The Ins and Outs of Foreign Exchange: Understanding the Tools of Foreign Exchange Trading
Understanding the tools of forex trading available to a business can help ensure that favorable exchange rates are leveraged, thereby maximizing profits. For a business just entering the world of foreign exchange can seem confusing and daunting with terms like: spot rates, forward contracts, and FX hedging; that may seem foreign.
But understanding these basics are critical, and easy, if a business wants to stay ahead of the game.
Spot Rates vs. Forward Rates
The first step in understanding foreign currency exchanges is to have a grasp of the concept of spot rates and forward rates (also known as forward contracts), and the difference between the two.
A spot rate is a currency’s foreign exchange rate at the present moment in time. It is a static price of the currency at this second, this minute, hour, or day. What is important to remember when discussing or working with a spot rate is that it is the rate “right now,” and is the price that has to be paid (or received) for a particular foreign currency if a foreign exchange trade is executed at that moment. In instances that may require the urgent or immediate transfer of foreign currency, to be sent or received, executing a foreign exchange trade using a spot rate is popular because waiting to transfer the foreign currency is not a viable option.
A forward rate is the exchange rate for a foreign currency, at a future point in time, and is obtained through a forward contract. Essentially, a forward contract is an agreement between two parties, who intend to exchange two different currencies at a specified rate, at a future date. This agreement – the forward contract – can result in one party receiving the better end of the bargain, depending on whether the exchange rate between those two currencies moves as predicted, and what the exchange rate is on the date that the forward contract is exercised (the date the currencies are exchanged).
A company is based in the United States, and it has contracted with a company in Japan to purchase goods from it, with payment due in Japanese Yen thirty days from the date of the contract. The company can make the decision to make the payment immediately, executing the foreign currency exchange of U.S. Dollars (USD) to Japanese Yen today at the current spot rate.
The company can also choose to make the payment to the Japanese company at another date, within the thirty-day payment period of the contract terms. However, this means that the company can be exposed to fluctuations in the spot rate, between the two currencies. If the Japanese Yen becomes more expensive to buy in U.S. Dollars, the company may be faced with having to spend more to pay the contract. A forward contract offers the opportunity to lock in a rate in which to exchange the currency at a future point in time. In this way, the company can plan its foreign currency transfer needs, while knowing how much it will cost in its home currency (in this case, U.S. Dollars).
What is FX Hedging?
Using a forward contract to protect a company from the risk of foreign currency exchange rate fluctuations, and the associated costs, can give that business a significant competitive advantage. This is referred to as FX hedging. As noted in the example above, a business can use a forward contract to lock in a specific foreign exchange rate at a future date. While FX hedging is not appropriate for everyone, it can be a powerful tool if used properly. A full explanation of the intricacies of utilizing a forward contract, or multiple forward contracts in conjunction to protect a business from fluctuations in spot rates, while still leaving the possibility to profit from changes in spot rates, should be discussed with a currency exchange provider.
Dealing in the Spot Market
An effective forex trading strategy does not have to be limited to only forward contracts. At times, Trading foreign currency directly in the spot market, at the current spot rate, is the most effective strategy for a business to minimize its costs or maximize its profits. Sometimes, it can be more profitable to execute a currency exchange at the current spot rate to take advantage of favorable pricing for a product, or to receive payment immediately from a client, regardless of what the current spot rate is. But even when transacting in the spot market, there are various tools a firm can use to maximize its profit (or miminimze its loss) on the currency exchange. There are various types of trade orders a firm can utilize in a foreign currency strategy, which give flexability in limiting the price at which it can buy or sell a currency in the spot market, to prevent surprises should prices rise or drop while the currency exchange is being executed. Some of these trading tools are briefly outlined here:
Limit orders are used to buy or sell a specific amount of a foreign currency at a specified exchange rate (or better). A buy limit order will only be triggered at the specified FX rate (or lower); whereas a sell limit order will only be triggered at the specified FX rate (or higher). For example, a business places a buy limit order to exchange $10,000 U.S. Dollars for Euro, but only if the Euro spot rate reached $1.10 or lower.
Stop Loss Order
A stop loss order protects the value of a business’s currency holding by establishing a “floor” on an acceptable exchange rate. This floor represents the maximum the business is prepared to lose on the currency trade: if the value of its currency holding declines below the floor, the holding is liquidated (sold) to ensure that the business doesn’t lose value (or if the floor is set below an exchange rate in which there is already a loss of value, it can serve to limit further losses).
One Cancels Other (OCO) Order
By combining a limit order with a stop loss order, and adding the condition that if one of these orders is triggered then the other is canceled, a one cancels other (OCO) order is created. For example, an OCO order can be used to set an upper limit order and a lower stop loss order at which a currency holding is to be sold. If one is triggered, the other is cancelled, thus the currency holding is free to trade within this pre-set range.
These are the basic terms and tools to be familiar with when seeking to engage in more than just basic forex trading in the foreign currency markets. The next step is to involve an expert foreign exchange partner, who can help make sense of the market and guide a business in reducing currency exchange risk and maximizing returns