Question Paper

International Finance and Trade – I (221) : April 2003

Section A : Basic Concepts (30 Marks)
• • This section consists of questions with serial number 1 - 30.
• • Answer all questions.
• • Each question carries one mark.
• • Maximum time for answering Section A is 30 Minutes.
< Answer
1. A crawling peg system is a >

(a) Fixed exchange rate system (b) Floating exchange rate system
(c) Hybrid of fixed and flexible exchange rate system
(d) Currency board system (e) Free float system.
< Answer
2. Which of the following is not an assumption of theory of comparative advantage? >

(a) Perfect competition (b) Full employment

(c) Perfect mobility of labor between sectors and perfect immobility between countries
(d) Continuous technological innovation
(e) Average and marginal product of labor is constant.
< Answer
3. Which of the following is not a suitable strategy to hedge economic exposure? >

(a) Product strategy (b) Plant location

(c) Promotional Strategy (d) Pricing strategy
(e) Currency swap.
< Answer
4. If there is a strong probability of positive cash flows being generated, the discount rate for calculating >
the present value of depreciation tax shield would be
(a) Domestic nominal risk free rate (b) All equity discount rate
(c) Host country nominal risk free rate
(d) Competitive borrowing rate in host country
(e) Cost of capital of the parent company.
< Answer
5. A transaction in which the goods supplied do not leave the country and the payment for the goods is >
received by the supplier in India under the projects aided by International Institutions is called
(a) Deemed exports (b) Merchant trade
(c) Counter trade (d) Barter trade (e) Project exports.
< Answer
6. Which of the following is true with respect to irrevocable letter of credit? >

(a) It cannot be canceled by the issuing bank without the consent of the beneficiary
(b) The applicant in the irrevocable letter of credit is the exporter
(c) It can be canceled by the issuing bank at the request of the applicant
(d) It cannot be confirmed by any bank other than the issuing bank
(e) The credit available to the beneficiary gets reinstated after being utilized once.
< Answer
7. Fiat money is the money >

(a) Whose face value is less than its intrinsic value

(b) Whose value is backed by faith of the monetary authority
(c) Which can be converted into foreign currency without restrictions
(d) Which has wide acceptability the world over
(e) Which can be converted into gold.
< Answer
8. A dealer found that he has over bought US$ by 5 million, when the market quote for Rs./$ is 45.18/22. >
To ensure a square position and discourage further sellers of US$ – he should
(a) Increase the bid rate and decrease the ask rate
(b) Decrease the bid rate and increase the ask rate
(c) Increase both bid and ask rates above the market quotes
(d) Decrease both bid and ask rates below the market quotes
(e) Both (a) and (b) above.
 < Answer
9. Seigniorage gains refer to the >

(a) Benefits accruing from the ability to finance unlimited imports by printing more money
(b) Benefits derived by trading in gold
(c) Benefits derived by trading in foreign currency
(d) Benefits derived by holding more SDRs with IMF
(e) Benefits derived by lending gold or foreign currency.
< Answer
10. If the one month outright forward rate of Rs./$ is 45.20/22 and the relevant swap points are 3/4, the >
spot rate is
(a) Rs./$ 45.18/22 (b) Rs./$ 45.23/26
(c) Rs./$ 45.17/18 (d) Rs./$ 45.21/23 (e) Rs./$ 45.17/26.
< Answer
11. If interest rate parity holds and the transaction costs are zero, covered foreign financing will result in an >
effective borrowing rate that is
(a) Less than domestic interest rate (b) Greater than domestic interest rate
(c) Equal to domestic interest rate
(d) Less than domestic interest rate if forward rate is in discount
(e) None of the above.
< Answer
12. Free flow among member nations of not only goods but also factors of production is allowed in the case >
of
(a) Free trade area (b) Customs union
(c) Common market (d) Economic Union (e) Both (b) and (c) above.
< Answer
13. Which of the following is/are an example(s) of a Euroyen deposit? >

(a) A yen deposit held by a Japanese resident in a US bank

(b) A yen deposit held by any one in a London bank
(c) A yen deposit held by non-resident Japanese in a bank in Japan
(d) A yen deposit held by a foreigner in a bank in Japan
(e) Both (a) and (b) above.
< Answer
14. A speculator buys Euro at Rs.57.92 and expects to make a profit by keeping an open position for 1 >
month. He expects that
(a) The spot ask rate after 1 month will be less than the current spot bid rate
(b) The spot ask rate after 1 month will be more than the current spot ask rate
(c) The spot bid rate after 1 month will be less than the current spot ask rate
(d) The spot bid rate after 1 month will be less than the current spot bid rate
(e) The spot bid rate after 1 month will be more than the current spot ask rate.
< Answer
15. Which of the following is not a current account item in India’s balance of payment? >

(a) Receipts in foreign exchange from foreign tourists

(b) NRI / FCNR deposits with banks
(c) Profit remitted by the foreign branch of an Indian Company to the parent company
(d) Non-monetary gold imports
(e) Premium on all kinds of insurance provided by Indian Insurance Companies.
< Answer
16. To ensure that there is no three point arbitrage, the relationship among the rates of three currencies >
should conform to

