Foreign Exchange Risk Management

Foreign Exchange Risk Management Contents: 1. Introduction 2. Bid, Ask and Spread 3. Exchange rate quotation (One way quote & Two way quote) 4. Spot rate and forward rate 5. Swap point/forward margin/forward Spot differential. 6. Exchange margin 7. Direct quote & Indirect quote 8. How transaction takes place in FOREX? 9. Hedging: - Forward cover - Lead Payment - Lagging - Money (Cash) market operation - Rupee roll over forward contract - Currency option (Refer Derivative) - Currency Future (Refer derivative) 10. IRPT (Interest rate parity theorem) 11. PPPT (Purchasing power parity theorem)/ Inflation rate parity theorem 12. Cross rate of foreign exchange 13. Arbitrage 14. Cancellation of forward contract 15. Modification in forward contract 16. Early delivery of currency. 17. Interest rate swap (Refer OTC derivative) 18. Nostro A/C and Vostro A/C 19. Maintaining Exchange position and Nostro A/C 20. Multinational Capital Budgeting (Refer Capital budgeting) 21. FOREX with other topic Introduction In this chapter we will study how to minimize the loss /risk which will arise due to the adverse change in exchange rate of foreign currency. Normally, Payment will be receivable or payable at some future date and exchange rate will not be same at that day. As a result loss/gain will arise. The exchange rate is the relationship between two currencies at a given point of time. For example: $1 = 46 1 = 70 $1 = 46-46.5 1 = 70-70.5 One way quote Two way quote CA. Nagendra Sah Page 1

Bid, Ask & Spread Bid rate (Bank s buying rate): Bid rate is the rate at which bank buys left hand currency. Ask rate (Bank s selling rate): Ask rate is the rate at which bank sells left hand currency. Note: Ask rate will always be greater than bid rate (i.e. Ask rate > Bid rate) Spread: The difference between Ask and Bid rates is called the spread. Mathematically, Spread = Ask rate Bid rate % Spread = 100 Exchange rate quotation To remember: Think it is similar to Gross profit ratio = 100 (i) One way quote: When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are same, it is the one way quote. For example: 1 = $ 1.50 It means bank will buy left hand currency (i.e. ) at $ 1.50 and also sale left hand currency (i.e. ) at $ 1.50. (ii) Two way quote: When bid rate (i.e. Buy rate) and Ask rate (i.e. sale rate) are different, it is the two way quote. For example: 1 = $ 1.50 - $ 1.55 Bid rate Ask rate Buying rate Of bank selling rate of bank Bid rate is always less than Ask rate It means bank will buy left hand currency (i.e. ) at $ 1.50. And bank will sale left hand currency (i.e. ) at $ 1.55 How to apply two way quote rate, for converting one currency into other currency? 1. Identify amount payable or receivable? For example: assume invoice amount is $ 1,00,000/- which will be payable in 3 month time. 2. Choose applicable Bid or Ask rate Take the given exchange rate and draw the following diagram and identify what will do bank for left hand currency. Rate: 1 = $ 1.50 1.55 Bank Buy sale $ Here amount payable is $ 1,00,000/-, means customer have to buy $ from bank. We have made diagram on the basis of our requirement. But we have to think, what will do bank CA. Nagendra Sah Page 2

for currency and not for $ currency because left hand currency given in rate is currency. Conclusion: Apply Bid rate i.e. $ 1.5 for conversion of $1,00,000. 3. Identify whether multiply by 1.5 or divide by 1.5 for conversion In which currency you are converting? Ans: in as per our example See whether is greater in term of figure? Ans: no, smaller Hence divide by rate chosen in step 2 i.e. 1.5. Therefore, equivalent amount in = 1,00,000 = 66,666.67/- Important Note: If exchange rate is quoted in form /, it, normally, means price of 1 currency in currency. But it is not always true. Sometime / means pair of currency (It means either per or per). You have to apply your common sense on the basis of strength of the currency. Stronger currency have lower figure. For example: 1. Rate: / 60.00 60.25. It means: 1 = 60.00 60.25 2. Rate: / 0.0165 0.0175 It means: 1 = 0.0165 0.0175 It doesn t mean 1 = 0.0165 0.0175 We know is the stronger currency than. And stronger currency have lower figure. See example-1: have lower figure and have greater figure. See example-2: have greater figure and have lower figure. Example 3: Rate ( per ) 0.0165 0.0175 In this case you may solve question assuming: (i) (ii) per even rate is illogical, because rate is specifically written as per and we know that specific provision overrides general. or per on the basis of strength. Both will get same mark in exam. Strength wise currency list for some important currency: (strongest to weakest currency sequence): 1. Pound GBP ( ) 71 2. Euro-EUR ( ) 61 3. Swiss Franc (CHF) 46 4. US Dollar-USD ($) 45 5. German Mark (DEM) 31 6. French Franc (FRF) 9 7. Indian Rupee-INR () 1 8. Japanese Yen-JPY ( ) 0.5 Spot Rate Spot rate is the rate applicable for immediate settlement. In practice settlement actually takes place within 2 business day. Forward Rate: Forward rate is the rate contracted today for future settlement. Forward rate are usually quoted for fixed period of 30, 60, 90 or 180 days from the date of contract. Forward premium & Discount: If the currency is costlier in future as compare to spot it is said to be at a premium. If the currency is cheaper in future as compare to spot it is said to be at a discount. How to calculate forward rate when forward premium & Discount given? CA. Nagendra Sah Page 3

Take spot rate. (say $1 = 45) FOREX Summary Multiply by (1premium rate of one currency in decimal ) to the other currency (i.e. if premium is on $ then multiply in amount or vice versa). Or Multiply by (1- discount rate of one currency in decimal ) to other currency (i.e. if discount is on $ then multiply in amount or vice versa). How to calculate forward premium or discount when spot rate and forward rate is given: First decide on which currency you have to calculate premium rate of discount rate. check the quotation, whether it is direct quote or indirect quote for the decided currency. If it is direct quote, apply following formula: Forward premium/discount = If it is indirect quote, apply following formula: Forward premium/discount = Swap point/forward margin/forward Spot differential. The difference between forward rate and spot rate is known as swap points/forward margin (not exchange margin)/forward premium (forward premium in value not in %. If it is in % then do as discussed earlier) How to calculate forward rate using swap point/forward margin? When we are given the Spot rate with forward margin / forward premium / forward swap / forward points for buying rate or selling rate (Bid or Ask), Check whether the margin for buying or selling is in increasing order OR in decreasing order, to find the forward rate. Add to spot rate to arrive forward rate. Example 1: Spot Rate $1 = 40.4800 / 4900 Forward Premium.1100 /.1300 (increasing trend) Solution: Forward Rate: 40.4800 / 40.4900.1100.1300 40.5900 40.6200 i.e. Forward rate: $ 1 = 40.5900 / 40.6200 Deduct from spot rate to arrive forward rate. Example1: Spot rate $1 = 40. 4800 / 4900 Forward premium.1255 /.1200 (decreasing trend) Solution: Forward Rate: 40.4800 / 40.4900 (-).1255 (-).1200 40.3545 40.3700 i.e. Forward rate: $ 1 = 40.3545 / 40.3700 Example 2: Spot Rate $1 = 52.60 / 70 3 Month Forward 20 / 70 (increasing trend) Solution: Forward Rate: 52.60 / 52.70. 20. 70 52.80 53.40 i.e. Forward rate: $ 1 = 52.80 / 53.40 Example 2: Spot rate $1 = 52.60 / 70 3 Month Forward 30 / 25 (decreasing trend) Solution: Forward Rate: 52.60 / 52.70 (-).30 (-).25 52.30 52.45 i.e. Forward rate: $ 1 = 52.30 / 52.45 Notes for example-2: The point 70 given in spot rate is not swap point because it is not the difference in forward rate and spot rate. It is simply the quotation method as we quote telephone No 24321152/53 it means we are quoting two telephone no. (1) 24321152 and (2) 24321153. However point given in 3 month forward is not quotation method like telephone no. it is difference in forward rate and spot rate. Exchange margin Exchange margin is the extra amount or percentage charged by the bank over and above the rate quoted by bank. CA. Nagendra Sah Page 4

