DEFINITION of 'Inverse Transaction'

A transaction that can cancel 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 is considered the transaction that “undoes” or closes out a previous transaction made by an investor.

BREAKING DOWN 'Inverse Transaction'

Investors purchasing forwards can choose to take possession of the underlying asset, such as currency, at the time of expiration or can close the contract out before the expiration date is reached. To close out the position, the investor must buy or sell an offsetting transaction. An inverse transaction can be made through a clearing house, which matches the transaction details from the investor with the transaction details of an outside buyer or seller.

For example, a U.S. company purchases €100,000 at $1.14 per euro in March. When it closes the position, it uses an inverse transaction by selling €100,000 with the same date as the forward it purchased in March. The company’s locked in profit 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 inverse transaction is completed with a bank that is different from the bank that the investor purchased the forward contract through, using an inverse transaction will make the transaction fully covered with a profit or a loss. The transaction will not be closed out because there will be two offsetting forwards purchased through two different banks.

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.

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