Glossary

A foreign-exchange commission, charged by an FX broker, is part of the cost of executing of foreign currency transactions. Brokers are middlemen who try to match the buy and sell order from their clients to other clients buy and sell orders. Because they have established connections with liquidity providers, they can offer very tight spreads. To compensate for the tight spreads, brokers charge fixed foreign exchange commissions. For example, If a broker charges 50% of a pip spread, it can also charge a fixed EUR 6 commission per standard lot of EUR 100,000 to buy and sell. So a EUR 100,000 trade to buy and sell would produce EUR 17 to the broker. Still, that compares favourably with the EUR 30 cost of a dealer who would charge no foreign exchange commission, but a full pip spread instead.

Foreign exchange controls are restrictions applied by some governments to ban or limit the sale or purchase of foreign currencies by nationals and/or the sale or purchase of the local currency by foreigners. Foreign exchange controls are mostly used by governments who fear that free convertibility could lead to unwanted currency volatility. Foreign exchange controls often pose serious challenges to companies with international operations, either by hindering cash transactions or by making it difficult to use financial instruments such as currency forward contracts to hedge FX risk.

A foreign exchange gain and loss, or FX gain and loss, is the result of a change in the exchange rate used when an invoice is entered at one rate, and valued in a financial statement at another. A freign exchange gain or loss can be unrealised or realised. An unrealised FX gain or loss reflects the change in the value of foreign currency denominated sales or purchase transactions that are recorded in financial statements prior to the settlement of the invoices. When the transaction is settled, the FX gain and loss is realised.

A foreign currency hedge is the creation of an offsetting position, undertaken with a financial derivative instrument (most of the time, a forward contract), in order to neutralize any gain or loss on the original currency exposure by a corresponding foreign exchange loss or gain on the hedge. Whether the exchange rate goes up or down, the company is protected because the hedge has locked in a home-currency value for the exposure. A company that undertakes a foreign currency hedge is therefore indifferent to the movement of market prices in currency markets. A foreign currency hedge differs from a speculative position, where a currency position is taken in anticipation of an expected change in currency rates. Whether business managers desire to protect its budget from FX fluctuations with static, rolling or layered hedging programs, or whether it aims at ‘microheding’ its many foreign currency-denominated transactions, Currency Management Automation solutions allow them to systematically achieve their risk management goals.

A foreign currency hedging strategy or program is a set of procedures that allows a company to achieve its goals in terms of managing currency risk. It is based on the business specifics of the company, including its pricing parameters, the location of its competitors and the weight of foreign exchange in the business. A foreign exchange hedging strategy or program also takes into account the company’s sources of information, IT systems, degree of cash flow visibility, and key decision makers (their risk tolerance, their familiarity with different risk management styles, etc.) The most widely used foreign currency hedging strategies or programs include: static budget hedging, rolling hedging, layered hedging, hedging based on conditional orders, SO/PO (sales orders/purchase orders) and combinations of programs. Some of these programs and combinations of programs can be quite demanding in terms of calculations and/or currency trading, a real challenge for treasury teams relying on manual systemes. Their proper implementation and management requires, therefore, automated solutions provided by Currency Management Automation.

A foreign exchange line of credit is a credit facility allowing a company to draw in one or in several currencies other than its functional currency. For example, a company with EUR as its functional currency may borrow from the same credit line in USD or GBP, depending on its specific needs at the moment. Such foreign exchange lines of credit in multiple currencies may save a multinational corporation the time and expense incurred in FX transactions.

A foreign exchange long position in FX forward markets is a commitment to buy a specified amount of one currency against payment in another currency at a fixed future date, known as the value date, at a specified exchange rate. Typically, a foreign exchange long position offsets a corresponding ‘short’ position that a company takes when it agrees to buy goods for delivery at a future date. In effect, such a foreign exchange long position enables the company to convert a short underlying position to a zero net exposed position, with the forward contract receipt cancelling out the corresponding account payable.

