Page 194 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes (a) A forward contract. (b) A swap.
(c) A futures contract. (d) A foreign exchange option.
(e) A spot contract.
(vi) A saver will prefer asset X to asset Y if:
(a) Asset X is more liquid. (b) Asset X has a higher expected return.
(c) Asset X is less risky. (d) All of the above.
(e) None of the above.

16.5 Summary

• In this Unit we initially analyzed the theories of exchange rate determination, and we concluded
that the exchange rate of a currency, just like commodities, determine its price responding to
the forces of supply and demand.
• However, it remains difficult to evaluate the 'weight' of each factor that influences the supply
and demand flows. In this respect, we can argue that in the long term fundamental forces drive
the currency's movements, e.g., inflation rates, interest rates, and GDP levels, to mention just a
few, while in the short run, news and events drive the exchange rates movements. Moreover,
we still remain unsure as to the ranking of the factors that finally determine the exchange rates.
• We have further considered various concepts and models thought to be reliable forecasters of
the exchange rates. We have concluded that the forward rates are not good predictors of the
future spot rates. In other words, the forward rate does not provide an 'unbiased' estimate of
the exchange rate movements.
• Taking into consideration the time horizons, we come to the conclusion that fundamental
economic forces, such as purchasing power parity and the balance of payments, did not
automatically affect the exchange rates, but they require a considerable amount of time. As a
result they are not reliable over short time periods. Conversely, we can argue that the technical
analysis performs comparatively well in the short run since news and events are incorporated
into the diagrams and trends.
• We finally conclude the following: Firstly, the foreign exchange market is not an efficient one.
Otherwise, it would be futile to beat or try to forecast the market. Secondly, because of so many
determinants of the exchange rates, it is difficult to proceed to a reliable estimation for future
rates. Thirdly, there is no unfailing method available to forecast exchange rates, and we have
further determined that the forward rate provides a biased estimate of the future spot rate. As
a result, companies trading internationally face exposure to exchange rate risk.
• In this respect, the mentioned 'costly' hedging22 instruments in Appendix 1 have been developed
in order to manage the exposure related to unfavorable currency movements. More specifically,
it can be argued that there is no 'perfect' hedge or in other words a hedge with 100 % efficiency.
What in practice happens is that a small profit or loss is made. For example, when an importing
company has a liability that is payable in six months, it can hedge its exposure to exchange rate
risk by using a forward contract. e.g., the company can buy the due amount at the six months
forward rate. The company having used the aforementioned hedging instrument has no
'uncertainty' about the exchange rate movements because it will pay a specific and previously
known amount in its own currency. In other words, the company has 'locked' its exposure, and
consequently, its cost irrespective of whether or not the after six months 'spot' rate proved to be
in favour of or not in favour of his decision to hedge.
• Finally, we wish to underline that as indicated earlier, there are no unfailing methods to forecast
exchange rates; consequently, the companies face an exposure related to the currencies'
fluctuation. However, their exposure to exchange rates movements can be managed, controlled,
and even more, eliminated by using hedging instruments.

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