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Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade
forex: the spot market, the forwards market and the futures market. The spot
market always has been the largest market because it is the "underlying" real
asset that the forwards and futures markets are based on. In the past, the futures
market was the most popular venue for traders because it was available to
individual investors for a longer period of time.
However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and
now surpasses the futures market as the preferred trading market for individual
investors and speculators. When people refer to the forex market, they usually
are referring to the spot market. The forwards and futures markets tend to be
more popular with companies that need to hedge their foreign exchange risks out
to a specific date in the future.
Spot Market
More specifically, the spot market is where currencies are bought and sold
according to the current price. That price, determined by supply and demand, is a
reflection of many things, including current interest rates, economic performance,
sentiment towards ongoing political situations (both locally and internationally),
as well as the perception of the future performance of one currency against
another. When a deal is finalized, this is known as a "spot deal".
It is a bilateraltransaction by which one party delivers an agreed-upon currency amount to the
counter party and receives a specified amount of another currency at the agreedupon
exchange rate value. After a position is closed, the settlement is in cash.
Although the spot market is commonly known as one that deals with transactions
in the present (rather than the future), these trades actually take two days for
settlement.
Forwards and Futures Markets
Unlike the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a certain
currency type, a specific price per unit and a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties,
who determine the terms of the agreement between themselves.
Investopedia.com – the resource for investing and personal finance education.
In the futures market, futures contracts are bought and sold based upon a
standard size and settlement date on public commodities markets, such as the
Chicago Mercantile Exchange. In the U.S., the National Futures Association
regulates the futures market. Futures contracts have specific details, including
the number of units being traded, delivery and settlement dates, and minimum
price increments that cannot be customized. The exchange acts as a counterpart
to the trader, providing clearance and settlement.
Both types of contracts are binding and are typically settled for cash for the
exchange in question upon expiry, although contracts can also be bought and
sold before they expire. The forwards and futures markets can offer protection
against risk when trading currencies. Usually, big international corporations use
these markets in order to hedge against future exchange rate fluctuations, but
speculators take part in these markets as well. (For a more in-depth introduction
to futures, see Futures Fundamentals.)
Note that you'll see the terms: FX, forex, foreign-exchange market and currency
market. These terms are synonymous and all refer to the forex market.
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