6 Types of Forex Markets
The foreign exchange market is a global, decentralized market that is used for trading currencies.
The foreign exchange market provides investors with a way to hedge against the risk of currency fluctuations, speculate on changes in exchange rates and take advantage of interest rate differentials between two countries.
Spot Market
In the foreign exchange market, the spot market is the market in which foreign currencies are bought and sold for immediate settlement. This means that in a spot transaction, the two parties agree to exchange currencies at the prevailing exchange rate and settle the transaction within three business days.
The spot market is the most widely traded market in the foreign exchange market. It is the market in which individuals, companies and financial institutions exchange one currency for another to meet immediate payment commitments, such as the purchase of goods and services in another country or the settlement of foreign investments.
Over-the-counter markets
Spot transactions are executed in over-the-counter markets, i.e. where buyers and sellers negotiate the terms of the transaction directly with each other, often with the help of intermediaries such as market makers, brokers or agents.
An important point to mention is that here trades are usually settled through electronic systems, such as the SWIFT network.
The spot market is also the most liquid market in the foreign exchange market, with the highest trading volume, and spot market prices are used as a benchmark for other markets.
Forward Markets
Also known as forward transactions, they are a type of over-the-counter market in which two parties agree to exchange a fixed amount of one currency for another currency at a predetermined exchange rate on a specific future date.
These contracts are financial agreements between two parties to buy or sell a currency at a future date, but at a fixed exchange rate agreed at the time of the contract.
A feature of these contracts is that they can be settled in cash or by physical delivery of the underlying currencies.
Forward contracts are used by companies and investors to manage foreign exchange risk, particularly in situations of uncertainty about future exchange rates.
If a company expects to receive payment in a foreign currency at a future date, it can use a forward contract to fix an exchange rate for that currency, thereby protecting itself against potential losses due to currency fluctuations.
Futures Market
In this type of over-the-counter market, participants can buy or sell standardized contracts for the future delivery of a specified quantity of one currency in exchange for another currency at a fixed price on a specified date.
Futures markets offer participants a transparent, regulated and centralized market for managing foreign exchange risk.
In addition, they allow market participants to take both long and short positions in the underlying currency pair, giving them the ability to profit from both rising and falling exchange rates.
Participants in these exchanges include commercial banks, investment banks, hedge funds, companies and individual traders.
Unlike the contracts used in the Forward Market, here the contracts are standardized and traded on exchanges.
Each contract generally represents a fixed quantity of a currency pair, and the contract specifications are pre-determined, including the contract size, expiration date and minimum price movement, also known as the tick size.
The tick size
The smallest possible price movement a currency pair can make. It is the smallest possible increment by which the exchange rate can change.
The «tick» is measured in pips, which is the smallest unit of price change in the foreign exchange market. One pip is usually equivalent to 0.0001 of the currency value.
In the case that the Euro/Dollar currency pair is quoted at 1.2000 and the price rises to 1.2001, this represents a one pip increase in the exchange rate.
Swap markets
In this type of market, participants can exchange currencies for a specified period of time and exchange them back at the end of the period at an agreed exchange rate.
A currency swap is a financial agreement between two parties to exchange a specified sum of one currency for another at an agreed exchange rate, with the exchange usually occurring at two different times.
Companies and investors can use currency swaps to manage foreign exchange risk, finance foreign investments or operations, and take advantage of interest rate differentials between two countries.
A company that has borrowed money in a foreign currency can use a currency swap to convert the foreign currency back into its domestic currency, thus avoiding currency fluctuations that could negatively affect the value of the loan.
Swaps
There are several types of swaps in the foreign exchange market, among them we have:
Currency Swaps
As mentioned above, it is an agreement between two parties to exchange a fixed amount of one currency for another currency at an agreed exchange rate.
Interest rate swaps
It is a financial agreement between two parties to exchange cash flows based on different interest rates.
Here one company may agree to pay a fixed interest rate, while the other agrees to pay a floating interest rate.
Cash flows are exchanged periodically, usually quarterly or semi-annually.
Credit default swaps
These involve the exchange of cash flows based on the default of a specific bond or loan.
Commodity swaps
Commodity swaps involve the exchange of a fixed or variable price for a commodity, such as oil or natural gas, at a future date.
Equity swaps
Equity swaps are equity swaps, which means that the exchange of cash flows is a function of the performance of an underlying stock or index.
Foreign Exchange Options Market
A foreign exchange option is a contract that gives the holder the right, but not the obligation, to buy or sell a specified amount of a currency at a predetermined exchange rate and date.
A company exposed to exchange rate risk can use options to hedge against adverse movements in exchange rates.
An investor could use options to speculate on a possible currency movement or to hedge a portfolio against exchange rate risk.
Options markets in the foreign exchange market are generally less liquid than other foreign exchange markets.
This market is mainly used by institutional investors and large corporations. However, they can offer participants greater flexibility in managing their currency risk and investment strategies.
There are two types of currency options
Call options
A type of financial contract in the options market that gives the holder the right, but not the obligation, to buy an asset at a specified price, known as the strike price, on or before a specified date, known as the expiration date.
The holder of a call option pays a premium for the right to buy the underlying asset at the strike price, but is not obligated to do so.
In the context of the foreign exchange market, a call option on a currency gives the holder the right to buy a specified amount of the currency at the strike price on or before the expiration date.
It is common for a trader to purchase a call option on the euro with a strike price of $1.20 and an expiration date of one month, the trader has the right to buy euros at a rate of $1.20 per euro at any time during the following month, regardless of the current exchange rate.
Put options
A type of financial contract in the options market that gives the holder the right, but not the obligation, to sell an asset in question, such as a stock or a currency, at a specified price, known as the strike price, on a specified date.
Similar to a call option, the holder of a put option pays a premium for the right to sell the underlying asset at the strike price, but is not obligated to do so.
Interbank Market
A financial market in which banks and other large financial institutions trade foreign exchange among themselves.
It is a wholesale market, which means that transactions in this market are generally carried out in large quantities and are only available to institutional clients with significant financial resources.
In the foreign exchange market, the interbank market is the largest and most important market, as it fixes currency exchange rates.
It is a decentralized market, in which transactions are carried out electronically and over the counter, directly between counterparties.
Banks and financial institutions participate in the interbank market for a variety of reasons, such as hedging their foreign exchange risks, managing their foreign exchange positions and providing liquidity to other market participants.
The interbank market is also used by central banks to execute their monetary policy, buying or selling currencies to influence their exchange rates.
This market is not accessible to individual investors or traders, as transactions in this market are carried out in large quantities and require significant financial resources. However, the exchange rates set in the interbank market may have an impact on the exchange rates offered to retail customers in other markets, such as the retail foreign exchange market or foreign exchange services.