ifm notes full rudramurthy sir

Rudramurthy B.V

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FROM 25 TH MAY TO 31 ST MAY

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Rudramurthy B.V

INTERNATIONAL FINANCIAL MANAGEMENT

BASICS

• Extends the area of operations to outside the geographical boundaries of the domestic country.

• Generally, Domestic Corporates face with only business and financial risks only.

• Multinational Companies are exposed to currency risk.

QUOTES:

There are two types of Quotes:

1. Direct Quotes.

2. Indirect Quotes.

Direct Quote: One unit of foreign currency expressed in so many units of home currency.

EX: 1$ = INR 40. 1P = INR 70. 1Kg of Sugar = INR 15. 1BG = INR 50,000.

Indirect Quote: One unit of home currency expressed in so many units of foreign currency. (1/DQ)

EX: 1INR = $ 0.025 1INR = £ 0.0143 1INR = S 0.0667 1INR = BG 0.00005

Exceptions:Certain Currencies are always quoted for 100units instead of 1unit.EX: Japanese Yen. South Korean Won Indonesian Rupiah

Caution:All over the world, direct quotes are followed, except in UK and Euro countries where indirect quotes are followed.

Bid Rate: It is the Buying rate of the Authorized dealer i.e. the Selling rate for the customer.

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Rudramurthy B.V

Offer Rate: It is the Selling rate of the Authorized dealer i.e. the Buying rate for the customer.

Spread: It is the difference between Offer rate and Bid Rate.

Spread: (In %) = Spread in Rs × 100Offer Rate

Computation of indirect quote for a two way direct quote:

Bid rate of Indirect Quote = 1 . Offer rate of Direct Quote

Offer rate of Indirect Quote = 1 . Bid rate of Direct Quote

Cross Rates:

Authorized dealers may have quotation only for some popularly traded foreign currencies. If a customer needs a quotation for a currency other than these currencies, CROSS RATES are used.

PROBLEM:

1. Suppose RM plans to invest in Martin ltd, a British corporation that is currently selling for £50 per share. RM has $1,12,500 to invest at current exchange rate of $2.25/1£a) How many shares can RM purchase?b) What is his net return if the price of Martin ltd at the end of the year is 60£ and

the exchange rate at that time is $2.00/1£

Solutiona)

RM has $112500 to invest = $ 112500 = 50000 £ 2.25

RM can purchase = 5000 = 1000 shares 50

b)His return in pounds would be 1000 × 60 £ = 60000 £His return in dollars would be 60000 × 2 = $120000

Return in % (Pounds) = 60000 – 50000 = 20 % 50000

Return in % (Dollars) = 120000 – 112500 = 6.67 %112500

This change in percentage is due to CURRENCY RISK

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Rudramurthy B.V

Factors influencing Capital Budgeting1. Estimated cash out flow2. Estimated future cash inflow3. Estimated life of the project4. Discounting factor (Risk adjusted rate)5. Spot rate and expected forward rate6. Risk free rate in home country an foreign country

There are two approaches to evaluate international capital budgetinga) Home currency approachb) Foreign currency approach

Problem2. Indian Pharma ltd an Indian based foreign MNC is evaluating an overseas

investment proposal, India Pharma ltd exporter of pharmaceutical products is considering to build a plant in United States the project will entail an initial outlay of $ 100 million and it is expected to give the following cash flow over its life of 4 years

Years Cash Flow (in million $)

1 302 403 504 60

The current spot exchange rate is Rs 45/$ the risk free rate of interest in India is 11 % and in US it is 6 %. India Pharma requires a rupee return of 15 % on the above project. Calculate the NPV under both home currency and foreign currency approach.

Solutiona) Home currency approach

Calculation of expected forward rate according to International Fischer effect t

St = S0 1 + rhc

1 + rfc

Where St = forward rate for year tS0 = spot raterhc = risk free rate in the home countryrfc = risk free rate in the foreign countryt = time period

S1 = 45 1 + 0.11 = 47.12 1 + 0.06

S2 = 45 1 + 0.11 2 = 49.35 1 + 0.06

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Rudramurthy B.V

S3 = 45 1 + 0.11 3 = 51.67 1 + 0.06

S4 = 45 1 + 0.11 4 = 54.11 1 + 0.06

Calculation of NPVYear Cash Flow (in

million $)ER Cash Flow (in

million Rs)DF @ 15% DCF

0 (100) 45.00 (4500) 1.0000 (4500)1 30 47.12 1413.60 0.8696 1229.222 40 49.35 1974.00 0.7561 1492.633 50 51.67 2583.50 0.6575 1698.694 60 54.11 3246.60 0.5718 1856.25

4717.70 1776.79

Since NPV is positive, the above foreign project shall be accepted

b) Foreign currency approach

(1 + risk adjusted rupee rate) = (1 + Rf rupee rate) × (1 + risk premium)

(1 + 0.15) = (1 + 0.11) (1 + rp)

(1 + rp) = 1.15/1.11 = 1.036

rp = 3.6 %

(1 + risk adjusted dollar rate) = (1 + Rf dollar rate) × (1 + risk premium)

(1 + risk adjusted dollar rate) = (1 + 0.06) × (1 + 0.036)

(1 + risk adjusted dollar rate) = 1.09816

risk adjusted dollar rate = 9.8 %

Calculation of NPVYears Cash Flow in million $ DF @ 9.8 % DCF

0 (100) 1 -1001 30 0.9107 27.32242 40 0.8295 33.17843 50 0.7554 37.77144 60 0.6880 41.2802

39.552439.5244 × 45 = 1779.86

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Rudramurthy B.V

Home currency approach

1. Calculation of Expected Forward rate (ERF) using international Fischer effect2. Convert cash flows in foreign currency to local currency using spot rate and

ERF3. Calculate present value of cash flows in local currency (Risk adjusted local

country rate i.e. DF)4. Evaluate the project by calculating its NPV, if NPV is positive accept or reject

the proposal

Foreign currency approach

1. Calculation of Risk premium rate2. Calculation of risk adjusted foreign country rate3. Calculation of cash flow using risk adjusted foreign country rate and

discounting factor4. Evaluate the proposal using NPV

Problem3. Barret Corporation presently has no existing business in France but is considering

the establishment of a subsidiary there. The following information is given to assess this project

The initial investment required is FF 60 million. The existing spot rate is $ 0.20; the initial investment in dollars is $ 12 million. In addition to FF 60 million initial investment on plant and equipment, FF 10 million is needed for working capital and will be borrowed by the subsidiary from French bank. The French subsidiary of Barret will pay interest only on the loan each year at an interest of 10%.

The loan principal is to be paid in 10 years

The project will be terminated at the end of year 3, when subsidiary will be sold.

The price, demand, and variable cost of the product in France are as follows:

Year Price (FF) Demand Variable Cost (FF)1 600 40000 252 650 50000 303 700 60000 40

The fixed costs are estimated to be FF 5 million per year.

The exchange rate of the French Franc is expected to be $ 0.22 at the end of year 1, $0.25 at the end of year 2 and $ 0.28 at the end of year 3.

The French government will impose a withholding tax of 10 % on earnings remitted by the subsidiary. The U.S government will allow a tax credit on remitted earnings and will not impose any additional taxes.

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Rudramurthy B.V

All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations.

The plant and equipment are depreciated over 10 years, using straight-line depreciation method. Since the plant and equipment are initially valued at FF 60 million, the annual depreciation expense is FF 6 million.

In three years, the subsidiary is to be sold. Barret plans to let the acquiring firm assume the existing French loan. The working capital will not be liquidated, but will be used by the acquiring firm

The required rate of return on this project is 15 %.

a) Determine the net present value of this project. Should Barret accept this project?

b) Assume that Barret Co. provides the additional funds for working capital so that the loan from the French government is not necessary.

c) Would the NPV of this project from the parent’s perspective be more sensitive to exchange rate movements if the subsidiary used French financing to cover the working capital? Explain

d) Assume Barret Co. uses the original proposed financing arrangement and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 8 % (after taxes) until the end of year 3. How is the project’s NPV affected?

e) Assume that Barret Co. decided to implement the project, using the original proposed financing arrangement; also assume that after one year, a French firm offers Barret Co. a price of $ 30 million after taxes for the subsidiary, and that Barret Co. original forecasts for years 2 and 3 have not changed. Should Barret Co. divest the subsidiary? Explain

Solutiona)To find cash flow transferred to parent co

FF in millionParticulars 1 2 3

Sales- Variable Cost

241

32.51.5

422.4

Contribution- Fixed Cost

235

315

39.65

EBITD- Depreciation

186

266

34.66

EBIT after Depreciation- Interest

121

201

28.61

EBT (after interest and depreciation)- tax

11-

19-

27.6-

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Rudramurthy B.V

EAT+ depreciation

116

196

27.66

EATBD+ Salvage value (60 – (6×3))

17-

25-

33.642

Cash flow transferable to parent co- withholding tax

171.7

252.5

75.67.56

Cash flow transferred to parent co 15.3 22.5 68.04

Calculation of NPV

Years Cash flow (in million FF )

Exchange rate Cash flow (in million dollar)

DF @ 15 % DCF

0 (60) 0.20 (12) 1.0000 (12)1 15.3 0.22 3.366 0.8696 2.92702 22.5 0.25 5.625 0.7561 4.25333 68.04 0.28 19.0512 0.6575 12.5265

7.7067The above project shall be accepted since NPV is positive

b) To find cash flow transferred to parent co

FF in millionParticulars 1 2 3


12-

20-

28.6-


12-

20-

28.6-

EAT+ depreciation

126

206

28.66

EATBD+ Salvage value (60 – (6×3))

18-

26-

34.642

Cash flow transferable to parent co- withholding tax

181.8

262.6

76.67.66


Calculation of NPV



DF @ 15 % DCF

0 (70) 0.20 (14) 1.0000 (14)1 16.2 0.22 3.564 0.8696 3.09912 23.4 0.25 5.85 0.7561 4.42343 68.94 0.28 19.3032 0.6575 12.6922


c) If Barret Corporation funds the working capital requirement of its subsidiary, then it is exposed to French Franc 70 million, where as if the subsidiary finances its working capital from French Bank then Barret Corporation is exposed to a total capital of FF 60 million. Thus to minimize currency risk it is

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Rudramurthy B.V

advisable to borrow working capital required from French Bank. Higher the exposure higher is the risk and visa versa.

d) FF in million

Particulars 1 2 3Cash flow transferable to parent co 17 25 75.6+ interest received at the end of year 2+ interest received at the end of year 3

1.361.468

-2

--

Cash Flow 19.83 27 75.6

Calculation of NPV



DF @ 15 % DCF

0 (60) 0.20 (12) 1.0000 (12)1 19.83 0.22 4.3626 0.8696 3.79362 27.00 0.25 6.75 0.7561 5.10403 75.60 0.28 21.168 0.6575 13.9183

10.8158Note: - For calculating interest time value of money is ignored

e)Particulars

Cash Flow(FF)- withholding tax @ 10 %

171.7

Cash Flow after WT 15.3Cash Flow after WT in Dollar (15.3 × 0.22)

+ Salvage Value3.366

30Cash Flow in Dollar

Discounted cash inflow (DF @ 15 %) (33.366 ×0. 8696)

33.366

29.015- Discounted cash outflow 12

NPV 17.015It is better to sell the subsidiary at the end of year 1 as higher NPV of $17.015 million is achieved under this situation.

4. Yes corporation expects to receive cash dividend from a French joint venture over the coming 3 years. The first dividend is expected to be paid on 31/12/02 and is expected to be € 720000 the dividend is then expected to grow 10 % per year over the following 2 years, the current exchange rate is $0.9180/€ the weighted average cost of capital for Yes corporation is 12 %.

a) What is present value of expected Euro dividend stream if the Euro is expected to appreciate 4 % per annum against dollar?

b) What is the present value of expected Euro dividend stream if the Euro were to depreciate at the rate of 3 % per annum against dollar?

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Rudramurthy B.V

Solutiona) Calculation of PV of dividends

Years 0 1 2 3Expected dividend - 720000 792000 871200

WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118Expected return (increase

by 4 % every year) 0.9180 0.9547 0.9929 1.0326Present value of dividends - 613749 626900 640334 1880983

b) Calculation of PV of dividendsYears 0 1 2 3

Expected dividend - 720000 792000 871200WACOC or DF @ 12 % 1 0.8929 0.7972 0.7118

Expected return (decrease by 3 % every year) 0.9180 0.8905 0.8637 0.8378

Present value of dividends - 572439 545350 519543 1637332

5. X Corporation presently has no existing business in New Zealand but is considering the establishment of a subsidiary there. The following information is given to assess this project

The initial investment required is $ 50 million in NZ dollars. The existing spot rate is 0.50 USD/ 1 NZD; the initial investment in USD is $ 25 million. In addition to 50 million NZD initial investments on plant and equipments 20 million NZD is needed for working capital and will be borrowed by the subsidiary from NZ bank. The NZ subsidiary of X will pay interest only on the loan each year at an interest of 14%.

The loan principal is to be paid in 10 years

The project will be terminated at the end of year 3, when subsidiary will be sold.

The price, demand, and variable cost of the product in NZ are as follows:

Year Price (NZD) Demand Variable Cost (NZD)1 500 40000 302 511 50000 353 530 60000 40

The fixed costs are estimated to be 6 million NZD per year.

The exchange rates of the NZD is expected to be $ 0.52 at the end of year 1, $0.54 at the end of year 2 and $ 0.56 at the end of year 3.

The NZ government will impose an income tax of 30 % on income in addition it will impose a withholding tax of 10 % on earnings remitted by the subsidiary. The U.S government will allow a tax credit on remitted earnings and will not impose any additional taxes.

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Rudramurthy B.V

All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations.

The plant and equipment are depreciated over 10 years, using straight-line depreciation method. Since the plant and equipment are initially valued at 50 million NZD, the annual depreciation expense is 5 million NZD.

In three years, the subsidiary is to be sold. X plans to let the acquiring firm assume the existing NZ loan. The working capital will not be liquidated, but will be used by the acquiring firm. When it sells the subsidiary X corporation expected to receive 52 million NZD after subtracting capital gain tax, assume that this amount is not subjected to a withholding tax

X corporation requires 20 % ROI on this project

a) Determine the net present value of this project. Should X Corp. accept this project?

b) Assume that X Corp. is also considering an alternative financing arrangement in which the parent would invest an additional $ 10 million to cover working capital required so that subsidiary would avoid the NZ bank loan. If this arrangement is used the selling price of the subsidiary after subtracting any capital gains tax is expected to be 18 million NZD higher. Is this alternative financing arrangement more feasible for the parent than original proposal?

c) From the parent’s perspective would the NPV of this project be more sensitive to exchange rate movements. If the subsidiary uses NZ financing to cover the working capital or if the parent invests more of its own funds to cover the working capital explain.

d) Assume X Corp. uses the original proposed financing arrangement and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 % (after taxes) until the end of year 3. How is the project’s NPV affected?

e) What is the break-even salvage value of this project if X Corp. uses original financing proposal and funds are not blocked?

f) Assume that X Corp. decided to implement the project, using the original proposed financing arrangement; also assume that after one year a NZ firm offers X Corp. a price of $ 27 million after taxes for the subsidiary, and that X Corp. original forecasts for years 2 and 3 have not changed. Should X Corp. divest the subsidiary? Explain

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Rudramurthy B.V

Solutiona)To find cash flow transferred to parent co

NZD in millionParticulars 1 2 3

Sales- Variable Cost

20.01.2

25.551.75

31.82.4


18.86

23.86

29.46

EBITD- Depreciation

12.85

17.85

23.45


7.82.8

12.82.8

18.42.8


51.5

103

15.64.68

EAT+ depreciation

3.55

75

10.925

EATBD- withholding tax

8.50.85

121.2

15.921.59

EATBD after Withholding tax+ Salvage value

7.65-

10.8-

14.3352


Calculation of NPV

Years Cash flow (in million NZD )


DF @ 20 % DCF

0 (50) 0.50 (25) 1.0000 (25)1 7.65 0.52 3.978 0.8333 3.31502 10.80 0.54 5.832 0.6944 4.05003 66.33 0.56 37.1448 0.5787 21.4958


b) To find cash flow transferred to parent co

NZD in millionParticulars 1 2 3


7.8-

12.8-

18.4-


7.82.34

12.83.84

18.45.52

EAT+ depreciation

5.465

8.965

12.885

EATBD- withholding tax

10.461.05

13.961.4

17.881.8

EATBD after Withholding tax+ Salvage value

9.41-

12.56-

16.0870


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Rudramurthy B.V

Calculation of NPV



DF @ 20 % DCF

0 (70) 0.50 (35) 1.0000 (35)1 9.41 0.52 4.8932 0.8696 4.07772 12.56 0.54 6.7824 0.7561 4.71003 86.08 0.56 48.2048 0.6575 27.8963

1.684The above project shall be accepted since NPV is positive the original proposal is more feasible as NPV of original proposal is higher compared to new proposal.

c) If X Corp. funds the working capital requirement of its subsidiary, then it is exposed to NZD 70 million, where as if the subsidiary finances its working capital from NZ Bank then X Corp. is exposed to a total capital of NZD 50 million. Thus to minimize currency risk it is advisable to borrow working capital required from NZ Bank. Higher the exposure higher is the risk and visa versa.

d) NZD in million

Particulars 1 2 3Cash flow transferable to parent co 10.46 13.96 87.88+ interest received at the end of year 2+ interest received at the end of year 3

0.62760.6653

-0.84

--

Cash Flow 11.753 14.8 87.88

Calculation of NPV



DF @ 15 % DCF

0 (50) 0.50 (25) 1.0000 (25)1 11.75 0.52 6.11 0.8333 5.09172 14.80 0.54 7.992 0.6944 5.55003 87.88 0.56 49.2128 0.5787 28.4796

14.1213Note: - For calculating interest time value of money is ignored

e)



DF @ 15 % DCF

0 (50) 0.50 (25) 1.0000 (25)1 7.65 0.52 6.11 0.8333 5.09172 10.80 0.54 7.992 0.6944 5.55003 14.33 + SV 0.56 30.4648 0.5787 17.6350

0By reverse method we get (14.33 + SV) × 0.56 = 30.4648

Therefore SV = 40.07

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Rudramurthy B.V

f)Particulars

Cash Flow(FF)- withholding tax @ 10 %

10.461.05

Cash Flow after WT 9.41Cash Flow after WT in Dollar (9.41 × 0.52)

+ Salvage Value4.8927

Cash Flow in Dollar Discounted cash inflow (DF @ 15 %) (31.89

× 0. 8333)

31.89

26.58- Discounted cash outflow 25

NPV 1.577It is better not sell the subsidiary at the end of year 1 NPV of $1.577 million is achieved under this situation which is less than the actual NPV of $ 3.8608 million.

