there to a New York bank, and finally to a foreign
bank abroad. The process allows payments to be
made for foreign goods without a physical transfer
or movement of money across countries.
Third, the market furnishes facilities for hedging
so that businesses can cover or reduce their foreign
exchange risks. Hedging is an activity that is used
as a temporary substitute purchase or sale for the
actual currency. This temporary transaction allows
users to protect the price they secure from fluctua-
tions because it establishes equal and opposite posi-
tions in the market.
The rationale for hedging lies in the exchange
rate fluctuation, which can move significantly and
erratically, even within a short time. For example,
due to inflation and instability, the Russian ruble lost
27 percent of its value against the US dollar in a
single day in 1994. The panic started when the
central bank stopped supporting the declining
ruble. The ruble tumbled from 3081 to the dollar
to 3926, and it was a record fall. In just three
months, the ruble lost half its value. Consumers, to
hedge against price increases, bought merchandise
as much as they could, while merchants sharply
marked up prices.
Figure 19.1 provides a good illustration of the
high degree of volatility in the foreign exchange
market. Since it is common for a customer to take
some time in accepting the quoted price, placing an
order, and making payments,financial loss caused by
exchange rate movement can easily occur.Without
a hedge, an American exporter selling to an Italian
customer will suffer financially when the euro
declines in value (or the dollar increases in value)
because the euros paid, after conversion, will yield
fewer dollars than first expected.
Some observers may conclude that, though the
danger of the falling euro to the US exporter is real
and serious, there is an equal opportunity for the
euro to gain in value instead. Under this scenario,
the exporter can increase the expected profit –
once from the sale of the goods and again from
the exchange gain. Based on this contention, the
exporter would miss the windfall profit if the
exporter had hedged. The problem with this idea,
however, is that the exporter is in reality a mere
amateur as far as the speculation game is concerned.
He or she may be an expert in and have wide know-
ledge of the manufacturing and selling of products.
However, the exporter is not in the business of
making windfall profits and should concentrate on
familiar trading operations rather than attempting
to be a gambler in the unfamiliar and risky game of
currency speculation. The caution applies to the
Italian importer as well, especially when payment is
to be made in dollars instead of euro. As demon-
strated by Shell Sekiyu, a Japanese-Dutch oil refiner
and distributor, its finance department lost more
than $1 billion by making a bad bet in the futures
market that the dollar would rise in 1993.
The foreign exchange market provides a hedging
mechanism needed to protect corporate profits
against undesirable changes in the exchange rate
that may occur in the future. For this purpose, the
market has two submarkets – spot and forward.The
two differ with respect to the time of currency
delivery.The spot market is a cash market where
foreign exchange is available for immediate delivery.
In practice, delivery of major currencies occurs
within one or two business days of the transaction,
whereas other currencies may take slightly longer.
A US firm holding foreign currency can go to its
bank for immediate conversion into dollars based on
the spot rate for that day.
Exporters should also consider doing some
hedging well before the arrival of foreign funds, and
this is where the forward market becomes sig-
nificant. Companies can protect themselves by
selling their expected foreign exchange forward. A
forward contract is a commitment to buy or sell
currencies at some specified time in the future at a
specified rate. By signing a forward contract of, say,
forty-five days, a company has locked in a certain
rate of exchange and knows precisely how many
dollars, after conversion, it will get – even though
payment, conversion, and delivery will not be made
until later (i.e., forty-five days after).
It should be understood that the exchange rate
specified in the forty-five-day forward contract is
not necessarily the same rate as the forward rate of
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