As a currency trader, there are numerous kinds of financial instruments that you can use. While retail forex traders typically use foreign currency options as a hedging tool, banks are more likely to use options, swaps and other more complicated derivatives to meet their particular hedging needs. Some of the common financial instruments used in Forex are spot transactions, forwards, futures, swaps and options.
A spot transaction is an agreement to buy or sell a currency at the current exchange rate. In other words, it’s a simple exchange of one currency for another. It is generally settled within two business days after the trade date and entails a cash exchange instead of the creation of a longer-term contract.
The currencies are exchanged at the spot rate at the time of the contract. The spot rate is constantly fluctuating as the value of currency moves up and down according to future expectations. Spot transactions do not involve an immediate payment or settlement, with the settlement date usually set to the second business day after the trade date. The trade date is the date on which you agree to make the transaction. The two-day period provides ample time to the traders to validate the agreement and coordinate the clearing and required debiting and crediting of bank accounts. Interest is not included in the pre-fixed transaction.
Spot transactions carry high risk because they do not provide protection against unfavorable movements in exchange rates between pricing a contract and the need to buy/sell the foreign currency.
Currency traders use spot transactions to make profits in the same way as equity or commodity traders, buying low and selling high.
Forwards transactions involve the buying or selling of foreign currency for settlement no less than three days later, and at predetermined exchange rates. In short, a buyer and seller agree to trade currency at a particular time and at a particular exchange rate, regardless of what the exchange rate is when the transaction is actually made. A forward contract can also be arranged for up to a year in advance.
By locking in a specific exchange rate, the trader is protected against currency fluctuations for the term of the contract. Forward currency prices consist of the spot exchange rate (the rate at which the currency could be purchased in a spot transaction) and the forward price, calculated from a forward spread (the difference between the spot exchange rate and the forward price). Forward contracts are not standardized and are not traded on exchanges.
This type of financial instrument enables the trader to take advantage of currently favorable exchange rates at a future date, as well as protect the trader against the risk of exchange rate volatility.
A futures contract is a forward contract with a pre-determined currency amount, maturity date and interest amount. A futures contact is an agreement to buy or sell a currency in a designated future month at a price determined by the buyer and seller. They are standardized and traded on futures exchanges such as the Chicago Mercantile Exchange (CME). A future transaction is usually carried out within three months. Currency futures are always quoted in terms of the currency value with respect to the US Dollar.
In a swap transaction, one currency is exchanged for another for a specified length of time. The transaction is reversed at a specified future date, in which the original amounts are swapped. The two exchanges occur at different exchange rates. It is the difference in the two exchange rates that determines the swap price. Swaps have various maturity periods. A swap is another form of forward contract.
A currency option is similar to a futures contract, as it entails a fixed currency transaction at some future point in time. A currency option gives the holder the right, but not the obligation, to either buy from the option writer or to sell to the option writer a stated quantity of one currency in exchange for another currency at a fixed rate of exchange. The fixed rate of exchange is called the strike price.
The option styles can be American or European. In an American-style option the option can be exercised at any date before the agreed upon expiration. European options can only be exercised on the exercise date, not before.The option holder pays a premium to the option writer for the option. The premium is lost if the buyer does not exercise the option. Options protect the holder against the risk of unfavorable changes in the exchange rates.