Adjusted NPVIn this NPV method all cash flows are discounted at weighted average cost of

capital and it is assumed that uncertainty is involved in different cash flow schemes are same.

Adjusted NPV method provides the flexibility of adopting the different discount factors for different cash flow schemes. Higher the uncertainty involved from a cash flow scheme, higher is the discount factor and vice versa.

Problem 6. A 10 million USD is invested in Thailand for a period of 5 years. It is financed by

50 % debt and 50 % equity, normally the cost of debt would be 12 % for project of this type in Thailand, the world bank is however willing to lend us 5 million USD at a subsidized rate of 10 %. The project is expected to generate 3 million USD operating cash flow every year for a period of 5 years and the marginal tax rate is 40 %.Calculate adjusted NPV for the above project assuming discount rate of 14.6%.

Solution Cash Flow Scheme 1: Operating cash flow 3 million every year to be discounted at the rate of 14.6 %.

Cash Flow Scheme 2: Savings in interestNormal debt rate applicable in Thailand is 12 %, rate paid for debt borrowed from World Bank is 10 % therefore savings in interest rate is 2 %.Savings in interest = 5 million × 2 % = 0.1 millionThe above savings in interest should be discounted at the general debt capital rate of 12 %

Cash Flow Scheme 3: Tax benefit on account of payment of interestDebt capital borrowed from World Bank 5 million, rate of interest 10 %Annual interest = 5 million ×10 % = 0.5 millionTax benefit = Annual interest × tax rate

= 0.5 million × 40 % = 0.2 million

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Rudramurthy B.V

Calculation of Adjusted NPVType of Cash Flow Cash Flow

($ in million)Period Discount

RateAnnuity

Discount rateDCF

Operating Cash Flow

3 1-5 14.6 % 3.3841 10.1523

Savings in interest 0.1 1-5 12 % 3.605 0.3605Tax benefit 0.2 1-5 12 % 3.605 0.721

11.234∑ DCI = 11.234 million

- ∑ DCO = 10 millionANPV = 1.234 millionThe above project shall be accepted since ANPV is positive

7. C limited an Indian manufacturer of high quality sports goods and related equipment, the company is planning to increase its exports in the coming years as a part of its strategy it is thinking of establishing a subsidiary in France that could manufacture and sell goods locally. The management has asked various departments of the company to supply all relevant information for multinational capital budgeting analysis, the relevant information is given below

Investment: - The total initial investment to finance plant and equipment is estimated at 20 million French Franc that will be invested by the parent. Working capital requirements estimated at FF 10 million will be borrowed by subsidiary from a local financing institution at an interest rate of 8 % per annum, the principal will be paid at the end of 5 th year when the project is terminated while the interest payments are it be paid by the subsidiary annually.

Depreciation: - The French government will allow the company to depreciate the plant and equipment using straight-line method, the depreciation expense sill be FF 4 million per year the live of the project is excepted to be 5 years. The forecast price and sales schedule for the next 5 years are as given below

Year Price/unit Sales in France1 FF 600 500002 FF 600 500003 FF 650 800004 FF 660 1000005 FF 680 120000

The variable cost are FF 220/unit in year 1 and in year 2 it is expected to rise to FF 300/unit and remain constant for years 3, 4 and 5. The fixed costs other then depreciation are expected to be FF 1.5 million/year.

Exchange Rate: - The spot exchange rate of the French Franc is Rs 6.6 the forecasted exchange rate for all future period is Rs 6.8

Remittance: - All profits after tax realized are to be transferred to the parent at the end of each year. The French government plans to impose no restrictions on the remittance of cash flows but will impose a 5 % withholding tax on funds remitted by subsidiary to the parent as mentioned earlier.

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Rudramurthy B.V

French government taxes on income earned by subsidiary: - The Indian government will allow a tax credit on taxes paid in France, the company requires a 10 % return on this project.

Advise the Indian company regarding the financial viability of the proposal, should the project be setup in France or not.

Additional Considerations1. Assume that all funds are blocked until the end of 5th year this funds can be

reinvested locally to yield 6 % annually after taxes, show the calculations and comment on the result.

2. Assume the following exchange rate scenario and recalculate your resultsAlternative 1

Year Exchange Rate1 6.802 6.903 6.954 7.005 7.05

Alternative 2Year Exchange Rate

1 6.552 6.503 6.404 6.385 6.35

SolutionCalculation of cash flow to parent company

Particulars 1 2 3 4 5Sales

- Variable Cost3011

3011

5224

6630

81.636


191.5

191.5

281.5

361.5

45.61.5

EBITD- Depreciation

17.54

17.54

26.54

34.54

44.14

EBIT- Interest (10 × 8 %)

13.50.8

13.50.8

22.50.8

30.50.8

40.10.8

EBT- Tax

12.7-

12.7-

21.7-

29.7-

39.3-

EAT+ Depreciation

12.74

12.74

21.74

29.74

39.34

EATBD+ Working Capital

- Repayment of loan- Withholding Tax

16.7--

0.84

16.7--

0.84

25.7--

1.29

33.7--

1.69

43.31010

2.17Cash Flow

Transferred to parent company

15.86 15.86 24.41 32.01 41.13

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Rudramurthy B.V

Calculation of NPVYears Cash Flow

(FF in million)

ExchangeRate

Cash Flow(Rs in

million)

DF @10% DCF

0 (20) 6.6 (132) 1 (132)1 15.86 6.8 107.85 0.9091 98.042 15.86 6.8 107.85 0.8264 89.133 24.41 6.8 164.63 0.7513 123.694 32.01 6.8 217.67 0.6830 148.675 41.13 6.8 279.68 0.6209 173.66

502.22

Since NPV is positive, accept the project

Additional consideration a)

Interest for 1st year = 16.7 × (1.06)4 = 21.08Interest for 2nd year = 16.7 × (1.06)3 = 19.89Interest for 3rd year = 25.7 × (1.06)2 = 28.88Interest for 4th year = 33.7 × (1.06)1 = 35.72Interest for 5th year = 43.3 × (1.06)0 = 43.30


(FF in million)

ExchangeRate

Cash Flow(Rs in

million)

DF @10% DCF

0 (20) 6.6 (132) 1 (132)1 21.08 6.8 143.34 0.9091 130.312 19.89 6.8 135.25 0.8264 111.783 28.88 6.8 196.38 0.7513 147.554 35.72 6.8 242.90 0.6830 165.905 43.30 6.8 294.44 0.6209 182.82

606.36b) Alternative 1


(FF in million)

ExchangeRate

Cash Flow(Rs in

million)

DF @10% DCF

0 (20) 6.60 (132) 1 (132)1 15.86 6.80 107.85 0.9091 98.042 15.86 6.90 109.43 0.8264 90.443 24.21 6.95 169.65 0.7513 127.464 32.01 7.00 224.07 0.6830 153.045 41.13 7.05 289.97 0.6209 180.05

517.03

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Rudramurthy B.V

Alternative 2


(FF in million)

ExchangeRate

Cash Flow(Rs in

million)

DF @10% DCF

0 (20) 6.60 (132) 1 (132)1 15.86 6.55 103.88 0.9091 94.442 15.86 6.50 103.09 0.8264 85.203 24.21 6.40 156.22 0.7513 117.374 32.01 6.38 204.22 0.6830 139.495 41.13 6.35 261.18 0.6209 162.17

466.67

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Rudramurthy B.V

PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING

Meaning of arbitrage: - It is simultaneous purchase and sale of the same assets or commodities on different markets to profit from price discrepancies.

Law of one price: - In competitive markets characterized by numerous buyers and sellers, having low cost access to information exchange adjusted prices of identical tradable goods and financial assets must be within transition costs of equality worldwide.

International arbitrageurs who follow the principle of “Buy low and sell high” enforce the above rule of law of one price.

Forward Premium and Discount: - A foreign currency is said to be at premium if forward rate expressed is terms of home currency is greater than spot rate or else it is said to be at discount.

Annualized % of forward = FR – SR × 360 . Premium or Discount SR Forward contract period in days

The following five economic relationships arise due to the prevalence of “law or one price” and international arbitraging opportunities.

1. PURCHASE POWER PARITY (PPP)2. FISHER EFFECT (FE)3. INTERNATIONAL FISHER EFFECT (IFE)4. INTEREST RATE PARITY(IRP)5. FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT

RATES (UFSR)

If inflation in US is expected to exceed inflation in India by 2 % for the coming year then the US dollar should decline in value by 2 % relative to Rupee by the same rate, the one year USD forward should sell at a 2 % discount relative to the Indian Rupees. Similarly, 1-year interest rates in US should be about 2 % higher than one-year interest rates on securities of comparable risk in India.

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PURCHASING POWER PARITY [PPP]

If international arbitrage enforces the law of one price, then the exchange rate between the home currency and domestic goods must be equal to the exchange rate between home currency and foreign goods.

In other words, one unit of home currency should have the same purchasing power worldwide. Ex: - If a pen costs Rs 50 in India and the same model pen costs $1 in US, then exchange rate shall be $1 = Rs 50.

For same purchasing power to remain constant world wide, the foreign exchange rate must change approximately the same as difference between the domestic and foreign rates of inflation.

Swedish economist ‘Gustav Cassel’ first stated purchasing power parity in a rigorous manner in 1918. He used it as the basis for recommending a new set of official exchange rates at the end of World War Ι.

Purchasing power parity in its absolute version states that price levels should be same world wide when expressed in common currency. A unit of home currency should have the same purchasing power worldwide. This theory is application of law of one price to national price levels or else arbitrage opportunities would exist. However, absolute PPP ignores the effects of transportation costs, tariffs quotas and other restrictions and product differentiations in free trade.

The relative version of PPP states that the exchange rate between the home currency and foreign currency will adjust to reflect changes in the price levels of two countries. Ex: - If inflation in India is 5 % and in US is 2% then the rupee value of the USD must rise by about 3 % to equalize the Rupee price of goods in both the countries.

If ih and if are inflations of home country and foreign country respectively, e0

is home currency value of 1 unit of foreign currency at the beginning of the period and et is the spot exchange rate in period t, then

et = (1 + i h) t e0 (1 + if)t

et = e0 (1 + i h) t (1 + if)t

The value of et represents PPP rate.Note: - the above formula works for direct quote. In case of indirect quote the formula shall be

et = e0 (1 + i f) t (1 + ih)t

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Ex: - The US (hc) and Switzerland (fc) are running annual inflation rates of 5 % and 3 % respectively and the spot rate is SFr 1 = $0.75 then calculate the PPP rate after 1,2 and 3 years

et = e0 (1 + i h) t (1 + if)t

e1 = 0.75 (1 + 0.05 ) 1 = $0.7646 (1 + 0.03)1

e2 = 0.75 (1 + 0.05 ) 2 = $0.7794 (1 + 0.03)2

e3 = 0.75 (1 + 0.05 ) 3 = $0.7945 (1 + 0.03)3

Thus according to PPP the exchange rate change during a period should be equal to the inflation differential for the same time-period. In effect, PPP says that currencies with high rates of inflation should devalue relative to currencies with lower rate of inflation.

Inflation change of 2 % more in US should result in devaluation of USD by 2 %.Therefore e1 = $ 0.75 × 102 % = $ 0.765

Point ‘A’ on the parity line is an equilibrium point wherein 3 % change in inflation is offset by 3 % appreciation in foreign currency, whereas Point ‘B’ is at disequilibrium since 3 % change in inflation is offset just by 1 % appreciation in foreign currency.

Real Exchange rate: - The real exchange rate is the nominal exchange rate adjusted for changes in

the relative purchasing power of each currency since some base periodét = et × Pf

Ph

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By indexing these price levels to 100 as of the base period their ratio reflects the change in the relative purchasing power of these currencies since time 0. Increase in foreign price level and foreign currency depreciation have offsetting effects on the real exchange rate and similarly home price level increases and foreign currency appreciation offset each other.

An alternative way to represent the real exchange rate is to directly reflects the change in relative purchasing powers of these currencies by adjusting the nominal exchange rate for inflation in both countries since time 0 (base period).

ét = et × (1 + i h) t (1 + if)t

Note: - et shall be in direct quote.

Empirical Evidence: - The strictest version of PPP, that all goods and financial assets obey the law of

one price is demonstrably false. The risk and costs of shipping goods internationally as well as government erected barriers to trade and capital flows, are at times high enough to cause exchange adjusted prices to systematically differ between countries.

The general conclusion from empirical study of PPP is that theory holds up well in long run, but not as well over shorter time-periods. Thus in long run the real exchange rate tends to revert to its predicted value of e0. That is if ét > e0, then the real exchange rate should fall over time towards e0. Where as if ét < e0 the real exchange rate should rise over time towards e0.

THE FISHER EFFECT: (∆ NIR = ∆ EXPECTED INFLATION)

The real interest rate shall be adjustable to reflect expected inflation to obtain the nominal interest rate. According to Fisher effect the interest rate(r) is made of two components

a) Real interest rate (a)b) Expected inflation rate (i)

Therefore (1 + Nominal interest rate) = (1 + real interest rate) (1 + expected inflation rate)

(1 + r) = (1 + a) (1 + i)

(1 + r) = 1 + a + i + ai

r = a + i + aiHowever often approximated ‘r’ is calculated as equal to ‘a + i’.Ex: If required real interest rate is 3 % and expected inflation rate is 10 %. Calculate the nominal interest rate

(1 + r) = (1 + a) (1 + i)(1 + r) = (1 + 0.03) (1 + 0.10)(1 + r) = 1.133r = 0.133 or 13.3 %

Alternativelyr = a + i + ai r = 0.03 + 0.10 + (0.03) (0.10) = 0.133 or 13.3 %

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According to FE the lender should not only be compensated for interest (3 %) but also for depreciation in principal value by (10.3 %) for passage of time

“According to generalized version of FE the real returns are equalized across the countries through arbitrage” i.e. ah = af. If expected real returns were higher in one currency than the other, capital would flow from the second to the first currency.

In an equilibrium with no government interference, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two currencies.

rh – rf = ih – if ∆ NIR = ∆ InflationWhere rh and rf represents nominal interest rate at home country and foreign

country respectively, ih and if represents inflation at home country and foreign country respectively.

In other words, according to FE,(1 + r h) t = (1 + i h) t (1 + rf)t (1 + if)t

THE INTERNATIONAL FISHER EFFECT [IFE]

It is the combination of Purchasing power parity (PPP) and generalized Fisher Effect (FE) which gives way to International Fisher Effect (IEF)

According to PPP∆ ER = ∆ IR

et = (1 + i h) t …………………………(1)e0 (1 + if)t

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According to FE(1 + NIR) = (1 + RIR) (1 + IR)(1 + r) = (1 + a) (1 + i)

Therefore ∆ NIR = ∆ Expected Inflation rate

(1 + r h) t = (1 + i h) t ……………………(2)(1 + rf)t (1 + if)t

Equation 1 and 2 gives et = (1 + r h) t e0 (1 + rf)t

i.e. ∆ ER = ∆ NIR

Therefore et = e0 (1 + r h) t (1 + rf)t

According to IFE, the interest rate differential between any two countries is an unbiased predictor of the future change in spot exchange rate. Hence currency with higher interest rates will depreciate and those with low interest rates will appreciate.

Point ‘A’ on parity line is at equilibrium whereas point ‘B’ outside the parity line is not at equilibrium.

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INTEREST RATE PARITY THEORY [IRP]

According to IRP theory, the interest differential should be equal to the forward differential i.e. the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with higher interest rate. If the above condition is satisfied, the forward rate is said to be at interest rate parity and equilibrium prevails in money market.

Covered Interest Differential:Interest parity ensures that the return on a hedged or covered foreign

investment will just equal the domestic interest rate on investment of identical risk or else it gives rise to covered interest arbitrage. The process of covered interest arbitrage continues until interest parity holds, unless there is government interference.

THE RELATIONSHIP BETWEEN THE FORWARD RATE AND FUTURE SPOT RATE

An unbiased nature of forward rate is that the forward rate should reflect the expected future spot rate on the date of settlement of the forward contract.

Ft = ēt

Where Ft = forward rate at time‘t’.ēt = expected future spot rate

Equilibrium is achieved only when the forward differential equals the expected change in the exchange rate.

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PARITY CONDITIONS

I. PURCHASING POWER PARITY [PPP]

∆ ER = ∆ IR

et = (1 + i h) t e0 (1 + if)t

et = e0 (1 + i h) t (1 + if)t

II. FISHER EFFECT [FE]

∆ NIR = ∆ Expected Inflation rate

(1 + NIR) = (1 + RIR) (1 + IR)

(1 + r) = (1 + a) (1 + i)

(1 + r) = 1 + a + i + ai

r = a + i + ai

III. INTERNATIONAL FISHER EFFECT [IFE]

∆ ER = ∆ NIR

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Rudramurthy B.V

et = (1 + r h) t e0 (1 + rf)t

et = e0 (1 + r h) t (1 + rf)t

IV. INTEREST RATE PARITY [IRP]

Forward rate differential = Interest differential

Ft = (1 + r h) t e0 (1 + rf)t

V. UNBIASED FORWARD RATES [UFR]

Ft = ēt

Ft – e0 = ēt –e0

e0 e0

Problems

1. Given the following date calculate any arbitrage possibility is available Spot rate: Rs 42.0010 = $ 16 months forward rate: Rs 42.8020 = $1Annualized interest rate on 6 months dollar = 8 %Annualized interest rate on 6 months Rupees = 12 %

Solution

Calculation of forward differentials

= FR – SR × 360 . SR Forward contract period in days

= 42.8020 – 42.0010 × 36042.0010 180

= 3.8142 %

Calculation of interest differentials

Interest differential = Annualized Interest rate in India – Annualized interest rate in US

Interest differential = 12 % - 8 % = 4%

Since interest differential is grater than forward rate differential an arbitrager shall prefer investment in that country where interest rate is higher. Thus, investment shall be done in India and funds shall be borrowed from US.

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Calculation of arbitrage profitIt is assumed that $ 100000 is borrowed from US bank at the rate of 8 % P.a.Convert $ 100000 into Rupees using spot rate of $ 1 = Rs 42.0010Therefore $ 100000 = 100000 × 42.0010 = Rs 4200100Invest the above sum in India at the rate of 12 % P.a. for 6 monthsInterest amount after 6 months = 4200100 × 12 % × 6/12 = Rs 252006Total amount at maturity = 4200100 + 252006 = Rs 4452106 Convert the above Rupees to dollars

4452106 = $ 104016 42.8020

Loan amount to be refund along with interest = 100000 + (100000 × 0.08 × 6/12) = $104000

Arbitrage profit = $104016 - $104000 = $16

Arbitrage profit (%) = 16 . × 100 = 0.016 % 100000

2. Given the following date calculate any arbitrage possibility is available Spot rate: $ 1 = Rs 44.0030 6 months forward rate: $1 = Rs 45.0010Annualized interest rate on 6 months Rupees = 12 %Annualized interest rate on 6 months Dollars = 8 %

Solution



= 45.0010 – 44.0030 × 36044.0030 180

= 4.536 %


Interest differential = Annualized Interest rate in India – Annualized interest rate in US


Since forward rate differential is grater than interest differential, invest in that country’s currency which is expected to appreciate. Here in this case borrow in India and invest in US.

Calculation of arbitrage profitIt is assumed that Rs 100000 is borrowed from Indian bank at the rate of 12 % P.a.Convert Rs 100000 into Dollars using spot rate of $ 1 = Rs 44.0030Therefore $ 100000 = 100000 ÷ 44.0030 = $ 2273

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Invest the above sum in US at the rate of 8 % P.a. for 6 monthsInterest amount after 6 months = 2273 × 8 % × 6/12 = $ 90.92Total amount at maturity = 2273 + 90.92 = $ 2363.92 Convert the above Dollars to Rupees

2363.92 × 45.0010 = Rs 106379

Loan amount to be refund along with interest = 100000 + (100000 × 0.12 × 6/12) = Rs106000

Arbitrage profit = Rs106379 – Rs106000 = Rs 379

Arbitrage profit (%) = 379 . × 100 = 0.379 % 100000

3. Given the following date calculate any arbitrage possibility is available Spot rate: ₣ 6 = $ 1 (₣ = French Franc)6 months forward rate: ₣ 6.0020 = $1Annualized interest rate on 6 months USD = 5 %Annualized interest rate on 6 months FFR = 8 %

Solution



= 6.0020 – 6.0000 × 3606.0000 180

= 0.067 %


Interest differential = Annualized Interest rate in France – Annualized interest rate in US


Since interest differential is grater than forward rate differential an arbitrager shall prefer investment in that country where interest rate is higher. Thus, investment shall be done in France and funds shall be borrowed from US.

Calculation of arbitrage profitIt is assumed that $ 100000 is borrowed from US Bank at the rate of 5 % P.a.Convert $ 100000 into French Franc using spot rate of $ 1 = ₣ 6Therefore $ 100000 = 100000 × 6 = ₣ 600000Invest the above sum in France at the rate of 8 % P.a. for 6 monthsInterest amount after 6 months = 600000 × 8 % × 6/12 = ₣ 24000Total amount at maturity = 600000 + 24000 = ₣ 624000 Convert the above French Franc to Dollars

624000 × 6.002 = $ 103965

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Loan amount to be refund along with interest = 100000 + (100000 × 0.05 × 6/12) = $102500

Arbitrage profit = $103965 – $102500 = $1465.34

Arbitrage profit (%) = 1465.34 . × 100 = 1.465 % 100000

4. Assume the buying rate for DM (Dutch Mark) spot in New York is $ 0.40 a) What would you expect the price of USD to be in Germany?b) If the dollar to be quoted in Germany at DM 2.6 how is the market supposed

to react?Solution

a) The price of USD in Germany is expected to be (1÷0.4) = 2.5 DM/$b) Since dollar is cheaper in New York, Buy dollar at the rate of 2.5 DM/$ in

New York and sell the same in Germany at the rate of 2.6 DM/$ thus making an arbitrage profit of DM 0.1/$.

5. You have called your foreign exchange trader and asked for quotation on the spot, 1-month, 3-month and 6-month forward rate. The trader has responded with the following$ 0.2479/81, 3/5, 8/7, 13/10

a) What does this mean in terms of dollars per Euros?b) If you wished to buy spot Euros, how much would you pay in Dollars?c) If you wanted to purchase spot USD, how much would you have to pay in

Euro?d) What is the premium or discount in the 1, 3, 6 month forward rate in annual

percentage?Solution

a) Assume you are buying Euros

Swap points: - Forward rates can be expressed by giving spot rates and their respective swap points

E.g.1:- 3/5 in the above problem indicates premium swap point since bid swap point is lesser than ask swap point/offer swap point.

E.g.2:- 8/7 in the above problem indicates discount swap point since bid swap point is greater than ask swap point/offer swap point.

Forward rate = Spot rate + Premium Swap point orForward rate = Spot rate – Discount Swap point

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Particulars Buying Rate Offer RateSpot Rate 0.2479 0.2481

1 Month Forward Rate 0.2482 0.24863 Month Forward Rate 0.2471 0.24746 Month Forward Rate 0.2466 0.2471

Rudramurthy B.V

b) €(4.0306/4.0339)/USDSpot Euros can be bought at bankers offer rate of $ 0.2481/€

Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling rate will be banker’s buying rate.

c) Purchase of spot USD can be made at banker’s offer rate of €4.0339/$

d) Calculation of Forward premium or discount

1-month Forward premium


= 0.2486 – 0.2481 × 3600.2481 30

= 2.42 %

3-month Forward discount


= 0.2474 – 0.2481 × 3600.2481 90

= 1.13 %



= 0.2471 – 0.2481 × 3600.2481 180

= 0.806 %

6. An American firm purchases $ 4000 worth of perfume (₣ 20000) from a French firm, the American distributor must make the payment in 90 days in French Franc the following quotations and expectations exists for the French Franc Spot rate = $ 0.200, 90-day forward rate = $ 0.220, interest rate in US = 15 %, interest rate in France = 10 %. Your expectation of spot rate 90 days hence is $ 0.240

a) What is the premium on the forward French Franc? What is the interest rate differential between France and US? Is there an incentive for covered interest arbitrage?

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b) If there is a covered interest arbitrage how can an arbitrager take advantage of given situation assume the arbitrager is willing to borrow $ 4000 or French Franc (₣) 20000 and there are no transaction costs.

c) If transaction costs are $ 50 would an opportunity still exists for covered interest arbitrage.

d) Calculate the cost covered interest arbitrage and suggest whether covered interest arbitrage was required considering above cost of hedging.

Solutiona) Calculation of Forward premium on French Franc


= 0.2200 – 0.2000 × 3600.2000 90

= 40 % Calculation of interest differential

US interest rate per annum = 15 % France interest rate per annum = 10 %Interest rate differential = 5 %

There exists covered interest arbitrage opportunity since forward differential and interest rate differential are not equal.

b) Since forward differential is grater than interest differential invest in that country’s currency which is expected to appreciate thus borrow in US and invest in FranceCalculation of arbitrage profit

1. Borrow $ 4000 in US at the rate of 15 % for 90 days.

2. Convert the above dollars into French Franc using spot rate.

= 4000/0.200 = ₣ 20000

3. Invest ₣ 20000 at the rate of 10 % for 90 days in France

Interest = 20000 × 0.10 × 90/360 = 500Principal = 20000Maturity Value = 20500

4. Convert the above amount to dollars using 90-day forward rate.

= 20500 × 0.2200 = 4510

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5. Calculate loan repayment amount

Loan Interest = 4000 × 0.15 × 90/360 = 150Principal amount = 4000Loan repayment = 4150

6. Arbitrage profit = $ 4510 – $ 4150 = $ 360

c) Calculation of arbitrage profit after transaction cost

Arbitrage profit before transaction cost = $ 360 Less transaction cost = $ 050 Arbitrage Profit = $310

d) Calculation of arbitrage profit on uncovered interest arbitrage = ₣ 20500 × 0.240 = $ 4920Arbitrage profit = $ 4920 - $ 4150 = $ 770Arbitrage profit after transaction cost = $ 770 - $ 50 = $ 720Cost of hedging = Transaction cost + forgone profitCost of hedging = 50 + (770 – 360) = $ 460

7. Is covered interest arbitrage possible in the following situation? If so calculate arbitrage profit

a) Spot rate Canadian dollar = 1.317/USD, Canada interest rate = 6 %6-month forward rate = C$ 1.2950/USD, US interest rate = 10 %.

b) Spot rate 100 Yen = Rs 35.002, Indian interest rate = 12 %6-month forward rate = Rs 35.9010/100 Yen, Japan interest rate = 7 %.

Solutiona)

Direct Quote = Nr = Home Country . Dr Foreign Country

= FR – SR × 360 . × 100 SR Forward contract period in days

= 1.3170 – 1.2950 × 360 × 1001.3170 90

= 3.34 %

Interest rate differential = 10 – 6 = 4%

Strategy: - Interest rate differential > Forward rate differential Invest in US and borrow in Canada

Calculation of arbitrage profit

1. Borrow Canadian $ 100000 in Canada at the rate of 6 % for 180 days

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2. Convert the above Canadian dollars into USD using spot rate.

= 100000/1.317 = 75930 USD

3. Invest ₣ 20000 at the rate of 10 % for 90 days in France

Interest = 75930 × 0.10 × 6/12 = 3796.50Principal = 75930 . Maturity Value = 79726.50

4. Convert the above amount to dollars using 6-month forward rate.

= 79726 × 1.2950 = 103245.8C$



6. Arbitrage profit = C$ 103245.8 – C$ 103000 = C$ 245.8Calculation of arbitrage profit in Percentage

= C$ 246 × 100 = 0.246 % 100000

b)Calculation of Forward rate differential

= FR – SR × 360 . × 100 SR Forward contract period in days

= 35.9010 – 35.002 × 360 × 10035.002 90

= 5.14 %

Interest rate differential = 12 – 7 = 5%

Strategy: - Interest rate differential < Forward rate differential Invest in Japan and borrow in India


1. Borrow Indian Rs 100000 in India at the rate of 12 % for 6 months

2. Convert the above Indian Rupees into Yen using spot rate.

= (100000 × 100)/35.002 = ¥ 285698

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3. Invest ¥ 285698 at the rate of 7 % for 6 months in Japan

Interest = 285698 × 0.07 × 6/12 = 9999Principal = 285698 . Maturity Value = 295697

4. Convert the above amount to Rupees using 6-month forward rate.

= 295697 × 35.9010/100 = Rs 106158



6. Arbitrage profit = Rs 106158 – Rs 106000 = Rs 158Calculation of arbitrage profit in Percentage

= Rs 158 × 100 = 0.158 % 100000

8. Spot quotation of Singapore $ is Rs 25. Interest rate in Singapore is 6 % and interest rate in India is 10 %. What shall be the forward rate a year latter, also calculate 270-day forward rate.

Solution Calculation of 1-year forward rate using Interest rate parity theory

et = e0 (1 + r hc) t (1 + rfc)t

et = 25 (1 + 0.10) 1 (1 + 0.06)1

FR = Rs 25.94

Calculation of 270-day forward rate using Interest rate parity theory

et = e0 (1 + r hc) t t = 270/360 = 0.75 (1 + rfc)t

et = 25 (1 + 0.10) 0.75 (1 + 0.06)0.75

FR = Rs 25.7046

9. Calculate Forward rate using the following data

Particulars India USACost of Dairy Milk Rs 40 $ 1

Inflation 10 % 6 %

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SolutionSpot rate $ 1 = Rs 40FR = SR (1 + r) n CFV = PV (1 + r) n

FR = 40 (1 + 0.10)1 44 = PV (1 + 0.06)1

FR = Rs 44 PV = 44/1.06 = 41.509

Calculation of 1-year forward rate using Interest rate parity theory

et = e0 (1 + r hc) t (1 + rfc)t

et = 40 (1 + 0.10) 1 (1 + 0.06)1

FR = Rs 41.509

10. Following are rates quoted in Mumbai for British Pound Rs/BP = 52.60/70 and three month forward rate 20/70, interest rate in India is 8 %, interest rate in London is 5 %. Verify weather there is any scope for Covered interest arbitrage if you borrow in RS (India).

Solution Spot rate: Rs/BP = 52.60/70 = 52.60/52.70 Forward rate: Rs/BP = 52.80/53.40 Strategy: Borrow in India and invest in London


1. Borrow Rs 100000 in India at the rate of 8 % for 3 months

2. Convert the above Indian Rupees into Pounds using spot rate.

= 100000/52.70 = £ 1898

3. Invest £ 1898 at the rate of 5 % for 3 months in UK


4. Convert the above amount to Rupees using 3-month forward rate.

= 295697 × 52.80 = Rs 101467



6. Arbitrage profit = Rs 101467 – Rs 102000 = - Rs 533

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Strategy: Borrow in London and invest in India


1. Borrow £ 100000 at the rate of 5 % for 3 months

2. Convert the above London Pounds into Rupees using spot rate.

= 100000 × 52.60 = Rs 5260000

3. Invest Rs 5260000 at the rate of 8 % for 3 months in India


4. Convert the above amount to Pounds using 3-month forward rate.

= 5365200 ÷ 52.40 = £ 100471.91



6. Arbitrage profit = Rs 100471.91 – Rs 101250 = - Rs 778.08

Note: - Covered Interest Arbitrage with two-way quote should be done using trial and error method; both strategies can give loss because of “SPREAD”

11. Find cross rates from the following informationa) $/£ = 1.5240, ¥/£ = 235.20, ¥/$ =?b) €/£ = 2.5150, €/T = 205.80, T/£ =?c) $/£ = 1.5537/59, €/$ = 0.1982/92, €/£ =?d) $/£ = 2.0015/30, $/SFR = 0.6965/70, £/SFR =?

Solutiona) ¥ = ¥ × £ = 235.20 × 1 . = 154.330

$ £ $ 1.5240

b) T = T × € = 1 . × 2.5150 = 0.0122£ € £ 205.80

c) € = € × $ = (0.1982 × 1.5537) / (0.1992 × 1.5559). = 0.3079/0.3099£ $ £

d) £ = £ × $ = [(2.0030)-1 × 0.6965]/ [(2.0015)-1 × 0.6970] = 0.3477 / 82SFR $ SFR

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12. A foreign exchange trader quotes for Belgium Franc spot, 1-month, 3-month and 6-month forward rate to US based treasurer$ 0.02478/80, 4/6, 9/8, 14/11 a) Calculate the outright quote for 1, 3, 6 month forward.b) If treasurer wished to buy Belgium Franc 3-months forward, how much would

you pay in Dollars?c) If you wanted to purchase USD 1-month forward, how much would you have

to pay in Belgium Franc?d) Assuming Belgium Franc was brought what is the premium or discount in the

1, 3, 6 month forward rate in annual percentage?e) What do the above quotations imply in respect of term structure of interest in

USA and Belgium?Solution

a) Assume you are buying Euros

Swap points: - Forward rates can be expressed by giving spot rates and their respective swap points

E.g.1:- 4/6 in the above problem indicates premium swap point since bid swap point is lesser than ask swap point/offer swap point.

E.g.2:- 9/8 in the above problem indicates discount swap point since bid swap point is greater than ask swap point/offer swap point.

Forward rate = Spot rate + Premium Swap point orForward rate = Spot rate – Discount Swap point

b) The treasurer can buy Belgium Franc 3-month forward at his bid rate of $ 0.02469/Belgium Franc

Note: - Customer’s buying rate will be banker’s selling rate and customer’s selling rate will be banker’s buying rate.

c) $ 0.02482/86 for 1BFrBFr = (1/0.02486 – 1/0.02482) per $BFr = (40.2252-2901) per $

d) Calculation of Forward premium or discount



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Particulars Buying Rate Offer RateSpot Rate 0.02478 0.02480

1 Month Forward Rate 0.02482 0.024863 Month Forward Rate 0.02469 0.024726 Month Forward Rate 0.02464 0.02469

Rudramurthy B.V

= 0.02482 – 0.02478 × 360 0.02478 30

= 1.94 %



= 0.02478 – 0.02469 × 360 0.02478 90

= 1.45 %



= 0.02478 – 0.02464 × 360 0.02478 180

= 1.13 %

e) Spot to 1-month forward Since dollar is depreciating from spot to 1-month forward, interest rate

in US is higher compared to interest rate in Belgium.

Spot to 3-month forward Since dollar is appreciating from spot to 3-month forward, interest rate

in Belgium is higher compared to interest rate in US

Spot to 6-month forward Since dollar is appreciating from spot to 3-month forward, interest rate

in Belgium is higher compared to interest rate in US

13. Dutch Mark spot was quoted at $0.4/DM in New York, the price of Pound Sterling was quoted at $1.8/£

a) What would you expect the price of Pound to be in Germany?b) If the Pound were quoted in Frank Fort at DM 4.40/£ what would you do

to profit from the above situationSolution

e) DM = DM × $ = 1 . × 1.8 = 4.5 £ $ £ 0.4

f) Buy 1 pound for DM 4.4 in Frank Fort and with the above pound buy $1.80 in New York and with the above dollars buy DM 4.5 in Germany thus arbitrage will make profit of DM 0.1 for an investment of DM 4.40

Arbitrage profit in (%) = 0.1/4.4 × 100 = 2.27 %

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Selective Hedging

14. An Indian Company AB limited imports machinery worth of £ 2 million and is to make the payment after 6 months the current rates are Spot rate = Rs66.96/£6-month forward rate =Rs67.50/£

a) What should AB limited do if they expect that in 6 months time the pound will settle at Rs67.15/£?

b) What are the options available to the company in case of an expected appreciation or depreciation in Rupee?

Solutiona) In the case of receivable exposure if FR (Forward Rate) > FSP (Forward Spot

Rate) hedge your position where as incase of payable position if FR > FSP do not hedge your position.

In the above problem AB limited has payable exposure and since FR > FSP, do not hedge your position

b) If Rupee appreciates (£ is depreciating) no hedging If Rupee depreciates (£ is appreciating) hedging is required.

15. Brun Herbal products located in India is an old line producer of herbal teas and medicines, their products are marketed throughout India and Europe

Brun Herbal generally invoices in rupees when it sells to foreign customers in order to guard against exchange rate changes however company has received an order from large wholesaler in France for ₣ 40 lakhs of its product. The condition is that the delivery should be in 3 months time and order invoiced in French Franc. The manager decides to contact firm’s bankers for suggestions about hedging the exchange rate exposure.

The banker informs company that spot rate is 1 ₣ = Rs 6.60 thus invoice amount should be Rs 26400000. The 90-day forward rate for Rs and ₣ and USD are 1₣ = Rs 6.50 and 1$ = 42.0283. The banker offers to setup Forward hedge for selling FFr receivable for Rupee based on cross forward exchange rates implicit in forward rate against dollar, what would be your decision if you were manager of Brun Herbal? Show the relevant calculations

Interest rates in India and France are 9 % Pa and 12 % Pa respectively.Solution

Selective hedging (receivable position)FSP > FR do not hedge FSP < FR hedge

Calculation of expected future spot price according to IRPInterest rate differential = Forward differentialInterest rate differential = 12% - 9% = 3 %Forward rate for 90 days should be calculated

-3 % = x – 6.6 × 360 × 100 6.6 90

x – 6.6 = -3 × 6.6 4 × 100

x – 6.6 = -0.0495

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Rudramurthy B.V

x = 6.5505 i.e. 90-day forward for 1₣ = Rs 6.5505

Hence it would be advisable for the company not to hedge its risk by selling French Franc forward. Expected spot price (1₣ = Rs 6.5505) is greater than forward rate (1₣ = Rs 6.5)

16. In Frank Fort the French Franc is selling for DM 0.4343 spot and the 3-month forward rate is DM 0.4300. The 3-month Euro DM inter bank rate is 5.75 % and the Euro French inter bank rate is 9 %.

a) Are exchange rate and money market rate in equilibrium? Why?b) Is there any way to take advantage of the situation? If so how?c) What rate trends would appear in the market if a large number of operators

took the action indicated in (B) above?Solution

a) Calculation of interest rate differential3-month Euro-DM inter bank rate = 5.75 % 3-month Euro-FFr inter bank rate = 9 % . Interest differential = 3.25 %

Calculation of Forward discount


= 0.4343 – 0.4300 × 3600.4343 90

= 3.96 %Since interest rate differential is not equal to forward rate differential there

exists no equilibrium between exchange rate and money market.

b) Since there is no equilibrium between exchange rates and money market there exists arbitrage opportunity.Strategy: - Borrow in France and invest in Germany.

1. Borrow ₣ 100000 at the rate of 9 % pa for 3 months

2. Convert the above French Franc into Dutch Mark using spot rate.

= 100000 × 0.4343 = DM 43430

3. Invest DM 43430 at the rate of 5.75 % for 3 months


4. Convert the above amount to French Franc using 3-month forward rate.

= 5365200 ÷ 0.43 = ₣ 102451

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Rudramurthy B.V



6. Arbitrage profit = ₣ 102451 – ₣ 102250 = ₣ 201

c) Large number of operators by taking arbitrage opportunity as indicated in ‘b’ above brings back the equilibrium in exchange rate and money market there by no further arbitrage opportunity exists.

17. A trader works for New York bank, the spot exchange rate against Canadian dollar is USD 0.9968 and 1-month and 1-year forward rates are USD 0.9985 and USD 1.0166 respectively. Twelve-month interest rate in USA and Canada may be taken as 6.45 % and 4.46 % respectively.

a) What is the forward premium as annual percentage?b) Which currency is at a premium? Why?

The trader becomes party to some insider information which suggests the US interest rate will rise by 1 % pa during the next month. The bank has a rule that in foreign exchange markets “Buy equals Sell” this means that for any currency the total of long positions must be equal to the total of short positions but this aggregation disregards maturity.

c) Indicate the mechanism of two operations by which you may trade in expectation of profit for the bank. Should the insider information turns out to be well founded

Solutiona) Calculation of Forward premium or discount



= 0.9985 – 0.9968 × 360 0.9968 30

= 2.05 %........................................................... (1)

1-year Forward premium


= 1.0166 – 0.9968 × 360 0.9968 90

= 1.99 %

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Rudramurthy B.V

b) Canadian dollar is at premium because 1-month forward and 1-year forward is grater than spot rate

Current interest rate in US = 6.45 %+ Expected increase based on insider information = 1 % . = 7.45 %

Calculation of interest rate differential

Expected interest rate in US = 7.45 % Interest rate in Canada = 4.46 %Interest rate differential = 2.99 %........................ (2)

c) Interest rate differential = 2.99 % (from (2))1-month forward differential in Canada = 2.05 (from (1))

Since interest rate differential is grater than forward differential arbitrage opportunity exists

Strategy: -Borrow in Canada and invest in US.


1. Borrow C $ 100000 at the rate of 4.46 % for 1 month

2. Convert the above Canadian Dollars into USD using spot rate.

= 100000 × 0.99680 = $ 99680

3. Invest US $ 99680 at the rate of 7.45 % for 1 month in US

Interest = 99680 × 0.0645 × 1/12 = 618.85Principal = 99680 . Maturity Value = 100299

4. Convert the above amount to C $ using 1-month forward rate.

= 100299 ÷ 0.9985 = C $100449.5



6. Arbitrage profit = C $ 100449.5 – C $ 100372 = C $ 77.5

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Rudramurthy B.V

18. Your company has to make USD 2 million payment in 3 months time, the dollars are available now. You decide to invest them for 3 months and you are given the following information.

The US deposit rate is 8 % pa The sterling deposit rate is 9 % pa The spot expected rate is $ 1.81/£ The 3-month forward rate is $ 1.78/£

a) Where should your company invest for better returns?b) Assume that the US interest rates and the spot expected return remain as

above, what forward rate would yield an equilibrium situation?c) Assuming that the US interest rate, Spot and forward rates remains as in the

original question, where would you invest if the sterling deposit rate is 14 % pa?

d) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium sterling deposit rate?

Solution

a) Alternative 1: -

Invest USD 1 million in US at the rate of 8 % pa for 3 months

Interest income = 1 million × 8 % × 3/12 = US $20000

Alternative 2:-

Invest in London at the rate of 10 % pa for 3 months

1. Convert 1 million USD into equivalent pounds using spot rate.

= 1000000 ÷ 1.8 = £ 555556

2. Invest £ 555556 at the rate of 10 % pa for 3 month

Interest = 555556 × 0.10 × 3/12 = 13889Principal = 555556 . Maturity Value = 569445

3. Convert the above amount to USD using forward rate.

= 569445 × 1.78 = $1013612

4. Profit or gain = $ 1013612 – $ 1000000 = $ 13612

Conclusion: - Invest in US since gain is more when compared to London

b) Interest rate in US is 8 % pa

Interest rate for sterling deposit is 10 % pa

Interest rate differential = 10 % - 8 % = 2 %

Expected spot rate is

-2 % = x – 1.8 × 360 × 100 1.8 90

x – 1.8 = -2 × 1.8 4 × 100

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Rudramurthy B.V

x – 1.8 = -0.009

x = $ 1.79

Expected future spot rate = $ 1.79

c)

1) Invest £ 555556 at the rate of 14 % pa for 3 month


2) Convert the above amount to USD using forward rate.

= 575000 × 1.78 = $ 1023500

3) Profit or gain = $ 1023500 – $ 1000000 = $ 23500

Conclusion: - Invest in London if the sterling deposit rate is 14 %

d) Calculation of equilibrium sterling rate

Calculation of Forward rate differential

= FR – SR × 360 . × 100

SR Forward contract period in days

= 1.78 – 1.8 × 360 × 1001.8 90

= 4.44 %

Interest in London = Interest in US + FRD

= 8 % + 4.4 %

= 12.44 %

Alternative method

£ 555556 + x % = $ 1020000

i.e. at what rate if we invest £ 555556 in London for 3 months after converting the gain into USD should be $ 1020000 then only attain a sterling deposit rate equilibrium

1020000 ÷ 1.78 = £ 573033

555556 + x % = 573033

x % = 573033 – 555556

x % = 17478

For £ 555556 ======== interest amount is £ 17478

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Rudramurthy B.V

For £ 100 = 100 × 17478 = 3.15 % 555556

Annualized sterling deposit rate is 3.15 % × 4 = 12.6 %

19. Calculate the nominal interest rates using Fisher effect from the following data given below

Real interest rate = 8 %

Inflation rate = 3.5 %

Solution

r = a + i + ai

Where r = nominal interest rate, a = real interest, i = inflation rate

r = 8 % + 3.5 % + (8 × 3.5)

r = 0.1178 or r = 11.78 %

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Rudramurthy B.V

Foreign Exchange Risk Management

Exposure: - Exposure refers to the level of commitment and degree to which a company is affected by exchange rate movements.

Types of Exposure1. Accounting Exposure/Translation Exposure2. Economic Exposure

a) Operating Exposureb) Transaction Exposure

Accounting Exposure: - It is also called as translation exposure where in the measurement of exposure is retrospective in nature. It is based on the past activities and it measures the effect of exchange rate changes on published financial statements, it effects both income statement and balance sheet statement.

Economic Exposure: - Operating exposure and transaction exposure together constitutes a firm’s economic exposure. It is the extent to which the value of the firm measured by its present value of expected cash flow changes with changes in exchange rate movements (i.e. NPV).

Operating Exposure: - It measures the extent to which currency exposure can alter a company’s future operating cash flows the measurement of operating exposure is prospective in nature and it is based on future activities of the firm it affects revenues and costs associated with future sales.

Transaction Exposure: - It arises due to changes in the value of outstanding foreign currency denominated contracts. The measurement of transaction exposure is both retrospective and prospective in nature because it is based on activities that occurred in the past but will be settled in the future.

Methods of Accounting Exposure (Translation Exposure)

1. Current and Non Current Method

Under this method all current assets and current liabilities of foreign affiliated are translated into home currency at the current exchange rate while the non current assets and non current liabilities are translated at historical rate.

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Rudramurthy B.V

2. Monetary and Non Monetary method

According to this method all monetary assets and monetary liabilities are translated at current rates where as non monetary assets and non monetary liabilities are translated at historical rates.

Monetary items are those items which represent a claim to receive or an obligation to pay a fixed amount of foreign currency units.

Eg: - Cash, accounts receivable (Debtors + Bills Receivable), accounts payable (Creditors + Bills Payable), other current liabilities, long term debts etc.

Non Monetary items are those items that do not represent a claim to receive or an obligation to pay a fixed amount of foreign currency units.

Eg: - Stock, fixed assets, equity shares, preference shares etc.

3. Temporal Method

It is a modified version of monetary and non monetary method the only difference between monetary and non monetary method is valuation of stock.

Under monetary and non monetary method, stock is considered as non monetary assets and it is valued at historical rate where as under temporal method stock is valued at historical rate if it is shown at cost price or valued at current rate if it is shown at market price.

4. Current Rate Method

Under this method all balance sheet items are translated at current exchange rate except for shareholders equity (Share Capital + Reserve & Surplus) which is translated at historical rate.

Exchange Rate under Accounting Exposure Method

Items Current/ Non-current Method

Monetary/Non-monetary Method

Temporal Method

Current Rate Method

Cash CR CR CR CR

Receivables CR CR CR CR

Inventory CR HR HR /CR CR

Fixed Assets HR HR HR CR

Payables CR CR CR CR

Long term Debt

HR CR CR CR

Net worth HR HR HR HR

CR = Current Rate, HR = Historical Rate

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Rudramurthy B.V

Problems

1. Assume that a foreign subsidiary of US multinational has the following

Particulars Amount

Cash FC 100

Account Receivable FC 150

Inventory FC 200

Fixed Assets FC 250

Current Liabilities FC 100

Long term Debt FC 300

Net worth FC 300

Assume historical exchange rate is $2 = FC 1, current exchange rate is $1= FC 1 and inventory is carried at market price. Calculate the gain or loss under different translation methods.

Solution

Particulars FCCurrent &

Non Current

Monetary & Non

MonetaryTemporal Current Rate

Ass

ets

Cash 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100

Account Receivables

150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150 150 ×1 = $150

Inventory 200 200 ×1 = $200 200 ×2 = $400 200 ×1 = $200 200 ×1 = $200

Fixed Assets 250 250 ×2 = $500 250 ×2 = $500 250 ×2 = $500 250 ×2 = $250

CTA a/c balance - $350 - $50 $300

Total 700 $1300 $1150 $1000 $1000

Lia

bil

itie

s

Current Liabilities 100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100 100 ×1 = $100

Long term Debt 300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300 300 ×1 = $300

Net worth 300 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600 300 ×2 = $600

CTA a/c balance - - $150 - -

Total 700 $1300 $1150 $1000 $1000

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Rudramurthy B.V

2. Farm products is Canadian affiliate of US manufacturing company, its balance sheet in thousands of Canadian dollar for 01/01/2007 is shown below

Liabilities CAN$ Assets CAN$

Current Liabilities

Long term Debt

Capital Stock (Net worth)

60000

160000

620000

Cash

Account Receivables

Inventory

Net Plant & Machinery

100000

220000

320000

200000

Total 840000 Total 840000

The Expected return as on 01/01/2007 was CAN$ 1.6 per USD determine Farm product accounting exposure on 01/01/2008 using current rate method and monetary and non-monetary method.

Calculate Farm product contribution to its parents accounting loss if the expected return on 31/12/2007 was CAN$ 1.8 per USD. Assume all account to remain as they were in beginning of the year.

Solution

Particulars CAN$ Current RateMonetary & Non

Monetary

Ass

ets

Cash 100000 ÷ 1.8 = $ 55556 ÷ 1.8 = $ 55556

Account Receivables

220000 ÷ 1.8 = $ 122223 ÷ 1.8 = $ 122223

Inventory 320000 ÷ 1.8 = $ 177778 ÷ 1.6 = $ 200000

Net Plant & Machinery

200000 ÷ 1.8 = $ 111111 ÷ 1.6 = $ 125000

CTA a/c balance - $ 43054 $ 6943

Total $ 509722 $ 509722

Lia

bil

itie

s

Current Liabilities 60000 ÷ 1.8 = 33333 ÷ 1.8 = 33333

Long term Debt 160000 ÷ 1.8 = 88889 ÷ 1.8 = 88889

Net worth 620000 ÷ 1.6 = 387500 ÷ 1.6 = 387500

CTA a/c balance - - -

Total $ 509722 $ 509722

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Rudramurthy B.V

Calculation of Accounting Exposure under Current rate method

Accounting Exposure = (Exposed assets – Exposed liabilities) except CTA a/c

Accounting Exposure = $ 466666.67 - $ 122222.22

AE = $ 344444.45

Calculation of Accounting Exposure under Monetary & Non monetary method

Accounting Exposure = (Exposed assets – Exposed liabilities) except CTA a/c

Accounting Exposure = $ 177778 - $ 122222

AE = $ 55556

Note: -

Exposed assets are those assets which are exposed to exchange rate fluctuations (Valued at current rate).

Exposed liabilities are those liabilities which are exposed to exchange rate fluctuations (Valued at current rate).

Transaction Exposure

Transaction exposure form the possibility of incurring future exchange gains or losses on transaction already entered in and denominated in foreign currency.

3. Suppose Boing airlines sell A-747 to Garuda, the Indonesian airlines in Rupaiah (RP) at a price of RP 140 billion. To help to reduce the impact on Indonesian balance of payment Boing agrees to buy parts from various Indonesian companies worth RP 55 billion

a) If the spot rate is $ 0.004/RP what is Boing’s net Rupaiah transaction exposure?

b) If the Rupaiah depreciates $ 0.0035/RP what is Boing’s transaction loss?

Solution

a) Boing’s net Rupaiah transaction exposure = (RP 140 - RP 55) billion

= RP 85 billion (receivable exposure)

Net transaction exposure in $ = RP 85 billion × $ 0.004

NTE = $ 0.34 billion receivable exposure

b) Transaction loss = RP 85 billion × (0.004 – 0.0035)

Transaction loss = RP 85 billion × 0.0005

Transaction loss = $ 0.0425 billion

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HEDGING

Hedging is a particular currency exposure, means establishing an offsetting currency position so as to lock in the home currency value for the currency exposure and eliminate currency fluctuation risk.

Problems

1. In March multinational industry incorporation assesses the September spot rate for Sterling at the following rates

$ 1.30/£ with probability 0.15





a) What is the expected spot rate for September?

b) If 6-month forward rate is $1.40 should the firm sell forward its pound 500000 receivable

c) During receivable what factors are likely to affect multinational industry hedging decision

Solution

a) Calculation of expected spot rate for the month of September

Expected Spot Rate (X) Probability (P) X × P

$ 1.30

$ 1.35

$ 1.40

$ 1.45

$ 1.50

0.15

0.20

0.25

0.20

0.20

0.195

0.270

0.350

0.290

0.300

Total $1.405/£

Expected spot rate for the month of September is $1.405/£

b) Cash inflow by hedging

£ 500000 × $1.40 = $ 700000

Cash inflow by not hedging

£ 500000 × $1.405 = $ 702500Strategy: Do not hedgeCost of hedging: $ 2500

c) During Receivable factors that likely affect multinational industry hedging are

Risk bearing capacity of firm

Accuracy of Estimation

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Exposure Netting: - It refers to offsetting exposure in one currency with exposure in the same or another currency whose exchange rates are expected to move in a way such that loss or gain on first exposed position will be offset by gain or loss in the second exposed position

Eg: - If A limited has $ 10000 receivable position and $ 6000 payable position both for 3 months exposure netting can be done and it is enough if A limited hedges for $ 4000 receivable positions

Centralized v/s Decentralized Hedging

Centralized hedging refers to total corporate exposure hedged as a totality instead of each individual hedging where specific exposure are hedged at branch levels which is referred to as decentralized hedging.

Centralized hedging reduces cost of hedging because of netting however centralized hedging requires strong real time information qualified and trained employees to operate real time system etc.

Thus before deciding for centralized or decentralized hedging a detailed cost benefit analysis should be undertaken i.e. if the cost of implementation, then go for centralized hedging or else decentralized hedging is a better option.

Methods for managing Translation Exposure (Accounting Exposure)

1) Adjusted fund flows: - It involves altering either the amount of currencies or both cash flows of parent or subsidiary to reduce the firm’s local currency exposure

If local currency devaluation is expected then exports are priced in hard currency (Foreign currency) and imports are priced in soft currency (Local currency).

Other techniques like investing in hard currency replacing hard currency borrowing with soft currency loans etc are also considered.

2) Entering into forward contracts: - It demands a formal market in the respective local currency. Forward 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 forward market.

If a firm cannot find a forward market for currency in which it has exposure it can hedge such risk through a forward contract on a related currency whose relationship is estimated by examining historical currency fluctuations between actual and related currency.

3) Exposure netting: - It refers to offsetting exposure in one currency with exposure in the same or another currency whose exchange rates are expected to move in a way such that loss or gain on first exposed position will be offset by gain or loss in the second exposed position.

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Managing Transaction Exposure

Transaction exposure can be managed by using

Price adjustment

Forward market

Money market

Currency option

Borrowing or lending in foreign currency etc.

Forward market hedge v/s money market hedge

In a forward market hedge a company that is long (buy) on foreign currency will sell foreign currency forward where as a company that is short (sell) on foreign currency will buy the foreign currency forward. In this way the company can fix the home currency value of future foreign currency cash flow.

Hedging with forward contract eliminates the downside risks at the expense of foregoing upside potentials (cost of hedging).

Money market hedge is alternative to forward market hedge which involves simultaneous borrowing and lending activities in two different currencies to lock in home currency value of a future foreign currency cash flow. The effective rate on forward contract will equal the actual forward rate if interest parity holds.

Problems

2. Pepsi Company would like to hedge its CAN $ 40 million payable to ‘A’ limited, a Canadian aluminum producer which is due in 90 days suppose it faces the following exchange and interest rates.

Spot rate $ 0.7307/12 per CAN $

Forward rate (90 days) $ 0.7320/41 per CAN $

CAN $ 90 day interest rate (annualized) 4.71 % - 4.64 %

US $ 90 day interest rate (annualized) 5.50 % - 5.35 %

Which hedging alternative would you recommend? The first rate is the borrowing rated and second rated is the lending rate.

Solution

Forward Market Hedge

Payable position CAN $ 40 million after 3 months

Spot rate $ 0.7307 - $ 0.7312 per CAN $

Forward rate $ 0.7320 - $ 0.7341 per CAN $

Forward market payable = CAN $ 40 million × $ 0.7341

Forward market payable = $ 29.364 million

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Money Market Hedge

Explanation

Pepsi Company has a payable exposure of CAN $ 40 million after 3 months.

The Present Value (PV) of C $ 40 million should be invested as on today in a Canada bank so that along with interest it will mature at C $ 40 million after 3 months.

Invest rate in Canada is 4.64 % per annum

For 3 months = 4.64 % × 3/12 = 1.16 %

PV = FV × 1 . = 40 million × 1 . = C $ 39.5413 million (1 + r) n (1 + 0.0116)

USD equivalent of C $ 39.5413 million shall be borrowed form a US bank as on today

= C $ 39.5413 × $ 0.7312

= $ 28.9126

Note: - for conversion spot rate shall be considered since it is conversion as on today. To buy C $ offer rate of banker shall be considered ($0.7312/C$)

Loan borrowed form US bank ($ 28.9126 million) should be repaid along with interest after 3 months

Interest rate = 5.5 % pa

For 3 months = 5.5 % × 3/12 = 1.375 %

Maturity value of the loan = $ 28.9126 × (1 + 0.01375)

Money market hedge payable = $ 29.3101

Conclusion: - Money Market hedge shall be preferred for the above problem

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US Canada

Borrow CAN $ 39.5413 million at spot rate of $ 0.7312

i.e. C $ 39.5413 × $0.7312

= USD 28.9123

= PV of C $ 40 million

= 40 million × 1 . (1 + 0.0116)

= C $ 39.5413 million

FV of USD 28.9126

= 28.9126 × (1 + 0.01375)

= $ 29.3101 (Payable)

C $ 40 million (payable in 90 days)

i.e. Future value

Rudramurthy B.V

3. DC corporation is a US based software consultant specialized in financial software for several fortune 500 it has an office in India, UK, Europe and Australia. In 2002 DC corporation required £ 100000 in 180 days and had 4 options before it


Money Market Hedge

Option Hedge

No Hedge

Its analyst developed the following information which was used to asses the alternative solution

Current spot rate of £ is $ 1.50 and 180-day forward rate of £ is $ 1.48

Interest rates were as follows

Particulars UK US

180 day deposit rate 4.5 % 4.5 %

180 day borrowing rate 5.1 % 5.1 %

The company also had the following information available to it

A call option on £ that expires in 180 days has an exercise price of 1.5 and a premium of $ 0.02. The future spot rate in 180 days are forecasted as follows

An analysis of hedging technique should be made and advice DC corporation on the best alternative for hedging

Solution


DC Corporation has payable position £ 100000 in 180 days

To meet the above payment DC Corporation has to buy bounds at prevailing forward rate

180-day forward rate $ 1.48/£

Forward market hedge = £ 100000 × 1.48 = $148000

Money Market Hedge

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Possible outcome Probability

$ 1.44

$ 1.46

$ 1.53

20 %

60 %

20 %

Rudramurthy B.V

No

Hedge

Calculation of Expected future spot price

Possible outcome (X) Probability (P) X × P

$ 1.44

$ 1.46

$ 1.53

0.2

0.6

0.2

0.288

0.876

0.306

Expected future spot rate $ 1.47

Expected future payable = £ 100000 × 1.47 = $ 147000

Option Hedge

Strike price = $ 1.5

Premium = $ 0.02

Possible outcome Option Probability Premium Payoff

$ 1.44

$ 1.46

$ 1.53

Not Exercise

(FSP < SP)

Not Exercise

(FSP < SP)

Exercise

(FSP > SP)

0.2

0.6

0.2

$ 0.02

$ 0.02

$ 0.02

- $ 0.02

- $ 0.02

$ 0.01

The probability of exercising the call option is 0.2(20 %); the probability of not exercising the call option is 0.8 (80 %)

Calculation of probable option price

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US UK

Borrow £ 95694 at spot rate of $ 1.5

i.e. 95694 × $ 1.5

= $ 143541

= PV of £ 100000

= 100000 × 1 . (1 + 0.045)

= £ 95694

FV of USD 143541

= 143541 × (1 + 0.051)

= $ 150861 (Payable)

£ 100000 (payable in 180 days)

i.e. Future value

Rudramurthy B.V

Possible outcome

PremiumExpected price

including premiumProbability

Expected price

$ 1.44

$ 1.46

$ 1.53

$ 0.02

$ 0.02

$ 0.02

$ 1.44

$ 1.46

$ 1.53

0.2

0.6

0.2

0.292

0.888

0.310

$ 1.49

Option hedge = £ 100000 × 1.5 = 150000

Since FSP < SP, DC Corporation will exercise the contract

Decision

Alternative Cash Outflow ($)


Money Market Hedge

No Hedge

Option Hedge

$ 148000

$ 150861

$ 147000

$ 150000

DC Corporation shall not hedge as the no hedge option is the lowest value in all the set of alternatives

4. P Company is a US based multinational Pharmaceutical company is evaluating an export sale of its extremely effective cholesterol reduction drug. The purchase would be for 750 million Indonesian Rupaiah, which current spot rate of RP 8800/$ translates into a little more than $ 85000 although not a big sale, the policy of P Company dictates that sale must be settled at least for a minimum gross margin which results at $ 78000 on the above sale

The current 90-day forward rate is 9800 RP/$. Although this appears to be unattractive, P Company has to contact several major banks before even finding the forward quote on the RP the consequences of currency forecasters at the movement however is that the Rupaiah is holding out relative study. The possible rate of RP is RP 9400 over the coming 90 days analyze the prospective sale and make the hedging recommendation.

Solution

Given

Spot rate = RP 8800/$

90-day forward rate = RP 9800/$

Expected future spot rate = RP 9400/$

Since P Company has receivable exposure of RP 750 million

Hedging Strategy: - Forward market hedge

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Rudramurthy B.V

P Company should go to forward market and short the Indonesian Rupaiah. 90-day forward market rate is RP 9800/$

Therefore cash inflow = 75000000/98000 = $ 76530

The company’s policy is not to sell below $ 78000 but if the company sell today then they will get $ 85227.27 using the spot rate of RP 8800/$.

