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Dec
5
Written by:
admin
12/5/2007
 Part 1: Transaction Risk
Of the various exposures to forex risk the transaction exposure is the simplest one to understand and manage. For instance, let’s suppose we are a manufacturing company in the eurozone and we order a new machine from US in US dollars. If we pay the machine when it will arrive, say in 6 months, we will pay the amount of euros equivalent to the price of the machine, price established at the moment of buying it, i.e., 6 months earlier. The uncertainty of the amount of equivalent euros is called forex transaction risk. As a consequence, when we make such transactions we are exposed to such risk. By risk we mean its financial definition, of course, which implies the fluctuation potential or uncertainty of the amount or value. In engineering or day-to-day terms we refer at risk as the possibility of an accident or failure.
How do we manage forex transaction exposure?The creative financial specialists and consultants long ago solved the problem by creating the forward exchange rate market. This market decides what the value of a certain currency will be in the future, thus removing the uncertainty (risk) for the transaction. At a price, of course. It is like buying insurance, but the cost is well worth it because it fulfils the primary goal of a financial director, which is to provide a clear and non fluctuating cost of the transaction in the home or base currency, whatever happens between the order of the machine and the payment.
How is the forward exchange rate determined?The market fixes the prices, but technically the banks usually act as the counterparts for the buyer of the forward contract. The value, as in any market, depends on several factors; among them, supply and demand, currency volatility, political stability, interest rate differential, strength of the respective economies, their current and capital account of nations, and so on. Incidentally, in an efficient market central banks have a difficult task trying to use the single lever of the interest rate to control at the same time internal inflation, currency stability and strength and economic growth (which in many cases depend on capability to export, just to close the loop with the forex risk topic…).
A few definitions:Spot rate: the current exchange rate between two currencies
Forward outright: the future or forecast exchange rate between two currencies
Forward margin: the difference between forward outright and spot rate
They are connected by the following relationship:
Forward outright = Spot rate + Forward margin
The Rectangle ModelIn an efficient market there is no room for arbitrage (or, better, arbitrage is instantaneous), i.e., the possibility to make money by buying cheaper in a market and selling higher onto another. Currency markets, operating round the world 24/7, are a good approximation of an efficient market. In theory I cannot buy EUR today, put them on a bank account with interest and then convert them to US dollars in 6 months and have more dollars than if I had bought them today at the current spot prices. It is the principle of the “rectangle”, shown in the picture above.
In the example given we assume a spot value of 1.3$ for 1€. If the interest differential is 3% a year, we have to expect the EUR to become “weaker” in 6 months by such differential (in nominal terms 1.5% weaker). That is why in 6 months one could buy 1€ with only 1.28$, at least according to the forward rates. In this case the EUR is said to be traded at a discount, i.e., the dollar will buy more EUR in 6 months than today, while the USD is said to be traded at a premium.
I can go “round the rectangle” either way, but will end up with the same result. At least this should be true in the long run, if we exclude daily fluctuations.
What matters here is that this mechanism provides secure means for companies and traders to cover their forex transaction exposures.
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