Foreign exchange is simply the exchange of one currency for another, but it can take many forms. Here we discuss – 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. To enter into a spot deal you advise us of the amount, both currencies involved and which currency you would like to buy or sell.
Purpose
All companies that have foreign currency exposure may use a spot deal, but companies exposed to transactional risk most commonly use them.
Settlement
A spot deal will settle (in other words the physical exchange of currencies will take place) two working days after the deal is struck. This 'value date' reflects both the need to arrange the transfer of funds and, in most cases, the time difference between the currency centres involved, one or other of which may well be closed at the time of the trade.
Summary
Forecasting exchange rates is very difficult – you cannot know for certain what the exchange rate is likely to be by the end of today, let alone a few months. A company using only the spot market for its foreign currency requirements is using the simplest method, but at the same time the most risky. If you placed an order for raw materials from Germany for payment in three months, and use the spot market to meet the invoice when it falls due, your company could lose significantly if rates move against you over that three month period.
Currency pairs: In any currency pair where there is a liquid market
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 or before a certain date. Contracts can be taken out for completion on an agreed date or at any point between two pre-agreed dates (up to three months apart). To take out a forward contract you need to advise us of the amount, both currencies involved, the expiry date and whether you would like to buy or sell the currency on the expiry date or anytime during a pre-agreed period.
Purpose
A forward contract is the simplest method of covering exchange risk, without having to worry whether the spot market is going to move against you. This 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 that represents the interest rate differential between the two currencies concerned. For example, you need to buy US dollars in three months. Say US interest rates are higher than UK interest rates. The pricing principle assumes that Intamoney buys US dollars now, paying for the dollars with sterling, in order to meet our obligation to you under the contract in three months.
We pass on to 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 protects your company against adverse movements in exchange rates.
You can be sure of meeting a budget rate for the transaction.
A forward contract is an obligation. 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.
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: In any currency pair where there is a liquid forward market
Important: Please read carefully
The information and opinions in this document are derived from sources believed to be reliable.
Spot and forward foreign exchange transactions generally are not ‘designated investments’ as defined in the United Kingdom Financial Services and Markets Act 2000 ("the Act") and therefore do not benefit from the protections in the Act and in the Rules of the Financial Services Authority.
Any other product described in this document (including a forward extra, forward extra plus, fading forward extra, participating forward or walk away forward contract) is a ‘designated investment’ as defined in the Act, even when used to cover a commercial trade position.
Investments can fluctuate in price or value and prices, values or income may fall against an investor’s interests. Changes in rates of exchange and rates of interest may have an adverse effect on the value, price or income of these investments. Past performance is not necessarily a guide to future performance. The levels and bases of taxation can change.
The products described in this document are not readily realisable investments, as there is no recognised secondary market for them. Non readily realisable investments may be difficult to sell or realise; it may also be difficult to obtain reliable information about their value or the extent of the risks to which they are exposed.
Contingent liability transactions (such as interest rate or currency swaps or collar options) may result in the loss of all the amount originally invested or deposited, and may also require future payments to be made by the investor.
No opinions are expressed as to the merits or suitability of a product. Investments may not be suitable for all requirements and if you have any doubts, seek advice from your investment adviser.
