CA Final Course Paper 2 Strategic Financial Management Chapter 12
CA. Rajiv Singh
1.1 Introduction Forex Market
1.2 Forex Market in India
1.3 Merchant Deal Structure
1.4 Inter bank Quote
1.5 Forex Quote convention
1.6 Types of Forex transaction
1.7 Calculating Merchant rate
1.8 Nostro, Vostro and Loro accounts
1.9 Forex Quote style
1.10 Cross rate
1.11 Forward rate
1.12 International finance theory
1.13 International Arbitrage
The largest and most liquid sector of Global Financial Market
Turnover average $ 4 trillion* per day 24 hour market [day begins with Tokyo, Singapore,
India, Bahrain, Frankfurt, Paris, London, New York, Sydney and back to Tokyo
Two tier market (Interbank & Merchant)
Two way quotes (Buy rate & Sell rate)
Duality-currency pairs (EUR/USD; USD/JPY)
• * April 2010 survey by bank for international settlement
Serves as primary mechanism for making payments across borders,
transferring fund’s & determining exchange rates.
In 89% of transactions USD is involved.
No specific location-most trade by Reuters dealing and SWIFT (society for
worldwide Interbank Financial Telecommunications)
Not uniform (e.g. restricted)
Country based regulation
Forex transactions can be undertaken only with Authorised dealers.
A foreign exchange rate is the price of one
currency expressed in terms of another currency.
A foreign exchange quote is a statement of
willingness to buy or sell at an announced rate.

TRANSACTION
TYPE
DOT
DOS
Cash / Ready
Today
Today
Today
Tomorrow (=DOT + 1
Business working
day)
Today
Day after tomorrow
(=DOT+ 2 Business
working day)
Today
Beyond day after
tomorrow (=DOT+
more than 2 business
working days)
TOM
SPOT
Forward
Spot rate USD/INR 62.4560 /61
What should be the merchant rate if bank wants
5 paise margin ?
An Indian banker wants to fund their Nostro account
with a USA correspondence bank by USD 5,00,000
against INR when interbank rate is 1 USD= INR
47.20/50. The deal is struck and overseas bank’s
vostro account that is being maintained with the
Indian bank will be credited by INR--------------
Ex 1 USD/ CAD 1.1034/35
USD/ SGD 1.4055 /56
Ex 2 GBP/ USD 1.4034/35
AUD/ USD 1.0560/61
Ex3 USD/INR 62.3560/61
GBP/USD 1.4034/35
A forward exchange rate prevails today for settlement at
a future date. It is calculated by adding or deducting
forward point or margin (interest differential) from
today’s spot rate.
Forward points or margin are quoted on month basis in
India and are available for 12 months at any point of
time.

Spot
Bid
Ask
Bid
Ask
Bid(%P
.A.)
Ask(%P
.A.)
05:32:00 PM
Spot Date :
Jun 08, 2011
Jun 10, 2011
Cash
Tom
30-Jun
29-Jul
31-Aug
30-Sep
31-Oct
30-Nov
31-Dec
31-Jan
29-Feb
30-Mar
30-Apr
31-May
1.2500
-0.0100
16.00
39.00
64.50
86.50
109.50
128.50
148.00
166.50
184.50
203.00
222.50
240.50
1.7500
-0.0100
18.00
41.00
66.50
88.50
111.00
130.50
150.00
168.50
186.50
205.00
224.50
242.50
44.6825
44.7001
44.8600
45.0900
45.3450
45.5650
45.7950
45.9850
46.1800
46.3650
46.5450
46.7300
46.9250
47.1050
44.6975
44.7101
44.8900
45.1200
45.3750
45.5950
45.8200
46.0150
46.2100
46.3950
46.5750
46.7600
46.9550
47.1350
---
---
---
6.53
6.50
6.42
6.31
6.25
6.07
5.95
5.79
5.71
5.64
5.59
5.52
---
---
---
7.35
6.83
6.62
6.45
6.34
6.16
6.03
5.85
5.77
5.69
5.64
5.56
44.700
0
44.710
0
44.700
0
44.710
0
On Jan 28,2005 an importer customer requested a bank to
remit Singapore Dollar (SGD) 25,00,000 under an irrevocable
LC. However due to bank strikes, the bank could effect the
remittances only on February4, 2005. The inter bank market
rates were as follows
Jan 28, 2005
Step I: 1 $ = 45.90 Rs
II: 1 £ = $ 1.7850
1 $ = 1/1.7850£
III: SGD with £ proceeds
3.1575/1.7850
Feb 4, 2005
1 $ = 45.97 Rs
1 £ = $ 1.7775
1 $ = 1/1.7775 £
SGD with £ proceeds
3.1380/1.7775
IV: 45.90 Rs = 3.1575/1.7850 45.97 Rs = 3.1380/1.7775 SGD
SGD
1 SGD
= 26.0394 Rs
1 SGD
= 25.9482 add: EM(.125%) = 0.0325
Rs
26.0719
add: EM(.125%) = 0.0324
25.9806
Loss to the importer
= (26.0719 – 25.9806) 25000000 = 228250
Your forex dealer had entered into a cross currency deal and had sold US $
10,00,000
against EURO at US $ 1 = EUR 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in
compliance with his management’s guidelines had to square – up the
position when the quotations were:
Spot US $ 1
INR 31.4300/4500
1 month margin
25/20
2 months margin
45/35
Spot US $ 1
EURO 1.4400/4450
1 month forward
1.4425/4490
2 months forward
1.4460/4530
What will be the gain or loss in the transaction?


