Q2.

(a) What is (a) spot exchange rate (b) forward exchange rate (c) foreign exchange
swap?
 The spot exchange rate is the exchange rate based on the value of the currency at
the moment of the quote.
 The forward exchange rate is the exchange rate at which a bank agrees to
exchange one currency for another at a future date when it enters into a forward
contract with an investor.
 Foreign exchange swap or FX swap is a simultaneous purchase and sale of
identical amounts of one currency for another with two different value dates
(normally spot to forward) and may utilize foreign exchange derivatives. An FX
swap allows sums of a certain currency to be used to fund charges designated in
another currency without acquiring foreign exchange risk.

(b) How are forward rates determined in:

i) International forex markets
 For countries that have fully-convertible currencies, the forward premium is
deduced from their interest rate differentials 

 Forward premium/ discount:

ii) Indian forex markets.

 Because INR is not fully convertible, the forward rate cannot be determined using
interest rate differential. It depends more on the supply and demand like the spot
rate.

(c) Assume 3 month USD LIBOR is 0.3 % p.a., 3 month INR MIBOR is 8% p.a.
and the USD is quoting at a premium of 6% p.a. in the forward market
 against the INR. Does CIP hold true? If not then is it possible to arbitrage
between rupee money market and dollar money market? If so then would it
be “Buy-Sell” or “Sell-Buy” swap?
 CIP holds true if (F-S)/S = i-i*
In this problem the interest rate differential is more thus CIP does not hold true.
Yes, arbitrage is possible because in this case (F-S)/S +i* < i
Thus we will need to invest in INR market and hence it will be a Sell-buy swap
(with reference to USD)

(d) Bank “A” quotes Euro-USD rate: 1.0330/35 and Bank “B” quotes Euro-USD Rate
1.0315/20. Is it possible for a third bank “C” to exploit risk-free arbitrage
opportunity? If so then explain how?
 Yes. Buy Euro from Bank B at 1.0320 and sell it to Bank A at 1.0330 and make a
risk free profit of 10 pips

(e) Bank “A” buys USD 10 mio from Bank “B” on 28th September 2014 for delivery 1
month forward at the INR 61.50/USD . What is the date of settlement of the
transaction? When is the transaction settled if the settlement date falls on a
holiday? Show how debits and credits take place on the settlement day.
 Date of settlement is 30th October
 31st Oct if it is a business day otherwise on 29th Oct.?
 For Bank A, USD 10 mio gets credited to its nostro account with Bank B?
And credit INR 615 mio to Bank B’s vostro account with Bank A?

(f) Explain what is meant by Yen carry Trade? What are risks faced in undertaking
Yen Carry Trade?
 The yen carry trade is when investors borrow yen at a low interest rate. They
exchange it for U.S. dollars or any currency in a country that pays a high interest
rate on its bonds. They receive a low-risk profit when they receive high interest
on the money invested, but pay low interest on the money borrowed.
 Risk: Traders get into big trouble if the value of the yen increases or the value of
the dollar declines.

[Carry Trade is profitable as long as the interest differential between high

interest currency and low interest currency is greater than the depreciation of the
high interest currency i.e. the investment currency.

The Yen carry trade collapsed in 2008 following Lehman shock and appreciation
of Yen.]

(g) An Indian importer wants to import equipment from his overseas office in
Singapore. Can the Singapore office of the company book a Non-Deliverable
Forward (NDF) to hedge INR-USD exchange rate risk ? If “Yes” then explain the
mechanism.
 Yes, the importer will get into a Non-Deliverable Forward contract which is
basically an outright forward to buy USD at a fixed rate at a particular future
 date. There will be no actual exchange of notional amount. The only exchange of
cash flows is the difference between the NDF rate and the prevailing spot market
rate—that is determined on the fixing date and exchanged on the settlement date.