The foreign exchange market is the place where currencies are traded. A EUR-based company selling in USD will ultimately be interested in receiving EUR, just as a USD-based exporter to Europe would want to receive USD. Because it would be inconvenient for individual buyers and sellers to seek out one another, the foreing exchange market was developed to act as an intermediary. Most currency transactions take place through the worldwide interbank market, the wholesale market in which major banks trade with one another. According to the Bank for International Settlements (BIS), the size of the foreign exchange market is $6.6 trillion a day. The foreign exchange market comprises the spot market, the forward market, the futures market, as well as swap transactions. While spot trading amounts to about $ 2 trillion per day, the size of the forward market is just below the $ 1 trillion mark. The most widely traded currencies in foreign exchange markets are USD, EUR, JPY, GBP and CHF.

Foreign exchange netting involves offsetting accounts receivable/payables in one currency with accounts payable/receivable in the same currency. When currency rates move, FX gains (losses) on one position should then be offset by FX losses (gains) on the other. There are more possibilities yet. If the exchange rate movements of two currencies are positively correlated, a long position in one currency can offset a short position in the other. If the exchange rate movements of two currencies are negatively correlated, a long (short) position in one currency can offset a short (long) position in the other. The aim of foreign exchange netting is to manage currency exposures on a portfolio basis and to save on hedging costs, as only the resulting net exposures are hedged with forward contracts.

In terms of FX hedging, the foreign exchange opportunity cost measures the real cost of hedging. The cost of hedging is sometimes measured as the forward discount or premium. However, this approach is wrong because the relevant comparison must include the cash flow difference between hedging and not hedging, a calculation that requires the future (unknown) spot rate on the date of settlement. That is, the real cost of hedging is an opportunity cost. In terms of business strategy, the foreign exchange opportunity cost is the set of business opportunities that firms forego as they buy and sell in one or two currencies only. By doing so, they lose the opportunities afforded by ‘embracing’ currencies, both on the contracting side and on the selling side.

The foreign exchange outright rate is the exchange rate of a currency forward contract. A currency forward is an agreement to buy or sell a specified amount of one currency against payment in another currency at a fixed future date known as the value date. The foreign exchange outright rate is fixed at the time the contract is entered into. It reflects the interest rate differential between the two components of a currency pair. The currency with the higher interest rate trades at a forward discount with respect to the other. For example, if the spot USD-MXN rate is 20.5000, and one-year interest rates are 1.5% in USD and 7.5% in MXN, then the one-year foreign exchange outright rate is 21.7188 = 20.5000 (1.075/1.015). The foreign exchange outright rate always is exactly set at a level that makes riskless arbitrage impossible.

Payment default is a concept referring to a party's failure to meet its contractual obligations to make a specified payment at a specified date.In foreign exchange, a payment default often occurs if a counterparty fails to protect itself against transaction risk and is then subject to negative exchange rate movements.For example, a company in London places an order with an American supplier, with the goods order costing $1 million. The payment is due in 60 days from the time of placing the order. The exchange rate at the time of placing the order is USD/GBP 0.60.In order to make the payment, the London-based company requests a line of credit to cover this amount.However, in the intervening period, the Bank of England announces a monetary stimulus package, which weakens the pound's value severely against the dollar, with the rate moving to USD/GBP 0.75.Due to that depreciation of the pound, the line of credit obtained is no longer sufficient for the company to pay the agreed amount in dollars and it therefore defaults on its payment.Payment defaults can be damaging to companies. They disrupt trade and, at a certain level, they may have a toxic effect on the general economy. If a sector, or indeed an economy, suffers from a default spiral, where payment defaults build and begin to cause more defaults in a domino effect, it can cause severe economic damage. On a smaller scale, it can severely dent a company's profit margins and even plunge a company into debt or insolvency.For such reasons, it is of fundamental importance to hedge against credit risk and foreign exchange volatility.