Balance of Payment 20

8/2/2019 Balance of Payment 20

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Example

You are required to find out the overall balance,

showing clearly all the sub-balances from the followingdata:

(1)UC Corporation of the USA invests in IndiaRs.3,00,000 to modernise its India subsidiary.

(2) A tourist from Egypt buys souvenirs worthRs.3000 to carry with him. He also pays hotel andtravel bills of Rs.5,000 to Delhi Tourist Agency.

(3)The Indian subsidiary of UC Corporation remits,as usual, Rs.5,000 as dividends to its parentcompany in the USA.

(4) This Indian subsidiary of UC Corporation sells apart of its production in other Asian countries for

Rs.1,00,000.(5) The Indian subsidiary borrows a sum ofRs.2,00,000 (to be paid back in a years time)from the German money market to resolve itsurgent liquidity problem.

(6) An Indian company buys a machine forRs.1,00,000 from Japan and 60 per cent payment

is made immediately; the remaining amount is tobe paid after 3 years.

(7)An Indian subsidiary of French Company borrowsRs.50,000 from the Indian public to invest in itsmodernisation programme.

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Solution

Sources and Uses of Funds

S. No. Sources Uses Nature

1.2. (a)

(b)3.4.

5.6. (a)

(b)

3,00,0003,0005,000

1,00,000

2,00,000

40,000

5,000

1,00,000

Direct Foreign InvestmentGoods exportedServices (invisible) renderedDividends paidGoods exported

Short-term borrowingEquipment importedIncrease in claim to India(Portfolio)

6,48,000 1,05,000

BOP Statement

Current Account

Goods AccountExports : Rs. 1,03,000 (+)Imports : Rs. 1,00,000 (-)Balance : Rs. 3,000 (+)

Invisible AccountPayment Received : Rs. 5,000 (+)Payments Made : Rs. 5,000 (-)

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Balance : Nil

Current Account Balance: Rs. 3,000 (+)

B. Capital Account

Foreign Direct Investment

Inflow : Rs. 3,00,000 (+)Outflow : NilBalance : Rs. 3,00,000 (+)

Portfolio Investment

Inflow : Rs. 40,000 (+)Outflow : NilBalance : Rs. 40,000 (+)

Long-term Capital Balance: Rs.3,40,000 (+)(FDI + Portfolio)

Short-term Capital AccountInflow : Rs. 2,00,0000 (+)Outflow : Nil

Balance : Rs. 2,00,000 (+)

Capital Accounts Balance: Rs.5,40,000 (+)Overall Balance: Rs. 5,43,000 (+)

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There is a net surplus of Rs.5,43,000 in the balanceof payments. This means, there will be an increase ofreserves by this amount.

Notes: The transaction No. 7 did not enter into theBOP Statement since this transaction does not involveany foreign country. The entire transaction has taken

place in Indian rupees within India.

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FOREIGN EXCHANGE MARKET

INTRODUCTION

The foreign exchange market is the market where thecurrency of one country is exchanged for that ofanother country and where the rate of exchange isdetermined. The genesis of Foreign Exchange (FE)market can be traced to the need for foreign currenciesarising from:

international trade;

foreign investment; and

lending to and borrower from foreigners.

In order to maintain an equilibrium in the FE market,demand for foreign currency (or the supply of homecurrency) should equal supply of foreign currency (or

the demand for home currency). In operational terms,the demand for and supply of home currency should beequal. In the event of a disequilibrium situation, themonetary authority of the concerned country normallyintervenes/steps in to bring out the desired balance by:

variation in the exchange rate; or

changes in official reserves; or

both.

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PARTICIPANTS IN THE FE MARKET

Major participants in the FE market are:

Large commercial banks (through their cambistes

or dealers) operating either at retail level forindividual exporters and corporations, or atwholesale level in the interbank market;

Central banks of various countries that intervene inorder to maintain or to influence the exchange rateof their currencies within a certain range, as also to

execute the orders of government; Individual brokers or corporations. Bank dealers

often use brokers to stay anonymous since theidentity of banks can influence short-term quotes.

Exchange markets primarily function throughtelephone and telex. Further, it may be mentioned hem

that currencies with limited convertibility play a minorrole in the FE market. And, only a small number ofcountries have established fill convertibility of theircurrencies for all transactions.

QUOTING IN THE FE MARKET

Foreign exchange rates ale quoted either for immediatedelivery (spot rate) or for delivery on a future date(forward rate). In practice, delivery in spot market ismade two days later.

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A FE quotation is the price of a currency expressed inthe units of another currency. The quotation can beother direct or indirect. It is direct when quoted as so

many units of local currency per unit of foreigncurrency. For example, Rs. 35 = US$ 1, is a directquotation for US dollars in India. Similarly, a quotationin the USA will be $ 0.22 = FFr 1 whereas in France, itwould be FFr 3.3 = DM 1, etc.

On the other hand, an indirect quotation is the onewhere exchange rate is given in terms of variable unitsof foreign currency as equivalent to a fixed number ofunits of home currency. For example, in India US$2.857 = Rs. 100 is an indirect quotation. This type of cpis made in the UK. For example, in London a quotationmay be made as $1.55 = 1.

Since 2 August 1993, all quotations in India usethe direct method of quotation. Some currencies arequoted as so many rupees against one unit while othersas so many rupees against 100 units, as indicated inTables 1 to 3 below.

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Table 1 Foreign Currencies Quoted against their

One Unit

1. Australian dollar(A$)

2. Austrian schilling(Sch)

3. Bahrain dinar

4. Canadian dollar(Can$)

5. Danish kroner(DKr)

6. Deutschmark (DM)

7. Dutch guilder (FI

8. Egyptian pound

9. European CurrencyUnit (ECU)

10. Finish mark(FM)11. French franc(FFr)

12. Hong Kongdollar (HK$)

13. Irish pound (I )

14. Kuwaiti dinar

15. Malaysianringgit

16. New Zealanddollar (NZ$)17. Norvegiankroner (NKr)

18. Omani riyal

19. Qatar riyal

20. Saudi riyal (SR)

21. Singapore dollar(S$)

22. Sterling pound()

23. Swedish kroner(SKr)

24. Swiss franc (Sfr)

25. Thai baht (Br)

26. UAE Dirham

27. US Dollar ($)

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Table 2 Foreign Currencies Quoted against their

100 Units1. Belgian franc (BFr) 3. Italian lira 5. Kenyan shilling

2. Indonesian rupiah 4. Japanese yen 6. Spanish peseta

Table 3: Asian Clearing Union Currencies Quoted

against their 100 Units

1. Bangladesh taka 3. Iranian rial 5. Sri Lankanrupee

2. Burmese Kyat 4. Pakistani rupee

Foreign exchange rates are always quoted as atwo-way price, i.e. a rate at which the bank (dealer) iswilling to buy foreign currency (buying rate) and a rateat which the bank sells foreign currency (selling rate).Dealers do expect some profit in exchange operations

and hence there is always some difference in buyingand selling rates. However, the maximum spreadavailable to dealers may be restricted by their central

bank. All exchange rates by authorized dealers arequoted in terms of their capacity as buyer or seller.

Two-Way Quote

A dealer usually quotes a two-way price for a givencurrency-the price at which he is buying (bid price) andthe price at which he is selling (offer or ask price) thecurrency. In either case, the currency for which the bidor ask price is given is the unit of the item priced.

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In a bid quote of Rs 35/US$ 1, the dealer conveysthat he will buy dollars at the price of Rs 35 per dollar,which also means that he is willing to sell 35 m at the

price of one dollar. Likewise, when the dealer quotesan offer price per dollar, he implicitly quotes the rate atwhich rupees would be bought per dollar.

All foreign exchange dealers are set to make profitout of each transaction, whether it is a sale or purchaseof foreign currency. Therefore, when a dealer in India

buys foreign currency (the customer selling thecurrency), he endeavours to give as few units of thelocal currency as he can against every one unit of theforeign currency he buys. But when he sells foreigncurrency (the customer buying the currency), heendeavours to take as many units of the local currency

as he can against every unit of foreign currency hegives to the customer.

For example, a dealer in New Delhi may quote:US$ 1 = Rs 35.000 35.0050.

This means that he will buy dollars from an

exporter at US$ 1 = Rs 35.0000, and sell dollars to animporter at US$ 1 = Rs 35.0050. Thus, the lower rate isthe buy (bid) quote and the higher rate is the selling(ask) quote.

