The $6 Trillion Financial Instrument: The Many Divisions of the Forex Market
Do you know what makes up the $6 trillion forex market? Aside from .popular spot trading, forex also encompasses swaps, forwards, futures, and options trading.
Much of the trading literature online will mention the several trillions of dollars traded in the forex market. Many might not know the great diversity of forex, consisting of speculators in spot trading, hedgers in futures, and other traders participating for different reasons.
Except for some options, futures, and forwards, all forex transactions occur in a decentralized or over-the-counter market consisting of numerous dealers, liquidity providers, or market makers in ECNs (electronic communication networks).
While spot forex is immensely popular and the instrument most are familiar with, other prominent forex divisions also exist, which are worth knowing. The Bank of International Settlements conducted the latest recognized in-depth study of the actual traded volume in forex in 2019 as part of their triennial survey.
In summary, the survey concluded approximately $6.6 trillion was traded daily in the entire forex market, a figure that has likely since grown. Within this astronomical number, the study also gave the subsets of forex contributing to the volume:
$3.3 trillion in foreign exchange and currency swaps
$2 trillion in spot
$1 trillion in futures/forwards
$294 billion in options
It might surprise many that the popular version of forex, spot, doesn’t contribute the most to the total traded size. So, what are currency swaps? What about futures? Read on to discover more.
Foreign exchange and currency swaps
Confusion is likely to be present over the differences between a foreign exchange or FX swap and a currency swap. Ultimately, both involve a process of exchanging or ‘swapping’ two different currencies and are primarily used by prominent institutional participants.
An FX swap involves concurrently buying/selling one currency to sell/buy another with two legs, a spot deal, and a futures deal. Massive corporations use futures in forex to lock in price values at a predefined date in the future.
The purpose of an FX swap is purely to manage foreign exchange risk, especially when a firm holds too much of one currency. Let’s look at a simple example:
A Japanese company may possess large amounts of US dollars from their American sales but operate mainly in Japan. The corporation has their manufacturers in the States, which they would need to pay in USD in a month’s time, while also needing to deal with their expenses using JPY in Japan in the meantime.
Naturally, the firm would sell all the USD to receive JPY to cover their expenses in Japan. However, in a month, when they need to do the reverse by selling JPY to buy USD, the exchange rate might be unfavorable at that moment.
This would require them to sell a lot more yen to buy the same amount of USD as would have been purchased a month prior. The FX swap would involve a sell USD-buy JPY spot trade and a buy USD-sell JPY forward contract locking in the USD/JPY exchange rate.
Performing this transaction allows the enterprise to kill two birds with one stone; have enough JPY to settle their bills, and receive USD at an advantageous rate to pay their American costs.
Currency swaps typically occur between a financial and non-financial institution where both parties exchange different currencies in the form of a loan to be repaid later. FX swaps are more short-term and used primarily by large corporations for mitigating foreign exchange risk.
Currency swaps are more long-term and utilized mainly by corporations, investors, and financial institutions for securing cheaper debt through beneficial interest rates, hedging against exchange risk, and even speculating.
The spot forex market is the instrument most are familiar with as it involves the immediate delivery of foreign exchange trading. This version of forex is known for having a substantial number of retail and institutional investors speculating for profit.
Additionally, spot forex is used by non-trading individuals and businesses to facilitate the general exchange of currencies. For instance, someone from the United States traveling to London would need to sell their US dollars to receive British pounds.
Trades occur according to the spot exchange rates determined by a plethora of supply and demand forces.
Futures and forwards
Futures and forwards, just like FX and currency swaps, are quite similar. Each involves the process of buying and selling currencies for a specified date and price in the future. They are both also used by institutional rather than retail participants.
The distinctions are:
Futures contracts occur on a recognized centralized exchange like the Chicago Mercantile Exchange, where price settlement occurs daily until the end of the contract
Forwards happen privately off-exchange or over-the-counter, whereby prices are settled once at the end of the contract.
Ultimately, the point of futures and forwards, as illustrated in the swaps example, is to hedge against price fluctuations of currencies by locking in exchange rates for a later date in the future.
Options in forex are a type of instrument enabling holders the right but not the obligation to buy or sell a currency pair at a specified price (called the strike price) before the expiry date. For this privilege, traders pay a premium.
The advantage of options is they come with uncapped upside potential and a predictable downside only limited to the premium. This is unlike spot forex, where traders need to employ stop losses.
We have two different options, a call (buying) and put (selling). For instance, a trader might take a call option of GBP/USD at 1.500 (the strike price) if they believe the pair will rise above this point before the expiry date.
The profit potential would be unlimited depending on how far the price moves away from 1.500 prior to the expiry. Should the pair move below the strike price after expiry, the trader is only liable for the premium.
There is also flexibility since one can decide to opt-out at any time and only need to settle the premium or take the profit depending on where the pair is.
In this example, investors did not actually buy or sell any currencies as they would on the spot, which is one of the attractions for trading options. Options are more accessible to retail traders and are also utilized by institutional guys to hedge against currency fluctuations and speculate for profit.
Forex is an astronomical financial market going beyond the traditional spot trading most are accustomed to. Each of the contributors participates in the forex market for different reasons.
The spot is the simplest to understand as it involves the immediate delivery of currencies for trading profit and exchange purposes. FX swaps help when enterprises hold too much of one currency and need to convert to another temporarily.
Currency swaps are used to secure cheaper debt through favorable interest rates between currencies and benefit institutions by hedging against and speculating price movements.
Futures, forwards, and options are all different methods used by mostly institutional and some retail traders to mitigate fluctuation uncertainties.