Introduction to Finance

158
Forward Contracts in 
International Finance
LO 6.8
Explain how forward contracts can be used in global business and investing.
6.8
Exchange Rate Risks 
in Global Business
One risk that is faced by all international businesses is currency exchange rate risk, which 
is the risk that exchange rates may change between the time a transaction is negotiated and 
when the contract is due. Here are four situations that involve uncertain cash fl ows or returns 
because of fl uctuating exchange rates.
1.
A U.S. company has to pay a supplier in Japan in 60 days, in yen. It wants to hold onto the cash 
as long as possible but the fi rm’s treasurer is concerned about changing exchange rates between 
now and when the bill comes due.
2.
A U.S. manufacturer shipped goods to Europe. It expects to receive payments, in euros, in 
90 days at which time the US fi rm will convert them to dollars. Can it “lock in” an exchange 
rate today?
3.
A speculator believes the market’s expectations about future exchange rates, as refl ected 
in today’s forward rate, are incorrect. How can they take advantage of the situation and 
profi t—if indeed the speculator’s expectations are correct?
4.
A U.S. corporate treasurer is deciding whether to invest extra funds for the next few month 
in the United States or to invest them overseas where interest rates are higher—but where 
there is also the risk of changing exchange rates.
International businesses, individuals, or institutional investors involved in paying, 
receiving, or investing face risks from fl uctuating exchange rates if the transaction involves 
a currency besides the “home” currency. As with most risks, the situation may work in our 
favor—or against us. A U.S.-based fi rm may receive more U.S. dollars than expected or pay 
fewer U.S. dollars than expected due to favorable exchange rate changes. Or exchange rates 
may move to decrease U.S. dollar receipts or increase our costs. 
Suppose $1 can purchase 120 Japanese yen. Today, an item that costs 2.4 million yen will 
cost, in U.S. dollar terms, 
2.4 million yen × ($1/120 yen) = $20,000 
But as we’ve seen in Chapter 6, international trade can take place over several months. Goods 
are ordered, manufactured, transported, shipped, and received by the customer, then inspected 
by the customer and accepted if everything is in proper order. During this time-consuming 
process, the exchange rate may change. Let’s say this process takes place over 60 days. During 
these 60 days, suppose the dollar weakens and buys fewer yen (say, $1 will now purchase 100 yen) 
so that 2.4 million yen item will now cost a U.S. fi rm, 
2.4 million yen × ($1/100 yen) = $24,000 
More dollars will be needed to buy the item. The yen price hasn’t changed—it is still 2.4 million 
yen—but more dollars are needed to purchase the item since the dollar is weaker and the yen is 
stronger. 
Learning Extension