Foreign Exchange, International Financial Management and Interest Rate Risk — Practice

Question 1

The spot USD/INR rate is ₹83.00 per dollar. The one-year interest rate in India is 7%, and in the US is 4%. Compute the theoretical one-year forward USD/INR rate using interest rate parity.

Accepted Answer

Using interest rate parity, quoting INR per USD, the rupee (quote currency, since USD/INR means rupees per dollar) interest rate goes in the numerator and the dollar (base currency) rate in the denominator: Forward = Spot × [(1 + i_INR) ÷ (1 + i_USD)] = ₹83.00 × [(1.07) ÷ (1.04)] = ₹83.00 × 1.02885 = ₹85.39 (approximately). Since the rupee interest rate (7%) exceeds the dollar interest rate (4%), the rupee is expected to trade at a forward discount to the dollar (more rupees needed per dollar in the forward market than in the spot market), consistent with interest rate parity's requirement that the currency with the higher interest rate must trade at a forward discount, to prevent a risk-free arbitrage profit from simply borrowing in the lower-rate currency and investing in the higher-rate one.

Question 2

Using the same facts as the previous problem (spot ₹83.00, Indian rate 7%, US rate 4%), suppose the actual quoted one-year forward rate is ₹87.00, higher than the theoretical parity rate of ₹85.39. Explain the covered interest arbitrage strategy an investor could use to profit from this mispricing.

Accepted Answer

Since the actual forward rate of ₹87.00 exceeds the theoretical parity rate of ₹85.39, the rupee is priced at a larger forward discount (more rupees per dollar in the forward market) than interest rate parity justifies, meaning holding dollars and converting back to rupees forward is more attractive than parity implies it should be. The arbitrage strategy: borrow rupees today at 7%, convert the borrowed rupees to dollars at the spot rate of ₹83.00, invest the dollars at the US rate of 4% for one year, and simultaneously enter a forward contract to convert the dollar investment's proceeds back to rupees at the favourable ₹87.00 forward rate; at the end of the year, the dollar investment plus interest, converted back at ₹87.00, will yield more rupees than needed to repay the rupee borrowing plus its 7% interest, since the forward rate used for reconversion is more favourable than the parity-implied rate that would leave exactly zero arbitrage profit, locking in a risk-free profit with no net investment. This specific arbitrage mechanism, in a genuinely efficient, liquid forward market, would itself push the forward rate back down toward the parity-implied ₹85.39, as increased demand to sell dollars forward (from arbitrageurs executing this strategy) exerts downward pressure on the forward USD/INR rate.

Question 3

Explain why the forward exchange rate reflecting the interest rate differential between two currencies is a fundamentally different concept from a market forecast of where the spot rate will actually be at that future date, even though both are sometimes loosely described using similar language.

Accepted Answer

The forward exchange rate is derived purely from the no-arbitrage interest rate parity relationship, reflecting today's interest rate differential between the two currencies and the current spot rate, a relationship that must hold to prevent risk-free covered interest arbitrage, regardless of what any market participant genuinely believes or expects about where the spot rate will actually be at the forward date. A market forecast of the future spot rate, by contrast, would reflect market participants' genuine expectations about future economic conditions, monetary policy, and other fundamental drivers of exchange rate movements, which is a fundamentally different question from the purely arbitrage-driven interest rate differential the forward rate mechanically reflects. While the 'unbiased forward rate' hypothesis proposes that the forward rate is, on average across many observations, an unbiased predictor of the future spot rate, this is a distinct, empirically debatable economic claim about market efficiency, not a definitional or mechanical property of how forward rates are actually determined; the forward rate would exist and be computable via interest rate parity even in a world where it turned out to be a systematically poor predictor of the future spot rate, since its determination depends only on today's interest rates and spot rate, not on any genuine forecast of the future.

Question 4

Classify each of the following as transaction, translation, or economic exposure, and briefly justify

Accepted Answer

A

Question 5

An Indian importer has a USD 200,000 payable due in 90 days. An Indian exporter has a USD 150,000 receivable due in 90 days. State the correct currency option position (call or put) each should take to hedge, and explain the reasoning for each.

