Topic 2: Foward Exchange


Importers of goods and services normally do not pay for them until delivery and frequently not until 30 to 90 days after receipt of the product. A substantial period can therefore elapse between the time a decision to purchase a good or service is made and payment occurs. The decisions of the importer to purchase and the exporter to sell are based on expected present and future costs and returns in home currency calculated on the date the decision is made. Risk arises because the actual domestic currency costs or receipts can be different than expected because of a change in the exchange rate between the decision date and the payment date.

Suppose, for example, that a Canadian firm buys $100,000 worth of computer equipment from Japan, and is given 90 days to pay. At the time the selling price is agreed upon the rate of exchange of the yen for the dollar is, let us say, 360 yen equals one Canadian dollar. There is no guarantee that the Canadian dollar will be worth 360 yen in ninety days when payment is made. Suppose the exchange rate turns out to be 350 yen for one dollar. Then the Canadian dollars received will yield only 35 million yen rather than the 36 million yen that had been expected---a loss of just under 3 percent to the Japanese firm. Had the Canadian exporting firm agreed to pay 36 million yen instead of 100 thousand dollars, it would have had to pay $102,857, losing nearly 3 percent on the transaction.

It is possible, of course, that the Canadian dollar could be worth 370 yen on the date of payment rather than 360 yen. In this case there would have been a gain to either the Canadian importer or Japanese exporter from the change in the exchange rate. While such a gain would be welcome, the possibility that it will occur doesn't compensate for the possible loss that will arise should the exchange rate move in the other direction. The Canadian exporter and Japanese importer are in the computer business and are not interested in or skilled at speculating in foreign exchange markets. They will prefer to avoid these foreign exchange risks and concentrate on dealing with risks specific to producing and marketing computer equipment.

The two parties can avoid this foreign exchange risk by finding someone who will agree to exchange dollars for yen in 90 days at a price agreed upon now. Suppose that this agreed-upon rate is 355 yen for one Canadian dollar. The buyer and seller of computer equipment can then decide on price and quantity terms for the equipment that will be profitable to both parties, knowing that whatever happens to the exchange rate between the dollar and the yen, they will be able to exchange yen for dollars at the rate 355 yen for one Canadian dollar. This exchange rate is called the forward rate.

The forward exchange rate is the rate of exchange, agreed upon now, for a foreign exchange market transaction that will occur at a specified date in the future. The agreement to make such an exchange in the future at a rate agreed upon now is called a forward contract. In making a forward contract---purchasing yen forward in this case---our Japanese exporter and Canadian importer hedge or cover themselves against a future rise in the dollar price of the yen. They shift the risk from future exchange rate changes onto the party who sells them yen forward. That seller of forward yen has to deliver yen for dollars at an exchange rate of 355 yen for one Canadian dollar in 90 days. When the forward contract matures in 90 days, the forward seller has to purchase yen for Canadian dollars spot at the going market price---that is, the spot exchange rate---at that time in order to deliver them at the agreed-upon forward price. In other words, this seller is short on yen, or sold yen short.

Of course, the seller of forward yen could cover himself by stocking up on them at the time the forward contract is made rather than purchase them at the market price when the contract matures. Better than that, he could obtain cover by finding other exporters and importers who are going to have to sell yen in return for Canadian dollars in 90 days and therefore want to make a forward sale of yen. By purchasing yen forward from these people at a slightly more favorable rate than he sells the forward yen to our Japanese and Canadian computer equipment firms, this foreign exchange dealer can eliminate the risk to all parties of a future change in the exchange rate and at the same time make a profit for himself.

The existence of a forward exchange market allows firms and individuals to shift the risk of future exchange rate changes to others. It could happen that for every unit of foreign currency that exporters and importers want to purchase forward with domestic currency there is a unit of foreign currency that some other exporters and importers want to sell forward for domestic currency---in this case, all risk would be eliminated. But it is unlikely that the hedging pressure in both directions will be the same, so someone will have to take an uncovered position.

Even in this case, however, cover can be obtained by actually holding the shortted currency---or, better, by holding bonds and other interest bearing assets denominated in that currency---during the life of the forward contract. As we will see later this possibility of shifting asset holdings between currencies to offset an imbalance of forward contracts leads to a relationship between the forward exchange rate, the spot exchange rate, and interest rates on securities denominated in the two currencies involved.

Forward contracts in foreign exchange arise as a result of the actions of intermediaries who bring together people who want to buy a currency forward in return for another currency and those who want to sell it forward. At the present time, it is possible to purchase forward exchange contracts for all the major currencies and many of the minor ones. Contracts running for 30, 60, 90, and 180 days and one year are usually available. This means that there will be a structure of forward exchange rates between currencies on contracts of various lengths in addition to the usual spot rates. Arbitrage will insure that the forward rates on contracts of a given length are consistent across currencies in the same way that it ensures consistency of spot rates.

Individuals who are involved in international transactions can wear three hats. They can hedge themselves by always maintaining a covered position---that is, every time they incur a future obligation to pay foreign currency or a future right to receive it they can buy or sell the currency forward to ensure that their assets and liabilities, measured in domestic currency, are known with certainty. Or they can speculate either by not hedging in the course of their normal business activities or by deliberately purchasing or selling foreign currency forward to take an uncovered position Or they can take advantage of discrepancies either in spot exchange rates or forward rates across currencies by engaging in arbitrage.

Arbitrage is usually conducted by dealers who specialize in foreign exchange market transactions. Those individuals also hedge themselves and speculate from time to time. Most everyone else who makes international transactions will hedge sometimes and speculate at other times.

For example, a non-resident of the United States who plans to go to Las Vegas during easter break and spend $1500 runs the risk that the U.S. dollar will appreciate in terms of the domestic currency between the time at which the trip is planned and the time the funds are to be spent. If her home country is one like Canada, the U.K., or France, the probable loss from a change in the exchange rate is likely too small to make a forward purchase of $1500 worth-while. On the other hand, if a U.S. resident's grandmother in Italy dies and leaves him $500,000 worth of lire at the current exchange rate to be received in one year, he might well want to buy those dollars forward right now. This would be especially true if he is having a new house built to be completed and paid for when the funds arrive.

Whether one hedges or remains uncovered at a particular point in time will depend on how exposed one's wealth position is to changes in a particular exchange rate, on one's estimate of how likely and how large an unfavorable movement in that exchange rate will be, and on how much it costs to obtain forward cover.

It test time again. As always, be sure to think up your own answers before looking at the ones provided.

Question 1
Question 2

Choose Another Topic in the Lesson