4. Traded Instruments
The trading departments in larger banks consider various factors when determining exchange rates: besides taking into account their inventory positions, they also watch for volumes and recent price action and apply their particular analysis to see where each currency is headed. Usually they will quote more favorable rates to their counter-parties in the opposite direction they think the price is going for any particular currency.
They do this trading several Forex financial instruments. A financial instrument is a medium which can be traded, commonly categorized into two categories: cash instruments and derivative instruments. The first being such financial instruments like securities, loans, and deposits. These are readily transferable and their value is determined directly by the market. And the later, the derivatives, can be divided into two further categories: over the counter (OTC) derivatives and exchange-traded derivatives.
Foreign Exchange instruments and transactions have their own category in which: standard derivatives are Foreign Exchange futures; main OTC derivatives are Foreign exchange options, forwards and swaps; and cash instruments is the spot.
Many folks tend to think strictly of the spot market, but it is not the only one. An array of other investment vehicles have been popping up in the Forex world, providing traders even more ways to take positions in this market. These are the most traded ones:
In the case of forwards it is a transaction in which money does not actually change hands until a specific (and a previously agreed-upon) future date. In this case, the exchange rate is one which the buyer and the seller have agreed upon any future date, and it is not necessarily based on current market rates, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
The currency futures are transactions with standard contract sizes and a maturity date (usually of three months). Futures are standardized and are usually traded via an exchange created for this purpose and usually include an interest amount. The futures market has become a bit more attractive for small speculators with the expansion of e-mini currency contracts.
It should also be noted that although some folks will claim there is no rollover in Forex futures, the interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot market rates. As the futures contracts approach their delivery date their prices will converge with the spot rate so that the holders will pay or receive the differential just as if they had been in a spot position.
A foreign exchange option is another Forex instrument belonging to the derivatives, where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. This category also includes exotic foreign exchange options such as average rate options and barrier options.
This is the most common type of forward transaction. In a currency swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at an pre-agreed maturity. These are not standardized contracts nor traded through an exchange. Currency swaps can be used to secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan), or to hedge against (reduce exposure to) exchange rate fluctuations.
Among the Forex instruments you can also find the exchange traded funds (ETFs) typically traded on an exchange as baskets of securities with an underlying index. ETFs are open ended investment companies that can be traded now replicating investments in the currency markets. These funds track the price movements of world currencies versus the US dollar, and increase in value directly counter to the US dollar, allowing for speculation.
As an investment, currency ETFs closely resemble savings accounts; the ETFs hold cash and invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are unlikely to gain or lose much value -- a share worth 100 Euro now will probably be worth 100 Euro next month or 10 years from now. Each deposit account will pay slightly less than the currency overnight interest rate, and is subject to fund expenses.
Finally, the currency spot, the transaction type most covered in the Learning Center: in the spot market currencies are sold for cash and delivered immediately and prices reflect what one currency is currently worth in terms of another currency. In the most cases it's technically a two-day "maturity" transaction, in which two currencies are traded with cash (rather than a contract). Spot has the second largest share by volume in FX transactions among all instruments after the swap transactions. The spot is traded over-the-counter (OTC), meaning it is traded through a dealer network and not through an exchange.
There are many currencies traded on a day-to-day basis on the spot market. You will notice that is always a currency moving up or down. From a price-action perspective, currencies rarely spend much time in tight trading ranges and tend to develop strong trends. Remember, most of the currency trading volume is speculative in nature and, as a result, the market frequently overshoots and then corrects.
This volatility will assure endless short-term and long-term cashing opportunities, allowing you to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to equity markets. We will cautiously consider all the so-called "advantages" of currency trading in more detail below.
As attractive as this market characteristics may seem, they will also expose you to higher levels of risk and therefore it should not be undertaken without proper training and knowledge.
Many of the instruments utilized in Forex will appear similar to those used in the equity markets. Since the instruments on the Forex often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments. You will learn more about this intricacies in the next chapter.
The growth in retail Forex has been very rapid, especially as equity and futures traders realized the approaches they've been using for years in their respective markets, particularly price-based techniques based on technical and quantitative analysis are equally applicable to Forex.
For aspiring traders, this market represents a unique alternative as where to put into practice the new acquired skills. While in other markets investors must choose from hundreds of instruments and shares, here there are only a few major currencies to exchange, which helps tremendously to gain focus and expertise.