Module-2(BU)

International Monetary System – Gold standard – IMF and World Bank

Exchange Rate mechanism – factors influencing exchange rate –
Purchasing power parity and Interest Rate parity theorems.

International Monetary System

Business is much older than money itself. Business was happening even
before the introduction of money by way of Barter system. The introduction
of money has enabled smooth business. World monetary order has
prompted the world trade to flourish.

“Efficient multilateral financial system is a prerequisite for efficient

operation of world trade”. International Monetary System comprises of
world monetary and financial organizations that facilitates:

A. Transfer of funds between the parties,

B. Conversion of national currencies into other currency

C. Acquisition and liquidation of financial assets

D. International Credit Creation.

Areas of International Monetary System: International

monetary system is a very broad area and comprises of the following
important components:

I. The Exchange Rate Regimes II. International Liquidity III.The International

Monetary Fund (IMF) IV.The Adjustment Process (how the payment
imbalances between trading nations are managed) and V. The Currency
blocks and unions like the Economic and Monetary Union (EMU) and
European Currency Union (ECU).

I. Exchange Rate Regimes:“Exchange rate regime refers to

the mechanism, procedure and institutional framework for
determining exchange rates at a given point of time including the
factors responsible for the change”.Three exchange rates are
possible:1.Fixed/Rigid exchange rate2.Floating/ Flexible exchange rate3.
Managed Float .

Exchange Rate Regimes: “Exchange rate regime refers to the

mechanism, procedure and institutional framework for determining
exchange rates at a given point of time including the factors
responsible for the change”. Three exchange rates are
possible:1.Fixed/Rigid exchange rate 2.Floating/ Flexible exchange rate3.
Managed Float .

1. Gold Standard Regime of Fixed Exchange Rates:

(upto 1972): A system in which the actual currency in circulation consisted
of gold coins with fixed gold content is called the Gold Specie standard.
In a system in which the currency in circulation consists of paper money
issued by the central bank as a fixed weight of the gold in reserve is called
the Gold Bullion Standard.

“Under the gold bullion standard, the monetary authorities will fix the rate of
conversion of paper currency into gold”. For centuries, the values of many
currencies were fixed in relation to gold. For example upto 1933 the US fixed 1
ounce of gold at $20, this means that the government of the United States was
exchanging 1 ounce of gold for 20 US dollars. It has to be remembered that, at the
time of weighing gold, 31.103 grams of gold = 1 ounce of gold. However, during the
great depression (1929 to early 1940s in the US), the gold standard was
finally abandoned

The Bretton Woods System:

The Bretton Woods Conference, officially known as the United Nations

Monetary and Financial Conference, was a gathering of delegates from 44
nations who met from July 1 to 22, 1944 in Bretton Woods, New Hampshire,
US to agree upon a series of new rules for the post-World war-II international
monetary system. The two major accomplishments of the conference were
the creation of the International Monetary Fund (IMF) and the International
Bank for Reconstruction and Development (IBRD), now the world bank. The
US and the UK took the task of revamping the world monetary system which
is called the Bretton Woods System.“The exchange rate regime was called
as Gold Exchange Standard”.

Features of the Gold Exchange Standard: As per the

Bretton Woods System:
1.The US Govt to convert the US dollar freely into gold as a fixed parity of
$35 per ounce of gold.(28.35 Grams)

2. The member countries of the IMF agreed to fix the parity of their currency
with the dollar with variation within 1% on either side being permissible.

3. If the variation exceeded the limit, the monitory authorities of the

concerned countries were to buy or sell their currencies against the dollar to
keep their exchange rate within the limits.

4. The member countries were entitled credit facilities from IMF to operate in
their currency market.

The US dollar became the international money and other countries were
accumulating US dollars for international payments. This system continued
as long as the US dollar was stable and the countries were having
confidence in the US Dollar. When the US dollar came under pressure due to
political and economic factors in the mid 1960, on 15 th August 1971, the US
Government abandoned the fixed exchange rate, and the major currencies
went on to the floating exchange rates. An attempt was made by
increasing the price of the gold and widening the band from +- 1% to +-2.5%
around the central parity. This was called as Smithsonian Agreement.
This too failed. In the early 1973 the world moved towards the floating rates
regime.

2. The Floating Rate Regime: (Since 1973 to

approximately 1985)
In view of the collapse of the Bretton Woods system of exchange rate,
countries started to move towards the floating rate regime. In floating rate
regime, the exchange rate is not fixed nor administered but it is determined
by the market forces of demand and supply in respect of foreign currency.
The floating rate regime ensured better stability to the exchange rate. The
exchange rate tend to be closer to the equilibrium in the long run. (For ex:
due to inflation, if the currency depreciated, it led to the greater volume of
exports and greater volume of exports resulting in currency appreciation and
the equilibrium was thus maintained). The floating rate regime also enjoyed
higher protection to the exchange rates from the external shocks as the
governments were empowered to adopt independent economic policy.

However, after the period of wild fluctuations in the exchange rates, since
1985 countries stared to swing towards managed floating.
3.Managed Floating (1985 Onwards)
Under the regime of managed floating,the central bank influences the
exchange rate by means of active intervention in the foreign exchange
market by changing the interest rates and buying or selling the currency
against the home currency.The monitory authorities of the country involve in
direct or indirect interventions to stabilize the exchange rate.

In the direct intervention, the monitory authorities will buy and sell the
foreign currencies in the domestic market and in the indirect intervention the
monetary authorities will change the interest rates. The government
intervenes through the monitory authorities (the central Bank) to bring in
stability in the exchange rates.

Indian Rupee Finally Managed Float:

The Indian rupee went through varying experiences. India being a member of
the Sterling area (Group of countries, which were mostly dominions (self-
governing colony or autonomous state within the British Empire)
and colonies of the British Empire) rupee was linked to the British pound.
Under the fixed parity regime, the value of sterling-linked rupee was fixed as
equivalent to 0.268601 gram of fine gold. In the year 1949, its devaluation
(officially lowering of the value of a country's currency) changed its gold
content to 0.186621 gram of gold and again as a result of 1966 devaluation,
its gold content dropped to 0.118489 gram.

In August 1971, it was briefly pegged (Peg=unit of measurement) Pegging of

currency means fixing a currency of a country with a strong currency of
another country with which it has a very large part of the trade) to the US
dollar at Rs 7.50 per dollar for about five months till December. It was
pegged again to British pound at Rs 18.9677 per pound.

After the collapse of the fixed parity system, rupee was de-linked from
sterling in September 1975 and was pegged to a basket of five currencies,
(US dollar, British pound, French franc, German Mark and Japanese Yen. In
July 1991, during the external sector reforms rupee was devalued by about
20 percent to Rs 25.80/dollar. Finally, from march 1993, rupee came on to
managed float with Reserve Bank of India making off and on intervention in
order to stabilize the exchange rate.
II. International Liquidity and Special Drawing
Rights (SDR)
International Liquidity is the stock of means to make international
payments and International Reserve are the assets which a country can
use in settlement of payments imbalances with other countries. They are
held by the monetary authorities of the countries and will be used to
intervene in foreign exchange markets.