1 S (A / B) ask
×S (C / B) bid ×S ( A / C) ask ≤1
S ( A / B) ask S (C / B) ask
(a) (b) ≥ S (A/C)bid
1 1
×
S (C / B) ask S ( A / C) ask
(c) S (A/B)bid × ≤1 (d) Both (a) and (b) above
(e) All of (a), (b) and (c) above.
< Answer
17. Which of the following methods is suggested to correct the disequilibrium in Balance of Payments, if >
the country adopts a flexible exchange rate system?
(a) Expansion of money supply in the domestic economy
(b) Higher rate of interest in the domestic economy
(c) Appreciation of home currency
(d) Depreciation of home currency
(e) Both (a) and (d) above.
 < Answer
18. Which of the following is a non-tariff barrier in international trade? >

(a) Embargo (b) Export duty

(c) Import duty (d) Specific duty (e) Both (b) and (c) above.
< Answer
19. In an option forward contract for an import transaction under direct quote, when the currency is at a >
discount, the bank will
(a) Add maximum discount to the ask rate
(b) Add minimum discount to the ask rate
(c) Deduct maximum discount from the ask rate
(d) Deduct minimum discount from the ask rate
(e) Give more discount.
< Answer
20. Which of the following statements is false? >

(a) Authorised dealers are market makers in the foreign exchange market
(b) Foreign currency broker acts as a middleman between two market makers
(c) The counterparty in the foreign exchange market is another bank
(d) Banks buy and sell for their own account and carry `inventory’ of currencies
(e) Foreign exchange brokers buy and sell foreign currencies for their own account.
< Answer
21. Devaluation of a currency means >

(a) Government lowering the value of the local currency under fixed exchange rate system
(b) Market forces lowering the value of the local currency under fixed exchange rate system
(c) Market forces lowering the value of a local currency under flexible exchange rate system
(d) Government increasing the value of the local currency in terms of foreign currency
(e) Both (b) and (c) of the above.
< Answer
22. The reserve currency under the Bretton Woods system was >

(a) Sterling (b) Dollar

(c) SDR (d) Gold (e) Japanese Yen.
< Answer
23. In the case of forward cover, the cost of hedging is >

(a) The annualized forward premium

(b) The difference between the forward rate and expected spot rate for the maturity date
(c) The difference between the forward rate and current spot rate
(d) The difference between the forward rate and actual spot rate prevailing on the date of maturity
(e) Zero since the bank charges no extra amount.
< Answer
24. The current interest rates are as under: >

Year 1 2 3
Interest Rate 5% 6% 7% The expected 1 year rate after 2 years is r12
and expected 2 years rate after 1 year is r21, then which of the following is true?
(a) r12 = 8% r21 = 7 % (b) r12 = 8% r21 = 8%
(c) r12 = 9% r21 = 7% (d) r12 = 9% r21 = 9%
(e) r12 = 9% r21 = 8%.
< Answer
25. Which of the following will not cause a change in the bid-ask spread? >

(a) High market volatility (b) Trading volume

(c) Decrease in forward maturity (d) Market downturn
(e) Both (a) and (d) above.
< Answer
26. The maximum time limit for repatriation of the proceeds of cash exports into India is >

(a) 1 month (b) 2 months

(c) 3 months (d) 6 months (e) No time limit.
< Answer
27. The method of translating financial statements in which items are classified based on whether they are >
valued at historical basis or on market price basis is known as
(a) Current rate method (b) Current/non-current method
(c) Monetary/non-monetary method (d) Temporal method
(e) Average rate method.
< Answer
28. Long-term EXIM Policy is announced for a period of >
 (a) 1 year (b) 2 years (c) 3 years (d) 5 years (e) 6 years.
< Answer
29. The rates available in the market rates are: >

Rs./$ Spot 45.78 / 79

£/$ 0.5285 /86
If an Indian importer requires pounds, the rate quoted to him is
(a) Rs.85.68/£ (b) Rs.85.72/£
(c) Rs.85.79/£ (d) Rs.86.64/£ (e) Rs.86.89/£.
< Answer
30. Which of the following statements is not true with respect to SDRs? >

(a) SDRs are reserves created by IMF and allocated to member countries
(b) SDRs are only used to cover current account deficit
(c) Interest is paid to those who hold SDRs and by those who draw down their SDRs
(d) The interest rate of SDRs is based on an average money market rates in major countries.
(e) None of the above.

