Globalisation has dramatically expanded investors’ opportunities beyond domestic markets. Financial advisers in Australia now routinely encounter clients with assets, income, or liabilities in foreign currencies. International equities, overseas property investments, and cross-border business dealings are increasingly common. While global diversification offers higher return potential and broader diversification, it also exposes clients to foreign exchange (FX) risk. FX risk – the possibility that currency movements will affect investment values or costs – has become a critical consideration in financial planning.
This guide provides a comprehensive overview of foreign exchange fundamentals for financial advisers. It explains how FX markets function, what drives exchange rates, and the role of central banks. It examines the impact of currency fluctuations on client portfolios and outlines the main FX instruments (such as forwards and options) available to manage currency risk. The guide also discusses practical hedging strategies and illustrates how advisers can help clients mitigate unwanted FX exposures. Finally, it covers the taxation of FX gains and losses in Australia and compares key regulatory frameworks (ASIC, FCA, SEC/CFTC) to highlight compliance obligations when dealing with FX transactions. Throughout, best-practice insights and research findings are included to ensure the content meets Continuing Professional Development (CPD) standards for Australian financial planners. By the end, advisers should be equipped to identify FX risks, clearly explain their implications to clients, and recommend appropriate risk management strategies in line with global best practices and ethical standards.
Overview of Foreign Exchange Markets
The foreign exchange market is the largest and most liquid financial market in the world. As of 2022, global FX trading volume reached an astonishing $7.5 trillion per day, reflecting the immense scale of currency transactions worldwide. Unlike centralized stock exchanges, the FX market is a decentralized over-the-counter (OTC) network with no single physical location. Trading occurs electronically 24 hours a day across major financial centers – beginning each week in Sydney and Tokyo, moving through London (the largest FX hub), and then New York, before the cycle repeats. This continuous global operation means exchange rates can fluctuate at any time in response to economic news or market sentiment.
Key Participants: A wide range of players participate in FX markets:
Market Structure: Most FX trading is OTC, meaning trades are bilateral agreements between parties (often through electronic trading systems operated by banks or dealers). There is no centralized exchange setting currency prices; instead, exchange rates are determined by the continuous flow of buy and sell orders globally. Prices are quoted as currency pairs (e.g. AUD/USD = 0.75 means 1 AUD is worth 0.75 USD). Each pair has a “base currency” (first) and “quote currency” (second); the quote tells how many units of the quote currency equal one unit of the base. Currencies are identified by three-letter ISO codes (AUD, USD, EUR, JPY, etc.). The FX market operates on a bid-offer spread system: dealers quote a bid (price they will pay for the base currency) and an ask/offer (price they will sell the base currency), earning the spread as profit for providing liquidity. For major currency pairs like AUD/USD, spreads are typically very tight (reflecting high liquidity), while exotic or thinly traded currencies have wider spreads.
There are a few exchange-traded elements in FX markets: currency futures and options are traded on exchanges (like the Chicago Mercantile Exchange), and currency exchange-traded funds (ETFs) trade on stock exchanges. However, these are a small portion of total FX activity. The vast majority (over 95%) of FX volume is OTC interbank trading. Within the OTC market, various instruments are used (explained in a later section on FX instruments), including spot transactions, forwards, swaps, and options. Notably, FX swaps (which involve exchanging currencies and reversing the exchange later) account for over half of daily global turnover. These swaps are heavily used by banks and companies for short-term funding and hedging. Spot transactions (outright currency buys/sells for near-immediate delivery) make up roughly one-quarter to one-third of turnover, while outright forward contracts comprise around 15%. Options and other instruments form the remainder.
Market Liquidity and Hours: The FX market’s depth and continuous operation generally ensure high liquidity in major currencies. This means large orders can typically be executed quickly without causing excessive price swings. It also means exchange rates react quickly to new information. For example, if economic data or a central bank announcement surprises markets, currency values can adjust within seconds. Advisers should be aware that currency quotes can change overnight; a client’s overseas investments might gain or lose value due not only to market moves in the asset but also due to AUD’s movement while the client sleeps.
