Cma Final - Book 2 - Forex and Derivatives

ADHISH SIR CLASSES 1
CMA FINAL
PAPER – 14
STRATEGIC FINANCIAL MANAGEMENT
BOOK – 2 – FOREX AND DERIVATIVES
COMPILED BY – FCA ADHISH BHANSALI
CONTACT AT – 9829279730
CHAPTER – 3 – “INTERNATIONAL FINANCE”

FOREIGN EXCHANGE AND RISK MANAGEMENT (FOREX)
COVERAGE INDEX
CMA STUDY QUESTIONS IN CMA PAST EXAM

MATERIAL NOTES QUESTIONS
ILLUSTRATION 1 QUESTION: 51 JUNE 2012
ILLUSTRATION 2 QUESTION: 52 DECEMBER 2011
ILLUSTRATION 5 CLASS JUNE 2010 QUESTION: 32
EXAMPLE – 41
ILLUSTRATION 11 IN CHAPTER JUNE 2007
DERIVATIVE
ILLUSTRATION 12 QUESTION: 72 DECEMBER 2006 QUESTION: 21
ILLUSTRATION 13 QUESTION: 75 JUNE 2006 QUESTION: 34
ILLUSTRATION 14 QUESTION: 80
ILLUSTRATION 15 QUESTION: 83
UNSOLVED – 12 QUESTION: 25
CMA WORK – BOOK

QUESTION: 6 CLASS
EXAMPLE: 53
QUESTION: 7
CMA PAST EXAM

QUESTIONS
JUNE 2018 QUESTION: 14
DECEMBER 2017 QUESTION: 43
QUESTION: 16
QUESTION: 35
DECEMBER 2016
JUNE 2016
DECEMBER 2015
DECEMBER 2014
DECEMBER 2013
JUNE 2013 CLASS
EXAMPLE: 8
DECEMBER 2012
S.NO. TOPICS
1. INRODUCION / REGULATOR OF FOREIGN EXCHANGE MARKET IN
INDIA
2. TYPES OF FOREX MARKET
3. TYPES OF TRANSACTIONS
4. EXCHANGE RATE QUATATIONS (ONE WAY AND TWO WAY
QUOTE)
5. DIRECT QUOTE AND INDIRECT QUOTE
6. ASK RATE, BID RATE AND SPREAD
7. FORWARD PREMIUM OR DISCOUNT/ APPRECIATION OR
DEPRECIATION OF CURRENCY
8. CONCEPT OF SPOT RATE AND FORWARD RATE
9. COMPUTATION OF FORWARD RATES
 WITH THE HELP OF SWAP POINTS / MARGIN POINTS
 WITH THE HELP OF IRP (INTEREST RATE PARITY)
 WITH THE HELP OF PPP (PURCHASING POWER PARITY)
10. CONCEPT OF EXCHANGE MARGIN
11. HOW TO COMPUTE CROSS RATE
12. FORWARD HEDGING VS NO HEDGING TECHNIQUE
13. CANCELLATION OF FORWARD CONTRACT
 CANCELLATION ON DUE DATE
 CANCELLATION BEFORE DUE DATE
 CANCELLATION AFTER DUE DATE BUT WITHIN 15 DAYS
 AUTOMATIC CANCELLATION AFTER 15 DAYS
14. EXTENSION OF FORWARD CONTRACT
15. EARLY DELIVERY OF FORWARD CONTRACT
16. RUPEE ROLL – OVER OF FORWARD CONTRACT
17. OPTION FORWARD CONTRACTS
18. CALCULATION OF FORWARD RATE FOR BROKEN PERIOD
19. MMH (MONEY MARKET HEDGING)/ HEDGING THROUGH CASH
MARKET OPERATION
20. NETTING
21. INTEREST RATE PARITY
22. PURCHASING POWER PARITY THEORY
23. ARBITRAGE / COVERED INTEREST ARBITRAG
24. FISHER’S EFFECT
25. LEADING VS. LAGGING TECHNIQUE
26. COVER DEAL
27. INTERNATIONAL CAPITAL BUDGETING
28. INTERNATIONAL JOINT VENTURE
29. INTERNATIONAL CASH MANAGEMENT
30. NOSTRO, VESTRO AND LORO ACCOUNT
31. INTEREST RATE SWAP
32. CONCEPT OF WITH – HOLDING TAX
33. VARIOUS EXPOSURES IN FOREX MARKET
LIST OF IMPORTANT CURRENCIES

Country Unit name Symbol Currency name
Argentina Peso ARS Argentine Peso
Australia Dollar AUD Australian Dollar
Brazil Real BRL Brazilian Real
Canada Dollar CAD Canadian Dollar
China Yuan CNY Chinese Yuan
Czech Republic Koruna CZK Czech Koruna
Denmark Krone DKK Danish Krone
Hong Kong Dollar HKD Hong Kong Dollar
India Rupee ₹ Indian Rupee
Japan Yen JPY Japanese Yen
Malaysia Ringgit MYR Malaysian Ringgit
Mexico Peso MXN Mexican Peso
New Zealand Dollar NZD New Zealand Dollar
Russia Rouble RUB Russian Rouble
Singapore Dollar SGD Singapore Dollar
South Africa Rand ZAR South African Rand
Switzerland Franc CHF Swiss Franc
Taiwan Dollar TWD New Taiwan Dollar
United Kingdom Pound GBP British Pound
United States of Dollar USD American Dollar
America (USA)
Topic: 1 Introduction / Regulator of forex market in India

(a) If any transaction involves foreign currency, then such transaction is known as foreign exchange
transaction.
(b) If any transaction involves foreign currency, then this transaction is regulated by –
 RBI
 FEDAI (Foreign exchange dealers association of India)
(c) RBI established in accordance with the provisions of RBI Act, 1934. RBI manage FEMA act and maintain
foreign exchange market.
(d) FEDAI is established under section 25 of the company act. FEDAI regulate inter – bank foreign currency
business.
(e) The foreign exchange market is divided in 3 tiers as shown below:
Foreign banks
Bank
Customer
Notes:
(1) Foreign banks are banks which are licenced by the RBI to deal in foreign exchange.
(2) Only bank can enter into transactions of foreign currency with foreign bank.
(3) The rate at which transaction between foreign bank and bank taken place is known as Inter – bank rate.
(4) The rate at which transaction between bank and customer has taken place is known as Merchant rate.
(5) For any foreign exchange transaction always think from view point of bank.
(6) Think always view point of base currency / Commodity currency / Currency with 1 attached.
(7) Since bank is always in win – win position, hence bank always purchase foreign currency at lower rate and
sell foreign currency at higher rate.
Topic: 2 Types of forex market
(1) Wholesale market / Inter – bank market
 Under inter – bank market one bank can deal with another bank.
 Exchange rate of inter – bank market is known as inter – bank rate.
 Only bank can deal at inter – bank rate.
(2) Retail market

 Under retail market bank deal with customer.
 Exchange rate of retail market is known as merchant rate.
 A customer can buy or sale currency only at merchant rate.
 Merchant rate is derived from inter – bank rate by adding or deducting exchange margin.
Topic: 3 Types of transactions under forex market

(1) Cash transaction / Ready transaction – Transactions entered today for immediate settlement is known as
ready transaction. Ready rate is applicable for this transaction. This transaction can be entered by one bank
with another bank. In other words, we can say that this is a inter – bank market transaction.
(2) Value tom transaction – Transactions entered today for T + 1 business day settlement (i.e. next business
day settlement) is known as value tom transaction. Applicable rate for this transaction is value tom rate. This
transaction is possible in inter – bank market only.
(3) Spot transaction – Transactions entered today for T + 2 business day settlement is known as spot
transaction. Applicable rate for this transaction is spot rate.
(4) Forward transaction – Transactions entered today for settlement at a future date is known as forward
transaction. Applicable rate for this transaction is forward rate.
Topic: 4 Exchange rate quotations
One way quote Two – way quote

When buying rate (Bid rate) and When bid rate and ask rate are different then
selling rate (Ask rate) are same, this is known as two – way quote. Bid rate is
quotation is known as one way always less than ask rate because bank always
quote. purchase foreign currency at lower rate and
Example: Exchange rate = 1$ = `50 sale foreign currency at higher rate.
It means that 1 $ can be purchased Example: Exchange rate = 1$ = `50 / 50.50
or sold at `50 only. It means that bank will purchase 1 $ at `50
and sale 1 $ at `50.50.
HOW TO APPLY TWO – WAY QUOTE FOR CONVERTING ONE CURRENCY INTO ANOTHER
CURRENCY.
Following steps will be applied for conversion:

Step: 1 Identify amount payable / receivable.
Step: 2 Select applicable bid rate or ask rate by assuming that what will do bank for left hand currency i.e.
commodity currency.
Note: If bank has to purchase base currency then applicable rate is bid rate and if bank has to sell base currency
than applicable rate is ask rate. In other words we can say that bank always purchase foreign currency at lower
rate and sale foreign currency at higher rate.
Step: 3 Convert one currency into another currency by using selected rate.
Class example: 1 Calculate how many rupees Shri Ras Bihari Ji Ltd., a New Delhi basedfirm, will receive or
pay for its following four foreign currency transactions:
(i) The firm receives dividend amounting to Euro 1,12,000 from its French Associate Company.
(ii) The firm pays interest amounting to 2,00,000 Yens for its borrowings from a Japanese Bank.
(iii) The firm exported goods to USA and has just received USD 3,00,000.
(iv) The firm has imported goods from Singapore amounting to Singapore Dollars (SGD) 4,00,000.
Given: 1$ = Rs.40.00/40.05
1 Euro = Rs.56.00/56.04
1 SGD = Rs.24.98/25.00
100 Yens = Rs.44.00/44.10
Solution:
(i) Firm receive Euro = 1,12,000
Applicable exchange rate = 1 Euro = ₹56.00 / 56.04
Since bank purchase Euro hence applicable rate is bid rate i.e. ₹56
Hence firm will receive = 1,12,000 * 56 = ₹62,72,000
(ii) Payment by firm = 2,00,000 ¥

Exchange rate: 100 ¥ = ₹44.00/ 44.10
Since bank sell ¥ hence applicable rate is ask rate i.e. ₹44.10
Payment by firm = 2,00,000 / 100 * 44.10 = ₹88,200
(iii) Firm receive = 3,00,000 $

Exchange rate: 1 $ = 40.00 / 40.05
Since bank purchase $ and hence applicable rate is bid rate i.e. ₹40.00
Hence firm receive = 3,00,000 * 40 = ₹1,20,00,000
(iv) Payment by firm = 4,00,000 SGD

Exchange rate: 1 SGD = ₹24.98 / 25.00
Since bank sell SGD hence applicable rate is ask rate i.e 1 SGD = ₹25
Hence firm pays = 4,00,000 * 25 = ₹1,00,00,000
Class example: 2Calculate how many British pounds a London based firm will receive orpay for its
following four foreign currency transactions:
Given: 1$ = £0.50/0.51 1 Euro = £0.60/0.61

1 SGD = £0.39 /0.40 1 Yen = £0.0049 / 0.0050
Answer:
(i) Firm receive = £ 72,000
(i) Firm pays = 1,000 £
(iii) Firm receive = 1,50,000 £
(iv) Firm pays = 1,60,000 £
Class example: 3 Calculate how many US$ a New York based firm will receive or pay forits following four
foreign currency transactions:
(iii) The firm exported goods to UK and has just received £3,00,000.
Given: 1£ = $ 2.00/2.01 1 Euro = $ 1.20/1.21
1 SGD = $ 0.49/0.50 100 Yens = $ 0.89/0.90
Answer:
(i) Firm received = 1,44,000 $
(ii) Firm pays = 2,700 $
(iii) Firm received = 6,00,000 $
(iv) Firm pays = 2,00,000 $
Class example: 4 Calculate how many rupees a New Delhi based firm will receive or payfor its following four
foreign currency transactions:
(i) The firm receives dividend amounting to Euro 90,000 from its French Associate Company.
Given:
1 Re = Euro 0.0178/0.0180
1 Re = Yens 2.50/2.51
1 Re. = $ 0.0249/0.0250
1 Re = SGD 0.040 / 0.041
Solution:
(i) Receive dividend = Euro 90,000
Applicable rate: Bank sell₹ at 0.0180
Firm receive = 90,000 / 0.0180 = ₹50,00,000
(ii) Payment of interest = 2,00,000 ¥

Applicable rate = Bank is buying ₹ at 2.50
Payment = 2,00,000 / 2.50 = ₹80,000
(iii) Firm received = 3,00,000 $
Applicable rate = Bank selling ₹ at 0.0250
Firm receives = 3,00,000 / 0.0250 = ₹1,20,00,000
(iv) Payment by firm = 4,00,000 SGD

Applicable rate = Bank by ₹ at 0.040
Hence payment = 4,00,000 / 0.040 = ₹1,00,00,000
Topic: 5 Exchange rate interpretation – Exchange rate would be defined as the price of currency in terms of
another. Thus JPY 130.0250 per EUR means that 1 EUR = JPY 130.0250. Here Euro is known as base
currency and JPY is known as the price currency.
In general terms A/B, where
A = Price currency
B = Base currency
₹/$implies that 1 $ = ₹
$/£ implies that 1£ = $
Topic: 6 Direct quote and Indirect quote

(a) Direct quote is the home currency price for 1 unit of foreign currency. Means,
Direct quote: 1 unit of foreign currency = How many units of home currency
(b) Indirect quote is the foreign currency price for 1 unit of home currency. Means,
Indirect quote: 1 unit of home currency = How many units of foreign currency.
How to convert direct quote into indirect quote or vice – versa – Direct quote and indirect quote are reciprocal
of each other. Hence,
1
Direct quote =
Indirect quote
OR
1
Indirect quote = Direct quote
Note: In two – way quote, when we calculate reciprocal then bid rate becomes ask rate and ask rate becomes
bid rate.
Class example: 5Identify whether the following is a direct quote in USA. If not, find it.
(i) ₹46 = 1 $
(ii) 1 $ = S$ 1.60
(iii) 1 GBP = $ 0.639
Answer:
(i) No; 1 ₹ = 0.0217 $
(ii) No; 1 S$ = 0.6250
(iii) Yes
Class example: 6A Mumbai banker has given the following quotes. Identify whether they are direct or
indirect. For each direct quote give the corresponding indirect quote and vice – versa.
Currency Rate Quote
SEK 6.16 ₹per Kroner
Euro 0.0148 € per ₹
SGD 0.0299 SGD per ₹
AED 13.85 ₹ per UAE Dirham
Solution:
Given quote Nature Other quote New rate
₹ per Kroner Direct Korner per ₹ 0.1623
€ per ₹ Indirect ₹ per € 67.5676
SGD per ₹ Indirect ₹ per SED 33.4448
₹ per UAE Dirhan Direct AED per ₹ 0.0722
Class example: 7 Convert the direct quotes into indirect quotes:

(a) 1$ = Rs.40.00 / 40.05
(b) 1£ = Rs.82.00/82.07
(c) 1Euro = Rs.56.00/ 56.18
Topic: 7 Bid rate, Ask rate and spread

 Bid rate is the rate at which bank buys base currency / left hand side currency.
 Ask rate is the rate at which bank sell base currency / left hand side currency.
 Ask rate will always be greater than bid rate.
 Spread is the difference between ask rate and bid rate.
Spread = Ask rate – Bid rate
Ask rate−Bid rate
% of Spread = X 100
Bid rate
Note: Sometimes, the ask rate may be given in incomplete fashion, and then it should be interpreted as under:
₹/$ = 47.30 / 70 implies 47.30 / 47.70
₹/$ = 47.40 / 10 implies 47.40 / 48.10
$/£ = 1.3520 / 70 implies 1.3520 / 1.3570
$ /£ = 1.3260 / 10 implies 1.3260 / 1.3310
Class example: 8 [CMA – June, 2013]

Consider the following quotes.
Spot (Euro/Pound) = 1.6543/1.6557
Spot (Pound/NZ$) = 0.2786/0.2800
1. Calculate the % spread on the Euro/Pound Rate
2. Calculate the % spread on the Pound 1 NZ $ Rate
3. The maximum possible % spread on the cross rate between the Euro and the NZ $.
Topic: 8 Concept of exchange margin

Exchange margin is the extra amount or % charged by the bank over and above the rate quoted in inter – bank
market. With the help of exchange margin we can calculate merchant rate applicable for customers.
How to calculate exchange rate using exchange margin:
Rule: 1 Deduct margin from buying rate to get desired exchange rate.
Rule: 2 Add margin to selling rate to get desired exchange rate.
Class example: 9 Mr. A imported goods worth $ 1,00,000. Exchange rate on that date was 1$ = ₹40.80 /
40.90. If bank wants to earn margin of 0.8 %, then what rate should be quoted by the bank to customer.
SOLUTION:
Bank sell $ at ask rate 40.90
Add: Margin @ 0.80 % 0.3272
Applicable rate for customer 41.2272
Class example: 10In the inter – bank market, we have the following quote:
₹ /$ = 59.20 / 59.40
TT buying commission = 0.8 %
TT selling commission = 0.90 %.
Calculate merchant / retail rates for customer.
SOLUTION:
Statement of retail rates for customer:
Bid Ask
Inter – bank rate 59.20 59.40

Adjustment of margin:
0.80 % (0.4736) -
0.90 % 0.5346
Applicable rate 58.7264 59.9346
Class example: 11In the inter-bank market, the DM is quoting Rs.21.50. If the bank charges
0.125%commission for IT selling and 0.15% for TT buying, what rate should it quote?
Answer: Applicable rate: 1 DM = ₹21.46775 / 21.52688
Topic: 9 Concept of spot rate and forward rate

Spot rate – Spot rate is the exchange rate at which we can buy or sell currency now. In other words spot rate is
the rate which prevails today.
Forward rate – Forward rate is the rate agreed today but settlement takes place at future date.
How to determine forward rate – Forward rate may be given in question directly or information is provided for
calculating it. If forward rate is directly given in question, then it is known as outright forward rate. If forward
rate is not given directly, then we should calculate forward rate as per the following method as provided.
Method: 1 With the help of swap points / Margin points / Forward points
Forward rate = Spot rate ± Swap points
Rules for determining forward rate with the help of swap points –
Rule: 1 If swap points / forward points are in increasing order then add to spot rate to arrive forward rate.
Rule: 2 If swap points / forward points are in decreasing order then should be deducted from spot rate to arrive
forward rate.
Method: 2 With the application of IRPT (Interest rate parity theory):
1+Rq
Forward rate = Spot rate X
1+Rb
Rq = Rate of quote / price currency
Rb = Rate of base currency
Method: 3 with the application of PPPT (Purchasing power parity theory)
1+Iq
Forward rate / Expected spot rate = Spot rate X
1+Ib
Iq = Inflation rate of quote / price currency
Ib= Inflation rate of base currency
Class example: 12The following quotes are available

Spot (DM/$): 1.5105/1.5120
Three-month swap points: 25/20
Six-month swap points: 30/25
Calculate the three-month and six-month forward rates.
Class example: 13The 90 – day interest rate is quoted at 5 % in the US and 6% in UK. Current spot rate
is $ 2.02 / £. What will be the 90 – days forward rate. Assume 360 days in a year.
SOLUTION:
Spot rate = 1£ = 2.02 $
Interest rate in US = 5 % p.a. or 1.25 % for 90 days

Interest rate in UK = 6 % p.a. or 1.50 % for 90 days
1+Rq
Hence, Forward rate = Spot rate X
1+Rb
1.0125
Forward rate = 2.02 X = 2.0150
1.0150
Class example: 14The current spot rate for the British pound is ₹81. The expected inflation rate is 4 % in
India and 2.7 % in UK. What is the expected spot rate of British pound a year hence?
SOLUTION:
1+Iq
1+Ib
1.04
Forward rate / Expected spot rate = 81 X = 82.025
1.027
Class example: 15The inflation rate in US is expected to be 2.7 % per year and the inflation rate in Japan
is expected to be 0.40 % per year. If the current spot rate is 114 Yen/$ , what will be the expected spot
rate in year 3?
SOLUTION:
1+Iq
1+Ib
1.004
For year 1 = 114 X = 111.4469
1.027
1.004
For year 2 = 111.4469 X = 108.9510
1.027
1.004
For year 3 = 108.9510 X 1.027 = 106.5110
Class example: 16
Spot rate = € / $: 0.9450/0.9470
3 months swap points = 80 / 70
6 months swap points = 120 /110
Calculate 3 months and 6 months forward rates.
SOLUTION:
(a) Calculation of 3 – months forward rate:
Bid Ask
Spot rate 0.9450 0.9470
Less: 3 – months swap points 0.0080 0.0070
3 – months forward rate 0.9370 0.9400
(b) Calculation of 6 – months forward rate:

Bid Ask
Spot rate 0.9450 0.9470
Less: 6 – months swap points 0.0120 0.0110
6 – months forward rate 0.9330 0.9360
Class example: 17
Spot rate: ₹/$ = 58.60/ 58.90
1 month swap point = 50/60
3 months swap point = 90 /110
Calculate 1 month and 3 months forward rate.
Answer:
(a) 1 – Month forward rate = 59.10 / 59.50
(b) 3 – Month forward rate = 59.50 / 60.00
Topic: 10 Forward premium or discount/ Appreciation or depreciation in currency

Forward premium – If currency is costlier in future as compared to spot it is said to be at premium.
Forward discount – If currency is cheaper in future as compared to spot it is said to be at discount.
Calculation of Annualized forward premium / Discount on currency:

Currency terms = A/B
A = Price currency
B = Base currency
Forward rate−Spot rate 12

Annualized forward premium on currency B = X 100 X Period
Spot rate
Spot rate−Forward rate 12

Annualized forward premium on currency A = X100 X Period
Forward rate
Note: A negative answer would imply annualized discount rate.
Class example: 18The exchange rate for Mexican peso was 0.1086 in December 2004, and 0.0913 in
November 2004, against dollar. Which currency has depreciated and by how much?
SOLUTION:
Nov. 04: 1 $ = 0.0913 Peso
Dec. 04: 1 $ = 0.1086 peso
Quote is: peso / $
𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒−𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
Hence for peso: X 100
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
0.0913−0.1086
0.1086
X 100
−0.0173
0.1086
X 100 = - 15.93 %
Hence, Mexican Peso depreciated 15.93 % against $
Class example: 19The dollar is currently trading at ₹40. If Rupee depreciates by 10%, what will be
thespot rate? If dollar appreciates by 10% what will be the spot rate?
SOLUTION:
Spot rate: 1 $ = ₹40
To find depreciation of ₹, we need to have a quote of ₹. Since, given quote is in $ and hence we need to
convert it. So, 1₹ = 1 / 40 = 0.025 $
If ₹ depreciate by 10 %, then new rate would be –
0.025 – 0.0025 = 0.0225
Hence, 1 $ = 1 / 0.0225 = ₹44.44

(b) If $ appreciates by 10 %, then we can apply 10 % directly to $ quote.
Hence, new rate would be: 40 + 10 % = 44
Hence, 1 $ = ₹44
Class example: 20
Spot rate: $ / £ = 1.3650
3 months forward rate $ / £ = 1.3710
Calculate annualized forward premium / discount on pound and dollar.
SOLUTION:
Quote: (A/B) = ($ / £)
𝐹−𝑆 12
(a) Annualized forward premium on pound = 𝑆 X 100 X 𝑛
1.3710−1.3650 12
1.3650
X 100 X 3
0.006 12
1.3650
X 100 X 3 = 1.7582 %
(b) Annualized forward premium on $ (Currency A)

𝑆−𝐹 12
𝐹
X 100 X 𝑛
1.3650−1.3710 12
X 100 X
1.3710 3
− 0.006 12
X 100 X = - 1.7505 % (Discount)
1.3710 3
Class example: 21
Spot rate: ₹/€ = 70.20
6 months forward rate = 68.10
Compute the annualized forward premium / discount on € and ₹.
Answer: Forward premium on € = - 5.9829 %
Forward premium on ₹ = 6.1674 %
Class example: 22
3 months forward rate (₹/$) = 60
Based on 3 months forward rate, annualized forward discount on $ against ₹ = 5 %
Based on 6 months forward rate, annualized forward premium on ₹ against $ = 7 %
Compute 6 month forward rate (₹/$).
Solution:
Calculation of spot rate using 3 months forward rate
𝐹−𝑆 12
𝑆
X 100 X 𝑛 = - 5
60−𝑆 12
𝑆
X 100 X 3 = - 5
60−𝑆
X 400 = - 5
𝑆
24,000 – 400 S = - 5 S
395 S = 24,000
S = 60.7595
Calculation of 6 – months forward rate (Currency A)

𝑆−𝐹 12
𝐹
X 100 X 𝑛 = 7
60.7595−𝐹 12
X 100 X =7
𝐹 6
60.7595−𝐹
X 200 = 7
𝐹
12,151.90 – 200 F = 7 F
207 F = 12,151.90
F = 58.7048
Class example: 23
6 months forward rate = $0.9750/€
Based on 6 months forward rate, the annualized forward premium on $ = 8 %
Based on 3 months forward rate, the annualized forward discount on € = 6 %
Calculate 3 months forward rate.
Topic: 11 Concept of cross rate

Cross rate is the exchange rate between two currencies where neither of the currencies are of the country in
which the exchange rate is quoted. In other words, whenever desired exchange rate will calculate with the help
of two or more another exchange rates then such rate is known as cross rate.
Class example: 24Following exchange rates are quoted by bank:

Dollar – Euro exchange rate ($/€) = 1.5968
Dollar – Yen exchange rate (¥ / $) = 108.0030
Calculate Euro – Yen (¥ / €) cross rate.
Answer: 1¥ = 0.0058 €
SOLUTION:
1€ = 1.5968 $
So, 1 $ = 1/1.5968 € or 1 $ = 0.6263 €
1 $ = 0.6263 €
1 $ = 108.0030 ¥
So, 108.0030 ¥ = 0.6263 €

1 ¥ = 0.6263 / 108.0030
1 ¥ = 0.0058 €

Dollar – Euro exchange rate: 1 € = 1.5451 $
Dollar – Pound exchange rate: 1£ = 2.0975 $
Calculate Euro – pound (€ / £) cross rate.
Answer: 1£ = 1.3575 €

1 $ = 1.1641 / 1.1646 CAD
1 $ = 1.2948 / 1.2956 AUD
Calculate cross rate between AUD / CAD.
Answer: 1 CAD = 1.1118 / 1.1130 AUD
SOLUTION:
Interpretation of quotes:
(i) Bank buy 1 $ and sell 1.1641 CAD
Bank sell 1 $ and buy 1.1646 CAD
(ii) Bank buy 1 $ and sell 1.2948 AUD

Bank sell 1 $ and buy 1.2956 AUD
If bank buy I CAD against AUD If bank sell 1 CAD against AUD
Bank must sell AUD and purchase $ and Bank sell $ and buy AUD and buy $ and sell CAD
simultaneously sell $ and buy CAD 1 $ = 1.2956 AUD
Hence, applicable rates: 1 $ = 1.1641 CAD
1 $ = 1.2948 AUD 1.1641 CAD = 1.2956 AUD
1 $ = 1.1646 CAD 1 CAD = 1.2956 / 1.1641
So, 1.1646CAD = 1.2948 AUD 1 CAD = 1.1130 AUD
1 CAD = 1.2948 / 1.1646 = 1.1118 AUD
Class example: 27Following rates are quoted by bank:

Rate between ¥ and $ (¥ / $) = 119.05 – 121.95
Rate between € and $ (€ / $) = 0.7920 – 0.7932
Calculate cross rate between ¥ and € (¥ / €)
Answer: 1€ = 150.0883 / 153.9773
Class example: 28You are given the following exchange rates:

1 $ = 1.6000 / 1.6035 SF
1 £ = 1.9810 / 1.9850 $
Find out cross rate between 1£ = SF.
Answer: 1£ = 3.1696 / 3.1829 SF
SOLUTION:
Interpretation of quotes:
(i) Bank buy $ and sell SF at 1.6000
Bank sell $ and buy SF at 1.6035
(ii) Bank buy £ and sell $ at 1.9810

Bank sell £ and buy $ at 1.9850
Bank buy £ against SF Bank sell £ against SF
Buy £ and sell $ and Buy $ and sell SF Sell £ and buy $ and sell £ and SF
1 £ = 1.9810 $ or 1 $ = 1 / 1.9810 £ 1 £ = 1.9850 $ or 1 $ = 1/1.9850
1 $ = 1.6000 SF 1 $ = 1.6035 SF
1 / 1.9810 £ = 1.6000 SF 1 / 1.9850 £ = 1.6035 SF
1 £ = 1.6000 * 1.9810 = 3.1696 SF 1 £ = 1.6035 * 1.9850 = 3.1829
Class example: 29 A bank is quoting the following exchange rate against the dollar for the Swiss franc and the
AUD:
SF/$ = 1.5960 / 70
AUD / $ = 1.7225 / 35
An Australian firm asks the bank for an AUD / SF quote. What cross rate would the bank quote?
Answer: 1 SF = 1.0786 / 1.0799 AUD
Class example: 30Assume a French trader who imports from London. He would like to buy Pound against
euro. The following market rates prevail:
EURO / $ = 1.18 / 1.19
Pound / $ = 0.69 / 0.70
At what rate the French would book his Pound?
Answer: 1£ = 1.7246 €
Class example: 31Consider the following rates:
Spot ₹/$ 42.17/42.59
₹/DM 24.61/25.10
3-m forward ₹/$ 43.15/43.60
₹/DM 25.36/25.90
From these rates calculate the spot and forward DM/$ rates.
Answer: Spot rate – 1 $ = 1.6801 / 1.7306 DM
3 months forward rate – 1 $ = 1.6660 / 1.7192 DM
Class example: 32You are given the following information

Spot DM/$: 1.5105/1.5130
Three-month swap: 25/35
Spot $/£: 1.6105/1.6120
Three-month swap: 35/25
Calculate the three-month DM/£ rate.
Answer: 1£ = 2.4314 / 2.4408 DM
Class example: 33A bank has to submit a quote to a customer for buying DM against Rupees. The
customerhave the option of taking delivery of ₹at the end of the second month. Given the following spot
and forward rates what rate should it quote?
₹/$ Spot: 35.20/35.30
One-month forward: 15/25
Two-month forward: 20/30
DM/$ Spot: 1.51/1.52
One-month forward: 15/10
Two-month forward: 20/15.
Answer: 1 DM = ₹25.84
Topic: 12 Forward hedging Vs No hedging
Hedging means protect himself due to risk arise from exchange fluctuation. For hedging importer or exporter
has following alternatives:
(a) Forward cover or forward hedging
(b) Money market hedging / Cash market hedging
(c) Option hedging
(d) Future hedging
arise in future in respect of payables or receivables.

 No hedging means no protection against future payables or receivables. Under this approach importer or
exporter wait till settlement date and settle transaction at applicable rate.
 Under forward cover Vs no cover following steps would be followed:
Step: 1 Book a forward contract today at applicable forward rate.
Step: 2 Calculate cash flows due to such forward cover.
Cash flow = Contract size * Forward rate
Step: 3 Calculate cash flow at spot rate prevails on due date (i.e. No cover)
Step: 4 Compare both cash flows and take decision.
Class example: 34 JKL Ltd, an Indian company has an export exposure of JPY 1,00,00,000 payable August
31, 2014. Japanese Yen (JPY) is not directly quoted against Indian Rupee.
The current spot rates are:
INR / US $ ₹62.22
JPY / US $ JPY 102.34
It is estimated that Japanese Yen will depreciate to 124 level and Indian Rupee to depreciate against US $ to
₹65.
Forward rates for August 2014 are:
INR / US $ ₹66.50
JPY / US $ 110.35
Required:
(i) Calculate the expected loss, if the hedging is not done. How the position will change, if the firm takes
forward cover?
(ii) If the spot rates on August 31, 2014 are:
INR / US $ ₹66.25
JPY / US $ JPY 110.85
Is the decision to take forward cover justified?
Class example: 35
At the end of the of July, 2007, an Indian company has an export exposure of EUR 50,000 due at the end of
August 2007. EUR is not directly quoted against INR. The current spot rates are INR 46 / USD and EUR 2.30 /
USD. It is estimated that EUR will depreciate to EUR 2.5 level against USD and that INR will depreciate
against USD to INR 47. One month forward rate at the end of July 2007 are EUR 2.45 / USD and INR 47.04 /
USD.
(a) Calculate expected loss if hedging is not done. How the position will change with the company taking a
forward cover?
(b) If spot rate on 31st August 2007 are eventually EUR 2.52 / USD and INR 47.88 / USD is the decision to
take forward cover justified?
Class example: 36
Fleur du lac, a French company, has shipped goods to an American importer under a letter of credit
arrangement, which calls for payment at the end of 90 days. The invoice is for 1,24,000 $. Presently the
exchange rate is 5.70 French francs to the $ if the French franc were to strengthen by 5 % by the end of 90
days, what would be the transactions gain or loss to exporter in French francs? If it were to weaken by 5 %,
what would happen?
Class example: 37
A company is considering hedging its foreign exchange risk. It has made a purchase on 1st January, 2008 for
which it has to make a payment of US $ 50,000 on September 30, 2008. The present exchange rate is 1 US $ =
Rs. 40. It can purchase forward 1 US $ at Rs. 39. The company will have to make a upfront premium of 2 % of
the forward amount purchased. The cost of fund to the company is 10 % per annum and the rate of corporate
tax is 50 %. Ignore taxation. Consider the following situations and compute the profit / loss the company will
make, if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is Rs. 42 per US $.
(ii) If the exchange rate on September 30, 2008 is Rs. 38 per US $.
Topic: 13 Cancellation of forward contract – Whenever customer requested bank for not fulfilling his
obligation then it is known as cancellation of forward contract.
(a) Cancellation on due date – whenever bank book a forward contract with any customer then at the same
time bank also book counter contract with the market. If on the due date customer requests to bank for
cancellation of his forward contract even then bank also has to fulfil his counter obligation. For fulfilling his
counter obligation bank have to go in the market on the date of cancellation and purchase / sale of foreign
currency. Bank has to pay an additional amount for this new contract can be recovered from customer and if
there is any gain to bank then bank has to refund this gain to customer. Gain / loss to customer can be
calculated as under:
Spot rate for the new contract on the date cancellation xxx
Add/ Less: Margin xxx
xxx
Less: Original contract rate xxx
Loss or gain to customer xxx
(b) Cancellation before due date – Whenever bank book a forward contract with any customer then at the
same time bank also book counter contract with the market. If before the due date customer requests to bank
for cancellation of his forward contract even then bank also has to fulfil his counter contract on due date. For
this purpose, bank has to book a new contract with market for the remaining period of the original contract.
Gain / loss to customer can be calculated as under:
Forward rate of new contract xxx
Add/ Less: Margin xxx
xxx
Less: Original contract rate xxx
Gain / loss to customer xxx
(c) Cancellation of forward contract after due date but within 14 days –
contract after due date but within 14 days then bank will recover loss arising from cancellation of forward
contract from the customer. If there is any gain on cancellation then such gain will not be given to customer.
This situation generally involve following steps:
Step: 1 Calculate swap difference on due date of original transaction:
Note:
(i) Swap loss should be recovered from customer but if there is swap gain, then ignore swap gain.
(ii) Swap difference will always be calculated by using inter – bank rate because swap difference is calculated
when bank booked two contracts with market on same day at his own behalf.
Step: 2 Calculate gain / loss due to cancellation of contract

 Gain /Loss will calculate on the date of request by customer for cancellation/ extension.
 Gain / Loss will calculate using merchant rate.
 Gain / Loss will calculate by comparing original contract rate and spot rate applicable on the date of
request for cancellation / extension.
Step: 3 Calculate interest charges for the period starting from due date of original contract to date of request by
customer.
 Interest is always calculated on actual cash flow.
Step: 4 Now calculate total amount which is to be recovered from customer / Total cost
(d) Automatic cancellation on 15th Day – In this situation bank does opposite action on spot basis. Exchange
loss if any is recovered from the customer but if there is any gain due to such cancellation the entire gain will
be retain by the bank itself.
This situation generally involve following steps:
Note:
(i) Swap loss should be recovered from customer but if there is swap gain, then ignore swap gain.
Step: 2 Calculate gain / loss due to cancellation of contract

