Basics of Spot Trades, Forwards, and Options
Aug 3, 2022
There are many strategies to manage currency risk and many more theories about the best way to do it. After a few Google searches, you may find yourself deep into an academic analysis of the empirical performance of butterfly Option strategies and conclude that you must need a Master’s degree in finance to properly manage currency risk.
However, the reality is that while some companies use extremely complicated structures to protect themselves from fluctuating exchange rates, most companies use a combination of three basic financial instruments. These are Spot Trades, Forward Contracts, and Options.
Spot trades are extremely common and if you do business internationally, you likely have done many Spot Trades even if you haven’t referred to them that way. Technically speaking, for most currency markets, a spot trade is an agreement to exchange one currency for another and typically the transaction settles in two business days. Many payment service providers and FX brokers may also refer to any transaction that settles in less than two business days as a spot trade. These providers may also settle these transactions more quickly than two business days to help their clients have a good experience. Banks, FX brokers, and many payments companies worldwide facilitate millions of Spot Trades daily for businesses around the world. These companies use Spot Trades to receive a foreign currency and swap it for a local currency or to swap currencies to make a payment in a foreign currency to a provider.
Managing currency risk with Spot Trades is operationally simple. When you receive a foreign currency your bank may automatically convert it to your local currency for you, or they might hold it for you in multiple currency accounts and you convert it to your local currency when you need to.
Another option would be to use a specialist FX broker or online service that provides a better exchange rate and you route your payments through your provider who then exchanges the currencies for you.
The primary advantage of using Spot Trades when dealing with foreign currencies is that it’s a simple process and doesn’t require any forethought.
The primary disadvantage of using only Spot Trades is that you’re subject to the exchange rate on the day of your payments. The day you send or receive an international payment may or may not have a favorable exchange rate for you. As a British company receiving revenue from a customer in USD, you might be disadvantaged if the USD weakens to GBP for unforeseen political reasons for a few days--right at the time the revenue is coming in.
Forward contracts are similar to a spot trade in that it is an agreement between two parties to exchange one currency for another, but the date of the actual settlement is pushed forward into the future. For example, you could agree with your bank to exchange EUR for GBP at an agreed-upon exchange rate in two weeks' time. This is a Forward Contract.
Forward contracts can vary in length, sometimes with parties agreeing to a transaction years into the future.
For companies that try to actively manage their currency risk, Forward contracts are very common. Forward contracts can be used in a number of ways to mitigate currency risk and to make incoming or outgoing cash flows more predictable.
For example, if you operate your business in Italy and owe a Japanese supplier ¥10,000,000 JPY in six months, you could use a Forward Contract to lock in an exchange rate for that payment. With the Forward Contract in place, you know today exactly how much EUR that will cost you. You won’t need to stress about the exchange rate potentially moving against you over the next six months.
In principle, Forward Contracts are easy to understand and they are great for providing predictability for foreign cash flows in the future.
However, in reality, there are some challenges with using Forward Contracts. First of all, in many lines of business predicting the exact timing of any cash flow is difficult. What happens if a customer doesn’t pay you after all? Or if a project gets delayed? A Forward Contract is a binding agreement. When you agree to the trade, you’ll need to honor that obligation. If your underlying payment doesn’t happen or is delayed you still need to fulfill your obligation to your bank or FX broker. Adjusting the timing or amounts of the settlement is possible, but may cost you money.
Also, your bank or FX broker may also require you to hold a minimum balance or place a deposit with them to ensure that you complete the transaction as agreed. If exchange rates move dramatically your deposit may need to be topped up during the lifecycle of the contract. This can create a cash flow challenge for some businesses.
An Option gives you the right, but not the obligation, to exchange one currency for another at a particular time and for a particular amount. Options are used less frequently than Forward contracts and providers of Options are generally regulated at a higher level than providers of Spot Trades or Forward contracts as most regulators consider Options to be complex financial instruments.
In some ways, an Option operates like an insurance policy. When you insure your car, you pay a premium (fee) today and if you get into an accident, your insurer helps you cover the loss. The mechanics may be different, but the principle is similar.
If you are a German exporter and you’ve recently signed a contract with an American customer who agreed to pay you $1,000,000 USD in six months. You likely care about how many Euros will be in your bank account at that time. You manufacture your products and pay your employees in EUR and you want to make sure you have enough EUR to cover those costs and make a fair profit. You could buy an Option to exchange €850,000 EUR for $1,000,000 USD in six months. You will pay a fee today for that Option. Essentially what you’ve done is secure that exchange rate. You pay your Option Premium (fee) today and in six months, you have no obligation to exchange the USD for EUR, but you can if you want.
In practice, this means that you’ll look at the exchange rate when the USD comes in. If the spot rate is more favorable and would net you €870,000, then you simply ignore your Option and exchange with the spot rate. You’re happy that you received more than your minimum expectation. This is like paying for car insurance but never getting in an accident. You paid for the peace of mind to know that you were protected, but you actually didn’t use the insurance company’s money.
However, if the spot rate would only net you €830,000, then you will exercise your Option and your bank or FX broker will exchange the $1,000,000 for €850,0000 and you end up where you expect to be. This is like when you get in an accident in your car and the insurance company has to come in and cover some of your loss.
The benefit of Options is they allow you to benefit from advantageous moves in exchange rates while protecting you from potential losses. They are also highly flexible.
The downside of Options is the cost. You pay for this flexibility.
Something to consider when buying Options is the level of protection you need. The Strike Price for an Option is essentially the insured rate. You should think about the level you want the insurance to activate. Do you want to protect the current exchange rate, after a one percent movement, or only after a more significant change? You can insure whatever rate you want and the Option Premium (fee) will adjust accordingly. It is less expensive to insure a rate far away from today’s current rate as it would take a more significant swing in an exchange rate before your Bank or FX Broker would need to step in to cover your loss.