This aspect of the foreign exchange market is less easily understood. In domestic trade the seller faces the paramount risk that the buyer will wholly or partially fail to make payment. The foreign trader faces the same risk. This credit risk is probably no greater and may even be less in foreign trade than in domestic. If the transaction is arranged in a foreign currency there is, however, a peculiar risk undertaken by the exporter or importer, the risk of exchange fluctuation. To cover this exchange risk the foreign exchange dealers offer the machinery of the "forward market"--although unfortunately not in all currencies.
"Exchange risk" arises from both the transfer and the credit elements in foreign exchange. Let us assume that this risk is to be borne by the importer and leave for later chapters the question of whether it is usual for importers to assume it. An American importer, then, buys goods invoiced at £1,000 from an English exporter. At the time that the deal is closed the dollar-sterling demand rate is $1.90. If the importer pays cash in advance he may ignore any fluctuation in the exchange rate, but if a considerable period (say, 15 to 90 days) is to elapse before payment is made in sterling, a very material exchange risk may arise.
Suppose the English exporter allows the American importer 60 days in which to pay and draws a 60-day £1,000 draft on the American firm. The American firm is obligated, on accepting the draft, to remit £1,000 to the English exporter 60 days later. If, when that time has come, the dollar-sterling demand rate is $1.90, the importer will have sustained neither gain nor loss in exchange, but if, say, sterling should strengthen to $1.92, he will have to pay $20 more for the £1,000 draft than he had anticipated. He might lose much more if sterling rose still further; or, conversely, he might gain materially if dollars, instead of sterling, strengthened. In any case, here is an undeniable risk which the importer or exporter faces and which is not encountered in purely domestic trade.
Whether or not the foreign trader will voluntarily take his chances on this speculation in fluctuating exchanges is not the question just now. The question is: Can the risk be avoided, or must one or the other of the two parties to the trade (exporter or importer) assume it? Sometimes it can be avoided and sometimes not, depending on the existence of a forward market in the foreign currency involved. In the case just imagined, let us suppose the American importer wishes to "hedge" against any shift in the dollar-sterling rate to his disadvantage in the 60 days during which he has assumed an obligation to pay £1,000. He will do so by obtaining from his bank a contract obligating the bank to deliver £1,000 to him 60 days hence at a stated rate. We shall not stop now to inquire how that "future" rate will be determined and whether or not it will vary from the present or "spot" rate. The point to be noted here is that if the importer does contract to obtain the "future" sterling he needs at a fixed rate he is fully protected from any losses due to an increase in the dollar-sterling rate during the 60 days, although at the same time he foregoes any gains should the rate decrease.
Unfortunately, forward markets are not available in all currencies--although we shall postpone to a later chapter any query about the conditions prerequisite to a dependable forward market. To the extent that the foreign exchange market offers forward facilities in a given currency, the hedging function of foreign exchange may be fulfilled.
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