Introduction to Finance

1.
Does the fi rm want to buy or sell currency? 
In this example, the U.S. fi rm wants to buy Japanese 
yen.
2.
How much does it wish to buy or sell? 
In this example, the cost of the item is 2.4 million 
Japanese yen, so the fi rm wants to buy 2.4 million Japanese yen.
3.
What is the time frame? 
In this example, the U.S. fi rm is entering into an agreement today 
but will not buy the yen for 60 days.
4.
What is the forward rate? 
In this example, the forward rate is agreed to be 125 yen per dollar.
In 60 days, the fi rm will give the bank $19,200 in order to purchase 2.4 million yen at 
the forward rate of 125 yen per dollar. The fi rm will then use the yen to complete its transac-
tion for purchasing the Japanese product. By locking in a known exchange rate, the U.S. fi rm 
eliminates the exchange rate risk for this transaction. This is an example of using forward 
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We use forward rate to describe currency transactions to be settled on a specifi c date in the future that are negotiated 
outside of an exchange. In Chapter 11, we will review future contracts, which are similar to forward contracts except 
that they are traded on exchanges and are standardized. For example, the Japanese yen futures contract traded on the 
Chicago Mercantile Exchange is for 12,500,000 yen. As a negotiated agreement, a forward contract is more fl exible 
and can accommodate the desired quantity to be exchanged and specifi c transaction dates. Also discussed in Chapter 
11 are options contracts—exchange-traded contracts with a specifi ed contract price (called a strike or exercise price) 
for future delivery of a specifi ed quantity. For example, the Japanese yen options contract traded on the Chicago Merc 
is a contract for 12,500,000 yen.

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C H A PT E R 6 International Finance and Trade
rates to 
hedge
(the concept of hedging was introduced earlier in the chapter) or reduce the risk 
of changing prices—in this case, of price of one currency in terms of another. By locking in 
the exchange rate today, the U.S. fi rm is insuring itself against adverse moves (in this case, a 
weaker dollar) in the exchange rate over the next 60 days.
Speculating or Taking Educated Guesses 
on Exchange Rate Movements
As another example, forward agreements can be used by speculators to try to profi t from 
future exchange rate movements. For example, suppose Kristen, a speculator, believes that in 
two months the spot rate between the U.S. dollar and the euro (€) will be $1.20 per euro. Right 
now, the two-month forward rate is $1.25 per euro ($1.25/€), refl ecting the market’s expecta-
tion that the euro will be stronger than Kristen believes to be true. What can a speculator like 
Kristen do to take advantage of her expectations? 
The way to make money speculating—in any asset, even in currencies—is to buy low 
and sell high. Right now, the forward rate for euros is higher ($1.25/€) than the speculator 
believes is appropriate. So the speculator will want to enter a forward contract to sell euros at 
$1.25/€ (that is, sell high). In two months, if Kristen’s prediction of a $1.20/€ spot exchange 
rate is indeed correct, she will convert dollars to euros at $1.20/€ (buy at the lower price) 
and then fulfi ll the forward contract by selling these euros at the agreed-upon forward rate of 
$1.25/€. By buying euros at $1.20 and selling them at $1.25 she will gain a profi t of $0.05 
per euro.
For example, today she will enter a two-month forward contract to sell, say, €100,000 at 
$1.25/€. In two months, if her predictions are correct, she will buy €100,000 at her predicted 
spot rate of $1.20/€, costing her $120,000. Next, the forward contract is executed by selling 
the €100,000 at $1.25/€. She will receive $125,000 from selling the euros. This gives her a 
profi t of $5,000 ($125,000 − $120,000).
Note there are four requirements for our speculator to determine before entering this 
contract:
1.
Is the speculator wanting to buy or sell currency? 
In this example, the U.S. speculator wants to 
sell as the forward rate is higher than her predictions for the spot rate.
2.
How much does the speculator wish to buy or sell? 
In this example, this number is 
determined by the speculator and how much money she wishes to put at risk.
3.
What is the time frame? 
In this example, the time frame is two months. The speculator 
wants to take advantage of an expected diff erence between what she expects the spot rate 
to be two months from today and today’s two-month forward rate. 
4.
What is the forward rate? 
In this example, the forward rate is agreed to be 1.25 dollars per euro.
This is a risky investment. If, for example, our speculator’s expectations were incorrect 
and in two months the spot rate was $1.27/€ rather than $1.20/€, she would lose $2,000. That 
is, two months from today, to fulfi ll the forward contract, she would have to use $127,000 
to purchase €100,000; she would then fulfi ll the forward contract, as she is obligated to sell 
€100,000 at the forward rate of $1.25/€. Fulfi lling her obligation, she will receive $125,000 
from the sale, which represents a loss of $2,000 on the transaction.
Let’s change this example to show what would happen if the expected spot rate were 
higher 
than today’s forward rate. The two-month forward rate is $1.25/€ but now the specu-
lator believes in two months the spot rate will be $1.30/€. What transactions should the spec-
ulator do to profi t from the diff erence between today’s forward rate and what she expects the 
spot rate to be two months from now?
To buy low and sell high, the speculator will want to buy euros two months from today 
at today’s forward rate of $1.25 per euro and sell them at the predicted spot rate of $1.30 per 
euro. For example, she could convert $125,000 to €100,000 in two months at today’s $1.25/€ 
forward rate. Then she will sell the euros at the spot rate of (if her prediction is correct) 

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$1.30/€. By buying at $1.25 and selling at $1.30 she will make a profi t of $0.05 per euro. In 
this case, she will make a profi t of $5,000.
Where to Invest?
A corporate treasurer needs to decide whether to invest funds in the United States or over-
seas. Forward exchange rates can be used to lock in a future exchange rate from an overseas 
investment. Let’s suppose the current exchange rate between the U.S. dollar and the euro is 
€0.90/$ (or $1.111/€). Assume that the one-year interest rate in the United States is 5 percent 
and the one-year interest rate in Europe is 7 percent. One other piece of information we need 
is the one-year forward rate: let’s say it is €0.87/$ (or $1.1494/€). The treasurer has $100,000 
to invest—where should he invest it? 
Alternative 1: If he invests the funds in the United States, after one year he will have 
$100,000 × 1.05 = $105,000.
Alternative 2: If he converts the funds to euros and invests in Europe, after one year he 
will have €96,300. That is, converting $100,000 to euros today (spot rate is €0.90/$) results in 
$100,000 × €0.90/$ = €90,000. After being invested at 7 percent for one year, they will grow 
to €90,000 × 1.07 = €96,300.
Is it better to have $105,000 or €96,300 after one year? That depends on the exchange rate 
at which the euros can be converted back to U.S. dollars. If the treasurer entered into a forward 
contract today to sell the €96,300 one year from today, the treasurer would be able convert the 
euros at the agreed-upon forward rate of €0.87/$ (or $1.1494/€, as 1/0.87 = 1.1494): 
€96,300 × $1.1494/€ = $110,687.22.
6
In this case, the treasurer will want to invest in Europe and lock in the one-year forward exchange 
rate. The combined eff ect of the exchange rates and European interest rate ($110,687.22) 
results in a larger sum than investing at the U.S. interest rate ($105,000).
Note the four requirements are met in this example:
1.
Is the investor wanting to buy or sell currency? 
In this example, the treasurer wants to 
sell 
euros 
in the forward market. He will buy euros at today’s spot rate, invest them for a year, and then 
sell
them for dollars at the forward rate to convert the euros back to dollars. 
2.
How much does the investor wish to buy or sell? 
In this example, this number is determined 
by the treasurer and how much money the fi rm has to invest.