News & Resources

Blog

Latest Insights
Press Releases
Latest Insights

Foreign Exchange Transactions: Spot, Forwards and Vanilla Options explained

by Darryl Hood | May 10, 2018

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;

  1. Bid price – In GBPEUR terms, this is the price at which you will buy Euros.
  2. Offer price – In GBPEUR terms, this is the price at which you will sell Euros.

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:

  • Currency pair: you are more likely to get a better spread on a commonly traded currency pair, such as GBP/USD, EUR/GBP or USD/JPY. If the currency pair is more exotic, i.e. not as commonly traded, the spread is likely to be higher. Examples of less common currency pairs include GBP/BRL, USD/TRY and USD/MXN.
  • Volume: as with most tradable commodities, the more you buy the better the price, and foreign exchange is no different. So a business buying $1,000,000 USD from GBP is likely to get a better price than if they bought $10,000 USD from GBP.
  • Customer standing: businesses are generally assessed on the level of income they bring in, so if you also have other financial products with your provider they may offer you a better price on your foreign exchange transactions as a result.

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.

  • The price of a forward contract is calculated using the spot price and the interest rate differential between the two currencies over the length of term of the contract. The same factors will influence the price a business pays on a forward contract as they do a spot transaction.
  • Once the contract has been agreed the business has the FX rate protected for the duration of the contract.  Upon the value date, the business is obliged to exchange the agreed sum of currency at the agreed FX rate.
  • The business has certainty over the rate it will receive in the future irrespective of where the spot rate moves over the time period.

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).

  • This route means a business can take advantage of exchange rates whilst still being protected against adverse currency moves.
  • The FX provider will ask for a premium upfront before the contract period begins which acts as insurance.
  • The price of the premium is predominantly based around the proximity of the rate you are looking to protect against the forward rate for the same time period, and the length of the contract. Essentially the more you pay the better the rate you are insuring. In addition, the longer the time period you want to insure, the greater the cost also.

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.

If you would like to speak with one of our experts about your foreign exchange hedging strategies please get in touch

“Cambridge Global Payments” is a trade name, which in this document refers specifically to one or more of these legal entities: Cambridge Mercantile Corp., Cambridge Mercantile Corp. (U.S.A.), Cambridge Mercantile Corp. (Nevada), Cambridge Mercantile (Australia) Pty. Ltd.

Cambridge Global Payments (“Cambridge”) provides this document as general market information subject to: Cambridge’s copyright, and all contract terms in place, if any, between you and the Cambridge entity you have contracted with. This document is based on sources Cambridge considers reliable, but without independent verification. Cambridge makes no guarantee of its accuracy or completeness. Cambridge is not responsible for any errors in or related to the document, or for damages arising out of any person’s reliance upon this information. All charts or graphs are from publicly available sources or proprietary data. The information in this document is subject to sudden change without notice.

Cambridge may sell to you and/or buy from you foreign exchange instruments (including spot and/or derivative transactions; both kinds are here called “FXI”s) covered by Cambridge on a principal basis.

This document is NOT: 1) Advice of any kind, or 2) Approved or reviewed by any regulatory authority, or 3) An offer to sell or a solicitation of an offer to buy any FXIs, or to participate in any trading strategy.

Before acting on this document, you must consider the appropriateness of the information, based on your objectives, needs and finances. For advice, you must contact someone independent of Cambridge.

Certain FXIs mentioned in this document may be ineligible for sale in some locations, and/or unsuitable for you. Contact your Cambridge representative for further information regarding product availability/suitability before you enter into any FXI contract.

FXIs are volatile and may cause losses. Past performance of a FXI product cannot be relied on to determine future performance.

This document is intended only for persons in Canada, the US, and Australia. This document is not intended for persons in the UK or elsewhere in the EEA. In Australia, this publication has been distributed by Cambridge Mercantile (Australia) Pty. Ltd. (ABN 85 126 642 448, AFSL 351278); for the general information of its customers (as defined in the Corporations Act 2001). This entity makes no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law.

Fees may be earned by Cambridge (and its agents) in respect of any business transacted with Cambridge.

The document is intended to be distributed in its entirety. Unless governing law permits otherwise, you must contact the applicable Cambridge if you wish to use Cambridge services to enter a transaction involving any instrument mentioned in this document.

© Copyright 2018, Cambridge Mercantile Corp., ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of Cambridge Mercantile Corp. See www.cambridgefx.com for contact details.