What Every Aspiring Accountant Should Know About FX Rates

The first thing you should know is that FX spot rates are written with the base currency first and the terms currency second. (The base currency is the denominator currency. The terms currency is the numerator currency.) For example "USD/JPY 120.50" means 120.50 Yen per Dollar. BASE/TERMS is contrary to the way most people would write a fraction, but it is the convention of the market. What is the market convention for determining which currency is the base currency of a currency pair? There is a hierarchy of currencies: EUR, GBP, AUD, NZD, USD, CAD, JPY. Given a currency pair, the base currency will usually be the first one you reach in this list.

The second thing you should know is that FX spot rates are actually two day forward rates. That's because FX spot contracts are for settlement in two business days. If you agree to the spot trade on Monday, each party is expected to make payment two days later on Wednesday. The exception in USD/CAD. Spot settlement is only one business day forward for USD/CAD. There is an FX market for immediate delivery. It's called the cash market and the rate is called "the cash rate." Also, there is an FX market for next-day delivery. The rate is called "the tom rate." (Tom for tomorrow.) Note that the tom rate is the same as the spot rate for USD/CAD, because for USD/CAD, spot contracts already deliver the next day.

Finally, you must be aware that an FX spot rate should never be applied to an income statement item to change it into another currency. FX spot rates should only be applied to balance sheet items. A balance sheet is a snapshot in time and balance sheet items are balances that existed at that moment. An income statement shows change in balances over a period of time. If you were going to use an FX rate to change an income statement item to another currency, would you use the FX rate at the start of the period, the end of the period, or an average rate? The answer is none of the above. Do not apply FX rates to income statement items.

Here is an example. Suppose you are a US-based entity and you buy a European bond (1 million Euros face) for one month and then sell it. You want to calculate your PNL in USD.

Date EUR/USD Bond Price (EUR)
Jan 1 1.2050 100
Feb 1 1.0050 101


Here is how NOT to calculate the PNL in USD.
(1,000,000 EUR) x (1.01 - 1.00) x (1.0050 USD per EUR) = 10,050 USD

This is the correct way to calculate the PNL in USD:
[(1,000,000 EUR) x (1.01) x (1.0050 USD per EUR)] - [(1,000,000 EUR) x (1.00) x (1.2050 USD per EUR)] = -189,950 USD

In this example the bond has increased in price by one Euro cent. But the US-based investor lost money on the position, because the Euro weakened dramatically over the period. Notice that in the correct calculation we are applying FX rates only to balance sheet amounts.