Example You are required to find out the overall balance, showing clearly all the sub-balances from

the following data: (1) UC Corporation of the USA invests in India Rs.3,00,000 to modernise its India subsidiary. (2) A tourist from Egypt buys souvenirs worth Rs.3000 to carry with him. He also pays hotel and travel bills of Rs.5,000 to Delhi Tourist Agency. (3) The Indian subsidiary of UC Corporation remits, as usual, Rs.5,000 as dividends to its parent company in the USA. (4) This Indian subsidiary of UC Corporation sells a part of its production in other Asian countries for Rs.1,00,000. (5) The Indian subsidiary borrows a sum of Rs.2,00,000 (to be paid back in a years time) from the German money market to resolve its urgent liquidity problem. (6) An Indian company buys a machine for Rs.1,00,000 from Japan and 60 per cent payment is made immediately; the remaining amount is to be paid after 3 years. (7) An Indian subsidiary of French Company borrows Rs.50,000 from the Indian public to invest in its modernisation programme.
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Solution Sources and Uses of Funds

S. No. 1. 2. (a) (b) 3. 4. 5. 6. (a) (b) Sources 3,00,000 3,000 5,000 1,00,000 2,00,000 40,000 6,48,000 Uses Nature Direct Foreign Investment Goods exported Services (invisible) rendered 5,000 Dividends paid Goods exported Short-term borrowing 1,00,000 Equipment imported Increase in claim to India (Portfolio) 1,05,000

BOP Statement Current Account Goods Account Exports : Rs. 1,03,000 (+) Imports : Rs. 1,00,000 (-) Balance : Rs. 3,000 (+)

Invisible Account Payment Received Payments Made

: :
2

Rs. 5,000 (+) Rs. 5,000 (-)

Balance

Nil

Current Account Balance: Rs. 3,000 (+) B. Capital Account Foreign Direct Investment Inflow Outflow Balance : : : Rs. 3,00,000 (+) Nil Rs. 3,00,000 (+)

Portfolio Investment Inflow Outflow Balance : : : Rs. 40,000 (+) Nil Rs. 40,000 (+)

Long-term Capital Balance: Rs.3,40,000 (+) (FDI + Portfolio) Short-term Capital Account Inflow : Rs. 2,00,0000 (+) Outflow : Nil Balance : Rs. 2,00,000 (+) Capital Accounts Balance: Rs.5,40,000 (+) Overall Balance: Rs. 5,43,000 (+)
3

There is a net surplus of Rs.5,43,000 in the balance of payments. This means, there will be an increase of reserves by this amount. Notes: The transaction No. 7 did not enter into the BOP Statement since this transaction does not involve any foreign country. The entire transaction has taken place in Indian rupees within India.

FOREIGN EXCHANGE MARKET INTRODUCTION The foreign exchange market is the market where the currency of one country is exchanged for that of another country and where the rate of exchange is determined. The genesis of Foreign Exchange (FE) market can be traced to the need for foreign currencies arising from: international trade; foreign investment; and lending to and borrower from foreigners. In order to maintain an equilibrium in the FE market, demand for foreign currency (or the supply of home currency) should equal supply of foreign currency (or the demand for home currency). In operational terms, the demand for and supply of home currency should be equal. In the event of a disequilibrium situation, the monetary authority of the concerned country normally intervenes/steps in to bring out the desired balance by: variation in the exchange rate; or changes in official reserves; or both.

PARTICIPANTS IN THE FE MARKET Major participants in the FE market are: Large commercial banks (through their cambistes or dealers) operating either at retail level for individual exporters and corporations, or at wholesale level in the interbank market; Central banks of various countries that intervene in order to maintain or to influence the exchange rate of their currencies within a certain range, as also to execute the orders of government; Individual brokers or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks can influence short-term quotes. Exchange markets primarily function through telephone and telex. Further, it may be mentioned hem that currencies with limited convertibility play a minor role in the FE market. And, only a small number of countries have established fill convertibility of their currencies for all transactions. QUOTING IN THE FE MARKET Foreign exchange rates ale quoted either for immediate delivery (spot rate) or for delivery on a future date (forward rate). In practice, delivery in spot market is made two days later.

A FE quotation is the price of a currency expressed in the units of another currency. The quotation can be other direct or indirect. It is direct when quoted as so many units of local currency per unit of foreign currency. For example, Rs. 35 = US$ 1, is a direct quotation for US dollars in India. Similarly, a quotation in the USA will be $ 0.22 = FFr 1 whereas in France, it would be FFr 3.3 = DM 1, etc. On the other hand, an indirect quotation is the one where exchange rate is given in terms of variable units of foreign currency as equivalent to a fixed number of units of home currency. For example, in India US$ 2.857 = Rs. 100 is an indirect quotation. This type of cp is made in the UK. For example, in London a quotation may be made as $1.55 = 1. Since 2 August 1993, all quotations in India use the direct method of quotation. Some currencies are quoted as so many rupees against one unit while others as so many rupees against 100 units, as indicated in Tables 1 to 3 below.

Table 1 Foreign Currencies Quoted against their One Unit

1. Australian dollar (A$) 2. Austrian schilling (Sch) 10. Finish (FM) 11. French (FFr) mark 19. Qatar riyal franc 20. Saudi riyal (SR)

21. Singapore dollar 3. Bahrain dinar 12. Hong Kong (S$) dollar (HK$) 4. Canadian dollar 13. Irish pound (I ) 22. Sterling pound (Can$) () 5. Danish (DKr) kroner 14. Kuwaiti dinar Malaysian 24. Swiss franc (Sfr) 23. Swedish kroner (SKr)

15. 6. Deutschmark (DM) ringgit 7. Dutch guilder (FI

16. New Zealand 25. Thai baht (Br) dollar (NZ$) 8. Egyptian pound 17. Norvegian 26. UAE Dirham kroner (NKr) 9. European Currency 27. US Dollar ($) Unit (ECU) 18. Omani riyal

Table 2 Foreign Currencies Quoted against their 100 Units

1. Belgian franc (BFr) 2. Indonesian rupiah 3. Italian lira 5. Kenyan shilling 4. Japanese yen 6. Spanish peseta

Table 3: Asian Clearing Union Currencies Quoted against their 100 Units 1. Bangladesh taka 3. Iranian rial 5. Sri Lankan rupee 2. Burmese Kyat 4. Pakistani rupee Foreign exchange rates are always quoted as a two-way price, i.e. a rate at which the bank (dealer) is willing to buy foreign currency (buying rate) and a rate at which the bank sells foreign currency (selling rate). Dealers do expect some profit in exchange operations and hence there is always some difference in buying and selling rates. However, the maximum spread available to dealers may be restricted by their central bank. All exchange rates by authorized dealers are quoted in terms of their capacity as buyer or seller. Two-Way Quote A dealer usually quotes a two-way price for a given currency-the price at which he is buying (bid price) and the price at which he is selling (offer or ask price) the currency. In either case, the currency for which the bid or ask price is given is the unit of the item priced.
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In a bid quote of Rs 35/US$ 1, the dealer conveys that he will buy dollars at the price of Rs 35 per dollar, which also means that he is willing to sell 35 m at the price of one dollar. Likewise, when the dealer quotes an offer price per dollar, he implicitly quotes the rate at which rupees would be bought per dollar. All foreign exchange dealers are set to make profit out of each transaction, whether it is a sale or purchase of foreign currency. Therefore, when a dealer in India buys foreign currency (the customer selling the currency), he endeavours to give as few units of the local currency as he can against every one unit of the foreign currency he buys. But when he sells foreign currency (the customer buying the currency), he endeavours to take as many units of the local currency as he can against every unit of foreign currency he gives to the customer. For example, a dealer in New Delhi may quote: US$ 1 = Rs 35.000 35.0050. This means that he will buy dollars from an exporter at US$ 1 = Rs 35.0000, and sell dollars to an importer at US$ 1 = Rs 35.0050. Thus, the lower rate is the buy (bid) quote and the higher rate is the selling (ask) quote.
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Spread Spread means the difference between a banks buying (bid) and selling (offer or ask) rates in an exchange rate quotation or an interest quotation. It fluctuates according to the level of stability in the market, the currency in question, and the volume of the business. Thus, if there is a degree of volatility in an exchange rate, and if business is thin and if (rumours persist about the currency that) the current rate is rumoured to be unsustainable, the dealer will protect himself by widening the quote. That is, he will offer less currency while selling but demand more when buying. The spread represents the gross return to the dealer for the risks inherent in making a market. The spread can also be expressed as a percentage. That is, Ask price Bid price x 100 Per cent spread = Ask price For example, with dollar quoted at Rs 35.000 35.0050, the percentage spread equals 0.014. Per cent spread = = 0.014. 35.0050 35.0000 x 100 35.0050

