Forex Financial Instruments

A spot Forex transaction is exchanging one currency for another at the current exchange rate.

The currencies are exchanged at the spot rate at the time of the contract, and the contract is usually settled within two business days, involves cash rather than a contract, and interest is not included in the transaction.

Forward/Future

Forward transactions are agreements to buy or sell a foreign currency at an agreed upon price at a future date. The difference between a forward and a future is that a future is traded on exchanges, and usually has a contract length of three months.

Forwards are commonly used to hedge foreign exchange risks, as by agreeing upon an exchange rate at the time of the contract, you are protected from possible exchange rate fluctuations. The party agreeing to buy the currency in the future takes on a long position, while the party agreeing to sell the currency takes on a short position.

Swap

In a Forex swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction by exchanging the same amount of currency at a later date. Swaps allow you to use funds in one currency to fund obligations in another, without incurring a foreign exchange risk.

A Forex swap is usually structured with a spot Forex transaction, then a forward Forex transaction.

For example, my British company might need to do a 3 month project in Europe. The funding requirement for the project is EUR300,000. As my company has GBP300,000 currently available, I would like to use this to meet the European funding requirement. As the current exchange rate GBP0.8915 for EUR1, I exchange GBP267,450 for EUR300,000 at the bank – the initial spot Forex transaction.

At the same time I organise a forward transaction to buy back the GBP and sell the EUR in three months’ time. I will exchange the money for the same 0.8915 rate, adjusted for forward points. A forward points adjustment equalises the interest rate differential between two currencies.

So, as the current interest rate in the eurozone is 1.25%, and the current interest rate in Britain is 0.5%, in the three months the bank has GBP267,450 it will earn GBP334.31 in interest ([EUR267,450 x 0.5%]/12months x 3months = GBP334.31). Meanwhile, my euros will earn EUR937.50 in interest ([EUR300,000 x 1.25%]/12months x 3months = EUR937.50).

At the end of the period the bank will have GBP267,450 + GBP334.31 = GBP267,784.31

At the end of the period I will have EUR300,000 + EUR937.50 = EUR300,937.50
GBP267,784.31/EUR300,937.50 = forward exchange rate of 0.8898

As the original spot Forex transaction used an exchange rate of 0.8915, there has been a forward points adjustment of -0.0017.

The transaction is closed by the bank paying you back the original GBP265,450, and you paying the bank EUR301,501.76 (the EUR564.26 loss you made on the transaction is the difference between the interest rates on the two currencies. The bank earned 0.5% interest for three months, while you earned 1.25% interest, a difference of -0.75%. As the difference is negative, you need to pay back the bank ([EUR300,937.50 x 0.75%]/12months x 3months = EUR564.26). If the difference had been positive, you would have made a gain).

Option

A Forex option is gives the owner the right but not the obligation to either buy or sell a stated quantity of currency at a certain exchange rate. This exchange rate is known as the strike price. American options can be exercised on or before the option expiry date, while European options can only be exercised on the expiry date.

If the owner chooses not to exercise the option, he will lose his deposit.

Options are usually used to hedge against foreign exchange risks, with corporations generally hedging certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

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