Risks inherent in Spot and Forward transactions

In spot transactions, settlements are effected within two working days of striking the deal. Although both payments are to be made simultaneously, because of geographical distance, the differing timing zones and the technicalities of the respective clearing systems, it is only possible to ascertain on the following day whether payment has actually been made by the counter-party, hence the credit risk. Accordingly, when negotiating the deal, it is necessary to ascertain the credit worthiness of the counter-party relative to the amount of the transaction.

In forward transactions, the risks greater as the period is longer during which the circumstances may go against and the financial position of the counter-party could weaken. If for any reason the counter-party is unable to deliver the foreign currency in respect of a forward sale contract or take up the contract in respect of a forward purchase, the bank would have to purchase or sell at current rates to complete the deal, resulting in a loss to the extent the rates have moved adversely. This is termed as the “ten percent risk” whereas if one party fulfills its part of the contract while the other party defaults, this may result in loss of the principal amount, termed the “hundred percent risk”.

Accordingly, when entering into forward contracts, the bank usually takes into consideration the credit-worthiness, past track record and business reputation of the customer and satisfies itself that the customer is entering into a deal for a genuine commercial need and not for speculative purposes.

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