CA-FINAL SFM
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SFM
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CHAPTER-12B OPTIONS
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international Finance
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CA-FINAL SFM
A derivatives does not have any physical existence but emerges out of a [M-8] [SP] A Ltd of U K has imported some chemical worth of USD 364
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CA-FINAL
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FOREIGN EXCHANGE
EXPOSURE AND RISK
MANAGEMENT
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M11 N11M12
0510152025
M11 N11
Chapter Analysis
THEORY
PRACTICAL
M12N12 M13 N13 M14N14
M12 N12 M13 N13 M14
N14M15 N15
N14 M15 N15
Chap - 10 SUMMARY OF FOREX 10A.1
Index Particulars Summary of Topics Q No
Exam10.0 FOREIGN EXCHANGE
MARKET Every firm and individual operating in international environment faces problems with foreign exchange
i.e., the exchange of foreign currency into domestic currency and vice-a-versa. Because the value ofone currency relative to another is constantly changing, the conversion become risky. It has resulted in
the foreign exchange risk management becoming one of the basic issues in international financial
management. 10.0.1 MARKET PARTICIPANTS Non-bank Entities; Banks; Speculators; Arbitrageurs; Governments. 10.0.2 Fixed and Floating
Exchange Rates In some countries the government fixes the rate of exchange called 'fixed exchange rate' for its own
currency. This is called 'official rate of exchange'. In other countries, the rates move, depending on the demand and supply pressures and will be furtherinfluenced by market forces and economic conditions of the respective countries. This is called 'floating
exchange rate'. 10.0.3 International CreditInstruments Telegraphic or Cable Transfer; Mail Transfer; Banker's Draft and Banker's Cheques; Letter of Credit;
International Money Orders; Buying and Selling Rates; TC Buying and Selling Rates. 10.1 Foreign Exchange
Exposure or Risk /
Types of Exchange
Rate Risk Transaction Exposure; Translation Exposure; Economic Exposure 10.1.1 RISK CONSIDERATIONS Financial Risk, Business Risk, Credit or Default Risk, Country Risk, Interest Rate Risk, Political Risk,
Market Risk, Foreign Exchange Risk 10.1.2 Techniques for ManagingRisk/ Methods of
Managing Risk Open position No hedging, Forward contract, Currency Futures or Option, Futures contract, Money
market hedge, Netting, Matching, Leading and lagging, Price variation, Invoicing in foreign Currency,
Assets and liability management, Arbtirage, Foreign Currency Bank Account 10.2 Exchange Rate Determination A foreign exchange rate, represents the value of a specific currency compared to that of another
country.The currency listed on the left is called the reference (or base) currency while the one listed to the right
is the quote (or term) currency.In the Foreign exchange market, the quote may be denoted as direct or indirect. Direct Quote It indicates the number of units of the domestic currency required to buy one unit of foreign currency.
Example: $1 = Rs.45 is a direct quotation for US $ in India. Indirect Quote It indicates the number of units of foreign currency that can be exchanged for one unit of the domestic
currency.Example Rs.1 = US $ 0.02065 is an indirect quotation in India. Direct Quote = 1/Indirect Quote
Chap - 10 SUMMARY OF FOREX 10A.2
American Quote It refers to quoting per unit of any currency in terms of American Dollars European Quote It refers to quoting per unit of American Dollars in terms of any other currency. 10.3 Party who is affected
by Foreign exchangefluctuation In foreign Exchange transaction, Only one party remains at risk. The Party whose payable/ receivable
currency are different from his domestic currency remains at risk. 10.4 Spot and forward rate Spot Exchange Rates: The spot exchange rate is the current rate at which one currency can be
immediately converted into another currency. The spot rate is the rate paid for delivery within two
business days after the day the transaction takes place. A forward exchange rate occurs when buyers and sellers of currencies agree to deliver the currency
at some future date. They agree to transact a specific amount of currency at a specific rate at a
specified future date.It is set and agreed by the parties and remains fixed for the contract period regardless of the
fluctuations in the spot exchange rates in future.If funds to fulfill the contract are available on hand or are due to be received by the business, the
hedge is considered to be 'covered'.In situations where funds to fulfill the contract are not available but have to be purchased in the spot
market at some future date, then such a hedge is known as 'uncovered'.Forward contract is not entered into for gain or loss but it is entered into to make payable/ receivable
certain or risk free. Entering into forward contract is known as hedging. 10.5 Relationship between
Spot Rate and
Forward
Rates/Expected Spot
Rate/maturity Spot
Rate Difference between Spot rate and future rate is known as premium or discount in any one currency
Premium/Dis on LHC ≠ Dis/Premium on RHC
Currency is said to have appreciated if its value has increased, i.e. USD 1 = Rs.40 becomes USD 1 =Rs.42. Here the value of USD has increased.
