As the owner of Foreign Exchange Certificate (FEC), you have the right – but not the obligation – to convert the pre-specified amount of the pre-specified currency into another pre-specified currency at a pre-specified exchange rate.
Example: You own a Foreign Exchange Certificate that gives your the right to convert 500,000 SEK into EUR at an exchange rate of 9.00 SEK per 1 EURO.
When can I exercise my foreign exchange certificate?
The most common type of foreign exchange certificate is the one that can be exercised on any day until it has expired. Alternatives to this type of foreign exchange certificate is the one that can only be exercised on the expiration date and the one that can only be exercised on certain pre-specified dates outlined in the foreign exchange certificate contract.
Always check the details of the foreign exchange certificate contract to find out the terms.
Why would I buy a foreign exchange certificate?
Originally, the foreign exchange certificate was created due to the need for individuals and legal entities to protect themselves from currency risk. By owning a foreign exchange certificate, you know beforehand exactly what the currency rate will be on the day you need to trade one currency for another, e.g. to pay a foreign supplier.
Today, it is also common for traders to purchase foreign exchange certificate as a form of speculation. The typical foreign exchange certificate is a bearer instrument, which means that anyone who is in possession of it it can elect to exercise it. Bearer instruments are easy to trade and they can change hands quickly with a minimal amount of administration involved. The modern digital trading platforms of today makes trading in foreign exchange certificates a rapid and easy pursuit.
When a speculator purchases a foreign exchange certificate, the goal is not to reduce currency risk for the speculator but to make a profit from the exchange rate. It doesn’t matter if you think that the value of a currency will increase, decrease or remain stable in relation to another currency – you can find suitable foreign exchange certificates for all these predictions.
Foreign exchange certificates as surrogate for national currency
Foreign exchange certificates can be used as a tool for currency exchange control in countries where the national currency is not convertible or where the government wish to employ a strict currency exchange control.
Several eastern-block countries employed FEC:s in this manner in the past, including the Soviet Union, Poland, Bulgaria (Corecom), East Germany (forum checks) and Czechoslovakia (Tuzex). China used FEC:s in 1980 – 1994. More modern day examples are Myanmar/Burma and Cuba (Cuba’s convertible peso is a type of FEC).
How a FEC can be used as protection against currency risk
Company QQQ is based in Canada and use Canadian Dollars for their business. They have ordered a large shipment of steel from the United States and this shipment must be paid for, in United States Dollars, by September 30 this year.
Company QQQ know that they will be making a payment of 5 million United States Dollars (USD) on September 30, but they don’t know what the exchange rate will be when their Canadian Dollars (CAD) is exchanged for USD.
It is now January, but Company QQQ want to know for sure right now how much CAD they will need to convert to get 5 millions USD by September 30. This is partly because they are afraid that the CAD will lose in value against the USD during the year, and partly because they want to be able to give potential investors in Company QQQ clear and reliable information about the company’s financial situation.
Company QQQ decides to purchase a foreign exchange certificate that gives them the right (but not the obligation) to convert 6.5 million CAD to 5 million USD on September 29 this year. By doing so, they will know right now exactly how much CAD they will need to pay their bill, without actually having to convert any CAD into USD right now and sit on it until the end of September.
If, by the end of September, Company QQQ sees that they can actually get 5 million USD for less than 6.5 milllion CAD by doing a regular spot price currency exchange, they can just do this instead and not bother with exercising the FEC. They only have a right to exercise the FEC – not an obligation.