Official reserve assets and other foreign currency assets at

IMF
(approximate market value)

In Millions of US Dollars as on July 2013

A.Official Reserve assets: 74,079.81
(1)Foreign currency reserves (In convertible foreign currencies) 51,971.63
(2) IMF reserve position 0.00
(3) SDRs (Special Drawing rights) 848.27
(4) Gold (including gold deposits) 21,218.76
(5) Other Reserve Assets (financial derivatives, loans to 41.15
nonbank nonresidents etc)
B. Other Foreign Currency Assets: 4,970.16
Total (Total of A and B) 79,049.97

Reserve assets consists of Foreign Exchange Reserves, SDR’s, Gold and

other reserve assets.

Currency Composition of Official Foreign Currency Reserves (COFER) at IMF

as on June 28, 2013 is as follows:
 Special Drawing Rights (SDRs)

The SDR is an international reserve asset, created by the IMF in 1969 to

supplement its member countries' official reserves. Its value is based on a
basket of four key international currencies namely the euro, japanese yen,
pound sterling, and the U.S. dollarand SDRs can be exchanged for freely
usable currencies. IMF members often need to buy SDRs to discharge their
obligations to the IMF, or they may wish to sell SDRs in order to adjust the
composition of their reserves.
The IMF may allocate SDRs to member countries in proportion to their IMF
quotas. Such an allocation provides each member with a costless,
unconditional international reserve asset on which interest is neither earned
nor paid. However, if a member's SDR holdings rise above its allocation, it
earns interest on the excess. Conversely, if it holds fewer SDRs than
allocated, it pays interest on the shortfall.

III. The International Monetary Fund (IMF):

The IMF is an international institution to supervise and promote an open and
stable international monetary system. The Functions of the IMF include:

1.Regulation of the financial relations of its members including

supervision and law enforcement relating to exchange rates and balance of
payments.
2. Providing of the financial assistance to the members experiencing
balance of payment difficulties. The IMF acts as a lender of the last resort to
countries with balance of payment problems.

3. Giving of consultation to the governments by way of pursuing them

to dismantle the exchange controls and to permit free trade and the free
movement of capital.

The Objectives of the IMF are:

1.To Promote International Monetary Co-operation through a

permanent institution which provides the machinery for consultation and
collaboration on international monetary problems.

2. To facilitate expansion and balanced growth of international

trade and to contribute thereby to the promotion and maintenance of high
levels of employment and real income and to the development of the
productive resources of all members as primary objectives of economic
policy.

3. To promote exchange stability to maintain orderly exchange

arrangements among members and to avoid competitive exchange
depreciation.

4. To assist in the establishment of multilateral system of payments

in respect of current transactions between members and in the elimination
of foreign exchange restrictions which hamper the growth of trade.

5. To give confidence to members by making the general resources of

the fund temporarily available to them under adequate safeguards, thus
providing them with opportunity to correct maladjustments in their balance
of payments without resorting to measures destructive of national or
international prosperity.

6. To shorten the duration and lessen the degree of disequilibrium in

the international balance of payments of members.

India and the IMF At a Glance

India joined the IMF on December 27, 1945, as one of the IMF's original
members.While India has not been a frequent user of IMF resources, IMF
credit has been instrumental in helping India respond to emerging balance of
payments problems on two occasions. In 1981-82, India borrowed SDR 3.9
billion under an Extended Fund Facility, the largest arrangement in IMF
history at the time. In 1991-93, India borrowed a total of SDR 2.2 billion
under two stand by arrangements, and in 1991 it borrowed SDR 1.4 billion
under the Compensatory Financing Facility.

Technical Assistance by IMF to India:

In recent years, the Fund has provided India with technical assistance in a in
areas like, development of government securities market, foreign exchange
market reform, public expenditure management, tax and customs
administration, and strengthening statistical systems in connection with the
Special Data Dissemination Standards. Since 1981 the IMF Institute has
provided training to Indian officials in national accounts, tax administration,
balance of payments compilation, monetary policy, and other areas.

Gold at IMF:

IMF remains one of the world’s largest official holders of gold. The IMF held
90.5 million ounces (2,814.1 metric tons) of gold at designated
depositories at mid-March 2013. The IMF’s total gold holdings are valued
on its balance sheet at SDR 3.2 billion (about $4.8 billion) on the basis of
historical cost. As of March 13, 2013, the IMF's holdings amounted to
$143.8 billion at current market prices.
The IMF acquired its current gold holdings throughfour main types of
transactions:

 First, when the IMF was founded in 1944 it was decided that
25 percent of initial quota subscriptions and subsequent quota
increases were to be paid in gold. This represents the largest source
of the IMF's gold.
 Second, all payments of charges (interest on member countries' use
of IMF credit) were normally made in gold.
  Third, a member wishing to acquire the currency of another member
could do so by selling gold to the IMF. The major use of this provision
was sales of gold to the IMF by South Africa in 1970–71.
 Finally, member countries could use gold to repay the IMF for credit
previously extended.

IV.The Adjustment Process:

Any open economy from time to time faces the problems of imbalances in
external transactions (Balance of payments-BOP). The disequilibrium in BOP
may be temporary or persistent. Temporary disequilibrium in BOP can be set
right, by Its own reserves, borrowings from IMF, Borrowings from others or a
combination of the above.
In the case of Persistent Imbalances in BOP, the disequilibrium needs to be
adjusted by “financing the gap” by way of Curtailing Imports, Promoting
exports and by Encourage capital inflows from foreign investors.

V. Currency blocks and unions like the Economic

and Monetary Union (EMU) and European Currency
Union (ECU):
European Union is an economic and political union of 27 member states
which are located primarily in Europe. The EU operates through a system of
supranational independent institutions (European Commission, the Council of
the European Union, the European Council, the Court of Justice of the
European Union, and the European Central Bank.) and intergovernmental
negotiated decisions by the member states. The European Parliament is
elected every five years by EU citizens. The EU's de facto capital is Brussels.

The European Union is composed of 27 sovereign member States: Austria,

Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia,
Finland, France, Germany, Greece, Hungary, Ireland, Italy,
Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland,
Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United
Kingdom. Single currency “EURO” came into existence on 1 Jan 1999.
The parities for some of the member counties were fixed as follows:

1 euro=13.7603 Austrian schilling, 1 euro=40.3399 Belgium Franc, 1

euro=2.2037 Dutch Guilder etc

“The Economic and Monetary Union (EMU) and the EURO provide a
model for other currency unions-a regime in which a group of
sovereign nations share a single currency and vest the power to
design and conduct monetary policy with a supra-natural central
bank”.