In summary, the FX market is a globally integrated, around-the-clock marketplace connecting a diverse set of participants. It underpins international trade and investment by enabling currency conversion and risk management. For advisers, understanding this market’s scale and structure provides context for why exchange rates move and how easily (or not) clients can transact or hedge currency exposures.
Drivers of Exchange Rate Movements
Exchange rates are essentially prices of currencies, and like any price they are determined by supply and demand. If more market participants want to buy Australian dollars than sell them, the AUD will appreciate, and vice versa. However, currency values are influenced by a complex mix of economic fundamentals, market sentiment, and external events. Some factors affect exchange rates over the long term, while others cause short-term fluctuations. Below we outline the key drivers:
1. Interest Rate Differentials: Perhaps the most important fundamental driver of exchange rates is the difference in interest rates between countries. Investors seek higher returns, so if Australian interest rates rise relative to other countries, Australian-dollar assets become more attractive. Foreign investors will demand more AUD to invest in Australian bonds or deposits, and domestic investors will be less inclined to invest abroad (reducing AUD selling). This higher demand and lower supply of AUD tends to push the currency up. Conversely, if Australian rates fall below other major economies’ rates, capital may flow out in search of yield, weakening the AUD. The Reserve Bank of Australia’s monetary policy decisions thus have a significant influence on the AUD’s value. In general, all else equal, a currency tends to strengthen when its home country’s interest rates increase relative to other countries (and tends to weaken when its rates decline relative to others). This relationship underpins the concept of “carry trade” – investors borrow in low-interest-rate currencies and invest in high-rate currencies, profiting from the rate differential, which in turn can support the high-rate currency’s value. However, interest rate expectations can be just as important: currency markets often move in anticipation of future rate changes (based on central bank signals or economic data).
2. Inflation and Purchasing Power: Over the longer term, relative inflation rates impact currency values through purchasing power parity (PPP). In theory, if one country’s inflation is consistently higher than another’s, its currency should gradually depreciate to offset the loss of purchasing power. For example, if Australia has higher inflation than the US, prices of Australian goods rise faster; demand for those goods (and AUD) may fall as they become relatively expensive, leading to AUD depreciation until Australian goods are competitively priced again for foreigners. PPP tends to act as a long-run anchor for exchange rates, but in the short run exchange rates can deviate from PPP significantly. Still, very high inflation or hyperinflation will swiftly erode a currency’s value – as seen in extreme cases globally – because each unit of currency buys much less than before.
3. Terms of Trade and Commodity Prices: For commodity-exporting countries like Australia, terms of trade (the ratio of export prices to import prices) is a crucial driver. When commodity prices (like iron ore, coal, LNG – major Australian exports) rise strongly, Australia’s terms of trade improve. Foreign buyers need more AUD to purchase Australian exports, boosting demand for AUD. Historically, the Australian dollar has shown a positive correlation with commodity prices, earning it the label “commodity currency.” During the mining boom of the 2000s, surging export prices led to record-high AUD exchange rates (at one point exceeding parity with the USD). Conversely, a collapse in commodity prices can hurt the AUD. The terms of trade effect also links to economic prospects: high commodity prices often signal robust global demand and a stronger Australian trade balance, attracting investment and supporting the currency.
4. Trade and Current Account Balances: The flow of goods and services between countries drives currency demand/supply. When Australia runs a trade surplus (exports > imports), foreign buyers are converting more of their currency into AUD to pay for Australian exports, which supports the AUD’s value. If Australia imports heavily (trade deficit), Australians are supplying AUD to buy foreign currencies for imports, which can weigh on AUD. The current account (which includes trade plus income flows) similarly reflects net currency flow. That said, modern economies often experience situations where capital flows (investment flows) dominate trade flows in moving exchange rates. Nonetheless, sustained current account deficits could contribute to gradual currency weakness over time, while persistent surpluses can be a strength factor.
