Foreign Exchange Risk Mitigation Techniques/Common Instruments to Offset Risk
|Unit 2.1- Foreign Exchange Risk Mitigation Techniques||
Introduction | Rates of Exchange | Market Drivers | Measuring FX Exposure | Business Needs for Foreign Currency | Foreign Exchange Trading | Common Instruments to Offset Risk | Summary | Resources | Activities | Assessment
Common Instruments to Offset Risk
Spot trades are priced and executed on the spot based on the current market rate and are paid for immediately. Spot contracts are generally done verbally and considered binding. When executing a trade, an offer price is provided; if accepted, the contract is considered done. Delivery of the currency is generally two days forward; the two-day’s time is used for the bank to receive the currency it purchased and deliver the currency to the beneficiary as provided by the buyer.
Forward contracts are priced by combining the current spot price with the forward points. Forward points are based on the differential in interest rates of the two countries. The discount or premium points, once determined, are combined with the spot rate to create the forward rate. Some currencies are not traded openly, but there is a non-deliverable currency market. By hedging with a non-deliverable forward, a purchaser can protect against rate fluctuations rather than settling a transaction at maturity using the exchange rate that is posted on that date. Settlement would be in the local currency to provide additional local funds to settle the transaction.
Spot contracts are settled immediately while a forward contract has a fixed maturity and must be settled at maturity. Capital can be tied up when the need to deliver the currency has been delayed. Swaps provide an opportunity to exchange the foreign currency for the local currency for a fixed period of time and “swap” it back when it is needed.
Options provide protection for large denominations by taking advantage of rate improvements while protecting against the negative impact of a rate change. Alternatives Countertrade forms can and are often used when a currency cannot be traded. Bartering is most commonly used, but other forms are counter purchase, advance purchase, buy backs and bilateral arrangements.