IF SOLUTION SET
Q1. The following quote is given in India:
USD/INR = 83.1500 – 83.2500
You are required to:
1. In which country is this quote Direct?
2. In which country is this quote Indirect?
3. Calculate Mid Rate
4. Calculate Absolute Spread
5. Calculate % Spread
6. Calculate the Inverse Quote
Solution
1. In which country is this quote Direct?
A Direct Quote means the domestic currency is quoted per unit of foreign currency.
Here the quote is:
USD/INR = 83.1500 – 83.2500
Meaning 1 USD = ₹83.1500 – ₹83.2500
Since Indian Rupees are quoted for 1 US Dollar, it is a Direct Quote in India.
Answer:
Direct Quote in India
2. In which country is this quote Indirect?
An Indirect Quote means the foreign currency is quoted per unit of domestic currency.
In the United States, the domestic currency is USD.
But here USD is quoted against INR.
Therefore, from the USA perspective, this becomes an Indirect Quote.
Answer:
Indirect Quote in USA
3. Mid Rate
Formula:
Mid Rate = (Bid Rate + Ask Rate) / 2
Mid Rate = (83.1500 + 83.2500) / 2
Mid Rate = 166.4000 / 2
Mid Rate = 83.2000
4. Absolute Spread
Formula:
Absolute Spread = Ask Rate – Bid Rate
Absolute Spread = 83.2500 – 83.1500
Absolute Spread = 0.1000
5. Percentage Spread
Formula:
% Spread = (Absolute Spread / Mid Rate) × 100
% Spread = (0.1000 / 83.2000) × 100
% Spread = 0.0012019 × 100
% Spread ≈ 0.12%
6. Inverse Quote
Formula:
Inverse Bid = 1 / Ask
Inverse Ask = 1 / Bid
Bid = 1 / 83.2500 = 0.01201
Ask = 1 / 83.1500 = 0.01203
Inverse Quote:
INR/USD = 0.01201 – 0.01203
Final Answers (Summary)
1. Direct Quote: India
2. Indirect Quote: USA
3. Mid Rate: 83.2000
4. Absolute Spread: 0.1000
5. % Spread: 0.12%
6. Inverse Quote:
INR/USD = 0.01201 – 0.01203
Q2. The following quotations are available in London:
1 USD = EUR 0.9100 – 0.9200
1 USD = GBP 0.7900 – 0.8000
In New York:
1 GBP = EUR 1.1500 – 1.1650
Required:
• Derive cross rate of GBP/EUR using London rates
• Compare with New York rate
• Identify whether arbitrage opportunity exists
• Assume capital GBP 1,000,000
Solution :
(1) Meaning of Cross Rate
A cross rate is the exchange rate between two currencies derived using their common relationship with a
third currency (here, USD).
(2) Given Data
London Market:
1 USD = EUR 0.9100 – 0.9200
1 USD = GBP 0.7900 – 0.8000
New York Market:
1 GBP = EUR 1.1500 – 1.1650
(3) Derivation of Cross Rate (GBP/EUR)
Formula:
𝑼𝑺𝑫/𝑬𝑼𝑹
𝑮𝑩𝑷/𝑬𝑼𝑹 =
𝑼𝑺𝑫/𝑮𝑩𝑷
Step 1: Calculate Bid Rate
𝟎. 𝟗𝟏𝟎𝟎
Bid = = 𝟏. 𝟏𝟑𝟕𝟓
𝟎. 𝟖𝟎𝟎𝟎
Step 2: Calculate Ask Rate
𝟎. 𝟗𝟐𝟎𝟎
Ask = = 𝟏. 𝟏𝟔𝟒𝟔
𝟎. 𝟕𝟗𝟎𝟎
Cross Rate (London):
𝟏 𝑮𝑩𝑷 = 𝑬𝑼𝑹 𝟏. 𝟏𝟑𝟕𝟓 – 𝟏. 𝟏𝟔𝟒𝟔
(4) Comparison with New York Rate
Market GBP/EUR
London (Derived) 1.1375 – 1.1646
New York 1.1500 – 1.1650
(5) Identification of Arbitrage Opportunity
London Ask = 1.1646
New York Bid = 1.1500
Since:
London Ask > New York Bid
There is NO arbitrage opportunity, because buying in London and selling in New York will result in a
loss.