Q3. Answer (a) to (c) with reference to the following Table from Reuter Screen:

CCY SPOT 1 MTH 2MTH 3 MTH 6 MTH

EUR 1.1356/57 3.7/3.8 8.5/8.6 13.4/13.7 30.7/31.2
GBP 1.5856/60 1.5/1.3 2.8/2.6 3.9/3.5 7.2/5.7
JPY 115.36/40 1.8/1.7 4.2/4.0 6.9/6.8 17.6/17.2
CHF 0.9717/21 5.48/5.32 12.40/12.00 19.80/19.10 45.86/44.14
INR 61.6700/00 66.50/66.60 78.00/80.00 109.30/111.50 171.00/173.00

. (a) Which of the above quotes are (i) Direct and (ii) Indirect ?
 Direct- JPY, CHF, INR
 Indirect – EUR, GBP

(b) Which are the currencies that are quoting at (i) Premium to USD and which
currencies are quoting at (ii) Discount to USD?
 Premium – EUR, JPY, CHF
Currencies are always represented as Base/Quote currency. It is generally more valuable of the
two quoted currencies. It means 1 Euro = 1.3245 and at 1 month forward it will be trading at a
premium

 Discount – GBP, INR

. It means 1 Euro = 1.3245 and at 1 month forward it will be trading at a premium

(c) Compute outright forward quotations for the following currencies: (i) 1 mth
forward Euro (ii) 2 mth forward Pound Sterling (iii) 3 mth forward Yen (iv) 4
mth forward Swiss Francs and (v) 6 mth forward Indian Rupee.
 Outright forward = Spot + Forward premium or Spot –Forward discount
i. 1.1360/61 – as EUR is trading at a premium
1-month Forward Euro (Bid rate) = 1.1356 + (3.7/1000) = 1.1356+0.00037 = 1.1359

1-month Forward Euro (Ask rate) = 1.1357 + (3.8/1000) = 1.1357+0.00038 = 1.1360

ii. 1.5853/57
iii. 115.29/33
iv. 0.9692/97
v. 63.37/73

(c) Explain with the help of a numerical example how an Indian importer can make
profit by cancelling his forward contract when the rupee depreciates and the
forward discount on the rupee rises sharply.
 Let us assume the importer has a 3 month forward contract to sell USD at 60.00. Now
if the rupee depreciates sharply and the forward discount on the rupee rises sharply
he will simply cancel the forward and get into a new forward contract at the increased
exchange rate and make the profits after paying for the cancellation. ???

(d) A Japanese company wants to acquire a 15% equity stake in an Indian company
and hedge exchange rate risk. Explain the mechanism through which it can do so.
 Forex swap or an upright currency forward

(e) What is meant by convertibility of a currency on the capital account? What is

meant by convertibility of a currency on the current account? Explain what are the
pre-conditions of making the rupee convertible on the capital account?
 Capital Account Convertibility means that rupee can be freely convertible into any
foreign currencies for the acquisition of assets like shares, properties, and assets
abroad. Further, the banks can accept deposits in any currency.
 Current account convertibility implies that the Indian rupee can be converted to any
foreign currency at existing market rates for trade purposes for any amount. It allows
easy financial transactions for the export and import of goods and services.

 Pre-conditions of making the rupee convertible on the capital account:

The Tarapore Committee recommended that, before adopting capital account

convertibility (CAC), India should fulfill three crucial pre-conditions:

(i) Fiscal deficit should be reduced to 3.5 per cent. The Government should also set up
a Consolidated Sinking Fund (CSF) to reduce Government debt.
 (ii) The Governments should fix the annual inflation target between 3 to 5 per cent.
This was called mandated inflation target — and give foil freedom to RBI to use
monetary weapons to achieve the inflation target.

(iii) The Indian financial sector should be strengthened. For this, interest rates should
be folly deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent,
the average effective CRR should be reduced to 3 per cent and weak banks should
either be liquidated or be merged with other strong banks.