Accepted Answer

The importer, who must pay dollars in 90 days and is concerned the rupee will weaken (requiring more rupees to acquire the needed dollars), should buy a call option on the dollar (equivalently, a call on USD/INR), giving the importer the right to buy dollars at a specified strike rate; if the rupee weakens beyond the strike rate, the importer exercises the call and acquires dollars at the more favourable strike rate, while if the rupee strengthens instead, the importer simply lets the option lapse and buys dollars more cheaply in the spot market, retaining the benefit of a favourable currency movement while being protected against an unfavourable one, precisely the asymmetric protection an option (as opposed to a forward, which would lock in one specific rate either way) provides. The exporter, who will receive dollars in 90 days and is concerned the rupee will strengthen (reducing the rupee value of the dollars received), should buy a put option on the dollar, giving the right to sell dollars at a specified strike rate; if the rupee strengthens beyond the strike rate, the exporter exercises the put and sells the received dollars at the more favourable strike rate, while if the rupee weakens instead, the exporter lets the put lapse and sells the dollars in the spot market at the more favourable prevailing rate, again retaining upside while being protected on the downside, at the cost of the put premium paid upfront.

Question 6

A US-based multinational is evaluating a project in India expected to generate ₹40 crore in cash flow in one year. The current spot rate is ₹83 per USD, the one-year forward rate (consistent with interest rate parity) is ₹85.39 per USD, India's cost of capital for a project of this risk is 14%, and the US dollar cost of capital for a project of this risk is 10.5% (consistent with parity given the interest rate differential in an earlier problem). Compute the project's dollar-equivalent present value of this one-year cash flow using both the (a) discount-in-rupees-then-convert and (b) convert-then-discount-in-dollars approaches, and confirm they produce approximately the same result.

Accepted Answer

Approach (a), discount in rupees then convert: Present value in rupees = ₹40 crore ÷ 1.14 = ₹35.09 crore. Converting this rupee present value to dollars at the current spot rate: ₹35.09 crore ÷ 83 = USD 4.227 million (approximately). Approach (b), convert then discount in dollars: Convert the future rupee cash flow to dollars using the forward rate (the appropriate rate for converting a specific future cash flow, since it reflects the market's arbitrage-consistent rate for that specific future date) = ₹40 crore ÷ 85.39 = USD 4.685 million; discount this dollar cash flow at the dollar cost of capital: USD 4.685 million ÷ 1.105 = USD 4.239 million (approximately). Both approaches produce approximately the same dollar present value, USD 4.227 million and USD 4.239 million respectively (the small remaining difference reflecting rounding in the given rates), confirming that under internally consistent assumptions, specifically that the given forward rate and the two discount rates are themselves mutually consistent with interest rate parity, both approaches to international capital budgeting converge to the same answer; a materially larger divergence between the two approaches in an actual exam answer should be read as a signal that the given rates are not genuinely parity-consistent, or that an error has been made in one of the two computations, rather than accepted as two independently valid but different answers.

Question 7

A multinational's foreign subsidiary generates local cash flow of USD 2 million in a given year, but host country regulations restrict repatriation of profits above USD 1.2 million per year to the parent, with any excess required to remain invested locally, earning a return of only 3% until it can eventually be repatriated in a later year. Explain how this blocked funds situation should be reflected in the parent's capital budgeting analysis of this foreign project.

