The rationale for the existence of forward exchange market lies in its being a means of avoiding exchange rate risk by those who are sure that they will make or receive future payments in some foreign currency.
(a) First, consider the case of a person who is to make a future payment in a foreign currency. He does not know exactly how much it would cost him (at the time of making the payment) in terms of home currency.
This uncertainty about his side of the transaction is his exchange rate risk. He, therefore, protects himself against this uncertainty by making a forward purchase of the foreign currency.
previews.123rf.com
ADVERTISEMENTS:
By entering into this purchase agreement, he is assured of getting a specified amount of foreign currency (and be in a position to meet his payment obligation) on a specified future date by paying a pre-determined amount of home currency.
That way, he protects himself against the risk of having to pay more in domestic currency. It is, of course, also possible, that exchange rate may move in favour of the domestic currency.
If that happens, he would be able to get a given amount of foreign currency by paying less in domestic currency, had he not entered into a forward purchase agreement.
ADVERTISEMENTS:
In other words, he has avoided the risk of having to pay more (in domestic currency) by foregoing a possible gain (in domestic currency). The more volatile the situation/trends, the more attractive are the option of forward cover.
(b) Similarly, consider the case of a person who is to receive a payment in a foreign currency on some future date. The recipient is not sure of the amount of the equivalent home currency which he shall be able to get by selling the received foreign exchange in the foreign exchange market.
He therefore, sells that (to be received) amount of foreign currency in forward market against home currency at an agreed price.
In order not to get less of home currency when he is paid in future in foreign exchange (in case rupee is showing a rising trend), he foregoes a possible gain which would arise if the exchange rate moves against home currency.’
ADVERTISEMENTS:
It is obvious that in actual practice, there will be many forward rates in the market pertaining to various points of time in future. All these rates are influenced by what the market as a whole thinks is likely to be the behaviour of exchange rate in future.
The forward market provides protection, against exchange rate variations, to those who are to make and receive future payments in foreign currencies.
It promotes trade because it enables the trade transactions to be carried out with assured although smaller profit margins.
The basic utility of forward exchange market lies in fact that shocks of actual fluctuations in exchange rate is absorbed by professional dealers and institutions.
It is also noteworthy that in the forward exchange market, transactions and exchange rates influence each other, giving shape to future exchange rates even before the future arrives.