(f) What are the perils RBI perceives by making the Indian rupee fully convertible on
the capital account?
 Capital flight
 High volatility: Amid a lack of suitable regulatory control and rates subject to open
markets with large number of global market participants, high levels of volatility,
devaluation or inflation in forex rates may happen, challenging the country’s
economy.
 Foreign debt burden: Businesses can easily raise foreign debt, but they are prone to
the risk of high repayments if exchange rates become unfavorable. Imagine an Indian
business taking a U.S. dollar loan at a rate of 4%, compared to one available in India
at 7%. However, if the U.S. dollar appreciates against Indian rupee, more rupees will
be needed to get same number of dollars, making the repayment costly.
 Affects balance of trade, and exports: A rising unregulated rupee makes Indian
exports less competitive in the international markets. Export-oriented economies like
India and China prefer to keep their exchanges rates lower to retain the low-cost
advantage. Once the regulations on exchange rates go away, India risks losing its
competitiveness in the international market.
 Lack of fundamentals: Full capital account convertibility has worked well in well-
regulated nations that have a robust infrastructure in place. India’s basic challenges
—high dependence on exports, burgeoning population, corruption, socio-economic
complexities and challenges of bureaucracy—may lead to economic setbacks post-full
rupee convertibility

(g) What is the difference between nominal and real exchange rate? What is the
significance of real effective exchange rate (REER)? What is NEER?
 Nominal Exchange Rate: The amount of currency you can receive in exchange for
another currency. Real Exchange Rate: Exchange rate adjusted for inflation.
 Difference: While the nominal exchange rate tells how much foreign currency can be
exchanged for a unit of domestic currency, the real exchange rate tells how much the
goods and services in the domestic country can be exchanged for the goods and
services in a foreign country.
 The “real effective exchange rate” (REER), is the weighted average of a nominal
exchange rate to an index or basket of other major currencies adjusted for the effects
of inflation.
 Significance of real effective exchange rate: A country's REER is an important
measure when assessing its trade capabilities and current import/export situation. The
 REER can be used to measure the equilibrium value of a country's currency, identify
the underlying factors of a country's trade flow, look at any changes in international
price or cost competition, and allocate incentives between tradable and non-tradable
sectors.
 The nominal effective exchange rate (NEER) is an unadjusted weighted average rate
at which one country's currency exchanges for a basket of multiple foreign currencies.
In economics, the NEER is an indicator of a country's international competitiveness in
terms of the foreign exchange (forex) market. Forex traders sometimes refer to the
NEER as the trade-weighted currency index.

(h) The USD/INR exchange rate a year ago was 61. The inflation differential during
the past one year between India and the U.S. has been 5% p.a. What should be the
fair value of the INR according to PPP Theory? At the current exchange of 60.50 is
the INR overvalued or undervalued against the USD? By how much in percentage
terms?
 The change in exchange rate should equal the interest rate differential. The fair value
of INR should be (61+5% of 61) = 64.05
 At current rate of 60.50 INR is overvalued against USD by 5.54%

Q4. (a) What is meant by Balance of Payments? What are its components?
 The Balance of Payments 'BOP' is an account of all transactions between one country
and all other countries--transactions that are measured in terms of receipts and
payments. Balance of Payment is the measure of demand and supply of foreign
currency. If the balance of payment is high and positive (Exports higher than imports),
it will lead to excess supply of foreign currencies and therefore local currency will
appreciate. In the reverse case, domestic currency will depreciate.

 Balance of Payment account has three main components: -

1. The Current Account including Merchandise Trade balance, service balance,
investment income, unilateral transfers (military aid, gifts etc.,)
2. The Capital Account including Direct Foreign Investments, Portfolio
management, other short-term and long-term capital flows
3. The Official Reserve Account: Records changes in the amount of “official reserve
asset held by the Central bank. Official reserves asset include gold and foreign
currencies that are used in international trade and financial transaction, SDR's
and other payments.