Exchange Rate
Exchange rate plays a very important role in foreign exchange. It is the rate
between the two currencies. In simple words it is the price of a currency in
terms of the other currency. For Ex: Exchange rate of US dollar against the
British Pound is 1.7656 means, 1.7656 US Dollars is equal to one British
pound. It also means 0.5663(1/ 1.7656 ) British pound is equal to 1 US
dollar. Exchange rate of Indian rupee against the US dollar is Rs 50 means,
India’s Rs 50 is equal to 1 US Dollar. It also means USD 0.02 (1/50) is equal
to INR 1 .
The International Standards Organization (ISO) has developed three letter
codes for all the currencies. These codes are used to carry out inter-bank
transactions. Selected country codes are as follows:

1. US Dollar=USD, 2. British Pound=GBP, 3.Japanese Yen=JPY, 4.Canadian

Dollar=CAD, 5. Swedish Kroner=SEK, 6.Indian Rupee=INR, 7. Euro=EUR, 8.
Australian Dollar= AUD, 9.Newzeland Dollar=NZD, 10. Saudi Riyal=SAR

Movement of Indian Rupee against the US Dollar

between 1993-2009

Year Range Averag Year Range Average

 e

93-94 31.21-31.49 31.37 01-02 46.56-48.85 47.69

94-95 31.37-31.97 31.40 02-03 47.51-49.06 48.40

95-96 31.37-37.95 33.46 03-04 43.45-47.46 45.92

96-97 34.14-35.96 35.52 04-05 43.36-46.46 44.95

97-98 35.70-40.36 37.18 05-06 43.30-46.33 44.28

98-99 39.48-43.42 42.13 06-07 43.14-46.97 45.28

99-00 42.44-43.64 43.34 07-08 39.26-43.15 40.24

00-01 43.61-46.89 45.71 08-09 39.89-52.09 45.92

The Indian rupee went through varying experiences. India being a member
of the Sterling area, rupee was linked to the British pound. Under the fixed
parity regime, the value of sterling-linked rupee was fixed as equivalent to
0.268601 gram of fine gold. In the year 1949, its devaluation changed its
gold content to 0.186621 gram of gold and again as a result of 1966
devaluation, its gold content dropped to 0.118489 gram. In August 1971, it
was briefly pegged to the US dollar at Rs 7.50 per dollar for about five
months till December. It was pegged again to British pound at Rs 18.9677
per pound. After the collapse of the fixed parity system, rupee was de-linked
from sterling in September 1975 and was pegged to a basket of five
currencies, (US dollar, British pound, French franc, German Mark and
Japanese Yen).

In July 1991, during the external sector reforms rupee was devalued by
about 20 percent to Rs 25.80/dollar. Finally, from march 1993, rupee came
on to managed float with Reserve Bank of India making off and on
intervention in order to stabilize the exchange rate. Based on Sodhani
Committee report, the RBI announced the convertibility of Indian Rupee on
current account. (Convertibility can be related as the extent to which a
country's regulations allow free flow of money into and outside the country.
I.e. exporters and importers were allowed to buy and sell foreign currency)

According to the table, the exchange rate of INR against the USD is upwards
since 93-94. It crossed the Rs 40 mark in 1999-2000. The average was Rs
48.40 during 2002-2003. During 2009-10 the rate was around Rs 46-47. At
present it is around Rs 50.

Exchange Rate Equilibrium

The exchange rate is determined by the interplay of demand and supply
forces. The exchange rate between, say the rupee and the US dollar
depends upon the demand for the US dollar and the supply of US dollars in
the Indian foreign exchange market. The demand for dollar comes from
individuals and firms who have to make payments on account of Imports of
goods, services and purchase of securities. The supply of dollars will happen
from the receipt of dollars on account of export or sale of financial securities
to the US.
 Y

INR/USD S

Rs 42 S1

Rs 40

D1

O Q1 Q2 Q3 X

Demand and Supply of USD

INR in terms of USD is shown on the vertical axis Y and the demand and
supply of USD is shown on the horizontal axis X.

The demand curve slops downwards towards the right as a result of increase
in the dollar rate from Rs 40 to Rs 42.

The equilibrium exchange rate Rs 40/USD is reached where the supply curve
intersects the demand curve at Q1.

If the demand for USD increases from D to D1 as a result of increase in

imports and intersects with the supply curve at Q2, the equilibrium rate for
INR will be Rs 42 per USD.

Changes in demand and supply conditions causes the exchange rate

to adjust frequently to a new equilibrium.

Factors Which Effect Foreign Exchange Rate

Aside from factors such as interest rate and inflation, the exchange rate is
one of the most important determinants of a country's relative level of
economic health. Exchange rates play a vital role in a country's level of
trade, which is critical to most every free market economy in the world.
Here are some of the major forces behind exchange rate movements.
A higher currency makes a country's exports more expensive and
imports cheaper in foreign markets; a lower currency makes a
country's exports cheaper and its imports more expensive in foreign
markets. A higher exchange rate can be expected to lower the
country's balance of trade, while a lower exchange rate would
increase it. The following are some of the Factors that effect the Exchange
rate:

1. Differentials in Inflation: As a general rule, a country with a

consistently lower inflation rate exhibits a rising currency value, as its
purchasing power increases relative to other currencies. During the last half
of the twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved low inflation
only later. Those countries with higher inflation typically see depreciation in
their currency in relation to the currencies of their trading partners. This is
also usually accompanied by higher interest rates.

2. Differentials in Interest Rates: Interest rates, inflation and exchange

rates are all highly correlated. By manipulating interest rates, central banks
exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders
in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The
impact of higher interest rates is mitigated, however, if inflation in the
country is much higher than in others, or if additional factors serve to drive
the currency down. The opposite relationship exists for decreasing interest
rates - that is, lower interest rates tend to decrease exchange rates.

3.Current- Account Deficits: The current account is the balance of trade

between a country and its trading partners, reflecting all payments between
countries for goods, services, interest and dividends. A deficit in the current
account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it
receives through sales of exports, and it supplies more of its own currency
than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and
services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests.
4.Public Debt: Countries will engage in large-scale deficit financing to pay
for public sector projects and governmental funding. While such activity
stimulates the domestic economy, nations with large public deficits and
debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.

5. Terms of Trade: A ratio comparing export prices to import prices, the

terms of trade is related to current accounts and the balance of payments. If
the price of a country's exports rises by a greater rate than that of its
imports, its terms of trade have favorably improved.

6. Political Stability and Economic Performance: Foreign investors

inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw
investment funds away from other countries perceived to have more political
and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of
more stable countries.

Forecasting Foreign Exchange Rate

Exchange rate is the rate at which the value of one currency is expressed in
terms of another currency. It is the relative price of one currency in terms of
another. It is one of the most important macro economic variables like the
interest rates, inflation, price levels etc.,

During the Briton and Woods regime of fixed exchange rate the focus was
upon the effects of exchange rate changes on the balance of payments
(BOP). With the advent of the floating rate regime since 1973 importance is
once again shifted to the factors that determine the exchange rate.

