The rate of inflation in India it is likely to be 6.5%.

and in USA is likely to be 3% per

annum
The current spot rate of US $ in India is Rs. 43.40. Find the expected rate of US $ in
India

after one year and 3 years from now using purchasing power parity theory.

Annualized interest rate for 6 months (US$) = 8%

Interest rate differential = 12% - 8% = 4%
Since the interest rate differential is negative in the U.S and is greater than forward
premium, there is a possibility of arbitrage inflow into India.
The advantage by using Money Market arbitrage possibility can be analyzed as follows: i)
The US deposit rate is 8% p.a.
(ii) The sterling deposit rate is 10% p.a.
(iii) The spot exchange rate is S 1.80 / pound.
(iv) The three month forward rate is $ 1.78/ pound.
Where should your company invest for better results?
Assuming that the interest rates and the spot exchange rate remain as above, what
forward rate would yield an equilibrium situation?
Assuming that the US interest rate and the spot and forward rates remain as in the
original question, where would you invest if the sterling deposit rate were 14% per
annum?
With the originally stated spot and forward rates and the same dollar deposit rate, what
is
the equilibrium sterling deposit rate?
Answer
(i) Invest for better results
Since the US $ are available now, amount can be invested in
1. US $ Deposits@ 8% p.a. or
2. Converted into Sterling Currency at the Spot Rate and invested in UK Deposits.
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Alternative 1
Particulars Value
Invest in $ deposits @ 8% p.a. for 3 months.
Income = $ 10,00,000 x 8/100x3/12 $ 20,000
Gain in Alternative 1 is higher. Hence, company should invest in US Deposits.
(ii) Equilibrium Forward Rate 3 Months Forward; (for 1 £) = Spot Rate X [(1 + US
Interest Rate for 3 Months) / (1 + Sterling Interest Rate for 3 Months]
= $ 1.8 x [(1 + 8%/4) / (1 + 10%/4)] = $1.7912/ £ [Interest Rate Parity Method]
Equilibrium 3 months Forward Rate = $ 1.7912 / £
(iii) Investment if Sterling Deposit: Rate is 14%
Particulars Amount
1. Amount invested in Sterling
Deposit Rate
£ 5,55,556
2. Interest Income @ 14% for 3
months £ 5,55.556 x 14 % x 3 /
12
£ 19,444
3. Total Cash Inflow at the end of
3 months [(2)+ (3)]
£ 5,75,000
4. Amount earned in US $ = [(4) x
1.78 (Forward Rate) ]
US $ 10,23,500
5. Gain in US $ [10,23,500 -
10,00,000]
US $ 23,500
Conclusion: Gain is highest of all the considered alternatives, therefore amount
should be invested in Sterling Deposits @ 14%.
(iv) Equilibrium Sterling Deposit Rate
Assuming Sterling Interest Rate = x, applying the same in Interest Rate Parity Formula
for determining Forward Rate:
1 £ = $1.80 x (1 + 8%/4) / (1 + x/4) 1 £ = $1.80 x (1 + 0.02) / (1 + x/4);
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⇒ $1.78 = $1.80 x (1 + 0.02)/ (1 + x/4):
⇒ 1+ x/4 = $ 1.80 X 1.02/$ 1.78
⇒ x/4 = 1.03146 -1 = 0.03146 or 3.146%
⇒ x= 12.58%
Equilibrium Sterling Interest Rate = 12.58%
Question 28
XYZ Ltd.. is considering a new plan in Austrailia. The plan will cost 26 Million Austrailian
Dollar (AUD). Incremental Cash Flows are expected to be 3 Million AUD per year for the
first 3 years. 4 Million AUD for the next 3, 5 Million AUD in Years 7 to 9, and 6 Million
AUD
in years 10 through 19, after which the project will terminate with no residual value.
The present exchange rate is 1.90 AUD per dollar. The required rate of return on
repatriated dollar is 16%.
(a) If the exchange rate states at 1.90, what is the project NPV?
(b) If the AUD appreciates to 1.84 for years 1 - 3, to 1.78 for years 4-6,1.72 for years 7-
9,
and to 1.65 for years 10-19, what happens to the NPV?
Answer
1. Net Present Value under Fixed Exchange Rate ($ 1 = AUD 1.90)
Particulars Years
0 0 1- 3 4 - 6 7 - 9 10 - 19
(a) Cash Flows in
AUD
(26.00) 3.00 p.a. 4.00 p.a. 5.00 p.a. 6.00 p.a.
(b) Exchange Rate
[AUD /$]
1.90 1.90 1.90 1.90 1.90
(c) Cash Flow in $ (13.6842)
[26.00/1.90]
1.5789
[3.00/1.90]
2.1053
[4.00/1.90]
2.6312
[5.00/1.90]
3.1579
[6.00/1.90]
(d) Discount Factor
