What Constitutes a Foreign Exchange Agreement?
A foreign exchange agreement is a contract between two parties to exchange specified currencies at a future date. The purpose of this type of contract is almost always to hedge against fluctuations in the value of one or both currencies over time, particularly where there is a significant gap between the time something is purchased and the time payment is due .
Hedging with foreign exchange contracts can be used in a wide variety of circumstances where a party has a potential liability in another currency at a specified future time. A common situation is when a parent company intends to provide a capital contribution to a foreign subsidiary. In that case, the parent can hedge against fluctuations in the exchange rate by entering into a foreign exchange agreement to purchase a specified amount of the foreign currency on the date that it is to make the capital contribution.
Ingredients of a Foreign Exchange Agreement
A typical foreign exchange agreement will contain the following:
The Parties
In most transactions there are three basic groups of parties involved in foreign exchange: an exporter of goods who wishes to repatriate proceeds earned abroad, an importer who wishes to make a foreign payment, and a financial institution acting as banker. However, there are many different types of counterparties in the foreign exchange market. These can include central banks, corporations and other institutions.
The Time and Place of Delivery
Foreign exchange may be delivered at any time and any place in the world. Most large banks have foreign exchange centers in New York, London, Tokyo, Paris and Zurich, which operate virtually 24 hours a day. They will process trades so that a currency foreign to their country will be delivered on the same day, or at a later date if requested by the counterparties.
The Money (The Amount of Exchange)
This is the actual amount and currency of a particular transaction. The amount of currency delivered is usually expressed in terms of a base unit. Therefore, the record entry of the actual trade for an amount of U.S. $10,000 in Japanese yen would appear as an entry of yen 1,250,000.
Price (The Rate of Exchange)
The price of a foreign exchange purchase is expressed as the number of units of one currency that must be delivered for each unit of another currency. This is expressed as the domestic-to-foreign rate, or as the foreign-to-domestic rate. In a dollar/yen transaction, a dollar is being used to purchase yen, therefore the amount of yen delivered per dollar is the domestic-to-foreign rate.
The Terms of Payment
The terms of payment are generally 2 days forward from the date of the contract in the United States. This means that the foreign exchange will be delivered at the end of the 2nd following business day.
After delivery, the currency is held as the banker’s deposits, until the time of the actual payment or receipt.
Legal Aspects of Foreign Exchange Agreements
A foreign exchange agreement is a legally binding contract, usually executed under seal, related to a foreign currency. Pursuant to the Foreign Exchange Management Act, 1999 (FEMA), only certain types of transactions are permissible.
As per Rule 5 of the Foreign Exchange Management (Foreign Currency Accounts by a Person Resident in India) Rules, 2015 ("FCA Rule"), a person resident in India as defined under section 2, subsection (v) of FEMA shall deal in foreign exchange strictly in accordance with the provisions of the Foreign Exchange Management Act, 1999 or the rules and regulations made thereunder.
Under Rule 6 of the FCA Rule, a person resident outside India may open, hold and maintain a foreign currency account in India with an authorized dealer in accordance with and subject to the limits and conditions of the FCNRB scheme of that Authorized Dealer and may remit the balances of such account at any time to any place outside India.
Rule 7 of the FCA Rule states that a person resident in India may open a foreign currency account with a branch outside India of an authorized dealer in India and maintain such account in accordance with the conditions, including maintenance of minimum balance, if any, laid down by the authorized dealer for maintaining such an account and may credit into such account foreign currency up to US$ 10,000 per financial year. Further, a person resident in India, who is a proprietor of a firm, a partner in a partnership firm, director of a company or an employee of an Indian company may, for and on behalf of the firm or company, open along with the authorized dealer in India, a foreign currency account in the correspondent bank of the Authorised Dealer in India and may credit foreign currency into such account from the remittances received by the firm or company provided the Authorised Dealer has received documentary evidence of such remittance. Any balance in such foreign currency account shall be repatriated to India.
A resident with a foreign currency account shall obtain a statement of account in respect of such account in such form and within such time and in such manner as may be specified by the Reserve Bank. In respect of such foreign currency accounts, the Reserve Bank may issue directions, including the requirement of prior approval of the Reserve Bank.
Any dispute arising from a foreign exchange agreement should be resolved in accordance with the provisions of the Indian Arbitration and Conciliation Act, 1996 or the provisions of the Bombay International Arbitration Centre (International and Domestic Arbitration Proceedings) Rules, 2016.
