The foreign exchange, also known as FX and ForEx, is a global marketplace where investors exchange national currencies for conducting foreign trade. Currencies are bought and sold against each other’s exchange rates in pairs.
Foreign exchange consists of three markets (spot, forwards, and futures) where individual and corporate investors exchange currency. FX markets are the largest and most liquid markets globally and are commonly used for hedging and speculating international currency, and portfolio diversification.
In this article, we’ll explore an overview of the ForEx market through the uses of the three foreign-exchange markets. Read on to learn how to navigate the complexities, risks, and rewards within the foreign exchange marketplace so you can decide where you best fit.
An Overview of ForEx Markets and Platforms
Foreign exchange is a necessary component of foreign trade. In order to exchange foreign goods, foreign currencies must be exchanged against each other at their current values.
While, globally, it is the largest financial marketplace, foreign exchange is a somewhat unpopular form of investment trading for individual investors; it is mainly a corporation’s investment game.
This is due to several complexities at play, including:
- Currency fluctuation
- Foreign trade lot sizes
- Transaction prices
- Profit-loss potential
Fortunately, there is likely a ForEx market to suit each investor’s needs.
Let’s start with the three ForEx markets and the types of transactions found within each one.
Like all investments, foreign exchange transactions are time-sensitive. While ForEx markets are open 24 hours a day, five days a week, your transaction’s timeliness will depend on the ForEx category you use.
Currency transactions can take place immediately—in spot markets—or at a later contracted time—in forwards and futures markets.
Take a look at the table below for a quick overview of the spot, forwards, and futures foreign exchange markets.
|Market Name||Key Features||Example Market|
|Spot Market||Cash market Buyer and seller trade assets “on the spot.”It takes two days to settle fundsBecoming more popular with individual investors||New York Stock Exchange (NYSE)|
|Forwards Market||Over-the-counter (OTC) markets Assets traded via customizable contractsBuyer and seller determine trade price and dateBuyer and seller settle differences in spot price at the end of the contractUsed for hedging or speculationPopular with large international and corporate investors||OTC marketsTransactions are not made on centralized exchangesAssets are traded via broker-dealer networks|
|Futures Market||Auction marketTrades conducted via standardized contractsBuyer and seller determine the size of trade and settlement dateContract prices are not affected by changing spot pricesUsed for hedging or speculationPopular with international large and corporate investors||Chicago Mercantile Exchange (CME)New York Mercantile Exchange (NYMEX)|
How to Read a Foreign Exchange Quote
Foreign currencies are hardly ever equal in value. Foreign factors such as geopolitics, foreign economic activity, and government-reported economic data all constantly affect the rate of a country’s currency value.
Here we’ll go over a simple example of what a currency exchange rate may look like in a foreign transaction.
Foreign exchanged goods are rarely ever sold in individual units.
Instead, they are commonly sold in unit lots, usually on the magnitude of thousands, ten thousands, hundreds of thousands, etc.
Additionally, when foreign assets are bought and sold, ForEx currencies are exchanged against each other’s current value rates. A ForEx currency exchange rate is called a quote.
In a ForEx transaction, a base currency is bought or sold against a pip, or quote currency (for simplicity, we’ll use “quote currency” instead of “pip”).
One unit of the base currency is traded against the rate of the quote currency. The quote currency is usually priced to four decimal places.
For example, one unit of USD exchanged against the rate of CAD could look like: $1 / C$1.0125.
These unit rates are then applied to ForEx lots to calculate transaction costs. To calculate the transaction cost, divide the lot size by the exchange rate.
Fun Fact: There are 18 total currencies that can be traded in the ForEx market. Of those 18, the most popularly traded currencies are the:
- U.S. dollar (USD)
- Canadian dollar (CAD)
- Euro (EUR)
- British pound (GBP)
- Swiss franc (CHF)
- New Zealand dollar (NZD)
- Australian dollar (AUD)
- Japanese yen (JPY)
Trading in the Spot Market
Thanks to the rising popularity of electronic trading, the spot market has become the most popular form of all three foreign exchange markets.
To some, the spot market is synonymous with ForEx.
