IFM Notes Full Rudramurthy Sir

Rudramurthy B.
V
CRASH COURSE FOR IFM AND
PROJECT FINANCE WILL BE HELD
FROM 25
TH
MAY TO 31
ST
MAY
2011.
TIMINGS: 5 to !".
FEES: R#.1$500%& !'( #)*+',t.
CO-ERAGE. ALL PRACTICAL
AREAS.
GROUP DISCOUNT A-AILABLE
FOR SAME COLLEGE STUDENTS:
L/"/t'0 #'1t#222 M13' 4o) 10"/##/o5# 1t
t6' '1(7/'#t 1# 8' t13' o574 1 B1t,6. Fo(
R'9/#t(1t/o5 150 :)(t6'( 0't1/7# 4o) ,15
,o5t1,t M(.S191( ; <=5>20530 O(
<535>22<5.
1
Rudramurthy B.V
INTERNATIONAL FINANCIAL MANAGEMENT
BASICS
Extends the area of operations to outside the geographical boundaries of the
domestic country.
Generally, Domestic orporates face !ith only business and financial ris"s
only.
#ultinational ompanies are exposed to currency ris".
?UOTES:
$here are t!o types of %uotes&
1. Direct %uotes.
'. (ndirect %uotes.
D/(',t ?)ot': )ne unit of foreign currency expressed in so many units of home
currency.
E*& 1+ , (-R ./.
10 , (-R 1/.
12g of 3ugar , (-R 14.
1BG , (-R 4/,///.
I50/(',t ?)ot': )ne unit of home currency expressed in so many units of foreign
currency. 516D%7
E*& 1(-R , + /./'4
1(-R , 8 /./1.9
1(-R , 3 /./::1
1(-R , BG /.////4
E@,'!t/o5#:
ertain urrencies are al!ays ;uoted for 1//units instead of 1unit.
E*& <apanese =en.
3outh 2orean >on
(ndonesian Rupiah
C1)t/o5:
?ll o@er the !orld, direct ;uotes are follo!ed, except in A2 and Euro countries !here
indirect ;uotes are follo!ed.
B/0 R1t': (t is the Buying rate of the ?uthoriBed dealer i.e. the 3elling rate for the
customer.
'
Rudramurthy B.V
O::'( R1t': (t is the 3elling rate of the ?uthoriBed dealer i.e. the Buying rate for the
customer.
S!('10: (t is the difference bet!een )ffer rate and Bid Rate.
S!('10: AI5 BC D 3pread in Rs C 1//
)ffer Rate
Co"!)t1t/o5 o: /50/(',t E)ot' :o( 1 t8o 814 0/(',t E)ot':
Bid rate of (ndirect %uote , 1 .
)ffer rate of Direct %uote
)ffer rate of (ndirect %uote , 1 .
Bid rate of Direct %uote
C(o## R1t'#:
?uthoriBed dealers may ha@e ;uotation only for some popularly traded foreign
currencies. (f a customer needs a ;uotation for a currency other than these currencies,
R)33 R?$E3 are used.
PROBLEM:
1. 3uppose R# plans to in@est in #artin ltd, a British corporation that is currently
selling for 84/ per share. R# has +1,1',4// to in@est at current exchange rate of
+'.'4618
a7 Do! many shares can R# purchaseE
b7 >hat is his net return if the price of #artin ltd at the end of the year is :/8 and
the exchange rate at that time is +'.//618
So7)t/o5
a7
R# has +11'4// to in@est , + 11'4// , 4//// 8
'.'4
R# can purchase , 4/// , 1/// shares
4/
b7
Dis return in pounds !ould be 1/// C :/ 8 , ://// 8
Dis return in dollars !ould be ://// C ' , +1'////
Return in F 50ounds7 , ://// G 4//// , '/ F
4////
Return in F 5Dollars7 , 1'//// G 11'4// , :.:1 F
11'4//
$his change in percentage is due to ARRE-= R(32
9
Rudramurthy B.V
Hactors influencing apital Budgeting
1. Estimated cash out flo!
'. Estimated future cash inflo!
9. Estimated life of the proIect
.. Discounting factor 5Ris" adIusted rate7
4. 3pot rate and expected for!ard rate
:. Ris" free rate in home country an foreign country
$here are t!o approaches to e@aluate international capital budgeting
a7 Dome currency approach
b7 Horeign currency approach
P(o*7'"
'. (ndian 0harma ltd an (ndian based foreign #- is e@aluating an o@erseas
in@estment proposal, (ndia 0harma ltd exporter of pharmaceutical products is
considering to build a plant in Anited 3tates the proIect !ill entail an initial outlay
of + 1// million and it is expected to gi@e the follo!ing cash flo! o@er its life of .
years

