Foreign Exchange explained

In simple terms, foreign exchange is about exchanging one currency for another. It can get a little complex because of three factors:

1)      What is the amount of foreign exchange exposure

2)      What the future rate of exchange will be, and

3)      When will the exchange of currencies actually occur

1. Foreign Exchange Exposure

Foreign exchange exposure can arise from a variety of different activities. For example;

  • A traveller visiting another country has the risk that if the currency of the country being visited appreciates against their own, the cost of their trip will increase.
  • An exporter who receives foreign currency for their product has the risk of decreased revenue in the exporter’s home currency, if the foreign currency falls in value. Conversely, an importer paying for goods priced in a foreign currency has the risk of the foreign currency appreciating, thereby making the imported goods more expensive than expected in their local currency.

The general objective of foreign exchange risk management involves stabilising cash flows and reducing the uncertainty from financial forecasts. Fortunately a number of currency hedging instruments exist which achieve exactly that goal.

2. Spot and Forward Foreign Exchange Contracts

Spot and forward contracts are the most basic risk management tools used in foreign exchange. These contracts specify the terms of an exchange of two currencies between an end user and their financial institution.

In any forex contract, a number of variables need to be agreed upon. These are:

  1. The currencies bought and sold - every forex contract involves two currencies, one that is purchased and one that is sold.
  2. The amount of currency to be transacted.
  3. The date when the contract matures.
  4. The rate of exchange at which the transaction will occur.

Point three requires some further explanation. Whenever you see exchange rates either advertised in newspapers or through various information services, the rates of exchange assume a maturity of two business days later. A deal done on this basis is known as a spot deal in the forex market.

In a spot transaction, the currency that is sold is payable in two days, while the currency that is bought will be receivable in two days. This rule applies to all major and minor currencies except the Canadian Dollar, which typically settles in just one business day.

Although most participants in the forex market want to exchange currencies at a time other than two days in advance, they often like to receive a quote on the current rate of exchange.

Example: UK based ABC Ltd has a contract to purchase a machine from a U.S. based supplier for a price of $1,000,000 payable in six months, but they wanted the assurance that the U.S. Dollar would not strengthen too much in the interim.

ABC Ltd could enter into a ‘forward contract’ to buy U.S. Dollars and sell Pounds Sterling for delivery in six months’ time.

In other words ABC Ltd could negotiate an exchange rate at which it could commit to purchasing U.S. Dollars at some point in the future. They would set the date, the exchange rate and the amount of U.S. Dollars needed, thereby fixing their Pound Sterling purchasing price now.

To determine the forward exchange rate at some point in the future, three components need to be considered:

1)      The current spot rate

2)      The delivery date

3)      The forward rate adjustment

The current spot rate is the present market exchange rate between two currencies as determined by supply and demand, while the delivery date of the forward contract is when the two currencies will be settled.

The forward rate adjustment involves a more complicated calculation having to do with the interest rates of the currencies involved.


Currency Converter

Market Rate For information purposes only. Terms of Use
For details, see My FX Dashboard

For UKForex’s customer rate
Log In or Register Now
Rate: 1.2366
Rate: 0.8087

Register Free

Send money overseas at better rates than the banks.

Get our Free Commentary

RSS Follow Facebook Twitter Follow on LinkedIn Google Plus Follow on YouTube

Get free rate alerts

Choose currency pair and enter the exchange rate. An alert will be triggered when the exchange rate is reached and an email will be sent to you. You can unsubscribe any time and your email address is safe – see our Privacy Policy.

NOTE: These rates are for informational purposes only

UKForex is rated 4.5 stars by Trustpilot based on 125 reviews.

IMPORTANT: Use of this website is subject to the Website Terms. Use of the Services of the UKForex Limited is subject to the Client Agreement. Nothing on this website constitutes or should be construed as financial advice. This information has been prepared for distribution over the internet and without taking into account the investment objectives, financial situation and particular needs of any particular person. UKForex Limited makes no recommendations as to the merits of any financial product referred to in this website, emails or its related websites.

UKForex is registered in England and Wales (company no. 04631395) with registered office at 1st Floor 85 Gracechurch Street, London EC3V 0AA.

DISCLAIMER: UKForex makes no warranty, express or implied, concerning the suitability, completeness, quality or exactness of the information and models provided in this web site. Read full disclaimer.

UKForex provides international money transfer services to individual clients and business customers. Use our free currency calculator, exchange rate charts, economic calendar, in-depth currency news and updates and benefit from competitive exchange rates and outstanding customer service.

UKForex is authorised by the Financial Conduct Authority (FRN: 521566) for the provision of payment services. 

Money Laundering Regulation Number (MSB): 12219180. Issued by HM Revenue & Customs (HMRC)
Read our Money Laundering Statement

Privacy Policy