The foreign exchange market, better known as ForEx, or more simply as FX, is a market where foreign currencies are traded. The ForEx is the largest global market, open 24 hours a day, five days a week (except holidays), with trillions of dollars exchanging hands daily.
The five types of foreign exchange transactions are spot, forward, future, option, and swap. Using these different transactions, parties enter into a contractual agreement that one type of currency will be exchanged for another.
Continue reading for the difference between these transaction types and everything you need to know about the ForEx market.
ForEx can be overwhelming for those who don’t understand the market, but it’s a straightforward concept in reality. Essentially, the ForEx market is just an exchange of one type of currency for another.
You have most likely participated in this market type if you have ever traveled outside the country. ForEx is the same concept as exchanging your denomination for foreign currency to spend money in that country.
When these foreign transactions occur, you’ll notice that the exchange rate isn’t 1:1.
The exchange rate is constantly in a state of flux depending on the strength of the currency being traded.
Traders use different information to leverage the strength of currency to make money. Traders will try to buy a currency with the thought that it will increase vs. another type, or sell if they think it will decrease.
A few factors can influence the exchange rate strength of a currency.
- Political Environment
Based on some or all of these factors, a currency’s strength will increase or decrease accordingly.
If you think about it from a fundamental economic standpoint, the factors above influence supply and demand. The better the country’s economic situation, the higher the demand, the worse the situation, the lower the demand.
Higher demand means the currency price is likely to increase. The inverse is also true.
Note that you are directly trading between only two types of currency in a ForEx transaction.
Who Trades on the ForEx Market
Traders in the ForEx market are varied but can be as big as commercial banks and as small as individual investors. The following are the different types of investors that make up the multi-trillion-dollar FX market.
- Commercial banks – These institutions make up the bulk of trades that take place through banks that trade currency electronically
- Central Banks – These are the Governmental banks that set their currency rate
- Hedge Fund Managers – Manages investment decisions of large accounts
- Corporations – Importers and exporters
- Individuals – Individual investors make up the smallest portion of ForEx trades
Regardless of the person or entity investing, proper use of leverage can lead to large payoffs.
Before we talk about the transaction types, let’s first examine some of the currency pairs found in the ForEx marketplace.
The following are the most common currencies traded on the ForEx market.
- USD (US Dollar)
- EUR (Euro)
- JPY (Japanese Yen)
- GBP (British Pound)
- CHF (Swiss Franc)
- CAD (Canadian Dollar)
- AUD (Australian Dollar)
- NZD (New Zealand Dollar)
To be considered a major currency pair, the transaction needs to involve the US Dollar and any other of the seven currency options.
For example, USD/JPY or USD/CAD
Since it must include USD, only seven possible combinations can be considered a major currency pair.
To be considered a minor currency pair, it must involve two of the above most common currencies, excluding the US Dollar.
For example, GBP/JPY or CHF/NZD
This potential combination of currencies allows for many more possibilities to be considered a minor currency pair.
Simply put, an exotic currency is just any currency that wasn’t listed above. Though every other type of money is considered exotic, many exchanges are much less likely to be traded.
As we touched on earlier with supply and demand, there just isn’t a great demand for several types of currency.
There are about 18 other types of currencies that are generally likened to exotics.
These currencies are considered exotic because of their trade frequency. Some of the most common types of exotic currencies include the Russian Ruble (RUB), the South Korean Won (KRW), the Mexican Peso (MXN), and the Indian Rupee (INR).
For example, RUB/KRW or MXN/INR
Types of Foreign Exchange Transactions
As we discussed, there are five different types of foreign exchange markets:
In these various markets, no physical money changes hands. All of the trading is done electronically as part of the largest trading market in the world.
Regardless of the transaction type you use, you are always leveraging the position of one currency versus another. If you buy a currency, you are selling the other and vice versa.
Let’s take a closer look at some of the various foreign exchange transactions and some of the situations you may enter into a contract.
Spot markets involve the exchange of currency between a buyer and a seller, to occur immediately.
Of all of the transaction methods, this is both the most popular and happens the quickest.
While the premise of this type of transaction bases around the idea of an immediate trade between parties, in reality, and in most cases, the trade won’t finalize for two business days.
A couple of factors can influence the amount of time that it takes for a transaction to close.
- First, if the transaction is USD/CAD or CAD/USD, it will take one business day to finalize.
- Second, the time will be longer, as much as six business days, if the trade occurs during holidays.
It’s crucial to understand that, again, while spot market transactions are considered to be immediate, they take time to complete. The price is likely to change because of the time duration between the contractual agreement and the trade’s finalization.
The exchange rates of currencies are changing every second, based on the health of the economy. This changing exchange rate is one of the inherent risks that traders take on.
While you may agree to make your trade at a specific price, a significant event can drastically change the exchange rates before the transaction has been finalized.
Say, for instance, if a country unexpectedly declares war, its currency valuation may radically drop.
Since you’ve agreed to the contract, you are stuck in this agreement.
How much the price changes and how often has a lot to do with these currencies’ liquidity.
The most popular currencies are usually more liquid because they have a flexible exchange rate. Flexible exchange rates are tied directly to their countries’ economies, so if the economy’s health rises or falls, the currency will react similarly.
Some currencies use a fixed rate, where the government controls the exchange rate, so they continuously remain stable.
Forward contracts work by locking in a specific exchange rate for a trade happening later, which can be as short as a day, or as long as many months or more. By locking in an exchange rate, you’re hedging your bet that the price will move against you.
By holding this price then, even if the price moves adversely, by the time the transaction takes place, you have a price that you’ve agreed upon locked in.
The Forward’s price is determined by the interest rates between the trading currencies.
Currency forwards are also not traded on exchanges, so they are unregulated and can have very customized terms. Since they aren’t traded on any centralized market, they are considered an over-the-counter (OTC) instrument.