The spot market is the largest of all three foreign-exchange markets because it is the basis for all three markets, meaning the forwards and futures markets’ transactions rely on spot markets’ assets.
The spot market is a cash market where financial investments are bought and sold “on the spot.”
While the purchase and delivery of assets are immediate, they usually take two days to settle transaction funds. Spot market transactions are comparable to stock-traded transactions.
In spot markets, the price of an asset is called its spot price.
Spot prices are determined by the supply and demand of buyer and seller orders. In liquid markets, spot prices can change rapidly, as asset orders are filled and replaced.
Example of a Spot Market Transaction
Let’s use an example of a ceramic goods importer to illustrate a spot market exchange.
Imagine an American ceramic importer wants to buy $100,000 worth of ceramic goods from a Japanese retailer. In this transaction, the base currency is USD, and the quote currency is JPY. In this example, we’ll say $1 USD exchanges for ¥0.0222 JPY.
The importer places an order with the retailer.
To execute the foreign exchange transaction, the importer divides the lot size by the exchange rate: 100,000 / 0.0222.
The importer must pay the retailer ¥4,504,504.5045. The importer uses their $100,000 to purchase the equivalent amount of JPY and completes their order after the foreign currency exchange settles.
A Note on the Forwards and Futures Markets
The forwards and futures markets trade with contracts, rather than “on the spot” currency exchanges.
Buyers and sellers of forwards and futures contracts claim:
- A specific currency type
- Unit price
- Future settlement date
Trading in forwards and futures contracts is most common with large international companies whose livelihoods rely on the foreign trade of volatile or market-dependent goods.
However, companies engaging in foreign trade are at the mercy of currency value fluctuations.
Fluctuations in currency values affect a foreign good’s spot price. It can prove challenging for a company to plan and make prudent trades if:
- A good’s spot price regularly changes, and
- Foreign goods must be bought and sold in large unit lots
To prepare for these complexities and minimize possible losses, ForEx companies use forwards and futures contracts.
Forwards and futures contracts can help hedge this risk by contracting to exchange assets at favorable:
- Settlement dates
Trading in the Forwards Market
The forwards market is known as an over-the-counter (OTC) market, unlike the spot and futures market, which trade on centralized exchange markets.
In a forwards contract, a buyer and seller determine the type and price of an asset, as well as the date of settlement among themselves. The agreed-upon price is used as a standard against the asset’s spot price at the time of the contract’s settlement.
When it comes time to settle the contract, one unit of the contracted asset is either less than, greater than, or equal to the current spot price. If there is an inequality between the contracted price and spot price, the responsible party pays the difference.
This may seem confusing, so let’s go over an example of how a forwards contract works.
Example of a Forwards Market Transaction
Imagine an alfalfa farmer plans to sell 10,000 bushels of alfalfa in the next harvest season. The next harvest season is eight months away, and alfalfa farmers in his area have struggled with e.Coli contaminations in their crops.
Because the farmer is worried these unfavorable events will lower alfalfa’s market price, he enters a forward contract with a bank where he agrees to sell 10,000 bushels of alfalfa for $10 a bushel. Depending on alfalfa’s spot price in eight months, both parties agree to settle the difference if the current price is unfavorable.
In eight months, when it is time to sell the alfalfa, the spot price of alfalfa could cost:
- $10 / bushel. In this case, neither contracting party has to make any cash settlements.
- $9.50 / bushel: In this event that the alfalfa sells for less than the contract price, the bank will pay the farmer the difference in spot price on the order of the 10,000 bushels of alfalfa.
- $12 / bushel. In this event that the alfalfa sells for more than the contract price, the farmer will pay the bank the difference in spot price on the order of the 10,000 bushels of alfalfa.
As shown in case two, companies may favor forwards contracts for hedging decreases in the spot price. If the value moves unfavorably between the time of the contract’s creation and the settlement date, the asset’s agreed price will help them offset any possible losses.
As shown in case three, companies may favor forwards contracts in the event a spot price increases by the contract’s time of settlement, thereby rewarding the investor with a profit.
A Word of Caution with Forwards Contracts
Investors should exercise caution and due diligence with assets listed on over-the-counter markets.
