Question

Mini-Case: Use of Foreign Exchange Markets

Each month, the O'Hare Sports Export Company (a U.S. firm based in Newport, RI) receives an order for footballs from a British Sporting Goods distributor. The monthly payment for the footballs is denominated in British pounds, as requested by the British distributor. John Novack, owner of the O'Hare Sports Export Company, must convert the pounds received into dollars.

Questions to answer:

1. Define the spot market.

2. Explain how the O'Hare Sports Export Company could use the spot market to facilitate the exchange of currencies. Be specific.

3. Define the forward market.

4. Explain how the O'Hare Sports Export Company is exposed to exchange rate risk and how it could use the forward market to hedge this risk.

*Please answer in DETAIL, thank you!*

Answer 1

1) The market is the place where products or goods exchanged by the buyers and sellers. The spot market is the market where the exchange and delivery of the goods take place immediately. The spot market is widely developed all over the world for commodities as well as currencies and financial securities.

2) The foreign exchange received by any company or person needs to be converted into domestic currency to be used or invested. There are many services or companies which convert the currency but if the amount is recurring and quite large then the commission could be significantly higher. The spot market is a large marketplace where the large volume of transaction takes place and the brokerage reduces drastically for market participants. The spot market also operates according to the rules established by the market regulator which also reduces counterparty risk.

3) The forward market also trades for commodities, securities, and currencies. However, it differs from the spot market in the fact that delivery of the underlying asset is agreed upon some future date which varies according to the exchange rule and asset type. Financial securities tens to be more liquid just like currencies but agricultural commodities tend to have longer contracts as they are not that much liquid.

4) The O'Hare sports company is using spot market for their conversion of currency. However, the company will have to convert that currency according to the prevailing exchange rate in the market. The market characteristically is always volatile and it is affected more by sentiments. If there is any drastic news then the company is at receiving end while converting the currency.
The company in such scenario can use forward market where it can hedge its position for any drastic fluctuation by entering into futures or swap contract. Alternatively, it can also use the option strategy to minimize volatility.