When most people talk or write about Forex, they are referring to the spot forex (See below). However, there are different type of currency investing markets that you should be aware of:
1. The Spot Currency Market
The spot market (also known as cash currency market) is the current or actual price of a currency at that moment in time. It is the price at which you will get a currency for immediate delivery. Every time you go to a bank to exchange your Japanese yen for Canadian dollars, you are engaging in the spot currency market. For the spot forex trader, it is the price in which you contact your forex broker either by phone or through his trading platform and ask for the price you wish to trade a particular currency.
Most retail forex traders deal in the spot currency market which is the forex market. With the advent of new technology, transactions of this kind are normally concluded in seconds but the normal delivery time for spot forex contracts is two days with the exception of the Canadian dollar which is one day.
2. The Forwards Currency Market
A more complicated currency market is the forwards currency market. Forward trading is different from spot trading in that you must take into account the interest rate differences ,otherwise called the interest rate differential, between the countries currencies you are trading in. For example, when dealing with the currency pair GBP/USD (Great Britain Pound against the USA dollar), you must take into account the interest rate differences between Britain and the USA. If the interest rate in Britain is 5% and the interest rate in the USA is 3%, the interest rate differential is 2%.
A forward currency contract attempts to calculate the fair value of two currencies taking into account the interest rates of the two countries in the future. The future rate or the forward rate is normally 3 days to 3 years, but most such contracts are under 6 months. The forward rate is calculated as
(Spot rate x interest differential (e.g. Dollar interest rate - British Pound Interest Rate) x days/360) / (1+ ( British Pound Interest Rate x Days/360)
Before you get your calculator out, note that the determination of the forward price is not a prediction of a future exchange rate but is merely a tool to allow parties to fix a rate in the future. Currency forwards are the domain of large financial institutions and corporations.
3. Currency Swaps
A currency swap is a combination of a spot currency trade and a forward contract. This type of contract is also very complicated and involves multinationals trying to get better rates in their trading activities.
For example, a car manufacturer in the USA makes a deal in Europe but believes it will get better interest rates in the USA because of better relationships in the USA. The manufacturer borrows funds in the USA over the next 5 years.
The USA manufacturer then makes a deal with European banks to trade it's future dollar interest rate liability to the USA banks in Euros. As such the European bank agrees to pay the car manufacturer enough dollars to service it's dollar loan and in return, the car manufacturer agrees to make payments to the European bank in Euros.
4. The Currency Futures
Currency futures fall under forward currency contracts. They however have specific contract sizes, maturity dates and are traded in a formal exchange. Most currency futures are traded in the Chicago Mercantile Exchange.
Retail currency traders can trade in the currency futures market however they are more expensive to trade than spot forex in that one needs to trade through a member of the exchange. Another disadvantage is that unlike the spot market where the trader only risks the capital available with his forex broker, trading in currency futures puts at risk all the wealth a trader may have.
Spot forex traders have been known to look at currency futures rates as a guide to the trend in a currency.
5. Currency Options
Forex options are slowly being introduced and these provide a buyer with the right but not the obligation to sell or buy an amount of forex at an exchange rate and a date specified in advance.
For example, a forex trader may bet on the price of the EURUSD going to the rate of 2.1222 on July 31st 2009. He can then buy currency options at the rate of 2.1190 . If the price goes above this, the forex trader will still have the option to buy the currency at 2.1190 even if the price has risen to 2.1222 and then resell the currency at the open market for a profit. If the market does not reach 2.1190, the currency options trader has no obligation to buy the currency.
To be able to buy the currency options, the forex trader must pay a premium to the writer of the option which is normally the bank or the forex broker.
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