INTERNATIONAL BANKING

best practices:

Foreign exchange risk management

Ex Ecu t i v E
S umm a ry

As the aftershocks of the credit crisis fade away, U.S. companies have
resumed their pursuit of global trade opportunities. Companies are
increasing production with overseas partners, importing and exporting
goods and services, and pursuing merger and acquisition opportunities.
Against this backdrop, more and more businesses are addressing their need
for strategic foreign exchange (FX) risk management.
The resurgence of foreign trade combined
with volatility in the global financial markets
heightens the importance of having a foreign
exchange risk management strategy in place.
After all, FX exposure can significantly influence
a companys accounting and economic activities
and affect the strength of its bottom line.

A strong FX strategy begins with a clear

framework. It should include:
Identification of specific risks and how
they impact financials
Measurement and collection of FX risk data
Management of the identified risks
Definition and evaluation of the
programs success
This paper provides a number of
recommendations and best practices to
help you develop a plan to manage the
foreign exchange risk your company faces.

I n Te r n AT Io n Al bA n k In g

Why hedge?
A successful hedging program mutes
volatility in the value of earnings and
the cash generated overseas.
There is a common misperception that hedging is about making money. The
real purpose of a hedging program is to diminish volatility in earnings and
cash flow.
The growth of international trade, combined with the recent volatility
in global markets, has heightened the need for foreign exchange risk
management. but, while a hedging program should not be confused with
a profit center, an active yet prudent risk management plan can add value.
The reason: hedging allows managers to focus on maximizing the operating
value of their firm while minimizing the financial disruptions caused by
market fluctuations.
In fact, academic research by Allayannis and Weston (2001) concluded
that the hedging premium for public companies defined as a higher firm
value can be as much as five percent. It is not just public companies that
hedge; U.S. companies of all sizes now conduct business overseas, and
their numbers are growing.
According to the U.S. International Trade in Goods and Services Reports1,
exports of U.S. goods and services in 2011 rose 14.5 percent to $2.103
trillion, up from $1.838 trillion in 2010. For the month of December
alone, U.S. exports of goods and services were 9.0 percent higher than in
December 2010 and imports increased 11.3 percent over that same period.
This pick-up in overseas activity amplifies not only the need for FX risk
management, but also the need for a successful program. Such programs
require a disciplined strategy to manage FX risk in an orderly manner,
and that begins with a defined methodology to understand and manage
the financial implications of your companys international operations and
expansion plans.

This report is issued by the Department of Commerces U.S. Census bureau and the bureau of economic Analysis.

Develop The FrAMeWork

polICy AnD proCeDUre
Hedging programs, while not universal, are becoming increasingly
popular among global companies. A March 2012 J.P. Morgan
survey conducted among large corporations in Japan, Europe
and the U.S. revealed that global customers had already hedged
approximately 46 percent of their 2012 FX exposure and 13
percent of their 2013 FX exposure.
The framework for a successful FX risk reduction strategy is based on
the creation of a board-approved policy, and it ends with the execution
of that policy.
The formation of such a policy should be guided by five key elements:
Definition of the hedging objectives
establishment of risk management procedures
Definition of the term and percentage exposure to be hedged
Agreement as to the permitted hedge instruments
Delegation of the authority for hedging decisions and execution
In general, the implementation of a policy will involve a number of
best practices. These should include:
Identification of the FX risks
Central measurement and data collection
Management of global FX exposures
Utilization of all prudent hedging tools, including forwards and
options
Determination of the criteria for defining the success of the
program
In the sections that follow, we will look at the best practices for each
element of the framework.

beST prACTICeS: Framing the challenge in foreign exchange risk management

identify risks

if there are plans to sell overseas assets. The translation of a subsidiarys

income statement, however, is significant. It is also difficult to hedge.
however, this risk may be addressable through the proper application of a
forecast risk-hedging program.
To understand how the different risks impact the development of a hedging
program, we will take a closer look at each.

FX risk arises in one of four ways, as the chart below demonstrates.

Forecast risk
Revaluation risk for monetary items
Foreign denominated cash risk
Earnings translation risk

Forecast risk and cash flow hedging

Forecast risk involves future transactions where revenues will be
denominated in one currency and expenses in another. The risk has to do
with the ultimate accuracy of the forecasts for future currency exchange
and how it affects future margins. This can cause the realized value of
receipts to vary significantly from the amount that was budgeted. It can
also lead to differences in period-over-period comparisons. This risk
would arise, for example, when a U.S. manufacturer exports its products
to germany and receives payment in euros (eUr) at some future date.
between the time a sale is projected and the time at which the sale is
made, profit margins will vary with changes in the eUr/USD exchange rate.

