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Question Paper

International Finance and Trade I (221) – October 2004


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 country experiencing hyper inflation should see a rapid >

(a) Appreciation of its currency (b) Decrease in its nominal interest rates
(c) Increase in its real asset prices (d) Devaluation of its currency
(e) Both (a) and (b) above.
< Answer
2. The US economy which is undergoing a huge trade deficit is currently financing it by >

(a) Selling domestic assets like bonds, stocks and real estate to foreign investors
(b) Buying foreign assets like bonds, stocks and real estate
(c) Retiring stocks and bonds held by foreigners
(d) Foreign aid
(e) IMF loan.
< Answer
3. Brazil has a comparative advantage in coffee if >

(a) It produces more coffee than its trading partner


(b) It has more land to grow coffee then its trading partner
(c) It produces coffee at a lower opportunity cost than its trading partner
(d) It produces coffee at a higher opportunity cost than its trading partner
(e) It produces less coffee at a higher cost than its trading partner.
< Answer
4. An import quota is >

(a) A tax on imported goods


(b) A ban not to import such goods
(c) A flat duty on imports
(d) A limit on the number of units that can be imported
(e) A tariff barrier.
< Answer
5. According to the Heckscher-Ohlin model, the source of comparative advantages is a country’s >

(a) Technology (b) Human capital


(c) Factor endowments (d) Ability to publicize its products
(e) Both (a) and (b) above.
< Answer
6. If a country adopting a fixed exchange rate has a balance of payments deficit, then in order to maintain >
the exchange rate the central bank must
(a) Supply foreign exchange to the market
(b) Demand foreign exchange from the market
(c) Supply domestic currency to the market
(d) Neither supply nor demand foreign exchange
(e) Neither supply nor demand domestic currency.
< Answer
7. Trade involving financial assets and international investments is recorded in the _____ account. >

(a) Current (b) Capital (c) Unilateral transfers


(d) Merchandise (e) Services.
< Answer
8. Which of the following statements is true? >

(a) If the current account is in surplus, then capital account must also be in surplus
(b) If the capital account is in deficit, then current account must also be in deficit
(c) The overall sum of all the entries in the balance of payments must be positive
(d) The overall sum of all the entries in the balance of payments must be negative
(e) The overall sum of all the entries in the balance of payments must be zero.
< Answer
9. Which of the following is false under a currency board system? >

(a) The interest rates are automatically set by the market mechanism
(b) The Central Bank of a country cannot act as the lender of the last resort
(c) Exchange rates under the currency board system are stable
(d) Lending to either the Government or the domestic banks by the board is not allowed
(e) When there is a higher demand for the anchor currency, the reserves with the currency board get
enhanced.
< Answer
10. Which of the following forms of purchasing power parity states that changes in spot rates over a period >
of time reflect the changes in the price levels over the same period in the currencies of the concerned
economies?
(a) Absolute form (b) Expectations form
(c) Relative form (d) Both (a) and (b) above
(e) Both (b) and (c) above.
< Answer
11. Which of the following risks is/are classified by Export Credit Guarantee Corporation as political risk? >

(a) Buyer’s failure to accept the goods


(b) Insolvency of the buyer
(c) Cancellation of a valid import license
(d) Buyer’s failure to make the payment within the due date
(e) Both (a) and (d) above.
< Answer
12. The following are the exchange rates quoted in New York: >

CHF / $ 1.2552 / 54
$ / CAD 0.7427 / 29
The synthetic quotes of Swiss Franc per Canadian dollar are
(a) CHF / CAD 0.9322 / 26 (b) CHF / CAD 0.9323 / 25
(c) CHF / CAD 1.6898 / 00 (d) CHF / CAD 1.6896 / 03
(e) CHF / CAD 0.9320 / 22.
< Answer
13. The pound sterling quote of a bank is Rs.83.79 / 84. If the banker agrees to quote a better rate by 2 paise >
to an Exporter, who is buying £200000, the rate quoted is
(a) Rs.83.77 (b) Rs.83.86 (c) Rs.83.81 (d) Rs.83.83 (e) Rs.83.82.
< Answer
14. According to the Monetary Approach of exchange rate forecasting, inflation is the outcome of >

