Trading in Foreign Exchange

Importers exporters tourists and governments buy and sell currencies in the foreign exchange market. For example, when a U.S. trader imports automobiles from Germany, payment will probably be made in German marks. The importer buys marks (through its bank) in the foreign exchange market much as one buys common stocks on the New York Stock Exchange or pork bellies on the Chicago Mercantile Exchange. However, whereas stock and commodity exchanges have organized trading floors, the foreign exchange market consists of a network of brokers and banks based in New York, London, Tokyo and other financial centers. Most buy and sell orders are conducted by computer and telephone.

Spot Rates and Forward Rates

The exchange rates shown earlier in tables 18-1 and 18-2 are known as spot rates which means the rate paid for delivery of the currency “on the spot” or in reality no more than two days after the day of the trade. For most of the world’s major currencies, it is also possible to buy (or sell) currencies for delivery at some agreed-upon future date, usually 30.90 or 180 days from the day the transaction is negotiated. This rate is know as the forward exchange rate. For example, if a U.S. firm must make payment to a Japanese firm in 30 days, the U.S. firm’s treasurer can buy Japanese yen today for delivery in 30 days paying the 30-day forward rate of $0.0088 per Japanese yen (which equals 113.50 yen per dollar). Forward rates are analogous to futures prices on commodity exchanges. Where contracts are drawn up for wheat or corn to be delivered at agreed-upon prices at some future date. The contract is signed today and the future dollar cost of the Japanese yen is then known with certainty. Purchasing a forward contract is one technique for eliminating the volatility of future cash flows caused by fluctuations in exchange rates. This technique, which is called hedging, will be discussed in more detail in Chapter 19.

Recent forward rates for 30-90- and 180-day delivery, along with the current spot rates for some commonly traded currencies, are given in table 18-3. if one can obtain more of the foreign currency for a dollar in the forward than in the spot market the forward currency is less valuable than the spot currency and the forward currency is said to be selling at a discount. Thus because I dollar could buy 0.6006 British pound in the spot market but 0.6035 pound in the 180-

Forward Rates
	Spot	30	90	180	Forward Rate at a Premium or Discount
	Rate	Days	Days	Days
British pound	0.6006	0.6009	0.6019	0.6035	Discount
Japanese yen	114.0400	113.5000	112.5900	111.1300	Premium
German mark	1.5581	1.5551	1.5493	1.5401	Premium

day forward market, forward pounds sell at a discount as compared with spot pounds. Conversely, since a dollar would buy fewer yen in the forward than in the spot market the forward yen is selling at a premium.