The first two exposures, forecast risk and revaluation risk, are transactional
in nature. They apply to the full cash and earnings cycle, running from the
initial budget to the final cash collections and payments.
With forecast risk, budgets are exposed to assumptions that need to be
made about the exchange rates that will be in effect as future foreign
revenues or expenses are generated. As the forecasts are replaced by
actual results, and the foreign receivables and payables are recorded on
the financial statements, the result of currency volatility is transaction
remeasurement risk that impacts current earnings.

hedge accounting treatment is essential in avoiding such earnings volatility.

In the absence of cash flow hedge accounting, the hedge instrument would
have to be revalued at each accounting period (affecting earnings) prior
to the time the sale is recognized. Cash flow hedge accounting enables
the earnings impact of the hedge instrument to be matched up with the
exposure recognition in the income statement.

The other two categories of FX risk foreign denominated cash risk and
earnings translation risk are translational.
The translation of a subsidiarys balance sheet is generally not a key risk
unless there is substantial foreign currency cash held at the subsidiary or

U N D ERSTANDING RI S K: T H E FO U R T Y P E S O F FX R I S K
TRANSACTIONAL RISK
Forecast
Risk
Cash Flow Hedging

Budget

TRANSLATIONAL RISK

Revaluation Risk
for Monetary Items
Balance Sheet Hedging

Sale/Expense

Foreign Denominated
Cash Risk
Balance Sheet Translation

Cash Flow

CONSIDERATIONS FOR IMPLEMENTATION

Earnings
Translation Risk
Income Statement Hedging

Use of Cash/
Repatriation

Translation at
Consolidation

Strategic/long term

Automatic rolling program

Immediately identifiable exposure

Minimized via forecast program

Earnings and cash risk

Earnings and cash risk

Cash risk

Earnings risk

FX risk arises in different ways. Each type of risk has a different

impact on a companys financial results.

I n Te r n AT Ion A l bA n k In g

Cash flow hedge accounting impacts

balance sheets rather than the income
statements over the life of the hedge.
Many companies believe that pricing a forecasted transaction with a
foreign customer or supplier in USD does not incur FX risk since they are
denominated in USD. but this view may be an illusion. In reality, the risk has
simply been transferred to the customer or vendor.
Consider the case of an overseas vendor who accepts payment in USD. That
vendor will have to sell the USD received in payment and purchase local
currency to cover its costs. If FX rates shift, the vendor may attempt to get
a price adjustment for a shortfall. over time, the vendor may seek to raise
its prices or may just be unable to supply the product to foreign buyers. In
short, the transfer of risk to the vendor is real. Therefore, a better solution
may be to pay the vendor in the local currency and manage the FX risk.
This would leave the importer in control of the exposure rather than at the
mercy of the vendors ability to deliver as promised.

Foreign denominated cash risk

The next two risk categories (depicted in the chart on page 2) refer to the
impact a foreign subsidiary has on a parent companys balance sheet and
its income statement.
In such cases, when the parent company consolidates its financial results,
it will have to translate its foreign subsidiarys balance sheet and income
statement into USD. Due to FX rate movements between accounting periods
that translation will result in a gain or loss in the parent companys financial
statements. however, the translation of the balance sheet exposure of
the net investment does not impact earnings. The gain or loss will be
reported as an entry that affects equity.
hedging net investment translation risk is less common than hedging
the other risks we have mentioned because it does not create earnings
volatility. Companies that do hedge this type of risk do it to protect the USD
value of foreign cash held on a subsidiarys balance sheet. They will hedge
in anticipation of a future dividend or against the USD value of the entire
net asset when the divestiture of an overseas operation is planned.
net investment hedge accounting allows the hedge to be marked to market
and reported in equity, bypassing any earnings volatility from hedging this
type of exposure.

revaluation risk and balance sheet hedging

Most companies begin hedging their transaction exposure as it relates
to current earnings and near-term cash generation. because changes in
value of transaction exposures due to FX are reported in current earnings,
cash flow hedge accounting is not required or desirable. Typically, a shortdated forward contract is an effective hedge in these situations. Forwards
are simple to execute and flexible enough to be rolled over into a new
hedge at the end of the period and for a different amount if warranted
by changes in the notional of the exposure. online tools, such as Morgan
Direct Commercial, can make this recurring process more efficient. longerdated exposures, such as intercompany loans, may also be hedged through
the use of forward contracts that have a longer maturity or through
cross-currency swaps. Finally, exposures in high-yield currencies require
additional analysis before they can be addressed through forward
contract hedges.

