Glossary

The foreign exchange market is the place where currencies are traded. A EUR-based company selling in USD will ultimately be interested in receiving EUR, just as a USD-based exporter to Europe would want to receive USD. Because it would be inconvenient for individual buyers and sellers to seek out one another, the foreing exchange market was developed to act as an intermediary. Most currency transactions take place through the worldwide interbank market, the wholesale market in which major banks trade with one another. According to the Bank for International Settlements (BIS), the size of the foreign exchange market is $6.6 trillion a day. The foreign exchange market comprises the spot market, the forward market, the futures market, as well as swap transactions. While spot trading amounts to about $ 2 trillion per day, the size of the forward market is just below the $ 1 trillion mark. The most widely traded currencies in foreign exchange markets are USD, EUR, JPY, GBP and CHF.

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.

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, in the context of foreign exchange, 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 fixed at the time the contract is entered into. A forward contract effectively ‘locks in’ today’s exchange rate, plus or minus the forward points, i.e. the difference between the forward and the spot rate due to interest rate differentials between currencies. An open forward contract, the funds can be exchanged before the value date. By contrast, when both parties are legally obliged to exchange the funds on the value date, the forward contract is said to be’ closed’ or ‘standard’.

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.