Usually, in transactions among dealers, only the last two digits are quoted, to save time and the rest is
11

understood. Thus, a dealer in New Delhi may quote a spot price for the dollar which is US$ 1 = Rs 35.0050 35.0080 only by referring to the last two digits, i.e. 5080, instead of quoting the rate in its entirety. The last digits are called points, e.g. in US dollar terms, a point is 1/10,000 part of the unit. Or, one point US$ 0.0001. A pip is one further decimal place to the right, i.e. US$ 0.00001 and represents 1/100000 part of a dollar. Most quoted currencies are expressed to four decimal places but the currencies with low value relative to others are quoted up to two decimal places. Italian Lira and Japanese yen are examples of such currencies. Cross Rates (Chain Rule) Cross rate is the price of any currency other than the home currency. In her words, it is the direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. Thus, in India, a cross rate is any exchange rate which excludes rupees, for example, US$/FFr, DM/BFr, etc.

12

If an importer has to remit French francs from India with the knowledge that Rupee/FFr rates are not normally quoted, would first buy dollars against the rupees and the same dollars will be used overseas to acquire French francs. If, say, rates in New Delhi am US$ I = Rs 35.0010 Rs 35.0080 and rates in Paris market are US$ 1 = FFr 5.1025/50, he will get US$ 1 by paying Rs. 35.0080 and for one US$, he will get FFr 5.1025. Thus, a sort of chain is formed as under: FFr 5.1025 = US$1 US$ 1 = Rs. 35.0080 Therefore, FFr 1 = 35.0080/5.1025 or, FFr1 = Rs 6.8609 SETTLEMENTS Cash Cash rate or Ready rate is the rate when the exchange of currencies takes places on the date of the deal. If delivery is made on the day the contract is booked, it is called a Telegraphic Transfer (TT) or cash or value-day deal. Tom When the exchange of currencies takes place on the next working day after the date of deal, it is called the TOM (tomorrow) rate.
13

Spot When the exchange of currencies takes place on the second working day after the date of the deal, it is called the spot rate. This time is allowed to banks to process the necessary paperwork and transfer the funds. Such transfers to and from banks will be effected when their overseas currency accounts we either credited or debited, depending on whether the bank is buying or selling. The rate of the agreed deal on telephone is called the contract dale; the value date is the one when the deposit is credited or debited. Normally, a deal done on Tuesday will b settled on Thursday and a deal done on Friday will be settled on the following Tuesday. A business day is defined as one in which both banks are open for business in both settlement countries. Most dealings now-a-days are done spot. In the case of a US$/DM deal done on Tuesday, settlement is normally expected on Thursday. Settlement would not be affected by a US holiday on the following Wednesday, but would be affected by a German holiday on this Wednesday. In the latter case, the spot date would be postponed until Friday, provided that both centres were open on Friday. If Wednesday were a normal day and Thursday a holiday in either the USA or Germany, the spat day would be Friday, if both centres were open on that day.
14

In the case of a US$/DM deal done, say, in London, the occurrence of bank holiday in the UK during the spot period is entirely irrelevant. This is because all bank account transfers are made in the settlement country rather than the dealing centre. Settlement of both sides of a foreign exchange deal should be made on the same business day. Because of time zone differences, settlement on any given business day will take place earlier in the Far East, later in Europe, mid later still in the USA. The principle that the two sides of the deal should be completed on the same day is referred to as the principle of compensated value. The only exception o the principle of compensated value arises for deals in Middle East countries for settlement on Friday. This is a holiday in most Middle East countries. Even though a person buying the Middle Eastern currency (say, Saudi riyals) may make payment (say, in pound sterling) on Friday, the delivery of riyals would take place on Saturday, provided it was a business day in both the relevant countries: For some currencies, such as US$/Can$ transactions, a spot transaction is only one day by convention and agreement among the market participants.

15

ADJUSTMENT OF DEMAND AND SUPPLY ON THE SPOT MARKET: PROCESS OF ARBITRAGE Arbitrage can be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage). Example An Arbitrage between Two Currencies Suppose two traders A and B are quoting the following rates: Trader A (Paris) Trader B (New York) FFr 5.5012/US$ US$ 0.1817/FFr We assume that buying and selling rates for these traders are the same. We find out the reciprocal rate of the quote given by the trader B, which is FFr 55036/US$ (= 1/0.1817). A combiste buys, say, US$ 10,000 from the trader A by paying FFr 55,012. Then he sells these US dollars to the trader B and receives FFr 55,036. In the process, he gains FFr 24 (= 55,036 55,012).

16

Since, in practice, buying and selling rates are likely to be different, so the quotation is likely to be as follows:
Trader A FFr 5.4500/US$ - FFr 5.50121US$ Trader B US$0.1785/FFr - US$ 0.18/FFr

These rates mean that the trader A would be willing to buy one unit of US dollar by paying FFr 5.45 while he would sell one US dollar for FFr 5.5012. The same holds true for the corresponding figures of the trader B. By observing these figures, it is clear that in order to make an arbitrage gain, the selling rate of the trader A has to be lower than the buying rate of the trader B. But this process would tend to increase the selling rate at the trader A because of the increase in demand of US do and the reverse would happen at the trader B because of increased supply of US dollars. This would lead to an equilibrium after some time.

17

Example An Arbitrage between Three Currencies Now suppose both traders A and B are located at New York and quoting as follows: Trader A Trader B $ 0.60/SF $ 0.60/SFr $0.51/DM $0.52/DM Since three currencies are involved hem, we find cross rates between SFr and DM as well. These are: SFr 0.85/DM (= 0.5110.64 at the trader A and SFr 0.867/DM (= 0.52/0.60) at the trader B. Thus, the situation looks like as follows: Trader A Trader B $ 0.51/SFr $ 0.60/SFr $0.51/DM $ 0.52/DM SFr 0.85/DM SFr 0.867/DM So what are the arbitrage possibilities? There is no arbitrage gain possible between the US dollar and Swiss franc. The following two arbitrages ale, however, possible: Deutschmark against the US dollar is being quoted higher at the trader B. So buy Deutschmarks from the trader A and sell them to the trader B.
18

 A similar possibility of arbitrage gain exists between the Swiss franc and Deutschmark: buy Deutschmarks against Swiss francs from the trader A and sell them to the trader B. FORWARD RATE If the exchange of currencies takes place after a certain period from the date of the deal (more than two working days), it is called the Forward Rate. A forward exchange contract is a binding contract between a customer and a dealer for the purchase or sale of a specific quantity of stated foreign currency, at a rate of exchange fixed at the time of making the contract (for executing by delivery and payment at a future time agreed upon when making the contract). Forward rates are generally expressed by indicating premium/discount on the spot rate for the forward period. Premium on one countrys currency implies discount on another countrys currency. For instance, if a currency (say the US dollar) is at a premium vis--vis another currency (say the Indian rupee), it obviously implies that the Indian rupee is at a discount vis-a-vis the US dollar. The forward market is not located at any specified place. Operations take place mostly by telephone/telex, etc., through brokers. Generally, participants in the
19

market are banks which want to cover orders for their clients. Though the forward rate may be quoted by a trader for any future date, the normal practice is to quote them for 30 days (1 month), 60 days (2 months), 90 days (3 months) and 180 days (6 months). Quotations for forward rates can be made in two ways. They can be made in terms of the exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency. This is called the outright rate and it is used by traders in quoting to customers. The forward rates can also be quoted in terms of points of premium or discount on the spot rate, which is used in intetbank quotations. To find the outright forward rates when premium or discount on quotes of forward rates are given in terms of points, the points are added to the spot price if the foreign currency is trading at a forward premium; the points are subtracted from the spot price if the foreign currency is trading at a forward discount. The traders know well whether the quotes in points represent a premium or a discount on the spot rate. This can be determined in a mechanical fashion. If the first forward quote (the bid or buying figure) is smaller than the second forward quote (the offer or the asking or
20

selling figure), then there is a premium. In such a situation, points are added to the spot rate. Conversely, if the first quote is greater than the second, then it is a discount. If, however, both the figures are the same, then the trader has to specify whether the forward rate is at premium or discount. This procedure ensures that the buy price is lower than the sell price, and the trader profits from the spread between the two prices. Example
Spot (FFr/US$) 5.2321/2340 1-month 25/20 3-month 40/32 6-month 20/26

