Glosario

The foreign exchange outright rate is the exchange rate of a currency forward contract. A currency forward is an agreement to buy or sell a specified amount of one currency against payment in another currency at a fixed future date known as the value date. The foreign exchange outright rate is fixed at the time the contract is entered into. It reflects the interest rate differential between the two components of a currency pair. The currency with the higher interest rate trades at a forward discount with respect to the other. For example, if the spot USD-MXN rate is 20.5000, and one-year interest rates are 1.5% in USD and 7.5% in MXN, then the one-year foreign exchange outright rate is 21.7188 = 20.5000 (1.075/1.015). The foreign exchange outright rate always is exactly set at a level that makes riskless arbitrage impossible.

Payment default is a concept referring to a party's failure to meet its contractual obligations to make a specified payment at a specified date.In foreign exchange, a payment default often occurs if a counterparty fails to protect itself against transaction risk and is then subject to negative exchange rate movements.For example, a company in London places an order with an American supplier, with the goods order costing $1 million. The payment is due in 60 days from the time of placing the order. The exchange rate at the time of placing the order is USD/GBP 0.60.In order to make the payment, the London-based company requests a line of credit to cover this amount.However, in the intervening period, the Bank of England announces a monetary stimulus package, which weakens the pound's value severely against the dollar, with the rate moving to USD/GBP 0.75.Due to that depreciation of the pound, the line of credit obtained is no longer sufficient for the company to pay the agreed amount in dollars and it therefore defaults on its payment.Payment defaults can be damaging to companies. They disrupt trade and, at a certain level, they may have a toxic effect on the general economy. If a sector, or indeed an economy, suffers from a default spiral, where payment defaults build and begin to cause more defaults in a domino effect, it can cause severe economic damage. On a smaller scale, it can severely dent a company's profit margins and even plunge a company into debt or insolvency.For such reasons, it is of fundamental importance to hedge against credit risk and foreign exchange volatility.

Foreign exchange risk or foreign currency risk, also known as exchange rate risk, is the possibility that currency fluctuations can affect a firm’s expected future operating cash flows, i.e., its future revenues and costs. Exchange rate risk affects all companies with international operations. For companies desiring to take advantage of the growth opportunities from buying and selling in multiple currencies, effectively managing currency risk is an essential task. Foreign exchange risk can be decomposed into: Pricing risk, between the moment a transaction is priced and settled Transaction risk, between the moment a transaction is agreed and settled Accounting risk, between the moment the invoice is created and settled The most effective tool to manage foreign currency risk is to deploy FX hedging programs —and combinations of hedging programs — that allow management to achieve the firm’s goals in a systematic way, meaning: (a) targets must be consistently accomplished over time; (b) the goals of the program must be clearly communicated across the enterprise in as much detail as possible.

A foreign exchange risk management 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, the weight of FX in the business. A foreign exchange risk management 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. Once the program is established, a particular FX solution —with partial or complete automation of the processes involved— can be implemented.

A foreign exchange short position in FX forward markets is a commitment to sell 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 short position offsets a corresponding ‘long’ position that a company takes when it agrees to sell goods for delivery at a future date. In effect, such a foreign exchange short position enables the company to convert a long underlying position to a zero net exposed position, with the forward contract receipt cancelling out the corresponding account receivable.

A foreign exchange FX swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed-upon principal amount of debt denominated in another currency. By swapping their future cash-flow obligations, the counterparties are able to replace cash flows denominated in on currency with cash flows in a more desired currency. A company borrowing in GBP at a fixed interest rate can convert its debt into a fully hedged USD liability by exchanging flows with another company with the opposite need. At each payment date, the company will pay a fixed interest rate in USD and receive a fixed rate in GBP. Unlike interest rate swaps, where no exchange of principal takes place, foreign exchange FX swaps include the exchange of principal amounts at the start and at the end of the agreement. Depending on the nature of the corresponding interest rate payments —at a fixed or floating interest rate—, currency swaps can be arranged as ‘fixed-for-fixed’, ‘fixed-for-floating’ or ‘floating-for-floating’.

A forex trading platform is a portal or software interface that allows customers to trade currencies with execution in all major FX instruments, including spot, forwards, NDFs, limit orders, options and swaps. Forex trading platforms provide liquidity through a single dealer (single dealer platform) or multiple dealers (multi-dealer platforms). Forex trading platforms advertise their capacity in terms of displaying transparent pricing, complying with best price execution requirements and providing trade history. Leading forex trading platforms targeting corporate clients offer seamless integration to Treasury Management Systems (TMS) with Straight-Through Processing (STP). Currency Management Automation solutions integrate forex trading platforms, providing connectivity between the ERP/TMS and forex trading platforms in order to automate FX hedging and distribute risks among multiple banks.

A forward contract opportunity profit exists when the value of a long (short) forward position increases (decreases) prior to contract expiration, reflecting a shift in the underlying spot exchange rate. A speculator might take the opportunity profit and close out the position. However, closing out a forward position taken as a hedge would leave the underlying exposure unprotected. When forward points are not favourable and the firm tolerates some degree of deviation between the budget rate and the spot rate at the time of setting the budget, the budget can be hedged with conditional orders—’take-profit’ if currency markets move in the firm’s favour, and ‘stop-loss’ if markets move against. This program allows the firm to protect a ‘worst-case scenario’ budget rate while delaying hedging as much as possible and still allowing it to profit from possible favourable market moves.

The forward element is a concept introduced by the IFRS 9 standards for general hedge accounting and defines the forward points of a forward contract, to distinguish it from the spot element of the contract. Forward points are the basis points added to or deducted from the current spot rate to determine the forward rate at which the forward contract will be settled on the delivery date. These forward points result from the difference between the interest rates of the two currencies and the duration of the contract. One of the changes under IFRS 9 is the possibility of excluding it from the designation of a forward contract as the hedging instrument and accounting for it as costs of hedging.Under IFRS 9, companies can store the forward element in other comprehensive income (OCI). Changes in the fair value of the forward points, thus, will not affect the profit and loss, thereby increasing the effectiveness of the hedging relationship and mitigating income statement volatility.

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.

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.