=ears ash Hlo! 5in million +7
1 9/
' ./
9 4/
. :/
$he current spot exchange rate is Rs .46+ the ris" free rate of interest in (ndia is 11
F and in A3 it is : F. (ndia 0harma re;uires a rupee return of 14 F on the abo@e
proIect. alculate the -0V under both home currency and foreign currency
approach.
So7)t/o5
a7 Dome currency approach
alculation of expected for!ard rate according to (nternational Hischer effect
t
3
t
, 3
/
1 J r
hc
1 J r
fc
>here 3
t
, for!ard rate for year t
3
/
, spot rate
r
hc
, ris" free rate in the home country
r
fc
, ris" free rate in the foreign country
t , time period
3
1
, .4 1 J /.11 , .1.1'
1 J /./:
3
'
, .4 1 J /.11
'
, .K.94
1 J /./:
.
Rudramurthy B.V
3
9
, .4 1 J /.11
9
, 41.:1
1 J /./:
3
.
, .4 1 J /.11
.
, 4..11
1 J /./:
C17,)71t/o5 o: NP-
=ear ash Hlo! 5in
million +7
ER ash Hlo! 5in
million Rs7
DH L 14F DH
/ 51//7 .4.// 5.4//7 1.//// 5.4//7
1 9/ .1.1' 1.19.:/ /.M:K: 1''K.''
' ./ .K.94 1K1..// /.14:1 1.K'.:9
9 4/ 41.:1 '4M9.4/ /.:414 1:KM.:K
. :/ 4..11 9'.:.:/ /.411M 1M4:.'4
=F1F.F0 1FF>.F<
3ince -0V is positi@e, the abo@e foreign proIect shall be accepted
b7 Horeign currency approach
51 J ris" adIusted rupee rate7 , 51 J R
f
rupee rate7 C 51 J ris" premium7
51 J /.147 , 51 J /.117 51 J r
p
7
51 J r
p
7 , 1.1461.11 , 1./9:
r
p
, 9.: F
51 J ris" adIusted dollar rate7 , 51 J R
f
dollar rate7 C 51 J ris" premium7
51 J ris" adIusted dollar rate7 , 51 J /./:7 C 51 J /./9:7
51 J ris" adIusted dollar rate7 , 1./KM1:
ris" adIusted dollar rate , K.M F
alculation of -0V
=ears ash Hlo! in million + DH L K.M F DH
/ 51//7 1 N1//
1 9/ /.K1/1 '1.9''.
' ./ /.M'K4 99.11M.
9 4/ /.144. 91.111.
. :/ /.:MM/ .1.'M/'
3<.552=
9K.4'.. C .4 , 1FF<.>
4
Rudramurthy B.V
Dome currency approach
1. alculation of Expected Hor!ard rate 5ERH7 using international Hischer effect
'. on@ert cash flo!s in foreign currency to local currency using spot rate and
ERH
9. alculate present @alue of cash flo!s in local currency 5Ris" adIusted local
country rate i.e. DH7
.. E@aluate the proIect by calculating its -0V, if -0V is positi@e accept or reIect
the proposal
Horeign currency approach
1. alculation of Ris" premium rate
'. alculation of ris" adIusted foreign country rate
9. alculation of cash flo! using ris" adIusted foreign country rate and
discounting factor
.. E@aluate the proposal using -0V
P(o*7'"
9. Barret orporation presently has no existing business in Hrance but is considering
the establishment of a subsidiary there. $he follo!ing information is gi@en to
assess this proIect
$he initial in@estment re;uired is HH :/ million. $he existing spot rate is + /.'/O
the initial in@estment in dollars is + 1' million. (n addition to HH :/ million
initial in@estment on plant and e;uipment, HH 1/ million is needed for !or"ing
capital and !ill be borro!ed by the subsidiary from Hrench ban". $he Hrench
subsidiary of Barret !ill pay interest only on the loan each year at an interest of
1/F.
$he loan principal is to be paid in 1/ years
$he proIect !ill be terminated at the end of year 9, !hen subsidiary !ill be sold.
$he price, demand, and @ariable cost of the product in Hrance are as follo!s&
=ear 0rice 5HH7 Demand Variable ost 5HH7
1 :// .//// '4
' :4/ 4//// 9/
9 1// ://// ./
$he fixed costs are estimated to be HH 4 million per year.
$he exchange rate of the Hrench Hranc is expected to be + /.'' at the end of year
1, +/.'4 at the end of year ' and + /.'M at the end of year 9.
$he Hrench go@ernment !ill impose a !ithholding tax of 1/ F on earnings
remitted by the subsidiary. $he A.3 go@ernment !ill allo! a tax credit on
remitted earnings and !ill not impose any additional taxes.
:
Rudramurthy B.V
?ll cash flo!s recei@ed by the subsidiary are to be sent to the parent at the end
of each year. $he subsidiary !ill use its !or"ing capital to support ongoing
operations.
$he plant and e;uipment are depreciated o@er 1/ years, using straightNline
depreciation method. 3ince the plant and e;uipment are initially @alued at HH :/
million, the annual depreciation expense is HH : million.
(n three years, the subsidiary is to be sold. Barret plans to let the ac;uiring firm
assume the existing Hrench loan. $he !or"ing capital !ill not be li;uidated, but
!ill be used by the ac;uiring firm
$he re;uired rate of return on this proIect is 14 F.
a7 Determine the net present @alue of this proIect. 3hould Barret accept this
proIectE
b7 ?ssume that Barret o. pro@ides the additional funds for !or"ing capital
so that the loan from the Hrench go@ernment is not necessary.
c7 >ould the -0V of this proIect from the parentPs perspecti@e be more
sensiti@e to exchange rate mo@ements if the subsidiary used Hrench
financing to co@er the !or"ing capitalE Explain
d7 ?ssume Barret o. uses the original proposed financing arrangement and
that funds are bloc"ed until the subsidiary is sold. $he funds to be remitted
are rein@ested at a rate of M F 5after taxes7 until the end of year 9. Do! is
the proIectPs -0V affectedE
e7 ?ssume that Barret o. decided to implement the proIect, using the
original proposed financing arrangementO also assume that after one year, a
Hrench firm offers Barret o. a price of + 9/ million after taxes for the
subsidiary, and that Barret o. original forecasts for years ' and 9 ha@e not
changed. 3hould Barret o. di@est the subsidiaryE Explain
So7)t/o5
a7
$o find cash flo! transferred to parent co
HH in million
P1(t/,)71(# 1 2 3
3ales
N Variable ost
'.
1
9'.4
1.4
.'
'..
Co5t(/*)t/o5
N Hixed ost
23
4
31
4
3<.>
4
EBITD
N Depreciation
1
:
2>
:
3=.>
:
EBIT 1:t'( D'!(',/1t/o5
N (nterest
12
1
20
1
2.>
1
EBT A1:t'( /5t'('#t 150 0'!(',/1t/o5C 11 1< 2F.>
1
Rudramurthy B.V
N tax N N N
EAT
J depreciation
11
:
1<
:
2F.>
:
EATBD
J 3al@age @alue 5:/ G 5:C977
1F
N
25
N
33.>
.'
C1#6 :7o8 t(15#:'(1*7' to !1('5t ,o
N !ithholding tax
1F
1.1
25
'.4
F5.>
1.4:
C1#6 :7o8 t(15#:'(('0 to !1('5t ,o 15.3 22.5 >.0=
alculation of -0V
=ears ash flo! 5in
million HH 7
Exchange rate ash flo! 5in
million dollar7
DH L 14 F DH
/ 5:/7 /.'/ 51'7 1.//// 51'7
1 14.9 /.'' 9.9:: /.M:K: '.K'1/
' ''.4 /.'4 4.:'4 /.14:1 ..'499
9 :M./. /.'M 1K./41' /.:414 1'.4':4
F.F0>F
$he abo@e proIect shall be accepted since -0V is positi@e
b7
HH in million
P1(t/,)71(# 1 2 3
EBIT 1:t'( D'!(',/1t/o5
N (nterest
12
N
20
N
2.>
N
EBT A1:t'( /5t'('#t 150 0'!(',/1t/o5C
N tax
12
N
20
N
2.>
N
EAT
J depreciation
12
:
20
:
2.>
:
EATBD
J 3al@age @alue 5:/ G 5:C977
1
N
2>
N
3=.>
.'
C1#6 :7o8 t(15#:'(1*7' to !1('5t ,o
N !ithholding tax
1
1.M
2>
'.:
F>.>
1.::
C1#6 :7o8 t(15#:'(('0 to !1('5t ,o 1>.2 23.= >.<=
alculation of -0V
=ears ash flo! 5in
million HH 7
million dollar7
DH L 14 F DH
/ 51/7 /.'/ 51.7 1.//// 51.7
1 1:.' /.'' 9.4:. /.M:K: 9./KK1
' '9.. /.'4 4.M4 /.14:1 ...'9.
9 :M.K. /.'M 1K.9/9' /.:414 1'.:K''
>.21=F
c7 (f Barret orporation funds the !or"ing capital re;uirement of its subsidiary,
then it is exposed to Hrench Hranc 1/ million, !here as if the subsidiary
finances its !or"ing capital from Hrench Ban" then Barret orporation is
M
Rudramurthy B.V
exposed to a total capital of HH :/ million. $hus to minimiBe currency ris" it is
ad@isable to borro! !or"ing capital re;uired from Hrench Ban". Digher the
exposure higher is the ris" and @isa @ersa.
d7
HH in million
P1(t/,)71(# 1 2 3
C1#6 :7o8 t(15#:'(1*7' to !1('5t ,o 1F 25 F5.>
J interest recei@ed at the end of year '
J interest recei@ed at the end of year 9
1.9:
1..:M
N
'
N
N
C1#6 F7o8 1<.3 2F F5.>
alculation of -0V
=ears ash flo! 5in
million HH 7
million dollar7
DH L 14 F DH
/ 5:/7 /.'/ 51'7 1.//// 51'7
1 1K.M9 /.'' ..9:': /.M:K: 9.1K9:
' '1.// /.'4 :.14 /.14:1 4.1/./
9 14.:/ /.'M '1.1:M /.:414 19.K1M9
10.15
-ote& N Hor calculating interest time @alue of money is ignored
e7
P1(t/,)71(#
C1#6 F7o8AFFC
N !ithholding tax L 1/ F
1F
1.1
C1#6 F7o8 1:t'( WT 15.3
C1#6 F7o8 1:t'( WT /5 Do771( A15.3 G 0.22C
J 3al@age Value
3.3>>
9/
ash Hlo! in Dollar
D/#,o)5t'0 ,1#6 /5:7o8 ADF ; 15 BC
A33.3>> G0. ><>C
99.9::
2<.015
N Discounted cash outflo! 1'
NP- 11./14
(t is better to sell the subsidiary at the end of year 1 as higher -0V of +11./14
million is achie@ed under this situation.
.. =es corporation expects to recei@e cash di@idend from a Hrench Ioint @enture o@er
the coming 9 years. $he first di@idend is expected to be paid on 9161'6/' and is
expected to be Q 1'//// the di@idend is then expected to gro! 1/ F per year o@er
the follo!ing ' years, the current exchange rate is +/.K1M/6Q the !eighted a@erage
cost of capital for =es corporation is 1' F.
a7 >hat is present @alue of expected Euro di@idend stream if the Euro is
expected to appreciate . F per annum against dollarE
b7 >hat is the present @alue of expected Euro di@idend stream if the Euro !ere to
depreciate at the rate of 9 F per annum against dollarE
K
Rudramurthy B.V
So7)t/o5
a7 alculation of 0V of di@idends
=ears / 1 ' 9
Expected di@idend N 1'//// 1K'/// M11'//
>?) or DH L 1' F 1 /.MK'K /.1K1' /.111M
Expected return 5increase
by . F e@ery year7 /.K1M/ /.K4.1 /.KK'K 1./9':
0resent @alue of di@idends N :191.K :':K// :./99. 10<3
b7 alculation of 0V of di@idends
=ears / 1 ' 9
Expected di@idend N 1'//// 1K'/// M11'//
>?) or DH L 1' F 1 /.MK'K /.1K1' /.111M
Expected return 5decrease
by 9 F e@ery year7 /.K1M/ /.MK/4 /.M:91 /.M91M
0resent @alue of di@idends N 41'.9K 4.494/ 41K4.9 1>3F332
4. * orporation presently has no existing business in -e! Realand but is
considering the establishment of a subsidiary there. $he follo!ing information is
gi@en to assess this proIect
$he initial in@estment re;uired is + 4/ million in -R dollars. $he existing spot
rate is /.4/ A3D6 1 -RDO the initial in@estment in A3D is + '4 million. (n
addition to 4/ million -RD initial in@estments on plant and e;uipments '/
million -RD is needed for !or"ing capital and !ill be borro!ed by the
subsidiary from -R ban". $he -R subsidiary of * !ill pay interest only on the
loan each year at an interest of 1.F.
$he loan principal is to be paid in 1/ years
$he proIect !ill be terminated at the end of year 9, !hen subsidiary !ill be sold.
$he price, demand, and @ariable cost of the product in -R are as follo!s&
=ear 0rice 5-RD7 Demand Variable ost 5-RD7
1 4// .//// 9/
' 411 4//// 94
9 49/ ://// ./
$he fixed costs are estimated to be : million -RD per year.
$he exchange rates of the -RD is expected to be + /.4' at the end of year 1,
+/.4. at the end of year ' and + /.4: at the end of year 9.
$he -R go@ernment !ill impose an income tax of 9/ F on income in addition it
!ill impose a !ithholding tax of 1/ F on earnings remitted by the subsidiary.
$he A.3 go@ernment !ill allo! a tax credit on remitted earnings and !ill not
impose any additional taxes.
1/
Rudramurthy B.V
?ll cash flo!s recei@ed by the subsidiary are to be sent to the parent at the end
of each year. $he subsidiary !ill use its !or"ing capital to support ongoing
operations.
$he plant and e;uipment are depreciated o@er 1/ years, using straightNline
depreciation method. 3ince the plant and e;uipment are initially @alued at 4/
million -RD, the annual depreciation expense is 4 million -RD.
(n three years, the subsidiary is to be sold. * plans to let the ac;uiring firm
assume the existing -R loan. $he !or"ing capital !ill not be li;uidated, but !ill
be used by the ac;uiring firm. >hen it sells the subsidiary * corporation
expected to recei@e 4' million -RD after subtracting capital gain tax, assume
that this amount is not subIected to a !ithholding tax
* corporation re;uires '/ F R)( on this proIect
a7 Determine the net present @alue of this proIect. 3hould * orp. accept this
proIectE
b7 ?ssume that * orp. is also considering an alternati@e financing
arrangement in !hich the parent !ould in@est an additional + 1/ million to
co@er !or"ing capital re;uired so that subsidiary !ould a@oid the -R ban"
loan. (f this arrangement is used the selling price of the subsidiary after
subtracting any capital gains tax is expected to be 1M million -RD higher.
(s this alternati@e financing arrangement more feasible for the parent than
original proposalE
c7 Hrom the parentPs perspecti@e !ould the -0V of this proIect be more
sensiti@e to exchange rate mo@ements. (f the subsidiary uses -R financing
to co@er the !or"ing capital or if the parent in@ests more of its o!n funds
to co@er the !or"ing capital explain.
d7 ?ssume * orp. uses the original proposed financing arrangement and
that funds are bloc"ed until the subsidiary is sold. $he funds to be remitted
are rein@ested at a rate of : F 5after taxes7 until the end of year 9. Do! is
the proIectPs -0V affectedE
e7 >hat is the brea"Ne@en sal@age @alue of this proIect if * orp. uses
original financing proposal and funds are not bloc"edE
f7 ?ssume that * orp. decided to implement the proIect, using the original
proposed financing arrangementO also assume that after one year a -R firm
offers * orp. a price of + '1 million after taxes for the subsidiary, and
that * orp. original forecasts for years ' and 9 ha@e not changed. 3hould
* orp. di@est the subsidiaryE Explain
11
Rudramurthy B.V
So7)t/o5
a7
-RD in million
P1(t/,)71(# 1 2 3
3ales
N Variable ost
'/./
1.'
'4.44
1.14
91.M
'..
Co5t(/*)t/o5
N Hixed ost
1.
:
23.
:
2<.=
:
EBITD
N Depreciation
12.
4
1F.
4
23.=
4
EBIT 1:t'( D'!(',/1t/o5
N (nterest
F.
'.M
12.
'.M
1.=
'.M
EBT A1:t'( /5t'('#t 150 0'!(',/1t/o5C
N tax
5
1.4
10
9
15.>
..:M
EAT
J depreciation
3.5
4
F
4
10.<2
4
EATBD
N !ithholding tax
.5
/.M4
12
1.'
15.<2
1.4K
EATBD 1:t'( W/t66o70/59 t1@
J 3al@age @alue
F.>5
N
10.
N
1=.33
4'
C1#6 :7o8 t(15#:'(('0 to !1('5t ,o F.>5 10. >>.33
alculation of -0V
=ears ash flo! 5in
million -RD 7
million dollar7
DH L '/ F DH
/ 54/7 /.4/ 5'47 1.//// 5'47
1 1.:4 /.4' 9.K1M /.M999 9.914/
' 1/.M/ /.4. 4.M9' /.:K.. ../4//
9 ::.99 /.4: 91.1..M /.41M1 '1..K4M
3.>0
b7
-RD in million
P1(t/,)71(# 1 2 3
EBIT 1:t'( D'!(',/1t/o5
N (nterest
F.
N
12.
N
1.=
N
EBT A1:t'( /5t'('#t 150 0'!(',/1t/o5C
N tax
F.
'.9.
12.
9.M.
1.=
4.4'
EAT
J depreciation
5.=>
4
.<>
4
12.
4
EATBD
N !ithholding tax
10.=>
1./4
13.<>
1..
1F.
1.M
EATBD 1:t'( W/t66o70/59 t1@
J 3al@age @alue
<.=1
N
12.5>
N
1>.0
1/
C1#6 :7o8 t(15#:'(('0 to !1('5t ,o <.=1 12.5> >.0
1'
Rudramurthy B.V
alculation of -0V
=ears ash flo! 5in
million HH 7
million dollar7
DH L '/ F DH
/ 51/7 /.4/ 5947 1.//// 5947
1 K..1 /.4' ..MK9' /.M:K: ../111
' 1'.4: /.4. :.1M'. /.14:1 ..11//
9 M:./M /.4: .M.'/.M /.:414 '1.MK:9
1.>=
$he abo@e proIect shall be accepted since -0V is positi@e the original proposal is
more feasible as -0V of original proposal is higher compared to ne! proposal.
c7 (f * orp. funds the !or"ing capital re;uirement of its subsidiary, then it is
exposed to -RD 1/ million, !here as if the subsidiary finances its !or"ing
capital from -R Ban" then * orp. is exposed to a total capital of -RD 4/
million. $hus to minimiBe currency ris" it is ad@isable to borro! !or"ing
capital re;uired from -R Ban". Digher the exposure higher is the ris" and
@isa @ersa.
d7
-RD in million
P1(t/,)71(# 1 2 3
C1#6 :7o8 t(15#:'(1*7' to !1('5t ,o 10.=> 13.<> F.
J interest recei@ed at the end of year '
J interest recei@ed at the end of year 9
/.:'1:
/.::49
N
/.M.
N
N
C1#6 F7o8 11.F53 1=. F.
alculation of -0V
=ears ash flo! 5in
million -RD 7
million dollar7
DH L 14 F DH
/ 54/7 /.4/ 5'47 1.//// 5'47
1 11.14 /.4' :.11 /.M999 4./K11
' 1..M/ /.4. 1.KK' /.:K.. 4.44//
9 M1.MM /.4: .K.'1'M /.41M1 'M..1K:
1=.1213
-ote& N Hor calculating interest time @alue of money is ignored
e7
=ears ash flo! 5in
million -RD 7
million dollar7
DH L 14 F DH
/ 54/7 /.4/ 5'47 1.//// 5'47
1 1.:4 /.4' :.11 /.M999 4./K11
' 1/.M/ /.4. 1.KK' /.:K.. 4.44//
9 1=.33 H S- 0.5> 30.=>= 0.5FF 1F.>350
0
By re@erse method !e get 51..99 J 3V7 C /.4: , 9/..:.M
$herefore S- D =0.0F
19
Rudramurthy B.V
f7
P1(t/,)71(#
C1#6 F7o8AFFC
N !ithholding tax L 1/ F
10.=>
1./4
C1#6 F7o8 1:t'( WT <.=1
C1#6 F7o8 1:t'( WT /5 Do771( A<.=1 G 0.52C
J 3al@age Value
=.<
'1
ash Hlo! in Dollar
D/#,o)5t'0 ,1#6 /5:7o8 ADF ; 15 BC A31.<
G 0. 333C
91.MK
2>.5
N Discounted cash outflo! '4
NP- 1.5FF
(t is better not sell the subsidiary at the end of year 1 -0V of +1.411 million is
achie@ed under this situation !hich is less than the actual -0V of + 9.M:/M million.
A0+)#t'0 NP-
(n this -0V method all cash flo!s are discounted at !eighted a@erage cost of
capital and it is assumed that uncertainty is in@ol@ed in different cash flo! schemes
are same.
?dIusted -0V method pro@ides the flexibility of adopting the different
discount factors for different cash flo! schemes. Digher the uncertainty in@ol@ed
from a cash flo! scheme, higher is the discount factor and @ice @ersa.
P(o*7'"
:. ? 1/ million A3D is in@ested in $hailand for a period of 4 years. (t is financed by
4/ F debt and 4/ F e;uity, normally the cost of debt !ould be 1' F for proIect of
this type in $hailand, the !orld ban" is ho!e@er !illing to lend us 4 million A3D
at a subsidiBed rate of 1/ F. $he proIect is expected to generate 9 million A3D
operating cash flo! e@ery year for a period of 4 years and the marginal tax rate is
./ F.alculate adIusted -0V for the abo@e proIect assuming discount rate of
1..:F.
So7)t/o5
ash Hlo! 3cheme 1&
)perating cash flo! 9 million e@ery year to be discounted at the rate of 1..: F.
ash Hlo! 3cheme '& 3a@ings in interest
-ormal debt rate applicable in $hailand is 1' F, rate paid for debt borro!ed
from >orld Ban" is 1/ F therefore sa@ings in interest rate is ' F.
3a@ings in interest , 4 million C ' F , /.1 million
$he abo@e sa@ings in interest should be discounted at the general debt capital
rate of 1' F
ash Hlo! 3cheme 9& $ax benefit on account of payment of interest
Debt capital borro!ed from >orld Ban" 4 million, rate of interest 1/ F
?nnual interest , 4 million C1/ F , /.4 million
$ax benefit , ?nnual interest C tax rate
, /.4 million C ./ F , /.' million
1.
Rudramurthy B.V
alculation of ?dIusted -0V
$ype of ash Hlo! ash Hlo!
5+ in million7
0eriod Discount
Rate
?nnuity
Discount rate
DH
)perating ash
Hlo!
9 1N4 1..: F 9.9M.1 1/.14'9
3a@ings in interest /.1 1N4 1' F 9.:/4 /.9:/4
$ax benefit /.' 1N4 1' F 9.:/4 /.1'1
11.23=
S D( , 11.'9. million
N S D) , 1/ million
?-0V , 1.'9. million
$he abo@e proIect shall be accepted since ?-0V is positi@e
1. limited an (ndian manufacturer of high ;uality sports goods and related
e;uipment, the company is planning to increase its exports in the coming years as
a part of its strategy it is thin"ing of establishing a subsidiary in Hrance that could
manufacture and sell goods locally. $he management has as"ed @arious
departments of the company to supply all rele@ant information for multinational
capital budgeting analysis, the rele@ant information is gi@en belo!
(n@estment& N $he total initial in@estment to finance plant and e;uipment is
estimated at '/ million Hrench Hranc that !ill be in@ested by the parent. >or"ing
capital re;uirements estimated at HH 1/ million !ill be borro!ed by subsidiary
from a local financing institution at an interest rate of M F per annum, the
principal !ill be paid at the end of 4
th
year !hen the proIect is terminated !hile
the interest payments are it be paid by the subsidiary annually.
Depreciation& N $he Hrench go@ernment !ill allo! the company to depreciate the
plant and e;uipment using straightNline method, the depreciation expense sill be
HH . million per year the li@e of the proIect is excepted to be 4 years. $he forecast
price and sales schedule for the next 4 years are as gi@en belo!
=ear 0rice6unit 3ales in Hrance
1 HH :// 4////
' HH :// 4////
9 HH :4/ M////
. HH ::/ 1/////
4 HH :M/ 1'////
$he @ariable cost are HH ''/6unit in year 1 and in year ' it is expected to rise to
HH 9//6unit and remain constant for years 9, . and 4. $he fixed costs other then
depreciation are expected to be HH 1.4 million6year.
Exchange Rate& N $he spot exchange rate of the Hrench Hranc is Rs :.: the
forecasted exchange rate for all future period is Rs :.M
Remittance& N ?ll profits after tax realiBed are to be transferred to the parent at the
end of each year. $he Hrench go@ernment plans to impose no restrictions on the
remittance of cash flo!s but !ill impose a 4 F !ithholding tax on funds remitted
by subsidiary to the parent as mentioned earlier.
14
Rudramurthy B.V
Hrench go@ernment taxes on income earned by subsidiary& N $he (ndian
go@ernment !ill allo! a tax credit on taxes paid in Hrance, the company re;uires a
1/ F return on this proIect.
?d@ise the (ndian company regarding the financial @iability of the proposal,
should the proIect be setup in Hrance or not.
?dditional onsiderations
1. ?ssume that all funds are bloc"ed until the end of 4
th
year this funds can be
rein@ested locally to yield : F annually after taxes, sho! the calculations
and comment on the result.
'. ?ssume the follo!ing exchange rate scenario and recalculate your results
?lternati@e 1
=ear Exchange Rate
1 :.M/
' :.K/
9 :.K4
. 1.//
4 1./4
?lternati@e '
=ear Exchange Rate
1 :.44
' :.4/
9 :../
. :.9M
4 :.94
So7)t/o5
alculation of cash flo! to parent company
P1(t/,)71(# 1 2 3 = 5
3ales
N Variable ost
9/
11
9/
11
4'
'.
::
9/
M1.:
9:
Co5t(/*)t/o5
N Hixed ost
1<
1.4
1<
1.4
2
1.4
3>
1.4
=5.>
1.4
EBITD
N Depreciation
1F.5
.
1F.5
.
2>.5
.
3=.5
.
==.1
.
EBIT
N (nterest 51/ C M F7
13.5
/.M
13.5
/.M
22.5
/.M
30.5
/.M
=0.1
/.M
EBT
N $ax
12.F
N
12.F
N
21.F
N
2<.F
N
3<.3
N
EAT
J Depreciation
12.F
.
12.F
.
21.F
.
2<.F
.
3<.3
.
EATBD
J >or"ing apital
N Repayment of loan
N >ithholding $ax
1>.F
N
N
/.M.
1>.F
N
N
/.M.
25.F
N
N
1.'K
33.F
N
N
1.:K
=3.3
1/
1/
'.11
C1#6 F7o8
T(15#:'(('0 to
!1('5t ,o"!154
15.> 15.> 2=.=1 32.01 =1.13
1:
Rudramurthy B.V
alculation of -0V
=ears ash Hlo!
5HH in
million7
Exchange
Rate
ash Hlo!
5Rs in
million7
DH L1/F DH
/ 5'/7 :.: 519'7 1 519'7
1 14.M: :.M 1/1.M4 /.K/K1 KM./.
' 14.M: :.M 1/1.M4 /.M':. MK.19
9 '...1 :.M 1:..:9 /.1419 1'9.:K
. 9'./1 :.M '11.:1 /.:M9/ 1.M.:1
4 .1.19 :.M '1K.:M /.:'/K 119.::
502.22
3ince -0V is positi@e, accept the proIect
?dditional consideration
a7
(nterest for 1
st
year , 1:.1 C 51./:7
.
, '1./M
(nterest for '
nd
year , 1:.1 C 51./:7
9
, 1K.MK
(nterest for 9
rd
year , '4.1 C 51./:7
'
, 'M.MM
(nterest for .
th
year , 99.1 C 51./:7
1
, 94.1'
(nterest for 4
th
year , .9.9 C 51./:7
/
, .9.9/
alculation of -0V
=ears ash Hlo!
5HH in
million7
Exchange
Rate
ash Hlo!
5Rs in
million7
DH L1/F DH
/ 5'/7 :.: 519'7 1 519'7
1 '1./M :.M 1.9.9. /.K/K1 19/.91
' 1K.MK :.M 194.'4 /.M':. 111.1M
9 'M.MM :.M 1K:.9M /.1419 1.1.44
. 94.1' :.M '.'.K/ /.:M9/ 1:4.K/
4 .9.9/ :.M 'K.... /.:'/K 1M'.M'
>0>.3>
b7 ?lternati@e 1
alculation of -0V
=ears ash Hlo!
5HH in
million7
Exchange
Rate
ash Hlo!
5Rs in
million7
DH L1/F DH
/ 5'/7 :.:/ 519'7 1 519'7
1 14.M: :.M/ 1/1.M4 /.K/K1 KM./.
' 14.M: :.K/ 1/K..9 /.M':. K/...
9 '..'1 :.K4 1:K.:4 /.1419 1'1..:
. 9'./1 1.// ''../1 /.:M9/ 149./.
4 .1.19 1./4 'MK.K1 /.:'/K 1M/./4
51F.03
11
Rudramurthy B.V
?lternati@e '
alculation of -0V
=ears ash Hlo!
5HH in
million7
Exchange
Rate
ash Hlo!
5Rs in
million7
DH L1/F DH
/ 5'/7 :.:/ 519'7 1 519'7
1 14.M: :.44 1/9.MM /.K/K1 K....
' 14.M: :.4/ 1/9./K /.M':. M4.'/
9 '..'1 :../ 14:.'' /.1419 111.91
. 9'./1 :.9M '/..'' /.:M9/ 19K..K
4 .1.19 :.94 ':1.1M /.:'/K 1:'.11
=>>.>F
1M
Rudramurthy B.V
PARITY CONDITIONS IN INTERNATIONAL FINANCE AND
CURRENCY FORECASTING
#eaning of arbitrage& N (t is simultaneous purchase and sale of the same assets or
commodities on different mar"ets to profit from price discrepancies.
Ta! of one price& N (n competiti@e mar"ets characteriBed by numerous buyers and
sellers, ha@ing lo! cost access to information exchange adIusted prices of identical
tradable goods and financial assets must be !ithin transition costs of e;uality
!orld!ide.
(nternational arbitrageurs !ho follo! the principle of UBuy lo! and sell highV
enforce the abo@e rule of la! of one price.
Hor!ard 0remium and Discount& N ? foreign currency is said to be at premium if
for!ard rate expressed is terms of home currency is greater than spot rate or else it is
said to be at discount.
?nnualiBed F of for!ard , HR G 3R C 9:/ .
0remium or Discount 3R Hor!ard contract period in days
$he follo!ing fi@e economic relationships arise due to the pre@alence of Ula! or one
priceV and international arbitraging opportunities.
1. 0ARD?3E 0)>ER 0?R($= 50007
'. H(3DER EHHE$ 5HE7
9. (-$ER-?$()-?T H(3DER EHHE$ 5(HE7
.. (-$ERE3$ R?$E 0?R($=5(R07
4. H)R>?RD R?$E3 ?3 A-B(?3ED 0RED($)R3 )H HA$ARE 30)$
R?$E3 5AH3R7
(f inflation in A3 is expected to exceed inflation in (ndia by ' F for the
coming year then the A3 dollar should decline in @alue by ' F relati@e to Rupee by
the same rate, the one year A3D for!ard should sell at a ' F discount relati@e to the
(ndian Rupees. 3imilarly, 1Nyear interest rates in A3 should be about ' F higher than
oneNyear interest rates on securities of comparable ris" in (ndia.
1K
Rudramurthy B.V
PURCHASING POWER PARITY IPPPJ
(f international arbitrage enforces the la! of one price, then the exchange rate
bet!een the home currency and domestic goods must be e;ual to the exchange rate
bet!een home currency and foreign goods.
(n other !ords, one unit of home currency should ha@e the same purchasing
po!er !orld!ide. Ex& N (f a pen costs Rs 4/ in (ndia and the same model pen costs +1
in A3, then exchange rate shall be +1 , Rs 4/.
Hor same purchasing po!er to remain constant !orld !ide, the foreign
exchange rate must change approximately the same as difference bet!een the
domestic and foreign rates of inflation.
3!edish economist WGusta@ asselP first stated purchasing po!er parity in a
rigorous manner in 1K1M. De used it as the basis for recommending a ne! set of
official exchange rates at the end of >orld >ar X.
0urchasing po!er parity in its absolute @ersion states that price le@els should
be same !orld !ide !hen expressed in common currency. ? unit of home currency
should ha@e the same purchasing po!er !orld!ide. $his theory is application of la!
of one price to national price le@els or else arbitrage opportunities !ould exist.
Do!e@er, absolute 000 ignores the effects of transportation costs, tariffs ;uotas and
other restrictions and product differentiations in free trade.
$he relati@e @ersion of 000 states that the exchange rate bet!een the home
currency and foreign currency !ill adIust to reflect changes in the price le@els of t!o
countries. Ex& N (f inflation in (ndia is 4 F and in A3 is 'F then the rupee @alue of the
A3D must rise by about 9 F to e;ualiBe the Rupee price of goods in both the
countries.
(f i
h
and i
f
are inflations of home country and foreign country respecti@ely, e
/
is
home currency @alue of 1 unit of foreign currency at the beginning of the period and e
t
is the spot exchange rate in period t, then
e
t

,
51 J i
h
7
t
e
/
51 J i
f
7
t
e
t

,
e
/
51 J i
h
7
t
51 J i
f
7
t
$he @alue of e
t
represents 000 rate.
-ote& N the abo@e formula !or"s for direct ;uote. (n case of indirect ;uote the formula
shall be
e
t

,
e
/
51 J i
f
7
t
51 J i
h
7
t
'/
Rudramurthy B.V
Ex& N $he A3 5hc7 and 3!itBerland 5fc7 are running annual inflation rates of 4 F and
9 F respecti@ely and the spot rate is 3Hr 1 , +/.14 then calculate the 000 rate after
1,' and 9 years
e
t
, e
/
51 J i
h
7
t
51 J i
f
7
t
e
1
, /.14 51 J /./4 7
1
, +/.1:.:
51 J /./97
1
e
'
, /.14 51 J /./4 7
'
, +/.11K.
51 J /./97
'
e
9
, /.14 51 J /./4 7
9
, +/.1K.4
51 J /./97
9
$hus according to 000 the exchange rate change during a period should be
e;ual to the inflation differential for the same timeNperiod. (n effect, 000 says that
currencies !ith high rates of inflation should de@alue relati@e to currencies !ith lo!er
rate of inflation.
(nflation change of ' F more in A3 should result in de@aluation of A3D by ' F.
$herefore e
1
, + /.14 C 1/' F , + /.1:4
0oint W?P on the parity line is an e;uilibrium point !herein 9 F change in inflation is
offset by 9 F appreciation in foreign currency, !hereas 0oint WBP is at dise;uilibrium
since 9 F change in inflation is offset Iust by 1 F appreciation in foreign currency.
R'17 E@,6159' (1t': &
$he real exchange rate is the nominal exchange rate adIusted for changes in
the relati@e purchasing po!er of each currency since some base period
Y
t
, e
t
C 0
f
0
h
'1
Rudramurthy B.V
By indexing these price le@els to 1// as of the base period their ratio reflects
the change in the relati@e purchasing po!er of these currencies since time /. (ncrease
in foreign price le@el and foreign currency depreciation ha@e offsetting effects on the
real exchange rate and similarly home price le@el increases and foreign currency
appreciation offset each other.
?n alternati@e !ay to represent the real exchange rate is to directly reflects the
change in relati@e purchasing po!ers of these currencies by adIusting the nominal
exchange rate for inflation in both countries since time / 5base period7.
Y
t
, e
t
C 51 J i
h
7
t
51 J i
f
7
t
-ote& N e
t
shall be in direct ;uote.
Empirical E@idence& N
$he strictest @ersion of 000, that all goods and financial assets obey the la! of
one price is demonstrably false. $he ris" and costs of shipping goods internationally
as !ell as go@ernment erected barriers to trade and capital flo!s, are at times high
enough to cause exchange adIusted prices to systematically differ bet!een countries.
$he general conclusion from empirical study of 000 is that theory holds up
!ell in long run, but not as !ell o@er shorter timeNperiods. $hus in long run the real
exchange rate tends to re@ert to its predicted @alue of e
/
. $hat is if Y
t
Z e
/
, then the real
exchange rate should fall o@er time to!ards e
/
. >here as if Y
t
[ e
/
the real exchange
rate should rise o@er time to!ards e
/
.
THE FISHER EFFECT: AK NIR D K ELPECTED INFLATIONC
$he real interest rate shall be adIustable to reflect expected inflation to obtain
the nominal interest rate. ?ccording to Hisher effect the interest rate5r7 is made of t!o
components
a7 Real interest rate 5a7
b7 Expected inflation rate 5i7
$herefore
51 J -ominal interest rate7 , 51 J real interest rate7 51 J expected inflation rate7
51 J r7 , 51 J a7 51 J i7
51 J r7 , 1 J a J i J ai
( D 1 H / H 1/
Do!e@er often approximated WrP is calculated as e;ual to Wa J iP.
Ex& (f re;uired real interest rate is 9 F and expected inflation rate is 1/ F. alculate
the nominal interest rate
51 J r7 , 51 J a7 51 J i7
51 J r7 , 51 J /./97 51 J /.1/7
51 J r7 , 1.199
r , /.199 or 19.9 F
?lternati@ely
r , a J i J ai
r , /./9 J /.1/ J 5/./97 5/.1/7 , /.199 or 19.9 F
''
Rudramurthy B.V
?ccording to HE the lender should not only be compensated for interest 59 F7 but also
for depreciation in principal @alue by 51/.9 F7 for passage of time
U?ccording to generaliBed @ersion of HE the real returns are e;ualiBed across
the countries through arbitrageV i.e. a
h
, a
f
. (f expected real returns !ere higher in one
currency than the other, capital !ould flo! from the second to the first currency.
(n an e;uilibrium !ith no go@ernment interference, the nominal interest rate
differential !ill approximately e;ual the anticipated inflation differential bet!een the
t!o currencies.
r
h
G r
f
, i
h
G i
f

