214 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
no good reason why the euro/yen rate would change, for instance, or the euro/gbp
rate etc. Part of the pressure is diverted to yen and pound spot markets and thence
to all yen and pound forward markets too, and so on. Spreading pressure helps to
dampen the impact the initial spot sales wave would have had if there had been an
isolated market.
The above looks at the markets as a self-centered system where hedgers place
orders for exogenous reasons and where market makers just react to order flow. The
role of speculators, then, is to link prices to the rest of the world. Notably, the
forward price is also a risk-adjusted expected future value. So when the forward
dollar depreciates while investors see no good arguments why it should, they would
start buying forward, thus limiting the deviation between the forward value and
the expected future value.^20 Again, this “speculative” function is a role that can be
assumed by a “hedger” too; for instance, if the forward is already pretty low relative
to expectations, potential hedgers of long positions may get second thoughts and
decide not to sell forward after all, while players with short positions would see the
extra expected gain as a nice boon that might tilt the balance in favor of hedging.
If hedgers also function as arbitrageurs (when shopping around) or as speculators
(when judging the expected cost of closing out), does that mean that the usual
trichotomy of players is misleading? Well, hedgersarespecial, or distinct: they
start from a long or short position that has been dictated by others, like the sales or
procurement departments, and they have to deal with this optimally. Speculators do
not have such an exogenous motivation. But both will look at expected deviations
between forward prices and expected future spot rates—“speculation”—and both
will do their trades in the most economical way, thus spreading shocks into related
markets—“arbitrage”. So speculation and arbitrage are roles, or functions, that
should be assumed by all sapient humans, including hedgers.
We are now ready to move to two related instruments—younger cousins, in fact,
to forward contracts: futures, and swaps.
(^20) If they take big positions, then they also assume more risk, so the risk correction may go up,
too. This explains why, even at constant expectations, the forward rate may move. The point is
that the discrepancy should be limited, though.