Foreign exchange
In order to convert the US dollars to the Yuan, we use the exchange rate USD/CNY 6.5766. This therefore means that 1 USD = 6.5766 Yuan. USD100,000 will therefore be 6.5766*100,000 = 657660 Yuan. The Chinese supplier will therefore be paid a total of 657660 Yuan.
Foreign exchange can simply be defined as the currency of a foreign country or the currency of a country that a person or company does not belong to. It can also be defined as the purchase or sale of a country’s currency in exchange for another country’s currency. This transaction is usually carried out in a market setting in order to make it easy for the transacting parties. This market is referred to as the foreign exchange market (forex).
A foreign exchange market is therefore a market where trading of different currencies takes place in order for the traders to be able to meet their financial obligations in foreign countries. Foreign exchange makes it possible for companies operating on the international scope to carry out their business transactions which normally involve conversions of money from one country’s currency to that of another (Carbaugh, 2004).
Foreign currency derivatives
According to Gitman (2007), a derivative can be defined as “a financial instrument whose value is vested in another item such as an interest rate or an asset”. Derivatives are usually in the form of contracts where the parties agree to make payments based on the value of the underlying entity at a particular time in future.
Derivatives are mainly used as a risk minimisation strategy by one party and a return maximisation strategy for the other party. A foreign currency derivative is therefore a financial derivative whose future payment depends on the exchange rate of two or more currencies (Gitman, 2007).
Businesses generally enter in to foreign exchange derivative contracts in order to hedge themselves against the risk of loss due to unexpected adverse movements of the foreign exchange rate of the currencies they trade in. Businesses also use financial derivatives to protect themselves against the risks that are caused by volatility in exchange rates.
They are also used by businesses to negotiate for better terms when seeking financing from banks and other lenders. The trader can therefore enter in to a forward exchange derivative contract to pay the goods in 30 days time if the exchange rate of the USD to the Yuan is expected to depreciate (Michael, 2011).
Types of foreign currency derivatives
A foreign exchange futures contract is defined as a contract which is entered in to by parties in order to exchange a particular currency for another, at a specific date in future. The exchange price is normally agreed upon at the date of purchasing the futures contract and in most cases, one of the currencies is normally the US dollar.
Therefore in this case, the trader can enter in to a foreign exchange futures contract to pay at a particular amount at a future date at an agreed exchange rate. A foreign exchange spot on the other hand is a contract or an agreement between two parties to exchange currencies at a specific exchange rate on the date of entering the contract also referred to as the spot date.
This means that the exchange rate that is agreed upon by the two parties is normally the spot exchange rate. The current example where the trader is expected to pay USD 100,000 at the given exchange rate of USD/CNY 6.5766 can therefore be referred to as a foreign exchange spot contract if it is agreed that he has to pay on that particular date (Mehraj, 1997).
Lastly, it is important to distinguish between a foreign exchange futures contract and a foreign exchange forward contract. A foreign exchange forward contract is the situation where parties agree to buy or sell currency at a future specific date at an exchange rate that is agreed upon today. In this case, the trader and the supplier can agree on the future date of payment and also decide on the exchange rate that they will use. This is normally necessary when a trader does not have the funds to pay for the transaction at hand (Mehraj, 1997).
Bid / Ask Spread
A bid price has been defined by Eiteman, Stonehill & Moffett (2010) as “the highest price that a buyer is willing and able to pay in order to purchase a foreign currency while the ask price is the lowest price that a seller is willing and able to accept in order to sell a particular currency to a buyer”.
In the financial industry, the bid price is commonly known as the bid by financial players while the ask price is commonly known as the offer. The difference between the two prices is what is commonly referred to as the bid / ask spread. This spread is what attracts traders to the foreign exchange market since this is what defines their gains or losses when they trade (Eiteman, Stonehill & Moffett, 2010).
Currency options
A currency option has been defined as a contract that gives the holder the right but not the obligation to engage in foreign exchange transactions at a specified exchange rate and at a specified period of time. This is normally used to hedge against foreign currency exchange risk. A business or person can therefore purchase a call or a put option for this purpose (Hull, 2000).
References
Carbaugh, R. J. (2004). International Economics (9th ed.). Thomson: Mason, OH.
Eiteman, D., Stonehill, A., & Moffett, M. (2010). Multinational Business Finance (12th ed.). Prentice Hall: Upper Saddle River, NJ.
Gitman, L.J. (2007). Principles of Managerial Finance, (11th ed.). Pearson Education: London, UK.
Hull, J.C. (2000). Options, Futures and other Derivatives. Prentice-Hall: Upper Saddle River, NJ.
Mehraj, M. (1997). Structured Derivatives: New Tools for Investment Management: A Handbook of Structuring, Pricing & Investor Applications. Financial Times: London.
Michael, D. (2011). All About Derivatives (2nd ed.). McGraw-Hill: New York.