 Gain /Loss will calculate on the date of request by customer for cancellation/ extension.
 Gain / Loss will calculate using merchant rate.
 Gain / Loss will calculate by comparing original contract rate and spot rate applicable on the date of
request for cancellation / extension.
Step: 3 Calculate interest charges for the period starting from due date of original contract to date of request by
customer.
Step: 4Now calculate total amount which is to be recovered from customer / Total cost
Topic: 14 Extension of forward contract – Whenever customer approaches to bank for increasing the time
limit of contract, it is known as extension of forward contract.
(a) Extension on due date - An exporter finds that he is not able to export on the due date but expects to do so
in about two months. An importer is unable to pay on the due date but is confident of making payment a month
later. In both these cases, they may approach their bank with which they have entered into forward contracts to
postpone the due date of the contract. Such postponement of the date of delivery under a forward contract is
known as the extension of forward contract. When a forward contract is sought to be extended. It shall be
cancelled and rebooked for the new delivery period at the prevailing exchange rates. FEDAI has clarified that
it would not be necessary to load exchange margins when both the cancellation and re-booking of forward
contracts are undertaken simultaneously. However, it is observed that banks do include margin for cancellation
and rebooking as in any other case.
Flow chart for extension of forward contract
For extension of contract first we have Bank has to rebook a new contract
to cancel the original contract. At the with customer for the extended
time of cancellation bank has to fulfil period.
his counter contract by purchasing /
selling foreign currency in market.
Same contract with customer
for extended period. In other
words, bank again booked a
Extension charges = Spot rate on the date of extension
new forward contract with
(with margin, if any) – original contract rate customer. New forward rate
should be calculated.
Early extension - When the request for extension is received earlier to the due date, it is known as early
extension. Due to such early extension, bank has to make a new forward contract for the remaining period of
original contract with the market. The difference between new forward rate and original contract rate is known
as extension charges which should be either recovered from customer or paid to customer. Bank also decides a
new forward rate for extended period.
Class example: 38
A customer with whom the bank had entered into 3 month’s forward purchase contract for 50,000 $ at the rate
of ₹50.25 comes to the bank on due date and requests cancellation of the contract. Spot rate on the date of
cancellation are:
1 $ = ₹50.85 / 51.00. What are the loss/ gain to the customer on cancellation?
Class example: 39
An exporter requests his bank to extend the forward contract for US $20,000 which is due for maturity on 31st
October, 2014 for a further period of 3 months. He agrees to pay the required margin money for such extension
of the contract.
Contracted rate – US $1= ₹62.32
The US $quoted on 31.10.2014:
Spot rate: - 61.5000/ 61.5200
3 months discount – 0.93 % / 0.87 %
Margin money from bank’s point of view for buying and selling rate is 0.45 % and 0.20 % respectively.
Compute:
(a) The cost of importer in respect of the extension of the forward contract, and
(b) The rate of new forward contract. [RTP – May, 2015]
SOLUTION:
Statement showing extension charges:
Applicable spot rate (Selling rate) 61.5200
Add: Margin @ 0.20 % 0.1230
Adjusted rate 61.64
Less: original rate 62.32
Gain per $ 0.68
Exposure amount 20,000
Total gain 13,600
Calculation of new forward rate:

Applicable spot rate 61.50
Less: Discount rate @ 0.93 % 0.5720
60.9280
Less: Margin @ 0.45 % 0.2742
New rate 60.65
Class example: 40 [CWA – Study Material(2012)]

On 1.4.2007, Sangeet International (SI) concluded a contract for purchase of 10,00,000 blue ray discs from an
American company at $ 1.48 per Disc, to be supplied over the next 3 months. SI is required to make the
payment immediately upon receipt of all the discs. To meet the obligation, SI had booked a forward contract
with its bankers to buy $ 3 months hence. The following are the exchange rates on 1.4.2007 –
Spot rate: ₹41.30 – 70
3 months forward rate: ₹42.00 – 50
On 1.7.2007, the American company expressed its inability to supply the last installment of 3,00,000 Blue Ray
discs due to export restrictions in US and required SI to settle for the quantity supplied. Spot rate on 1.7.2007
was ₹40.90 – 41.20.
(a) Ascertain the total cash outgo for SI for purchase of 7,00,000 discs.
(b) Would total cash outgo undergo any change if the American company had informed on 1.6.2007, when the
following exchange rates were available –
Spot rate: ₹41.70 – 42.20
1 months forward: ₹42.10 – 42.50
Solution:
(a) Bank booked forward sale Bank booked forward purchase
14,80,000 $ @ 42.50 Due date of contract

Spot rate: 41.30 / 41.70 4,44,000 $ contract will be cancelled
Spot rate: 40.90 / 41.20

Statement showing calculation of cash outflow:
(a) Amount paid for honored contract (i.e. for 7,00,000 discs) (10,36,000 *
42.50)
(7,00,000 * 1.48 * 42.50) 4,40,30,000
(b) Amount paid due to cancellation of contract (40.90 – 42.50) * 4,44,000 7,10,400
Total cash outflow 4,47,40,400
(b)
Bank booked forward sale Bank booked forward purchase
14,80,000 $ @ 42.50 1.7.2007 Due date of contract

Spot rate: 41.30 / 41.70 Cancellation
Spot rate: 41.70 / 42.20
1 months forward = 42.10 / 42.50
Customer cancel its contract before due date. Bank has booked 1 month forward sale contract with market.
Since market purchases $, Lower rate will (i.e. 42.10) apply. Hence cash outflow will be as under:
Statement showing calculation of cash outflow:
(a) Amount paid for honored contract (i.e. for 7,00,000 discs) (10,36,000 *
42.50)
(7,00,000 * 1.48 * 42.50) 4,40,30,000
(b) Amount paid due to cancellation of contract (42.10 – 42.50) * 4,44,000 1,77,600
Total cash outflow 4,42,07,600
Class example: 41 [CMA – Study material - 5]

Ankita Papers Ltd (APL), on 1st July 2015 entered into a 3 Month forward contract for buying GBP 1,00,000
for meeting an import obligation. The relevant rates on various dates are –
Date Nature of quote Quote
1.7.2015 Spot ₹81.50 – 81.85
3 – months forward ₹81.90 – 82.30
1.8.2015 Spot ₹82.10 – 82.40
2 – months forward ₹82.25 – 82.60
1.9.2015 Spot ₹81.70 – 82.05
1 month forward ₹82.00 – 82.30
2 months forward ₹82.40 – 82.70
1.10.2015 Spot ₹82.50 – 82.75
1 month forward ₹82.60 – 82.90
Explain the further course of action if APL—
(a) Honours the contract on
• 01.10. 2015
• 01.09. 2015; and meets the import obligation on the same date.
(b) Cancels the contract on —

• 01.08. 2015
• 01.09. 2015
• 01.10. 2015; as the import obligation does not materialize.
(c) Rolls over the contract for --
• 2 Months on 01.09.2015
• 1 Month on 01.10. 2015; as the import obligation gets postponed to 01.11.2015. Also determine the cost
/ gain of that action. Ignore transaction costs.
Topic: 15 Early delivery of forward contract – When a customer requests early delivery of a forward
contract, i.e., delivery before its due date, the bank may accede to the request provided the customer agrees to
bear the loss, if any,that may accrue to the bank. At the time of early delivery, following procedure will be
adopted by bank:
Following steps should be applied in case of early delivery:

Note:
(i) Swap loss should be recovered from customer and swap gain is refunded to customer.
Step: 2 Calculate interest cost

Calculate interest charges for the period starting from date of early delivery to due date of original contract. .
RUPEE ROLL – OVER OF FORWARD CONTRACT

Rollover forward contracts are one where forward exchange contract is initially booked for the total amount of
loan etc. to be re-paid. As and when installment falls due, the same is paid by the customer at the exchange rate
fixed in forward exchange contract. The balance amount of the contract rolled over till the date for the next
installment. The process of extension continues till the loan amount has been re-paid.
A corporate can book with the Authorised Dealer a forward cover on roll-over basis as necessitated by the
maturity dates of the underlying transactions, market conditions and the need to reduce the cost to the
customer.
ADDITIONAL QUESTIONS RELATED TO CANCELLATION, EXTENSION, EARLY DELIVERY

OF FORWARD CONTRACTS
Q.1 On 15th November, ICICI bank booked a 3 months forward purchase contract of $ 20,000 for its export
customer. On that date exchange rate was as follows:
Spot rate: 1 $ = ₹49.3200 / 3325
3 months swap points = 1,000 / 1500
Margin = 0.10 % / 0.125 %
On the due date customer requests for cancellation of this contract. Exchange rate prevailing on that date is as
follows:
Spot rate: 1 $ = ₹47.5300 / 5400
3 months swap point = 500 / 1000
Margin = 0.10 % / 0.125 %
Calculate the amount recoverable from or payable to customer.
Answer: Amount payable to customer: ₹35,424

Q.2 On April, the bank entered into a forward purchase contract of $ 1,00,000 at ₹44 due on 1st June. On
1st
the same day bank covered its position by a forward sale at ₹45. On the due date the customer requested for
cancellation of the contract. The prevailing exchange rate on 1st June were as under:
Spot inter – bank rate: 1 $ = ₹44.5500 / 6000
Margin = 0.15 %
Spot merchant rate = 1 $ = ₹44.43 / 44.67
Calculate the amount recoverable from or payable to the customer.
Answer: Amount recoverable from customer: ₹67,000
Q.3 In the previous question assumes that the customer made the request for cancellation of the contract on 1st
May. The prevailing prices on 1st May are as under:
Spot inter – bank rate: 1 $ = ₹44.2000 / 3000
Forward June = 2,000 / 2500
Margin = 0.15 %
Forward June (Merchant rate): 1 $ = ₹44.34 / 44.62
Calculate the amount recoverable from the customer.
Answer: Amount recoverable from customer = ₹62,000
Q.4 On 15th January you booked a forward sale contract for French Francs 2,50,000 for your import customer
delivery 15th February at ₹6.95. on the due date the customer requests cancellation of the contract. Assuming
French Francs were quoted in the London foreign exchange market as under:
Spot rate: 1 $ = FF 5.0200 / 0300
And the US $ were quoted in the local inter – bank exchange market as under on the date of cancellation:
Spot rate: 1 $ = ₹34.7900 / 7975
Exchange margin required by you is 0.15 %. What will be the cancellation charges payable by the customer, if
any?
Answer: Cancellation charges = ₹10,000
Q.5 The bank entered into an agreement with its customer on 10th July for a forward purchase contract for $
4,000 to be delivered 10th September at the rate of ₹28.14 per $ covering itself by a forward sale at ₹28.16. on
10th August, the customer requests the bank to settle the contract. Calculate the amount that would be paid to
the customer assuming the following rates in the inter – bank market on 10th August:
Spot rate: 1 $ = ₹28.1025 / 1075
Delivery September: 1 $ = ₹28.6475 / 6550

Interest on outlay of funds at 12 % and inflow of funds at 8 %.
Answer: Total recovery from customer = ₹2,212
Q.6 Bank entered into an agreement with its customer on 1st January, 2014 for a forward purchase contract for
$ 10,000 delivery 31st May, 2014.
Spot rate on 1st January, 2014: 1 $ = ₹62.00
Forward premium (May end): ₹2.00 / ₹2.03
On 31st March, 2014, customer requests the bank for settlement of its forward transaction. Following rates are
prevail in market on 31st March, 2014:
Forward premium (May end): ₹0.85 / 0.87
Interest on outlay of funds at 18 % and inflow of funds at 15 %. Calculate amount payable to customer /
recoverable from customer.
Answer:
Q.7 The bank entered into an agreement with Mr. A on 31st July for a forward purchase contract for GBP 8,000
to be delivered on 30th September at the rate of ₹56.28 per pound covering itself by a forward sale at ₹56.32.
On 31st August, the customer requests the bank to settle the contract of 8,000 GBP. Calculate the amount that
would be paid to the customer assuming the following rates in the inter – bank market on 31st August:
Spot rate: 1 GBP = ₹56.2050 / 2150
Delivery September: 1 GBP = ₹55.2950 / 3100
Interest on outlay of funds at 12 % and inflow of funds at 9 %.
Answer: Net amount payable to customer = ₹7,154
Q.8 The bank had agreed on 1st January that it will sell on 1st April to customer Dirham 10,000 at ₹17.29. on
the same day bank covered its position by buying forward from the market due 1st April at the rate of
₹17.2775. On 1st March, the customer approaches the bank to sell Dirham 10,000 under the forward contract
earlier entered into. The rates prevailing in the inter – bank market on this date are:
Spot rate: 1 Dirham = ₹17.2350 / 2400
April: 1 Dirham = ₹17.1275 / 1300
Interest on outlay of funds at 18 % and inflow of funds at 12 %. What is the amount that would be
recovered from the customer on the transaction?
Answer: Net amount recovered from customer = ₹1,120
Q.9 A bank enters into a forward purchase TT covering an export bill for Swiss francs 1,00,000 at ₹ 32.4000
due on 25th April and covered itself for same delivery in the local inter-bank market at ₹ 32.4200. However on
25th March, exporter sought for cancellation of contract as the tenor of the bill is changed
In Singapore market, Swiss Francs were quoted against US dollars as under:
Spot: 1 $ = Sw. Fcs 1.5076 / 1.5120
One month forward: 1.5150 / 1.5160
Two month forward: 1.5250 / 1.5270
Three month forward: 1.5415 / 1.5445
And the inter – bank market US $ were quoted as under:
Spot rate: 1 $ = ₹49.4302 / 0.4455
Spot / April: 0.4100 / 0.4200
Spot / May: 0.4300 / 0.4400
Spot / June: 0.4500 / 0.4600
Calculate the cancellation charges payable by the customer if exchange margin required by the bank is 0.10%
on buying and selling [CA – Nov. 2015]
Answer: Cancellation charges: ₹55,000
Q.10 A bank had booked a forward purchase contract with a customer for $ 2,50,000 at the rate of 1$ = ₹33.50
delivery due on October 30. On September 30 customer approaches bank with a request to cancel the forward
purchase contract. What will be the cancellation charges of the bank, if following are the rates in the interbank
market on September, 30?

Spot rate: 1$ = ₹34.7400 / 35.0800
1 month forward: 8 -15 paise per US $
2 months forward: 31 – 41 paise per US $
3 months forward: 60 – 70 paise per US $
The bank is to load an exchange margin of 0.15 %.
Answer:
Q.11 Date of maturity of forward sale contract: September 30th 2002
Amount: $ 2,50,000
Contract rate: 1$ = ₹49.4500
On August 10, 02 the customer requests to extend the forward contract for October 31st 2002. Interbank market
rates on August 10, 02:
Spot: 1$ = ₹48.1325 / 48.1675
Forward spot/ August 2200 / 2100
Spot / September 4700 / 4500
Spot / October 6900 / 6300
Compute extension charges payable / receivable. You are allowed to load an exchange margin of 0.08 % on
TT buying and 0.15 % on TT selling rate.
Answer:
Q.12 On 20th November, 2002 you booked a forward purchase contract for DEM 50,000 from your export
customer delivery 20th Feb. At ₹28.2500. On the due date the customer requests cancellation of the contract.
The rates prevailing on that day are:
Spot USD 1 = DEM 1.5150 / 1.5170
Spot USD 1 = ₹42.6125 / 2975
Exchange margin is 0.10%. Calculate gain or loss to customer, if any?
Answer:
Q.13 The company had agreed on 20 February that it will buy on 20th April from the banker USD 10,000 at
th
₹44.57. On 20th March, the company approaches the bank to buy USD 10,000 under the forward contract
earlier entered into. The rates prevailing in the market on this date are:
Spot rate: 1$ = ₹44.4725/ 4800
April: 1 $ = ₹44.2550/ 2625
Ignoring interest and fine out the amount that would be paid / received by the company on early delivery.
Answer:
Q.14 An Importer booked a Forward Contract with his Bank on 10th April forUSD 2,00,000 due on 10th June
@ ₹64.4000. The Bank covered its position in the market at ₹64.2800. The Exchange Rates for Dollar in the
Inter–Bank Market on 10th June and 20th June were:
10th June 20th June
Spot USD 1 ₹63.8000 / 8200 ₹63.6800 / 7200
Spot / June ₹63.9200 / 9500 ₹63.8000/8500
July ₹64.0500 / 0900 ₹63.9300 / 9900
August ₹64.3000 / 3500 ₹64.1800 / 2500
September ₹64.6000 / 6600 ₹64.4800 / 5600
Exchange Margin 0.10% and interest on Outlay of Funds @12%. TheImporter requested on 20th June for
extension of contract with due date on 10th August. Rates rounded to 4 decimal in multiples of 0.0025.
On 10th June, Bank Swaps by selling spot and buying one month forward.
Calculate the following:
(i) Cancellation Rate (iv) Interest on Outlay of Funds, if any
(ii) Amount Payable on $ 2,00,000(v) New Contract Rate
(iii) Swap Loss (vi) Total Cost [CA – May, 2015]
Answer: (i) Cancellation rate – 63.6175 (ii) Amount payable - ₹1,56,740 (iii) Swap loss – 30,000 (iv)
Interest cost – 320 (v) New contract rate – 64.3150 (vi) Total cost – 1,87,060
Q.15 On 1st January, the bank enters into a forward purchase contract with an export customer for $ 10,000 due
on 1st March at an exchange rate of ₹35.60 and covers its position in the market at ₹35.65. The customer
defaults to execute the contract on the due date. On 15th March the cancels the contract. The following were
the exchange rate prevalent:
On 1st March:
Inter – bank rate: 1 $ = ₹35.75 / 80
1 month forward (can be used for 15 days forward also) = 1 $ = 35.90 / 95
Merchant rate: 1 $ = ₹35.67 / 90
On 15th March:
Inter – bank rate: 1 $ = ₹36.10 / 15
Merchant rate: 1 $ = ₹36.05 / 20
Interest rate applicable = 12 % per annum.
Calculate amount recoverable from customer.
Q.16 An Import customer booked a forward contract with the bank on 10th April for $ 20,000 due 10th June at
₹36.40. The bank covered its position in the market at ₹36.28. The exchange rates for dollar in the inter – bank
market on 10th June and 25th June were:
10th June 25th June
Spot 1 $ ₹35.80 / 82 ₹35.68 / 72
June ₹35.92 / 95 ₹35.80 / 85
July ₹36.05 / 09 ₹35.93 / 99
August ₹36.30 / 35 ₹36.18 / 25
September ₹36.60 / 66 ₹36.48 / 56
Exchange margin = 0.15 %
Interest on outlay of funds = 12 %
How will the bank react if the customer requests on 25th June:
(a) To cancel the contract
(b) To execute the contract
(c) To execute the contract with due date to fall in August.
Q.17 Mr. A sold goods to USA worth $ 3,00,000 on 1.4.2015 receivable after 3 months from today. Mr. A
booked a forward contract with bank @ ₹45.4530 per $. On due date customer request for cancellation of
forward contract. Exchange rate prevail in market on due date were:
1 $ = ₹46.3025 / 35
Calculate gain / loss to customer due to cancellation
Total Loss: ₹2,55,150
Q.18 Mr. A exported goods on 1st January, 2015 to Germany worth 40,000 € to be received after 4 months.
Mr. A booked a forward contract with bank. On due date customer requested for cancellation of contract.
Following are the exchange rates prevail on 1st January and 30th April, 2015:
On 1st January:
1 € = 67.4560 / 70
On 30th April:
1 € = 67.7235 / 55
Calculate gain or loss due to customer. Exchange margin is 0.10 %
Total loss - ₹16,128
Q.19 Mr. A imported goods from USA on 1st January, worth $ 1,00,000 payable on 31st May, 2015. For
hedging Mr. A book a forward contract with bank. Exchange rate on 1.1.2015 were as under:
1 $ = ₹62.7345 / 55
Interest rates were:
$ = 12 % per annum
₹ = 10 % per annum
On due date, Mr. A cancel the contract. Exchange rates on date of cancellation were:
1$ = 62.8532 / 42.
Exchange margin = 0.08 %.
Calculate gain or loss due to cancellation of contract.
(a) Quoted rate by bank initially - ₹62.2894
(b) Cancellation rate - ₹62.8029
(c) Amount payable to customer - ₹51,350
Q.20 An exporter booked a forward contract with his bank on 1.4.2015 for $ 50,000 due on 30.6.2015 at
₹44.50 per $. Bank covered its position in the market at ₹44.80. Exchange rates in the inter – bank market on
30.6.2015 and 10.7.2015 were as under:
Exchange rates on 30.6.2015:
Spot rate: 1 $ = 44.65 / 44.75
1 months swap point: 15 / 20 (Can be used for part of the month)
Spot rate: 1 $ = 44.60 / 44.75
Interest on fund @ 12 % per annum. The exporter requested on 10th July for cancellation of contract. Bank
swaps necessary contracts.
Calculate the following:
(i) Swap cost / gain
(ii) Cancellation charges
(iii) Interest on funds
(iv) Total cost
(i) Swap gain - ₹2,500 (Ignore)
(ii) Cancellation charges – ₹12,500
(iii) interest payable to customer - ₹8
(iv) Total amount recovered from customer - ₹12,492
Q.21 Mr. A imported goods on 1.5.2015 from USA worth $ 50,000. Amount is payable after 4 months. Mr. A
booked a forward contract with his bank on 1.5.2015.
Exchange rate on 1.5.2015:
Spot rate: 1 $ = 45.4545 / 50
Swap points: July – 25 / 30
August – 35 / 40
Bank covered its position in the market at ₹45.4000. Following are the exchange rates available:
On 31.8.2015
Spot rate: 1 $ = 43.7500 / 80
1 month swap points: 15 /10
Spot rate: 1 $ = 44.7230 / 40
Exchange margin = 0.12 % and interest on fund 10 % per annum. Bank swaps by selling spot and buy 1 month
forward. Customer requested for cancellation of contract on 12.9.2015.
Required:
(a) Swap cost
(b) Cancellation charges
(c) Interest charges
(d) Total amount receivable / payable to customer.
(a) Swap cost - ₹350
(b) Cancellation rate – 44.6693; Cancellation charges – ₹42,215
(c) Interest cost - ₹271
(d) Total amount recovered from customer - ₹42,836

Q.22 Mr. X sold goods worth € 1,20,000 on 1.4.2015 receivable after 3 months. Mr. X booked a forward
contract with his bank on 1.4.2015. Bank covered its position in the market at ₹70.3680 per €.
Exchange rate on 1.4.2015:
Spot rate: 1€ = 70.4350 / 70
On 10th July, 2015 Mr. X requested for cancellation of contract. On 30.6.2015, bank swaps by purchasing spot
and selling 1 month forward. Exchange margin 0.10 % and interest rate on funds @ 10 %.
Spot rate: 1€ = 70.2650 / 30
1 months swap point: 30 / 50
Spot rate on 10th July, 2015: 1 € = 70.3000 /15
Required:
(a) Swap cost
(b) Cancellation charges
(c) Interest on fund
(d) Total amount payable to / recoverable from customers.
(a) Swap cost - ₹600

(b) Cancellation charges - ₹564
(c) Interest payable to customer - ₹31
(d) Total amount recovered from customer - ₹1133
Topic: 16 Option forward contract

Option forward contracts are contracts which allow option (choice) about date of settlement during last month
of the contract.
When to use option forward contract – When the customer is not certain about settlement date, then customer
must use option forward contract. In India, maximum period is 1 month.
How to price option forward contract:

 It is a simple forward rate, which will be used in normal forward contract.
 For calculation of forward rate we need spot rate, forward points and exchange margin.
 Option forward contract is priced considering the uncertainty involved in settlement from t= 1 to t = 2.
 Bank follows worst case scenario approach.
Summary rule: Bank will quote such rate which is beneficial for bank. Either start of option period or end of
option period. The burden of uncertainty is on customer.
Class example: 42
1 USD = 49.8825 / 49.8975
Spot / May = 2500 / 2700
Spot / June = 5200 / 7700
Spot / July = 7700 / 8200

An exporter is likely to receive USD in July. What rate authorised dealer should quote for option forward
contract?
Solution:
Statement of applicable rate:
Hence, Forward rate for option contract = 50.4025.
Class example: 42
A Bank is quoting the following rates:
A firm wishes to buy Riyals against DM 3 month forward with an option over 3rd month. What rate will the
bank quote?
Answer: Bank should sell riyals at 0.4251 DM
Topic No. 17: Money market hedging / Cash market hedging (MMH) – Whenever our exposure is for
foreign currency receivables or payables for a short period then we can hedge our receivables or payables
through money market hedging.
Case: A: Money market hedging for exporter – For an exporter under MMH we should apply following
steps:
Step: 1 Create foreign currency loan amount which is the discounted value of receivables. For this purpose
discount rate should be foreign currency borrowing rate.
Step: 2 Convert foreign currency loan into home currency amount by using spot rate.
Step: 3 Investment home currency amount at deposit rate.

Step: 4 On maturity amount realized from foreign currency debtors and repay foreign currency loan from such
value.
Step: 5 Realize from investment with interest

Hence, Inflow under MMH = Investment amount + Interest on investment.
Case: B Money market hedging for Importer – For an Importer under MMH we should apply following steps:
Step: 1 Take home currency loan at spot rate for amount of investment.
Step: 2 Create foreign currency deposit / investment which is the discounted value of foreign currency payable.
The discount rate should be the deposit rate.
Step: 3 On maturity realized from investment and pay for foreign currency payables.
Step: 4 Repay home foreign currency loan with interest.

Hence, outflow = Loan amount + Interest on loan
Note:
(1) Interest rates given in the question is always quoted on per annum basis.
(2) if deposit and borrowing rates are not specifically mentioned then assume lower rate as deposit rate and
higher rate as borrowing rate.
Class example:43
Assume the following information:
US interest rate = 16 %
British interest rate = 18 %
Spot rate of British pound = $ 1.50
180 – days forward rate of British pound = $1.48
Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be
better off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue
for each type of hedge. Assume 360 days in a year.
Answer: Alternative 1: Forward cover - $ 5,92,000; Alternative 2: MMH – 5,94,495.416 $
Class example: 44
U.S. interest rate = 16 % p.a.
Malaysian interest rate = 12 %
Spot rate of Malaysian ringgit = $.404
90-day forward rate of Malaysian ringgit = $.400
Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to
hedge this payables position. Would it be better off using a forward hedge or a money market hedge?
Substantiate your answer with estimated costs for each type of hedge.
Answer: Alternative: 1 Forward cover – 1,20,000; Alternative: 2 – MMH – 1,22,376.70 $
Class example: 45
Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the
Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a
probability distribution for the future spot rate in one year as follows:
Future spot rate Probability
$ 0.61 20 %
$ 0.63 50 %
$ 0.67 30 %
Assume the following money market rates:
US Singapore
Deposit rate 8% 5%
Borrowing rate 9% 6%
Decide that which of the following hedging strategy is most appropriate for Carbondale Co.
(i) Forward hedging
(ii) Money market hedging
(iii) No hedging
Answer: Alternative: 1 Forward cover – 3,10,000; Alternative: 2 MMH – 3,05,660.38; Alternative: 3 No

hedging – 3,19,000
Class example: 46
Columbus Surgical Inc. is based in US, has recently imported surgical raw material from the UK and has
been invoiced for £4,80,000, payable in 3 months. It has also exported surgical goods to India and France.
The Indian customer has been invoiced for £1,38,000 payable in 3 months and the France customer has
been invoiced for €5,90,000 payable in 4 months.
Current spot rate and forward rates are as follows:
£ / US $
Spot rate: 0.9830 – 0.9850
Three months forward: 0.9520 – 0.9545
US $ / €
Spot rate: 1.8890 – 1.8920
Four months forward: 1.9510 – 1.9540
Current money market rates are as follows:
UK: 10.0 % - 12.0 % p.a.
France: 14.0 % - 16.0 % p.a.
USA: 11.50 % - 13.0 % p.a.
You as treasury manager are required to show how the company can hedge its foreign exchange exposure
using forward market and money market hedge and suggest and suggest which the best hedging technique
is.
Solution: Since Columbus has £ receipts and £ payments maturing at same time so net liability of £
3,42,000 (4,80,000 – 1,38,000) to be hedged.
(a) Forward hedging
Amount payable after 3 months £ 3,42,000
Applicable forward rate 0.9520
Total payment (3,42,000 / 0.9520) 3,59,244 $
(b) Money Market hedging:
Foreign currency receivables

Foreign currency liability
3months
3,42,000 3,42,000
= 1.025 = 3,33,658 £
10
£ 3,42,000 1+ 𝑥3
12
Borrow in $
3,33,658
Borrowings: 0.9830 = 3,39,428 $
Steps for MMH:

Step: 1Borrow $ 3,39,428 for 3 months @ 13 % p.a.
Step:2 Convert $ into £ at spot rate i.e. 0.9830

Hence £ = 3,39,428 * 0.9830 = 3,33,658 £
Step: 3 Invest £3,33,658 @ 10 % for 3 months.
Step: 4 Realize investment in Foreign currency and paid FC liabilities.

Step: 5 Repay $ loan with interest

Cash outflow = 3,39,428 + 3,39,428 *13 % * 3/12
= 3,39,428 + 11,031 = $ 3,50,459
For receivable after 4 months:

Option 1: Forward hedging
Amount receivable after 4 months € 5,90,000
Applicable forward rate 1.9510
Total receipt (5,90,000 * 1.9510) 11,51,090 $
Option 2: Money Market hedging:
Foreign currency loan

Foreign currency receivable
3months 5,90,000 5,90,000
= 1.0533 = € 5,60,144
16
€ 5,90,000 1+ 𝑥4
12
Convert at spot rate and invest

5,60,144 € * 1.8890
= 10,58,112 $
Step: 1 Borrow 5,60,144 € @ 16 % for 4 months
Step: 2 Convert loan amount in $ at spot rate

Hence, $ = 5,60,144 * 1.8890 = $ 10,58,112
Step: 3 Invest $ 10,58,112 for 4 months @ 11.50 %.
Step: 5 realize from foreign currency debtors and repay foreign currency loan.
Step: 6 Realize from investment

10,58,112 + 10,58,112 * 11.5 % * 4/12
= 10,58,112 + 40,561 = 10,98,673 $.
Decision: Go for forward hedging.
Topic: 20 Cover deal / cover rate / Profit or loss of dealer due to contract
Whenever, dealer (i.e. bank) booked a contract with customer, at the same time dealer also booked a
counter contract with the market. This counter contract is known as cover deal. The rate applicable for the
counter contract with the market is known as cover rate.
How to find out profit or loss of dealer due to cover = Cover rate – Contract rate with customer
Topic: 21 Leading and Lagging technique

Under leading technique settlement will be done before due date whereas under lagging technique there is
delay in settlement. Generally name of technique is given in the question but if not given then apply
following rules:
Foreign currency at premium Foreign currency at discount
Importer Lead Lag
Exporter Lag Lead
Class example: 47
A firm is contemplating import of a consignment from the USA for a value of US $ 10,000. The firm requires
90 days to make payment. The supplier has offered 60 days interest – free credit and is willing to offer
additional 30 days credit at an interest rate of 6 % per annum. The bankers of the firm offer a short loan for 30
days at 9 % per annum. The banker’s quotation for foreign exchange is:
Spot rate: 1 $ = Rs. 46
60 days forward 1 $ = Rs. 46.20
90 days forward 1 $ = Rs. 46.35
You are required to advise the firm as to whether it should:
(i) Pay the supplier in 60 days, or
(ii) Avail the supplier’s offer of 90 days credit. Show your calculations.
Class example: 48
An Indian importer has to settle an import bill for $ 1,30,000. The exporter has given the Indian exporter two
options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 % per annum.
The importer’s bank charges 15 % per annum on overdrafts. The exchange rates in the market are as follows:
Spot rate (Rs. /$): 48.35 / 48.36
3 months forward rate (Rs. /$): 48.81 / 48.83
The importer seeks your advice. Give your advice.
Topic: 21 Concept of Interest rate parity (IRP) and arbitrage process
As per IRP, interest rates across the world on a covered basis must be equal. Thus, whichever currency
has a lower interest rate, the currency of that country should be at a forward premium.
(A) Concept understanding:
Person of USA have two possible alternatives for investment:
A1 (Invest in USA)
t=0 t=1
100 $ $ 105
5%
8%
A2 (Invest in India)
t = 0 (exchange rate = 40) t=1
₹4,000 (100 * 40) ₹4,320 (assume exchange rate = ₹40)
4,320 /40 = $ 108
In the above situation it is better for investor to invest in India for a year as it gives more $ in return in
comparison to invest in USA. However as per IRP theory the exchange rate will adjust in such a way that there
is no benefit to investor. In other words we can say that investor is indifferent between alternative 1 and
alternative 2.
Hence, as per IRP exchange rate should be = 4,320 / 105 = ₹41.1429.
Summary:
(i) If IRP theory hold good = There is no arbitrage
(ii) If IRP theory does not hold good = Investor can earn arbitrage.
(B) How to compute forward rate with the help of interest rate parity theory (IRP)
1+Rq
Forward rate = Spot rate X
1+Rb
Rq = Rate of quote / price currency
Rb = Rate of base currency
(C) How to check arbitrage

 Arbitrage means risk less profit.
 Ideally buy low and sale high.
 While carrying out arbitrage equal amount is bought or sold.
 If money market interest differential is equal to forex market differential then IRP is valid and hence
arbitrage is not possible. In other words, if money market differential is not equal to forex differential
then arbitrage is possible and this is called covered interest arbitrage.
 If interest rate differential is higher than forex differential, then investor should go for deposit in
country where interest rate is higher.
 If interest rate differential is lower than forex differential, then investor should go for deposit in
country where interest rate is lower.
(D) Locational arbitrage – Locational arbitrage can occur when the spot rate of a given currency varies
among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location.
The disparity in rates can occur since information is not always immediately available to all banks. If a
disparity does exist, locational arbitrage is possible.
Class example: 49
Beal bank Yardely bank
Bid price of New Zealand $ $ 0.401 $ 0.398
Ask rate $ 0.404 $ 0.400
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage
and compute the profit from this arbitrage if you has $ 10,00,000 to use.
Class example: 50
SBI bank BOB bank
Bid rate 1 $ = 45.05 1 $ = 45.08
Ask rate 1 $ = 45.07 1 $ = 45.09
Given this information is locational arbitrage possible? If so, explain the steps involved in locational arbitrage
and compute the profit from this arbitrage if you has ₹1,00,000 to use.
(E) Covered interest arbitrage
Class example: 51
Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-
month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can
borrow as much as $1,500,000 or £1,000,000.
(i) Determine whether the interest rate parity is currently holding.
(ii) If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and
determine the arbitrage profit.
Class example: 52
Following information is given:
Exchange rate - Canadian dollar 0.666 per DM (spot)
Canadian dollar 0.671 per DM (3 months)
Interest rates - DM 7.5% p.a.
Canadian Dollar 9.5% p.a.
To take the possible arbitrage gains, what operations would be carried out?
Class example: 53 [work book]

You are given the following information–
You are required to find out any arbitrage opportunity exists.

If so, show how $20,000 available with you can be used to generate risk - less profit.
Class example: 54
The spot exchange rate is ₹15 /€ and the three months forward exchange rate is ₹15.20 / €. The three month
interest rate in India is 8 % per annum and 5.80 % per annum in Germany. Assume that you can borrow as
much as ₹15 lakhs or € 10 lakhs.
(i) Determine whether the interest rate parity is currently holding
(ii) How would you carry out covered interest arbitrage? Show all steps and determine the arbitrage profit.
Class example: 55
Check arbitrage opportunity from the following information:
Spot rate 1 $ = ₹40
6 months forward rate 1 $ = ₹40.50
Indian interest rate 8%
USA interest rate 5%
Solution:
Step: 1 Calculate theoretical forward rate: SR x 1+𝑅𝑎𝑡𝑒 𝑜𝑓 𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦𝑅𝑎𝑡𝑒 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
= 40 x 1.041.025 = 40.59
Quoted forward rate = 40.50
Since theoretical forward rate ≠ Quoted forward rate, so arbitrage is possible. For arbitrage, arbitrager should
borrow $ and invest in ₹.
Step: 2 Following is the process of arbitrage

(i) Borrow 10,000 $ @ 5 % per annum for 6 months.
(ii) Convert into ₹by using spot rate
10,000 x 40 = ₹4,00,000
(iii) Invest ₹4,00,000 @ 8 % per annum for 6 months.
(iv) Buy forward purchase contract of $ at ₹40.50
(v) Realize from investment with interest
4,00,000 + 4,00,000 x 8100 x 612
4,00,000 + 16,000 = 4,16,000
(vi) Buy $ at agreed forward rate
$ Inflow = 4,16,00040.50= $ 10,271.605
(vii) Repay loan with interest
$ Outflow = 10,000 + 10,000 x 5100 x 612
10,000 + 250 = $ 10,250
(viii) Arbitrage profit = 10,271.605 – 10,250 = 21.605 $
Class example: 56
Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-
month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can
borrow as much as $1,500,000 or £1,000,000.
(i) Determine whether the interest rate parity is currently holding.

