Glossary

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.

Forward points express the difference in price between currency rates for two different delivery and payment dates, usually spot and forward (although it could be two forward rates with different maturity). Forward points mainly reflect the interest rate differential between two currencies as reflected in the Interest Parity Theorem. They are expressed in pips. Forward points play an important role in pricing and in FX hedging. They are said to be ‘in favour of’ (‘against’) a firm that sells (buys) in currencies that trade at a forward premium and/or buys (sells) in currencies that trade at a forward discount. Hedging with currency forwards allows firms to ‘capture’ the financial benefit of favourable forward points. If forward points are ‘against’, a variety of automated hedging tools and programs can help mitigate their impact by delaying hedging as much as possible.

The forward point premium is the additional value of a given currency against another, when the forward and spot rates are compared. For example, if spot JPY-USD is 0.009189 and the corresponding 180-day forward rate is 0.009360, JPY trades at a 171-point premium. The forward premium can also be calculated in percentage terms. In this case, the annualised 180-day JPY premium is 3.72% = [(9360-9189)/9189] x 360/180. The forward premium reflects the interest rate differential between USD and JPY. In this example, short-term interest rates are lower in JPY than in USD, which explains the forward premium of JPY. The forward rate makes it impossible for arbitrageurs to take advantage of interest rates differentials without risk.

A full convertible currency is the monetary unit of a country where holders of the currency have the right to convert it freely at the going exchange rate into any other currency. A currency is deemed to be fully convertible if it fulfills the following three criteria: it can be used for all purposes without restrictions; it can be exchanged for another currency without limitations; it can be exchanged at a given exchange rate. A fully convertible currency is the monetary unit of a country where holders of the currency have the right to convert it freely at the going exchange rate into any other currency. A currency is said to be fully convertible if it fulfills one or more of the following three criteria about usability, exchangeability and market value: it can be used for all purposes without restrictions; it can be exchanged for another currency without limitations; It can be exchanged at a given exchange rate.

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.

FX or ‘foreign exchange’, also known as ‘forex’, 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 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.

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.

An FX gain/loss is the change in the value of foreign exchange-denominated transaction as reflected in the income statement. A sales transaction creates an FX gain (loss) when the foreign currency appreciates (depreciates) against the home currency of the company.  If this position is hedged with a financial instrument like a currency forward contract, this contract will create offsetting FX losses and gains. An FX gain/loss is said to be unrealised when it is reflected in financial statements while the transaction has not yet been settled. When the transaction is settled, the FX gain/loss is realised.

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.

FX market participants are the main players in the world of global foreign exchange. They can be classified into three broad categories: liquidity providers, end-users and governments. Helped by brokers and dealers with whom they have close relationships, international banks are the key liquidity providers. They facilitate end-users’ access to liquidity. The most important end-users are corporations, hedgers and speculators. Corporations use FX markets to settle foreign-currency denominated transactions and to hedge the corresponding currency risk, mainly with forward contracts. Speculators include FX- and macro-oriented hedge funds, asset managers and retail investors. Governments are active in FX markets mainly with the activities of central banks. Central banks are the issuers of individual currencies; they can affect currency rates by intervening directly in FX markets or —as happens much more frequently— by altering liquidity conditions through monetary policy tools to act on short-term interest rates.

FX policy is the process by which companies capture the growth opportunities that result from buying and selling in multiple currencies. A firm’s FX policy is therefore of strategic value; it comprises the entire FX workflow: the pre-trade phase (including the firm’s pricing policy), the trade phase (hedging) and the post-trade phase (cash management and accounting). By pricing and selling in the client’s currency, firms ‘speak the language’ of their customers, allowing commercial teams to add promising new markets to the portfolio. Buying in suppliers’ currency allows companies to widen the range of potential suppliers and to bypass supplier markups, thus leading to higher profit margins. An effective FX policy presupposes effective FX hedging. Depending on a company’s specific parameters, many types of hedging programs can be designed to protect a company from FX risk. The implementation and management of these FX hedging programs may be quite burdensome for treasury teams that rely on manual execution and spreadsheets. However, Currency Management Automation solutions allows firms to run them smoothly, on a fully automated basis.

FX policy guidelines are a set of procedures that spell out a firm’s methodology and tools in terms of managing currency risk. Drawn by the finance team, FX policy guidelines are 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 the situation in terms of forward points. FX policy guidelines should be clearly communicated across the enterprise, in as much detail as possible. This is especially true in the case of firms with high ‘FX sensitivity’, i.e. firms with low profit margins and/or a high weight of foreign currencies in their business. In such firms, FX-related matters are of strategic importance. Therefore, FX policy guidelines should be clearly communicated and explained by the finance team to all relevant stakeholders within the enterprise. They should be well understood and assimilated by top-level managers, including the CEO and the Board.