\ -(R , \ (nflation
>here r
h
and r
f
represents nominal interest rate at home country and foreign
country respecti@ely, i
h
and i
f
represents inflation at home country and foreign country
respecti@ely.
(n other !ords, according to HE,
51 J r
h
7
t
, 51 J i
h
7
t
51 J r
f
7
t
51 J i
f
7
t
THE INTERNATIONAL FISHER EFFECT IIFEJ
(t is the combination of 0urchasing po!er parity 50007 and generaliBed Hisher
Effect 5HE7 !hich gi@es !ay to (nternational Hisher Effect 5(EH7
?ccording to 000
\ ER , \ (R
e
t

,
51 J i
h
7
t
]]]]]]]]]]517
e
/
51 J i
f
7
t
'9
Rudramurthy B.V
?ccording to HE
51 J -(R7 , 51 J R(R7 51 J (R7
51 J r7 , 51 J a7 51 J i7
$herefore \ -(R , \ Expected (nflation rate
51 J r
h
7
t
, 51 J i
h
7
t
]]]]]]]]5'7
51 J r
f
7
t
51 J i
f
7
t
E;uation 1 and ' gi@es
e
t

,
51 J r
h
7
t
e
/
51 J r
f
7
t
i.e. \ ER , \ -(R
$herefore
e
t
, e
/
51 J r
h
7
t
51 J r
f
7
t
?ccording to (HE, the interest rate differential bet!een any t!o countries is an
unbiased predictor of the future change in spot exchange rate. Dence currency !ith
higher interest rates !ill depreciate and those !ith lo! interest rates !ill appreciate.
0oint W?P on parity line is at e;uilibrium !hereas point WBP outside the parity
line is not at e;uilibrium.
'.
Rudramurthy B.V
INTEREST RATE PARITY THEORY IIRPJ
?ccording to (R0 theory, the interest differential should be e;ual to the
for!ard differential i.e. the currency of the country !ith a lo!er interest rate should
be at a for!ard premium in terms of the currency of the country !ith higher interest
rate. (f the abo@e condition is satisfied, the for!ard rate is said to be at interest rate
parity and e;uilibrium pre@ails in money mar"et.
o@ered (nterest Differential&
(nterest parity ensures that the return on a hedged or co@ered foreign
in@estment !ill Iust e;ual the domestic interest rate on in@estment of identical ris" or
else it gi@es rise to co@ered interest arbitrage. $he process of co@ered interest
arbitrage continues until interest parity holds, unless there is go@ernment interference.
THE RELATIONSHIP BETWEEN THE FORWARD RATE AND FUTURE
SPOT RATE
?n unbiased nature of for!ard rate is that the for!ard rate should reflect the
expected future spot rate on the date of settlement of the for!ard contract.
H
t
, ^
t
>here H
t
, for!ard rate at timeWtP.
^t , expected future spot rate
E;uilibrium is achie@ed only !hen the for!ard differential e;uals the
expected change in the exchange rate.
'4
Rudramurthy B.V
PARITY CONDITIONS
(. 0ARD?3(-G 0)>ER 0?R($= _000`
\ ER , \ (R
e
t

,
51 J i
h
7
t
e
/
51 J i
f
7
t
e
t

,
e
/
51 J i
h
7
t
51 J i
f
7
t
((. H(3DER EHHE$ _HE`
\ -(R , \ Expected (nflation rate
51 J -(R7 , 51 J R(R7 51 J (R7
51 J r7 , 51 J a7 51 J i7
51 J r7 , 1 J a J i J ai
( D 1 H / H 1/
(((. (-$ER-?$()-?T H(3DER EHHE$ _(HE`
\ ER , \ -(R
':
Rudramurthy B.V
e
t
, 51 J r
h
7
t
e
/
51 J r
f
7
t
e
t
, e
/
51 J r
h
7
t
51 J r
f
7
t
(V. (-$ERE3$ R?$E 0?R($= _(R0`
Hor!ard rate differential , (nterest differential
H
t
, 51 J r
h
7
t
e
/
51 J r
f
7
t
V. A-B(?3ED H)R>?RD R?$E3 _AHR`
H
t
, ^
t
Ht G e
/
, ^
t
Ge
/
e
/
e
/
P(o*7'"#
1. Gi@en the follo!ing date calculate any arbitrage possibility is a@ailable
3pot rate& Rs .'.//1/ , + 1
: months for!ard rate& Rs .'.M/'/ , +1
?nnualiBed interest rate on : months dollar , M F
?nnualiBed interest rate on : months Rupees , 1' F
So7)t/o5
C17,)71t/o5 o: :o(81(0 0/::'('5t/17#
, HR G 3R C 9:/ .
3R Hor!ard contract period in days
, .'.M/'/ G .'.//1/ C 9:/
.'.//1/ 1M/
, 9.M1.' F
C17,)71t/o5 o: /5t'('#t 0/::'('5t/17#
(nterest differential , ?nnualiBed (nterest rate in (ndia G ?nnualiBed interest rate in A3
(nterest differential , 1' F N M F , .F
3ince interest differential is grater than for!ard rate differential an arbitrager shall
prefer in@estment in that country !here interest rate is higher. $hus, in@estment shall
be done in (ndia and funds shall be borro!ed from A3.
'1
Rudramurthy B.V
C17,)71t/o5 o: 1(*/t(19' !(o:/t
(t is assumed that + 1///// is borro!ed from A3 ban" at the rate of M F 0.a.
on@ert + 1///// into Rupees using spot rate of + 1 , Rs .'.//1/
$herefore + 1///// , 1///// C .'.//1/ , R# =200100
(n@est the abo@e sum in (ndia at the rate of 1' F 0.a. for : months
(nterest amount after : months , .'//1// C 1' F C :61' , Rs '4'//:
$otal amount at maturity , .'//1// J '4'//: , R# ==5210>
on@ert the abo@e Rupees to dollars
..4'1/: , + 1/./1:
.'.M/'/
Toan amount to be refund along !ith interest , 1///// J 51///// C /./M C :61'7
, +1/.///
?rbitrage profit , +1/./1: N +1/./// , +1:
?rbitrage profit 5F7 , 1: . C 1// , 0.01> B
1/////
'. Gi@en the follo!ing date calculate any arbitrage possibility is a@ailable
3pot rate& + 1 , Rs ...//9/
: months for!ard rate& +1 , Rs .4.//1/
?nnualiBed interest rate on : months Rupees , 1' F
?nnualiBed interest rate on : months Dollars , M F
So7)t/o5
C17,)71t/o5 o: :o(81(0 0/::'('5t/17#
, HR G 3R C 9:/ .
, .4.//1/ G ...//9/ C 9:/
...//9/ 1M/
, ..49: F
C17,)71t/o5 o: /5t'('#t 0/::'('5t/17#
(nterest differential , ?nnualiBed (nterest rate in (ndia G ?nnualiBed interest rate in A3
(nterest differential , 1' F N M F , .F
3ince for!ard rate differential is grater than interest differential, in@est in that
countryPs currency !hich is expected to appreciate. Dere in this case borro! in (ndia
and in@est in A3.
C17,)71t/o5 o: 1(*/t(19' !(o:/t
(t is assumed that Rs 1///// is borro!ed from (ndian ban" at the rate of 1' F 0.a.
on@ert Rs 1///// into Dollars using spot rate of + 1 , Rs ...//9/
$herefore + 1///// , 1///// a ...//9/ , M 22F3
'M
Rudramurthy B.V
(n@est the abo@e sum in A3 at the rate of M F 0.a. for : months
(nterest amount after : months , ''19 C M F C :61' , + K/.K'
$otal amount at maturity , ''19 J K/.K' , M 23>3.<2
on@ert the abo@e Dollars to Rupees
'9:9.K' C .4.//1/ , Rs 1/:91K
Toan amount to be refund along !ith interest , 1///// J 51///// C /.1' C :61'7
, Rs1/:///
?rbitrage profit , Rs1/:91K G Rs1/:/// , Rs 91K
?rbitrage profit 5F7 , 91K . C 1// , /.91K F
1/////
9. Gi@en the follo!ing date calculate any arbitrage possibility is a@ailable
3pot rate& b : , + 1 5b , Hrench Hranc7
: months for!ard rate& b :.//'/ , +1
?nnualiBed interest rate on : months A3D , 4 F
?nnualiBed interest rate on : months HHR , M F
So7)t/o5
C17,)71t/o5 o: :o(81(0 0/::'('5t/17#
, HR G 3R C 9:/ .
, :.//'/ G :.//// C 9:/
:.//// 1M/
, /./:1 F
C17,)71t/o5 o: /5t'('#t 0/::'('5t/17#
(nterest differential , ?nnualiBed (nterest rate in Hrance G ?nnualiBed interest rate in A3
(nterest differential , M F N 4 F , 9F
3ince interest differential is grater than for!ard rate differential an arbitrager shall
prefer in@estment in that country !here interest rate is higher. $hus, in@estment shall
be done in Hrance and funds shall be borro!ed from A3.
C17,)71t/o5 o: 1(*/t(19' !(o:/t
(t is assumed that + 1///// is borro!ed from A3 Ban" at the rate of 4 F 0.a.
on@ert + 1///// into Hrench Hranc using spot rate of + 1 , b :
$herefore + 1///// , 1///// C : , N >00000
(n@est the abo@e sum in Hrance at the rate of M F 0.a. for : months
(nterest amount after : months , :///// C M F C :61' , b './//
$otal amount at maturity , :///// J './// , N >2=000
on@ert the abo@e Hrench Hranc to Dollars
:'./// C :.//' , + 1/9K:4
'K
Rudramurthy B.V
Toan amount to be refund along !ith interest , 1///// J 51///// C /./4 C :61'7
, +1/'4//
?rbitrage profit , +1/9K:4 G +1/'4// , +1.:4.9.
?rbitrage profit 5F7 , 1.:4.9. . C 1// , 1..:4 F
1/////
.. ?ssume the buying rate for D# 5Dutch #ar"7 spot in -e! =or" is + /../
a7 >hat !ould you expect the price of A3D to be in GermanyE
b7 (f the dollar to be ;uoted in Germany at D# '.: ho! is the mar"et supposed
to reactE
So7)t/o5
a7 $he price of A3D in Germany is expected to be 51a/..7 , '.4 D#6+
b7 3ince dollar is cheaper in -e! =or", Buy dollar at the rate of '.4 D#6+ in
-e! =or" and sell the same in Germany at the rate of '.: D#6+ thus ma"ing
an arbitrage profit of D# /.16+.
4. =ou ha@e called your foreign exchange trader and as"ed for ;uotation on the spot,
1Nmonth, 9Nmonth and :Nmonth for!ard rate. $he trader has responded !ith the
follo!ing
+ /.'.1K6M1, 964, M61, 1961/
a7 >hat does this mean in terms of dollars per EurosE
b7 (f you !ished to buy spot Euros, ho! much !ould you pay in DollarsE
c7 (f you !anted to purchase spot A3D, ho! much !ould you ha@e to pay in
EuroE
d7 >hat is the premium or discount in the 1, 9, : month for!ard rate in annual
percentageE
So7)t/o5
a7 ?ssume you are buying Euros
3!ap points& N Hor!ard rates can be expressed by gi@ing spot rates and their
respecti@e s!ap points
E.g.1&N 964 in the abo@e problem indicates premium s!ap point since bid s!ap point is
lesser than as" s!ap point6offer s!ap point.
E.g.'&N M61 in the abo@e problem indicates discount s!ap point since bid s!ap point is
greater than as" s!ap point6offer s!ap point.
Hor!ard rate , 3pot rate J 0remium 3!ap point or
Hor!ard rate , 3pot rate G Discount 3!ap point
9/
0articulars Buying Rate )ffer Rate
3pot Rate /.'.1K /.'.M1
1 #onth Hor!ard Rate /.'.M' /.'.M:
9 #onth Hor!ard Rate /.'.11 /.'.1.
: #onth Hor!ard Rate /.'.:: /.'.11
Rudramurthy B.V
b7 Q5../9/:6../99K76A3D
3pot Euros can be bought at ban"ers offer rate of + /.'.M16Q
-ote& N ustomerPs buying rate !ill be ban"erPs selling rate and customerPs selling
rate !ill be ban"erPs buying rate.
c7 0urchase of spot A3D can be made at ban"erPs offer rate of Q../99K6+
d7 alculation of Hor!ard premium or discount
1Nmonth Hor!ard premium
, HR G 3R C 9:/ .
, /.'.M: G /.'.M1 C 9:/
/.'.M1 9/
, '..' F
9Nmonth Hor!ard discount
, HR G 3R C 9:/ .
, /.'.1. G /.'.M1 C 9:/
/.'.M1 K/
, 1.19 F
:Nmonth Hor!ard discount
, HR G 3R C 9:/ .
, /.'.11 G /.'.M1 C 9:/
/.'.M1 1M/
, /.M/: F
:. ?n ?merican firm purchases + ./// !orth of perfume 5b '////7 from a Hrench
firm, the ?merican distributor must ma"e the payment in K/ days in Hrench Hranc
the follo!ing ;uotations and expectations exists for the Hrench Hranc
3pot rate , + /.'//, K/Nday for!ard rate , + /.''/, interest rate in A3 , 14 F,
interest rate in Hrance , 1/ F.
=our expectation of spot rate K/ days hence is + /.'./
a7 >hat is the premium on the for!ard Hrench HrancE >hat is the interest
rate differential bet!een Hrance and A3E (s there an incenti@e for co@ered
interest arbitrageE
91
Rudramurthy B.V
b7 (f there is a co@ered interest arbitrage ho! can an arbitrager ta"e ad@antage
of gi@en situation assume the arbitrager is !illing to borro! + ./// or
Hrench Hranc 5b7 '//// and there are no transaction costs.
c7 (f transaction costs are + 4/ !ould an opportunity still exists for co@ered
interest arbitrage.
d7 alculate the cost co@ered interest arbitrage and suggest !hether co@ered
interest arbitrage !as re;uired considering abo@e cost of hedging.
So7)t/o5
a7 alculation of Hor!ard premium on Hrench Hranc

, HR G 3R C 9:/ .
, /.''// G /.'/// C 9:/
/.'/// K/
, ./ F

alculation of interest differential
A3 interest rate per annum , 14 F
Hrance interest rate per annum , 1/ F
(nterest rate differential , 4 F
$here exists co@ered interest arbitrage opportunity since for!ard
differential and interest rate differential are not e;ual.
b7 3ince for!ard differential is grater than interest differential in@est in that
countryPs currency !hich is expected to appreciate thus borro! in A3 and
in@est in Hrance
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! + ./// in A3 at the rate of 14 F for K/ days.
'. on@ert the abo@e dollars into Hrench Hranc using spot rate.
, .///6/.'// , b '////
9. (n@est b '//// at the rate of 1/ F for K/ days in Hrance
(nterest , '//// C /.1/ C K/69:/ , 4//
0rincipal , '////
#aturity Value , '/4//
.. on@ert the abo@e amount to dollars using K/Nday for!ard rate.
, '/4// C /.''// , =510
9'
Rudramurthy B.V
4. alculate loan repayment amount
Toan (nterest , ./// C /.14 C K/69:/ , 14/
0rincipal amount , .///
Toan repayment , =150
:. ?rbitrage profit , + .41/ G + .14/ , + 9:/
c7 alculation of arbitrage profit after transaction cost
?rbitrage profit before transaction cost , + 9:/
Tess transaction cost , + /4/
?rbitrage 0rofit , M310
d7 alculation of arbitrage profit on unco@ered interest arbitrage
, b '/4// C /.'./ , + .K'/
?rbitrage profit , + .K'/ N + .14/ , + 11/
?rbitrage profit after transaction cost , + 11/ N + 4/ , + 1'/
ost of hedging , $ransaction cost J forgone profit
ost of hedging , 4/ J 511/ G 9:/7 , + .:/
1. (s co@ered interest arbitrage possible in the follo!ing situationE (f so calculate
arbitrage profit
a7 3pot rate anadian dollar , 1.9116A3D, anada interest rate , : F
:Nmonth for!ard rate , + 1.'K4/6A3D, A3 interest rate , 1/ F.
b7 3pot rate 1// =en , Rs 94.//', (ndian interest rate , 1' F
:Nmonth for!ard rate , Rs 94.K/1/61// =en, <apan interest rate , 1 F.
So7)t/o5
a7
Direct %uote , -r , Dome ountry .
Dr Horeign ountry
, HR G 3R C 9:/ . C 1//
, 1.911/ G 1.'K4/ C 9:/ C 1//
1.911/ K/
, 9.9. F
(nterest rate differential , 1/ G : , .F
St(1t'94: & (nterest rate differential Z Hor!ard rate differential
(n@est in A3 and borro! in anada
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! anadian + 1///// in anada at the rate of : F for 1M/ days
99
Rudramurthy B.V
'. on@ert the abo@e anadian dollars into A3D using spot rate.
, 1/////61.911 , 14K9/ A3D
9. (n@est b '//// at the rate of 1/ F for K/ days in Hrance
(nterest , 14K9/ C /.1/ C :61' , 91K:.4/
0rincipal , 14K9/ .
#aturity Value , 1K1':.4/
.. on@ert the abo@e amount to dollars using :Nmonth for!ard rate.
, 1K1': C 1.'K4/ , 1032=5.CM
Toan (nterest , 1///// C /.: C :61' , 9///
0rincipal amount , 1/////
Toan repayment , 103000
:. ?rbitrage profit , + 1/9'.4.M G + 1/9/// , + '.4.M
alculation of arbitrage profit in 0ercentage
, + '.: C 1// , /.'.: F
1/////
b7
alculation of Hor!ard rate differential
, HR G 3R C 9:/ . C 1//
, 94.K/1/ G 94.//' C 9:/ C 1//
94.//' K/
, 4.1. F
(nterest rate differential , 1' G 1 , 4F
St(1t'94: & (nterest rate differential [ Hor!ard rate differential
(n@est in <apan and borro! in (ndia
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! (ndian Rs 1///// in (ndia at the rate of 1' F for : months
'. on@ert the abo@e (ndian Rupees into =en using spot rate.
, 51///// C 1//7694.//' , c 'M4:KM
9.
Rudramurthy B.V
9. (n@est c 'M4:KM at the rate of 1 F for : months in <apan
(nterest , 'M4:KM C /./1 C :61' , KKKK
0rincipal , 'M4:KM .
#aturity Value , 'K4:K1
.. on@ert the abo@e amount to Rupees using :Nmonth for!ard rate.
, 'K4:K1 C 94.K/1/61// , R# 10>15
Toan (nterest , 1///// C /.1' C :61' , :///
Toan repayment , 10>000
:. ?rbitrage profit , Rs 1/:14M G Rs 1/:/// , Rs 14M
alculation of arbitrage profit in 0ercentage
, Rs 14M C 1// , /.14M F
1/////
M. 3pot ;uotation of 3ingapore + is Rs '4. (nterest rate in 3ingapore is : F and
interest rate in (ndia is 1/ F. >hat shall be the for!ard rate a year latter, also
calculate '1/Nday for!ard rate.
So7)t/o5
alculation of 1Nyear for!ard rate using (nterest rate parity theory
e
t
, e
/
51 J r
hc
7
t
51 J r
fc
7
t
e
t
, '4 51 J /.1/7
1
51 J /./:7
1

HR , Rs '4.K.
alculation of '1/Nday for!ard rate using (nterest rate parity theory
e
t
, e
/
51 J r
hc
7
t
t , '1/69:/ , /.14
51 J r
fc
7
t
e
t
, '4 51 J /.1/7
/.14
51 J /./:7
/.14

