The foreign exchange market is a platform where the currency of one country could be converted in to that of another country. The exchange rate determines the ratio at which one currency is converted into another currency.
The foreign exchange market is one of the most dynamic forces in international business and enables investors to undertake foreign investments worldwide. Without it, international trade and investment on the magnitude we experience today would not be possible.
Many international traders use the foreign exchange market to invest for short terms in money markets. Currency speculation is the short-term exchange of funds from one currency to another in anticipation of movements in exchange rates. The rate of return it earns on this investment depends not only on the specific country’s interest rate, but also the changes in the value of the concerned currencies in the intervening period.
Operating in the foreign exchange market is an ongoing challenge for the Entrepreneur and involves some risk. Foreign exchange risk arises from changes in exchange rates. Such fluctuations in the currency market can alter the Entrepreneur’s expected value of international transactions, simply because it can imply a change in the export opportunities available and also have an impact on imports. However, it is possible to eliminate some of the risks involved by using the foreign exchange market.
Spot Exchange Rates
The spot exchange rate is the same as the exchange rate for that particular day. Spot exchanges are updated on a daily basis and can be found on the internet or in the financial pages of newspapers. The dynamics between the demand and the supply of a specific currency compared to that of other currencies, determines the value of a currency.
Forward Exchange Rates
A forward exchange rate is a fixed rate for some time in the future, but traded upon in the present. For most of the prominent currencies, forward exchange rates are quoted for 30 days, 90 days and 180 into the future. To illustrate this explanation, the following example is used:
On the 26 June 2008, the 90 day forward exchange rate for converting Pounds into Indian Rupees (INR) is £1 = INR 110. The importer enters into a 90-day forward exchange contract with a foreign trader at this rate and is guaranteed to be unaffected should the Rupees/Pound exchange rate fluctuate.
A currency swap occurs when you buy and sell a certain amount of currency for two different value dates simultaneously. The most frequent kind of currency swap, is spot against forward. To illustrate this explanation, the following example is used:
On the 26 June 2008, the Spot exchange rate is £1 = INR 120 and the 90 day forward exchange rate is £1 = INR 110. The international entrepreneur sells £1 million to its bank in return for INR 120 million, and at the same time enters into a 90 forward exchange deal with its bank for converting INR120 million into pounds. This implies that the entrepreneur will receive £1.09 million (INR120 million/110 = £1.09 million).