In a floating rate regime, when the exchange rate changes with the changes
in the market forces, it is significant to make a forecast of the exchange rate
and to design the financial activities accordingly. Forecasting of exchange
rate is to determine the probable exchange rate for the future.
This is very important as it helps to decide:

Objectives of Foreign-Exchange Forecasting/Why foreign exchange

forecasting/Benefits of forecasting:
1.To decide to hedge or not, if yes to what extent hedging is to be done.

2.To decide about the currency for short term borrowings and investments.

3.To decide about the currency for long term borrowings and investments.

4. To decide about the invoicing currency.

5. To decide about the pricing of exports.

6. To sell the forecasted data by the professional organizations.

International Parity Relationships

(Inflation and Interest)
1. Inflation: Among the factors which influence the exchange rate,
inflation is the most influencing factor. Inflation rate differentials between
the two countries influence the exchange rate between the two currencies.

Inflation rate differentials between the two countries means that

the rate of inflation between the two countries that is country which
is used as the Base currency and the country with which the
currency is quoted is different. For Ex USD/INR. If Indian rupee is
quoted with the USD as the base currency it results in what is
called as the inflation rate differentials as the rate of inflation in
India is much higher than that of the US.

Purchasing Power Parity Theory (PPP Theory-Cassel, officer ):The

influence of inflation on the exchange rate is neatly explained in the
Purchasing Power Parity theory (PPP Theory).

“The PPP-T suggests that at any given time, the rate of exchange between
two currencies is determined by their purchasing power. If e is the
exchange rate and PA and PB are the purchasing power of the two
currencies A and B, the equation can be written as e= PA /P B ”.

Countries experiencing higher inflation will experience a corresponding

depreciation in its currency and the country with a lower inflation rate will
experience an appreciation in the value of its currency.
The PPP-T is based on the concept of one price in which the domestic price
of any good equals its foreign price quoted in the same currency. For Ex: if
the exchange rate USD/INR= Rs 50, the price of a particular commodity
which is Rs 100 in India should be equal to 2 USD in the USA. In case if it is
not same, arbitragers will come to picture by operating. They start to buy in
the country in which it is less and sell in the country in which it is more. In
this process equilibrium is restored. For ex considering the above example
if the price of the commodity increases from Rs 100 to 125 in India and in
the USA it remains the same, the arbitrager will buy the goods from the
USA and start selling in India and earns a profit of Rs 25. This he does till
the price in the US increase to 2.5 USD which is =INR 125 (USD/INR= Rs
50)1 USD= 50 INR, 125 INR= ?, 125 INRX1USD/50 INR=2.5 USD. This version
of the PPP-T is known as the absolute version. This theory will hold good
only if the same commodities are included in the same proportion in the
domestic market basket and the world market basket. If not, the PPP-T will
not hold good. This theory also does not cover the non-traded goods and
services. In view of the above limitations, another version of this theory has
evolved which is known as the relative versionof the PPP-T.

According to the relative version of the PPP-T, “A change in exchange rate

that would retain the original level of relative price of tradable to non
tradable goods in the economy, would establish an equilibrium exchange
rate”. It further states that the exchange between currencies of any two
counties should be a constant multiple of the general price indices prevailing
in them. In other words, percentage change in exchange rate should equal
the percentage change in the ratio of price indices in the two countries”.

To put it in the form of an equation:

et = (1+IA )t
eo (1+IB) t

IA and IB are the rates of inflation in country A and country B

et is the spot exchange rate at the end of period t

eo is the value of the country A currency in terms of one unit of Bs currency

in the beginning of period, 2005-06

Problem:If the exchange rate at the end of 2004-05 is Rs 43.91/USD and if

the rate of inflation in India and USA during 2005-06 is respectively 7% and
4% find:
1. Inflation rate differential between the two countries and

2. The exchange rate at the end of 2005-06.

Solution:

1. Inflation rate differential between the two countries=

Inflation in India during 2005-06= 7%=100+7=107

Inflation in USA during 2005-06=4% =100+4=104

Inflation rate differential=

104 (Base currency USD)=100

107 =?

107X100/104=102.88

Therefore Inflation rate differential=102.88-100=2.8846%

2.Exchange rate at the end of 2005-06=

et = (1+IA )t

eo (1+IB) t

IA and IB are the rates of inflation in India and USA.

India=7/100 =0.07 and , USA= 4/100=0.04

et is the value of the country A currency in terms of one unit of Bs currency

in the end of period. =1

eo is the spot exchange rate in period t = 43.91

et = (1+IA )t

eo (1+IB) t
 et= 1+7%= (1+0.07)(1.07)
43.91 1+4% (1+0.04) = (1.04)

et = (1.07)
43.91 (1.04)

etX1.04=1.07X43.91=1.04et=46.9837

et=46.9837÷1.04=45.1746

Exchange rate at the end of 2005-06= INR 45.1746

Problem:Calculate the value of Indian rupee at the end of 2 years, assuming

that the inflation rate in India is 5% and that of USA it is 3% and the initial
exchange rate is Rs 40 per USD. Also calculate the inflation rate differentials
between the two countries.

Solution:

1. Value of Indian Rupee at the end of 2 years. =

et = (1+IA )t

eo (1+IB) t

IA and IB are the rates of inflation in India and USA.

India=5/100 =0.05 and , USA= 3/100=0.03

et is the value of the country A currency in terms of one unit of Bs currency

in the end of period

eo is the spot exchange rate in period t = 40.00

et = (1+IA )t

eo (1+IB) t

et= (1+0.05) 2 (1.05)2

40.00 (1+0.03)2 = (1.03)2

et= (1.1025)

40.00(1.0609)
etX1.0609=1.1025X40.00

1.0609et= 44.10

et=44.10÷1.0609

=41.5684 INR

2. Calculation of Inflation rate differential between the two countries=

Inflation in India 5%=100+5=105

Inflation in USA during =3% =100+3=103

Inflation rate differential=

103 (Base currency USD)=100

105 =? =105X100/103=101.94

Inflation rate differential=101.94-100=1.94%

Such inflation adjusted rate is known as the real exchange rate. Rate to
which the inflation is not adjusted is known as the nominal exchange rate.

“The PPP-T suggests that a country with a high rate of inflation

should devalue its currency relative to the currency of the countries
with lower inflation rates”.

2. Interest rate: Experts differ as to the impact of interest rates on

the exchange rates. The flexible price version of the monetary theory says
that “any rise in the domestic interest rate, lowers the demand for money
and lower demand causes depreciation in the value of the domestic
currency”.