(ii) If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and
determine the arbitrage profit.
Solution: SR = 1£ = 1.50 $
Theoretical forward rate = 1.50 x 1.021.0145 = 1.5081
Quoted forward rate = 1.52
Since, TFR ≠ quoted forward rate, thus IRP is not holding exactly.
For arbitrage borrow $ and invest in pound. Process of arbitrage is as under:
(i) Borrow 15,00,000 $ for 3 months @ 8 % per annum.
(ii) Purchase / Convert into £ by using spot rate

15,00,000 $ = 15,00,0001.50 = 10,00,000 £
(iii) Invest 10,00,000 £ for 3 months @ 5.80 % per annum.
(iv) Book forward sell contract of pound at 1.52
(v) Realize from investment with interest
£ Inflow = 10,00,000 + 10,00,000 x 5.80100 x 312
= 10,00,000 + 14,500 = 10,14,500
(vi) Sell £ at applicable forward rate
$ Inflow = 10,14,500 x 1.52 = 15,42,040 $
(vii) Repay loan with interest
$ Outflow = 15,00,000 + 15,00,000 x 8100 x 312
= 15,00,000 + 30,000 = $ 15,30,000
(viii) Arbitrage profit = 15,42,040 – 15,30,000 = 12,040 $
(F) Triangular arbitrage - As the name suggest triangular arbitrage involve 3 currencies. Under
triangular arbitrage start with currency A; then go to currency B (means sell currency A and buy currency
B); then go to currency C and finally come back to currency A.
In the process, if you end up with more A then you start with, triangular arbitrage is possible.
Class example: 57
Consider the following quotations:
Bank A: $ / £ = 1.4680 / 10
Bank B: € / £ = 1.3150 / 90
Bank C: $ / € = 0.6810 / 50
Show the process of arbitrage using $ 6,000.
Class example: 58
Consider the following quotations:
Bank A: CHF / AUD = 0.8210 / 50
Bank B: CHF / CAD = 0.7650 / 90
Bank C: AUD / CAD = 0.9650 / 0.9710
Show the arbitrage process of triangular arbitrage using CHF 80,000.
Class example: 59
The Dollar to Swiss Franc spot exchange rate is $0.8918/SF1.00, the Dollar to Pound spot exchange rate is
$1.6302/£1.00, and the SF to Pound spot exchange rate is SF1.7914/£1.00. Determine the triangular arbitrage
profit that is possible if you have $8,000,000.
Topic: 22 Purchasing power parity theory

As per the purchasing power parity theory goods market prices are used to determine the exchange rates
between two currencies. The exchange rate of 2 countries would be affected due to inflation rates in 2
countries. So we have to adjust inflation rate to find out expected spot rate. In other words, the expected spot
rate can be estimated using today’s spot rate and inflation differential of 2 countries.
1+Iq
Expected spot rate = Spot rate X
1+Ib
Iq = Inflation rate of quote / price currency
Ib= Inflation rate of base currency
Topic: 23 International capital budgeting

Whenever an entity of any one country wants to establish a project or business unit in another country then
entity has to decide whether project should be establish or not with the help of capital budgeting process. If
NPV of the project is positive then project should establish otherwise not. For calculation NPV we should
apply either of the following approach:
Approach 1: Home currency approach

Step: 1 Calculate foreign currency cash flows of each year.
Step: 2 Convert foreign currency cash flows into home currency cash flows by using exchange rates.
Step: 3 Compute home currency discount rate
Step: 4 Compute home currency NPV in its usual manner
Decision: If NPV of the project is positive, then accept the project.
Approach 2: Foreign currency approach

Step: 1 Calculate foreign currency cash flows of each year
Step: 2 Calculate foreign currency discount rate
Step: 3 Calculate foreign currency NPV of the project
Step: 4 Convert foreign currency NPV into home currency NPV by using spot rate.
Notes:
(i) Discount rate under both approach are different.
(ii) Discount rate should always be risk adjusted discount rate.
(iii) How to find out risk adjusted discount rate.
Risk adjusted discount rate = RF + Risk premium
OR
Risk adjusted discount rate = (1 + RADR) = (1 + RF) (1 + Risk premium)
(iv) Risk premium under both approaches are assumed to be same if question is silent.
(v) If exchange rates are missing use IRP theory or PPP theory to find out exchange rates.
Topic: 24 Concept of withholding tax

Whenever a foreign company invest in a home country then home country charges an additional tax over and
above the normal tax. Such tax is known as withholding tax. Withholding tax is applicable on surplus profits or
profits which are taken back by foreign company in his own country.
Topic: 25 International cash management

Cash management means manage surplus cash in such a manner that entity can get maximum return by
investing such surplus fund. Under cash management parent company may follow either decentralised cash
management system or centralised cash management system.
Decentralised cash management – If decentralised cash management system is followed then no set – off of
cash deficit is possible from any surplus cash available with another subsidiary. In other words, we should
calculate cash requirement for each subsidiary separately.
Centralised cash management – Under this system we can set – off deficit of a company with surplus of any
other company under the same management and cash requirement will calculate on net basis.
Topic: 26 International joint venture

Whenever any business is in form of joint venture then we should compute NPV of the project as per share of
joint venture. Each joint venture is liable to contribute in cash outflow and receive his share of inflow from the
project.
QUESTION BANK
Q.1 Assume you have a German customer who experts to London and would like to sell
pounds against Euros. The following market rates prevail:
Euro/$ 1.1875/1.1890
Pound/$ 0.6957/0.7008
If your customer wants a Cross Rate for Pound/Euro in Euro terms from you, what rate will you quote
assuming you want a spread of 0.0020 points.
Q.2 An Indian bank sells FF 1,000,000 spot to a customer at Rs.6.40. At that point of time,the following rates
were being quoted.
FF/$ : 5.5880/5.5920
Rs./$ : 35.50/35.60
How much profit do you think the bank has made in the transaction?
Q. 3 As a dealer in the bank, you observed the following quotes in the market.
Rs./$ 42.18 42.60
Rs./£ 68.59 69.96
Rs./€46.25 47.17
Compute the cross rates for $/£ and $/€.
Q.4 From the following quotes of a bank, determine the rate at which Yen can be purchasedwith Rupees.
Rs./Pd. Sterling 75.31-33
Pd.Sterling/Doliar 1.563-65
Dollar/Yen 1.048/52 [Per 100 Yen]
Q.5 Q.14 Spot rate: 1 $ = 25.45 / 25.60

6 months forward swap points: 0.12/ .07
Find out forward rate.
Answer: Forward rate: 1 $ = 25.33 / 25.53
Q. 6 The following quotes are available:

Spot (DM/$) = 1.5105 / 1.5120
Three months swap points = 25/20
Six months swap points = 30/25
Calculate the three – months and six months outright forward rates.
Answer: 1£ = 2.4314 / 2.4408 DM
Q.7 An Indian customer who has imported equipment from Germany has approached its bank for booking a
forward DM contract. The delivery is expected at the end of the 6th month from now. The following rates are
being quoted.
Spot (DM/$) = 1.584 / 1.585
Three – months forward = 0.030 / 0.029
Six – months forward = 0.059 / 0.058
Spot (Rs. / $) = 35.60 / 35.70
Three – months forward = 15/25
Six – months forward = 20/30
What rate will the bank quote if it needs a margin of 0.5 %?
Answer: 1 DM = ₹23.73
Q.8 On January 28, 2007 an importer customer requested a bank to remit SGD 25,00,000 under an irrevocable
LC. However, due to bank strike, the bank could effect the remittance only on February 4, 2007. The inter –
bank market rates were as follows:
January 28 February 4
USD 1 INR 45.85/90 INR 45.91 / 97
GBP 1 USD 1.7840 / 50 USD 1.7765 / 75
GBP 1 SGD 3.1575 / 90 SGD 3.1380 / 90
The bank wishes to retain an exchange margin of 0.125 %. How much does the customer stand to gain or loss
due to the delay? [CA – May, 05]
Q. 9 Excel exporters are holding an export bill in united states dollar (USD) 1,00,000 due 60 days, hence they
are worried about the falling USD value which is currently at Rs. 45.60 per USD. The concerned export
consignment has been priced on an exchange rate of Rs. 45.50 per USD. The firm’s bankers have quoted a 60
– days forward rate of Rs. 45.20.
Calculate:
(a) Rate of discount quoted by bank.
(b) The probable loss of operating profit if the forward sale is agreed to. [CA – Nov. 04]
SOLUTION:
Spot rate: 1 $ = ₹45.60
60 days forward rate: 1 $ = 45.20
(i) Rate of discount quoted by bank
𝐹𝑅−𝑆𝑅 365
x 100 x
𝑆𝑅 𝑛
45.20−45.60 365
x 100 x = 5.336 %
45.60 60
(ii) Probable loss of operating profit if forward sale is agreed:

Spot rate 45.50
Forward rate 45.20
Loss per $ 0.30
Contract size 1,00,000
Total loss 30,000
Question: 10 [CWA – Dec. 02]

An importer has to settle a bill for $ 1,35,000. The exporter has given the Indian company two option:
(i) Pay immediately without any interest charge.
(ii) Pay after 3 months, with interest 6 % p.a.
The importer’s bank charges 16 % p.a. on overdrafts. If the exchange rates are as follows, what should the
company do?
Spot rate (RS. / $) = 48.35/ 48.36 3 months forward rate (Rs. /$) = 48.81 / 48.83
SOLUTION:
Option: 1 Pay immediately without any interest
Invoice value (1,35,000 * 48.36) 65,28,600
Add: Interest on overdraft facility (65,28,600 * 16 % * 3/12) 2,61,144
Total amount payable 67,89,744
Option: 2 Pay after 3 months with 6 % interest:

Invoice value $1,35,000
Add: Interest @ 6 % for 3 months (1,35,000 * 6 % * 3/12) $2,025
Total amount $1,37,025
Applicable rate 48.83
Total amount payable 66,90,931
Decision: It is advisable to settle the payable after 3 months. It will provide saving of ₹98,813.
Q.11 The following rates are appears in the foreign exchange market:
Spot rate: (Rs./ $) = Rs. 45.80 / 46.05
2 months forward rate (Rs. / $) = Rs. 46.50 / 47.00
(i) How many dollars should a firm sell to get Rs. 5 crores after 2 months?
(ii) How many rupees is the firm required to pay to obtain $ 2,00,000 in the spot market.
(iii) Assume the firm has $ 50,000. How many rupees does the firm obtain in exchange of $.
[CS – Dec. 03]
SOLUTION:
(i) 5,00,00,000 / 46.50 = 10,75,268.82 $
(ii) 2,00,000 * 46.05 = 92,10,000
(iii) 50,000 * 45.80 = 22,90,000
Question: 12 [Study material – Illustration 4]

The following 2 – way quotes appear in the foreign exchange market –
required –
(a) How many US Dollars should a firm sell to get ₹ 25 lakhs after two months?
(b) How many Rupees is the firm required to pay to obtain US $2,00,000 in the spot market?
(c) Assume the firm has US $ 69,000 current account's earning interest. ROI on Rupee Investment is 10% p.a.
should the firm encash the US $ now, 2 months later?

a laptop Bag is priced at $ 105.00 at new York. the same bag is priced at ₹ 4,250 in Mumbai. Determine
exchange rate in Mumbai.
(a) if, over the next one year, price of the bag increases by 7% in Mumbai and by 4% in new York, determine
the price of the bag at Mumbai and-new York? Also determine the exchange rate prevailing at new York for
₹100.
(b) Determine the appreciation or depreciation in ₹ in one year from now.
Question: 14 [June, 2018]

The following two-way quotes appear in the foreign exchange market:
(i) How many US Dollars should a firm sell to get ₹ 50 Lakh after two months?
(ii) How many Rupees is the firm required to pay to obtain US $ 3,00,000 in the spot market?
(iii) Assume that the firm has US $ 1,19,000 earning no interest. ROI on Rupee Investment is 8% p.a. Should
the firm encash the US $ now or 2 months later?

The following two way quotes appear in the Foreign Exchange Market
(i) By what % has the Dollar currency changed? Indicate the nature of change. (Answer with reference to the
ask rate).
(ii) By what % has the Rupee changed? Indicate the nature of change. (Answer with reference to the bid rate).
(iii) How many US Dollars should a firm sell to get ₹ 45 lakhs after three months?
(iv) How many rupees is the firm required to pay so as to obtain US $ 2,20,000 in the spot market?
(v) Assume that the firm has US $ 90,000 in current account earning interest. Return on rupee investment is
10% per annum. Should the firm encash the US $ now or 3 months later?

P Ltd. exports electronic instruments to importers of USA, and Japan on 180 days credit terms. You are given
the following information of the company:
You are asked to advise P Ltd. whether it should hedge its foreign currency risk or not. Present relevant figures
in support of your advice.

The following two-way quotes appear in the foreign exchange market –
Required:
(1) How many US Dollars should a firm sell to get ₹ 30 Lakhs after two months?
(2) How many Rupees is the firm required to pay to obtain US $ 2,40,000 in the Spot market?
(3) Assume the firm has US $ 69,000 Current Account’s earning interest. ROI on Rupee investment is 10%
p.a. should the firm encash the US $ now 2 months later?
Question: 18
A UK company, is due to receive 5,00,000 Northland dollars in six month’s time for goods supplied. The
company secedes to hedge its currency exposure by using the forward market. The spot rate of exchange is 2.5
Northland dollars to the pound. The forward rate of exchange is 2.5354 Northland dollars to the pound.
Calculate how much UK company actually gains or losses as a result of the hedging transaction if at the end of
the six months, the pound in relation to the Northland dollar, has (i) gained 4 %, (ii) lost 2 % or (iii) remained
stable.
QUESTIONS RELATED TO EXTENSION/ CANCELLATION/ EARLY DELIVERY OF FORWARD

CONTRACT
Question: 19
A customer with whom the bank had entered into 3 month’s forward purchase contract for Swiss Francs
10,000 at the rate of ₹27.25 comes to the bank after 2 months and requests cancellation of the contract. On the
date, the rates prevailing are:
Spot: CHF 1 = ₹27.30 / 27.35
One month forward: CHF 1 = ₹27.45 / 27.52
What is the loss / gain to the customer on cancellation?
HINT: Total loss on cancellation recovered from customer: ₹2,700
Question: 20
A customer with whom the bank had entered into 3 month’s forward purchase contract for Swiss Francs
1,00,000 at the rate of ₹36.25 comes to the bank after 2 months and requests cancellation of the contract. On
this date, the rates are:
Spot: CHF 1 = ₹36.30 / 36.35
One month forward: CHF 1 = ₹36.45 / 36.52
Determine the amount of profit or loss to the customer due to cancellation of the contract.
Answer: Applicable rate - ₹36.52
Total loss recovered from customer - ₹27,000
Question: 21 [CMA – Dec, 2006]

NBA bank Ltd. transacted on August 19, 2010 the following:
(i) Sold $ 1,00,000 two months forward to Alpha Manufacturing Co. Ltd. at ₹44.50.
(ii) Purchase EURO 10,00,000 two months forward from Beta Trading Co. Ltd. at ₹47.20.
On October 19, 2010 both the customers approached the bank. Alpha Manufacturing Co. wants the forward
contract to be cancelled while Beta Trading Co. wants the contract to be extended by one month. The
following exchange rates prevailed on that day:
Based on the above information (ignore interest etc.), you are required to:
(i) Calculate the amount to be paid to or received from Alpha Manufacturing Co. due to the cancellation of the
forward contract.
(ii) Calculate the amount to be paid to or recovered from Beta Trading Co. due to the extension of the forward
contract.
Question: 22
A bank entered into a forward sale contract with a customer for US $ 5,00,000 due September 15 at the rate of
1 $ = ₹34.60. On September 15, customer requests the bank to cancel the contract. What will be the
cancellation charges if the following is the spot rate in the interbank market:
1 $ = ₹34.5000 / 34.5225. Exchange margin to be loaded by the bank is 0.080 %.
Question: 23
A bank booked a forward purchase contract for $ 2,50,000 with a customer at the rate of 1$ = ₹34.50 due
October 30th 2005. On the due date customer requests the bank to cancel the contract. The rates ruling in the
interbank market on October 30, 2005 are as under:
Spot rate: 1$ = 34.9025 / 35.2050. What will be the cancellation charges of the bank if bank load 0.150% for
their exchange margin.
Question: 24
An Indian telecom company had approached Punjab National bank for forward contract of £ 5,00,000 delivery
on 31st May, 2008. The had quoted a rate of ₹61.60 / £ for the purchase of Pound sterling from the customer.
On 31st May, 2008, the customer informed the bank that it was not able to deliver the Pound sterling as
anticipated receivable from London has not materialised and requested the bank to extend the contract for
delivery by 31st July, 2008.
The following are the market quotes available on 31st May, 2008:
Spot rate (₹ /£) 62.60 /65
1 – Month forward premium 20 / 25
Flat charges for cancellation of forward contract is₹500.
You are required:
To find out the extension charges payable by the telecom company.
Question: 25 [Study material – unsolved problem - 12]

Aradhya Ltd. (AL), on 1st January 2015 entered into a 3 month forward contract for selling USD 1,00,000.
The relevant rates on various dates are —
Explain the further course of action if al —

(a) Honours the contract on —

• 01.02.2015
• 01.03.2015
• 01.04.2015; and converts the Export Proceeds on the same date.
(b) Cancels the contract on —
• 01.02.2015
• 01.03.2015
• 01.04.2015; as the Export Proceeds did not materialize. .
(c) Rolls over the contract for—

• 3 Months on 01.02.2015
• 2 Months on 01.03.2015
• 1 Month on 01.04.2015; as the Export Proceeds will materialize only on 01.05.2015.
Also determine the cost / gain of that action. ignore transaction costs.
Question: 26
Y has to remit USD $1,00,000 for his son’s education on 4th April 2018. Accordingly, he has booked a
forward contract with his bank on 4th January @ 63.8775. The Bank has covered its position in the market @
₹ 63.7575. The exchange rates for USD $ in the interbank market on 4th April and 14th April were:
Exchange margin of 0.10 percent and interest outlay of funds @ 12 percent are applicable. The remitter, due to
rescheduling of the semester, has requested on 14th April 2018 for extension of contract with due date on
14thJune 2018. Rates must be rounded to 4 decimal place in multiples of 0.0025.
Calculate:
(i) Cancellation Rate;
(ii) Amount Payable on $ 100,000;
(iii) Swap loss;
(iv) Interest on outlay of funds, if any;
(v) New Contract Rate; and
(vi) Total Cost
Question: 27
A customer with whom the bank had booked a forward purchase contract for $ 2,00,000 at ₹43.52. However,
on the maturity date your customer requested you to extend contract by one month. Assuming the interbank
market rates for US $ are as under:
Spot rate: 1$ = ₹43.6925 / 7075
1 month forward: 600 / 700
2 months forward: 900 / 1,000
3 months forward: 1200 / 1300
What will be the extension charges payable by your customer bearing in mind that you require an exchange
margin of 0.08 % for TT buying and 0.10 % for TT selling? Also determine the new forward rate.
SOLUTION
Question: 28
Date of maturity of forward purchase contract: April 30th 2002
Amount: $ 2,50,000
Contract rate: 1$ = ₹49.4500
Date of booking: 1 January, 2002
On March 1, 02 the customer requests to extend the forward contract for May 31st 2002. Interbank market rates
on March 1, 02:
Spot: 1$ = ₹48.9325 / 48.9650
Forward spot/ March 2000 / 2100
Spot / April 4200 / 4500
Spot / May 6300 / 6700
Compute extension charges payable / receivable. You are allowed to load an exchange margin of 0.08 % on
TT buying and 0.15 % on TT selling rate.
SOLUTION:
Question: 29
On 30th June 2009 when a forward contract matured for execution you are asked by an importer customer to
extend the validity of the forward sale contract for US $ 10,000 for a further period of three months.
Contracted rate: 1$ = ₹41.87
The US$ quoted on 30.6.2009:
Spot rate: 1$ = ₹40.4800 / 40.4900
Premium July: 0.1100 / 0.1300
Premium August: 0.2300 / 0.2500
Premium September: 0.3500 / 0.3750
Calculate the cost for your customer in respect of the extension of the forward contract. Rupee values to be
rounded off to the nearest rupee. Margin 0.080 % for buying and 0.25 % for selling rate.
Question: 30
Your import customer requested you to him Danish Kroners (DKR) 12,50,000 six months forward at ₹7.0200.
However, after two months, customer requests cancellation of the contract. The rates prevailing on that day
are:
Spot: USD 1 = DKR 6.2800 / 2900
4 months forward 900 / 850
Spot USD 1 = ₹42.6125 / 6200
4 months forward 42.6800 / 6925
Exchange margin is 0.10%. Calculate gain or loss to customer, if any?
Question: 31
A company entered into an agreement with its banker on 15th March, for a forward sale contract for DEM
4,000 delivered on 1st July at the rate of 28.14 per mark. On 15th April, the company requested the bank to sell
the bill for DEM 4,000 under this contract. Calculate the amount payable/ receivable to the company assuming
the following rates on 15th April:
Spot rate: 1 DEM = ₹28.1025 / 1075
Delivery July: 28.6475/6550
Ignore interest and the penal provisions under FEDAI rules.
Question: 32 [CMA – June, 2010]

A Ltd. Exports edible oils to Middle – East and African countries. In June the company exported an
assignment worth $ 5 million to Jambia. The payment for the same is expected to realize during the month of
September. For the company has entered into an option forward contract for delivery of $ 5 million over the
month of September. The market quotes on June 30 at the time of entering into the contract were as follows:
On September 1, the company approached the bank for extension of the contract by another two months, that is
for delivery during the month of November. The market quotes on September 01 were as follows:
On November 01, the company approached the bank to cancel the forward contract. The exchange rates as on
November 01, were as follow:
You are required to calculate:

(a) The forward rate to be quoted to A Ltd.
(b) The exchange rate to be quoted be the bank on September 01 for the extension of the contract.
(c) The amount of cash flows due to extension of the contract.
(d) The exchange rate at which the forward contract to be cancelled on November 01.
(e) The amount of cash flows due to cancellation of the contract.
(a) Applicable rate - ₹47.52

(b) Exchange rate quoted on extension - ₹47.95
(c) Extension charges - ₹14,00,000
(d) Exchange rate on cancellation of contract – 48.17
(e) Cash flow due to cancellation - ₹11,00,000
QUESTIONS RELATED TO MONEY MARKET HEDGE AND FORWARD COVER:

MN a UK company, has a substantial portfolio of its trade with American and German companies. It has
recently invoiced a US customer the sum of $ 50,00,000, receivable in one year’s time. MN finance director is
considering two methods of hedging the exchange risk:
Method: 1- Borrowing present value of $ 5 million now for one year, converting the amount into sterling and
repaying the loan out of eventual receipts.
Method: 2- Entering into a 12 month forward exchange contract with the company’s bank to sell the $ 5
million.
The spot rate of exchange is £ 1= US $ 1.6355. The 12 month forward rate of exchange is £ 1= US $ 1.6125.
Interest rate for 12 months are USA 3.5 % and UK 4 %. You are required to calculate the net proceeds in
sterling under both methods and advise the company.

The finance director of M Ltd. has been studying exchange rates and interest rates relevant in India and USA.
M Ltd. has purchased goods from the US Co. at a cost of $ 40.50 lakhs payable in $ in 3 months time. In order
to maintain profit margins the finance director wishes to adopt, if possible a risk – free strategy that will ensure
that the cost of goods to M Ltd. is no more than ₹18 crores:
₹/ $ spot: ₹41 / 43
₹/ $ (1 month forward) ₹42 / 44
₹/ $ (3 months forward) ₹43 / 46
Interest rate available of M Ltd.:
Calculate whether is it possible for M Ltd. to achieve a cost directly associated with transaction not more than
₹18 crore, by means of a forward market hedge or money market hedge. Ignore transaction costs.
SOLUTION:
Step 1: Borrow ₹17,20,00.000 for 3 months @ 13% p.a.

Step 2: Purchase $ at spot rate i.e. 1$ = 43
Hence $ = 17,20,00,000 /43 = 40,00,000 $
Step 3: Invest 40,00,000$ @ 5% p.a. for 3 months
Step 4: Realize investment in FC and paid FC liability
Step 5: Reply home currency loan with interest
Cash outflow after 3 months : 17,20,00,000 + (17,20,00,000 x13% x3/12) = 17,75,90,000 ₹

Amount payable in 3 month time = 40,50,000$
3 month forward rate: 1 $ = 46₹
Decision: Since cash outflow is less in close of MMH, Hence it is suggested to choose MMH
Question: 35 [CMA - June, 2017]

JB ltd. an American Company will need £ 3,00,000 in 180 days. In this connection, the following information
is available:
Spot rate £1= $2.00
180 days forward rate of £ as of today = $ 1.96
Interest rates are as follows:
The Company has forecast the spot rates 180 days hence as follows:
Compare the benefits of money market hedge Vs. Nod hedge and advise JB Ltd. on the choice of the better
strategy.
Question: 36
The Chief Finance Officer (CFO) of Yati Ltd. hass been studying the exchange rates and interest rates relevant
to India and USA. Yati Ltd. purchased materials from an American company at a cost of US $ 5.05 millions,
payable in US $ in 3 months time. In order to maintain profits margins, the CFO wishes to adopt, if possible, a
risk free strategy that will ensure that the cost of the goods to Yati Ltd. does not exceed ₹21 crores.
Interest rates (available to Yati Ltd.):
Calculate whether it is possible for Yati Ltd. to achieve a cost directly associated with this transaction of no
more than ₹ 21 crores, by means of a forward hedge or money market hedge. Transaction costs may be
ignored.
Solution:
Step 1: Borrow ₹20,32,50,000 for 3 months @ 13% p.a.

Step 2: Convert borrowed amount in $ at spot rate to be invested
In FC 20,32,50,00040.65 = 50,00,000 $
Step 3: Invest 50,00,000$ for 3 months at 4% rate

Step 4: Realize investment after 3 months and paid FC liability
Step 5: Reply home currency loan with interest
Hence, Total cash outflow under, MMH = 20,32,50,000 + 20,32,50,000 x13/100 x3/12
= 20,32,50,000 + 66,05,625 = 20,98,55,625

Payment in $ after 3 month period = 50,50,000$
Forward rate: 1 $ = 42.50 ₹
Decision: GO for MMH.
Question: 37
An exporter is a UK based company. Invoice amount is $ 3,50,000. Credit period is three months.
Compute and show how a money market hedge can be put in place. Compare and contrast the outcome with a
forward contract.
Solution:
Step 1: Borrow P.V. of 3,50,000 $ = 3,50,000/1.0225 = 3,42,298.29 $

Step 2: Convert in to ₤ at spot rate = 3,42,298.29/1.5905 = 2,15,214.27 ₤
Step 3: Deposit 2,15,214.27₤. for 3 months at 5%
Step 4: on maturity realize from debtors and paid FC loan.
Step 5: Amount received from deposit with interest
Hence, inflow = 2,14,215.27 + 2,690.18 = 2,17,904.45

Invoice amount = 3,50,000 $
3 month forward rate 1₤ = 1.6100/1.6140
Hence, inflow = 3,50,000 /1.6140 = 2,16,852.54 $
Decision: Go for money market hedge.
Question: 38
F Ltd. is a medium size UK company with export and import trade with the USA. The following transactions
are due within next 6 months.
Sale of finished goods, cash receipt due in three months $ 1,97,000
Purchase of finished goods, cash payment due in 6 months $ 2,93,000
Exchange rates (London market):
Calculate the net sterling pound receipts and payments that F Ltd. might expect for both its three and six
months transactions if the company hedges foreign exchange risk on (1) Forward foreign exchange market (2)
On money market operation basis. You may assume following interests rates:
SOLUTION:
Hence, Inflow = 1,12,407 + [1,12,407 * 9.50 % * 3/12]

1,12,407 +2,670 = 1,15,077 £
Decision: Go for forward hedging.
(B) 6 – Months receivables:

Alternative: 1 Forward cover
Question: 39
An Indian company has availed the services of two London based interior decorators and are required to pay
GBP 50,000 in 3 months. From the following information, advice the course of action to minimize rupee
outflow –
Answer:
(a) Cash flow under MMH - ₹41,55,516
(b) Cash flow under forward cover - ₹41,50,000
Question: 40
An Indian exporting firm, Rohit and Bros. would be cover itself against a likely depreciation of pound sterling.
The following data is given:
Receivables of Rohit Bros. £ 5,00,000
Spot rate 1 £ = ₹56
Payment date 3 months
3 months interest rate India: 12 % per annum
UK: 5 % per annum
What should the exporter do?
Question: 41
Wenden Co. is a Dutch – based company which has the following expected transactions.
One month: Expected receipt of £ 2,40,000
One month: Expected payment of £ 1,40,000
Three months: Expected receipts of £ 3,00,000
The finance manager has collected the following information:
Spot rate (1€ = £) : 1.7820 ± 0.0002
One month forward rate (1€ = £) : 1.7829 ± 0.0003
Three months forward rate (1€ = £) : 1.7846 ± 0.0004
Borrowing Deposit
One year euro interest rate 4.90 % 4.60 %
One year sterling interest rate 5.4 % 5.10 %
Assume it is now 1st April.
Required:
(a) Calculate the expected Euro receipts in one month and in three months using the forward market.
(b) Calculate the expected Euro receipts in three months using money market hedge and recommend whether a
forward market hedge or a money market hedge should be used.
Answer:
(a) Receipts using forward contract: 1 month - € 56,079; 3 months - € 1,68,067
(b) Receipt under MMH - € 1,67,999.10

Sunny Ltd. (SL), have exported goods to UAE for Arab emirates Dirham (AED) 5,00,000 at a credit period of
90 days. rupee is appreciating against the AED and SL is exploring alternatives to mitigate loss due to AED
Depreciation. from the following information, analyze the possibility of money market Hedge —

IP, an importer in India has imported a machine from USA for US $ 20,000 for which the payment is due in
three months. The following information is given:
Show with appropriate supporting calculations whether a money market hedge is possible or not. Compute the
cost (in annualized percentage) of a Forward Contract Hedge.
Question: 44 [Study Material – Unsolved problem 13]

An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three months.
Compute and show how a money market hedge can be put in place. Compare and contrast the outcome
with a forward contract.
QUESTIONS RELATED TO LEADING AND LAGGING
Question: 45
An Indian importer has to make payment of $ 1,00,000 import bill to US party 3 months from now. Spot rate 1
$ = ₹45.40 / 45.80. 3 months forward rate: 1 $ = ₹46.10 / 46.75.
The US party is willing to offer a cash discount of 2 % for immediate payment. The INR loan borrowing rate is
14 %. Advise the importer whether he should enter into a forward contract or make lead payment today?
Solution:
Alternative: 1 Forward cover:
Alternative: 2 Lead payment

Decision: Leading option should be preferred.
Question: 46
An Indian importer has to settle a bill for $ 1,35,000. The exporter has given the Indian company two options:
(i) Pay immediately without any interest charge,
(ii) Pay after 3 months, with interest 6 % p.a.
The importer’s bank charges 16 % p.a. on overdrafts. If the exchange rates are as follows, what should the
company do? Spot rate: 1$ = ₹48.35 / 48.36
3 months forward rate: 1$ = ₹48.81 / 48.83
Answer:
Pay immediately - ₹67,89,744
Pay after 3 months - ₹66,90,930.75
Question: 47
An Indian firm has imported a machine from USA, the invoice is $ 1,00,000/-. The payment is to be made in 2
months time. The USD rates are quoted in the market as follows:
2 month forward 1$ = ₹45.30/ 45.36
3 month forward 1$ = ₹44.80/ 44.85
The importer firm is considering the ‘lagging. The exporter firm will charge interest at the rate of 9% p.a. if the
payment is delayed after it becomes due. Your cost of capital is 12%. Opine.
Answer:
Alternative: 1 – Pay after 2 months - ₹45,81,360
Alternative: 2 – Pay after 3 months - ₹45,18,637.50
Question: 48
CQS plc is a UK company that sells goods solely within UK. CQS plc has recently tried a foreign supplier in
Netherland for the first time and need to pay € 2,50,000 to the supplier in six month’s time. You as financial
manager are concerned that the cost of these supplies may rise in Pound Sterling terms and has decided to
hedge the currency risk of this account payable. The following information has been provided by the
company’s bank:
Spot rate (€ per £): 1.998 ± 0.002
Six months forward rate (€ per £): 1.979 ± 0.004
Money market rates available to CQS plc:
Assuming CQS plc has no surplus cash at the present time. You are required to evaluate whether a money
market hedge, a forward hedge or a lead payment should be used to hedge the foreign account payable.
QUESTIONS RELATED TO COVER RATE / COVER DEAL/ PROFIT OR LOSS OF DEALERS
Question: 49
You sold HK $ 10 million value spot to your customer at ₹5.70 and covered in London market on the same
day, when the exchange rates were 1 $ = HK $ 7.5880 / 7.5920. Local interbank market rates for US $ were
spot: 1 $ = ₹42.70 / 42.85.
Calculate cover rate and ascertain profit or loss in the transaction. Ignore brokerage.
Solution:
Since bank has to book forward purchase contract with market to cover itself, applicable rate should be the ask
rate.
1 HK $ = ₹
Market sell HK $ and buy ₹
Sell HK $ and buy $ at 7.5880 (i.e 1 $ = 7.5880 HK$)
Sell $ and buy ₹at ₹42.85 (1 $ = ₹42.85)
7.5880 HK $ = ₹42.85
42.85
1 HK $ = = 5.6471 or 5.65
7.5880
Statement showing gain / loss of dealer:
Question: 50
A dealer sold 1 lakh Hong Kong Dollar @ ₹6.37 and cover himself in London market on the same day when
the existing rate were:
US$ 1 = HK $ 7.5780 / 7.5810
Local bank rate for US $ were:
Spot rate US $ 1 = ₹47.20 / ₹47.40
Calculate cover rate and ascertain profit or loss in the deal.
Solution:
Since bank has to book forward purchase contract with market to cover itself, applicable rate should be ask
rate.
1 HK $ = ₹[sell HK $ and buy ₹]

Sell HK $ and buy $ at 7.5780
Sell $ and buy ₹at ₹47.40
So, 7.5780 HK $ = ₹47.40
47.40
1 HK $ = = 6.2549
7.5780
SOME OTHER QUESTIONS
Question: 51 [CMA – Study material – Illustration 1]

On 25th march 2015, a customer requested his bank to remit DG 12,50,000 to Holland in payment of import of
diamonds under an irrevocable LC. However due to bank strikes, the bank could affect the remittance only on
2nd April 2015. The interbank market rates were as follows:
The bank wishes to retain an exchange margin of 0.25%. How much does the customer stand to gain or lose
due to the delay?
Question: 52 [CMA – Study Material – Illustration 2]

You have the following quotes from Bank a and Bank B —
Calculate —
(a) How much minimum CHF amount you have to pay for 1 million GBP spot?
(b) Considering the quotes from Bank a only, for GBP / CHF, what are the implied swap Points for spot over 3
months?
INTEREST RATE PARITY / PURCHASING POWER PARITY / INTEREST COVERED

ARBRITRAGE
Question: 53
It is given that Dollar 6 month T-Bills rate = 7 % and Risk Free 6-month Japanese bonds = 5.5%; Spot
exchange rate is 1 Yen = $ 0.009. What is the 6-months forward exchange rate?
Question: 54
The united State Dollar is selling in India at ₹45.50. if the interest rate of a 6 months borrowing in India is 8%
per annum and the corresponding rate in USA is 2%.
(a) Do you accept United State Dollar to be at a premium or at discount in the Indian forward market;
(b) What is the expected 6-months forward rate for United State Dollar in India; and
(c) What is the rate of forward premium or discount?
Question: 55
The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5 %. The current spot
rate of US $ in India in ₹43.40. Find the expected rate of US $ in India after one year and 3 years from now
using purchasing power parity theory.
Solution:
Inflation rate in USA = 3 %
Inflation rate in India = 6.5 %
Spot rate = 1$ = ₹43.40
(i) Expected rate after one year:
Expected rate = SR * 1 + iq/ 1 + ib
43.40 * 1.065 / 1.03 = 44.8748
(ii) Calculation of expected rate after 3 years:

Expected rate = SR * 1 + iq/ 1 + ib
Question: 56
The rate of inflation in India is 8 % per annum and in USA it is 4 %. The current spot rate of USD in India is
₹46. What will be the expected rate after 1 year and after 4 years applying purchasing power parity theory?
Solution:
Question: 57
On April,1, 3 months interest rate in UK £ and US $ are 7.5 % and 3.5 % per annum respectively. The £/$ spot
rate is 0.7570. What would be the forward rate for $ for delivery on 30th June?
Solution:
Interest rate in UK = 7.5 %
Interest rate in US = 3.5 %
Spot rate = 1 $ = 0.7570£
Forward rate = SR * 1 + iq/ 1 + ib
0.7570 * 1.01875 / 1.00875 = 0.7645
Question: 58
The expected annual inflation in Mexico is 5 %. The expected inflation for the US is 1.5 %. If the spot rate for
the peso is 3.4 peso/$, estimate the expected 1 year future spot rate.
Question: 59
On 1st April, 3 month’s interest rate in the US and Germany are 6.5 % and 4.5 % per annum respectively. The
$/ DM spot rate is 0.6560. What would be the forward for DM for delivery on 30th June?
Solution:
Spot rate: 1 DM = $ 0.6560
Question: 60
An Indian company is planning to invest in US. The US inflation rate is expected to be 3 % and that of India is
expected to be 8 % annually. If the spot rate currently is ₹45 per $, what spot rate can you expect after 5 years.
Solution:
Question: 61
Spot rate: $ .02090/ ₹
6 months forward rate: $ 0.02105/ ₹
6 months T – bill rate in India = 5.50 % p.a.
US 6 months T – bill rate will be =?
Question: 62
Spot rate: 1 $ = ₹47.7123
180 days forward rate: 1 $ = 48.6690
Interest rate in India = 12 % p.a.
Interest rate in US = 8 % p.a.
An arbitrageur takes loan of ₹40,00,000 from Indian bank for 6 months and goes for arbitrage. What is his gain
or loss? (Take 1 year = 360 days).

