Numerical Questions - IFM

CALCULATION OF THE FORWARD

EXCHANGE RATE
F = (r* - r) s + s
(1 + r)
Where,
F is one year forward rate quotation in foreign
currency per unit of domestic currency
S is the spot quotation in foreign currency per unit
of domestic currency
r is one year domestic interest rate
r* is one year foreign interest rate
CALCULATION OF THE FORWARD
PREMIUM or DISCOUNT
Premium / Discount = FR – SR x 100 x 12
SR n

Where,
* n is no. of months for which the forward is
traded.
Question 1
Assume the following foreign exchange quotations
are given for a 90 day contract. Calculate the
premium or discount on an annualized basis.
SR = $ 0.8576 / GBP
FR = $ 0.8500 / GBP

Solu: - Premium / Discount = FR – SR x 100 x 12

SR n
Where,
* n is no. of months for which the forward is traded.
Question 2
The Danish Kroner is quoted in New York at
$0.18536/DKr Spot, $0.18524/DKr 30
days forward, $0.18510/DKr 90 days
forward and $0.18485/DKr 180 days
forward. Calculate the forward discounts
or Premiums on the Kroner.
Solution
Spot Rate = $0.18536/ DKr

Forward Rate =
30 days forward rate = $0.18524/DKr,
90 days forward rate = $0.18510/DKr
180 days forward rate = $0.18485/DKr

Prem. / Dis. = Forward Rate – Spot Rate / Spot Rate x 100 x 12 / n

Case 1 – 30 Days Forward
• Spot Rate = $0.18536/ DKr
• 30 days forward rate = $0.18524/DKr
Prem. / Dis. = Forward Rate – Spot Rate / Spot Rate
x 100 x 12 / n
{(0.18524 - 0.18536) / 0.18536} x 100 x 12/1
 - 0.775 % or (0.775 %)

Thus the 30 Days discount percentage for Danish

Kroner is 0.775 %
Case 2 – 90 Days Forward
• Spot Rate = $0.18536/ DKr
• 90 days forward rate = $0.18510/DKr
Prem. / Dis. = Forward Rate – Spot Rate / Spot Rate
x 100 x 12 / n
{(0.18510 - 0.18536) / 0.18536} x 100 x 12/3
 -.561 % or (.561 %)

Thus the 90 Days discount percentage for Danish

Kroner is .561 %
Case 3 – 180 Days Forward
• Spot Rate = $0.18536/ DKr
• 180 days forward rate = $0.18485/DKr
Prem. / Dis. = Forward Rate – Spot Rate / Spot Rate
x 100 x 12 / n
{(0.18485 - 0.18536) / 0.18536} x 100 x 12/6
 -.550 % or (.550 %)

Thus the 180 Days discount percentage for Danish

Kroner is .550 %
Question 3
For the following Spot and Forward quotes, calculate
Premiums / discount on Indian Rupee as (a) an
annualized percentage premium / discount:

Spot $ / INR Forward @ $ / Days Forward

INR
0.009056355 0.008968508 30
0.009056355 0.008772955 90
0.009056355 0.008489201 180
0.009056355 0.007920280 360
Solution
Prem. / Dis. = Forward Rate – Spot Rate / Spot
Rate x 100 x 12 / n

Days Forward Annualized % (Prem. / Dis.)

30 - 11.64 % (Discount)
90 - 12.51 % (Discount)
180 - 12.52 % (Discount)
360 - 12.54 % (Discount)
Question 4
A foreign exchange trader gives the following
quotes for the Euro Spot, one month, three
month and six month to a US based treasurer
$0.02368 / 70 4/5 (8/7) (14/12)
Calculate the outright quotes for one , three and
six month forward.
Solution
US$ per 1 Euro

Maturity BID (Buy) ASK (Sell) Spread

Spot Rate $ 0.02368 $ 0.02370 .00002
1 Month $ 0.02372 $ 0.02375 .00003
3 Month $ 0.02360 $ 0.02363 .00003
6 Month $ 0.02354 $ 0.02358 .00004
Question 5
Euro Bid and Ask prices on the Japanese Yen are
quoted Direct in Paris at Euro 0.007745 / Yen
Bid and Euro 0.007756 / Yen Ask. What are
the corresponding Indirect quotes for Euros?
Solution
Direct Quotes
Bid = Euro 0.007745 / Yen
Ask = Euro 0.007756 / Yen

Indirect Quotes
Bid = 1 / 0.007745 = 129.11556 Yen / Euro
Ask = 1 / 0.007756 = 128.9324 Yen / Euro
Question 6
A foreign exchange trader gives the following quotes for the
Euro Spot, one month, three month and six month to a US
based treasurer
$0.02368 / 70 4/5 (8/7) (14/12)
a) Calculate the outright quotes for one , three and six
month forward.
b) If the treasurer wished to buy a Euro three month
forward, how much he have to pay in Dollars.
c) If he wished to purchase US Dollar one month Forward ,
how much would he pay in Euro?
d) Assuming that Euro are being bought, what is the
premium or discount for the one, three and six month
forward.
Solution
BID ASK
a)
Spot $ 0.02368 $ 0.02370
1 month $ 0.02372 $ 0.02375
3 month $ 0.02360 $ 0.02363
6 month $ 0.02354 $ 0.02358

b) To buy Euro 3 months Forward the treasurer

has to pay $ 0.02363
Solution contd.