END OF SECTION A
 Section B : Problems (50 Marks)
• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. Suppose that on January 01, 2003, the cost of borrowing dollars for the year was 8%. During the year, inflation
rates in Euro zone and US were 3% and 2% respectively. If Euro/$ quotes available in the market were:
Exchange rate on the date of availing the loan (01.01.2003) : Euro 0.90/$
Exchange rate on the date of repaying the loan (31.12.2003) : Euro 0.78/$
You are required to calculate the real cost of borrowing dollars in Euro terms for the year.
(10 marks) < Answer >
2. The covered after-tax lending and borrowing rates for three units of a Multinational Corporation located in the
United States, Singapore and Hong Kong are
Lending (%) Borrowing (%)
United States 3.1 3.9
Singapore 3.0 4.2
Hong Kong 3.2 4.4
Currently, the Singapore and
Hong Kong units owe $2 million and $ 3 million, respectively to their US parent. The Singapore unit also has $ 1
million in receivables from its Hong Kong affiliate. The timing of these payments can be changed by up to 60 days
in either direction. If US Parent is borrowing funds, while both the Singapore and Hong Kong subsidiaries have
surplus cash available, you are required to
a. Determine the MNC’s optimal leading and lagging strategies
b. Calculate the net profit impact of these adjustments
c. Indicate the change in the MNC’s optimal strategy, if the US parent has surplus cash available.
(3 + 4 + 3 = 10 marks) < Answer >
3. The treasurer of an MNC in US observed that the company has a surplus of US$ 1million for a period of 2months.
The treasurer has sought the permission of the CEO to invest in a local bank at a rate of 2.4% p.a. The CEO has
asked the treasurer to consider the following FAX message received from an Offshore Banking Unit (OBU) of a
US Bank in Hong Kong for a better return, if invested in Hong Kong dollars.
$/Euro Spot 1.2820/22
Three months 1.2836/39
HK$/Euro Spot 9.9690/92
Three months 9.9680/83
Interest rates for 2 months in HK$ (p.a.) : 3.6% – 3.8%
Interest rates for 2 months in Euro (p.a.): 3.2% –3.4%
You are required to suggest as to which of the following currencies would be recommended for investment?
i. U.S dollars
ii. Euro
iii. Hong Kong dollars.
(9 marks) < Answer >
4. Prasanth Appliances Ltd., is engaged in importing the components and other equipment required for producing the
consumer durables and exporting the finished goods. As on January 15, 2003, the company has to meet an export
obligation in the month of April 2003. The value of the export contract is US $ 450,000. They have also opened a
letter of credit to import machinery worth US $ 150,000. As per the terms of the letter of credit, the import bill will
be due for payment during 2nd week of April 2003. Accordingly, the company obtained the forward cover for both
the transactions when the ongoing forex market rates are as under:
Spot rate: Rs./$45.18/45.19
Forward premium
 Spot January 3/4 Paise
February 6/7 Paise
March 9/10 Paise
April 12/13 Paise
May 15/16 Paise
On February 17, 2003, the company approached the bank to
extend the forward contract booked for export payment to fixed delivery May 15, 2003.
The ongoing rates on February 17, 2003 are as follows:
Spot rate:Rs./$ 45.10/45.12
Spot February 4/5 Paise
March 9/10 Paise
April 13/15 Paise
May 17/18 Paise
On March 5, 2003 the company approached the bank for
early delivery of the dollar, which they had booked on January15, 2003 to meet the import obligation.
The ongoing exchange rates on March 5, 2003 are as follows
Spot: Rs./$ 45.03/45.05
Spot March 4/5 Paise
April 8/9 Paise
May 12/13 Paise
Note: Assume that partial delivery of the option forward is
permitted. Consider prorata premium for option deliveries by taking 4 weeks for the month.
You are required to calculate
a. Outright forward export and import rates as on January 15, 2003 from February to May 2003.
b. Forward rates quoted to the company as on January 15, 2003 for their export and import transactions.
c. Exchange rate quoted to the company on February 17,2003 for fixed delivery contract
d. Swap gain or loss if any, for early delivery of dollar as on March 5, 2003
e. Total cash flows to the company, if the company has to pay/receive interest @ 4% p.a. for cash outlay/cash
inflow, for the import transaction.
(2 + 3 + 2 + 3 + 4 = 14 marks) < Answer >
5. You are given the following information by your banker.
Rs./Euro Spot 57.92/57.98
Three-month interest rates
Euro 4%–5%
Rupees 7%–8% Assuming that Interest Parity holds good, you are required
to calculate the expected limits for spot rates after three months to ensure that there is no scope for arbitrage
profits.
(7 marks) < Answer >
END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 - 7.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.

6. Exchange rate forecasting is very important for players in the international markets, as the exchange rates have a
great impact on their profits. A plethora of factors affect the levels of, and movements in exchange rates. A number
of theories were propounded to explain these effects. Explain the various models of exchange rate forecasting in
brief.
(10 marks) < Answer >
 7. Mr. Rahul, who joined as the General Manager of Classic Diamond Exports Company, observed that the cost of
borrowing for preshipment credit is around 8%. In order to improve profit margin and quote competitive prices to
the company’s buyers in U.S., he wants to avail preshipment credit in foreign currency (in US $), since the
company also has to pay US$ for the import of diamonds from Antwerp. Explain how the scheme is operated by
the banks. And also explain the sources available to banks to extend preshipment credit in foreign currency.
(6 + 4 = 10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

International Finance and Trade – I (221) : April 2003

Section A: Basic Concepts
1. Answer : (c) < TOP >

Reason : A crawling peg system is a hybrid of fixed and flexible exchange rate system. Under this system
the value of a currency is fixed in terms of a reference currency and this peg itself keeps
changing in accordance with the underlying economic fundamentals, by letting the market
forces play a role in determining the exchange rate.
2. Answer : (d) < TOP >

Reason : As explained by David Ricardo, the assumptions of the theory of comparative advantage are
perfect competition, constant average and marginal product of labor, full employment, perfect
mobility of labor between sectors, but perfect immobility between countries and no
technological innovation to kept the marginal product of labor constant. Here alternative (d) is
not the assumption of the theory of comparative advantage. Hence it is the answer.
3. Answer : (e) < TOP >

Reason : Suitable strategies to hedge economic exposure are market selection, pricing strategy,
promotional strategy, product strategy, input mix, product sourcing and plant location. Among
the given alternatives, Currency swap is not a suitable strategy to hedge economic exposure,
where as the other options of (a), (b), (c) and (d) are the strategies used to hedge economic
exposure
4. Answer : (a) < TOP >

Reason : Since the depreciation charge is based on the historical cost of assets and is hence contractual,
the discount rate should be the domestic nominal rate. If there is a strong probability of positive
cash flows being generated, and hence of the depreciation tax shield being availed, the risk
premium bay be negligible, and the domestic nominal risk free rate may be used.
5. Answer : (a) < TOP >

Reason : A transaction in which the goods supplied do not leave the country and the payment for the
goods is received by the supplier in India under project aided by International Institutions is
called deemed exports.
6. Answer : (a) < TOP >

Reason : An irrevocable Letter of Credit is one which cannot be canceled by the issuing bank without the
consent of the beneficiary. The applicant in the irrevocable letter of credit is importer. When any
bank other than the issuing bank does not confirm a letter of credit, it is called an unconfirmed
letter of credit. If the credit available to the beneficiary gets reinstated after being utilized once,
it is called revolving letter of credit. Hence alternative (a) is the answer.
7. Answer : (b) < TOP >

Reason : FIAT money is the money which has insignificant intrinsic value but a high face value because
of faith on the monetary authority.
8. Answer : (d) < TOP >

Reason : Since the dealer has over bought position, he should decrease both bid and ask rates for the
following reasons, to ensure a square position. By decreasing bid rate, he is discouraging sellers
of US$.
 By decreasing ask rate he is encouraging buyers of US$ in the market.
9. Answer : (a) < TOP >

Reason : Seigniorage gains refer to the benefits accruing from the ability to finance unlimited imports by
printing more money. The other options in (b), (c) (d), and (e) are not correct.
10. Answer : (c) < TOP >

Reason : Since the dollar is in premium, the forward rate is arrived, by adding the premium to the spot
rates. In the question forward rate is inclusive of premium, which should be deducted to arrive
the spot rates.

Hence,
Forward rate is 45.20
Less: Premium 0.03
Spot rate 45.17
11. Answer : (c) < TOP >

Reason : According to the Interest rate parity or the covered interest parity condition, the cost of
borrowing money or the rate of return on financial investments, when adjusted for the cost of
covering foreign exchange risk is equal across different currencies. Hence, If interest rate parity
holds and the transaction costs are zero, covered foreign financing will result in an effective
borrowing rate that is Equal to domestic interest rate.
12. Answer : (c) < TOP >

Reason : A common market allows free flow among member nations of not only goods, but also factors
of production (labour and capital) and services.
a) In a free trade area, there are no barriers to trade among the member countries. But the
member countries individually decide upon their trade policies as applicable to non-
member countries, to prevent misuse of the system/arrangement by any member country,
by stipulating documents/conditions such as certificate of origin.
b) Under a Customs Union, in addition to the absence of internal trade barriers, among the
member nations, the external barriers for non-members are also common.
c) Under economic union, the members have completely co-ordinated economic and social
policies. There is a unified central bank and a common currency. The fiscal as well as
monetary policies are well co-ordinated, some of them being decided upon by the central
bank.
Hence the correct answer is (c).
13. Answer : (e) < TOP >

Reason : Yen deposit held outside Japan is called as ‘Euroyen deposit’. Hence the yen deposits held in a
U. S. bank as well as London bank are called as Euroyen deposit.
Items of (c) and (d) are the examples of Foreign bonds. Hence the correct answer is (e).
14. Answer : (e) < TOP >

Reason : The speculator who purchased Euro at Rs.57.92 can book profit, by keeping an open position for
1 month, when the spot bid rate after 1 month will be more than the current spot ask rate. The
speculator books profit since he is buying at a low price and selling at a high price.
The speculator bought Euro at Rs.57.92 (at market ask rate). Hence the relevant rate to be
applied after 1 month is the market bid rate (when the speculator sells Euro). Hence all the other
options under (a), (b), (c) and (d) are not correct. The correct answer is (e).
15. Answer : (b) < TOP >

Reason : Foreign currency deposits of NRIs are classified under capital account in India’s balance of
payment. All items under (a), (c), (d) and (e) come under current account. Correct answer is (b).
16. Answer : (c) < TOP >

Reason : To ensure that there is no three point arbitrage the relationship among the rates of three
currencies should conform to
S (A/B)bid × S (B/C)bid × S (C/A)bid ≤ 1
 1 1
×
S (C / B) S (A / C)
or, S (A/B)bid × ≤1
ask ask

and S (A/B)ask × S(B/C)ask × S(C/A)ask ≥ 1

in alternative (a) S(A/C)ask is not a correct term, it should be S(A/C) bid for no arbitrage and in
alternative (b) if S(C/B)ask term is S(C/B)bid then it will also give the no arbitrage condition
Hence, the other two options under (a) and (b) do not satisfy the no arbitrage relationship.
And give rise to three point arbitrage.
Hence, the correct answer is (c).