(b) What is meant by convertibility of the rupee on (i) current account

(ii) capital account? Explain.
 Current account convertibility implies that the Indian rupee can be converted to any
foreign currency at existing market rates for trade purposes for any amount. It allows
easy financial transactions for the export and import of goods and services.

 Capital Account Convertibility means that rupee can be freely convertible into any
foreign currencies for the acquisition of assets like shares, properties, and assets
abroad. Further, the banks can accept deposits in any currency.
(c) What are the risks of making the rupee convertible on the capital account?
Convertibility of currency can give rise to following problems:

 Firstly, since market determined exchange rate is generally higher than the
previous officially fixed exchange rate, prices of essential imports rise which
may generate cost-push inflation in the economy.

 Secondly, if current account convertibility is not properly managed and

monitored, market exchange rate may lead to the depreciation of domestic
currency. If a currency depreciates heavily, the confidence in it is shaken and
no one will accept it in its transactions. As a result, trade and capital flows in
the country are adversely affected.

 Thirdly, convertibility of a currency sometimes makes it highly volatile.

Further, operations by speculators make it more volatile.

(d) Explain with the help of a diagram the “Impossible Trinity Trilemma”. In the
context of the steep depreciation of the Indian rupee against the dollar from INR
55/USD in May’13 to INR 69/USD in Aug’13 explain the impossible trinity
trilemma that RBI faced.

 The Impossible trinity (also known as the Trilemma) is a trilemma in

international economics which states that it is impossible to have all three of the
following at the same time:
o a fixed foreign exchange rate
o free capital movement (absence of capital controls)
o an independent monetary policy

 According to the trilemma model, a country has three options. It can

o set a fixed exchange rate between its currency and another while
allowing capital to flow freely across its borders,
 o allow capital to flow freely and set its own monetary policy, or
o set its own monetary policy and maintain a fixed exchange rate.

[[[As it happened in India, after lowering interest rates over the previous year,
RBI went ahead to protect the rupee by sucking liquidity out of the system,
which has resulted in higher cost of money and higher interest rates.
From a pure monetary policy standpoint, RBI had no intention of raising interest
rates.
In fact there was a case to cut policy rates to support growth, but while targeting
currency it lost a bit of control on the monetary policy, which resulted in higher
interest rates.]]]?

(e) What is the difference between nominal and real exchange rate? What is the
significance of real exchange rate? Explain.
 Q. 3(g)
Significance of real exchange rate: The real rate tells us how many times more
or less goods and services can be purchased abroad (after conversion into a
foreign currency) than in the domestic market for a given amount. In practice,
changes of the real exchange rate rather than its absolute level are important.

(f) What is Purchasing Power Parity (PPP) also known as the “Law of One Price”
(LOOP) state? What is Absolute PPP? How does it differ from relative PPP?
Explain.
 Law of One Price:
Prices of identical goods sold in different countries must be the same when expressed
in terms of the same currency.
Assumptions:
 Goods produced by each country are homogenous
 Goods produced are tradable
 There are no impediments to international trade such as official trade barriers,
transportation costs etc.

 Absolute PPP:
It is the application of the law of one price across countries for all goods and services,
or typically for “baskets” of goods and services.
  Relative PPP:
If the assumptions of absolute PPP theory are relaxed, we observe Relative Purchasing
Power Parity.

 Difference between Absolute and Relative PPP

o Absolute PPP implies that "a bundle of goods should cost the same in Canada
and the United States once you take the exchange rate into account". Any
deviations from this (if a basket of goods is cheaper in Canada than in the
United States), then we should expect relative prices and the exchange rate
between the two countries to move towards a level at which the basket of
goods have the same price in the two countries.
o Relative PPP describes differences in the rates of inflation between two
countries. Specifically, suppose the rate of inflation in Canada is higher than
that in the US, causing the price of a basket of goods in Canada to rise.
Purchasing power parity requires the basket be the same price in each
country, so this implies that the Canadian dollar must depreciate vis-a-vis the
U.S. dollar. The percentage change in the value of the currency should then
equal the difference in the inflation rates between the two countries.
o Relative purchasing power parity is an economic theory which predicts a
relationship between the inflation rates of two countries over a specified period
and the movement in the exchange rate between their two currencies over the
same period. It is a dynamic version of the absolute PPP theory.

