We take a look at three different types of foreign exchange transactions your business may choose to consider…
There are a number of different foreign exchange transactions your business can use to minimise potential losses in the FX market. You’ve probably come across three of the most common: spot transactions, forward contracts and Vanilla options – let’s take a look at each one in more detail.
What are spot transactions?
A foreign exchange spot transaction is the quickest foreign exchange transaction, normally settled within two days. Two parties agree to exchange currency at the foreign exchange rate at the time of trade, or ‘on the spot’.
Typically businesses will either use a bank or a non-bank foreign exchange provider for a spot transaction. To do this, they will either telephone their provider or go online and be given two prices, bid and offer;
The prices you see are your rate to buy or sell currency, this differs from the interbank rate which financial institutions buy and sell currency at. The difference between the interbank rate and your rate is known as the spread, this is the profit the bank or broker is making from the transaction excluding associated costs. The interbank FX rate fluctuates throughout the day, and the bank or broker spread applied to a deal can vary depending on a number of factors including:
What are forward contracts and when are they typically used?
A forward contract is the agreement to exchange one currency for another at an agreed point in the future, known as the value date.
Instead of using a forward contract, you could exchange one currency for another using a spot transaction then hold the currency on deposit in the corresponding currency account until needed. However, this may impact on cash flow, which is why some businesses prefer to use forward contracts.
For more information on forward contracts see our blog Five questions to ask before you consider foreign exchange hedging
What are Vanilla options and when are they typically used?
A Vanilla option gives a business the right (but not the obligation) to exchange one currency with another currency at a pre-agreed exchange rate on a specified date in the future.
Vanilla options are normally used to hedge uncertain foreign currency cash flows (as opposed to certain, covered above).
Deciding on the most appropriate foreign exchange transaction is largely down to understanding your business requirements and your risk appetite, the nature of you foreign exchange exposure (is it contracted or merely forecasted) and then matching all this to the appropriate transaction type.
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