5. Capital Flows and Investment Sentiment: Beyond trade, capital flows (money moving for investments) are a major influence. This ties in with interest rates as discussed, but also general investor sentiment about a country. If global investors view Australia as an attractive investment destination – due to strong economic growth, political stability, or other opportunities – they will move capital into AUD assets (stocks, real estate, businesses), boosting the AUD. On the flip side, if international sentiment towards Australia or the region turns negative (e.g. concerns about an economic downturn or geopolitical risk), capital outflows may occur, putting downward pressure on the currency. One aspect of capital flow is foreign direct investment (FDI) – for example, a foreign company acquiring an Australian company would need to buy AUD to complete the purchase. Another aspect is portfolio investment – global fund managers adjusting their allocations to Australian vs. foreign securities. Australia has historically run current account deficits offset by capital inflows (foreign investment funding the gap), which means global risk appetite can significantly impact the AUD.
6. Risk Sentiment and Safe Havens: In the short term, currencies are often swayed by global market sentiment – the appetite for riskier investments versus safe assets. The Australian dollar is often considered a “risk-sensitive” currency. In periods of global optimism and equity market rises (risk-on environments), investors tend to seek higher returns in riskier assets, and currencies like AUD (and other commodity or emerging market currencies) often appreciate. In contrast, during global market stress or uncertainty (risk-off periods), investors flock to perceived safe havens. The US dollar, Japanese yen, and Swiss franc are traditional safe-haven currencies that investors buy during crises, causing those currencies to strengthen while risk-sensitive currencies fall. This dynamic was evident during the early 2020 COVID-19 market panic: the AUD, which is tightly linked to global growth expectations, depreciated sharply as investors sought safety in USD and JPY. Subsequently, as markets stabilized and risk appetite returned, AUD recovered. For advisers, it’s important to recognize that in a diversified portfolio context, the AUD tends to fall when global equities fall, which actually cushions Australian investors’ offshore assets (more on this in the next section). The inverse relationship between AUD and global risk sentiment is a key nuance in managing currency risk.
7. Economic Growth and Outlook: A country’s economic performance and growth outlook influence its currency. Strong GDP growth, low unemployment, and robust productivity tend to attract investment and strengthen a currency (as they signal good returns and possibly higher interest rates ahead). Conversely, a weakening economy can lead to a weaker currency as investors anticipate possible rate cuts or lower corporate earnings. In Australia’s case, factors like China’s demand (as a major export destination) indirectly affect AUD: if China’s economy is booming and buying more Australian commodities, that bodes well for AUD; if China slows, the AUD may soften due to expectations of reduced export revenue.
8. Political and Fiscal Factors: Political stability and government policies also play a role. Currencies generally prefer stability – a sudden change in government, geopolitical tensions, or policy uncertainty can deter investment and weaken a currency. On the other hand, market-friendly policies or resolution of political uncertainty can boost confidence in a currency. Fiscal strength is relevant too: if a government runs very large budget deficits and accumulates debt, over time investors may lose confidence, fearing inflation or default, which could devalue the currency. That said, in developed economies like Australia, moderate deficits are normal and financed by foreign investors; only when fiscal paths look unsustainable might the currency be penalized significantly.
9. Central Bank Actions and Jawboning: Beyond interest rate setting, central banks can directly or indirectly influence exchange rates through their communications and actions. “Jawboning” refers to verbal interventions – officials hinting that a currency is too high or too low in an attempt to nudge it. For example, RBA or government officials might remark that a very strong AUD is hurting exports, signaling a preference for a lower AUD, which markets sometimes heed by selling the currency. Direct FX intervention is when a central bank actually buys or sells its own currency in the market to move it. Australia’s exchange rate has floated since 1983, and the RBA rarely intervenes nowadays – only in disorderly market conditions or if the AUD is extremely misaligned with fundamentals. The last notable RBA intervention was during the 2008 Global Financial Crisis, when it bought AUD to stem a precipitous fall and restore market liquidity. Generally, in major economies, direct interventions are infrequent; however, some central banks (e.g. the Swiss National Bank or Bank of Japan) have been more active at times in curbing their currencies. For advisers, the key point is that central banks set the backdrop via monetary policy and can, in exceptional cases, step in to counteract excessive currency moves.