P Company has a expectation of future spot rate of RP 9400/$ then the company need not go for hedging option as it will give the cash inflow of $ 79787.23

750000000/9400 = $ 79787.23

Decision: - By taking ‘not hedging option’, company can receive $ 79787.23 which is more than their minimum expectation of $ 78000. Hence company can opt for not hedging. But the company’s business is not to make profit by doing currency business they are in pharmaceutical business if they do not hedge or if they expose their receivables open they will get $ 79787.23 but expected future spot price may not become true then company loose their minimum expectation of $ 78000

5. Hindustan Lever Uniliver’s Subsidiary in India, procures much of its toiletries product line form Japanese Company. Due to shortage of working capital in India payment terms by Indian importers are typically 180 days or longer. Hindustan Lever wishes to hedge 8.5 million Japanese Yen payable.

Although options are not available on the Indian Rupee, forward rates are available against Yen. Additionally a common practice in India is for companies like Hindustan Lever to work with a currency agent who will in this case lock in current spot exchange rate in exchange for 4.85 % fee.

Using the following exchange rate and interest rate data, recommend a hedging strategy

Spot rate ¥/$ = ¥ 120.60/$

Spot rate Rs/$ = Rs 47.75/$

180-day forward rate ¥/Rs = ¥ 2.4000/Rs

Expected spot rate in 180 days = ¥ 2.6000/Rs

180-day Yen investment rate = 1.5 %

180-day Rupee investment rate = 8.0 %

Hindustan Lever’s cost of capital =12 %

Solution

Given

Spot rate ¥/$ = ¥ 120.60/$

Spot rate Rs/$ = Rs 47.75/$

Hence ¥/Rs = 120.6/47.75 = 2.5257

180-day forward rate ¥/Rs = ¥ 2.4000/Rs

Expected spot rate in 180 days = ¥ 2.6000/Rs

180-day Yen investment rate = 1.5 %

180-day Rupee investment rate = 8.0 %

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Rudramurthy B.V

Hindustan Lever’s cost of capital =12 %

Agent exchange rate commission is 4.85 %

No Hedge

= ¥ 8.5 million/Rs 2.6 = Rs 3.2692 million


Buy 8.5 million Yen in forward market at the spot rate of ¥ 2.4 /Rs¥ 8.5 million/Rs 2.4 = Rs 3.5417 million

Money Market Hedge

Currency agent hedge

Exposure ¥ 8.5 million

Agent hedge = ¥ 8.5 million/2.5257 = Rs 3.3654 million

Agent commission = 4.85 % × 3.3654 million = Rs 0.1632 million (today’s value)

FV of the above commission is

= 0.1632 × (1.06) = Rs 0.1730 million

Total outflow = (3.3654 + 0.1730) = Rs 3.5384 million

Decision

Alternative Cash Outflow ($)

No Hedge


Money Market Hedge

Agent Hedge

Rs 3.2692 million

Rs 3.5417 million

Rs 3.5384 million

Rs 3.5384 million

No hedge shall be preferred as it gives least cash outflow of Rs 3.2692 million

6. Dayton Company has concluded the target sale deal with a UK Company by name Crown. The total payment due from crown for 90-days is £ 30 lakhs the

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India Japan

Borrow ¥ 8.4367 million at spot rate of Rs 2.5257

i.e. ¥ 8.4367 ÷ Rs 2.5257

= Rs 3.3403 million

= PV of ¥ 8.5 million= 8.5 × 1 . (1 + 0.045)

= ¥ 8.4367 million

FV of Rs 3.3403 million

= 3.3403 × (1 + 0.06)

= Rs 3.3403 million (Payable)

¥ 8.5 million (payable after 6 months)

i.e. Future value

Rudramurthy B.V

borrowing rate in UK is 14 % pa given the following exchange rate and interest rate what transaction exposure hedge is now in Dayton’s best interest?

Spot rate = $1.7620/£

Expected spot rate in 90 days = $1.7850/£

90-days forward rate = $ 1.7550/£

90-days dollar deposit rate = 6 % pa

90-days dollar borrowing rate = 8 % pa

90-days pound deposit rate = 8 % pa

90-days pound borrowing rate = 14 % pa

Dayton’s weighted average cost of capital = 12 %

Dayton has also collected data on 2 specific options

Solution

Money Market Hedge

No

Hedge

Expected spot rate in 90 days is $ 1.7850/£

£ 3000000 × 1.7850 = $ 5355000


90 days forward rate is $ 1.7550/£

£ 3000000 × 1.7550 = $ 5265000

Option Hedge

61

Option Type Strike Price Premium

90-day put option on pound

90-day put option on pound

$ 1.75/£

$1.71/£

1.5 %

1.0 %

India Japan

Borrow £ 2898551 into equivalent dollar at spot rate $ 1.7620/£ = £ 2898551 × 1.7620 = $ 5107246

= PV of £ 3000000 at 14 % pa = 3000000 × 1 . (1 + 0.045)

= £ 2898551

FV of $ 5107246 is

= $ 5107246 × (1 + 0.03)

= $ 5260463

Borrow £ 3000000 in UK

Rudramurthy B.V

Particulars A B

Strike price

Premium

Receivable exposure

Spot rate

Option premium

FV of option premium

$ 1.75/£

1.5 %

£ 3000000

$ 1.7620/£

3000000 × 1.762 × 1.5 %= $ 79290

$ 79290 × 1.03 = $ 81669

$ 1.71/£

1.0 %

£ 3000000

$ 1.7620/£

3000000 × 1.762 × 1.5 %= $ 79290

$ 79290 × 1.03 = $ 81669

Option exercised

- FV of option premium

3000000 × 1.75 = $ 5250000

- $ 81669

3000000 × 1.75 = $ 5250000

- $ 81669

$ 5168331 $ 5075554

Calculation of minimum and maximum values

Considering certain cash flows (Except No Hedge Option) the best alternative is forward market hedge. It gives a receivable of $ 5265000 after 90 days. To accept option hedging the minimum future spot price should be

Particulars A B

Forward market hedge

+ Future value of option premium

$ 5265000

$ 81669

$ 5265000

$ 54446

Minimum future spot price

$ 5346669

$ 5346669 ÷ 3000000 = $ 1.782

$ 5319446

$ 5319446 ÷ 3000000 = $ 1.7736

If FSP > 1.782 for option A and 1.773 for option B then option hedge shall be preferred over forward market hedge.

7. Nike International needs to order supplies 2 months ahead of delivery date. It is considering an order from Japanese that requires a payment of ¥ 12.5 million payable as of the delivery date. Nike has two option or choice

a. Purchase 2 call option contracts each option contract size is ¥ 6250000

b. Purchase one future contract representing ¥ 12.5 million

c. The future price of yen has historically exhibited a slight discount form the existing spot rate however the firm likes to use currency option to hedge in Japanese Yen for transaction 2 months in advance. Nike would prefer hedging since it is uncomfortable to leave position open giving historical volatility of Yen.

The current Yen spot rate is $ 0.0072 there are 2 call options available, call A with an excise price of 5 % above spot price with premium of 2 % the price to be paid

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per Yen if the option is exercised. Call B with an excise price of 10 % above spot price with premium of 1.5 % the price to be paid per Yen if the option is exercised.

The 2-month future price of Yen is $ 0.006912 as an analyst you have been asked to answer insight of how to hedge assume the spot rate remain unchanged after 2 months.

a) Calculate option exercise price and premium for both the call options

b) If Nike decides to use call option to hedge Yen which call option should it use.

c) If Nike decides to allow Yen to be un-hedged, will it benefit? If so calculate trade-off.

d) Which is the optimal choice for the company, call A or call B or future contract if the spot price on expiry becomes $ 0.00781?

Solution

a) Calculation of Option exercise price and premium

Particulars A B

Spot price

Exercise price

Payable exposure

Option premium

$ 0.0072

0.0072 × 1.05= 0.00756

¥ 12500000

12500000 × 0.00756 × 2 %= $ 1890

$ 0.0072

0.0072 × 1.10= 0.00792

¥ 12500000

12500000 × 0.00792 × 1.5 %= $ 1485

b)

Particulars A B

Exercise price

Payable exposure

Option premium

0.0072 × 1.05= 0.00756

¥ 12500000

12500000 × 0.00756 × 2 %= $ 1890

0.0072 × 1.10= 0.00792

¥ 12500000

12500000 × 0.00792 × 1.5 %= $ 1485

Option exercised

+ Option premium

12500000 × 0.00756 = $ 94500

$1890

12500000 × 0.00792= $ 99000

$ 1485

$ 96390 $ 100485

Interpretation: - Option A shall be preferred

c) No hedge

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Rudramurthy B.V

= 12500000 × 0.0072

= $ 90000

2-month future price of the Yen is assumed to be $ 0.006912 then the payable exposure will be

= 12500000 × 0.006912

= $ 86400

d) If the spot price on expiry is $ 0.00781 call option A shall be preferred since FSP > SP

Particulars A B

Future spot price

Exercise price

Exercise or Lapse

Option premium

$ 0.00781

= 0.00756

Exercise (FSP >SP)

= $ 1890

$ 0.00781

= 0.00792

Lapse (FSP < SP)

= $ 1485

Option exercised / Lapsed

+ Option premium

12500000 × 0.00756 = $ 94500

$1890

12500000 × 0.00781= $ 97625

$ 1485

Payable exposure including premium

$ 96390 $ 99110

Interpretation: - Option A shall be preferred

8. A call option in Canadian dollar is available with strike price of $ 0.60 and he purchased by a speculator at $ 0.06/unit. Contract size is 50000 units, C $ spot rate is $ 0.65 at the time option is exercise. What is the net profit to the speculator? What spot rate will earn the speculator BEP (Break Even Point) and at what rate will the seller earn profit?

Solution

Type of option = Call option

Strike price = $ 0.60

Premium = $ 0.06

Contract Size = 50000 units

FSP =$ 0.65

Call option is exercised when FSP > SP

= ($ 0.65 – 0.60) × 50000

= $2500

Cash flow

= 2500 – [0.06 × 50000] = $ 2500 - $2000 = $ 500

Break Even Point (BEP) for call holder (Buyer)

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Rudramurthy B.V

= Strike price + Premium

= 0.60 + 0.06 = 0.66

Seller makes profit if FSP < 0.66

9. P international has sold Australian put option at a price of $ 0.01/unit with strike price of $ 0.76/unit. If the following rates prevail, determine net profit or net loss

$ 0.72, $ 0.74, $ 0.76, $ 0.78, $0.79

Solution

FSP SP Exercise/LapseProfit before

premiumPremium

Profit/Loss for holders including

premium

Writer’s profit/Loss

0.72

0.74

0.76

0.78

0.79

0.76

0.76

0.76

0.76

0.76

Exercise

Exercise

Exercise/Lapse

Lapse

Lapse

0.04

0.01

0.01

-

-

0.01

0.01

0.01

0.01

0.01

0.03

0.01

-0.01

-0.01

-0.01

-0.03

-0.01

0.01

0.01

0.01

10. An Indian importer is required to pay US $ 10 lakh on June 30, 2000. The import of goods took place on April 1, 2000. Following further details are furnished

Spot rate on April 1, 2000 = Rs 44.25/37

3-month forward rate = Rs 44.54/73

Strike price of option (3 months) = Rs 44.50

Option premium = 0.25

What will happen to importer if he takes the following?

a) Forward cover

b) Option cover

The spot prices on June 30, 2000 are

1) 45.0/1

2) 44.00/12

Solution

a) Forward market cover

Payable exposure = $ 1000000 Spot rate = 44.25/44.37

3-month forward rate = 44.54/44.73

Payable exposure after 3 months

= 1000000 × 44.73 (consider offer rate while buying)

= 44730000

b) Option cover

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Rudramurthy B.V

1) When future spot rate is 45.00/45.10

Payable exposure = $1000000

FSP = Rs 45.00

SP = Rs 44.50

Premium = 0.25

Payable exposure = (1000000 × 44.50) + premium paid

Payable exposure = (1000000 × 44.50) + (1000000 × 0.25) = Rs 44750000

2) When future spot rate is 44.00/44.15

Payable exposure = $1000000

FSP = Rs 44.00

SP = Rs 44.50

Premium = 0.25

Payable exposure = (1000000 × 44.15) + premium paid

Payable exposure = (1000000 × 44.50) + (1000000 × 0.25) = Rs 44400000

Interpretation

Alternative Payable Exposure

Forward cover

Call option FSP 45.0/1

Call option FSP 44.00/15

Rs 44730000

Rs 44750000

Rs 44400000

If FSP is 45.0/1 forward cover shall be preferred

If FSP is 44.00/44.15 option cover shall be preferred

11. City Corporation sell a call option in DM (contract size is DM 600000) at a premium of $ 0.04 per DM. If the exercise price is $ 0.71 and spot price on the day of expiration is $ 0.73 what is profit/loss on above call option sold by City Corporation?

Solution

Calculation of Pay-off for the holder

Writer of call option (City Corporation)

SP = $ 0.71

FSP = $ 0.73

Call option is exercised by the holder since FSP > SP

Profit/loss = ($ 0.71 - $0.73) × 500000

= -0.02 × 500000 = -$ 10000

Therefore pay-off for writer = $10000

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Rudramurthy B.V

12. During the month of June, European pound sterling are quoting the following quotes in terms of USD

Call option premium Strike price

0.06

0.03

0.01

1.61

1.65

1.60

Determine the conditions under which profit can be made by

a) Option buyer

b) Option writer

Solution

Calculation of profit/loss for option buyer

FSP

Premium

1.61 1.65 1.66

0.06 0.03 0.01

BEP 1.67 1.68 1.67

Option buyer will make profit when FSP > SP + premium

For SP of 1.61, option buyer will make profit if FSP > 1.67



An option writer makes profit when FSP < SP + premium

For SP of 1.61, option writer will make profit if FSP < 1.67



13. Calculate the following rates into outright rates

Particulars Spot 1-month 3-month 6-month

Rs / $ 35.6300/25 20/25 25/35 30/40

Rs / £ 55.2200/35 40/30 50/35 55/42

Rs / DM 23.9000/30 30/25 40/60 45/65

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Solution

Particulars

Spot 1-month 3-month 6-month

Rs / $ 35.6300/35.6325 35.6320/35.6350 35.6325/35.6360 35.6330/35.6365

Rs / £ 55.2200/55.2235 55.2160/55.2205 55.2150/55.2200 55.2145/55.2193

Rs / DM 23.9000/23.9030 23.8970/23.9005 23.9040/23.9090 23.9045/23.9095

14. Calculate outright rates and spread percentage


USD / INR 43.1010/1100 225/275 300/330 375/455

Solution


USD / INR 43.1010/43.1100 43.1235/43.1375 43.1310/43.1430 43.1385/43.1555

Spread in %

43.1100 – 43.101043.11

= 0.0208 %

43.1375 – 43.123543.1375

= 0.0325 %

43.1430 – 43.131043.1430

= 0.0278 %

43.1555 – 43.138543.1555

= 0.0394 %

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Rudramurthy B.V

International Portfolio Diversification

Problems

1. X limited is thinking to invest in two different risky assets in an index of US equity market and German equity market. The two equities are characterized by the following expected return and expected risk

Particulars Expected return Expected risk

US Equity index

German Equity index

14 %

18 %

15 %

20 %

Correlation co-efficient between US and German market is 0.34

If the weights of investment are 0.4 for US Equity index and 0.6 for German equity index, calculate

a. Expected return of above portfolio

b. Covariance between US and German Equity index

c. Risk of the above international portfolio

Solution

a. Calculation of expected return on portfolio

Portfolio Weight (W) Expected return (R) W × R

US Equity index

German Equity index

0.4

0.6

14 %

18 %

5.6 %

10.8 %

Expected return on portfolio 16.4 %

b. Calculation of covariance

COVUG = σU × σG × rUG

COVUG = 15 × 20 ×0.34

COVUG = 102

c. Calculation of risk of the portfolio

σP2 = σU

2 WU2+ σG

2 WG2 + 2 COVUG WU WG

σP2 = (15)2 (0.4)2 + (20)2 (0.6)2 + 2 × 0.4 ×0.6 ×102

σP2 = 228.96

σP = 15.13

2. Boing Company and Uniliver company are from US and UK, an investor is evaluating a two asset portfolio of the following two securities

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Rudramurthy B.V

Particulars Expected return Standard Deviation

Boing Company 18.6 % 22.8 %

Uniliver Company 16 % 24 %

Co-efficient of correlation 0.6

a. What is the expected return and the risk of the portfolio if they are equally weighed?

b. If the weights are changed to 0.7 for Boing and 0.3 for Uniliver, what is the Expected return and risk

Solution

a. Calculation of expected return on portfolio of equal weights


Boing Company

Uniliver Company

0.5

0.5

18.6 %

16 %

9.3 %

8 %


Calculation of risk of the portfolio of equal weights

σP2 = σB

2 WB2+ σU

2 WU2 + 2 rBU σB σU WB WU

σP2 = (22.8)2 (0.5)2 + (24)2 (0.5)2 + 2 × 0.6 × 24 × 22.8 × 0.5 × 0.5

σP2 = 438.12

σP = 20.93 %

b. Calculation of expected return on portfolio of 0.7 and 0.3 for Boing and Uniliver respectively


Boing Company

Uniliver Company

0.7

0.3

18.6 %

16 %

13.02 %

8 %


Calculation of risk of the portfolio of 0.7 and 0.3 for Boing and Uniliver respectively

σP2 = σB

2 WB2+ σU

2 WU2 + 2 rBU σB σU WB WU

σP2 = (22.8)2 (0.7)2 + (24)2 (0.3)2 + 2 × 0.6 × 24 × 22.8 × 0.7 × 0.3

σP2 = 444.45

σP = 21.08 %

3. An investor is evaluating a two asset portfolio of the following two securities

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Rudramurthy B.V

Particulars Expected return Standard Deviation

Anglo Equity 12.5 % 26.4 %

American Equity 10.8 % 22.5 %

The correlation co-efficient between the two equity funds is 0.72.

