Introduction to Finance

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6.8 Exchange Rate Risks in Global Business
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On the other hand, suppose over this 60-day time frame the dollar strengthens against the 
yen. Now, 60 days after placing the order, one dollar can purchase more yen (say, $1 can buy 
150 yen), so the 2.4 million yen product will now cost a U.S. fi rm, 
2.4 million yen × ($1/150 yen) = $16,000 
Fewer dollars will be needed to buy the item. The yen price hasn’t changed—it is still 
2.4 million yen—but fewer dollars are needed to purchase the item as the dollar strengthened 
and the yen weakened. So, if you are doing business in the United States and you wish 
to purchase that Japanese item—you’d like very much to place your order and then have the 
U.S. dollar strengthen against the yen!
The problem is that it is diffi
cult to predict exchange rate changes. Changing trade 
balances, expectations of changes in infl ation and interest rates between countries, polit-
ical discussions, and one economy unexpectedly growing more quickly than the other 
can all aff ect the current, or spot, price of one currency in terms of the other, as well as 
the price of one currency in terms of another at a given date in the future—namely, the 
forward rate. 
We learned in this chapter that the 
forward rate
is the negotiated exchange rate for the 
purchase or sale of currency when the delivery will take place at an agreed-upon future date. 
Usually such agreements are made with banks that are willing to buy currency that you wish 
to sell or they are willing to sell the currency you wish to purchase.
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Forward rates can be used 
to mitigate or reduce currency exchange rate risk and to try to profi t from expected currency 
exchange rate changes.
Hedging Cash Flows
In the case of our U.S. fi rm purchasing the 2.4 million yen item, the U.S. fi rm will seek out a 
partner who is willing to sell yen in exchange for dollars in 60 days. By agreeing on a specifi c 
exchange rate for a specifi c date, the forward contract will “lock in” the exchange rate and 
remove exchange rate risk from the transaction. If an Asian bank and the U.S. fi rm agree to 
exchange U.S. dollars for yen in 60 days at 125 yen to the dollar, the U.S. fi rm now knows its 
dollar cost: the Japanese product will cost, 
2.4 million yen × ($1/125 yen) = $19,200
Note that there are four requirements the U.S. fi rm must determine before entering this 
contract: