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 foreign exchange market is important because it is here that 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. EUR/USD is the most traded currency pair in the world.
According to BRI triennial surveythe total daily forex turnover for 2019 was US$6.6 trillion.
It is the largest and most liquid financial market in the world with market players like central banks, commercial banks, dealers, brokers and individuals making up the ecosystem.
The Forex market is open 24 hours a day and has four major sessions/time zones per day. These are Sydney, Tokyo, London and New York.
When you trade in any market, you have different financial instruments that you can use to trade. These instruments can be used for hedging, speculating and trading or a combination of the three.
We will look at some of the trading instruments and options available to traders in the forex market.
When you trade in the forex market, you can choose to settle the trades immediately or later. If you choose to settle immediately, you settle it at the spot price which is the current market rate.
The spot price is the current price of an asset in the market at the time of trade settlement. In spot FX trading, the settlement date is T+2 days.
According to the BIS triennial survey, spot transactions worth US$1.98 trillion were transacted daily in 2019. The majority of SME and corporate payments are made through Spot FX.
Retail foreign exchange trading contributes to the turnover of the spot foreign exchange market with a daily turnover of 65 billion USD.
Many Forex brokers offer spot forex trading to retail traders through derivatives, and you buy and sell currency at the spot price, which is the current market price without owning the asset.
It is an agreement between two parties to buy or sell currencies at a predetermined rate on a future date. It is used to hedge against currency fluctuations and protect the holder. It is normally used by investors and companies like importers and exporters for hedging purposes.
If a Japanese investor wants to invest in a company in the United States in 5 months and needs to buy USD for his investment, he fears that in 5 months the USD will appreciate against the Japanese yen. So, they enter into a forward contract with the seller to buy the USD at a specified rate, on a specified date.
By doing so, they can hedge against the risk of fluctuations in the USD exchange rate.
When the forward exchange rate of the currency is higher than the spot price, the currency is called premium currency and when the forward exchange rate of the currency is lower than the spot price, it is called the discount currency. If the spot rate and the forward rate are the same, the currency is said to be at par.
Futures contracts are not traded on an exchange, they are traded over the counter.
Forex and currency swaps
These are the most traded forex instruments in the market. According to the BIS triennial survey, currency swap transactions worth more than US$3 trillion were traded in 2019 alone.
Currency swaps generally involve exchanging a corresponding amount of one currency with another similar amount of another currency. Example of USD/GBP exchange.
A currency swap is technically a currency swap, but they are different in terms of interest rate (currency swaps usually do not involve interest rates) and duration (currency swaps are fixed-term agreements). long term).
In currency swaps, a loan in one foreign currency is exchanged for another loan in another foreign currency.
Popular among businesses looking to borrow in a foreign currency, they use currency swaps to avoid going to the market to borrow at high interest rates. Financial institutions sometimes act on behalf of large corporations.
Suppose Company “A” has an outstanding loan of £5000 but needs to take out another foreign currency loan of US$5000, it contacts Company B which already has an outstanding loan of 5 $000.
They both exchange the principal of 5,000 at the spot rate and agree to settle the interest payment which will accrue for the amount exchanged during the exchange period only.
By doing so, Company “A” avoided trying to obtain a foreign currency loan at higher interest rates. At the end of the loan period, companies “A” and “B” exchange the principal at the prevailing spot rate or at a rate they have predetermined and adjust their books.
According to the BIS triennial survey, more than US$297 billion worth of forex options were traded daily in 2019.
A forex option is simply a contractual agreement between two parties whereby the option holder has the right but not the obligation to buy or sell a predetermined amount of foreign currency at a predetermined price called the strike price and at a predetermined date.
A buy agreement is called a call option and a sell agreement is called a put option. The option holder buys it from the option seller or 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 only be exercised on the expiration of the given date while American options can be exercised anytime before the expiration date.
Options can be used to hedge against risk in business. If a company in South Africa is concerned that the US dollar will soon appreciate against the South African rand (ZAR), it may choose to contact a broker and purchase a call option (paying a premium to the seller of the option) which gives him the right but not the obligation to buy US dollars from the seller at an agreed price and date.
If that date arrives and the US dollar does not appreciate, the option is not exercised or used and the South African company loses the premium paid. By doing so, they have protected themselves against the risk of currency exchange in USD.
CFD stands for contract for difference. Here, leverage is used to trade on the currency exchange rate fluctuation. CFDs can be used for speculation by traders, as you will see in the example below.
Forex Beginner UK explains how it works, “If a trader thinks the price of a currency is likely to rise, they can approach their broker and buy a CFD contract to take advantage of that rise. If they think the value of the currency will drop, they could do the same and place a sell order instead.
The trader using leverage only pays a fraction of the cost of the total volume traded, and the rest is borrowed from the broker.
If the speculation is good and the price goes up, the trader closes their position and the difference is settled in cash minus the brokerage fee. But you could lose if your speculation is wrong.
Most small retail traders who trade in forex trade through CFD brokers that offer both forex and CFD trading. It is important to understand the risks involved before trading CFD instruments.
A forward contract is an agreement between two parties to sell or buy a given amount of currency, at a given rate on a specified future date.
Futures contracts normally have a duration of 3 months and interest rates are taken into consideration when dealing with futures contracts. Futures contracts differ from futures contracts in that futures contracts are sold on an exchange and futures contracts are not.
Futures contracts are either cash settled or physically delivered. Cash-settled futures contracts are settled daily based on the market price. In the case of a cash settlement, both parties to the futures contract are required to pay a deposit called margin to the settlement company, and price changes are settled daily. This is to avoid the risk of default by one of the parties involved. While in physical settlement, the currencies must be exchanged at the end of the contract period.
For example, a forex broker in Japan who intends to use the US dollar in 2 months, can meet with their broker and buy a forex futures contract to lock in the price of the US dollar. By doing so, the Japanese dealer buys the US dollar at the price stated in the contract within 2 months, regardless of the market price of the US dollar at that time.
Non-Deliverable Forward Contracts NDFs are a forward contract in which the difference is settled in cash.
These are used to speculate or to hedge against exchange rate risk normally where it is normally difficult to trade a currency directly in the spot market, for reasons such as exchange controls. These are popular in some countries.
The currencies of the contract cannot be delivered hence the term undeliverable. Trades are settled in cash based on the difference between the spot price and the NDF rate, and they are settled in a major currency such as the US dollar.
They can include different currency pairs placed in a 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 the currency movements of the various currency pairs that make up that ETF.
For example, there are ETFs based on the US dollar index that are bullish on the US dollar against a basket of currencies. The ETF price increases in value if the USD appreciates, and vice versa.