10. External Shocks and Events: Unforeseen events – natural disasters, pandemics, geopolitical conflicts – can cause abrupt currency movements. Such events often trigger flight-to-safety flows or disrupt trade relationships. For instance, geopolitical tensions (like war) might weaken currencies of countries seen as riskier or directly involved, while boosting safe havens. Trade wars or tariffs can also hit currencies by altering trade balances and growth prospects. In a more positive sense, a discovery of a major natural resource or a tech boom in a country could strengthen its currency through improved economic prospects.
Short-Term vs Long-Term: It’s important to distinguish short-term volatility drivers from long-term trends. Day-to-day, currencies might swing on market sentiment, news headlines, or traders’ speculative positions. Over months and years, fundamental factors like interest rate differentials, relative inflation, and economic growth drive broader trends. For example, the interest rate inversion between the US and Australia in recent years (with U.S. rates rising above Australia’s) contributed to a weaker AUD for a time. But if the cycle turns (Australia’s rates move higher relative to the US), that fundamental could fuel a trend reversal. As an adviser, one cannot predict these movements with certainty, but understanding the causes aids in explaining portfolio impacts and making informed decisions on hedging.
In summary, exchange rates are shaped by a confluence of macroeconomic fundamentals (rates, inflation, trade), market psychology (risk appetite, momentum), and policy influences. The Australian dollar’s value at any given time reflects the interplay of Australia’s economic conditions and global factors. Recognising the key drivers of currency fluctuations enables advisers to better anticipate how and why FX changes might affect client portfolios.
The Role of Central Banks in FX Markets
Central banks warrant special attention in any FX discussion because of their dual role: they influence exchange rates indirectly through monetary policy and sometimes directly via intervention or reserves management.
Monetary Policy Influence: Central banks set benchmark interest rates (like the RBA’s cash rate or the US Federal Reserve’s federal funds rate) to manage inflation and economic growth. As discussed, these interest rates are a primary driver of currency values. When a central bank raises rates, it often boosts the currency’s value by attracting capital – this is known as “tightening bias” benefiting the currency. Conversely, cutting rates (“easing”) tends to weaken a currency as yield-seeking funds flow out. Importantly, currencies are forward-looking: traders respond not just to current rate changes but to guidance about future policy. If a central bank signals it will hike faster than expected, the currency usually jumps in anticipation. For example, if the RBA adopts a more hawkish tone due to rising inflation, markets may bid up the AUD even before rates actually rise.
Central banks also deploy unconventional policies (quantitative easing or tightening, asset purchases) which can affect currencies. A major expansion of money supply via quantitative easing can put depreciation pressure on a currency (all else equal) because increasing the supply of currency in circulation can dilute its value. The era of ultra-low global rates and QE after 2008 saw some currencies weaken as a side effect (e.g. the Japanese yen under aggressive Bank of Japan easing). On the other hand, when central banks unwind stimulus and reduce liquidity, currencies might strengthen if higher yields are expected.
FX Reserves and Intervention: Central banks hold foreign exchange reserves – large stockpiles of foreign currencies – mainly for crisis management and to maintain confidence. In Australia’s case, the RBA holds reserves (mostly in USD and other major currencies) and can use them to intervene in FX markets if needed. As noted, Australia has a free-floating currency policy, so routine intervention is not practiced. But the central bank stands ready to step in during disorderly market conditions, such as a rapid, liquidity-starved drop or spike in AUD that is not justified by fundamentals. By buying or selling its currency (using its FX reserves), a central bank can sometimes stabilize an unruly market. Such moves are generally defensive and meant to calm markets rather than target a specific long-term exchange rate.
Some other central banks have more active exchange rate policies. For instance, the Swiss National Bank for years intervened to prevent the Swiss franc from appreciating too much (even setting a peg at one point) because a too-strong franc hurt their economy. China’s central bank manages the renminbi’s value within a band, using tools to guide it. These examples highlight that in certain cases, exchange rates are not purely free-market determined but are managed as a policy tool.