What is expected return and risk for the following portfolio weights

a. 75 % Anglo 25 % American

b. 50 % Anglo 50 % American

c. 25 % Anglo 75 % American

Which of the above portfolio is preferable and on what basis?

Solution

a. 75 % Anglo 25 % American

Expected return on portfolio

ERP = WAN × EAN + WAM × EAM

ERP = (0.75) (12.5) + (0.25) (10.8)

ERP = 12.075 %

Risk of the portfolio

σP2 = σAN

2 WAN2+ σAM

2 WAM2 + 2 rAN,AM σAN σAM WAN WAM

σP2 = (26.4)2 (0.75)2 + (22.5)2 (0.25)2 + 2 × 0.72 × 26.4 × 22.5 × 0.75 × 0.25

σP2 = 584.06

σP = 24.17 %

b. 50 % Anglo 50 % American



ERP = (0.5) (12.5) + (0.5) (10.8)

ERP = 11.65 %


σP2 = σAN

2 WAN2+ σAM


σP2 = (26.4)2 (0.5)2 + (22.5)2 (0.5)2 + 2 × 0.72 × 26.4 × 22.5 × 0.5 × 0.5

σP2 = 514.64

σP = 22.69 %

c. 25 % Anglo 75 % American

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Rudramurthy B.V



ERP = (0.25) (12.5) + (0.75) (10.8)

ERP = 11.225 %


σP2 = σAN

2 WAN2+ σAM


σP2 = (26.4)2 (0.25)2 + (22.5)2 (0.75)2 + 2 × 0.72 × 26.4 × 22.5 × 0.25 × 0.75

σP2 = 488.71

σP = 22.11 %

Interpretation

Option ‘a’ shall be preferred based on return as it gives higher return and option ‘c’ shall be preferred based on risks as it gives lower risks

Risk reward ratio

a. Risk / Return = 24.17 ÷ 12.075 = 2.0017

b. Risk / Return = 22.69 ÷ 11.650 = 1.9476

c. Risk / Return = 22.11 ÷ 11.225 = 1.9679

Option ‘b’ shall be preferred based on both risk and return i.e. an investor can get a maximum return with minimum risk levels only if the weights of the two securities are equal.

4. Assume the US dollar rate of return, standard deviation Risk free rate of return and β value for three Baltic republic are given as follows

Country Mean Return Standard deviation Risk Free return β

Estonia

Latvia

Lithuania

1.12 %

0.75 %

1.60 %

15 %

22.8 %

13.5 %

0.42 %

0.42 %

0.42 %

1.65

1.53

1.00

Calculate Sharpe, Treynor, Jenson measure

TRYENOR measure

TM = R p – R f β p

TME = 1.12 – 0.42 = 0.42 TMLi = 1.6 – 0.42 = 1.18 1.65 1.00

TMLa = 0.75 – 0.42 = 0.22 1.53

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Rudramurthy B.V

TRYENOR measure

SM = R p – R f σ p

SME = 1.12 – 0.42 = 0.0438 16

SMLa = 0.75 – 0.42 = 0.0145 22.8

SMLi = 1.6 – 0.42 = 0.0874 13.5

JENSEN measure

JM = R p – SML

JM = R p – [R f + β (ER m – R f)]

JMA = 1.12 – [0.42 + 1.65(1.6 – 0.42)] = -1.247

JMB = 0.75 – [0.42 + 1.53(1.6 – 0.42)] = -1.4754

JMC = 1.60 – [0.42 + 1.00(1.6 – 0.42)] = 0

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International Cost of Capital and Capital Structure

International cost of capital is much cheaper than domestic weighted average cost of capital (WACC) because company can increase finance through global market where it will get at cheaper rate

Problems

1. MS Oil Company’s cost of debt is 7 %. The risk free rate of interest is 3 %. The expected return on the market portfolio is 8 %. After depletion allowances MS oil’s effective tax rate is 25 % its optimal capital structure is 60 % debt and 40 % equity.

a. If MS Oil’s beta is estimated at 1.1, what is WACC?

b. If MS Oil’s beta is estimated at 0.8, significantly lower because of continuing profit prospects in the global energy sector, what is WACC?

Solution

a. When beta is 1.1

Post tax cost of debt = Pre tax cost of debt (1 – tax)

KD = 7 % (1 – 0.25)

KD = 7 % × 0.75 = 5.25 %

Calculation of cost of equity

KE = RF + [ERM – RF] β

KE = 3 % + [8 – 3] 1.1

KE = 3 % + 5.5 %

KE = 8.5 %

Calculation of weighted average cost of capital

WACC = WD KD + WE KE

WACC = 0.6 × 5.25 + 0.4 × 8.5

WACC = 6.55 %

b. When beta is 0.8


KD = 7 % (1 – 0.25) = 5.25 %

Calculation of cost of equity


KE = 3 % + [8 – 3] 0.8 = 7 %

Calculation of weighted average cost of capital


WACC = 0.6 × 5.25 + 0.4 × 7

WACC = 5.95 %

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Rudramurthy B.V

2. Using the following data calculate

a. Cost of Equity

b. Cost of Debt

c. Weighted average cost of capital (WACC)

RF = 4 %, KD = 7 %, Tax = 30 %, β = 1.3, ERM = 9 %, D/(D + E) = 50 %

Solution

a. Calculation of cost of equity


KE = 4 % + [9 – 4] 1.3 = 10.5 %

b. Calculation of post tax cost of debt


KD = 7 % (1 – 0.3) = 4.9 %

c. Calculation of weighted average cost of capital (WACC)


WACC = 0.5 × 4.9 + 0.5 × 10.5

WACC = 7.7 %

Cost of Capital across Countries

Just like technology or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantages to MNCs in the following ways

Increased competitive advantage results to the MNC as a result of using low cost of capital obtained from international financial markets compared to domestic firms in the foreign country. This in turn, results in lower costs that can be translated into higher market shares.

MNCs have the ability to adjust international operations to capitalize on cost of capital differences among countries, something not possible for domestic companies.

Country differences in the use of debt or equity can be understood and capitalized by MNC

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Rudramurthy B.V

Swaps

A swap is an agreement between two companies to exchange cash flows so as to gain the difference.

Types of Swaps

1. Interest Rate Swaps

2. Currency Swaps

An interest rate swap is a swap where in a company borrows fixed rate of interest (Comparative advantage in fixed rate interest) and ends up paying in floating rate (wishes to pay floating rate of interest) by entering into swap agreement with other company with opposite cash flows.

LIBOR (London Inter Bank Offer Rate)

It is the rate of interest at which bank deposits money with other banks in the euro currency markets generally 1-month, 3-month, 6-month and 1-year LIBOR’s are used.

Advantages of Swap

1. A swap agreement can be used to transform a floating rate of loan into fixed rate of loan and vice versa.

2. A swap agreement can also be used to transform an asset turning fixed rate of interest into an asset turning floating rate of interest.

Comparative Advantage Theory

The popularity of swaps comes into picture only because of Comparative Advantage Theory.

According to this theory a company should borrow or invest for that rate of interest in which it has comparative advantage.

But however it wants to satisfy its wish of opposite rate, it should enter into swap agreement.

Critics of Comparative Advantage Theory argue that the benefit of swap will not exist in reality because of arbitragers operating in market.

Comparative Advantage Theory makes an assumption that floating rate of interest remains unchanged throughout the period of swap agreement. However in reality floating rate might change due to change in the creditworthiness of the company.

Currency Swap

It involves exchange of principal and interest payment of receipts and payments in one currency with that of another currency.

Advantages of currency swap

Transformation of liabilities.

Transformation of assets.

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Rudramurthy B.V

Problems

1. Company A and company B have been offered the following rates pa on a $ 20 million 5 year loan

Company Fixed rate Floating rate

A

B

12 %

13.4 %

LIBOR + 0.1 %

LIBOR + 0.6 %

Company A requires floating rate loan and company B requires a fixed rate loan. Design a swap agreement that will net a bank acting as intermediary 0.1 % pa and that will appear equally attractive to both the companies

Solution



A

B

12 %

13.4 %

LIBOR + 0.1 %

LIBOR + 0.6 %

Interest rate differential 1.4 % 0.5 %

Calculation of profit or gain on swap

Swap gain = 1.4 % - 0.5 % = 0.9 %

Less banker commission = 0.1 %

Net swap gain = 0.8 %

Swap gains are shared equally by A and B respectively

Net swap gain to Company A = 0.4 %

Net swap gain to Company B = 0.4 %

Net Cash outflow for A = LIBOR + (0.1 – 0.4) = LIBOR – 0.3 %

Net Cash outflow for B = 13.4 % - 0.4 % = 13 %

Intermediary Gain = 0.1 %

Company Comparative advantage Actual Borrowing rate

A Fixed rate Floating rate

B Floating rate Fixed rate

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2. Company ‘A’ wishes to borrow 10 million at a fixed rate for 5 years and has been offered 11 % fixed or 6-month LIBOR + 1 %. Company B wishes to borrow 10 million at a floating rate for 5 years and has been offered 10 % fixed or 6-month LIBOR + 0.5 %. How do they enter into a Swap agreement in which each benefit equally? What risk did this arrangement generate?

Solution



A

B

11 %

10 %

6-M LIBOR + 1 %

6-M LIBOR + 0.5 %

Interest rate differential 1 % 0.5 %

Calculation of profit or gain on swap

Swap gain = 1.0 % - 0.5 % = 0.5 %

Swap gains are shared equally by A and B respectively

Net swap gain to Company A = 0.25 %

Net swap gain to Company B = 0.25 %

Net Cash outflow for A = 11 % - 0.25 % = 10.75 %

Net Cash outflow for B = 6-M LIBOR + (0.5 – 0.25) = 6-M LIBOR + 0.25 %

Company Comparative advantage Actual Borrowing rate

A Floating rate Fixed rate

B Fixed rate Floating rate

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Spot Rate: It is the rate paid for delivery within 2 business days after the date of transaction, in other words it is the current exchange rate between 2 or more currencies.

Forward Rate: It is rate quoted for delivery of foreign currency on a future day which is established at the time of entering into the contract. Forward rates are usually quoted for fixed periods of 30, 60, 90 and so on days.

Cross Rate: An exchange rate between two countries that is derived from the exchange rate of those currencies with a 3rd known currency is known as cross rate of exchange.

Derivative: A derivative may be a commodity derivative or financial derivative whose value is derived from an underlying asset.

Forward: A forward contract is a tailor made contract whose terms are negotiated between the buyer and the seller which are not traded on organized exchanges and are useful to hedge forward receivables and payables where the exact date of such transactions is not fixed or known.

Future: A future contract where quantity, date and delivery conditions are standardized. The futures contracts are traded on organized exchanges which are settled with the differences

Option: An option gives its owner the right to buy or sell an underlying asset on or before a given date at a fixed price but with no obligation to buy or sell the same for a fixed premium.

Swap: A swap is a contract between two counter parties to exchange two streams of payments for an agreed period to time swaps may either be interest rate or currency swaps

Interest rate swap: It is an arrangement between parties or through the help of an intermediary where fixed rate interest cash flows are exchanged for floating rate interest cash flows or vice versa so as to benefit form exchange

Currency swaps: It is an arrangement between parties through an intermediary wherein receipts or payments in one currency is exchanged for receipts or payments in another currency so as to benefit from such transactions

Currency future: A currency future is the price of a particular currency for settlement at a specified future date. Currency futures are traded on future exchanges where the contracts are freely transferable.

Call option: Call option gives the option holder the right to buy an asset at a fixed price during a certain period without any obligation to buy.

Put option: Put option gives the option holder the right to buy an asset at a fixed price during a certain period without any obligation to buy.

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Covered call: A covered call involves writing a call option or an asset along with buying the asset. It is a covered call since potential obligation to deliver the stock is covered by underlying stock in the portfolio.

Uncovered call: An uncovered call or naked call refers to a speculative position not covered by an asset where the potentials of gains/losses are unlimited.

Dirty float: Dirty float refers to partly managed floating exchange rate wherein the central bank intervenes to smoothen the fluctuation or to manage the value of the domestic currency.

Clean float: Clean float it is left to the market forces of demand and supply to determine the exchange rate.

Arbitrage: Arbitrage is the simultaneous purchase and sale of the same asset or commodities on different markets to profit form price discrepancies.

Law of one price: In completive market characterized by numerous buyers and sellers having low cost access to information exchange adjusted prices of identical tradable goods and financial assets must be within transaction costs of equality world wide.

Difference between risk and exposure: Risk is the measure of uncertainty of expected return meeting with actual return. Risk is a pact of exposure where higher the exposure, higher is the degree of risk.

Comparative advantage theory of swaps: Swap contracts are entered in order to benefit form the comparative advantage where parties entering into swap agreement have in one interest rate say fixed rate over the other rate say floating rate.

Hard currency: A hard currency is a currency which is widely and popularly traded in the market. It is also that currency which is expected to appreciate in future.

Soft currency: A soft currency lacks liquidity and is expected to depreciate in future.

Difference between speculation and hedging: Speculation involves taking an uncovered call position to have exposed to unlimited profits and losses whereas hedging is process of covered position which removes risk of future appreciation/ depreciation of currency.

Marked to market: It is a system of calculating profits or losses on a daily basis and the same is credited or debited to customer’s account at the end of each trading day.

Currency option: The right to buy/sell an underlying asset being a currency for a premium without obligation to buy/sell.

Distinguish between absolute and relative PPP: Absolute PPP ignores the effect of transportation cost, tariff, quotas and other restrictions and product differentiation in free trade which is considered by relative PPP.

Participants in foreign exchange markets: Banker and other intermediary, importer, exporter etc.

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Floor: A contract that protects the holder against the fall in prices below a certain point or lower limit.

Dollarization: The complete replacement of local currency with the US dollar. It helps in providing economic stability.

Currency collar (Range Forward): It is an arrangement wherein the currency move outside an agreed upon range is protected.

Agency cost: Cost of conflicting interest between subsidiary company and parent company’s interest.

Devaluation of currency: It refers to drop in the foreign exchange value of a currency.

International Financial Management

It is concerned with application of functions of management to financing activity, investing activity, dividend decision and liquidity of a business keeping in mind the global perspective and crossing the geographical boundaries of the country.

Activities of IFM

1. Financing activity: How to raise the fund and from what source (debt or equity)

2. Investing activity: Where to invest (application of funds collected through financing activity)

3. Dividend decision: It decides how much of profit to be distributed to share holders as dividend and how much of profits to be retained

4. Liquidity decision or asset management decision: It studies the proportion of current assets and fixed assets in the total asset of the firm. Higher the proportion of current asset in the total asset of the firm, higher is the liquidity and vice versa.

Ex of IFM

Borrowing money from USA (financing decision) and employing the same in Japan (Investing decision).

