Question

Define a forward transaction in the foreign exchange market and give an example of how it is used. Define a swap transaction in the foreign exchange market and give an example of how it is used.

Answer 1

Forward transaction for Foreign Exchange Market

Forward transaction for foreign transactions is an agreement entered with the bank to purchase one currency by selling the other currency to get the delivery of the currency at a date in future. In case any person needs to make the payment in foreign currency in future, the agreement is entered with the bank today to make the payment in future at the rate agreed.

Example

There is a firm that must make the payments to the suppliers in USD after 2 months. The firm’s income is in CAD. To mitigate the foreign exchange losses, the firm enters into an agreement with the bank to purchase USD at the rate 1.31 CAD after 2 months.

At the time of making the payment to the suppliers, the firm will get the USD at the rate of 1.31 CAD irrespective of the exchange rate on that day.

In case the rate is higher than 1.31 CAD, the firm gets the benefit of the contract. Else, the forex loss is recognised for the variance.

Swap transaction in the foreign exchange market

Swap transactions in the foreign exchange market consist of the foreign exchange spot transaction and forward transaction. In this arrangement, the parties agree to sell or purchase one currency in exchange of another currency or the same currency at the price agreed in the future date.

Example

The firm dealing in CAD has received 20,000 USD from the customers in USA. The firm needs to pay to its suppliers after 2 months in USD. In such a scenario, the swap transaction in foreign exchange helps the firm to avoid the foreign exchange losses.

The firm enters into a spot transaction to exchange the USD received today with the bank to receive the CAD. Further, the firm enters into a forward contract to repurchase the amount after 2 months at the rate agreed today.