How to calculate Exchange rate (for both spot rate and forward rate) using exchange margin? When we are given the Spot rate / forward rate with margin for buying rate and margin for selling rate then effective rate will be calculated as: Deduct margin from buying rate to get desired exchange rate. Hence, Actual buying rate = Bid rate (1-exchange margin) Example: Given rate $1 =. 40.4800 / 40.4900 Margin 0.08% for Buying rate Add margin to selling rate to get desired exchange rate. Hence, Actual selling rate = Ask rate (1exchange margin) Example: Given rate $1 =. 40.8300 / 40.8650 Margin.25% for selling rate Solution: Desired buying rate $1=40.4800 (1-0.0008) =. 40.4476 Solution: Desired selling rate $1 = 40.8650 (10.0025) =. 40.9672 Logic behind addition or deduction: Everyone wants to buy at low rate and wants to sell at high rate. Hence deduct margin from buying rate to arrive at low rate and add margin to selling rate to arrive at high rate. Special situation for calculation of exchange rate: Suppose given exchange rate quotation is: Spot rate ( per ) : 1.7820 1 month forward rate ( per ) : 1.7829 It means spot rate is: 1 = (1.7820-0.0002) / (1.78200.0002) = 1.7818 / 1.7822 (Note: It doesn t mean that bid rate is 1.7820 and Ask rate is (1.78200.0002) 1 month forward rate is: 1 = (1.7829-0.0003) / (1.78290.0003) = 1.7826 / 1.7832 Direct quote & Indirect quote Indirect quote: A direct quote is the home currency price for one unit foreign currency. Example: $1 = 48 is a direct quote for an Indian (Or it is direct quote of $) Indirect quote: An indirect quote is the foreign currency price for one unit of home currency. Example:. 1 = $ 0.0208 is an indirect quote for an Indian. (or it is indirect quote of $) Converting direct quote into indirect quote: Conversion for one way quote Direct quote = OR Indirect quote = Example: Direct quote: $ 1 = 45 Indirect Q. 1 = $ Conversion for two way quote: Example: $1 = 45 / 45.50 1 = / i.e. 1 = 0.0222/0.0219 Here, Because of Bid rate > Ask rate, above conversion is not correct. CA. Nagendra Sah Page 5

Hence Use following: Direct quote: $1 = 45 / 45.50 FOREX Summary Indirect quote: 1 = / i.e. 1 = 0.0219 / 0.0222 (Bid rate < Ask rate) How transaction takes place in forex Each party want to trade and deal in own currency but the invoice can be made in single currency. Hence the agreed currency would be the home currency, foreign currency or any other currency. USA Company($) Inflow at 3 Month Export to UK co. Invoice Amount: Option A: $ 10,000 Option B: 5,000 Option C: 7,000 (Credit period 3M) 1 UK Company ( ) Outflow at 3 Month 2B 2A 4B 4A 3 UK co. make payment at 3 month $ / time in $, or in. $/ USA Bank Buy /, Sell $ When invoice is in When invoice is in $ UK Bank Buy, sell $/ Risk of currency fluctuation lies on USA co. Because USA Co have to convert into $ at 3 month time. In this case: Step 2A and 2B is not applicable. Risk of currency fluctuation lies on UK co. Because UK Co have to convert into $ at 3 month time. In this case: Step 4A and 4B is not applicable A: When invoice is in $ : chain in steps, made in figure 12A2B3. (at end, USA co. get money in $) B: When invoice is in : chain in steps, made in figure 134A4B. (at end, USA co. get money in $) C: When Invoice is in : Risk lies on both UK co. and USA co. because both companies have to convert one currency into other. UK co convert into and USA co convert into $. In this case all steps (i.e. 2A, 2B, 4A, 4B) are applicable. Analysis for USA co: when invoice is in home currency ($) No risk on USA co. No need to hedge foreign currency receipt and hence no need to study FOREX. Analysis for UK co: when invoice is in home currency ( ) No risk on UK co. No need to hedge foreign currency receipt and hence no need to study FOREX. Conclusion: If question ask for any measures of hedging, it mean the currency payable or receivable is always foreign currency. Hence do not get confused to recognize which currency is foreign currency and which currency is home currency. Just identify the currency in which invoice is being made (i.e. currency in which amount payable or receivable), and conclude that invoice currency is always foreign currency. On basis of this currency identify the company who has to take corrective action to minimize loss. CA. Nagendra Sah Page 6

