Question

Explain spot exchanges rate, forward exchanges rates and currency swaps with example? Which strategy is more suitable to reduce risk and losses from changes in exchange rates?

Answer 1

Spot Exchange Rate - : It can be defined as the current price agreed upon by the trader / country to exchange one currency for the other currency. The delivery is immediate in this case. In usual cases , the settlement is done within 2 business days of transaction i.e. in T+2 days.

Example -: A U.S MNC imports mobiles from India . The company has to pay 2 billion Indian Rupee to the Indian company today . The U.S. MNC uses the current exchange rate where 1 Indian Rupee = 0.013 USD . tHEREFORE, Indian rupee = 2,000,000(0.013) = $26,000. Hence the U.S. MNC will need to sell only $26,000 to pay the supplier from India.

Forward Exchange rate -: It is the price at which the currency will be exchanged at some specified time in future. The forward exchange rate is determined at the time of sale but the payment is made in future when the exchange takes place. It is of two types : i) Closed forward -: when settlement future date is specified.

ii) open forward -: When the settlement date consists of ranges of dates.

Example -: A japanese Firm agreed to deliver an order of electronic goods to America after 5 months at a price of 8000yen when 1yen = $0.10.Today the payment in American $ = 8000(0.10) = $800. After 5 month the exchange rate fluctuated and changed to 1 yen = $0.20.Now the payment as per exchange rate = 8000(0.20) = $1600. But it cant take advantage of changes in exchange rate and it has to deliver the goods at the agreed exchange rate of 1 yen = $0.10 i.e. will get payment $800 after 5 months .

Currency Swaps -: It is defined as the combination of spot of currency with a forward repurchase in a single transaction. The swap rate is the difference between spot exchange rate and forward exchange rate. It is used to lock exchange rates for a specific period of time . It allows to save the parties from uncertainty of exchange rate fluctuations.

Example -:A gives to B 10 million pounds in exchange for $15 million , this means that exchange rate (pounds/dollars) is 1.5 . If the agreement is for 15 years, at the end of 15 years the parties will exchange the same amounts back to each other usually at the same agreed exchange rate. However, there would be a drastic change in exchange rate in 15 years but the EXCHANGE WILL BE MADE ON AGREED exchange rate.

Which Strategy is most suitable to minimise risk ?

-: Currency Swaps are most suitable to hedge the risk of exchange rate volatility . It is so beacuse under this optipon both the parties are aware what they are paying now and what they will get in the future on maturity. It saves them from the opportunity cost of exchange rate fluctuations. It is largely used by financial institutionswho lock the the rates or amount of money and not speculate. It can also be used to purchase less expensive debt. Last but not the least , currency swaps allow the countries to have acess to income by allowing other countries to borrow their own currency.