I’m going to explain what you really need to know about foreign exchange (‘FX’). What is in truth very straightforward, is made complicated by those in whose interests it is to do so. Read this and you won’t be FX’d by anyone ever again.
‘SPOT’ FX – “I WANT FOREIGN CURRENCY TODAY PLEASE”
For a legal professional, perhaps the most common situation involves payment of charges from a foreign firm in local currency; the bill comes in and you want to pay it today. The circumstances are no different to one that we all know well and that I will use to explain the principles involved.
You turn up at the airport and need some cash for when you arrive at your holiday destination. You have US Dollars and want UK Pounds. The exchange rate offered is to buy £1 will cost you US$ 1.4400 (FX rates are quoted to 4 decimal places).
You say “Hey, I thought the rate was 1.3400 – I looked it up on the internet this morning”.
The cashier replies “Sorry sir, the rate you are referring to was probably an interbank rate and would only have been available to you if you had exchanged a million dollars or more, and we don’t handle transactions of that size here.”
“Oh” you say, feeling a little foolish, “I only need £100” and to which the cashier replies, “the cost to you, sir, will be US$ 144.”
In the professional situation, where you are paying an invoice in foreign currency, your objective should be to get the best rate for your client. This may mean negotiating with your bank for better rates or working with some of the challenger currency providers such as CurrencyFair and Transferwise.
In the example, the key difference is between 1.3400 (the interbank rate) and 1.4400 – i.e. 10 cents (or 100 basis points if you want to speak like an FX trader). The provider makes US$ 10 on the deal and the profit is built into the rate so if you change your mind and want £500 then the provider makes US$ 50.
FORWARD CONTRACT – “I WANT A SPECIFIC AMOUNT OF FOREIGN CURRENCY ON A SPECIFIC FUTURE DATE”
Example: You have to send a payment of US$ 10,000 to pay an agreed fee to a US patent agent six weeks from now and want to be sure that you collect the right amount from your client in advance. You ring your bank.
You say “I need US$ 10,000 in six weeks’ time. How much is that going to cost me in addition to the spot price?”
The bank’s FX person replies, “at this time interest rates are the same for US Dollars and Sterling for the six-week period, so the spot and forward rates are the same – I can give you a rate of 1.3100”.
“What if the interest rates had been different?” you might ask.
The answer is quite simple:
- You always start with the spot rate on the day you negotiate the forward contract.
- If the interest rate earned by the currency you have is higher than the currency you want then the forward contract will have a cost (a ‘hedging’ cost) and will be reflected in the rate – essentially you will get a worse rate than the spot rate.
- If the interest rate earned by the currency you have is lower than the currency you want then the forward contract will have a gain (a ‘hedging’ gain) and will be reflected in the rate – essentially you will get a better rate than the spot rate.
WHY DO INTEREST RATES MATTER?
If you enter into a forward contract that matures in six weeks then it is assumed that you and the bank will each place the money on deposit for six weeks earning the relevant interest rate. So, if there is a difference then that difference is applied for the period (six weeks) and added as a cost, or as a gain, depending which currency earns more.
FX BUYING POWER
If you are regularly handling large foreign exchange transactions then the spot rates you get should be nearer to the interbank rate. Buying power does not influence the hedging cost (or gain) in a forward contract as that is determined by interest rate differentials alone.
CONCLUSION – LET THERE BE NO UNCERTAINTY!
Legal service firms do not need to take risks with FX. There is no need for uncertainty. Charging for FX risk that does not, and need not, arise must be wrong. Charging for organising FX transactions may well be a service that firms wish to charge for, in which case those charges are professional fees that should be made clear to clients in advance.
This post was originally published on pacipr.com.