This article looks at the different foreign exchange markets, namely, the spot, futures and forwards markets.
Individuals, corporations and institutions trade forex in three different ways. They trade via the spot market, the futures market and the forwards market. The spot market is the largest as it forms the basis for the other two markets. The futures market was the most popular market in the past as this is where individual investors were allowed to trade. The onset of electronic trading has caused a massive increase in activity in the spot market to the point where the spot market has overtaken the futures market as the preferred trading arena for speculators and individuals. The spot market is what people refer to when they talk about the foreign exchange market. The futures and forwards markets are more popular with large corporations that are required to hedge their forex risks to a particular future date.
The Spot Market
This market is where all currencies are purchased and disposed of at the current market price. The price is based on supply and demand and reflects factors such as economic performance, interest rates, sentiment towards both local and international political situations and the perception of the possible future value of one currency to another. When deals are finalised in this market, they are referred to as ‘spot deals’. It is a two-way transaction where one entity delivers a currency amount to another entity and for that receives a set amount of the other currency at a mutually agreed currency price. Once the position has been closed, the amount is settled in cash. The spot market may refer to deals that happen in the present instead of the future, but these trades can take a couple of days before it is settled.
Foreign Exchange Futures and Forwards Market
The futures and forwards markets are not used to trade in currencies. They work with contracts that provide you with a claim to a particular type of currency, a set unit price and a settlement date sometime in the future.
The futures market deals with contracts that are based on a standard settlement date and size. These contracts are done through public commodities markets, like the Chicago Mercantile Exchange. This market is regulated in most countries. Futures contracts contain specific details. This includes the unit number that is being traded, the delivery date, the settlement date and the non-customizable increments in price. The exchange normally acts as the other part of the deal to the trader, providing both settlement and clearance.
The forwards market deals with contracts that are purchased and sold between two entities who agree upon the terms of the contract.
Both these types of contract are binding and are normally settled in cash on the date stipulated. The parties have the option to buy or sell the contracts prior to the expiry date. These markets are traditionally used by large international corporations to protect against future currency fluctuations. It is possible for speculators to partake in these particular markets. It offers currency traders protection against potential risk.
The foreign exchange markets that you can trade in depend entirely upon your trading plan and strategy. You can make use of the spot, futures or forwards market for your currency trading.
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