Accepted Answer

The parent's capital budgeting analysis should be built from the cash flows genuinely available to the parent, not the subsidiary's own local cash flow generation, since it is the parent's own shareholders whose wealth the NPV computation is ultimately meant to serve; here, only USD 1.2 million of the USD 2 million generated is actually repatriable to the parent in the given year, and this USD 1.2 million should be treated as the year's relevant cash flow for the parent's own NPV computation, discounted at the parent's appropriate cost of capital as usual. The remaining USD 0.8 million blocked amount is not simply lost or ignored, however; it remains invested locally, earning a return of only 3%, presumably below what the parent's own cost of capital or the subsidiary's own project return would otherwise generate, representing a genuine opportunity cost of the blocked funds restriction, and this blocked amount, together with the modest 3% return it earns while blocked, should be tracked forward and incorporated as a cash flow to the parent in whatever future year it is eventually permitted to be repatriated, meaning the blocked funds restriction effectively delays and reduces the present value the parent can attribute to this portion of the project's cash generation, a genuine cost of the host country's capital controls that a naive analysis assuming full, immediate repatriability would overlook entirely.

Question 8

A company enters a forward rate agreement (FRA) to fix a 6-month interest rate at 8% on a notional of ₹50 lakh, for a period beginning in 3 months. At the settlement date (3 months from now), the actual 6-month reference rate is observed at 9.5%. Compute the settlement amount, and state which party pays which.

Accepted Answer

Settlement amount (undiscounted) = Notional × (Reference rate − FRA rate) × (period in months/12) = ₹50,00,000 × (9.5% − 8%) × (6/12) = ₹50,00,000 × 0.015 × 0.5 = ₹37,500. Since FRAs settle at the start of the reference period rather than its end, this amount is typically discounted back using the actual reference rate for the period: Discounted settlement = ₹37,500 ÷ (1 + 9.5% × 6/12) = ₹37,500 ÷ 1.0475 ≈ ₹35,799. Since the actual reference rate (9.5%) exceeds the FRA rate (8%), the party who agreed to pay the fixed FRA rate and receive the floating reference rate (the 'buyer' of the FRA, typically a borrower hedging against rising rates) receives this settlement payment from the FRA seller, since the buyer is compensated for the reference rate having risen above the rate they had fixed, exactly as intended: a borrower who fixed 8% via the FRA is protected from the actual 9.5% market rate, receiving this settlement payment to offset the higher interest cost they will now face on their actual underlying borrowing at the higher prevailing market rate.

Question 9

A company with floating-rate debt purchases an interest rate cap with a strike (cap) rate of 9%, on a notional matching its debt, paying an upfront premium. In one settlement period, the floating reference rate is 11%; in the next, it is 7%. Explain the cap's payoff in each period and the company's overall effective borrowing cost in each case, ignoring the premium's amortised cost for simplicity.

Accepted Answer

In the period where the floating reference rate is 11%, which exceeds the cap's strike rate of 9%, the cap pays out to the company an amount equal to the difference, 11% − 9% = 2%, applied to the notional, effectively subsidising the company's floating-rate interest cost so that its net effective borrowing cost for that period is capped at 9%, the strike rate, despite the market rate being materially higher at 11%; the cap has done exactly what it was purchased to do, protecting the company against the rate rising above 9%. In the period where the floating reference rate is 7%, which is below the cap's strike rate of 9%, the cap pays out nothing at all, since the cap only pays when the reference rate exceeds the strike; the company simply pays its actual floating rate of 7% on its underlying debt, benefiting fully from the lower prevailing rate, exactly as intended, since a cap is designed to protect only against rates rising above the strike while preserving the full benefit of rates falling below it, in contrast to a swap, which would lock the company into a single fixed rate regardless of which direction the floating rate actually moves, foregoing the benefit of a rate decline that the cap, at the cost of its upfront premium, allows the company to retain.

Question 10

A multinational is evaluating two otherwise identical foreign investment opportunities of similar expected cash flow and operating risk, in two different host countries: Country X has a stable, long-established legal and regulatory environment; Country Y has a recent history of sudden regulatory changes affecting foreign investors and periodic currency control impositions. Explain two distinct ways political risk could be incorporated into the capital budgeting analysis of the Country Y project, beyond simply using the same discount rate as for Country X.

Accepted Answer

First, the discount rate applied to the Country Y project's cash flows could be increased above the rate used for the otherwise identical Country X project, adding a specific political risk premium reflecting the additional, non-diversifiable (from the perspective of this specific project's own risk) uncertainty created by Country Y's history of sudden regulatory changes and currency controls; this approach folds the political risk adjustment into the discount rate, penalising the project's valuation uniformly across all its future cash flows through a higher required return. Second, rather than adjusting the discount rate, the expected cash flows themselves could be explicitly adjusted downward to reflect the probability and expected magnitude of specific adverse political events, such as explicitly modelling a probability-weighted scenario where currency controls block a portion of profit repatriation for some years, or where a sudden regulatory change reduces the project's expected local cash generation, building these specific, identifiable risks directly into the cash flow projections themselves rather than into a single, blended discount rate adjustment; this second approach is generally considered more analytically precise, since it identifies and separately quantifies the specific political risks at play rather than bundling an ill-defined risk premium into the discount rate, though it requires more detailed information and judgement about the specific probability and magnitude of the political risks the project genuinely faces in Country Y.

Question 11

Country A has an inflation rate of 3% per annum, and Country B has an inflation rate of 9% per annum. Using purchasing power parity, explain what should happen to Country B's currency relative to Country A's currency over time, and why this occurs.

Accepted Answer

Purchasing power parity predicts that Country B's currency should depreciate against Country A's currency over time, roughly by the inflation differential of approximately 6 percentage points (9% − 3%) per annum, since Country B's higher inflation means prices for identical goods rise faster in Country B's currency than in Country A's; if the exchange rate did not adjust to reflect this, identical goods would become progressively cheaper in Country A's currency than in Country B's currency once converted at a constant exchange rate, creating an arbitrage-like incentive for goods to be purchased in Country A and effectively resold or substituted for in Country B, and more broadly reducing Country B's exports' competitiveness and increasing its imports, which over time is expected to exert downward pressure on Country B's currency until purchasing power parity is restored, with Country B's currency depreciating enough that the real, inflation-adjusted price of goods is again roughly equalised between the two countries when measured in a common currency.

Question 12

An Indian importer has a USD 100,000 payable due in 3 months. The Indian borrowing rate is 8% per annum, the US deposit rate is 3% per annum, and the current spot rate is ₹83 per USD. Explain how a money market hedge could be constructed to hedge this payable, as an alternative to a forward contract.

Accepted Answer

A money market hedge for a foreign currency payable involves borrowing in the domestic currency today, converting the proceeds to the foreign currency at the spot rate, and investing that foreign currency amount at the foreign deposit rate so that it grows to exactly the USD 100,000 needed at the payable's due date, eliminating the need for a forward contract entirely. Specifically: the importer needs to invest an amount today that will grow to USD 100,000 in 3 months at the 3% annual US deposit rate (0.75% for 3 months); amount to invest today = USD 100,000 ÷ (1 + 0.0075) = USD 99,256 (approximately). Converting this at the spot rate of ₹83 per USD requires ₹99,256 × 83 = ₹82,38,248 (approximately) today, which the importer borrows in rupees at the 8% Indian borrowing rate; in 3 months, this rupee borrowing, with 2% interest for the quarter (8%/4), grows to approximately ₹82,38,248 × 1.02 = ₹84,03,013, which represents the importer's actual, locked-in rupee cost of meeting the USD 100,000 payable, achieved entirely through borrowing and investing in the two money markets rather than through a forward contract; under interest rate parity, this money market hedge cost should closely approximate what a forward contract-based hedge would cost, since both approaches are, in substance, replicating the same underlying no-arbitrage relationship, though in practice one may be marginally cheaper than the other depending on the specific borrowing and lending rates genuinely available to the importer versus the forward rate quoted by a bank.

Question 13

A company purchases an interest rate cap at a strike of 10% for a premium of ₹2 lakh, and simultaneously writes (sells) an interest rate floor at a strike of 6% for a premium received of ₹1.2 lakh, on the same notional. Explain the net effect of this collar, including the net premium cost and the range of effective interest rates the company will experience.

