BIM39570 - Foreign exchange: currency contracts

Any trader who undertakes transactions in a foreign currency risks financial loss if exchange rates move adversely. He or she may minimise, or hedge, that risk by using currency derivatives. These fall into three categories:

• Forward currency contracts - an agreement to buy or sell currency at a predetermined price on a specified future date. Currency futures, which are essentially forward contracts traded on an exchange, are less widely used.
• Currency options - the option holder has the right, but not the obligation, to buy or sell a specified amount of currency at a particular price.
• Currency swaps - an arrangement amounting to the parties swapping a loan in a foreign currency for a loan of equivalent amount in sterling, or a second currency.

There is background information on currency contracts, which is applicable to non-corporates as well as to companies, at CFM13400 onwards.

Exchange gains or losses may arise on currency contracts. Forward currency contracts or currency swaps may, however, be accounted for at the rate implied by the contract, in which case no gain or loss will be shown in the accounts.

Example

A trader, who prepares accounts to 30 September, knows he will have to pay $5,000 for trading stock on 30 November 2012. On 1 September 2012 he enters into a forward contract to buy $5,000 for £2,750 on 30 November. At 30 November, $5,000 is worth £3,000 at spot rates.

Suppose that the trader goes on to sell the trading stock for £4,000. It is clear that he makes a commercial profit of £1,250 on the overall transactions. He may, in his accounts, simply translate the purchase price of the stock into sterling at the rate implied by the currency contract, i.e. record the purchase at £2,750. The forward currency contract will not appear separately in his accounts.

Alternatively, he might bring in an exchange profit of £250 (£3,000 - £2,750) on the forward contract. This will be spread between the period ended 30 September 2012 and the following period. He will record the purchase at £3,000, giving the same overall profit.

Exchange gains or losses on a currency contract will be on revenue account if - as in the above example - the contract is ancillary to a trading transaction. They are on capital account if the contract hedges a capital asset or liability. Statement of Practice SP03/02, while relating specifically to derivatives that are financial futures or options within S143 Taxation of Chargeable Gains Act 1992, sets out general principles for determining whether profits or losses on a derivative are trading income or expenses.