Solution of Evaluation Test

Booklet
Paper 1: Foreign Exchange & Global Market
16th May 2010
SECTION A:

1. True
2. True
3. False
4. False
5. False
6. False
7. False
8. True
9. True
10. False
11. False
12. False
13. True
14. True
15. False
16.
A

Currency Futures

ISDA Master Agreement

Derivative Losses

FCCB

Held to maturity

17. c

18. a
19. c
20. b
21. a
22. c
23. c
24. c
25. d
26. a
27. a
28. d
29. d
30. d
31. b
32. d
33. c
34. b
35. d
36. d
37. b
38. c
39. b
40. d
41. b
42. b
43. b
44. b
45. c

46. b
47. c
48. b
49. c
50. a
51. b
52. d
53. a
54. c
55. d
56. b
57. c
58. a
59. b
60. c
61. b
62. a
63. c
64. d
65. a
66. c
67. a
68. c
69. b
70. b
71. d
72. c
73. a

74. a
75. d
76. c
77. Under the Bretton Woods system, central banks of countries other than the United
States were given the task of maintaining fixed exchange rates between their currencies
and the dollar. They did this by intervening in foreign exchange markets. If a country's
currency was too high relative to the dollar, its central bank would sell its currency in
exchange for dollars, driving down the value of its currency. Conversely, if the value of a
country's money was too low, the country would buy its own currency, thereby driving up
the price.
The Bretton Woods system lasted until 1971. By that time, inflation in the United States and
a growing American trade deficit were undermining the value of the dollar. Americans urged
Germany and Japan, both of which had favorable payments balances, to appreciate their
currencies. But those nations were reluctant to take that step, since raising the value of
their currencies would increases prices for their goods and hurt their exports. Finally, the
United States abandoned the fixed value of the dollar and allowed it to "float" -- that is, to
fluctuate against other currencies. The dollar promptly fell. World leaders sought to revive
the Bretton Woods system with the so-called Smithsonian Agreement in 1971, but the effort
failed. By 1973, the United States and other nations agreed to allow exchange rates to float.
Economists call the resulting system a "managed float regime," meaning that even though
exchange rates for most currencies float, central banks still intervene to prevent sharp
changes. As in 1971, countries with large trade surpluses often sell their own currencies in
an effort to prevent them from appreciating (and thereby hurting exports). By the same
token, countries with large deficits often buy their own currencies in order to prevent
depreciation , which raises domestic prices. But there are limits to what can be
accomplished through intervention, especially for countries with large trade deficits.
Eventually, a country that intervenes to support its currency may deplete its international
reserves, making it unable to continue buttressing the currency and potentially leaving it
unable to meet its international obligations.
78. In view of the voluminous and complex nature of transactions handled by a treasury,
various functions are segregated as under.
Front- Office: Dealing -: Risk Taking
Mid-Office: Risk Management and Management Information
Back-Office: Confirmations, Settlements, Accounting and Reconciliation
The organisation of a treasury depends on the volume of activities. It is important that the
above three functions are distinct and work in water-tight compartments. The dealers are
not supposed to handle settlement or accounts. The Back-Office should not perform dealing
but may perform accounting function, and accounting section should not perform dealing
but may perform Back Office function.
The corporate treasury is headed by an appropriate senior executive who directs controls
and co-ordinates the activities of the treasury. He/She also co-ordinates the work between
the chief dealer, the Head of Back Office, Head of Research, and is totally responsible for
the management of funds, investments and forex activity. He/ She will also be a member of
Assets Liability Management Committee (ALCO) and help the committee in deciding on

