Uses For Spot Transactions

Client groups, such as corporations, investors, funds and institutions, will use spot transactions as part of their foreign exchange management programmes. Speculators will also, use this market because it is extremely active and liquid with roughly two-thirds of all foreign exchange

Figure 7.3 The spot exchange risk

activity being traded. There can be plenty of movement (volatility) in any one day, which will enable a speculator to possibly benefit from such gyrations.

7.7.1 Risk consideration

It must be remembered that there are risks with spot transactions. Firstly, there is a credit risk. Like the risk a bank incurs when making a loan, a foreign exchange contract poses the risk that the client will not perform according to the terms of the contract (i.e. will not deliver the appropriate currency on time). In a foreign exchange transaction, the market maker and the client agree that each will deliver to the other a specified amount of a currency on a specific date, at an agreed rate. Trading the currencies of countries that are in different time zones compounds the risk.

Secondly, there is a market/price risk. Trading in any currency has a degree of risk. Exchange rate risk is inevitable because currency values rise and fall constantly in response to market pressures. When engaging in a foreign exchange trade, the client's position is open until it is closed or covered. While that position is open, the client is exposed to the risk of changes in exchange rates. A few moments can transform a potentially profitable transaction into a loss.

Thirdly, there is a country risk. Some countries (and their currencies) are more risky than others. Country risk may be due to anything from governmental regulations and restrictions to political situations, or the amount of foreign currency reserves the country holds. However, this risk is usually of less significance. The spot exchange risk is shown graphically in Figure 7.3.

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