Friday, September 4, 2009

Functions of the forward exchange market:commercial covering

The export or import of goods and services usually requires someone to deliver payment in a foreign currency or to receive payment in a foreign currency. Either the payor or payee, then, is subject to currency risk, since no one knows for sure what the spot price will be for a currency at the time payment must be made. The forward-exchange market can be used as a buffer against currency risk associated with the export or import of goods and services.
To illustrate, suppose an American importer of cameras has agreed to pay 5,000 marks to a West German manufacturer upon receipt of a new shipment. The cameras are expected to arrive dockside in 30 days. The importer has no idea at this point what 5,000 marks will cost in U.S. dollars 30 days from now. to reduce the risk that the price of marks in terms of dollars may rise significantly, the importer negotiates a forward contract with his bank for delivery of 5,000 marks at 0,30\DM in 30 days. When payment is due, the importer simply takes delivery of the marks (usually by acquiring ownership of a deposit denominated in marks) at the agreed-upon price and pays the West German manufacturer. Because the price is fixed in advance, the risk associated with fluctuations in foreign exchange rates has been eliminated. Today, export and import firms routinely cover their large purchases overseas with forward currency contracts.

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