(a) Increase in wages in the economy


(b) Increase in real output growth
(c) Increase in government spending
(d) Adverse effect of political factors on the economy
(e) Increase in money supply in excess of real output growth.
< Answer
15. Which of the following is/are the reason(s) for the J-Curve effect? >

(a) The inelastic nature of short-run foreign demand for exported goods allows export businesses to
achieve a temporary unfair advantage
(b) The elastic nature of short-run foreign demand for exported goods allows export businesses to
achieve a temporary unfair advantage
(c) The elastic nature of short-run foreign demand for exported goods delays the benefits that export
businesses should realize
(d) The inelastic nature of short-run foreign demand for exported goods delays the benefits that export
businesses should realize
(e) Both (a) and (b) above.
< Answer
16. Which of the following serves as an evidence that the goods have actually been imported into India for >
the remittance sent in foreign currency by an Authorized Dealer?
(a) Bill of Lading (b) Bill of Entry
(c) Air Way Bill (d) Combined Transport bill of lading
(e) House airway bill.
< Answer
17. A letter of credit which allows the Issuing bank to make payment to the beneficiary in installments is >
known as
(a) Red clause L/c (b) Green clause L/c (c) Revolving L/c
(d) Transferable L/c (e) Deferred L/c.
< Answer
18. Which of the following conditions is/are to be satisfied, in order to ensure that there is no triangular >
arbitrage?
(a) (A/B)bid × (B/C)bid ≤ (A/C) ask (b) (A/B)bid × (B/C)bid ≤ (A/C)bid
(c) (A/B)ask × (B/C) ask ≤ (A/C)bid (d) Both (a) and (c) above
(e) (a), (b) and (c) above.
< Answer
19. Samurai bond is a bond >

(a) Denominated in yen and issued outside Japan


(b) Denominated in a currency other than yen and issued to the public in Japan
(c) Denominated in yen and issued under Private placement by non-Japanese borrowers in Japan
(d) Denominated in yen and issued by non-Japanese borrowers to the public in Japan
(e) Denominated in yen and issued by Japanese borrower in US.
< Answer
20. If probability of positive NPV is high, the discount rate used in the APV method for calculating the value >
of incremental borrowing capacity is
(a) The risk free interest rate in the home country
(b) The risk free interest rate in the host country
(c) Competitive borrowing rate in the home country
(d) Competitive borrowing rate in the host country
(e) Cost of capital for the parent company.
< Answer
21. Consider the following rates >

Spot Rs./$46.01/04
1 month 5/4 paise
2 months 10/9 paise
3 months 15/14 paise
If an Indian importer seeks to have an option of taking dollar over third month, then the bank will quote
(a) Rs.45.95/$ (b) Rs.45.90/$ (c) Rs.45.91/$ (d) Rs.45.86/$ (e) Rs.46.00/$.
< Answer
22. Overshooting of exchange rates is explained by >

(a) Fisher open condition (b) Triffin’s paradox


(c) Dornbush sticky price theory (d) Marshall-Lerner condition
(e) Asset approach.
< Answer
23. Compensatory financing is >

(a) A form of counter trade


(b) A form of transaction that involves asset transfer as a condition of purchase of goods
(c) An IMF program to assist countries facing temporary shortfall in reserves
(d) A form of overdraft in foreign exchange given by RBI to authorized dealers
(e) A form of electronic funds transfer.
< Answer
24. Free flow of not only goods but also factors of production is allowed among member nations in the case >
of
(a) Free trade area (b) Customs union
(c) Common market (d) Both (a) and (b) above
(e) Both (b) and (c) above.
< Answer
25. According to UCPDC, the L/C issuing bank while issuing L/C, should clearly indicate whether it is >
revocable or irrevocable. In the absence of such indication –
(a) The credit shall be deemed to be revocable
(b) The credit shall be deemed to be irrevocable
(c) The credit shall be deemed to be 50% revocable and 50% irrevocable
(d) The credit shall be amended at the option of applicant
(e) The credit shall be amended at the option of beneficiary.
< Answer
26. Which of the following statements is/are false? >

(a) SDR transactions involve no exchange of currencies but only book entries
(b) SDR is defined in terms of certain gold equivalent
(c) Issue of SDRs to a member country is in proportion to its quota in IMF
(d) SDR is a composite currency unit
(e) Both (a) and (c) above.
< Answer
27. A loan which is arranged through public arrangement between lending banks and a borrower is known as >