HR , Rs '4.1/.:
K. alculate Hor!ard rate using the follo!ing data
P1(t/,)71(# I50/1 USA
ost of Dairy #il" Rs ./ + 1
(nflation 1/ F : F
94
Rudramurthy B.V
So7)t/o5
3pot rate + 1 , Rs ./
HR , 3R 51 J r7
n
HV , 0V 51 J r7
n
HR , ./ 51 J /.1/7
1
.. , 0V 51 J /./:7
1
HR , Rs .. 0V , ..61./: , .1.4/K
alculation of 1Nyear for!ard rate using (nterest rate parity theory
e
t
, e
/
51 J r
hc
7
t
51 J r
fc
7
t
e
t
, ./ 51 J /.1/7
1
51 J /./:7
1

HR , Rs .1.4/K
1/. Hollo!ing are rates ;uoted in #umbai for British 0ound Rs6B0 , 4'.:/61/ and
three month for!ard rate '/61/, interest rate in (ndia is M F, interest rate in
Tondon is 4 F. Verify !eather there is any scope for o@ered interest arbitrage if
you borro! in R3 5(ndia7.
So7)t/o5
3pot rate& Rs6B0 , 4'.:/61/ , 4'.:/64'.1/
Hor!ard rate& Rs6B0 , 4'.M/649../
St(1t'94& Borro! in (ndia and in@est in Tondon
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! Rs 1///// in (ndia at the rate of M F for 9 months
'. on@ert the abo@e (ndian Rupees into 0ounds using spot rate.
, 1/////64'.1/ , 8 1MKM
9. (n@est 8 1MKM at the rate of 4 F for 9 months in A2
(nterest , 1MKM C /./4 C 961' , '9.19
0rincipal , 1MKM .
#aturity Value , 1K'1.19
.. on@ert the abo@e amount to Rupees using 9Nmonth for!ard rate.
, 'K4:K1 C 4'.M/ , R# 101=>F
Toan (nterest , 1///// C /./M C 961' , '///
:. ?rbitrage profit , Rs 1/1.:1 G Rs 1/'/// , N Rs 499
9:
Rudramurthy B.V
St(1t'94& Borro! in Tondon and in@est in (ndia
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! 8 1///// at the rate of 4 F for 9 months
'. on@ert the abo@e Tondon 0ounds into Rupees using spot rate.
, 1///// C 4'.:/ , Rs 4':////
9. (n@est Rs 4'://// at the rate of M F for 9 months in (ndia
(nterest , 4'://// C /./M C 961' , 1/4'//
0rincipal , 4':////
#aturity Value , 49:4'//
.. on@ert the abo@e amount to 0ounds using 9Nmonth for!ard rate.
, 49:4'// a 4'../ , O 100=F1.<1
Toan (nterest , 1///// C /./4 C 961' , 1'4/
:. ?rbitrage profit , Rs 1//.11.K1 G Rs 1/1'4/ , N Rs 11M./M
-ote& N o@ered (nterest ?rbitrage !ith t!oN!ay ;uote should be done using trial and
error methodO both strategies can gi@e loss because of PSPREADQ
11. Hind cross rates from the follo!ing information
a7 +68 , 1.4'./, c68 , '94.'/, c6+ ,E
b7 Q68 , '.414/, Q6$ , '/4.M/, $68 ,E
c7 +68 , 1.449164K, Q6+ , /.1KM'6K', Q68 ,E
d7 +68 , './/1469/, +63HR , /.:K:461/, 863HR ,E
So7)t/o5
a7 c , c C 8 , '94.'/ C 1 . , 14..99/
+ 8 + 1.4'./
b7 $ , $ C Q , 1 . C '.414/ , /./1''
8 Q 8 '/4.M/
c7 Q , Q C + , 5/.1KM' C 1.44917 6 5/.1KK' C 1.444K7. , /.9/1K6/.9/KK
8 + 8
d7 8 , 8 C + , _5'.//9/7
N1
C /.:K:4`6 _5'.//147
N1
C /.:K1/` , /.9.11 6 M'
3HR + 3HR
91
Rudramurthy B.V
1'. ? foreign exchange trader ;uotes for Belgium Hranc spot, 1Nmonth, 9Nmonth and
:Nmonth for!ard rate to A3 based treasurer
+ /./'.1M6M/, .6:, K6M, 1.611
a7 alculate the outright ;uote for 1, 9, : month for!ard.
b7 (f treasurer !ished to buy Belgium Hranc 9Nmonths for!ard, ho! much !ould
you pay in DollarsE
c7 (f you !anted to purchase A3D 1Nmonth for!ard, ho! much !ould you ha@e
to pay in Belgium HrancE
d7 ?ssuming Belgium Hranc !as brought !hat is the premium or discount in the
1, 9, : month for!ard rate in annual percentageE
e7 >hat do the abo@e ;uotations imply in respect of term structure of interest in
A3? and BelgiumE
So7)t/o5
a7 ?ssume you are buying Euros
3!ap points& N Hor!ard rates can be expressed by gi@ing spot rates and their
respecti@e s!ap points
E.g.1&N .6: in the abo@e problem indicates premium s!ap point since bid s!ap point is
lesser than as" s!ap point6offer s!ap point.
E.g.'&N K6M in the abo@e problem indicates discount s!ap point since bid s!ap point is
greater than as" s!ap point6offer s!ap point.
Hor!ard rate , 3pot rate J 0remium 3!ap point or
Hor!ard rate , 3pot rate G Discount 3!ap point
b7 $he treasurer can buy Belgium Hranc 9Nmonth for!ard at his bid rate of
+ /./'.:K6Belgium Hranc
-ote& N ustomerPs buying rate !ill be ban"erPs selling rate and customerPs selling
rate !ill be ban"erPs buying rate.
c7 + /./'.M'6M: for 1BHr
BHr , 516/./'.M: G 16/./'.M'7 per +
BHr , 5./.''4'N'K/17 per +
d7 alculation of Hor!ard premium or discount
, HR G 3R C 9:/ .
9M
0articulars Buying Rate )ffer Rate
3pot Rate /./'.1M /./'.M/
1 #onth Hor!ard Rate /./'.M' /./'.M:
9 #onth Hor!ard Rate /./'.:K /./'.1'
: #onth Hor!ard Rate /./'.:. /./'.:K
Rudramurthy B.V
, /./'.M' G /./'.1M C 9:/
/./'.1M 9/
, 1.K. F
9Nmonth Hor!ard discount
, HR G 3R C 9:/ .
, /./'.1M G /./'.:K C 9:/
/./'.1M K/
, 1..4 F
:Nmonth Hor!ard discount
, HR G 3R C 9:/ .
, /./'.1M G /./'.:. C 9:/
/./'.1M 1M/
, 1.19 F
e7 3pot to 1Nmonth for!ard
3ince dollar is depreciating from spot to 1Nmonth for!ard, interest rate
in A3 is higher compared to interest rate in Belgium.
3pot to 9Nmonth for!ard
3ince dollar is appreciating from spot to 9Nmonth for!ard, interest rate
in Belgium is higher compared to interest rate in A3
3pot to :Nmonth for!ard
3ince dollar is appreciating from spot to 9Nmonth for!ard, interest rate
in Belgium is higher compared to interest rate in A3
19. Dutch #ar" spot !as ;uoted at +/..6D# in -e! =or", the price of 0ound 3terling
!as ;uoted at +1.M68
a7 >hat !ould you expect the price of 0ound to be in GermanyE
b7 (f the 0ound !ere ;uoted in Hran" Hort at D# .../68 !hat !ould you do
to profit from the abo@e situation
So7)t/o5
e7 D# , D# C + , 1 . C 1.M , ..4
8 + 8 /..
f7 Buy 1 pound for D# ... in Hran" Hort and !ith the abo@e pound buy +1.M/ in
-e! =or" and !ith the abo@e dollars buy D# ..4 in Germany thus arbitrage
!ill ma"e profit of D# /.1 for an in@estment of D# .../
?rbitrage profit in 5F7 , /.16... C 1// , '.'1 F
9K
Rudramurthy B.V
3electi@e Dedging
1.. ?n (ndian ompany ?B limited imports machinery !orth of 8 ' million and is to
ma"e the payment after : months the current rates are
3pot rate , Rs::.K:68
:Nmonth for!ard rate ,Rs:1.4/68
a7 >hat should ?B limited do if they expect that in : months time the pound
!ill settle at Rs:1.1468E
b7 >hat are the options a@ailable to the company in case of an expected
appreciation or depreciation in RupeeE
So7)t/o5
a7 (n the case of recei@able exposure if HR 5Hor!ard Rate7 Z H30 5Hor!ard 3pot
Rate7 hedge your position !here as incase of payable position if HR Z H30 do
not hedge your position.
(n the abo@e problem ?B limited has payable exposure and since HR Z
H30, do not hedge your position
b7 (f Rupee appreciates 58 is depreciating7 no hedging
(f Rupee depreciates 58 is appreciating7 hedging is re;uired.
14. Brun Derbal products located in (ndia is an old line producer of herbal teas and
medicines, their products are mar"eted throughout (ndia and Europe
Brun Derbal generally in@oices in rupees !hen it sells to foreign customers in
order to guard against exchange rate changes ho!e@er company has recei@ed an
order from large !holesaler in Hrance for b ./ la"hs of its product. $he condition
is that the deli@ery should be in 9 months time and order in@oiced in Hrench Hranc.
$he manager decides to contact firmPs ban"ers for suggestions about hedging the
exchange rate exposure.
$he ban"er informs company that spot rate is 1 b , Rs :.:/ thus in@oice
amount should be Rs ':./////. $he K/Nday for!ard rate for Rs and b and A3D
are 1b , Rs :.4/ and 1+ , .'./'M9. $he ban"er offers to setup Hor!ard hedge for
selling HHr recei@able for Rupee based on cross for!ard exchange rates implicit in
for!ard rate against dollar, !hat !ould be your decision if you !ere manager of
Brun DerbalE 3ho! the rele@ant calculations
(nterest rates in (ndia and Hrance are K F 0a and 1' F 0a respecti@ely.
So7)t/o5
3electi@e hedging 5recei@able position7
H30 Z HR do not hedge
H30 [ HR hedge
alculation of expected future spot price according to (R0
(nterest rate differential , Hor!ard differential
(nterest rate differential , 1'F N KF , 9 F
Hor!ard rate for K/ days should be calculated
N9 F , x G :.: C 9:/ C 1//
:.: K/
x G :.: , N9 C :.:
. C 1//
x G :.: , N/./.K4
./
Rudramurthy B.V
x , :.44/4
i.e. K/Nday for!ard for 1b , Rs :.44/4
Dence it !ould be ad@isable for the company not to hedge its ris" by selling
Hrench Hranc for!ard. Expected spot price 51b , Rs :.44/47 is greater than
for!ard rate 51b , Rs :.47
1:. (n Hran" Hort the Hrench Hranc is selling for D# /..9.9 spot and the 9Nmonth
for!ard rate is D# /..9//. $he 9Nmonth Euro D# inter ban" rate is 4.14 F and
the Euro Hrench inter ban" rate is K F.
a7 ?re exchange rate and money mar"et rate in e;uilibriumE >hyE
b7 (s there any !ay to ta"e ad@antage of the situationE (f so ho!E
c7 >hat rate trends !ould appear in the mar"et if a large number of operators
too" the action indicated in 5B7 abo@eE
So7)t/o5
a7 alculation of interest rate differential
9Nmonth EuroND# inter ban" rate , 4.14 F
9Nmonth EuroNHHr inter ban" rate , K F .
(nterest differential , 9.'4 F
alculation of Hor!ard discount

, HR G 3R C 9:/ .
, /..9.9 G /..9// C 9:/
/..9.9 K/
, 9.K: F
3ince interest rate differential is not e;ual to for!ard rate differential there
exists no e;uilibrium bet!een exchange rate and money mar"et.
b7 3ince there is no e;uilibrium bet!een exchange rates and money mar"et there
exists arbitrage opportunity.
3trategy& N Borro! in Hrance and in@est in Germany.
1. Borro! b 1///// at the rate of K F pa for 9 months
'. on@ert the abo@e Hrench Hranc into Dutch #ar" using spot rate.
, 1///// C /..9.9 , D# .9.9/
9. (n@est D# .9.9/ at the rate of 4.14 F for 9 months
(nterest , 4'://// C /./414 C 961' , :'.
0rincipal , .9.9/
#aturity Value , ../4.
.. on@ert the abo@e amount to Hrench Hranc using 9Nmonth for!ard
rate.
, 49:4'// a /..9 , N 102=51
.1
Rudramurthy B.V
Toan (nterest , 1///// C /./K C 961' , ''4/
:. ?rbitrage profit , b 1/'.41 G b 1/''4/ , b '/1
c7 Targe number of operators by ta"ing arbitrage opportunity as indicated in WbP
abo@e brings bac" the e;uilibrium in exchange rate and money mar"et there by
no further arbitrage opportunity exists.
11. ? trader !or"s for -e! =or" ban", the spot exchange rate against anadian dollar
is A3D /.KK:M and 1Nmonth and 1Nyear for!ard rates are A3D /.KKM4 and A3D
1./1:: respecti@ely. $!el@eNmonth interest rate in A3? and anada may be ta"en
as :..4 F and ...: F respecti@ely.
a7 >hat is the for!ard premium as annual percentageE
b7 >hich currency is at a premiumE >hyE
$he trader becomes party to some insider information !hich suggests
the A3 interest rate !ill rise by 1 F pa during the next month. $he
ban" has a rule that in foreign exchange mar"ets UBuy e;uals 3ellV this
means that for any currency the total of long positions must be e;ual to
the total of short positions but this aggregation disregards maturity.
c7 (ndicate the mechanism of t!o operations by !hich you may trade in
expectation of profit for the ban". 3hould the insider information turns out
to be !ell founded
So7)t/o5
a7 alculation of Hor!ard premium or discount
, HR G 3R C 9:/ .
, /.KKM4 G /.KK:M C 9:/
/.KK:M 9/
, './4 F........................................................... 517
1Nyear Hor!ard premium
, HR G 3R C 9:/ .
, 1./1:: G /.KK:M C 9:/
/.KK:M K/
, 1.KK F
.'
Rudramurthy B.V
b7 anadian dollar is at premium because 1Nmonth for!ard and 1Nyear for!ard is
grater than spot rate
urrent interest rate in A3 , :..4 F
J Expected increase based on insider information , 1 F .
, 1..4 F
alculation of interest rate differential
Expected interest rate in A3 , 1..4 F
(nterest rate in anada , ...: F
(nterest rate differential , '.KK F........................ 5'7
c7 (nterest rate differential , '.KK F 5from 5'77
1Nmonth for!ard differential in anada , './4 5from 5177
3ince interest rate differential is grater than for!ard differential
arbitrage opportunity exists
3trategy& NBorro! in anada and in@est in A3.
C17,)71t/o5 o: 1(*/t(19' !(o:/t
1. Borro! + 1///// at the rate of ...: F for 1 month
'. on@ert the abo@e anadian Dollars into A3D using spot rate.
, 1///// C /.KK:M/ , + KK:M/
9. (n@est A3 + KK:M/ at the rate of 1..4 F for 1 month in A3
(nterest , KK:M/ C /./:.4 C 161' , :1M.M4
0rincipal , KK:M/ .
#aturity Value , 1//'KK
.. on@ert the abo@e amount to + using 1Nmonth for!ard rate.
, 1//'KK a /.KKM4 , +1//..K.4
Toan (nterest , 1///// C /./..: C 161' , 91'
Toan repayment , 1003F2
:. ?rbitrage profit , + 1//..K.4 G + 1//91' , + 11.4
.9
Rudramurthy B.V
1M. =our company has to ma"e A3D ' million payment in 9 months time, the dollars
are a@ailable no!. =ou decide to in@est them for 9 months and you are gi@en the
follo!ing information.
$he A3 deposit rate is M F pa
$he sterling deposit rate is K F pa
$he spot expected rate is + 1.M168
$he 9Nmonth for!ard rate is + 1.1M68
a7 >here should your company in@est for better returnsE
b7 ?ssume that the A3 interest rates and the spot expected return remain as
abo@e, !hat for!ard rate !ould yield an e;uilibrium situationE
c7 ?ssuming that the A3 interest rate, 3pot and for!ard rates remains as in the
original ;uestion, !here !ould you in@est if the sterling deposit rate is
1. F paE
d7 >ith the originally stated spot and for!ard rates and the same dollar deposit
rate, !hat is the e;uilibrium sterling deposit rateE
So7)t/o5
a7 ?lternati@e 1& N
(n@est A3D 1 million in A3 at the rate of M F pa for 9 months
(nterest income , 1 million C M F C 961' , A3 +'////
?lternati@e '&N
(n@est in Tondon at the rate of 1/ F pa for 9 months
1. on@ert 1 million A3D into e;ui@alent pounds using spot rate.
, 1////// a 1.M , 8 44444:
'. (n@est 8 44444: at the rate of 1/ F pa for 9 month
(nterest , 44444: C /.1/ C 961' , 19MMK
0rincipal , 44444: .
#aturity Value , 4:K..4
9. on@ert the abo@e amount to A3D using for!ard rate.
, 4:K..4 C 1.1M , +1/19:1'
.. 0rofit or gain , + 1/19:1' G + 1////// , + 19:1'
Co5,7)#/o5: & (n@est in A3 since gain is more !hen compared to Tondon
b7 (nterest rate in A3 is M F pa
(nterest rate for sterling deposit is 1/ F pa
(nterest rate differential , 1/ F N M F , ' F
Expected spot rate is
N' F , x G 1.M C 9:/ C 1//
1.M K/
x G 1.M , N' C 1.M
..
Rudramurthy B.V
. C 1//
x G 1.M , N/.//K
x , + 1.1K
E@!',t'0 :)t)(' #!ot (1t' , + 1.1K
c7
17 (n@est 8 44444: at the rate of 1. F pa for 9 month
(nterest , 44444: C /.1. C 961' , 1K....4
0rincipal , 44444: .
#aturity Value , 414///.4
'7 on@ert the abo@e amount to A3D using for!ard rate.
, 414/// C 1.1M , + 1/'94//
97 0rofit or gain , + 1/'94// G + 1////// , + '94//
Co5,7)#/o5: & (n@est in Tondon if the sterling deposit rate is 1. F
d7 C17,)71t/o5 o: 'E)/7/*(/)" #t'(7/59 (1t'
alculation of Hor!ard rate differential

