Friday, September 4, 2009

Functions of the forward exchange market:Hedging an investment position

Thousands of American corporations have invested in long-term capital projects overseas, building manufacturing plants, warehouse and dock facilities, retail stores, shopping centers, and office building. in recent years a large return flow of long-term investments by foreign firms in the United States also has occurred. Of course, the market value of these foreign investments may change drastically as the price of a foreign currency changes over time. For example, a drop in the exchange value of the British pound against the dollar may turn an otherwise profitable commercial project launched by a U.S. firm in Britain into a loss, particularly if the firm involved plans to sell the property while currency values are depressed.
To illustrate, suppose an American commercial bank constructed an office building in downtown London. When completed, the office facility had an estimated market value of £2,000,000. The current spot rate on pounds is, let us say, $2.20\£. The bank values the new building on its consolidated financial statement, therefore, at $4.4 million. However, suppose the pound has declined rapidly in value in recent months due to persistent balance-of-payments problems and rapid inflation in the British economy. Some market analysts expect pounds to be selling at $1.98\£ in a few months. In the absence of hedged position, the bulk would take a loss of $440,000 on its building. This is due to the fact that, at an exchange rate of $1.98\£ the office building will have a book value of only $3,960,000.
Can this kind of loss be avoid or at least reduced? Yes, provided the bank can negotiate sale of pounds forward at a higher price. For example, the bank may be able to arrange with a dealer for the sale of £2 million for future delivery at 210¢US (i.e., $2.10\£). When this forward contract matures, if the spot price has fallen to $1.98\£, the bank can buy pounds at this rate and deliver them to the dealer at 210¢US as agreed. The result is a profit on the foreign-exchange transaction of $240,000, partially offsetting the financial loss on the building due to declining currency values.

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