Glosario

A limit order, in the context of foregin exchange risk management, is an order to buy or sell a currency forward at a specific exchange rate or better. This exchange rate is determined by the treasury team. A buy limit order can only be executed at the limit exchange rate or lower; a sell limit order can only be executed at the limit exchange rate or higher. Limit orders are the most common type of conditional orders. Other conditional orders, used in Currency Management Automation solutions like Dynamic Hedging, are stop-loss orders and take-profit orders. For example, a British company that pays a China-based supplier USD 1 million every 3 months must exchange GBP to USD in order to complete the transactions. If the current exchange rate is GBP-USD 1.30, the company may impose a limit order to buy USD at an exchange rate no lower than GBP-USD 1.28. If USD appreciates to GBP/USD1.25, the company will have stemmed the FX losses through its limit order at 1.28.

A line of credit is a loan facility agreement between a lender and a borrower. A total amount is agreed for the credit line.It is extended to creditworthy customers by banks and money lenders.Lines of credit form an integral function in assisting businesses in completing purchasing operations.Advantages to using a line of credit over a loan1. A line of credit allows the borrower to draw down as many times as they need to, up to the maximum amount permitted.2. Unlike a loan, interest on a line of credit is only charged on the actual credit that is used. Any available credit not used up does not incur any interest payment.A line of credit is often used in conjunction with a letter of credit obtained from the same money lender when making international transactions.

Liquidity is a financial concept that refers to the ability to convert assets into cash.It is crucial for a company to have good liquidity in order to pay its bills in a timely manner. In order to fulfil payment obligations on an ongoing basis, a company must ensure that total cash flow exceeds total liabilities, ensuring a minimum level of liquidity.Managing liquidity is seen as one of the core functions of a company's treasury department. Since the 2007-09 global financial crisis, maintaining good levels of liquidity has been an increasing challenge for many companies due to a variety of factors, including the marked decrease in bank credit globally.A company that maintains a minimum level of liquidity is said to be solvent.Foreign exchange risk is a major threat to a company's liquidity. Companies with business lines in foreign markets may experience an adverse impact on their cash flow if they are not able to protect their margins, which might end up eroding their liquidity ratio.

In corporate finance, liquidity ratios measure the level of assets that can be quickly and cheaply converted into cash and their proportion to the firm’s short-term obligations. Because the book value of liquid assets is usually reliable, liquidity ratios allow investors to get a picture of a firms’ liquidity position. The most widely used liquidity ratios are the current ratio, the quick ratio and the cash ratio. In these three ratios, the denominator is the level of current liabilities. The current ratio is simply the ratio of current assets to current liabilities. Because some current assets are closer to cash than others, inventory is subtracted from the numerator (of the current ratio) when calculating the quick ratio, which is also known as the ‘acid test’. Finally, the cash ratio is even more stringent, as it only includes cash and marketable securities in the numerator. While investors generally applaud firms with strong liquidity ratios, an excess of liquidity can indicate sloppy use of capital.

In corporate finance, liquidity risk is the risk that a firm may not be in a position to lay its hands on the cash needed to meet its short-term obligations. To assess liquidity risk, investors look at several financial ratios, including the current ratio, the quick ratio and the cash ratio.

Live exchange rates are real time spot and forward currency quotes provided by liquidity providers such as banks, FX brokers and dealers, and multi-dealer trading platforms. Live exchange rates allow managers to monitor their FX exposure and to execute hedges when required. By connecting to providers of live exchange rates, Currency Management Automation solutions allow managers to monitor their exposure in real time, 24/5, in any currency pair, and for any number of transactions.

A long currency hedge refers to a strategy aiming to minimise the risk related to cash flows due for settlement at a future date, for instance in one year’s time. The hedger secures the current exchange rate for that payment to protect themselves from potential losses due to exchange rate fluctuations.For example, a French company (which uses the euro as its functional currency) places a large order with its US supplier (who accept payments in US dollars) worth $10 million, to be paid for in a year’s time. By using a long currency hedge to set the exchange rate at the current rate, the company reduces its exposure to the fluctuation of the EUR/USD exchange rate.For instance, if the one-year forward rate is EUR/USD 1.20 and the spot rate in one year’s time is EUR/USD 1.15, the company will have benefited by locking in the exchange rate in advance, saving the equivalent of $500,000 that would otherwise be lost to the FX market. However, if the dollar appreciates against the euro, the company will have made a loss against the exchange rate available when they have to pay for their order.If this loss is sizeable, it could be highly detrimental to the company. To diversify risk, the company could choose to only take a long currency position for a specific percentage of its exposure and mix its hedging methods.

Major currency pairs are the most widely traded currency pairs: EUR-USD, USD-JPY, GBP-USD and USD-CHF. According to data from the Bank for International Settlements (BIS), the U.S. dollar is the most widely traded currency, being on one side of 88% of all trades in the $6.1 trillion/day FX market. Other major currency pairs include EUR-CHF, USD-CAD, AUD-USD. Major currency pairs are traded 24/5 all over the world in highly liquid markets, with low bid-offer spreads both in spot and forward markets.

A managed floating exchange rate (also known as dirty float’) is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed. Rather, the value of the currency is kept in a range against another currency (or against a basket of currencies) by central bank intervention. By far the most significant system of managed floating exchange rate in recent years is the Chinese currency regime. At the start of each trading day, China’s central bank sets a ‘reference rate’ against which the renminbi is allowed to rise or fall no more than 2 per cent against USD in onshore trading. A managed floating exchange rate gives the central the power to set a corridor for the exchange rate, in order to avoid situations of currency over- or under-valuation. In order to be credible, a managed floating exchange rate has to be managed by an autonomous or semi-autonomous central bank with a high level of FX reserves, strong credibility. Above all, the target corridor for the exchange rate should not be too far away from market-based levels.

Margin is the security required from the borrower in all kinds of financial transactions. It protects lenders against the risk of a payment default. If a borrower fails to pay the amount owed on the due date, the lender can claim the collateral in order to minimise losses from the defaulted payment. Margin is a crucial element in loans and other financial instruments like forward or futures contracts, as it lowers the risk of default and limits the negative impact of any default to a transaction as well as, more generally speaking, to international trade and the financial markets.

A margin call is a demand to deposit additional funds or securities to cover possible losses. A margin call usually indicates that the collateral held for a given position has lost value. Let us imagine a situation where a ‘short’ EUR forward position is initiated, on which a 5% margin is requested. The position is ‘long’ USD 100,000 and the forward rate is EUR-USD 1.1111. Measured in EUR, the initial margin requirement is EUR 4,500 = 100,000 x 0.9000 x 0.05. If the forward rate moves to 1.1240, the forward position loses EUR 1,032.03. A margin call may be triggered if the ‘cover’ (the loss in proportion to collateral in deposit) falls below, say, 80%. This would be the situation in our example, as the ‘cover’ would be 77.07% = (4500 - 1,032.03)/4,500. An unheeded margin call on such a position may result in the automatic closing of the position at the prevailing market rate. That would happen if the ‘cover’ falls below, say, 60%.