, HR G 3R C 9:/ . C 1//
, 1.1M G 1.M C 9:/ C 1//
1.M K/
, .... F
(nterest in Tondon , (nterest in A3 J HRD
, M F J ... F
, 1'... F
A7t'(51t/R' "'t6o0
8 44444: J x F , + 1/'////
i.e. at !hat rate if !e in@est 8 44444: in Tondon for 9 months after con@erting the
gain into A3D should be + 1/'//// then only attain a sterling deposit rate
e;uilibrium
1/'//// a 1.1M , 8 419/99
44444: J x F , 419/99
x F , 419/99 G 44444:
x F , 11.1M
Hor 8 44444: ,,,,,,,, interest amount is 8 11.1M
.4
Rudramurthy B.V
Hor 8 1// , 1// C 11.1M , 9.14 F
44444:
?nnualiBed sterling deposit rate is 9.14 F C . , 1'.: F
1K. alculate the nominal interest rates using Hisher effect from the follo!ing data
gi@en belo!
Real interest rate , M F
(nflation rate , 9.4 F
So7)t/o5
r , a J i J ai
>here r , nominal interest rate, a , real interest, i , inflation rate
r , M F J 9.4 F J 5M C 9.47
r , /.111M or r , 11.1M F
.:
Rudramurthy B.V
Fo('/95 E@,6159'A'@!o#)(' Rt)C R/#3 M1519'"'5t
Exposure& N Exposure refers to the le@el of commitment and degree to !hich a
company is affected by exchange rate mo@ements.
$ypes of Exposure
1. ?ccounting Exposure6$ranslation Exposure
'. Economic Exposure
a7 )perating Exposure
b7 $ransaction Exposure
A,,o)5t/59 E@!o#)('& N (t is also called as translation exposure !here in the
measurement of exposure is retrospecti@e in nature. (t is based on the past acti@ities
and it measures the effect of exchange rate changes on published financial statements,
it effects both income statement and balance sheet statement.
E,o5o"/, E@!o#)('& N )perating exposure and transaction exposure together
constitutes a firmPs economic exposure. (t is the extent to !hich the @alue of the firm
measured by its present @alue of expected cash flo! changes !ith changes in
exchange rate mo@ements 5i.e. -0V7.
O!'(1t/59 E@!o#)('& N (t measures the extent to !hich currency exposure can
alter a companyPs future operating cash flo!s the measurement of operating
exposure is prospecti@e in nature and it is based on future acti@ities of the firm it
affects re@enues and costs associated !ith future sales.
T(15#1,t/o5 E@!o#)('& N (t arises due to changes in the @alue of outstanding
foreign currency denominated contracts. $he measurement of transaction
exposure is both retrospecti@e and prospecti@e in nature because it is based on
acti@ities that occurred in the past but !ill be settled in the future.
M't6o0# o: A,,o)5t/59 E@!o#)(' AT(15#71t/o5 E@!o#)('C
1. C)(('5t 150 No5 C)(('5t M't6o0
Ander this method all current assets and current liabilities of foreign
affiliated are translated into home currency at the current exchange rate !hile
.1
Rudramurthy B.V
the non current assets and non current liabilities are translated at historical
rate.
2. Mo5't1(4 150 No5 Mo5't1(4 "'t6o0
?ccording to this method all monetary assets and monetary liabilities
are translated at current rates !here as non monetary assets and non monetary
liabilities are translated at historical rates.
#onetary items are those items !hich represent a claim to recei@e or
an obligation to pay a fixed amount of foreign currency units.
Eg& N ash, accounts recei@able 5Debtors J Bills Recei@able7, accounts
payable 5reditors J Bills 0ayable7, other current liabilities, long term debts
etc.
-on #onetary items are those items that do not represent a claim to
recei@e or an obligation to pay a fixed amount of foreign currency units.
Eg& N 3toc", fixed assets, e;uity shares, preference shares etc.
9. T'"!o(17 M't6o0
(t is a modified @ersion of monetary and non monetary method the only
difference bet!een monetary and non monetary method is valuation of stock.
Ander monetary and non monetary method, stoc" is considered as non
monetary assets and it is @alued at historical rate !here as under temporal
method stoc" is @alued at historical rate if it is sho!n at cost price or @alued at
current rate if it is sho!n at mar"et price.
.. C)(('5t R1t' M't6o0
Ander this method all balance sheet items are translated at current
exchange rate except for shareholders e;uity 53hare apital J Reser@e d
3urplus7 !hich is translated at historical rate.
E@,6159' R1t' )50'( A,,o)5t/59 E@!o#)(' M't6o0
(tems urrent6 -onN
current #ethod
#onetary6-onN
monetary #ethod
$emporal
#ethod
urrent Rate
#ethod
ash R R R R
Recei@ables R R R R
(n@entory R DR DR 6R R
Hixed ?ssets DR DR DR R
0ayables R R R R
Tong term
Debt
DR R R R
.M
Rudramurthy B.V
-et !orth DR DR DR DR
R , urrent Rate, DR , Distorical Rate
0roblems
1. ?ssume that a foreign subsidiary of A3 multinational has the follo!ing
P1(t/,)71(# A"o)5t
ash H 1//
?ccount Recei@able H 14/
(n@entory H '//
Hixed ?ssets H '4/
urrent Tiabilities H 1//
Tong term Debt H 9//
-et !orth H 9//
?ssume historical exchange rate is +' , H 1, current exchange rate is
+1, H 1 and in@entory is carried at mar"et price. alculate the gain or loss
under different translation methods.
So7)t/o5
P1(t/,)71(# FC
C)(('5t S
No5 C)(('5t
Mo5't1(4 S
No5
Mo5't1(4
T'"!o(17 C)(('5t R1t'
A
#
#
'
t
#
ash 1// 1// C1 , +1// 1// C1 , +1// 1// C1 , +1// 1// C1 , +1//
?ccount
Recei@ables
14/ 14/ C1 , +14/ 14/ C1 , +14/ 14/ C1 , +14/ 14/ C1 , +14/
(n@entory '// '// C1 , +'// '// C' , +.// '// C1 , +'// '// C1 , +'//
Hixed ?ssets '4/ '4/ C' , +4// '4/ C' , +4// '4/ C' , +4// '4/ C' , +'4/
$? a6c balance N $350 - $50 $300
Tot17 F00 M1300 M1150 M1000 M1000
L
/
1
*
/
7
/
t
/
'
#
urrent Tiabilities 1// 1// C1 , +1// 1// C1 , +1// 1// C1 , +1// 1// C1 , +1//
Tong term Debt 9// 9// C1 , +9// 9// C1 , +9// 9// C1 , +9// 9// C1 , +9//
-et !orth
9// 9// C' , +:// 9// C' , +:// 9// C' , +:// 9// C' , +://
.K
Rudramurthy B.V
$? a6c balance N N $150 N N
Tot17 F00 M1300 M1150 M1000 M1000
'. Harm products is anadian affiliate of A3 manufacturing company, its balance
sheet in thousands of anadian dollar for /16/16'//1 is sho!n belo!
L/1*/7/t/'# CANM A##'t# CANM
urrent Tiabilities
Tong term Debt
apital 3toc" 5-et !orth7
:////
1:////
:'////
ash
?ccount Recei@ables
(n@entory
-et 0lant d #achinery
1/////
''////
9'////
'/////
Tot17 =0000 Tot17 =0000
$he Expected return as on /16/16'//1 !as ?-+ 1.: per A3D determine
Harm product accounting exposure on /16/16'//M using current rate method and
monetary and nonNmonetary method.
alculate Harm product contribution to its parents accounting loss if the
expected return on 9161'6'//1 !as ?-+ 1.M per A3D. ?ssume all account to
remain as they !ere in beginning of the year.
So7)t/o5
P1(t/,)71(# CANM C)(('5t R1t'
Mo5't1(4 S No5
Mo5't1(4
A
#
#
'
t
#
ash 1///// a 1.M , + 4444: a 1.M , + 4444:
?ccount
Recei@ables
''//// a 1.M , + 1''''9 a 1.M , + 1''''9
(n@entory 9'//// a 1.M , + 11111M a 1.: , + '/////
-et 0lant d
#achinery
'///// a 1.M , + 111111 a 1.: , + 1'4///
$? a6c balance N $ 43054 $ 6943
Tot17 M 50<F22 M 50<F22
L
/
1
*
/
7
/
t
/
'
#
urrent Tiabilities ://// a 1.M , 99999 a 1.M , 99999
Tong term Debt 1://// a 1.M , MMMMK a 1.M , MMMMK
-et !orth :'//// a 1.: , 9M14// a 1.: , 9M14//
$? a6c balance N N N
4/
Rudramurthy B.V
Tot17 M 50<F22 M 50<F22
alculation of ?ccounting Exposure under urrent rate method
?ccounting Exposure , 5Exposed assets G Exposed liabilities7 except $? a6c
?ccounting Exposure , + .:::::.:1 N + 1'''''.''
?E , + 9.......4
alculation of ?ccounting Exposure under #onetary d -on monetary method
?ccounting Exposure , 5Exposed assets G Exposed liabilities7 except $? a6c
?ccounting Exposure , + 11111M N + 1'''''
?E , + 4444:
Not': &
Exposed assets are those assets !hich are exposed to exchange rate
fluctuations 5Valued at current rate7.
Exposed liabilities are those liabilities !hich are exposed to exchange
rate fluctuations 5Valued at current rate7.
T(15#1,t/o5 E@!o#)('
$ransaction exposure form the possibility of incurring future exchange gains
or losses on transaction already entered in and denominated in foreign currency.
9. 3uppose Boing airlines sell ?N1.1 to Garuda, the (ndonesian airlines in Rupaiah
5R
0
7 at a price of R
0
1./ billion. $o help to reduce the impact on (ndonesian
balance of payment Boing agrees to buy parts from @arious (ndonesian companies
!orth R
0
44 billion
a7 (f the spot rate is + /.//.6R
0
!hat is BoingPs net Rupaiah transaction
exposureE
b7 (f the Rupaiah depreciates + /.//946R
0
!hat is BoingPs transaction
lossE
So7)t/o5
a7 BoingPs net Rupaiah transaction exposure , 5R
0
1./ N R
0
447 billion
D R
0
M4 billion 5recei@able exposure7
-et transaction exposure in + , R
0
M4 billion C + /.//.
-$E , + /.9. billion recei@able exposure
b7 $ransaction loss , R
0
M4 billion C 5/.//. G /.//947
$ransaction loss , R
0
M4 billion C /.///4
$ransaction loss , + /./.'4 billion
41
Rudramurthy B.V
HEDGING
Dedging is a particular currency exposure, means establishing an offsetting
currency position so as to loc" in the home currency @alue for the currency exposure
and eliminate currency fluctuation ris".
P(o*7'"#
1. (n #arch multinational industry incorporation assesses the 3eptember spot
rate for 3terling at the follo!ing rates
+ 1.9/68 !ith probability /.14
+ 1.9468 !ith probability /.'/
+ 1../68 !ith probability /.'4
+ 1..468 !ith probability /.'/
+ 1.4/68 !ith probability /.'/
a7 >hat is the expected spot rate for 3eptemberE
b7 (f :Nmonth for!ard rate is +1../ should the firm sell for!ard its pound 4/////
recei@able
c7 During recei@able !hat factors are li"ely to affect multinational industry
hedging decision
So7)t/o5
a7 alculation of expected spot rate for the month of 3eptember
Expected 3pot Rate 5*7 0robability 507 * C 0
+ 1.9/
+ 1.94
+ 1../
+ 1..4
+ 1.4/
/.14
/.'/
/.'4
/.'/
/.'/
/.1K4
/.'1/
/.94/
/.'K/
/.9//
Tot17 M1.=05%O
Expected spot rate for the month of 3eptember is M1.=05%O
b7 ash inflo! by hedging
8 4///// C +1../ , + 1/////
ash inflo! by not hedging
8 4///// C +1../4 , + 1/'4//
3trategy& Do not hedge
ost of hedging& + '4//
c7 During Recei@able factors that li"ely affect multinational industry hedging are
4'
Rudramurthy B.V
Ris" bearing capacity of firm
?ccuracy of Estimation
E@!o#)(' N'tt/59& N (t refers to offsetting exposure in one currency !ith exposure in
the same or another currency !hose exchange rates are expected to mo@e in a !ay
such that loss or gain on first exposed position !ill be offset by gain or loss in the
second exposed position
Eg& N (f ? limited has + 1//// recei@able position and + :/// payable position both
for 9 months exposure netting can be done and it is enough if ? limited hedges for
+ ./// recei@able positions
C'5t(17/T'0 R%# D','5t(17/T'0 H'09/59
entraliBed hedging refers to total corporate exposure hedged as a totality
instead of each indi@idual hedging !here specific exposure are hedged at branch
le@els !hich is referred to as decentraliBed hedging.
entraliBed hedging reduces cost of hedging because of netting ho!e@er
centraliBed hedging re;uires strong real time information ;ualified and trained
employees to operate real time system etc.
$hus before deciding for centraliBed or decentraliBed hedging a detailed cost
benefit analysis should be underta"en i.e. if the cost of implementation, then go for
centraliBed hedging or else decentraliBed hedging is a better option.
M't6o0# :o( "1519/59 T(15#71t/o5 E@!o#)(' AA,,o)5t/59 E@!o#)('C
1C A0+)#t'0 :)50 :7o8#: & (t in@ol@es altering either the amount of currencies or
both cash flo!s of parent or subsidiary to reduce the firmPs local currency
exposure
(f local currency de@aluation is expected then exports are priced in
hard currency 5Horeign currency7 and imports are priced in soft currency
5Tocal currency7.
)ther techni;ues li"e in@esting in hard currency replacing hard
currency borro!ing !ith soft currency loans etc are also considered.
2C E5t'(/59 /5to :o(81(0 ,o5t(1,t#: & (t demands a formal mar"et in the
respecti@e local currency. Hor!ard contract creates an offsetting asset or
liability in the foreign currency, the gain or loss on the transaction exposure is
offset by a corresponding loss or gain in for!ard mar"et.
(f a firm cannot find a for!ard mar"et for currency in !hich it has
exposure it can hedge such ris" through a for!ard contract on a related
currency !hose relationship is estimated by examining historical currency
fluctuations bet!een actual and related currency.
3C E@!o#)(' 5'tt/59: & (t refers to offsetting exposure in one currency !ith
exposure in the same or another currency !hose exchange rates are expected
49
Rudramurthy B.V
to mo@e in a !ay such that loss or gain on first exposed position !ill be offset
by gain or loss in the second exposed position.
M1519/59 T(15#1,t/o5 E@!o#)('
$ransaction exposure can be managed by using
0rice adIustment
Hor!ard mar"et
#oney mar"et
urrency option
Borro!ing or lending in foreign currency etc.
Fo(81(0 "1(3't 6'09' R%# "o5'4 "1(3't 6'09'
(n a for!ard mar"et hedge a company that is long 5buy7 on foreign currency
!ill sell foreign currency for!ard !here as a company that is short 5sell7 on foreign
currency !ill buy the foreign currency for!ard. (n this !ay the company can fix the
home currency @alue of future foreign currency cash flo!.
Dedging !ith for!ard contract eliminates the do!nside ris"s at the expense of
foregoing upside potentials 5cost of hedging7.
#oney mar"et hedge is alternati@e to for!ard mar"et hedge !hich in@ol@es
simultaneous borro!ing and lending acti@ities in t!o different currencies to loc" in
home currency @alue of a future foreign currency cash flo!. $he effecti@e rate on
for!ard contract !ill e;ual the actual for!ard rate if interest parity holds.
P(o*7'"#
'. 0epsi ompany !ould li"e to hedge its ?- + ./ million payable to W?P
limited, a anadian aluminum producer !hich is due in K/ days suppose it
faces the follo!ing exchange and interest rates.
3pot rate + /.19/161' per ?- +
Hor!ard rate 5K/ days7 + /.19'/6.1 per ?- +
?- + K/ day interest rate 5annualiBed7 ..11 F N ..:. F
A3 + K/ day interest rate 5annualiBed7 4.4/ F N 4.94 F
>hich hedging alternati@e !ould you recommendE $he first rate is the
borro!ing rated and second rated is the lending rate.
So7)t/o5
Fo(81(0 M1(3't H'09'
0ayable position ?- + ./ million after 9 months
3pot rate + /.19/1 N + /.191' per ?- +
Hor!ard rate + /.19'/ N + /.19.1 per ?- +
4.
Rudramurthy B.V
Hor!ard mar"et payable , ?- + ./ million C + /.19.1
Fo(81(0 "1(3't !141*7' D M 2<.3>= "/77/o5
Mo5'4 M1(3't H'09'
Explanation
0epsi ompany has a payable exposure of ?- + ./ million after 9
months.
$he 0resent Value 50V7 of + ./ million should be in@ested as on today
in a anada ban" so that along !ith interest it !ill mature at + ./
million after 9 months.
(n@est rate in anada is ..:. F per annum
Hor 9 months , ..:. F C 961' , 1.1: F
0V , HV C 1 . , ./ million C 1 . , + 9K.4.19 million
51 J r7
n
51 J /./11:7
A3D e;ui@alent of + 9K.4.19 million shall be borro!ed form a A3 ban"
as on today
, + 9K.4.19 C + /.191'
, + 'M.K1':
-ote& N for con@ersion spot rate shall be considered since it is con@ersion
as on today. $o buy + offer rate of ban"er shall be considered
5+/.191'6+7
Toan borro!ed form A3 ban" 5+ 'M.K1': million7 should be repaid along
!ith interest after 9 months
(nterest rate , 4.4 F pa
Hor 9 months , 4.4 F C 961' , 1.914 F
#aturity @alue of the loan , + 'M.K1': C 51 J /./19147
#oney mar"et hedge payable , + 'K.91/1
44
A3 anada
Borro! ?- + 9K.4.19 million
at spot rate of + /.191'
i.e. + 9K.4.19 C +/.191'
, A3D 'M.K1'9
, 0V of + ./ million
, ./ million C 1 .
51 J /./11:7
, + 9K.4.19 million
HV of A3D 'M.K1':
, 'M.K1': C 51 J /./19147
, M 2<.3101 AP141*7'C
+ ./ million 5payable in K/ days7
i.e. Huture @alue
Rudramurthy B.V
Co5,7)#/o5& N #oney #ar"et hedge shall be preferred for the abo@e problem
9. D corporation is a A3 based soft!are consultant specialiBed in financial
soft!are for se@eral fortune 4// it has an office in (ndia, A2, Europe and
?ustralia. (n '//' D corporation re;uired 8 1///// in 1M/ days and had .
options before it
Hor!ard #ar"et Dedge
#oney #ar"et Dedge
)ption Dedge
-o Dedge
(ts analyst de@eloped the follo!ing information !hich !as used to asses
the alternati@e solution
urrent spot rate of 8 is + 1.4/ and 1M/Nday for!ard rate of 8 is + 1..M
(nterest rates !ere as follo!s
0articulars A2 A3
1M/ day deposit rate ..4 F ..4 F
1M/ day borro!ing rate 4.1 F 4.1 F
$he company also had the follo!ing information a@ailable to it
? call option on 8 that expires in 1M/ days has an exercise price of 1.4 and
a premium of + /./'. $he future spot rate in 1M/ days are forecasted as follo!s
?n analysis of hedging techni;ue should be made and ad@ice D
corporation on the best alternati@e for hedging
So7)t/o5
Fo(81(0 M1(3't H'09'
D orporation has payable position 8 1///// in 1M/ days
$o meet the abo@e payment D orporation has to buy bounds at pre@ailing
for!ard rate
1M/Nday for!ard rate + 1..M68
Hor!ard mar"et hedge , 8 1///// C 1..M , M1=000
4:
0ossible outcome 0robability
+ 1...
+ 1..:
+ 1.49
'/ F
:/ F
'/ F
Rudramurthy B.V
Mo5'4 M1(3't H'09'
No H'09'
alculation of Expected future spot price
0ossible outcome 5*7 0robability 507 * C 0
+ 1...
+ 1..:
+ 1.49
/.'
/.:
/.'
/.'MM
/.M1:
/.9/:
E@!',t'0 :)t)(' #!ot (1t' M 1.=F
E@!',t'0 :)t)(' !141*7' , 8 1///// C 1..1 , M 1=F000
O!t/o5 H'09'
3tri"e price , + 1.4
0remium , + /./'
0ossible outcome )ption 0robability 0remium 0ayoff
+ 1...
+ 1..:
+ 1.49
-ot Exercise
5H30 [ 307
-ot Exercise
5H30 [ 307
Exercise
5H30 Z 307
/.'
/.:
/.'
+ /./'
+ /./'
+ /./'
N + /./'
N + /./'
+ /./1
41
A3 A2
Borro! 8 K4:K. at spot rate of
+ 1.4
i.e. K4:K. C + 1.4
, + 1.94.1
, 0V of 8 1/////
, 1///// C 1 .
51 J /./.47
, 8 K4:K.
HV of A3D 1.94.1
, 1.94.1 C 51 J /./417
, M 150>1 AP141*7'C
8 1///// 5payable in 1M/ days7
i.e. Huture @alue
Rudramurthy B.V
$he probability of exercising the call option is /.'5'/ F7O the probability of not
exercising the call option is /.M 5M/ F7
alculation of probable option price
0ossible
outcome
0remium
Expected price
including premium
0robability
Expected
price
+ 1...
+ 1..:
+ 1.49
+ /./'
+ /./'
+ /./'
+ 1...
+ 1..:
+ 1.49
/.'
/.:
/.'
/.'K'
/.MMM
/.91/
M 1.=<
)ption hedge , 8 1///// C 1.4 , 14////
3ince H30 [ 30, D orporation !ill exercise the contract
D',/#/o5
?lternati@e ash )utflo! 5+7
#oney #ar"et Dedge
-o Dedge
)ption Dedge
+ 1.M///
+ 14/M:1
+ 1.1///
+ 14////
D orporation shall not hedge as the no hedge option is the lo!est @alue in
all the set of alternati@es
.. 0 ompany is a A3 based multinational 0harmaceutical company is e@aluating an
export sale of its extremely effecti@e cholesterol reduction drug. $he purchase
!ould be for 14/ million (ndonesian Rupaiah, !hich current spot rate of
R
0
MM//6+ translates into a little more than + M4/// although not a big sale, the
policy of 0 ompany dictates that sale must be settled at least for a minimum
gross margin !hich results at + 1M/// on the abo@e sale
$he current K/Nday for!ard rate is KM// R
0
6+. ?lthough this appears to be
unattracti@e, 0 ompany has to contact se@eral maIor ban"s before e@en finding
the for!ard ;uote on the R
0
the conse;uences of currency forecasters at the
mo@ement ho!e@er is that the Rupaiah is holding out relati@e study. $he possible
rate of R
0
is R
0
K.// o@er the coming K/ days analyBe the prospecti@e sale and
ma"e the hedging recommendation.
So7)t/o5
Gi@en
3pot rate , R
0
MM//6+
4M
Rudramurthy B.V
K/Nday for!ard rate , R
0
KM//6+
Expected future spot rate , R
0
K.//6+
3ince 0 ompany has recei@able exposure of R
0
14/ million
Dedging 3trategy& N Hor!ard mar"et hedge
0 ompany should go to for!ard mar"et and short the (ndonesian Rupaiah.
K/Nday for!ard mar"et rate is R
0
KM//6+
$herefore cash inflo! , 14//////6KM/// , + 1:49/
$he companyPs policy is not to sell belo! + 1M/// but if the company sell
today then they !ill get + M4''1.'1 using the spot rate of R
0
MM//6+.
0 ompany has a expectation of future spot rate of R
0
K.//6+ then the
company need not go for hedging option as it !ill gi@e the cash inflo! of + 1K1M1.'9
14///////6K.// , + 1K1M1.'9
Decision& N By ta"ing Wnot hedging optionP, company can recei@e + 1K1M1.'9 !hich is
more than their minimum expectation of + 1M///. Dence company can opt for not
hedging. But the companyPs business is not to ma"e profit by doing currency business
they are in pharmaceutical business if they do not hedge or if they expose their
recei@ables open they !ill get + 1K1M1.'9 but expected future spot price may not
become true then company loose their minimum expectation of + 1M///
4. Dindustan Te@er Anili@erPs 3ubsidiary in (ndia, procures much of its toiletries
product line form <apanese ompany. Due to shortage of !or"ing capital in (ndia
payment terms by (ndian importers are typically 1M/ days or longer. Dindustan
Te@er !ishes to hedge M.4 million <apanese =en payable.
?lthough options are not a@ailable on the (ndian Rupee, for!ard rates are
a@ailable against =en. ?dditionally a common practice in (ndia is for companies
li"e Dindustan Te@er to !or" !ith a currency agent !ho !ill in this case loc" in
current spot exchange rate in exchange for ..M4 F fee.
Asing the follo!ing exchange rate and interest rate data, recommend a
hedging strategy
3pot rate c6+ , c 1'/.:/6+
3pot rate Rs6+ , Rs .1.146+
1M/Nday for!ard rate c6Rs , c '..///6Rs
Expected spot rate in 1M/ days , c '.:///6Rs
1M/Nday =en in@estment rate , 1.4 F
1M/Nday Rupee in@estment rate , M./ F
Dindustan Te@erPs cost of capital ,1' F
So7)t/o5
Gi@en
3pot rate c6+ , c 1'/.:/6+
3pot rate Rs6+ , Rs .1.146+
Dence U%R# , 1'/.:6.1.14 , 2.525F
4K
Rudramurthy B.V
1M/Nday for!ard rate c6Rs , c '..///6Rs
Expected spot rate in 1M/ days , c '.:///6Rs
1M/Nday =en in@estment rate , 1.4 F
1M/Nday Rupee in@estment rate , M./ F
Dindustan Te@erPs cost of capital ,1' F
?gent exchange rate commission is ..M4 F
No H'09'
, c M.4 million6Rs '.: , R# 3.2><2 "/77/o5
Fo(81(0 M1(3't H'09'
Buy M.4 million =en in for!ard mar"et at the spot rate of c '.. 6Rs
c M.4 million6Rs '.. , R# 3.5=1F "/77/o5
Mo5'4 M1(3't H'09'
C)(('5,4 19'5t 6'09'
Exposure c M.4 million
?gent hedge , c M.4 million6'.4'41 , Rs 9.9:4. million
?gent commission , ..M4 F C 9.9:4. million
, Rs /.1:9' million 5todayPs @alue7
HV of the abo@e commission is
, /.1:9' C 51./:7 , Rs /.119/ million
$otal outflo! , 59.9:4. J /.119/7 , R# 3.53= "/77/o5
D',/#/o5
?lternati@e ash )utflo! 5+7
-o Dedge
#oney #ar"et Dedge
Rs 9.':K' million
Rs 9.4.11 million
Rs 9.49M. million
:/
(ndia <apan
Borro! c M..9:1 million at spot
rate of Rs '.4'41
i.e. c M..9:1 a Rs '.4'41
, Rs 9.9./9 million
, 0V of c M.4 million
, M.4 C 1 .
51 J /./.47
, c M..9:1 million
HV of Rs 9.9./9 million
, 9.9./9 C 51 J /./:7
, R# 3.3=03 "/77/o5 AP141*7'C
c M.4 million 5payable after : months7
i.e. Huture @alue
Rudramurthy B.V
?gent Dedge Rs 9.49M. million
-o hedge shall be preferred as it gi@es least cash outflo! of Rs 9.':K' million
:. Dayton ompany has concluded the target sale deal !ith a A2 ompany by name
ro!n. $he total payment due from cro!n for K/Ndays is 8 9/ la"hs the
borro!ing rate in A2 is 1. F pa gi@en the follo!ing exchange rate and interest
rate !hat transaction exposure hedge is no! in DaytonPs best interestE
3pot rate , +1.1:'/68
Expected spot rate in K/ days , +1.1M4/68
K/Ndays for!ard rate , + 1.144/68
K/Ndays dollar deposit rate , : F pa
K/Ndays dollar borro!ing rate , M F pa
K/Ndays pound deposit rate , M F pa
K/Ndays pound borro!ing rate , 1. F pa
DaytonPs !eighted a@erage cost of capital , 1' F
Dayton has also collected data on ' specific options
So7)t/o5
Mo5'4 M1(3't H'09'
No
H'09'
Expected spot rate in K/ days is + 1.1M4/68
8 9////// C 1.1M4/ , + 4944///
Fo(81(0 M1(3't H'09'
K/ days for!ard rate is + 1.144/68
:1
)ption $ype 3tri"e 0rice 0remium
K/Nday put option on pound
K/Nday put option on pound
+ 1.1468
+1.1168
1.4 F
1./ F
(ndia <apan
Borro! 8 'MKM441 into
e;ui@alent dollar at spot rate
+ 1.1:'/68
, 8 'MKM441 C 1.1:'/
, + 41/1'.:
, 0V of 8 9////// at 1. F pa
, 9////// C 1 .
51 J /./.47
, 8 'MKM441
HV of + 41/1'.: is
, + 41/1'.: C 51 J /./97
, M 52>0=>3
Borro! 8 9////// in A2
Rudramurthy B.V
8 9////// C 1.144/ , + 4':4///
O!t/o5 H'09'
0articulars ? B
3tri"e price
0remium
Recei@able exposure
3pot rate
)ption premium
HV of option premium
+ 1.1468
1.4 F
8 9//////
+ 1.1:'/68
9////// C 1.1:' C 1.4 F
, + 1K'K/
+ 1K'K/ C 1./9 , + M1::K
+ 1.1168
1./ F
8 9//////
+ 1.1:'/68
9////// C 1.1:' C 1.4 F
, + 1K'K/
+ 1K'K/ C 1./9 , + M1::K
)ption exercised
N HV of option premium
9////// C 1.14 , + 4'4////
N + M1::K
9////// C 1.14 , + 4'4////
N + M1::K
M 51>331 M 50F555=
C17,)71t/o5 o: "/5/")" 150 "1@/")" R17)'#
onsidering certain cash flo!s 5Except -o Dedge )ption7 the best alternati@e
is for!ard mar"et hedge. (t gi@es a recei@able of + 4':4/// after K/ days. $o accept
option hedging the minimum future spot price should be
0articulars ? B
Hor!ard mar"et hedge
J Huture @alue of option
premium
+ 4':4///
+ M1::K
+ 4':4///
+ 4...:
#inimum future spot price
+ 49.:::K
+ 49.:::K a 9//////
, + 1.1M'
+ 491K..:
+ 491K..: a 9//////
, + 1.119:
(f H30 Z 1.1M' for option ? and 1.119 for option B then option hedge shall be
preferred o@er for!ard mar"et hedge.
1. -i"e (nternational needs to order supplies ' months ahead of deli@ery date. (t is
considering an order from <apanese that re;uires a payment of c 1'.4 million
payable as of the deli@ery date. -i"e has t!o option or choice
a. 0urchase ' call option contracts each option contract siBe is c :'4////
b. 0urchase one future contract representing c 1'.4 million
c. $he future price of yen has historically exhibited a slight discount form the
existing spot rate ho!e@er the firm li"es to use currency option to hedge in
<apanese =en for transaction ' months in ad@ance. -i"e !ould prefer hedging
:'
Rudramurthy B.V
since it is uncomfortable to lea@e position open gi@ing historical @olatility of
=en.
$he current =en spot rate is + /.//1' there are ' call options a@ailable, call ?
!ith an excise price of 4 F abo@e spot price !ith premium of ' F the price to be paid
per =en if the option is exercised. all B !ith an excise price of 1/ F abo@e spot
price !ith premium of 1.4 F the price to be paid per =en if the option is exercised.
$he 'Nmonth future price of =en is + /.//:K1' as an analyst you ha@e been
as"ed to ans!er insight of ho! to hedge assume the spot rate remain unchanged after
' months.
a7 alculate option exercise price and premium for both the call options
b7 (f -i"e decides to use call option to hedge =en !hich call option should it use.
c7 (f -i"e decides to allo! =en to be unNhedged, !ill it benefitE (f so calculate
tradeNoff.
d7 >hich is the optimal choice for the company, call ? or call B or future
contract if the spot price on expiry becomes + /.//1M1E
So7)t/o5
a7 alculation of )ption exercise price and premium
0articulars ? B
3pot price
Exercise price
0ayable exposure
)ption premium
+ /.//1'
/.//1' C 1./4
D 0.00F5>
c 1'4/////
1'4///// C /.//14: C ' F
D M 1<0
+ /.//1'
/.//1' C 1.1/
D 0.00F<2
c 1'4/////
1'4///// C /.//1K' C 1.4 F
D M 1=5
b7
0articulars ? B
Exercise price
0ayable exposure
)ption premium
/.//1' C 1./4
D 0.00F5>
c 1'4/////
1'4///// C /.//14: C ' F
D M 1<0
/.//1' C 1.1/
D 0.00F<2
c 1'4/////
1'4///// C /.//1K' C 1.4 F
D M 1=5
)ption exercised

