17: International Investment DecisionsPILGRIMAGE TO MATA MATA
As a devoted Lord of the Rings fan, you decide to
make a trip to New Zealand to visit Mata Mata, the
site of ‘Hobbiton’ from the films. After you pay for
your airfare, you plan to spend 5000 Australian dollars
on hotels, food, transportation around New Zealand
and souvenirs. At the time you put together your
budget, one New Zealand dollar was worth about$0.76, meaning you could spend $5000 ÷ 0.76 =
NZ$6579 during your stay. However, by the time
you actually travel to New Zealand, the exchange
rate has moved up to $0.81/NZ$, so if you stay true
to your planned budget – to spend no more than
$5000 – you have just NZ$6173 to spend on your
trip.finance in practiceFor each currency, Table 17.4 lists the spot exchange rate. The spot exchange rate is just another term
for the current exchange rate. That is, if you are going to trade currencies right now, the relevant exchange
rate is the spot exchange rate. In many currencies, it is possible to enter a contract today to trade foreign
currency at a fixed price at some future date. The price at which that future trade will take place is called
the forward exchange rate. If traders choose to transact through a forward contract, no cash changes hands
until the date specified by the contract.
Just as we compared movements in the spot exchange rate from one day to the next, we can also
examine differences in the spot exchange rate for current transactions and the forward rate for future
transactions. For example, look at the rate quotes for Japanese yen. On the spot market, one yen costs
US$0.00796, but if the exchange rate for trades that will take place six months later is, for example,
US$0.00798/¥, then one yen will buy more dollars on the forward market than on the spot market. When
one currency buys more of another on the forward market than it does on the spot market, traders say that
the first currency trades at a forward premium. The forward premium is usually expressed as a percentage
relative to the spot rate, so for the yen, we can calculate the six-month forward premium as follows:
FS
SUS$0.00798/¥ US$0.00796/¥
US$0.00796/¥0.00251 0.25%
−
=−
==where F is the symbol for the forward rate and S stands for the spot rate, both quoted in terms of
US$/¥. This calculation means that one yen buys 0.25% more US dollars on the six-month forward
market than it buys on the spot market. Recognising that the yen’s 0.25% forward premium refers to a
six-month contract, we could restate the premium in annual terms by multiplying the premium times 2,
which would yield an annualised forward premium of 0.50%.
If the yen trades at a forward premium relative to the US dollar, then the US dollar must trade at a
forward discount relative to the yen, meaning that one US dollar buys fewer yen on the forward market than
it does on the spot market. To calculate the forward discount on the US dollar, we use the same equation
as above, but we express the exchange rate in terms of yen per US dollar:^2
FS
S//
/¥125.313US$ ¥125.628US$
¥125.628US$0.00251 0.25%
−
=−
=− =−2 Note, that although the exchange rate for Japanese yen in US dollars is usually quoted to 2 decimal places, we have included an extra
decimal place in this calculation to reduce rounding errors.
spot exchange rate
The exchange rate that
applies to immediate currency
transactionsforward exchange rate
The exchange rate quoted for
a transaction that will occur
on a future dateforward premium
When one currency buys more
of the other currency on the
forward market than it buys on
the spot marketforward discount
When one currency buys less
of the other currency on the
forward market than it buys on
the spot market