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Spread

Spread means the difference between a banks buying(bid) and selling (offer or ask) rates in an exchange rate

quotation or an interest quotation. It fluctuatesaccording to the level of stability in the market, thecurrency in question, and the volume of the business.Thus, if there is a degree of volatility in an exchangerate, and if business is thin and if (rumours persistabout the currency that) the current rate is rumoured to

be unsustainable, the dealer will protect himself bywidening the quote. That is, he will offer less currencywhile selling but demand more when buying. Thespread represents the gross return to the dealer for therisks inherent in making a market. The spread can also

be expressed as a percentage. That is,

Ask price Bid price x 100Per cent spread = Ask price

For example, with dollar quoted at Rs 35.000 -35.0050, the percentage spread equals 0.014.

35.0050 35.0000 x 100

Per cent spread = 35.0050= 0.014.

Usually, in transactions among dealers, only the

last two digits are quoted, to save time and the rest is

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understood. Thus, a dealer in New Delhi may quote aspot price for the dollar which is US$ 1 = Rs 35.0050 -35.0080 only by referring to the last two digits, i.e. 50-

80, instead of quoting the rate in its entirety.

The last digits are called points, e.g. in US dollarterms, a point is 1/10,000 part of the unit. Or, one pointUS$ 0.0001. A pip is one further decimal place to theright, i.e. US$ 0.00001 and represents 1/100000 part ofa dollar.

Most quoted currencies are expressed to fourdecimal places but the currencies with low valuerelative to others are quoted up to two decimal places.Italian Lira and Japanese yen are examples of suchcurrencies.

Cross Rates (Chain Rule)

Cross rate is the price of any currency other than thehome currency. In her words, it is the directrelationship between two non-home currencies in aforeign exchange market concerned with or used intransactions in a country to which none of the

currencies belongs. Thus, in India, a cross rate is anyexchange rate which excludes rupees, for example,US$/FFr, DM/BFr, etc.

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If an importer has to remit French francs from Indiawith the knowledge that Rupee/FFr rates are notnormally quoted, would first buy dollars against the

rupees and the same dollars will be used overseas toacquire French francs. If, say, rates in New Delhi amUS$ I = Rs 35.0010 Rs 35.0080 and rates in Parismarket are US$ 1 = FFr 5.1025/50, he will get US$ 1

by paying Rs. 35.0080 and for one US$, he will getFFr 5.1025. Thus, a sort of chain is formed as under:

FFr 5.1025 = US$1US$ 1 = Rs. 35.0080

Therefore, FFr 1 = 35.0080/5.1025or, FFr1 = Rs 6.8609

SETTLEMENTSCash

Cash rate or Ready rate is the rate when the exchangeof currencies takes places on the date of the deal. Ifdelivery is made on the day the contract is booked, it iscalled a Telegraphic Transfer (TT) or cash or value-daydeal.

Tom

When the exchange of currencies takes place on thenext working day after the date of deal, it is called theTOM (tomorrow) rate.

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Spot

When the exchange of currencies takes place on thesecond working day after the date of the deal, it is

called the spot rate. This time is allowed to banks toprocess the necessary paperwork and transfer the funds.Such transfers to and from banks will be effected whentheir overseas currency accounts we either credited ordebited, depending on whether the bank is buying orselling. The rate of the agreed deal on telephone iscalled the contract dale; the value date is the one whenthe deposit is credited or debited. Normally, a dealdone on Tuesday will b settled on Thursday and a dealdone on Friday will be settled on the followingTuesday. A business day is defined as one in which

both banks are open for business in both settlementcountries. Most dealings now-a-days are done spot.

In the case of a US$/DM deal done on Tuesday,settlement is normally expected on Thursday.Settlement would not be affected by a US holiday onthe following Wednesday, but would be affected by aGerman holiday on this Wednesday. In the latter case,the spot date would be postponed until Friday, provided

that both centres were open on Friday. If Wednesdaywere a normal day and Thursday a holiday in either theUSA or Germany, the spat day would be Friday, if bothcentres were open on that day.

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In the case of a US$/DM deal done, say, inLondon, the occurrence of bank holiday in the UKduring the spot period is entirely irrelevant. This is

because all bank account transfers are made in thesettlement country rather than the dealing centre.Settlement of both sides of a foreign exchange dealshould be made on the same business day. Because oftime zone differences, settlement on any given businessday will take place earlier in the Far East, later inEurope, mid later still in the USA. The principle thatthe two sides of the deal should be completed on thesame day is referred to as the principle of compensatedvalue.

The only exception o the principle of compensatedvalue arises for deals in Middle East countries for

settlement on Friday. This is a holiday in most MiddleEast countries. Even though a person buying theMiddle Eastern currency (say, Saudi riyals) may make

payment (say, in pound sterling) on Friday, the deliveryof riyals would take place on Saturday, provided it wasa business day in both the relevant countries:

For some currencies, such as US$/Can$ transactions, aspot transaction is only one day by convention andagreement among the market participants.

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ADJUSTMENT OF DEMAND AND SUPPLY ON

THE SPOT MARKET: PROCESS OF

ARBITRAGE

Arbitrage can be defined as an operation that consistsin deriving a profit without risk from a differentialexisting between different quoted rates. It may resultfrom two currencies (also known as geographicalarbitrage) or from three currencies (also known astriangular arbitrage).

Example

An Arbitrage between Two Currencies

Suppose two traders A and B are quoting the followingrates:

Trader A (Paris) Trader B (New York)

FFr 5.5012/US$ US$ 0.1817/FFr

We assume that buying and selling rates for thesetraders are the same. We find out the reciprocal rate ofthe quote given by the trader B, which is FFr55036/US$ (= 1/0.1817). A combiste buys, say, US$10,000 from the trader A by paying FFr 55,012. Then

he sells these US dollars to the trader B and receivesFFr 55,036. In the process, he gains FFr 24 (= 55,036 -55,012).

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Since, in practice, buying and selling rates arelikely to be different, so the quotation is likely to be asfollows:

Trader A Trader BFFr 5.4500/US$ - FFr 5.50121US$ US$0.1785/FFr - US$ 0.18/FFr

These rates mean that the trader A would bewilling to buy one unit of US dollar by paying FFr 5.45while he would sell one US dollar for FFr 5.5012. Thesame holds true for the corresponding figures of the

trader B.

By observing these figures, it is clear that in orderto make an arbitrage gain, the selling rate of the traderA has to be lower than the buying rate of the trader B.

But this process would tend to increase the selling

rate at the trader A because of the increase in demandof US do and the reverse would happen at the trader B

because of increased supply of US dollars. This wouldlead to an equilibrium after some time.

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Example

An Arbitrage between Three Currencies

Now suppose both traders A and B are located at NewYork and quoting as follows:

Trader A Trader B$ 0.60/SF $ 0.60/SFr $0.51/DM $0.52/DM

Since three currencies are involved hem, we findcross rates between SFr and DM as well. These are:

SFr 0.85/DM (= 0.5110.64 at the trader A and SFr0.867/DM (= 0.52/0.60) at the trader B. Thus, thesituation looks like as follows:

Trader A Trader B

$ 0.51/SFr $ 0.60/SFr $0.51/DM $ 0.52/DMSFr 0.85/DM SFr 0.867/DM

So what are the arbitrage possibilities?

There is no arbitrage gain possible between the USdollar and Swiss franc. The following two arbitrages

ale, however, possible: Deutschmark against the US dollar is being quoted

higher at the trader B. So buy Deutschmarks fromthe trader A and sell them to the trader B.

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A similar possibility of arbitrage gain existsbetween the Swiss franc and Deutschmark: buyDeutschmarks against Swiss francs from the trader

A and sell them to the trader B.

FORWARD RATE

If the exchange of currencies takes place after a certainperiod from the date of the deal (more than twoworking days), it is called the Forward Rate. A forwardexchange contract is a binding contract between acustomer and a dealer for the purchase or sale of aspecific quantity of stated foreign currency, at a rate ofexchange fixed at the time of making the contract (forexecuting by delivery and payment at a future timeagreed upon when making the contract).

Forward rates are generally expressed byindicating premium/discount on the spot rate for theforward period. Premium on one countrys currencyimplies discount on another countrys currency. Forinstance, if a currency (say the US dollar) is at a

premium vis--vis another currency (say the Indianrupee), it obviously implies that the Indian rupee is at a

discount vis-a-vis the US dollar.

The forward market is not located at any specifiedplace. Operations take place mostly by telephone/telex,etc., through brokers. Generally, participants in the

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market are banks which want to cover orders for theirclients.

Though the forward rate may be quoted by a traderfor any future date, the normal practice is to quote themfor 30 days (1 month), 60 days (2 months), 90 days (3months) and 180 days (6 months).