For advisers dealing with major freely floating currencies (AUD, USD, GBP, EUR, etc.), direct intervention is rare enough that it usually only matters in extraordinary times. However, central bank communications are a daily factor – when Fed or RBA officials speak, currency markets listen closely. Sudden hawkish or dovish statements can move FX rates within minutes. Advisers should therefore be aware of the monetary policy calendar (e.g. scheduled central bank meetings, speeches, and economic data releases) since these often lead to FX volatility that can impact client portfolios.
Currency Wars and Competitiveness: A concept relevant to central banks is the idea of “currency wars” – when countries attempt to devalue their currencies to gain competitive trade advantage (since a weaker currency makes exports cheaper and can boost domestic growth). While no central bank admits to targeting exchange rates outright, there have been periods (for example, post-2008 financial crisis) where multiple central banks eased policy aggressively, indirectly depreciating their currencies. This can create tensions (one country’s export gain is another’s loss). The G20 generally discourages explicit currency devaluation policies, but advisers should note that at times central banks have been under political pressure to help exporters via a weaker currency. The 2024 comment by a US politician about “we have a big currency problem” – referring to a strong USD hurting manufacturing – exemplifies the kind of rhetoric that can emerge. If such pressures mount, they might influence central bank bias or prompt talk of intervention, which currency markets would factor in.
Summary: Central banks are pivotal in FX for two main reasons. First, their policies on interest rates and liquidity set the fundamental backdrop that currencies respond to. Second, in exceptional cases they may act directly to influence exchange rates for stability or competitive reasons. For advisers, understanding central bank roles means knowing that FX movements often hinge on central bank policy expectations. It also means recognizing that extreme currency values might provoke a response. Keeping an eye on central bank commentary and policy decisions is thus essential for anticipating possible FX impacts on client situations.
Impact of Currency Movements on Client Portfolios
Foreign exchange fluctuations can significantly affect investment performance and financial outcomes for clients. When a client holds assets or liabilities denominated in a foreign currency, changes in the exchange rate between that currency and the client’s home currency (AUD for Australian clients) will alter the home-currency value of those holdings. Advisers need to identify such exposures and consider both the potential risks and, sometimes, benefits of currency movements. Below, we explore how currency changes impact various aspects of client portfolios and financial plans:
Investment Returns and Portfolio Value: Perhaps the most common context is an investment portfolio with international assets. For example, imagine an Australian client owns a portfolio of global equities via an unhedged international equity fund. Suppose over a year the global equities gain 5% in their local markets. If during that year the Australian dollar depreciates by 10% against those foreign currencies, the client’s return in AUD will actually be higher than the local market return – roughly 15% – because the foreign assets are worth more in AUD terms once converted (the weaker AUD makes each unit of foreign currency translate to more AUD). Conversely, if the AUD appreciates, it can eat away or even completely negate positive foreign-market returns. For instance, if global equities rose 5% but the AUD rose 10%, the client might see a loss in AUD terms (approximately –5%) because the currency gains reduce the local asset gains when converting back to AUD.
In other words, currency movement adds a second layer of volatility on top of the underlying asset’s own performance. This can either boost returns or detract from them, depending on the direction of the currency move. Over long periods, currency effects may even out (especially among major currencies if they mean-revert around fundamentals), but in the medium term they can dominate investment outcomes. A stark illustration was the period from mid-2014 to early 2015 when a sharp rise in the US dollar significantly reduced the AUD value of international assets for unhedged Australian investors – one analysis noted that a surging USD over about 9 months wiped out around $1 trillion of value from U.S. pension funds’ non-US assets. Australian portfolios saw the opposite effect in that case (a benefit from USD strength), but the point remains: currency swings can greatly sway portfolio valuations.
