Exchange Rate
A forward contract to buy or sell foreign currency can be compared to an insurance policy against possible losses arising from exchange rate fluctuation between the date of the contract and date of delivery of the contracted amount of the said currency. For example, an exporter in USA forward contracts to sell a firm in London certain amount of electronic goods at a price of USD10000.00. Before agreeing to this price, the exporter calculates his cost of raw material and other overhead expenditure and adds a reasonable margin for profit satisfies that the proceeds of USD10000.00 would cover this amount. He bases his calculation on the exchange rate prevailing as on the date of his quotation. For example, if the exchange rate on the date is USD2.40 per sterling pound, he expects to receive 2.4 X 10000.00 on the execution of the contract. The exchange rate is not stable even under the best of circumstances. By the time the exporter execute his contract and receives the payment, say after a lapse of 3 months, the exchange rate might turn against him. This uncertainty about the rate that would prevail on a future date is know as the exchange risk. For the exporter, the exchange risk is that the foreign currency in which the transaction is designated may depreciate in future and may bring less than the expected amount of money in term of local currency .
The importer too faces exchange risk when the transaction is designated in a foreign currency. The risk is that the foreign currency may appreciate in value and he may be compelled to pay in local currency an amount higher that that was originally contemplated generally make arrangements for loan for payment for the imports. If the foreign currency appreciates subsequent to the arrangement of the loan, the importer may find that the resources are not sufficient to meet the import bill putting him in a difficult situation.