J )ption premium
1'4///// C /.//14:
D M <=500
+1MK/
1'4///// C /.//1K'
D M <<000
+ 1.M4
M <>3<0 M 100=5
:9
Rudramurthy B.V
(nterpretation& N )ption ? shall be preferred
c7 -o hedge
, 1'4///// C /.//1'
, + K////
'Nmonth future price of the =en is assumed to be + /.//:K1' then the payable
exposure !ill be
, 1'4///// C /.//:K1'
, + M:.//
d7 (f the spot price on expiry is + /.//1M1 call option ? shall be preferred since
H30 Z 30
0articulars ? B
Huture spot price
Exercise price
Exercise or Tapse
)ption premium
+ /.//1M1
D 0.00F5>
Exercise 5H30 Z307
D M 1<0
+ /.//1M1
D 0.00F<2
Tapse 5H30 [ 307
D M 1=5
)ption exercised 6 Tapsed

J )ption premium
1'4///// C /.//14:
D M <=500
+1MK/
1'4///// C /.//1M1
D M <F>25
+ 1.M4
0ayable exposure
including premium
M <>3<0 M <<110
(nterpretation& N )ption ? shall be preferred
M. ? call option in anadian dollar is a@ailable !ith stri"e price of + /.:/ and he
purchased by a speculator at + /./:6unit. ontract siBe is 4//// units, + spot rate
is + /.:4 at the time option is exercise. >hat is the net profit to the speculatorE
>hat spot rate !ill earn the speculator BE0 5Brea" E@en 0oint7 and at !hat rate
!ill the seller earn profitE
So7)t/o5
$ype of option , all option
3tri"e price , + /.:/
0remium , + /./:
ontract 3iBe , 4//// units
H30 ,+ /.:4
all option is exercised !hen H30 Z 30
, 5+ /.:4 G /.:/7 C 4////
, +'4//
:.
Rudramurthy B.V
ash flo!
, '4// G _/./: C 4////` , + '4// N +'/// , + 4//
Brea" E@en 0oint 5BE07 for call holder 5Buyer7
, 3tri"e price J 0remium
, /.:/ J /./: , /.::
3eller ma"es profit if H30 [ /.::
K. 0 international has sold ?ustralian put option at a price of + /./16unit !ith stri"e
price of + /.1:6unit. (f the follo!ing rates pre@ail, determine net profit or net loss
+ /.1', + /.1., + /.1:, + /.1M, +/.1K
So7)t/o5
H30 30 Exercise6Tapse
0rofit
before
premium
0remium
0rofit6Toss for
holders including
premium
>riterPs
profit6Toss
/.1'
/.1.
/.1:
/.1M
/.1K
/.1:
/.1:
/.1:
/.1:
/.1:
Exercise
Exercise
Exercise6Tapse
Tapse
Tapse
/./.
/./1
/./1
N
N
/./1
/./1
/./1
/./1
/./1
/./9
/./1
N/./1
N/./1
N/./1
N/./9
N/./1
/./1
/./1
/./1
1/. ?n (ndian importer is re;uired to pay A3 + 1/ la"h on <une 9/, '///. $he import
of goods too" place on ?pril 1, '///. Hollo!ing further details are furnished
3pot rate on ?pril 1, '/// , Rs ...'4691
9Nmonth for!ard rate , Rs ...4.619
3tri"e price of option 59 months7 , Rs ...4/
)ption premium , /.'4
>hat !ill happen to importer if he ta"es the follo!ingE
a7 Hor!ard co@er
b7 )ption co@er
$he spot prices on <une 9/, '/// are
17 .4./61
'7 ...//61'
So7)t/o5
a7 Hor!ard mar"et co@er
0ayable exposure , + 1////// 3pot rate , ...'46...91
9Nmonth for!ard rate , ...4.6...19
0ayable exposure after 9 months
:4
Rudramurthy B.V
, 1////// C ...19 5consider offer rate !hile buying7
, ..19////
b7 )ption co@er
17 >hen future spot rate is .4.//6.4.1/
0ayable exposure , +1//////
H30 , Rs .4.//
30 , Rs ...4/
0remium , /.'4
0ayable exposure , 51////// C ...4/7 J premium paid
0ayable exposure , 51////// C ...4/7 J 51////// C /.'47 , Rs ..14////
'7 >hen future spot rate is ...//6...14
0ayable exposure , +1//////
H30 , Rs ...//
30 , Rs ...4/
0remium , /.'4
0ayable exposure , 51////// C ...147 J premium paid
0ayable exposure , 51////// C ...4/7 J 51////// C /.'47 , Rs .../////
I5t'(!('t1t/o5
?lternati@e 0ayable Exposure
Hor!ard co@er
all option H30 .4./61
all option H30 ...//614
Rs ..19////
Rs ..14////
Rs .../////
(f H30 is .4./61 for!ard co@er shall be preferred
(f H30 is ...//6...14 option co@er shall be preferred
11. ity orporation sell a call option in D# 5contract siBe is D# ://///7 at a
premium of + /./. per D#. (f the exercise price is + /.11 and spot price on the
day of expiration is + /.19 !hat is profit6loss on abo@e call option sold by ity
orporationE
So7)t/o5
alculation of 0ayNoff for the holder
>riter of call option 5ity orporation7
30 , + /.11
H30 , + /.19
all option is exercised by the holder since H30 Z 30
0rofit6loss , 5+ /.11 N +/.197 C 4/////
::
Rudramurthy B.V
, N/./' C 4///// , N+ 1////
$herefore payNoff for !riter , +1////
1'. During the month of <une, European pound sterling are ;uoting the follo!ing
;uotes in terms of A3D
all option premium 3tri"e price
/./:
/./9
/./1
1.:1
1.:4
1.:/
Determine the conditions under !hich profit can be made by
a7 )ption buyer
b7 )ption !riter
So7)t/o5
alculation of profit6loss for option buyer
H30
0remium
1.:1 1.:4 1.::
/./: /./9 /./1
BE0 1.:1 1.:M 1.:1
)ption buyer !ill ma"e profit !hen H30 Z 30 J premium
Hor 30 of 1.:1, option buyer !ill ma"e profit if H30 Z 1.:1
Hor 30 of 1.:4, option buyer !ill ma"e profit if H30 Z 1.:M
Hor 30 of 1.::, option buyer !ill ma"e profit if H30 Z 1.:1
?n option !riter ma"es profit !hen H30 [ 30 J premium
Hor 30 of 1.:1, option !riter !ill ma"e profit if H30 [ 1.:1
Hor 30 of 1.:4, option !riter !ill ma"e profit if H30 [ 1.:M
Hor 30 of 1.::, option !riter !ill ma"e profit if H30 [ 1.:1
19. alculate the follo!ing rates into outright rates
P1(t/,)71(# S!ot 1&"o5t6 3&"o5t6 >&"o5t6
Rs 6 + 94.:9//6'4 '/6'4 '4694 9/6./
Rs 6 8 44.''//694 ./69/ 4/694 446.'
Rs 6 D# '9.K///69/ 9/6'4 ./6:/ .46:4
:1
Rudramurthy B.V
So7)t/o5
P1(t/,)71(
#
S!ot 1&"o5t6 3&"o5t6 >&"o5t6
Rs 6 + 94.:9//694.:9'4 94.:9'/694.:94/ 94.:9'4694.:9:/ 94.:99/694.:9:4
Rs 6 8 44.''//644.''94 44.'1:/644.''/4 44.'14/644.''// 44.'1.4644.'1K9
Rs 6 D# '9.K///6'9.K/9/ '9.MK1/6'9.K//4 '9.K/./6'9.K/K/ '9.K/.46'9.K/K4
1.. alculate outright rates and spread percentage
P1(t/,)71(# S!ot 1&"o5t6 3&"o5t6 >&"o5t6
A3D 6 (-R .9.1/1/611// ''46'14 9//699/ 9146.44
So7)t/o5
P1(t/,)71(# S!ot 1&"o5t6 3&"o5t6 >&"o5t6
A3D 6 (-R .9.1/1/6.9.11// .9.1'946.9.1914 .9.191/6.9.1.9/ .9.19M46.9.1444
3pread in
F
.9.11// G .9.1/1/
.9.11
, /./'/M F
.9.1914 G .9.1'94
.9.1914
, /./9'4 F
.9.1.9/ G .9.191/
.9.1.9/
, /./'1M F
.9.1444 G .9.19M4
.9.1444
, /./9K. F
:M
Rudramurthy B.V
I5t'(51t/o517 Po(t:o7/o D/R'(#/:/,1t/o5
0roblems
1. * limited is thin"ing to in@est in t!o different ris"y assets in an index of A3
e;uity mar"et and German e;uity mar"et. $he t!o e;uities are characteriBed
by the follo!ing expected return and expected ris"
P1(t/,)71(# E@!',t'0 ('t)(5 E@!',t'0 (/#3
A3 E;uity index
German E;uity index
1. F
1M F
14 F
'/ F
orrelation coNefficient bet!een A3 and German mar"et is /.9.
(f the !eights of in@estment are /.. for A3 E;uity index and /.: for
German e;uity index, calculate
a. Expected return of abo@e portfolio
b. o@ariance bet!een A3 and German E;uity index
c. Ris" of the abo@e international portfolio
So7)t/o5
a. alculation of expected return on portfolio
Po(t:o7/o W'/96t AWC E@!',t'0 ('t)(5 ARC W G R
A3 E;uity index
German E;uity index
/..
/.:
1. F
1M F
4.: F
1/.M F
E@!',t'0 ('t)(5 o5 !o(t:o7/o 1>.= B
b. alculation of co@ariance
)V
AG
, e
A
C e
G
C r
AG
)V
AG
, 14 C '/ C/.9.
CO-
UG
D 102
c. alculation of ris" of the portfolio
e
0
'

, e
A
'
>
A
'
J e
G
'
>
G
'
J ' )V
AG
>
A
>
G
e
0
'

, 5147
'
5/..7
'
J 5'/7
'
5/.:7
'
J ' C /.. C/.: C1/'
e
0
'

, ''M.K:
V
P
D 15.13
'. Boing ompany and Anili@er company are from A3 and A2, an in@estor is
e@aluating a t!o asset portfolio of the follo!ing t!o securities
:K
Rudramurthy B.V
P1(t/,)71(# E@!',t'0 ('t)(5 St1501(0 D'R/1t/o5
Boing ompany 1M.: F ''.M F
Anili@er ompany 1: F '. F
oNefficient of correlation /.:
a. >hat is the expected return and the ris" of the portfolio if they are
e;ually !eighedE
b. (f the !eights are changed to /.1 for Boing and /.9 for Anili@er, !hat
is the Expected return and ris"
So7)t/o5
a. alculation of expected return on portfolio of e;ual !eights
Boing ompany
Anili@er ompany
/.4
/.4
1M.: F
1: F
K.9 F
M F
E@!',t'0 ('t)(5 o5 !o(t:o7/o 1F.3 B
alculation of ris" of the portfolio of e;ual !eights
e
0
'

, e
B
'
>
B
'
J e
A
'
>
A
'
J ' r
BA
e
B
e
A
>
B
>
A
e
0
'

, 5''.M7
'
5/.47
'
J 5'.7
'
5/.47
'
J ' C /.: C '. C ''.M C /.4 C /.4
e
0
'

