Current Assets and Liabilities in Forex

When trading in Forex, in general, it is the current assets and liabilities in foreign currency that are affected by changes in currency values.

The net amount is defined as working capital. Two factors should be borne in mind. First, only current assets and current liabilities that are actually due or payable in the currency concerned should be taken into account. For example, a dollar cash account held by a U.K. company in a New York bank, even though expressed in sterling, all the U.K. company's books are not subject to change, as far as dollars are concerned.

Similarly, a U.K. company may owe dollars to a U.S. exporter. Even though expressed in sterling, the payable has a constant value, as far as dollars are concerned. The sterling value may, of course, vary. Second, the working capital position is fluid, and changes from period to period.

Protection is, therefore, required for average figures, rather than for precise amounts. Current or spot rates have, in the past, fluctuated within narrow bands around a preset parity. It is not generally desirable, or necessary, to try to protect working capital amounts against those changes, which, given no major currency value changes, tend to average out.

What is required is consideration of the possible impact of major currency value changes. Furthermore, those changes have been related to a much longer time frame - generally years rather than days or months. Starting in August 1971, however, the time has shortened. There are three ways in which protection may be provided: purchase of forward coverage; management of the assets and liabilities concerned to reduce the amount exposed to possible currency change; and the flexible pricing, and planning policies, to compensate for actual, or expected changes, in currency values.

Let us take the first protection possibility: Purchase of forward coverage. The first step is to determine the working capital level, or other net assets, for which coverage might be desirable. As stated, the level may be managed to reduce the exposure. The determination should be in the local currency; the possible change in the value of local currency against another currency can then be compared with the cost of obtaining forward coverage.

Basically, for a particular transaction, the possible future spot rate must be related to the present forward rate. Forward rates are normally quoted, in relation to the present spot rate, as so many points' premiums, discounts, or as x percent per annum - however, that is a valuation of the present spot rate in relation to the future spot rate.