A Guide to Forex Transactions
The forex (Foreign Currency Exchange) is the largest financial market in the world. Unlike other financial markets, the forex is not hampered by geographical boundaries or different time zones. With the exception of weekends, it operates 24 hours a day, with over $3 trillion moving about daily.
If you are interested in becoming a forex trader, you should know what kind of financial transactions and elements comprise the market itself. These include spot transactions, forex swaps, trade flows, flow-ins, and derivatives.
Trade flows consist of a country's imports and exports. Because these commodities are paid for in currencies, they figure in the forex, although not by a significant amount. Large trade flows broken into smaller parts are called flow-ins and also part of the currencies market.
By far spot trading makes up the largest volume of all trading in the forex. In simple terms, spot trading involves purchasing a currency with another foreign currency. Unlike futures or forwards, spot commodities usually involve cash, and the time frame for each transaction rarely exceeds two days.
Of the $ 3 trillion dollar forex turnover rate, over $ 2 trillion come from financial transactions in the form of derivatives. These derivatives come in various forms, including, futures, forwards, swaps and options.
A forward contract is a financial transaction between two parties, wherein the commodity will be bought or sold at a predetermined future date with a set price. In contrast with spot trading, where the value changes with the fluctuations in the forex, the forward contract ensures that regardless of the price movement, the asset will be bought or sold at the amount and date agreed upon.
Similar to forward contracts are future contracts, or futures. A futures contract states that the buying or selling of a commodity must be of an approved amount and delivered on a specified future date, as agreed upon by both parties. Futures are a type of forward contract, but there are distinctions between the two.
While a forward contract is executed only upon the purchase and delivery dates, futures are rebalanced everyday based on the spot price of a forward contract with the same price. By allowing room for adjustments, the risks are lessened for both parties.
A forex swap, as its name implies, entails currency exchange between two parties, with the understanding that at a certain period in the future the currencies will be reverted back. Swaps are often used by traders and investors as a hedging strategy. By exchanging (temporarily) currencies that are (or might be) subject to volatility in favor of a more stable one, the investment risk is reduced.
The tenets of an FX option are very similar to a forex swap, except the decision to exchange currencies is up to the owner.
With a basic understanding of the financial instruments in the forex, you will have a better grasp of the concepts and ideas in the currencies market. You will also learn which derivative is right and most profitable for you.