, .9M.1'
V
P
D 20.<3 B
b. alculation of expected return on portfolio of /.1 and /.9 for Boing and Anili@er
respecti@ely
Boing ompany
Anili@er ompany
/.1
/.9
1M.: F
1: F
19./' F
M F
E@!',t'0 ('t)(5 o5 !o(t:o7/o 1F.3 B
alculation of ris" of the portfolio of /.1 and /.9 for Boing and Anili@er respecti@ely
e
0
'

, e
B
'
>
B
'
J e
A
'
>
A
'
J ' r
BA
e
B
e
A
>
B
>
A
e
0
'

, 5''.M7
'
5/.17
'
J 5'.7
'
5/.97
'
J ' C /.: C '. C ''.M C /.1 C /.9
e
0
'

, .....4
V
P
D 21.0 B
1/
Rudramurthy B.V
9. ?n in@estor is e@aluating a t!o asset portfolio of the follo!ing t!o securities
P1(t/,)71(# E@!',t'0 ('t)(5 St1501(0 D'R/1t/o5
?nglo E;uity 1'.4 F ':.. F
?merican E;uity 1/.M F ''.4 F
$he correlation coNefficient bet!een the t!o e;uity funds is /.1'.
>hat is expected return and ris" for the follo!ing portfolio !eights
a. 14 F ?nglo '4 F ?merican
b. 4/ F ?nglo 4/ F ?merican
c. '4 F ?nglo 14 F ?merican
>hich of the abo@e portfolio is preferable and on !hat basisE
So7)t/o5
1. F5 B A597o 25 B A"'(/,15
Expected return on portfolio
ER
0
, >
?-
C E
?-
J >
?#
C E
?#
ER
0
, 5/.147 51'.47 J 5/.'47 51/.M7
ER
0
, 1'./14 F
Ris" of the portfolio
e
0
'

, e
?-
'
>
?-
'
J e
?#
'
>
?#
'
J ' r
?-,?#
e
?-
e
?#
>
?-
>
?#
e
0
'

, 5':..7
'
5/.147
'
J 5''.47
'
5/.'47
'
J ' C /.1' C ':.. C ''.4 C /.14 C /.'4
e
0
'

, 4M../:
V
P
D 2=.1F B
*. 50 B A597o 50 B A"'(/,15
ER
0
, >
?-
C E
?-
J >
?#
C E
?#
ER
0
, 5/.47 51'.47 J 5/.47 51/.M7
ER
0
, 11.:4 F
e
0
'

, e
?-
'
>
?-
'
J e
?#
'
>
?#
'
J ' r
?-,?#
e
?-
e
?#
>
?-
>
?#
e
0
'

, 5':..7
'
5/.47
'
J 5''.47
'
5/.47
'
J ' C /.1' C ':.. C ''.4 C /.4 C /.4
e
0
'

, 41..:.
V
P
D 22.>< B
11
Rudramurthy B.V
,. 25 B A597o F5 B A"'(/,15
ER
0
, >
?-
C E
?-
J >
?#
C E
?#
ER
0
, 5/.'47 51'.47 J 5/.147 51/.M7
ER
0
, 11.''4 F
e
0
'

, e
?-
'
>
?-
'
J e
?#
'
>
?#
'
J ' r
?-,?#
e
?-
e
?#
>
?-
>
?#
e
0
'

, 5':..7
'
5/.'47
'
J 5''.47
'
5/.147
'
J ' C /.1' C ':.. C ''.4 C /.'4 C /.14
e
0
'

, .MM.11
V
P
D 22.11 B
(nterpretation
)ption WaP shall be preferred based on return as it gi@es higher return and
option WcP shall be preferred based on ris"s as it gi@es lo!er ris"s
Ris" re!ard ratio
a. Ris" 6 Return , '..11 a 1'./14 , './/11
b. Ris" 6 Return , ''.:K a 11.:4/ , 1.K.1:
c. Ris" 6 Return , ''.11 a 11.''4 , 1.K:1K
)ption WbP shall be preferred based on both ris" and return i.e. an in@estor can
get a maximum return !ith minimum ris" le@els only if the !eights of the t!o
securities are e;ual.
.. ?ssume the A3 dollar rate of return, standard de@iation Ris" free rate of return
and f @alue for three Baltic republic are gi@en as follo!s
ountry #ean Return 3tandard de@iation Ris" Hree return f
Estonia
Tat@ia
Tithuania
1.1' F
/.14 F
1.:/ F
14 F
''.M F
19.4 F
/..' F
/..' F
/..' F
1.:4
1.49
1.//
alculate 3harpe, $reynor, <enson measure

TRYENOR "'1#)('
$# , R
p
G R
f

f
p

$#
E
, 1.1' G /..' , 0.=2 $#
Ti
, 1.: G /..' , 1.1
1.:4 1.//
$#
Ta
, /.14 G /..' , 0.22
1.49
1'
Rudramurthy B.V
TRYENOR "'1#)('
3# , R
p
G R
f

e
p
3#
E
, 1.1' G /..' , 0.0=3
1:
3#
Ta
, /.14 G /..' , 0.01=5
''.M
3#
Ti
, 1.: G /..' , 0.0F=
19.4
JENSEN "'1#)('
<# , R
p
G 3#T
<# , R
p
G _R
f
J f 5ER
m
G R
f
7`
<#
?
, 1.1' G _/..' J 1.:451.: G /..'7` , &1.2=F
<#
B
, /.14 G _/..' J 1.4951.: G /..'7` , &1.=F5=
<#
, 1.:/ G _/..' J 1.//51.: G /..'7` , 0