(g) Explain carefully what is meant by the statement “the Indian Rupee is overvalued
against the U.S. Dollar?
 We will explain this by using the method called purchasing power parity.
Let's say you can buy a burger in McDonalds for Rs.100. The same burger can be
bought in United States for $2. With this you can say that exchange rate must be
Rs.50 per USD.
 However, if the rupee actually trades in the market for Rs.60 per USD then rupee is
undervalued. If the rupee trades for 40 per USD then it's overvalued.

Q10. (a) What is “Covered Interest Parity or Arbitrage”? Does it hold true in Indian the
forex market? Explain.
 Covered interest rate parity refers to a theoretical condition in which the relationship
between interest rates and the spot and forward currency values of two countries are
in equilibrium. According to covered interest parity investors gets or earns the same
return regardless of the currency in which they invest or borrowers incur same cost
regardless of currency they borrow.
CIP illustrates the relationship between exchange rates and interest rates. It is a
linkage between the forex market and the money market.

The percentage exchange rate change of two currencies should equal the percentage
change in their interest rate differential or else arbitrage is possible. If (F-S)/S = i-i*,
arbitrage is not possible.

 CIP does not hold true in the Indian foreign market because
o The Indian currency is not fully convertible and thus the is not free flow of
capital between India and other foreign markets which is essential for CIP to
hold true.

(b) Assume 3 month USD LIBOR is 0.3 % p.a., 3 month INR MIBOR is 8% p.a. and
the USD is quoting at a premium of 6% p.a. in the forward market against the
INR. Does CIP hold true? If not then is it possible to arbitrage between rupee
money market and dollar money market? If so then would it be “Buy-Sell” or
“Sell-Buy” swap?
 CIP holds true if (F-S)/S = i-i*
In this problem the interest rate differential is more thus CIP does not hold true.
Yes, arbitrage is possible because in this case (F-S)/S +i* < i
Sell-buy swap (with reference to USD)

(c) Takeshi Miyake is a currency trader in Mizuho Bank, Tokyo. The Spot
USD/JPY exchange rate on 12th November 2014 was 120 and the current
indications are that short-term interest rates in the U.S. i.e. 90 day rates are about
to rise from the current level of 0.50% p.a. The Fed is concerned about expected
inflation and has been publicly considering raising rates by 25 basis points. The
90 day forward rate quoted to Miyake are all about the same i.e. USD/JPY
119.50. The current 90 days JPY Euro deposit rate of interest is 0.125% p.a.
Takeshi has JPY 250 mio at his disposal.
(i) Can Takeshi make profit? If so how much profit in JPY can he hope to make?
Yes?
Compared to investing the JPY in JPY Euro deposit at interest rate of 0.125%
and get 250,000,000 *0.00125*3/12 =JPY 78,125
If he tries to exploit the interest rate differential and hedges the exchange rate
risk by getting in the forward contract at 119.50 he will lose money/
 [[[Step 1: Convert the JPY 250 mio into USD at the rate 120 and get
USD 2,083,333
Step 2: Invest the proceeds in the US money markets and get 0.5%. So he
will be left with 2083333*0.005*3/12 + 2083333 = USD 2085937
Step 3: Convert the USD 2085937 to JPY at the forward rate of 119.50
and get 2085937*119.5 = JPY249,269,491
This results a loss of 730509]] ?

(ii) If future spot exchange rates were determined by interest differentials alone (i.e.
forward ate was a very good forecast of future spot exchange rate) what would
Takeshi expect the spot rate in 90 days if the U.S. does the expected.
 (F-S)/S = i-i*
F=120.75

(iii) If Takeshi’s expectations of future spot rate is that of (ii), what profit could he be
expected to make from uncovered interest parity?
He will do the steps 1 to step 3 as explained in (i) but will cover for foreign
exchange rate risk. Thus he will convert the USD 2085937 to JPY at the
increased rate of 120.75 and get JPY 251,876,892.