(a) Club loan (b) Syndicated euro credit


(c) Note Issuance facility (d) Multiple component facility
(e) Commercial paper.
< Answer
28. A banker who relied on the inter bank rate of Rs./$ 46.06/10 is requested by an Exporter for purchase of >
dollars. What is the rate to be quoted if the banker wants a margin of 0.10%?
(a) Rs.46.11 (b) Rs.46.01 (c) Rs.46.15 (d) Rs.46.05 (e) Rs.46.10.
< Answer
29. Which of the following theory(ies) of exchange rate states that the changes that are expected to occur in >
the value of a currency in future, gets reflected in the exchange rates immediately?
(a) Demand – supply (b) Monetary
(c) Portfolio balance (d) Efficient market hypothesis approach
(e) Both (a) and (d) above.
< Answer
30. If the outright forward rate of US $ for 3 months is Rs.46.10/13 and the relevant swap points are 5/6 >
paise, then the spot rate is
(a) 46.15/19 (b) 46.16/18 (c) 46.05/07 (d) 46.04/07 (e) 46.05/08.

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. Consider the following exchange rates :
US $ Equivalent Foreign currency
per US $
US Market
Japanese Yen (¥) Spot 0.009091 110
90 – day forward 0.009140 109.41
Swiss Franc (CHF) Spot 0.7654 1.3065
90 – day forward 0.7710 1.2970
Equivalent Foreign Currency per
Yen Yen
Japanese Market
Swiss Franc 84.59 0.011822
a. You are required to verify whether there is a triangular arbitrage to exploit the difference between Yen-Franc
cross rates in the U.S market and the Yen – Franc rates in the Japanese market. Indicate clearly which
currency you would buy/sell and in which market.
If you buy $ 1 million worth of foreign currency in the US market what is the profit or loss from the
triangular arbitrage, in US dollars.
b. The risk less rate of interest in the Japanese market for a 90-day investment is 1.25% p.a. compounded
annually. What is the 90-day risk less interest rate in the U.S (expressed as effective annual rate)?
(5 + 5 = 10 marks)< Answer >
2. An institutional investor plans to increase the returns by international diversification. It is in this backdrop the
following information is collected.
United States United Kingdom Singapore
Expected return (%) 12 16 10
Standard deviation of return (%) 8 6 5
Correlation with the United States 1.0 0.60 0.05

a. What is the expected return and standard deviation of returns of a portfolio with 25% invested in the U.K.
and 75% in the US?
b. What is the expected return and standard deviation of returns of a portfolio with 50% invested in Singapore
and 50% in the US?
c. Which country is to be considered for a better set of risk-return choices? Singapore or UK?
(5 + 5 + 2 = 12 marks)< Answer >
3. An exporter in London expects to receive Euro 5,00,000 after 3 months. He has collected the following
information from his banker.
Euro / £ Spot 1.4970/72
3 months forward 1.4981/84
3 months interest rates (p.a.)
Euro 3.20% - 3.60%
£ 4.00% - 4.40%
Which of the following would be a better alternative to the exporter for covering the exposure?
(i) Forward market
(ii) Money market
(8 marks)< Answer >
4. An Indian Company based at Chennai needs short-term funds of Rs.50 million for a period of 3 months. The
company collected the following information from its banker:
Rs./$ Rs./£
Spot 46.11/14 83.77/80
3 months forward 25/26 paise 19/20 paise
3 months Interest rates (p.a.)
Rs : 8%
$ : 2%
£ : 5%
You are required to calculate the annualized effective cost of borrowing,
a. If the company borrows in USD and
(i) Covers the exchange rate risk through forward market
(ii) Keeps the position open and spot rate after 3 months turns out to be Rs/$ 46.21/24.
b. If the company borrows in pounds and
(i) Covers the exchange rate risk through forward market
(ii) Keeps the position open and spot rate after 3 months turns out to be Rs/£ 83.87/90.
(5 + 5 = 10 marks)< Answer >
5. Indira Crafts exports handicrafts to Germany. On July 01, 2004, the company requested its banker to book a
forward contract for Euro 200000 with an option to deliver in September 2004.
On July 01, 2004 the following rates prevailed in the inter bank market for US dollars in Mumbai
Rs/$ Spot : 46.10/11
July : 10/11 paise
August : 20/21 paise
September : 30/31 paise