Quotations for forward rates can be made in twoways. They can be made in terms of the exact amountof local currency at which the trader quoting the rateswill buy and sell a unit of foreign currency. This iscalled the outright rate and it is used by traders inquoting to customers. The forward rates can also bequoted in terms of points of premium or discount on thespot rate, which is used in intetbank quotations. To find

the outright forward rates when premium or discounton quotes of forward rates are given in terms of points,the points are added to the spot price if the foreigncurrency is trading at a forward premium; the points aresubtracted from the spot price if the foreign currency istrading at a forward discount.

The traders know well whether the quotes in pointsrepresent a premium or a discount on the spot rate. Thiscan be determined in a mechanical fashion. If the firstforward quote (the bid or buying figure) is smaller thanthe second forward quote (the offer or the asking or

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selling figure), then there is a premium. In such asituation, points are added to the spot rate. Conversely,if the first quote is greater than the second, then it is a

discount. If, however, both the figures are the same,then the trader has to specify whether the forward rateis at premium or discount. This procedure ensures thatthe buy price is lower than the sell price, and the trader

profits from the spread between the two prices.

ExampleSpot 1-month 3-month 6-month

(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms, these quotes would be expressedas below:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot FFr 5.2321 per US$ FFr 5.2340 per US$ 0.00191-month FFr 5.2296 per US$ FFr 5.2320 per US$ 0.00243-months FFr 5.2281 per US$ FFr 5.2308 per US$ 0.00276-months FFr 5.2341 per US$ FFr 5.2366 per US$ 0.0025

It may be noted that in the case of forward deals of1 month and 3 months, US dollar is at discount against

French franc while 6 months forward is at premium.The first figure is greater than the second both in 1month and 3 months forward quotes. Therefore, thesequotes ale at a discount and accordingly these pointshave been subtracted from the spot rates to arrive at

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outright rates. The reverse is the case for 6 monthsforward.

ExampleLet us take an example of a quotation for the US dollaragainst rupees, given by a trader in New Delhi:

Spot 1-month 3-months 6-months

Rs. 32.1010 Rs. 32.1100 225/275 300/350 375/455Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from the quotation will be asfollows:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs. 32.1010 per US$ Rs. 32.1100 per US$ 0.00901-month Rs 32.1235 per US$ Rs 32.1375 per USS 0.01403-months Rs 32.1310 per US$ Rs 32.1450 per US$ 0.0140

6-months Rs. 32.1385 per US$ Rs 32.1555 per US$ 0.0170

Here, we notice that the US dollar is at premiumfor all the three forward periods.

Also, it should be noted that the spreads in forwardrates are always equal to the sum of the spread of the

spot rate and that of the corresponding forward points.For example, the spread of 1 month forward is 0.0140(= 0.0090 + 0.0050), and, so on.

Major Currencies Quoted in the Forward Market

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The major currencies quoted on the forward market aregiven below. They are generally in terms of the USdollar.

Deutschmark Swiss franc

Pound sterling

Belgian franc

Dutch guilder

Japanese yen

Peseta Canadian dollar

Australian dollar

Generally currencies ate quoted in terms of 1 month,3 months, 6 months and one year forward. Butenterprises may obtain from banks quotations fordifferent periods.

Premium or Discount

Premium or discount of a currency in the forwardmarket on the spot rate (SR) is calculated as follows:

Premium or discount (per cent) =

[(Fwd rate - Spot rate)/Spot rate] x (12/n) x 100*

where n is the number of months forward.If FR> SR, it implies premium.


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* To annualize the rate. 12/n is inserted to express inpercentage, 100 is introduced.

Arbitrage in Case of Forward Market (or CoveredInterest Arbitrage)

In the case of forward market, the arbitrage operates onthe differential of interest rates and the premium ordiscount on exchange rates.

The rule is that if the interest rate differentia isgreater than the premium or discount, place the moneyin the currency that has higher rate of interest or vice-versa. Consider next two Examples.

Example

Exchange rate: Can$ 1.317 per US$ (Spot)

Can$ 1.2950 per USS (6-monthsforward)6-months interest rate:

US$ 10 per centCan$ 6 per cent

Work out the possibilities of arbitrage gain.

SolutionIn this case, it is clear that. US$ is at discount on 6-months forward market. The rate of annualizeddiscount is:

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[(1.2950 - l.317)/l.317] x (12/6) x 1 = 3.34 per centDifferential in the interest rate = 10 - 6 = 4 per cent

Here, the interest rate differential is greater thanthe discount. So in order to derive an arbitrage gain,mosey is to be placed in US$ money market since thiscurrency has a higher rate of interest.

The following steps are involved:(i) Borrow Can$ l000 at 6 per cent p.a. for 6-

months.(ii) Transform this sum into US$ at the spot rate to

obtain US$ 759.3 (= 1000/1.317);(iii) Place these US dollars at 10 per cent p.a. for 6-

months in the money market to obtain US$797.23 [= 759.3 x ( 1 + 0.1x 6/12)]

(iv) Sell US$ 79723 in the forward market in y at theend of 6-months, Canadian $ 1032.4 (= 797.23 x1.295);

(v) At the end of 6-months, refund the debt taken inCanadian dollars plus interest, i.e. Canadian $1030 [ = 1000 x (1 + 0.06 x 6/12)]

Net gain = Canadian $ 1032.4 Canadian $1030 =Canadian $2.4.

Thus, starting from zero, one is richer by Canadian$2.4 at the end of 6 months period. Accordingly, on

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borrowings of Canadian $ million, one will be richer by(100,00,00 x $2.4/1000, i.e. Canadian $2400.

ExampleExchange rates: Can$ 0.665 per DM (Spot)

Can$ 0.670 per DM (3 months)Interest rates: DM 7 per cent p.a.

Can$ 9 per cent p.a.

Calculate the arbitrage gain possible from theabove data.

Solution

In this ease, DM is at a premium against the Can$.Premium = [(0.67 - 0.665)/0.665] x (12/3) x 100

= 3.01 per cent

Interest rate differential = 9 - 7 = 2 per cent.

Since the interest rate differential is smaller thanthe premium, it will be profitable to place money inDeutschmarks the currency whose 3-months interest islower.

The following operations are carried out:(i) Borrow Can$ 1000 at 9 per cent for 3-months;(ii) Change this sum into DM at the spot rate to

obtain DM 1503.7 (= 1000/0.665);

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(iii) Place DM 15037 in the money market for 3months to obtain a Sum of DM 1530 [ = 1503.7x (1 + 0.07 x 3/12)];

(iv) Sell DM at 3-months forward to obtain Can$1025.1 (= 1530 x 0.67);

(v) Refund the debt taken in Can$ with the interestdue on it, i.e. Can$ 1022.5 [=1000 x (1 + 0.09 x3/12)];

Net gain = 1025.1 1022.5 = Can$ 2.6

SPECULATION IN THE FORWARD MARKET

(a) Let us say that the US dollar is quoted asfollows:

Spot: FFr 5.60 per US$6-months forward: FFr 5.65 per US$

If a speculator anticipates that the US dollar is going tobe FFr 5.7 in 6-months, he will take a long position inthat currency. He will buy US dollars at FFr 5.65, 6-months forward. If his anticipation turns out to be true,he will sell his US dollars at FFr 5.7 per unit and his

profit will be FFr 0.05 per US$ (= FR 5.7 FFr 5.65).

This speculator could have bought on spot marketas well but his operation is much more risky and hewould have to block a part of this cash.

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(b) Now, suppose that the speculator anticipates adecrease in the value of the US dollar in next 6-months.He thinks that it will be available for FFr 5.5 per US$.

Then he will take a short position in dollars by sellingthem at 6-months forward. If his anticipation comestale, he will make a profit of FFr 0.15 per US$. On theother hand, if the dollar rate in 6-months actuallyclimbs to FFr 5.75 per USS, he will end up incurring aloss of FFr 0.1 per US$ ( =FFr 5.65 FFr 5.75).

CONCLUSION

Exchange markets are influenced by numerouseconomic factors such as imports and exports,investments and disinvestments; by financial operationssuch as lending and borrowing; by psychologicalfactors like anticipation of depreciation or appreciation

of currency; by socio-political factors like stability ofgovernment, etc. The major players in the foreignexchange market are big banks. Operations ofspeculators and arbitragers also affect the markets.

