Types of Transactions

There are different types of FX transactions:

Spot transactions: This type of transaction accounts for almost a third of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.

Spot Transaction: How it works

A trader calls another trader and asks for a price of a currency, say British pounds.

This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell.

The second trader provides the first trader with prices for both buying and selling (two-way price).

When the traders agree to do business, one will send pounds and the other will send dollars.

By convention the payment is actually made two days later, but next day settlements are used as well.

Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.

Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan.

Tools will be ready in six months and will cost 120 million yen.

At the time of the order, the yen is trading at 120 to a dollar.

U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,00 yen ¸ 120 yen per dollar = $1,000,000)

There is no guarantee that the rate will remain the same six months later.

Suppose the rate drops to 100 yen per dollar:

Cost in U.S. dollars would increase (120,000,000 ¸ 100 = $1,200,000) by $200,000.

Conversely, if the rate goes up to 140 yen to a dollar:

Cost in U.S. dollars would decrease (120,000,000 ¸ 140 = $857,142.86) by over $142,000

One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.

Floating and Fixed Exchange Rates

The FX market was not always quick to respond to changing events. For most of the 20th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard.