Exchange rate requiring delivery of the traded currency within two business days.
Market for currency transactions at spot rates.
1. Converting income generated from sales abroad into their home-country currency
2. Converting funds into the currency of an international supplier
3. Converting funds into the currency of a country in which they wish to invest
Buy and Sell Rates
The spot rate is available only for trades worth millions of dollars. That is why it is available only to banks and foreign exchange brokers. If you are traveling to another country and want to exchange currencies at your bank before departing, you will not be quoted the spot rate. Rather, banks and other institutions will give you a buy rate (the exchange rate at which the bank will buy a currency) and an ask rate (the rate at which it will sell a currency). In other words, you will receive what we described when introducing the foreign exchange market as bid and ask quotes. These rates reflect the amounts that large currency traders are charging, plus a markup.
For example, suppose you are leaving Mexico for a business trip to Canada and need to buy some Canadian dollars (C$). The bank will quote you exchange rate terms, such as peso 10.088/98 per C$. In other words, the bank will buy Canadian dollars at the rate of peso 10.088/C$ and sell them at the rate of peso 10.098/C$.
When a company knows that it will need a certain amount of foreign currency on a certain future date, it can exchange currencies using a forward rate—an exchange rate at which two parties agree to exchange currencies on a specified future date. Forward rates represent the expectations of currency traders and bankers regarding a currency’s future spot rate. Reflected in these expectations are a country’s present and future economic conditions (including inflation rate, national debt, taxes, trade balance, and economic growth rate) as well as its social and political situation. The forward market is the market for currency transactions at forward rates.
Exchange rate at which two parties agree to exchange currencies on a specified future date.
Market for currency transactions at forward rates.
To insure themselves against unfavorable exchange-rate changes, companies commonly turn to the forward market. It can be used for all types of transactions that require future payment in other currencies, including credit sales or purchases, interest receipts or payments on investments or loans, and dividend payments to stockholders in other countries. But not all nations’ currencies trade in the forward market, such as countries experiencing high inflation or currencies not in demand on international financial markets.
Suppose a Brazilian bicycle maker imports parts from a Japanese supplier. Under the terms of their contract, the Brazilian importer must pay 100 million Japanese yen in 90 days. The Brazilian firm can wait until one or two days before payment is due, buy yen in the spot market, and pay the Japanese supplier. But in the 90 days between the contract date and the due date, the exchange rate will likely change. What if the value of the Brazilian real goes down? In that case, the Brazilian importer will have to pay more reais (plural of real) to get the same 100 million Japanese yen. Therefore, our importer may want to pay off the debt before the 90-day term. But what if it does not have the cash on hand? What if it needs those 90 days to collect accounts receivable from its own customers?
To decrease its exchange-rate risk, our Brazilian importer can enter into a forward contract—a contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. Forward contracts are commonly signed for 30, 90, and 180 days into the future, but customized contracts (say, for 76 days) are possible. Note that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate: The bank must deliver the yen, and the Brazilian importer must buy them at the prearranged price. Forward contracts belong to a family of financial instruments called derivatives—instruments whose values derive from other commodities or financial instruments. These include not only forward contracts, but also currency swaps, options, and futures (presented later in this chapter).
Contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.
Financial instrument whose value derives from other commodities or financial instruments.
In our example, the Brazilian importer can use a forward contract to pay yen to its Japanese supplier in 90 days. It is always possible, of course, that in 90 days, the value of the real will be lower than its current value. But by locking in at the forward rate, the Brazilian firm protects itself against the less favorable spot rate at which it would have to buy yen in 90 days. In this case, the Brazilian company protects itself from paying more to the supplier at the end of 90 days than if it were to pay at the spot rate in 90 days. Thus it protects its profit from further erosion if the spot rate becomes even more unfavorable over the next three months. Remember, too, that such a contract prevents the Brazilian importer from taking advantage of any increase in the value of the real in 90 days that would reduce what the company owed its Japanese supplier.
PREMIUMS AND DISCOUNTS
As we have already seen, a currency’s forward exchange rate can be higher or lower than its current spot rate. If its forward rate is higher than its spot rate, the currency is trading at a premium. If its forward rate is lower than its spot rate, it is trading at a discount. Again, look at Table 9.1. Locate the row under “U.K. (pound)” labeled “1-mos forward.” This is the 30-day forward exchange rate for the British pound (GBP). Note that the rate of $1.9769/GBP is less than the spot rate of $1.9815/GBP (the spot rate quoted in the previous row of Table 9.1). The pound, therefore, is trading at a discount on the one-month forward contract. We know, then, that a contract to deliver British pounds in 30 days costs $0.0046 less per pound in 30 days than it does today. Likewise, the three- and six-month forward rates tell us that pounds cost $0.0140 and $0.0268 less in 90 and 180 days, respectively. Clearly, the pound is also trading at a discount on three- and six-month forward contracts.