Problem 1

Convert the following into outright rates and indicate

their spreads:

Spot 1-month 3-month 6-months

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

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Rs/Rs/DM

55.2200/3523.9000/30

40/3030/25

50/3540/60

55/4245/65

Solution

(a) Rupee Rate of DollarAn observation of the figures indicates that the firstfigure is lower than the second in all 3 forward quotes,implying dollar is being quoted at premium in theforward market. Thus, the points will be added to the

corresponding spot rates. Accordingly, the rates are:


Bid price (Rs)Ask price (Rs)Spread (Rs)

35.630035.63250.0025

35.632035.63500.0030

35.632535.63600.0035

35.633035.63650.0035

(b) Rupee Rate of Pound SterlingWhile observing figures of forward quotations, it isclear that pound sterling is at discount in the forwardmarket since points corresponding to the bid price arehigher than those corresponding to the ask price.Therefore, the forward points will be subtracted fromthe spot rate figures. Thus, outright rates are:


Bid price (Rs)Ask price (Rs)

55.220055.2235

55.216055.2205

55.215055.2200

55.214555.2193

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Spread (Rs) 0.0035 0.0045 0.0050 0.0048

(c) Rupee Rate of Deutschmark

Figures as given indicate that 1-month forward DM isat discount whereas 3-months and 6-months forwardrates are at premium. So, for 10-month forwardcorresponding points will be subtracted from outrightspot rates while points corresponding to 3-months and6-months forward will be added. Thus, outright ratesare:


Bid price (Rs)Ask price (Rs)Spread (Rs)

23.900023.90300.0030

23.897023.90050.0035

23.904023.90900.0050

23.904523.90950.0050

Problem 2

Calculate premium or discount from the rupee-dollarrates given in the Problem 1 above.

Solution

(i) 1-month forward: As already indicated dollar isquoted at a premium, which is calculated as follows:

35.6320 35.6300 x 12 x 100Bid price premium = 35.6300 1

= 0.066 per cent

35.6350 35.6325 x 12 x 100

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Ask price premium = 35.6325 1= 0.0835 per cent

(ii) 3-months forward: Similarly, dollar premium on3-months forward can be calculated as follows:


= 0.028 per cent

35.6360 35.6325 x 12 x 100Ask price premium = 35.6325 3

= 0.0393 per cent

(iii) 6-months forward: In the like manner, thepremium on 6-months forward is also calculated:


= 0.0168 per cent35.6365 35.6325 x 12 x 100

Ask price premium = 35.6325 6

= 0.0224 per centProblem 3

Are there any arbitrage gains possible from the datagiven below? Assume there are no transaction costs:

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Rs. 55.5000 = 1 in LondonRs. 35.625 = $ 1 in Delhi

Rs. 1.5820 = 1 in New York

Solution

From the given data, a triangular currency arbitrage ispossible since the dollar/pound rate found by using therates at London and Delhi is different from that of NewYork. The following sequence will result into a gain:

(i) Use $ 1000 to buy rupees in Delhi. Thearbitrageur would get Rs.35,625 (=100 x 35.625)

(ii) Sell Rs. 35,625 in London to get 641.89 (=35625/55.5)

(iii) Sell 641.89 in New York go get $ 1015.47 (=

641.89 x 1.5820)(iv) Net profit is $ 15.47 (= 1015.47 1000)

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EXTERNAL TECHNIQUES FOR COVERING

EXCHANGE RATE RISK

INTRODUCTIONThe preceding discussion has dealt with internal

techniques to cover exchange rate risk; the objective ofthe present discussion is to dwell on externaltechniques concerning the subject matter. The majortechniques in this regard are:

Covering risk in the forward market;

Covering in the money market

Advances in foreign currency;

Covering in financial futures market;

Covering in the options market;

Covering through currency swaps;

Recourse to specialised organisations.

COVERING RISK IN THE FORWARD

MARKET

CoveringaTransactionExposureIn order to cover himself against an exchange rate risk,

arising from an eventual depreciation of the currency inwhich he has invoiced his exports, an exporter will sellhis foreign exchange in the forward market.Conversely, an importer wanting to cover himself

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against the eventual appreciation of foreign currency,will buy foreign exchange forward.

Example 1Suppose a German exporter Hartmann sells somemachinery to an American company, for which hewould receive payment of US$ 1 million in 3-monthstime, The exchange rates are as follows:

Spot 3-months forwardDM 1.4810/US$ DM 1.4700/US$

The exporter sells his receivables at 3-monthsforward. Thus, he would receive DM 1,470,030 at theend of 3 months. If the spot rate at the end of 3 monthshad remained as it is today, he would have received

DM 1,481,003. Thus, for him, the cost of covering riskin the forward market against probable depreciation ofthe US dollar is DM 11,000 (1,481,000 - 1,470,000).

Let us say that depreciation of the US dollar didtake place and the rate on the date of payment (i.e. after3 months) was established at DM 1,4069/US$. In that

case, without covering, the loss to the exporter wouldhave been substantial. He would have received onlyDM 1,406,900 and so loss would have been DM 74,100(= 1,481,000 - 1406,900). Therefore, by coveringhimself in the forward market, he has reduced his risk

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by becoming certain of his receiving DM 1,470,000irrespective of the degree of depreciation of the USdollar.

Example 2

Let us suppose, a French importer is to pay 10,000 USdollars in three months time. The exchange rates are

being quoted as follows:

Spot 3-months forwardFFr 5.60/US$ FFr 5.80/US$

The importer covers himself by buying US dollarsin the forward market. He will be paying FFr 58,000 (=5.8 x 10,000). If on the maturity date, the rate was as onthe date of contract, he would have had to pay, in that

case only FFr 56,000 (= 5.6 x 10,000). So, by coveringin the forward market, he suffered a loss of FFr 2,000.But, this loss (or the cost of covering) was certain.

If the rate had appreciated to, say FFr 6.00/US$, hewould have had to pay FFr 60,000 (= 6.00 x 10,000).Therefore, by covering himself in a forward market, he

in a way gained as he would have otherwise beenrequired to pay FFr 60,000.

The cost of covering in the forward market is equalto the cost of premium or discount.

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Pre. = [(5.8 5.6)/5.6] x (12/3) x 100 = 14.28 per centAnd, the cost of covering

= [(2,000/56,000 x (12/3) x 100 = 14.28 per cent

Covering a Consolidation Exposure

The magnitude of exposure depends on the method oftranslation used by the parent company.

Example 3Suppose a French multinational has an Indiansubsidiary. The total translation exposure is estimatedto be Indian Rs 1.0 million. The exchange rates are asfollows:

Spot 12-months

Rs 6.000/FFr Rs 6.0600/FFr

The French company anticipates a. depreciation of6 per cent of the Indian m over the period of a year.That is, the anticipated rate is Rs. 6.3600/FFr. Ifnothing is done to cover the exchange rate risk, thecompany will register, at the end of the year, a

translation loss

= 1,000,000 /6.0000 1,000,000 /6.3600= 166,667 157,233= 9,434 French francs

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Now to avoid this potential loss, the company cancover itself in the forward market by selling forward acertain sum of rupees, say X such that

9,434 = X (Forward rate Anticipated rate)= X [1/6.0600) (1/6.3600)]= X [0.00778]

orX = 1,212,005

The forward sale of Indian rupees gives Frenchfrancs 203,001 (= 1212005/6.06). If the anticipationsturn out to be right, the company will buy rupees forFFr 190,567 (= 1,212,005/6.36). The difference

between the two is 9,434 (FFr 200,001 - FFr 1,90,567)French francs.

Thus, potential loss has been compensated by areal gain.

COVERING IN THE MONEY MARKET

Covering a Transaction Exposure

Example 4

Let us take the Example 1 of the German exporterHartmann, who wants to cover himself against a

probable depreciation of the US dollar. He can do thefollowing:

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Borrow US dollars for 3-months;

Convert these dollars into Deutschmarks on thespot;

Place the marks in German money market; Reimburse the loan taken in dollars with interest

after 3-months.

Suppose the 3-months rates of interest are:

Germany: 5 per cent p.a. USA: 6 per cent p.a.Spot rate: DM 1.481 = $ 1

Borrowing dollars (D) should be such that

D [1 + (0.06 x 3/12)] = $1,000,000or D = $ 985,222

Conversion of dollars into Deutschmarks at thespot rate gives

985,222 x 1.481 = 1,459,114 Deutschmarks

The sum obtained by placing marks in 3-months moneymarket is

1,459,114 x [1 +(0.05 x 3/12)]= 14,77,353 marks

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The sum received from the client in dollars at theend of 3-months is $ 1.0 million. This is used to refund

the loan taken in dollars.

Thus, the cost of covering in the money market is= 1,000,000 x 1.481 1,477,353= 3,647 marks

Note: If the markets are in equilibrium or are efficient,the cost of covering either in the forward market or inthe money market will same as in an efficient market,differential in interest rates is equal to premium ordiscount. Since the markets are rarely in equilibrium,one should actually carry out calculations to knowwhere the cost of covering is less; emphasis should be

also on the ease of covering.

