Spot vs. Forward Exchange Rates

A currency transaction that involves the immediate delivery of the currency is referred to as a __spot transaction__. If the spot exchange rate between US dollars and UK sterling (USD/GBP) was equal to 5, which of the following could you also conclude?

Correct! In practice, it is worth pointing out that spot transactions are typically required to be settled within one to two days.

Incorrect. Note that the price currency is in the numerator. In this case, a trader would need USD 25 to purchase GBP 5.

Incorrect. Spot transactions involve currency trades that require immediate delivery.

Individuals sometimes want to ensure that a future exchange rate is guaranteed. In these cases, an individual may want an agreement where they are able to trade a currency at some point in the future for a rate that is agreed upon today. These transactions are called __forward contracts__. Which of the following is a scenario where you might want to enter into a forward contract?

Correct! By using a forward contract, you have guaranteed an exchange rate for that conversion in the future. This allows you to eliminate exchange rate risk.

Incorrect. In this case, you would likely be conducting a spot transaction—converting domestic currency into foreign currency for immediate delivery.

Incorrect. In this case, the retiree would likely engage in a spot transaction, converting the proceeds into his domestic currency.

Imagine that a US investor wanted to buy a one-year sterling-denominated bond in the UK then convert the proceeds back into dollars upon maturity. If she also wanted to limit exchange rate risk, which of the following could she do?

Incorrect. By selling sterling at the spot rate, the investor is not hedging against exchange rate risk. If the exchange rate moved between now and the maturity date, the value of the investment could be impacted when converted into dollars.

Incorrect. The investor would need to sell US dollars at the spot rate in order to buy the sterling-denominated bond.

Correct! By doing so, this investor guaranteed an exchange rate in one year’s time. Any changes in the exchange rate during that period would not affect her investment.

Imagine an investor in the US traded dollars for Mexican pesos in the spot market in order to purchase a peso-denominated one-year bond. In order to eliminate exchange rate risk, she would need to enter into a forward contract. A dealer quoted the following: | | | |------------------------------------------|-------| | Spot Exchange Rate (MXN/USD) | 14.75 | | One-Year Forward Exchange Rate (MXN/USD) | 15.05 | If she enters into a forward contract to eliminate exchange rate risk, what will happen to her position?

Incorrect. When converting from pesos to dollars in one year, the rate is less favorable to the investor than the spot exchange rate today.

Correct! In this case, USD 1 can be exchanged for MXN 14.75 in the spot market, but on return to US dollars one year later, MXN 15.05 is needed to buy USD 1, which is about 2% more.

Incorrect. It is not clear which alternative would be better because the spot MXN/USD rate one year from now is not given and cannot be known.

Considering spot and forward contracts in general, which of the following statements might you use to describe how these contracts are used?

Incorrect. It is not possible to know in advance which direction (let alone by how much) a currency will fluctuate.

Incorrect. Since a forward contract involves an agreement to trade currency at a set exchange rate agreed upon today, there is no exchange rate risk.

Correct! By doing so, any changes in the exchange rate during the period of an investment are irrelevant to the investor since they are guaranteed an exchange rate and a transaction date.

In summary: [[summary]]

USD 1 could purchase GBP 0.2 for immediate delivery

USD 1 could purchase GBP 5 for immediate delivery

USD 1 could purchase GBP 0.2 deliverable within 30 days

You have purchased bonds denominated in a foreign currency, and you know that at maturity you will want to convert the proceeds back into your domestic currency

You have arrived in a foreign nation, and you need that nation's currency because you want to get something to eat right away

You are a retiree that has sold stock in a foreign company, and you now wish to repatriate the proceeds

Sell US dollars and UK sterling at the spot rate

Sell US dollars at the forward rate and sell UK sterling at the spot rate

Sell US dollars at the spot rate and sell UK sterling at a forward rate

With a forward contract, she will add 2% to her gains due to currency conversions

Eliminating exchange rate risk will cost her about 2% of her gains

She will be better off entering into a forward contract than she would if she waited a year and sold pesos for dollars in the spot market at that time

Investors typically do not use forward exchange contracts since exchange rate risk is often beneficial to the investor

Forward contracts minimize but do not eliminate exchange rate risk

An investor can use forward exchange rates to protect themselves from exchange rate risk

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