Forex: The Exchange Risk on Foreign Exchange

To start with the simplest type of solution, a businessman enters into an agreement to receive or make payment in a currency other than his own on a predetermined future date.

Let us assume that a U.S. exporter sells goods to an importer in the United Kingdom for ₤100,000 payable 90 days from date of sale. On the date of sale, spot sterling is selling at $2.40 per pound and forward sterling for delivery in 90 days is selling at $2.397 per pound.

The U.S. exporter enters into a forward contract with a U.S. bank for the delivery of ₤100,000 in 9 days at $2.397 per pound. When the pounds are paid to him by the U.K importer on the due date, they are paid to the account of the U.S. bank in London in settlement of the contract and the exporter's account in the United States is credited on the same day with $239,700.

No matter what changes occur, either from market fluctuations or from devaluation or revaluation, the exporter receives a precise amount in dollars. The U.S. bank has assumed the exchange risk.

Now what has happened?

Assuming that the exporter has not adjusted his price to compensate for a differential between the value or the currency he will receive and the value of the same currency at time of sale, he has paid $300 for insurance against any fluctuation in the value of the currency he is to receive.

On a per annum basis, that could be figured as $300 x 4, or $1,200, in relation to $240,000, which is equivalent to ? of 1 percent per annum. That would be included in the U.S. accounts of the exporter either as accost or as a reduction of the sale price. The U.K. importer's pound costs are fixed.

To turn the transaction around, the U.S. exporter now bills the same sale to the U.K. importer in dollars for $240,000. The U.K. importer buys forward form his U.K. bank the dollars required at the same rate of $2.397 per pound. That means he must pay ₤100,125 to buy $240,000. When the forward contract comes due, he pays his bank the ₤100,125 for $240,000 and has the dollars paid to the U.S. exporter in the United States.

On a per annum basis, the cost would be figured as 4 x ₤125, or ₤500, in relation to ₤100,000, which again is equivalent to ? of 1 percent. The importer normally takes into his accounts the total pound cost as the cost of the goods purchased. Here again the importer has no risk. Regardless of what happens to the relationship of the pound to the dollar, the U.K. bank takes the exchange risk. That is a normal banking function.