The sticky price version of the monetary theory says that “a rise in the
interest rate, increases the supply of lonable funds leading to greater supply
of money and depreciation in the domestic currency”. It also says that
“higher interest rate at home than in the foreign country will attract capital
from aboard and the inflow of foreign currency results in increase of supply
of foreign currency and raises the value of domestic currency”.

International Parity Relationships-Interest Rate: Fisher Effect:

Irving Fisher is of the opinion that interest rate cannot be thought of isolating
with inflation. Fisher says that if the interest rate is 10% and if the inflation
rate is also 10% the return of capital is be zero. This is because the gain
from interest is lost in the form of inflation.

Fisher decomposed the nominal interest rate into two parts namely the real
interest rate and the expected rate of inflation. “The relationship
between the real interest rate and the expected rate of inflation is
known as the Fisher Effect”. The Fisher effect states that whenever an
investor thinks of an investment, he is interested in a particular nominal
interest rate which covers both the real interest rate and the expected rate
of inflation. Mathematically:

1+r=(1+a) (1+I)

r= nominal interest rate, a=real interest rate and I=expected rate of

inflation.

Problem : Calculate the nominal rate of interest assuming that the real
interest rate in the USA is 5% and the inflation rate is 8%.

1+r=(1+a) (1+I)

a=real interest rate=5%, I=expected rate of inflation=8%

r= nominal interest rate=?

Solution:

1+r=(1+5%) (1+8%)

=1+r=(1+0.05) (1+0.08)

=1+r=(1.05)(1.08)

=1+r=1.134

=1-1.134+r=0

-0.134=-r or

+r=+0.134 or in terms of percentage= 0.134X100=13.4%

Verification:

1+r=(1+a) (1+Inf)

=1+0.134=(1+0.05) (1+0.08)
=1.134=(1.05)(1.08)

=1.134=1.134

Problem: Find out the rate of inflation, assuming that the nominal interest is
15% and the real interest rate is 5%.

Solution:

1+r=(1+a) (1+Inf)

a=real interest rate=5%

Inf=expected rate of inflation=?

r= nominal interest rate=15%

1+r=(1+a) (1+Inf)

=1+15%=(1+5%) (1+Inf%)

=1+0.15=(1+.05)(1+Inf/100)

=1.15=(1.05) (1 Inf)

= 1.15=1.05 Inf

= Inf= 1.15/1.05=1.0952

=1.0952 =1

? =100

1.0952x100/1= 109.52

Int 109.52-100=9.52%

(Notes: (1 Inf)

(1+Inf/100) (1+1/100)

=1/1=Inf/100

=100+Inf/100= 1 Inf

Note: Inf=Inflation)
The concept of real interest applies to all investments. An Investor invests in
a foreign country if the real interest rate differentials is likely to be in his
favor, but when such a differential exists, arbitrage begins in the form of
international capital flow that ultimately equals the real interest rate across
countries.

The capital flow will continue till the real interest rate in the two countries
becomes equal. Since the real interest rate is equal in different countries, the
country with higher nominal interest rate will be facing a higher rate of
inflation.

Interest Rate Parity (IRP) Theory

Interest Rate Parity (IPR) theory is used to analyze the relationship between the spot
rate and a corresponding forward (future) rate of currencies.

The IRP theory states interest rate differentials between two different
currencies will be reflected in the premium or discount for the forward
exchange rate on the foreign currency if there is no arbitrage - the activity
of buying shares or currency in one financial market and selling it at a profit
in another.

The theory further states size of the forward premium or discount on a

foreign currency should be equal to the interest rate differentials between
the countries in comparison.

Miscellaneous illustrations:

1.From the following data calculate the arbitrage possibilities: Spot rate: Rs
48.0010 per USD, 6 months forward rate is Rs 48.8020 per USD, annualized
interest rate on 6 month rupee: 12% and annualized interest rate on 6 month
USD is 8%.

Solution:

Rule:

IRD>FPR= Place the money in the currency which has a higher interest rate

IRD<FPR= Do not place the money in the currency which has a higher
interest rate

Interest rate differentials (IRD) (12%-8%=4%)

Forward Premium Rate (FPR)= FR-SR X 12 X 100

 SR n

FR= Forward rate= Rs 48.8020, SR= Spot rate= Rs 48.0010, 12= Total
number of months in the year, n=no of forward months=6 months

Rs 48.8020- Rs 48.0010 X 12 X 100 =

Rs 48.0010 6

= Rs 0.8010 X 12 X 100 = 3.3374%

Rs 48.0010 6

Rule:

IRD>FPR= Place the money in the currency which has a higher interest rate

IRD<FPR= Do not place the money in the currency which has a higher
interest rate

Therefore, in this case there is a possibility of arbitrage in-flow in India. This

means the arbitragers may borrow at 8% in the US and invest at 12% in India
at the spot rate of Rs 48.0010 per USD for 6 months.

Let us assume that he borrows 1000 USD in the US at 8% in the US at Rs

48.0010 per USD and invests in India at 12% for 6 months, The result will
be as follows:

The arbitrager will borrow 1,000 USD in the US and converts 1,000 USD into
INR in India at the spot rate of Rs 48.0010 per USD and invests in India.
After 6 months he converts both the principal and the interest into the USD
at the forward rate of Rs 48.8020 and repay 1,000 USD + interest in the US

He will invest in India 1000 USD X Rs 48.0010 per USD at the spot rate=Rs
48,001

He will earn after 6 months=Rs 48001x12/100x6/12= Rs 2,880 (Interest)

Principal (Rs 48,001)+Interest (Rs 2,880)= Rs 50,881/Rs 48.8020 (Forward

rate)=1042.6007 dollars

He has to repay principal with interest in USD after 6 months in the US

1000x8/100x6/12=40 USD(interest)

Principal (1,000 USD)+Interest (40 USD)= 1,040 USD

He will receive1042.6007 USD - pays 1,040 USD and still makes a profit of
2.6007 USD.

2. From the following data calculate the arbitrage possibilities: Spot rate: Rs
47.0030 per USD, 6 months forward rate is Rs 48.0010 per USD, annualized
interest rate on 6 month rupee: 12% and annualized interest rate on 6 month
USD is 8%.

