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International Financial Management

Notes The Spot exchange market is an over-the-counter (OTC) market. This market is a worldwide
linkage of Currency traders, non-bank dealers, foreign exchange brokers who are connected to
one another via a network of telephones, computer terminals and automated dealing systems.
The largest vendors of screen monitors used in the Currency trading are Reuters, Bloomberg,
etc.

Forward Market

A Forward Market is a market for exchange of foreign currencies at a future date. In the Forward
Market, trades are made for delivery at some future date, according to an agreed upon delivery
date, exchange rate and amount. The price of foreign Currency for future delivery is known as
a forward rate. Thus, the forward rate, once contracted, will be valid for settlement irrespective
of the actual Spot rate on the Maturity Date of the forward contract.
A forward transaction is defined as an agreement to buy or sell a specified amount of a foreign
Currency any time in the future. A forward contract usually represents a contract between a
large money center bank and a well-known customer having a well-defined need to hedge
exposure to fluctuations in exchange rates. Forward Contracts are usually defined, so that the
exchange can occur in 30, 90 or 180 days. Also, the contract can be customized to Call for the
exchange of any desired quantity of Currency at any future date acceptable to both parties to the
contract.

Example: Some transactions may be entered into on one day but not completed until
sometime in the future. For example, a French exporter of perfume might sell perfume to a US
importer with immediate delivery but not require payment for 30 days. The US importer has an
obligation to pay the required francs in 30 days, so he or she may enter into a contract with a
trader to deliver dollars for francs in 30 days at a forward rate – the rate today for future
delivery.
Thus, the forward rate is the rate quoted by foreign exchange traders for the purchase or sale of
foreign exchange in the future. There is a difference between the Spot rate and the forward rate
known as the ‘spread’ in the Forward Market. In order to understand how Spot and forward rates
are determined, we should first know how to calculate the spread between the Spot and forward
rates.

Consider another example. Suppose the Spot Japanese yen of August 6, 2009, sold at $0.006879
while 90 day forward yen was priced at $0.006902. Based on these rates, the Swap rate for the
90 day forward yen was quoted as a 23 point premium (0.006902 - 0.006879). Similarly, because
the 90 day British pound was quoted at $1.6745 while the Spot pound was $1.7015, the 90 day
British pound sold at a 2.70 point discount.

Need for a Forward Market

The actual need for the existence of a Forward Market is not Speculation. Today, there is no
clear-cut line of distinction between Hedging and speculating. However, there are a couple of
characteristic of people who use the Forward Market in order to cover for time lags. The first
group includes exporters and importers. As receipts and payments do not usually coincide
time-wise, these people buy forward the Currency that they will have to pay and sell forward
the Currency that they will receive. In this way they overcome undesirable market fluctuations
and take care of future cash flows. The second group consists of people who use the Forward
Market to preserve the value and nature of their assets without speculating against future
trends. These operators use both the Spot and Forward Market through Swaps.

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