Problems of internationalisationOne problem with using the forward market to solve the transaction risk problem
is that the business cannot benefit should the exchange rate move favourably. The rea-
son for a business, with an obligation to make a payment in a foreign currency, to use
the forward market is to avoid the risk that the foreign currency will strengthen
against the home currency during the period of the contract. This would leave the
business with a larger home currency payment to make than if it converted the cur-
rency immediately or undertook the forward-market transaction. But what if the home
currency strengthened against the foreign one? The business could have had a cheaper
bill had it left the risk uncovered. Obviously, users of the forward market are prepared
to accept the lack of ability to benefit from a favourable movement in exchange rates,
if they can eliminate the risk of loss through an adverse one.
Another problem is that, because the contract is binding, both parties must com-
plete it. If the UK business, expecting to receive the $1 million, fails to receive it
because the customer defaults, the business is still left to fulfil its obligation under the
forward contract.
The use of forward contracts seems to be very widespread, among larger businesses
at least. In 1995, Ricci and Di Nino surveyed the largest 200 UK businesses listed on
the London Stock Exchange. They found that 75 per cent of their respondents often
used forward contracts and that a further 21 per cent used them, but less often (Ricci
and Di Nino 2000).Money market hedges
Businesses use money market hedgesto avoid transaction risk by combining the spot
foreign exchange market with borrowing or lending.
Suppose that a UK business is expecting to receive $1 million in three months’ time.
It can borrow an amount in dollars that, with interest, will grow to $1 million. The bor-
rowed dollars can be converted to sterling immediately, thus eliminating the risk. If
the interest rate for three months is 2 per cent, then the amount to be borrowed is
$980,392 (that is, $1 million ×100/102). This will be converted to sterling immediately.
When the $1 million is received, it will exactly pay off the loan, with interest.
Similarly, if another UK business has to pay $1 million to a US supplier in three
months’ time, it can immediately convert sterling into dollars such that the amount of
dollars would be, with interest, $1 million in three months’ time. Again, assuming a
2 per cent interest rate, the amount necessary would be $980,392, so assuming an
exchange rate of £1 =$1.95, £502,765 (that is, 980,392/1.95) would be necessary to con-
vert into dollars on the spot market.
The disadvantages of this approach are much the same as those of using the for-
ward markets. The first is losing the opportunity to gain from any favourable ex-
change rate movement. The second is that the business either has an obligation or an
asset in a foreign currency and so is relying on a foreign currency receipt or payment
to complete the hedge.Currency options
As we have seen, the problem with some of the strategies for eliminating transac-
tion risk is that both the downside and upside risks are eliminated. This means that
there is no opportunity for the business to benefit from any favourable movement
in exchange rates. They also leave the business exposed if the overseas customer
defaults. Currency optionsoffer a solution to both of these problems. Options were
introduced in Chapter 1. A foreign exchange option gives the owner the right, but not‘
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