The Reason for the Market
The forward Currency Exchange Market allows interested parties to trade forward contracts on currencies (Madura, 2006, p117). Forward contracts are an agreement between a firm and a commercial bank to exchange a specified amount of currency, at a specified exchange rate and on a specified date. Forward contracts are being used around the world to mitigate the risk of wildly fluctuating foreign exchange rates in day to day business transactions. Firms use the forward contracts when they know they will need a certain amount of foreign currency at a set date in the future, it allows them to lock in a future exchange rate (Wikipedia, 2006).
There may also be a credit risk associated with foreign exchange currency because a ‘buyer’ is essentially promising to purchase the currency on a future date. The buyer may not be able to complete the transaction simply because the funds are not available at the time. So, in cases where commercial bank does not know a company well, and to protect against the credit risk, they require some form of security (such as a mortgage be put forward or a deposit).
Air Rarotonga is a prime example of where and how forward contracts are used on a regular basis. This airline operates to and from countries and small islands around the Pacific. Air Rarotonga operates its business dealings using New Zealand Dollars, that is they sell their plane tickets, pay salaries and run day to day business transactions using New Zealand Dollars. As with many airlines around the world they must pay for their aviation fuel in U.S. Dollars, therefore exposing them to exchange rate risk between their New Zealand Dollar income stream (from the sale of tickets) and their US dollar expenses. As the airline is continually selling their plane tickets at a set rate they cannot easily change their income levels by putting prices up. Air Rarotonga has forward contracts set up for all of their fuel needs ahead of time to overcome this risk.
Method of Operation
Exchange rates are quoted both on ‘buy’ and ‘sell’ prices. The spread between buy and sell prices represents the bank’s profit margin. For example, a bank may offer to sell (ask rate) a firm Canadian Dollars in 30 days for C$0.80 and at the same time agree to buy (bid rate) Canadian Dollars from another firm in 30 days at C$0.77. For less popular currencies such as Mexican Pesos or New Zealand Dollars the spread is wider because banks may not be able to find buyers for these currencies quite so easily and may have to hold them for lengthy periods of time (Madura, 2006, pp118-119).
Competition between banks keeps the spread on the rates low, which means that if a particular bank would like more business all they would have to do is adjust their rates.
On the forward rate there will always be either a premium or a discount. The premium or discount is found by working out the difference between the forward rate and the spot rate (which is the rate the currency is trading for right now). If the foreign currency is higher in the forward market then there is a premium but if the forward rate is less than the spot rate then the number is negative and there is a discount. The market dictates whether it be a discount or a premium by supply and demand (Madura, 2006, p119).
Currency futures are a special type of contract traded on the exchange. The main difference...