Currency is said to have depreciated if its value has decreased, i.e. USD 1 = Rs.41 becomes USD 1 =Rs.39. Here the value of USD has decreased. Premium/(Discount) in % may be ascertained as follows Premium/(Discount) on LHC for period of Quote = (FR-SR)*100/SR
Premium/(Discount) on RHC for period of Quote = (SR-FR)*100/FR 1 10.6 If SR and Prem/ Disc is given, then we cancalculate FR or ESR or MSR as follows If premium/ Dis is on LHC Currency = 1 LHC = SR*(1+-Prem/Disc)
If premium/ Dis is on RHC Currency = 1 LHC = SR/(1+-Prem/Disc) 210.7 Calculation of Gain or
loss due to foreignExchange fluctuation Rules for calculation of Gain/ Loss on Foreign Exchange Transaction Rule-1 If foreign currency is to be received in future [FC-Sell; DC-Buy]
Chap - 10 SUMMARY OF FOREX 10A.3
If foreign currency is to be paid [FC-Buy; DC-Sell]Rule-2
for conversion of one currency to anothercurrency If required/available currency and LHC is same, then at the time of conversion we will multiply with
Exchange rate
If required/available currency and LHC is different, then at the time of conversion we will divide with
Exchange rate 10.7.1 Calculate gain loss if nohedging is done Compare TSR vs MSR If MSR is not given, then we can assume ESR as MSR 3 Calculate gain loss if
hedging is done Compare TSR vs FR10.7.2 Whether hedging should
be done or not Compare ESR vs FR Calculate ESR and FR of Same maturity date, then we should compare both rates as follows
Always think about LHC
If LHC is receivable and is to be sold - Select Higher of ESR and FR for decisionIf LHC is payable and to be purchased - Select Lower of ESR and FR for decision 4 N-03 10.7.3 Calculation of ESR
through probability ESR = ESR 1*P1 + ESR
2*P2 + ESR
3*P3 5 M-03
10.7.4 Analysis of Decision of
hedging on maturityDate Compare FR vs MSR
6-7 10.8 Cross Rates Cross Rate denotes an exchange rate that does not involve the required currency. It is an exchange
rate between the currencies of two countries that are not quoted against each other, but are quoted against one common currency. 8-10 M-14 10.9 Two Way QuoteTwo way
quotes refer to quoting exchange rates by an exchange dealer in terms of buying (Bid)Rate and selling (Ask) Rate.
Bid rate is the rate at which the dealer is willing to buy LHC. In other words it is selling rate of LHC for
customer.Offer (Ask) Rate is the rate at which Dealer is willing to sell LHC. In other words it is buying rate of
LHC for customer.
$ 1 = Rs.48.80 - 48.90.Dealer is willing to buy $ at Rs.48.80 (sell rupees and buy dollars), while he will sell $ at Rs. 48.90 (buy
rupees and sell dollars). From the Dealer point of view: First is Buying Rate and Second is Selling rate of LHC From the Customer point of view: First is Selling Rate and Second is Buying rate of LHC 11Spread
The difference between the bid and the offer is called the spread.Spread (%) = [Bid - Ask]*100/Bid
Spread (Amt) = [Bid - Ask]
Chap - 10 SUMMARY OF FOREX 10A.4
Conversion of direct quote into indirect quote 1$ = Rs.40.00 - 40.05 Rs.1 = $1/40.05 - 1/40.00 = $0.0249 - 0.025 10.10 Swap Points Swap Points are movement in Exchange Rate expressed in absolute terms, i.e. in value terms
If Swap points is given in ascending order (increasing order) or spread is positive, we add it to right
hand side currency to calculate Forward Rate. It indicates that the left hand side currency is at
premium. If forward margin is given in decending order (decreasing order) we deduct it from right hand sidecurrency to calculate Forward rate. It indicates that the left hand side currency is at discount. 12-13 10.11 Analysis of decision of
hedging under twoQuote rates
14-15 M-09-O 10.12 Money Market Hedge Money Market Operations refers to creating an equivalent asset or liability against a Foreign Currency
Liability or Receivable.