The exchange rates in Singapore market are:


Euro/$ Spot : 0.8222/23
July : 0.8215/17
August : 0.8208/11
September : 0.8200/04
However, the company could not export the handicrafts due to a dispute over the price. Hence, the company
requested its banker to cancel the contract on September 30, 2004.
On September 30, 2004 the following rates prevailed in the inter-bank market for US dollars in Mumbai.
Rs./$ Spot : 46.00/01
1 month forward : 7/8 paise
2 months forward : 14/15 paise
The exchange rates in Singapore market are:
Euro/$ Spot : 0.8202/04
Exchange margin collected by the bank is 0.10% while quoting the rates.
You are required to compute:
a. The forward rate quoted by the bank on July 01, 2004.
b. The cancellation charges, if any, payable by or to the company.
(4 + 6 = 10 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. There are various techniques of managing foreign exchange exposure so as to reduce or eliminate foreign
exchange risk. These techniques can be broadly classified as internal and external hedging techniques. How do
you differentiate between internal and external hedging techniques? Also describe briefly the different internal
hedging techniques.
(10 marks) < Answer >
7. Exporters are to be provided adequate credit at competitive interest rates in order to ensure steady export growth.
Explain in detail about pre-shipment finance.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER


Suggested Answers
International Finance and Trade I (221) – October 2004
Section A : Basic Concepts
1. Answer : (d) < TOP >

Reason : A country experiencing from hyper inflation should see a rapid devaluation of its currency due to the
application of purchasing power party principle.
2. Answer : (a) < TOP >

Reason : The US economy is currently financing its trade deficit by selling domestic assets like bonds, stocks and
real estate to foreign investors.
3. Answer : (c) < TOP >

Reason : A country with a comparative advantage in the production of a good produces that good at a lower
opportunity cost than its trading partner.
4. Answer : (d) < TOP >

Reason : An import quota is a limit on the number of units that can be imported.
5. Answer : (c) < TOP >

Reason : According to the Heckscher-Owlin model, the source of comparative advantages is a country’s factor
endowments.
6. Answer : (a) < TOP >

Reason : Under a BOP deficit, the quantity demanded of foreign exchange exceeds the quantity supplied. This
amounts to a shortage of foreign exchange. To maintain the exchange rate the central bank must supply
the extra foreign exchange demanded. Hence correct answer is (a).
7. Answer : (b) < TOP >

Reason : Trade involving financial assets and international investments is recorded in the capital account.
8. Answer : (e) < TOP >

Reason : The overall sum of all the entries in the balance of payments must be zero.
9. Answer : (e) < TOP >

Reason : Options in (a), (b), (c) and (d) are true. Option in (e) is false.
10. Answer : (c) < TOP >

Reason : Relative form of PPP states that changes in spot rates over a period of time reflect the changes in the
price levels over the same period in the currencies of the concerned economies. Absolute form of PPP
states that the respective price levels in the two countries determine the exchange rate between the two
countries currencies. According to the expectations form of PPP, the expected percentage change in the
spot rate is equal to the difference in the expected inflation rates in the two countries. Correct answer is
(c).
11. Answer : (c) < TOP >

Reason : Cancellation of a valid import license in the buyers country is classified by ECGC as political risk.
Options in (a), (b) and (d) are the examples of commercial risks.
12. Answer : (a) < TOP >

Reason : CHF/CAD bid rate = 1.2552 × 0.7427 = 0.9322


CHF/CAD ask rate = 1.2554 × 0.7429 = 0.9326.
13. Answer : (c) < TOP >

Reason : Bid rate for pound is Rs.83.79. This means banker gives Rs.83.79 to take one pound. If banker agrees to
quote a better rate he pays still more by 2 paise to take one pound. So 2 paise is to be added to the bid
rate. Correct answer is Rs.83.81.
14. Answer : (e) < TOP >

Reason : According to the Monetary Approach, an increase in the money supply causes the currency to
depreciate. The outcome of the increase in money supply in excess of real output growth is inflation.
15. Answer : (d) < TOP >

