export credit from banks at lower interest
rate.
Depository Receipts
A depository receipts is a negotiable instrument that usually represents a
company’s publicly traded securities (debt/equity) in foreign market.
Depository receipts are issued for stock traded abroad wherein an
intermediaries acts on behalf of the issuing company rises funds without listing the
securities mandatory on the respective country’s stock market.
Objectives of issuing Depository Receipts
 To raise capital in foreign market

 To build good will and reputation
 To improve liquidity position of its securities
 To allow employees outside the home market
 To support for potential mergers and acquisition
American Depository Receipts (ADR)
Non US based company rising funds through issue of depositary receipts in

US without compulsion of listing on US stock exchange.
Benefits of ADR to Issuing Companies
1. To raise additional funds

2. To build good will and reputation
3. To support for potential merger and acquisition
4. Increase share holder base
5. Enables companies to tap US security market
6. It provides a US way for US employees of Non-US companies to invest in
their company’s employee stock option (ESO)
Benefits of ADR to Investors
1. High security
2. High liquidity
3. Diversification of risk
4. Higher return
94
Rudramurthy B.V
Global Depository Receipts
It is an instrument to raise capital in multiple markets outside the issuer’s

domestic market through stocks which are traded in foreign stock markets. GDR has
become synonyms with selling equity in Euro markets.
Differences between ADR & GDR
ADR GDR
1. ADR may be listed in New York 1. GDR may be listed in London
stock exchange. stock exchange
2. Issue expenses are more in ADR 2. Issue expenses are low in GDR
a compared to ADR
3. Compulsory voting rights to 3. Optional voting rights
investors 4. It is enough if you show a
4. US GAP has to be followed and reconciliation statement
re-accounting has to be done 5. GDR does not demand less
5. It demands more transparency of transparency as that of ADR
account
Difference between Options and Futures
Futures Options
1. It is a standardized forward 1. It is an agreement to buy/sell not

contract obligation to do.
2. No premium payment 2. Premium payment exist
3. One can buy/sell futures 3. One can become holder/writer of

either call/put option
4. Unlimited profits and unlimited 4. Holder has limited loss and

loss unlimited profit where as writer has
limited profits and limited loss
5. Contracts exercised square off at 5. Option are exercised at the strike

current future rate existing on the date price
of square off
6. No concept of strike price 6. There exists concept of strike

price
7. No concept of “in the money, at 7. There exists concept of “in the

the money, out of the money”. money, at the money, out of the
95
Rudramurthy B.V
money”.
8. Brokerage calculated on contract 8. Brokerage calculated on premium

value
9. High liquidity 9. Low liquidity
10. Small spreads 10.Huge spread
Difference between Forward and Future
Futures Options
1. It is a non standardize future 1. It is a standardized forward

contract contract
2. No intermediary 2. There exists intermediary
3. Traded in OTCEI market 3. Traded in recognized exchange
4. Cost of forward is less since there 4. There exists transaction cost and
is no brokerage brokerage
5. High level of counter party risk 5. No such risk is prevalent in future

market since exchange act as
intermediary
6. Generally contracts are exercised 6. Either exercised or squared off
7. Contracts are settled either by 7. Contracts are settled on cash basis

delivery or cash settlement
8. No liquidity 8. There exists high liquidity
96

IFM Notes Full Rudramurthy Sir

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IFM Notes Full Rudramurthy Sir

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Rudramurthy B.

CRASH COURSE FOR IFM AND

INTERNATIONAL FINANCIAL MANAGEMENT

• Extends the area of operations to outside the geographical boundaries of the

• Multinational Companies are exposed to currency risk.

There are two types of Quotes:

EX: 1$ = INR 40.

EX: 1INR = $ 0.025

Spread: It is the difference between Offer rate and Bid Rate.

Spread: (In %) = Spread in Rs × 100

Computation of indirect quote for a two way direct quote:

Bid rate of Indirect Quote = 1 .

Offer rate of Indirect Quote = 1 .

1. Suppose RM plans to invest in Martin ltd, a British corporation that is

RM can purchase = 5000 = 1000 shares

Return in % (Pounds) = 60000 – 50000 = 20 %

This change in percentage is due to CURRENCY RISK

Factors influencing Capital Budgeting

There are two approaches to evaluate international capital budgeting

Years Cash Flow (in million $)

Where St = forward rate for year t

Since NPV is positive, the above foreign project shall be accepted

b) Foreign currency approach

(1 + risk adjusted rupee rate) = (1 + Rf rupee rate) × (1 + risk premium)

(1 + 0.15) = (1 + 0.11) (1 + rp)

(1 + rp) = 1.15/1.11 = 1.036

(1 + risk adjusted dollar rate) = (1 + Rf dollar rate) × (1 + risk premium)

(1 + risk adjusted dollar rate) = (1 + 0.06) × (1 + 0.036)

(1 + risk adjusted dollar rate) = 1.09816

risk adjusted dollar rate = 9.8 %

Home currency approach

1. Calculation of Expected Forward rate (ERF) using international Fischer effect

Foreign currency approach

1. Calculation of Risk premium rate

Year Price (FF) Demand Variable Cost (FF)

 The fixed costs are estimated to be FF 5 million per year.

 The French government will impose a withholding tax of 10 % on earnings

 The required rate of return on this project is 15 %.

a) Determine the net present value of this project. Should Barret

b) Assume that Barret Co. provides the additional funds for

c) Would the NPV of this project from the parent’s perspective be

d) Assume Barret Co. uses the original proposed financing

e) Assume that Barret Co. decided to implement the project, using

EBT (after interest and depreciation) 11 19 27.6

c) If Barret Corporation funds the working capital requirement of its subsidiary,

a) What is present value of expected Euro dividend stream if the Euro is

5. X Corporation presently has no existing business in New Zealand but is

 The initial investment required is $ 50 million in NZ dollars. The existing spot

Year Price (NZD) Demand Variable Cost (NZD)

 The fixed costs are estimated to be 6 million NZD per year.

 The NZ government will impose an income tax of 30 % on income in addition it

 X corporation requires 20 % ROI on this project

a) Determine the net present value of this project. Should X Corp.

b) Assume that X Corp. is also considering an alternative

c) From the parent’s perspective would the NPV of this project be

d) Assume X Corp. uses the original proposed financing

e) What is the break-even salvage value of this project if X Corp.

f) Assume that X Corp. decided to implement the project, using

c) If X Corp. funds the working capital requirement of its

million NZD ) million dollar)

Cash Flow Scheme 2: Savings in interest

Cash Flow Scheme 3: Tax benefit on account of payment of interest

Calculation of Adjusted NPV