The Spot contract can be used to buy one currency and sell another for near-immediate delivery. Typically, a major currency transferred via this method will be delivered same or next day dependant on the provider settlement terms. Exotic currencies can take up to 3 working days taking into account time differences. This the most basic foreign exchange contract product and the most widely used.
The currency pair and transfer are arranged and money is sent almost immediately subject to the availability of funds.
Benefits and drawbacks of a spot contract
The main benefit of a spot contract is that you can arrange a Quick transfer, ensuring your beneficiary is credited in a timely fashion. It can be made the same day providing the funds are ready to be sent.
The drawbacks are that you may have been able to trade at a better rate if you had been more proactive in your currency management. Essentially, not applying foresight and losing the opportunity of targeting a better exchange rate.
Spot contract example – the importance of timing
A private client visits Spain and decides to purchase a home overseas, but only opens a foreign exchange brokerage account a few days before. They trade at 1.10 having missed opportunities to trade over 1.12.
A Forward Contract
A forward contract or ‘Forward’ allows the client or individual to fix today’s rate for a deliverable date in the future. The benefit of this foreign exchange contract is that the recipient instantly achieves certainty and knows the cost of his transaction in his original currency. The contract can normally be fixed for anything up to 2 years meaning it’s ideal for managing a company’s import cost or property development. The downside is that the future Spot price may be more attractive on the date of execution. Although the risk-averse may still feel very comfortable with the forward contract.
Benefits of a forward contract
A forward contract allows you to lock in a favourable rate for a deliverable date up to 24 months in the future. The benefit is you guarantee a rate the amount of currency you need to pay (base currency) and the amount of foreign currency you receive. This can be very advantageous when dealing with a volatile currency pair.
Example of a forward contract
In this instance, a forward contract has been locked in at GBP/EUR 1.12. The transfer is extremely well timed at the GBP/EUR rate then falls to 1.0863.
the client has avoided a huge erosion in the rate and saved over 3 cents on the money exchanged. As an example, if you were exchanging £100,000 @1.0863 you would end up with £108,630, by locking in a rate at 1.12 the client received €3,370 extra.
The Stop loss contract allows you to set a minimum acceptable level at which you buy the currency and is ideal if your purchase or investment has a set budget. It is also normally used in tandem with an order (see below), which means you have the opportunity to buy high yet protect yourself if the rate goes against you.
Benefits of a stop loss
If a client is unsure about currencies they are exchanging and believes that the pair could lose value a stop loss can be a great way of limiting risk. If the currency pair does lose value a stop loss can be agreed at a certain rate or level and if the rate drops the currency can be purchased automatically. This is beneficial if a company or individual has a ‘worse case scenario’ rate and can be useful to ensure projects stay on budget and that purchase remains viable.
Example of a stop loss
A client feels that the GBP/USD is waning and decides to place a stop loss at the 1.31 mark to ensure his GBP value isn’t eroded due to the currency pairs movement
His thought process is proved correct and he protects himself from a slide in the GBP/USD rate. The pair touching a low of around 1.2795
Market Or Limit Order
A Market or Limit order product allows the recipient or company to target a certain rate. When or even if this pre-agreed rate is achievable the currency provider, broker or bank can purchase the currency automatically on behalf of the client and the recipient achieves the rate they set out to.
Benefits of a Market or limit order
Market or limit orders can be beneficial when a client or company either has time on their hands and is trading a volatile pair or if the currency pair they are trading has trended upwards recently. It allows the client or company to benefit from positive market movements and trade at a superior rate than is currently available.
A market or limit order can also be used in conjunction with a stop loss to cover every eventuality.
Example of a market or limit order
The following client begins to interact with a foreign exchange broker a few weeks before their money needs to be sent to Australia. The broker and the client agree that for several reasons that they feel the GBP/AUD rate will trend higher. Both parties agree to set a limit order for 1.83.
The GBP strengthens against the Australian dollar and the clients limit is triggered at 1.83. seeing a 5 cent rate improvement in just a few weeks.
FX one cancels the other (OCO) contract
The OCO contract allows a client to place a market/limit order and a stop loss for the same transfer. The stop loss is treated as a worst-case scenario rate and the limit or market order as a best-case and ideal exchange rate. Whichever is triggered first the client has to trade at. A one cancels the other contract can be cancelled at any stage providing it has been triggered.
Benefits of a one cancels the other (OCO) contract
The OCO contract allows a client to target a better than current market exchange rate whilst also providing a layer of protection if foreign exchange markets become volatile. A way of capitalising on positive currency movements but limiting the effect of a weakening in the currency pair you are trading.
Example of a one cancels the other contract
A client plans to emigrate to New Zealand. He is ideally looking to trade at 2.00 GBP/NZD but is aware the rate recently has been as low as 1.9044. He agrees with his broker to add a layer of protection (stop loss) at 1.92 and target his ideal rate of 2.00 with a market or limit order. The client being conscious that the GBP/NZD rate could fall victim to FX volatility.
The gbp/nzd fortunately for him trends up and he is able to trade at 2.00 a few weeks later. Saving his a significant amount of money for his relocation to NZ.
An Option contract which tends to come with a heavier spread or margin than the other contracts previously covered allows the party to fix a rate similar to the forward contract but also offers the advantage of the holder to opt for a better rate. Therefore, if a rate is agreed at 1.39 but on the planned day of contract execution a rate of 1.3972 is available the party has the right to opt for the improved rate. This can be extremely useful for a large global business and corporation.
Benefits of an Option contract
An FX option supplies you with the right to yet not the commitment to purchase or sell currency at a specified exchange rate on a precise future day. A vanilla option contract combines 100% security supplied by a forward contract (see above) with the flexibility of taking advantage of currency market improvements and agreeing a better foreign exchange rate.
This works like an insurance policy agreement. In exchange for such a privilege (without the obligation), the option contract holder (client) normally pays a price which is referred to as the ‘option premium’ for the FX option contract.
This feature of FX Options makes them exceptionally helpful for hedging FX danger when the direction of activities in exchange rates is uncertain.
FX Options are handy tools which can be conveniently incorporated with Spot and forward foreign exchange contracts to produce bespoke hedging strategies. FX options can be made use of to create bespoke options and work to eliminate the premium.