policies on treasury management. Banks which have separate forex operations, will have
dealers for forex operations.
Front- Office
The front office of a treasury has a responsibility to manage investment and market risks in
accordance with instructions received from the bank's ALCO. This is undertaken through the
Dealing Room which acts as the bank's interface to international and domestic financial
markets. The Dealing Room is the center for market and risk management activities in the
bank. It is the clearing house for risk and has the responsibility to manage the treasury
risks taken in all areas of the bank, on behalf of customers, and on behalf of the bank,
within the policies and limits prescribed by the Board and Risk Management Committee. For
this reason significant authority is given to the 'Treasurer' and the Dealing Room staff to
commit the bank to market. Treasury also functions as a profit center of the bank. It is
therefore important that the treasury is managed efficiently. In view of this, control over the
activities of the treasury and its staff are critical to ensure that the bank is protected from
undue market risk.
Mid-Office
Mid-office is responsible for onsite risk measurement, monitoring and management
reporting. The other functions of Mid Office are:
(a) Limit setting and monitoring exposures in relation to limits;
(b) Assessing likely market movements based on internal assessments and external/internal
research;
(c) Evolving hedging strategies for assets and liabilities;
(d) Interacting with the bank's Risk Management Department on liquidity and market risk;
(e) Monitoring open currency positions;
(f) Calculating and reporting VAR;
(g) Stress testing and back testing of investment and trading portfolios;
(h) Risk-return analysis; and
(i) Marking open positions to market to assess unrealized gain and losses.
Back-Office
The key functions of back-office are:
(a) Deal slip verification;
(b) Generation and dispatch of interbank confirmations;
(c) Monitoring receipt of confirmations from counterparty banks;
(d) Monitoring receipt of confirmations of forward contracts;
(e) Effecting/receiving payments;
(f) Settlement through CCIL or direct through nostro as applicable;
(g) Monitoring receipt of forex funds in interbank contracts;
(h) Statutory reports to the RBI;
(i) Management of nostro funds-to advise latest funds position to enable the F/O to take the
decision for the surplus/ short fall of funds;
(j) Reconciliation of nostro/ other accounts;
(k) Monitoring approved exposure and position limits; and

(o) Accounting.
79. Internal Factors

Inter-bank transactions between banks as they account for 90% of the total
transactions in Forex market.

Industrial Deficit of the country.

Fiscal Deficit of the country.

GDP and GNP of the country.

Foreign Exchange Reserves.

Inflation Rate of the Country.

Agricultural growth and production.

Different types of policies like EXIM Policy, Credit Policy of the country as well
reforms undertaken in the yearly Budget.

Infrastructure of the Country

Political instability prevalent mainly after 1996.

Special factors such as Pokhran Nuclear Test, Kargil War etc.

External Factors

Export trade and Import trade with the foreign country.

Loan sanction by World Bank and IMF

Relationship with the foreign country.

Internationally Oil Price and Gold Price.

Foreign Direct Investment, Portfolio Investment by the country.

80. Under a forward contract the banker and XYZ Ltd. Shall enter into a contract to buy
175000 on 30 July 2010 at Rs.60\.
According to Rule 7, of FEDAI, a forward contract is deliverable at a future date, duration
of the contract being computed from the spot value date of transaction. Accordingly,
suppose XYZ Ltd. Have exported goods say on 10 May 2010 and today its 22 may 2010,
then shall be booked on 28 May, 2010, the period of 2 months should commence from 30
may 2010 and the forward contract will fall due on 30 July 2010.
Date of delivery under the contract will be date of rupees to the customer on realization

While booking forward contract for XYZ Ltd. Bank shall require observing that the exchange
regulations forward contract.
Mutual rights and obligations of XYZ Ltd. And bank shall be as follows:
(a) The bank, through verifications of documentary evidence, should be satisfied about
the genuineness of exposure of 175000 of XYZ Ltd.
(b) Bank should ensure that the hedging period should not exceed maturity of the
underlying transaction i.e. 30 July 2010.
(c) The tenor (2 months, assured) and currency in current case , shall be determined
by XYZ Ltd.
(d) Here the amount of underlying transactions is ascertainable; it can also be booked
on a reasonable estimate.
(e) XYZ Ltd., (customer) should resident.
(f) XYZ Ltd. shall furnish a declaration to the bank.
(g) XYZ Ltd. Shall submits a certificate from its Chartered Accountant that all the
guidelines have been adhered to while using the facility of advance forward booking.
(h) XYZ Ltd. Can cancel and rebook freely the contract falling due within one year.
(i) XYZ Ltd. Can cancel with one bank and can rebook with other subject to following
conditions:
i.

Switch is warranted by competitive rates.

ii.

Cancelation and rebooking are clone simultaneously on maturity date.

iii.

The responsibility of ensuring that original contract has been cancelled

rests with the bank undertake rebooking of the contracts.

