By Frances Coppola
A single currency issued by a number of states or countries collectively and used by them all for both domestic and international trade. The best-known examples are the Euro and the US dollar, but British pound sterling, Canadian dollar and Swiss franc are also common currencies.
A system of exchange rate adjustment in which a currency is allowed to fluctuate within a band of rates, rather than floating freely. The par value of the currency may need to be adjusted from time to time due to economic factors such as inflation. E.g. China’s onshore yuan has historically had a crawling peg to the US dollar; the Chinese central bank maintained it in a fluctuation band of 2% either side of a rate that was reset each day in accordance with government objectives. In August 2015, the People’s Bank of China announced its intention to move to a managed float.
The value of a currency is determined by comparison with another currency. The first currency of a currency pair is called the "base currency", and the second currency is called the "quote currency". ISO three-character currency codes are used for currency pairs; USD = US dollar, AUD = Australian dollar, GBP = UK pound sterling, etc.
So, for example, USDGBP is the value of the UK pound sterling in US dollars; USDCNH is the value of the offshore Chinese yuan in US dollars.
The risk that an import or export business’s competitiveness may be adversely affected by macroeconomic factors such as exchange rate movements, by regulatory changes, or by political factors such as instability or regime change, in a country in which it is operating.
In a fixed exchange rate system, the value of the currency is set by the government or central bank. The value may be tied to another currency (such as the US dollar or the Euro), to a basket of currencies, or to gold. E.g. Bulgaria’s currency, the lev, is fixed to the Euro at a rate of 1.95583 leva = 1 Euro; this is a "currency board" arrangement whereby the Bulgarian central bank maintains FX reserves sufficient to guarantee conversion of leva to Euro at the fixed rate.
Since the demise of the gold standard, fixed rate currency regimes have become increasingly rare: most countries which actively control the external value of their currencies do so by means of a crawling peg or managed float.
The value of a floating currency is determined by purchases and sales of that currency relative to other currencies on international FX markets. If there are more sales than purchases, the exchange rate falls: if there are more purchases than sales, the exchange rate rises.
A simple forward FX contract purchases or sells foreign currency priced from today’s exchange rate for delivery on a specific date in the future. A “window forward” purchases or sells foreign currency priced from today’s exchange rate for delivery on or before a specific date in the future. Window forward transactions may involve several payments as long as the whole amount is delivered by the settlement date.
A standardised contract to buy or sell a specified amount of a given currency at a predetermined price on a set date in the future. Unlike FX forward contracts, futures are traded on recognised exchanges.
A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specific exchange rate for a limited period of time. For this right, the holder must pay the broker an amount known as the “premium”. The exchange rate is known as the “strike price”. An option that has not reached its strike price is said to be “out of the money”, while an option that has reached its strike price is “in the money” and would normally be exercised. If an option reaches its termination date without being exercised, it expires and the premium is lost. Options are a good way of limiting losses due to adverse exchange rate movements while benefiting from favourable movements.
An FX swap consists of simultaneous spot purchase or sale of one currency for another and forward purchase or sale of the same amount in the same currency pair in the opposite direction. It is equivalent to a term loan in one currency and a term deposit in the other.
A system of exchange rate management in which the currency is allowed to float versus other currencies, but the central bank influences the exchange rate by market purchases and sales of the currency. Most countries have managed rather than free-floating currencies. Managed float is also known as “dirty float”.
A non-deliverable forward, or NDF, is a forward contract in which there is no exchange of currencies at maturity. Instead, at maturity the counterparties cash settle the difference between the contract rate and the prevailing spot rate on an agreed notional amount.
The Real Effective Exchange Rate, or REER, is a measure of a country’s competitiveness. It is the trade-weighted average of the currency’s nominal exchange rates versus the currencies of the country’s principal trading partners, adjusted for the effects of inflation.
A Foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency and sell another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate.
The IMF defines =SDRs as international reserve assets, created by the IMF in 1969 to supplement member countries' official reserves. SDR value is based on a basket of four international currencies, currently US dollar, British pound sterling, Euro and Japanese yen. SDRs cannot be used for trade but can be freely exchanged for usable currencies.
The risk that a company will incur losses due to adverse exchange rate movements between entering into and settling a transaction in a foreign currency.
When a company denominates part of its equity, assets, liabilities or income in a foreign currency, it incurs the risk that the value of these will change due to exchange rate movements. Typically a problem of multinationals whose subsidiaries’ accounts are in a different currency from the parent company. Also known as "accounting exposure".
The language of FX can seem complex, but being familiar with commonly-used terminology can help you and your FX provider engage in meaningful dialogue to develop strategies that benefit your business.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.