In outright terms, these quotes would be expressed as below:

Maturity Spot 1-month 3-months 6-months Bid/Buy FFr 5.2321 per US$ FFr 5.2296 per US$ FFr 5.2281 per US$ FFr 5.2341 per US$ Sell/Offer/Ask FFr 5.2340 per US$ FFr 5.2320 per US$ FFr 5.2308 per US$ FFr 5.2366 per US$ Spread 0.0019 0.0024 0.0027 0.0025

It may be noted that in the case of forward deals of 1 month and 3 months, US dollar is at discount against French franc while 6 months forward is at premium. The first figure is greater than the second both in 1 month and 3 months forward quotes. Therefore, these quotes ale at a discount and accordingly these points have been subtracted from the spot rates to arrive at
21

outright rates. The reverse is the case for 6 months forward. Example Let us take an example of a quotation for the US dollar against rupees, given by a trader in New Delhi:
Spot Rs. 32.1010 Rs. 32.1100 Spread 0.0090 1-month 3-months 6-months

225/275 300/350 375/455 0.0050 0.0050 0.0080

The outright rates from the quotation will be as follows:

Maturity Spot 1-month 3-months 6-months Bid/Buy Rs. 32.1010 per US$ Rs 32.1235 per US$ Rs 32.1310 per US$ Rs. 32.1385 per US$ Sell/Offer/Ask Rs. 32.1100 per US$ Rs 32.1375 per USS Rs 32.1450 per US$ Rs 32.1555 per US$ Spread 0.0090 0.0140 0.0140 0.0170

Here, we notice that the US dollar is at premium for all the three forward periods. Also, it should be noted that the spreads in forward rates are always equal to the sum of the spread of the spot rate and that of the corresponding forward points. For example, the spread of 1 month forward is 0.0140 (= 0.0090 + 0.0050), and, so on. Major Currencies Quoted in the Forward Market
22

The major currencies quoted on the forward market are given below. They are generally in terms of the US dollar. Deutschmark Swiss franc Pound sterling Belgian franc Dutch guilder Japanese yen Peseta Canadian dollar Australian dollar Generally currencies ate quoted in terms of 1 month, 3 months, 6 months and one year forward. But enterprises may obtain from banks quotations for different periods. Premium or Discount Premium or discount of a currency in the forward market on the spot rate (SR) is calculated as follows: Premium or discount (per cent) = [(Fwd rate - Spot rate)/Spot rate] x (12/n) x 100* where n is the number of months forward. If FR> SR, it implies premium. <SR, it signals discount.
23

* To annualize the rate. 12/n is inserted to express in percentage, 100 is introduced. Arbitrage in Case of Forward Market (or Covered Interest Arbitrage) In the case of forward market, the arbitrage operates on the differential of interest rates and the premium or discount on exchange rates. The rule is that if the interest rate differentia is greater than the premium or discount, place the money in the currency that has higher rate of interest or viceversa. Consider next two Examples. Example Exchange rate: Can$ 1.317 per US$ (Spot) Can$ 1.2950 per USS (6-months forward) 6-months interest rate: US$ 10 per cent Can$ 6 per cent Work out the possibilities of arbitrage gain. Solution In this case, it is clear that. US$ is at discount on 6months forward market. The rate of annualized discount is:
24

[(1.2950 - l.317)/l.317] x (12/6) x 1 = 3.34 per cent Differential in the interest rate = 10 - 6 = 4 per cent Here, the interest rate differential is greater than the discount. So in order to derive an arbitrage gain, mosey is to be placed in US$ money market since this currency has a higher rate of interest. The following steps are involved: (i) Borrow Can$ l000 at 6 per cent p.a. for 6months. (ii) Transform this sum into US$ at the spot rate to obtain US$ 759.3 (= 1000/1.317); (iii) Place these US dollars at 10 per cent p.a. for 6months in the money market to obtain US$ 797.23 [= 759.3 x ( 1 + 0.1x 6/12)] (iv) Sell US$ 79723 in the forward market in y at the end of 6-months, Canadian $ 1032.4 (= 797.23 x 1.295); (v) At the end of 6-months, refund the debt taken in Canadian dollars plus interest, i.e. Canadian $ 1030 [ = 1000 x (1 + 0.06 x 6/12)] Net gain = Canadian $ 1032.4 Canadian $1030 = Canadian $2.4. Thus, starting from zero, one is richer by Canadian $2.4 at the end of 6 months period. Accordingly, on
25

borrowings of Canadian $ million, one will be richer by (100,00,00 x $2.4/1000, i.e. Canadian $2400. Example Exchange rates: Can$ 0.665 per DM (Spot) Can$ 0.670 per DM (3 months) Interest rates: DM 7 per cent p.a. Can$ 9 per cent p.a. Calculate the arbitrage gain possible from the above data. Solution In this ease, DM is at a premium against the Can$. Premium = [(0.67 - 0.665)/0.665] x (12/3) x 100 = 3.01 per cent Interest rate differential = 9 - 7 = 2 per cent. Since the interest rate differential is smaller than the premium, it will be profitable to place money in Deutschmarks the currency whose 3-months interest is lower. The following operations are carried out: (i) Borrow Can$ 1000 at 9 per cent for 3-months; (ii) Change this sum into DM at the spot rate to obtain DM 1503.7 (= 1000/0.665);
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(iii) Place DM 15037 in the money market for 3 months to obtain a Sum of DM 1530 [ = 1503.7 x (1 + 0.07 x 3/12)]; (iv) Sell DM at 3-months forward to obtain Can$ 1025.1 (= 1530 x 0.67); (v) Refund the debt taken in Can$ with the interest due on it, i.e. Can$ 1022.5 [=1000 x (1 + 0.09 x 3/12)]; Net gain = 1025.1 1022.5 = Can$ 2.6 SPECULATION IN THE FORWARD MARKET (a) Let us say that the US dollar is quoted as follows: Spot: FFr 5.60 per US$ 6-months forward: FFr 5.65 per US$ If a speculator anticipates that the US dollar is going to be FFr 5.7 in 6-months, he will take a long position in that currency. He will buy US dollars at FFr 5.65, 6months forward. If his anticipation turns out to be true, he will sell his US dollars at FFr 5.7 per unit and his profit will be FFr 0.05 per US$ (= FR 5.7 FFr 5.65). This speculator could have bought on spot market as well but his operation is much more risky and he would have to block a part of this cash.
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(b) Now, suppose that the speculator anticipates a decrease in the value of the US dollar in next 6-months. He thinks that it will be available for FFr 5.5 per US$. Then he will take a short position in dollars by selling them at 6-months forward. If his anticipation comes tale, he will make a profit of FFr 0.15 per US$. On the other hand, if the dollar rate in 6-months actually climbs to FFr 5.75 per USS, he will end up incurring a loss of FFr 0.1 per US$ ( =FFr 5.65 FFr 5.75). CONCLUSION Exchange markets are influenced by numerous economic factors such as imports and exports, investments and disinvestments; by financial operations such as lending and borrowing; by psychological factors like anticipation of depreciation or appreciation of currency; by socio-political factors like stability of government, etc. The major players in the foreign exchange market are big banks. Operations of speculators and arbitragers also affect the markets. Problem 1 Convert the following into outright rates and indicate their spreads: Spot 1-month 3-month 6-months 35.6300/25 20/25 25/35 30/40
28

Rs/$

Rs/ Rs/DM Solution

55.2200/35 40/30 23.9000/30 30/25

50/35 40/60

55/42 45/65

(a) Rupee Rate of Dollar An observation of the figures indicates that the first figure is lower than the second in all 3 forward quotes, implying dollar is being quoted at premium in the forward market. Thus, the points will be added to the corresponding spot rates. Accordingly, the rates are:
Spot Bid price (Rs) 35.6300 Ask price (Rs) 35.6325 Spread (Rs) 0.0025 1-month 35.6320 35.6350 0.0030 3-month 35.6325 35.6360 0.0035 6-months 35.6330 35.6365 0.0035

