Money, Banking, and International Finance2,500 000
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International banks created several financial securities to hedge against foreign exchange
rate risk. Moreover, some financial securities allow international banks to circumvent
government regulations and to facilitate international trade.
A bank, business, or investor can use a derivative as the first line of defense against the
exchange rate risk. A derivative is a contract for a future exchange of a commodity for money at
a known price on a particular date. Common commodities include foreign currencies, petroleum,
coffee, corn, wheat, Eurodollars, stocks, and bonds. For example, a buyer and seller agree to a
future price of coffee today. The day the contract expires; the buyer must buy the coffee for the
price and quantity specified in the contract. Derivative contract protects a bank, company, or
investor from price fluctuations, and they can buy and sell the contracts on the secondary
markets before the contract matures. For the exchange rate risk, the investors can buy
derivatives contracts where they buy a quantity of foreign currencies on a future date with a
fixed exchange rate. On the other hand, the buyer and seller exchange a commodity for money
immediately in the spot market, and the spot market provides no protection against future price
fluctuations.
A derivative contract has many different forms. First form is a forward contract. For
example, an international bank granted a loan to a business in Malaysia. As the business repays
the bank in Malaysian ringgits, the international bank can use a forward contract to exchange
ringgits for U.S. dollars at a future fixed exchange rate. Thus, the international bank protects
itself from the foreign exchange rate risk. A forward contract contains the commodity’s
quantity, a fixed price, and the future transaction date. Furthermore, a forward contract is a
tailor-made contract, and international banks usually write forwards for foreign currencies.
Another derivative, similar to a forward, is a futures contract. Futures contracts are standardized,
and investors can buy or sell easily the contracts on the futures markets. Forwards and futures
have maturities of 1, 2, 3, 6, or 12 months.
International banks and investors use currency swaps to reduce exchange rate risk and
lower transaction costs. A currency swap is the exchange of debt instruments denominated in
different currencies. For instance, a forward-forward swap means a firm and a bank exchange
two forward contracts with each other. Bank sells a forward contract for a specific currency to a
firm, and the firm simultaneously sells a contract to the dealer for the opposite currency with the
same maturity. Thus, a currency swap is similar to a loan with collateral from the bank, and it
was a $3.2 trillion market in April 2007.
Intel, for example, wants to build a factory in Germany while Volkswagen wants to build a
new factory in the United States. Intel needs euros while Volkswagen needs U.S. dollars for
these investments. These companies are well known within their own countries and can borrow
on favorable terms with their banks. A U.S. bank lends to Intel while a German bank lends to