(6) Arbitrage Check with Capital GBP 1,000,000
Step 1: Convert GBP to EUR in London (Sell GBP)
Use Bid rate = 1.1375
𝐺𝐵𝑃 1,000,000 × 1.1375 = 𝐸𝑈𝑅 1,137,500
Step 2: Convert EUR to GBP in New York
Use Ask rate = 1.1650
1,137,500
= 𝐺𝐵𝑃 976,395 (𝑎𝑝𝑝𝑟𝑜𝑥)
1.1650
Step 3: Profit / Loss
𝑳𝒐𝒔𝒔 = 𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 − 𝟗𝟕𝟔, 𝟑𝟗𝟓 = 𝑮𝑩𝑷 𝟐𝟑, 𝟔𝟎𝟓
(7) Final Conclusion
Cross Rate (London): 1.1375 – 1.1646
New York Rate: 1.1500 – 1.1650
No Arbitrage Opportunity Exists
Arbitrage results in loss of GBP 23,605
The derived cross rate of GBP/EUR in London is 1.1375 – 1.1646, which is consistent with New York
rates. Since the buying cost in London exceeds the selling price in New York, no arbitrage opportunity
exists. A transaction with GBP 1,000,000 results in a loss of GBP 23,605, confirming absence of
arbitrage.
Q3. Consider the following information:
Spot USD/INR = 83.2000
Forward margins (paise):
1 Month: 15 / 18
2 Month: 30 / 36
3 Month: 45 / 54
6 Month: 80 / 95
Required:
1 Month Forward Rate
2 Month Forward Rate
3 Month Forward Rate
6 Month Forward Rate
State whether USD is at premium or discount.
Solution
1 Month Forward Rate
Bid Rate = 83.2000 + 0.15 = 83.3500
Ask Rate = 83.2000 + 0.18 = 83.3800
1 Month Forward Rate
USD/INR = 83.3500 – 83.3800
2 Month Forward Rate
Bid Rate = 83.2000 + 0.30 = 83.5000
Ask Rate = 83.2000 + 0.36 = 83.5600
2 Month Forward Rate
USD/INR = 83.5000 – 83.5600
3 Month Forward Rate
Bid Rate = 83.2000 + 0.45 = 83.6500
Ask Rate = 83.2000 + 0.54 = 83.7400
3 Month Forward Rate
USD/INR = 83.6500 – 83.7400
6 Month Forward Rate
Bid Rate = 83.2000 + 0.80 = 84.0000
Ask Rate = 83.2000 + 0.95 = 84.1500
6 Month Forward Rate
USD/INR = 84.0000 – 84.1500
Premium or Discount
Since the forward rate is higher than the spot rate, USD is at Premium and INR is at Discount.
Final Answers
Period Forward Rate
1 Month 83.3500 – 83.3800
2 Month 83.5000 – 83.5600
3 Month 83.6500 – 83.7400
6 Month 84.0000 – 84.1500
USD is at Premium.
Q4. Spot USD/INR = 83.4000
3-Month Forward USD/INR = 83.8500
Required:
1. Calculate 3-Month Forward Margin.
2. Calculate 3-Month Annualised Forward Margin (AFM).
3. State whether USD is at Premium or Discount.
4. Interpret the result with reference to interest rate differential.
Solution
1. Calculate 3-Month Forward Margin
Formula:
Forward Margin = Forward Rate − Spot Rate
Forward Margin = 83.8500 − 83.4000
Forward Margin = 0.4500
2. Calculate 3-Month Annualised Forward Margin (AFM)
Formula:
𝑭−𝑺 𝟏𝟐
𝑨𝑭𝑴 = × × 𝟏𝟎𝟎
𝑺 𝒏
Where:
F = Forward Rate
S = Spot Rate
n = Number of months
𝟖𝟑. 𝟖𝟓𝟎𝟎 − 𝟖𝟑. 𝟒𝟎𝟎𝟎 𝟏𝟐
𝑨𝑭𝑴 = × × 𝟏𝟎𝟎
𝟖𝟑. 𝟒𝟎𝟎𝟎 𝟑
Step-wise Calculation:
83.8500 − 83.4000 = 0.4500
0.4500 / 83.4000 = 0.005395
0.005395 × 4 = 0.02158
0.02158 × 100 = 2.16%
3-Month AFM = 2.16% (approx.)
3. Premium or Discount
Rule:
If Forward Rate > Spot Rate → Premium
If Forward Rate < Spot Rate → Discount
Since 83.8500 > 83.4000
USD is at Premium
INR is at Discount
4. Interpretation with Reference to Interest Rate Differential
When a currency is at forward premium, it indicates that the interest rate of that country is lower
compared to the other country.
Therefore:
USD at Premium
INR at Discount
This implies that:
Interest rates in India are higher than interest rates in the USA.
