One of the first things newbies hear about the forex market is the trillions traded daily by market participants. The type of currency trading to which the average Joe exposes themselves to is spot forex. Yet, it’s not the only division of currencies and surprisingly only the second-largest.
The Bank of International Settlements conducts a triennial survey looking at the trading volume figures of the numerous forex sectors, the last of which one they did in 2019. It found roughly $6.6 trillion was traded daily in forex, another testament to the sheer size of this financial instrument.
Below is an approximate breakdown according to Wikipedia:
- $3.3 trillion in swaps
- $2 trillion in spot
- $1 trillion in forwards/futures
- $294 billion in options and other products
The spot market is the easiest to understand, but what on Earth are futures, options, swaps, and forwards? We’ll briefly cover how each of these individual instruments works within currencies.
Swaps
As the term suggests, swaps involve a process of swapping two currencies that apply for various purposes. Primarily, these are for hedging fluctuation risk but, in other cases, also for securing cheaper debt, earning from interest yields, and speculating.
Much of the literature suggests we have FX and currency swaps, which is confusing and why some use them interchangeably. The two function similarly but have a few distinctions separating them.
Both swap forms tend to be used by large corporate and financial institutions instead of retail investors or traders.
FX swaps
An FX swap stipulates two parties to simultaneously buy and sell two different currencies at two rates, the spot and the future. FX swaps are used primarily for hedging against exchange risk.
There are two legs in this swap denoting the spot and future price. Imagine a European corporation has € 1 000 000 in the bank but needs some US dollars in three months.
To maintain the value of their euros, they would sell their euros for dollars at the present EUR/USD spot price (first leg) and promise to buy their euros by selling USD in three months at a future price (second leg).
Currency swaps
A currency swap, also used by large corporations and institutions, functions as a loan for borrowing foreign currency at a reduced cost. It involves two parties exchanging defined amounts of different currencies with pre-agreed principal and interest rates.
Typically, currency swaps work whereby two institutions need to borrow from each other. So, the two entities exchange a sequence of payments in one currency for a series of payments in another.
So, for instance, a Japanese company needing American dollars would do a currency swap with an American company needing Japanese yen. Both groups would decide on a particular fixed or floating interest rate, borrowed amounts, and set maturity dates.
The point of such deals is for both parties to gain access to cheaper debt with reduced exposure to exchange fluctuation variances.
Spot
The spot version of forex is the most popular market catering to everyone from the average Joe to enormous multinational banks. Spot forex is the most straightforward market to understand because we exchange currencies at their present or ‘spot’ price primarily for speculative purposes.
Hence, spot contracts are the most common type of forex transaction worldwide. We should also remember that millions of people and businesses exchange currencies immediately around the globe for conversion reasons.
For online trading, the spot is characterized by decentralized liquidity providers or market makers, 24/5 opening times, huge volume, electronic trading systems, high leverage, and overall low entry barriers.
Forwards/futures
Forwards and futures are near-identical because they each involve the practice of a contractual agreement between two parties to buy/sell a specific currency at a predetermined price on expiry date.
The purpose of these markets is ‘locking in’ exchange rates or hedging against them when large institutions have too much of one currency but need another temporarily. The main difference is futures are traded on established centralized exchanges while forwards are decentralized or privately over-the-counter.
Moreover, prices with futures settle daily, whereas with forwards, this occurs once at the contract’s termination.
While hedgers have traditionally utilized forwards and futures, these markets (particularly futures) have become more accessible even for retail traders who can speculate on them as they would in spot forex.
However, these instruments have more restrictions because of the high capital requirements, limited leverage, slight complexity, etc.
Options (and other products)
Forex options function very much like those in other financial instruments. An option is a trading instrument where one has the right but not the obligation to buy or sell a currency pair at a particular price (known as the strike price) before the predetermined expiry date.
Traders only pay a premium for the option, meaning their downside is capped while the upside is theoretically uncapped. To simplify options, we should think of them as a bet where traders don’t take any ownership of the currencies.
The most popular options are known as ‘vanilla options, which involve a call (buying) and put (selling). So, for instance, if we were going long on or buying the GBP/USD at 1.200, we would be obligated to put down some funds and take responsibility for any inevitable negative or positive fluctuations.
With an option (in this case, a call), the trader simply states the pair will be above the strike price (1.200) before a pre-specified expiry time. If the market falls below this level, you would only pay a premium, unlike in spot currencies where traders worry about stop losses.
Similar to futures, all kinds of traders use options for hedging and speculative purposes. Like spot forex, options trading is decentralized and very accessible for both retail and institutional investors.
- Spread betting: Another forex traded product is spread betting, where traders ‘bet’ how many points a pair’s exchange rate will rise or fall. Spread betting works quite similarly to spot forex, and prices are derived from the spot market.
The primary difference is profits from spread betting are generally non-taxable and incur no stamp duties. Spread betting is popular mainly in the United Kingdom and a few European regions.
Final word
Diversity in forex is a wonderful thing, affording people from all walks of life different ways of trading in the markets. Whether you trade futures, options, or spot, currencies are generally driven by the same technical and economic factors, which traders need to study.
Moreover, exchange rates risks are more or less the same across the board, which is another factor one must appreciate. Despite the diverse number of markets, spot forex remains the most popular and accessible for everyone.
