Foreign Exchange Rate
Exchange rates are volatile and open short or long currency positions can lead to sizable losses. The foreign exchange rate measures the price of one currency in terms of another. A convertible currency can legally be exchanged for another convertible currency at a given rate of exchange. A currency could be partially convertible when it can be legally used to purchase foreign exchange to finance only certain transactions. An increase in the exchange rate of a country may be expressed as a depreciation of the US dollars to buy one unit of the other currency.
Conversely, a downslide in the dollar cost of the other currency is an appreciation of the dollar. A downslide or fall may be noticed when it costs less in the home currency to buy one unit of foreign exchange, thus the home currency has appreciated in value. During the era of gold exchange standards the exchange rates between the currencies were determined by the quanta of weights of gold defining the currencies. Exchange rates are of two categories -spot exchange rate and forward exchange rate.
Spot exchange rates are quoted for delivery of the currency purchased within a period of two days while the forward exchange rate quotations are for the prices agreed today that sustain for delivery at one of the future dates – maybe one to three months ahead. These quotations are usually made by commercial banks and other customized maturities may be negotiated. Foreign currencies are bought at spot rates for many reasons, including finance for imports, buying foreign assets such as bonds and real estate, etc. Most users of the forward market engage in swap transactions, in which the same currency is bought and sold simultaneously but is delivered at two different points of time.
Swift movements in exchange rates occur in step with changes in the international economic and diplomatic relations between countries. Any change in the expectations of the market participants also affects the exchange rates. In the long run, the interaction among the currencies is shaped by political and economic conditions, as may be seen in the case of Germany and the US, where there has been longstanding stability in the political and economic systems over decades. These currencies are thus viewed as safe. On the contrary the currencies of Brazil, Israel and Mexico lost their purchasing power as they faced hyperinflation in the recent past.
In international business, the process of buying or selling foreign exchange on a spot or forward basis will be on contract with an international bank. The bank will charge the firm the prevailing wholesale rate for the currency, plus a small premium for its services. Because of the bank’s extensive involvement in the foreign-exchange market, it is typically willing and able to customize the spot, forward, or swap contract to meet the customer’s specific needs.
Foreign exchange markets have also developed other mechanisms to enable companies to obtain foreign exchange in future. These processes consist of currency futures and currency options. A currency future is a contract that resembles a forward contract on many exchanges worldwide. However, unlike the forward contract, the currency future is for a standard amount on a standard delivery date. In case of a forward contract, a firm signing a currency future contract must complete the transaction in order to obtain the specified amount of foreign currency at the specified price and time.
This obligation is usually not troublesome, however; a firm wanting to be released from a currency-future obligation can simply make an offsetting transaction. In practice, a large amount of currency futures are settled in this manner. However, currency futures represent only 1 per cent of the foreign-exchange market. Alternatively, the currency option does not require a firm to buy or sell a specified amount of a foreign currency at a specified price at any time up to a specified date.
A call option grants the right to buy the foreign currency, while a put option grants the right to sell the foreign currency. Currency options are publicly traded in all the recognized exchanges worldwide. Foreign currency options not only provide a fixed exchange rate for a future date if rates move adversely, but also the added flexibility of being able to use the prevailing spot rate if rates have moved favorably.
Forward market currency options, and currency futures facilitate international trade and investment by allowing firms to hedge, or reduce the foreign exchange risks inherent in international transactions. The forward price of a foreign currency often differs from its spot price. If the forward price (using a direct quote) is less than the spot price, the currency is selling at a forward discount and in case the forward price is higher than the spot price, the currency is selling at a forward premium. The forward price represents the aggregate prediction of the spot price of the exchange rate in the future in the marketplace.
Thus, the forward price helps international business people forecast future changes in exchange rates. These variations can affect the price of imported components as well as the competitiveness and profitability of the exports of a company. If a currency is selling at a forward discount, the foreign exchange market believes the currency will depreciate over time. Firms may want to reduce their holdings of assets or increase their liabilities denominated in such a currency.
The currencies of countries suffering balance of payment (BoP) deficits or high inflation rates often sell at a forward discount. On the contrary, if a currency is selling at a forward premium, the foreign-exchange market assumes that the currency will appreciate over time. Firms may want to increase their holdings of assets and reduce their liabilities denominated in such a currency. The currencies of countries enjoying BoP surpluses generated of trade or low inflation rates often sell at a forward premium. Thus the difference between the spot and forward prices of a country’s currency often signals the expectations of a market regarding macroeconomic policies and prospects of the country.