@ 16%
1 2.246 1.439 0.922 1.270
(e) Discounted Cash
Flow
(13.6842) 3.5462 3.030 2.4260 4.0105
Net Present Value = US $ (0.6714) Million
Recommendation: Since the Net Present Value is negative, the project should not be
accepted.
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Net Present Value under Variable Exchange Rates
Particulars Years
0 0 1-3 4-6 7 -9 10-19
Cash Flows in
AUD
(26.00) 3.00 p.a. 4.00 p.a. 5.00 p.a. 6.00 p.a.
Exchange Rate
[AUD / $]
1.90 1.84 1.78 1.72 1.65
Cash Flow in $ (13.6842)
[26.00/1.90]
1.6304
[3.00/1.84]
2.2472
[4.00/1.78]
2.9070
[5.00/1.72]
3.6364
[6.00/1.65]
Discount Factor
@ 16%
1 2.246 1.439 0.922 1.270
Discounted Cash
Flow
(13.6842) 3.6619 3.2337 2.6803 4.6182
Net Present Value = US $ 0.5099 Million
Recommendation: Since the Net Present Value is positive, the project may be
accepted.
Question 29
Astro Ltd. is planning to import a machine from Japan at a cost of 7,640 Yen. The
company
can avail loan at 12% interest per annum with quarterly rests with which it can import
the machine. However, there is an offer from Tokyo branch of an India-based bank
extending credit of 180 days at 1.5% per annum against opening of an irrevocable letter
of credit.
Other information :
Present exchange rate Rs.100 = 382 Yen
180-Day forward rate Rs.100 = 388 Yen
Commission charges for letter of credit at 2% per 12 months. Advise whether the offer
from the foreign branch should be accepted?
Answer
Option I (To finance the purchase by availing loan at 12 p.a.)
Cost of machine Rs.
7,640 yen as Rs. 100 = 382 yen = 2,000.00
Add : interest at 3% I Quarter = 60.00
Add : interest at 3% II Quarter on 2060.00 = 61.80
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Total outflow in rupees = 2,121.80
Alternatively, interest may also be calculated on
compound basis, i.e. Rs. 2,000 x (1.03)2 = Rs. 2,121.80
Option II (To accept the offer from foreign branch)
Cost of letter credit Rs.
At 2% on 7640 yen as Rs. 100 = 382 yen for 6 months = 20.000
Add : interest I Quarter = 0.600
Add : interest II Quarter = 0.618
(A) = 21.218
Payment at the end of 180 days :
Cost = 7,640.00 yen
Interest at 1.5% p.a. [7640 x 1.5% x 180/365] = 56.52 yen
7696.52 yen
Conversion at Rs. 100 = 388 yen,
[7696.52/388 x 100] (B) Rs. 1,983.64
Total Cost : (A + B) Rs. 2,004.86
Advice : Option No. II is cheaper. Hence the offer can be accepted.
Question 30
Following are the details of cash and outflows in foreign currency denominations of ABC
Co., an Indian export firm, which has no foreign subsidiaries —
Currency Inflow Outflow Spot rate Forward rate
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (F
Fr)
2,00,00,000 80,00,000 7.45 8.12
UK £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(a) Determine the net exposure of each foreign currency in terms of Rupees.
(b) Are any of the exposure positions off-setting to some extent?
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Answer
(a) Computation of Net Exposure
Particulars US $ F Fr UK £ Japanese Yen
Inflow (in Lakhs) 400.00 200.00 300.00 150.00
Less : Outflow (200.00) (80.00) (200.00) (250.00)
Net Exposure
(Foreign Currency
Terms)
200.00 120.00 100.00 (100.00)
Spot Exchange Rate 48.01 7.45 75.57 3.20
Net Exposure (in
Rupee Terms based
on Spot Exchange
Rate)
9602
[200x48.01]
894
[120 x 7.45]
7557
[100 x 75.57]
(32)
[100 x 3.20/10]
Particulars US $ F Fr UK£ Japanese Yen
Forward Rate [Rs. , FC]
Less : Spot Exchange Rate
[Rs. / FC]
48.82
48.01
8.12
7.45
75.98
75.57
2.40
3.20
Forward Premium/
(Discount)
0.81 0.67 0.41 (0.80)
Net Exposure in Rupee
Terms based on extent of
uncertainty represented
by Premium / (Discount)
162.0
[200 x 0.81]
80.4
[120 x 0.67]
41.0
[100 x 0.41]
8.0
[(100) x (0.8)/ 10]
(b) Off Setting Position
(i) Net Exposure in all the currencies are offset by better forward rates. In the case of
USD, F Fr and UK Pound, the net exposure is receivable, and the forward rates are
quoted at a premium for these currencies.
(ii) In case of Japanese Yen, the net exposure is payable, and the forward rate is

quoted at a discount. There