The Role of Banks in Forward Exchange

Banks normally undertake no risks in providing forward exchange facilities. There are importers who want to cover themselves against exchange risks by purchasing forward exchange. At the same time, there are exporters who want to sell forward exchange with a similar motive. The banks earn their commission simply by acting as intermediaries between the buyers and sellers of forward exchange.

If a bank contracts to sell forward exchange to an importer, the bank, at the same time, undertakes to purchase forward exchange from an exporter. So long as forward purchases and sales of a bank are exactly matched, no risk is involved, for whatever may be the spot exchange rate at the time, its forward contracts mature.

It is, however, not necessary that the demand for, and supply of, forward exchange should exactly match, at any point in time. If the sales of a bank exceed its purchases of forward exchange, it will be taking an uncovered position, and thereby expose itself to the risks of fluctuations in exchange rates.

Next is a concrete example to illustrate the main alternatives available to a bank for covering its position:

Suppose a bank's sale of a ninety-day forward sterling exceeds its purchases of forward sterling of the same maturity. After ninety days, it will be required to deliver more sterling than that which it receives from its purchases. One way for the bank to match purchases to its sales is to buy ninety-days sterling bills on the exchange market. These bills will mature after ninety days and provide the required sterling at the time the banks sales of sterling fall due.

An alternative will be to buy spot sterling from exporters, or from banks having surplus sterling. If the bank does so, it will have to hold sterling in London for ninety days because these funds can be lent only in London, otherwise it will lose interest on these funds.

Another alternative will be to buy sterling from speculators. Speculators intentionally take an open, or uncovered, position, expecting to make profits from changes in exchange rates. In case the bank does not find it possible to buy sterling from any of these sources, it will simply refuse to sell additional forward sterling.

Forward exchange rates, like spot exchange rates, are determined by the demand for, and the supply of, forward exchange. If the supply of forward exchange exceeds the demand for it, the forward rates will be quoted at a discount over the spot rate - i.e., forward exchange rate will be lower than the spot exchange rate.