Glosario

Foreign exchange or ‘FX’ is a term used to describe the exchange or trading of one currency to another. The foreign exchange market has no central marketplace: spot and forward market transactions take place in an ‘Over-the-Counter’ market made up of dealers and large commercial and investment banks. Turnover in global foreign exchange (FX) markets reached $6.6 trillion per day in April 2019, according to data from the Bank for International Settlements (BIS). It is by far the largest financial market in the world. OTC markets are larger and more diversified than ever, owing in part to the rise of electronic and automated trading While trading continues to be dominated by the major currencies, in particular the US dollar and the euro, in FX markets the trading of emerging market currencies is growing faster than that of major currencies. The rise in electronic and automated trading is one of the key features of today’s foreign exchange markets.

Foreign exchange accounting or FX accounting consists in reporting, in a company’s presentation currency, all assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies. The rules that govern foreign exchange accounting are devised by accounting associations such as the Financial Accounting Standards Board (FASB). It is important not to confuse foreign exchange accounting, applicable to all companies that transact in foreign currencies with ‘Hedge Accounting’, an optional technique that modifies the normal accounting basis for recognising gains and losses on associated hedging instruments and hedged items, so that both are recognised in P&L (or OCI) in the same accounting period.

A foreign exchange broker, also known as an FX broker or a forex broker, buys and sells currencies on behalf of clients while charging a commission for the service. Foreign exchange brokers are ‘middlemen’ who match the currency buy and sell orders from their clients to other clients orders. A foreign exchange broker will guarantee that trades will be actually settled, avoiding the need for buyers and sellers to check each other’s creditworthiness. Thanks to a wide range of connections with liquidity providers (mostly banks) and dealers, a foreign exchange broker will usually get preferential exchange rates that can be passed on to clients at low spreads.

A foreign-exchange commission, charged by an FX broker, is part of the cost of executing of foreign currency transactions. Brokers are middlemen who try to match the buy and sell order from their clients to other clients buy and sell orders. Because they have established connections with liquidity providers, they can offer very tight spreads. To compensate for the tight spreads, brokers charge fixed foreign exchange commissions. For example, If a broker charges 50% of a pip spread, it can also charge a fixed EUR 6 commission per standard lot of EUR 100,000 to buy and sell. So a EUR 100,000 trade to buy and sell would produce EUR 17 to the broker. Still, that compares favourably with the EUR 30 cost of a dealer who would charge no foreign exchange commission, but a full pip spread instead.

Foreign exchange controls are restrictions applied by some governments to ban or limit the sale or purchase of foreign currencies by nationals and/or the sale or purchase of the local currency by foreigners. Foreign exchange controls are mostly used by governments who fear that free convertibility could lead to unwanted currency volatility. Foreign exchange controls often pose serious challenges to companies with international operations, either by hindering cash transactions or by making it difficult to use financial instruments such as currency forward contracts to hedge FX risk.

A foreign exchange gain and loss, or FX gain and loss, is the result of a change in the exchange rate used when an invoice is entered at one rate, and valued in a financial statement at another. A freign exchange gain or loss can be unrealised or realised. An unrealised FX gain or loss reflects the change in the value of foreign currency denominated sales or purchase transactions that are recorded in financial statements prior to the settlement of the invoices. When the transaction is settled, the FX gain and loss is realised.

A foreign currency hedge is the creation of an offsetting position, undertaken with a financial derivative instrument (most of the time, a forward contract), in order to neutralize any gain or loss on the original currency exposure by a corresponding foreign exchange loss or gain on the hedge. Whether the exchange rate goes up or down, the company is protected because the hedge has locked in a home-currency value for the exposure. A company that undertakes a foreign currency hedge is therefore indifferent to the movement of market prices in currency markets. A foreign currency hedge differs from a speculative position, where a currency position is taken in anticipation of an expected change in currency rates. Whether business managers desire to protect its budget from FX fluctuations with static, rolling or layered hedging programs, or whether it aims at ‘microheding’ its many foreign currency-denominated transactions, Currency Management Automation solutions allow them to systematically achieve their risk management goals.

A foreign currency hedging strategy or program is a set of procedures that allows a company to achieve its goals in terms of managing currency risk. It is based on the business specifics of the company, including its pricing parameters, the location of its competitors and the weight of foreign exchange in the business. A foreign exchange hedging strategy or program also takes into account the company’s sources of information, IT systems, degree of cash flow visibility, and key decision makers (their risk tolerance, their familiarity with different risk management styles, etc.) The most widely used foreign currency hedging strategies or programs include: static budget hedging, rolling hedging, layered hedging, hedging based on conditional orders, SO/PO (sales orders/purchase orders) and combinations of programs. Some of these programs and combinations of programs can be quite demanding in terms of calculations and/or currency trading, a real challenge for treasury teams relying on manual systemes. Their proper implementation and management requires, therefore, automated solutions provided by Currency Management Automation.

A foreign exchange line of credit is a credit facility allowing a company to draw in one or in several currencies other than its functional currency. For example, a company with EUR as its functional currency may borrow from the same credit line in USD or GBP, depending on its specific needs at the moment. Such foreign exchange lines of credit in multiple currencies may save a multinational corporation the time and expense incurred in FX transactions.

A foreign exchange long position in FX forward markets is a commitment to buy a specified amount of one currency against payment in another currency at a fixed future date, known as the value date, at a specified exchange rate. Typically, a foreign exchange long position offsets a corresponding ‘short’ position that a company takes when it agrees to buy goods for delivery at a future date. In effect, such a foreign exchange long position enables the company to convert a short underlying position to a zero net exposed position, with the forward contract receipt cancelling out the corresponding account payable.

Foreign exchange netting involves offsetting accounts receivable/payables in one currency with accounts payable/receivable in the same currency. When currency rates move, FX gains (losses) on one position should then be offset by FX losses (gains) on the other. There are more possibilities yet. If the exchange rate movements of two currencies are positively correlated, a long position in one currency can offset a short position in the other. If the exchange rate movements of two currencies are negatively correlated, a long (short) position in one currency can offset a short (long) position in the other. The aim of foreign exchange netting is to manage currency exposures on a portfolio basis and to save on hedging costs, as only the resulting net exposures are hedged with forward contracts.

In terms of FX hedging, the foreign exchange opportunity cost measures the real cost of hedging. The cost of hedging is sometimes measured as the forward discount or premium. However, this approach is wrong because the relevant comparison must include the cash flow difference between hedging and not hedging, a calculation that requires the future (unknown) spot rate on the date of settlement. That is, the real cost of hedging is an opportunity cost. In terms of business strategy, the foreign exchange opportunity cost is the set of business opportunities that firms forego as they buy and sell in one or two currencies only. By doing so, they lose the opportunities afforded by ‘embracing’ currencies, both on the contracting side and on the selling side.