Earnings translation risk

earnings translation risk exposure arises with the translation of a foreign
subsidiarys income statement. Since hedge accounting is not available in
this situation, it offers a special challenge. As previously noted, this type
of risk can often be managed with a hedge of the anticipated cross-border
cash flows through the forecast risk program.

Transaction exposure involves

receivables, payables, cash or repayable
intercompany loans denominated in
a nonfunctional currency that need to
be revalued when reported as earnings.

beST prACTICeS: Framing the challenge in foreign exchange risk management

measure and collect data

While a U.S. parent may own foreign interests and have subsidiaries that
report in their local foreign currency, it is important to conduct analysis on
a consolidated basis and at the parent level. When risk is measured at the
parent company, the risk management function becomes centralized and
USD-centric. This approach offers a clear advantage to the company.

FX risk is nuanced the way it is

incurred will affect different aspects
of a companys financial operations.

by addressing all sources of FX risk it faces, a company is able to:

Maximize the use of the natural offsets that arise across the enterprise
Increase the control of offshore hedging activity
Minimize transaction costs

collect the risk data

risk management can be less effective when it is decentralized. Assume a

U.S. parent has a subsidiary in germany with eUr-denominated sales and
expenses, which leads to eUr-denominated earnings and free cash flow.
From the parents USD perspective, this represents a long eUr exposure.
but the subsidiary may view the risk differently. If the subsidiarys operating
management is measured in terms of eUr-denominated results, it will be
disinclined to hedge risk, leaving the parent exposed to earnings volatility.
The example becomes more complicated if we assume the subsidiary also
has some USD-denominated sales. given the parent is already long in
terms of eUr exposure, should the parent allow the subsidiary to hedge
the expected USD-denominated revenue sell USD and buy eUr? Such
a trade would actually add to the overall consolidated risk of the firm;
therefore, the subsidiary should not enter into the trade. Situations like
these emphasize the need to consider all risk exposure within a hedging
program, whether it lies at the parent or subsidiary level.

Companies with highly developed risk management practices tend to think

about the organization of their data in the following way:
BAlAncE SHEEt RiSk
Transaction risk data is integrated into the monthly accounting process
in order to hedge effectively.
generally, the booked transaction risk is fairly easy to identify. The
revaluation of the underlying exposures themselves affects earnings, and
unexpected gains and losses are thoroughly investigated.
FoREcASt RiSk
Forecast risk data is integrated into the quarterly or annual budget
process.
Forecast risk can be problematic, especially if a series of foreign
acquisitions has left a company with numerous reporting systems around
the world.
Sales and expense data, listed by the currency in which those
transactions will take place, is gathered before a full forecast hedge
program is implemented.
While the new processes may take a budget cycle or two to fully implement,
the real FX exposures faced by a company will be highlighted if forecasted
data is regularly collected.

I n Te r n AT Io n Al bA n k In g

manage risk
As noted earlier, an approved policy for hedging program procedures
provides guidance for FX risk management.
While some questions may be related to control issues such as who can
hedge and how large of a trade will be allowed before additional approvals
are necessary four of the most important questions to address include:
When should a company hedge?
how much discretion should an FX policy permit?
how far out into the future should a company hedge?
What hedging tools should be utilized?

When should a company hedge?

Some companies lock in the exchange rates related to an annual plan. The
following year, the cycle is repeated, and the next twelve months worth
of risk is covered with a strip of twelve monthly hedges. This approach
effectively locks in the plan for a year and creates a greater level of certainty
in operational results for that year.

In addition, companies that choose to execute hedges monthly rather than

quarterly would follow the same rolling and layering plan, but would also have
more hedges built into the eventual average rate.

