CA Final Course Paper 2 Strategic Financial Management Chapter 12. CA. Rajiv Singh

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1 CA Final Course Paper 2 Strategic Financial Management Chapter 12 CA. Rajiv Singh

2 1.1 Introduction Forex Market 1.2 Forex Market in India 1.3 Merchant Deal Structure 1.4 Inter bank Quote 1.5 Forex Quote convention 1.6 Types of Forex transaction 1.7 Calculating Merchant rate

3 1.8 Nostro, Vostro and Loro accounts 1.9 Forex Quote style 1.10 Cross rate 1.11 Forward rate 1.12 International finance theory 1.13 International Arbitrage

4 The largest and most liquid sector of Global Financial Market Turnover average $ 4 trillion* per day 24 hour market [day begins with Tokyo, Singapore, India, Bahrain, Frankfurt, Paris, London, New York, Sydney and back to Tokyo Two tier market (Interbank & Merchant) Two way quotes (Buy rate & Sell rate) Duality-currency pairs (EUR/USD; USD/JPY) * April 2010 survey by bank for international settlement

5 Serves as primary mechanism for making payments across borders, transferring fund s & determining exchange rates. In 89% of transactions USD is involved. No specific location-most trade by Reuters dealing and SWIFT (society for worldwide Interbank Financial Telecommunications) Not uniform (e.g. restricted) Country based regulation Forex transactions can be undertaken only with Authorised dealers.

6 A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quote is a statement of willingness to buy or sell at an announced rate.

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13 TRANSACTION TYPE DOT DOS Cash / Ready Today Today TOM SPOT Forward Today Today Today Tomorrow (=DOT + 1 Business working day) Day after tomorrow (=DOT+ 2 Business working day) Beyond day after tomorrow (=DOT+ more than 2 business working days)

14 Spot rate USD/INR /61 What should be the merchant rate if bank wants 5 paise margin?

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16 An Indian banker wants to fund their Nostro account with a USA correspondence bank by USD 5,00,000 against INR when interbank rate is 1 USD= INR 47.20/50. The deal is struck and overseas bank s vostro account that is being maintained with the Indian bank will be credited by INR

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18 Ex 1 USD/ CAD /35 USD/ SGD /56 Ex 2 GBP/ USD /35 AUD/ USD /61 Ex3 USD/INR /61 GBP/USD /35

19 A forward exchange rate prevails today for settlement at a future date. It is calculated by adding or deducting forward point or margin (interest differential) from today s spot rate. Forward points or margin are quoted on month basis in India and are available for 12 months at any point of time.

20 05:32:00 PM Jun 08, 2011 Spot Date : Jun 10, 2011 Spot Cash Tom 30-Jun 29-Jul 31-Aug 30-Sep 31-Oct 30-Nov 31-Dec 31-Jan 29-Feb 30-Mar 30-Apr 31-May Bid Ask Bid Ask Bid(%P.A.) Ask(%P.A.)

21 On Jan 28,2005 an importer customer requested a bank to remit Singapore Dollar (SGD) 25,00,000 under an irrevocable LC. However due to bank strikes, the bank could effect the remittances only on February4, The inter bank market rates were as follows

22 Jan 28, 2005 Feb 4, 2005 Step I: 1 $ = Rs 1 $ = Rs II: 1 = $ $ = 1/ III: SGD with proceeds / IV: Rs = / SGD 1 SGD = Rs add: EM(.125%) = = $ $ = 1/ SGD with proceeds / Rs = / SGD 1 SGD = Rs add: EM(.125%) = Loss to the importer = ( ) =

23 Your forex dealer had entered into a cross currency deal and had sold US $ 10,00,000 against EURO at US $ 1 = EUR for spot delivery. However, later during the day, the market became volatile and the dealer in compliance with his management s guidelines had to square up the position when the quotations were: Spot US $ 1 INR / month margin 25/20 2 months margin 45/35 Spot US $ 1 EURO / month forward / months forward /4530 What will be the gain or loss in the transaction?

