Understanding Forex Transactions with Associated Risks

Forex Transactions indicate the sale and purchase of foreign currencies. It is an agreement of exchanging currency of one country for the currency of the other at an agreed exchange rate on a pre-determined date.

1. Different types of foreign exchange transactions
2. Spot Transaction

The fastest way of exchanging currencies is transacting in Spot Market. Under spot transactions, the exchange of currencies is settled between buyer and seller within two days of the deal to enter into such transaction. In spot transactions, the currencies are exchanged at the prevailing rate known as Spot Exchange Rate.

2. Forward Transaction

In forward transactions, the buyer and seller agree to sell and purchase currency after 90 days of the agreement at a fixed exchange rate called Forward Exchange Rate on a pre-determined date. Forward transactions take place in Forward Market.

3. Future Transaction

The primary mechanism of future transactions is similar to that of forward transactions. However, future transactions are more rigid and standardized as compared to forward transactions in terms of features, date and size. Also, an opening margin is fixed in future transactions and kept as collateral to establish a future position.

4. Option Transactions

Under option transactions, an investor acquires the right to exchange the currency in one denomination to another at a fixed exchange rate on a pre-determined date. However, he is not obligated to exercise the option. An option to buy the currency is called a Call Option, while selling the currency is called a Put Option.

5. Swap Transactions

Synchronous borrowing and lending of two different currencies between two investors come under the definition of swap transactions. Here, the agreement consists of exchanging principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency.

The obligation to refund the currencies is used as collateral, and the amount is repaid at a forward rate.

6. Arbitrage

Arbitrage refers to buying a foreign currency in one market and simultaneously selling it in the other at a higher price, thereby allowing investors to make profits from the difference in the exchange rate prevailing simultaneously in different markets.

2. Foreign Exchange Risk

Foreign exchange risk indicates the possibility of losses that can be incurred while trading in foreign currencies due to currency fluctuations.

It outlines the probability that an investment’s worth may decline due to changes in the relative value of the involved currencies.

Transaction risk

When a person enters into a forex transaction, there is often a time lag between agreeing on the transaction terms and performing it to settle the contract. This interval creates a short-term vulnerability to currency risk, which arises from the possible variation in the price of one currency in relation to the other.

Such exchange rate risk, explicitly associated with the time delay between entering into a deal and its settlement, is termed as transaction risk. It can result in unanticipated profits and losses.

The more prolonged the time delay between entering the contract and its settlement, the higher the transaction risk because in such a case, there would be more time available for the exchange rate to fluctuate.

3. How to tackle transaction risk

The following strategies can be followed to hedge transaction risk –

1. Investing in Forward Contracts

A person can invest in a forward contract to be executed at an agreed future date by locking a predetermined exchange price for the currency.

2. Investing in Options

A person can also make the investment in options to reduce the transaction risk. By acquiring an option, the investor will not be obligated to execute the deal. Suppose the spot rate at the time of execution of the option is more favourable to the investor. In that case, he can perform the transaction in the open market instead of exercising the option.

3. Undertaking Near-time Contracts

Since the transaction risk is directly proportional to the time lag between entering in contract and its settlement, a near-time contract should be preferred to minimise risk vulnerability.

Conclusion

Foreign exchange transaction refers to converting currency of one country to that of the other to settle payments.

Risk is an integral part of every forex transaction. But, it can be minimised and the investor can gain greater control over the profits and losses of the trade if a strategic and planned approach is followed.

Authored by CA Manish Gupta and assisted by Kriti Agrawal

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