Glosario

The functional currency is the currency of the primary economic environment in which a company operates. It is the currency in which a company primarily generates and expends its cash. In most cases, the functional currency is also the firm’s ‘accounting currency’ or ‘reporting currency’, i.e. the monetary unit used by a firm to record its transactions and to present its financial statements. A company can decide to present its financial statements in a currency different from its functional currency, for example when preparing a consolidated report for its parent in a foreign country. While a company can choose its accounting currency, it cannot change its functional currency.

A foreign exchange broker is an intermediary who matches the buy and sell orders from its clients to other clients buy and sell orders. They organise trades on behalf of their clients, the traders. This is the main difference with forex dealers, who trade with and against their clients. There are several benefits that an FX broker can bring to its clients. A broker will guarantee that there is trust and creditworthiness between the two trading parties. This means that trades will actually be settled and also there is no need for traders to check every other trader’s creditworthiness to make the exchange. This would be impossible without the broker. A second benefit is that the broker has access to liquidity providers and market makers. These relationships with banks, financial institutions and dealers mean that the broker will get preferential exchange rates that they then pass on to their clients.

A significant step-change in pricing that occurs when businesses pass on the accumulated impact of sharp foreign exchange movements to their customers at the beginning of a new campaign period. This phenomenon represents the acceptance by clients of price adjustments that reflect currency market changes that occurred during the previous period, essentially creating a pricing discontinuity or "cliff" between periods.

The FX ‘cliff’ plays a major role in both FX-driven firms and non FX-driven firms. In the first case, firms that use an FX rate in pricing while facing a competitive landscape may need to keep prices as steady as possible, for example, a South Korean exporter of commodity-type chemicals. In the second case, companies that desire to display the same prices to their customers for commercial reasons, period after period, for example, Netflix who has recently announced a layered FX hedging program.

This term denotes the impact of currency fluctuations on profit margins. The principal aim of layered FX hedging programs is to achieve a smooth hedge rate to mitigate the impact of ‘cliff’-related episodes.

The FX Global Code of Conduct is a set of global principles of good practice in the foreign exchange market, developed to provide a common set of guidelines to promote the integrity and effective functioning of the wholesale foreign exchange market. It is intended to promote a robust, fair, liquid, open, and appropriately transparent market. The FX Global Code of Conduct was put together as a joint effort by central banks (the so-called Foreign Exchange Working Group or FXWG) and the private sector side (the so-called Market Participants Group or MPG. The FX Global Code of Conduct does not impose legal or regulatory obligations on market participants, nor does it substitute for regulation. Signatories, however, are expected to abide by its informal set of recommendations in the following areas: ethics, governance, execution, information sharing, risk management and compliance and confirmation and settlement process.

FX market participants are the main players in the world of global foreign exchange. They can be classified into three broad categories: liquidity providers, end-users and governments. Helped by brokers and dealers with whom they have close relationships, international banks are the key liquidity providers. They facilitate end-users’ access to liquidity. The most important end-users are corporations, hedgers and speculators. Corporations use FX markets to settle foreign-currency denominated transactions and to hedge the corresponding currency risk, mainly with forward contracts. Speculators include FX- and macro-oriented hedge funds, asset managers and retail investors. Governments are active in FX markets mainly with the activities of central banks. Central banks are the issuers of individual currencies; they can affect currency rates by intervening directly in FX markets or —as happens much more frequently— by altering liquidity conditions through monetary policy tools to act on short-term interest rates.

The deliberate difference or margin applied between the spot foreign exchange rate at the time of budget creation and the actual rate used for pricing during the campaign period.

For example, if a EUR-based company purchases inputs in PLN and the spot EUR-PLN rate is 4.3113 at budget creation, using a budget rate of 4.1820 for pricing represents a 3% markup. This markup serves as a buffer against adverse currency movements and helps maintain profitability.

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FX policy guidelines are a set of procedures that spell out a firm’s methodology and tools in terms of managing currency risk. Drawn by the finance team, FX policy guidelines are based on the business specifics of each company, including its pricing parameters, the location of its competitors, the weight of FX in the business, and the situation in terms of forward points. FX policy guidelines should be clearly communicated across the enterprise, in as much detail as possible. This is especially true in the case of firms with high ‘FX sensitivity’, i.e. firms with low profit margins and/or a high weight of foreign currencies in their business. In such firms, FX-related matters are of strategic importance. Therefore, FX policy guidelines should be clearly communicated and explained by the finance team to all relevant stakeholders within the enterprise. They should be well understood and assimilated by top-level managers, including the CEO and the Board.

A company’s FX policy mandate is the document that sets out: (a) management’s strategic objectives in terms of currency management; (b) the goals of the firm’s FX hedging program. Given the FX policy mandate, the finance team spells out the practical steps needed to execute the firm’s hedging program. For example, a firm in the industrial machinery space that expands into emerging markets can include, in its FX policy mandate, the instruction to price in local currencies, and the goal of hedging the corresponding FX risk in a way that creates savings in terms of the cost of carry.

An FX Policy Template is a document that sets out a firm’s strategic objectives in terms of currency management, as well as the goals of its hedging program or combination of programs. The FX Policy Template also enumerates the resources allocated to the finance team in order to execute FX hedging. In firms that automate part or most of their FX hedging, the FX Policy Template should provide a detailed ‘FX Workflow’ framework, a step-by-step description of the procedures involved in the pre-trade, trade and post-trade phases of the FX hedging execution.

Hedge accounting allows companies to recognise gains and losses on hedging instruments and the exposure they are intended to hedge, with both being registered in the same accounting period. This procedure reduces income statement volatility that would otherwise arise if both elements were accounted for separately.The financial instruments standard that deals with the accounting of FX hedges is called IFRS 9. Issued by the International Accounting Standards Board (IASB), IFRS 9 requires firms that implement hedge accounting to provide detailed documentation on their risk management objectives, hedging instrument, hedged item and the nature of the risk hedged, as well as the results of tests that determine the effectiveness of the hedging relationship and the sources of ineffectiveness.