c) US $ 1 month Forward = 1 / 0.02375

Euro = 42.10526

d) 1 Month Prem. / Dis. = FR – SR/SR x 100 x 12 / n

(0.02372 – 0.02368) / 0.02368 X 100 x 12 / 1
 2.027 % ( Forward Premium)
 Solution contd.

3 Month Prem. / Dis. = FR – SR/SR x 100 x 12 / n

(0.02360 – 0.02368) / 0.02368 X 100 x 12 / 3
 - 1.351 % (Forward Discount)

6 Month Prem. / Dis. = FR – SR/SR x 100 x 12 / n

(0.02354 – 0.02368) / 0.02368 X 100 x 12 / 6
 - 1.18 % (Forward Discount)
Question 7 - Arbitrage
Calculate the Arbitrage possibilities from the
following data:
Home Country - India
Foreign Country – US
Spot Rate = 62 Rs / $
One Year Forward Rate = 63 RS / $
Annualized interest Rate in India = 12 % p.a.
Annualized interest Rate in US = 10 % p.a.
Solution
Suppose the investment amount is Rs. 1000
If invested in Domestic country (India)
Rs 1000 @ 12 % p.a. interest rate
1000 x 12 / 100
 Rs 120 Interest earned

So, amount after 1 year

Principal amount + interest earned
1000 + 120
1120 Rs
Solution
If invested in Foreign country (US)
Firstly, convert Rs 1000/- to US $
=> 1000 ÷ 62 (which is a spot rate)
=> $ 16.129
Now invest the US$ @ 10 % p. a.
 16.129 x 10 / 100
 $ 1.613
So, amount after 1 year
 Principal amount + interest earned
 $ 16.129 + $ 1.613
 $ 17.742
Solution
Convert the amount back in Rs. @ One year
Forward Rate i.e., Rs 63
$ 17.742 x 63
Rs. 1117.746
Hence, there exists NO ARBITRAGE POSSIBILITY
as interest earned in Domestic market is
higher than the earning from the Foreign
Market.
Question 8
Calculate the Arbitrage possibilities from the
following data:
Spot Rate = Rs 42.0010 / $
6 Month Forward Rate = Rs 43.961 / $
Annualized interest Rate in India = 12 % p.a.
Annualized interest Rate in US = 8 % p.a.
Investment Amount Rs. 1,00,000.
Solution
If invested in Domestic country (India)
Rs 100000 @ 12 % p.a. interest rate for 6 months
100000 x 12 / 100 x 6 / 12
 Rs 6000 Interest earned

