Lecture 1 OST

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Transcript of Lecture 1 OST

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Accounting for OverseasTransactions
Introduction.
Foreign Exchange Market Definitions Terminology
Interest Rate Calculations Compound interest Loan repayment schedules

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Foreign Exchange Rates
A foreign exchange rate is a price more
specifically it the relative price of two currencieswith respect to each other.
Exchange rate can be expressed or quoted in
two different ways:
The Directquotation method
The Indirectquotation method

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Direct Pricesdomestic markets
This is the normal way that prices are
quoted domestically within any country. For example, the price of a litre of petrol is
stated terms of units of the domestic
currency:The price of one litre of petrol = $1.20
Within the borders of any country allcommodities are stated in terms of thedomestic currency.

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FX price quotations
When currencies of two different countries are
exchanged, price determination can becomeconfusing.
One currency is being bought and the other is
being sold. If Australian dollars (AUD) areexchanged for American dollars (USD) then theAUD is being both bought and sold and similarlythe USD is being both bought and sold.
In quoting a price it will depend on whoseperspective we are looking at; the dealer in
Australia or the dealer in America.

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FX price quotations
Directquotations are the number of units
of the domestic currency per unit of theforeign currency.
Indirectquotations are the number offoreign currency units per unit of thedomestic currency.
The indirect quote is the reciprocal of thedirect quote. (and visa versa)

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FX price quotations
As FX rates can be expressed in two
different ways and to overcome possibleconfusion most countries currencies arequoted in terms of units of currency thatone USD will buy.

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FX price quotations
In our studies we will mainly use the indirect
quotations that are commonly used and reportedby the Australian market and financial press.
For example;
1.00 AUD = 0.75 USD 1.00 AUD = 0.40 GBP
We will also need to be able to analyse FX rates
expressed in direct quotation form. 1.00 USD = 1.3333 AUD
1.00 GBP = 2.5000 AUD

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FX crossrates
FX crossrate quotes relate to FX rates
between two currencies which does notinclude that of the domestic currency.
Assume that an Australian bank hasBritish pounds (GBP) that it wishes tochange into American dollars (USD).
Theoretically, it could change the Britishpounds into Australian dollars and thenbuy US dollars.

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Twoway Quotations
It is normal that rates published in newspapers and bybanks only give selling rates, whereas most dealers give
twoway quotations, i.e. both buying and selling rates. Selling rates are called offer or ask rates, buying rates
are called bid rates. The difference between bid and
ask rates is known as the spread or the bidaskspread.
The spread is essential the dealers profit margin. Thebid and ask rates quoted are given from the viewpoint ofthe dealer. As such, the dealer will only make a profit ifhe/she buys at the low price and sells at the high price.

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AUD / USD 0.8245  85
Quoted in this way a dealer will buy AUD 1 for USD0.8245 and sell AUD 1 for USD 0.8285 making a profit
of 0.0040. Assume an American tourist arrives at Sydney Airport
wanting to exchange USD for AUD. The tourist wants to
buy AUD with USD. The dealer will sell AUD 1 for USD0.8285 which implies that the dealer buys USD 1 forAUD 1.2070.
Later when the tourist returns to leave Australia anyunused AUD can be sold back to the dealer. The dealerwill sell USD 1 for AUD 1.2129. (this assumes the sameexchange rates a most unlikely event).

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Interest Rate Calculations
Interest is usually expressed as a percentagerate per period normally a year.
eg. 12% pa. (per annum)
When interest is accrued for a period lessthan the stated interest period the accrual ofinterest will be calculated on either a :
Simple interest basis or
Compound interest basis

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Simple Interest
Simple interest accrued during an interest
period is calculated on a proportional orlinear basis.
For example: A loan of $1,000 at 12% pa.simple interest would accrue interest asfollows ;
$120 for a full year $60 for half a year
$30 for a quarter of the year.

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Compound Interest
Compound interest is accrued during an
interest period on an exponential basis.For example: A loan of $1,000 at 12% pa.
compounded annually would accrue interestas follows ;
$120 for a full year
$58.30 for half a year $28.74 for a quarter of the year.