(b) Rupee Rate of Pound Sterling While observing figures of forward quotations, it is clear that pound sterling is at discount in the forward market since points corresponding to the bid price are higher than those corresponding to the ask price. Therefore, the forward points will be subtracted from the spot rate figures. Thus, outright rates are:
Spot Bid price (Rs) 55.2200 Ask price (Rs) 55.2235 1-month 55.2160 55.2205
29

3-month 55.2150 55.2200

6-months 55.2145 55.2193

Spread (Rs)

0.0035

0.0045

0.0050

0.0048

(c) Rupee Rate of Deutschmark Figures as given indicate that 1-month forward DM is at discount whereas 3-months and 6-months forward rates are at premium. So, for 10-month forward corresponding points will be subtracted from outright spot rates while points corresponding to 3-months and 6-months forward will be added. Thus, outright rates are:
Spot Bid price (Rs) 23.9000 Ask price (Rs) 23.9030 Spread (Rs) 0.0030 1-month 23.8970 23.9005 0.0035 3-month 23.9040 23.9090 0.0050 6-months 23.9045 23.9095 0.0050

Problem 2 Calculate premium or discount from the rupee-dollar rates given in the Problem 1 above. Solution (i) 1-month forward: As already indicated dollar is quoted at a premium, which is calculated as follows: 35.6320 35.6300 x 12 x 100 Bid price premium = 35.6300 1 = 0.066 per cent 35.6350 35.6325 x 12 x 100
30

Ask price premium = 35.6325 = 0.0835 per cent

(ii) 3-months forward: Similarly, dollar premium on 3-months forward can be calculated as follows: 35.6325 35.6300 x 12 x 100 Bid price premium = 35.6300 3 = 0.028 per cent 35.6360 35.6325 x 12 x 100 Ask price premium = 35.6325 3 = 0.0393 per cent (iii) 6-months forward: In the like manner, the premium on 6-months forward is also calculated: 35.6330 35.6300 x 12 x 100 Bid price premium = 35.6300 6 = 0.0168 per cent 35.6365 35.6325 x 12 x 100 Ask price premium = 35.6325 6 = 0.0224 per cent Problem 3 Are there any arbitrage gains possible from the data given below? Assume there are no transaction costs:
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Rs. 55.5000 = 1 in London Rs. 35.625 = $ 1 in Delhi Rs. 1.5820 = 1 in New York Solution From the given data, a triangular currency arbitrage is possible since the dollar/pound rate found by using the rates at London and Delhi is different from that of New York. The following sequence will result into a gain: (i) Use $ 1000 to buy rupees in Delhi. The arbitrageur would get Rs.35,625 (=100 x 35.625) (ii) Sell Rs. 35,625 in London to get 641.89 (= 35625/55.5) (iii) Sell 641.89 in New York go get $ 1015.47 (= 641.89 x 1.5820) (iv) Net profit is $ 15.47 (= 1015.47 1000)

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EXTERNAL TECHNIQUES FOR COVERING EXCHANGE RATE RISK INTRODUCTION The preceding discussion has dealt with internal techniques to cover exchange rate risk; the objective of the present discussion is to dwell on external techniques concerning the subject matter. The major techniques in this regard are: Covering risk in the forward market; Covering in the money market Advances in foreign currency; Covering in financial futures market; Covering in the options market; Covering through currency swaps; Recourse to specialised organisations. COVERING MARKET RISK IN THE FORWARD

Covering a Transaction Exposure In order to cover himself against an exchange rate risk, arising from an eventual depreciation of the currency in which he has invoiced his exports, an exporter will sell his foreign exchange in the forward market. Conversely, an importer wanting to cover himself

33

against the eventual appreciation of foreign currency, will buy foreign exchange forward. Example 1 Suppose a German exporter Hartmann sells some machinery to an American company, for which he would receive payment of US$ 1 million in 3-months time, The exchange rates are as follows: Spot 3-months forward DM 1.4810/US$ DM 1.4700/US$ The exporter sells his receivables at 3-months forward. Thus, he would receive DM 1,470,030 at the end of 3 months. If the spot rate at the end of 3 months had remained as it is today, he would have received DM 1,481,003. Thus, for him, the cost of covering risk in the forward market against probable depreciation of the US dollar is DM 11,000 (1,481,000 - 1,470,000). Let us say that depreciation of the US dollar did take place and the rate on the date of payment (i.e. after 3 months) was established at DM 1,4069/US$. In that case, without covering, the loss to the exporter would have been substantial. He would have received only DM 1,406,900 and so loss would have been DM 74,100 (= 1,481,000 - 1406,900). Therefore, by covering himself in the forward market, he has reduced his risk
34

by becoming certain of his receiving DM 1,470,000 irrespective of the degree of depreciation of the US dollar. Example 2 Let us suppose, a French importer is to pay 10,000 US dollars in three months time. The exchange rates are being quoted as follows: Spot FFr 5.60/US$ 3-months forward FFr 5.80/US$

The importer covers himself by buying US dollars in the forward market. He will be paying FFr 58,000 (= 5.8 x 10,000). If on the maturity date, the rate was as on the date of contract, he would have had to pay, in that case only FFr 56,000 (= 5.6 x 10,000). So, by covering in the forward market, he suffered a loss of FFr 2,000. But, this loss (or the cost of covering) was certain. If the rate had appreciated to, say FFr 6.00/US$, he would have had to pay FFr 60,000 (= 6.00 x 10,000). Therefore, by covering himself in a forward market, he in a way gained as he would have otherwise been required to pay FFr 60,000. The cost of covering in the forward market is equal to the cost of premium or discount.
35

Pre. = [(5.8 5.6)/5.6] x (12/3) x 100 = 14.28 per cent And, the cost of covering = [(2,000/56,000 x (12/3) x 100 = 14.28 per cent Covering a Consolidation Exposure The magnitude of exposure depends on the method of translation used by the parent company. Example 3 Suppose a French multinational has an Indian subsidiary. The total translation exposure is estimated to be Indian Rs 1.0 million. The exchange rates are as follows: Spot Rs 6.000/FFr 12-months Rs 6.0600/FFr

The French company anticipates a. depreciation of 6 per cent of the Indian m over the period of a year. That is, the anticipated rate is Rs. 6.3600/FFr. If nothing is done to cover the exchange rate risk, the company will register, at the end of the year, a translation loss = 1,000,000 /6.0000 1,000,000 /6.3600 = 166,667 157,233 = 9,434 French francs
36

Now to avoid this potential loss, the company can cover itself in the forward market by selling forward a certain sum of rupees, say X such that 9,434 or X = 1,212,005 The forward sale of Indian rupees gives French francs 203,001 (= 1212005/6.06). If the anticipations turn out to be right, the company will buy rupees for FFr 190,567 (= 1,212,005/6.36). The difference between the two is 9,434 (FFr 200,001 - FFr 1,90,567) French francs. Thus, potential loss has been compensated by a real gain. COVERING IN THE MONEY MARKET Covering a Transaction Exposure Example 4 Let us take the Example 1 of the German exporter Hartmann, who wants to cover himself against a probable depreciation of the US dollar. He can do the following:
37

= X (Forward rate Anticipated rate) = X [1/6.0600) (1/6.3600)] = X [0.00778]

 Borrow US dollars for 3-months; Convert these dollars into Deutschmarks on the spot; Place the marks in German money market; Reimburse the loan taken in dollars with interest after 3-months. Suppose the 3-months rates of interest are: Germany: 5 per cent p.a. Spot rate: DM 1.481 = $ 1 USA: 6 per cent p.a.

