What Is an Inverse Transaction?

Inverse transaction refers to the process of closing out an existing contract or position held by two different parties where one reverses the transaction executed by the other.

More specifically, an inverse transaction is one that can be executed by closing an open forward contract or an options contract with the same value date. This allows the investor to quantify the profit or loss of the entire transaction.

Key Takeaways

  • An inverse transaction is the closing out of a contract position held by two different parties.
  • Inverse transactions are commonly used to close out or offset options and forward contracts, allowing one party to reverse the transaction executed by the other.
  • Closing an open forward contract with the same value date allows an investor to quantify the profit or loss of the entire transaction.
  • Investors who purchase forwards can take possession of the underlying asset when the contract expires or they can close it before reaching the expiration date.
  • An inverse transaction can result in either a profit or loss to the investor.

Understanding Inverse Transactions

An inverse transaction is one that is used to undo or offset another transaction made previously by an investor with the same transaction details. Inverse transactions are commonly used with options and forwards. This leaves the investor with a fixed gain or loss when the transaction is closed.

Investors who purchase forwards can choose to take possession of the underlying asset, such as a currency, at the time of expiration or they can close the contract before the expiration date is reached. To close the position, the investor must buy or sell an offsetting transaction.

If the inverse transaction is completed with a different party other than the investor purchased the original forward contract through, then this results in a separate trade that fully covers or locks in the profit or loss on the first transaction. The first transaction won't be closed out, even though the net result of these two transactions offsets since they were done through two different parties.

An inverse transaction can result in either a profit or loss to the investor. If the trades use leverage (where the investor borrows funds to initiate the transactions), then the losses could trigger margin calls.

An inverse transaction can be made through a clearinghouse that matches the transaction details from the investor with the transaction details of an outside buyer or seller.

Example of an Inverse Transaction

Here's a hypothetical example of how inverse transactions work. Assume an American company purchases a €150,000 forward contract at the specified price of $1.20 per one euro in April to be transacted in June. It can do an inverse transaction by selling €150,000 with the same expiration date as the forward it purchased in April.

By doing this, the company has locked in a profit or loss. This will be the amount of money received for selling the euro less the amount paid for the purchase of the euros with the forward contract. If the euro rises in value since the purchase, then the buyer comes out ahead.

Let's say the two parties agree to an exchange rate of $1.20 EUR/USD, so if the price rises to $1.25, they were better off buying at $1.20. On the other hand, if the euro falls to $1.15, they are worse off since they are contractually obligated to transact at $1.20.

Companies use forwards to lock in rates on funds they will need in the future and are more concerned with knowing what their future cash inflows and outflows will be, rather than the potential price volatility.