Consider the following:
Spot rate: $ 0.75 / DM
1 year forward rate: $ 0.77 / DM
Interest rate (DM) = 7 % p.a.
Interest rate ($) = 9 % p.a.
(i) Assuming no transaction cost or taxes exist, do covered arbitrage profits exist in the above situation?
Explain
(ii) Suppose now that transaction costs in the foreign exchange market equal 0.25 % per transaction. Do
unexploited covered arbitrage profit opportunities still exist?
Question: 64
The annual interest rate is 5 % in the US and 8 % in UK. The spot exchange rate is STG / USD = 1.50 and
forward exchange rate, with one year maturity is STG / USD = 1.48. In view of the fact that the arbitrager can
borrow $ 10,00,000 at current spot rate, what would be the arbitrager profit or loss?
Question: 65 [CMA – Study Material – Illustration - 8]

Spot rate 1 $ = ₹48.0123
180 days forward rate for 1 $ = ₹48.8190
Annualized interest rate for 6 months (₹) = 12 %
Annualized interest rate for 6 months ($) = 8 %
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is willing
to borrow ₹40,00,000 or $ 83,312.
Question: 66
Following are the rates quoted at Mumbai for British Pound
Spot rate: 1 BP = ₹52.60 / 70
3 months forward rate: 20 /30
6 months forward rate: 50 /75
Interest rates are as under:
Verify whether there is any scope of covered interest arbitrage if you borrow rupees.
Question: 67 [CMA – Study material – Illustration - 7]

Given Spot Exchange rate $ = FF 7.05. Complete missing entries.

Given the following –
Find out if any arbitrage opportunity exists.

If so, show how $10,000 available with you can be used to generate risk - less profit.
Question: 69 [CMA – Study material – Illustration 10]
Verify whether there is any scope for covered interest arbitrage by borrowing in rupee.
Question: 70
Exchange rates:
Spot rate: 1 DM = 0.665 Can. $
3 months forward rate: 1 DM = 0.670 Can $
Interest rate: DM = 7 %; Can $ = 9 %.
What operations would be carried out to take the possible arbitrage gain?
Question: 71
Syntex Ltd. has to make a US $ 5 million payment in three months’ time. The required amount in dollars in
available with Syntex Ltd. The management of the company decides to invest them for three months and
following information is available in this context:
The US $ deposit rate is 9% per annum.
The Sterling pound deposit rate is 11% per annum.
The Spot exchange rate is $ 1.82/pound.
The three month forward rate is $1.80 /pound
Answer the following Questions –
(a) Where should the company invest for better returns?
(b) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would yield
an equilibrium situation?
(c) Assuming that the US interest rate and the spot and forward rates remain as above, where should the
company invest if the sterling pound deposit rate were 15% per annum?
(d) With the originally stated spot and forward rates and the same dollars deposit rate, what is the equilibrium
sterling pound deposit rate?
Question: 72 [CMA – Study Material – illustration - 12]

Your company has to make a Us $ 1 million payment in three month’s time. the dollars are available now. You
decide to invest them for three months and you are given the following information.
(i) The US deposit rate is 8% p.a.
(ii) The sterling deposit rate is 10% p.a.
(iii) The spot exchange rate is $ 1.80 / pound.
(iv) The three month forward rate is $ 1.78/ pound.
 Where should your company invest for better results?
• Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would yield
an equilibrium situation?
• Assuming that the US interest rate and the spot and forward rates remain as in the original question, where
would you invest if the sterling deposit rate were 14% per annum?
• With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium
sterling deposit rate?
Question: 73
In London, a dealer quotes:
1 GBP = 3.5250 / 55 CHF
1 GBP = 180.80 / 181.30 JPY
(i) What do you expect the 1 CHF = JPY rate to be in Geneva?
(ii) Suppose that in Geneva you get 1 CHF = 51.1530 / 51.2550 JPY. Is there an arbitrage opportunity?
Question: 74
Following are the spot exchange rates quoted at three different forex markets:
1 $ = ₹48.30 in Mumbai
1 GBP = ₹77.52 in London
1 GBP = 1.6231 in New York
The arbitrageur has $ 1,00,00,000. Assuming that there are no transaction costs, explain whether there is any
arbitrage gain possible from the quoted spot exchange rates.
QUESTIONS RELATED TO INTERNATIONAL CAPITAL BUDGETING / CASH MANAGEMENT /

TREATMENT OF WITHHOLDING TAX / JOINT VENTURE

DS Inc. is considering a new plan in Netherlands. The plan will cost 26 million guilders. Incremental cash
flows are expected to be 3 Million Guilders per year for the first 3 years. 4 Million Guilders for the next 3, 5
Million Guilders in Years 7 to 9, and 6 million guilders in years 10 through 19, after which the project will
terminate with no residual value.
The present exchange rate is 1.90 guilders per dollar. The required rate of return on repatriated dollar is 16%.
(a) If the exchange rate states at 1.90, what is the project NPV?
(b) If the guider appreciates to 1.84 for years 1 - 3, to 1.78 for years 4-6,1.72 for years 7-9, and to 1.65 for
years 10 -19, what happens to the NPV?
Question: 76 [CMA – Study material – unsolved problem - 14]

ABC Ltd is considering a project in US, which will involve an initial investment of Us $1,10,00,000. The
project will have 5 years of life. Current spot exchange rate is ₹ 48 per US $. The risk free rate in Us is 8% and
the same in India is 12%. Cash inflows from the project are as follows —
Calculate the NPV of the project using foreign currency approach. required rate of return on this project is
14%.

PQR LTD. is considering a project in U.S.A., which will involve an initial investment of US $ 1,40,00,000.
The project will have 5 years of life. Current spot exchange rate is ₹60.30 per US $. The risk-free rate in USA
is 7% and the same in India is 8%. Cash inflows from the project are as follows:
Calculate the NPV of the Project using foreign currency approach. Required rate of return on the Project is
15%. [Given: PV factors for 13.93% (for 5 Years) are 0.878, 0.770, 0.676, 0.594, 0.521]
Question: 78
A Ltd. an India based MNC is evaluating an overseas investment proposal. It is considering a project building
a plant in United Kingdom. The proposal would initially cost 50 million pound and is expected to generate the
following cash flows, over its 4 years life:
The current spot rate = 1£ = ₹70. Risk free rate in India = 10 % in United Kingdom is 6 %. The companies cost
of capital is 20 %. Will the project be undertaken?
Question: 79
An American firm is evaluating an investment proposal in Holland. The project cost is 1.3 million NLG
(Netherlands guilders). The interest rate in Holland and USA are respectively 6 % and 5 %. The spot rate in
NLG = 0.5 $. Cost of capital in USA = 16 % and the NLG discount rate is 17.1 %. The cash flows for 5 years
project are as follows:
Evaluate under both approaches and advise whether the project should be taken up.
Question: 80 [CMA – Study Material – Illustration 14]

Following are the details of cash inflows and outflows in foreign currency denominations of M Co., an
Indian export firm, which have no foreign subsidiaries —
(a) Determine the net exposure of each foreign currency in terms of rupees.
(b) Are any of the exposure positions off-setting to some extent?
Question: 81
ABC Ltd. is considering a project in US, which will involve an initial investment of US $ 1,10,00,000. The
project will have 5 years of life. Current spot exchange rate is ₹48 per US $. The risk free rate in US is 8 %
and the same in India is 12 %. Cash inflows from the project are as follows:
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is 14
%.
Question: 82
XYZ Inc. currently exports 500 calculators per month to UAE @ $ 60 per piece. The variable cost per unit is $
40. There is a proposal to establish a manufacturing plant in UAE, for which the company decided to make an
equity investment of $ 1 million, half of which would represent working capital and the balance is fixed assets.
The company would sell the plant to a local entrepreneur for a sum of $ 1 million at the end of 5th year and the
Government of UAE would repay the company $ 5,00,000 for working capital. XYZ Inc. will sell its
calculators at $ 50 per unit in the UAE. The total cost of local managers and material would be $ 15 per
calculator. Other materials would be purchased from parent company at $ 10 per unit and the parent company
would receive a direct contribution to overhead variable costs $ 5 per unit sold. The company expects to sell
12,000 calculators per annum. The fixed assets are to be depreciated on a straight line basis over a 5 year
period. The company will have to pay income tax at 50 % on profits. The current exchange rate is 10 UAE
dinars per $ and is expected to stay the same for the next five years. There is no restriction on cash flow
repatriation.
(i) Determine the NPV of the project at 10 %.
(ii) XYZ Inc. has been informed that if it decides to reject the project, it would lose its entire export sales to
UAE. How does this affect decision of XYZ?

OJ Ltd. is a supplier of leather goods to retailers in the UK and other Western European countries. The
company is considering entering into a Joint venture with a manufacturer in South America. The two
companies will each own 50 % of the limited liability company JV (SA) and will share profits equally. £
4,50,000 of the initial capital is being provided by OJ Ltd. and the equivalent in South America dollars (SA$)
is being provided by the foreign partner. Manager of the joint venture expects the following net operating cash
flows, which are in nominal terms:
For tax reasons JV (SA) the company to be formed specifically for the joint venture, will be registered in South
America. Ignore taxation in your calculation.
Requirements:
Assume you are financial adviser retained by OJ Limited to advice on the proposed joint venture. Calculate the
NPV of the project under the two assumptions explained below. Use a discount rate of 16 % for both
assumptions.
Assumption: 1 The South America country has exchange control which prohibit the payment of dividends
above 50 % of the annual cash flows for the first three years of the project. The accumulated balance can be
repatriated at the end of the third year.
Assumption: 2 The government of South America country is considering removing exchange controls and
restriction on repatriation of profits. If this happens all cash flows will be distributed as dividends to the
partner companies at the end of each year.
Question: 84
AMK Ltd. an Indian based company has subsidiaries in US and UK. Forecasts of surplus funds for the next 30
days from two subsidiaries are as below:
Following exchange rate information are obtained:
Annual borrowing / deposit rates (Simple) are available.
The Indian operation is forecasting a cash deficit of ₹500 million. It is assumed that interest rates are based on
a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in ₹for each company under each of the following
scenarios ignoring transaction costs and taxes:
(a) Each company invests / finances its own cash balances / deficits in local currency independently.
(b) Cash balances are pooled immediately in India and the net balances are invested / borrowed for the 30 days
period.
(ii) Which method do you think is preferable from the parent company’s point of view?
Question: 85
An American multinational corporation has subsidies whose cash positions for the month of September, 2002
are given below:
Swiss subsidiary: Cash surplus of SF 1,50,00,000
Canadian subsidiary: Cash deficit of Can $ 2,50,00,000
UK subsidiary: Cash deficit of 30,00,000 (UK pound)
What are the cash requirements, if –
(i) Decentralized cash management is adopted?
(ii) Centralized cash management is adopted?
[Exchange rate: SF 1.48 / $; Can $ 1.58 / $; $ 1.50 / £]
Solution:
(a) Decentralized cash management is adopted:
(b) Centralized cash management:
MISCELLIOUNS QUESTION BANK

Question:86 [CMA – June, 2018]
X Ltd. has imported goods from USA worth US $ 10 million and it requires 90 days to make the payment. The
USA supplier has offered a 60 days interest free credit period and for additional credit for 30 days interest is to
be charged at 8% per annum. (Consider 360 days p.a.)
The banker of X Ltd. Offers a 30 days loan at 10% per annum and its quotes for foreign exchange are as
follows:
You are required to evaluate the following options:

(i) Pay the USA supplier in 60 days or
(ii) Avail the supplier's offer of 90 days' credit. Advise X Ltd. accordingly.
Question:87 [CMA – June, 2017]

A student ordered a book from USA on 01-05-2017 for $ 90, when the spot rate was ₹ 68.50/$. Payment was
made ten days later, on 11-05-2017 when the book was delivered. By this time, the rupee had appreciated by
10%. How much did it cost the student in Rupees? (Ignore transaction and delivery cost).

The following quotes are available.
Spot ($/Euro) 0.8385/0.8391
3-m swap points 20/30
Spot ($/Pound) 1.4548/1.4554
3-m swap points 35/25
Find the 3-m (€/£) outright forward rates

The following information is given:
Does any arbitrage opportunity exist? Discuss the sequence of activities for gain using 1000 units of currency
and compute the gains, if any.
Question: 90
Given the following:
$/£ 1.3670/1.3708
S.Fr/DEM 1.0030/1.0078
$ / S. Fr 0.8790 / 0.8803
Find out the cross rate for DEM / S. Fr.

It is given that ₹/£ quote is ₹100.68 – 102.95 and ₹/$ quote is ₹61.86 – 62.87. What would be the $/£ quote?
Question:92 [CMA – Dec. 2013]

A 8-version Laptop is priced at $ 461.5 at New York. The same version Laptop is priced ₹ 30,500 in New
Delhi. Calculate the exchange rate in New Delhi, if over the next year, price of the Laptop increased by 8% in
New Delhi and 5% in New York. Determine the price of Laptop at New Delhi and New York.
Question: 93 [CMA – Dec. 2019]

GLOBAL Limited, an Indian company will need $ 5,00,000 in 90 days. The following information is given:
Spot Rate $ 1 = ₹ 69.50
90 days forward rate of $ 1 as of today = ₹ 71.50
Interest Rates are as follows:
Compare the strategies of money market hedge vs. no hedging and compute the net advantage. Present
calculations up to two decimal places.

On 1st August 2019, a bank entered into a forward purchase contract with an export customer for USD 25,000
due on 1st November at an exchange rate of INR 72.6000 and covered its position in the market at INR
72.6500. The customer remained silent on the due rate. On 16th November, the bank cancelled the contract
without further notice as fifteen days had expired after the contract due date. The following exchange rates
prevailed:
Interest on outlay of funds is 12% p.a. Explain the position of the bank in relation to the customer and the
market on various dates, compute the swap loss/gain, ignore margin and find out the charges payable by the
customer on cancellation.

IP, an importer in India has imported a machine from USA for US $ 20,000 for which the payment is due in
three months. The following information is given:
(i) Show with appropriate supporting calculations whether a money market hedge is possible or not.
(ii) Compute the cost (in annualized percentage) of a Forward Contract Hedge.
(iii) Present rupee outflows under (i) and (ii) and advise the importer on the best course of action to minimize
rupee outflow. (Exchange rate and values should be shown upto two decimal places).

The US $ is selling in India ₹75.90. The interest rate for a 6 months borrowing in India is 10% per annum and
the corresponding rate in US is 4%.
(i) Do you expect that US$ will be at a premium or at a discount in the Indian Forex Market? Why?
(ii) What will be the expected 6-months forward rate for US $ in India?
(iii) What will be the annualized rate of forward premium or discount?

A company operating in USA has on 1st September 2018 invoiced sales in $ to an Indian company, the
payment being due on 1st December 2018. The invoice amount is $ 13,750. At spot rate on 1/9/2018 it is
equivalent to Rs. 10,18,875. The 3 months forward rate is presently quoted at $ 0.01340 per rupee. The
importer wants to hedge half his exposure by a forward contract. Explain the hedging transaction by forward
contract that he will enter into and calculate the pay outs and the net gain or loss due to hedging if the spot
rates are as follows on 1st December 2018.
(i) $ 0.01338
(ii) $ 0.01352
Present your calculation using Rs./$ upto two decimal places. Ignore transaction cost.
Question: 98 [RTP – May, 2023]

XYZ has taken a six-month loan from its foreign collaborator for USD 2 millions. Interest is payable on
maturity @ LIBOR plus 1%. The following information is available:
You are required to:

(i) Calculate Rupee requirements if forward cover is taken.
(ii) Advise the company on the forward cover.
What will be your opinion if spot rate of INR/USD is 68.4275
Question: 99 [RTP – May, 2023]

A US based company is planning to set up a subsidiary company in India (where so far it was exporting) in
view of growing demand for its product and competition from other US based companies. The initial project
cost consisting of plant and machinery including installation is estimated to be US$ 490 million. The net
working capital requirements are estimated at US$ 60 million. The company follows straight line method of
depreciation. Currently, the company is exporting two million units every year at a unit price of US$ 90,
its variable cost per unit being US$ 50. The CFO of the Company has estimated the following operating cost
and other data in respect of proposed project:
(i) Variable operating cost will be US $ 30 per unit of production;
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of allocated fixed cost will be
US $ 3 million p.a. based on principle of ability to share;
(iii) Expected useful life of the proposed plant is five years with no salvage value;
(iv) Production capacity of the proposed project in India will be 5 million units;
(v) Existing working capital investment for production and sale of two million units through exports was US $
25 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units, provided the company does not
set up subsidiary company in India, in view of the presence of competing other US based companies that are in
the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all profits will be
repatriated as there will be no withholding tax, Estimate Net Present Value of the proposed project in India and
give your advice. Present Value Interest Factors (PVIF) @ 12% for five years is as below:
Question: 100
M/s. Daksh Ltd is planning to import multipurpose machine from USA at a cost of $15000. The company can
avail loans at 19% Interest per annum with quarterly rests with which it can import the machine.
However, there is an offer from New York branch of an Indian based bank extending credit of 180 days at 2%
per annum against opening of an irrevocable letter of credit.
Other Information:
Spot rate US$ 1 = ₹ 75
180 days forward rate US $ 1 = ₹ 77
Commission charges for letter of credit at 2% per 12 months.
(i) Justify why the offer from the foreign branch should be accepted?
(ii) Based on the present market condition company is not interested to take the risk of currency fluctuations
and wanted to hedge with an additional expenses of ₹ 30,000, if so, what is your advise to the company?
Assume 360 days in the year
Question: 101 [CA – Dec. 2021]

A US company wants to setup a manufacturing plant in India which requires an initial outlay of ₹ 8 Million. It
is expected to have a useful life of 5 years with a salvage of ₹ 2 Million. The company follows straight line
method of depreciation. To support additional level of activity, investment would require one time additional
working capital of ₹ 1 Million. Since the cost of production lower in India, the variable cost of production
would be ₹ 30 per unit. Additional fixed cost per annum is estimated at ₹ 0.5 Million. The company is
projecting its annual sales to 80000 units at the price of ₹ 100 per unit. Applicable tax rate to the company is
34% and its cost of capital is 8%. Inflation rates in US and India are expected to be 8% and 9% respectively.
The current exchange rate is ₹ 72 per US Dollar.
Assuming that all profit will be repatriated every year and there will be no withholding taxes, estimate the net
present value of the proposed project in India and evaluate its feasibility.
PVF @ 8% for the five years are as under:
Question: 102 [CA – Dec. 2021]

A Japanese Company effected sales to X Ltd., an Indian Company, the payment being due after 3 months. The
invoice amount is JPY 216 lakhs, at today’s spot rate it is equalent to ₹ 50 lakhs. It is anticipated that exchange
rate will decline by 8% over the 3 months period and in order to protect the JPY payments, the importer
proposes to take appropriate action in the foreign exchange market. The 3 months forward rate is presently
quoted as JPY 4.12 per rupee. You are required to calculate the expected loss and show how it can be hedged
by a forward contract
Question: 103 [CA – July, 2021]

XP Pharma Ltd., has acquired an export order for ₹ 10 million for formulations to a European company. The
Company has also planned to import bulk drugs worth ₹ 5 million from a company in UK. The proceeds of
exports will be realized in 3 months from now and the payments for imports will be due after 6 months from
now. The invoicing of these exports and imports can be done in any currency i.e. Dollar, Euro or Pounds
sterling at company's choice. The following market quotes are available.
(Calculation should be upto three decimal places)
Question: 104 [CA – Nov. 2022]

The following 2-way quotes appear in the foreign exchange market:
(i) You are required to calculate:

(a) 2 months forward rates.
(b) How many US dollars should the firm sell to get ₹ 10 lakhs in the spot market and after 2 months?
(c) How many Rupees is the firm required to pay to obtain US $ 80,000 in the spot market and after 2 months?
(ii) Assume the firm has US $ 27,600 in current account earning no interest. ROI on Rupee investment is 10%
p.a. Should the firm encash the US $ now or after 2 months?
Question: 105
S Limited engaged in the production of synthetic yarn is planning to expand its operation. In this context, the
company is planning to import a multi – purpose machine from Japan at a cost of ¥ 2,460 lakhs. The company
is in a position to borrow funds from its bank in India to finance import at an interest rate of 12 % per annum
with quarterly rests. A bank in Tokyo has also offered to extend credit of 90 days at 2 % per annum against
opening of irrevocable letter of credit. Other information is as under:
Present exchange rate:
₹ 100 = ¥ 246
90 days forward rate: ₹ 100 = ¥ 250
Commission charges for letter of credit is @ 4 % per annum.
Assume 1 year = 365 days
Question: 106 [CMA – Study Material]

A Ltd. is considering an expansion project in USA. For the proposed project, it requires an investment of $20
million (net of issue expenses/floatation cost). The floatation cost is estimated at 2%. The company has
proposed to issue GDR to finance the project.
You have been appointed as the principal financial consultant for the project. Compute the number of GDRs to
be issued and cost of the GDR with the help of following additional information.
(i) Expected market price of share at the time of issue of GDR is ₹500 (Face Value ₹100)
(ii) 2 Shares shall underly each GDR and shall be priced at 10% discount to market price.
(iii) Expected exchange rate ₹72/$.
(iv) Dividend expected to be paid is 20% with growth rate 10%.
Question: 107
Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from Aidscure Ltd., a company
engaged in manufacturing of drugs to cure Dengue, to set up a manufacturing
unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a royalty @ US
$0.01 per bottle. The initial investment will be ₹ 200 crores for machinery and factory. The scrap value of
machinery and factory is estimated at the end of five (5) year to be ₹ 5 crores. The machinery is depreciable @
20% on the value net of salvage value using Straight Line Method. An initial working capital to the tune of ₹
50 crores shall be required and thereafter ₹ 5 crores each year.
As per GOI directions, it is estimated that the price per bottle will be ₹ 7.50 and production will be 24
crores bottles per year. The price in addition to inflation of respective years shall be increased by ₹ 1 each
year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxation Avoidance Agreement
between India and US. According to the agreement tax credit shall be given in US for the tax paid in India.
In both the countries, taxes shall be paid in the following year in which profit have arisen.
The Spot rate of $ is ₹ 57. The inflation in India is 6% (expected to decrease by 0.50% every year) and 5%
in US. As per the policy of GOI, only 50% of the share can be remitted in the year in which they are earned
and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from subsidiary point of view).
Question: 108
Shanti exported 200 pieces of designer jewellery to USA at $ 200 each. To manufacture and design this
jewellery she imported raw material from Japan of the cost of JP¥ 6000 for each piece.
The labour cost and variable overhead incurred in producing each piece of jewellery are ₹1,300 and ₹650
respectively.
Suppose Spot Rates are:
₹/ US$ ₹65.00 – ₹66.00
JP¥/ US$ JP¥ 115 – JP¥ 120
Shanti is expecting that by the time the export remittance is received and payment of import is made the
expected Spot Rates are likely to be as follows:
₹/ US$ ₹68.90 – ₹69.25
JP¥/ US$ JP¥ 105 – JP¥ 112
You are required to calculate the resultant transaction exposure.
Question: 109
Rolls-Royce, the British jet engine manufacturer, sells engines to U.S. airlines and buys parts from U.S.
companies. Suppose it has accounts receivable of $1.5 billion and accounts payable of $740 million. It also
borrowed $600 million. The current spot rate is $1.5128/£.
(a) What is Rolls-Royce's dollar transaction exposure in dollar terms? In pound terms?
(b) Suppose the pound appreciates to $1.7642/£. What is Rolls-Royce's gain or loss, in pound terms, on its
dollar transaction exposure?
Question: 110
An Indian exporter has obtained an order for supplying automotive brakes at the rate of $ 100 per piece. The
exporter will have to import parts worth $ 50 per piece. In addition, variable cost of ₹ 200 will be incurred per
piece. Explain the impact of transaction exposure if the exchange rate which is currently ₹36 / $ moves to ₹40 /
$.
Question: 111
An Indian exporter has an ongoing order from USA for 2,000 pieces per month at a price of $ 100 per piece.
To execute the order, the exporter has to import Yen 6,000 worth of material per piece. Labour costs are ₹350
per Piece while other variable overheads add up to ₹700 per piece. The exchange rates are currently ₹35/$ and
Yen 120 / $. Assuming that the order will be executed after 3 months and payment is obtained immediately on
shipment of goods, calculate the loss / gain due to transaction exposure if the exchange rate change to ₹36 / $
and Yen 110 / $.
Question: 112
NP and Co. has imported goods for US $ 7,00,000. The amount is payable after three months. The company
has also exported goods for US $ 4,50,000 and this amount is receivable in two month. For receivable amount
a forward contract is already taken at ₹48.90.
The market rates for ₹ and Dollar areas under:
Spot ₹ 48.50 / 70
Two month 25 / 30 point
Three month 40/45 point
The company wants to cover the risk and it has two options as under:
(a) To cover payables in the forward market and
(b) To lag the receivables by one month and cover the risk only for net amount. No interest for delaying the
receivables is earned. Evaluate both the options if the cost of Rupee fund is 12 %. Which option is preferable?
Question: 113
XY Limited is engaged in large retail business in India. It is contemplating for the expansion into a country of
Africa by acquiring a group of stores having the same line of operation as that of India. The exchange rate for
the currency of the proposed African country is extremely volatile. Rate of inflation is presently 40 % in a
year. Inflation in India is currently 10 % a year. Management of XY Limited expects these rates likely to
continue for the foreseeable future. Estimated projected cash flows, in real terms, in India as well as African
country for the first three years of the project are as follows –
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It evaluates
all investments using normal cash flows and a nominal discount rate. The present exchange rate is African
Rand 6 to ₹1.
You are required to calculate the Net present value of the proposed investment considering the following –
(i) African Rand cash flows are converted into ₹ and discounted at a risk adjusted rate.
(ii) All cash flows for these projects will be discounted at a rate of 20 % to reflect it’s high risk.
Question: 114
An automobile company in Gujarat exports its goods to Singapore at a price of SG $ 500 per unit.
The company also imports components from Italy and the cost of components for each unit is € 200. The
company’s CEO executed an agreement for the supply of 20,000 units on January 1, 2010 and on the same
date paid for the imported components. The company’s variable cost of production per unit is ₹1,250 and the
allocable fixed costs of the company are ₹1,00,00,000. The exchange rates as on 1st January, 2010 were as
follows:
Spot ₹ /SG $ = 33.00 / 33.04

₹ / € = 56.49 / 56.56
Mr. A, the treasury manager of company is observing the movement of exchange rates on a day to day basis
and has expected that the rupee would appreciate against SG $ and would depreciate against €. As per his
estimates the following are expected rates for 30th June, 2010.
Spot: ₹ / SG $ 32.15 / 32.21
₹ /€ 57.27 / 57.32
Required: find out
(i) The change in profitability due to transaction exposure for the contract entered into.
(ii) How many units should the company increases its sales in order to maintain the current profit level for the
proposed contract in the end of June, 2010.
Question: 115
M/s Omega Electronics Ltd exports air-conditioners to Germany by importing the components from
Singapore. The company is exporting 2400 units at a price of Euro 500 per unit. The cost of imported
components is S$ 800 per unit, The fixed cost and other variable cost per unit are ₹1000 and ₹1500
respectively. The cash-flows in foreign currencies are due in six months. The current exchange rates are as
follows:
₹/Euro 51.50/55
₹/S$ 27.20/25
After six months the exchange rates turn out as follows:
₹/Euro 52.00/05
₹/S$ 27.70/75
(1) You are to calculate the gain/loss due to transaction exposure.
(2) Based on the following additional information calculate the loss/gain due to transaction and operating
exposure if the contracted price of the air conditioner is ₹25000:
(i) The current exchange rate is:
₹/Euro 51.75/80
₹/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5.
(iii) Payments and receipts are to be settled in six-months.
Question: 116
On 1st March, 2008 A, Inc. a US company bought certain products from Tapland. The currency of Tapland is
Tapa. The price agreed was Tapa 9,00,000 payable on 31st May, 2008. The spot price on 1st March, 2008 was
10 Tapa per $. The expected future spot rate was 8 Tapa per $ and the 3 months forward rate is 9 Tapa per $.
The US and Tapland annual interest rate are 12 % and 8 % respectively. The tax rate for both countries is 40
%. A Inc. is considering three alternatives to deal with the risk of exchange rate fluctuations.
(i) To enter the forward market to buy Tapa 9,00,000 at 3 months forward rate.
(ii) To borrow appropriate amount in $ to buy Tapa at current spot rate and to invest the Tapa purchased for 3
months.
(iii) To wait until May, 2008 and buy Tapas at whatever spot rate prevailing at that time. Which alternative the
A Inc. should follow in order to minimize its cost of future payment of Tapas.
Question: 117
Following information is given:
Exchange rate - Canadian dollar 0.666 per DM (spot)
Canadian dollar 0.671 per DM (3 months)
Interest rates - DM 7.5% p.a.
Canadian Dollar 9.5% p.a.
To take the possible arbitrage gains, what operations would be carried out?
Question: 118
ABC Ltd. of UK has exported goods worth CAN$ 5,00,000 receivable in 6 months. The exporter wants to
hedge the receipt in the forward market. The following information is available.
Spot Exchange Rate CAN $2.5/£
Interest rate in UK 12%
Interest rate in Canada 15%
The forward rates truly reflect the interest rate differential.
Find out the gain/loss to UK exporter if CAN$ spot rates (i) declines 2%, (ii) gains 4% or (iii) remains
unchanged over next 6 months.
CHAPTER – 4 - “DERIVATIVES”
TOPIC: 1 FORWARD RATE AGREEMENT
(1)Meaning of forward rate agreement – Forward rate agreement is a contract to borrow or invest a specified
amount of money at a specified rate of interest for a specified period in future. Under such type of agreement
principal amount is called notional principal and it is agreed only for interest calculation.
For example: Mr. A wants to borrow ₹500 lakhs for 6 months period after 3 months from today. If he contracts
for such amount at a specified interest rate today which will prevail in future, then such agreement is known as
forward rate agreement.
After 3 months Loan for 6 months
T=0 T=1 T=2

Today
(Agreement day)
(2)Forward rate agreement is an over the counter product (OTC), where the counter party is always bank.
(3) Forward rate agreement is a single settlement derivative. It can be settled in advance or at the expiry of the
contract period.
(4) Participants of forward rate agreement – There are three types of participants in market:
 Hedger – Participants who wishes to hedge against future interest rate risks by setting the future
interest rate today.
 Speculator – Participants who want to make profits based on their expectations on the future interest
rates.
 Arbitrager – Participants who try to take advantage of the different prices of FRAs.
(5) Buying FRA or selling FRA – For deciding buying of FRA or selling of FRA we always talk with respect
to fixed interest rate payment / receipts.
 Buying FRA – Pay fixed interest rate and receives floating interest rate. Borrower should buy FRA to
get protection from rising interest rate.
 Selling FRA – Receive fixed interest rate and pay floating interest rate. Depositor / Lender should sell
FRA to get protection from the falling of interest rate.
 Buying FRA means contracting to borrow a certain amount.
 Selling FRA means contracting
(6) FRA quotes style –

 Prices of FRAs are quoted as the same way as the money market rate i.e. as an annualized %.
 FRA are written as 3 -9, 3X9, 3Vs 9 etc. The difference between two figures is known as contract
period.
 FRA interpretation – 3 Vs 9 FRA means a contract which will start 3 months from today and would
run for a period of 6 months. Both 3 and 9 are counted from today i.e. t = 0.
TYPE: 1Problem: HOW TO CALCULATE SETTLEMENT AMOUNT UNDER FRA

FRAs are cash settled derivatives. Under forward rate agreement settlement amount will calculate in either of
the following two ways as specified by the question.
 At settlement date:
Notional principal X Interest rate differential X t/12
Settlement amount = 1+(Index rate X t/12)
 At contract expiry date:

Settlement amount = Notional principal X Interest rate differential X T/12
 If question is silent then FRA are always settled on settlement date i.e. at t = 1.
 FRA should be settled at present value of difference.
T=0 T=1 T=2

Today (Settlement date) (Contract expiry date)
(Agreement day)
Class example: 1 Nestle rolls over a 25 million $ loan priced at LIBOR 3 on a three – month basis. The
company feels that interest rates are rising and that rates will be higher at the next roll – over date in three
months. Suppose the current LIBOR 3 is 5.4375 %.
(a) Explain how Nestle can use an FRA at 6 % to reduce its interest rate risk on this loan?
(b) In three months, interest rates have risen to 6.25 %. How much will Nestle receive / pay on its FRA?
Solution:
(a) Nestle can buy a FRA priced at 6 % to lock its interest rate. Whatever happens to LIBOR 3 at the rollover
date Nestle will pay LIBOR 3 of 6 % in three months’ time.
(b) If actual rate is 6.25 %, Nestle will receive due to FRA

2,50,00,000 X (6.25 % − 6 %) X 3/12

1 + (6.5 X 3/12)
15,625
= 1.0156 = 15,384.994 $
Class example: 2 A lender plans to invest $ 100 million for 150 days, 60 days from today (i.e. if today is 0,
the loan will be initiated on day 60 and will mature on day 210). The implied forward rate over 150 days, and
hence the rate on a 150 – day FRA is 2.50 %. Consider 360 days in a year.
(a) If interest rate on day 60 is 2.80 %, how much lender will have to pay / receive if the FRA is settled on day
60? How much if it is settled on day 210?
(b) If the interest rate on day 60 is 2.20 %, how much will the lender have to pay / receive if the FRA is settled
on day 60? How much if it is settled on day 210?
Solution:
(a) Interest rate is higher than the rate of FRA, so the lender must pay the borrower.
(i) Settled on day 60:
Settlement amount =
1+(Index rate X t/12)
10,00,00,000 X (2.50 %−2.80 %) X 150/360

Settlement amount = 1+(2.80 X 150/360)
1,25,000
Settlement amount = = 1,23,554.41 $
1.0117
(ii) Settled on 210 day
Settlement amount = Notional principal X Interest rate differential X t/12

Settlement amount = 10,00,00,000 * (2.80 % - 2.50 %) * 150 / 360
= 1,25,000 $
(b) Interest rate is lower than FRA, so lender will receive under FRA.
(i) Settled on 60 day:
Settlement amount =
10,00,00,000X (2.50 %−2.20 %)X 150/360

Settlement amount = 1+(2.20 X 150/360)
1,25,000
Settlement amount = 1.0092
= 1,23,860.48 $
(ii) Settled on 210 day

= 10,00,00,000 * (2.50 % - 2.20 %) * 150 / 360 = $ 1,25,000
Class example: 3 Yati Industries has decided to borrow ₹2,00,00,000 for 3 months, after 3 months from today.
As the treasurer, you are concerned that interest rates will rise over the next three months. To reduce the
company’s interest rate exposure, you decide to purchase a 3X6 FRA whereby you pay the dealer’s quoted
fixed rate of 5.85 % in exchange for receiving 3 – month LIBOR at the settlement date. Assume that there are
90 days between month 3 and month 6. Assume 360 days in a year.
(i) Assuming that 3 – month LIBOR is 6 % on the rate determination day and the contract specified that
settlement will takes place at contract expiry day, calculate settlement amount.
(ii) If contract specified that settlement will be in advance, then calculate settlement amount.
Solution:
(i) Since reference rate is higher than quoted rate and hence Yati Industries will receive:
= 2,00,00,000 * (6.00 % - 5.85 %) * 90/360 = 7,500
(ii) If contract specified settlement in advance, then calculate settlement amount

2,00,00,000 X (6.00 %−5.85 %) X 90/360

Settlement amount = 1+(6% X 90/360)
7,500
Settlement amount = 1.015 = 7,389.16
Class example: 4These are the current euro FRA quotations:

FRA Bid Ask
3X6 3.42 % 3.46 %
3X9 3.30 % 3.34 %
6X12 3.36 % 3.40 %
(a) A company knows it will have to issue 1 million euros 6 months debt in 6 months and wants to hedge
against interest rate movements. What should it do?
(b) After 6 months the spot rate is 4 %. Calculate settlement amount and decide who will make payment under
FRA?
(a) Company should buy 6 X 12 FRA at the rate of 3.40 %.
10,00,000 X (4.00 %−3.40 %) X 6/12

(b) Settlement amount = 1+(4 X 6/12)
3,000
= 2,941.17
TYPE: 2 HOW TO CALCULATE EFFECTIVE COST UNDER FRA/ HEDGING THROUGH FRA
Through FRA borrower or depositor can lock its interest rate and get protection against movement in interest
rates. This technique, under which borrower or depositor can lock its rate is known as hedging through FRA.
Following steps should be followed for calculation of effective cost of borrowing:

Step: 1 Calculate settlement amount at t =1 i.e. settlement date as under:
Step: 2 Identify amount to be borrowed at t = 1after adjusting settlement amount calculated in step: 1.
Step: 3 Repayment of loan with interest at agreed rate at t = 2 i.e. contract expiry date.
Repayment = Amount borrowed + Amount borrowed * agreed rate of interest * T / 12
Step: 4 Calculate effective cost of borrowing as under:

Repayment of amount −Fund enjoyed 12
Effective cost = Fund enjoyed
X 100 X Period
Class example: 5 X Limited has contracted to borrow ₹500 lakhs after 6 months for 3 months period at a
spread of 100 basis point over the 3 month LIBOR. 6 X 9 FRA is quoted at 8 % / 9 %. Find out the annual cost
of borrowing when hedged through FRA if 3 months LIBOR after 6 months happens to be –
(a) 11 % (b) 7 %
Solution:
(a) FRA rate: 9 %
Borrowing rate: L + 1 %
Step: 1 Calculate settlement amount at t = 1

Settlement amount =
500 lakhs X (11 %−9 %) X 3/12

Settlement amount = 1+(11X 3/12)
2.50
Settlement amount = = 2.43 lakhs
1.0275
Step: 2 Calculate amount to be borrowed at t =1

500 lakhs – 2.43 lakhs = 497.57 lakhs
Step: 3 Loan repayment in 3 month with interest of L + 1 % i.e. 12 %

Repayment = 497.57 + 497.57 * 12 % * 3/12
= 497.57 + 14.93 = 512.50 lakhs
Step: 4 Calculate effective cost

X 100 X Period
512.50 −500 12
Effective cost = 500
X 100 X 3
= 10 %
(b) FRA rate = 9 %

Borrowing rate = L + 1
Step: 1 Calculate settlement amount at t = 1
500 lakhs X (7 %−9 %) X 3/12

Settlement amount = 1+(7X 3/12)
500 X 2% X 3/12
= 2.50 / 1.0175 = 2.46 lakhs
Step: 2 Calculate amount to be borrowed at t = 1

500 lakhs + 2.46 lakhs = 502.46 lakhs
Step: 3 Repayment of loan with interest after 3 months

502.46 + 502.46 * 8 % * 3/12
= 502.46 + 10.05 = 512.51 lakhs
Step: 4 Calculate effective cost of borrowing

X 100 X Period
512.50 −500 12
Effective cost = X 100 X = 10 %
500 3
Class example: 6 A company’s financial projections show an expected cash deficit in two months’ time of ₹8
million, which will last for approximately three months. It is now 1st November 2014. The treasurer is
concerned that interest rates may rise before 1st January 2015. The treasurer can look into an interest rate
today, for a future loan. A 2 – 5 FRA at 4.70 % / 5 % is agreed. Show how company hedged through FRA by
calculating effective cost if in two months’ time the market rate is –
(a) 7 % (b) 4 %
Solution:
(a) If market rate is 7 %
Step: 1 Calculate settlement amount

8 M X (7 %−5 %) X 3/12
Settlement amount = = 0.0399 / 1.0175 = 0.0392 M
1+(7X 3/12)
Step: 2 Borrowed required amount for 3 months at 7 %

Borrowed amount = 8 – 0.0392 = 7.9608
Step: 3 Repayment of loan with interest

Repayment = 7.9608 + 7.9608 * 7 % * 3/12
= 7.9608 + 0.1393 = 8.1001

X 100 X Period
8.1001 −8 12
Effective cost = X 100 X =5%
8 3
(b) If market rate is 4 %
Step: 1 Calculate settlement amount

8 M X (4 %−5 %) X 3/12
Settlement amount = = 0.0399 / 1.0175 = 0.0197 M
1+(4X 3/12)
Step: 2 Borrow required amount for 3 months at 4 %

8 M + 0.0197 M = 8.0197
Step: 3 Repayment of loan with interest

Repayment = 8.0197 + 8.0197 * 4 % * 3 /12
= 8.0197 + 0.0802 = 8.0999
Effective cost = X 100 X
Fund enjoyed Period
8.0999 −8 12
Effective cost = 8
X 100 X 3
=5%
TYPE: 3 PRICING OF FRA

Price of a FRA refers to the forward rate that should prevail in order to prevent arbitrage. In other words, price
of FRA should be calculated in such manner that there is no arbitrage.
We can understand the pricing of FRA with the help of following example:
Class Example: 7 A company’s yield curve has been calculated as:

Year Individual yield curve (%)
1 3.96
2 4.25
3 4.56
Calculate rate for a 12 X 24 FRA.
Solution: Company will have to pay interest of 3.96 % if it wants to borrow money for 1 year, 4.25 % if it
wants to borrow for 2 years etc. An alternative to borrow for 2 years at 4.25 % throughout is to borrow for 1
year initially at 3.96 % and then to borrow for another year in 1 years’ time at an unknown rate. This unknown
rate is to decide in such a manner that there will be no arbitrage. It means whatever is the alternative choose by
the company interest cost remains same.
4.25 %
A1
A2 3.96 % r =?
Let amount borrowed for 2 years is ₹100 at 4.25 % p.a., then total repayment under alternative 1
100 (1.0425)2 = 108.6806
Amount borrowed under alternative 2 where borrow for 1 year at 3.96 % and for another year at r % then r is
to be decided in such manner that total repayment must be 108.6806. Hence,
100 (1.0396) (1 + r) = 108.6806

103.96 (1 + r) = 108.6806
1 + r = 108.6806 / 103.96
1 + r = 1.0454
r = 1.0454 – 1 = 0.0454 or 4.54 %
Class example: 8 Given the following term structure of LIBOR:

Period LIBOR
1 month 6%
2 months 7%
3 months 7.20 %
6 months 8%
9 months 10 %
Calculate the price of 1 X2 FRA, 1 X 6 FRA, 3 X 9 FRA and 6 X 9 FRA.
Solution:
Price of 1X 2 FRA
7 % p.a. (1.17 %)
A1
A2 6 % (0.50 %) r =?
1.0117 = (1.005) (1 + r)
1 + r = 1.0117 / 1.005
1+ r = 1.0067
r = 1.0067 – 1
r = 0.0067
Hence price (p.a.) = 0.0067 * 100 * 12 = 8.04 %
Price of 1 X 6 FRA
8 % p.a. (4 %)
A1
A2 6 % (0.50 %) r =?
1.04 = (1.005) (1 + r)
1 + r = 1.04 / 1.005
1 + r = 1.0348
r = 1.0348 – 1
r = 0.0348
Hence Price (p.a.) = 0.0348 * 100 * 12 / 5 = 8.35 %
Price of 3 X 9 FRA
10 % p.a. (7.50 %)
A1
A2 7.20 % (1.80 %) r =?
1.075 = (1.018) (1 + r)
1 + r = 1.075 / 1.018
1 + r = 1.056
r = 1.056 – 1 = 0.056
Hence, Price (p.a.) = 0.056 * 100 * 12 / 6 = 11.20 %
Price of 6 X 9 FRA
10 % p.a. (7.50 %)
A1
A2 8 % (4 %) r =?
1.075 = (1.04) (1 + r)
1 + r = 1.075 / 1.04
1 + r = 1.0337
r = 1.0337 – 1 = 0.0337
Hence, price (p.a.) = 0.0337 * 100 * 12 / 3 = 13.48 %
TYPE: 4 ARBITRAGE THROUG FRA
Class example: 9 Consider the following term of structure:
6 – Months LIBOR 5%
12 – Months LIBOR 5.75 %
The 6X 12 FRA is quoted at 7%/8%
Required:
(a) What should be the price of 6X 12 FRA?
(b) Show the process of arbitrage (Assume $ 1,00,000)
Solution:
(i) Price of FRA:
5.75 %
A1
6 Months
A2 5 % (2.50 %) r =?
1.0575 = (1.025) (1 + r)
1 + r = 1.0575 / 1.025 = 1.0317
r = 1.0317 – 1 = 0.0317
Price of FRA = 0.0317 * 100 * 12 / 6 = 6.34 %
(ii) Process of Arbitrage:

Borrow alternative
5.75 %
A1
Quoted = 7 % / 8 %
A25 % (2.50 %) r =? 6.34 %

Deposit alternative
Step: 1 Borrow $ 1,00,000 for 12 months @ 5.75 % per annum. Hence cash outflow after 12 months
1,00,000 (1.0575) = $ 1,0,750
Step: 2 Invest $ 1,00,000 for 6 months @ 5 % per annum and agree to deposit for further 6 months @ 7 % per
annum.
Cash inflow = $ 1,00,000 (1.025) (1.035) = $1,06,087.50
Step: 3 Arbitrage profit = $ 1,06,087.50 – 1,05,750 = $ 337.50
Class example: 10Consider the following term structure:

3 – Months T- bill rate 6%
6 – Months T – bill rate 7%
3 X 6 FRA is quoted in market at 9 %
Required:
(a) What should the price of 3X 6 FRA?
(b) Show the process of arbitrage (Assume ₹1,00,000)
Hint: (i) Price of FRA = 7.88 %

(ii) Process of arbitrage: Inflow = 1,03,783.75; Outflow = 1,03,500
Arbitrage profit = 283.75
Class example: 11 Assume that the 3 months and 9 months interbank rates (LIBOR) are the following:
(a) Calculate the highest and lowest FRA (3X9) rates.

(b) Assume the market FRA rate is 4.20 %. Would there be the possibility of an arbitrage?
(c) How would the arbitrage be structured?
TYPE: 5 VALUATION OF FRA / MARKET VALUE OF FRA
Class example: 12 A corporate treasurer, wishes to hedge against an increase in future borrowing cost due to a
possible rise in short – term interest rates. She proposes to hedge against this risk by entering into a long 6 X
12 FRA. The current term structure for LIBOR is as follows:
(a) Indicate when this 6 X 12 FRA expires and identify which term of the LIBOR this FRA is based on.
(b) Calculate the rate; the treasurer would receive on a 6 X 12 FRA.
(c) Suppose the treasurer went long this FRA. Now, 45 days later, interest rates have risen and the LIBOR term
structure is as follows:
135 days 5.90 %
315 days 6.15 %
Calculate the market value of this FRA based on a notional principal of $1,00,00,000.
(d) At expiration, the 180 – day LIBOR is 6.25 %. Calculate the pay – off on the FRA.
Class example: 13 A financial manager needs to hedge against a possible decrease in short term interest rates.
He decides to hedge his risk exposure by going short on an FRA that expires in 90 days and is based on 90 day
LIBOR. The current term structure for LIBOR is as follows:
(a) Identify the type of FRA used by the financial manager using the appropriate terminology.
(b) Calculate the rate the manager would receive on this FRA.
(c) It is now 30 days since the manager took a short position in the FRA. Interest rates have shifted down, and
the new term structure for LIBOR is as follows:
60 days 5.50 %
150 days 5.62 %
Calculate the market value of this FRA based on a notional principal of $ 1,50,00,000.
TYPE: 6 SPECULATIONS WITH FRA
Class example: 14 A “three against nine” FRA has an agreement rate of 4.75 %. You believe six month
LIBOR in three months will be 5.125 %. You decided to take speculative position in a FRA with a $ 10,00,000
notional value. There are 183 days in the FRA period. Determine whether you should buy or sell the FRA and
what is your expected profit will be if your forecast is correct about the six – month LIBOR rate. Consider 360
days.
QUESTIONS OF FRA
Q.1 Consider that a bank sells a 3 x 6 FRA worth $3,00,00,000. The agreed rate with the buyer is 5.5 percent.
There are actually 92 days in the three-month FRA period. Assume that three months from today the
settlement rate is 4-7/8percent. Determine how much the FRA is worth and who pays who i.e. whether the
buyer pays the seller or seller pays the buyer. Had the settlement rate been 6-1/8 percent, what is the answer?
[CMA – Study material (45)]
Q.2 Suppose that in order to hedge interest rate risk on your borrowing, you enter into an FRA that will
guarantee a 6% effective annual interest rate for 1 year on $500,000.00. On the date you borrow the
$500,000.00, the actual interest rate is 5%. Determine the dollar settlement of the FRA assuming:
(a) Settlement occurs on the date the loan is initiated.
(b) Settlement occurs on the date the loan is repaid.
Q.3MNC rolls over a $25 million loan priced at LIBOR on a three-month basis. The company feels that
interest rates arerising and that rates will be higher at the next roll-over date in three months. Suppose the
current LIBOR is 5.4375%.
Explain how MNC can use FRA at 6% offered by a bank to reduce its interest rate risk on this loan. In three
months, if interest rates have risen to 6.25%, how much will MNC receive/pay on its FRA? Assume the three
month period as 90 days. [CMA – study material (47)]
Q.4 Consider the following data:

3 Months LIBOR 8%
9 Months LIBOR 10 %
3X9 FRA 15 % / 16 %
(a) What should be the price of 3X 9 FRA?
(b) Show the process of arbitrage using $ 1,000.
Q.5 On January 25, a European Bank wants USD 100 million of 6-month deposit. However, it is offered USD
100 million of 9-month deposit at the bank’s bid rate. At the current market, the other rates are these:
Cash FRA
Bid Ask Bid Ask
6 months 10.4375 10.5625 6X9 10.48 10.58
9 months 10.5625 10.6875
Should the bank take the 9-month deposit? Explain with calculations and payoff. [CMA – study material (46)]
Q.6The following market data is available –

Spot USD / JPY – 116.00.
Deposit rates p.a. USD JPY
3 months 4.50 % 0.25 %
6 months 5.00 % 0.25 %
Forward rate agreement (FRA) for YEN is Nil.
(i) What should be 3 months FRA rate at 3 months forward?
(ii) The 6 and 12 months LIBOR are 5 % and 6.50 % respectively. A Bank is quoting 6/12 USD FRA at 6.50 –
6.75 %. Is any arbitrage opportunity available? Calculate profit in such cases.
Q.7 M/s Parker and Company is contemplating to borrow an amount of ₹60 crores for a period of 3 months in
the coming 6 month’s time from now. The current rate of interest is 9 % p.a. but it may go up in 6 month’s
time. The company wants to hedge itself against the likely increase in interest rate. The company’s Bankers
quoted an FRA at 9.30 % p.a.
What will be the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest after
6 months happens to be (i) 9.60 % p.a. and (ii) 8.80 % p.a.
Q.8 AB Tech plans to borrow $ 10 million in 30 days at 90 day LIBOR plus 100 basis points. To lock in a
borrowing rate of 7 %, it purchases an FRA at a rate of 6 %. This contract would be referred to as a 1X4 FRA
because it expires in one month (30 days) and the underlying $ matures four months (120 days) from now.
Thirty days later, LIBOR is 7.5 %. Demonstrate that AB Tech’s effective borrowing rate is 7 % if LIBOR in
30 days is 7.5 %.
Q.9 TM Fincorp has bought a 6X9 ₹ 100 crore Forward Rate Agreement (FRA) at 5.25%. On fixing date
reference rate i.e. MIBOR turns out be as follows:
You are required to determine:

(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.
(Assume 360 days in a year)
Question: 9A
Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate
Agreement). They want to borrow a sum of ₹ 100 crores after 2 years for a period of 1 year. Bank has
calculated Yield Curve of both companies as follows:
Year XYZ Ltd. ABC Ltd.*
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
* The difference in yield curve is due to lower credit rating of ABC Ltd. compared to XYZ Ltd.
(i) You are required to calculate the rate of interest DEF bank would quote under 2V3 FRA, using the
company’s yield information as quoted above.
(ii) Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of the amount of loan, you are
required to calculate the interest payable by XYZ Ltd. if interest in 2 years turns out to be
(a) 4.50%
(b) 5.50%
Question: 9 B
Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature. In 6
months of a year, firm has a huge cash deposits and especially near Christmas time and other 6 months firm
cash crunch, leading to borrowing of money to cover up its exposures for running the business. It is expected
that firm shall borrow a sum of € 50 million for the entire period of slack season in about 3 months.
A bank has given the following quotations:
Spot rate: 5.50 % - 5.75 %
3 X 6 FRA 5.59 % - 5.82 %
3 X 9 FRA 5.64 % - 5.94 %
3 months € 50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85 %). You are
required to determine:
(i) How a FRA, shall be useful if the actual interest rate after 6 months turnout to be:
(a) 4.50 % (b) 6.50 %
(ii) How 3 months future contract shall be useful for company if interest rate turns out as mentioned in part (i)
above.
TOPIC: 2 INTEREST RATE SWAP

(1) Meaning – An interest rate swap (IRS ) is a contractual agreement entered into between two counterparties
under which they agree to exchange fixed for variable interest rates (mostly LIBOR ) periodically, for an
agreed period of time based upon a notional amount of principal. The principal amount is notional because
there is no need to exchange actual amounts of principal. Equally, however, a notional amount of principal is
required in order to compute the actual cash amounts that will be periodically exchanged.
In other words we can say Interest rate swap is a contract between two parties where parties are
agreed for exchange of interest. One party receive one type of interest and pays another type of
interest.
Under interest rate swap principal amount never exchanged. It is only agreed for interest
calculation and hence principal amount is always called notional principal.
(2) Swap structure: Swap structure can be shown as below:
Pay fixed interest rate

Company A Company B
Receive floating interest rate
(3) Interest rate swap is multiple settlement derivatives. Multiple settlements mean interest is to be exchanged
on every re – set date. Re – set date means date of payment of interest.
(4) Interest rate swap contracts are over the counter products where counter party can be bank or other
corporate.
(5) Parties of interest rate swap – Interest rate swap involve buyer of interest rate swap and seller of interest
rate swap. Under interest rate swap we always talk with respect of fixed interest rate payer / receiver.
 Buyer of interest rate swap means who pay fixed interest rate and receive floating interest rate.
 Seller of interest rate swap means who receive fixed interest and pay floating interest rate.
(6) The basic object behind the interest rate swap contracts are hedging of interest rate risk. In other words we
can say that due to entering into swap contract both parties are able to reduce their interest rate risk.
TYPE: 1 THERE IS NO SWAP DEALER INVOLVES AND ALSO THERE IS NO SWAP PAYMENT
IS GIVEN
Following steps should be followed:

Step: 1 Identify absolute advantage party and calculate comparative advantage for such party under both
market. The party having advantage in both the market is known as absolute advantage party.
Step: 2 Identify the market for each party. Select the market for absolute advantage party where comparative
gain is higher and the other party’s market will automatically decide.
Step: 3 Now they can enter into a swap with each other and prepare the flow chart of swap.
Step: 4 Prepare statement showing gain or loss due to swap and its allocation between parties.
Particulars A Limited B Limited
Cost due to IRS:
A Ltd. pay to B Ltd. Xxx
B Ltd. pay to A Ltd. xxx
Cost without IRS:

A Ltd. pay Xxx
B Ltd. pay xxx
Gain / (Loss) due to IRS (xxx) xxx
Net gain due to IRS xxx
Share of each party Xxx xxx
Step: 5 Prepare a statement showing effective cost of borrowing for each party:
Particulars A Limited B Limited
Paid to bank xxx xxx
Paid to other party due to swap xxx xxx
Receive from other party due to swap xxx xxx
Share in loss xxx xxx
Share in gain xxx xxx
Effective cost xxx xxx
Class example: 15 Cat Limited and Dog Limited both want to borrow £150 million for 8 years. Cat Limited
would like to borrow on a fixed rate basis whereas Dog Limited prefers to borrow at floating rates. Following
data are provided to you:
Name of company Fixed Floating
Cat Limited 10 % L+2%
Dog Limited 8% L+1%
Design a swap between both the parties by assuming that swap gain will be distributed equally by the parties.
Solution:
Step: 1 Identify absolute advantage party if any and calculate comparative advantage for such party. Absolute
advantage party means party who can obtain cheaper loan under both market.
Here Dog Limited is absolute advantage party:
Dog Limited’s advantage in fixed market: 2 %
Dog Limited’s advantage in floating market: 1 %
Hence,
Dog Limited should borrow fixed rate loan
Cat Limited should borrow floating rate loan.
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap
Due to swap dog Ltd. pay to Cat Ltd. L + 2 %
Dog Limited Cat Limited

Due to swap Cat Ltd. pay 8 % to
Dog Ltd.
Obtain loan at 8 % from obtain loan at L + 2 %
bank from bank
Bank Bank
Step: 4 Prepare a statement showing gain / loss due to swap and its allocation:
Particulars Dog Limited Cat Limited
Cost due to IRS:
Dog Ltd. pay to Cat Ltd. L+2% -
Cat Ltd. pay to Dog Ltd. - 8%
Cost without IRS:

Dog Ltd. pay L+1%
Cat Ltd. pay 10 %
Gain / (Loss) due to IRS (1 %) 2%
Net gain due to IRS 1%
Share of each party 0.50 % 0.50 %
Particulars Dog Limited Cat Limited
Paid to bank 8% L+2%
Paid to other party due to swap L+2% 8%
Receive from other party due to swap (8 %) (L + 2 %)
Share in loss (0.50) 0.50
Share in gain (1 %) 1%
Effective cost L + 0.50 % 9.50 %
Class example: 16 Company A wishes to raise $10m and to pay interest at a floating rate, as it would like to
be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a
floating rate of 1% above LIBOR.
Company B also wishes to raise $10m. They would prefer to issue fixed rate debt because they want certainty
about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR + 2% floating,
as it has a lower credit rating than company A.
Required:
Calculate the effective swap rate for each company – assume savings are split equally.
Solution:
Before solving the problem we can summarize the problem as under:
Company A B
Fixed rate 10 % 13 %
Floating rate L+1% L+2%
Here, Company A is absolute advantage party
Company A’s advantage in fixed market = 3 %
Company A’s advantage in floating market = 1 %
Hence,
Company A should borrow fixed rate loan
Company B should borrow floating rate loan
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap:
Due to swap A pays B L + 2 %
Company A Company B
Due to swap B pays A 10 %
Loan obtain @ 10 % from Loan obtain @ L + 2 %

bank
Bank Bank
Step: 4 Prepare a statement showing gain / loss due to swap and its allocation:
Particulars Company A Company B
Cost due to IRS:
Company A pays B L+2% -
Company B pays A - 10 %
Cost without IRS:

Company A pays L+1%
Company B pays - 13 %
Gain / (Loss) due to IRS (1 %) 3%
Net gain 2%
Share of each party 1% 1%
Paid to bank 10 % L+2%
Paid to other party due to swap L+2% 10 %
Receive from other party due to swap (10 %) (L + 2 %)
Share in loss (0.50 %) 0.50
Share in gain (1.50 % ) 1.50
Effective cost L 12 %
TYPE: 2 IF SWAP DEALER INVOLVES BUT SWAP PAYMENTS ARE NOT GIVEN
Class example: 17 Companies A and B faces the following interest rates:
US $ (Floating) L + 0.50 % L+1%
Canadian (Fixed) 5% 6.50 %
Assume that A wants to borrow US $ at a floating rate of interest and B wants to borrow Canadian dollars at a
fixed rate of interest. A financial institution is planning to arrange a swap and requires a 50 basis point spread.
If the swap is equally attractive to A and B, what rates of interest will A and B end up paying?
[RTP – May, 2005]
Solution:
Here, Company A is absolute advantage party
Company A’s advantage in fixed market (Canadian $) = 1.5 %
Company A’s advantage in floating market (US $) = 0.50 %
Hence,
Company A should borrow fixed rate loan
Company B should borrow floating rate loan
Step: 3 Now they can enter into a swap with each other and following is the flow chart of swap:
Company B
Company A Swap dealer
Loan at L + 1 %
Loan @ 5 % fixed
Bank Bank
Class example: 18 Alpha and Beta companies can borrow for a five – year term at the following rates:
Alpha desires floating rate debt and Beta desires fixed rate debt. Develop an interest rate swap in which both
Alpha and Beta have an equal cost saving. No sap bank is involved in this transaction.
Class example: 19 Company A is a AAA rated firm desiring to issue five – year FRNs. It finds that it can
issue FRNs at six – month LIBOR + 0.125 % or three – month LIBOR + 0.125 %. Given its asset structure,
three months LIBOR is the preferred index. Company B is an A – rated firm that also desires to issue 5 year
FRNs. It finds it can issue at six – month LIBOR + 1 % or at three – months LIBOR + 0.625 %. Given its asset
structure, six months LIBOR is the preferred index. Assume a notional principal of $ 1,50,00,000. Design a
floating for floating rate swap where the swap bank receives 0.125 % and the counter parties share the
remaining savings equally.
TYPE: 3 IF SWAP PAYMENTS ARE GIVEN IN THE QUESTION

Class example: 20 Bank A is a AAA – rated international bank located in U.K. and wishes to raise $
1,00,00,000 to finance floating rate Eurodollar loans. Bank A can issue 5 – years fixed rate Eurodollars bonds
at 10 %. Alternatively, Bank A can raise money by issuing 5 – years floating notes at LIBOR.
Firm B is a BBB – rated US company. It needs $ 1,00,00,000 for 5 – years. Firm B is considering issuing 5 –
years fixed rate Eurodollar bonds at 11.75 %. Alternatively, firm B can raise money by issuing 5 – year
floating rate note at L + 0.50 %. Firm B is preferred to borrow at a fixed rate.
A swap bank offers to Bank A: You pay L – 0.125 % per year and we will pay you 10.375 % for 5 years.
Swap bank makes offer to company B: You pay us 10.50 % and we will pay you L – 0.25 %.
Required:
(i) With the help of a diagram, show how the swap deal can be structured?
(ii) What are the savings earned by each party?
(iii) how much swap bank received?
Solution: Borrowing opportunities are as under:

Fixed Floating
Bank A 10 % L
Company B 11.75 % L + 0.50 %
Step: 1 Identify the absolute advantage party. The party for which it is cheaper to borrow amount in both
market.
Bank A’s advantage in fixed market = 1.75 %
Bank A’s advantage in floating market = 0.50 %
Step: 2 Select the market for the absolute advantage party where comparative gain is higher and the other
party’s market will automatically decide.
Hence,
Bank A should borrow fixed rate loan
Company B should borrows floating rate loan
Step: 3 Now they can enter into a swap with each other through swap banker. Structure of swap will be as
under:
L - 0.125 % L – 0.25 %
Company B
Bank A Swap dealer
10.375 % 10.50 %
Obtain loan at Obtain loan at

10 % fixed L + 0.50 %
Bank Bank
Step: 4 Calculate interest saving for each party as under:

Particulars Bank A Company B
(A) Net cost due to IRS:
Paid to banker 10 % L + 0.50 %
Paid to swap dealer L – 0.125 % 10.50 %
Received from swap dealer 10.375 % L – 0.25
Net cost due to swap L – 0.50 % 11.25 %
(B) Cost without IRS L 11.75 %
Savings (A - B) 0.50 % 0.50 %

Step: 5 Calculate gain of swap dealer:
Paid to Bank A 10.375 %
Received from Bank A L – 0.125 %
Paid to company B L – 0.25 %
Received from company B 10.50 %
Gain of swap dealer 0.25 %
TYPE: 4 CALCULATION OF CASF FLOWS DUE TO SWAP

Class example: 21 Company A pays ₹75,000 as interest payment at the end of one year. Company B pays the
current LIBOR + 50 basis points on a ₹10,00,000 loan at the end of the year. Suppose that the two companies
enter into an interest rate swap. Suppose that in one year the current LIBOR rate is 6.45 %. Find which
company is making payment at the end of year and its amount.
Answer: A will make payment to B ₹5,500
Solution:
Swap structure:
Fixed @ 7.5 %
A Limited B Limited
Receive L + 0.50
At the end of the year company A will make payment to company B

10,00,000 (7.50 % - 6.95 %) = ₹5,500
Class example: 22 A Limited and B Limited enter into a swap deal on March 15, 2006. A Limited agrees to
pay fixed interest @ 5 % p.a. on the principal of ₹100 lakhs to B every six months and B Limited to pay a
floating rate of L + 0.70 % to A Limited. The interest obligations of the parties are to be calculated with
reference to the interest rates effective on the first day of the interest period. The deal is for a period of 2 years.
The deal specifies for the exchange of differential cash flows. LIBOR rate for 2006, 2007 and 2008 are 4.20 %,
4.60 % and 4.30 %.
Answer: Cash flows for A Limited:

- 5,000; - 5,000; 15,000; 15,000
Solution:
Fixed @ 5 %
A Limited B Limited
Receive L + 0.70
Statement of cash flow from A Limited point of view:

Re – set date Fixed interest Floating interest Net cash flows
payment received
15.3.06 100 * 5 % * 6/12 = 100 * 4.90 % * 6/12 = - 5,000
2,50,000 2,45,000
15.9.06 100 * 5 % * 6/12 = 100 * 4.90 % * 6/12 = - 5,000
2,50,000 2,45,000
15.3.07 100 * 5 % * 6/12 = 100 * 5.10 % * 6/12 = 15,000
2,50,000 2,65,000
15.9.07 100 * 5 % * 6/12 = 100 * 5.10 % * 6/12 = 15,000

2,50,000 2,65,000
Class example: 23A three – year swap initiated on 1st April, 2006 between P Limited and Q Limited. By the
swap arranged, P Limited agrees to pay 10 % fixed to Q Limited on ₹100 lakhs every half year. In return, Q
Limited agrees to pay floating rate LIBOR to P Limited every half year. Suppose the 6 – month annual LIBOR
rates are as below:
Date LIBOR
1.4.2006 10.4 %
1.10.2006 11.20 %
1.4.2007 11.40 %
1.10.2007 10.6 %
1.4.2008 9.60 %
1.10.2008 9.00 %
Calculate cash flows under the swap arrangement from the view point of P Limited.
Answer: 20,000; 60,000; 70,000; 30,000; (20,000); (50,000)
Class example: 24 On 1.1.2010 A and B enter into a interest rate swap having following features:
Notional principal $ 500 million
Term of the swap 1 year
Payment frequency 3 months
Fixed rate 10 %
Floating rate 3 – months LIBOR
The swap is shown below:

3 – Months L on $ 500 million
A B
10 % on $ 500 million
The 3 – Months LIBOR at the beginning of each quarter happen to be:

Date 3 – Months LIBOR
1.1.2010 11 %
1.4.2010 8%
1.7.2010 7%
1.10.2010 13 %
Calculate net cash flows at the end of each quarter.
Answer:
1st quarter: B will receive $ 1.25 million
2nd quarter: A will receive $ 2.50 million
3rd quarter: A will receive $ 3.75 million
4th quarter: B will receive $ 3.75 million
Solution:
1st Quarter:
Relevant LIBOR: 11 %; Fixed rate: 10 %
B will receive 11 % - 10 % i.e. 1 %
Amount = 500 (11 % - 10 %) * 3/12 = $ 1.25 million
2nd Quarter:
A will receive (10 % - 8 %) = 2 %
Amount = 500 (10 % - 8 %) * 3/12 = $ 2.50 Million

3rd Quarter:
A will receive 3 % (10 % - 7 %)
Amount = 500 (10 % - 7 %) * 3/12 = $ 3.75 million
4th Quarter:
B will receive (13 % - 10 %)
Amount = 500 (13 % - 10 %) * 3/12 = $ 3.75 Million
QUESTION BANK FOR SWAP

Q.10 Companies X and Y face the following interest rates:
X Y
US $ (Floating rate) LIBOR + 0.50 % LIBOR + 1.00 %
Canadian $ (Fixed rate) 5.00 % 6.50 %
X wants to borrow U.S. Dollars at a floating rate of interest and Y wants to borrow Canadian dollars at a fixed
rate of interest.
X financial institution is planning to arrange a swap and requires a 50 basis point spread.
If the swap is attractive to X and Y at 60 : 40 ratio, what rates of interest will X and Y end up paying?
Q.11 Company PQR and DEF have been offered the following rate per annum on a $ 200 million five year
loan;
Company Fixed rate Floating rate
PQR 12.0 L + 0.10
DEF 13.40 L + 0.60
Company PQR requires a floating - rate loan; Company DEF requires a fixed rate loan.
Design a swap that will net a bank acting as intermediary at 0.5 percent per annum and be equally attractive to
both the companies. [CMA – Study material (44)]
Q.12 Companies X and Y have been offered the following rates per annum on a $ 5 million to years
investment:
Company X requires a fixed rate investment; Company Y requires a floating rate investment. Design a swap
that will net a bank, acting as intermediary, 0.20 % per annum and will appear equally attractive to X and Y.
Q.13 Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y wishes to borrow
Japanese yen at a fixed rate of interest. The amount required by the two companies are roughly the same at the
current exchange rate. The companies have quoted the following interest rates:
Yen Dollar
Company X 6.0 % 9.60 %
Company Y 7.50 % 10.00 %
Design a swap that will net a bank, acting as an intermediary, 50 basis points per annum. Make the swap
appear equally attractive to the two companies. [CMA – Study Material (49)]
Q. 16 Derivative bank entered into a plain vanilla swap through on OIS (Overnight index swap) on a principal
of ₹10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on the principal. The
swap was entered into on Monday, 2nd August, 2010 and was to commence on 3rd August, 2010 and run for a
period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:

7.75 %, 8.15 %, 8.12 %,7.95 %, 7.98 %,8.15 %.
If derivative bank received ₹317 net on settlement, calculate fixed rate.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.
Q. 17 Euroloan bank has a differential advantage in issuing variable – rate loans, but wishes to avoid the
income risk associated with such loan. Currently bank has a portfolio € 2,50,00,000 loans with PLR + 150
basis points, reset monthly PLR is currently 4 %. IB an investment bank has arranged for Eurolaon to swap
into a fixed interest payment of 6.50 % on notional amount of loan for its variable interest income. If Euroloan
agrees to this, what amount of interest is received and given in the first month? Further, assume that PLR
increased by 200 bp.
Q.18 United Bankers Ltd offer the following interest rates to two of its customers for a loan of ₹100 crores,
repayable in 7 Years —
Company Somnath Limited Amal IT service Limited
Nature of activity Supply and Installation of Providing IT support to various
Security Systems for Home, Airlines, Shipping Companies and
Office, Corporate Surveillance government companies
and other Security Services and
products
Years in industry 25 1.50
Market position Market Leaders market entrants (infant)
Rating by UBL A++ B+
Floating interest rate MIBOR – 0.50% MIBOR + 1%
Fixed interest rate 10.00 % 12.50 %
Share in the net gain on account of 60 % 40 %
interest rate swap
Assuming, principal amount is repaid at the end of the seven years, what is the effective gain in percentage as
well as in value for both the Companies, if they enter into an Swap Arrangement for reducing interest effect.
Also ascertain the net interest cost (in %) for both the Companies. [CMA – Study material (41)]
Q.19 Structure a Swap Arrangements in the following situations and also ascertain the extent of gain —
Case Company D Company E
Interest rates Expectation Interest rates Expectation on
Floating Fixed on interest interest rate
rate Floating Fixed
1 PLR + 0.50 % 12.00 % Increase PLR + 0.50 % 11.00 % Increase
2 PLR + 1.00 % 11.00 Decrease PLR + 2.00 % 12.00 % Increase
3 PLR + 1.25 % 11.25 % Decrease PLR – 0.50 % 10.75 % Decrease
4 PLR – 1.50 % 10.00 % Increase PLR – 0.50 % 11.50 % Decrease
PLR refers to Prime Lending Rate of a Bank i.e. Benchmark Lending rate, which are altered from time to time
bythe Banks. [CMA – Study Material (42)]
Q. 20 Suppose a dealer Rupam quotes ‘All – in – cost’ for a generic swap at 8 % against 6 month LIBOR. If
the notional principal amount of swap is ₹5,00,000.
(i) Calculate Semi – annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of swap to
the settlement date comprises 181 days and that the corresponding LIBOR was 6 % on the effective date of
swap.
(iii) In (ii) above, if settlement is on ‘net basis’, how much the fixed rate payer would pay to the floating rate
payer?
(iv) Generic swap is based on 30 /360 days basis. [CMA – Study Material (39)]
Q.21 Sandip Ltd.is planning to expand its cotton apparel division, by setting up 100 looms and installing
adequate machinery in Gujrat. It expect the total cost of the project, including cost of the land to be ₹3 crores,
repayable at the end of the third year.
Fixed interest rate 11.00 %
Floating interest rate MIBOR + 2.50 %
Susmita consumer goods Ltd. (SCGL) is also an expansion mode. It also requires ₹3 crores, repayable at the
end of the third year.
Fixed interest rate 10.00 %
Floating interest rate MIBOR + 1.00 %
Sandip anticipates a contraction in economy and therefore a reduction in interest rate, and therefore wants to
opt for floating rate. SCGL is worried about rising inflation and wants to freeze its interest rate by option
choosing fixed interest rate option. Both these companies enter into a swap arrangement. If interest payments
are to be made half – yearly based on interest prevailing at the beginning of the 6 month period. MIBOR today
is 10 % and rate at the beginning of the next five half years are 9.00 %, 9.50 %, 11.00 %, 10.00 % and 8.00 %.
Ascertain the cash flows.
Q.22ABC Ltd. is a financial institution which enjoys very good credit rating. It lends at floating rates and
borrows at fixed and it has risk of floating rates fall. XYZ is a manufacturing company enters into a fixed price
contract to purchase machinery. It has higher funding costs, whether fixed or floating. It has risk of losses if
funded on a floating rate basis. The relative borrowing costs of ABC Ltd. and XYZ Ltd. are as follows:
Company Floating rate Fixed rate
ABC Ltd. (Financial institution) Libor 8%
XYZ Ltd. (Manufacturing company) Libor + 1 % 10%
Differential borrowing cost 1 2
What is the saving for both the companies?
SOLUTION:
Step: 1 Identify the absolute advantage party
Advantage of ABC in fixed market = 2
Advantage of ABC in floating market = 1
Step: 2 Decide the market for both parties. First decide market of absolute advantage party and the other
party’s market get automatically decided.
ABC Company should go in fixed market and XYZ Company should go in floating market.
Step: 3 Structure of IRS can be shown as under:
L + 1.00
Company ABC Company XYZ
8%
Fixed Floating @ L + 1.00
@8%
Bank Bank
Step: 4 Statement of gain / loss due to interest rate swap and allocation of swap gain:
ABC XYZ
(A) Cost due to IRS:
ABC pays L + 1.00 -
XYZ Pays 8
(B) Cost without IRS L 10
Gain / (loss due to IRS) (1) 2
Net gain 1.00
Less: Dealer’s margin -
Net gain 1.00
Share of each party 0.50 0.50
Step: 5 Statement of effective rate:

ABC XYZ
Cost without IRS L 10
Less: Share in gain due to IRS (0.50) (0.50)
Effective rate L – 0.50 9.50
Q. 23 Company A has outstanding debt on which it currently pays fixed rate of interest at 9.5 %. The company
intends to refinance the debt with a floating rate of interest. The best floating rate it can obtain is Libor + 2 %.
However, it does not want to pay more than Libor. Another company B is looking for a loan at a fixed rate of
interest to finance its exports. The best rate it can obtain is 13.5 % bit it cannot afford to pay more than 12 %.
However, one bank has agreed to offer finance at a floating rate of Libor + 2 %. Citi bank is in the process of
arranging an interest rate swap between these two companies.
(i) With a schematic diagram, show how the swap deal can be structured.
(ii) What are the interest saving by each company?
(iii) How much would Citi bank receive? [CWA – Dec. 05 / Study material (48)]
SOLUTION:
(i) Structure of interest rate swap
L + 2.00
9.50 %
Company A Company XYZ
Fixed @ Floating @ L + 2
9.50 % 12 %
Bank Swap dealer Bank

L
(ii) Calculation of interest saving by each party:
Company A Company B
(A) Cost due to swap:
Paid to swap dealer L 12
Received from swap dealer 9.50 L+2
Paid to bank 9.50 L+2
Net cost due to swap L 12
(B) Cost without swap L+2 13.50
Saving of party 2 1.50
Statement of gain earned by city bank:

Received from A L
Paid to A (9.50)
Received from B 12
Paid to B L+2%
Gain of city bank 0.50
Q. 24Yorkshire Industries a British industries firm with a US Subsidiary seeks to refinance some of its existing
British pound debt to include floating rate obligations. The best floating rate if can obtain in London is LIBOR
+ 2.0%, but cannot afford more than L. Its current debts are as follows:
(i.) $ 10 Million owed to Citibank at 9.5% (fixed annually); and
(ii) £ 5 Million owed to Midland Bank at 9.5% (fixed) annually.
Huron River Salt Company wishes to Finance exports to Britain with £ 3 million of pound rate in London for
less than 13.5% interest because of its lack of credit history in the U.K. however, Lloyds Bank is willing to
extend a floating rate British pound Loan at LIBOR + 2%. Huron, however, cannot afford to pay more than
12%. How can Yorkshire and Huron help one another via an interest rate swap? Assume that Yorkshire is in a
strong bargaining position and can negotiable the best deal possible, but Huron will not pay over 12%, Assume
further that transaction costs are 0.5% and exchange rates do not change. Illustrate the effective post-swap
interest rates of each party with boxes and arrows. What are the interest savings by each party over the six
months period of the swap? [CWA – June, 07]
SOLUTION:
(i) Structure of interest rate swap
L + 2.00
9.50 %
Yorkshire Huron
Fixed @ Floating @ L + 2
9.50 % 12 %
Bank Swap dealer Bank

L
(ii) Calculation of interest saving by each party:

Yorkshire Huron
Paid to swap dealer L 12
Received from swap dealer 9.50 L+2
Paid to bank 9.50 L+2
Net cost due to swap L 12
(B) Cost without swap L+2 13.50
Saving of party 2 1.50
Statement of gain earned by swap dealer:

Received from A L
Paid to A (9.50)
Received from B 12
Paid to B L+2%
Q. 25MUMBAI LTD. is an Indian Company; they are in the process of raising a US dollar loan and are
negotiating the rates with City Bank. The Company has been offered a fixed rate of 7% p. a. with a proviso
that should they opt for a floating rate, the interest rate is likely to be linked to the Bench mark rate of 60 basis
points over the 10 years US T Bill rate, with interest re fixation on a three monthly basis. The expectations of
Mumbai Ltd are that the dollar interest rates with fall, and are inclined to have a flexible mechanism built into
their interest rates. On enquiry they find that they could go for a swap arrangement with Chennai India Ltd.
Who have been offered a floating rate of 120 basis points over 10-year US T Bill Rate, as against a fixed rate
of 8.20% Describe the swap on the assumption that the swap differential is shared between Mumbai Ltd and
Chennai India Ltd. in the preparation of 2:1. [CWA – June, 08]
SOLUTION:
Available interest rates are as follows:
Mumbai Ltd. Chennai Ltd.
Fixed rate 7% 8.20 %
Floating rate Bench mark + 60 BP Bench mark + 120 BP
Step: 1 Identify absolute advantage party

Advantage of Mumbai Ltd. in fixed market = 1.20
Advantage of Mumbai Ltd. in floating market = 60 BP or 0.60
Hence absolute advantage party = Mumbai Ltd.
Step: 2 Decide market for both party.

Mumbai Ltd. should go in fixed market and Chennai Ltd. should go in floating market.
Step: 3 Structure of IRS can be shown as under:
Bench mark + 1.20

7%
Fixed Floating @
@7% Bench mark + 1.20
Bank Bank
Mumbai Ltd. pays Bench mark + 1.20 -
Chennai Ltd. Pays 7
(B) Cost without IRS Bench mark + 0.60 8.20
Gain / (loss) due to IRS (0.60) 1.20
Net gain 0.60
Less: Dealer’s margin -
Net gain 0.60

Cost without IRS Bench mark + 0.60 8.20
Effective rate Bench mark + 0.20 8.00
Q.26X Company Ltd. And Y Company Ltd. Both wish to raise US 40 M Dollar’s Loan for five years, X
Company Ltd. has the choice of issuing fixed rate debt at 7.50% or floating rate debt at LIBOR+25 basis point.
On the other, Y Company Ltd. which has a lower credit rating can issue fixed rate debt of the same maturity at
8.45% or floating rate at LIBOR + 37 basis points. X Company Ltd. prefers to issue floating rate debt and Y
Company Ltd. prefers fixed rate debt with a lower coupon. City Bank is in the process of arranging an interest
rate swap between these two companies.
X Company Ltd. negotiates to pay the Bank a fixed a floating rate of LIBOR flat while the Bank agrees to pay
X Company Ltd. a fixed rate of 7.60%. Y Company Ltd. agrees to pay Bank a fixed rate of 7.75% while the
Bank pays Y Company Ltd a floating rate of LIBOR flat.
Required:
(i) With a schematic diagram, show how the swap deal can be structured.
(ii) What are interests saving by each company?
(iii) How much would City bank receive? [CWA – June, 09]
SOLUTION:
Available interest rates are as follows:
Company X Company Y
Fixed rate 7.50 % 8.45 %
Floating rate L + 0.25 L + 0.37
Step: 1 Identify absolute advantage party
Advantage of company X in fixed market = 0.95
Advantage of company X in floating market = 0.12
Hence, absolute advantage party = Company X
Step: 2 Identify the market of loan for both party and then enter into swap contract.
Company X should go in fixed market whereas company Y should go in floating market.
Step: 3Structure of interest rate swap

L
7.60 %
Company X Company Y
Fixed @ Floating @ L + 0.37

7.50 % 7.75 %
Bank City bank Bank

L
Calculation of interest saving by each party:

Company X Company Y
Paid to swap dealer L 7.75
Received from swap dealer 7.60 L
Paid to bank 7.50 L + 0.37
Net cost due to swap L – 0.10 8.12
(B) Cost without swap L + 0.25 8.45
Saving of party 0.35 0.33
Statement of gain earned by swap dealer:

Received from X L
Paid to X (7.60)
Received from Y 7.75
Paid to Y (L)
Q.27Soni Ltd. and Tony Ltd. face the following interest rate:
Particulars Soni Ltd. Tony Ltd.
US Dollar (Floating rate) Libor + 0.25 % Libor + 2.25 %
Japanese Yen (Fixed rate) 1.75 % 2%
Toni Ltd. Wants to borrow US Dollar at a floating rate of interest and Soni Ltd. wants to borrow Japanese Yen
at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 100 basis points
spread. If the swap is equally attractive to Soni Ltd. Toni Ltd. What rate of interest will they end up paying?
[CS – June, 06]
SOLUTION:
Advantage of Soni Ltd. in fixed rate loan = 0.25
Advantage of Soni Ltd. in floating rate loan = 2.00
Hence, absolute advantage party is Soni Ltd.
Step: 2 Decide market for each party. Decide market for the absolute advantage party and other party’s market
will automatically decide.
Soni Ltd. borrow floating rate loan and Tony Ltd. borrow fixed rate loan.
Step: 3 Structure of interest rate swap

2%
L + 0.25
Soni Ltd. Tony Ltd.
Fixed @ Borrow @ 2 %
L + 0.25 % L + 0.25
Financial
Bank Bank
2% institution
Sony Ltd. Tony Ltd.
Soni Ltd. pays 2% -
Tony Ltd. Pays - L + 0.25
(B) Cost without IRS 1.75 % L + 2.25
Net gain 1.75
Less: Dealer’s margin 1.00
Net gain 0.75
Sony Ltd. Tony Ltd.
Cost without IRS 1.75 L + 2.25
Effective rate 1.375 L + 1.875
Q.28 Celina Ltd. wishes to borrow US Dollars at a fixed rate of interest. Priyanka Ltd. wishes to borrow
Japanese Yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at
current exchange rate. The companies have been quoted the following interest rates:
Name of company Yen Dollar
Celina Ltd. 4.0 % 8.6 %
Priyanka Ltd. 5.5 % 9%
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap
equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.
[CS – June, 05]
SOLUTION:
Advantage of Celina Ltd. in Yen loan = 1.50
Advantage of Celina Ltd. in $ loan = 0.40
Step: 2 Decide market for each party. Decide market for the absolute advantage party and other party’s market
will automatically decide.
Celina Ltd. borrow Yen loan and Priyanka Ltd. borrow $ loan.
Step: 3 Structure of interest rate swap
9%
4%
Celina Ltd. Priyanka Ltd.
Yen loan $ loan @ 9 %

4% 4%
Financial
Bank Bank
9% institution
Tony Ltd.
Celina Ltd. pays 9%
Priyanka Ltd. Pays 4%
(B) Cost without IRS 8.60 5.50
Net gain 1.10
Less: Dealer’s margin 0.50
Net gain 0.60
Celina Ltd. Priyanka Ltd.
Cost without IRS 8.60 5.50
Effective rate 8.30 5.20
TOPIC: FUTURES
(1) Meaning of futures – Future contracts are forwards except they are always traded on exchange whereas
forwards are always traded as OTC (Over the counter).
Party A Party B
Enter into an agreement to buy 100 shares

of reliance for ₹2,500 each. Settlement will take
place in future.
Under future contract both the parties have rights as well as obligation. This can be explained as under:
Party Right Obligation
A To receive 100 shares of reliance To pay ₹2,500 per share
B To receive ₹2,500 per share To deliver 100 shares of reliance
In other words, futures are –

(i) Futures are financial derivatives.
(ii) They are traded on the exchange.
(iii) Under futures buy or sell a specified amount or quantity at an agreed price.
(iv) Agreement is to be entered today for the settlement at specified future date.
(2) Difference between futures and forwards – Future contracts are same as forward contracts because both
futures and forwards involves a contract to buy or sell a asset at some letter date at a price per – determined
today. However, the following differences exist between futures and forward –
Futures Forwards
1. Futures are exchange traded 1. Forwards are over the counter
2. Futures are standardized contract (i.e. lot size, 2. Forwards are customized contracts
maturity date is fixed)
3. Margin requirement 3. No margin requirement
4.Daily mark to market features 4. No mark – to – market features
5. High liquidity 5. Low liquidity
6. Highly regulated 6. Less regulations
7. Futures are cash settled contracts 7. Forwards are physically settled
(3) Meaning of buying and selling futures –
Buying futures means Selling futures means

taking delivery of giving delivery of
underlying. underlying.
(4) Margin requirement under future contracts – The person dealing in derivative transaction has to deposit
an initial margin as specified. This margin is adjusted for daily gain or loss. His transaction is daily settled at
market price known as mark – to – market. The adjusted margin is then compared with maintenance margin
and made margin call and withdrawn accordingly.
Following rules should be followed for margin:

(i) If adjusted margin is less then initial margin but more than maintenance margin, no further adjustment is to
be done.
(ii) If adjusted margin is greater than initial margin, he can withdraw the excess amount as allowed.
(iii) If adjusted margin is below the maintenance margin then he will bring further amount to make his margin
balance equal to the initial margin.
Flow chart of process of margin:

Excess amount can be withdrawn
Initial margin
Maintenance margin By depositing margin, so that margin balance

should be equal to the initial margin
Note: Generally initial and maintenance margin will be given. If it is not given, we are required to use the
following formula.
Initial margin = µ + 3σ
Maintenance margin = 75 % of initial margin
Here,
µ = mean of daily absolute change in the value of future contract.
σ = Standard deviation of the daily absolute change in the value of the future contract.
The formula is based on the property of normal distribution whereby a variable cannot deviate from its mean
by more than 3 standard deviation.
How to prepare statement showing margin call and closing balance of margin account:
Day Settlement Opening Mark to Adjusted Margin Margin Closing
price balance of market margin call withdrawal balance of
margin margin margin account
account
1 Xxx xxx Xxx Xxx xxx xxx Xxx
2 Xxx xxx xxx Xxx xxx xxx Xxx
Class example: 25 – (Video lecture – Class example - 35)

The settlement price of an index future contract on a particular day was 1,760. The multiple associated with
the contract is 100. The maximum amount by which the contract can realistically change is 50 points per day.
The initial margin is, therefore set at 50 X 100 = ₹5,000. The maintenance margin is set at ₹4,000. The
settlement prices on the following four days are as follows:
Day Settlement price
1 1,800
2 1,752
3 1,780
4 1,824
Required:
Calculate the mark – to – market cash flows, the daily closing balances and net profit (loss) in the accounts of,
(a) An investor who has gone long at 1,760.

(b) An investor who has gone short at 1,760.
Solution:
(a) Statement showing closing balance of margin account: (Investor has gone long at 1,760)
Day Settlement Opening Mark – to – Adjusted Margin Closing
price balance market balance call balance
1 1,800 5,000 4,000 9,000 - 9,000
2 1,752 9,000 (4,800) 4,200 - 4,200
3 1,780 4,200 2,800 7,000 - 7,000
4 1,824 7,000 4,400 11,400 - 11,400
(b) Statement showing closing balance of margin account: (Investor has short at 1,760)
Day Settlement Opening Mark – to – Adjusted Margin Closing
price balance market balance call balance
1 1,800 5,000 (4,000) 1,000 4,000 5,000
2 1,752 5,000 4,800 9,800 - 9,800
3 1,780 9,800 (2,800) 7,000 - 7,000
4 1,824 7,000 (4,400) 2,600 2,400 5,000
Class example: 26
A trader has gone long on 5 Brent crude futures for December settlement at $ 26.32 per barrel. The minimum
contract size for Brent futures contract is 1,00,000 barrel. The initial margin is $ 50,000 and the maintenance
margin is $ 30,000. The future closes at the following prices on the next 10 trading days:
Day 1 2 3 4 5 6 7 8 9 10
Settlement 26.19 26.30 26.45 26.48 26.34 26.21 25.98 25.87 25.90 25.95
price ($)
The trader will take out the profit out of the margin account whenever he gets the opportunity to do so.
You are required to:
(a) Prepare the margin account showing all the cash flows.
(b) Find the profit / loss for the trader after 10 trading days.
Solution: Initial Margin for 5 contracts = 5 X 50,000 = $ 2,50,000

Maintenance margin for 5 contracts = 5 X 30,000 = $ 1,50,000
Statement showing closing balance of margin account

Day Settlement Opening Mark – to Adjusted Margin Withdrawn Closing balance
price balance market margin call of margin account
1 26.19 2,50,000 (65,000) 1,85,000 - - 1,85,000
2 26.30 1,85,000 55,000 2,40,000 - - 2,40,000
3 26.45 2,40,000 75,000 3,15,000 - 65,000 2,50,000
4 26.48 2,50,000 15,000 2,65,000 - 15,000 2,50,000
5 26.34 2,50,000 (70,000) 1,80,000 - - 1,80,000
6 26.21 1,80,000 (65,000) 1,15,000 1,35,000 - 2,50,000
7 25.98 2,50,000 (1,15,000) 1,35,000 1,15,000 - 2,50,000
8 25.87 2,50,000 (55,000) 1,95,000 - - 1,95,000
9 25.90 1,95,000 15,000 2,10,000 - - 2,10,000
10 25.95 2,10,000 25,000 2,35,000 - - 2,35,000
(5) Currency futures

Currency futures were introduced in India in 2008.
Underlying currency of the currency future contract – The currency in which contract size is given is known as
underlying currency.
Currency further is available for 1 month, 2 months, …….. 12 months. This means expiry date of the contract
is fixed by the exchange and that is last working day of the month.
Currency future contracts are cash settled contracts. Physical settlement is not allowed.
How to use currency future for hedging:
Three critical dates for currency future contract:
T=0 T=1 T=2

Date on which contract Date on which future Contract expiry date
bought or sold contract will be settled
(Transaction settlement date)
Creation of hedging strategy:
Either OR
Buy at t = 0 and sell at t = 1 sell at t = 0 and buy at t =1
How to decide whether we should buy currency future at t = 0 or sell it at t = 0 – Do the same thing what you
have done in case of forward contract.
Which period future contract is to be settled – Next nearest expiry currency future contract from t = 1 (that is
expiry date of transaction)
STEPS FOR CURRENCY FUTURE HEDGING: Following are the steps to be followed under currency
future –
Step: 1 Identify the underlying currency of the future contract. Underlying currency is the currency in which
contract size is given.
Step: 2 Calculate numbers of future contracts to be taken for hedging purpose

𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒𝑎𝑚𝑜𝑢𝑛𝑡
No. of contracts = 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠𝑖𝑧𝑒/ 𝑙𝑜𝑡𝑠𝑖𝑧𝑒
Note: Number of future contracts should be in rounding off.
Step: 3 Create a hedging strategy to hedge the risk.
Step: 4 On settlement date calculate hedge efficiency (if required) by comparing spot market result and future
market result.
OR
Step: 4 On settlement date calculate final cash flow due to currency future contract as under:
Cash flow due to spot market transaction Xx
Add/ Less: Cash flow due to future contract Xxx
Net amount Xxx
Step: 5 Calculate effective costs per unit due to currency future

Net amount
Effective cost per unit of currency =
exposure amount
Class example: 26 – (Video lecture – Class example 38)

A Japanese company plans to set up a plant in UK. The plant is to be imported from USA at a cost of $ 50
million. Japanese company will settle the dollar liability on December 15. The current market quotes are:
Spot rate ($ / ¥) = 0.6545
December ¥ future = 0.6441
3 month $ / ¥ forward rate = 0.6432
Explain how the company can hedge currency risk. Also, calculate the effective cost in ¥ if the following rates
materialize on December 15:
Spot rate ($ / ¥) = 0.6400
December ¥ futures = 0.6389
(Assume standard size of a future contract is ¥ 12.50 million)
Class example: 27
A corporate is expecting to receive Yen 50 million after 3 months. It decides to hedge the foreign exchange
risk using the future markets. The standard size of Yen future contract is Yen 12.50 million. Currently, both
spot and future Yen are quoting $ 0.00892. If after 3 months, when the corporate close out, the futures are
quoting $ 0.00885 and the spot price of the Yen is also $ 0.00885. Calculate the effective realization for the
corporate while selling the receivables.
Solution:
No. of future contracts = 50 / 12.50 = 4 contracts
Hedging strategy: Sell 4 Yen future contracts at t = 0.
T=0 T=1
Sell Yen future at 0.00892 Buy Yen future at 0.00885
Statement showing final settlement amount at t = 1

Amount realized from sell of Yen in spot market (5,00,00,000 *0.00885) 4,42,500
Add: Gain in future market (0.00892 – 0.00885) * 4 * 1,25,00,000 3,500
Net realization 4,46,000
Hence effective cost per unit = 4,46,000 / 5,00,00,000 = $ 0.00892 per Yen
Class example: 28 – (Video lecture – Class example - 40)

A germen company is planning to set up a plant in India. The whole plant will be imported from USA at a cost
of $ 2 million. German company will be settling the dollar liability on December, 10. The current market
quotes are:
$ / € spot rate = 0.8949
December € future = 0.8876
3 – month $ / € Forward rate = 0.8850
Explain how the company can hedge currency risk. Also, calculate the effective cost in € if the following rates
materialize on December, 10:
$ / € spot rate = 0.8760
December € futures = 0.8695
Assume that the standard size of a future contract is € 1,25,000.
Class example: 29
A US importing firm has a payable of euro 1 million on December 11th. Today is September 8 and the firm
wants to hedge against appreciation of the euro. The following are the rates prevailing today:
$ / € spot rate = 0.8950
The standard size of the contract is 1,25,000 euro.
If the following are the rates that prevail on December, 11:
Case A: $ / € spot rate = 0.8972
Case B: $ / € spot rate =0.8942

Calculate effective cost of purchase of euro.
(6) Pricing of future contracts / How to calculate theoretical future price – The spot price of a commodity
is known and standing today. Future price is known today but standing on future. The link between these two
is Rf i.e. either compound S or discounting F. This model is also known as cost of carry model. We can apply
cost of carry model in either of the following two forms:
Type: 1 Future value type
F = Spot price + Interest + future value of other factors
Type: 2 Present value type

Present value of F = S + Present value of other factors
Note: According to text book we should apply following formula for calculating theoretical value
F = S.ert
Here,
F = Theoretical price of future contract
S = Spot rate
r = Rate of interest p.a.
t = Time period
e = exponential value
where ex can be substituted by 1+ x
Following are the cases to find out theoretical future price:
Case A: Securities providing no income (Non – dividend paying shares or stock)

F = S.ert
Class example: 30
Spot rate ₹60
Maturity period of future contract 3 months
Risk – free rate of interest 8 % p.a.
Calculate theoretical future price.
Case B: Securities providing known income

Following steps should be followed:
Step: 1 Calculate present value of cash income (cash income Y)
Cash income.e-rt
Step: 2 Calculate adjusted spot price

Adjusted S = Spot price – Present value of cash income
Step: 3 Now compute theoretical future price

F = Adjusted S. ert
Class example: 31
Spot price ₹40
Period for future contract 6 months
Lot size 100 shares
Risk – free rate of return 12 % p.a.
Dividend payment (3 months from now) ₹2.5 per share
Calculate future price.
Class example: 32
Spot price ₹120
Contract size 50 shares
Dividend income after 4 months ₹3 per share
Calculate future price for 8 months contract.
Class example: 33
Spot price ₹1,100
Risk – free rate 15 % p.a.
Dividend income:
After 3 months ₹4
After 6 months ₹6
After 9 months ₹8
Calculate theoretical future price for 1 year contract.
Case C: Securities providing a known dividend yield

F = S. e(r - y)* t/12
y = Dividend yield
Note:
(i) If time period of contract and period of income is same then above formula will apply directly.
(ii) If time period of contract and period of income is different than apply case B.
(iii) If dividend rate is given then apply on face value.
(iv) If dividend yield is given then apply on spot price (market price).
Class example: 34From the following information calculate 1 month theoretical future price:
Spot price ₹500
Risk – free interest rate 15 % p.a.
Dividend yield 3 % p.a.
Class example: 35From the following information calculate 3 – months theoretical future price
Spot price ₹500
Dividend yield 4%
Class example: 36 Calculate 4 – months theoretical future price.

Spot price ₹600
Risk – free rate of return 18 %
Dividend yield (to be received after 1 month) 6%
Class example: 37 Calculate 2 month theoretical price from the following data:
Spot price ₹500
Risk – free rate 15 % p.a.
Dividend rate (dividend is expected to be received after 1 month) 25 %
Face value ₹100
Case D: Commodities having come storage cost

If storage cost is involved then storage cost can be considered as negative cash income. In such situation
following steps will apply.
Step: 1 Calculate present value of storage cost

Present value of storage cost = Storage cost. e-rt
Step: 2 Calculate adjusted spot price

Adjusted spot price = spot price + present value of storage cost
Step: 3 Now calculate theoretical future price as under

F = Adjusted S.ert
Concept of convenience yield – A Convenience yield, a common concept in the valuation of commodity
futures. Convenience yield is the benefit from storage of the physical commodity. Storage may provide profit
opportunities in case of temporary shortages in the commodity. When shortage occur, the spot price for the
commodity is high, generating a convenience yield.
Case: E Future price of commodity when convenience yield is given in % terms

F = Spot price. e(r - c)* t
Where c = Convenience yield in % terms
Case F: Future price of commodity when convenience yield is given in amount terms
Step: 1 Calculate present value of convenience yield
Present value of CY = CY.e-rt
Step: 2 Calculate adjusted S

Adjusted S = Spot price – Present value of CY
Step: 3 Calculate future price

F = Adjusted S. ert
Case: G Future price of commodity when storage cost and convenience yield both are given
Step: 1 Calculate present value of storage cost
Step: 2 Calculate present value of convenience yield
Step: 3 Calculate adjusted S in the following manner

Adjusted S = Spot price + Present value of storage cost – Present value of convenience yield
Step: 4 Calculate Future price in the following manner

F = Adjusted S.ert
Class example: 38
Spot price of commodity ₹320

Risk – free interest rate 9.60 %
Time period 9 months

Storage cost (To be paid after 6 months) ₹60
Calculate future price of the commodity
Class example: 39

Risk – free interest rate 12 %
Time period of contract 12 months
Storage cost: Payable after 3 months ₹20
Payable after 6 months ₹40
Payable after 9 months ₹60
Calculate future price of commodity
Class example: 40

Risk – free rate of return 9.60 %
Cash rebate (Receivable after 4 months) ₹50
Class example: 41

Risk – free interest rate 8.40 %
Cash benefits (Receivable after 8 months) ₹75
Case: HPricing of currency future – The pricing of currency future is exactly similar to pricing of stock
future in case of dividend yield form but the currency does not give any dividend, therefore we would replace
it with interest rate.
F = S + S. (Quote currency interest rate – Base currency interest rate) * T/12
Class example: 42Suppose three month LIBOR on the USD is 1.28% and on the Euro is 2.52%. The spot rate
is 1 USD 0.9250 Euro. What should be the three month forward rate between USD and Euro?
Class example: 43 J Limited trades in paper boards and manufacture carton boxes. Following information is
available in the future market on paper board –
Single layer paper Double layer paper board
board
Spot price ₹500 per Kg. ₹720 per Kg.
Carrying cost (₹ per quintal per quarter) payable ₹150 ₹200
at the end of each quarter
Cash rebate for high volume purchase (receivable ₹10 per Kg. ₹15 per Kg.
after 4 months)
6 – months future contract rate for 1 tonne ₹5,20,000 ₹7,40,000
Risk free interest rate is 9 % per annum. Calculate future price for 6 months period.
Class example: 44 [CMA – Study Material - 3]

Compute the theoretical forward price of the following securities for 1 month, 3 months and 6 months —
You may assume a risk free interest rate of 9% p.a and 12% p.a.
Class example: 45

Risk – free rate of interest 12 %
(To be paid after 6 months) ₹25
Cash benefits (To be received after 8 months) ₹35
Class example: 46
Spot price of stock ₹585

Dividend income to be received after 4 months ₹40
Dividend income to be received to be received after 6 months ₹25
Calculate future price of contract.
Class example: 47 [CMA – Study Material - 4 ]

Shares of sandeep ltd are being quoted at ₹600 . 3-Months Futures Contract Rate is ₹636 per share for a lot
size of 500 shares. if the sandeep ltd is not expected to distribute any dividend in the interim, risk free rate of
return is 9%, what is the recommended course of action for a trader in shares?
If the 3-Months Futures Contract Rate is ₹ 600, what should be the action?

Compute the theoretical forward price of the following securities for 2 month, 3 months and 4 months —
You may assume a risk free interest rate of 9% p.a. What action should follow to benefit from futures contract?

Super Polycarbons Ltd. has the following information about LDPE and HDPE Granules (raw material used for
Manufacturing Plastic Films, Polyfilms and Plastic Sheets –
Risk free interest rate is at 12% p.a. Advise Super Polycarbons on the course of action to be taken?
Class example: 50

Future price of commodity ₹620
Calculate present value of storage cost.
Class example: 51
9 – Months future price of a commodity = ₹635
Risk – free rate of return = 8 % p.a. compounded quarterly
Calculate spot price.
Class example: 52
6 – Months future price: ₹165
Spot price: ₹160
Storage cost: ₹8 at the end of every month.
Risk – free rate of return: 12 % p.a. compounded monthly
Calculate present value of CY.
Class example: 53
Spot price: ₹430
Risk – free rate of return: 1.50 % per month
Storage cost: 0.90 % per month
Monetary benefits: 0.60 % per month
Convenience yield: 0.80 per month
All these rates are compounded continuously. Find the price of 3 months future. Given e0.03 = 1.03045
(7) Commodity futures – A future contract is an agreement for buying or selling a commodity for a
predetermined delivery period at a specific future price is known as commodity future. Suppose a farmer is
expecting a crop of wheat to be ready in 2 months, time, but is worried that the price of wheat may decline in
this period. In order to minimize a risk, he can enter to future contract to sell his crop in 2 months’ time at a
price determined now. This way he is able to hedge his risk arising from a possible adverse change in the price
of his commodity.
How to compute net gain / loss due to commodity futures:

(A) Gain or loss in spot market
Difference between cash flows due to spot market dealing Xxx
(B) Gain / Loss in future market
(i) Difference between buying and selling rate xxx
(ii) No. of future contracts xxx
(iii) Size of each contract xxx
Gain / loss due to future contract (i * ii* iii) Xxx
Net profit (A + B) Xxx
How to compute effective rate:

Cash flow due to transaction in spot market Xxx
Add/Less: cash flow due to future market Xxx
Net cash flow Xxx
Total quantity Xxx

Effective rate per unit (Net cash flow / total quantity) Xxx
Class example: 54 In March, a wheat farmer is planning to plant 1,00,000 bushels of wheat, which will be
ready for harvesting by late August and delivery in September. The farmer knows from past years that the total
cost of planting and harvesting the crops is about to $ 6.30 per bushel. At that time, September wheat futures
are trading at $ 6.70 per bushel and the wheat farmer wishes to lock in this selling price. Each wheat future
contract covering 5,000 bushels. By mid – August, his wheat crops are ready for harvesting. However, the
price of wheat have since fallen and the price has dropped to $ 6.20 per bushel. Correspondingly, prices of
September wheat future have also fallen and are now trading at $ 6.33 per bushel. Calculate net profit / loss to
wheat farmer.
SOLUTION:
(A) Gain or loss in spot market:
Amount realized from sale (1,00,000 * 6.20) $ 6,20,000
Less: Planting and harvesting cost $ 6,30,000
Loss in spot market $10,000
(B) Gain / loss in future market:
Rate at t = 0 (Selling rate) 6.70
Rate at t = 1 (Buying rate) 6.33
Profit $ 0.37
No of future contracts (1,00,000 / 5,000) 20
Size of each contract 5,000
Profit due to future market (5,000 * 20 * 0.37) $ 37,000
Net profit $ 27,000
Class example: 55 In June a farmer expects to harvest at least 10,000 bushels of soybeans during September.
By hedging, he can lock in a price for his soybeans in June and protect himself against the possibility of falling
prices. In June following prices are available:
Spot rate for new crop soybeans = $ 6 per bushel
November future price = $ 6.25 per bushel
Contract size is 5,000 bushels of soybeans. At the beginning of September when farmer wants to sell his crop,
the prices are as under:
Spot rate = $ 5.72 per bushel
November soybeans future = $ 5.95 per bushel
Calculate effective selling price for the farmer.
Solution:
Cash inflow due to sale in spot market (10,000 * 5.72) 57,200
Cash inflow due to future:
Selling rate 6.25
Buying rate 5.95
Profit 0.30
Contract size (2,000 * 5) 10,000
Cash inflow due to future 3,000
Total cash inflows 60,200
Total quantity 10,000
Effective rate (60,200 / 10,000) 6.02
Class example: 56 It is June 8 and a company knows that it will need to purchase 20,000 barrels of crude oil
at some time in October or November. Oil future contracts are currently traded for delivery every month and
contract size is 1,000 barrels. The company therefore decides to use the December contract for hedging. The
future price on June 8 is $ 68.00 per barrel. The company finds that it is ready to purchase the crude oil on
November 10. It therefore closes out its future contract on that date. The spot price and future price on
November 10 are $ 70.00 per barrel and $ 69.10 per barrel.
Class example: 57 [RTP – June, 2013]

Bharat Oil Corporation (BOC) imports crude oil for its requirements on a regular basis. Its requirements are
estimated at 100 tonnees per month.
Of late, there has been a surge in the prices of oil. The current price (month of June) of crude oil is ₹5,500 per
barrel. The firm expects the price to rise in coming months to ₹5,800 by August. It wants to hedge against the
rising prices for its requirements of the month of August.
Multi Commodity Exchange (MCX) in India offers a futures contract in crude oil. The contract size is 100
barrels and August contract is currently traded at ₹5,668 per barrel.
(a) How can BOC hedge its exposure against the rising price of crude oil?
(b) If Bharat Oil Corporation hede its exposure at MCX, how many contracts it must book?
(c) Analyse the position of BOC if in the month of August (i) the spot price is ₹5,750 and futures price is
₹5,788, (ii) the spot price is ₹5,417 and futures market were matched?
Ignore marking-to-the-market and initial margin on futures contracts.
Class example: 58 [CMA – Study Material]

A sugar mill in Uttar Pradesh is expected to produce 100 MT of sugar in the month of April. The current spot
price is ₹22 per Kg. April future contract is sugar is trading at ₹25 per kg. To execute the hedging strategy the
sugar mill has to take the opposite position in the futures market. Assuming each contract for sugar is for 10
MT. Calculate effective realization rate in the following situation:
(a) When spot and future price falls to ₹22.
(b) When spot and future price rises to ₹26.

