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Exercise 1

Sachin, in his capacity as an exporter, approaches Divine Bank with an offer to sell to the bank Spot

USD 200,000. As someone working in the Export Section in Divine Bank, how would you go about

arriving at the rate to be quoted to Sachin? Instead of Sachin, if Konara Bank were to approach

Divine Bank for a similar transaction, how would your bank s trader proceed?

By the way, what would your approach be if you have to give a quote to Saurav who wants to buy

Spot USD 500,000 for effecting his import payments?

Incidentally, if Saurav wants you to quote forward rate for effecting his import payments after three

months, what would you do? In the latter case, since Saurav is giving you enough time for

completion of the transaction, would the forward rate you would be quoting be cheaper than the

spot rate?

Solution:-

Part I - Rate calculations for Sachin:-

The type of rate to be quoted by the bank for Sachin will be the Merchant rate. This will be

calculated as follows (as he is an exporter and selling the USD the margin will be deducted to buy the

USD cheaper by bank):-

Merchant rate = Interbank rate - Margin of the bank (generally 0.1%)

Part II - Rate computations for Conara bank:-

The similar transaction for Conara bank will dealt at the interbank rates only.

Part III Forward rate computations for Saurav

For this transaction bank has to decide the price of USD in futures market and calculate the bill

selling rate accordingly. It has to take the future price of USD (i.e. whether the USD is quoting at a

premium of discount in three month futures and has to consider the three month swap points

accordingly). It will be calculated as follows:-

Bill selling rate for Saurav = interbank selling rate + forward premium (as per the swap points) +

exchange margin for TT selling rate + add exchange margin for bill selling rate.

Bank has nothing to do with the amount of the time Saurav has given before execution of thetransaction.

Exercise 2

If you are a forex trader, what would be your maxim vis--vis buying and selling of foreign currencies

respectively under direct and indirect quotation systems.

Solution:-

Under direct quotation system: - Buy low and sell high

Under indirect quotation system:- Buy high and sell low

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Exercise 3

Delphi Bank purchases spot USD 1 mn from one of its export customers at the rate of Rs.46.35.

Everything else remaining the same, in the normal course, purely from a revenue point of view, what

could be the move that could make the bank maximise its gains? [Please suppose that the forex

rates are steady and avoid focusing on exchange position .]

Solution:-

Delphi bank will take the opposite stand in the interbank market and will put the USD 1 mn for sale

in interbank market at a premium.

Exercise 4

In the case of two-way quote, under what scenario a banks bid rate would be more than its offer

rate? Elaborate.

Solution:-

Exercise 5

In the foreign exchange markets, forward rates are definitely nothing but future spot rates. [This

means, for instance, 2 month forward rate today in the market would exactly turn out to be the spot

rate after 2 months]. Take a stand and defend.

Solution:-

Forward rates are affected by following factors:-

1. Political situations2. Demand supply for the currency3. Central bank approach/actions4. GDP capital flows5. Interest rates6. Speculations

Some factor of the ibid list can be expressed in terms of mathematical models and using them the

future prices of the foreign exchange prices are determined. However; some factors cannot be

predicted and hence are not catered while calculation of swap points. Forward rates are definitely

the future spot prices considering that everything remains the same as what was there at time ofcalculation of future rates.

Exercise 6

Tony is a Chandigarh-based high-value exporter and he is totally risk-averse. While so far he has

been using currency forwards to hedge his export receivables, he is not exactly enchanted with the

instrument as it denies him the upside, even while according him protection against the downside. If

you are Tonys advisor, which hedging instrument would you recommend to him for the following

independent cases: -

Case A

Tony wants to hedge in such a way that he can give up the hedge in no time if he so wants.

Case B

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Tony does not want to forego the possible upside in the name of hedging. In other words, he wants

hedging only against the downside.

Solution:-

Case ATony wants to hedge in such a way that he can give up the hedge in no time if he so wants.

This can be done using the forex futures they are very flexible and marked to market on daily basis.

He can go long on selling the USD in futures market and hedge for the USD he will be receiving. He

can get rid of the futures by selling it any time in the market.

Case B

Tony does not want to forego the possible upside in the name of hedging. In other words, he wants

hedging only against the downside.

This can be better done using the foreign exchange options. By paying nominal premium he canhedge against the downside and will give him the unlimited gains on the other side.

Exercise 7

If, at a point in time, the spot rate, 1 month forward, 3 month forward, 6 month forward and 1 year

forward rates are identical for a currency pair, what could it mean? By the way, whether such an

absolute parity of rates is possible at all in the first place? [Consider all possibilities while

responding.]

Solution:-

It means that the total amount of the foreign currency in the country is same. Thus is manages tokeep the foreign speculators away and keeps the market stable. Its possible and existing in Hong-

Kong and Singapore.

