Question

Why do forward markets for foreign exchange exist? Explain how they allow firms to hedge (eliminate) their exposure to foreign-exchange risk.   

Answer 1

Forward markets for foreign exchange exists so that the parties involved in the foreign exchange transactions can manage their risks. Foreign exchange rates keep fluctuating and these fluctuations have significant impact on the decisions of business. Forwards are used to manage exchange rate risks. The term which is used for managing risks is called hedging. Forwards are custom agreements in which the exchange rate is fixed by two parties for a transaction that will take place in the future. If the parties enter into a forward contract, then regardless of the spot exchange rate on the due date of the forward contract, the foreign exchange transaction will take place at the rate specified in the forward contract.

Suppose that an investor who is from USA fears that the rate of Canadian dollars will fall in value in the next one year. So he can hedge this risk by a forward contract. He enters into a contract that he will sell 1 million Canadian dollars at a fixed exchange rate against the US dollars a year later. So even if one year later the Canadian dollar depreciates in value, the investor would be protected and the outcome will be in his favour.