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Forward Market for Foreign Exchange

The forward market facilitates foreign exchange transactions that involve the future exchange of currencies. The exchange rate at which one currency can be exchanged for another currency on a specific future date is referred to as the forward rate. The forward rate quote is usually close to the spot rate quote at a given point in time for most widely traded currency. Many of the commercial banks that participate in the spot market also participate in the forward market by accommodating requests of firms and investors. They provide quotes to firms or investors who wish to purchase or sell a specific foreign currency at a future time.

Firms or investors who use the forward market negotiate a forward contract with a commercial bank. This contract specifies the amount of a particular currency that will be exchanged, the exchange rate at which that currency will be exchanged (the forward rate), and the future date on which the exchange will occur. When a firm expects to need a foreign currency in the future, it can engage in a forward contract by "buying the currency forward." Conversely, if it expects to receive a foreign currency in the future, it can engage in a forward contract in which it "sells the currency forward."

forward market

A market that facilitates foreign exchange transactions that involve the future exchange of currencies.

forward rate

The rate at which one currency can be exchanged for another currency on a specific future date.

forward contract

An agreement that specifies the amount of a specific currency that will be exchanged, the exchange rate, and the future date at which a currency exchange will occur.

EXAMPLE

Charlotte Co. expects to receive 100,000 euros from exporting products to a Dutch firm at the end of each of the next 3 months. The spot rate of the euro is $1.10. The forward rate of the euro for each of the next 3 months is also $1.10. Charlotte Co. expects that the euro will depreciate to $1.02 in 3 months.

If Charlotte Co. does not use a forward contract, it will convert the euros received into dollars at the spot rate that exists in 3 months. A comparison of the expected dollar cash flows that will occur in 3 months follows.

Thus Charlotte expects that its dollar cash inflows would be $8,000 higher as a result of hedging with a forward contract and decides to negotiate a forward contract to sell 100,000 euros forward. If Charlotte Co. were an investor instead of an exporter, and expected to receive euros in the future, it could have used a forward contract in the same manner.

REVIEW QUESTION

RQ-12 Distinguish between the spot market and forward market for foreign exchange.

 
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