17. Answer : (e) < TOP >

Reason : To correct the disequilibrium in BOP ultimate goal is to depreciate home currency, which can
also be achieved by increasing money supply in the economy.
The options under (b) and (c) do not correct the disequilibrium in Balance of payment, if the
country adopts a flexible exchange rate system.
Hence the correct answer is (e).
18. Answer : (a) < TOP >

Reason : Embargo is a non-tariff barrier in international trade. Options in b, c and d are examples of trade
barriers. Tariff is a tax levied on goods traded internationally. Non-tariff barriers include all the
rules, regulations which help in keeping foreign goods out of the domestic markets.
19. Answer : (d) < TOP >

Reason : The principle to be followed in the case of a direct quote is Buy low – sell high. Discount is to
be deducted either from the bid rate or ask rate. In an option forward contract, for an import
transaction, the banker gives minimum discount assuming that the importer may ask for the
delivery of foreign currency on the first day of the option period. Premium is to be added either
to the bid rate or ask rate. Hence the correct answer is (d).
20. Answer : (e) < TOP >

Reason : Foreign exchange brokers do not actually buy or sell any currency. They do the work of bringing
buyers and sellers together.
21. Answer : (a) < TOP >

Reason : In devaluation government lowers the value of domestic currency when fixed exchange rate
system prevails.
< TOP >
22. Answer : (b)
Reason : Dollar was used as the reserve currency under the Bretten Woods system.
< TOP >
23. Answer : (b)
Reason : Cost of hedging in case of forward cover is the difference between forward rate and expected
spot rate for the maturity date.
24. Answer : (e) < TOP >

Reason : r1 = 5%, r2 = 6%, r3 = 7%

(1 + r3)3 = (1 + r2)2 (1 + r12)
or, (1.07)3 = (1.06)2 (1 + r12)
(1.07) 3
−1
(1.06) 2
or, r12 = = 9%
(1 + r3)3 = (1 + r1) (1 + r21)2
or, (1.07)3 = (1.05)(1 + r21)2
 (1.07)3 
 
 (1.05) 
 
or, (1 + r21)2 = = 1.1667
r21 = 8%

25. Answer : (d) < TOP >

Reason : Options in (a), (b) and (c) can cause a change in the bid-ask spread. Market downturn will cause
rates to fall but not necessarily the spread. Correct answer is (d).
26. Answer : (d) < TOP >

Reason : It is mandatory to get the proceeds of cash exports to India, within 6 months from the date of
shipment.
27. Answer : (d) < TOP >

Reason : a) Under current rate method, all assets, liabilities, incomes and expenditures are translated at
the current or closing rate
b) Current non-current method advocates the conversion of all current assets and liabilities at
the closing rate and all non current assets and liabilities at the historical rate.
c) Under monetary/non-monetary method, the monetary assets and liabilities (like cash,
accounts receivables, accounts payable) are translated at the closing rate and the non
monetary items (like inventory, building etc.) are translated at the historical rate.
d) All the items of the balance sheet that are valued on historical cost basis are translated at
the historical rate and those which are valued on current value (or realizable value) are
valued at the closing rate.
e) There is no average rate method. Hence the correct answer is (d).
28. Answer : (d) < TOP >

Reason : EXIM policy is announced for a period of 5 years for operational flexibility.
29. Answer : (d) < TOP >

Reason : The rate to be quoted to the Importer is the ask rate

= (Rs./$) ask × ($/£) ask
= (Rs./$) ask ×(1/£/$) bid
= 45.79 × (1/0.5285) = Rs.86.64/£
30. Answer : (b) < TOP >

Reason : It is not correct to say that SDRs are only used to cover current account deficit.
 Section B : Problems
1. Exchange rate on January 1, 2003 was $ 1= Euro 0.90
Exchange rate on December 31, 2003 was $ 1= Euro 0.78
Interest rate for dollar loan = 8%
1
0.90
The amount borrowed in $ which is equivalent to 1 Euro= $ = $1.1111
The loan amount to be repaid, which includes both principal and interest in dollar terms
= $1.1111 (1.08)= $1.20
Since, exchange rate on December 31, 2003 was $ 1= Euro 0.78
The nominal loan amount to be repaid in terms of Euro
= $1.20 (0.78) = Euro 0.936
Therefore, for each Euro worth of dollars borrowed at the beginning of the year, it costs only Euro 0.936 to repay
the principal and interest.
Hence, the nominal Euro cost of borrowing dollars
Loan repayment in E uro terms −Initial Loan amount in Euro terms
Initial Loan amount in Euro terms
=
Euro 0.936 − Euro1
Euro1
= = –0.064 = –6.4 %
Since inflation rate in Euro Zone is 3%,
0.936
1.03
The loan amount to be repaid in real terms in Euro = = 0.9087
The real Euro cost borrowing dollars
Loan repayment in real term s in Euro −Initial loan amount
Initial loan amount
=
Euro 0.9087 −Euro 1
Euro 1
= – 0.0913 = – 9.13 %
< TOP >