Example5Taking the Example 2 of the French importer who is to

pay $ 10,000 and fears an appreciation of the dollar, heshould have a quantity of dollars, say S, that would

become $ 10,000 on the due date. The 30-days interest

rates are:

US$: 6 per annum and, FFr: 8 per annumSpot rate: FFr 5.6 = $1

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Steps involved are:

Buy S dollars and place them in the money market

so as to obtain $ 10,000 after one month:

S (1 + 0.06 x 1/12) = 10,000or

S = $9,950 (= 10,000/1.005)

To buy these dollars, borrow from the spot marketa sum of French francs, equal to 55,720 (= 9,950 x5.6).

Refund the loan in French francs after 30 days bypaying 55,720 x [ + (008 x 1/12)] 56,092 francs.

Pay to the seller the sum of US$ 10,000.

So the cost of covering in the money market is FFr92 (= 56,092 56,000). It may be noted that this costis equal to the interest differential:

= 56,000 x (0.080.06) x (l/12)= 93 francs

Covering a Translation Exposure

If a company wants to cover in the money market, theamount of the borrowing on that market would be equalto the exposure position.

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Example 6

Taking example 8 of the Indian subsidiary of theFrench multinational, the following operations willhave to be done. We assume that interest rates are 12

per cent on Indian rupee and 8 per cent on Frenchfranc.

Borrow Rs 1.0 million for a year on the Indianmarket;

Convert these rupees into French francs at the spotrate to obtain FFr 166,667(= 1,000,000/6);

Place the francs in the French money market,which would give FFr 180, after one year (=

1,66,667 x 1.08) Reimburse the loan with interest after one year in

rupees, that is a sum of Rs. 1.12 million [= 1 + (l x0.12)].

Depending on the evolution of the Indian rupee, thecompany will make a gain or loss. The loss would besizeable if the rupee underwent an appreciation insteadof a depreciation.

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If unfavourable movement is stronger thananticipated, the company will have a net gain.

Say the exchange rate at the year end is Rs 6.3/FFr asanticipated, the refund would be equal to FFr 176,101( Rs. 1.12 niillio/6.36). This means a net gain of FFr3,899 = (180 - 176,101).

Comparison between Risk Covering in Forward

and Money Markets

(a) When a risk is covered in the forward market,the transaction does not appear in the balancesheet. The financial structure of the balance sheetis not affected. On the other hand, if the risk iscovered in the money market, it figures in the

balance sheet and results into an increase in debtratio.

(b) If interest differential is equal to the premiumor discount on exchange rates, that is, if interest

parity exists, the costs of covering in the twomarkets am identical. It is equal to:

premium or discount for covering in the forwardmarket;

interest differential for covering in the money market.

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For the German exporter, to cover for US$ 1 million,for example, the cost will be US$ 2,500 if the interestdifferential is 1 per cent on the 3-months money

market. The cost of covering should be the same in theforward market as well provided the markets areefficient. But, if the markets are not efficient (say, thereare exchange controls), the cost of covering is likely to

be different. The operator would opt for forward marketor money market, depending on where the cost is less.

In the above discussion, it has been assumed thatpurchase and sale of foreign currency in the forwardmarket as well as obtaining loans in the money marketis always possible and there are no constraints.

FOREIGN CURRENCY ADVANCES

Advances can be obtained by exporting enterprises. Forthem, advances constitute a means of tem financing. Inaddition, for an exporter, advances are a protectionagainst exchange risk as well. Likewise, importers mayavail advances, say, from the financial institutions toguard against possible fluctuations in exchange rate.

Exporting enterprises surrender the foreignexchange to the bank at the spot rate. This enables themto get cash in the national currency. The exchange raterisk is thus neutralized Advances in foreign exchangeare even more beneficial if the rate of interest on the

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foreign currency happens to be lower than that oncredits in national currency. However, monetaryauthorities in certain countries may impose certain

restrictions on such advances. For example, in France,advance cannot be availed of until and unless theexported goods have passed through customauthorities. As a result, the exchange rate risk continuesto exist between the date of contract and the date whenthe goods pass customs clearance.

Foreign currency advances cannot cover theexchange risk for importers. These advances are givenon a fixed rate for a fixed period. They help settle onspot the dues of the suppliers and thus enable theimporter to avail discounts from suppliers. And onmaturity in order to refund the advances, the importer

has to arrange the requisite amount of foreign exchangefrom the exchange market.

COVERING IN FOREIGN EXCHANGE

FUTURES

(OR FINANCIAL FORWARD) CONTRACT

MARKETInitially, futures markets were engaged in merchandise

business only, e.g. eggs, butter, cereals, raw materialand so on. The currency futures were launched for thefirst time in 1972 on the International Money Market

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(IMM) of Chicago, (presently a division of the ChicagoMercantile Exchange).

Futures Markets and ContractsCurrency futures markets are now functioning atChicago New York, London, Singapore, Tokyo,Sydney, etc. The most important of them is the IMM ofChicago.

A currency futures contract is a commitment tobuy or to sell a specified quantity of a currency on afuture date, at the pre-determined/decided price existingon the date of the contract. These contracts have thefollowing characteristics:

Transactions are traded in standard lots. For

illustration purposes Table 1 contains the values ofmajor currency futures contracts, traded on IMMChicago.

Quotations are made in terms of US$ per unit ofanother currency. For example, Table 2 indicatesthe quotation for Deutschmark on a particular day.

Fluctuations differ according to currencies. Thesmallest variation (also called tick) is 0.01 percent. So if the contract is of the value DM 125,000,the value of minimal fluctuation is 125,000 x0.01/100 = DM 12.50.

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Table 1: Transaction Lots of Major Currencies on

Futures Contract at IMM

Currency AmountAustralian dollar 10,000Canadian dollar 100,000Pound sterling 62,500French franc 500,000Deutschmark 125,000Japanese yen 12,500,000Swiss franc 125,000

Table 2: Deutschmark Futures Quotation in

Relation to US$ on IMM

(Contract amount: DM 125,000)

Open Latest ChangeHigh Low EstimatedVolume

March 0.6520 0.6536 + 0.0011 0,6539 0.6507 74,433June 0.6547 0.6564 - 0.0005 0.6564 0.6546 2,023September - 0.6581 - - - 0.6581 148

Maturity periods are also standardised, say, MarchJune, September and December.

A guarantee deposit is required to be made forselling or buying of a contract. This deposit is ofthe order of US$ 1,000 and is made with theClearing House.

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Futures rates differ from spot rates for the samereasons as forward rates. They are very close toforward rates of the same currency for the same

maturity date.

In fact, if forward rates were much different fromfutures rates of the same maturity, it would be easy to

buy in the forward market if the currency was cheaperand sell futures contracts in the same currency at thesame time. Thus, there would be a profit to the operatorwithout risk, assuming there were no transaction costs.

Operating Procedure of Futures Markets

First of all, the interested enterprise is required to makea guarantee deposit with a broker who is a mediator

between the enterprise (or the player in the market) and

the Clearing House. The broker will deposit this sumwith the Clearing House. For instance, an enterprise Abuys a currency futures contract through a broker Xfrom another enterprise B ass with/related to broker Y.Once the engagement has been made, both enterprisesdeal directly with the Clearing House.

Everyday, the Clearing House calculates thesituation of each operator. As the rate of the contractevolves, it proceeds to call for maintenance marginsfrom the operator who has registered a loss and

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conversely, credits the account of the other party whohas registered a gain.

If the enterprise A wants to sell its contract, thesame is executed by him through his broker who findsanother buyer. The enterprise A will have made a gainor loss depending on the evolution of the rate offutures. Most of the contracts (98 per cent) on thefutures market are not delivered. They are closed by areverse operation: the buyers resell the contracts andthe sellers repurchase the contracts.

Principle of Covering the Risk

The principle is to compensate a loss of opportunity onthe s market by a gain of almost the same amount onthe futures market. In other words, one should take a

reverse position on the futures market vis--vis theposition that one has on the spot market.

Purchase of a currency future protects against anappreciation of the currency of contract. Similarly, saleof a currency future contract protects against adepreciation of the currency of contract.

A company that has exported and is to receive itsdues in pound sterling will sell future contracts in

pound sterling corresponding to the value of exports,with a similar settlement date.

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A company that has imported and is to pay inDeutschmarks will buy DM future contracts to protect

against an appreciation of Deutschmark.