OTC markets are considered riskier transactions because their products are not stable, nor are the companies regulated. As a result, these transactions are:
- Less liquid
- More prone to default
Trading in the Futures Market
The futures market is an auction market, meaning contract buyers and sellers make competitive bids and offers.
Matching bids and offers are paired and executed as orders.
In a futures market, sellers create competitive offers for specific assets for which buyers buy the right receive assets at a future date.
The mechanics of futures contracts are comparable to options contracts.
Futures contracts are standardized. Meaning assets are bought and sold on a set unit basis, such as 10,000 or 100,000 units per contract.
Like forwards contracts, futures contracts can be used by companies to hedge losses or gain profits from speculative trading.
However, commodities in futures contracts, like oil, are naturally volatile items with naturally volatile spot prices.
Companies use futures contracts to hedge losses or speculate profits by capitalizing on the traded asset’s market price.
Unlike the forwards market, the American futures market is regulated by the Commodity Future Trading Commission (CFTC).
Also, unlike forwards contracts, whose deregulation makes them prone to defaulting, fraud, and misinformation—futures contracts are created and monitored under strict guidelines to protect investors.
Foreign futures markets are also regulated within their own regulatory commissions.
Example of a Futures Market Transaction
If two parties in foreign exchange are making a profit from their goods, it is in their best interest to fix the prices of the foods they trade amongst each other.
Imagine in a futures market transaction where the following bids and offers are matched:
- A farmer offers to sell 10,000 units of saffron for $40 / unit. In the farmer’s market, the price per unit of saffron is $30.
- A retailer bids to buy 10,000 units of saffron for $40 / unit. The retailer re-sells each unit for $50 / unit.
In both cases, each party makes a profit from their transaction.
By engaging their bids and offers in a futures contract with an investor, both the farmer and retailer agree to buy or sell a saffron unit at the contracted price at a contract end date, and the investor agrees to buy the lot size of contracts.
At the contract end date, if the spot price for saffron increases above the contracted price of $40, the investor gets to keep the profit.
Conversely, if the spot price for saffron decreases below the contracted price of $40, the investor will pay the difference to the saffron farmer and retailer.
Risks and Rewards in ForEx Trading
Ironically, foreign exchanges are approached with lots of caution and excitement. These markets are high risk-high reward; trading in foreign exchange markets is not for novice investors.
Successful investments require a thorough understanding of one’s:
- Target foreign market
We recommend engaging in this type of trading after you have had experience creating a strong personal investment portfolio.
On the risk and reward of ForEx trading, investment authorities like Investopedia state:
“Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect supply and demand for currencies, which creates daily volatility in the ForEx markets. An opportunity exists to profit from changes that may increase or reduce one currency’s value compared to another.” (source)
Simply put, if you want to make a substantial profit from foreign exchange trading, you need to have a reliable forecast of your target economy and their current events.
Resources that can help you create this forecast include up-to-date:
- Statistics from foreign indexes
- Socio-economic reports
Keeping up to date with technical and political trends can also be useful resources for tracking favorable outcomes in your target market. Still, we advise you to use them with caution because their results are more anecdotal than statistical.
If you learn to anticipate your target market, asset, or currency, you can make lucrative profits from any of the ForEx transactions we explored above.
Just be warned: when engaging in foreign exchange markets, remember they are prone to sudden and steep changes in supply, demand, and value.
Start Your Adventure with ForEx Today, Cautiously
If you are still a novice investor, we encourage you to re-read this article and explore our linked vocabularies to broaden your understanding of this topic.
Foreign exchange is a broad and diverse investment topic; it’s okay if you don’t get it in one day. If you want to have a harmless try at ForEx trading, we suggest you try a demo ForEx account.
If you are a seasoned investor, it may be the right time for you to diversify your portfolio through foreign exchange trading. This trading form can give you a whole new data set to analyze, speculate, and invest upon. We recommend you check out this awesome list of ForEx brokers if you’re serious about getting started today.
Regardless of where you are in your ForEx journey, we hope you have fun learning lots about the foreign markets surrounding you!