Exchange Risk

FOREX: Spot Transaction

Suppose a U.S. company orders machine tools from a company in Japan.

* Tools will be ready in six months and will cost 120 million yen.
* At the time of the order, the yen is trading at 120 to a dollar.
* U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,00 yen ¸ 120 yen per dollar = $1,000,000)

There is no guarantee that the rate will remain the same six months later.

Suppose the rate drops to 100 yen per dollar:
* Cost in U.S. dollars would increase (120,000,000 ¸ 100 = $1,200,000) by $200,000.

Conversely, if the rate goes up to 140 yen to a dollar:
* Cost in U.S. dollars would decrease (120,000,000 ¸ 140 = $857,142.86) by over $142,000

One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.