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Interest Comparison
Simple Interest Compound interest

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Nominal and effective interest rates
When the interest rate period is the same
as the compounding period the interestrate is an effective interest rate.
The following would be examples ofeffective rates:
12% pa. compounded annually
8% per quarter, compounded quarterly
1.5% per month, compounded monthly

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Nominal and effective interest rates
When the compounding period is less than
the period of the interest rate then the rateis a nominal rate ( i.e., not the true rate).
All interest rate calculations and interesttables are based on effective interestrates.

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Compound Interest
Calculation: Compound interest calculations
Interest ($) = P
Where
P = Principal borrowed
i = nominal interest rate % per annum
n = number of compounding periods per annum
t = number of compounding periods for which interest is
being accrued
( ) 11 +t
ni

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Illustrative Example 1
On ,March 1, 2006 a company borrows$150,000 at a nominal interest rate of
12% pa. with interest being compoundedmonthly. Calculate the interest that wouldbe accrued on June 30, 2006 assuming
that no repayments had been made by thecompany during the period.

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Solution Example 1
Interest ($) = P
= 150,000
= $ 6,090.60
( ) 11 +t
ni
( ) 141212.01 +

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Loan Repayment Schedules
Loan repayment arrangements will depend on theterms agreed on between the borrower and the lender.
Three types of repayment options commonly used bybusinesses are:
1. Payment of interest only loans with the full principalbeing repaid in full at the end of the loan period.
2. Regular equal instalments of the principlecomponent with a payment of all interest accrued ateach instalment date.
3. Equal repayment instalments which includescomponents for both principal and interest accrued.

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1. Interest only loan
On March 1, 2006, a company borrows
$100,000 on an interest only basis with theprincipal to be repaid in full in 4 years. Intereston this loan is to be paid as it accrues each 6
months. Interest charged at 12% pa,compounded monthly.
Under these arrangements The company will
pay the accrued interest of $6,152 each 6months and the principal sum of $100,000 in 4years time.

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2. Equal repayment of principal
On March 1, 2006, a company borrows$100,000 to be repaid by 8 equal 6 monthly
instalments of $12,500 plus interest accrued atthe rate of 12% pa, compounded monthly.
The 1st
instalment due on Sept 1, 2006 would be$18,652 ( $12,500 paid off the principal; andinterest for the first 6 month period of $6,152)
The 2nd instalment will include $12,500 paid offthe principal however the interest component willbe less as the principal was reduced by the first
instalment.

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2. Equal repayment of principal
Illustrative example repayment schedule
Principal Principal TotalPeriod before Instalment after Interest paymentpayment payment
1 $100,000.00 $12,500.00 $87,500.00 $6,152 $18,652.02
2 $87,500.00 $12,500.00 $75,000.00 $5,383 $17,883.01 3 $75,000.00 $12,500.00 $62,500.00 $4,614 $17,114.01 4 $62,500.00 $12,500.00 $50,000.00 $3,845 $16,345.01 5 $50,000.00 $12,500.00 $37,500.00 $3,076 $15,576.01
6 $37,500.00 $12,500.00 $25,000.00 $2,307 $14,807.01 7 $25,000.00 $12,500.00 $12,500.00 $1,538 $14,038.00 8 $12,500.00 $12,500.00 $  $ 769 $13,269.00

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3.  Equal Instalments
On March 1, 2006, a company borrows$100,000 to be repaid by 8 equal 6monthly instalments of $16,200.62including interest accrued at the rate of12% pa, compounded monthly.
Including bothprincipal and interest

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3.  Equal Instalments Repayment Schedule
Instalment Principal Principal Principal
period before payment Instalment Interest component after payment
1 $ 100,000.00 $16,200.62 $ 6,152 $10,048.60 $ 89,951.40
2 $ 89,951.40 $16,200.62 $ 5,534 $10,666.79 $ 79,284.61
3 $ 79,284.61 $16,200.62 $ 4,878 $11,323.01 $ 67,961.59
4 $ 67,961.59 $16,200.62 $ 4,181 $12,019.61 $ 55,941.99
5 $ 55,941.99 $16,200.62 $ 3,442 $12,759.06 $ 43,182.93
6 $ 43,182.93 $16,200.62 $ 2,657 $13,543.99 $ 29,638.94
7 $ 29,638.94 $16,200.62 $ 1,823 $14,377.22 $ 15,261.71
8 $ 15,261.71 $16,200.62 $ 939 $15,261.71 $ 0.00