True Blue Cosmetics Ltd. is an old line producer of cosmetics products made up of herbals. Their products are popular in India and all over the world but are more popular in Europe.
The company invoice in Indian Rupee when it exports to guard itself against the fluctuation in exchange rate. As the company is enjoying monopoly position, the buyer normally never objected to such invoices. However, recently, an order has been received from a whole-saler of France for FFr 80,00,000. The other conditions of the order are as follows:
- The delivery shall be made within 3 months.
- The invoice should be FFr.
Since, company is not interested in losing this contract only because of practice of invoicing in Indian Rupee. The Export Manger Mr. E approached the banker of Company seeking their guidance and further course of action.
The banker provided following information to Mr. E.
- Spot rate 1 FFr = Rs. 6.60
- Forward rate (90 days) of 1 FFr = Rs. 6.50
- Interest rate in India is 9% and in France is 12%.
Mr. E entered in forward contract with banker for 90 days to sell FFr at above mentioned rate.
When the matter come for consideration before Mr. A, Accounts Manager of company, he approaches you.
You as a Forex consultant is required to comment on:
- Whether there is an arbitrage opportunity exists or not.
- Whether the action taken by Mr. E is correct and if bank agrees for negotiation of rate, then at what forward rate company should sell FFr to bank.
Solution
Invoice amount in Indian Rupee = FFr 80,00,000 € Rs. 6.60 = Rs. 5,28,00,000
- Interest Rate in India 9% p.a.
Interest Rate in France 12% p.a
The interest rate differential 9% – 12% = 3% (Positive Interest Differential)
Forward Discount = F – S / S x 12/n x 100
= 6.5 – 6.6 /6.6 x 12/n x 100 = – 6.061% (forward Discount)
Since the forward discount is greater than interest rate differential there will be arbitrage inflow into the country (India).
- The decision taken by Mr. E was not correct because as per Interest Rate Parity
Theory, forward rate for sale should be 1 FFr = Rs. 6.65, calculated as follows:
Let F be the forward rate, then as per Interest Rate Parity theory, it should have been as follows:
= F – S / S x 12/n x 100 = -3
= F – 6.6 /6.6 x12/3 x100 =-3
F = 6.6495
Also study these questions
- The US dollar is selling in India at Rs. 55.50.
- Z Ltd. importing goods worth USD 2 million,
- ABC Ltd. is considering a project in US
- You as a dealer in foreign exchange
- The rate of inflation in USA is likely to be 3% per annum