Portfolio Volatility and Risk: The effect of currency can either increase or decrease overall portfolio volatility, depending on correlations. For Australian investors, the AUD has historically had a positive correlation with global equity markets (it tends to rise in good times and fall in bad times). This is important: when an Australian investor holds foreign equities without hedging the currency, during a global market downturn those foreign equities might drop in value, but the accompanying fall in AUD provides a cushion (foreign currencies like USD strengthen, boosting the AUD value of the holdings). This diversification effect can reduce overall portfolio drawdowns and volatility. A case in point is the COVID-19 crisis in March 2020: Unhedged global equity funds for Australian investors fell far less than their hedged equivalents. Data shows that in March 2020, an unhedged global equities index fell around –20%, while the same index hedged to AUD fell roughly –33%. The 13% performance gap was because AUD fell sharply and propped up unhedged asset values. As markets rebounded later (and AUD recovered), the hedged portfolio caught up, but during the crash the unhedged position provided valuable downside protection.
Over the long run, studies and historical analysis indicate that for Australians, leaving some portion of foreign equity exposure unhedged can lower portfolio volatility. In fact, an internal analysis by investment researchers found that a diversified portfolio’s volatility was minimized when about 0% to 30% of the foreign equity exposure was hedged (and 70–100% left unhedged). Fully hedging foreign equities often resulted in higher volatility for Australians, because it removes that natural hedge of AUD falling in bad times. By contrast, for investors whose home currency is a safe haven (like a Japanese or US investor), unhedged foreign assets can increase volatility, and more hedging tends to reduce it. This underscores that the optimal hedging policy can depend on the home currency’s characteristics. For Australians, the AUD’s “risk-on” nature means unhedged foreign investments provide a bit of protection in downturns, whereas for say a US-based investor, unhedged foreign investments can amplify losses in a crisis (since USD typically strengthens, hurting their unhedged foreign holdings).
Income Streams and Expenses: Currency movements affect not just investment principal, but also income streams. Consider an Australian retiree receiving a pension from the UK or dividends from overseas stocks: if the AUD strengthens against the foreign currency, each payment converts to fewer AUD – effectively a pay cut. If the AUD weakens, their foreign-sourced income is worth more in AUD. Similar risks apply to someone planning for overseas expenses. For example, a family intending to pay for a child’s university education in the United States in a few years faces uncertainty about how many AUD will be needed to cover, say, $50,000 USD of annual tuition. If today 1 AUD = 0.75 USD (so AUD1 = USD0.75), $50k USD costs about AUD66,667. But if in two years the rate is 0.65 (AUD has weakened), that same $50k would cost ~AUD76,923 – a substantial increase in the AUD outlay. On the other hand, if AUD strengthens to parity (1.00 USD), $50k would cost only AUD50,000. Such currency swings can dramatically impact budgeting for overseas travel, education, or property purchases. Advisers should identify clients with known future foreign-currency expenses or liabilities and plan for the FX risk accordingly (for instance, using forward contracts to lock in rates as discussed later).
Asset Values and Balance Sheet Effects: Some clients may have foreign assets like real estate or businesses abroad. The home-currency value of those assets will rise or fall with exchange rates, even if the underlying asset’s local value is steady. An Australian who owns an apartment in New York sees the AUD value of that property fluctuate as AUD/USD moves. If AUD drops, the Aussie’s net worth (in AUD terms) rises, and vice versa. Similarly, any foreign-currency-denominated debt (such as a mortgage on an overseas property or a margin loan in foreign currency) will have changing AUD costs. A depreciating AUD makes the debt larger in AUD terms, potentially a nasty surprise if not managed.
Managed Funds and Unit Price Variability: Many managed funds or ETFs offer both hedged and unhedged versions for international assets. Advisers need to help clients understand that the performance of these can diverge markedly due to currency moves. For example, global equity ETF “A” might be unhedged and ETF “B” hedged; over a period, “A” could outperform “B” simply because of a falling AUD (even if the underlying stocks performed the same in local terms). The choice between hedged vs unhedged vehicles is a strategic decision balancing risk vs return expectations. If a client strongly believes the AUD will weaken in coming years, they might favour unhedged (to gain from that weakness). If they worry about AUD strength or just want to eliminate currency noise, they might choose hedged. Often, a 50/50 approach is used by diversified funds to get some of both benefits.