Solution:

IRD>FPR= Place the money in the currency which has a higher interest rate

IRD<FPR= Do not place the money in the currency which has a higher
interest rate

Interest rate differentials (IRD) (12%-8%=4%)

Forward Premium Rate (FPR)= FR-SR X 12 X 100

SR n

FR= Forward rate= Rs 48.0010, SR= Spot rate= Rs 47.0030, 12= Total
number of months in the year, n=no of forward months=6 months

Rs 48.0010- Rs 47.0030 X 12 X 100 =

Rs 47.0030 6

Rs 0.998 X 12 X 100 = 4.2465%

Rs 47.0030 6

Rule:

IRD>FPR= Place the money in the currency which has a higher interest rate

IRD<FPR= Do not place the money in the currency which has a higher
interest rate

IRD=4%, FPR=4.2465%
IRD is not more than FPR, so it not worth borrowing from the US at 8% and
investing in India at 12%

Let us take the above example and assume that arbitrager borrows
1000 USD , assuming all other things to be the same the result will
be as follows:

The arbitrager will borrow 1,000 USD in the US and converts 1,000 USD into
INR in India at the spot rate of RsRs 47.0030 per USD per USD and invests in
India. After 6 months he converts both the principal and the interest into the
USD at the forward rate of Rs 48.0010 and repay 1,000 USD + interest in the
US

He will invest in India 1000 USD X Rs 47.0030 per USD at the spot rate=Rs
47,003

He will earn after 6 months=Rs 47,003x12/100x6/12= Rs 2,820 (Interest)

Principal (Rs 47,003)+Interest (Rs 2,820)= Rs 49,823 /Rs 48.0010 (Forward

rate)=1037.9575 dollars

He has to repay principal with interest in USD after 6 months in the US

1000x8/100x6/12=40 USD(interest)

Principal (1,000 USD)+Interest (40 USD)= 1,040 USD

He will receive1037.9575 USD - pays 1,040 USD and incurs a loss of 2.0425
USD.

3.An American distributor purchases 4,000 $ worth of perfume from a French

firm (French Francs worth 20,000). The American distributor must make a
payment in 90 days in French Francs. The following quotations exists for the
FFR (French Francs)

Present spot rate $ 0.2000, 90 days forward rate $ 0.2200, US Interest rate
15% and French interest rate 10%.
a.What is the premium or discount on the forward French franc?

b.What is the interest rate differential between the US and the France?

c.How can an arbitrageurs take advantage of the situation assuming that the
arbitrageur is willing to borrow $ 4,000 and invest in france

d.If transaction cost are $50, would arbitrage opportunity still exits.

Solution:

American dealer purchases $ 4,000 worth perfume from France equal to

20,000 French francs meaning 1 French Franc is 0.2000 USD (4,000/20,000)

a. Premium or discount on the forward French franc=

Forward Premium Rate (FPR)= FR-SR X 12 X 100

SR n

$ 0.2200,-$ 0.2000 X 360 days X 100 =40% (Forward Premium Rate)

$ 0.2000 90 days

FR= Forward rate= $ 0.22.00, SR= Spot rate= $ 0.2000, 12= Total number
of months in the year or 360 days , n=no of forward months or days=90

b. Interest rate differential between the US and the France=

US Interest rate 15% - French interest rate 10%=5%

c. How can an arbitrageurs take advantage of the situation assuming that

the arbitrageur is willing to borrow $ 4,000

Borrow $ 4,000 for 90 days at 15% interest

Therefore interest on borrowing = $4,000X90/360X15/100 =150 USD

Therefore principal + Interest to be repaid= $4,000+$ 150= $4,150

Converts $ 4,000 for 20,000 FFR (at the rate of 1 French Franc is 0.2000
USD (4,000/20,000)

Invests 20,000 FFR in France at the rate of 10% for 90 days

Therefore interest on investment= FFR 20,000X90/360X10/100=500 FFR

Therefore principal + Interest to be received= 20,000 FFR+500 FFR=20,500

FFR

1 FFR = 0.2200 USD (Forward rate given)

20,500 FFR=?

20,500 FFR X 0.2200/1= 4,510 USD

Therefore principal + Interest to be received in = USD 4,510

Received in = USD 4,510 – repaid = $ 4,150= Gain = 360 USD

d. If transaction cost are $50, would arbitrage opportunity still exits ?

Received in = USD 4,510 – repaid = $ 4,150 + transaction cost 50 USD = 4,200

USD

Yes, Still there will be Gain of 310 USD ( USD 4,510- 4,200 USD)

4.Apple I-Phone is costing in US $ 500. The same i-phone is costing 750

curoud in Germany. What is the spot rate between curoud and dollar.

Solution:

Price of I phone in the US=Price of I phone in Germany

500 USD=750 Curoud

1 USD = ?

750 X 1/500=1.5000
1 USD=1.5000 Curoud

500 USD=750 Curoud

? = 1 Curoud

500 X 1/750= 0.6666

1 Curoud=0.6666 USD

5. In Australia a cricket bat is sold for 50 AUD (Australian Dollar) while in

India it is sold for 1,000 INR. According to the PPP what should be the Rs per
AUD rate. If the price of the cricket bat in Australia goes up to AUD 60 and
the price of cricket bat in India goes up to Rs 1,075 what is the one year
forward Rs per AUD rate.

Cricket bat in India, 1000 INR=Cricket bat in Australia, 50 AUD

? =1 AUD

1,000X1/50=20

1 AUD=20 INR

Cricket bat in India goes to , 1075 INR=Cricket bat is Australia goes to, 60
AUD

?=1 AUD

1075X1/60=17.9166

1 AUD=17.9166 INR

One year forward rate of Rs per AUD=17.9166

6. It is given that 6 months dollar bonds=7% pa, risk free 6 months Japanese
bonds=6.5% pa. Spot exchange rate is 1 Yen=0.008. What is the six
months forward exchange rate.

Formula:

(FR) Forward Exchange Rate =1 + yh (US)

(SR)Spot Exchange Rate 1 + yf (Japan)

Yh= Interest rate in the home country,

Yf=Interest rate in the foreign country

FR =1+ 3.5%*

0.0081 + 3.25%*

= FR= 1+0.0350

0.008 1+0.0325

FR =1.0350

0.008 1.0325

1.0325XFR=1.0350X0.008

1.0325FR=0.00828

FR=0.00828÷1.0325=0.0080USD

6 months forward exchange rate for 1 Yen=0.0080 USD

*Dollar bonds=7% interest PA (12 *Japanese Bonds-=6.5% Interest PA (12

Months) Months)
12 months=7% 12 months=6.5%
6 months= 6x7/12=3.5% 6 months= 6x6.5/12= 3.25%

7. Given that the nominal rate of 90 days US risk free securities= 5%, rate of
90 day British risk free securities=5.25%. The spot rate is 1GBP=1.55USD.
Is the pound forward rate selling at premium or discount ?what is the forward
rate?

