Foreign exchange transactions (also called forex transactions) refer to the buying and selling foreign currencies. A foreign exchange transaction is an agreement to exchange one country’s currency for another at an agreed exchange rate on a specified date.
Types of foreign exchange transactions
- Spot transaction
When a buyer and seller of different currencies settle their payments within two days of the transaction, this is a spot transaction. It is the quickest way of exchanging currency. The currencies are exchanged here over two days; therefore, no contract exists between the countries. The exchange rate at which the currencies are traded is the spot exchange rate. This rate is generally the current exchange rate. The market that facilitates the selling and purchase of currencies is known as the spot market.
- Forward transaction
In forward transactions, the buyer and seller admit to sell and buy currency after 90 days of the agreement at a predetermined exchange rate on a specific day in the future. The rate at which the currency is traded is known as the forward exchange rate. The forward market is the market in which negotiations for the selling and purchase of currency at a future date are made.
- Future transaction
The main system of future transactions is similar to that of forward transactions. However, future transactions are more hard and standardized than forward transactions in terms of features, date and size. Also, an opening margin is anchored in future transactions and kept as collateral to set up in a future position.
- Option transactions
The foreign exchange option provides an investor the right to exchange one currency to another at an exchange rate agreed on a predefined date, but it is not obligatory. An option to purchase the currency is called a call option, whereas selling the currency is called a put option.
- Swap transactions
Swap transactions involve borrowing and lending two distinct currencies between two investors simultaneously. Here, the agreement involves exchanging principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. The accountability to pay back the currencies is used as collateral, and the sum of money is remunerated at a forward rate.
Arbitrage is the purchase of a foreign currency in one market and simultaneous sale of the same currency in another market at a higher price, allowing investors to benefit from the difference in exchange rates that exist concurrently in different markets.
Foreign exchange risk
Foreign exchange risk refers to the risk of incurring losses as a result of currency fluctuations while trading in foreign currencies. Additionally, known as currency risk, FX risk and exchange-rate risk, it expresses the probability that the value of an investment may fall due to changes in the relative importance of the currencies involved. In addition, investors may experience jurisdiction risk in the form of foreign exchange risk. The three kinds of foreign exchange risk include:
- Transaction risk
When a person engages in a foreign exchange transaction, there is frequently a time lag between acknowledging the terms of the transaction and performing it to settle the contract. This intermission creates a short-time vulnerability to currency risk, which appears from the possible contrast in the price of one currency in connection with the other. Such exchange rate risk, explicitly related with the time delay between entering into a deal and its settlement, is termed transaction risk. It can result in unforeseen profits and losses. The more elongated the time delay between entering the contract and its settlement, the higher the transaction risk in such a case; there would be more time available for the exchange rate to fluctuate.
- Economic risk
Economic risk, also known as forecast risk, is the risk that a firm’s market value is affected by unavoidable exposure to exchange rate fluctuations. This type of risk is normally generated by macroeconomic conditions such as geopolitical instability and/or government rules. For example, a canadian furniture company that sells provincially will face economic risk from furniture importers, significantly if the canadian currency unexpectedly strengthens.
- Translation risk
Translation risk, also known as translation exposure, refers to the threat overlooked by a firm headquartering internally but conducting business in a foreign jurisdiction and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a firm holds a more significant part of its assets, liabilities or equities in a foreign currency. For instance, a parent company that reports in canadian dollars but oversees a judiciary based in china faces translation risk. The subsidiary’s financial performance in chinese yuan is translated into canadian dollar for reporting purposes.
How to deal with transaction risk?
To mitigate transaction risk, the following measures can be used:
- Investing in forwarding contracts
A person can lock in a predetermined exchange rate for the currency by investing in a forward contract to be executed later.
- Investing in options
A person can also invest in options to decrease transaction risk. By purchasing an alternative, the investor is not required to complete the transaction. For example, assume that the spot rate at option execution is more favourable to the investor. Instead of exercising the option, he can complete the transaction on the open market in such a situation.
- Undertaking near-time contracts
Because transaction risk is directly proportional to the time lag between contract entry and contract settlement, a near-time contract should be favoured to reduce risk vulnerability.
Every currency transaction involves some level of risk. However, if a systematic and planned strategy is taken, it may be minimized, and the investor may have better control over the trade’s earnings and losses.
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