Hedging through forward Market: For hedging (safeguard) future receipt or future payment one has to enter forward contract (i.e. today s contract for future delivery) at forward rate. At due date convert one currency into other currency at the agreed rate the rate at which forward contract is made, doesn t matter what is the actual rate on due date. Calculation of gain/loss due to forward hedge: Suppose XYZ have to make payment $ 1,00,000/- at 6 month time. Today 6 month XYZ enters buying contract today for $ 1,00,000 @ 45 Actual rate 1$ =45.5 At 6 month time he buys $ from bank @ 45, even at that date actual rate is 45.5. For calculation of loss/gain think if Mr. XYZ not taken forward contract then at which rate he buy $? He will buy $ (think $ is apple) @ 45.5 but due to forward contract he will buy $ @ 45 (at lower rate) hence he will gain 1,00,000 (45.5 45) = 50,000/- Lead Payment Lead payment is a payment as on today for a transaction forgetting the credit period given by supplier. Importer makes the lead payment when he feels that the loss due to currency fluctuation will become higher than that of the benefit which he will get due to time value of money. Notes: We know comparison can never be done between rickshaw wale and chartered accountant. Similarly, Lead payment can never be comparable with Forward cover because under lead payment outflow become today and under forward cover outflow become at some future date. Hence, for making lead payment comparable with forward cover we make payment today taking loan (for the period equal to forward cover) so that the outflow become at the time of repayment of loan. [Refer Question No. -87] Lagging See page-15 Cross rate of foreign exchange The cross rate is the currency exchange rate between two currencies, where neither of the currencies are of the country in which the exchange rate is given. Example of cross rate: Exchange rate: 1 = 1.21 in India. Exchange rate: 1 = 106 in India. In both rate neither of the currencies is of India (i.e. ) hence it is cross rate, in India. How to calculate required exchange rate using cross rate? Suppose an Indian importer have to make payment in currency but currency quote is not available directly with. One way quote: Rate quoted by Indian bank is: (i) 1 = $ 1.55 (ii) 1 = 72 (iii) 1= $ 1.27 (iv) 1 = 106 What is the applicable rate to Indian importer for payment in? We can calculate required rate / using following relationship: = = = 0.5565 Hence, required rate: 1 = 0.5565 CA. Nagendra Sah Page 7

Two way quote: Rate quoted by bank is: (i) 1 = 130 131 (ii) 1 = 72 72.5 Convert into indirect quote: (i) 1 = (ii) 1 = Calculate required rate using following relationship: = = = 0.5496 0.5577 for Bid for Ask Hence, required rate: 1 = 0.5496 0.5577 Hedging through Money (cash) Market Operation: A. Amount Receivable in foreign currency: Export to USA FOREX Summary Indian Company Inflow at 3 Month Invoice for $ 10,000/- Credit period 3M USA Company Outflow at 3 Month 3 2 1 4 $ Indian B 1 Rate: 10-12% Indian B 2 SR: 1$=40-41 USA Bank Rate; 5%-6% 1. Borrow less amount today from the USA bank for 3 month at borrowing rate of USA. = $ 10,000 / (10.06 X 3/12) = $ 9,852 1. Convert $ 9,852 into Rupee @ spot rate. $9,852 = 9,852 X 40 = 3,94,080 2. Invest 3,94,080 in India for 3 month at Deposit rate of India. Deposit amount after 3 month = 3,94,080 X (10.10X3/12) = 4,03,932 2. Borrowing amount with interest will become Invoice amount at 3 month time which will pay by USA company to USA Bank. Hence, Amount receivable under money market operation at 3 month time is equal to 4,03,932/- 3. Concept: Why borrowed money from foreign bank to be deposit in home country bank? Why not keep with him self today? 4. If we not deposit money in home country bank today, then the inflow become today s time and it is not comparable with forward contract or with other hedging option. Hence deposit today in home country bank by taking loan in foreign currency. CA. Nagendra Sah Page 8

