One of the most unique aspects of the forex market, which is a huge international market, is that there is no central market place for foreign exchange. The majority of the regular stocks trade on defined market places such as the New York Stock Exchange. When you trade currencies, on the other hand, you have to do it electronically over-the-counter, which means that all transactions around the world take place through computer networks among traders instead of one centralized exchange. In this article, we’ll tackle the three different ways that forex market participants can trade currencies.
The Spot Market
The spot market is simply the place where participants can buy and sell currencies according to the current price. The price at which they exchange is determined by supply and demand, and it reflects many things like current interest rates offered on loans, economic performance of countries, ongoing political situations, and the perception of the future performance or one currency compared to another.
A deal that has been completed is also known as a “spot deal.” It is a bilateral transaction by which one party sells some specified amount of currency and receives a specified amount of another currency in cash.
Even though the spot market is though as transactions at the present, the trades actually take two days to settle.
Forwards and Futures Market
Unlike the spot market, the forwards and futures market do what their names suggest. Their delivery takes place in the future. In addition, unlike the spot market, rather than buying the currency at today’s price and getting it now, the contracts enable you to lock in a currency type, price per unit, and a date in the future for settlement.
In the forwards market, the contracts are bought and sold over the counter between two parties who have determined the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold on an exchange, like the Chicago Mercantile Exchange, and are based upon a standard size and delivery date. The National Futures Association regulates the futures market in the US.
The contracts have certain details that include the number of units, settlement and delivery dates, and the minimum price increments that cannot be customized.
Both types of contracts are binding and, upon expiry, are usually settled for cash, although contracts can also be bought and sold before they expire. The exchange serves as the counter party to the trader and offers clearance and settlement.
How This Works
Speculators may take part in these markets, and the forwards and futures markets can diminish the risk trading currencies.
For instance, company A based in the US agrees to sell a machine for 200 million euros. It will take a year to create the machine and deliver it. Company A will receive 200 million euros, but if the euro loses value against the USD during that period, converting them would the yield to as much.
Company A could enter into a futures contract to deliver 200 million euros at an acceptable exchange. Therefore, the company is guaranteed an amount of money and could hedge against the risk of receiving substantially less.