81. A Swedish economist, Gustav Cassel, stated in 1918 that purchasing power of a
currency is determined by the amount of goods and services that can be purchased with one
unit of that currency. If there are two currencies, it would be fair to say that the exchange
rate between these two currencies would be such that it reflects their respective purchasing
power. This principle is referred to as Purchasing Power Parity (PPP). If the current
exchange rate is such that it does not reflect purchasing power parity, it is a situation of
disequilibrium. It is expected that, eventually, the exchange rate between the two
currencies will move in such a manner as to reflect purchasing power parity.
Let us illustrate this concept with the help of an example. Suppose, at the period zero, a
basket of goods and services is costing 100 in the Germany and $180 in USA. There is no
restriction of buying this basket of goods and services either from the Germany or from the
USA. Then, it would be correct to conclude that the two amounts paid in respective
currencies are equivalent. In other words,
100 = $180
or I = $1.80
Or, we can simply say that the exchange rate at the time zero is $1.80/. If we use the
symbol S0 to designate this exchange rate, then we write:
S0 = $1.80/

Say after one year (period 1), the same basket of goods and services costs 103 in the
German market while it costs $186 in the USA market. Again, it is reasonable to say that
these twos sums are equal. That is,
103=$186
or 1 =$1.80.58
or the exchange rate, S1, at the period 1 is: $1.8050/.
This theory breaks down into the two main concepts of absolute parity, relative parity and
interest rate parity.
Absolute PPP
The Absolute Form also called the Law of One Price suggests that prices of similar
products of two different countries should be equal when measured in a common
currency. If a discrepancy in prices as measured by a common currency exists, the
demand should shift so that these prices should converge.
An alternative version of the absolute form that accounts for the possibility of market
imperfections such as transportation costs, tariffs, and quotas embeds the sectoral
constant. It suggests that because of these market imperfections, prices of similar
products of different countries will not necessarily be the same when measured in a
common currency. However, it states that the rate of change in the prices of products
should be somewhat similar when measured in a common currency, as long as the
transportation costs and trade barriers are unchanged.
In Equilibrium Form:

S=

PD
PF

Where,
S(Rs./$) = spot rate
PD = is the price level in India, the domestic market.
PF = is the price level in the foreign market, the US in this case.
= Sectoral price and sectoral shares constant.
Relative PPP
The Relative Form of the Purchasing Power Parity tries to overcome the problems of
market imperfections and consumption patterns between different countries. A simple
explanation of the Relative Purchase Power Parity is given below:
Assume the current exchange rate between INR and USD is Rs. 50 / $1. The inflation
rates are 12% in India and 4% in the US. Therefore, a basket of goods in India, let us
say costing now Rs. 50 will cost one year hence Rs. 50 x 1.12 = Rs. 56.00.A similar
basket of goods in the US will cost USD 1.04 one year from now. If PPP holds, the
exchange rate between USD and INR, one year hence, would be Rs. 56.00 = $1.04. This
means, the exchange rate would be Rs. 53.8462 / $1, one year from now. This can also
be worked backwards to say what should have been the exchange rate one year before,
taking into account the inflation rates during last year and the current spot rate.
Expected spot rate = Current Spot Rate x expected difference in inflation rates

E(S1) = S0 x

(1 + Id )
(1 + 1f )

Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
82) A derivative must have an underlying( variable) and any change in the variable affects
the fair value of the derivative (here the underlying is iron ore) .It needs no initial
investment (or significantly less investment as compared to a similar exposure ) .It is
settled at future date. All the tests are satisfied here. Therefore it falls within the scope of
derivatives If it could not be settled net in cash, it would not have been a financial
instrument
83) Yes, there is a clear opportunity of arbitrage. Since Bank A is selling for US$ 1.7285
and Bank B is purchasing at US$ 1.7287, Mr. A (Arbitrageur) shall buy 1 at US$ 1.7285
from Bank A and shall sell it to Bank at US$ 1.7285, making a clear gain of US$ 0.0002 (2
Pips) per .
84) (a) Swaps are nothing but an exchange of two payment streams. Swaps can be
arranged either directly between two parties or through a third party like a bank or a
financial institution. Swap market has been developing at a fast pace in the last two
decades, A currency swap enables the substitution of one debt denominated in one currency
at a fixed or floating rate to a debt denominated in another currency at a fixed or floating
rate. It enables both parties to draw benefit from the differences of interest rates existing
on segmented markets. Thus, currency swaps can be fixed-to-fixed type as well as fixed-tofloating type.
In a fixed-to-fixed swap, the two parties want to borrow at a fixed rate of interest. The swap
deal enables them to get the desired currency at a favourable rate.
The steps to be followed in the fixed-to-floating rate swap are the same as in fixed to-fixed
swap. Here the only difference is that one currency has fixed rate while the other has
floating rate.
(b) If forward rate of a currency is greater than its spot rate, it is said to be at a forward
premium. On the other hand, if its forward rate is smaller than spot rate, it is at forward
discount. For example Re/ spot rate is Rs 55.50/ and three-month forward rate is Rs.
56/. This shows that euro is at a forward premium. When one currency of the pair is at
forward premium, the other is automatically at discount. But normally, premium or discount
is calculated in respect of the currency whose price is quoted. Here, in our example, the
price of euro is quoted in terms of rupees. So we talk of premium of euro rather than
discount of rupee. The annualized premium or discount can be calculated with following
equations. That is,
Premium or Discount =