Example 7An American company has exported in January of thecurrent year to a German client. The payments of DM1.0 million are due in March. The American companywants to cover itself against the risk of a depreciationof DM. The DM March future contracts are quoted atUS$ 0.587 per DM. The spot rate in January is US$0.588 per DM.

In January the American company deposits theguarantee with the Clearing House and sells 8 DM

future contracts, each of DM 125,000. The totalamount covered is DM 1.0 million (= 8 x 125,000).

During all this period up to the maturity date, theAmerican company will pay maintenance marginsif DM rises and conversely will have its accountcredited if DM slips. In March, this companyrepurchases (or closes) the contract at a rate of

0.559 dollar per DM. It makes a gain of 28,0000dollars [= (0.587 0.559) x 8 x 125,000]. Thisgain is equal to the loss of opportunity on the spotmarket, that is 28P dollars [=(0588 0.560) x

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1,000,000]. The spot rate on the date of closure orrepurchase of the contact is 0.56 dollar per DM.

Note: To simplify the calculations, the rates have beenso chosen as to compensate the loss of opportunity intotality. In reality, there may be some uncovered lossand some costs of transactions which have beenignored here.

Also, the amount to be covered may not always be inexact multiples of standard futures contract lots. Thus,the amount covered may be less or more than the suminvolved in a transaction. For instance, if the sum to becovered was DM 1.1 million, then, the number offutures contracts should be either 8 or 9. In case it is 9,we would be covering DM 1.125 rather than DM 1.1

million. And, in the case of 8 contracts, we would becovering DM 1 million.

Comparison between Covering on the Forward

Market and the Futures Market

Both the forward market and the futures market servethe same objective of covering the foreign exchange

risk. However, there arc some significant differences intheir modus-operandi. Table 3 provides a comparativesummary of forward market and futures market.

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Table 3: Comparison between Covering on

Forward Market and

Future Market

Futures Market Forward MarketStandardized contracts Tailor-made risk coverageGuarantee deposit No guarantee depositClearing house Contract with a bank Quotation on market Quotation by a bank Commission or brokerage Quoted rate (Spread between

buying and selling rates)

COVERING IN THE FOREIGN EXCHANGE

OPTIONS MARKET

An option gives its holder a right (but not anobligation) to buy or sell an asset in future at a pricethat is agreed upon today. Nowadays, interested

investors/enterprises can deal in options to buy or sellcommon equity, bonds, commodities and currencies,etc.

The first organized market in options in currencieswas opened in Philadelphia in 1982. Many othermarkets have since developed, for example, atAmsterdam. London, Pads, Montreal, Vancouver, NewYork, Chicago, Singapore, etc.

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It is an instrument that permits its holder (buyer orowner) to take advantage of a favourable evolution ofexchange rate. It is taken recourse to by companies to

cover the exchange rate risk.

There exist two types of options: call and putoptions. These are bought or sold at a premium, whichis paid to the writer of the option, usually in localcurrency per unit of foreign currency.

Call Option

The holder of a call option acquires a right but not anobligation to buy a certain quantity of foreign currencyat a predetermined price (also called exercise or strike

price). A writer (or seller) of a call option has anobligation to sell a certain amount of foreign currency

at a predetermined price.

Put Option

The holder of a put option acquires a right but not anobligation to sell a certain quantity of foreign currencyat a predetermined strike price. The writer of a putoption has an obligation to buy a certain amount of

foreign currency at a predetermined price. Thus, it isthe holder (buyer or owner) of an option who has achoice to use or abandon the exercise of the optionwhereas the seller of an option should be ready to sell

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(in case of call) or buy (in case of put) the amountagreed upon. The latter has no choice of his own.

It should be noted that unlike stock options, a calloption on, say, US dollar is also simultaneously a putoption on the other currency of transaction, say, Indianrupees For, if the holder has a right to buy US dollarsagainst Indian rupees at a predecided price, then he hasalso a right to sell Indian rupees at a specified dollarrate.

The option which a holder enjoys could be the onewhere he can exercise his right any time during the lifeof the option. This type of option is referred to as ofAmerican style. The other type is of European stylewhere the holder can exercise his right only on

expiration of, or on, the maturity date.

Premium on Options

The premium paid for buying a put or call optiondepends upon several factors and is comparable to aninsurance premium. The major factors in this regardare:

The difference between the exercise price and spotprice;

The maturity periods;

Volatility of price movements;

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Interest rates, etc.

Determinants of Option Value

These are: Spot rate;

Strike price;

Expiration date (time to expiration);

Risk free interest rate in the, domestic country;

Risk free interest rate in the foreign country;

Volatility of the spot currency rate.

Spot rate: The effect of this variable on the optionprice is quite evident. In the case of a call option, thehigher the spot rate, the higher will be the option

premium and vice-versa. A put option becomes lessvaluable with the rise in spot price and vice-versa.

Strike price: Strike price is the price at which the dealwill take place when an option (call or put) isexercised. A call option tends to vary inversely with thestrike price. With the rise in strike price, the call optiontends to lose value. This is because the holder stands to

lose when he exercises the call option. A put optionmoves in direct relation with the strike price and withthe rise in strike price, the holder tends to gain onexercising the option.

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Time to expiration: With the increase in the time toexpiration, both call and put options gain value. This is

because the option with a longer time to expiration,

other things being held constant, will have a highertime value.

Example 8A French imparter has bought an equipment from a USfirm for US$ 1 million on 1 March in the current yearto be paid for in 3 months. The importer fears anappreciation of the US dollar. He decides to coverhimself in the option market. The data are:

Exchange rate: FFr 500/US$ or US$ 0.20/FFr

He is considering call option for the purpose as he

will be required to buy foreign exchange (i.e. USdollars). The characteristics of call option are:

Strike price: FFr 5.05/US$Maturity date: 1 JunePremium: 3 per cent

The buyer of the call option, i.e. the importer paysthe premium amount of US$ 30,000 (= 1 million x0.03) or FFr 150,00) (= 30,000 x 5).

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On 1 June, there are three possibilities:

1st Possibility: The US currency has appreciated and

the spat rate is FFr 5.5/US$. In this situation, the holderof the call option will exercise his option and buy USdollars at the strike price of FFr 5.05 per US dollar. Hewill pay thus, FFr 5.05 million (= 5.05 x 1.0 million).

Total cost = (5,050,000 + 150,000) French francs

= 5.20 million French francs

Thus, his net price is FFr 5.20/US$ instead of FFr5.5/US$.

2nd Possibility: The US currency has undergone adepreciation and on 1 June, it is at FFr 4.75/US$.

In this situation, he abandons his call option andbuys dollars from the market at FFr 4.75/US$. His totalpayment is thus:

(4.75 x 1.0 million + 0.15 million) French francs= 4.90 million French francs

Thus, his net price is FFr 4.9/US$ instead of FFr4.75/US$.

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3rd Possibility: The US dollar is at FFr 5.05/US$.Here, he can afford to be indifferent to either themarket option or the call option. He will pay the same

price whether he resorts to one or the other. He pays:

(5,050,000 + 150,000) French francs

= 5.20 million French francs, that is, the sameamount as in the first possibility.

This means he has never to pay more than FFr 5.20million, whatever be the level of appreciation of the USdollar.

The graphic representation of the call option is given inFig. 1.

5.20

ZN

5.05 5.1 5.2 5.3 Exchange rate (FFr/$)

Fig.1: Sum to be Paid under the Call Option

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Example 9

An Indian importer is to pay DM 1.0 million on 1September in the current year. He wants to make sure

that he does not pay too high in case the Deutschmarkappreciates. He buys a call option by paying 2 per cent

premium on the current price. The current rate isRs.21.75/DM. The strike price is decided to beRs.22/DM.

In the case of appreciation of the Deutschmark, thenet price to be paid by the importer is going to beRs.22.435/DM (= 22.00 + 0.02 x 21.75). Conversely, ifthe German currency depreciates, the importer willabandon his call option. The operation is graphicallyrepresented in Fig. 2.

22.435

ZN

21 22 23 24 25 26 Exchange rate (Rs/DM)

Fig. 2: Sum to be Paid under the Call Option

Example 10

A French exporter is to receive US$ 1.0 million on 1March in the current year, having sold his product inJanuary. Fearing a depreciation of the US dollar, he

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decides to cover his risk through a put option. The dataare:

Spot rate: FFr 5.0/US$Premium: 3 per centDate of maturity: 1 MarchExercise or strike price: FFr 4.95/US$.

