This is a document containing full revision notes of CA Final Strategic Financial Management's lengthiest chapter FOREX Management which are provided by one of the best teachers of the subject and have been used by over 58k students. These are to the point and accurate notes which are perfect for s...
FOREIGN EXCHANGE MANAGEMENT (SFM) - FULL REVISION IN 80 MINS - CA Final
SFM (OLD & NEW)
Bhavik Chokshi
Bhavik Chokshi explains the important concepts of foreign exchange in SMF, including direct
and indirect codes, currency quotations, and transaction rates. Foreign exchange is a crucial
topic in strategic financial management, with a weightage of around 15 marks in main
exams. Direct codes are codes per unit of the foreign currency, while indirect codes require
conversion to direct quotes which simplifies solving. Currency quotations are expressed as
rupees per dollar or any other currency, with the unit denoted in the denominator called the
base currency. The transaction takes place at the ask rate when the banker sells dollars.
When searching for the INR/USD rate, you'll find it currently at 73.26 INR per USD. However,
if you're provided with the rate in alphabetic capital letters, the institution may take the
inverse rate instead. To arrange the quotes such that rupees are in the numerator, cross
rates with bid and ask rates are both given. When doing the crossing, it can become a bit
challenging when deciding which rate to take, but it's fairly simple: for the bid cross rate, take
the bid terms for each, and for the ask cross rates, take the ask terms. The inverse of the bid
rate will always give you the ask rate.Exchange rates are based on the mathematical
property of 2 and 3, as demonstrated in the example below where we find the rupee per euro
bid rate. Note that in this example, cross rates are used throughout: For example, to find the
INR/EUR bid rate: the provided rate is in ask terms, but we need bid terms. Taking the
inverse of the ask rate will give us the bid rate.
The Purchasing Power Parity (PPP) theory states that a basket of goods should cost the
same across the world, and the exchange rate reflects the differences in purchasing power
worldwide.The Inflation Rate Parity theory, also known as a relative form of PPP, notes that
exchange rates must change concurrently with inflation rates. For instance, if the spot rate is
50 rupees per dollar, then rupees will be in the numerator and dollars will be in the
denominator. Similarly, if the exchange rate is euro per pound, then euro should be in the
denominator.We'll assume yearly compounding, meaning that if we have to calculate rates
after one year, we just raise it to the power of 'n,' where 'n' shows the number of years.
When dealing with non-base currencies, a different but also reliable formula can be used by
moving rupees to the denominator and employing the above formula. Another shortcut
method can be applied by using the same concept as that of recalling in eleventh or twenty
years, i.e., "one fifth on sales is the same as one fourth on cost."
Covered interest arbitrage is based on the interest rate parity theory, which is the same as
the inflation rate parity. However, if the parity theory fails, it creates an opportunity for
arbitrage, which can be exploited by an arbitrager, and the demand-supply pressures will
ensure that it works.Let's say you want to buy dollars but you don't want to invest your own
rupees because you're an arbitrager. In this case, you will borrow rupees and use them to
buy dollars at the spot rate. The difference between the two rates is the arbitrage gain, which
is riskless. Therefore, you are earning a profit without making any investment.Generally,
countries with higher inflation rates or interest rates will have a weaker currency. Conversely,
countries with lower inflation rates and lower interest rates will have a stronger currency. The
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