Borrowing dollars (D) should be such that D [1 + (0.06 x 3/12)] or = $1,000,000 D = $ 985,222

Conversion of dollars into Deutschmarks at the spot rate gives 985,222 x 1.481 = 1,459,114 Deutschmarks The sum obtained by placing marks in 3-months money market is 1,459,114 x [1 +(0.05 x 3/12)] = 14,77,353 marks
38

The sum received from the client in dollars at the end of 3-months is $ 1.0 million. This is used to refund the loan taken in dollars. Thus, the cost of covering in the money market is = 1,000,000 x 1.481 1,477,353 = 3,647 marks Note: If the markets are in equilibrium or are efficient, the cost of covering either in the forward market or in the money market will same as in an efficient market, differential in interest rates is equal to premium or discount. Since the markets are rarely in equilibrium, one should actually carry out calculations to know where the cost of covering is less; emphasis should be also on the ease of covering. Example 5 Taking the Example 2 of the French importer who is to pay $ 10,000 and fears an appreciation of the dollar, he should have a quantity of dollars, say S, that would become $ 10,000 on the due date. The 30-days interest rates are: US$: 6 per annum and, FFr: 8 per annum Spot rate: FFr 5.6 = $1
39

Steps involved are: Buy S dollars and place them in the money market so as to obtain $ 10,000 after one month: S (1 + 0.06 x 1/12) or S = $9,950 (= 10,000/1.005) To buy these dollars, borrow from the spot market a sum of French francs, equal to 55,720 (= 9,950 x 5.6). Refund the loan in French francs after 30 days by paying 55,720 x [ + (008 x 1/12)] 56,092 francs. Pay to the seller the sum of US$ 10,000. So the cost of covering in the money market is FFr 92 (= 56,092 56,000). It may be noted that this cost is equal to the interest differential: = 56,000 x (0.080.06) x (l/12) = 93 francs Covering a Translation Exposure If a company wants to cover in the money market, the amount of the borrowing on that market would be equal to the exposure position. = 10,000

40

Example 6 Taking example 8 of the Indian subsidiary of the French multinational, the following operations will have to be done. We assume that interest rates are 12 per cent on Indian rupee and 8 per cent on French franc. Borrow Rs 1.0 million for a year on the Indian market; Convert these rupees into French francs at the spot rate to obtain FFr 166,667 (= 1,000,000/6); Place the francs in the French money market, which would give FFr 180, after one year (= 1,66,667 x 1.08) Reimburse the loan with interest after one year in rupees, that is a sum of Rs. 1.12 million [= 1 + (l x 0.12)]. Depending on the evolution of the Indian rupee, the company will make a gain or loss. The loss would be sizeable if the rupee underwent an appreciation instead of a depreciation.

41

If unfavourable movement is stronger anticipated, the company will have a net gain.

than

Say the exchange rate at the year end is Rs 6.3/FFr as anticipated, the refund would be equal to FFr 176,101 ( Rs. 1.12 niillio/6.36). This means a net gain of FFr 3,899 = (180 - 176,101). Comparison between Risk Covering in Forward and Money Markets (a) When a risk is covered in the forward market, the transaction does not appear in the balance sheet. The financial structure of the balance sheet is not affected. On the other hand, if the risk is covered in the money market, it figures in the balance sheet and results into an increase in debt ratio. (b) If interest differential is equal to the premium or discount on exchange rates, that is, if interest parity exists, the costs of covering in the two markets am identical. It is equal to: premium or discount for covering in the forward market; interest differential for covering in the money market.
42

For the German exporter, to cover for US$ 1 million, for example, the cost will be US$ 2,500 if the interest differential is 1 per cent on the 3-months money market. The cost of covering should be the same in the forward market as well provided the markets are efficient. But, if the markets are not efficient (say, there are exchange controls), the cost of covering is likely to be different. The operator would opt for forward market or money market, depending on where the cost is less. In the above discussion, it has been assumed that purchase and sale of foreign currency in the forward market as well as obtaining loans in the money market is always possible and there are no constraints. FOREIGN CURRENCY ADVANCES Advances can be obtained by exporting enterprises. For them, advances constitute a means of tem financing. In addition, for an exporter, advances are a protection against exchange risk as well. Likewise, importers may avail advances, say, from the financial institutions to guard against possible fluctuations in exchange rate. Exporting enterprises surrender the foreign exchange to the bank at the spot rate. This enables them to get cash in the national currency. The exchange rate risk is thus neutralized Advances in foreign exchange are even more beneficial if the rate of interest on the
43

foreign currency happens to be lower than that on credits in national currency. However, monetary authorities in certain countries may impose certain restrictions on such advances. For example, in France, advance cannot be availed of until and unless the exported goods have passed through custom authorities. As a result, the exchange rate risk continues to exist between the date of contract and the date when the goods pass customs clearance. Foreign currency advances cannot cover the exchange risk for importers. These advances are given on a fixed rate for a fixed period. They help settle on spot the dues of the suppliers and thus enable the importer to avail discounts from suppliers. And on maturity in order to refund the advances, the importer has to arrange the requisite amount of foreign exchange from the exchange market. COVERING FUTURES IN FOREIGN EXCHANGE

(OR FINANCIAL FORWARD) CONTRACT MARKET Initially, futures markets were engaged in merchandise business only, e.g. eggs, butter, cereals, raw material and so on. The currency futures were launched for the first time in 1972 on the International Money Market
44

(IMM) of Chicago, (presently a division of the Chicago Mercantile Exchange). Futures Markets and Contracts Currency futures markets are now functioning at Chicago New York, London, Singapore, Tokyo, Sydney, etc. The most important of them is the IMM of Chicago. A currency futures contract is a commitment to buy or to sell a specified quantity of a currency on a future date, at the pre-determined/decided price existing on the date of the contract. These contracts have the following characteristics: Transactions are traded in standard lots. For illustration purposes Table 1 contains the values of major currency futures contracts, traded on IMM Chicago. Quotations are made in terms of US$ per unit of another currency. For example, Table 2 indicates the quotation for Deutschmark on a particular day. Fluctuations differ according to currencies. The smallest variation (also called tick) is 0.01 per cent. So if the contract is of the value DM 125,000, the value of minimal fluctuation is 125,000 x 0.01/100 = DM 12.50.
45

Table 1: Transaction Lots of Major Currencies on Futures Contract at IMM Currency Australian dollar Canadian dollar Pound sterling French franc Deutschmark Japanese yen Swiss franc Amount 10,000 100,000 62,500 500,000 125,000 12,500,000 125,000

Table 2: Deutschmark Futures Quotation in Relation to US$ on IMM (Contract amount: DM 125,000)
Open March June September 0.6520 0.6547 Latest 0.6536 0.6564 0.6581 ChangeHigh + 0.0011 - 0.0005 0,6539 0.6564 Low Estimated Volume 0.6507 74,433 0.6546 2,023 - 0.6581 148

Maturity periods are also standardised, say, March June, September and December. A guarantee deposit is required to be made for selling or buying of a contract. This deposit is of the order of US$ 1,000 and is made with the Clearing House.

46

Futures rates differ from spot rates for the same reasons as forward rates. They are very close to forward rates of the same currency for the same maturity date. In fact, if forward rates were much different from futures rates of the same maturity, it would be easy to buy in the forward market if the currency was cheaper and sell futures contracts in the same currency at the same time. Thus, there would be a profit to the operator without risk, assuming there were no transaction costs. Operating Procedure of Futures Markets First of all, the interested enterprise is required to make a guarantee deposit with a broker who is a mediator between the enterprise (or the player in the market) and the Clearing House. The broker will deposit this sum with the Clearing House. For instance, an enterprise A buys a currency futures contract through a broker X from another enterprise B ass with/related to broker Y. Once the engagement has been made, both enterprises deal directly with the Clearing House. Everyday, the Clearing House calculates the situation of each operator. As the rate of the contract evolves, it proceeds to call for maintenance margins from the operator who has registered a loss and
47

conversely, credits the account of the other party who has registered a gain. If the enterprise A wants to sell its contract, the same is executed by him through his broker who finds another buyer. The enterprise A will have made a gain or loss depending on the evolution of the rate of futures. Most of the contracts (98 per cent) on the futures market are not delivered. They are closed by a reverse operation: the buyers resell the contracts and the sellers repurchase the contracts. Principle of Covering the Risk The principle is to compensate a loss of opportunity on the s market by a gain of almost the same amount on the futures market. In other words, one should take a reverse position on the futures market vis--vis the position that one has on the spot market. Purchase of a currency future protects against an appreciation of the currency of contract. Similarly, sale of a currency future contract protects against a depreciation of the currency of contract. A company that has exported and is to receive its dues in pound sterling will sell future contracts in pound sterling corresponding to the value of exports, with a similar settlement date.
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A company that has imported and is to pay in Deutschmarks will buy DM future contracts to protect against an appreciation of Deutschmark. Example 7 An American company has exported in January of the current year to a German client. The payments of DM 1.0 million are due in March. The American company wants to cover itself against the risk of a depreciation of DM. The DM March future contracts are quoted at US$ 0.587 per DM. The spot rate in January is US$ 0.588 per DM. In January the American company deposits the guarantee with the Clearing House and sells 8 DM future contracts, each of DM 125,000. The total amount covered is DM 1.0 million (= 8 x 125,000). During all this period up to the maturity date, the American company will pay maintenance margins if DM rises and conversely will have its account credited if DM slips. In March, this company repurchases (or closes) the contract at a rate of 0.559 dollar per DM. It makes a gain of 28,0000 dollars [= (0.587 0.559) x 8 x 125,000]. This gain is equal to the loss of opportunity on the spot market, that is 28P dollars [=(0588 0.560) x
49