Step I: Loss in € due to squaring up the existing sale
position
1$ = (1.4450 – 1.4400) x 10,00,000€ = 5000€

Step II: Cross rate for € against Rs on spot basis
Bid: 31.4300/1.4450
Ask: 31.4500/1.4400 = 21.8403

Step III: Loss in Rs = 21.8403 x 5000€ = Rs 109201.


You have following quotes from Bank A and Bank B:
(i)
How much minimum CHF amount you have to pay for 1Million GBP
spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the
Implied Swap points for Spot over 3 months?
Example
Using quotes of Both Bank ‘A’ and ‘B’
Step I: Buy USD from Bank ‘A’
1USD = 1.4655 CHF
Step II: Buy GBP from Bank ‘B’ 1GBP = 1.7650 USD
1GBP = 1.4655 x 1.7650 = 2.5866 CHF
Step I
3 m FR
USD / CHF
Bid
1.4650 + .0005
= 1.4655
GBP / USD
1.7645 - .0025
= 1.7620
Step II 3m Fwd Cross GBP / CHF
rate
Less: Spot cross GBP / CHF
rate
Swap Point
Ask
1.4655 + .0010
= 1.4665
1.7620 - .0020
= 1.7640
1.4655 x 1.7620
1.4665 x 1.7640
= 2.5822
2.5850
= 2.5869
2.5881
- .0028
28/12
- .0012
Example
You sold Hong Kong Dollar 1,00,00,000 value spot to your customer at ` 5.70 &
covered yourself in London market on the same day, when the exchange rate
were: US$ 1 = HK$ 7.5880 and 7.5920. Local inter bank market rates for US$
were
Spot US$ 1= INR 42.70 and 42.85. Calculate cover rate & ascertain the
profit and loss in the transaction. Ignore brokerage.
Step I: Find out Cross rate
HK $/ INR
42.70
(base) (quote)
7.5920
=
5.6243
42.85
7.5880
= 5.6471
Bank’s cover rate for merchant sale transaction is the market selling rate and
hence cover rate is 1 HK$ = INR 5.6471. The merchant rate is given 1 HK$ = INR
5.70.
Step II Total Profit to the bank = 100 lacs (5.70 – 5.6471) = Rs 5,29,000.
As per this theory real interest rate are same for each country . As a
result of this high interest rate is due to high inflation rate and vice
versa
This combines relative PPP and Fisher effects. As
per this theory if real interest rates are same then
interest differential should predict future spot rate
Example
The US Dollar is selling in India at ` 45.50. If the interest rate for a 6-month borrowing in India is 8% per
annum and the corresponding rate in USA is 2%
(i) Do you expect US dollar to be at a premium or at discount in the Indian Forward Market?
(ii) What is expected 6-month forward rate for US dollar in India; and (iii) What is the rate of forward
premium or discount?
(i)
USD is expected to be on premium as interest rate in USA
is low as compared to India. The currency with low interest
rate rate should go on premium in the forward market as per
IRP.
(ii) FR = 45.50 x (1.04 / 1.01) = Rs 46.85
46.85 – 45.50
12
(iii)
45.50
x
6
x 100
= 5.93%
Note that the rate of fwd premium should be approx 6%
(= rq – rb).
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 is ` 43.40. Find the expected rate of US $ in India after
one year and 3 years from now using purchasing power parity
theory.
expected spot rate after one year = 43.40 x (1.065/1.03) = 44.8748
(ii) expected spot rate after three years = 43.40 x (1.065 /1.03)3
= 47.9763.
On April 1, 3 months interest rate in the UK £ and US
$ are 6.5% and 4.5% per annum respectively. The
UK £/US $ spot rate is 0.6560. What would be the
forward rate for US $ for delivery on 30th June?
(1 + 6.5%/4)
FR = .6560 x
(1 + 4.5%/4)
= .6592
Given the following information:
Exchange rate-Canadian Dollar 0.666 per DM (Spot)
Canadian Dollar 0.671 per DM (3 months)
Interest rates-DM 8% p.a.
Canadian Dollar 10% p.a.
What operations would be carried out to earn the possible arbitrage gains?
step I Synthetic FR = .666 x [ 1+ (10%/4)]/ [ 1+ (8%/4)]=.669
Step II Since quoted FR is more than synthetic FR hence it is
overvalued. Sell overvalued currency DM in fwd market and create
long. (invest) in DM in money mkt. This means borrow (short) CAD $ in
money mkt.
Step III Action
•Borrow .666 CAD @ 10 % for 3 m
•Buy 1DM at Spot rate
•Invest @ 8% for 3m
•Book fwd contract 1 DM = .671$
•DM deposit proceeds = 1.02
•Sell DM and get CAD $ at FR = 1.02 x .671 = .6844
•Pay loan
= .6827
•Profit
= .0017
BOB
USD/INR
SBI
USD/ INR
62.3568/69
62.3566/67
Do you see arbitrage opportunity based on the two quotes of
two banks
Followings are the spot exchange rates quoted at three different forex
markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD 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.
Sell 1 unit of USD and buy INR x sell 1 unit of INR and buy GBP x sell 1 unit of
GBP and buy USD
48.30 x 1/77.52 x 1.6231=1.01130
Less: investment 1
Profit per USD investment in USD 0.01130
Total profit for USD 100,00,000 investment= USD 1,13,000