What is an Inverse Transaction
An inverse transaction cancels out a forward contract that has the same value date. Inverse transactions are used with options and forwards, leaving the investor with a fixed gain or loss when the transaction is closed. An inverse transaction “undoes” or closes out a previous transaction made by an investor.
Breaking Down the Inverse Transaction
An inverse transaction can be made through a clearing house. They match the transaction details from the investor with the transaction details of an outside buyer or seller.
Investors who purchase forwards can choose to take possession of the underlying asset, such as a currency, at the time of expiration or can close the contract before the expiration date is reached. To close the position, the investor must buy or sell an offsetting transaction or make an inverse transaction.
Inverse Transaction Example
Assume a U.S. company purchases a €100,000 forward at $1.14 per euro in March. When it closes the position, it uses an inverse transaction by selling €100,000 with the same expiration date as the forward it purchased in March. The company’s locked in profit or loss 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 has risen in value since the purchase, then the buyer comes out ahead. For example, they purchased at $1.14, and if the price rises to $1.20 then they were better off buying when they did at $1.14. On the other hand, if the euro falls to $1.10, they are worse off since they locked in at $1.14 when they could currently purchase those euros for $1.10. Most companies use forwards to lock in rates on funds they will need or have in the future. Even though the price will move, they are more concerned with knowing what their future cash inflows and outflows will be.
If the inverse transaction is completed with a party that is different from the party that the investor purchased the original forward contract through, using an inverse transaction will create a separate trade that fully covers or locks in the profit or loss on the first forward. The first transaction will not be closed out because there will be two offsetting forwards purchased through two different parties.
While an investor may realize a profit after closing out a position through an inverse transaction, it is also possible that the investor will realize a loss. Depending on the amount of the loss, the investor may face a margin call if the transactions were made from borrowed funds.