The risk involved in dealing in the forward foreign exchange market can be covered by activities like hedging, speculation and arbitrage.
~ The activities allow the dealers not only to cover the risks involved but also to earn profit by taking advantage of the forward exchange market.
~ Hedging covers the risk arising out of changes in the exchange rate. It is especially essential for firms having large amounts receivables or commitments to pay in foreign currencies.
~ The strategy of hedging involves increasing the currency that is likely to appreciate and decreasing the currency that is likely to depreciate.
~ It also involves decreasing liabilities in the currency that is likely to appreciate and increasing liabilities in the currency that is likely to depreciate.
~ Speculation involves purchase and sale of foreign exchange in the forwards market with the intention of making profit by taking advantage of changes in foreign exchange rates.
~ They speculate on the basis of their own calculation of the difference between the forward rate and spot rate that may prevail at a future date.
~ Speculators try to minimise their loss by entering in spot and forward agreements simultaneously.
~ Speculation may have stabilising or destabilising effect.
~ Stabilising speculation refers to purchase of foreign currency when the domestic price of a foreign currency when the domestic price of a foreign currency falls with the expectation of its increase in the future.
~ Destabilising speculation refers to sale of foreign currency when the exchange rate falls with the expectation that it would fall further. This magnifies exchange rate fluctuations and proves highly disruptive to the international flow of trade and investment.
~ Arbitrage refers to purchase of an asset in a low price market and its sale in a higher price market.
~ This process leads to equalisation of price of an asset in all the segments of the market.
~ Arbitrageurs take advantage of the different exchange rates prevailing in various foreign exchange markets due to different interest rates.
~ They purchase foreign currency from the foreign exchange market with lower exchange rate and sell the same in market with a higher exchange rate.
~ Arbitrage is also possible within the country where two banks offer two different bids and asking rate.
~ When arbitrage involves only two currencies or two countries, it is called two-point arbitrage. It increases the supply of dearer currency.