Spot Market Forwards Swaps
Spot Market
The spot market or cash market is the actual price of a currency at that moment in time – the price for immediate delivery. A trader will contact his broker or bank and ask for a price for the pair of currencies he wants to trade.
A spot contract is a contract between two parties who exchange an agreed upon amount of two currencies at an agreed upon exchange rate.
The normal delivery time for a forex contract is two days. With the exception of the Canadian dollar which is one day. The reason for the two days for deliver was established long before modern technology and sufficient time was needed to verify all the details of the transaction. Nowadays, transactions are concluded in fractions of a second.
Transactions are normally concluded via telephone or automated dealing desks. When using the telephone to transact a trade it is important to know the correct etiquette. This can differ dramatically from broker to broker or bank to bank. It is important that you first contact your broker or bank and ask for the correct procedure for placing orders.
The spot market is the market this guide is concentrated on and is the market most traders will speculate on. I will however cover other common vehicles of trading forex for reference.
Forwards
Forwards or Forward trading is different from spot trading in that you must take into account the interest differential. As each country has its own interest rate, the difference in the interest rate must be taken into consideration. If the interest rate in one country is 5% and the interest rate in another country is 3% then the interest differential is 2%.
Forwards Outright deals are deal in which two parties agree the price of the two currencies involved at a forward (future) date, normally 3 days to 3 years, although the majority of contracts are for under six months. Because no one really knows what the exchange rate for two currencies will be in the future, a forward attempts to calculate what a fair value for the two currencies will be by taking into account the interest rate of each country. Forward rates are normally higher or lower at a premium or at a discount to the spot rate.
Premiums and discounts show the interest differential between two currencies at the time of the deal. The determination of a forward price is not a prediction of the future exchange rate. It is merely a tool to allow interested parties to fix a rate in the future.
Swaps
A swap is simply a combination of a spot deal whilst at the same time making a forward deal or vice versa. Let’s say that the ‘’Really Big Company’’ wants to do a deal in Europe but the bean counters believe they can get a better deal in the U.S. because they have good relationship with some financial institutions there.
So the ‘’Really Big Company’’ borrows $5 million at 4% over the next 5 years in the U.S. At the same time the ‘’Really Big Company’’ makes a deal to trade its future dollar liability for Euros. Under the terms of the deal the bank/broker agrees to pay the ‘’Really Big Company’’ enough dollars to service its dollar loan and in return the ‘’Really Big Company’’ agrees to make a serious of annual payment to the bank/broker in Euros. This is an example of currency swaps.