A petrochemical plant that needs to process 10,000 barrels of oil in three months time. To hedge against the
rising price petrochemical plant wants to take appropriate action in the future market.the spot price of
crude oil is ₹ 1,950 per barrel, while futures contract expiring three months from now is selling for ₹2,200 per
barrel. By going long on the futures the petrochemical plant can lock-in the procurement at ₹ 2,200 per
barrel.The size of one futures contract of 100 barrels. Calculate effective rate in the following situation:
(a) When spot and future price falls to ₹1,800
(b) When spot and futire price rises to ₹ 2,400.
(9) Arbitrage through futures – Whenever quoted future price is not equal to theoretical future price, then
there will be opportunity of arbitrage. By taking appropriate action an arbitrager can earn profit due to
mispriced future. There may be two situations for arbitrage:
Case A: Where F > (S + C) i.e. Quoted future price is more than theoretical future price
Step: 1 Sell future contract (i.e. Create short position)
Step: 2 Borrow sufficient amount and buy underlying at today’s spot price.
Step: 3 Repay loan with interest at contract expiry

Outflow = Loan amount + Interest
Step: 4 Calculate cash inflow due to future contract
Step: 5 Calculate arbitrage profit from the contract

Arbitrage profit = Inflow – Outflow
Case B: Where F< (S + C) i.e. quoted future price is less than theoretical future price
Step: 1 Buy future contract today (i.e. create long position)
Step: 2 Sell the underlying today and invest the proceeds for future period.
Step: 3 At contract expiry amount realized from investment with interest

Cash inflow = Value of investment + Interest
Step:4 Buy as per future contract and calculate cash outflow due to future contract.
Step: 5 Calculate arbitrage profit from the process

Arbitrage profit = Inflow – Outflow
Arbitrage problems can be categorized in following parts:

(a) Arbitrage of currency futures
(b) Arbitrage of stock futures
(c) Arbitrage of index future
(d) Arbitrage of commodity futures
Class example: 60Consider a stock, currently trading at $80 (assuming no dividend). The interest rate is 1%
per month (compounded monthly).
(a) What should be the “price” of a 3 month future on this stock?
(b) If a 6 month future is trading at $90, can you make arbitrage profit? How?
(c) If a 1 year future is trading at $90, can you make arbitrage profit? How?
Class example: 61The following data available from the financial markets:
Spot exchange rate (₹ per $) 49.7500
90 – days futures 51.4000
₹ interest rate 12 %
$ interest rate 8%
Based on these data, find out the fair price of the future contract. Is there any arbitrage opportunity? If yes,
how can the arbitrage be executed?
Class example: 62
Spot price of gold per gram $ 10
Storage cost 2 % of its value to store a gram for one year
Annual interest rate 7%
1 year future price $ 11
Class example: 63
Spot price of index ₹650
1 year future price ₹665
Risk – free – interest rate 5%
Dividend yield 3%
Class example: 64
Stock price 400
3 months future price 450
Risk – free interest rate 6%
Dividend yield 1%
Show the process of arbitrage.
Class example: 65
Stock price 800
6 – months future price 810
Risk – free rate 10 %
Dividend yield 4 % p.a.
Show the process of arbitrage.
Class example: 66 Current future price for delivery of gold in 60 days is $ 375 per troy oz. The current spot
price of gold is $ 365 per troy oz. Storing gold costs $ 12 per oz. per year and the storage costs are paid when
the gold is taken out of storage. Risk – free rate of interest is 6 % per year. Consider 360 days in a year.
Answer:
Theoretical future price = 370.65
Arbitrage strategy – sell gold future
Arbitrage profit – 4.35
Class example: 67Following data are available on March 15th:

IBM stock price $ 125
September 15 Future price $ 123
Risk – free rate 7%
Dividend in IBM (Paid on the first day of February, May, August and $ 2.50
November)
Show the process of arbitrage. Consider 360 days.
Answer:
Theoretical future price – 124.39 $
Arbitrage profit – 1.38
Class example: 68 Following data are available on January 10, 2002
Spot exchange rate (₹/$) 46.3500
Future exchange rate (₹ /$) : Quoted on June 9, 2002 46.7900
6 – months Indian interest rate 7 % p.a.
6 – months US interest rate 6 % p.a.
Show the process of arbitrage. Consider 360 days.
SOLUTION:
Step: 1 Calculate theoretical future price
S + S (interest rate of quote currency – interest rate of base currency) * t/12
46.35 + 46.35 (0.07 – 0.06) * 150 / 360
46.35 + 0.1931 = 46.5431
Step: 2 Since quoted future price is more than theoretical future price. Hence, for arbitrage we should sell $
future contract.
Step: 3 Process of arbitrage:
At t = 10th January
Activity Cash flows
Borrow fund at risk free rate of 7 % 46.3500
Purchase $ at spot rate and invest at 6 % (46.3500)
Sell $ future at 46.7900 0
Net cash flow 0
At t = 9th June
Activity Cash flow
Realise from investment and settle at future rate 47.9598
(1 + 6 % * 150 / 360 = 1.025 $ )
Repay loan with interest (46.35 + 7 % * 150 / 47.7019

360)
Arbitrage gain 0.2579
Class example: 69 On August 8, 2002, the following yields and price existed:
Spot exchange rate ($ / DM) 0.6262
December 9, 2002 future price ($ / DM) 0.6249
German interest rate 8.50 % p.a.
US interest rate 7 % p.a.
Time to maturity 130 days
From the above data, show an arbitrage opportunity.
Method: 3 Through index future and hedging

(i) Hedging is the process of taking opposite position in order to reduce loss caused by price fluctuation. The
basic objective behind hedging is to reduce the loss and not to earn profit.
(ii) Position to be taken for hedging purpose –
(a) If investor has long position in spot market, then hedging must be done taking a short position in future
market.
(b) If investor has short position in spot market, then hedging must be done taking a long position in future
market.
(iii) An Investor may hedge his portfolio in the following manner –
(a) Complete hedging = Current value of portfolio x existing beta
(b) Partial hedging = Current value of portfolio x existing beta x % of hedge

Notes:
(i) Whenever question is silent always assume complete hedging.
(ii) If hedge ratio is not given in the question, then we can compute hedge ratio with the help of following
formula:
Standard deviation of portfolio
Hedge ratio = x Correlation between portfolio and futures
Standard deviation of futures
(iii) Calculate desired beta with the help of hedge ratio:

Desired beta = 1 – Hedge ratio
(iv) How to calculate number of contracts to be bought and sold

(𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑏𝑒𝑡𝑎−𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑏𝑒𝑡𝑎)∗𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
= 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑖𝑛𝑑𝑒𝑥 𝑓𝑢𝑡𝑢𝑟𝑒
Value of one index future = Lot size * index price

𝑊𝐵
(v) Calculation of existing portfolio beta = βP =
∑𝑊
Weights should be based on market price of stocks.
(vi) Application of βp to find out % change in market or % change in security

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
βp = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡
Class example: 70
A high net worth individual (SRI) is holding the following portfolio in ₹ crores:
Investment in equity shares 80.00
Cash and bank balance 20.00
Total 100.00
The Beta of the portfolio is 1.2. The index future is selling at 5500 level. The SRI wants to decrease the beta of
the portfolio, for he believes that the market would go down from the current level. How many index futures
he should buy/sell so that the beta is decreased to 0.80? One index future consists of 100 units.

A unit trust wants to hedge its portfolios of shares worth ₹10 million using the BSE-SENSEX index futures.
The contract size is 100 times the index. The index is currently quoted at 6,840. The beta of the portfolio is 0.8.
The beta of the index may be taken as 1. What is the number of contracts to be traded?
Class example: 72
X had taken a long position on ICICI bank stock for ₹100. Beta of ICICI Limited is 2. X is afraid of fall in
prices of stock of ICICI. He wants to hedge his position by using NIFTY future. If prices of ICICI stock fall 10
% on maturity then prove that X hedged himself.
Class example: 73
Ram holds a diversified equity portfolio of ₹ 150 Crores with beta 1.5. Shyam holds his entire money in stock
X of same value with a beta of 0.9. Both are planning to hedge their holdings using futures. The following
futures are available:
(i) Nifty Index Futures @ 4550 (Each lot = 50 units)
(ii) Futures of stock X @ 1520 (Each lot = 100 units)
How Ram & Shyam would perfectly hedge their portfolios using the above futures? Examine all possible
options and find the number of contracts required to hedge, gain or loss overall on hedging if it is expected that
markets would fall by 10% from the current level. Today spot Nifty is at 4500 and stock X is quoting at ₹
1500. [CWA – RTP – June,
2015]
Class example: 74
An investor buys the stocks of Hindustan Lever Ltd. (HLL) worth ₹ 20 lakh due to its very strong
fundamentals. However, the market in general is considered to remain weak for about the next three months.
The beta of HLL is 1.2 and the current value of NIFTY is 2250 and 3-m futures is selling at 2310. Answer the
following:
1. How can the investor hedge himself against the expected fall in the market?
2. Analyse his position (a) if the market falls by 10% in 3 months and HLL drops to ₹ 178 from ₹ 200 (b) if
the market registers a rise of 6% and HLL rises to ₹ 215 from ₹ 200.
3. Given the standard deviations of the market as 12% and HLL as 18%, what is the risk of unhedged
portfolio? [CWA – RTP June, 2013]
Class example: 75
Consider the following portfolio:
Equity 200 lakhs with a beta of 3
Bond 150 lakhs with a beta of 0.40
Cash 50 lakhs with a beta of 0
Index future price = 4,000
Lot size = 100
(i) Calculate beta of the entire portfolio.
(ii) How many NIFTY future contracts should be bought or sold for complete hedge.
(iii) If market falls by 5 %, prove that you are hedged.
QUESTIONS FOR FUTURES
Question: 29 [CMA – Study Material - 10]

Given the following information—
BSE index 50,000
Value of Portfolio ₹1,01,00,000
risk free interest rate 9% p.a.
Dividend Yield on Index 6% p.a.
Beta of Portfolio 2.0
We assume that a futures contract on the Bse index with 4 months maturity is used to hedge the value of
portfolio over next 3 months. One future contract is for delivery of 50 times the index. Based on the
information, Calculate — (a) Price of future contract, (b) The gain on short futures position if index turns out
to be 45,000 in 3 months.

For imports from UK, Philadelphia Ltd. of USA owes £ 6,50,000 to London Ltd. payable on May, 2010. It is
now 12 February, 2010.
The following future contracts (Contract size £ 62,500) are available on the Philadelphia exchange.
Expiry Current futures rate
March 1.4900 $ / DM 1
June 1.4960 $ / DM 1
(a) Illustrate how Philadelphia Ltd. can use future contracts to reduce the transaction risk, if on 20th May the
spot rate is 1.5030 $ / £ 1 and June futures are trading at 1.5120 $ / £ 1. The spot rate on 12th February is
1.4850 $ / £ 1.
(b) Calculate the ‘Hedge efficiency’ and comment on it.
Question: 31
XYZ is an export oriented business house based in Mumbai. The company invoices in customer’s currency. Its
receipt of US $ 1,00,000 is due on September 1, 2010.
Market information as at June 1, 2010:
Contract size: ₹4,72,000
On September 1, 2010 the spot rate US $ / ₹is 0.02133 and currency future rate is 0.02134. Comment which of
the following method would be most advantageous for XYZ Ltd.
(a) Using forward contract
(b) Using currency futures
(c) No hedging
Question: 32
Suppose that there is a future contract on a share presently trading at ₹1000. The life of future contract is 90
days and during this time the company will pay dividends of ₹7.50 in 30 days, ₹8.50 in 60 days and ₹9.00 in
90 days. Assuming that the Compounded Continuously Risk free Rate of Interest (CCRRI) is 12% p.a. you are
required to find out:
(a) Fair Value of the contract if no arbitrage opportunity exists.
(b) Value of Cost to Carry.
[Given e-0.01= 0.9905, e-0.02= 0.9802, e-0.03= 0.97045 and e0.03= 1.03045]
Question: 33
January 1, 2009 Mr. A wants to enroll for CFA course for which $ 1,100 is payable on 15th September, 2009.
The current spot rate 1 $ = ₹40.56. Use currency future for hedging. Lot size is $ 1,000. The price of currency
future on 1.1.09 is –
August 2009 – 1 $ = ₹40.20
September 2009 – 1 $ = ₹40.80
October 2009 – 1 $ = ₹40.90
Calculate hedge efficiency in the following situations.
Case: 1On 15th September 2009 prices are as under:
September future price: 1 $ = 45.30
(b) Calculate cost per$ for Mr. A
Case: 2 On 15th September 2009 prices are as under:
September future price: 1$ = ₹37.25
Question: 34
ABC Technologic is expecting to receive a sum of US $ 4,00,000 after 3 months. The company decided to go
for future contract to hedge against the risk. The standard size of future contract available in the market is $
1000. As on date spot and future $ contract are quoting at ₹44.00 and ₹45.00 respectively. Suppose after 3
months the company closes out its position futures are quoting at ₹44.50 and spot rate is also quoting at
₹44.50. you are required to calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.
Question: 35
Ram buys 10,000 shares of X Ltd. at ₹22 and obtains a complete hedge of shorting 400 Nifty at ₹1,100 each.
He closes out his position at the closing price of next day at which point the shares of X Ltd. has dropped 2 %
and the Nifty future has dropped 1.5 %. What is the overall profit / loss of this set of transaction?
Question: 36
The following information is related to stock of A Ltd. A Ltd. has a beta of 0.50 with Nifty. Each Nifty
contract is equal to 100 units. A Ltd. now quotes at ₹250 and the Nifty future is 4,000 index points. You are
long on 1,200 shares of A Ltd. in the spot market.
(i) How many future contracts will you have to take?
(ii) Suppose the price in the spot market drops by 10 %, how are you protected?

The settlement price of Sensex future contract on a particular day was ₹4,600. The initial margin was set at
₹10,000, while the maintenance margin was fixed at ₹8,000. The multiplier of each contract is 50. The
settlement prices on the following five days were as follows:
Calculate the mark to market cash flows and the daily closing balances in the accounts of -
(a) An investor who has gone long, and
(b) An investor who has gone short at 4600
Calculate net profit (loss) on each of the contracts.

On August 2, Mr. T buys 5 contracts of December Reliance futures at 840. Each contract covers 50 shares.
Initial margin was set at ₹2,400 per contract while maintenance margin was fixed at ₹2,000 per contract. Daily
settlement prices are as follows:
Mr. T meet all margin calls. Whenever he is allowed to withdraw money from the margin account, he
withdraws half the maximum amount allowed.
Compute for each day –
(i) Margin call
(ii) Profit / loss on the contract
(iii) The balance in the account at the end of the day.
Question: 39 [CMA – Study Material – 7 ]

The price of compact stock of a face value of ₹10 on 31st December, 2013 was ₹414 and the futures price on
the same stock on the same date i.e., 31st December, 2013 for march, 2014 was ₹444.
Other features of the contract and the related information are as follows:
• Time to expiration 3 months (0.25 year)
• Annual dividend on the stock of 30% payable before 31.3.2014.
• Borrowing Rate is 20 % p.a.
Based on the above information, calculate future price for compact stock on 31st December, 2013. Please also
explain whether any arbitrage opportunity exists.
Question: 40
A wheat trader has planned to sell 440000 kgs of wheat after 6 months from now. The spot price of wheat is ₹
19 per kg and 6 months future on same is trading at ₹ 18.50 per kg (Contract Size= 2000 kg). The price is
expected to fall to as low as ₹ 17.00 per kg 6 month hence. What trader can do to mitigate its risk of reduced
profit? If he decides to make use of future market what would be effective realized price for its sale when after
6 months is spot price is ₹ 17.50 per kg and future contract price for 6 months is ₹ 17.55.
Question: 41 [CMA – Study Material – 9 ]
The following data relates to DCB Ltd’s share prices:
It is possible to borrow money in the market for securities transactions at the rate of 12 % p.a. required—
(a) Calculate the theoretical minimum price of 6 month-futures contract.
(b) Explain if any arbitraging opportunities exist.
Question: 42 [CMA – Study Material (17)]

Which position on the index future gives a speculator, a complete hedge against the following transactions:
(a) The share of Yes Limited is going to rise. He has a long position on the cash market of ₹100 Lakhs on the
Yes Limited. The beta of the Yes Limited is 1.25.
(b) The share of No Limited is going to depreciate. He has a short position on the cash market of ₹50 lakhs on
the no limited. The beta of the no limited is 0.90.
(c) The share of Fair Limited is going to stagnant. He has a short position on the cash market of ₹40 lakhs of
the fair limited. the beta of the fair limited is 0.75.
Question: 43
A trader is having in its portfolio shares worth ₹85 lakhs at current price and cash ₹15 lakhs. The beta if share
portfolio is 1.60. After 3 months the price of shares dropped by 3.20 %. Determine –
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on ₹100 lakhs Nifty
futures.
Question: 44
Ram buys 10,000 shares of X Ltd. at a price of ₹22 per share whose beta value is 1.50 and sells 5,000 shares of
A Ltd. at a price of ₹40 per share having a beta value of 2. He obtains a complete hedge by Nifty futures at
₹1,000 each. He closes out his future position at the closing price of the next day when the share of X Ltd.
dropped by 2 %, share of A Ltd. appreciated by 3 % and Nifty futures dropped by 1.50 %. What is the overall
profit / loss to Ram?
Question: 45
A portfolio manager owns 3 stocks:
The spot Nifty index is at 1,350 and futures price is 1,352 to use index futures to (a) decrease the portfolio beta
to 0.80 and (b) Increase the portfolio beta to 1.50. Assume the index factor is ₹100. Find out the number of
contracts to be bought or sold of stock index futures.
Question: 46
A portfolio manager owns 3 stocks:
The spot Nifty Index is at 2700 and futures price is 2704. Use stock index futures to (a) decrease the portfolio
beta to 0.8 and (b) increase the portfolio beta to 1.5. Assume the index factor is ₹100. find out the number of
contracts to be bought or sold of stock index futures.
Question: 47
A company is long on 10 MT of copper @ ₹474 per Kg. (Spot) and intends to remain so for the ensuing
quarter. The standard deviation of changes of its spot and future prices are 4 % and 6 % respectively, having
correlation coefficient of 0.75. What is its hedge ratio? What is the amount of the copper future it should short
to achieve a perfect hedge?
Question: 48 [CMA – SM - 11]

Fashion ltd. manufactures cruiser bikes for export to americana and europe. It requires a special type alloy
called“fecal”, made up of iron, aluminum and copper. fecal is sold at ₹230 per kg in the spot market. if fashion
ltd. has a requirement of 6 tonnes in 6 months time, and the 6-Months Future Contract rate is ₹2.42 lakhs per
tonne. carrying cost is 5% p.a. if the interest rate is 10%, should the company opt for futures contract?
Case A: If the Company does opt for Futures Contract for buying 6 Tonnes of Fecal, what will be the effect if
—
(a) Spot Rate at the end of 6 months is ₹2,55,000 per tonne?
(b) Spot Rate at the end of 6 months is ₹2,35,000 per tonne?
Has the company gained or lost? if the company has lost, is it proper to conclude that futures contract has
failed to save the company from loss, and therefore need not be resorted to?
Case B: What will be the course of action and effect of such action in the above two cases, if —
(a) There is no Futures Market for Fecal;
(b) Hedge ratio for Fecal with the Metal Index is 0.9 i.e. Beta of Fecal with Metal Index is 0.90 (i.e. beta for
change in values)
(c) Each Metal Index contract is equivalent to 500 Kgs of Fecal.
(d) 6-Months’ Metal Index Future is 4800 points. [Assume futures contract are divisible]
if in case a, fashion ltd. wants to cash in on an arbitrage opportunity, what should it do?

Emilee trading company has a beta of 0.80 with Bse 200. Each Bse 200 futures contract is worth 100 units.
Ranbiranticipates a bearish market for the next three months and has gone short on shares of 25,000 shares of
etc in the spot market. etc shares are traded at ₹100.3-Months’ Future BSE 200 is quoted at 12,500.
Required —
1. No. of BSE 200 Futures Contract to be taken by Ranbir if he wants to hedge price risk to the extent of — (a)
60%, (b) 100%, (c) 125%.
2. if price of etc falls or increases by 20% in the spot market, how is ranbir protected in the above three cases?
3. if price of etc falls by 30% in the spot market and Bse 200 is quoted at 12,000 on the same day, what is
ranbir’sposition in Case 1(b) above? What is the inference drawn in this case with reference to cross hedging?

A unit trust wants to hedge its portfolios of shares worth ₹10 million using the BSE-SENSEX index futures.
The contract size is 100 times the index. The index is currently quoted at 6,840. The beta of the portfolio is 0.8.
The beta of the index may be taken as 1. What is the number of contracts to be traded?

Fill up the blanks in the following matrix —
S&P index is quoted at 4000 and the lot size is 100.
Question: 52 [CMA – Study Material]

Today is 24th March. A refinery needs 1,075 barrels of crude oil in the month of September. The current price
ofcrude oil is ₹3,000 per barrel. September futures contract at multi commodity exchange (MCX) is trading at
₹3,200. The firm expects the price to go up further and beyond ₹3,200 in September. It has the option of
buying the stock now. Alternatively it can hedge through futures contract.
(a) If the cost of capital, insurance, and storage is 15% per annum, examine if it is beneficial for the firm to buy
now?
(b) Instead, if the upper limit to buying price is ₹ 3,200 what strategy can the firm adopt?
(c) If the firm decides to hedge through futures, find out the effective price it would pay for crude oil if at the
time of lifting the hedge (i) the spot and futures price are ₹ 2,900 and ₹ 2,910 respectively, (ii) the spot and
futures price are ₹ 3,300 and ₹ 3,315 respectively.
Question: 53
Consider Ram, who is optimistic on price rise of RIL, purchasing one futures contract of RIL when futures
traded at₹1000. Anand being pessimistic believed RIL prices going forward would fall and hence he sold one
contract of RIL at the same futures price. Each contract entailed 100 shares of the underlying equity shares of
RIL. Initial margin of 10% was applicable for both Ram and Anand. Both had a facility of maintenance margin
of 8%. Rules force bothof them to withdraw 50% of the excess over initial margin. margin calls whenever
made are promptly paid by both. Assume next three days the prices of RIL were 980, 960, and 1015
respectively. Calculate closing balance of margin account.

The stock of A Limited (FV ₹10) quotes ₹920 to day on NSE and the 3 month future price quotes at ₹950. The
one month borrowing rate is given as 8 % and the expected annual dividend yield is 15 % per annum payable
before expiry. You are required to calculate the price of 3 month Alimited’s futures.
Question: 54 A [CMA – Study Material (12)]

Bharat Investments Ltd is long on 25,000 Shares of Trinayan Earthmoving Equipments Ltd (TEEL). Its shares
are currently quoted at ₹180 per share. Bharat fears fall in prices of TEEL. It therefore wants to hedge its risk
under the Futures Contract route. However, future rate is not available for TEEL. Therefore, Bharat is looking
for cross hedge and the following particulars are made available –
Related index Nifty Infrastructure Iron and steel Bank index
index index
Beta of TEEL with Related Index 0.80 1.1 1.3 1.0
Correlation of TEEL with Related 0.60 0.80 0.60 0.30
Index
No. of Units of TEEL underlying every 1,000 500 1,000 1,250
Futures Contract of Index
Bharat contemplating taking a cross hedge in either Iron and Steel Index, because it has the highest Beta value,
consequently requiring less no. of Futures Contract, or Bank Index as it has the perfect Beta Value.
Advise Bharat.
Question: 54 B [CMA – Dec. 2019]

A silver merchant requires in three months’ time, 3000 kg of silver for making silver articles during a wedding
season. He expects the price to increase. Silver sells at spot rate of ₹ 5,100 per kg. Each silver futures contract
(for 50 kg), expiring in three months sells at ₹ 5,200 per kg. The merchant wants to hedge half his requirement
through futures and leave the remaining half uncovered. Explain his position and the gains/losses in the spot
and futures market, the number of futures to trade in, the effective price per kg for his entire requirement if
after 3 months,
(i) Spot rate is ₹ 5,250/kg and futures is at ₹ 5,400 per kg.
(ii) Spot rate is ₹ 5,000/kg and futures is at ₹ 4,900 per kg.
Question: 54 C [CMA – Dec. 2019]

The spot price of a share of Bevel Ltd. is ₹ 356 with a face value of ₹ 10 per share. The 3
months’ futures contract is ₹ 386 per share. Other features of the contract and the related information are as
follows:
(i) Time to expiration of the contract is 3 months
(ii) Annual dividend of the stock of 30% is payable after 3 months
(iii) Borrowing rate is 20% p.a. continuously compounded.
Based on the above information, as an investor, you are required to calculate the theoretical forward price for
Bevel share. Also explain whether any arbitrage opportunity exists or not.
Question: 54 D [CMA – Dec. 2017]

An Oil Company needs 1000 barrels of crude oil after six months. The current price per barrel of crude oil is ₹
3,300. It is expected that after 6 months, the price per barrel of crude oil is likely to touch ₹ 3,700. The
company wants to hedge against the rising price for its requirement after 6 months. The 6 months futures
contract price is now traded ₹ 3,500 per barrel. The size of a futures contract is 100 barrels.
(i) If the cost of capital, insurance and storage is 15% p.a., examine whether it is beneficial for the oil company
to buy now.
(ii) If the upper limit to buying price is ₹ 3,500, what strategy can the firm adopt?
(iii) If the company decided to hedge through futures, find out the effective price it would pay for crude oil if
at the time of lifting the hedge the spot and future prices are: Spot price- ₹ 3,420; Futures ₹ 3,600.
Question: 54 E [CMA – Dec. 2017]

A sugar mill M expects to produce 300 MT (1MT = 1000 kg) of sugar in 3 months' time. The current price of
sugar is ₹42 per kg. Three months' futures contract is trading at ₹45 per kg. The lot size is 10 MT. A chocolate
factory F, wants to purchase 300 MT of sugar in three month's time. M wants a cover of 50% while F wants a
100% cover on commodity futures.
(i) Identify the parties in the long and short position in the spot and futures market.
(ii) Identify the respective outflows and inflows for both these parties, if after three months, the price increases
to ₹46 or drops to ₹40 per kg.
Question: 54 F [CMA – Dec. 2017]

Shares of E Ltd. are being quoted at ₹600. Three months' futures contract rate is ₹636 per share with a lot size
of 500 shares. If the company does not expect to distribute any dividend in the interim period and the risk free
return is 9% p.a. continuously compounded, what is the recommended action for a trader in shares in the spot
and futures market? Substantiate your conclusion with logical steps and compute the gains, if any, due to
futures. What would be the answers if the three months' futures contract rate is ₹600?
Question: 54 G [CMA – June, 2017]

CNX Nifty is currently quoting at 9100. Each lot is 75. An investor purchases a May Futures contract at 9200.
He has been asked to pay 5% margin. What amount of initial margin is he required to deposit? To what level
NIFTY futures should in increase to get a gain of 4%?
Question: 54 H [CMA – June, 2017]

An investment management company wants to hedge its portfolios of shares worth ₹15 crore using NSE-
NIFTY index futures. The contract size is 100. The index is currently quoted at 9120. The beta of the portfolio
is 0.8. The beta of the index may be taken as 1. How many contacts to be traded by the investor?
Question: 54 I [CMA – Dec. 2016]

A petrochemical plant needs to process 32000 barrels in three months' time. The spot price per barrel is ₹
8,775. A futures contract expiring three months from now is selling for ₹9,800 per barrel.
Assume that the size of one futures contract is 100 barrels. The plant wants to hedge through futures.
Answer the following questions:

(i) What would its position be in the futures market?
(ii) How should the plant hedge itself against a price change after three months?
(iii) How many futures should be transacted and in what manner?
(iv) Explain and arrive at the effective price per barrel under the hedging strategy that would be paid by the
plant if after 3 months, the price per barrel
- declines to ₹ 7,900
- increases to ₹ 10,600
Question: 54 J [CMA – Dec. 2016]

The following data relate to JB Ltd's share price:
Current Price: ₹ 3,000 per share
6 months' future price = ₹ 3,500 per share
It is possible to borrow money in the market for transactions in securities at 12% p.a. Consider continuous
compounding of interest. Assume that no dividend was paid in the intervening period.
You are required to calculate the theoretical minimum price of a 6 months' forward purchase and explain the
possible arbitrage opportunity.
Question: 54 K [CMA – Dec. 2015]

The current price (in Dec 2015) of sugar is ₹40 per kg. Sugar Mill SM expects to produce 200 MT of sugar in
February 2016. February futures contract due on 20th February is trading at ₹ 45 per kg. SM wants to hedge
itself against a price decline to below ₹45 kg in February. 100% cover is required and each contract is for 10
MT.
(i) Explain SM’s appropriate hedging measure showing cash flows for full value if the price falls to ₹42 per kg
in February 2016.
(ii) What is the position of SM in the futures and in the spot market?
(1 MT = 1000 kg.)
TOPIC – OPTIONS
(1) INTRODUCTION – In this type of derivative instrument only one party will have right and the other
party will have only obligation. The party which buys the right is called option buyer and pays compensation
at the inception of the contract to the option seller (also called option writer). The compensation paid by the
option buyer is called option premium.
(3) IMPORTANT TERMS FOR OPTION CONTRACTS –

 Option buyer – The one who buys the right and pay premium.
 Option seller – The one who sells the right, take obligation and receive premium.
 Option price / Premium – It is a compensation payable by buyer option to seller of option at the time of
buying the option.
 Strike price / Exercise price – This is the price at which underlying can be bought or sold by the option buyer
in case of call or put respectively.
Notes:
(1) Intrinsic value can have either positive or zero value. It cannot be negative.
(2) Time value will always be positive except on the last day (where it will be zero). Time value cannot be
negative.
(3) Theoretically time value should be maximum at inception of the contract and it should decline gradually
over the life of the contract.
(6) CALCULATION OF PAY – OFF AND PROFIT –

 Pay – off of an option refers to the cash flow on maturity.
 Profit on the other hand refers to the entire calculation of gain or loss based on pay – off and initial premium
paid or received.

SundarRamalingam had entered into 5 Put Options and 5 Call Options in different securities, the particulars of
which are given below, along with their exercise price and actual market price on the date of exercise —
What is his position on the date of exercise and what would he do?

Stock of Swarup Air Cargo Ltd is currently quoted at ₹112. Ascertain the Time Value and Intrinsic Value of
Option from the following particulars available in relation to derivatives market —

Determine the value of option , both call and put, on expiry for the stock of NirmalSpice Foods (NSF) Ltd.
from the following information-
• Exercise Price - ₹510
• Spot Price on Exercise Date Ranges between ₹495 and ₹525, with interval of ₹5.
Also state what will be the action on the above range of prices for both the options.
Following are the steps for currency hedging:

Step: 1 Identify underlying currency and priced currency
 The currency in which contract size is given is considered as underlying currency.

 If lot size is not given, then underlying currency cannot be identified then identify price currency and another
currency will automatically consider as underlying.
 Price currency is the currency in which option price / premium is given.
Step: 2 Calculate number of contracts to be taken for hedging purpose
Number of contracts = 𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒
Note:
 Exposure amount and contract size must be in same currency.
 Number of contract must be rounded off.
 If number of contracts are in fraction then for the fractional part (converted in exposure amount) must be
covered if question is silent.
Step: 3 Decide option to be taken i.e. call option or put option
 Option to be taken must be decided as per the underlying currency.
Class example:79
(i) Calculate theoretical minimum price of a European call option expiring after one year.
(ii) If price of the call option is ₹30, then how can an arbitrageur make profit.
Class example: 80
Given the following data:
(i) Calculate the theoretical minimum price of a European put option.

(ii) If European put option price is ₹10, then how can an arbitrageur make profit.

(a) Calculate the theoretical minimum price of a European put option after 6 months.
(b) if European put option price is ₹5 , then how can an arbitrageur make profit.

Kiran, who trades in shares in the spot market, follows the rule “When prices are rising — Buy; When prices
are falling — Sell”. She ensures that her portfolio is intact at the end of every three months, even if she buys or
sells in between.
She is a first timer to the options market and wishes to apply the above rule in the options market, where she
understands that buy equates to call option and sell equals put option. For a three-month horizon, the following
information is available for 5 securities (of which Kiran holds sufficient quantities):-
If the expectations translates into actual, and Kiran follows her spot market rule in options market as well, how
much she would have earned in the options market? You may assume that she will deal only in 100 units of
scrip at a time and exercises her option, come what may.
What would have been the position if she had opted for options, not based on spot market rules, but based on
option market rules i.e. Exercise Price > Expected Price = Put Option; Expected Price > Exercise Price = Call
Option?
What is the lesson to be learnt? Ignore transaction costs, time value of money and cost of options.

CMC Ltd. shares are presently quoted at ₹100.3-Month’s call option carries a premium of ₹15 for a strike
price of ₹120, and 3-Month’s put option carries a premium of ₹20 for a strike price of ₹120.
If the spot price on the expiry date is in the range of ₹90 to ₹160, with intervals of ₹5, prepare Net Pay-Off
Graph for both Call Option and Put Option, from both the buyer’s perspective and the option writer’s
perspective.

Fill up the blanks in the following “Break Even Price” table ──

Fill up the blanks in the following table —
(10) OPTIONS PRICING METHODS/ VALUATION OF OPTIONS

METHOD: 1 RISK – NEUTRAL METHOD:
When there are two expected price of share at expiration date:
 One price is more than exercise price and the second price is less than exercise price.
(a) Calculate the probability of high price of shares at expiration date as:
The probability of low price of share = 1 – Probability of high price

OR
Calculation of probability of high price of shares at expiration date, if interest rate is continuously
compounded:
Spot price * ert– Low price / High price – Low price
The probability of low price of share = 1 – probability of high price
(b) Find expiration date value of option = Sum of (value of option * Probability)
(c) Find the current value as:
Note: The above method of finding probability of high price is known as risk neutral method.
METHOD: 3 BINOMIAL PRICING MODEL/ BINOMIAL TREE METHOD FOR CALCULATING

OPTION PRICE
 In a risk free world the expected return is equal to risk – free return.
 Risk neutral probability is required for this approach. The probability is called risk neutral because it remains
same trial after trial. This means every period will have similar probability for upward and downward.
 Each period μ (% of upward movement) and d (% of downward movement) will be the same.
Class example: 86
The current market price of an equity share of Penchant Ltd is ₹420. Within a period of 3 months, the
maximum and minimum price of it is expected to be ₹ 500 and ₹ 400 respectively. If the risk free rate of
interest be 8% p.a., what should be the value of a 3 months Call option under the “Risk Neutral” method at the
strike rate of ₹ 450? Given e0.02 = 1.0202.
Class example: 87
A share price is currently priced ₹40. It is known that at the end of one month it will be either ₹36 or ₹46. The
risk – free interest rate is 12 % per annum continuous compounding. Find the value of a one month European
call option with a strike price of ₹39 with the help of risk neutralization model.
Class example: 88
A share price is currently ₹50. It is known that at the end of four month it will be either ₹38 or ₹42. The risk –
free interest rate is 8 % per annum continuous compounding. Find the value of a four – month European call
option with a strike price of ₹58 with the help of risk neutralization method?
METHOD: 3 BINOMIAL PRICING MODEL/ BINOMIAL TREE METHOD FOR CALCULATING

OPTION PRICE
 In a risk free world the expected return is equal to risk – free return.
 Risk neutral probability is required for this approach. The probability is called risk neutral because it remains
same trial after trial. This means every period will have similar probability for upward and downward.
 Each period μ (% of upward movement) and d (% of downward movement) will be the same.
Class example 89 [CMA – Study Material - 34]

Stock of Kamla Woodwork is currently quoted at ₹110. In three months time it could either be ₹90 or ₹135.
Ascertain the value of Call Option with an exercise price of ₹120 if the risk free rate of return is 8%.

Nirmal Hydric Ltd. (NHL) is a newly listed Company. Its listing price today is ₹200. Though the industry
offers much potential, there are no proven past track records.
Analysts expect the price of NHL to either to rise by 40% every half year or fall by 20% every half year (on
the half yearly opening price), for the next one year, weightage being 40% for every increase and 60% for
every fall. If an One Year option carries a Exercise Price of ₹260, you required to compute the following under
Binomial Model — (1) Risk Free Rate of Return, (2) Value of Call (Future Value and Present Value), (3)
Value of Put (Future Value &Present Value)

A share price is currently priced ₹40, it is known that at end of one month, it will be either ₹38 or ₹ 42, the
risk free interest rate is 8% per annum with continuous compounding. Find the value of a one - month
European call option with a strike price of ₹39.5 with the help of Binomial and Risk Neutralization Model?
Class example: 92
A stock is currently selling for ₹50. The stock price could go up by 10 % or fall by 5 % each month. The risk
free rate of interest is 12 % p.a. Calculate the price of European call option on the stock with an exercise price
of ₹50 and a maturity of 2 months.
Solution:
Class example: 93
A stock is currently selling for ₹50. One month from today stock price could go up by 10 % or fall by 50 %. If
the risk – free interest rate is 12 % p.a., calculate the price of a European call option on the stock with an
exercise price of ₹48 and a maturity of one month.
Solution:
Class example: 94
A stock is currently selling for ₹50. The stock price could go up by 10 % or fall by 5 % each month. Risk –
free interest rate is 12 % per annum. Calculate the price of a European put option on the stock with an exercise
price of ₹55 and a maturity of two months.
Solution:
Class example: 95
A stock is currently selling for ₹50. The stock price could go up by 10 % or fall by 5 % each month. The risk –
free interest rate is 12 % per annum. Calculate the price of an American put option on the stock with an
exercise price of ₹55 and a maturity of 2 months.
Solution:
PERFECTLY HEDGED SITUATION THROUGH BINOMIAL METHOD: (OPTION DELTA

METHOD)
(i) Binomial method offers perfectly hedged situation for option writer. It is important to note that no other
method offers perfectly hedged situation. An option writer (Seller of the option) has written a call and receive
premium. At expiration date, if the market price goes up then he has to pay value of option to buyer of call. It
creates risk on his part.
(ii) To avoid this risk he may buy certain number of shares from the market. It is calculated through hedge
ratio.
Difference in option price at high or low value of a share
Hedge ratio =
Difference in share price
He will get the number of shares to be purchased to eliminate the risk.