Exercise 8

Which of the following two alignments of rates is universally correct for all currency pairs?

i) Cash Rate < Spot TOM < Spot < Forward

ii) Cash Rate > Spot TOM > Spot > Forward

Elaborate and justify your view.

Solution:-

i) Cash Rate < Spot TOM < Spot < Forward

Cash rate is the rate a bank quotes to its customer when foreign exchange needs to be delivered/

received on the same working day.

Banks quote Spot [TOM] rate when foreign exchange needs to be delivered/received on the next

working day.

Spot rate is quoted by banks when foreign exchange needs to be delivered/ received exactly two

working days after the transaction date.

Banks quote forward rate when foreign exchange needs to be delivered/received in future after a

fixed period of time, say, one month/two months/six months and so on.

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Exercise 9

Compare in all respects currency futures and currency options? Bring out the commonalities and

differences between them?

Solution:-

Commonalities:-

Currency futures and futures are standard contracts made for hedging/ speculation against the

foreign currency. They are traded though the central exchange (SEBI) and has no counter party risk

involved. They are helpful in gaining the profits in case of the currency exchange rate turns in favour.

Option gives unlimited profits prospects and limits the loss which is not the case with futures.

Options and futures can be shorted at any time.

Differences:-

Sl Futures Sl options1 An agreement to buy/ sell a standard

quantity of a foreign currency at a

predetermined price on a future date.

1 Gives an option/right only to the buyer of the

contract to buy/sell at a future date (or

before it) a fixed quantity of the agreed

currency at a predetermined rate

2 It is marked to market on a daily basis

and subjected to unlimited risk on both

the sides.

2 Option gives the protection to the buyer

against the adverse movements in rates

without extinguishing the opportunity to take

advantage of favourable movements

Exercise 10

If the aggregate values of forex buy and forex sell transactions respectively put through by a bank

on a trading day are equal, then automatically its exchange and cash positions will have got

squared. Is the statement correct? Elaborate.

Exercise 11

Of the situations given below, which one/ones can potentially be indifferent to Herstatt

Risk ?

Currency Pair Traded Counterparties / Trading Venue

USD-EURO Canara Bank IOB [Mumbai] ABN Amro Bank Citibank

[London]

USD-INR Canara Bank IOB [Mumbai] ABN Amro Bank Citibank

[Mumbai]

JPY-INR Canara Bank IOB [Mumbai] ABN Amro Bank Citibank

[Mumbai]

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Solution:-

The first transaction USD-INR between Canara bank and IOB (Mumbai) trading venue (Mumbai) is

indifferent to the Herstatt risk. As the counterparties and the trading venue both are in the same

time zone.

Exercise 12

Of the various types of forex transactions Cash, TOM, Spot and Forward, which one is more

susceptible to Herstatt Risk? Justify your view.

Solution:-

Transaction which is more susceptible to the Herstatt risk is the TOM transaction as the cash

position of the counterparty is open till the second working day and is always subject to any change

in the currency rates or the counterparty.

Exercise 13

In the normal course, in the following situations, which bank may have to suffer the consequences of

Herstatt Risk?

a) Konara Bank, Mumbai buys EURO from Khazana Bank, Mumbai for JPY;

b) Konara Bank, Mumbai buys USD from Bank of India, Mumbai for INR

c) Konara Bank, Mumbai buys JPY from SBI, Mumbai for INR;

d) Konara Bank, Mumbai buys EURO from DBS Bank, Singapore for USD.

Solution:-

a) Konara Bank, Mumbai buys EURO from Khazana Bank, Mumbai for JPY;

- Konara bank Mumbai

b) Konara Bank, Mumbai buys USD from Bank of India, Mumbai for INR

- Konara bank Mumbai

c) Konara Bank, Mumbai buys JPY from SBI, Mumbai for INR;

- Konara bank Mumbai

d) Konara Bank, Mumbai buys EURO from DBS Bank, Singapore for USD.

- Konara bank Mumbai

Exercise 14

Between a currency option and currency forward, the former is always better as it does not

extinguish the upside potential even while according protection against the downside . Do you

agree?

By the way, is there any downside at all to currency option contracts?

Solution:-

Yes! I agree with the statement. Yes there is a downside for the currency options as the premium

which is required to be paid for the hedging is higher if the risk taken by the writer is more.

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Exercise 15

When you come across different instruments in finance with the tag forward, among them what

would be the commonalities? Similarly, what is common among all the derivative instruments that

carry the tag futures?

By the way, can we reduce all option contracts to their barest bones and come out with theircommon features?

Solution:-

The commonalities between the different instruments in finance with the tag forward are:-

1. They are used for the hedging purpose as well as for the speculation in the market.2. They help in determining the price discovery of the underlying.3. They are different type of the contracts forwards are not standard ones but futures and

options are standard contracts.

Submitted By

Abhijit A Mahapure

E2010025