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“Suppose a U.S. company orders machine tools from a company in Japan, which will take 6 months and cost 120 million yen. When the order is placed, the yen is trading at 120 to a dollar. The U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,000 yen with 120 yen per dollar = $1,000,000).
However, the yen-dollar exchange rate will almost certainly be different 6 months later. Although the U.S. company could pay when the order is placed, it would lose the opportunity cost of the money during the 6-month period, when it could earn interest, for instance.
If, after the 6 months, the exchange rate is 100 yen per dollar, then the cost in U.S. dollars would increase by $200,000 (120,000,000 / 100 = $1,200,000), which would be a profit to the Japanese company but a loss for the American company.
But if the rate is 140 yen to a dollar, then the cost in U.S. dollars would decrease by over $142,000 (120,000,000 / 140 = $857,142.86), which would be a profit to the American company and a loss to the Japanese company. Most companies eliminate this foreign exchange risk by using forward contracts.”7
Source: www.financemagnates.com
“Spot transactions remains the preferred instrument for trading currencies with 43% volumes being trtasacted on that market. FX swaps are coming in second, while forwards ae holding the third position with 23%. Over-the-counter FX options have represented 5% of the total volume on the FX market in April.”8
Forward Transaction: FX risks can be prevented by forward transactions. The parties agree to a forward contract where negotiated prices are calculated using a forward exchange rate that depends on the current exchange rate, the difference in interest rates between the 2 countries, and on the settlement date, which is when payment will be made. The settlement date, like all the other contract terms of the forward contract, are negotiable, but the term of the forward contract is usually less than one year.
Forward contracts do, however, have counterparty risk, which is the risk that a party will be unable or unwilling to fulfill the contract on the settlement date. There is also business risk to a forward transaction, in that, if the needs of the parties change, the
contract cannot be amended or canceled unless both parties agree. Counterparty and business risks increase with the term of the contract.
When used as an investment strategy, the forward transaction can be helpful in securing assets that are anticipated to increase in value within a specified period of time. The investor purchases the asset or security, locking in a price based on current market value and agrees to the delivery of that security at some point in the future. Assuming that the security does in fact appreciate in value in the interim, the investor ultimately receives an asset that worth more than the purchase price. As a result, a return on the investment is generated and the investor has the option of holding the security as it continues to appreciate, or selling it to realize the profit soon after delivery.
As with any type of investment approach, there is some degree of risk associated with a forward transaction. If the value of the security does not increase as projected by the investor, it is still delivered on the date specified in the contract. This means that if the value of the security remains more or less stagnant from the purchase date to the delivery date, the investor has little to nothing to show for the effort. Should the security actually decrease in value in the interim, the investor must decide to either hold the asset in anticipation of a recovery, or sell it immediately and cut his or her losses.
Forward exchange rates are determined by the relationship between spot exchange rate and interest or inflation rates in the domestic and foreign countries.
Using the relative purchasing power parity, forward exchange rate can be calculated using the following formula:
F=Sx[ ]n
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