Final Answers
1. 3-Month Forward Margin: 0.4500
2. 3-Month AFM: 2.16%
3. USD is at Premium
4. Interpretation: Interest rates in India are higher than in the USA.
Q5. A Call Option has the following details:
Strike Price = ₹83.50
Premium = ₹0.60
Spot Price at Expiry = ₹86.20
Contract Size = USD 100,000
Required:
1. Whether the option will be exercised
2. Calculate Gross Payoff
3. Calculate Net Gain/Loss
4. Calculate Effective Cost per USD
5. State whether the importer benefited
Solution
1. Whether the Option will be Exercised
Rule:
A Call Option is exercised when Spot Price > Strike Price
Spot Price = 86.20
Strike Price = 83.50
Since 86.20 > 83.50
The Call Option will be Exercised.
2. Gross Payoff
Formula:
Gross Payoff = (Spot Price − Strike Price) × Contract Size
Gross Payoff = (86.20 − 83.50) × 100,000
Gross Payoff = 2.70 × 100,000
Gross Payoff = ₹270,000
SEE NEXT PAGE >
3. Net Gain / Loss
Formula:
Net Gain = Gross Payoff − Premium Paid
Premium Paid = 0.60 × 100,000
Premium Paid = ₹60,000
Net Gain = 270,000 − 60,000
Net Gain = ₹210,000
4. Effective Cost per USD
Formula:
Effective Cost = Strike Price + Premium
Effective Cost = 83.50 + 0.60
Effective Cost = ₹84.10 per USD
5. Whether the Importer Benefited
Market Rate at Expiry = ₹86.20
Effective Cost = ₹84.10
Since the importer effectively paid ₹84.10 instead of ₹86.20
The Importer Benefited.
Final Answers
1. Option Exercised: Yes
2. Gross Payoff: ₹270,000
3. Net Gain: ₹210,000
4. Effective Cost per USD: ₹84.10
5. Importer Benefited: Yes
Q6. An investor has INR 5,000,000 for 3 months.
Currency data:
Currency Spot 3M Forward Interest Rate (p.a.)
USD 83.50 83.80 5%
EUR 90.20 90.10 3%
GBP 101.50 101.90 4%
Required:
Determine best alternative for 3-month investment.
Solution :
1. Investment in USD
Step 1: Convert INR to USD
USD = 5,000,000 / 83.50
USD = 59,880.24
Step 2: Add 3-Month Interest
Interest = 5% × (3/12) = 1.25%
USD after interest:
59,880.24 × 1.0125 = 60,628.74
Step 3: Convert back to INR using Forward Rate
INR = 60,628.74 × 83.80
INR = ₹5,079,691
SEE NEXT PAGE >
2. Investment in EUR
Step 1: Convert INR to EUR
EUR = 5,000,000 / 90.20
EUR = 55,432.37
Step 2: Add 3-Month Interest
Interest = 3% × (3/12) = 0.75%
EUR after interest:
55,432.37 × 1.0075 = 55,848.11
Step 3: Convert back to INR
INR = 55,848.11 × 90.10
INR = ₹5,031,915
3. Investment in GBP
Step 1: Convert INR to GBP
GBP = 5,000,000 / 101.50
GBP = 49,261.08
Step 2: Add 3-Month Interest
Interest = 4% × (3/12) = 1%
GBP after interest:
49,261.08 × 1.01 = 49,753.69
Step 3: Convert back to INR
INR = 49,753.69 × 101.90
INR = ₹5,069,905
Comparison of Final Returns
Currency Final INR
USD ₹5,079,691
EUR ₹5,031,915
GBP ₹5,069,905
Conclusion
The USD investment gives the highest return.
Best Alternative: Invest in USD for 3 months.
Q7.
A project requires initial investment of USD 200,000.
Cash inflows:
Year Cash Flow Discount Factor (10%)
1 40,000 0.909
2 55,000 0.826
3 75,000 0.751
4 60,000 0.683
Required:
• Compute Present Value of each inflow
• Calculate NPV
• State whether project should be accepted
Solution :
1. Present Value of Each Inflow
Formula:
Present Value = Cash Flow × Discount Factor
Year 1
PV = 40,000 × 0.909
PV = 36,360
Year 2
PV = 55,000 × 0.826
PV = 45,430
Year 3
PV = 75,000 × 0.751
PV = 56,325
Year 4
PV = 60,000 × 0.683
PV = 40,980
2. Total Present Value of Cash Inflows
Total PV = 36,360 + 45,430 + 56,325 + 40,980
Total PV = 179,095
3. Net Present Value (NPV)
Formula:
NPV = Total Present Value − Initial Investment
NPV = 179,095 − 200,000
NPV = −20,905
4. Decision
Rule:
If NPV > 0 → Accept Project
If NPV < 0 → Reject Project
Since NPV is negative
The Project should be Rejected.
Final Answers
Present Value of Inflows:
Year PV
1 36,360
2 45,430
3 56,325
4 40,980
Total PV = 179,095
NPV = −20,905
Decision: Project should be Rejected.