Reason : The J-curve suggests that short run demand for domestic and foreign goods is inelastic, which means
they will not change easily. This is a result of contracts that may already be in place and the speed in
which buyer behavior will change. In fact the current account will become more negative at first as
importers pay even higher prices for volumes they cannot reduce and exporters can’t benefit from
additional sales until volumes can be increased.
16. Answer : (b) < TOP >

Reason : Bill of Entry serves as evidence that the goods have actually been imported into India for the remittance
sent in foreign currency by the ADs. Options in (a), (c), (d) and (e) are documents of title to the goods
and these documents are issued by carrier agents.
17. Answer : (e) < TOP >

Reason : A letter of credit which allows the issuing bank to make payments in installments is known as ‘Deferred
L/C’.
18. Answer : (a) < TOP >

Reason : To ensure that there is no triangular arbitrage, the following conditions are to be satisfied.
i. (A/B) bid × (B/C) bid ≤ (A/C) ask
ii. (A/B) ask × (B/C) ask ≥ (A/C) bid. Correct answer is (a).
19. Answer : (d) < TOP >

Reason : Samurai bond is a bond denominated in Yen and issued by non-Japanese borrowers to the public in
Japan.
20. Answer : (a) < TOP >

Reason : The discount rate used in the APV method for calculating the value of incremental borrowing capacity,
if probability of positive NPV is high, is the risk free interest rate in the home country.
21. Answer : (a) < TOP >

Reason : Forward margin is in discount. Discount is to be deducted. Discount for 2 months is to be given
assuming that the importer may deliver the foreign currency on the first day of the option period. Hence
2 months discount of 9 paise is to be deducted from the ask rate of Rs.46.04. Bank will quote
Rs.45.95/$.
< TOP >
22. Answer : (c)
Reason : (a) Fisher Open condition says that the nominal interest rates minus the expected inflation rates i.e. the
real interest rates are equal across different countries.
(b) The total number of dollars issued by the Federal Reserve (the American Central Bank) was
far in excess of the value of the gold held by it. As it would not have been possible for the
Fed to convert all dollars in to gold, it ran on the confidence of other countries. This created
a paradox in the system known as the Triffins Paradox.
(c) Dornbush sticky price theory explains the overshooting of exchange rates.
(d) Marshall Lerner condition states that the elasticities of Export supply and import demand curve
should together be greater than one to avoid exchange market instability.
(e) Asset approach is one of the exchange rate forecasting approaches. Correct answer is (c).
< TOP >
23. Answer : (c)
Reason : Compensatory financing is an IMF programme to assist countries facing temporary shortfall in reserves.
Options in (a), (b), (d) and (e) are not correct.
24. 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. Hence the correct answer is (c).
25. Answer : (b) < TOP >

Reason : If the L/c issuing bank fails to indicate, whether the documentary credit is revocable or irrevocable, then
the credit shall be deemed to be irrevocable.
26. Answer : (b) < TOP >

Reason : It is false that SDR is defined in terms of certain gold equivalent. SDR is defined in terms of the
weighted average value of 5 currencies (US Dollar, yen, pound, sterling, DM and French Franc).
All the other options under (a), (c), and (d) are true. Hence the correct answer is b.
27. Answer : (b) < TOP >

Reason : Syndicated euro credit is a loan which is arranged through public arrangement between lending banks
and a borrower.
28. Answer : (b) < TOP >

0.10
Reason : Profit margin of 0.10% is to be deducted from the bid rate. That is 46.06 × 100 = Rs.0.05
Spot bid rate = 46.06 – 0.05 = 46.01.
29. Answer : (d) < TOP >

Reason : Efficient market hypothesis approach also known as the asset approach states that the changes that are
expected to occur in the value of a currency in future, gets reflected in the exchange rates immediately.
30. Answer : (c) < TOP >

