Foreign Exchange explained


Foreign exchange is essentially about exchanging one currency for another. The complexity arises from three factors:

  1. What is the foreign exchange exposure
  2. What will be the rate of exchange, and
  3. When does the actual exchange occur.

Identification of Foreign Exchange Exposures

Foreign exchange exposures arise from many different activities. A traveller going to visit another country has the risk that if that country's currency appreciates against their own their trip will be more expensive.

An exporter who sells its product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter's home currency will be lower.

An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected.

Fund Managers and companies who own foreign assets are exposed to falls in the currencies where they own the assets. This is because if they were to sell (repatriate) those assets, their exchange rate would have a negative effect on the home currency value.

Other foreign exchange exposures are less obvious and relate to the exporting and importing in ones local currency but where the negotiated price is being affected by exchange rate movements.

Generally the aim of foreign exchange risk management is to stabilise the cash flows and reduce uncertainty from financial forecasts. Fortunately there are a range of hedging instruments that achieve exactly that.

Spot and Forward Foreign Exchange Contracts

The most basic tools of FX risk management are 'spot' and 'forward' contracts. These are contracts between end users and financial institutions that specify the terms of an exchange of two currencies. In any FX contract, there are a number of variables that need to be agreed upon and they are:

  1. The currencies to be bought and sold - in every contract there are two currencies the one that is bought and the one that is sold
  2. The amount of currency to be bought or sold
  3. The date at which the contract matures
  4. The rate at which the exchange of currencies will occur

It is point three that requires further explanation. Whenever you see exchange rates advertised either in the newspapers or on the various information services, the rates of exchange assume a deal with a maturity of two business days ahead -a deal done on this basis is called a Spot deal.

In a spot transaction, the currency that is bought will be receivable in two days whilst the currency that is sold will be payable in two days. This applies to all major currencies with the exception of the Canadian Dollar.

However most market participants want to exchange the currencies at a time other than two days in advance but would like to know the rate of exchange now. For example if ABC Ltd had contracted to purchase a machine for the price of USD1m payable in 6 months time (but wanted to be sure that the USD would not become too strong in the interim), ABC Ltd could agree now to buy the USD for delivery in 6 months time. In other words ABC Ltd could negotiate a rate at which it could buy USD at some time in the future, setting the amount of USD needed, the date needed etc. and hence be sure of the local currency purchasing price now.

In determining the rate of exchange in six months time there are two components:

1) the current spot rate
2) the forward rate adjustment

The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the interest rates of the currencies involved.

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