H E DGING ONCE A Y E AR
One-Year Back to Budget EUR Hedging Program
1.70

1.40

1.10

Spot

The downside to this approach is that it leads to what is referred to as a

cliff effect.
To avoid the cliff effect, many companies use a rolling and layering strategy,
which is also known as dollar-cost averaging. This approach is recommended
because it reduces the potential volatility in earnings and cash. The rolling and
layering approach involves first choosing a hedge horizon and the percentage
of the exposure to hedge each period. The hedge horizon is typically between
six and eighteen months, depending on factors such as the accuracy of
the forecast, the ability to change prices and the competitive environment.
As trades settle, the desired hedge ratio is maintained by layering in new
contracts.
For example, at the inception of a typical rolling and layering program, a
percentage of each quarters exposure will be hedged within a predefined
range. The nearest quarter may be hedged between 50 and 80 percent
for each month, and the next quarter may be hedged between 40 and 70
percent. This will continue to the maximum hedge horizon. At the end of each
quarter, each months exposure is then adjusted to the predefined hedge
percent.
once the program is active and as each months hedges mature, the result will
be calculated as the average of four rates: one from four quarters ago, one
from three quarters ago, one from two quarters ago, and one from the prior
quarter. over time, this results in dollar-cost averaging and helps smooth out
any unevenness in the programs bottom-line results. This eliminates the need
to ask: Is this a good time to hedge?

0.80
2/02

2/03

2/04

2/05

2/06

2/07

2/08

2/09

Effective Hedge Rate

2/10

2/11

2/12

Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, February 2012.

locking in the rate on an entire years worth of cash flow, which is

executed on a single date, results in a rate that may be an exceptional
rate or an undesirable rate when compared to the hedge rate for the
following year. this predicament is illustrated in the graph above.

A S MO OTH E R R IDE
One-Year Rolling EUR Hedging Program with Rolling and Layering
1.70

1.40

1.10

0.80
2/02

2/03

2/04

2/05

2/06

2/07

2/08

Spot

Effective Hedge Rate

2/09

2/10

Source: Foreign Exchange Risk Management Best Practices, J.P. Morgan, February 2012.

Dollar-cost averaging can smooth out the potential impact of

fluctuating rates.

2/11

2/12

beST prACTICeS: Framing the challenge in foreign exchange risk management

How much discretion should an Fx policy permit?

policies that mandate discipline when hedging forecasted cash flows,
yet allow for some degree of discretion, are generally recommended.
Discretion is especially recommended in terms of:
Whether the company hedges between the minimum required by its
policy and the maximum allowed in any given month
When the company determines it is time to add a layer
The chart below illustrates discretion allowed in a forecasted cash flow
hedging program.

How far out into the future should a company hedge?

each companys ability to forecast is different and changes over time.
however, through the use of the rolling and layering approach, adjustments
may be made to the percentages hedged as new information becomes
available.

GAIN ( LO SS ) O N H EDGE S O N LY
One-Year Hedging Program (%)
100%

% Hedged

When FX rates move in a favorable

direction, forward contracts inhibit
market gains. options, however, allow
participation in such moves.

Maximum Hedged
Minimum Hedged
Company Discretion to Hedge

75%

Most companies have sufficient visibility to hedge 6 to 18 months into the

future. Companies with long-term projects may need to hedge five years or
longer.

50%

What hedging tools should be utilized?

A transaction risk (balance sheet) program should generally rely only on
forward contracts. Typically, cash is collected or paid rather quickly, and the
amounts are known. balance sheet positions in emerging markets require
additional analysis (and perhaps the use of an option strategy), since high
interest rate differentials can adversely impact hedge results over time.

25%

0%
M1

M2

M3

M4

Source: J.P. Morgan, March 2012.

M5

M6

M7

Months

M8

M9 M10

M11

M12 M13

Where a forecasting program is involved, there is naturally more

uncertainty. Therefore, incorporating options products can provide greater
flexibility. The flexibility that options bring to a program can be simply
stated: protection when the FX rate moves in an unfavorable direction, and
participation when the FX rate moves in a favorable direction. This concept
becomes more important as the hedge horizon is extended.
options can lead to an increase in market share, improvement in margins,
or both. While the benefits of options are easy to appreciate, it is important
to consider their associated costs.

I n Te r n AT Ion A l bA n k In g

purchased options typically require a premium at inception (although this

premium can be paid at maturity). To determine whether or not purchased
options represent a better alternative to forward contracts, a comparison
needs to be made between:
FoRwARD contRActS

PURcHASED oPtionS

No cash paid up front

Known and limited

amount of cash
required at inception
or at maturity

Unknown amount of
cash required to settle
remains unknown

vs.

In this context, it becomes easier to evaluate the choice between forward

contracts and purchased options. In fact, in the accompanying charts,
recently conducted historical analysis quantifies the comparison.

