A foreign exchange certificate grants the owner the right, but not the obligation, to convert a pre-specified amount of one currency into another at a pre-specified exchange rate. Foreign exchange certificate are popular among Forex traders who wants to make a profit and companies who wants to reduce or remove currency risk.
A typical foreign exchange certificate can be exercised on any day until it has expired, but there are also foreign exchange certificate that can only be exercised on the expiration day or on certain pre-specified dates outlined in the foreign exchange certificate contract.
The purchase of a foreign exchange certificate is usually made to protect oneself from currency risk, i.e. the risk of losing money because of changing currency exchange rates. By purchasing a foreign exchange certificate, you will know in advance exactly how much of Currency B you will get for the specified amount of Currency A.
Foreign Exchange Certificates (FEC) are typically created as bearer instrument, i.e. instruments without a registered owner. Anyone who is in possession of this type of foreign exchange certificate can exercise it. This makes it easy to trade foreign exchange certificates, and there are speculators that purchase FEC:s not to protect themselves against currency risk but in the hopes of profiting from exchange rate changes (or, in rare cases, from exchange rate stability).
Using FEC:s as protection against currency risk
As mentioned above, foreign exchange certificates are frequently used to reduce or remove currency risk.
Company NNN is headquartered in the United States but know that they will receive a large delivery of steel from Sweden in June and will be required to pay 50 million SEK for the goods that same month. It is now January, and company NNN wants to know for sure exactly how much they will need in USD to pay the bill in June. They are not only concerned about the SEK going up in value against the USD between January and June; they also dislike being in a situation where they can not give potential investors in Company NNN any firm information about how much it will cost the company to pay the bill.
To fix the situation, Company NNN purchases a foreign exchange certificate that gives them the right to convert 6 million USD into 50 million SEK on June 20 that same year.
When June 20 arrives, Company NNN will look at the current exchange rate and decide if they want to exercise the FEC or not.
- In a situation where the exchange rate is 1 USD = 7 SEK they would most likely decide to exercise their FEC, because purchasing 50 million SEK to the current exchange rate would cost them over 7 million USD.
- In a situation where the exchange rate is 1 USD = 9 SEK, purchasing 50 million SEK to the current exchange rate would only cost a bit more than 5,5 million USD. Therefore, Company NNN would do best not to exercise their FEC.
Foreign exchange certificates as surrogate for national currency
Foreign exchange certificate are sometimes employed by governments as a surrogate for national currency. This will typically occur only in countries where the national currency is subject to exchange controls or non-convertible. Examples of countries that have employed FEC:s in this manner in the past are the Soviet Union, Czechoslovakia, Bulgaria, Poland, East Germany and Ghana. Mayanmar / Burma used FEC:s this way as late as 2013, and Cuba’s convertible peso is to an extent still a form of FEC.