Accepted Answer

The net premium cost of this collar is ₹2 lakh (paid for the cap) − ₹1.2 lakh (received for writing the floor) = ₹0.8 lakh, a materially lower net upfront cost than the ₹2 lakh a standalone cap would require, since the premium received from writing the floor partially offsets the cost of purchasing the cap. The effective range of interest rates the company will experience is bounded between the floor rate of 6% and the cap rate of 10%: if the floating reference rate exceeds 10%, the purchased cap pays out, capping the company's effective borrowing cost at 10%, exactly as a standalone cap would; if the floating reference rate falls below 6%, the written floor requires the company to pay out to the floor's buyer (since the company itself sold the floor), effectively raising the company's effective cost back up to 6%, meaning the company forgoes the full benefit of rates falling below 6% that it would have retained under a standalone cap alone; and if the floating rate falls between 6% and 10%, neither the cap nor the floor triggers, and the company simply pays the actual prevailing floating rate. This collar structure therefore narrows the company's range of possible effective interest rate outcomes to between 6% and 10%, at a substantially reduced net premium cost compared to a standalone cap, in exchange for giving up the potential benefit of very low rates below the floor.

Question 14

Explain the purpose of cash pooling for a multinational group with subsidiaries in multiple countries, each holding varying levels of surplus or deficit cash at any given time.

Accepted Answer

Cash pooling centralises the cash balances of multiple subsidiaries within a corporate group into a single pool, typically managed by the parent or a dedicated treasury centre, so that a subsidiary with a temporary cash surplus effectively funds another subsidiary within the same group facing a temporary cash deficit, rather than each subsidiary independently managing its own cash position, with surplus subsidiaries leaving idle cash in low-yielding deposits while deficit subsidiaries separately borrow externally at commercial rates, incurring an interest cost on money the group as a whole did not genuinely need to borrow from an outside source. By pooling cash across the group, the group as a whole reduces its aggregate external borrowing needs (since internal deficits can be funded from internal surpluses) and reduces the aggregate amount of idle, low-yielding cash held across all subsidiaries, capturing genuine efficiency gains — lower net interest cost and better overall cash utilisation across the group — that each subsidiary managing its own cash position independently and in isolation could not achieve on its own, particularly valuable precisely because different subsidiaries' cash positions typically do not move in perfect lockstep, exactly the kind of pooling and correlation-driven efficiency logic recurring throughout this paper's portfolio and securitization chapters as well.

Question 15

A domestic manufacturer facing significant economic exposure to currency movements (as its competitiveness against imports is affected by exchange rate changes it does not directly contract for) considers two responses: financial hedging using currency derivatives, and operational responses such as diversifying its supplier base across multiple countries or shifting some production overseas. Explain why financial hedging alone is generally considered insufficient to fully address economic exposure, unlike transaction exposure.

Accepted Answer

Financial hedging using currency derivatives is well suited to transaction exposure because that exposure arises from specific, identifiable, contracted cash flows with a known amount and a known settlement date, allowing a derivative of matching size and maturity to offset the exposure precisely; economic exposure, by contrast, arises from the broader, ongoing effect of exchange rate movements on the firm's ability to compete, price its products, and generate future cash flows, an effect that is neither a specific, known amount nor tied to any single settlement date, making it fundamentally difficult to hedge with a derivative instrument sized and dated to match a genuinely diffuse, ongoing, and uncertain exposure. Because economic exposure reflects a structural vulnerability in the firm's competitive position and cost structure relative to its currency-driven competitive environment, rather than a specific financial position, addressing it typically requires operational, rather than purely financial, responses: diversifying the supplier base across multiple countries and currencies reduces the firm's dependence on cost movements in any single currency; shifting some production overseas can create a natural hedge by aligning a portion of the firm's own cost base with the currency of its competitors or its key input markets; these operational responses address the underlying structural source of the economic exposure directly, in a way that a financial derivative, however skilfully sized, cannot fully replicate, since no single derivative contract can hedge an ongoing, structurally embedded competitive vulnerability the way it can hedge one specific, known future cash flow.

Practice — Foreign Exchange, International Financial Management and Interest Rate Risk

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