Importance of IFM

1. Increasing boundaries of business

2. Growing financial instruments markets and systems

3. Changing political economy

4. Globalization

5. Changing socio-economic conditions

Differences from domestic FM

1. Exchange rate

2. Wider boundary of business

3. Wider exposure and risk

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4. International taxation

5. International capital markets

6. Political treaties between countries

7. International capital budgeting

8. International working capital management decisions

Challenges of IFM

1. Fluctuations in exchange rate

2. Expanding geographical boundaries

3. Growing financial and monetary developments

4. Fiscal polices and monetary developments

5. Changing capital markets

Theories of IFM

1. Comparative advantage theory

2. Relative advantage theory

3. Imperfect market theory (Supplying of resources not restricted by exports and imports)

4. Product life cycle theory

Factors that affect exchange rates

1. Demand for a currency

2. Supply for a currency

3. Inflation rates

4. Interest rates

5. Income level

6. Government control

Multinational Company (MNC)

A multinational company (MNC) or a transnational company is a company which has gone global. It keeps in mind a global scenario and views the entire world as one single market by extending the boundaries of its operation in more than one country. Foreign operation of a company which has substantial interest on revenue and decision making is also considered as MNC.

Ex: - Sony, Samsung, General Motors, Ford etc

Goals or objectives of MNC

Maximize shareholder’s wealth

To increase its cash flow by tapping the available money in the overseas market.

To recognize additional foreign opportunities

Availability of cheap and abundance of funds

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Availability of cheap and talented labor

Creation of place, form and possession utility

To move with advancement of technology

To help the firm invest its capital in potential investment avenues

To minimize time and distance across the globe

To enjoy the benefits of large scale business operations

Expansion and diversification

The Balance of Payment (BOP)

The Balance of Payment (BOP) of a country is a systematic accounting record of all economic transactions during a given period of time (generally one year) between the residents of the country and residents of foreign country. In short BOP is a statement which records a country’s international economic transaction with that of rest of the world for a specific period of time.

Importance of BOP (uses)

1. It indicates the pressure on a country’s foreign exchange rate.

2. Changes in BOP signal the imposition or removal of controls over payment of dividends, interest, license fee etc.

3. BOP helps to forecast a country’s market potential.

4. Decides a country’s monetary policy.

Economic transaction include

1. One real transfer: unilateral gift in kind

2. One financial transfer: unilateral financial gift

3. Two real transfer: barter transaction

4. Two financial transfer: exchange of financial items

5. One real transfer & one financial transfer: sale or purchase of goods or services for cash or credit

Accounting principles in BOP

BOP statement follows rules of double entry system of book keeping i.e. for every debt entry there is a corresponding credit entry.

Leaving aside errors & omissions BOP must always balance i.e. total debits = total credits.

Components of BOP

1. Current account

2. Capital account

3. Reserves account

4. Errors and omissions

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If credits are more than debits then we call it as surplus BOP, if credits are less than debits we call it as surplus BOP and if credit is equal to debit then we call it as balanced BOP.

Format of Balance of Payment

Particulars Credit Debit Net

A.CURRENT ACCOUNT

1. Merchandise (goods) BOT

2. Invisibles (a + b + c)

a) Services

b) Transfers

c) Incomes (Investment incomes)

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

Total Current Account (1 + 2) XXX XXX XXX

B. CAPITAL ACCOUNT

1. Foreign investment

2. Loans

3. Banking capital

4. Rupee debt services

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

XXX

Total Capital Account (1 + 2 + 3 + 4) XXX XXX XXX

C. ERRORS & OMISSIONS XXX XXX XXX

Overall Balance XXX XXX XXX

D. OFFICIAL RESERVES ACCOUNT

1. IMF

2. Foreign Balance reserve (increase or decrease)

XXX

XXX

XXX

XXX

XXX

XXX

Rules and guidance notes on recording

Imports are debt entry where as exports are credit entry

Increase in foreign asset or decrease in foreign liability is a debit entry whereas increase in foreign liability or decrease in foreign asset is a credit entry i.e. Increase in FA & Decrease in FL is a Debit

Decrease in FA & Increase in FL is a Credit

Merchandise imports and exports of goods and services are recorded in current account whereas transactions related to financial assets or liabilities are recorded in capital account.

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Capital outflow is a debit entry whereas capital inflow is a credit entry (netting)

Financial transfers and real transfers are recorded in current account.

Income form investment to be recorded in current account.

International monetary system

International monetary system is defined as the institutional frame work within which international payment are made, movement of capital accommodated and exchange rates among currencies are determined.

In short it is a complex whole of agreement, rules, institutions, mechanism and policies regarding

1. Exchange rates

2. International payments

3. Flow of capital

Stages of International Monetary System

1. Bimetallism (Before 1875)

It is a double standard system of free coin age for both silver and gold. Both silver and gold were used as international means of payment and the exchange rate among countries currency were determined by either gold or silver reserves

2. Classical Gold Standards (1875 – 1914) 39 years

Classical gold standards system as an international monetary system lasted for about 40 years. During this period London became the center of international financial system reflecting Britain’s advanced economy and its predominant position in international trade.

Under the gold standards, the exchange rate between any two currencies was determined by their gold content.

Ex: If 1 Kg of gold is 1000 £ and 1 kg of gold is 1500 $ then the exchange rate between £ and $ is £ 1 = $ 1.5

3. Inter-war period (1915 – 1944) 29 years

World war first ended the classical gold standards in August 1914, as all major countries suspend redemption of bank notes in gold countries, lacked the political will to abide by the “rules of the game” and so automatic adjustment mechanism of gold standards was unable to work. The event of great depression 1929 accompanying financial crisis added for further downfall of classical gold standards.

Paper standard came into being when gold standard was abandoned.

4. Breton Hood conference system (1945 – 1972) 27 years

Only July 1944 representative of 44 nations gathered at Breton Hood to discuss and design the post war international monetary system.

It paved way for establishment of International Monetary Fund (IMF) and its sister institution World Bank.

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US dollar was held as the only currency that was fully convertible to gold. Countries held gold and US dollars as the means of international payments.

5. Flexible exchange rate system (1973 – till date)

International Monetary Fund (IMF) members met at Jamaica and agreed for a new set of rules for international monetary system. The agreement include

Flexible exchange rate where central bank was allowed to intervene in exchange market to cut down the volatility.

Gold reserves were abandoned and half of the gold holding was returned to members and other half was sold and proceed was used to help poor nations.

Non oil exporting countries and less developed countries were given grater access to IMF funds.

Current Scenario

G5 countries meet at Plaza in New York in 1985 and G7 countries economic summit in Paris in 1987 made developed countries to more closely consult and co-ordinate their macro-economic policy and to achieve greater exchange rate stability. The exchange rates were determined by market force.

International Project Appraisal (Factors determining international capital budgeting)

A company can go global by any of the following means

1) Export trade

2) Establishment of subsidiary in the foreign country

3) Joint venture in foreign country

4) Establishing branch in foreign country

5) Agencies and franchise relationship

The following features distinguish a domestic project with that of international project appraisal (factors)

1. Exchange rate risk

Cash inflows form a foreign project will be in terms of foreign currency and there is exchange rate risk involved while converting the same to local currency.

2. Capital market segmentation

A precise cost of capital cannot be ascertained while appraising an international foreign project since cost of capital in home country varies with that of the host countries.

3. International taxation

Host country charges tax on income earned through a foreign project and even with holding tax is also charged on remittances made to parent company.

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Due considerations shall be given to tax credits allowed by home countries for payments of taxes in host countries.

4. Political risk or country risk

Changes in government policies of host country, entry and exit barriers, fluctuation in tax rate, penalties and subsidies, nationalization policy of host country etc determine the level of international project acceptability.

5. Inflation

Rates of inflation between home country and host country act as a factor for international project appraisal.

6. Salvage value

Salvage value offered by the host country at the time of repurchasing the project determines a factor for international project appraisal.

Country Risk Analysis

There is great interest developed in recent years among private and official lending institution in the systematic evaluation of country’s risk.

Need

Whether a country will be able to get loans at reasonable cost?

Whether a country will be able to attract foreign capital?

Factors to be considered in country-risk analysis

Political Risk Factors

According to Hans, it is said that “Political risk is 50 % of the country’s risk analysis but it is inseparable from economic risk”.

The following factors indicate political risk

a) Political Stability: - Changes in government, level of violence in country, internal and external conflicts etc determine political risk of each nation.

b) Attitude of host government: - The host government may impose restrictions on transfer of funds by subsidiary to parent company by charging the corporate tax, with-holding tax etc.

c) War: - Safety of local employees hired by MNCs and the project cash inflows are subject to volatility because of war.

d) Business Cycle: - The period of Business Cycle in which a country is operating decides the risk factor. In periods of trough, risk factor is more and in periods of boom risk factor is less

e) Priorities: - The host government may support the MNC and be friendly with the subsidiaries of parent company which determines the risk levels.

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Economic Risk Factors

The following factors indicate economic risk of a country

a) Rate of inflation: - It determines economic instability, government’s mismanagement, purchasing power of consumers etc

b) Current and potential state of country: -

An MNC which exports to a country or sets up a subsidiary there is concerned with present and future dement of its product.

Levels of external debt, foreign exchange reserve, BOP, GDP growth rate etc determines the country’s state or position.

c) Exchange rate: - It signifies the influence of the demand for a country’s export which in turn affects the country’s product and income level.

d) Resource base: - It includes natural resources, human resources and other intangible resources available in a country which measures the economic risk level.

e) Adjustment to external shock: - Countries with greater adaptability to external shocks have lesser economic risk compared to other countries whose level of adaptability is low.

Techniques to assess country risk

1) Debt related factors

Borrowing capacity of the country

Debt servicing capacity.

Liquidity and solvency problem

Indicators of debt servicing

Debt/GDP

Debt/foreign exchange receipt

Interest payment/foreign exchange receipt

2) Balance of payment

It represents difference between national income and national expenditure. It indicates the rate at which a country is building its foreign assets or foreign liabilities.

Indicators of BOP

a) Current account balance

b) Capital account balance

c) Reserve balance

3) Economic performance

It can be measured in terms of country’s rate of growth and rate of inflation

Indicators of Economic performance

a) GDP/GNP

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b) Gross domestic savings/GNP

c) Gross domestic investment/GDP

4) Political instability

Direct effect: - It includes political protest like strikes, lock outs etc

Indirect effect: - Adverse consequences on growth, inflation, foreign exchange reserve etc

5) Checklist approach

a) Identification of country risk factors

b) Assign weights

c) Prepare rating scale

d) Calculation of product (wt × rating scale)

e) Calculate country risk score

International Cost of Capital

It is the return what a total capital (domestic as well as international) expects from a project.

International Capital Structure

It is the means of financing a project using an ideal mix of various sources of capital like debt, equity and preference shares so as to maximize the value of firm and minimize the overall cost of capital.

Differences in cost of capital for an MNC and domestic firm can be because of the following factors

(1) Size of the firm

(2) Foreign exchange risk

(3) Access to international capital market

(4) International diversification effect

(5) Country risk

1. Political risk

2. Economic risk

Multinational Taxation

The objective of multinational taxation is to minimize the total tax burden on multinational projects.

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.

Double Taxation

An income earned in a foreign country may be charged to tax both in foreign country as well as home country. This concept of charging tax twice for the same income is called double taxation.

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As provided in natural law, same income shall not be charged to tax twice. Thus double taxation relief might be awarded based on section 90 (bilateral agreement) and section 91 (unilateral agreement) of Indian Income Tax Act of 1961.

1) Bilateral agreement under section 90

Two different countries can come to an agreement not to charge tax on same income earned in any one of the two 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 with tax in both countries.

2) Unilateral agreement under section 91

Where bilateral agreements are not there, income earned in such countries shall be given tax credit under section 91 of Indian Income Tax Act of 1961.

Factors considered in multinational tax management

a) Bilateral agreement

b) Tax holiday

c) Deductions available under chapter (6) of Indian Income Tax Act of 1961.

d) Exemption under section 10 of Indian Income Tax Act of 1961.

e) Mutual benefits

Multinational Cash Management

It involves estimation of various cash inflows from both domestic as well as international projects and optimum utilization of funds.

Objectives

a) To maximize foreign exchange risk exposure

b) To minimize political risk

c) To minimize country risk

d) To minimize transaction costs

e) To minimize cash requirement of multinational firm

Techniques of optimize cash flow

1) Accelerating cash inflows

2) Managing blocked funds

3) Leading and lagging strategy

4) Netting

5) Minimization of tax using international transfer pricing

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Multinational Inventory Management

A multinational firm might maintain inventory and re-order level far in excess of the economic order quantity. The following reasons shall be attributable for the same.

1) Anticipating devaluation

If devaluation of local currency is expected in near future, after devaluation imported inventory will cost more in local currency. Hence higher level of inventory is maintained but however a trade off on higher holding cost and high local interest rate is to be made.

2) Anticipating price freeze

When local government enforces price freeze following devaluation, the organization establishes price of an imported item at a high level with actual sales made at discount. In the event of devaluation sales continue at the posted price but discounts are withdrawn

3) Purchase of forward contract

Future purchases can be hedged with exchange rate fluctuations by entering into a forward by contract.

Managing of Multinational Receivables

Multinational accounts receivable are created by two types of transactions

1. Sales to related subsidiaries

2. Sales to unrelated buyers

Independent customers (unrelated buyers)

It involves decisions regarding selection of currency and terms of payment. Seller prefers to price the commodity in stronger currency where buyer prefers weaker currency.

Receivables from sales in weaker currency should be collected as soon as possible whereas receivables from sales in a stronger currency should be delayed

Self liquidating bills

If the sale deed has the bills accepted by the buyer and endorsement of the seller, it can be rediscounted with the banker and net investment in receivable can be brought down to zero.

Financing by exporting government

Government bodies in many countries facilitate inventory financing by extending export credit or by guaranteeing export credit from banks at lower interest rate.

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Depository Receipts

A depository receipts is a negotiable instrument that usually represents a company’s publicly traded securities (debt/equity) in foreign market.

Depository receipts are issued for stock traded abroad wherein an intermediaries acts on behalf of the issuing company rises funds without listing the securities mandatory on the respective country’s stock market.

Objectives of issuing Depository Receipts

To raise capital in foreign market

To build good will and reputation

To improve liquidity position of its securities

To allow employees outside the home market

To support for potential mergers and acquisition

American Depository Receipts (ADR)

Non US based company rising funds through issue of depositary receipts in US without compulsion of listing on US stock exchange.

Benefits of ADR to Issuing Companies

1. To raise additional funds

2. To build good will and reputation

3. To support for potential merger and acquisition

4. Increase share holder base

5. Enables companies to tap US security market

6. It provides a US way for US employees of Non-US companies to invest in their company’s employee stock option (ESO)

Benefits of ADR to Investors

1. High security

2. High liquidity

3. Diversification of risk

4. Higher return

Global Depository Receipts

It is an instrument to raise capital in multiple markets outside the issuer’s domestic market through stocks which are traded in foreign stock markets. GDR has become synonyms with selling equity in Euro markets.

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Differences between ADR & GDR

ADR GDR

1. ADR may be listed in New York stock exchange.

2. Issue expenses are more in ADR a

3. Compulsory voting rights to investors

4. US GAP has to be followed and re-accounting has to be done

5. It demands more transparency of account

1. GDR may be listed in London stock exchange

2. Issue expenses are low in GDR compared to ADR

3. Optional voting rights

4. It is enough if you show a reconciliation statement

5. GDR does not demand less transparency as that of ADR

Difference between Options and Futures

Futures Options

1. It is a standardized forward contract 1. It is an agreement to buy/sell not obligation to do.

2. No premium payment 2. Premium payment exist

3. One can buy/sell futures 3. One can become holder/writer of either call/put option

4. Unlimited profits and unlimited loss 4. Holder has limited loss and unlimited profit where as writer has limited profits and limited loss

5. Contracts exercised square off at current future rate existing on the date of square off

5. Option are exercised at the strike price

6. No concept of strike price 6. There exists concept of strike price

7. No concept of “in the money, at the money, out of the money”.

7. There exists concept of “in the money, at the money, out of the money”.

8. Brokerage calculated on contract value

8. Brokerage calculated on premium

9. High liquidity 9. Low liquidity

10. Small spreads 10. Huge spread

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Difference between Forward and Future

Futures Options

1. It is a non standardize future contract 1. It is a standardized forward contract

2. No intermediary 2. There exists intermediary

3. Traded in OTCEI market 3. Traded in recognized exchange

4. Cost of forward is less since there is no brokerage

4. There exists transaction cost and brokerage

5. High level of counter party risk 5. No such risk is prevalent in future market since exchange act as intermediary

6. Generally contracts are exercised 6. Either exercised or squared off

7. Contracts are settled either by delivery or cash settlement

7. Contracts are settled on cash basis

8. No liquidity 8. There exists high liquidity

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