(iii) The expiration date value of hedged position is calculated for high – low price of shares.
Value of hedge = Value of number of shares held – Value of call (payable to buyer of call)
(iv) It is assumed that own fund invested to buy shares along with risk – free rate of interest is equal to value of
hedge at expiration date.
Value of hedge
Own fund invested =
(1  r )
(v) Purchase cost of share = Own fund invested + value of option (Premium initially recovered from buyer of
option)
And hence, we can then calculate value of option at start.
Following steps should be applied under this situation:

Step: 1 Calculate value of option at expiration date at high price as well as low price of share.
Step: 2 Calculate hedge ratio as under to identify number of shares purchased for perfect hedging
Difference in option price at high or low value of a share
Hedge ratio =
Difference in share price
Step: 3 Calculate hedge position at the expiration date by comparing value of shares and value of options.
Step: 4 Calculate own fund invested which should be equal to present value of hedge position at expiration
date.
Step: 5 Calculate value of option at the time of writing of call by satisfying following equation:
Purchase cost of shares at current price = Own fund invested + value of option

Ascertain the value of Options expiring one year later, for the following securities —
1. ABC Ltd (ABCL) is quoted at ₹110. At the end of 3 Months, the stock price will either be ₹100 or ₹150.
Exercise price is ₹120.
2. 3-Month Options on MN Ltd (MNL) carry an exercise price of ₹350. Stock Price is expected to be ₹250 or
₹450. Presently the shares are traded for ₹380
Risk Free Rate may be assumed at 12% for continuous discounting.

soumo has ₹3,00,000 to invest in the Capital Market. He considers stock of Kraft Components Ltd, an auto
mobile industry anciliary unit, to be a safe bet. KCL is currently traded at ₹200. Industry analysts say opine
that KCL will either remain at ₹190 or go upto₹250 in 6-Months time, considering the performance of the
industry. Soumo views this as an opportunity and has decided to invest ₹3,00,000 to buy shares of KCL and
earn a maximum of upto 25%, which is more than the risk free rate.
His actuarial friend, Rakesh, also has ₹3,00,000 to invest. However, he considers Soumo’s proposition to be
bit risky, Having some knowledge on options, Rakesh intends to buy calls and invest at Risk Free Rate of 12%.
6-Months option carries an Exercise Price of ₹220.
What should be the price of the call, for Rakesh ‘s proposition to yield the same result 6-months later (i.e. a
minimum net wealth of ₹3,00,000)? How many calls should Rakesh buy?
Who would be better off at the end of 6-Months, if the actual spot price is ₹180, ₹250 and ₹300?
Class example: 98
Suppose A’s stock price is currently ₹25. In the next 6 months it will either fall to ₹15 or rise to ₹40. What is
the current value of a six – month call option with an exercise price of ₹20. The risk – free interest rate is 10 %
per annum.

Shoaib is furnished with the following information about securities of two Companies — Manju Ltd and Sanju
Ltd.
1. Manju Ltd: Call option is traded at ₹85 for an exercise price of ₹700. Presently stock of Manju Ltd is traded
for ₹650. Put options is available for ₹110.
2. Sanju Ltd: Put option is traded at ₹40 at an exercise price of ₹200. Presently stock of Sanju are traded at
₹180.call options are available for ₹20.
If Shoaib has sufficient money and also holds stock in both these companies, wants to make only ascertained
profit and no loss, advice him on the course of action and the resultant gain / loss.
Risk Free Interest rate may be assumed at 10% and expiry date for option is 3 Months away.
Class example: 100 [CMA – June, 2009]

The following quotes are available for 3 months options in respect of a share currently traded at ₹31.
Strike price ₹30.00
Call option ₹3.00
Put option ₹2.00
An investor devises a strategy of buying a call and selling the share and a put option.
(i) What is the profit / loss profile if it is given that the rate of interest is 10 % per annum?
(ii) What would the position if the strategy adopted is selling a call option and buying the share and a put
option? [Given PVIF (10 % 0.25 years) = 0.9756]
Class example: 101 [CMA – Study material (31)]

Ascertain the value of Call Options expiring one year later, of four securities from the following information—
Stock Current spot price Exercise price Expected price one year later
X Limited 1,020 1.050 1,100
Y Limited 200 180 220
Z Limited 500 510 535
D Limited 80 80 90
Risk Free Rate may be assumed at 10% for continuous discounting. Also show in case of Security Z, how
choosing the Stock Route and Option Route with Risk Free Investment will have the same wealth for an
investor at the end of the year for the same cash outgo.

Fund Managers anticipate a big move in the stock of Bikram Ltd. Anup of ABC Fund believes such change to
be upwards, while Shyam of Premier Fund holds the opposite view. From the following information made
available of Bikram Ltd, explain what action will Anup and Shyam take and why?
Exercise price Premium for call option Premium for put option
₹100 ₹15 ₹10
METHOD: 4 BLACK – SCHOLES MODEL OF OPTION PRICING

Assumptions of Black – Scholes Model of option pricing:
– free interest rate must be continuous compounded rate which is known and constant.
volatility of the stock (σ) is known and constant.
i.e. Log es = Ln
Formula for European call option: Ce = S.N(d1) – X.e-rt N (d2)
S = Spot price of the underlying
X = Strike price of the underlying
X.e-rt = Present value of strike price
r = Risk free interest rate on per annum basis

t = Time period of option (Option life). Option life should always be expressed on per annum basis.
Steps for BSOPM

Step: 1 Calculate value of d1 and d2 as under:
d1 = [Ln (S/x)+(r+σ2/2)/T]/σ√T
d2 = d1 - σ√T
Step: 2 Now calculate N (d1) and N (d2)
N (d1) and N (d2) represent cumulative standard normal distribution table.
Step: 3 Plug values in BSOPM.
Class example: 103 [CMA – Dec. 2005]

Quickset company’s equity shares are currently selling at a price of ₹400 each. An investor is interested in
purchasing Quickset’s shares. The investor expects that there is a 70 % chance that the price will go up to ₹550
or a 30 % chance that it will go down to ₹350, three months from now. There is a call option on the shares of
Quickset that can be exercised only at three months at an exercise price of ₹450.
(i) If the investor wants a perfect hedge, what combination of the share and option should be selected?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price.
(iii) If the risk – free rate of return is 5 % for 3 months (periodic rate), what is the value of the option at the
beginning of the period?
(iv) What is the expected return on the option?
Class example: 104 [CMA – Dec. 2007]

The equity shares of ENDALOCO Limited are currently selling at a price of ₹500 each. An investor is
interested in purchasing the shares of Endaloco Limited. The investor expects that there is 80 % chance that the
price will go up to ₹650 or a 20 % chance that it will go down to ₹450, three months from now. There is a call
option on the shares of Endaloco Limited that can be exercised only at the end of three months at an exercise
price of ₹550. The risk –free rate is 12 % per annum.
(i) If the investor wants a perfect hedge, what combination of the share and option should he select?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price?
(iii) How much the investor should pay for buying this call option today?
(iv) What is the expected return on the option?
Class example: 105

Mr. Dayal is interested in purchasing equity shares of ABC Limited which are currently selling at ₹600 each.
He expects that price of share may go up to ₹780 or may go down to ₹480 in three months. The chances of
occurring such variation are 60 % and 40 % respectively. A call option on the shares of ABC Limited can be
exercised at the end of three months with a strike price of ₹630.
(i) What combination of shares and options should Mr. Dayal select if he wants a perfect hedge?
(ii) What should be the value of option today (the risk free rate is 10 % p.a.)?
(iii) What is the expected return on the option?

What is the price of a European put option on a non-dividend-paying stock when the stock price is ₹69, the
strike price is ₹ 70, the risk-free interest rate is 5% per annum, the volatility is 35% per annum, and the time to
maturity is six months?

Consider a European call option on a stock when there are ex-dividend dates in two months and five months.
The dividend on each ex-dividend date is expected to be ₹0.50. The current share price is ₹40, the exercise
price is ₹40, the stock price volatility is 30% per annum, the risk-free rate of interest is 9% per annum, and the
time to maturity is six months. Find out the European call price.

Calculate the price of a three-month European put option on a non-dividend-paying stock with a strike price of
₹ 50 when the current stock price is ₹ 50, the risk-free interest rate is 10% per annum, and the volatility is 30%
per annum.

What difference does it make to your calculations in class example 108 if a dividend of ₹ 1.50 is expected in
two months?

On 19th July following are the spot rates - Spot USD / EUR 1.20000 and INR / USD 44.8000. Following are
the quotes of European Options;
Currency Pair Call / Put Strike price Premium Expiry date
USD / EUR Call 12,000 ₹0.035 Oct. 19
USD / EUR Put 12,000 ₹0.04 Oct. 19
INR / USD Call 4,48,000 ₹0.12 Dec. 19
INR / USD Put 4,48,000 ₹ 0.04 Dec. 19
(a) A Trader sells an At-The-Money Spot Straddle expiring at three months (Oct. 19). Calculate the gain or
loss if three months later the spot rate is USD / EUR 1.2900.
(b) Which strategy gives a profit to the dealer if five months later (Dec. 19) expected spot rate is INR / USD
45.00. Also calculate profit for a transaction of USD 1.40 Millions.
PUT – CALL PARITY THEORY – Put – call parity define relationship between the price of an European
call option and price of an European put option, when they have same strike price and maturity date.
The relationship between put option and call option can be expressed as under:
Value of call + Present value of exercise price = Value of put + Current stock price

A put and a call option each have an expiration date 6 months hence and an exercise price of ₹9. The interest
rate for the 6 month period is 3 per cent.
(a) If the put has a market price of ₹2 and share is worth ₹10 per share, what is the value of the call?
(b) If the put has a market price of ₹1 and the call ₹4, what is the value of the share per share?
(c) If the call has a market value of ₹5 and market price of the share is ₹12 per share, what is the value of the
put?
Class example: 112 [CWA – RTP – Dec. 2013

The FERGUSON SYSTEMS was trading at ₹ 134 on April 3, 2009 and call option exercisable in three
months’ time had a strike price of ₹130.
The following are the other parameters of the option:
The annualized standard deviation in Ferguson Systems stock price over the previous year was 60%
The annualized Treasury Bill rate corresponding to this option life is 8%

Requirements:
(i) Compute the value of a three month CALL option on the stock of Ferguson system using Black and Scholes
model.
(ii) What would be the value of PUT?
(iii) If this CALL option is Priced at ₹15 what investment strategy would you adopt?
(iv) If this PUT option is available in the market at ₹14 what investment strategy would you adopt?
Note: Extracted from the tables:
(1) Natural logarithms: In (0.9701) = -0.0303
In (1.0308) = 0.0303
(2) Value of ex: e-0.02 = 0.9802, e-0.016 = 0.9841
(3) For N (X): where X ≥ 0: N (0.3177) = 0.6246
N (0.0177) = 0.5071
Where X ≤ 0: N (-0.3177) = 0.3754
N (-0.0177) = 0.4929

The spot Value of Nifty is 4430. An investor bought a one month Nifty 4410 call option for a premium of ₹
12. The option is:
(A) In the money
(B) At the money
(C) Out of the money
(D) Insufficient data

You are given the following information of a stock:
Strike Price ₹ 400
Current stock price ₹ 370
Risk free rate of interest 5%
Theoretical minimum price of a European 6 months’ put option after six months is –
(A) ₹ 9.37 (B) ₹ 20.12 (C) ₹ 30.76 (D) ₹ 20.63

An investor had purchased a 4 month call option on the equity shares of N Ltd. of ₹ 10 of which the current
market price is ₹ 132 and the exercise price is ₹ 150. You expect the price to range between ₹ 120 to ₹ 190.
The expected share price of N Ltd. and related probability is given below:
You are required to compute the following:

(i) Expected share price at the end of 4 months
(ii) Value of call option at the end of 4 months, if the expected price prevails.
(iii) In case the option is held to its maturity, what will be the expected value of the call option?

M buys a call option contract for a premium of Rs. 200. The exercise price is RS. 25 and the current market
price of the share is Rs. 22. If the share price after three months reaches Rs. 30, what is the profit made by M
on exercising the option? A contract is for 100 shares. Ignore transaction charges.
(A) Rs. 200 (B) Rs. 300 (C) Rs. 100 (D) Rs. 600

Presently, a company’s share price is Rs. 120. After 6 months, the price will be either Rs. 150 with a
probability of 0.8 or Rs. 110 with a probability of 0.2. A call option exists with an exercise price of Rs. 130.
What will be the expected value of call option at maturity date?
(A) Rs. 20 (B) Rs. 16 (C) Rs. 12 (D) Rs. 10

A stock is currently selling at Rs. 270. The call option to buy the stock at Rs. 265 costs Rs. 12. What is the
Time Value of the option ?
(A) Rs. 5 (B) Rs. 17 (C) Rs. 7 (D) None of (A), (B) or (C)

An Indian exporter has sold handicaraft items to an American business house. The exporter will be receiving
US dollar 1 lakh in 90 days. Premium for a dollar put option with a strike price of Rs. 71.00 and a 90 days
settlement is Rs. 1. The exporter anticipates the spot rate after 90 days to be Rs. 69.50.
(i) Should the exporter hedge its account receivable in the options market ?
(ii) If the exporter is anticipating a spot rate to be Rs. 70.50 or Rs. 71.50 after 90 days, how would it affect the
exporter’s decision?
Question: 62
An investor is bullish about X Ltd. which trades in the spot market at ₹ 1,150. He buys two call option
contracts with three months (one contract is 100 shares) with a strike price of ₹ 1,195 at a premium of ₹ 35 per
share. Three months later, the share is selling at ₹ 1,240. Net profit/loss of the investor on the position will be
(A) ₹ 1,000 (B) ₹ 16,000 (C) ₹ 11,000 (D) ₹ 2,000
Question: 63
A share is currently priced at ₹ 600. It is known that at the end of one month, it will be either ₹ 570 or ₹ 630.
The risk-free interest rate is 8% per annum with continuouscompounding. Find the value of a one month
European call option with a strike price of ₹ 592 with the help of a Binomial Model. (Given that e0.007 =
1.00702)
Question: 64
You are required to present Columns I, IV and V after filling up the contents of columns IV And V.
EP=Exercise Price; CMP=Current Market Price
Question: 65
A call option at a strike price of ₹ 200 is selling at a premium of ₹ 24. At what shareprice on maturity will it
break-even for the buyer of the option?
(A) ₹ 200 (B) ₹ 176 (C) ₹ 224 (D) ₹ 248
Question: 66
The following information is given:
(i) Calculate the theoretical minimum price of the put option at the end of 6 months. Show the arbitrage
process step by step and find out the gain if
(ii) The price on the expiration day is ₹ 200
(iii) The price on the expiration day is 220.
Question: 67
An investor buys a call option contract for a premium of ₹ 150. The exercise price is ₹ 15 and the current
market price of the share is ₹ 12. If the share price after three months reaches ₹ 20, what is the profit made by
the option holder on exercising the option? Contract is for 100 shares. Ignore the transaction charges.
Question: 68 [CA – May, 2007]

XYZ Ltd. a US firm need British Pound (BP) 3,00,000 in 180 days. In this connection, the following
information is available:
Spot rate 1 BP = $ 2.00
180 days forward rate of BP as of today = $ 1.96
Interest:
A call option on BP that expires 180 days has an exercise price of $ 1.97 and a premium of $ 0.04. XYZ has
forecast spot rates 180 days hence as follows:
Which of the following strategies would be most preferable to XYZ.

(a) Forward (b) Money market hedge (c) option hedging (d) No hedging .
Question: 69
Best of Luck Ltd, London will have to make a payment of $3,64,897 in six month’s time. It is currently 1st
October. The company is considering the various choices it has in order to hedge its transaction exposure.
Exchange rates:
Spot rate $ 1.5617 – 1.5773
Six – month forward rate $ 1.5455- 1.5609
Money market rates:
Foreign currency option prices (1 unit is £12,500):

Exercise price Call option (March) Put option (March)
$1.70 $0.037 $0.096
Question: 70
Carlhams corporation Ltd. in UK will need to make a payment of $ 2,50,000 in six months time. It is currently
1st January. The company is considering various choices it has, in order to hedge its transaction exposure.
Following market information is available:
Foreign currency option prices:

Exercise price Call option (June) Put option (June)
$1.70 $0.037 $0.096
Contract size (1 unit is £ 12,500)
Evaluate the hedging alternatives with necessary calculations and decide which of the same is the most
attractive to Carlhams corporation Ltd.
Question: 71
An American firm is under obligation to pay interest of Can $ 10,10,000 and Can $ 7,05,000 on 31st July and
30th September respectively. The firm is risk averse and its policy is to hedge the risks involved in all foreign
currency transactions. The finance manager of the firm is thinking of hedging the risk considering two methods
i.e. fixed forward or option contracts.
Price for a Can $ / US $ option on a US stock exchange (Cents per Can $, payable on purchase of the option,
contract size Can $ 50,000) are as follows:
According to the suggestion of finance manager if options are to be used, one month option should be bought
at a strike price of 94 cents and three months option at a strike price of 95 cents and for the remainder
uncovered by the option the firm would bear the risk itself. For this, it would use forward rate as the best
estimate of spot. Transaction costs are ignored. Recommend, which of the above two methods would be
appropriate for the American firm to hedge its foreign exchange risk on the two interest payments.

Zenith Ltd. (ZL) places an order to buy machinery with an American company. As per the agreement Zenith
Ltd. will be paying $ 2,00,000 after 180 days. The company Zenith Ltd. consider to use (a) A forward hedge;
(b) A money market hedge; (c) An option hedge or (d) no hedge. The consultant of Zenith Ltd. collects and
develops the following data / information as desired by the company, which can be used to assess the
alternative approaches for hedging.
(i) Spot rate of dollar as of today is ₹47 / $.
(ii) 180 days forward rate of dollar as of today is ₹47.50 / $.
(iii) Interest rates are as follows:
Assume 360 days in a year

(iv) Future spot rate in 180 days as estimated by the consultant is ₹47.75 / $.
(v) A call option on the dollar, which expires in 180 days has an exercise price of ₹47/ $ and premium ₹0.52/
$.
(vi) A Put option on the dollar, which expires in 180 days has an exercise price of ₹47.50 and premium of
₹0.40/ $.
Required: Carry out a comparative analysis of various outcomes (rupee cost of import) / alternatives and
decide which of the alternative is the best for Zenith Ltd.

Fresno Corporation Ltd. a US company will need £ 2,00,000 in 180 days. It considers using (a) A forward; (b)
A money market hedge; (c) Option hedge or (d) No hedge. Its analysts develop the following information,
which can be used to assess the alternative approaches to hedging:
(i) Spot rate of pound as of today = $ 1.50.
(ii) 180 days forward rate of pound as of today = $ 1.47.
(iii) Interest rates are as follows:
Assume 360 days in a year.

(iv) A call option on pounds that expires in 180 days has an exercise price of $ 1.48 and a premium of $ 0.03.
(v) Fresno Corporation forecasted the future spot rate in 180 days as follows:
Evaluate each alternative with necessary calculation and give your recommendations. Ignore transaction cost
or taxes.
Question: 76
ABC Co. excepts to receive S$ 5,00,000 in one year. The existing spot rate of Singapore dollar is $ 0.60. The
one year forward rate of the Singapore dollar is $ 0.62. ABC created a probability distribution for the future
spot rate in one year as follows:
Assume that one year put options on Singapore dollars are available, with an exercise price of $ 0.63 and a
premium of $ 0.04 per unit. One year call option on Singapore dollars are available with an exercise price of
0.60 and a premium of $0.03 per unit. Assume the following money market rates are available:
Determine whether a forward hedge, money market hedge or a currency option hedge would be most
appropriate. Then compare the most appropriate hedge to an un – hedged strategy and decide whether ABC
should hedge its receivables position.
Questions: 77
Suppose that a 1-year cap has a cap rate of 8% and a notional amount of ₹ 100 crore. The frequency of
settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for the next
four quarters is as shown below.
You are required to compute payoff for each quarter.
Question: 78
Suppose that a 1 year floor has a floor rate of 4 % and a notional principal of ₹200 crore. The frequency of
settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for the next
four quarters is as shown below.
You are required to compute payoff for each quarter.
Question: 79 [CMA – Study Material - 37]

Trie market received rumor about XYZ Corporation’s tie - up with a multinational company. This has induced
themarket price to move up. If the rumor is false, the XYZ Corporation’s stock price will probably fall
dramatically. To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a strike price of ₹42 for ₹2 premium, and paid ₹1 per share premium for
a 3 months put with a strike price of ₹40.
(a) Determine the Investor’s position if the tie up offer bids the price of XYZ Corporation’s stock up to ₹44 in
3 months.
(b) Determine the Investor’s ending position, if the tie up programme fails and the price of the stocks falls to
₹35 in 3 months.
Question: 80 [CMA – Study Material - ]

A British airline company has decided to take a 3 – year floating rate loan of British $ 1,000 million to finance
its acquisition. The loan is indexed to 6 month British $ LIBOR with a spread of 75 basis points. The company
has identified the following caps and floors quoted by a bank.
You are required to show how the company can hedge its interest rate exposure by using an interest rate collar
strategy. Also calculate the effective cost of the loan showing all the relevant cash flow if the 6month US $
LIBOR at the 6 reset dates turn out to be 3.85 %, 4.10 %, 3.50 %, 3.30 %, 3.10 % and 3.00 %. Use a discount
rate of 4 % to amortize the premium.
Question: 81 [CMA – Study Material -27 ]

A put and a call option each have an expiration date 6 months hence and an exercise price of ₹10. The interest
rate for the 6 month period is 3 %.
(a) If the put has a market price of ₹2 and share is worth ₹9 per share, what is the value of the call?
(b) If the put has a market price of ₹1 and the call ₹4, what is the value of per share?
(c) If the call has a market value of ₹5 and market price of the share is ₹12 per share, what is the value of put?
Question: 82
You are given three call options on a stock at exercise price of ₹30, ₹35 and ₹40 with expiration date in three
months and the premium of ₹4, ₹2 and ₹1 respectively. Show how the option can be used to create a butterfly
spread. Construct a table with different market prices and show how profit changes with stock prices ranging
from ₹20 to ₹50 by taking interval of ₹2.
Question: 83
Mr. Khan established the following spread on the Delta Corporation’s stock:
(i) Purchased one 3-month call option with a premium of ₹20 and an exercise price of ₹550.
(ii) Purchased one 3-month put option with a premium of ₹10 and an exercise price of ₹450.
Delta Corporation’s stock is currently selling at ₹500. Determine profit or loss, if the price of Delta
Corporation’s:
(i) Remains at ₹500 after 3 months.
(ii) Falls at ₹350 after 3 months.
(iii) Rises to ₹600.
Assume the size option is 100 shares of Delta Corporation.
Question: 84
A call and put exist on the same stock each of which is exercisable at ₹60. They now trade for –
Market price of stock or stock index - ₹55
Market price of call - ₹9
Market price of put - ₹1
Calculate the separation date cash flow, investment value and net profit from –
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put
For expiration date stock prices of ₹50, ₹55, ₹60, ₹65 and ₹70.
Question: 85
The equity share of VCC Ltd. is quoted at ₹210. A – 3 month call option is available at a premium of ₹6 per
share and A – 3 month put option is available at a premium of ₹5 per share. Ascertain the net pay off to the
option holder of a call option and a put option given that –
(i) Strike price in both cases is ₹220 and
(ii) The share price on the exercise day is ₹200, ₹210, ₹220, ₹230 and ₹240.
Also indicate the price range at which the call option and the put options may be gainfully exercised.
Question: 86
Mr. A purchased collar from CIT a 3 year collar with:
A cap rate of 6 %
A floor rate of 4 %
Notional principal - ₹1,00,00,000
Reset date – Quarterly
3 months LIBOR rate as the reference
Collar would be structured on a zero cost basis.

(a) If 3 month LIBOR is 7 % on a reset date, then what will be the pay off from collar option?
(b) If 3 months LIBOR is 3 % on a reset date, then what will be the pay off from collar option?
Question: 87
Mr. A purchased a 3 month call option for 100 shares in XYZ Limited at a premium of ₹30 per share, with an
exercise price of ₹550. He also purchased a 3 month put option for 100 shares of the same company at a
premium of ₹5 per share with an exercise price of ₹450. The market price of the share on the date of Mr. A’s
purchase of option is ₹500. Calculate the profit and loss that Mr. A would make assuming that the market price
falls to ₹350 at the end of 3 months.
Question: 88
XYZ Ltd. borrows £ 20 million of 6 months LIBOR + 0.25 % for a period of two years. T, Treasury manager
of XYZ, anticipates a rise in LIBOR, hence proposed to buy a cap option from ABC Bank at strike rate of 7 %.
The lump sum premium is 1 % for the whole of the three reset period and the fixed rate of interest is 6 % p.a.
The actual position of LIBOR during the forthcoming reset period is as follows:
You are required to show how far interest rate risk is hedged through cap option.
Question: 89
The market received rumor about ABC Corporation’s tie-up with a multinational company. This has induced
the market price to move up. If the rumor is false, the ABC corporation stock price will probably fall
dramatically. To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of ₹42 for ₹2 premium, and paid ₹1 per share premium
for a 3 months put with a striking price of 40.
(i) Determine the investor’s position in the tie up offer bids the price of ABC Corporation’s stock up to ₹43 in
3 months.
(ii) Determine the Investor’s ending position, if the tie up programme fails and the price of the stock falls to
₹36 in 3 months.

D Investment Ltd. deals in equity derivatives. Their current portfolio comprises of the following instruments:
(i) Infosys ₹5,600 call expiry June 2004, 2000 units bought at ₹97 each.
(ii) Infosys ₹5,700 call expiry June 2004, 3600 units bought at ₹131 each.
(iii) Infosys ₹5,400 Put expiry June 2004, 4000 units bought at ₹81 each.
What will the profit or loss to D investment Ltd. in the following situations?
(a) Infosys closes on the expiry day at ₹6041.
(b) Infosys closes on the expiry day at ₹5812.
(c) Infosys closes on the expiry day at ₹5085.
Question: 91
Identify profit or loss in each of the following cases:
(i) A call option with an exercise price of ₹200 bought for a premium of ₹89. The price of underlying share is
₹276 at the expiry date.
(ii) A put option with exercise price of ₹250 is bought for a premium of ₹42. The price of underlying share is
₹189 at the expiry date.
(iii) A put option with an exercise price of ₹300 is written for a premium of ₹57. The price of the underlying
share is ₹314 at the expiry date.

Calculate profit or loss from the following transactions:
(i) Mr. X writes a call option to purchase share at an exercise price of ₹60 for a premium of ₹12 per share. The
share price rises to ₹62 by the time the option expires.
(ii) Mr. Y buys put option at an exercise price of ₹80 for a premium of ₹8.50 per share. The share price falls to
₹60 by the time the option expires.
(iii) Mr. Z writes a put option at an exercise price of ₹80 for a premium of ₹11 per share. The price of the
share rises to ₹96 by the time the option expires.
(iv) Mr. XY writes a put option with an exercise price of ₹70 for a premium of ₹8 per share. The price falls to
₹48 by the time the option expires.
Question: 93
Mr. A enters into following transaction in an option contract in derivative market to buy a call option. On 2nd
September, 2010, Mr. A buys 400 call options on BSE sensex September, 2010 which is expiring on 26th
September, 2010 at a strike price of ₹3,500. The premium is ₹10 per call payable to the seller Mr. B. If on the
contract expiry date, the prevailing sensex is ₹3,300, the what is the gain or loss to Mr.A from this contract.
Would your answer differ if on the contract expiry date, the prevailing sensex is ₹3,600.

Rax Investment Ltd. deals in equity derivatives. Their current portfolio comprises of the following investment:
(i) Infosys ₹1,400 call expire December 2010: 200 units bought at ₹50 each (cost)
(ii) Infosys ₹1,425 call expire December 2010: 3000 units bought at ₹33 each (cost)
(iii) Infosys ₹1,350 Put expire December 2010: 4000 units bought at ₹22 each (cost)
What will be the profit or loss to Rax Investment Ltd. in the following situation?
(i) Infosys closes on the expiry day at ₹1550.
(ii) Infosys closes on the expiry day at ₹1460.
(iii) Infosys closes on the expiry day at ₹1,280.

An investor purchased Reliance November Future (600 shares Tick size) at ₹542 and write a ₹580 November
call option at a premium of ₹6 (600 share tick size). As on November 20 spot price rises and so the future price
and call premium. Future price rises to ₹575 and call premium rises to ₹12. Find out profit / loss of the
investor, if he / she settle the transaction on that date and at stated prices. Brokerage is 0.05 % for the
transaction value of future and strike price net of call premium for option.
Question: 96
The market received runmour about ABC Corporation’s tie – up with a multinational company. This has
induced the market price to move up. If the runmour is false, the ABC Corporation stock price will probably
fall dramatically. To protect from this an investor has bought the call and put options. He purchased one 3
months call with a strike price of ₹48 for ₹2 premium, and paid ₹4 per share premium for a 3 months put with
a striking price of ₹52.
(i) Determine the investor’s position if the tie – up offer bids the price of ABC Corporation’s stock up to ₹56
in 3 months.
(ii) Determine the investor’s ending position, if the tie – up program fails and the price of the stock falls to ₹39
in 3 months.
Question: 97
The shares of Bangalore Corporation Limited are selling at ₹105 each. C wants to chip in with buying a three
months call option at a premium of ₹10 per option. The exercise price is ₹110. Five possible prices per share
on the expiration date ranging from ₹100 to ₹140, with intervals of ₹10 are taken into consideration by him.
What is C’s payoff as call option holder on expiration?

An investor purchased Reliance November futures (600 tick size) at ₹1,150 and write a ₹1,190 November call
option at a premium of ₹10 (600 shares tick size). As on November 25, spot price rises and so the future price
and the call premium. Future price rises to ₹1,180 and call premium rises to ₹16. Brokerage is 0.045 % for the
transaction value of futures and strike price net of call premium for option. Find out the profit / loss for the
investor, if he / she settle the transaction on that date and at stated prices.
Question: 99
XYZ, an Indian firm, will need to pay JAPANESE YEN (JY) 5,00,000 on 30th June. In order to hedge the risk
involved in foreign currency transaction, the firm is considering two alternative methods i.e. forward market
cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.9516/1.9711. 1.9726./1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate. You are required to
recommend cheaper hedging alternative for XYZ.

Shares of Haryana Industrial Equipments Ltd. are quoted at ₹ 1,200. 30 days call option on HIEL is available
with an Exercise price of ₹ 1,250 with a premium of ₹ 30. Compute Time Value and Intrinsic Value of the
premium.
Question: 101 [CMA – Study material (50)]

Amit Company has borrowed $200 million on floating basis for 3 years. The interest rates are reset every year.
The spread over LIBOR is 25 bps. The company buys a 3 year cap on a 1-year LIBOR with a strike rate of 9%
and having a face value of $200 million. The cap carries a premium of 2% of face value or $4 million. Current
1 year LIBOR is 9%. If the LIBOR at the end of 1, 2 and 3 years are 9.5%, 8.5% and 10%, what is the cash
flow from cap each year? Amortize premium equally over three years.

A fund manager Mr. Adittya deposited $200 million on floating basis for 3 years, which pay LIBOR + 50 bps.
The interest rates are reset every year. The company buys a 3 year floor on a 1-year LIBOR with a strike rate
of 8% and having a face value of $200 million. The floor carries a premium of 1.5% of face value or $3
million. Current 1 year LIBOR is 8.60%. If the LIBOR at the end of 1, 2 and 3 years are 7.5%, 9% and 7%,
what is the cash flow from floor each year? Amortize premium equally over three years.

DY has purchased ₹400 million cap (i.e., call options on interest rates) of 9 percent at a premium of 0.65
percent of face value. ₹400 million floor (i.e., put options on interest rates) of 4 percent is also available at
premium of 0.69 percent of face value.
(a) If interest rates rise to 10 percent, what is the amount received by DY? What are the net savings after
deducting the premium?
(b) If DY also purchases a floor, what are the net savings if interest rates rise to 11 percent? What are the net
savings if interest rates fall to 3 percent?
(c) If, instead, DY sells (writes) the floor, what are the net savings if interest rates rise to 11 percent? What if
they fall to 3 percent?
(d) What amount of floors should it sell in order to compensate for its purchases of caps, given the above
premiums?

Suppose Shampa just signed a purchase and sale agreement on a new home and you have six weeks to obtain
a mortgage. Interest rates have been falling, so fixed-rate loans are now very attractive. Shampa could lock in a
fixed rate of 7% (annual percentage rate) for 30 years. On the other hand, rates are falling, so Shampa is
thinking about a 30-year variable-rate loan, which is currently at 4.5% and which is tied to the six-month
Treasury bill rate. A final mortgage option is a variable-rate loan that begins at 5% and cannot fall below 3%
but that can increase by only as much as 2% per year up to a maximum of 11%.
(a) If you wanted to take advantage of a possible fall in rates but not assume the risk that rates would increase
dramatically, which financing plan would you choose?
(b) What is the interest rate cap in this example?
(c) What is the interest rate floor in this example?
(d) How is an interest rate cap like buying insurance? How is she paying for this insurance?

The equity shares of MNB Ltd. are being sold at ₹ 315. A 3-month call option is available for a premium of ₹
9 per share and a 3 month put option is available for a premium of ₹ 8 per share. Find out the net pay off of the
holder of the call option and put option given that:
(i) The strike price in both cases is ₹ 330 and
(ii) The share price on the exercise day is ₹ 300 or ₹ 315 or ₹ 345 or ₹ 360.

The equity share of VCC Ltd., is quoted at ₹ 210. A 3-month call option is available at a premium of ₹ 6 per
share and a 3-month put option is available at a premium of 5 per share.
Ascertain the net pay-offs to the option holder of a call option and a put option if
(i) The strike price in both cases is ₹ 220 and
(ii) The share price on the exercise days is ₹ 200, 210 220, 230 and 240. 8
[on the expiry day for what threshold values of share price will each option holder be in the money?]

An investor buys a call option contract for a premium of ₹ 150. The exercise price is ₹ 15 and the current
market price of the share is ₹ 12. If the share price after three months reaches ₹ 20, what is the profit made by
the option holder on exercising the option? Contract is for 100 shares. Ignore the transaction charges

The strike price and the current stock price of a European put option are ₹ 1,000 and ₹ 925 respectively.
Compute its theoretical minimum price after 6 months, if the risk-free rate of interest is 5% p.a

A share is currently priced at ₹600. It is known that at the end of one month, it will be either ₹570 or ₹630.
The risk-free interest rate is 8% per annum with continuous compounding. Find the value of a 1-month
European call option with a strike price of ₹ 592, with the help of a Binomial Model.

The following quotes are available for 3-months options in respect of a share of P Ltd. which is currently
traded at ₹ 310.
An investor devises a strategy of buying a call and selling the share and a put option.
Risk free interest rate is 10% per annum.

Using Put-call parity theory
(i) Find out profit/loss of the investor.
(ii) What would be the position if the strategy adopted is selling a call and buying the put and the share?
(e0.025 = 1. 0253; e0.25 = 1. 2840)

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ADHISH SIR CLASSES 1

CHAPTER – 3 – “INTERNATIONAL FINANCE”

CMA STUDY QUESTIONS IN CMA PAST EXAM

CMA WORK – BOOK

CMA PAST EXAM

33. VARIOUS EXPOSURES IN FOREX MARKET

LIST OF IMPORTANT CURRENCIES

Topic: 1 Introduction / Regulator of forex market in India

(2) Retail market

Topic: 3 Types of transactions under forex market

One way quote Two – way quote

Following steps will be applied for conversion:

(ii) Payment by firm = 2,00,000 ¥

(iii) Firm receive = 3,00,000 $

(iv) Payment by firm = 4,00,000 SGD

Given: 1$ = £0.50/0.51 1 Euro = £0.60/0.61

(ii) Payment of interest = 2,00,000 ¥

(iv) Payment by firm = 4,00,000 SGD

Topic: 6 Direct quote and Indirect quote

Class example: 7 Convert the direct quotes into indirect quotes:

Topic: 7 Bid rate, Ask rate and spread

Class example: 8 [CMA – June, 2013]

Topic: 8 Concept of exchange margin

Rule: 2 Add margin to selling rate to get desired exchange rate.

Inter – bank rate 59.20 59.40

Topic: 9 Concept of spot rate and forward rate

Method: 3 with the application of PPPT (Purchasing power parity theory)

Class example: 12The following quotes are available

Interest rate in US = 5 % p.a. or 1.25 % for 90 days

(b) Calculation of 6 – months forward rate:

Topic: 10 Forward premium or discount/ Appreciation or depreciation in currency

Calculation of Annualized forward premium / Discount on currency:

Forward rate−Spot rate 12

Spot rate−Forward rate 12

Note: A negative answer would imply annualized discount rate.

Hence, 1 $ = 1 / 0.0225 = ₹44.44

(b) Annualized forward premium on $ (Currency A)

Calculation of 6 – months forward rate (Currency A)

Topic: 11 Concept of cross rate

Class example: 24Following exchange rates are quoted by bank:

So, 108.0030 ¥ = 0.6263 €

Class example: 25Following exchange rates are quoted by bank:

Class example: 26Following exchange rates are quoted by bank:

(ii) Bank buy 1 $ and sell 1.2948 AUD

Class example: 27Following rates are quoted by bank:

Class example: 28You are given the following exchange rates:

(ii) Bank buy £ and sell $ at 1.9810

Class example: 32You are given the following information

arise in future in respect of payables or receivables.

Step: 2 Calculate gain / loss due to cancellation of contract

Step: 2 Calculate gain / loss due to cancellation of contract

Flow chart for extension of forward contract

Calculation of new forward rate:

Class example: 40 [CWA – Study Material(2012)]

14,80,000 $ @ 42.50 Due date of contract

Spot rate: 40.90 / 41.20

14,80,000 $ @ 42.50 1.7.2007 Due date of contract

Class example: 41 [CMA – Study material - 5]