Psychological and Communication Aspects: Currency-driven fluctuations can be confusing or alarming to clients if they are not expecting them. A client might question why their international fund did “worse” than a local index even if foreign markets did well – not realizing a strong AUD offset those gains. Conversely, they might be puzzled by gains when markets fell, due to currency. This puts a premium on advisers’ ability to clearly explain the impact of FX changes. Using simple examples (like “if the AUD goes up, your US shares are worth less in AUD, and here’s why”) can help set expectations. It’s also important in performance reporting – attributing how much of a portfolio’s return came from investment selection vs. currency movements – so clients understand the source of outcomes.
Diversification and Unintended Bets: Lastly, advisers should recognize that leaving currency exposures unhedged is effectively taking a position (bet) that may or may not be intended. An Australian holding unhedged US stocks is not only betting on the stocks but also on USD relative to AUD. If the client’s goal was pure exposure to global equities, the currency fluctuation is an ancillary bet that could be unwanted. On the other hand, some advisers deliberately keep currency exposure as a diversifier or even as a tactical view (e.g. “we expect AUD to fall, so we’ll overweight unhedged foreign assets this year”). The key is intentionality – being aware of the currency risk and either accepting it for strategic reasons or mitigating it if it doesn’t align with the client’s risk profile.
In summary, currency movements can significantly impact both the returns and the risk profile of client portfolios and cash flows. A fall or rise in the Australian dollar can transform investment outcomes – sometimes for the better, sometimes for worse. Advisers must assess each client’s direct and indirect currency exposures, communicate the potential effects, and decide whether to neutralize those effects or embrace them as part of the strategy. This sets the stage for discussing FX risk management tools and hedging techniques in the following sections.
Foreign Exchange Instruments and Their Uses
To manage foreign exchange transactions and risks, a variety of financial instruments are available. Advisers don’t necessarily need to execute these instruments themselves (often banks or specialists will handle the trades), but understanding how they work is crucial for recommending strategies. Here we describe the main FX instruments – from basic to more complex – and their practical applications, particularly in hedging currency risk for clients.
Spot Foreign Exchange
The spot market refers to the purchase or sale of a currency for almost immediate delivery. “Spot” settlement for major currencies typically occurs two business days after the trade date (T+2), although some pairs settle T+1. A spot FX transaction is essentially what you do when you go to a bank or exchange booth and convert money for travel – it’s a straight exchange of one currency for another at the current market rate. In the context of advisers, a spot transaction might be used when a client needs to convert a sum of money from one currency to another without delay. For example, if a client inherited $100,000 USD and wants to convert it to AUD now, the spot market provides the prevailing exchange rate to do so. Spot rates are quoted with a bid/ask spread as discussed, and for retail clients there may also be fees or slightly wider spreads at banks or forex dealers.
Use Cases: Spot transactions are useful for immediate needs: funding a foreign purchase, repatriating overseas income, or rebalancing a portfolio’s currency allocation. They do not provide any protection against future moves – they simply execute at the current rate. If a client has foreign currency on hand and fears the exchange rate might worsen later, doing a spot conversion now secures the current value (but of course sacrifices any potential gain if the currency would have moved favorably). Essentially, spot trades are the simplest tool but with no hedge element; they settle current obligations.
Forward Contracts
A forward contract is one of the most important tools for managing FX risk. It is an agreement to exchange a specified amount of one currency for another at a predetermined exchange rate on a future date. Forwards are customizable OTC instruments – they can be tailored for any currency pair, any amount, and any delivery date (though liquidity is best for standard periods like 1, 3, 6, or 12 months forward). No money changes hands upfront (aside from possibly a small margin or credit arrangement); the exchange occurs at maturity. By locking in an exchange rate today for a future transaction, forwards allow one to eliminate the uncertainty of where the spot rate will be on that future date.