The left bar chart below demonstrates that the forward contracts
settlement value can incur a loss when compared to the gain (or smaller
loss) recorded by using options.
In fact, if you include the earnings impact of the exposure plus the hedge in
this analysis, you get an even more interesting cumulative result. The point
here is not that options should always be chosen over forward contracts,
but rather we suggest that options have the ability to provide a much
better outcome than forward contracts over the long term and the longer
the hedge horizon, the more valuable the flexibility offered by options
becomes.
The bottom line is that when it comes to choosing between hedging with
forwards and hedging with options, forwards lock in a specific FX rate. yet,
it is important to note that options turned in the better performance over
this time period, as they were able to capture the markets upside.

Companies that used simple purchased options to hedge forecasted

eUr-denominated sales over the past five years would have had a much
cheaper hedge than they would have experienced with forward contracts.

OPT ION S VS. FO RWA R DS PA RT I

OP TIO NS VS. FORWAR DS PART II

Forwards (selling EUR) vs. Options (buying EUR puts)

8 (in millions)

Forwards
ATM Options
OTM Options
Underlying Result
Spot

1.60

Forwards (selling EUR) vs. Options (buying EUR puts)

12 (in millions)
Cumulative Forward Net of Underlying
Cumulative ATM Net of Underlying
Cumulative OTM Net of Underlying

1.55
10
1.50

1.45

2
1.40
0

6
1.35

-2
1.30
-4

-8

1.25
2

-6

1.20

Y1

Y2

Y3

Y4

Y5

1.15

Source: J.P. Morgan, March 2012

An option premium of 4 or 5 percent may seem like a significant outlay

for a one-year hedge until it is compared to how much it can cost to
settle a forward contract at maturity.

Y1

Y2

Y3

Y4

Y5

Source: J.P. Morgan, March 2012

options resulted in the better performance over this time period, as they
were able to capture the market's upside.

beST prACTICeS: Framing the challenge in foreign exchange risk management

the final step: Determine the programs success

There is a common misconception in hedging that the only good hedge is
one that results in a realized gain. We urge you not to fall into this trap. It is
not unusual for treasury teams to be challenged by their management after
money is lost on a specific hedge. Such reactive behavior has been known
to lead to the cancellation of a hedging program at the bottom of a market
or even worse an attempt to trade the firms way out of a loss. A better
approach is to evaluate the effectiveness of a hedge against the gain or loss
on the underlying exposure.
While it is desirable to benchmark against an ideal hedge program, most
companies do not have the time or resources to complete this analysis.
So how do you recognize a successful hedge program? We suggest the
following be used as a benchmark:
BAlAncE SHEEt HEDging PRogRAM Meetings are no longer needed
at your company to discuss outsized, unexpected results in the other FX
gain/losses line item of the Income Statement.
FoREcASt RiSk PRogRAM your Ceo and CFo can read about a
weaker USD in The Wall Street Journal and know that your companys
overall budget has been positively (as an exporter) or negatively (as an
importer) affected by less than the overall market volatility.

ConClUSIon
As more and more U.S. companies pursue overseas
business opportunities, their need for a well-managed
FX risk management policy increases. Such a policy can
protect both the bottom line and the continued strength
of the balance sheet that supports it.
A well-designed FX policy will clearly define the
procedures and goals of the risk management program.
It will also include:
A list of approved traders
Allowable hedge products
Expected frequency of trading
The amount of discretion that will be permitted
When a company has a well-documented FX policy, its
management team can focus on the pursuit of new

nEt invEStMEnt PRogRAM The consolidated USD value of cash

(which may be trapped in foreign subsidiaries) has remained stable
despite volatility in FX rates.

Comparison of any gain or loss on

a hedge to the loss or gain on the
underlying exposure provides a good
measure of the hedges success.

opportunities for global expansion. This can be done

without undue concern over how previous cross-border
dealings may inhibit the companys financial capacity for
such new pursuits.

I n Te r n AT Ion A l bAn k I n g

STAnDArD heDgIng ToolS

FoRwARDS
Allows a company to lock in a fixed exchange rate for a specific
future date
provides 100 percent protection against negative currency
moves, but does not allow for the opportunity to benefit from
favorable moves
no outright transaction cost or upfront USD payment required
Credit or cash collateral may be required

PlAin vAnillA PURcHASED oPtionS

purchased options provide the company with the right, but noT the
obligation, to exchange a specified amount of currency on a specific
date at a predetermined rate known as the strike price
In exchange for this right, the company pays a premium
(upfront or deferred)
purchased plain vanilla options differ from forward contracts in
that the company is noT locked into an exchange rate and can thus
participate in 100 percent of all favorable market movements
If the company pays an upfront premium for this right, credit or cash
collateral is not required

1.37

No matter where the currency is trading at maturity,

the company will execute the FX transaction at the

1.37

1.32

Forward Rate.