Formula:

(FR) Forward Exchange Rate = 1 + yh (US)

(SR)Spot Exchange Rate 1 + yf (Britain)

Yh= Interest rate in the home country (US), Yf=Interest rate in the foreign
country(Britain)

FR =1 + 1.25% *

1.551 + 1.3125% *
= FR =1+0.0125

1.551+0.0131

= FR = 1.0125

1.55 1.0131

1.0131 X FR=1.0125 X1.55

1.0131FR=1.5693

FR=1.5693÷1.0131=1.5490

1.Pound forward rate is selling at Discount (forward rate (1.5490 USD) is less than
spot rate (1.5500)

2.Forward 1 GBP= 1.5490 USD

*US securities= *British securities=

5%PA for 12 months or 360 days 5.25% PA for 12 months or 360 days
? = 90 days ? = 90
90 X 5/360=1.25% days
90 X 5.25/360=1.3125%

8. ABC limited has to make a USD 10 million payment in three months. The
company decides to invest the amount for three months and the following
information is available.

a. The US deposit rate=8% pa

b. The Pound deposit rate=11%pa

c. The spot exchange rate is 1.65 dollars/pound

d. The 3 month forward rate is 1.60 dollars/pound. Answer the following

questions:

a. Will interest rate parity hold good?

b. Assuming that the interest rates and the spot exchange rate remain as
above, what forward rate would yield an equilibrium situation?

c. Assuming that the USD interest rate and the spot and forward rates
remain as above, where should the company invest if the sterling pound
deposit rates were 12%pa.
Solution:

a. The US deposit rate=8% pa

b. The Pound deposit rate=11%pa

c. The spot exchange rate is 1.65 dollars/pound

d. The 3 month forward rate is 1.60 dollars/pound

Solution:

a)For Interest rate parity (IRP) to hold good

LHS=RHS

FR=Forward rate= 1.60 dollars/pound, SR= Spot rate=1.65 dollars/pound,

rh=rate of interest at the home country=8%, rf=rate of interest in the
foreign country=11%

RHS= FR
X (1 + rf)
S

FR

(1 + rh) X (1 + rf)

1.60

(1 + 2*/100) X (1 + 2.75*/100)

1.65

(1 + 0.0200) = 0.9696 (1 +0.0275)

1.0200= 0.9696(1.0275)

1.02= 0.9963

LHS≠RHS
LHS¿ RHS

As LHS ≠ RHS, Interest rate parity (IRP) will not hold good

*The US deposit rate= *The Pound deposit rate=

8% pa=12 months 10%pa=12 months
? = 3 months ? = 3 months
8X3/12=2% 11X3/12=2.75%

b.Forward equilibrium rate:

FR 1+ rh
=
S 1+rf

FR(1 + 2*/100)
=
1.65(1 + 2.75*/100)

FR(1 + 0.0200)
=
1.65(1 + 0.0275)

FR (1.0200)
=
1.65 (1.0275)

FRX1.0275=1.0200X1.65

=1.0275FR=1.6830

FR=1.6830÷1.0275=1.6379 per pound equilibrium is achieved.

c. Assuming that the USD interest rate and the spot and forward rates
remain as above, where should the company invest if the sterling pound
deposit rates were 12%pa.

Solution:

a. The US deposit rate=8% pa (rh)

b. The Pound deposit rate=12%pa (rf)

c. The spot exchange rate is 1.65 dollars/pound

d. The 3 month forward rate is 1.60 dollars/pound

For Interest rate parity (IRP) to hold good

LHS=RHS

LHS=(1 + rh) = (1+ 0.02)=1.02

RHS=FR

X (1 + rf)
S

1.60

RHS= X (1 + 0.03)

1.65

1.60

RH S= X 1.03

1.65

1.60X1.03/1.65=0.9987

LHS≠ RHS, Therefore IRP is not holding

LHS(1.02)>RHS(0.9987)

LHS>RHS=Borrow foreign currency and invest in the home country

The company should invest in the US not in the pound sterling.

9. The 6 month interest rate for Canadian dollar is 9% PA, the 6 month
interest rate for US dollar is 6.75% pa. Quotation for Canadian dollar spot is
0.9100/USD and 6 month forward rate is 0.9025/USD.

a. Is interest rate parity holding good?

b. If not, how advantage can be taken?

c. If large number of operators decide to do arbitrage what will be the effect

on spot and forward quotation and upon the interest rate for the 2
currencies.

Solution:

6 month interest rate for Canadian dollar 9% PA,

6 month interest rate for US dollar is 6.75%

Quotation for Canadian dollar spot is 0.9100/USD,

6month forward rate is 0.9025/USD.

a.Interest rate parity to hold good: LHS=RHS

LHS=(1 + rh) = (1+ 4.5%)=(1+0.045)=(1.045)

RHS= X (1 + rf)

0.9025

RHS= X (1 + 3.375%)

0.9100

0.9025

RH S=X (1+0.03375)

0.9100

0.9025X1.03375/0.9100=1.0252

LHS≠ RHS, Therefore IRP is not holding

LHS(1.045)>RHS(1.0252)

LHS>RHS=Borrow foreign currency and invest in the home country

The company should invest in Canadian dollars.

b.If not, how advantage can be taken?

Advantage can be taken from borrowing from the US at 6.75% PA and

investing in Canada at 9% PA as follows:

For example: 1000 USD is borrowed at the rate of 6.75% in the US for 6 months

Amount to be repaid = Principal of 1,000 USD and interest of 33.75

USD=1033.75 USD

(Interest = 1,000x6.75/100/6/12=33.75 USD)

Investing the amount borrowed in the US in Canada at 9% PA for 6 months

Firstly converting the USD into Canadian dollar at the spot rate

Spot rate=0.9100=1 USD

? = 1,000 USD

1,000X0.9100=910 Canadian dollar

Interest on investing 910 Canadian dollars in Canada=

910x9/100x6/12=40.95.

Before paying back in USD in the US, converting the Canadian dollars into
USD at the 6 month forward rate of 0.9025.

Principal (910) + interest(40.95)=950.95 Canadian dollars to be converted

into USD at the 6 month forward rate of 0.9025.

1 USD=0.9025 Canadian Dollar

?=950.95

=950.95X1/0.9025=1053.6842 USD

Receipts 1053.6842 USD - Payments 1033.7500 USD=Profits= 19.9442 USD

c.If large number of operators decide to do arbitrage what will be the effect on spot
and forward quotation and upon the interest rate for the 2 currencies.

The arbitragers will borrow from the US at low rate of interest and invest in Canada
at high rate of interest. Because of this the demand for the funds in the US
increases, and the interest rate will also increase in the US. In Canada, the supply
of funds increases, and the interest rate is likely to decrease.

In future Canadian dollar will be expected to appreciate against the USD and the
spot rate and the forward rate of the Canadian dollar is likely to become more
stronger against the USD.

10. If the current INR per Dollar rate is INR 50.00, one year inflation rate is
10% for the INR and 2% for the dollar. What is the exchange rate of USD/INR
at the end of one year.

et = (1+IA )t

eo (1+IB) t

IA and IB are the rates of inflation in India and USA.

India=10/100 =0.10 and , USA= 2/100=0.02

et is the spot exchange rate in period t = ?

eo is the value of the country A currency in terms of one unit of Bs currency

in the beginning of period. =50.00

et = (1+IA )t

eo (1+IB) t

et = (1+0.10) et = (1.10) etx1.02=1.10x50.00

50.00 (1+0.02) = 50.00 (1.02) =

etx1.02=55

et=55/1.02= 53.9215

Exchange rate at the end of one year=INR 53.92

11. The spot exchange rate between INR per USD is 50.00 INR, if the annual
inflation rate is 10% in India and 3% in the US.