1,000,000]. The spot rate on the date of closure or repurchase of the contact is 0.56 dollar per DM. Note: To simplify the calculations, the rates have been so chosen as to compensate the loss of opportunity in totality. In reality, there may be some uncovered loss and some costs of transactions which have been ignored here. Also, the amount to be covered may not always be in exact multiples of standard futures contract lots. Thus, the amount covered may be less or more than the sum involved in a transaction. For instance, if the sum to be covered was DM 1.1 million, then, the number of futures contracts should be either 8 or 9. In case it is 9, we would be covering DM 1.125 rather than DM 1.1 million. And, in the case of 8 contracts, we would be covering DM 1 million. Comparison between Covering on the Forward Market and the Futures Market Both the forward market and the futures market serve the same objective of covering the foreign exchange risk. However, there arc some significant differences in their modus-operandi. Table 3 provides a comparative summary of forward market and futures market.

50

Table 3: Comparison between Covering on Forward Market and Future Market Futures Market
Standardized contracts Guarantee deposit Clearing house Quotation on market Commission or brokerage

Forward Market
Tailor-made risk coverage No guarantee deposit Contract with a bank Quotation by a bank Quoted rate (Spread between buying and selling rates)

COVERING IN THE FOREIGN EXCHANGE OPTIONS MARKET An option gives its holder a right (but not an obligation) to buy or sell an asset in future at a price that is agreed upon today. Nowadays, interested investors/enterprises can deal in options to buy or sell common equity, bonds, commodities and currencies, etc. The first organized market in options in currencies was opened in Philadelphia in 1982. Many other markets have since developed, for example, at Amsterdam. London, Pads, Montreal, Vancouver, New York, Chicago, Singapore, etc.

51

It is an instrument that permits its holder (buyer or owner) to take advantage of a favourable evolution of exchange rate. It is taken recourse to by companies to cover the exchange rate risk. There exist two types of options: call and put options. These are bought or sold at a premium, which is paid to the writer of the option, usually in local currency per unit of foreign currency. Call Option The holder of a call option acquires a right but not an obligation to buy a certain quantity of foreign currency at a predetermined price (also called exercise or strike price). A writer (or seller) of a call option has an obligation to sell a certain amount of foreign currency at a predetermined price. Put Option The holder of a put option acquires a right but not an obligation to sell a certain quantity of foreign currency at a predetermined strike price. The writer of a put option has an obligation to buy a certain amount of foreign currency at a predetermined price. Thus, it is the holder (buyer or owner) of an option who has a choice to use or abandon the exercise of the option whereas the seller of an option should be ready to sell
52

(in case of call) or buy (in case of put) the amount agreed upon. The latter has no choice of his own. It should be noted that unlike stock options, a call option on, say, US dollar is also simultaneously a put option on the other currency of transaction, say, Indian rupees For, if the holder has a right to buy US dollars against Indian rupees at a predecided price, then he has also a right to sell Indian rupees at a specified dollar rate. The option which a holder enjoys could be the one where he can exercise his right any time during the life of the option. This type of option is referred to as of American style. The other type is of European style where the holder can exercise his right only on expiration of, or on, the maturity date. Premium on Options The premium paid for buying a put or call option depends upon several factors and is comparable to an insurance premium. The major factors in this regard are: The difference between the exercise price and spot price; The maturity periods; Volatility of price movements;
53

 Interest rates, etc. Determinants of Option Value These are: Spot rate; Strike price; Expiration date (time to expiration); Risk free interest rate in the, domestic country; Risk free interest rate in the foreign country; Volatility of the spot currency rate. Spot rate: The effect of this variable on the option price is quite evident. In the case of a call option, the higher the spot rate, the higher will be the option premium and vice-versa. A put option becomes less valuable with the rise in spot price and vice-versa. Strike price: Strike price is the price at which the deal will take place when an option (call or put) is exercised. A call option tends to vary inversely with the strike price. With the rise in strike price, the call option tends to lose value. This is because the holder stands to lose when he exercises the call option. A put option moves in direct relation with the strike price and with the rise in strike price, the holder tends to gain on exercising the option.

54

Time to expiration: With the increase in the time to expiration, both call and put options gain value. This is because the option with a longer time to expiration, other things being held constant, will have a higher time value. Example 8 A French imparter has bought an equipment from a US firm for US$ 1 million on 1 March in the current year to be paid for in 3 months. The importer fears an appreciation of the US dollar. He decides to cover himself in the option market. The data are: Exchange rate: FFr 500/US$ or US$ 0.20/FFr

He is considering call option for the purpose as he will be required to buy foreign exchange (i.e. US dollars). The characteristics of call option are: Strike price: FFr 5.05/US$ Maturity date: 1 June Premium: 3 per cent The buyer of the call option, i.e. the importer pays the premium amount of US$ 30,000 (= 1 million x 0.03) or FFr 150,00) (= 30,000 x 5).

55

On 1 June, there are three possibilities: 1st Possibility: The US currency has appreciated and the spat rate is FFr 5.5/US$. In this situation, the holder of the call option will exercise his option and buy US dollars at the strike price of FFr 5.05 per US dollar. He will pay thus, FFr 5.05 million (= 5.05 x 1.0 million).
Total cost = (5,050,000 + 150,000) French francs

= 5.20 million French francs Thus, his net price is FFr 5.20/US$ instead of FFr 5.5/US$. 2nd Possibility: The US currency has undergone a depreciation and on 1 June, it is at FFr 4.75/US$. In this situation, he abandons his call option and buys dollars from the market at FFr 4.75/US$. His total payment is thus: (4.75 x 1.0 million + 0.15 million) French francs = 4.90 million French francs Thus, his net price is FFr 4.9/US$ instead of FFr 4.75/US$.

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3rd Possibility: The US dollar is at FFr 5.05/US$. Here, he can afford to be indifferent to either the market option or the call option. He will pay the same price whether he resorts to one or the other. He pays: (5,050,000 + 150,000) French francs = 5.20 million French francs, that is, the same amount as in the first possibility. This means he has never to pay more than FFr 5.20 million, whatever be the level of appreciation of the US dollar. The graphic representation of the call option is given in Fig. 1.
Sum paid (million FFrs)

5.20 Z N 5.05 5.1 5.2 5.3 Exchange rate (FFr/$)

Fig.1: Sum to be Paid under the Call Option

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Example 9 An Indian importer is to pay DM 1.0 million on 1 September in the current year. He wants to make sure that he does not pay too high in case the Deutschmark appreciates. He buys a call option by paying 2 per cent premium on the current price. The current rate is Rs.21.75/DM. The strike price is decided to be Rs.22/DM. In the case of appreciation of the Deutschmark, the net price to be paid by the importer is going to be Rs.22.435/DM (= 22.00 + 0.02 x 21.75). Conversely, if the German currency depreciates, the importer will abandon his call option. The operation is graphically represented in Fig. 2.
Sum paid (million Rs)

22.435

Z N
21 22 23 24 25 26 Exchange rate (Rs/DM)

