Foreign exchange rates are affected by a variety of factors. This is because the exchange rate is a key price in two international markets, the market for goods and services and the market for global investments. For that reason, it is understood by economists that exchange rates can sometimes behave in unpredictable ways. The last few years have introduced even more uncertainty and instability in foreign exchange rates. Brexit, Covid, and the conflict in Ukraine are all factors that affect constantly changing rates, making foreign exchange solutions all the more important.
The Russia-Ukraine conflict, for instance, threatens the Eurozone directly, and crucial European countries such as Germany and France are considered to be the most plausible alternatives to dollar assets. Economic research done by Deloitte suggests that “While financial prices and investment behaviour drive exchange rates in the short run, exchange rates tend to revert to levels that allow exports and imports to grow at sustainable long-run levels. The exchange rate at which a basket of traded goods costs the same in both currencies is called the “purchasing power parity” (PPP) exchange rate. Economists have found that, over long periods of time, exchange rates tend to move toward this level.”
In the short run, however, remittances must still be made, and concerns over wildly fluctuating exchange rates are valid. What can an individual or business do to ensure they do not lose a significant amount when dealing with necessary and time-sensitive cross-border remittances?
Foreign Exchange Solutions
The term “foreign exchange solutions” refers to the various financial products and services that allow individuals, businesses, and organisations to manage and mitigate the risks associated with fluctuating foreign currency exchange rates. These solutions include options such as foreign currency accounts, currency conversion and forward contracts.
Foreign Exchange Accounts
A foreign currency account allows individuals and businesses to deposit, withdraw and manage funds in a foreign currency. These accounts are typically offered by financial institutions, like PayAlly, and can be used for a variety of purposes, such as:
- Making international payments: Foreign currency accounts can be used to make and receive payments in foreign currencies. This can be useful for businesses that trade with companies in other countries and need to make payments in foreign currencies.
- Investing in foreign markets: Individual investors may use foreign currency accounts to invest in foreign markets. For example, an investor in the UK may open a foreign currency account in Japanese Yen and use that account to purchase Japanese stocks.
Foreign currency accounts can be opened with most financial institutions and can typically be accessed online or through mobile apps. The account holder may be required to provide identification and proof of residence and may also be required to maintain a minimum balance in the account. Withdrawals and transfers from foreign currency accounts may be subject to fees and exchange rate margins.
Foreign Exchange Conversion
Foreign exchange conversion is the process of converting one currency into another. This can be done for various reasons, such as when making an international payment or investing in a foreign market. Currency conversion can be done in different ways, including:
- Foreign exchange services, such as money transfer services or currency exchange offices, can be used to convert one currency into another. The exchange rate offered by these services will typically include a markup to cover their costs and make a profit.
- Online platforms, such as peer-to-peer exchanges or online brokers, can be used to convert one currency into another. These platforms typically offer real-time exchange rates and allow users to convert currencies quickly and easily.
- Spot transactions: A spot transaction is a type of foreign exchange solution that involves the exchange of one currency for another at the current exchange rate. Spot transactions can be used to convert one currency into another and can be done through a currency exchange service or an online platform.
A forward contract is a type of derivative contract in which two parties agree to exchange a specific amount of currency at a specific exchange rate on a future date. This type of contract is considered a foreign exchange solution because it can be used to hedge against the risk of currency fluctuations.
When entering into a forward contract, the buyer and the seller agree on the following details:
- The amount of currency to be exchanged
- The specific exchange rate at which the currencies will be exchanged
- The date on which the currencies will be exchanged or drawn down before a certain date (multiple payments from forward)
The exchange rate that is agreed upon is called the forward rate, which is determined based on the current spot rate and the interest rate differential between the two currencies.
One of the essential features of a forward contract is that it is a customised or “over-the-counter” (OTC) derivative, which means that the terms of the contract can be tailored to the specific needs of the two parties involved. This allows companies to lock in an exchange rate for a future transaction, which can help them protect against the risk of currency fluctuations. The parties involved in the forward contract are under an obligation to complete the transaction on the specified date and exchange rate, but they do not exchange any money at the time the contract is made.
Despite current events and the ever-changing nature of foreign exchange rates, foreign currency accounts, currency exchange, and forward contracts are some of the foreign exchange solutions available to mitigate the losses incurred when making cross-border remittances. For advice on which solution may work best for your needs, confer with your personal PayAlly Relationship Manager.