Foreign exchange risk, hedging, Speculation Lecture 05

Foreign exchange risk .when ever a future payment must be made or received in a foreign currency, a foreign exchange risk,or so called open position, is involved because spot exchange rate changes over time.

Suppose a US importer purchases €100,000 worth of goods from EU and has to pay in three months time in Euro. If the present spot rate is $1= €1 the current dollar value of the payment that he must make in three months is $100,000. However, in three months the spot rate might change to $1.10= €1 then the importer has to make a payment of $110,000 or $10,000 more for the imports.

Exchange rate risk for Exporter Similarly a US exporter who expects to receive a payment of €100,000 in three months time will receive only $90,000 if the spot rate in three months is $0.90= €1

Hedging Hedging refers to the avoidance of a foreign exchange risk, or the covering of an open position . For example, the importer of the previous example could borrow €100,000 at the present spot rate of $1= €1 and leave this sum on deposit in a bank for three months ,when payment is due. By doing so the importer avoids the risk that the spot rate in three months will be higher than what it is today and that he would have to pay more than $100,000 for the imports.

Similarly, the exporter could borrow €100,000 today, exchange this sum for $100,000 at today spot rate of $1= €1and deposit the $100,000 in a bank to earn interest. After three months, the exporter would reply the loan of €100,000 with the payment of €100,000 he will receives.

Speculation Speculation is the opposite of the hedging. Whereas a hedger seeks to cover foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk, or an open position in the hope of making a profit. if the speculator correctly anticipates future changes in spot rates, he or she makes a profit, otherwise he incurs a loss.

If a speculator believes that the spot rate of a particular foreign currency wil rise, he can purchase the currency now and hold it on deposit in a bank for resale later. If the speculator is correct and the spot rate does indeed rise, he earns a profit on each unit of the foreign currency equal to the spread between the previous lower spot rate at which he purchased the foreign currency and the higher subsequent spot rate at which he resells it.

If ,on the other hand, the speculator believes that the spot rate will fall, he borrows the foreign currency for three months, immediately exchanges it for the domestic currency at the prevailing spot rate and deposits the domestic currency in a bank to earn interest. After three months, if the spot rate on the foreign currency is lower as anticipated, the speculator earns a profit by purchasing the currency(to repay the foreign exchange loan)at the lower spot rate.

Of course for the speculator to earn profit, the new spot rate must be sufficiently lower than the previous spot rate to also overcome the possibly higher interest rate paid on a foreign currency deposit over the domestic currency deposit.

When a speculator buys a foreign currency on the spot market in the expectations of reselling it at a higher future spot rate, he is said to take a long position in the currency. On the other hand, when a speculator borrows or sells a foreign currency in the expectation of buying it at a future lower price to repay the foreign currency loan is said to take a short short position.

Stabilization vs Destabilization Speculation Stabilization speculation refers to the purchase of a foreign currency when the domestic price of the foreign currency falls or is low, in the expectation that it will soon rise, thus leading to a profit. Or it refers to the sale of the foreign currency when the exchange rate rises or high, in the expectation that it will soon fall. Stabilizing speculation moderates fluctuations in exchange rate over time and performs a useful function.

On the other hand,destablization speculation refers to the sale of a foreign currency when the exchange rate falls or is low in the expectation that it will fall even lower n the future, or the purchase of a foreign currency when the exchange rate is rising or is high in the expatiations that it will rise even higher in the future. Destabilization speculation thus magnifies exchange rate fluctuations over time and can prove very disruptive to the international flow of trade and investment.

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