(d) Explain with the help of a simple numerical example what is meant by Yen carry
Trade? What are risks faced in undertaking Yen Carry Trade?
 The yen carry trade is when investors borrow yen at a low interest rate. They
exchange it for U.S. dollars or any currency in a country that pays a high interest
rate on its bonds. They receive a low-risk profit when they receive high interest
on the money invested, but pay low interest on the money borrowed.
 Risk: Traders get into big trouble if the value of the yen increases or the value of
the dollar declines. That means they've got to come up with more dollars to pay
back the yen they've borrowed.

[Carry Trade is profitable as long as the interest differential between high

interest currency and low interest currency is greater than the depreciation of the
high interest currency i.e. the investment currency.]

(e) Bank “A” quotes Euro-USD rate: 1.0330/35 and Bank “B” quotes Euro-USD
Rate 1.0315/20. Is it possible for a third bank “C” to exploit risk-free arbitrage
opportunity? If so then explain how?
 Yes. Buy Euro from bank B at 1.0320 and sell Euro to bank A at 1.0330 and make a
risk-free arbitrage profits of 10 pips.

Q18. (I) Please answer questions: (a) to (d) based on the table below from Reuter Screen:

CCY BANK SPOT BANK PREV1 HIGH LOW

EUR BBHB 1.2357/60 DBSK 58/597 1.2381 1.2339

JPY SGAX 79.38/42 BCFX 37/43 79.49 79.24
 GBP SBFR 1.5704/05 WBCY 02/06 1.5738 1.5687
CHF JPMY 0.9719/22 BCPX 16/21 0.9733 0.9698
AUD CITIX 1.0441/42 SCBX 40/43 1.0528 1.0425
NZD BOAX 0.8073/75 BNPPX XAU UBSZ 1614.30/615.05
HKD HSHK 7.7561/73 DBSSG XAG MHBK 28.14/28.22
SGD BCFX 1.2523/26 BHFX CAD SGX 0.9874/75
MYR OCBM 3.1300/30 BOAM IDR MTJK 9485/9495
THB SCBK 31.520/540 BNSX INR CNFX 55.730/740
XAU UBSZ 1614.30/615.0
5
XAG MHBK 28.14/28.22
CAD SGX 0.9874/75
IDR MTJK 9485/9495
INR CNFX 55.730/740

(a) Toyota Motors sells Toyota cars to a U.S. importer and invoices in USD. At what
rate will Toyota Motor’s bank convert USD in to Japanese Yen?
 USD to JPY quote is given as 79.38/42
Thus Toyota motors will get to convert USD to Yen at 79.38 JPY per USD

(b) A Swiss car dealer imports BMWs from German car dealer. What rate does the
bank quote the car dealer so that he can buy Euro with Swiss Francs ?
 We need to calculate EUR/CHF exchange rate:
Here, USD/CHF: 0.9719/22
EUR/USD : 1.2357/60
Step 1: Sell CHF and buy USD at CHF 0.9722 per USD
Step 2: Sell USD and buy EUR at USD 1.2360 per EUR
The effective exchange rate for EUR/CHF is CHF 1.2016 per EUR

(c) Calculate the Rupee Yen bid and offer rates. \

 Assuming JPY as base currency calculate JPY/INR cross rate: 0.7017/22

(d) An Indian tourist wants to visit Bangkok. He wants to buy Thai Bhat 50,000. How
many rupees will he have to pay to buy Bhat 50,000?
 The tourist is buying THB and selling INR
To get 50,000 THB he needs (50,000/32.52) USD = 1537.52 USD
To get 1537.52 USD he needs (1537.52 x 55.74) INR = 85701.36 INR