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Business profitability goal benefits using foreign exchange, take place when a business:
- Uses currency exchanging to avoid fluctuations in currency values as a risk management tool
- Wants to earn short-term profits from fluctuations in exchange rate values
- Desires to obtain the foreign currency necessary to buy goods and services from other countries
The first scenario is highly common in international transactions. For example, a company in
the United States places an order for electronic devices from a company in Japan. The devices
will be completed and ready in 6 months. When the order is placed the yen is trading at 120 to
the dollar. The company in the United States agrees to pay $1,000,000 US dollars in Japanese
yen when they receive the devices, which is 120,000,000 yen at the current rate of exchange
(120,000,000 yen/120 yen per dollar = $1,000,000 USD). But there is no guarantee that the current
rate will be the same in 6 months. If the rate dropped to 100 yen to the dollar, the cost to the
US company would go up to $1,200,000 (120,000,000 yen/100 yen per dollar = $1,200,000 USD) Or
should the yen go up to 140 yen to the dollar, the cost to the US company would drop to $857,142.86
(120,000,000 yen/140 yen per dollar = $857,142.86) meaning a savings of over $142,000 USD.
Now the US company could pay for everything up front and be done with the transaction, but by
doing so it could lose 6 months interest and chances missing out on a potential favorable change
in exchange rates if the yen should actually go up. Other ways that the US company could employ
to deal with the risk in changing currency rates are:
- Forward Transactions
- Futures
- Swaps
- Foreign Currency Options
Forward Transactions In this type of transaction, money doesn't change hands until an
agreed upon future date. Both parties agree on an exchange rate for any date in the future with
the transaction occurring on that date. It makes no difference of what the market rates are then.
The date can be days, months or years out if so chosen by the participants.
Futures The futures contract is an obligation to exchange a good or instrument at a set
price at a future date. This would allow the US company to go to a futures exchange, purchase
such a contract for 120,000,000 yen for delivery in 6 months and not worry about rate volatility.
Swaps They are the most common type of forward transaction. Here,
two parties exchange currencies for a certain length of time and agree to reverse the transaction
at a later date. In all swaps, currency rates may change, but the buyer and seller are locked
into a contract at a fixed price. The advantage is that the market participants can plan safely,
since they know in advance what their costs will be.
Foreign Currency Options For a specific price, these give it's owner the right to buy or
sell a specified amount of foreign currency at a specified price at any time up to a specified
expiration date. Once purchased, the owner can buy or sell the underlying currency or let the
option lapse with no further obligation. They can also be sold and resold many times before the
expiration date. In our above scenario, the US company could purchase options to protect itself,
should the yen go lower in its relation to the dollar. Another use for speculation purposes, is
that the US company could also purchase options if the environment looks like the yen could rise
in relation to the dollar, allowing the company to profit from it's foresight.
Trading in the Forex market involves considerable risk. Therefore, before deciding to participate
in currency trading, one should carefully consider their investment objectives, level of
experience and risk appetite. And obtaining Forex Training is a good idea to increase your knowledge
on the subject. Most importantly, no one should invest money that they cannot
afford to lose.
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