- Many international business transactions involve payments to be made in the future. Such transactions include lending activities and purchases on credit. Because changes in currency values are common, such international transactions would appear to be risky in the post-Bretton Woods era. Currencies can be bought and sold for immediate delivery or for delivery at some point in the future.
- Spot market consists of foreign-exchange transactions that are to be consummated immediately. (Immediately is normally defined as two days after the trade date because of the time historically needed for payment to clear the international banking system.) Spot transactions account for 33 percent of all foreign-exchange transactions.
- Forward market consists of foreign-exchange transactions that are to occur sometime in the future. Prices are often published for foreign exchange that will be delivered 30 days, 90 days, and 180 days in the future.
Swap transaction is a transaction in which the same currency is bought
and sold simultaneously, but delivery is made at two different points in time. Many users of the forward market engage in swap transactions.
- For example, the Wall Street Journal excerpt shown in the slide indicates that on Wednesday, July 19, 2006, the spot price of the British pound was $1.4429, while the forward price for pounds for delivery in 30 days was $1.4428 and for delivery in 180 days was $1.4404.
- Normally, international business that wants to buy or sell foreign exchange on a spot or forward basis will contract with an international bank to do so. The bank will charge the firm the prevailing wholesale rate for the currency plus a small premium for its services. Because of bank's extensive involvement in the foreign-exchange market, it is typically willing an be able to customize the spot, forward or swap contract to meet the customer's specific needs.
- The first mechanism is the Currency Future. Publicly traded on many exchanges worldwide, a currency future is a contract that resembles a forward contract. However, unlike the forward contract, the currency future is for a standard amount (for example, ¥12.5 million or SwFr 125,000) on a standard delivery date (for example, the third Wednesday of the contract’s maturity month). As with a forward contract, a firm signing a currency-future contract must complete the transaction by buying or selling the specified amount of foreign currency at the specified price and time. This obligation is usually not troublesome, however; a firm wanting to be released from a currency-future obligation can simply make an offsetting transaction. In practice, 98 percent of currency futures are settled in this manner. Currency futures represent only 1 percent of the foreign-exchange market.
- The second mechanism, the Currency Option, allows, but does not require, a firm to buy or sell a specified amount of a foreign currency at a specified price at any time up to a specified date. A call option grants the right to buy the foreign currency in question; a put option grants the right to sell the foreign currency. Currency options are publicly traded on organized exchanges worldwide. Because of the inflexibility of publicly traded options, international bankers often are willing to write currency options customized as to amount and time for their commercial clients. Currency options account for 5 percent of foreign-exchange market activity.
The forward price of a foreign currency often differs from its spot price;
- Forward discount happen when the currency's forward price (using a direct quote) was less than a spot price
- Forward premium happen when the currency's forward price was higher than a spot price
The forward price represents the marketplace's aggregate prediction of the spot price of the exchange rate in the future. Thus, the forward price helps international business-people forecast future changes in the exchange rate. These changes can affect the price of imported components as well as the competitiveness and profitability of the firm's exports
The difference between the spot and forward prices of a country's currency often signals the market's expectations regarding the country's economic policies and prospects