1.32

1.27

The company pays a premium for full protection

from the downside, with the ability to participate in
100% of upside.

1.27

1.22

1.22
1.22

1.27

1.32

1.37

ZERo-PREMiUM collARS
Zero-premium option based strategy
provides protection against adverse currency fluctuations, while
allowing for participation in favorable moves up to a predetermined
participation level
Ability to execute better than the current forward rate if the
market permits
Flexibility in setting range for protection and participation
best-case and worst-case scenarios are known upfront
Credit or cash collateral may be required

The company is fully protected from the downside, and

can participate in upside to a predetermined level.

1.37

1.32

1.22

1.27

1.32

1.37

ZERo-PREMiUM PARticiPAting FoRwARD

Zero-premium option based strategy
like a plain vanilla forward, provides protection against adverse
currency moves at a given rate, yet allows for flexibility to participate
in favorable moves on a portion of the exposure
The company gives up some participation in profit for the benefit of
being fully hedged
The company has flexibility in setting the level of protection and/or
the percentage of participation
Worst-case scenario known upfront
Credit or cash collateral may be required
The company is fully protected from the
downside, and can fully participate in upside
on 50% of the exposure.

1.37

1.32

Protection Level

Protection Level

1.27

1.27

Participation Level
1.22

1.22
1.22

1.27

1.32

1.37

1.22

1.27

1.32

1.37

10

beST prACTICeS: Framing the challenge in foreign exchange risk management

gloSSAry oF TerMS
Base currency: Foreign exchange is quoted as
the number of units of one currency needed to
buy or sell one unit of another currency. The
currency whose value is set at 1.00 is the base
currency.

Forward: Actual exchange of currencies

where settlement takes place more than two
days after the trade at a fixed rate. The forward
price is comprised of the spot rate plus the
forward points.

call option: The right but not the obligation

to buy a fixed amount of a particular currency
at a predetermined strike rate. The purchaser
(holder) of a call option has the right to buy
currency at the predetermined strike rate. The
seller (writer) of a call option has the obligation
to sell currency at the predetermined strike rate
if the option is exercised.

Forward points: points calculated from the

interest rate differential between two currencies,
which is added to or subtracted from the spot
rate. Forward points compensate the buyer of
a higher-yielding currency so that there is no
economic difference between buying the foreign
currency forward vs. buying the foreign currency
spot and putting it on deposit.

confirmation: A communication with the

counterparty of a trade that details the relevant
data for settlement of the trade. Common types
of confirmation include: electronic (e-mail or
over a system), verbal (phone), mail (letter,
memo), or fax.

FX swap: Spot foreign exchange transaction

simultaneously reversed by a forward contract.
The difference in rates reflects interest rate
differentials between the two currencies.

currency appreciation: A rise in the value of

one currency in relation to another.
Deal date: The date on which two or more
parties enter into a contract. The deal date
is also referred to as the contract date or
trade date.
Expiry (date): The last date or only date on
which an option can be exercised.

Hedge: The forward sale or purchase of a

foreign currency (or the execution of an option
strategy) to reduce the exchange risk exposure
connected with the assets or liabilities (or
forecasted transactions) denominated in a
foreign currency.
Mark to market: To calculate the fair value
of a derivative instrument based on the
current market rates or prices of the
underlying exposure.
Maturity date: The settlement date or delivery
date agreed upon for a forward contract.

non-deliverable forwards (nDFs): Synthetic

forwards that entail no exchange of emerging
markets currencies at maturity. nDFs exist due
to tight currency controls from government
regulations. The settlement occurs in U.S. dollars
and is based on the difference between the
agreed contract rate and the market reference
rate at maturity.
Put option: The right but not the obligation
to sell a fixed amount of a particular currency
at a predetermined strike rate. The purchaser
(holder) of a put option has the right to sell
currency at the predetermined strike rate. The
seller (writer) of a put option has the obligation
to buy currency at the predetermined strike rate
if the option is exercised.
Settlement date: The date on which currency is
exchanged or delivered, or on which a contract
settles (also called value date).
Spot trade: Actual exchange of currencies where
settlement takes place two days after the trade
date. (In Canada, spot trades settle one day after
the trade date.)
volatility: A measure of uncertainty. The higher
the uncertainty is, the higher the price of
an option.

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