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.
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.