B. Amount Payable in foreign currency: Import from USA Indian Company Invoice for $ 10,000/- Credit period 3M USA Company Outflow at 3 Month Inflow at 3 Month 3 2 1 4 $ Indian B 1 Rate: 10-12% Indian B 2 SR: 1$=40-41 USA Bank Rate; 5%-6% 5. Deposit less amount today in the USA bank for 3 month at deposit rate of USA. = $ 10,000/ (1 0.05 X 3/12) = $ 9,876 6. Convert $ 9,876 into Rupee @ spot rate. $ 9,876 = 9,876 X 41 = 4,04,916 7. Borrow 4,04,916 in India for 3 month at borrowing rate of India. Borrowing amount after 3 month = 4,04,916 X (10.12X3/12) = 4,17,063 8. Deposit amount with interest will become Invoice amount at 3 month time which will receive by USA company from USA Bank. Hence, Amount payable under money market operation at 3 month time is equal to 4,17,063/- Concept: Why borrow money from home country bank to deposit fewer amounts in foreign bank? Why not from own pocket at today time? If we not borrow money from home country bank, then the outflow become today s time and it is not comparable with forward contract or with other hedging option. Hence deposit today by taking loan. IRPT (Interest rate parity theorem) Interest Rate prevailing in two countries affects the exchange rate between the currencies of those countries. According to this theory, difference between interest rate of two countries must be equal to the difference between the forward and spot Exchange rate IRPT mathematically express the relationship between SR, FR, and interest rate of two countries. CA. Nagendra Sah Page 9

At interest rate parity theorem, (i) (ii) = FOREX Summary If FR, SR and Interest rate of both countries are based on IRPT then arbitrage gain (risk free profit) is not possible. The currency with the Higher Interest Rates will sell at a discount in the forward market against a currency with the lower interest rate. Similarly currency with lower interest rate will sell at a premium in the forward market against the currency with the higher interest rate PPPT (Purchasing Power parity theorem): Purchasing power parity theorem (also known as inflation rate parity theorem) is same as Interest rate Parity theorem. If we replace the Interest rate by Inflation rate in above parity formula, then it will become Purchasing power parity. At purchasing power parity theorem/inflation rate parity theorem, (i) (ii) = Arbitrage Arbitrage is an act to earn risk free profit. The act may be: (i) Sale at high rate & purchase at low rate; (ii) borrowing at low rate & investing at high rate Arbitrage is not possible in Forex market if Exchange rates and interest rates are based on IRPT. Arbitrage Geographical Arbitrage Situation: Information of different rate (either one way quote or two way quote) for various markets are given. How to Solve question? 1. Assume a person have some money in any of the currency. 2. Sale at high rate in one market and Purchase at low rate in another market. Arbitrage gain = sale value purchase Value When arbitrage is possible? 1. Arbitrage is possible if there are mismatch in cross rates of various markets. Cover Interest Arbitrage Situation: Information of FR, SR and interest rate of two countries are given. How to solve question? 1. Assume a person have nothing today. 2. Borrow at low rate in one country for specific period and invest at high rate in another country for same period. Bring the deposit amount with interest in first country and repay the borrowing taken earlier. Arbitrage gain = Deposit amt borrowing amt. When arbitrage is possible? 1. Arbitrage is possible if there are mismatch in FR, SR and Interest rates. CA. Nagendra Sah Page 10

Note: - In one way quote, arbitrage gain is possible from only one route. If gain in one rout, there must be loss in another route. - In two way quote there may be loss in both routes. Note: - We can use short cut to find out the high rate and low rate if given quote is single quote. - If given rate is two way quote then check for arbitrage possibility for all the routs in trial and error method. Short cut for finding the countries to be invested or to be borrowed when one way quote is given (For Cover interest arbitrage) Calculate Premium/Discount on any currency using following formula Premium/discount = [Say calculated premium on one currency is 4%] Compare this 4% with interest rate differential of two countries and decide the country in which deposit should be made and country from which borrowing should be made. Situation - I Interest rate differential = Int. rate of country A (say 10%) Int. rate of Country B (say 4%) = 6% Because this rate is high Because this rate is low Why not 4%? Hence for arbitrage gain take borrowing from country B and invest in country A. Situation-II Interest rate differential = Int. rate of country A (say 8%) Int. rate of country B (say 5%) = 3% Because this rate is low Because this rate is high Why not 4%? Hence for arbitrage gain take borrowing from country A and invest in country B. Cancellation of forward Contract: Suppose a person enters forward contract on date A (i.e. today) for delivery on 3 month time. Due to some reason contract cannot be performed and hence he approaches for cancellation. We are discussing the position for 4 different situations. 2 month 3 month Date A B C D E Today before due date Due date After due date Due date 15 days Originally entered F. Contract for due date 3 4 1 2 Situation-1: Customer approaches to cancel forward contract before due date (on date B ): Bank enters sale contract, if original contract was for purchase (i.e. opposite contract), OR Bank enters Purchase contract if original contract was for Sale (i.e. opposite contract), CA. Nagendra Sah Page 11