So, amount after 6 month

Principal amount + interest earned
100000 + 6000
106000 Rs (Bal. Amount after 6 months if deposited in India)
Solution
If invested in Foreign country (US)
Firstly, convert Rs 100000/- to US $
=> 1,00,000 ÷ 42.0010 (which is a spot rate)
=> $ 2380.896
Now invest the US$ @ 8 % p. a.
 $2380.896 x 8 / 100 x 6 / 12
 $ 95.235
So, amount after 6 month
 Principal amount + interest earned
 $ 2380.896 + $ 95.235
 $ 2476.131
Solution
Convert the amount ($ 2476.13 ) back in Rs. @
Six Month Forward Rate i.e., Rs 43.961
$ 2476.13 x 43.961
Rs. 108850.718
Hence, there exists ARBITRAGE POSSIBILITY as
interest earned in Foreign market is more than
the earning from the domestic market by Rs
2850.718 (108850.718 – 106000).
Question 9
Compaq Co. has to make US$ 1 million payment
in 3 months time. The dollars are available
now. You decide to invest them for 3 months.
US Deposit rate 9% p. a.
UK deposit rate 10 % p.a.
Present spot Rate is $ 1.90 / pound
Three months forward Rate is $1.88 / pound
Where should co. invest for better returns?
Solution
Alternative 1
Invest US $ 1 Million in the US @ 9%p.a. for 3
months
Interest earned = 1,000,000 x 9 / 100 x 3/12)
$22,500
So, inv. amount after 3 month
Principal amount + interest earned
 $ 1,000,000 + $ 22,500
 $ 1,022,500
Solution
Alternative 2
Sell the US$ 1 million and buy £ from the Spot Market @ $
1.90 / £
1000000 / $1.90
=> £ 526,315.789
Invest the available £ @10% for 3 months yields an interest
(£ 526,315.789 x 10/100 x 3/12)
 £ 13,157.895
So, inv. amount after 3 month
Principal + Interest
£ 526,315.789 + £ 13157895
£ 539,473.684
Solution
Now, convert the pound to buy US$ @ 1.88 / £
three month Forward Rate.
£ 539,473.684 x 1.88
$1,014,210.526
Hence income $ 14,210.526 ($1,014,210.526 -
$1,000,000) is less than the $ 22,500 which is
earned when invested in US.
Investment in US will be beneficial by $ 8290.
Question 10
Compaq Co. has to make US$ 1 million payment in 3 months time.
The dollars are available now. You decide to invest them for 3
months.
US Deposit rate 9% p. a. ; UK deposit rate 10 % p.a.
Present spot Rate is $ 1.90 / pound
Three months forward Rate is $1.88 / pound
(a) Where should co. invest for better returns?
(b) Assuming that the interest rates and the returns Spot exchange
rate remain as above, what forward rate would yield an
equilibrium situation?
(c) If the sterling deposit rate was 12% p.a. and all other rates
remain as in the original question. where should you invest?
Solution (b)
Assume the forward rate be x.
For an equilibrium situation, amount at the end of
three months should be equal. Hence, amount
invested in sterling covered by forward rate
should be $1,022,500 (i.e. earnings from Alternative 1)
Hence x = $1,022,500 / £ 539,473.684 (i.e. earnings from
Alternative 1)
=> $1.895
Hence forward rate $1.895 / £
Solution (c)
Sell the US$ and buy £ from the Spot Market, we get
1000000 / 1.90
£526,315.789
Invest the available £ @12% for three months yields an
interest
£526,315.789 x 12/100 x 3/12
 £ 15789.473
(Principal + Interest) after three months
£ 526,315.789 + £ 15,789.473
£542,105.262
Solution (c)
Selling the pound to buy US$, we get
£542,105.262 x $ 1.88
 $1,019,157.893
Thus net income = $1,019,157.893
Since interest earned by investing in US is
$22,500, hence even if the sterling deposit
rate becomes 12 % p.a., investing in US is still
a more profitable alternative.
Question 11
An American firm purchases $4,000 worth of perfume (FF 20,000) from a
French firm. The American distributor must make the payment in 90 days
in French francs. The following quotation and expectations exist for the FF.
Present Spot rate $ 0.2000 US interest rate 15%
90 day forward rate 0.2200 French interest rate 10%
Your expectation of the SR 90 days hence 0.2400
a) What is the premium or discount on the forward French francs? What is
the interest differential between US and France? Is there an incentive for
covered Interest Arbitrage
b) If there is a CIA, how can an arbitrageur take advantage of the situation?
Assume :
(i) the arbitrageur is willing to borrow $ 4,000 or FF 20,000 and
(ii) there are no transaction costs
c) If transaction costs are $50, would an opportunity still exist for CIA?
Solution (a)
Forward premium or discount on FF
=> FR – SR / SR x 100 x 12 / n
.22 – .20 / .20 x 4 x 100
 40 %
The interest differential between US and France is
5%
Yes, there is an incentive for CIA (outflow of trends
from US) as interest differential in favour of
France is - 5% or 5% in favour of US.
Solution (b)
The arbitrageur can take advantage of the
situation in the following manner:
Borrow $ 4,000 for 90 days @ 15 % p.a.
4000 x 15 / 100 x 3 / 12
 $ 150
Amount to be repaid after 90 days :
 $ 4,000 + $ 150
$4,150
Solution (b)
Convert $4,000 into FF at current Spot Rate i.e.,
$0.2000
4000 / 0.2000
FF 20,000
Invest FF 20,000 @ 10% pa for 90 days
20000 x 10 / 100 x 3 / 12
FF 500 (interest earned)
Amount received at the end of 90 days
FF 20,000 + FF 500
 FF 20,500
Solution (b)
Sell investment proceeds forward rate $0.2200
Amount received in US dollars after 90 days by
selling FF 20,500
20,500 x .22
$ 4,510
Hence, Amount Earned = $ 4510
Amount to be paid = $ 4150
$ 360
An arbitrager can take an advantage of this
situation and can earn $ 360.
Solution (c)
As the profit of $360 > transaction cost of $50,
opportunity still exists for Covered Interest
Arbitrage.
Question 12
The annual interest rate in U.S. is 9 % and in
Europe is 10 %. The Euro is currently at a
discount of 2 % in the one year forward
market.
a) Does interest rate parity exist?
b) Can a US firm benefit from investing funds in
Europe using CIA?
c) Can a Europe subsidy of a US firm benefit by
investing funds in the US through CIA.
Solution
One year interest rate in Europe = 10 %
One year interest rate in US = 9 %
Hence, Interest rate differential
10 % – 9 % => 1 %
One Year Forward Market of Euro is
=> Discount @ 2 %
Solution
Thus,
a) The interest rate parity does not exist. Since
Interest rate differential < Discount. So it will
be better to invest money in US market.
b) US firm will suffer a loss by investing funds in
Euro.
c) Europe subsidy will benefit by investing in
US.