Foreign Exchange System - Essay Example

The 3-month forward is .009074 and the 6-month forward is .009124. This means that the Japanese currency is expected to progressively appreciate during this period.  The indirect quote column (Japanese currency calculated in US dollar terms) confirms the expected trend, showing that gradually it will require more dollars to pay for a fixed amount of Japanese yen.

I use the spot rate when I need the currency immediately. I go to a lending institution or a bank to arrange for a forward exchange contract when I need to protect the value of the US dollar against the possibility that the Japanese yen will rise in value (appreciate), and it would require me to spend more money to purchase a product priced or denominated in that currency. In this particular case, if I have to purchase Y100,000 now,  at the rate of $0.009035 per yen, the amount I have to pay will be $903.50, which is obtained by multiplying these two numbers. Since the 1-month forward rate is $0.009048, the amount of our contract with the bank will be $904.80, which is higher by $1.30. A month from now, I will obtain from the bank Y100,000 at this price.

I can either buy Y100,000 now at the spot market price at the rate of 1 Yen = $0.009035 and hold the currency until a month from now when I need to use it for payment, or I can arrange a forward contract which, at $0.009048, is $1.30 higher. The forward contract will protect me in case the Japanese yen appreciates. For example, if the Japanese yen, contrary to market expectations, rises to $0.009200 (or, conversely, $1 = 108.70, obtained by computing it's reciprocal - i.e., 1/.009200), I will need to pay  $920.00 a month from now – or $16.50 higher -  because I did not hedge my position by using the forward contract. This is also higher than the forward contract price.

Is hedging with a forward contract a wise decision? The answer is Not Always. If the Japanese yen depreciated (or, equivalently, the US dollar appreciated), it would require fewer dollars to buy the yen amount a month from now in the spot market. For example, if the yen dropped to $0.008900 ($1 = Y112.36), I would have been required to spend only $890.00 at the spot market to acquire Y100,000. But I could not back out from my commitment to the bank to pay $904.80.  I lost $14.80 because I resorted to hedging with a forward contract.

Therefore, the decision of whether to use the spot market or the forward contract would depend on what I believe will be the trend of the exchange rate between the two currencies. Usually, the quoted rates such as those in the above table are right because they are derived using macroeconomic data and interest rate differences. However, if the market expectation turns out wrong due to unforeseen developments, the decision to hedge would be a regrettable one.

In summary, I would either use the spot market if I feel it is safe because exchange rates are not likely to change, or I could use a forward contract to hedge my position.  Since I am entrusted with the duty of ensuring that I can buy Y100,000 at or near the current rate, without incurring any risk, I would hedge with a forward contract which costs only $1.40 more than the spot based on the quotes given. This means arranging the contract with a bank at $904.80, which is the amount I will pay the bank a month from now. While I could lose a profitable opportunity if the market moved in the opposite direction, I am at least protected from any adverse movement of the currencies.