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A Yen for Trade

How many yen will it cost a Japanese importer to purchase $1,000 worth of oranges from a California farmer? How many dollars will it take for that farmer to buy a Japanese VCR priced in Japan at 30,000 yen (АВАµ)?

The exchange rate is АВАµ107.52 per dollar. The $1,000 of oranges will require the Japanese importer to come up with 1,000 АГАз 107.52 = АВАµ107,520. The VCR will require the American importer to come up with 30,000/107.52 = $279.

The exchange rates in the first column of figures in Table 6.5 are the prices of currency for immediate delivery. These are known as spot rates of exchange. For example, the spot rate of exchange for Mexican pesos is pesos9.4380/$. In other words, it cost 9.438 Mexican pesos to buy one dollar.

Many countries allow their currencies to float, so that the exchange rate fluctuates from day to day, and from minute to minute. When the currency increases in value, meaning that you need less of the foreign currency to buy one dollar, the currency is said to appreciate. When you need more of the currency to buy one dollar, the currency is said to depreciate.

Some countries try to avoid fluctuations in the value of their currency and seek instead to maintain a fixed exchange rate. But fixed rates seldom last forever. If everybody tries to sell the currency, eventually the country will be forced to allow the currency to depreciate. When this happens, exchange rates can change dramatically. For example, when Indonesia gave up trying to fix its exchange rate in fall 1997, the value of the Indonesian rupiah fell by 80 percent in a few months.

These fluctuations in exchange rates can get companies into hot water. For example, suppose you have agreed to buy a shipment of Japanese VCRs for АВАµ100 million and to make the payment when you take delivery of the VCRs at the end of 12 months. You could wait until the 12 months have passed and then buy 100 million yen at the spot exchange rate. If the spot rate is unchanged at АВАµ107.52/$, then the VCRs will cost you 100 million/107.52 = $930,060. But you are taking a risk by waiting, for the yen may become more expensive. For example, if the yen appreciates to АВАµ100/$, then you will have to pay out 100 million/100 = $1 million.

You can avoid exchange rate risk and fix the dollar cost of VCRs by БІАААмbuying the yen forward,БІАААн that is, by arranging now to buy yen in the future. A foreign exchange forward contract is an agreement to exchange at a future date a given amount of currency at an exchange rate agreed to today. The forward exchange rate is the price of currency for

delivery at some time in the future. The second and third columns in Table 6.5 show 3- month and 1-year forward exchange rates. For example, the 1-year forward rate for the yen is quoted at 101.3 yen per dollar. If you buy 100 million yen forward, you don`t pay anything today; you simply fix today the price which you will pay for your yen in the future. At the end of the year you receive your 100 million yen and hand over 100 million/

101.3 = $987,167 in payment.

Notice that if you buy Japanese yen forward, you get fewer yen for your dollar than if you buy spot. In this case, the yen is said to trade at a forward premium relative to the dollar. Expressed as a percentage, the 1-year forward premium is 107.52 101.3 АГАз 100 = 6.14% 101.3

You could also say that the dollar was selling at a forward discount of about 6.14 percent.

A forward purchase or sale is a made-to-order transaction between you and the bank. It can be for any currency, any amount, and any delivery day. You could buy, say, 99,999 Vietnamese dong or Haitian gourdes for a year and a day forward as long as you can find a bank ready to deal. Most forward transactions are for 6 months or less, but banks

are prepared to buy or sell the major currencies for up to 10 years forward. There is also an organized market for currency for future delivery known as the currency futures market. Futures contracts are highly standardized versions of forward contractsБІАААд they exist only for the main currencies, they are for specified amounts, and choice of delivery dates is limited. The advantage of this standardization is that there is a very low-cost market in currency futures. Huge numbers of contracts are bought and sold daily on the futures exchanges.

Here is a minor point that sometimes causes confusion. To calculate the forward premium, we divide by the forward rate as long as the exchange quotes are indirect. If you use direct quotes, the correct formula is Forward premium = forward rate spot rate spot rate

In our example, the corresponding direct quote for spot yen is 1/107.52 = .009301, while the direct forward quote is 1/101.3 = .009872. Substituting these rates in our revised formula gives

Forward premium = .009872 .009301 .009301 = .0614, or 6.14%

The two methods give the same answer.

FORWARD EXCHANGE RATE Exchange rate for a forward transaction.

SPOT RATE OF EXCHANGE Exchange rate for an immediate transaction.