Currency exchange transaction for SME companies

A company, when carrying out its import/export activities, may need to conduct currency exchange transactions. In a currency exchange transaction, an amount expressed in one currency is converted into another currency using an exchange rate as the basis for calculation which depends on interbank valuations on the foreign exchange market.

Here are some of the principles governing the foreign exchange market in addition to the various services that b-Sharpe can provide to you.

The foreign exchange market

The foreign exchange market, generally referred to as forex (i.e Foreign Exchange), is the place where the currency exchange rate, also known as the rate of exchange, is determined by the intersection of supply and demand. These rates are constantly fluctuating throughout the week.

It's a decentralized place which touches almost all currencies in the world. Each currency is represented by a 3-letter ISO code which corresponds to a specific logic: the first two letters represent the country and the last letter represents the currency. For example, for the Swiss franc (CHF), "CH" corresponds to "Heveltic Confederation", and "F" corresponds to "Franc". Anecdotally, the euro is the only exception to the rule, as it has replaced many of the European Union's currencies.

There are two types of currencies:

  • Deliverable currencies: These are currencies that can be exchanged outside the borders of their countries of origin, such as the euro (EUR), the Swiss franc (CHF) and the American dollar (USD).
  • Non-deliverable currencies for which exchange controls exist : These are currencies, such as the Brazilian Real (BRL) or the Indian Rupee (INR), whose exchanges are strictly regulated by their supervising central banks. The main consequence of this type of exchange control is that it's impossible for an agent located geographically outside the country to process these currencies.

How to read a currency valuation

There are three different currency exchange markets:

  • the cash market (also called "Spot"),
  • the forward trading market (also known as "Futures")
  • and the options market.

These three markets are extremely interdependent, and variations in one have an impact on the other two and vice-versa.

The cash (SPOT) market

The cash market is the most common, and all futures and options market valuations are based on the spot market valuation.

In a spot foreign exchange transaction, the exchange rate used to carry out the transaction is the rate at which the currency pair with a value date of two business days is traded at time T.

In other words, if the transaction is conducted on day D, it's "delivered" on day D+2.

The Futures Market

The market for forward futures trading (Futures) differs from the spot market only in the value date of the transaction. The valuation of a futures contract is carried out by taking the spot valuation and adding what are called "forward points" or "swap points".
These swap points, which vary according to the length of the contract, depend on the difference in interest rates between the two currencies. As such, the valuation of a futures contract is in no way a forecast of what the spot valuation will be at maturity.

In specific terms, if a company buys 100,000 EUR at 1.0850 and sells 108,500 CHF at three months, and the spot at time T is 1.0803, this means that there are 0.0047 more futures points, which means that interest rates are higher in Switzerland than in the euro zone.

With this type of transaction, the company agrees to deliver 108,500 CHF, and the other party agrees to return 100,000 EUR, regardless of the price fluctuations between the order date and the expiry of the contract.

What would be the advantages of this type of transaction for a company?

For example, the Swiss company can draw up a quote in EUR for a customer based on a given EUR/CHF rate. However, if at the time of the receipt of payment (which may take place two or three months later), the EUR has fallen, when selling EUR to buy CHF to pay its expenses or otherwise, the company will have lost money.

Placing a futures order would have allowed it to fix the exchange rate as many months in advance as desired, and at the time of receipt of payment, its operating margin would not have been impacted by price fluctuations.

The options market

The options market differs from the futures market in that the buyer only acquires the right to buy or sell a particular currency against another currency. There's no obligation on the part of the option holder to exercise this right.

The option's main factors include:

  • maturity
  • its strike price The strike is the price, if crossed, from which the option is activated.
  • The price of an option, called a prime, is fixed according to the futures price at the expiry of the option, the volatility of the currency pair at the time of the transaction, the strike and the duration.

The higher the volatility, the more expensive the option. The longer the duration, the more expensive the option is as well. And the closer the strike is to the price observed at the time of purchase, the higher the prime will also be.

A company may be interested in buying an option for the same reasons as for buying a futures contract, i.e. to hedge against currency risk. The advantage of an option is that there's no commitment to exercise it.

This means that if, upon expiry, the company does not need to buy or sell foreign currencies, it's not obligated to conduct the transaction that it would have been obligated to conduct with a futures contract.

Discover how b-sharpe can support your SME in its foreign currency exchange transactions.

b-sharpe is the Swiss expert in foreign exchange transactions. Each year, we support hundreds of SME customers who benefit from our expertise as well as from some of the lowest rates in the market.

We advise our corporate clients on the implementation of a currency hedging and currency risk management strategy for import and export transactions. To get started, please contact us!