FEMA

Different types of Forex Transactions with Associated Risks

Forex transactions refer to the sale and purchase of the foreign currencies. It is an agreement of exchanging the currency of a country for the currency of another country at an agreed exchange rate on pre-determined date. This transaction involves converting currency of one country to that of the other to settle payments. In this article, we shall understand forex transactions and also look at associated risks. 

Different forms of Forex Transactions

The following are the types of forex transactions:

• Spot Transaction

The quickest method of exchanging currencies is transacting in spot market. In spot transactions, the currencies exchange is settled between buyer and seller within 2 days of the deal. In case of spot transactions, the currencies are exchanged at the existing rate called as Spot Exchange Rate.

• Forward Transaction

In case of forward transactions, the buyer and the seller agree to sell and purchase currency after 90 days period of the agreement at a fixed exchange rate. Forward transactions take place in the forward market.

• Future Transaction

The mechanism of future transaction is similar to forward transactions. However, future transactions are rigid and standardized as compared to the forward transactions in terms of features, date etc. An opening margin is fixed in case of future transactions and kept as collateral to establish a future position.

• Option Transactions

An investor gets the right to exchange the currency in one denomination to another at a fixed exchange rate under the option transactions. However, he isn’t obligated to exercise the option.

• Swap Transactions

Synchronous borrowing and lending of two currencies between two investors fall under Swap transactions.

• Arbitrage

This refers to buying a foreign currency in one market and selling it in the other at a higher price. It allows investors to make profits from the difference in the exchange rate in different markets.

What do you mean by Forex Transactions Risk?

This indicates the possibility of losses that may be incurred when trading in foreign currencies due to the fluctuations in currencies. It outlines the probability that the investments’ worth can decline due to the changes in the relative value of the currencies involved.

Transaction Risk

When an individual enters into a forex transaction, there is often a time lag in agreeing on the terms of the transaction and performing it to settle the contract. This interval creates a short term vulnerability to currency risk that arises from the possible variation in the price of the currency in relation to the other currency.

Such an exchange rate risk associated with the time delay between entering into a deal and its settlement is called the transaction risk. The transaction risk has the potential to cause unanticipated profits as well as losses.

The transaction risk is higher in case the time delay between entering the contract and its settlement is prolonged. This is due to the fact that there would be more time available for the exchange rate to fluctuate.

How can one tackle this transaction risk?

The following strategies can be adopted in order to hedge the transaction risk:

• Investing in forward contracts

A person may invest in a forward contract to be executed at a future date agreed by locking a pre-determined exchange price for the currency^[1].

• Invest in options

A person can make the investment in options in order to reduce the transaction risk. By acquiring the option, the investor won’t be obligated to execute the deal. For instance, the spot rate at the execution time of the option is favourable to the investor, in such scenario, the investor can perform the transaction in the open market rather than exercising the option.  

• Undertake near time contracts

As the transaction risk is directly proportional to the time lag between entering the contract and its settlement, a near time contract must be undertaken to minimize the risk vulnerability.

Conclusion

Risk is intrinsic to every forex transactions. The transaction risk has the potential to cause unanticipated profits as well as losses. However, the risk can be reduced, and the investor can get reasonable control over the profits and losses of the trade by following a strategic and planned approach. 

Read our article:Framework for Possession of Foreign Currency in India