1st Possibility: The US currency has depreciated to FFr4.70/US$. He exercises his put option and sells dollarsat FFr 4.95/US$. He, thus receives:

(4.95 x 1 0.03 x 5.0) million French francs= 4.8 million French francs

If he had not covered his risk through the put

option, he would have received only 4.7 million Frenchfrancs.

2nd Possibility: The US dollar has appreciated to, sayFFr 5.2/US$. He abandons his put option and sells hisdollars in the open exchange market. He thus receives:FFr (5.2 0.15) million = FFr 5.05 million.

3rd Possibility: The rate on 1 March is FFr 4.95/US$.In this case, he need not worry about either making useof his option, or selling in the open market. Either way,he will receive a sum of

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(4.95 0.15) million French francs= 4.8 million French francs

Thus, irrespective of the degree of depreciation ofthe US dollar, he is assured of getting at lease FFr 4.8million.

Any price above the strike price of FFR 4.95brings a greater advantage to him and a price less thanFFr4.95 does not affect his receipts which do not fall

below FFr 4.8 million.

The graphical representation of the operation isshown in Fig. 3.

4.8

4.9 4.95 5.0 5.1 5.2 Exchange rate (FFr/$)

Fig. 3: Sum to be Received under the Put Option

In view of the above, it is apparent that theenterprise/operator needs to be more vigilant/watchfultowards trends in exchange rate while covering in the

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option market unlike covering in the exchange marketwhere everything is certain.

Covering against Exchange Risk by PurchasingTunnel with a Zero Premium

Since premium represents a non-negligible cost, bankspropose to their clients the option with zero premiumcalled tunnel, but protection is available only withincertain limits. For example, let us consider the data ofthe Table 4. An Indian importer buys a 1-month tunnelwith zero premium, of narrow range. This means that ifafter a months time the dollar rate is Indian Rs 35.70,he would pay only Rs 35.60 per dollar. But, on theother hand, if the rate is Rs 34.90, he would have to payRs 35.00 per dollar. If the dollar price is establishedsomewhere within the range, then he would have to pay

the actual market price.

Besides the tunnels of narrow range, there aretunnels of wider range too. One would choose betweenthe two depending upon the anticipations of futurerates.

The importance of tunnels lies in the fact that onedc not have to pay premium but at the same time theydo not allow the operator to get the fill advantage of afavourable evolution of rates.

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Table 4 Tunnel with Zero Premium

Maturity Narrow range Wider range

1-month 35.00-35.60 34.25-36.25

3-months 35.50-36.00 34.00-36.306-months 35.75-36.35 33.80-36.50

Importance of Options

Options are used by:

exporters;

importers;

investors;

banks and financial institutions;

companies bidding for global contracts.

Call options are used by companies that have to pay fortheir imports in foreign currency but fear anappreciation of the currency of invoice. They areequally used by the foreign currency borrowers.

Put options are used by exporters who haveinvoiced in foreign currency and fear a depreciation ofthat currency. They are equally used by foreign

currency lenders.

CURRENCY SWAPS

Swap is essentially an exchange of two transactions; itis an important instrument for hedging for foreign

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exchange transactions in which two streams ofpayments am exchanged.

Suppose an American company wants to borrowDeutschmarks at a variable rate. The company is well

placed on the American market. It borrows US$ 1million on the American market at a fixed rate andenters into a swap deal with its bank. On the date of thecontract, there is an exchange of the principal: theAmerican company pays to its bank 1 million dollarsand receives 1.4 million Deutschmarks, the spot rate

being DM 1.4/US$. During the contract period, thecompany will pay a variable rate on the Deutschmarkswhile the bank will pay it a fixed rate on dollars. Themwill also be a re-exchange of the principal on thematurity date. Figure 4 illustrates the swap.

$ 1m

DM 1.4m

Variable rate

Fixed rate

DM 1.4m

$ 1m

Fig 4: Swap between a Company and its Bank

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American Company Bank




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Currency swaps are comparable to a forwardexchange transaction with a difference that thedifferential of rates is calculated periodically instead of

being settled just once at the end of the contract; thisfeature renders the swaps more efficient and moreflexible than covering in the forward market for long

periods.

CONCLUSION

Volatility of exchange rates makes it necessary forcompanies engaged in international operations to takemeasures for covering against exchange rate risk.Several techniques are used, internal as well asexternal. In periods of fixed rate regime, specialattention was paid to the possibility of a currencydevaluation. In floating rate regime, it comes important

to anticipate evolution of rates and adopt appropriatestrategies for covering risks. Nowadays a number oftechniques are available such as hedging in forwardrate market, money market, currency futures, optionsand swaps.

Problem 1

A French exporter, named Charles, is to receive DM1.0 million in 6 months. The exchange rates are quotedas follows:

Spot: FEr 3.3876/DM6-months forward: FFr 3.3368/DM

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(a) There is a fear of depreciating of DM in thenear future. What should Charles do?

(b) What would you suggest to Charles in case an

appreciation of DM is likely to take place?

Solution

(a) Since the rates given above indicate that DM is ata forward discount, Charles will do well to coverhimself in the forward market. When a currency isselling at discount in the forward market, there is a

possibility that it would undergo a depreciation. Soit is safe to cover the receivables of that currencyin the forward market.

Thus, Charles will sell his DM 1.0 million in theforward market and receive FFr3.3368 million at

the end of 6-months.If the spot rate at the end of 6-months was thesame as the spot rate today, the cost of covering(or the loss) for Charles would be FFr 50800 (=FFr 3.3876 million FFr 3.3368 million).

The depreciation of DM indicted by the forward

rate is the following:3.3876 3.3368 x 100

= 3.3876= 1.4966 or 1.5 per cent

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So, if DM depreciated more than 1.5 per centbetween now and 6-months hence, Charles would makea loss bigger than FFr 50,800 in case he decided not to

cover in the forward market.

(b) In case of a likely appreciation of DM,Charles need not do anything. Any appreciation inthe currency of receivables (DM in the presentcase) would be profitable to the receiver.

Problem 2

An Indian company C & Co. imports equipment worth$1.0 million and is to pay after 3 months. On the day ofthe contract, the rates are:

Spot: Rs.35.00/$3-months forward: Rs.36.25/$

(a) There is an anticipation of a further fall ofrupee. What can C & Co. do?

(b) What would C & Co. do if it knows with ahigh probability that, in 3-months, dollar will settleat Rs.36.00/$.

Solution(a) Since there is an anticipation of a further fall

in the value of rupee (or in other words anappreciation of dollar), it would be wise to coverthe payables in the forward market.

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Thus, C & Co. will have to pay at the end of threemonths Rs.36.25 million. So, the net cost of coveringthe payables in the forward market is Rs.1.25 million

(= Rs.36.25 million Rs.35 million).

If the rupee had fallen to Rs.37.10/$ ( adepreciation of 6 per cent) and if C & Co. had notcovered itself in the forward market, the loss to itwould have been Rs.2.10 million.

(b) If C & Co. knows with a high degree ofcertainty that the rupee is likely to settle atRs.36.00/$ in 3-months, it would be advised not tocover in the forward market. It would pay Rs.36million at the end of 3-months, the sum which isless than Rs.36.25 million.

Problem 3

An Indian exporting firm, Rohit and Bros, would liketo cover itself against a likely depreciation of poundsterling. The following data is given:

Receivables of Rohit and Bros: 500,000

Spot rate: 56.00/Payment date: 3-months3-months interest rate: India: 12 per cent per annum

UK: 5 per cent per annumWhat should the exporter do?

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Solution

Since no other date is available, the only thing that

Rohit and Bros can do is to cover itself in the moneymarket. The following steps are required to be taken:

(i) Borrow pound sterling for 3-months. Theborrowing has to be such that at the end ofthree months, the amount becomes 500,000.Say, the amount borrowed is D. Therefore,

3D 1 + 0.05 x 12 = 500,000 or D = 493,827

(ii) Convert the borrowed sum into rupee at thespot rate. This gives: Rs.493,827 x 56 =Rs.27,654,312

(iii) The sum thus obtained is placed in the moneymarket at 12 per cent to obtain at the end of 3-months:

3S = 27,654,312 x 1 + 0.12 x 12 = Rs. 28,483,941

(iv) The sum of 500,000 received from the clientat the end of 3-months is used to refund the

loan taken earlier.From the calculations, it is clear that the moneymarket operation has resulted into a net gain ofRs.483,941 (= 28,483,941 500,000 x 56).

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If pound sterling has depreciated in the meantime,the gain would be even bigger.

Problem 4A UK importer has to pay $100,000 in months time.He fears an appreciation of the dollar. What can he dowith the knowledge of the following data?

1-m interest rate: US$: 4 per centUK : 5 per centSpot rate: $ 1.553/

Solution

Since only the money market data are available, the UKimporter has to work out possibility that exist for himto cover himself in the money market. He can take the

following steps:

(i) Buy S dollars at the spot rate and place them inthe money market so as to obtain $ 100,000 in amonths time. That is,

1S 1 + 0.04 x 12 = 100,000

orS = $99,668.

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(ii) In order to buy S dollars, the equivalent amountof pound sterling is required to be borrowed.The borrowing B is,

99668B =1.5537 = 64,149

(iii) Refund the sterling loan after one month. Therefunded amount would be:

1R = 64149 1 + 0.05 x 12 = 64,416.3

(iv) In the meaning the sum of S dollars placed in themoney market would mature to $ 100,000. Usethis sum to pay the payable due.

The cost of covering in the money market works out to 53.81

100,000= 64,416.3 - 1.5537

In case, the dollar had appreciated and the payablewas not hedged, the loss would have been greater.Even 1 per cent depreciation of pound sterling ($1.5382/) would require a payment of 65,013,

which means a loss of about 650.

Problem 5

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An Indian subsidiary of a UK multinational has atranslation exposure or Rs.10 million. The rates areas follows:

Spot: Rs.55.0000/One-year forward: Rs.56.3200/

A 4 per cent depreciation of the rupee is expected.How can the exchange risk be hedged?

Solution

The anticipated rate after expected depreciation wouldbe: Rs. 57.200/.

Suppose, no action is taken to hedge the risk. Inthat risk, the company will suffer a translation loss

equal to:

10 million 10 million 55 - 57.2

= 6993.

To avoid this loss, the company will do well to buypound sterling forward (or sell rupee forward) such thatthe difference is equal to the anticipated loss. Say, itsells Rs. X. Then,

6993 = X (Forward rate - Anticipated rate)

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1 1= X 56.3200 - 57.2000

or6993 = X [0.017755680 0.017482517]

orX = Rs. 25,599,974

This amount of rupees will give the followingamount of pound sterling in the forward market:

25,599,97456.3200 = 454,545.45

However, if the anticipated depreciation of therupee (or appreciation of pound sterling) does take

place, the company will buy the Rs. X back, with lessamount of pounds sterling. That is, for

25,599,97457.2 = 447,555.99

The difference between the two ( 454,545.50 -

447,555.99) is equal to the loss ( 6959.51) that wouldhave accrued without hedging.

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Problem 6

Total translation exposure of a company is Rs. 1.5million. This exposure is in French francs. Interest rates

are 8 and 11 per cent for the franc and the rupeerespectively. How is hedging to be done? Spot rate isRs.6 per FFr. The rupee is likely to depreciate by 6 percent.

Solution

Since only the interest rate data is available, thehedging operation is to be done in the money market.The following steps are involved:

(1) Borrow Rs.1.5 million at 11 per cent andconvert them into French francs at spot rate toobtain: Rs.1.5 million/6 = 0.25 million FFr.

(2) Place FFr 0.25 million in the moneymarket for a year at 8 per cent. This wouldgive FFr 0.27 million after a year.

(3) The sum thus obtained is converted intorupees. If the anticipated depreciation of 6 percent does take place, the rate would settle atRs.6.36/FFr. So, the amount in rupees at the

end of the year would be Rs. (0.27 million x6.36) = Rs.1.7172 million.

(4) Refund the rupee loan with interest. Therefund amount works out to Rs.(1.5 million x1.11) = Rs.1.665 million.

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Thus, the hedging operation would result into a netgain of Rs.52,200 (= Rs. 1.7172 million Rs.1.665

million). The gain in French franc would be FFr 8,208.

Problem

A French company imports in January an equipmentfrom the USA for $6 million. The payment is USdollars. The spot rate is $0.2/FFr. The FFr futurecontract for June is quoted at $0.19/FFr. What shouldthe French importer do? Assume further spot rate onsettlement date is $0.185/FFr and the future contract islikely to be quoted at $0.178/FFr. What is the hedgingefficiency?

Solution

The US dollar is likely to appreciate against the Frenchfrancs. This also means that the French franc woulddepreciate.

To guard against the depreciation of the Frenchfranc, the importer can sell French franc futurecontracts. The amount involved is $6 million or FFr 30

million (= 6 million/0.2). Thus, the total number offuture contracts to be sold is 60 (= 30 million/0.5),since the value of one futures contract is FFr 500,000.

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The French importer deposits the security amountwith the Clearing House. During the period January-June, the importer will pay margins if the FFr rises and

have its account credited if the FFr slips. On the duedate in June the contract is closed (or repurchased).Say, the spot rate on the due date is $0.185/FFr and thefutures contract is being quoted at $0.178/FFr.

The importer makes a loss: FFr (6/0.2 6/0.185)million = FFr 2.432432 million. However, on the futuremarket, it makes a gain equal to $ (0.19 0.178) x 60 x500,000 = $ 360,000 = FFr 360,000/0.185 = FFr1,945,946.

Net loss = FFr 2,432,432 1,945,945= FFr 486,486.

Note: The loss is not fully covered as spot ratedeteriorated more than the future rate. Hedge efficiencycan be defined as the ratio between the gain made onthe future market and the loss payable due to ratemovement on spot market. It is equal to1,945,946/2,432,432 x 100 = 80 per cent.

Problem 8

A British exporter has $2.5 million receivable due inSeptember against the exports made in June. The pound

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sterling is heading for appreciation. The June data areas follows:

Spot rate: $1.5530/; Pound sterling September future contract$ 1.5600/

What can the exporter do?

Solution

If the British currency is going to appreciate between

June and September, the exporter will suffer a loss onthe data of payment. He can reduce this loss by hedgingwith future contracts. The amount of sterling future is 62,500. So, the number of contracts to be purchased is:

2,500,000/62,500 x 1.5530 = 25.75

Since the contracts are available only in integralnumbers, so the exporter can either buy 25 or 26contracts. Say, he buys 26 of them. Let us say thefollowing rates are being quoted on 15 September (thedate of payment):

Spot rate: $1.6250/

September, Sterling future rate: $1.6275/When the exporter receives his dues, he makes aloss of 2,500,000 [1/1.5530 1/1.6250] = 71,326.

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On the other hand, he makes a gain on the futurescontracts. The gain is: $(1.6275 1.5600) x 26 x62,500 = $109,688

109,688/1.6250 = 67,500.

So, the net loss is: (71,326 67,500) = 3,826.

The hedge efficiency = 67,500/71,326 x 100 = 94.33per cent.

Note: In case the exporter had decided to hedge with25 futures contracts, the gain would have been:

(1.6275 1.5600) x 25 x 62,500 x 1/1.6250 =

64,904. And, hedge efficiency would have been:64,904/71,326 = 91 per cent.

Problem 9

The company ABC & Co. has its receivables of DM1.0 million due in 3-months. The rupee has tendency toappreciate. The current rate is Rs.24.2020/DM. The

company would like to hedge in the options market.The data are as follows:

Strike price: RS.23.50/DM; Premium: 2 per cent

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Which type of option is involved? How is this option tobe used?

SolutionSince the company ABC & Co. is going to lose if therupee appreciates between now and 3-months hencewhen payments of its receivables will be due, it would

be wise to buy a put option on DM. The companywould pay the premium amount immediately, which isRs. 484,040.

The following possibilities may be considered:(i) Rupee does appreciate and its value settles at

Rs.22.5100/DM. The company will make useof its option to sell DM received at the strike

price of Rs.23.50/DM. Thus, it will receive a

sum of: Rs. (1,000,000 x 23.5 484,040) =Rs. 23,015,960 or Rs.23.016 million.

Net loss: Rs.24,202,000 Rs.23,015,960 =Rs.1,186,040.The loss without hedging would have been:Rs. (24.2020 22.5100) million =

Rs.1,692,000.

(ii) Rupee depreciates in a small measure and isquoting on the due date at Rs.24.2600/DM.

Naturally, in this situation, put option is

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abandoned. The company will receive a netsum of Rs.1,000,000 x 24.2600 484,040 =Rs.23,775,960.

Here, it is to be noted that the depreciation ofthe rupee has not been able to compensate the

premium amount paid for buying the putoption. Therefore, the net sum is still less thanRs.24,202,000.

Note: Irrespective of the level of appreciation of therupee, the company will always receive a minimumsum of Rs.23,015,960 (that is, the value correspondingto the strike rate minus the premium amount). Thus, thecompany is neutral between the choices of using andabandoning the option at a rate equal to the strike price,

that is Rs.(23.01596 + 0.02 x 24.202)/DM orRs.23.50/DM.

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