This fact sheet provides additional information to help with understanding the investment, tax and other financial planning concepts that we have discussed with you or included in your Statement of Advice.
Please contact your adviser if there is any aspect on which you need further information or clarification.
What is Foreign Exchange (FX)?
Foreign exchange, known as FX or Forex, involves the exchange of two currencies. The price of the conversion is known as the exchange rate or FX rate.
The FX market is the largest available financial market worldwide. For reasons of demand, liquidity and availability, the foreign exchange market also includes precious metals and precious metal accounts.
Several factors influence FX rates, including:
- interest and inflation rates
- political stability
- transparency of the country’s economic and political decisions
- general economic welfare.
Types of Foreign Exchange Transactions
There are two major types of foreign exchange transactions.
- FX Spot Transactions
- FX Forward Transactions
Spot Transactions
A spot transaction is the purchase or sale of a currency at the current (‘today’) rate (spot rate) for standard settlement.
Spot settlement for major currency pairs is the trade date plus two business days. Transactions require full coverage of the nominal value. Therefore there is no need for margin.
Forward Transactions
A forward transaction is an agreement for a currency trade with a settlement date in the future.
- The Forward Rate, which is the expected exchange rate at future settlement date.
- The spot rate, adjusted by the interest rate differential between the two currencies, becomes the forward rate.
The amount can be fixed freely, with maturity from three working days up to 5 years, and the counterparty will require collateral.
Early termination of a contract is not common, because exposure can be cleared during its lifetime by a counter transaction for the same maturity date. Depending on the counterparty, this may be inefficient from a collateral management perspective.
Non-Deliverable Forwards
Non-deliverable forwards are traded over the counter involve:
- One freely obtainable currency (e.g. USD) and,
- A currency which is not freely obtainable, thinly traded or on which forward trades have been banned (thus making them non-deliverable)
The trade is defined by:
- A notional amount
- The non-deliverable forward rate, which is the estimated exchange rate at the agreed value date of the forward contract, agreed on the fixing date (when the counterparties enter the agreement).
- A fixing and settlement date, when the difference between the actual spot rate at the fixing date and the non-deliverable forward rate is cash-settled with the freely obtainable currency.
Due to currency controls imposed by the Brazilian government, a common non-deliverable forward currency pair is USDBRL.
Other Forward Rate Transactions
Products such as FX options carry an expanded set of features and risks and require additional knowledge of derivative instruments.
Key Features
Investment in Foreign Exchange strategies may be suitable for investors with a high-risk tolerance and ability, who are primarily seeking capital gains.
When contemplating an investment in foreign exchange strategies, investors should consider the following key features in light of their investment needs.
Investment Horizon
Short-Term
Return Expectation
Capital Gain. Fluctuations in the exchange rate, adjusted for interest rate differentials, drive returns on foreign exchange markets.
Market Expectation
Suitable for rising and falling markets.
Maximum Gain
The maximum gain is unlimited.
Maximum Loss
There is a risk of unlimited loss.
Profit / Loss
Not predictable. Linear return relationship with changing exchange rates, unless investors use leverage or options. Trading commonly involves significant leverage, which can magnify gains, losses and volatility.
Trading Process
Currencies on the spot market require full coverage of the nominal value.
When executing a forward rate trade, a counterparty will require an initial deposit (a margin), which is usually lower than the nominal value of the transaction. A private bank will typically require 10% for a tier 1 currency pair.
Some forward products, such as outrights, swaps and options, are traded over the counter and are highly customisable in terms of maturity and size. Others, such as futures, options and warrants, are exchange-traded and standardised.
Trading Costs
The bid/offer spread reflects the main cost of a trade. This spread is typically lower for foreign exchange than other financial instruments. It will vary depending on the time of day, the traded currency pair, the size of the trade and the transaction venue.
There is also an opportunity cost, as collateral is tied up while the positions are open, though this is more efficient than fully funding a position.
Currency Regimes
Foreign exchange trades presuppose that currencies are freely tradable, though this is not the case for all currencies. The way that governments and central banks manage exchange rates is called a ‘regime’.
Examples of exchange rate regimes are:
- Free float - the exchange rate is determined by supply and demand, though the central bank may intervene to avoid excessive appreciation/depreciation.
- Pegged - fixed to a specific value or floating within a band.
For an investor, this may mean that certain currencies are not freely available or trade at exchange rates that do not reflect actual market conditions.
The authorities may change policies at any time with little warning, as happened in January 2015 when the Swiss National Bank removed the 1.20 EURCHF peg.
Advantages and Disadvantages
Currencies are often not only traded on the spot markets, and exchange rates serve as underlying for a wide variety of other financial instruments, such as mutual funds, futures, derivatives. Such instruments bear risks above and beyond the direct buying/selling of currencies and require corresponding investor knowledge.
Advantages
- Liquidity - the foreign exchange market is the largest liquid market in the world, and is open 24 hours a day, five days a week.
- Volume - high trading volumes mean that you can execute large orders without influencing prices
- Transaction Costs - the spread between bids and offers is low
- Margin - there are low margin requirements and fewer limitations when compared with futures.
- Hedging - movements are easily hedged using forwards or options
Disadvantages
- Leverage and margin maximise profits but possible losses as well
- Spreads for retail clients are generally much higher than for institutional clients.
- The market can be opaque for retail clients.
- Interventions by central banks create gap risk.
Risks
Market Risks
Exchange rates change as a result of many factors. Besides the regular forces of supply and demand, there is also a country risk. Country risk is the risk of political and economic changes in the currency’s home country or changes in the exchange policy of that country.
Agreements about currency trades in the future at an exchange rate fixed today also include additional risks.
Credit Risk
The ability of the counterparty to fulfil its obligations is an important consideration.
Liquidity Risk
The contract may be closed out before the settlement date using a counter deal. During the life of the agreement, the required margin will constrain investor liquidity.
Margin Call Risk
Margin requirements may change according to exchange rate volatility, necessitating the addition of further collateral or closing out positions (‘margin calls’).
Leverage Risk
The possibility to trade high volumes based on a minimum initial amount is called financial leverage. Leverage maximises not only possible profits but also potential losses. It contributes very significantly to the risks involved.
Important Information
Walbrook Wealth Management is a trading name of Barbacane Advisors Pty Ltd (ABN 32 626 694 139; AFSL No. 512465). Barbacane Advisors Pty Ltd is authorised to provide financial services and advice. This post is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or needs, unless expressly indicated otherwise. You should consider whether the information is suitable for your circumstances and where uncertain, seek further professional advice. The author has based this communication on information from sources believed to be reliable at the time of its preparation. Despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice, and we are not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, we accept no liability for any loss or damage as a result of any reliance on this information.
