Foreign Exchange - Spot & Forward contracts.

Vadivelrajan Sat Nov 12, 2011 4:11 pm

Foreign exchange - spot and forward contracts

Foreign exchange is simply the exchange of one currency for another, but it can take many forms. This article covers the two basic foreign exchange products - spot and forward exchange contracts.

Spot foreign exchange
A spot contract is a binding obligation to buy or sell a certain amount of foreign currency at the current market rate, for settlement in two business days' time. To enter into a spot deal you advise us of the amount, the two currencies involved and which currency you would like to buy or sell.

Purpose
Companies involved in international trade may be required to make payments, or to receive payments, in a foreign currency. A spot contract allows a company to buy or sell foreign currency on the day it chooses to deal.

Settlement
A spot deal will settle (in other words, the physical exchange of currencies) two working days after the deal is struck. The difference between the deal and settlement date reflects both the need to arrange the transfer of funds and, the time difference between the currency centres involved.

Summary
Forecasting exchange rates is very difficult. For a company to use only the spot market for its foreign currency requirements may be a high risk strategy because exchange rates could move significantly in a short period of time. For example, if you placed an order for raw materials from Germany for payment in three months' time, and use the spot market to meet the invoice when it falls due, your company could lose significantly if rates move against you.

Key facts
Minimum deal size: No minimum
Maximum deal size: No maximum
Credit line: Not required
Currency pairs: Any currency pair

Forward exchange contracts
A forward exchange contract (or forward contract) is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. To take out a forward contract you need to advise us of the amount, the two currencies involved, the expiry date and whether you would like to buy or sell the currency. It can be possible to build in some flexibility to allow the purchase or sale of the currency between two pre-defined dates rather than a single maturity date.

Purpose
A forward contract is the simplest method of covering exchange risk because it locks in an exchange rate. This strategy overcomes one of the problems that you can experience when importing or exporting in foreign currency, as you can now budget at a guaranteed rate of exchange.

Pricing
The price of a forward contract is based on the spot rate at the time the deal is booked, with an adjustment which represents the interest rate differential between the two currencies concerned. For example, a company needs to buy US dollars in three months' time, so enters into a forward contract while US interest rates are higher than UK interest rates. In order to meet the obligation under the contract, the bank buys US dollars now, paying for the dollars with sterling and then pass you the benefit of the higher rate of interest we earn on the dollars. The adjustment to the spot rate means that the forward contract rate would be more favourable than a spot deal rate. The reverse would apply if US interest rates were lower than UK rates.

Summary

· A forward contract is an obligation to buy or sell a certain amount of foreign currency at a pre-determined date. Even if your requirements change over the term of the forward contract, you are still obliged to deal.

· A forward contract obliges you to deal at a specific rate - you are not in a position to benefit from any favourable movements in exchange rates between booking the contract and completing the deal.

· No premium is payable.

Key facts
Minimum deal size: No minimum
Maximum deal size: No maximum
Period: Usually any period to two years - longer periods are available in certain currencies
Credit line: A credit line is required for forward contracts
Currency pairs: Any freely convertible currency pair