Risks Involved in Foreign Exchange Agreements
As with any type of contract, foreign exchange agreements pose risks for both parties. Most obviously, there are the risks involved with currency fluctuations. As previously discussed, one of the primary benefits of entering into an FX agreement is to minimize the risk to a party’s bottom line from ever-shifting currency values. However, many foreign currencies fluctuate wildly on a day-to-day or even hour-by-hour basis; consequently, the most carefully structured agreement can result in losses if the currencies at issue move in the wrong direction. A very basic example: if a company enters into an agreement to purchase a set amount of foreign currency at a fixed price of 20 units of its own currency, but then the market price of that foreign currency falls and it eventually buys it at a market price of only 15 units of the domestic currency, the gain of 5 units for each unit of foreign currency purchased would be negated by the fact that the original price for 20 units of the domestic currency had already been locked in .
In addition to financial risks for the agreed upon price, obtaining and negotiating a foreign exchange agreement poses other risks as well. Foreign trade and investment are strictly regulated by law in many countries, including the United States. For this reason, it is extremely important that both parties understand the requirements of the laws before entering into the agreement; if the foreign trade is regulated, it may be necessary to obtain special licenses from the government before entering into the agreement. Even when no special licenses are required, valuation and energy regulation may affect the pricing of the agreement. For example, energy prices and availability may play a significant role in determining whether the goods can be sold at a profit in the market. Failure to understand the risks involved in such agreements can lead to the collapse of the deal or, in the worst case, the collapse of the company itself.
Formulating a Foreign Exchange Agreement
A foreign exchange agreement is a legal document whose purpose is to define the obligations and rights of the parties in a foreign exchange transaction, usually a future transaction. In fact, these agreements are also known as forward exchange contracts. Foreign exchange transactions are premised upon the disposition of one currency in exchange for another currency at some future time at a rate of exchange agreed upon presently. For example, a bank in Japan (B) may wish to purchase from a bank in the United States a certain quantity of United States dollars (USD) with yen paid to the bank in the future at a percentage over the "ask" rate for USD at the "forward" at some point in the future. "Ask" is the price that the market will bear, or what financial institutions and professional trade groups are paying for a particular currency. The "ask" is generally higher than the "bid" (what a financial institution or professional trade group is willing to pay). The "ask" is sometimes called the "offer". The "bid" is how much of a currency a purchaser is offering.
It is easy to see how there could be a problem in how much yen bank B will actually end up paying for the quantity of United States dollars bank A has agreed to sell to bank B. If bank’s C, D, E, F, G, H, etc. enter into similar transactions with bank A, it follows that bank A is going to need a very precise calculation of precisely how many marketable units of currency B expects to receive for its contract on the particular day the transaction is to be processed. However, the bottom line is that coordinate banks may well have entered into several subsequent currency exchange agreements for the same units of currencies with a number of other banks, and the banks may not be able to effectively calculate how to convert the value of the other banks’ dealings with the value of their dealings with bank A.
The bottom line is that if bank B ends up getting more for its future sale of United States dollars than it had anticipated because an increase in the value of the dollar was unexpectedly favorable to bank B, then bank A will be out of pocket. The way this transaction should work is that bank B would have agreed to pay bank A a negotiated amount over the "ask" rate on the day in question.
So given, how can you properly draft an enforceable foreign exchange agreement? For starters, you need to explain how much money is involved and identify the currency (or currencies) in question. You should identify how much USD bank B is looking to purchase with yen, for example. Then, you should set out the terms by which bank A agrees to offer bank B the money it seeks. The foreign exchange agreement should specify the time period during which the currency exchange transaction will be valid. The agreement should also state the loan period for bank B to repay the money it needed to borrow from bank A to pick up the foreign currency it needed. Finally, the foreign exchange agreement should set out the interest rate to be paid on the loan bank B is obtaining from bank A. Finally, the foreign exchange agreement should specify whether there is a grace period for payment.
Common Issues in Foreign Exchange Agreements
Another common dispute that the parties to a foreign exchange agreement will encounter is the amount that each party may owe to another party following termination of the contract. Contractual termination triggers a calculation of the termination value, which is used to assess the net amount owed either to or by the relevant party, relating to a termination damages payment. The termination value is generally calculated in accordance with the netting provisions of the agreement.
The party who determines the termination value will send a notice to all other parties . This notice will set out the calculations that it used to arrive at the termination value. If a party believes that another party has incorrectly calculated the termination value or claims that the other party owes a higher amount, it may dispute the amount owed. Such disputes commonly circle around miscalculations of the termination value, or miscommunications around the amounts owed. It is critical that the disagreements be resolved quickly, as the process of foreign exchange trading is highly volatile and changes daily.