Fig. 2: Sum to be Paid under the Call Option Example 10 A French exporter is to receive US$ 1.0 million on 1 March in the current year, having sold his product in January. Fearing a depreciation of the US dollar, he
58

decides to cover his risk through a put option. The data are: Spot rate: FFr 5.0/US$ Premium: 3 per cent Date of maturity: 1 March Exercise or strike price: FFr 4.95/US$. 1st Possibility: The US currency has depreciated to FFr 4.70/US$. He exercises his put option and sells dollars at FFr 4.95/US$. He, thus receives: (4.95 x 1 0.03 x 5.0) million French francs = 4.8 million French francs If he had not covered his risk through the put option, he would have received only 4.7 million French francs. 2nd Possibility: The US dollar has appreciated to, say FFr 5.2/US$. He abandons his put option and sells his dollars in the open exchange market. He thus receives: FFr (5.2 0.15) million = FFr 5.05 million. 3rd Possibility: The rate on 1 March is FFr 4.95/US$. In this case, he need not worry about either making use of his option, or selling in the open market. Either way, he will receive a sum of
59

(4.95 0.15) million French francs = 4.8 million French francs Thus, irrespective of the degree of depreciation of the US dollar, he is assured of getting at lease FFr 4.8 million. Any price above the strike price of FFR 4.95 brings a greater advantage to him and a price less than FFr4.95 does not affect his receipts which do not fall below FFr 4.8 million. The graphical representation of the operation is shown in Fig. 3.
Sum received (million FFrs)

4.8

4.9

4.95

5.0

5.1

5.2

Exchange rate (FFr/$)

Fig. 3: Sum to be Received under the Put Option In view of the above, it is apparent that the enterprise/operator needs to be more vigilant/watchful towards trends in exchange rate while covering in the
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option market unlike covering in the exchange market where everything is certain. Covering against Exchange Risk by Purchasing Tunnel with a Zero Premium Since premium represents a non-negligible cost, banks propose to their clients the option with zero premium called tunnel, but protection is available only within certain limits. For example, let us consider the data of the Table 4. An Indian importer buys a 1-month tunnel with zero premium, of narrow range. This means that if after a months time the dollar rate is Indian Rs 35.70, he would pay only Rs 35.60 per dollar. But, on the other hand, if the rate is Rs 34.90, he would have to pay Rs 35.00 per dollar. If the dollar price is established somewhere within the range, then he would have to pay the actual market price. Besides the tunnels of narrow range, there are tunnels of wider range too. One would choose between the two depending upon the anticipations of future rates. The importance of tunnels lies in the fact that one dc not have to pay premium but at the same time they do not allow the operator to get the fill advantage of a favourable evolution of rates.
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Table 4 Tunnel with Zero Premium Maturity Narrow range Wider range 1-month 35.00-35.60 34.25-36.25 3-months 35.50-36.00 34.00-36.30 6-months 35.75-36.35 33.80-36.50 Importance of Options Options are used by: exporters; importers; investors; banks and financial institutions; companies bidding for global contracts. Call options are used by companies that have to pay for their imports in foreign currency but fear an appreciation of the currency of invoice. They are equally used by the foreign currency borrowers. Put options are used by exporters who have invoiced in foreign currency and fear a depreciation of that currency. They are equally used by foreign currency lenders. CURRENCY SWAPS Swap is essentially an exchange of two transactions; it is an important instrument for hedging for foreign
62

exchange transactions in which two streams of payments am exchanged. Suppose an American company wants to borrow Deutschmarks at a variable rate. The company is well placed on the American market. It borrows US$ 1 million on the American market at a fixed rate and enters into a swap deal with its bank. On the date of the contract, there is an exchange of the principal: the American company pays to its bank 1 million dollars and receives 1.4 million Deutschmarks, the spot rate being DM 1.4/US$. During the contract period, the company will pay a variable rate on the Deutschmarks while the bank will pay it a fixed rate on dollars. Them will also be a re-exchange of the principal on the maturity date. Figure 4 illustrates the swap.
$ 1m American Company DM 1.4m Variable rate American Company Fixed rate DM 1.4m American Company $ 1m Bank Bank Bank

Fig 4: Swap between a Company and its Bank

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Currency swaps are comparable to a forward exchange transaction with a difference that the differential of rates is calculated periodically instead of being settled just once at the end of the contract; this feature renders the swaps more efficient and more flexible than covering in the forward market for long periods. CONCLUSION Volatility of exchange rates makes it necessary for companies engaged in international operations to take measures for covering against exchange rate risk. Several techniques are used, internal as well as external. In periods of fixed rate regime, special attention was paid to the possibility of a currency devaluation. In floating rate regime, it comes important to anticipate evolution of rates and adopt appropriate strategies for covering risks. Nowadays a number of techniques are available such as hedging in forward rate market, money market, currency futures, options and swaps. Problem 1 A French exporter, named Charles, is to receive DM 1.0 million in 6 months. The exchange rates are quoted as follows: Spot: FEr 3.3876/DM 6-months forward: FFr 3.3368/DM
64

(a) There is a fear of depreciating of DM in the near future. What should Charles do? (b) What would you suggest to Charles in case an appreciation of DM is likely to take place? Solution (a) Since the rates given above indicate that DM is at a forward discount, Charles will do well to cover himself in the forward market. When a currency is selling at discount in the forward market, there is a possibility that it would undergo a depreciation. So it is safe to cover the receivables of that currency in the forward market. Thus, Charles will sell his DM 1.0 million in the forward market and receive FFr3.3368 million at the end of 6-months. If the spot rate at the end of 6-months was the same as the spot rate today, the cost of covering (or the loss) for Charles would be FFr 50800 (= FFr 3.3876 million FFr 3.3368 million). The depreciation of DM indicted by the forward rate is the following: 3.3876 3.3368 x 100 = 3.3876 = 1.4966 or 1.5 per cent
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So, if DM depreciated more than 1.5 per cent between now and 6-months hence, Charles would make a loss bigger than FFr 50,800 in case he decided not to cover in the forward market. (b) In case of a likely appreciation of DM, Charles need not do anything. Any appreciation in the currency of receivables (DM in the present case) would be profitable to the receiver. Problem 2 An Indian company C & Co. imports equipment worth $1.0 million and is to pay after 3 months. On the day of the contract, the rates are: Spot: Rs.35.00/$ 3-months forward: Rs.36.25/$ (a) There is an anticipation of a further fall of rupee. What can C & Co. do? (b) What would C & Co. do if it knows with a high probability that, in 3-months, dollar will settle at Rs.36.00/$. Solution (a) Since there is an anticipation of a further fall in the value of rupee (or in other words an appreciation of dollar), it would be wise to cover the payables in the forward market.
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Thus, C & Co. will have to pay at the end of three months Rs.36.25 million. So, the net cost of covering the payables in the forward market is Rs.1.25 million (= Rs.36.25 million Rs.35 million). If the rupee had fallen to Rs.37.10/$ ( a depreciation of 6 per cent) and if C & Co. had not covered itself in the forward market, the loss to it would have been Rs.2.10 million. (b) If C & Co. knows with a high degree of certainty that the rupee is likely to settle at Rs.36.00/$ in 3-months, it would be advised not to cover in the forward market. It would pay Rs.36 million at the end of 3-months, the sum which is less than Rs.36.25 million. Problem 3 An Indian exporting firm, Rohit and Bros, would like to cover itself against a likely depreciation of pound sterling. The following data is given: Receivables of Rohit and Bros: 500,000 Spot rate: 56.00/ Payment date: 3-months
3-months interest rate: India: 12 per cent per annum

UK: 5 per cent per annum What should the exporter do?
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Solution Since no other date is available, the only thing that Rohit and Bros can do is to cover itself in the money market. The following steps are required to be taken:
(i)

Borrow pound sterling for 3-months. The borrowing has to be such that at the end of three months, the amount becomes 500,000. Say, the amount borrowed is D. Therefore,
3 D 1 + 0.05 x 12 = 500,000 or D = 493,827

(ii) Convert the borrowed sum into rupee at the spot rate. This gives: Rs.493,827 x 56 = Rs.27,654,312 (iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the end of 3months:
3 S = 27,654,312 x 1 + 0.12 x 12 (iv) = Rs. 28,483,941

The sum of 500,000 received from the client at the end of 3-months is used to refund the loan taken earlier. From the calculations, it is clear that the money market operation has resulted into a net gain of Rs.483,941 (= 28,483,941 500,000 x 56).
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If pound sterling has depreciated in the meantime, the gain would be even bigger. Problem 4 A UK importer has to pay $100,000 in months time. He fears an appreciation of the dollar. What can he do with the knowledge of the following data? 1-m interest rate: US$: 4 per cent UK : 5 per cent Spot rate: $ 1.553/ Solution Since only the money market data are available, the UK importer has to work out possibility that exist for him to cover himself in the money market. He can take the following steps: (i) Buy S dollars at the spot rate and place them in the money market so as to obtain $ 100,000 in a months time. That is,
1 S 1 + 0.04 x 12 = 100,000

or S = $99,668.

