Types of Currency Exchange Markets: Spot and Forward Market Explained

There are several types of currency exchange markets. Two of them are the so called Spot Market and Forward Market.

Spot Market

Spot currency trading represents the most widely used foreign currency instrument. The spot foreign exchange market basic characteristics contributing to its popularity are:

• high volatility

  Volatility represents the degree of price fluctuation of a particular currency for a specific time period. This means that a particular currency pair may change its price with as many as 150 - 250 pips for as little as several seconds. This might represent a great opportunity for quick profits and yet, quick losses as well.

• high liquidity
• short-term contract execution

  In a spot deal, the bilateral contract between two parties exchanging currencies is based on a predetermined exchange rate within two business days of the contract date. The only exception to the 2-day rule is the Canadian dollar since the spot delivery is done in the next business day.

Those three characteristics lead to minimization of the credit risk on the spot market.

After having a deal, the trader is informed of the quota by the bank, which serves him/her. The quota represents the evaluation of the target currency, which is done either against the US dollar or any other currency. It has two components: the bid-price (the price which is wanted by the seller) and the ask-price (the price which the buyer is willing to pay for the currency pair). The difference between the two prices and is measured in pips (points) and is called spread.

Forward Market

The basic characteristics of the forex forward market are:

• decentralization

  This allows traders form all over the world to enter into different deals either by using the services of a broker or on one-on-one basis.

• no standard regarding the settlement dates

  The settlement dates that are established on the forward market can range from 3 days to 3 years. Currency swaps are rarely longer than a year but in principle no technical restrictions exist to execute such a deal. The only requirement is that the date is a valid business day for the currencies that are part of the deal.

There are two parts that make up the forward price:

1. the spot exchange rate - the most important part of the forward price, which provides its foundations.
2. the forward spread (also known as forward pips or forward points) - it is used for the adjustment of the spot rate when the settlement dates differ from the spot date. This implies that the maturity date is of significant importance in determining the value of the forward price.

The participants in the forward market typically apply two tools: forward outright deals and exchange deals (also known as swaps). The latter represents a combination between a forward outright deal and a spot deal.

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