for due date exchange rate i.e. 1 month forward rate on date B. FOREX Summary Bank s gain Gain to bank = Loss to customer or Customer s gain Loss to bank = Gain to customer Gain/Loss to bank = Sale value under original contract Purchase value under opposite contract OR, = sale value under opposite contract Purchase value under original contract Situation-2: Customer approaches to cancel forward contract on due date (i.e. on date C ) : To cancel forward contract on date C, bank enters opposite contract at spot rate on date C. Bank s gain Customer s gain Gain/Loss to both parties = same as above situation - 1 Situation-3: Customer approaches to cancel forward contract after due date (i.e. on date D ) : Bank enters opposite contract at spot rate on date D. Bank s gain Customer s gain Gain/Loss to both parties = same as above situation - 1 Situation-4: Customer doesn t approaches to cancel forward contract. Hence automatic cancellation on due date 15 days (on date E ) : Bank enters opposite contract at spot rate on date E. Bank s gain Gain/Loss to both parties = same as above situation - 1 Customer s gain Modification in forward contract: Situation-I: Some time customer enters forward contract to buy/sale the foreign currency but due to some reason (like defective goods) later on customer need less amount than contracted amount. Suppose customer originally entered forward purchase contract for $ 96,000 with bank but later on they need only $ 50,000 and not 96,000. What he will do. Solution: - Cancel the original forward contract on due date by entering the opposite contract. - Purchase $ 50,000 at spot rate prevailing on that date (i.e. due date) Situation-II: Some time customer enters forward contract to buy/sale the foreign currency but due to some reason (like defective goods) later on customer want to extend contract for some further period. What he will do. Solution: - Cancel earlier forward contract by entering opposite contract. - Make fresh forward contract for the desired period. CA. Nagendra Sah Page 12

Early delivery of currency Some time customer approaches the bank with early delivery of foreign currency before the forward contract period expires and at that time the spot rate is higher than that of original forward contract. In this case how the transaction will settled? Understand this with following example: Suppose, a customer has originally entered a 6 month forward contract to Sale $ 5,00,000 currency at a rate of 40. After 3 month time customer received $ 500,000 from US company and hence he approached bank with $ 5,00,000 to exchange in Rupee (when spot rate is 41.28-41.33 and 3 month forward rate is 41.80-41.89) against forward contract. How much amount will be payable to customer? Today 3 month 6 month Original contract @ 40 Spot rate 41.28-41.33 Swap charges 3 M FR 40.80-41.89 To settle this transaction bank will do two things: (i) Bank Purchase $ 5,00,000 at spot rate 41.28 but pay in two part as below: 40 1.28 Pay today as per earlier contract rate pay at due date with interest i.e. 40 5,00,000 = 200 lakh Reducing swap charges (i) Bank will collect swap charges with reference to spot purchase & forward sale. Swap charges = (forward sale spot purchase) 5,00,000 = (41.89 41.28) 5,00,000 = 3,05,000 At due date payment with interest reducing swap charges is equal to: (1.28 5,00,000) - 3,05,000 = 3,47,800 Customer will get two payment one at 3 month time 200 lakh and one at 6 month time 3,47,800 Rupee roll-over forward contract: [Refer Question No. -51] Forward rate for the period more than 6 month is not available. In this case rupee role over contract is used to hedge the future payment or receipt. When whole amount in foreign currency is receivable or payable at the time more than 6 month. Amt receivable/payable $1,00,000 at 2Y 0 Y 6m 1 Y 1.5 Y 2 Y 1 2 3 4 1. Originally enter 6m forward contract @ 6m FR on 0 Y to sell/buy $1,00,000/- 5 CA. Nagendra Sah Page 13