2. a. Both Singapore and Hong Kong subsidiaries (which have surplus cash) should speed up their payments to the
US parent(which is in deficit of cash), since the borrowing rate (3.9%) in US is more than the lending rates in
Singapore (3%) and Hong Kong (3.2%). However, the Hong Kong unit should lag its payments to its
Singapore affiliate, since lending rate in Singapore (3%) is less than the lending rate in Hong Kong (3.2%)
b. Speeding up the payments by Singapore and Hong Kong subsidiaries to the US parent:
The US parent reduces its borrowings by $5,000,000, when it receives funds 60 days earlier from its
affiliates.
Therefore, the interest savings by the US parent = $5,000,000 × (3.9/100) × (60/360) = $ 32,500
Since both Singapore and Hong Kong affiliates are paying 60 days earlier to their US parent, the available
cash with them will be reduced by $2 million and $3 million respectively.
Therefore,
The interest foregone by Singapore affiliate = $2,000,000 × (3/100) × (60/360) = $ 10,000
The interest foregone by Hong Kong affiliate = $3,000,000 × (3.2/100) × (60/360) = $ 16,000
The net savings from this transaction =
Interest saving by the US parent – Interest foregone by Singapore and Hong Kong affiliates
= $ 32,500 – ($ 10,000 + $ 16,000) = $6,500
Lagging the payment by Hong Kong subsidiary to its Singapore affiliate:
Cash available with Hong Kong subsidiary will be more by $1,000,000, when it lags the payment by 60 days
Interest earned by it = $1,000,000 × (3.2/100) × (60/360) = $ 5,333
 Interest foregone by Singapore affiliate = $1,000,000 × (3/100) × (60/360) = $ 5,000
The net savings from this transaction =$ 5,333– $ 5,000 = $ 333
c. If the US parent has surplus cash, Singapore subsidiary should lead its payments to the US parent, since
lending rate in US(3.1 %) is more than the lending rate in Singapore(3%). However, Hong Kong subsidiary
should lag the payment to the US parent, since lending rate in US(3.1 %) is less than the lending rate in Hong
Kong (3.2%).
Similarly, Hong Kong subsidiary should lag the payment to its Singapore affiliate, since interest rate in Hong
Kong (3.2%)is more than the lending rate in Singapore (3%).
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3. Option 1: Investment in US dollars for a period of 2 months at 2.4% p.a.
 0.024 
1 + 
 6 
= 1,000,000 × = $1,004,000
Return = 1,004,000 – 1,000,000 = $4,000
Option 2: Investment in Euro
Surplus of US$ 1,000,000is to be converted into Euro at the rate of $/Euro 1.2822 and the amount
is to be invested at 3.2% p.a. The amount with interest is to be converted into dollars at the
forward rate of $/Euro 1.2836
= 1,000,000/1.2822 = Euro 779,910
 0.032 
1 + 
 6 
If this amount is invested at 3.2%, it will fetch 779910 = Euro 784,070
If Euro 784,070 is converted into $, 784,070 (1.2836) =$ 1,006,432
Return = 1,006,432-1,000,000=$6,432
Option 3: Investment in HK$
Surplus of US $ 1,000,000 is to be converted into HK $ at the bid rate of HK$/$ and the amount is
to be invested at 3.6% p.a. The amount with interest is to be converted into dollars at the forward
ask rate of HK$/$.
(HK$/ $) bid rate = (HK$ /Euro)bid × (Euro /$) bid
1
( $ / Euro ) ask
= (HK$/Euro)bid ×
1
1.2822
= 9.9690 ×
= 7.7749
Forward (HK$/$) ask rate = (HK$/Euro)ask× (Euro/$)ask
1
( $ / Euro ) bid
= (HK$/Euro)ask ×
1
1.2836
= 9.9683 ×
= 7.7659
Inflow of HK$ = 1,000,000 × 7.7749 = HK$ 7,774,900
 0.036 
1 + 
 6 
Investment in HK$ at 3.6% p.a. = HK$ 7,774,900 ×
= HK$ 7,821,549
Convert into dollars at 3 months forward rate of HK $ 7.7659/$
= 7,821,549/7.7659
= $1007165.815 say $ 1007166
Return = 1,007,166 – 1,000,000
= $7,166
It is better to invest in HK$, as the return is more.
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4. a. Outright forward export rates:
May 45.21
June 45.24
July 45.27
August 45.30
Sept 45.33 Outright forward import rates:
May 45.23
June 45.26
July 45.29
August 45.32
Sept 45.35 b. Exchange rate for export transaction;
= 45.18 + 0.09 = 45.27
Exchange rate for import transaction,
= 45.19 + 0.115 = 45.305
c. Exchange rate quoted to the company on February 17, 2003 for fixed delivery May 15, 2003
= 45.10 + 0.15 = 45.25
d. Swap difference
It is a buy sell swap
Bank buys from market Rs.45.03
Bank sells to market (45.03 + 0.06) Rs.45.09
Swap difference Rs. 0.06
The premium upto April 15 would be (premium up to
March: 0.04 and for 15 days up to April 15: 0.02) Rs.0.06
This premium will be passed on to the customer.
e. Effective cost of the import transaction
Total cash outflow for the Import transaction per dollar Rs.45.305
Less Swap gain Rs. 0.060
Effective cost Rs.45.245
Interest on outlay of funds
The notional buy rate Rs. 45.030
Contracted rate Rs. 45.305
Inflow of funds per dollar Rs. 0.275
Bank at its discretion may pay interest on Rs.41,250
(1,50,000 × 0.275) from 05-03-03 to 15-04-03 at 4%
41, 250 ×4 ×40
36,500
=
= 180.82
Say Rs.181.
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5. Suppose a trader borrows Rs.100 at 8% for three months and converts Rupees into Euro, he would obtain
100/57.98 = 1.7247
Since repayment of loan has to be made only after three months, he can invest Euro at a rate of 4%.
After three months, he would obtain Euro 1.7247(1+0.04/4) = 1.741947 say Euro 1.742
The loan repayment after three months would be 100(1+0.08/4)= Rs.102
If interest parity holds goods,
Euro 1.742 = Rs.102
To leave no scope for arbitrage,
 Euro 1.742 Fb ≤ Rs.102
Fb≤ Rs.58.55/Euro
Suppose, he borrows Euro 100 at 5% and converts into Rupees,
He would obtain 100(57.92)= Rs.5, 792
This amount can be invested at 7%, to fetch
5,792 (1+0.07/4)= Rs.5,893.36
Loan repayment= Euro100(1+0.05/4)= Euro101.25
To leave no scope for arbitrage,
Euro 101.25 ≥ 5,893.36/Fa
Therefore, Fa ≥58.21
Therefore, the limits for three month forward quotes are
Fa ≥ Rs.58.21/Euro
Fb≤ Rs.58.55/Euro
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Section C: Applied Theory

