FOREX EDUCATION: Everything You Need To Know About Forex Trading
Characteristics of the Forex Market
There are different types of FX transactions: spot transactions, forwards, futures, swaps, and options. Spot transactions are immediate trades. Forwards, futures, swaps, and options on the other hand allow traders to manage risk or to profit for an extended period of time.
Spot transactions are the most common accounting for one-third of all Foreign Exchange transactions. It is the buying and selling of the currency with an agreed upon exchange rate. Spot transactions literally mean immediate delivery because they are delivered right away although FX market transactions in the spot market are actually settled two days later. In the spot FX markets no good is actually exchanged. In other words the sale of 10 million Euros for US Dollars does not obligate the seller to actually deliver the hard currency to the buyer, but simply requires him to settle out the difference between the entry price and the current market price.
1. A trader calls another trader and asks for a price of a currency for, say Swiss Franc. This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell. Otherwise, the other trader may skew her price in her favor if she knew specifically what the other wanted.
2. The second trader provides the first trader with both the buying and selling price.
3. When the traders agree to do business, one will send CHF and the other will send USD.
Normally, payment is made two days later, but settling payments the day after is also acceptable especially for the Canadian and U.S. dollar pair.
Spot transactions are popular but they leave the currency buyer exposed to some financial risks like exchange rate fluctuations which cause prices to increase or decrease.
Also known as forward deal, this type of transaction obligates one party to buy and the other party to sell but it does not require money to change hands until some agreed upon future date. A buyer and seller calculate:
a. a forward exchange rate that depends on the current exchange rate
b. the difference in interest rates between the two countries and
c. the date on which the exchange will take place
The date can be a few days, months, or years but for most cases, it is usually less than one year. Because a forward contract is negotiated between the parties, it is customized to their needs, especially when it comes to the amounts involved and the date of settlement.
A forward transaction is a direct transaction between the buyer and seller of currency in the over-the-counter (OTC) market that is why there is some credit risk involved that one of the parties will default on the transaction.
Foreign currency futures are forward transactions with a standardized, transferable, exchange-traded contract that requires delivery of a specified quality and quantity of currency at a specified price, on a specified future date, if not liquidated before the contract matures.
Because the exchange becomes the intermediary of the transaction- the buyer buying from the exchange and the seller selling to the exchange, the buyer and seller of the futures contract does not have to be concerned about the creditworthiness of the other party. The exchange takes on the credit risk of the transaction. The risk to the holder is unlimited, and because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Price transparency and liquidity are also greater given that there are many more traders for the standardized contracts.
Another advantage of futures over forwards is that a position in a futures contract can be closed out before the settlement date by buying or selling the offsetting contract. Because forwards are individually negotiated contracts, it would be difficult for either party to offset their position.
Swap is the simultaneous buying and selling of the same amount of a given currency for two different dates, against the sale and purchase of another. In other words, two parties exchange currencies for a given period of time and agree to reverse the transaction at a later date. The most common swap is an interest rate swap. In such a swap, one party agrees to pay a fixed interest rate to the other company in exchange for receiving its adjustable rate.
A swap can be a swap against a forward. In essence, swapping is somewhat similar to borrowing one currency and lending another for the same period. However, any rate of return or cost of funds is expressed in the price differential between the two sides of the transaction. Currency swap is the most common type of forward transaction.
Example - Currency Swap Transaction
All throughout the transactions, market rates might change. But the buyer and seller are locked into a contract at a fixed price that is not affected by any changes in the market rates. A currency swap allows the market participants to plan more safely, since they know in advance what their currency exchange will cost. It also allows them to avoid an immediate outlay of cash.
Forward and future transactions give the owner an obligation while options give the owner the right to buy or sell a specified amount of foreign currency at a specified price, called the strike price, within a predetermined time period. Most forwards and futures require performance at a specified time. But options are different because the option holder can just let the option expire. However this is only valid if, on the expiration date of the option, the owner is out of money.
At the expiration of a futures contract, the futures buyer would have to accept delivery of the currency, and the futures seller would have to actually deliver the currency unless it is a cash-settled contract. In which case, the seller would have to pay to the buyer the equivalent value in a specified currency. A call option allows the holder to buy currency at the strike price. A put option allows the holder to sell currency at the strike price.
Example - Option
Say a trader purchases a 6-month call on 1 million Euros at 0.88 USD to a Euro. During the 6 months the trader can either purchase the Euros at the 0.88 rate, or purchase them at the market rate. But after 6 months, the option will expire.