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(ii) In order to buy S dollars, the equivalent amount of pound sterling is required to be borrowed. The borrowing B is, 99668 B =1.5537 = 64,149 (iii) Refund the sterling loan after one month. The refunded amount would be:
R = 64149 1 1 + 0.05 x 12 = 64,416.3

(iv) In the meaning the sum of S dollars placed in the money market would mature to $ 100,000. Use this sum to pay the payable due. The cost of covering in the money market works out to 53.81
100,000 = 64,416.3 - 1.5537

In case, the dollar had appreciated and the payable was not hedged, the loss would have been greater. Even 1 per cent depreciation of pound sterling ($ 1.5382/) would require a payment of 65,013, which means a loss of about 650. Problem 5

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An Indian subsidiary of a UK multinational has a translation exposure or Rs.10 million. The rates are as follows: Spot: One-year forward: Rs.55.0000/ Rs.56.3200/

A 4 per cent depreciation of the rupee is expected. How can the exchange risk be hedged? Solution The anticipated rate after expected depreciation would be: Rs. 57.200/. Suppose, no action is taken to hedge the risk. In that risk, the company will suffer a translation loss equal to: 10 million 10 million 55 - 57.2 = 6993. To avoid this loss, the company will do well to buy pound sterling forward (or sell rupee forward) such that the difference is equal to the anticipated loss. Say, it sells Rs. X. Then, 6993 = X (Forward rate - Anticipated rate)
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1 1 = X 56.3200 - 57.2000 or 6993 or X = Rs. 25,599,974 This amount of rupees will give the following amount of pound sterling in the forward market: 25,599,974 56.3200 = 454,545.45 However, if the anticipated depreciation of the rupee (or appreciation of pound sterling) does take place, the company will buy the Rs. X back, with less amount of pounds sterling. That is, for 25,599,974 57.2 = 447,555.99 The difference between the two ( 454,545.50 - 447,555.99) is equal to the loss ( 6959.51) that would have accrued without hedging. = X [0.017755680 0.017482517]

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Problem 6 Total translation exposure of a company is Rs. 1.5 million. This exposure is in French francs. Interest rates are 8 and 11 per cent for the franc and the rupee respectively. How is hedging to be done? Spot rate is Rs.6 per FFr. The rupee is likely to depreciate by 6 per cent. Solution Since only the interest rate data is available, the hedging operation is to be done in the money market. The following steps are involved: (1) Borrow Rs.1.5 million at 11 per cent and convert them into French francs at spot rate to obtain: Rs.1.5 million/6 = 0.25 million FFr. (2) Place FFr 0.25 million in the money market for a year at 8 per cent. This would give FFr 0.27 million after a year. (3) The sum thus obtained is converted into rupees. If the anticipated depreciation of 6 per cent does take place, the rate would settle at Rs.6.36/FFr. So, the amount in rupees at the end of the year would be Rs. (0.27 million x 6.36) = Rs.1.7172 million. (4) Refund the rupee loan with interest. The refund amount works out to Rs.(1.5 million x 1.11) = Rs.1.665 million.
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Thus, the hedging operation would result into a net gain of Rs.52,200 (= Rs. 1.7172 million Rs.1.665 million). The gain in French franc would be FFr 8,208. Problem A French company imports in January an equipment from the USA for $6 million. The payment is US dollars. The spot rate is $0.2/FFr. The FFr future contract for June is quoted at $0.19/FFr. What should the French importer do? Assume further spot rate on settlement date is $0.185/FFr and the future contract is likely to be quoted at $0.178/FFr. What is the hedging efficiency? Solution The US dollar is likely to appreciate against the French francs. This also means that the French franc would depreciate. To guard against the depreciation of the French franc, the importer can sell French franc future contracts. The amount involved is $6 million or FFr 30 million (= 6 million/0.2). Thus, the total number of future contracts to be sold is 60 (= 30 million/0.5), since the value of one futures contract is FFr 500,000.

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The French importer deposits the security amount with the Clearing House. During the period JanuaryJune, the importer will pay margins if the FFr rises and have its account credited if the FFr slips. On the due date in June the contract is closed (or repurchased). Say, the spot rate on the due date is $0.185/FFr and the futures contract is being quoted at $0.178/FFr. The importer makes a loss: FFr (6/0.2 6/0.185) million = FFr 2.432432 million. However, on the future market, it makes a gain equal to $ (0.19 0.178) x 60 x 500,000 = $ 360,000 = FFr 360,000/0.185 = FFr 1,945,946. Net loss = FFr 2,432,432 1,945,945 = FFr 486,486. Note: The loss is not fully covered as spot rate deteriorated more than the future rate. Hedge efficiency can be defined as the ratio between the gain made on the future market and the loss payable due to rate movement on spot market. It is equal to 1,945,946/2,432,432 x 100 = 80 per cent. Problem 8 A British exporter has $2.5 million receivable due in September against the exports made in June. The pound
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sterling is heading for appreciation. The June data are as follows:

Spot rate: $1.5530/; Pound sterling September future contract $ 1.5600/

What can the exporter do? Solution If the British currency is going to appreciate between June and September, the exporter will suffer a loss on the data of payment. He can reduce this loss by hedging with future contracts. The amount of sterling future is 62,500. So, the number of contracts to be purchased is: 2,500,000/62,500 x 1.5530 = 25.75 Since the contracts are available only in integral numbers, so the exporter can either buy 25 or 26 contracts. Say, he buys 26 of them. Let us say the following rates are being quoted on 15 September (the date of payment): Spot rate: $1.6250/ September, Sterling future rate: $1.6275/ When the exporter receives his dues, he makes a loss of 2,500,000 [1/1.5530 1/1.6250] = 71,326.

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On the other hand, he makes a gain on the futures contracts. The gain is: $(1.6275 1.5600) x 26 x 62,500 = $109,688 109,688/1.6250 = 67,500. So, the net loss is: (71,326 67,500) = 3,826. The hedge efficiency = 67,500/71,326 x 100 = 94.33 per cent. Note: In case the exporter had decided to hedge with 25 futures contracts, the gain would have been: (1.6275 1.5600) x 25 x 62,500 x 1/1.6250 = 64,904. And, hedge efficiency would have been: 64,904/71,326 = 91 per cent. Problem 9 The company ABC & Co. has its receivables of DM 1.0 million due in 3-months. The rupee has tendency to appreciate. The current rate is Rs.24.2020/DM. The company would like to hedge in the options market. The data are as follows: Strike price: RS.23.50/DM; Premium: 2 per cent

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Which type of option is involved? How is this option to be used? Solution Since the company ABC & Co. is going to lose if the rupee appreciates between now and 3-months hence when payments of its receivables will be due, it would be wise to buy a put option on DM. The company would pay the premium amount immediately, which is Rs. 484,040. The following possibilities may be considered: (i) Rupee does appreciate and its value settles at Rs.22.5100/DM. The company will make use of its option to sell DM received at the strike price of Rs.23.50/DM. Thus, it will receive a sum of: Rs. (1,000,000 x 23.5 484,040) = Rs. 23,015,960 or Rs.23.016 million. Net loss: Rs.24,202,000 Rs.23,015,960 = Rs.1,186,040. The loss without hedging would have been: Rs. (24.2020 22.5100) million = Rs.1,692,000. (ii) Rupee depreciates in a small measure and is quoting on the due date at Rs.24.2600/DM. Naturally, in this situation, put option is
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abandoned. The company will receive a net sum of Rs.1,000,000 x 24.2600 484,040 = Rs.23,775,960. Here, it is to be noted that the depreciation of the rupee has not been able to compensate the premium amount paid for buying the put option. Therefore, the net sum is still less than Rs.24,202,000. Note: Irrespective of the level of appreciation of the rupee, the company will always receive a minimum sum of Rs.23,015,960 (that is, the value corresponding to the strike rate minus the premium amount). Thus, the company is neutral between the choices of using and abandoning the option at a rate equal to the strike price, that is Rs.(23.01596 + 0.02 x 24.202)/DM or Rs.23.50/DM.

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