6. The various models of exchange rate forecasting are

• • Forward rate
• • The demand-supply approach
• • The monetary approach
• • The asset approach
• • The portfolio balance approach
• • Role of news
• • Technical Analysis
Forward rate: Forward rates are indeed unbiased predictors of future spot rates, where the markets are
competitive. For the market to be competitive, the concerned currencies should be freely floating and heavily
traded without central bank intervention. However, there is no evidence to support that the forward rates are
accurate predictors of future rates. One possible reason for the inaccuracy of the forward rates is, that at any point
of time, the forward rate reflects only expected developments in the variables affecting the exchange rates. As the
unexpected developments cannot be factored in the forward rates, the estimates based on these are normally
inaccurate. Due to this, the shorter the time gap, the more accurate the forecast based on forward rates is expected
to be.
The demand-supply approach: A currency’s exchange rate is determined by the overall supply of and demand
for that currency. According to this view, changes in exchange rates can be forecasted by analyzing the factors that
affect the demand and supply of a currency. Since these factors are listed out in the balance of payments account,
this approach is also referred to as the balance-of-payments approach.
The demand curve of a currency is mainly derived from the country’s supply curve of exports. The supply of a
currency is derived mainly for the country’s imports. Other factors affecting the value of a currency are trade in
services, income flow (i.e. flows on account of interest, dividends, rents and profits), transfer payments and
foreign investments. While an exogenous increase in exports has the effect of appreciating the domestic currency,
an exogenous incr4ease in imports results in depreciating the local currency. A change in the level of trade in
services and other capital account transactions has a similar effect. In brief, all the transactions, which are recorded
on the debit side of balance of payments statement cause demand for foreign currency or supply of domestic
currency. Similarly, all transactions, which are recorded on the credit side of balance of payments statement cause
demand for domestic currency or supply of foreign currency.
An important aspect of this theory is that the mechanism employed to explain exchange rate changes implies that
any change in the value of a currency is an instrument to correct the temporary imbalance in the system.
The monetary approach: This approach assumes that PPP holds good, i.e. an increase in the price level results in
the depreciation of a country’s currency and vice versa. The predictions of the monetary theory can be summarized
 as follows.
• • An increase in the real GNP of a country causes its currency to appreciate. It follows that out of two
countries, the country having a higher growth in the GNP will see its currency appreciating against the other
country’s currency.
• • An increase in real money demand makes the currency appreciate.
• • An increase in nominal interest rates causes the currency to depreciate. This again goes against the
predictions of the demand-supply approach.
• • An increase in the money supply causes the currency to depreciate.
This theory also analyzes the effects of expected inflation. Expected inflation leads to higher nominal interest rates
(since the nominal interest rate includes a premium for inflation). This causes a depreciation of the currency.
According to the monetary approach, the effect on the exchange rates is immediate, rather than happening after the
inflation takes place.
The asset approach: This approach is also referred to as the efficient market hypothesis approach. It does not talk
about the effect of changes in the basic economic variables on the exchange rates. According to this approach,
whatever changes are expected to occur in the value of a currency in future (whether based on the monetary theory
or the demand-supply theory or any other approach) gets reflected in the exchange rates immediately. Hence, the
current exchange rate is the reflection of the expectations of the market as a whole. In an efficient market, a large
number of participants with their profit-maximizing activities ensure that all available information is quickly
absorbed by the market.
The portfolio balance approach: This approach states that the value of a currency is determined by two factors-
the relative demand and supply of money and the relative demand and supply of bonds. According to this
approach, people can hold assets across different countries, denominated in different currencies (mainly in the
form of currencies and bonds). Hence, any change in rates changes the wealth of the holders of these assets, which
becomes an instrument for maintaining equilibrium in money and bond markets.
Appreciation of the domestic currency accompanies an increase in interest rates, in order to maintain the
equilibrium in the bond market. The depreciation of the domestic currency accompanies an increase in the interest
rates, to maintain the equilibrium in the money markets. In this approach, the equilibrium level of interest rates and
exchange rate are determined by the interplay of money market and bonds market.
Role of news: One more factor that contributes to unpredictability of exchange rates, is news. News, as per its
definition, is something unexpected. Since unexpected happenings keep on occurring, so is their effect on
exchange rates.
Technical analysis: Forecasting future exchange rates with the use of past exchange rate movements is called
technical analysis. A pure technician is he, who believes that clues in the past movements lead him to the future.
Economic factors such as inflation rates, interest rates, balance of payments and political stability are ignored by
pure technicians. A technician believes that exchange rate movements are predictable by using the data on
historical movements, the contention being that irrespective of factors that contribute, the impact of all such
factors is finally reflected in prices.
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7. PRE-SHIPMENT CREDIT IN FOREIGN CURRENCY (PCFC)

