The Need for Forward Foreign Exchange Market Development in Korea

As the world moved into a floating exchange rate system in 1971 and Korea adopted a basket-currency gliding system in 1980, the need to hedge against foreign exchange rate fluctuations became much greater.

Since the five major countries (G5) — the United States, Japan, Germany, France, and the United Kingdom — readjusted their exchange rates in September 1985, the fluctuations in exchange rates have been more volatile. The sizeable appreciation of the Korean won (hereafter called the won) against the U.S. dollar resulted in large losses for exporters. Small and medium-sized export-related firms were especially affected since the large firms were generally able to transfer a large portion of their losses arising from foreign exchange rate changes to the former. Net losses from foreign exchange rate changes are estimated to be 6,800 billion and 1,900 billion won in 1985 and 1986, respectively (Lee 1987). Further, a variety of other factors, such as the decrease in finance to export-related activities, rapid rises in imported raw material prices and persistent protectionism in the advanced countries, have added to uncertainty for traders.

Thus, to hedge risks and to fix the costs and revenues arising from foreign trade in the stage when trade contracts are fixed, a forward foreign exchange market is needed. An active forward foreign exchange market amounts to having an export support scheme and enables an importer to fix import costs in advance. Such a system would improve export competitiveness and increase exports without causing retaliation or protectionism from trade partners. Moreover, the system enlarges the volume of trade and diversifies export regions.

The ongoing trade and capital liberalization requires foreign exchange liberalization as well. But decontrolling the foreign exchange market and internationalizing capital markets in turn requires developing a sound forward foreign exchange market.

The Current Situation and Problems in the Forward Foreign Exchange Market

The present status of the Korean forward foreign exchange market

Although the forward foreign exchange system was introduced in February 1968, it was not until February 1978 that all foreign currencies -were included in the system. And it was not until July 1980 that forward foreign exchange transactions between the won and foreign currencies were allowed. More recently, however, control of the forward foreign exchange system lessened, and currency futures, currency options, and currency swaps were allowed by October 1987.