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.

 

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