Reason : Outright forward rate for Rs./$


Spot rate + premium = Forward rate
Spot rate = Forward rate – premium

46.10
Forward rate 13
/

Less Premium 0.05 / 06

46.05
Spot rate 07
/
Section B : Problems

1. a. In the U.S market the cross rate of Yen/SFR


= 0.7654 × 110
= 84.194
The spot rate of Yen / SFR in the Japanese market = 84.59
Thus the Swiss Franc is cheaper in the U.S market and worth more in Japan. Therefore we buy Swiss Frances
in the U.S, sell Swiss Frances in Japan for Yen which we sell in the U.S. The triangular arbitrage is
implemented as follows.
First we buy $ 1000000 worth of Swiss Frances in the U.S
Thus we get SFR 1000000 × 1.3065
= SFR 1306500
Then sell this SFR 1306500 in the Japanese market for Yen.
Thus we get Yen = 1306500 × 84.59
= Yen 110516835
Finally, sell these Yen in the U.S. market for dollars
= 110516835 × 0.009091
= $ 1004708.547
Say $ 1004709
Profit on the transaction = 1004709 – 1000000 = $ 4709
b. 90 day risk less rate in Japan
= (1+0.0125)90/360 – 1
= 0.311%
By interest rate parity
1 + rus
→ F90 = S × 1 + ryen

1 + rus
0.009140 = 0.009091 × 1 + 0.00311
1 + rus 0.009140
or, 1 + 0.00311 = 0.009091
or, 1 + rus = 1.00539 × 1.00311
= 1.008517
rus = 0.8517% for 90 days
Effective annual rate = (1+0.008517) 360/90 – 1
= 3.45%.
< TOP >
2. a. Expected return and standard deviation of return of a portfolio with 25% invested in the U.K. and 75% in the
U.S.
Expected return = 0.25 x 16 + 0.75 x 12 = 13%

Standard deviation of the portfolio ( σ P )


2
= Wus2 σ us + Wuk2 σ uk2 + 2 covariance US, UK, Wus Wuk
2

Where Wus2 σ us2 = The variance of US stocks return multiplied by the weight
Wuk2 σ uk2 = The variance of UK stocks return multiplied by the weight
= (8) 2 (0.75) 2 + (6) 2 (0.25) 2 + 2 x 0.60 x 8 x 6 x 0.75 x 0.25
= 36 + 2.25 + 10.8
= 49.05 (%)2
σ p = 7%
b. Expected return and standard deviation of return of a portfolio with 50% invested in Singapore and 50% in
the US.
Expected return = 0.50 x 12 + 0.50 x 10 = 11%
Standard deviation of return of the portfolio
= (8) 2 (0.50) 2 + (5) 2 (0.50) 2 + 2 x 0.05 x 8 x 5 x 0.5 x 0.5
= 16 + 6.25 + 1.0
= 23.25 (%)2
σ p = 4.82%
c. Singapore offers better diversification opportunities because its fund returns are less correlated with the US
market (r= 0.05) than UK funds ( r = 0.60).

< TOP >


3. (i) Forward market
5, 00, 000
If the exporters uses the forward market, inflow after 3 months will be = 1.4984
= Euro 333689.27
(ii) Money market
If the exporter borrows euros, converts into pounds and invests for 3 months, the inflow will be
5, 00, 000
 0.036 
1 + 
Amount of Euros to be borrowed =  4 
= Euro 495540.14
The loan will be closed with the receivable of euro 5,00,000
Convert Euros into Pounds at the spot rate.
495540.14
Inflow of pounds = 1.4972
= £ 330977.92
Invest this amount for 3 months and the amount with interest after 3 months
 0.04 
1 + 
= 330977.92  4 
= £ 334287.70
Money market cover is better as it maximizes the inflow.
< TOP >
4. The company requires Rs.50 million
Borrow in Dollars:
50
Amount of dollars required to be borrowed = 46.11 = 1.08436 million
 0.02 
1 + 
Amount to be repaid after 6 months = 1.08436  4  = $ 1.08978 million
If covered through forward market, rupee outflow
= 1.08978 × 46.40
= 50.5658 million
50.5658 − 50 12
×
Annualized effective cost of borrowing = 50 3 = 4.53%
If kept open position, rupee outflow
= 1.08978 × 46.24
= 50.3914.
50.3914 − 50 12
×
Annualized effective cost of borrowing = 50 3 = 3.13%.
Borrow in sterling:
50
Amount of sterling required to be borrowed = 83.77 = £ 0.59687 million

 0.05 
1 + 
Amount to be repaid after 3 months = 0.59687  4  = £ 0.60433 million

If covered through forward market rupee outflow


= 0.60433 × 84 = Rs.50.7640 million
50.7640 − 50 12
Effective cost of borrowing = 50 × 3 = 6.11%
If kept open position, rupee outflow
= 0.60433 × 83.90 = Rs.50.7033 million.
50.7033 − 50 12
Effective cost of borrowing = 50 × 3 = 5.63%
So, it is better to borrow in dollars and keep open position.
< TOP >