2. At 6m time, cancel forward contract by entering opposite contract at 6m ) @ SR on 6 Month. - Calculate amount receivable/payable due to cancelation. - Again enter 6m forward contract @ 6m FR on 6m to sell/buy $ 1,00,000/- FOREX Summary (because payment not receivable/payable 3. At 1Y, cancel forward contract by entering opposite contract @ SR on 1 Year. - Calculate amount receivable/payable due to cancelation. - Again enter 6m forward contract @ 6m FR on 1 Y to sell/buy $ 1,00,000/- (because payment not receivable/payable at 1Y) 4. At 1.5Y, cancel forward contract by entering opposite contract (because payment not receivable/payable at 1.5Y) @ SR on 1.5 Year. - Calculate amount receivable/payable due to cancelation. - Again enter 6m forward contract @ 6m FR on 1.5 Y to sell/buy $ 1,00,000/- 5. At 2Y, sell/buy $1,00,000 @ committed 6m FR of 1.5Y time. - Calculate final amount receivable/payable. Total amount receivable/payable under Rupee roll over: A. When cost of debt/discount rate is not given: Amount receivable/payable = Amt at 6m Amt at 1Y Amt at 1.5Y Amt at 2Y. B. when cost of debt/discount rate is given: Option 1: Total amount receivable/payable under Rupee roll over at today s money term: Present value of receivable/payable = Amt at 6m (1PIR) 1 Amt at 1Y (1PIR) 2 Amt at 1.5Y (1PIR) 3 Amt at 6m PVIF(R, 1) Amt at 1Y PVIF(R, 2) OR Amt at 1.5Y PVIF(R, 3) Amt at 2Y (1PIR) 4 Amt at 2Y PVIF(R, 4) Option 2: Total amount receivable/payable under Rupee roll over at future s money term i.e. after 2Y: Amt at 6m Amt at 1Y Amt at 1.5Y Amt at 2Y Future value of receivable/payable = (1PIR) 3 (1PIR) 2 (1PIR) 1 (1PIR) 0 Nostro A/C and Vostro A/C Nostro A/C: Nostro Account is an account maintained by an Indian bank/dealer with a foreign bank in foreign currency. For example, Account of SBI Bank (an Indian bank) in London (UK) with London bank in pound ( ) currency. Vostro A/C: Vostro A/C is an account maintained by a foreign bank in India with Indian bank in Rupee currency. For example account of London bank in India with SBI in Rupee () Currency. CA. Nagendra Sah Page 14

Maintaining Exchange position and Nostro A/C [Nov-05] [RTP-Nov-08] General information: - Currency of Switzerland is Swiss Franc (CHF) - Zurich is a city of Switzerland - Telegraphic Transfer or Telex Transfer, often abbreviated to TT, is an electronic means of transferring funds overseas Exchange position: Exchange position (for CHF currency) of an Indian bank/dealer will affect by: - Purchase/sale of foreign currency, (the purchase/sale of currency may be spot or forward) - Issue/cancellation of demand draft, - Purchase/sale of Bills receivable, - Remittance of foreign currency [Remember that Indian bank do not remit foreign currency (say CHF) in Nostro account from India. All receipt in Swiss franc (CHF) and all payment/remittances in CHF will be made through Nostro account maintained with Switzer land bank] Cash Position (Nostro A/C): Nostro A/C of an Indian bank/dealer maintained with Switzerland bank will affect by: - Spot Purchase/Sale of foreign currency (CHF) (Forward Purchase/Sale of CHF do not affect Nostro A/C because there is no delivery of currency as on today) - Receipt/payment in CHF. Note: Spot purchase/sales of CHF affects both exchange position as well as Nostro A/C (Cash Position). However, forward purchase/sale affects only the exchange position. [Refer Question No 44] Lagging: Lagging means delaying the payment beyond the due date allowed by supplier. Example: Indian importer has to make payment for $ 5,000 at 3 month time to US supplier. If payment is delayed, supplier charges interest @ 6% p.a. 3 month forward rate: 1$ = 45.30-45.36 6 month forward rate: 1$ = 43.20-43.50 Indian company is considering the lagging if it is beneficial. Cost of capital of Indian company is 12%. 1. If Indian importer make payments at due date i.e. at 3 month time: Outflow in Rupee at 3 month = 5,000 45.36 = 2,26,800 2. In Indian importer make payment at 6 month time (i.e. lagging): Outflow in Dollar at 6 month= 5,000 Outflow in Rupee at 6 month= 5,075 43.50 = 2,20,762.5 = $ 5,075 [charge int. for 3M only) 0 Year 3 month 6 month = 2,14,332 2,20,762.5 Outflow under lagging will be 214332 and under normal credit period will be 2,26,800. Hence lagging is beneficial for importer. CA. Nagendra Sah Page 15