As the most liquid financial market in terms of daily trading volume, the forex (FX) market is essentially a 24-hour, decentralised over-the-counter (OTC) marketplace for currency trading.
Generally, its core purpose is to facilitate international trade and investment activities by supporting businesses that wish to convert one currency to another.
The FX market is where such currency exchange transactions can be executed, and transactions can either be FX Spot of Forwards contracts.
What is FX Spot Trading?
An FX spot transaction is basically an agreement between two parties to purchase one currency against selling another currency, at a specific agreed price for settlement on a spot date, typically two business days after the trade date.
As the FX market is not open on weekends, settlement typically happens on a weekday.
If the settlement date falls on a public holiday in one of the countries, settlement is delayed to the next business day.
What is the Spot Market?
Generally speaking, the spot market is where financial instruments like commodities and securities are traded for immediate delivery. There are two main types of spot markets, namely over the counter and market exchanges.
Spot markets are directly in contrast with futures exchanges, whereby the main assets traded are futures contracts.
What is a Spot Exchange Rate?
The exchange rate at which an FX spot transaction is executed is called the spot exchange rate. An FX spot contract is a contract in which a retail trader agrees to purchase or sell at the prevailing exchange rate.
This rate at which currencies can be exchanged for value spot, is essentially the most actively traded, and is largely determined by the demand and supply for each currency.
The spot exchange rate can fluctuate over time in reaction to news releases, economic data and geopolitical events, presenting a risk to a foreign exchange position.
A spot exchange rate also has great significance because it forms the underlying basis for the valuation of almost all foreign exchange derivatives, such as FX forwards, currency futures and currency options.
The spot exchange rate is usually expressed as the number of units of the counter currency that are required to purchase one unit of the base currency.
For example, if the spot exchange rate for GBPUSD is currently at 1.2000, it means that an FX trader would require $1.20 to purchase one British Pound in the timeframe of two business days.
What is Spot Value?
Spot value is basically two business days from the transaction date for any currency pair. The only other exception is for USD/CAD currency pairs, which are delivered in one business day, according to Forex market conventions.
Additionally, though electronic transactions currently permit the almost instantaneous delivery of currencies after an FX transaction takes place, the FX convention of typically waiting 2 business days to deliver the currencies continues to persist.
How does FX Spot trading work?
The FX market usually quotes the value of currencies against the USD. The exchange rate between two non-USD currencies is calculated from the rate for each currency against the dollar, and this is referred to as the cross rate.
Cross-rates are also traded between banks in addition to dollar-based rates as some pairs tend to be closely related. For instance, the Swiss Franc moves closely in line with the Euro and the EUR/CHF is thus commonly traded as well. .
FX Spot trading revolves around spot FX quotes. Principally, the spot FX quote is a two-way bid-offer price. The bid price indicates the rate at which a bank is prepared to buy the base currency against the quote currency while an offer price indicates the price at which a bank is willing to sell the currency. The difference between the bid and offer price is known as the spread, which can be viewed as the risk of making one unit currency transaction. The spread is also the profit that a market maker can make.
For example, if the bid price for USD/CAD is 1.2326, and the offer price is 1.2327. The 1 pip difference will be the spread.
For G10 currencies, one pip is usually 0.0001 (fourth decimal places). An exception to take note of would be JPY pairs, whereby one pip is usually 0.01 (two decimal places)
Spreads are often an indication of the liquidity of the currency pair. In practice, the smaller the spread is, the more liquid the currency pair is, as this suggests that there are more bids and offers in the market.
For example, for the most liquid currency pairs like EUR/USD and EUR/GBP, the spreads are typically minimal, at 0.5 or 1 pip during intra-day trading hours.
For less liquid pairs such as MXN/TRY (Mexican peso and Turkish Lira), the bid-offer spread can be as large as 20 or 30 pips, as there are fewer participants with bids and offers available.
What are FX Forwards?
An FX Forward contract is essentially an agreement that allows a buyer to lock in an exchange rate, for settlement on a future date.
Generally, FX forwards is one of the primary methods utilized to hedge against exchange rate volatility, as they help avert the impact of currency fluctuation over the period covered within the contract.
FX forward contracts are commonly employed by exporters and importers, and businesses with a frequent need to exchange currencies, to hedge their foreign currency payments from exchange rate fluctuations in the near term.
Characteristics of FX Forwards
- FX forwards are over-the-counter (OTC) instruments. However, unlike standardised FX futures, an FX forward can be customised to a particular amount and delivery period.
- FX forward settlements can either be on a cash or a delivery basis, given that the option is mutually acceptable, and has been defined beforehand in the contract.
- FX forward contracts typically carry a credit risk. If one of the parties is unable to fulfil its obligation at the settlement date, the other party is required to sign another contract with a third party, hence being exposed to market risk at that time. So, by locking in the exchange rates at which a currency shall be bought, the party forfeits the opportunity of profiting from a favourable exchange rate movement.
How are FX Forwards used?
FX forwards is generally an effective hedging vehicle that allows traders to indicate the precise amount to be exchanged, and the specific date on which to settle in the forward contract.
The exchange rate for an FX forward transaction is usually based on a forward rate, typically adjusted by a premium or a discount, and calculated as the interest margin between the two currencies over the term of the transaction.
In practice, if a trader is expecting to receive a cash flow denominated in a foreign currency on some future date, he can lock in the current exchange rate by entering into an offsetting forward position that expires on the date of the cash flow.
This will allow him to hedge the risk of exchange rate fluctuations during the period before he receives the cash flow.
FX forwards can also be utilised by traders to speculate future exchange rates.
FX Spot Trading vs FX Forwards: The key differences
In FX spot transactions, freely tradeable currencies are typically purchased or sold at the current exchange rate called the spot rate and settled within 2 business days.
On the other hand, FX Forward contracts are utilised by market participants to lock in an exchange rate on a specified date in the future, in order to hedge exchange rate risks for future flows of funds.
In FX forward transactions, freely tradeable currencies are usually bought or sold for a specific maturity date as the exchange rate is agreed upon when the forward transaction is concluded.
A combination of an FX spot transaction and an FX forward transaction is called a Forex swap transaction.
An FX swap transaction basically entails the simultaneous purchase and sale of identical amounts of one currency for another at a later specified date.
Overall, an FX spot deal constitutes a contract for immediate delivery in the prevailing rate of exchange, while an FX forward deal is one in which foreign exchange is purchased and sold for future delivery. Both types of transactions are commonly used in the FX market depending on the traders’ requirements.