or

Forward Rate Spot Rate

12
X
X100
Spot Rate
N

Premium or Discount =

Forward Rate Spot Rate

360
X
X100
N
Spot Rate

(c) Comparison between Forward and Futures Contract

S.
No.

Basis

Currency forward

Currency futures

1.

Size of Contract

Tailor made/customized as per

requirements

Standardized

2.

Maturity

Standardized

3.

Location of trading

4.

Settlement

Negotiated/Tailor made/
customized as per requirements
Normally over telephone and by
fax
Generally by delivery of
currencies

5.

Counterparties

Generally known to each other

Generally do not know each

other and Clearing house acts
as counterparty to each side

6.
7.

Negotiation hours
Margin deposit

Any time
No required

During market sessions

Requires Initial and variation
margins

8.

Marking-to-market

Not required

Gains/losses settled everyday

At Futures Exchange Ring

In majority of cases contracts
are settled through a reverse
operation

85) The latest due date is 30 November the forward rate for the same shall be calculated
as follows:
Interbank Spot Selling rate
49.5725
Add: Premium

0.2100
49.7825

Add: Exchange Margin for TT selling

0.0498
49.8323

Add: Exchange Margin for Bill selling

0.0747
49.9070

86) Using Interest Rate Parity formula the forward shall be:

0.067
)
(1 + 0.01675)
4
Rs. 58.65 X
= Rs. 58.65 X
= Rs. 58.8380
0.054
(1 + 0.0135)
(1 +
)
4
(1 +

Interest Rate Parity is not maintained as Euro is costlier in forward market. Hence there is
an opportunity for arbitrage opportunity.
The advantage of this situation can be taken in the following manner:
1. Borrow in India Rs. 10,00,000 (Rs. 1 Million) for 3 months.
Amount to be repaid after 3 months
= Rs. 10,00,000 (1+0.01675) = Rs. 10,16,750
2. Get Rs. 10,00,000 converted into Euro and get the principal i.e. 17,050.30
Interest on Investments for 3 months = 17,050.30 x 0.0135= 230.18
Total amount at the end of 3 months = (17,050.30 + 230.18) = 17,280.48
Converting the same at the forward rate by selling in Forward Market at available rate
= 17,280.48 x Rs. 59.40= Rs. 10,26,461
Hence the gain is Rs. 10,26,461 - Rs. 10,16,750 = Rs. 9,711
87) In this question we shall evaluate following alternatives:
(a) Using Forward Contract - At the forward rate of Rs. 57.20/ outflow after one year cash
outflow will be Rs. 57,200,000.
(b) Money Market HedgeBorrow Rs., convert to , invest , repay Rs. loan in one year
Amount in to be invested = 1,000,000/1.048 = 954,198.47
Amount of Rs. needed to convert into = 954,198.47 x Rs. 56.75 = Rs. 54,150,763
Interest and principal on Rs. loan after one year = Rs. 54,150,763 x 1.068 = Rs.
57,833,015
(c) If the position is kept uncovered (not hedged) there are 70% probability that the firm
shall require to pay more i.e. Rs. 57,400,000.
(d) Purchasing call option and exercising same at Rs. 57.25 + Premium of Rs. 0.15 will lead
to cash outflow to the tune of Rs. 57,400,000.
Since cash outflow is least in Forward contract it is the best option.