A) What will be the rate of return to Indian investor if the return in US is

10%?
B) What will be the rate of return to US investor if the return in India is 10%?

A)The rate of return to Indian investor=

The Indian investor in order to invest in the US has to first convert the INR
into USD at the spot rate of INR 50 per USD. After one year he will be
getting 10% that is:

1 USD X 110/100=1.10 USD, he has to reconvert the USD into INR at the rate
at the end of the year.

Rate at the end of the year=

et = (1+IA )t

eo (1+IB) t

et = (1+0.10) et = (1.10) etx1.03=1.10x50.00

50.00 (1+0.03) = 50.00 (1.03) =

etx1.03=55

et=55/1.03= 53.3980

After one year reconvert 1.10 USD into INR at 53.3980

Therefore, Rate of return=

1.10X53.3980=58.7378

50 has become 58.7378

100= ? 100X58.7378/50= 117.47=17.47%

B)The rate of return to US investor=

The US investor in order to invest in the India has to convert the USD into
INR at the spot rate of INR 50 per 1 USD or 0.0200 USD per INR. After one
year he will be getting 10% that is:

50X 110/100=55 INR, he has to reconvert the INR into USD at the rate at the
end of the year.

Rate at the end of the year=

et = (1+IA )t
eo (1+IB) t

et = (1+0.03) et = (1.03) etx1.10=1.03x0.0200

0.0200 (1+0.10) = 0.0200 (1.10) =

etx1.10=0.0206

et=0.0206/1.10= 0.0187

USD at the end of one year=0.0187

After one year reconvert 55 INR into USD at 0.0187

Therefore, Rate of return=

55X0.0187=1.02993

1 USD has become1.02993

100 =? 100x1.02993/1=102.993=2.9930%

12. An American mutual fund is planning to invest 10 million dollars either in

India or in Hong Kong for one year which is the holding period. The expected
rate of return in India is 18% and in Hong Kong it is 15%. Sport rate INR per
USD=49.50/50, HK$ (Hong Kong dollar) per USD=4/4.1. Rate of inflation in
India is 6%, HK (Hong Kong) 4% and US 2%. Tax in Indi is 20% and tax in
Hong Kong is 10%.

Investing in India:

The American mutual fund has to first convert its 10 Million USD into INR at
the spot rate of 49.50 INR per USD (USD/INR , Spot=49.50/50.00)

1,00,00,000X49.50=49,50,00,000 INR

The rate of return in India=18%

Therefore, after one year the American mutual fund will be getting:

49,50,00,000X18/100= 8,91,00,000 INR

Tax 20% on Interest of 8,91,00,000

=1,78,20,000

Returns after tax =8,91,00,000x20/100=1,78,20,000=7,12,80,000

The American mutual fund has to convert INR into USD after one year at the
rate at the end of one year. The rate at the end of one year=

et = (1+IA )t

eo (1+IB) t

et = (1+0.06) et = (1.06) etx1.02=1.06x49.50

49.50 (1+0.02) = 49.50 (1.02) =

etx1.02=52.47

et=52.47/1.02

Exchange rate at the end of one year=INR 51.4404

et = (1+0.06) et = (1.06) etx1.02=1.06x50.00

50.00 (1+0.02) = 50.00 (1.02) =

etx1.02=53

et=53/1.02

USD/INR=51.4404/51.9600

Amount to be repatriated:

Investment: 49,50,00,000 INR

+ 18 %Interest: 8,91,00,000 INR

-20 Tax on interest: 1,78,20,000 INR

=56,62,80,000 INR
1 USD=51.9600 INR (Sale rate)

? = 56,62,80,000 INR=56,62,80,000 INR X1 USD/51.9600 INR

=1,08,98,384 USD

(10 million= 1 Crore (1 million=10 lakhs)

1,00,00,000 USD has become 1,08,98,384 USD

100 = ?

100X1,08,98,384/1,00,00,000=108.9838=8.9838%

Investing in Hong Kong:

The American mutual fund has to first convert its 10 Million USD into HK$ at
the spot rate of 49.50 INR per USD (USD/HK$=4/4.1 )

1,00,00,000X4=4,00,00,000 INR

The rate of return in Hong Kong=15%

Therefore, after one year the American mutual fund will be getting:

4,00,00,000X15/100= 60,00,000

Tax 10% on Interest of 60,00,000

=6,00,000

Returns after tax =60,00,000-6,00,000=54,00,000

The American mutual fund has to convert HK$ into USD after one year at the
rate at the end of one year. The rate at the end of one year=

et = (1+IA )t

eo (1+IB) t

et = (1+0.04) et = (1.04) etx1.02=1.04x4.00

4.00 (1+0.02) = 4.00 (1.02) =

etx1.02=4.16

et=4.06/1.02

= Exchange rate at the end of one year HK$=4.0784

et = (1+0.04) et = (1.04) etx1.02=1.04x4.10

4.10 (1+0.02) = 4.10 (1.02) =

etx1.02=4.264

et=4.264/1.02

= Exchange rate at the end of one year=HK$=4.1803

USD/HK$=4.0784/4.1803

Amount to be repatriated:

Investment: 4,00,00,000 HK$

+ 15 %Interest: 60,00,000 HK$

-10 Tax on interest: 6,00,000 HK$

= 4,54,00,000 HK$

1 USD=4.1803 KH$ (Sale rate)

? = 4,54,00,000 HK$ =4,54,00,000 HK$ X1 USD/4.1803 KH$

=1,08,60,465 USD

(10 million= 1 Crore (1 million=10 lakhs)

1,00,00,000 USD has become 1,08,60,465 USD

100 = ?

100X 1,08,60,465 USD /1,00,00,000=108.6046=8.6046%

Rate of return in India= 8.9838%, Rate of return in Hong Kong=8.6046%.

Thus, it is better to invest in India rather than in Hong Kong.

Important Formula :
1.Interest rate parity to hold good: LHS=RHS

LHS= (1 + rh) rh= rate of interest in the home country.

RHS= X (1 + rf)

F=Forward rate, S=spot rate, rf=rate of interest in the foreign country.

2.LHS<RHS=Borrow in home country and invest in foreign country.

3.LHS>RHS=Borrow in foreign country and invest in home country.

4.IRD>FPR=Place the money in that currency which has higher interest rate

5. IRD<FPR=Do not place the money in the currency which has a high interest rate.

IRD=Interest rate differentials between the two countries.

FR-SR 12

FPR=Forward Premium rate=(FPR)= X X

100

SR n

FR= Forward rate, SR= Spot rate, 12= Total number of months in the year,
n=no of forward months

6. Forward equilibrium rate:

FR 1+ rh

=
S 1+ rf