Once you enter into a forward contract, you are liable and cannot walk away from your obligations, regardless if the outcome wasn’t in your favor. The only way to break this contract is if both parties agree to this break.
Since you are dealing directly with another party, you are entirely reliant on your counterparty.
This reliance can be a problem because there’s no security for you if, for instance, they go bankrupt on you. There is also no liquidity involved with this kind of contract because it’s an agreement between two parties.
No one else can take over the contract for you.
A future market works under the same concept as a forward’s market but with some critical differences.
Futures are traded on one of the many exchanges around the globe and are standardized.
They also benefit from having a middle man, known as the clearinghouse, responsible for collecting money and settling trade accounts.
Clearinghouses also require that you keep a minimum account balance to offset the risk of not completing payment.
Finally, these clearinghouses also ensure that the transaction is quoted in the public market.
Since you’re dealing with a third party instead of working directly with another party, you don’t have to worry about the potential of bankruptcy.
Other than the regulation changes mentioned above, the concept is similar to a forward, locking in a specific rate for a trade occurring in the future.
This video does a fantastic job discussing some of the differences between forwards and futures markets.
Options trading is a unique option (no pun intended) because it allows the buyer to limit their potential losses while having the prospect of gaining an unlimited amount of money.
Traders set prices and expiration dates that they believe fit their hedging strategy. They can either buy with the expectation that the currency will rise or fall.
If they buy assuming that the currency will rise, the person selling believes the opposite, and vice versa.
When trading options, the seller sets a premium for the cost to enter into the trade. If the price the buyer expects is met before the expiration date ends, they can purchase the option. If the price doesn’t meet the expected price, then there is no obligation to buy the currency.
If the option doesn’t meet the expected strike price, the only loss you’ll incur is the premium set by the seller.
There are two basic types of currency options, call and put.
A call option allows the buyer to purchase the contract at the strike price. In this scenario, the buyer expects the spot price to rise, while the seller expects this price to fall.
A put option is the exact opposite. While it again allows the buyer to purchase at a strike price, they expect the price to fall, while the seller is hoping it rises.
When looking at your profit and loss during an option contract, remember that you have to consider the premium incurred at the inception of the contract.
The at-the-money price is when the strike price is the same as the spot price.
If you have a spot price above the at-the-money price during a call option, you haven’t necessarily made a profit.
If you haven’t made enough profit to at least cover the premium cost, then you’ve lost money.
Though you may not have made a profit, if the spot price increases beyond the at-the-money price, you should still exercise your buy option. Buying the option at this point limits the loss you take.
As an example of the scenario above, say you have an at-the-money price of $1.00 with a premium cost of $0.05. At the expiration of the contract, if the spot price is at $1.02, you would still exercise your buy option, but at a loss of $0.03. If you didn’t exercise the buy option, you would have lost the full premium price, $0.05.
For a put option, the numbers would be reversed. You would be hoping that the spot price was less than the at-the-money price.
It is also important to note that European and American options aren’t equal.
You can exercise American options either on or before the expiration date occurs, while European options can only be exercised on the expiration date.
In a swap market, interest between two foreign parties is exchanged. This interest swap can occur in either a fixed-for-fixed or a floating-for-fixed.
A fixed-for-fixed swap finds two parties swapping fixed interest rates on a principal amount.
Usually, this type of market takes advantage of a potentially lower interest rate.
A fixed-for-fixed swap can pay significant dividends for those looking to collaborate to benefit mutually. Typically, in your native countries, you can achieve a lower interest rate. If you’re looking at other currencies, your interest rates will usually be higher.
In a fixed-for-fixed swap, you can work around these higher interest rates by paying the interest on each other’s principal loan.
For example, say that you’re an American firm, and you can take a loan out at 5%, but you want a loan in Canadian dollars, which has an interest of 10%. On the other hand, a Canadian firm wants to take a loan out in the US dollar. While the Canadian company could take the loan out in their own money for 3%, it will cost them 8% for US dollars.
In a fixed-for-fixed loan, they can agree to take the loan out for each other. The Americans can take out a loan in the US dollar and lend it to the Canadians. Canadians can do the same with the Canadian dollar. This swap provides both of them the currency they need, at a much lower interest rate.
A floating-for-fixed is just as it sounds, exchanging a floating interest rate in one currency for a fixed rate in another country.
A floating interest rate is a rate that is not stable and can vary based on the market. This type of exchange can either mitigate risk or hedge your bets on changing interest rates.
For those hoping to mitigate risk, a floating loan may not provide them with the stability they want.
Fixed Loan Swaps
If risk-averse entities are looking for more consistency, swapping with a fixed loan is ideal. A fixed loan will have a consistent interest rate that will allow them to plan accordingly and not have the potential of being surprised if the rate increases.
While it will provide them with stability, there is some potential opportunity cost lost. If the interest rates drop, a fixed rate may mean they may be paying more for their caution.
For someone who is looking to hedge their bets, they may look to trade a fixed rate for a floating loan. The theory behind doing this is while you are trading away the stability of a fixed rate; you are hedging your bets that the interest rates will drop.
If rates drop, you could save a lot of money over the lifetime of the loan. However, this is a risky choice because if the rates don’t act the way you projected, you may end up paying much more than the fixed rate.
This process can also work in the inverse. You may project that rates will increase, so you want to swap for a lower fixed rate.
For individual investors, the ForEx market can be a highly lucrative option for bolstering and diversifying their investment accounts. If you’re hedging your bets, it’s crucial to ensure that you’re staying current with relevant factors that can influence currency fluctuation.
It’s crucial to remember, even if you believe you have the correct information, the market can turn against you.
Education in general, and not overextending yourself past your means, can keep you in the black.