Kinds of the Forex

Spot Market. Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity (See Figure 1.2). The features of the fast-paced spot market are high volatility and quick profits (as well losses). A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from counterparty, based on an agreed exchange rate, within two business days of the deal date. The exception is the Canadian dollar, in which the spot delivery is executed next business day. The two-day spot delivery for currencies was developed long before technological breakthroughs in information processing.

This time period was necessary to check out all transactions' details among counterparties. Although technologically feasible, the contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery. By the entering into a contract on the spot market a bank serving a trader tells the latter the quota – an evaluation of the currency traded against the U.S. dollar or another currency.

A quota consists of two figures (for example, USD/JPY = 133.27/133.32 or USD/JPY = 133.27/32 which means the same). The first of these figures (the left part) is called the bid – price (that is a price at which the trader sells), the second (the right part) is called the ask - price (the price at which the trader buys the currency). The difference between asks and bid is called the spread. The spread, as any currency price alteration, is being measured in points (pips).
In terms of volume, currencies around the world are traded mostly against the U.S. dollar, because the U.S. dollar is the currency of reference. The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc. Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currencies crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen.

The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. For instance, in an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times "flying" 100-200 pips in a matter of seconds if the market gets wind of a significant event. On the other hand, the exchange rate may remain quite static for extended periods of time, even
in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. For example, there is a technical trading gap between around 4:30 PM and 6 PM EDT. In the New York market, the majority of transactions occur between 8 AM and 12 PM, when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support.

Overnight trading is limited, as very few banks have overnight desks. Most of the banks send their overnight orders to branches or other banks that operate in the active time zones. Reasons for the popularity of the spot-market include the rapid liquidity, thanks to the market volatility, and short term contract execution. Therefore, the credit risk is restricted. The profit and loss can be either realized or unrealized. The realized P&L is a certain amount of money netted when a
position is closed. The unrealized P&L consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate. The unrealized P&L changes continuously in tandem with the exchange rate. Forward Market. Two tools are used on the forward Forex: forward outright deals and exchange deals or swaps. A swap deal is a combination of a spot deal and a forward outright deal.

According to figures published by the Bank for International Settlements, the percentage share of the forward market was 57 percent in 1998. (See Figure 1.2). Translated into U.S. dollars, out of an estimated daily gross turnover of US$1.49 trillion, the total forward market represents US$900 billion. In the forward market there is no norm with regard to the settlement dates, which range from 3 days to 3 years. Volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals. Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies. The forward markets are decentralized markets, with players around the world entering into a variety of deals either on a one-on-one basis or through brokers. The forward price consists of two significant parts: the spot exchange rate and the forward spread.

The spot rate is the main building block. The forward spread is also known as the forward points or the forward pips. The forward spread is necessary for adjusting the spot rate for specific settlement dates different from the spot date. It holds, then, that the maturity date is another determining factor of the forward price.

Futures Market. Currency futures are specific types of forward outright deals. Because they are derived from the spot price, they are derivative instruments. (See Figure 1.2). They are specific with regard to the expiration date and the size of the trade amount. Whereas, generally, forward outright deals—those that mature past the spot delivery date—will mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency
futures mature only on the third Wednesday of March, June, September, and December.

The following are characteristics of currency futures that make them attractive. They are open to all market participants, individuals included. It is a central market, just as efficient as the cash market, and whereas the cash market is a much decentralized market, futures trading takes place under one roof. It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa. In turn, the Clearinghouse minimizes its own exposure by requiring traders who maintain a nonprofitable position to post
margins equal in size to their losses. Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities. Gaps, volume, and open interest are significant technical analysis tools (See Chapter 4) solely available in the futures market. Because of these benefits, currency futures trading volume has steadily attracted a large variety of players. Because futures are forward outright contracts and the forward prices are generally slow movers, the elimination of the forward spreads will transform the futures contracts into spot contracts.

For traders outside the exchange, the prices are available from on-line monitors. The most popular pages are found on Bridge, Telerate, Reuters, and Bloomberg. Telerate presents the currency futures on composite pages, while Reuters and Bloomberg display currency futures on individual pages that show the convergence between the futures and spot prices.