FOREIGN EXCHANGE TRANSACTION

Without foreign exchange transaction, international trade itself can’t exist. In former times, the transaction was based on bartering - goods were exchanged for other commodities. The introduction of gold or silver to pay for goods can be considered for the forerunner of the foreign exchange market.

The foreign exchange market consists of a network of brokers and banks based in New York, Tokyo, London and Hong Kong… etc. Most of the purchase and sale orders are conducted by computer and telephone. It is different from a stock exchange that the foreign exchange market is not a single, physical place where purchase and sale are executed.

Four kinds of Foreign Exchange Transaction

I-    Spot Transaction:

     1-   Importance for Spot Transaction:  

     The spot transactions hold a key position in exchange markets. The majority of transactions in the market are spot transaction, and other rates are quoted by reference to the spot rate.

     2-   Definition of Spot Transactions:

     Spot transaction here refers to spot exchange transactions, that is to say that foreign currency is bought or sold for immediate delivery.

     3-   Settlement of Spot Transactions:

     One-day settlement is normal in a spot transaction between a bank and its customer. However, in the spot trading market, the value date is normally set as the Second Working Day after the date on the transaction is concluded. Because the bank is closed on Saturday and Sunday. The spot transaction on Friday will show Monday as the value or settlement date.

     On the value date, most dollars deal in the world are settled through the computerized Clearing House Inter-bank Payments Systems (CHIPS) in New York.

     4-   A Typical Spot Transaction in the Inter-Bank Market:

     Suppose it is agreed on Monday that International bank sells US$ 10,000 to the Sanwa Bank, and this represents part of International Bank’s deposit with the Citicorp in New York. Then the bank in New York must be notified that on Wednesday it is to credit USD 100,000 to a bank which Sanwa bank nominates and to debit International Bank’s account.

II-   Forward Transaction:                                 

A forward transaction means that the delivery of a currency is specified to the place at a future date. German exporter of BMW cars to the United States know from their sale contract that they will receive a specified United States Dollars amount in six months. In order to protect themselves against fluctuating exchange sales, they can sell the dollars forward six months to their bank in Germany in return for Marks. Payment and delivery are not required until six months later. However, the rate of exchange is fixed on the date of contract. Forward rates are usually quoted on 30, 60, 90, 120 or 180 days basis, but major currency can have any maturity up to year and sometimes longer.

     1-   Basic Concepts:

     Forward Transactions refer to the exchange transactions which have been settled on an agreed date of the deal. The value date and the forward exchange are agreed at the time the contract is made. Sometimes the forward price of a currency can be identical with the spot price. But the forward price is always higher or lower than the spot price.

     The main purpose of buying or selling forward currencies is to hedge exchange rate exposure.

     2-   An Example:

Situation

Suppose that on February 1, 1990, a Cambodian Import & Export Company bought the color television from a Japanese manufacture for 100 million Japanese Yen. Payment was made in Japanese Yen 90 days after the goods were shipped. On May 1, so the Japanese Import & Export Company was extending trade credit for 90 days.

Problem

Since payment was 90 days away, the Cambodian company worried that the dollars would be weaker and weaker on account of large trade deficits. If the Japanese Yen appreciated rapidly, more dollars would be required to buy the 100,000,000 Yen, and the profits on television would be reduced. The Cambodian Import & Export Company did not want to forego 90 days of trade credit by paying cash at once.

Solution

The Cambodian Import & Export Company could take the trade credit and protected itself by buying 100 million Yen for delivery in 90 days. The 90 days rate was 100.00 Yen/$, so the dollar cost was 100,000,000 ¸ 100 = $ 1,000,000. When the payment came due on May 1, regardless of the spot rate on that day (99.74 Yen/$), the Cambodian firm could obtain the needed Japanese Yen at the agreed upon price of $1,000,000. Thus the Cambodian Import & Export Company is not only converted the exchange risk, but also saved $2,606.70 (100,000,000 ¸ 99.74 –100,000,000 ¸ 100).

     3-   Outright Forward

     A single forward purchase or single forward sale of a foreign currency against domestic currency or other foreign currency is known as an “outright forward” compared with a forward transaction can be a hedge, however, it is a speculative operation if it does not have a commercial underlying transaction.

III- Swap Transaction:

A Swap Transaction consists of the simultaneous purchase and sale of identical amounts of a currency for different value dates.

The main function of Swap is to eliminate the inherent exchange risk. For example, we need working balance in yen, but we don’t want to run the exchange risk of holding Yen (Japanese money). Thus, we use US dollars to buy Yen, and we simultaneously sell Yen forward. By this way, our exchange position in U.S dollar will be zero and no exchange risk.

IV- Option Transaction:

     1-   Kinds of Option:

     A- American Option:

     It can be exercised on any business day within the option period.

     B- European Option:

     It can only be exercised on the expiry date.

Based on the nature of Options

     A- Call Option:

     It refers the right to buy a certain amount of a currency at the fixed rate at a pre-arranged expiring date.

     B- Put Option:

     It refers the right to sell a certain amount of currency at a fixed rate at a pre-arranged expiry date.

     Under a flexible option transaction, the buyer of the option acquires the right, but not the obligation, to go ahead with the contract, to take up the option or to allow it to expire. The buyer has the chance to hedge against a currency loss as well as the chance to benefit from any profit on the foreign exchange transaction.

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