5. a. US dollar is at premium. Assuming that the dollar is delivered on the first day of the option period, premium
is to be taken for August 2004 only
Rs /$ Spot bid rate 46.10
Add premium for August 0.20
46.300
Less exchange margin at 0.10% 0.046
Forward buying rate for dollar 46.254
US dollar is at discount. Since selling rate is to be considered, earlier delivery ask rate of 0.8211 is to be
taken.
46.254
Forward bid rate of Euro = 0.8211
= Rs.56.33
b. On September 30, 2004 the contract is to be cancelled at the T.T. selling rate
Rs/$ spot ask rate = 46.01
0.046
Add Exchange margin at 0.10% = 46.056
Euro/$ spot buying rate 0.8202
46.056
T.T selling rate for Rs/Euro = 0.8202
= 56.152
Say Rs.56.15

Cancellation charges
Euro 200000 sold to the company at Rs.56.15 = Rs.1,12,30,000
Euro 200000 bought from the company at Rs.56.33 = Rs.1,12,66,000
Exchange difference payable to the company 36,000

The company is paid Rs.35,900 after deducting Rs.100/- towards cancellation charges.
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Section C: Applied Theory

6. These techniques can broadly be classified as internal and external hedging. Internal techniques are those, which
are a part of the day-to-day operations of a company, while external techniques are the ones, which are not a part
of the day-to-day activities and are especially undertaken for the purpose of hedging exchange rate risk. Here, it
needs to be noted that the term internal does not denote that no external party is involved. It only denotes that it is
a normal activity for the company.
The various internal hedging techniques are
• • Exposure netting
• • Leading and lagging
• • Choosing the currency of invoice
• • Sourcing
Exposure Netting
Exposure netting involves creating exposures in the normal course of business, which offset the existing
exposures. The exposures so created may be in the same currency as the existing exposures, or in any other
currency, but the effect should be that any movement in exchange rates that results in a loss on the original
exposure should result in a gain on the new exposure. This may be achieved by creating an opposite exposure in
the same currency or a currency, which moves in tandem with the currency of the original exposure. It may also be
achieved by creating a similar exposure in a currency, which moves, in the opposite direction to the currency of
the original exposure.
Leading and Lagging
Leading and lagging can also be used to hedge exposures. Leading involves advancing a payment, i.e. making a
payment before it is due. Lagging, on the other hand, refers to postponing a payment. A company can lead
payments required to be made in a currency that is likely to appreciate, and lag the payments that it needs to make
in a currency that is likely to depreciate.
Hedging by Choosing the Currency of Invoicing
One very simple way of eliminating transaction and translation exposure is to invoice all receivables and payables
in the domestic currency. However, only one of the parties involved can hedge itself in this manner. It will still
leave the other party exposed, as it will be dealing in a foreign currency. Also, as the other party needs to cover its
exposure, it is likely to build in the cost of doing so in the price it quotes/it is willing to accept.
Another way of using the choice of invoicing currency as a hedging tool relates to the outlook of a firm about
various currencies. This involves invoicing exports in a hard currency and imports in a soft currency. The currency
so chosen may not be the domestic currency for either of the parties involved, and may be selected because of its
stability (like the dollar, which serves as an international currency).
Another way the parties involved in international transactions may hedge exposures is by sharing the risk. This
may be achieved by denominating the transaction partly in each of the domestic currencies of the parties involved.
This way, the exposure for both the parties gets reduced.
Hedging through Sourcing
Sourcing is a specific way of exposure netting. It involves a firm buying the raw materials in the same currency in
which it sells its products. This results in netting of the exposure, at least to some extent. This technique has its
own disadvantages. A company may have to buy raw material, which is costlier or of lower quality than it can
otherwise buy, if it restricts the possible sources in this manner. Due to this, firms do not use this technique very
extensively.
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7. Pre-shipment finance is basically a short-term finance (inventory finance) extended to exporters in anticipation of
export of goods. This finance enables exporters to procure raw materials, process, manufacture, and warehouses,
ship the goods meant for export.
Pre-shipment finance can be classified as
a. Packing credit
b. Advance against incentives receivable from Government covered by ECGC Guarantee
c. Advance against cheques/drafts received as advance payment.
Packing Credit
It is a loan or advance granted to the exporter for purchase of raw materials/processing/packing based on Letter of
