The foreign exchange market also called Forex or FX market is a place where currencies are bought and sold. It is a decentralized and over the counter market meaning there is no central exchange.
The forex market is important because here exchange rates are determined, and international trade is facilitated. Here, currencies are traded in pairs like EUR/USD, EUR/GBP where one currency is used to buy the other. The EUR/USD is the most popularly traded currency pair in the world.
According to the BIS Triennial survey, total daily forex turnover for 2019 was 6.6 trillion US dollars.
It is the biggest and the most liquid financial market in the world with market players like central banks, commercial banks, dealers, brokers, and individuals making up the ecosystem.
Forex market is open 24 hours and has four major sessions/time zones daily. These are Sydney, Tokyo, London, and New York.
When trading in any market, you have different financial instruments which you can use to trade. These instruments can be used to hedge risk, speculate, and trade or a combination of the three.
We will look at some of the instruments & trading options that are available to the traders in the forex market.
Spot FX
When transacting in the forex market you could either choose to settle transactions immediately or later. If you choose to settle immediately, then you settle it at the spot price which is the current market rate.
Spot price is the current price of an asset in the market as at the time of settling the transaction. In FX spot trading, settlement date is T+2 days.
According to the BIS Triennial survey, spot transactions worth 1.98 trillion US Dollars were traded daily in 2019. Majority of SME and Business payments are made through Spot FX.
Retail FX trading contributes to the turnover of spot FX market with daily turnover of 65 billion USD.
Many Forex brokers offer Spot forex trading to retail traders through derivatives, and you are buying & selling a currency at spot price, which is the current market price without owning the asset.
FX Forwards
This is an agreement between two parties to buy or sell forex at a predetermined rate at a future date. It is used to hedge against foreign exchange price fluctuation and shield the holder. It is normally used by Investors and businesses like Importers and Exporters for hedging purposes.
If a Japanese investor wants to invest in a company in the USA in 5 months’ time and needs to buy USD for their investment, they fear that in 5 months the USD may appreciate against the Japanese yen. So, they enter a forward contract with the seller to buy the USD at a specified rate, at a specified date.
By doing this they can hedge against the risk of USD currency rate change.
When the forward exchange rate of the currency is greater than the spot value the currency is referred to as a premium currency and when the forward exchange rate of the currency is less than the spot price it is referred to as a discount currency. If spot rate and forward rate are the same, the currency is said to be at par.
Forward contracts are not traded on the exchange they are traded over the counter.
Forex and Currency Swaps
FX swaps
These are the most traded forex instruments in the market. According to the BIS Triennial survey forex swap transactions worth over 3 trillion US Dollars were traded in 2019 alone.
FX swaps usually entail swapping a corresponding amount of a currency with another similar amount of another currency. Example USD/GBP swap.
Currency swaps
A Currency swap technically is FX swap, but they are different in interest rate (FX swap usually don’t involve interest rates) & duration (currency swap are long term arrangements) aspects.
In currency swaps, a loan in one foreign currency is exchanged for another loan in another foreign currency.
Popular amongst companies looking to borrow in a foreign currency, they use currency swaps to avoid going to the market to borrow at expensive interest rates. Financial institutions sometimes act on behalf of bigger corporations.
Assume company ‘A’ has a running loan of 5,000 GBP but needs to take another foreign currency loan of 5,000 US dollars, it approaches company B that already has a running loan of $5,000.
They both swap the principal of 5,000 at the spot rate and agree to settle the interest payment that will accrue for the swapped amount during the swap period only.
By doing this company ‘A’ has avoided trying to source for a loan in a foreign currency at higher interest charges. At the end of the loan period, companies' ‘A’ and ‘B’ swap back the principal at the current spot rate or at a rate predetermined by them and square off their books.
FX Options
According to the BIS Triennial survey, over 297 billion US Dollar worth of forex options were traded daily in 2019.
A forex option is simply a contractual agreement between two parties that the holder of the option has the right but not the obligation to buy or sell a predetermined amount of foreign exchange at a predetermined price called the strike priceand at a predetermined date.
An agreement to buy is called a call option and an agreement to sell is called a put option. The holder of the option buys it from the seller or option writer at a premium. The act of putting the option into use is called exercising the option.
We have European and American style options. European options can be exercised only at the expiration of the given date while American options can be exercised at any time before the due date.
Options can be used to hedge against risk in business. If a company in South Africa is concerned that the US dollar may soon appreciate against South African Rand (ZAR), they may choose to contact a broker and buy a call option (by paying a premium to the option writer) that gives them the right but not obligation to buy US dollar from the seller at an agreed price and date.
If that date comes and the US dollar does not appreciate the option is not exercised or used and the South African company forfeits the premium paid. By doing this they have hedged against the risk of USD currency change.
Forex CFDs
CFD means contract for difference. Here, leverage is used to trade on the exchange rate fluctuation of the currencies. CFDs can be used for speculation by traders as you will see from the example below.
Forex Beginner UK explains how it works, “If a trader thinks that the price of a currency is likely to go up, they could approach their broker and buy a CFD contract to profit from that rise. If they think the value of the currency will drop, they could do the same thing & place a sell order instead.”
The trader using leverage pays only a fraction of the cost of the total volume being traded, and the rest is borrowed from the broker.
If the speculation is right and the price goes up, the trader closes their position & the difference is cash settled minus any brokerage fees. But you could lose if your speculation is wrong.
Most small retail traders trading forex are trading via CFD brokers that offer forex & CFD trading. It is important to understand the risks involved before trading CFD instruments.
Currency Futures
A futures contract is an agreement between two parties to sell or buy a given amount of currency, at a given rate at a specified future date.
Future contracts normally have a tenure of 3 months and interest rates are taken into consideration when dealing with futures. Futures differ from forward contracts in that futures are sold on the exchange and forwards are not.
Futures are either cash settled or physically delivered. Cash settled futures are settled daily on mark-to-market basis. In cash settlement, both parties in the future contract are required to pay a deposit known as a margin to the settlement house, and the price changes are settled daily. This is to avoid the risk of default by any of the parties involved. Whereas in physical settlement, the currencies must be exchanged at the end of contract period.
For example, a forex dealer in Japan who intends to use the US dollar in 2 months, may meet his broker and buy a forex future contract to lock in the price of the US dollar. By doing this the Japanese dealer buys the US dollar at the price stated in the contract in 2 months’ time irrespective of the market price of the US dollar at that time.
NDF
Non deliverable forwards NDFs are a forward contract where the difference is cash settled.
These are used to speculate or to hedge against currency risk normally when it is normally difficult to trade a currency directly on the spot market, for reasons like exchange control. These are popular in some countries.
The currencies in the contract cannot be delivered hence the term non deliverable. The transactions are cash settled based on the different in the spot price & the NDF rate, and it is settled in a major currency like the US Dollar.
Currency ETFs
They can comprise of different currency pairs put in one basket and traded on an exchange as an index.
They are similar to stocks and mutual funds. If you buy a currency ETF, you are speculating on currency fluctuations of different currency pairs which that ETF comprises.
For example, there are ETFs based on US Dollar Index that are bullish on US Dollar against a basket of currencies. The price of the ETF increases in value if the USD appreciates, and vice versa.