Under money market operation the following steps are taken. 16-18 N-15M-10-O
N-09 N-08 N-08M-07 M-15
N-13N-12 If foreign currency is to be received in future [Assets in FC] Borrowing in FC [Creating Liability in FC] = Amount of borrowing (X) = Amount receivable in FC/(1 +
PIR FC) Convert FC to DC = Domestic Currency receivable (Y) = (X)*Today SR or (X)/Today SR Investment in Domestic Currency [Creating Assets in DC] = Amount to be invested = YOn Maturity Date
Receive and Repay FC
Realisation of Investment in DC - Amount to be received = (Y)*(1+PIR DC)If foreign currency is to be paid in future [Liability in FC] Deposits in FC [Creating Assets in FC] = Deposit (X) = Amount payable in FC/ (1 + PIR
FC) Borrowing and Convert [Creating Liability in DC] = Amount to be borrowed (Y) = (X)*Today SR or (X)/Today SROn Maturity Date
Receive and Repay FC
Repayment of Borrowing in DC = Amt to Repay = (Y)*(1+PIR DC)10.12.1 Money market with Tax rate For incorporation of tax, calculate tax saving on Intt and Foreign Exchange Gain/ Loss as follows:
(a) Interest rate should be taken as net of tax. Intt (1-Tax Rate);(b) Calculate Gain/ Loss due to change in exchange rate and calculate tax/ tax saving on them. 19 10.13 Cancellation of
Forward Contract Forward contract can be cancelled at the request of the customer. This request may be made on or
before or after maturity date. Original forward Contract can be cancelled by entering into reverse
contract. 20 10.13.1 & 10.13.2 Cancellation of Forward Contract on or before maturity If the request is made on or before the maturity date
The bank recovers/pays, as the case may be, the difference between the contracted rate and the rate at which the cancellation is affected. 21-23 N-04 M-02Chap - 10 SUMMARY OF FOREX 10A.5
10.13.3 Cancellation after
maturity date but before15th day of maturity If the request is made after the maturity date Gain to Customer is not paid to him, but loss to customer is recovered from him 24 10.13.4 If customer did not
approach bank, then cancellation on 15th Day from the date of maturity In the absence of any instructions from the customerContracts which have matured are automatically cancelled on the fifteenth day from the date of
maturity. In case the fifteenth day falls on a Saturday or holiday, the contract is cancelled on the next
working day. Exchange difference, if any, is recovered from the customer, but customer is not paid any
gain accruing to him from such cancellations. 25 10.14 Extension of forward contract Extension of Forward contract involves Cancelation of Old contract + New forward contract as per requirement 26 10.14.1 Extension of Forward
Contract with margin
money If bank charges Margin Money, then Buying/ Selling rate for customer will be Buying Rate for LHC = Rate Selected as per rule + Margin Money Payable to Bank Selling Rate for LHC = Rate Selected as per rule - Margin Money Payable to Bank 27-28 N-15N-10-O M-15 10.15 THEORIES OF EXCHANGE RATE DETERMINATION/PARITY CONDITIONS IN INTERNATIONAL FINANCE There are three theories of exchange rate determination - Interest rate parity, Purchasing power parity
and International Fisher effect 10.15.1 Interest Rate ParityTheorem Forward exchange rate of the two countries is determined by various factors like, interest rate, inflation
rate, GDP, Monetary Policy etc.Interest rate parity theory assumes that the forward exchange rate of the two countries is determined
by their interest rate differential assuming other factors remain constant. 29-31 N-12 N-08quotesdbs_dbs6.pdfusesText_12[PDF] a major diatonic harmonica notes
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