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CA-FINAL

SSFFMM

FOREIGN EXCHANGE

EXPOSURE AND RISK

MANAGEMENT

RAJESH RITOLIA, FCA

HELPING HAND INSTITUTE

G-80, 2

ND FLOOR, GUPTA COMPLEX, LAXMI NAGAR, DELHI-92

PH: 9350171263, 9910071263

Email:

rritolia@correctingmyself.in; Web: correctingmyself.in Note: (a) Video CD of missing classes will be provided free of cost (b) Updated notes can be downloaded free of cost from our website: correctingmyself.in (c) Updated classes can be covered in future at free of cost

Positive Thoughts

EVEN A SMALL DOT CAN STOP A BIG SENTENCE. BUT FEW MORE DOTS CAN GIVE A CONTINUITY. AMAZING BUT TRUE, EVERY ENDING CAN BE A NEW BEGINNING.

DON'T WASTE TODAY FOR WHAT HAPPENED YESTERDAY

LIFE IS JUST LIKE A BEACH. WE ARE MOVING WITHOUT END. NOTHING STAY WITH US. WHAT REMAIN WITH US IS THE MEMORIES OF SOME SPECIAL PEOPLE WHO TOCHED US

AS WAVE.

I AM RESPONSIBLE FOR WHAT I SAY, NOT FOR WHAT YOU UNDERSTAND. THE WORLD IS CHANGED BY YOUR EXAMPLE, NOT BY YOUR OPINION. BE A GOOD PERSON, BUT DO NOT WASTE TIME TO PROVE IT

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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

Exam

10.0 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 of

one 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 further

influenced by market forces and economic conditions of the respective countries. This is called 'floating

exchange rate'. 10.0.3 International Credit

Instruments 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 Managing

Risk/ 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 exchange

fluctuation 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 can

calculate 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) 2

10.7 Calculation of Gain or

loss due to foreign

Exchange 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 another

currency 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 no

hedging 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 FR

10.7.2 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 decision

If 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*P

1 + ESR

2*P

2 + ESR

3*P

3 5 M-03

10.7.4 Analysis of Decision of

hedging on maturity

Date 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 Quote

Two 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 11

Spread

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 side

currency 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 two

Quote 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-15

M-10-O

N-09 N-08 N-08

M-07 M-15

N-13

N-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 = Y

On 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 SR

On 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-02

Chap - 10 SUMMARY OF FOREX 10A.5

10.13.3 Cancellation after

maturity date but before

15th 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 customer

Contracts 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-15

N-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 Parity

Theorem 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