Exporters often complain about the high cost of capital vis-à-vis their competitors from other countries. In order to
make their prices competitive and thereby give a boost to exports, the Government of India made available yet
another mode of financing – financing exporters in foreign currency at internationally competitive interest rates.
Pre-shipment Credit in Foreign Currency (PCFC) is made available to cover both the domestic as well as imported
inputs of the exported goods. It is available only for cash exports. It can also be extended in a convertible currency
other than the currency in which the export order is invoiced. An exporter who avails of credit under this scheme
will not be eligible to avail of post-shipment finance in Indian rupees. He will necessarily have to avail of post-
shipment finance in foreign currency only.
PCFC will initially be available for a maximum period of 180 days. Any extension beyond this time limit will be
subject to the same terms and conditions as rupee packing credit and it will also have an additional interest cost of
2% above the rate for the initial period of 180 days prevailing at the time of extension. Any extension beyond 270
days will be subject to the terms and conditions fixed by the authorized dealer concerned and if no export takes
place within 360 days, the PCFC will be adjusted at the TT selling rate of the currency concerned. In such cases
authorized dealers (ADs) can arrange to remit foreign exchange to repay the loan or line of credit raised abroad
and interest thereon without prior permission of RBI.
Liquidation of Credit
The credit will be self liquidating in nature and accordingly after the shipment of goods, the credit will be
liquidated by submission of export documents for discounting/ rediscounting under the rediscounting of export
bills abroad scheme. PCFC should not be liquidated with foreign exchange acquired from other sources. The
benefit such as credit by a part of export proceeds to EEFC account, etc. will accrue only after realization of the
export proceeds or when the resultant export bills are rediscounted ‘without recourse’ basis and not at the stage of
conversion of pre-shipment credit to post-shipment credit.
In case of cancellation of export order or where the export takes place after 360 days, the PCFC may be liquidated
by selling equivalent amount of foreign exchange (principal plus interest) at the T.T selling rate prevailing on the
date of liquidation. In such cases, interest will be payable on the rupee equivalent of the principal amount at the
rate of “Export credit not otherwise specified” plus a penal rate of 2 percent from the date of advance after
adjustment of interest of PCFC already recovered. Banks may extend PCFC to such exporters subsequently only
after ensuring that the earlier cancellation of PCFC was due to genuine reasons and not for speculative purposes.
Source of funds for the banks under PCFC are the foreign currency balances available in Exchange Earners
Foreign Currency (EEFC) Accounts, Resident Foreign Currency Accounts (RFC), Foreign Currency (Non
Resident) Accounts (Banks) Scheme, Escrow Accounts and Exporters Foreign Currency Accounts. In addition,
banks may arrange for lines of credit from abroad for which they need not obtain prior approval of the Reserve
Bank of India if the rate of interest on such foreign currency borrowings does not exceed 1 percent over six
months LIBOR. If banks avail of lines of credit, the liabilities arising out of utilization of the limits under the said
facility would be exempted from the maintenance of cash reserve ratio and statutory liquidity ratio.
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