24 Step I: Loss in due to squaring up the existing sale position 1$ = ( ) x 10,00,000 = 5000 Step II: Cross rate for against Rs on spot basis Bid: / Ask: / = Step III: Loss in Rs = x 5000 = Rs

25 You have following quotes from Bank A and Bank B: (i) How much minimum CHF amount you have to pay for 1Million GBP spot? (ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap points for Spot over 3 months?

26 Example Using quotes of Both Bank A and B Step I: Buy USD from Bank A 1USD = CHF Step II: Buy GBP from Bank B 1GBP = USD 1GBP = x = CHF Step I 3 m FR Bid Ask USD / CHF = = GBP / USD = = Step II 3m Fwd Cross GBP / CHF x x rate = = Less: Spot cross GBP / CHF rate Swap Point /

27 Example You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at ` 5.70 & covered yourself in London market on the same day, when the exchange rate were: US$ 1 = HK$ and Local inter bank market rates for US$ were Spot US$ 1= INR and Calculate cover rate & ascertain the profit and loss in the transaction. Ignore brokerage. Step I: Find out Cross rate HK $/ INR = (base) (quote) = Bank s cover rate for merchant sale transaction is the market selling rate and hence cover rate is 1 HK$ = INR The merchant rate is given 1 HK$ = INR Step II Total Profit to the bank = 100 lacs ( ) = Rs 5,29,000.

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30 As per this theory real interest rate are same for each country. As a result of this high interest rate is due to high inflation rate and vice versa

31 This combines relative PPP and Fisher effects. As per this theory if real interest rates are same then interest differential should predict future spot rate

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33 Example The US Dollar is selling in India at ` If the interest rate for a 6-month borrowing in India is 8% per annum and the corresponding rate in USA is 2% (i) Do you expect US dollar to be at a premium or at discount in the Indian Forward Market? (ii) What is expected 6-month forward rate for US dollar in India; and (iii) What is the rate of forward premium or discount? (i) USD is expected to be on premium as interest rate in USA is low as compared to India. The currency with low interest rate rate should go on premium in the forward market as per IRP. (ii) FR = x (1.04 / 1.01) = Rs (iii) x x 100 = 5.93% Note that the rate of fwd premium should be approx 6% (= r q r b ).

34 The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%. The current spot rate of US $ in India is ` Find the expected rate of US $ in India after one year and 3 years from now using purchasing power parity theory. expected spot rate after one year = x (1.065/1.03) = (ii) expected spot rate after three years = x (1.065 /1.03) 3 =

35 On April 1, 3 months interest rate in the UK and US $ are 6.5% and 4.5% per annum respectively. The UK /US $ spot rate is What would be the forward rate for US $ for delivery on 30th June? FR =.6560 x ( %/4) ( %/4) =.6592

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38 Given the following information: Exchange rate-canadian Dollar per DM (Spot) Canadian Dollar per DM (3 months) Interest rates-dm 8% p.a. Canadian Dollar 10% p.a. What operations would be carried out to earn the possible arbitrage gains?

39 step I Synthetic FR =.666 x [ 1+ (10%/4)]/ [ 1+ (8%/4)]=.669 Step II Since quoted FR is more than synthetic FR hence it is overvalued. Sell overvalued currency DM in fwd market and create long. (invest) in DM in money mkt. This means borrow (short) CAD $ in money mkt. Step III Action Borrow % for 3 m Buy 1DM at Spot rate 8% for 3m Book fwd contract 1 DM =.671$ DM deposit proceeds = 1.02 Sell DM and get CAD $ at FR = 1.02 x.671 =.6844 Pay loan =.6827 Profit =.0017

40 BOB USD/INR /69 SBI USD/ INR /67 Do you see arbitrage opportunity based on the two quotes of two banks

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42 Followings are the spot exchange rates quoted at three different forex markets: USD/INR in Mumbai GBP/INR in London GBP/USD in New York The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction costs, explain whether there is any arbitrage gain possible from the quoted spot exchange rates. Sell 1 unit of USD and buy INR x sell 1 unit of INR and buy GBP x sell 1 unit of GBP and buy USD x 1/77.52 x = Less: investment 1 Profit per USD investment in USD Total profit for USD 100,00,000 investment= USD 1,13,000

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