6-1. Foreign Exchange and Forward Contracts
Overview
Since currency is an integral part of trade, we’ll start with some terminology explanations!
Learning Points
- Foreign Exchange Risk (Exchange Rate 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 utilized as the international currency.
Foreign Exchange Risk (Exchange Rate Risk)
Currency fluctuations in the foreign exchange market can result in foreign exchange risk (exchange rate risk), which may cause financial loss or gain.
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
When the contract is made:
Exchange Rate: USD 1= 90 yen
Anticipated Payment Amount: 90 yen x 100 = 9,000 yen
When payment is made:
Exchange Rate: USD 1= 100 yen
Payment Amount: 100 yen x 100 = 10,000 yen
Loss: 1,000 yen
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
When the contract is made:
Exchange Rate: USD 1= 110 yen
Anticipated receive Amount: 110 yen x 100 = 11,000 yen
When payment is made:
Exchange Rate: USD 1= 100 yen
Payment Amount: 100 yen x 100 = 10,000 yen
Loss: 1,000 yen
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 USD 1= 130 yen by calling the bank.
Even if the exchange rate changes to USD 1= 110 yen in two months, the transaction will still be processed at the agreed rate of USD 1 = 130 yen.
・The exchange rate on the settlement date: 110 yen
・Applied rate: 130 yen
If you arrange a forward contract at USD 1= JPY 130.
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.
- Fixed date delivery: Reserving the rate for a specific future date
- Optional delivery: Reserving a rate for a certain period and executing it during that period.
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.
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.
Forward rates are usually offered for periods of up to approximately five years.
Interbank Rate and Retail Rates
Exchange rates are classified as interbank rates and retail rates based on the market and participants.
Interbank Rate
An interbank rate is the exchange rate traded exclusively among financial institutions, primarily banks. It represents the rates dealt with by securities professionals and the people involved in the financial sector.
Retail Rate
A retail Rate is the exchange rate traded between financial institutions such as banks and customers, including businesses or individuals.
Since this rate varies among banks and businesses, it is generally not publicly disclosed.
Summary
Trade involves exchange rate risk, so hedging the risks is 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.
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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.