19
Rudramurthy B.V
I5t'(51t/o517 Co#t o: C1!/t17 150 C1!/t17 St(),t)('
(nternational cost of capital is much cheaper than domestic !eighted a@erage
cost of capital 5>?7 because company can increase finance through global mar"et
!here it !ill get at cheaper rate
P(o*7'"#
1. #3 )il ompanyPs cost of debt is 1 F. $he ris" free rate of interest is 9 F.
$he expected return on the mar"et portfolio is M F. ?fter depletion allo!ances
#3 oilPs effecti@e tax rate is '4 F its optimal capital structure is :/ F debt
and ./ F e;uity.
a. (f #3 )ilPs beta is estimated at 1.1, !hat is >?E
b. (f #3 )ilPs beta is estimated at /.M, significantly lo!er because of
continuing profit prospects in the global energy sector, !hat is >?E
So7)t/o5
a. >hen beta is 1.1
0ost tax cost of debt , 0re tax cost of debt 51 G tax7
2
D
, 1 F 51 G /.'47
W
D
, 1 F C /.14 , 5.25 B
alculation of cost of e;uity
2
E
, R
H
J _ER
#
G R
H
` f
2
E
, 9 F J _M G 9` 1.1
2
E
, 9 F J 4.4 F
W
E
D .5 B
alculation of !eighted a@erage cost of capital
>? , >
D
2
D
J >
E
2
E
>? , /.: C 4.'4 J /.. C M.4
WACC D >.55 B
b. >hen beta is /.M
W
D
, 1 F 51 G /.'47 , 5.25 B
alculation of cost of e;uity
2
E
, R
H
J _ER
#
G R
H
` f
W
E
, 9 F J _M G 9` /.M , F B
alculation of !eighted a@erage cost of capital
>? , >
D
2
D
J >
E
2
E
>? , /.: C 4.'4 J /.. C 1
WACC D 5.<5 B
'. Asing the follo!ing data calculate
1.
Rudramurthy B.V
a. ost of E;uity
b. ost of Debt
c. >eighted a@erage cost of capital 5>?7
R
H
, . F, 2
D
, 1 F, $ax , 9/ F, f , 1.9, ER
#
, K F, D65D J E7 , 4/ F
So7)t/o5
a. alculation of cost of e;uity
2
E
, R
H
J _ER
#
G R
H
` f
W
E
, . F J _K G .` 1.9 , 10.5 B
b. alculation of post tax cost of debt
W
D
, 1 F 51 G /.97 , =.< B
c. alculation of !eighted a@erage cost of capital 5>?7
>? , >
D
2
D
J >
E
2
E
>? , /.4 C ..K J /.4 C 1/.4
WACC D F.F B
Co#t o: C1!/t17 1,(o## Co)5t(/'#
<ust li"e technology or resource differences, there exist differences in the cost
of capital across countries. 3uch differences can be ad@antages to #-s in the
follo!ing !ays
(ncreased competiti@e ad@antage results to the #- as a result of using lo!
cost of capital obtained from international financial mar"ets compared to
domestic firms in the foreign country. $his in turn, results in lo!er costs that
can be translated into higher mar"et shares.
#-s ha@e the ability to adIust international operations to capitaliBe on cost
of capital differences among countries, something not possible for domestic
companies.
ountry differences in the use of debt or e;uity can be understood and
capitaliBed by #-
S81!#
14
Rudramurthy B.V
? s!ap is an agreement bet!een t!o companies to exchange cash flo!s so as
to gain the difference.
T4!'# o: S81!#
1. (nterest Rate 3!aps
'. urrency 3!aps
?n /5t'('#t (1t' #81! is a s!ap !here in a company borro!s fixed rate of
interest 5omparati@e ad@antage in fixed rate interest7 and ends up paying in floating
rate 5!ishes to pay floating rate of interest7 by entering into s!ap agreement !ith
other company !ith opposite cash flo!s.
LIBOR 5London Inter Ban" Offer Rate7
(t is the rate of interest at !hich ban" deposits money !ith other ban"s in the
euro currency mar"ets generally 1Nmonth, 9Nmonth, :Nmonth and 1Nyear T(B)RPs are
used.
A0R15t19'# o: S81!
1. ? s!ap agreement can be used to transform a floating rate of loan into fixed
rate of loan and @ice @ersa.
'. ? s!ap agreement can also be used to transform an asset turning fixed rate of
interest into an asset turning floating rate of interest.
Co"!1(1t/R' A0R15t19' T6'o(4
$he popularity of s!aps comes into picture only because of omparati@e
?d@antage $heory.
?ccording to this theory a company should borro! or in@est for that rate of
interest in !hich it has comparati@e ad@antage.
But ho!e@er it !ants to satisfy its !ish of opposite rate, it should enter into
s!ap agreement.
ritics of omparati@e ?d@antage $heory argue that the benefit of s!ap !ill
not exist in reality because of arbitragers operating in mar"et.
omparati@e ?d@antage $heory ma"es an assumption that floating rate of
interest remains unchanged throughout the period of s!ap agreement.
Do!e@er in reality floating rate might change due to change in the
credit!orthiness of the company.
C)(('5,4 S81!
(t in@ol@es exchange of principal and interest payment of receipts and
payments in one currency !ith that of another currency.
A0R15t19'# o: ,)(('5,4 #81!
$ransformation of liabilities.
$ransformation of assets.
1:
Rudramurthy B.V
P(o*7'"#
1. ompany ? and company B ha@e been offered the follo!ing rates pa on a
+ '/ million 4 year loan
ompany Hixed rate Hloating rate
?
B
1' F
19.. F
T(B)R J /.1 F
T(B)R J /.: F
ompany ? re;uires floating rate loan and company B re;uires a fixed
rate loan. Design a s!ap agreement that !ill net a ban" acting as intermediary
/.1 F pa and that !ill appear e;ually attracti@e to both the companies
So7)t/o5
?
B
1' F
19.. F
T(B)R J /.1 F
T(B)R J /.: F
(nterest rate differential 1.. F /.4 F
alculation of profit or gain on s!ap
3!ap gain , 1.. F N /.4 F , /.K F
Tess ban"er commission , /.1 F
-et s!ap gain , /.M F
3!ap gains are shared e;ually by ? and B respecti@ely
-et s!ap gain to ompany ? , /.. F
-et s!ap gain to ompany B , /.. F
-et ash outflo! for ? , T(B)R J 5/.1 G /..7 , T(B)R G /.9 F
-et ash outflo! for B , 19.. F N /.. F , 19 F
(ntermediary Gain , /.1 F
ompany omparati@e ad@antage ?ctual Borro!ing rate
? Hixed rate Hloating rate
B Hloating rate Hixed rate
11
Rudramurthy B.V
'. ompany W?P !ishes to borro! 1/ million at a fixed rate for 4 years and has
been offered 11 F fixed or :Nmonth T(B)R J 1 F. ompany B !ishes to
borro! 1/ million at a floating rate for 4 years and has been offered 1/ F
fixed or :Nmonth T(B)R J /.4 F. Do! do they enter into a 3!ap agreement
in !hich each benefit e;uallyE >hat ris" did this arrangement generateE
So7)t/o5
?
B
11 F
1/ F
:N# T(B)R J 1 F
:N# T(B)R J /.4 F
(nterest rate differential 1 F /.4 F
alculation of profit or gain on s!ap
3!ap gain , 1./ F N /.4 F , /.4 F
3!ap gains are shared e;ually by ? and B respecti@ely
-et s!ap gain to ompany ? , /.'4 F
-et s!ap gain to ompany B , /.'4 F
-et ash outflo! for ? , 11 F N /.'4 F , 1/.14 F
-et ash outflo! for B , :N# T(B)R J 5/.4 G /.'47 , :N# T(B)R J /.'4 F
ompany omparati@e ad@antage ?ctual Borro!ing rate
? Hloating rate Hixed rate
B Hixed rate Hloating rate
1M
Rudramurthy B.V
3pot Rate& (t is the rate paid for deli@ery !ithin ' business days after the date of
transaction, in other !ords it is the current exchange rate bet!een ' or more
currencies.
Hor!ard Rate& (t is rate ;uoted for deli@ery of foreign currency on a future day !hich
is established at the time of entering into the contract. Hor!ard rates are usually
;uoted for fixed periods of 9/, :/, K/ and so on days.
ross Rate& ?n exchange rate bet!een t!o countries that is deri@ed from the
exchange rate of those currencies !ith a 9
rd
"no!n currency is "no!n as cross rate of
exchange.
Deri@ati@e& ? deri@ati@e may be a commodity deri@ati@e or financial deri@ati@e !hose
@alue is deri@ed from an underlying asset.
Hor!ard& ? for!ard contract is a tailor made contract !hose terms are negotiated
bet!een the buyer and the seller !hich are not traded on organiBed exchanges and are
useful to hedge for!ard recei@ables and payables !here the exact date of such
transactions is not fixed or "no!n.
Huture& ? future contract !here ;uantity, date and deli@ery conditions are
standardiBed. $he futures contracts are traded on organiBed exchanges !hich are
settled !ith the differences
)ption& ?n option gi@es its o!ner the right to buy or sell an underlying asset on or
before a gi@en date at a fixed price but !ith no obligation to buy or sell the same for a
fixed premium.
3!ap& ? s!ap is a contract bet!een t!o counter parties to exchange t!o streams of
payments for an agreed period to time s!aps may either be interest rate or currency
s!aps
(nterest rate s!ap& (t is an arrangement bet!een parties or through the help of an
intermediary !here fixed rate interest cash flo!s are exchanged for floating rate
interest cash flo!s or @ice @ersa so as to benefit form exchange
urrency s!aps& (t is an arrangement bet!een parties through an intermediary
!herein receipts or payments in one currency is exchanged for receipts or payments
in another currency so as to benefit from such transactions
urrency future& ? currency future is the price of a particular currency for settlement
at a specified future date. urrency futures are traded on future exchanges !here the
contracts are freely transferable.
all option& all option gi@es the option holder the right to buy an asset at a fixed
price during a certain period !ithout any obligation to buy.
0ut option& 0ut option gi@es the option holder the right to buy an asset at a fixed price
during a certain period !ithout any obligation to buy.
1K
Rudramurthy B.V
o@ered call& ? co@ered call in@ol@es !riting a call option or an asset along !ith
buying the asset. (t is a co@ered call since potential obligation to deli@er the stoc" is
co@ered by underlying stoc" in the portfolio.
Anco@ered call& ?n unco@ered call or na"ed call refers to a speculati@e position not
co@ered by an asset !here the potentials of gains6losses are unlimited.
Dirty float& Dirty float refers to partly managed floating exchange rate !herein the
central ban" inter@enes to smoothen the fluctuation or to manage the @alue of the
domestic currency.
lean float& lean float it is left to the mar"et forces of demand and supply to
determine the exchange rate.
?rbitrage& ?rbitrage is the simultaneous purchase and sale of the same asset or
commodities on different mar"ets to profit form price discrepancies.
Ta! of one price& (n completi@e mar"et characteriBed by numerous buyers and sellers
ha@ing lo! cost access to information exchange adIusted prices of identical tradable
goods and financial assets must be !ithin transaction costs of e;uality !orld !ide.
Difference bet!een ris" and exposure& Ris" is the measure of uncertainty of expected
return meeting !ith actual return. Ris" is a pact of exposure !here higher the
exposure, higher is the degree of ris".
omparati@e ad@antage theory of s!aps& 3!ap contracts are entered in order to
benefit form the comparati@e ad@antage !here parties entering into s!ap agreement
ha@e in one interest rate say fixed rate o@er the other rate say floating rate.
Dard currency& ? hard currency is a currency !hich is !idely and popularly traded in
the mar"et. (t is also that currency !hich is expected to appreciate in future.
3oft currency& ? soft currency lac"s li;uidity and is expected to depreciate in future.
Difference bet!een speculation and hedging& 3peculation in@ol@es ta"ing an
unco@ered call position to ha@e exposed to unlimited profits and losses !hereas
hedging is process of co@ered position !hich remo@es ris" of future appreciation6
depreciation of currency.
#ar"ed to mar"et& (t is a system of calculating profits or losses on a daily basis and
the same is credited or debited to customerPs account at the end of each trading day.
urrency option& $he right to buy6sell an underlying asset being a currency for a
premium !ithout obligation to buy6sell.
Distinguish bet!een absolute and relati@e 000& ?bsolute 000 ignores the effect of
transportation cost, tariff, ;uotas and other restrictions and product differentiation in
free trade !hich is considered by relati@e 000.
0articipants in foreign exchange mar"ets& Ban"er and other intermediary, importer,
exporter etc.
M/
Rudramurthy B.V
Hloor& ? contract that protects the holder against the fall in prices belo! a certain
point or lo!er limit.
DollariBation& $he complete replacement of local currency !ith the A3 dollar. (t helps
in pro@iding economic stability.
urrency collar 5Range Hor!ard7& (t is an arrangement !herein the currency mo@e
outside an agreed upon range is protected.
?gency cost& ost of conflicting interest bet!een subsidiary company and parent
companyPs interest.
De@aluation of currency& (t refers to drop in the foreign exchange @alue of a currency.
I5t'(51t/o517 F/515,/17 M1519'"'5t
(t is concerned !ith application of functions of management to financing
acti@ity, in@esting acti@ity, di@idend decision and li;uidity of a business "eeping in
mind the global perspecti@e and crossing the geographical boundaries of the country.
A,t/R/t/'# o: IFM
1. Hinancing acti@ity& Do! to raise the fund and from !hat source 5debt or
e;uity7
'. (n@esting acti@ity& >here to in@est 5application of funds collected through
financing acti@ity7
9. Di@idend decision& (t decides ho! much of profit to be distributed to share
holders as di@idend and ho! much of profits to be retained
.. Ti;uidity decision or asset management decision& (t studies the proportion of
current assets and fixed assets in the total asset of the firm. Digher the
proportion of current asset in the total asset of the firm, higher is the li;uidity
and @ice @ersa.
E@ o: IFM
Borro!ing money from A3? 5financing decision7 and employing the same in
<apan 5(n@esting decision7.
I"!o(t15,' o: IFM
1. (ncreasing boundaries of business
'. Gro!ing financial instruments mar"ets and systems
9. hanging political economy
.. GlobaliBation
4. hanging socioNeconomic conditions
D/::'('5,'# :(o" 0o"'#t/, FM
1. Exchange rate
'. >ider boundary of business
9. >ider exposure and ris"
M1
Rudramurthy B.V
.. (nternational taxation
4. (nternational capital mar"ets
:. 0olitical treaties bet!een countries
1. (nternational capital budgeting
M. (nternational !or"ing capital management decisions
C6177'59'# o: IFM
1. Hluctuations in exchange rate
'. Expanding geographical boundaries
9. Gro!ing financial and monetary de@elopments
.. Hiscal polices and monetary de@elopments
4. hanging capital mar"ets
T6'o(/'# o: IFM
1. omparati@e ad@antage theory
'. Relati@e ad@antage theory
9. (mperfect mar"et theory 53upplying of resources not restricted by exports and
imports7
.. 0roduct life cycle theory
F1,to(# t61t 1::',t '@,6159' (1t'#
1. Demand for a currency
'. 3upply for a currency
9. (nflation rates
.. (nterest rates
4. (ncome le@el
:. Go@ernment control
M)7t/51t/o517 Co"!154 AMNCC
? multinational company 5#-7 or a transnational company is a company
!hich has gone global. (t "eeps in mind a global scenario and @ie!s the entire !orld
as one single mar"et by extending the boundaries of its operation in more than one
country. Horeign operation of a company !hich has substantial interest on re@enue
and decision ma"ing is also considered as #-.
Ex& N 3ony, 3amsung, General #otors, Hord etc
Go17# o( o*+',t/R'# o: MNC
#aximiBe shareholderPs !ealth
$o increase its cash flo! by tapping the a@ailable money in the o@erseas
mar"et.
$o recogniBe additional foreign opportunities
?@ailability of cheap and abundance of funds
M'
Rudramurthy B.V
?@ailability of cheap and talented labor
reation of place, form and possession utility
$o mo@e !ith ad@ancement of technology
$o help the firm in@est its capital in potential in@estment a@enues
$o minimiBe time and distance across the globe
$o enIoy the benefits of large scale business operations
Expansion and di@ersification
T6' B1715,' o: P14"'5t ABOPC
$he Balance of 0ayment 5B)07 of a country is a systematic accounting record
of all economic transactions during a gi@en period of time 5generally one year7
bet!een the residents of the country and residents of foreign country. (n short B)0 is
a statement !hich records a countryPs international economic transaction !ith that of
rest of the !orld for a specific period of time.
I"!o(t15,' o: BOP A)#'#C
1. (t indicates the pressure on a countryPs foreign exchange rate.
'. hanges in B)0 signal the imposition or remo@al of controls o@er payment of
di@idends, interest, license fee etc.
9. B)0 helps to forecast a countryPs mar"et potential.
.. Decides a countryPs monetary policy.
E,o5o"/, t(15#1,t/o5 /5,7)0'
1. )ne real transfer& unilateral gift in "ind
'. )ne financial transfer& unilateral financial gift
9. $!o real transfer& barter transaction
.. $!o financial transfer& exchange of financial items
4. )ne real transfer d one financial transfer& sale or purchase of goods or
ser@ices for cash or credit
A,,o)5t/59 !(/5,/!7'# /5 BOP
B)0 statement follo!s rules of double entry system of boo" "eeping i.e. for
e@ery debt entry there is a corresponding credit entry.
Tea@ing aside errors d omissions B)0 must al!ays balance i.e. total debits ,
total credits.
Co"!o5'5t# o: BOP
1. urrent account
'. apital account
9. Reser@es account
.. Errors and omissions
M9
Rudramurthy B.V
(f credits are more than debits then !e call it as surplus B)0, if credits are less
than debits !e call it as surplus B)0 and if credit is e;ual to debit then !e call it as
balanced B)0.
Fo("1t o: B1715,' o: P14"'5t
P1(t/,)71(# C('0/t D'*/t N't
A.CURRENT ACCOUNT
1. #erchandise 5goods7 B)$
'. (n@isibles 5a J b J c7
a7 3er@ices
b7 $ransfers
c7 (ncomes 5(n@estment incomes7
***
***
***
***
***
***
***
***
***
***
***
***
***
***
Tot17 C)(('5t A,,o)5t A1 H 2C LLL LLL LLL
B. CAPITAL ACCOUNT
1. Horeign in@estment
'. Toans
9. Ban"ing capital
.. Rupee debt ser@ices
***
***
***
***
***
***
***
***
***
***
***
***
Tot17 C1!/t17 A,,o)5t A1 H 2 H 3 H =C LLL LLL LLL
C. ERRORS S OMISSIONS LLL LLL LLL
OR'(177 B1715,' LLL LLL LLL
D. OFFICIAL RESER-ES ACCOUNT
1. (#H
'. Horeign Balance reser@e 5increase or decrease7
***
***
***
***
***
***
R)7'# 150 9)/015,' 5ot'# o5 (',o(0/59
(mports are debt entry !here as exports are credit entry
(ncrease in foreign asset or decrease in foreign liability is a debit entry
!hereas increase in foreign liability or decrease in foreign asset is a credit
entry i.e. (ncrease in H? d Decrease in HT is a Debit
Decrease in H? d (ncrease in HT is a redit
#erchandise imports and exports of goods and ser@ices are recorded in current
account !hereas transactions related to financial assets or liabilities are
recorded in capital account.
M.
Rudramurthy B.V
apital outflo! is a debit entry !hereas capital inflo! is a credit entry
5netting7
Hinancial transfers and real transfers are recorded in current account.
(ncome form in@estment to be recorded in current account.
I5t'(51t/o517 "o5't1(4 #4#t'"
(nternational monetary system is defined as the institutional frame !or" !ithin
!hich international payment are made, mo@ement of capital accommodated and
exchange rates among currencies are determined.
(n short it is a complex !hole of agreement, rules, institutions, mechanism and
policies regarding
1. Exchange rates
'. (nternational payments
9. Hlo! of capital
St19'# o: I5t'(51t/o517 Mo5't1(4 S4#t'"
1. Bimetallism 5Before 1M147
(t is a double standard system of free coin age for both sil@er and gold.
Both sil@er and gold !ere used as international means of payment and the
exchange rate among countries currency !ere determined by either gold or
sil@er reser@es
'. lassical Gold 3tandards 51M14 G 1K1.7 9K years
lassical gold standards system as an international monetary system
lasted for about ./ years. During this period Tondon became the center of
international financial system reflecting BritainPs ad@anced economy and its
predominant position in international trade.
Ander the gold standards, the exchange rate bet!een any t!o
currencies !as determined by their gold content.
Ex& (f 1 2g of gold is 1/// 8 and 1 "g of gold is 14// + then the exchange rate
bet!een 8 and + is 8 1 , + 1.4
9. (nterN!ar period 51K14 G 1K..7 'K years
>orld !ar first ended the classical gold standards in ?ugust 1K1., as
all maIor countries suspend redemption of ban" notes in gold countries, lac"ed
the political !ill to abide by the Urules of the gameV and so automatic
adIustment mechanism of gold standards !as unable to !or". $he e@ent of
great depression 1K'K accompanying financial crisis added for further
do!nfall of classical gold standards.
0aper standard came into being !hen gold standard !as abandoned.
.. Breton Dood conference system 51K.4 G 1K1'7 '1 years
)nly <uly 1K.. representati@e of .. nations gathered at Breton Dood
to discuss and design the post !ar international monetary system.
(t pa@ed !ay for establishment of (nternational #onetary Hund 5(#H7
and its sister institution >orld Ban".
M4
Rudramurthy B.V
A3 dollar !as held as the only currency that !as fully con@ertible to
gold. ountries held gold and A3 dollars as the means of international
payments.
4. Hlexible exchange rate system 51K19 G till date7
(nternational #onetary Hund 5(#H7 members met at <amaica and
agreed for a ne! set of rules for international monetary system. $he agreement
include
Hlexible exchange rate !here central ban" !as allo!ed to
inter@ene in exchange mar"et to cut do!n the @olatility.
Gold reser@es !ere abandoned and half of the gold holding !as
returned to members and other half !as sold and proceed !as used
to help poor nations.
-on oil exporting countries and less de@eloped countries !ere
gi@en grater access to (#H funds.
C)(('5t S,'51(/o
G4 countries meet at 0laBa in -e! =or" in 1KM4 and G1 countries economic
summit in 0aris in 1KM1 made de@eloped countries to more closely consult and coN
ordinate their macroNeconomic policy and to achie@e greater exchange rate stability.
$he exchange rates !ere determined by mar"et force.
I5t'(51t/o517 P(o+',t A!!(1/#17 AF1,to(# 0't'("/5/59 /5t'(51t/o517 ,1!/t17
*)09't/59C
? company can go global by any of the follo!ing means
17 Export trade
'7 Establishment of subsidiary in the foreign country
97 <oint @enture in foreign country
.7 Establishing branch in foreign country
47 ?gencies and franchise relationship
$he follo!ing features distinguish a domestic proIect !ith that of international proIect
appraisal 5factors7
1. Exchange rate ris"
ash inflo!s form a foreign proIect !ill be in terms of foreign
currency and there is exchange rate ris" in@ol@ed !hile con@erting the same
to local currency.
'. apital mar"et segmentation
? precise cost of capital cannot be ascertained !hile appraising an
international foreign proIect since cost of capital in home country @aries !ith
that of the host countries.
9. (nternational taxation
Dost country charges tax on income earned through a foreign proIect
and e@en !ith holding tax is also charged on remittances made to parent
company.
M:
Rudramurthy B.V
Due considerations shall be gi@en to tax credits allo!ed by home
countries for payments of taxes in host countries.
.. 0olitical ris" or country ris"
hanges in go@ernment policies of host country, entry and exit
barriers, fluctuation in tax rate, penalties and subsidies, nationaliBation
policy of host country etc determine the le@el of international proIect
acceptability.
4. (nflation
Rates of inflation bet!een home country and host country act as a
factor for international proIect appraisal.
:. 3al@age @alue
3al@age @alue offered by the host country at the time of repurchasing
the proIect determines a factor for international proIect appraisal.
Co)5t(4 R/#3 A5174#/#
$here is great interest de@eloped in recent years among pri@ate and official
lending institution in the systematic e@aluation of countryPs ris".
N''0
>hether a country !ill be able to get loans at reasonable costE
>hether a country !ill be able to attract foreign capitalE
F1,to(# to *' ,o5#/0'('0 /5 ,o)5t(4&(/#3 15174#/#
0olitical Ris" Hactors
?ccording to Dans, it is said that U0olitical ris" is 4/ F of the countryPs
ris" analysis but it is inseparable from economic ris"V.
$he follo!ing factors indicate political ris"
a7 0olitical 3tability& N hanges in go@ernment, le@el of @iolence in
country, internal and external conflicts etc determine political ris" of
each nation.
b7 ?ttitude of host go@ernment& N $he host go@ernment may impose
restrictions on transfer of funds by subsidiary to parent company by
charging the corporate tax, !ithNholding tax etc.
c7 >ar& N 3afety of local employees hired by #-s and the proIect cash
inflo!s are subIect to @olatility because of !ar.
d7 Business ycle& N $he period of Business ycle in !hich a country is
operating decides the ris" factor. (n periods of trough, ris" factor is
more and in periods of boom ris" factor is less
e7 0riorities& N $he host go@ernment may support the #- and be
friendly !ith the subsidiaries of parent company !hich determines the
ris" le@els.
M1
Rudramurthy B.V
Economic Ris" Hactors
$he follo!ing factors indicate economic ris" of a country
a7 Rate of inflation& N (t determines economic instability, go@ernmentPs
mismanagement, purchasing po!er of consumers etc
b7 urrent and potential state of country& N
?n #- !hich exports to a country or sets up a subsidiary
there is concerned !ith present and future dement of its product.
Te@els of external debt, foreign exchange reser@e, B)0, GD0
gro!th rate etc determines the countryPs state or position.
c7 Exchange rate& N (t signifies the influence of the demand for a countryPs
export !hich in turn affects the countryPs product and income le@el.
d7 Resource base& N (t includes natural resources, human resources and
other intangible resources a@ailable in a country !hich measures the
economic ris" le@el.
e7 ?dIustment to external shoc"& N ountries !ith greater adaptability to
external shoc"s ha@e lesser economic ris" compared to other countries
!hose le@el of adaptability is lo!.
T',65/E)'# to 1##'## ,o)5t(4 (/#3
17 Debt related factors
Borro!ing capacity of the country
Debt ser@icing capacity.
Ti;uidity and sol@ency problem
(ndicators of debt ser@icing
Debt6GD0
Debt6foreign exchange receipt
(nterest payment6foreign exchange receipt
'7 Balance of payment
(t represents difference bet!een national income and national
expenditure. (t indicates the rate at !hich a country is building its foreign assets
or foreign liabilities.
(ndicators of B)0
a7 urrent account balance
b7 apital account balance
c7 Reser@e balance
97 Economic performance
(t can be measured in terms of countryPs rate of gro!th and rate of inflation
(ndicators of Economic performance
a7 GD06G-0
MM
Rudramurthy B.V
b7 Gross domestic sa@ings6G-0
c7 Gross domestic in@estment6GD0
.7 0olitical instability
Direct effect& N (t includes political protest li"e stri"es, loc" outs etc
(ndirect effect& N ?d@erse conse;uences on gro!th, inflation, foreign exchange
reser@e etc
47 hec"list approach
a7 (dentification of country ris" factors
b7 ?ssign !eights
c7 0repare rating scale
d7 alculation of product 5!t C rating scale7
e7 alculate country ris" score
I5t'(51t/o517 Co#t o: C1!/t17
(t is the return !hat a total capital 5domestic as !ell as international7 expects
from a proIect.
I5t'(51t/o517 C1!/t17 St(),t)('
(t is the means of financing a proIect using an ideal mix of @arious sources of
capital li"e debt, e;uity and preference shares so as to maximiBe the @alue of firm and
minimiBe the o@erall cost of capital.
Differences in cost of capital for an #- and domestic firm can be because of
the follo!ing factors
517 3iBe of the firm
5'7 Horeign exchange ris"
597 ?ccess to international capital mar"et
5.7 (nternational di@ersification effect
547 ountry ris"
1. 0olitical ris"
'. Economic ris"
M)7t/51t/o517 T1@1t/o5
$he obIecti@e of multinational taxation is to minimiBe the total tax burden on
multinational proIects.
Different countries charges tax based on either the source of income generated
from a particular place or based on residential status or a combination of both.
Do)*7' T1@1t/o5
?n income earned in a foreign country may be charged to tax both in foreign
country as !ell as home country. $his concept of charging tax t!ice for the same
income is called double taxation.
MK
Rudramurthy B.V
?s pro@ided in natural la!, same income shall not be charged to tax t!ice.
$hus double taxation relief might be a!arded based on section K/ 5bilateral
agreement7 and section K1 5unilateral agreement7 of (ndian (ncome $ax ?ct of 1K:1.
17 Bilateral agreement under section K/
$!o different countries can come to an agreement not to charge tax on
same income earned in any one of the t!o countries by resident or non
residents of these countries.
Based on double taxation agreements if tax is charged in host country
either no tax shall be charged in home country or part of income shall be
charged !ith tax in both countries.
'7 Anilateral agreement under section K1
>here bilateral agreements are not there, income earned in such
countries shall be gi@en tax credit under section K1 of (ndian (ncome $ax ?ct
of 1K:1.
Hactors considered in multinational tax management
a7 Bilateral agreement
b7 $ax holiday
c7 Deductions a@ailable under chapter 5:7 of (ndian (ncome $ax ?ct of 1K:1.
d7 Exemption under section 1/ of (ndian (ncome $ax ?ct of 1K:1.
e7 #utual benefits
M)7t/51t/o517 C1#6 M1519'"'5t
(t in@ol@es estimation of @arious cash inflo!s from both domestic as !ell as
international proIects and optimum utiliBation of funds.
O*+',t/R'#
a7 $o maximiBe foreign exchange ris" exposure
b7 $o minimiBe political ris"
c7 $o minimiBe country ris"
d7 $o minimiBe transaction costs
e7 $o minimiBe cash re;uirement of multinational firm
T',65/E)'# o: o!t/"/T' ,1#6 :7o8
17 ?ccelerating cash inflo!s
'7 #anaging bloc"ed funds
97 Teading and lagging strategy
.7 -etting
47 #inimiBation of tax using international transfer pricing
K/
Rudramurthy B.V
M)7t/51t/o517 I5R'5to(4 M1519'"'5t
? multinational firm might maintain in@entory and reNorder le@el far in excess
of the economic order ;uantity. $he follo!ing reasons shall be attributable for the
same.
17 ?nticipating de@aluation
(f de@aluation of local currency is expected in near future, after
de@aluation imported in@entory !ill cost more in local currency. Dence higher
le@el of in@entory is maintained but ho!e@er a trade off on higher holding cost
and high local interest rate is to be made.
'7 ?nticipating price freeBe
>hen local go@ernment enforces price freeBe follo!ing de@aluation,
the organiBation establishes price of an imported item at a high le@el !ith
actual sales made at discount. (n the e@ent of de@aluation sales continue at the
posted price but discounts are !ithdra!n
97 0urchase of for!ard contract
Huture purchases can be hedged !ith exchange rate fluctuations by
entering into a for!ard by contract.
M1519/59 o: M)7t/51t/o517 R','/R1*7'#
#ultinational accounts recei@able are created by t!o types of transactions
1. 3ales to related subsidiaries
'. 3ales to unrelated buyers
(ndependent customers 5unrelated buyers7
(t in@ol@es decisions regarding selection of currency and terms of payment.
3eller prefers to price the commodity in stronger currency !here buyer prefers !ea"er
currency.
Recei@ables from sales in !ea"er currency should be collected as soon as
possible !hereas recei@ables from sales in a stronger currency should be delayed
3elf li;uidating bills
(f the sale deed has the bills accepted by the buyer and endorsement of the
seller, it can be rediscounted !ith the ban"er and net in@estment in recei@able can be
brought do!n to Bero.
F/515,/59 *4 '@!o(t/59 9oR'(5"'5t
Go@ernment bodies in many countries facilitate in@entory financing by
extending export credit or by guaranteeing export credit from ban"s at lo!er interest
rate.
K1
Rudramurthy B.V
D'!o#/to(4 R','/!t#
? depository receipts is a negotiable instrument that usually represents a
companyPs publicly traded securities 5debt6e;uity7 in foreign mar"et.
Depository receipts are issued for stoc" traded abroad !herein an
intermediaries acts on behalf of the issuing company rises funds !ithout listing the
securities mandatory on the respecti@e countryPs stoc" mar"et.
O*+',t/R'# o: /##)/59 D'!o#/to(4 R','/!t#
$o raise capital in foreign mar"et
$o build good !ill and reputation
$o impro@e li;uidity position of its securities
$o allo! employees outside the home mar"et
$o support for potential mergers and ac;uisition
A"'(/,15 D'!o#/to(4 R','/!t# AADRC
-on A3 based company rising funds through issue of depositary receipts in
A3 !ithout compulsion of listing on A3 stoc" exchange.
B'5':/t# o: ADR to I##)/59 Co"!15/'#
1. $o raise additional funds
'. $o build good !ill and reputation
9. $o support for potential merger and ac;uisition
.. (ncrease share holder base
4. Enables companies to tap A3 security mar"et
:. (t pro@ides a A3 !ay for A3 employees of -onNA3 companies to in@est in
their companyPs employee stoc" option 5E3)7
B'5':/t# o: ADR to I5R'#to(#
1. Digh security
'. Digh li;uidity
9. Di@ersification of ris"
.. Digher return
G7o*17 D'!o#/to(4 R','/!t#
(t is an instrument to raise capital in multiple mar"ets outside the issuerPs
domestic mar"et through stoc"s !hich are traded in foreign stoc" mar"ets. GDR has
become synonyms !ith selling e;uity in Euro mar"ets.
K'
Rudramurthy B.V
D/::'('5,'# *'t8''5 ADR S GDR
?DR GDR
1. ?DR may be listed in -e! =or"
stoc" exchange.
'. (ssue expenses are more in ?DR
a
9. ompulsory @oting rights to in@estors
.. A3 G?0 has to be follo!ed and reN
accounting has to be done
4. (t demands more transparency of
account
1. GDR may be listed in Tondon stoc"
exchange
'. (ssue expenses are lo! in GDR
compared to ?DR
9. )ptional @oting rights
.. (t is enough if you sho! a
reconciliation statement
4. GDR does not demand less
transparency as that of ?DR
D/::'('5,' *'t8''5 O!t/o5# 150 F)t)('#
Hutures )ptions
1. (t is a standardiBed for!ard contract 1. (t is an agreement to buy6sell not
obligation to do.
'. -o premium payment '. 0remium payment exist
9. )ne can buy6sell futures 9. )ne can become holder6!riter of
either call6put option
.. Anlimited profits and unlimited loss .. Dolder has limited loss and unlimited
profit !here as !riter has limited
profits and limited loss
4. ontracts exercised s;uare off at
current future rate existing on the date
of s;uare off
4. )ption are exercised at the stri"e
price
:. -o concept of stri"e price :. $here exists concept of stri"e price
1. -o concept of Uin the money, at the
money, out of the moneyV.
1. $here exists concept of Uin the
money, at the money, out of the
moneyV.
M. Bro"erage calculated on contract
@alue
M. Bro"erage calculated on premium
K. Digh li;uidity K. To! li;uidity
1/. 3mall spreads 1/. Duge spread
K9
Rudramurthy B.V
D/::'('5,' *'t8''5 Fo(81(0 150 F)t)('
Hutures )ptions
1. (t is a non standardiBe future contract 1. (t is a standardiBed for!ard contract
'. -o intermediary '. $here exists intermediary
9. $raded in )$E( mar"et 9. $raded in recogniBed exchange
.. ost of for!ard is less since there is
no bro"erage
.. $here exists transaction cost and
bro"erage
4. Digh le@el of counter party ris" 4. -o such ris" is pre@alent in future
mar"et since exchange act as
intermediary
:. Generally contracts are exercised :. Either exercised or s;uared off
1. ontracts are settled either by
deli@ery or cash settlement
1. ontracts are settled on cash basis
M. -o li;uidity M. $here exists high li;uidity
K.

IFM Notes Full Rudramurthy Sir

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