Spot
A spot foreign exchange transaction is exchanging one currency for another at the current exchange rate.
Currencies are exchanged at the spot rate at the time of the contract, and the contract is generally settled within two business days, involves cash rather than a contract, and interest is not included in the transaction.
Forward/Future
Forward transactions are agreements to buy or sell a foreign currency at an agreed price at a future date. The difference between a forward contract and a future is that a future is traded on exchanges and typically has a contract length of three months.
Forward contracts are commonly used to hedge foreign exchange risks, as by agreeing on an exchange rate at the time of the contract, you are protected from possible fluctuations in the exchange rate. The party that agrees to buy the currency in the future takes a long position, while the party that agrees to sell the currency takes a short position.
exchange
In a Forex swap, two parties exchange currencies for a certain period of time and agree to reverse the transaction by exchanging the same number of currencies at a later date. Swaps allow you to use funds in one currency to finance obligations in another, without incurring currency risk.
A currency swap is typically structured with a spot currency transaction, then a forward currency transaction.
For example, my British company might need to do a 3-month project in Europe. The funding requirement for the project is EUR 300,000. As my company currently has GBP300,000 available, I would like to use this to meet the European funding requirement. At the current exchange rate GBP0.8915 to EUR1, I exchange GBP267,450 to EUR300,000 at the bank, the initial spot Forex transaction.
At the same time, I organize a forward transaction to buy back GBP and sell EUR within three months. I will exchange the money for the same rate of 0.8915, adjusted for forward points. A forward point adjustment equals the interest rate differential between two currencies.
So, since the current interest rate in the euro zone is 1.25% and the current interest rate in Great Britain is 0.5%, in the three months that the bank has GBP267,450 it will earn GBP334.31 in interest. ([EUR267,450 x 0.5%]/12 months x 3 months = GBP 334.31). Meanwhile, my euros will earn EUR937.50 in interest ([EUR300,000 x 1.25%]/12 months x 3 months = 937.50 EUR).
At the end of the period, the bank will have GBP267,450 + GBP334.31 = GBP267,784.31
At the end of the period I will have 300,000 EUR + 937.50 EUR = 300,937.50 EUR
GBP 267,784.31/EUR 300,937.50 = forward rate of 0.8898
Since the original spot FX transaction used an exchange rate of 0.8915, there has been a forward point adjustment of -0.0017.
The bank closes the transaction by returning the original GBP 265,450 to you and you paying the bank EUR 301,501.76 (the EUR 564.26 loss you had on the transaction is the difference between the interest rates of the two currencies. The bank earned 0, 5% interest for three months, while you earned 1.25% interest, a difference of -0.75% Since the difference is negative, you have to pay the bank back ([EUR300,937.50 x 0.75%]/12 months x 3 months = 564.26 EUR). If the difference had been positive, he would have made a profit.)
Option
A Forex option gives the owner the right, but not the obligation, to buy or sell a specified amount of currency at a specified exchange rate. This exchange rate is known as the strike price. American options can be exercised on or before the option expiration date, while European options can only be exercised on the expiration date.
If the owner chooses not to exercise the option, they will lose their deposit.
Options are typically used to hedge against currency risks, and corporations typically hedge certain foreign currency cash flows with forward contracts and uncertain foreign currency cash flows with options.
Suppose a UK manufacturer has ordered £250,000 worth of German parts, under a contract where both delivery and payment are due in 30 days. The current exchange rate is €1.1214 per pound, so GBP250,000 will equal EUR222,935.62 when converted. If the euro strengthens to 1.2005 against the pound over the next month, the German company will lose out on potential profits as it will only receive EUR208,246.56 when the currency is converted at the new rate. On the contrary, if the euro weakens to 1.0355, the German company’s profits would amount to 241,429.26 euros.
If the deal goes through, and consequently the GBP250,000, the German company could enter into a forward contract to sell the parts for GBP GBP250,000 in 30 days at the current exchange rate, protecting both companies from currency risk. .
If the deal is uncertain, the German company might prefer to use options. The use of options will protect the earnings of the German company from Forex risk, will generate a profit if the expected cash is not received due to the movement of Forex rates in its favor and will cost at most one option premium.
Using options instead of a forward contract will protect the German company’s earnings (assuming the money is received), make a profit if the expected cash is not received but Forex rates move in its favor, and will cost as maximum one premium option (unlike forward contracts). , which can have unlimited losses).