6-1.

Overview

IINO san

Let’s study about foreign exchange from this topic.
Since currency is an integral part of trade, we’ll start with some terminology explanations and then delve into important points!

If I understand it, can I use that knowledge to make profitable trades in the FX market?

Rookie

IINO san

It is not a get-rich-quick scheme, but rather a practical study to avoid exchange risks in trade. So please listen carefully.

What You Can Gain from This Topic

• Exchange Risk
• Forward Contract
• Spot rate and Forward rate
• Interbank rate and Retail rate

What is an Exchange Rate?

An exchange rate is the rate at which one currency can be exchanged for another.

In trade, deciding which currency to use is crucial when dealing with countries with different currencies. The U.S. Dollar is commonly used as the international currency.

IINO san

The transportation costs for maritime and air shipments are also denominated in U.S. Dollars.

Exchange Risk

Currency fluctuations in the foreign exchange market can result in exchange risk, which may cause financial loss or gain due to exchange rate fluctuations.

In Japan, the yen has been depreciating, and there’s a bit of a concerning atmosphere, isn’t there?

Rookie

IINO san

Exactly!

Fluctuation of Exchange Rates

The fluctuation of exchange rates refers to the continuous changes in the value of one currency about another. Exchange rates are influenced by various factors, including:

• Economic conditions
• Global situations

The fluctuation in exchange rates after the contract is signed often results in potential losses.

Case Study 1

The importer incurs a loss when the yen depreciates more than the exchange rate upon contract.

• Product Price: USD 1/pcs
• Quantity: 100 pcs

Case Study 2

If the yen appreciates beyond the exchange rate upon contract, the exporter will suffer a loss.

• Product Price: USD 1
• Quantity: 100 pcs

Foreign Exchange Hedges

The exchange rate significantly influences profits, and predicting its movement is challenging. Therefore, Foreign exchange hedges are taken to minimize exchange rate risk.

Forward Contract

There are several types of foreign exchange hedges, but one of the most common is a forward contract (forward foreign exchange contract).

A forward contract secures a predetermined exchange rate for the future to mitigate the risk of currency fluctuations and ensure profitability.

Use Case

For example, the seller intends to export automotive parts to Thailand two months from now. The seller can arrange a forward contract at a rate of 1 USD = 130 JPY by calling the bank.

Even if the exchange rate changes to 1 USD = 110 JPY in two months, the transaction will still be processed at the agreed rate of 1 USD = 130 JPY.

• Forward rate: 130 yen
• The exchange rate on the settlement date: 110 yen
• Applied rate: 130 yen

What if I import?

Rookie

IINO san

Same for imports.
If you arrange a forward contract at 1 USD = 130 JPY.
Even if the yen becomes remarkably weaker, like 150 JPY, you can still transact at the agreed rate two months later.

Types of Forward Contracts

The reservation methods are divided into the two types below, depending on the delivery timing.

IINO san

The latter has options to freely execute within a month, specify a particular month, like “February delivery,” or choose a fixed period for contract execution.

Forward contracts require credit examination before reservation. Once made, changes or cancellations are generally not allowed except in unavoidable circumstances.

Spot Rate and Forward Rate

Here are some exchange rates that you might find helpful to remember.

• Spot Rate
• Forward Rate

Spot Rate

The spot rate is an exchange rate commonly reported in newspapers and news sources. In transactions based on the spot rate, settlement occurs two business days after the transaction date.

IINO san

If there is an urgent need to export or import goods, the spot exchange rate will be used.

Forward Rate

Forward Rate is the rate used in a forward contract.

Specifically, a forward rate is the exchange rate used for a transaction that occurs more than two business days after the spot exchange rate.

Forward rates are usually offered for periods of up to approximately five years.

Interbank Rate and Exchange rate (Offered Rate)

Exchange rates are classified as interbank rates and retail rates based on the market and participants.

IINO san

In practical trade, only the latter term is used.

Interbank Rate

The interbank rate is the exchange rate traded exclusively among financial institutions, primarily banks, and represents the rates dealt with by securities professionals and individuals in the financial sector.

We don’t have to remember, right?

Rookie

IINO san

It’s okay to know the name.

Retail Rate

Retail Rate is the exchange rate traded between financial institutions such as banks and customers, including businesses or individuals.

IINO san

Simply put, it refers to the exchange rate that a bank offers for corporations or individuals.
Since this rate varies among banks and businesses, it is generally not publicly disclosed.

IINO san

Each relationship is somewhat like above!

Summary

Trade involves exchange rate risk, so hedge the risks as needed. Exchange rates are determined by the balance of demand and supply for each currency.

Since exchange rates constantly fluctuate due to various factors, forward contracts can be considered an effective means to mitigate the associated risks.

Enhanced Learning with Videos

Test Yourself

Reinforce your understanding of this topic by working through the exercises. Attempting the exercises without referring to the material as much as possible is advisable.

IINO san

The act of “remembering” helps it stick in your memory.