Example: Suppose it’s January and an Australian company knows it must pay USD 1,000,000 in April for imported goods. The current AUD/USD rate is 0.70. To protect against the AUD falling (which would make that USD payment more expensive in AUD terms), the company could enter a forward contract to buy $1,000,000 USD in April at today’s forward rate. If the agreed forward rate is, say, 0.7050 (which might reflect a slight adjustment for interest rate differentials), then come April the company will pay approximately AUD 1,418,000 (because 1,000,000/0.7050) and receive $1,000,000, regardless of where the market spot rate is in April. If by April the AUD/USD spot has indeed fallen to 0.65, the company is very happy – it effectively saved money by locking in earlier. If instead AUD/USD rose to 0.75 by April, the company still must honor the forward at 0.7050 and pay the higher effective AUD amount than if it had waited, so it forgoes the potential savings but that was the trade-off for certainty.
Forwards are widely used by businesses and can equally be used by individual investors or advisers through banks/brokers. They hedge FX risk by fixing the rate. The forward rate is determined by the spot rate adjusted for the interest rate differential between the two currencies for the duration of the contract (covered interest rate parity). This means if one currency’s interest rate is higher, its forward will trade at a discount to the spot (forward points adjust so that there’s no arbitrage). Practically, this implies there is a cost or benefit to entering a forward depending on rate differentials – sometimes the forward rate is slightly less favorable than today’s spot, other times more favorable. But those “forward points” are usually small for major currencies over short periods. The primary purpose remains risk management, not speculation on gaining a better rate.
Use Cases: Forwards are ideal for hedging known future cash flows. Advisers might use forwards for clients who have a future foreign currency need or exposure. For example:
Forward contracts are particularly attractive because they are flexible and OTC – you can customize the amount and date exactly to the client’s needs – and typically there is no upfront premium (unlike options). The trade-off is that forwards obligate both parties; there’s no turning back without mutual agreement or a closing trade. If circumstances change (say the client no longer needs the foreign currency), the forward must be closed out, which will result in a gain or loss depending on market rates at that time.
Currency Futures
Currency futures are similar in economic purpose to forwards – an agreement to exchange currency at a future date – but they are standardized contracts traded on futures exchanges. For example, the CME offers futures on major currency pairs (like AUD/USD) with set contract sizes and fixed quarterly settlement dates. A futures contract will lock in a rate just like a forward, and the pricing likewise reflects interest differentials. However, futures differ in that they are marked-to-market daily (gains or losses from price moves are settled to your account each day) and they require margin to be posted. They are exchange-traded, which means less flexibility in amounts and dates (you might have to trade multiples of the standard contract and perhaps roll them if your horizon doesn’t match the contract expiry).
For individual advisers in Australia, currency futures are less commonly used than forwards, primarily because accessing the futures market requires a futures trading facility and the standardized sizes may be too large or unwieldy for typical client needs. Nonetheless, some sophisticated investors or those with access via a broker might use futures to hedge or speculate. For instance, an investor who anticipates AUD will fall might go long an AUD futures contract (effectively locking in to buy AUD at a set price in future) or an investor with USD exposure could short a USD/JPY future, etc. The choice between forwards and futures often comes down to convenience and exposure size: corporations and many funds prefer forwards OTC with their bank (especially if they have an existing credit line), whereas some hedge funds or active traders prefer futures for transparency and to avoid counterparty risk (since the exchange clearinghouse guarantees the trade, mitigated by margin requirements).
Use Cases: Currency futures are used for hedging by funds and for speculative trading. For example, an Australian ETF provider offering a hedged international equity fund might use currency futures (or forwards) to implement the hedge. If using futures, they would sell foreign currency futures to offset currency exposure of the equities. Another example: a speculative trader thinking the EUR will rise might buy EUR futures rather than a forward, aiming to profit from price change and able to close the position anytime by selling the future. For most financial planning clients, direct use of currency futures is rare, but advisers should be aware of their existence, particularly if a client’s managed investments utilize them.