Glossary

A currency forward is a contractual 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 exchange rate is determined at the time the contract is entered into. In a typical currency forward, an American firm sells EUR 100,000 forward to a bank at a forward rate of 1.21 EUR-USD with payment due in 90 days, while the spot rate is 1.20. This is done to offset possible changes in the value of a EUR 100,000 sale to a European client, to be settled in 90 days. If, at settlement, the spot rate is 1.16, the value of the sale declines by USD 4,000 to 116,000. The firm delivers the EUR 100,000 obtained from the sale to the bank, and receives USD 121,000 as specified in the currency forward. The USD 5,000 gain on the forward reflects the change in the spot rate and also the forward points (the difference between spot and forward rate due to interest rate differentials).

Much like a currency forward, a currency future is a contractual agreement to buy or sell an amount of one currency against payment in another currency at a fixed future date. The exchange rate is determined at the time the contract is bought or sold. There are two key differences between forward and futures contracts. While the underlying amount and the value date of a forward contract can be negotiated between buyers and sellers, they are both standardised in the case of futures contracts. This is because forward contracts are ‘over-the-counter’ (informally arranged between buyers and sellers), whereas futures contracts are ‘exchange-based’ (formally arranged by a clearinghouse that buys and sells all positions). Because value dates and contract sizes are pre-determined, futures markets do not require participants to mutually check their creditworthiness. And, as standardised amounts are low, they provide a tempting tool for speculators. However, their cash flow implication (the required margins) and their lack of flexibility means that most companies, when hedging their FX exposure, rarely choose futures contracts. Instead, they rely on forward contracts, which are used in most Currency Management Automation solutions.

Currency hedging is the creation of an offsetting position, undertaken (most of the time) with forward contracts, 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. Currency hedging differs from a speculation, where a currency position is taken in anticipation of an expected change in currency rates. Currency hedging is usually implemented through hedging programs 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 other considerations. Some of these programs and combinations of programs can be quite demanding, a real challenge for treasury teams relying on manual systems. Their proper implementation and management requires, therefore, automated solutions provided by Currency Management Automation.

Currency management is the process by which companies can capture the growth opportunities that result from buying and selling in multiple currencies. Currency management is therefore of strategic value to most firms. Currency management is carried out across the entire FX workflow: the pre-trade phase (including the firm’s pricing policy), the trade phase (hedge execution) and the post-trade phase (cash management and accounting). By pricing and selling in their clients’ currencies, firms ‘speak the language’ of their customers, allowing commercial teams to add promising new markets to the portfolio. Moreover, they are in a position to capture the price mark-up usually applied by clients who receive quotes in foreign currencies. Buying in suppliers’ currency allows managers to widen the range of potential suppliers and to bypass supplier markups, thus leading to higher profit margins. Effective currency management presupposes effective FX hedging. Depending on a company’s specific parameters, Currency Management Automation solutions allow managers to design the hedging programs —and combinations of hedging programs— that best protect them for currency risk, in an automated manner.

In foreign exchange, currencies are quoted in pairs and usually with their currency code, containing three letters, rather than the long version name of the currencies.For example, the euro -U.S. dollar currency pair is quoted as EUR/USD, where the first element is known as the base currency and the element after the slash symbol is known as the quote currency.The currency pair is followed by an equals symbol and the exchange rate of the pair. That exchange rate means the cost in the quote currency required to pay one unit of the base currency, in other words, the base currency equals always one.In the following quote: EUR/USD = 1.1000 we understand that to buy one euro you need to pay 1.1000 dollars.

A currency peg is an exchange rate regime in which a country’s currency is maintained with margins of +/- 1 percent vis-à-vis another currency or a basket of currencies. There is usually no commitment to keep the parity irrevocably. To sustain a currency peg, the central bank uses direct intervention such as the sale or purchase of foreign exchange in the market, or indirect intervention via the use of interest rate policy or foreign exchange regulations.

A currency pip is the last digit in a forward rate quotation. Pips are often used to illustrate market changes in an exchange rate. For example, if the currency quote EUR-USD 1.3275 moves to EUR/USD 1.3300, there is a difference of 25 pips. In this example, it costs 25 pips, or 0.0025 dollars more to purchase one euro. Currency pips are used by traders in FX markets to calculate the P/L on their positions. They are also the unit of measurement of so-called ‘swap rates’, the differential between the spot rate and the forward rate. If spot GBP-USD trades at 1.3059 and the 90-day forward trades at 1.3000, then the 90-day GBP forward trades at a 59-pip (or forward points) discount.

A currency put option is a financial derivative instrument that gives the holder (buyer) the right —but not the obligation — to sell the contracted currency at a set price or exchange rate (the ‘strike price’), on a predetermined expiration date. The seller of the put option must fulfill the contract if the buyer so desires Because the currency put option has value, the buyer must pay the seller a premium in exchange for the right to exercise the option. An ‘American’ put option can be exercised at any time up to the expiration date; a ‘European’ put option can be exercised only at maturity. When hedging regular foreign currency inflows and outflows, forward contracts are more widely used than currency put options. However, currency put options can be an efficient tool when contingent business events are hedged.

Currency risk or exchange rate risk, also known as foreign currency risk, is the possibility that currency fluctuations can affect a firm’s expected future operating cash flows, i.e., its future revenues and costs. Currency 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. Currency 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 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.

The currency spot rate is the exchange rate between two currencies for immediate settlement ‘on the spot’ (usually two business days). For most currencies, the spot rate is usually displayed to four decimal places, though for certain currencies, e.g. the Japanese yen, it is only displayed to two decimal places. The spot rate is quoted with two different values: the first rate is the buy, or bid price; the second is the sell, or ask, or offer price. If a dealer quotes spot GBP as USD 1.3019-28, it means that banks are willing to buy pounds at USD 1.3019 and sell them at 1.3028. The dealer profits from the spread of USD 0.0009 between the bid and ask rates.

A currency spot trade, or simply spot trade, is a foreign exchange transaction executed at the spot rate. If a dealer quotes spot USD-JPY as 106.30-35 and a corporate client sells one million JPY against USD at that rate to International Bank XYZ, the trade date (‘day 0’) is today, but the transaction usually settles in two business days (‘day 2’). On day 2, the company must wire the bank one million JPY and will receive USD 9,402.91 from the bank.

A currency 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, currency 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’.