If you run a small business, handling foreign exchange transactions can be daunting. If you live in India and agree to receive a payment in USD, and by the time the payment reaches you the value of the dollar falls, you incur a loss; on the other hand, if you’re to make a payment in USD, and the value of the USD rises, you might need to shell out more money than you had bargained for. There are several ways to protect yourself against these movements in foreign currencies. Here’s an overview:
A spot transaction is the most basic currency transaction. This is essentially the purchase (or sale) of a currency on a specified spot date. Unlike many other transactions, time value is not taken into account, meaning the exchange rate that the transaction is based on is at the spot exchange rate. This can be thought of as the real exchange rate.
This is the most common way to exchange one currency for another. It’s relatively immediate, it is liquid and it is simple. The downside though is not its transparency but how unpredictable it is. Spot prices change by the second and so you don’t know what the price will be tomorrow when you need to purchase a currency. Not only this, but you don’t know that if you do purchase currency today, tomorrow at maybe much cheaper.
Holding investments or cash in a single currency exposes you to such price fluctuations – this is known as currency risk. The way to reduce this risk is to hedge against the currency. There are many ways to do this, and many ways to buy a currency in general. Here are your options (pun intended):
As we’ve already looked at spot transactions, we’ll jump straight into forward contracts. Forwards are a type of derivative, meaning they are agreements to buy a currency, as opposed to an instant transaction. The agreement is to pay a fixed price on a fixed date in the future. The market going up or down until that date will determine whether you’re going to over or under pay, because the price is locked in and will no longer follow the market. Once the settlement date comes around, if you’re lucky, it will be lower than the current spot rate.
It seems like you don’t really gain anything, yet you still can lose by overpaying. It depends how you look at it, though. Most hedgers look at it as: you are guaranteed a given price and so you’re no longer exposed to currency fluctuation (which is the core concern of spot transactions).
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy the asset/currency at a pre-agreed price on a given expiration date. The core difference here is that the buyer can choose not to, if the currency fell to a cheaper price (agreed price > spot price). So, what’s the catch? Well, unlike Forwards, Options require an upfront premium. Thus, with Options you pay a premium in order to limit more loss than you do with Forwards.
Swaps are slightly different to the previous two. An FX swap is a contract which one party simultaneously borrows and lends a currency to another party. Repayment obligations of the other party are used as collateral and the amounts to be paid back are fixed at the forward rate (pre-agreed at the start of the contract). Swaps can thus be seen as collateralized FX borrowing/lending with no FX risk. This is often used by companies who operate in various currencies. The only real risk is credit risk (the other party may default on the interest/principal payments).
Limit Entry Order
A limit transaction is essentially an automated purchase or sale of a currency with your own instructions as input. Basically, you place an order when the price is below the market or you sell when above the market at a given price – a price you decide.
For example, if USD/GBP is 0.77, you may decide you want to place an order for some GBP when the price hits 0.75. Instead of waiting and constantly checking the price, the limit order will purchase it automatically for you at this given price. It can then sell the GBP once it hits a certain price point too.
The key difference to limit entry orders is that stop entries will limit your losses with its sales, whilst the sell limit tries to maximize the amount you get upon a sale.
Are these transfer types readily available from your bank?
Unfortunately, they’re not. Commercial banks don’t tend to offer such financial products like investment banks do. There are however plenty of FOREX companies and brokers that provide such a service to retail investors.
You have to search for external providers for hedging tools and money transfers in general. Relying on your current bank for currency transfers is a terrible idea. Not just because they will not offer a variety of products, but the price they give you is terrible due to them taking a greedy spread. The idea of hedging your currency when paying a 4% spread is counter-intuitive in and of itself.
Recommended ways to hedge
Forwards have almost been the most popular way to hedge, and for good reason. They have no up-front fees, they’re simple and they require little market knowledge. You don’t need to be a genius to just take what the market is offering now. The mindset is a little bit like insurance. You’re not really going to gain much out of it, the best possible outcome is that you save a bit of money. Overpaying for many people is worth it, when the possible alternative is a much more drastic fluctuation. Better the devil you know than the devil you don’t is an apt description if you were to forward now because of Brexit, perhaps. The Pound is not in a good state, but there’s a small chance it could get much, much worse.
Limits are getting increasingly popular, but they require a little more understanding of the market. There’s more money to be made using limits (usually), but they’re not as effective at hedging and limiting losses.