Chapter 27 Managing International Risks 709
bre44380_ch27_707-731.indd 709 10/08/15 10:08 AM
You could also say that the dollar was selling at a forward premium.
A forward purchase or sale is a made-to-measure transaction between you and the bank. It can
be for any currency, any amount, and any delivery day. You could buy, say, 99,999 Vietnamese
dong or Haitian gourdes for a year and a day forward as long as you can find a bank ready to
deal. Most forward transactions are for six months or less, but the long-term currency swaps that
we described in Chapter 26 are equivalent to a bundle of forward transactions. When firms
want to enter into long-term forward contracts, they usually do so through a currency swap.^5
There is also an organized market for currency for future delivery known as the currency
futures market. Futures contracts are highly standardized; they are for specified amounts and
for a limited choice of delivery dates.^6
When you buy a forward or futures contract, you are committed to taking delivery of the
currency. As an alternative, you can take out an option to buy or sell currency in the future at
a price that is fixed today. Made-to-measure currency options can be bought from the major
banks, and standardized options are traded on the options exchanges.
(^6) See Chapter 26 for a further discussion of the difference between forward and futures contracts.
(^5) Notice that spot and short-term forward trades are sometimes undertaken together. For example, a company might need the use of
Brazilian reals for one month. In this case it would buy reals spot and simultaneously sell them forward.
27-2 Some Basic Relationships
You can’t develop a consistent international financial policy until you understand the reasons for
the differences in exchange rates and interest rates. We consider the following four problems:
∙ Problem 1. Why is the dollar rate of interest different from, say, the rate on Ruritanian
pesos (RUPs)?
∙ Problem 2. Why is the forward rate of exchange for the peso different from the spot rate?
∙ Problem 3. What determines next year’s expected spot rate of exchange between dollars
and pesos?
∙ Problem 4. What is the relationship between the inflation rate in the United States and
the inflation rate in Ruritania?
Suppose that individuals were not worried about risk and that there were no barriers or costs to
international trade on capital flows. In that case the spot exchange rates, forward exchange rates,
interest rates, and inflation rates would stand in the following simple relationship to one another:
equals
Difference in
interest rates
1 + Ruritanian
interest rate
1 + U.S.
interest rate
Expected difference
in inflation rates
1 + expected Ruritanian
inflation rate
equals
equals equals
Difference between
forward and spot rates
Forward peso
exchange rate
Expected change
in spot rate
Expected peso
spot rate
Current
peso spot
Current peso
spot rate
1 + expected U.S.
inflation rate
Why should this be so?