Credit (LC) opened in his favor by the importer. The LC/Confirmed order will be retained by the bank and will be
endorsed accordingly indicating that the exporter has availed of packing credit.
Eligibility
An exporter who wants to avail of pre-shipment finance should obtain an importer-exporter code number from the
DGFT. In addition, the exporter should not be under the caution list/special approval list of RBI/ECGC.
Usually, packing credit is extended to exporters who have the export order/letter of credit in their name. It can also
be extended where the contract is concluded by exchange of messages between the two parties, with the opening
of LC to be followed later on provided the track record of the exporter is good. In such instances banks may grant
packing credit based on the communication, provided the following information is made available:
a. Name of the overseas buyer
b. Particulars of goods to be exported
c. Quantity and unit prices or value of order
d. Dates of shipment
e. Terms of sales and payments.
Packing credit is also extended to supporting manufacturers/suppliers of goods who do not have LCs in their own
name but an LC holder has placed orders on them for supply of goods.
Type of Finance
Packing credit is normally a funded advance. It takes the form of an unsecured/clean loan in the initial stages of
disbursement of funds (i.e. when raw materials are yet to be procured). It is called extended packing credit. When
the exporter gets a title to the goods it becomes a secured advance.
At times pre-shipment finance will be extended in a non-fund form, like issuing LCs favoring the suppliers of raw
materials, opening guarantees for credit purchases, etc.
Quantum of Finance
Quantum of loan will not normally exceed FOB value of goods or domestic market value of goods whichever is
lower. However, there are certain exceptions to this. Packing credit may be granted up to the domestic cost of
goods even if it is higher than the FOB value, provided the goods are covered by export incentives of the
Government of India and availability of Export Production Finance Guarantee offered by ECGC. The excess of
advance over FOB value should be adjusted from the cash incentives/duty drawback received.
Margin Requirements
Pre-shipment finance being a need based finance; banks have the freedom to determine the margin that is to be
brought in by the exporters.
The percentage of margin will depend on the nature of the order, commodity, capability of the exporter, etc.
Disbursement of funds under packing credit takes place in phases depending on the length of the operating cycle.
Period of Finance
Packing credit can be extended at a concessional rate of interest for a maximum period of 180 days or for the
operating cycle of the particular activity whichever is lower. Banks may further extend this period to an additional
90 days (i.e. 180 + 90 = 270 days). Alternately, banks may extend packing credit for a maximum period of 270
days from the beginning itself. If the packing credit is outstanding after the due date it is called overdue packing
credit. Overdue packing credit is not eligible for concessional rate of interest.
It should be noted that concessional rates of interest will be applicable only if export of goods takes place within
the time stipulated. This period has been fixed as 360 days from the date of availing the finance. In case export of
goods does not take place within the stipulated period, banks are eligible to charge interest from the very first day
of advance at a rate prescribed for ‘Export credit not otherwise specified’.
Liquidation of Packing Credit
All packing credit advances should be liquidated from funds received by the exporter from either one or a
combination of any of the following sources:
a. Proceeds of export bills negotiated, purchased, or discounted
b. Proceeds of payments receivable from the Government of India, in the form of duty drawback or a payment
from the Market Development Fund (MDF) of the Central Government or from any other relevant source.
If a packing credit advance is not liquidated by export proceeds, that particular advance will not be entitled for
concessional rate of interest.
Advances against Incentives Receivable from Government of India
These advances are generally granted at post-shipment stage. However, in exceptional cases, where the value of
material to be procured for export is more than the FOB value of the contract and considering the availability of
receivables from Government of India, advances are granted for a maximum period of 90 days for more than the
FOB value. These advances are liquidated by negotiation of export bills and out of proceeds of receivables from
Government of India.
Advance against Duty Drawback
Pre-shipment finance can also be extended against duty drawback entitlements provisionally certified by the
Customs. The loans so extended will be adjusted when the final assessment is made by customs and they refund
duties. Banks normally grant duty drawback loans at the post-shipment stage for a period not exceeding 90 days at
lower interest rate as specified.

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