Foreign Exchange (FX)

FX transactions come in three main forms. A spot trade exchanges currencies for settlement typically two business days later (one day for some pairs, such as USD/CAD). A [forward](/glossary/forward-contract) fixes a rate for a later date, and an FX swap combines a spot trade with an opposite forward, often used to roll hedges or fund positions in another currency. Currency options and futures add further ways to take or hedge exposure. Much FX settlement risk is reduced through the CLS payment-versus-payment system.

Funds meet FX in several ways: buying securities denominated in foreign currencies, receiving foreign dividends and coupons, hedging share classes denominated in a currency other than the base currency, and hedging portfolio currency risk. Treasury teams also execute FX to fund margin and settlements in foreign markets.

How funds account for FX. Each non-base-currency asset and liability is translated into the base currency at the NAV valuation rate, commonly a published benchmark fixing such as the WM/Reuters 4pm London rate, as set out in the valuation policy. P&L on foreign securities is split into price gain or loss and currency gain or loss, and realized FX gains arise when foreign cash is converted or trades settle. FX forwards and swaps are carried at fair value using forward points. Hedge gains and losses for a hedged share class are allocated only to that class.

Pitfalls. Common issues are inconsistent FX rate sources or times within one NAV, not separating price and currency P&L (which distorts attribution and tax reporting), FX trades booked with wrong value dates, small residual foreign cash balances left unreconciled, and hedge-ratio drift in share classes when subscriptions and redemptions are not reflected in the next hedge roll.

Example

A USD fund buys EUR 1.00M of shares at EUR/USD 1.08 (cost USD 1.08M). At month-end the shares are worth EUR 1.05M and EUR/USD is 1.10, so the position is worth USD 1.155M. The USD 75,000 gain splits into a price gain of USD 54,000 (EUR 50,000 × 1.08) and a currency gain of USD 21,000 (EUR 1.05M × 0.02).