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All about Foreign Exchange

With the pound at an all-time low against the Euro, everyone is starting to notice the currency markets. Yet most of us don’t fully understand how Foreign Exchange (FX) works, and as a result we might not be getting the best possible deal, losing money in the process.

Added to this, banks don’t always provide consumers with the most competitive rates, which has led to the rise of a growing number of specialist exchanges that are handled by expert FX brokers. So how can you ensure that you are getting the best market rate with the plethora of options that are currently available?

Here, Helen Scott, Managing Director of 4X Currency, provides a comprehensive check list to help ensure you maximise your FX transactions. It covers the five key areas that everyone involved in FX trading should consider identifying the different kinds of exchange rates; understanding how to trade; looking out for hidden costs; ensuring the FX dealer is registered; and the importance of shopping around.

 

Understand the terminology – the three different types of exchange rates

Interbank Rates – This is the rate that banks and big financial organisations deal at amongst themselves and is not a rate for companies or individuals. Interbank Rates are effectively ‘wholesale’ trading prices that are used where large quantities of money are being exchanged. Ceefax and the BBC websites display Interbank Rates but you can’t deal at them. The Interbank Rate changes continuously, often exceeding half a million times per day.

Indication Rates – When a company quotes Indication Rates these are effectively meaningless. This is because an Indication Rate is simply an approximation based on the Interbank Rate at the time in question. A company is not legally bound to provide a deal at this rate and it may be used simply to entice a customer to register with them. A good bank or specialist FX provider would offer an Indication Rate that was fairly close to the Dealing Rate, however it can never be guaranteed.

Dealing Rates – This is the rate at which all foreign exchanges are dealt. Generally speaking, a prospective customer won’t be quoted this rate unless they become registered with either a bank or an FX company. In order to find the best Dealing Rate, it is recommended that you register with about five different providers. When registering you will go through a number of anti-money laundering checks and only then will you be able to receive an accurate Dealing Rate quote.

 

Trading your Money – Not as simple as it may seem?

Being FX knowledgeable involves having an understanding about the different types of trades available.

Spot Trade – This is a transaction based on the current market rate, which is paid for straightaway. It is suitable for anyone wishing to purchase currency straightaway, and pay for it all immediately.

Forward Trade – A Forward Trade is where you fix the exchange rate now for a specific date in the future (up to 1 year ahead). In other words you are ‘buying now, paying later’. To lock yourself into a guaranteed exchange rate you will have to pay for around 10 per cent of the value straight away (a margin deposit) and the balance on or before the maturity of the contract.

For people needing to minimise the risk of exchange rates movements, a forward trade could be the best option, but many are afraid to do so because they don’t fully understand the implications or benefits.
It is an agreement initiated by you to buy or sell a specific amount of foreign currency at a certain rate, on or before a certain date.

Forward foreign exchange contracts are a secure and simple way of hedging when you’re confident your deal will go ahead and the currency will be required.

Imagine you are buying a house in Bulgaria for 100,000 Euros, which will complete in 3 months’ time. One Euro might currently be worth 80 pence, meaning the house would theoretically cost £80,000.However, if the Euro increases in value to 88 pence over the next three months, the house will cost you £88,000.

So if you are worried about the Euro increasing in value, you might agree a forward foreign exchange contract to buy 100,000 euros for £80,000 on a specified date in three months time. Of course, you’ll lose out if the Euro falls in value.

Advantages
• You’re protected against any adverse movements in the exchange rate.
• You can set budgets knowing exactly how much the transaction costs.
Disadvantages
• You have to go ahead with the contract once you’ve arranged it, regardless of whether your circumstances change.
• Because the rate is fixed, you can’t benefit from any favourable movement in the exchange rate.