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The Forex Spot Market is the immediate exchange of currencies between a buyer and a seller at the prevailing Spot FX Exchange Rate. Spot FX transactions are typically settled in 2 business days on the Value Date. The major exception is the U.S. Dollar versus the Canadian Dollar, which usually settles in one business day.
For example, if on Monday 8/28/23 the spot FX rate for EUR/USD, is trading at 1.0825 (Bid) -1.0827 (Ask), and a buyer wants to buy Euros at the Ask price of 1.0827, that transaction would be settled on the Value Date of Wednesday 8/30/23. To settle that transaction, there would be a swap of Euro Dollars and US Dollars, using the spot exchange rate, at the time of the transaction.
The buyer would receive Euros from the seller, and in exchange the seller would receive the US Dollar equivalent of Euros from the buyer, using the exchange rate of 1.0827 EUR/USD. Once both parties have received the respective Euro Dollar and US Dollar notional amounts from the other party, using the currency exchange rate of 1.0827 EUR/USD, this transaction would be considered settled.
Spot FX rates are published each day. When a spot FX transaction occurs on any specific day, that day is considered the Trade Date. The actual money exchange for that transaction occurs on the Value Date, as outlined above. For trading purposes, the Value Date is the time at which a transaction is fully cleared and settled.
Of all the major currencies, the U.S. Dollar (USD) is the most actively traded currency. The other major currencies and most common pairs are USD versus Euro Dollar (EUR), Japanese Yen (JPY), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD), Australian Dollar (AUD), and New Zealand Dollar (NZD). This group, including the US Dollar (USD), make up what is called the G-7 Currencies.
Currency Pairs that do not include the U.S. Dollar are referred to as Cross Currency Pairs. The most common Cross Currency Pairs are Euro Dollar vs. the Japanese Yen (EURJPY), Euro Dollar vs. the British Pound (EURGBP) and the British Pound vs the Japanese Yen (GBPJPY)
Movement in the spot market is dominated by Technical and Fundamental trading. Technical trading consists of charting and graphs, whereby most trading decisions are created from technical signals that are derived from the charts. On the fundamental side, trading decisions are based on economic factors such as a country’s Central Bank monetary policy, reflected in their current interest rates and future economic projections.
Unlike Spot FX transactions, Forward FX transactions settle further in the future than a Spot FX transaction. The settlement of an FX Forward occurs on the Far Date of the FX Forward agreement, called the Forward Date.
FX Forwards are agreements (contracts) between parties (buyer and seller) to exchange currency amounts, at a predetermined rate and time in the future. Commonly referred to as an Outright Forward. The FX Forward rate represents the difference between the Spot FX rate, plus or minus the forward points.
The FX Forward rate reflects the current FX Spot rate, along with the interest rate differential between the two currencies, in the Forward FX agreement. Each Forward FX agreement can be customized by both counterparties. Most FX Forward transactions have a maturity of less than 1 year, but they can also be longer in duration.
For example, if two parties enter into an One-Month FX Forward agreement in EUR/USD, using the Spot FX rate and dates in the Spot FX example above, the Spot FX rate used to determine the Forward FX rate, would be 1.0825-1.0827. The one-month interest rate differentials between EUR Dollar (EUR) and US Dollar (USD) would be applied to adjust the Spot FX rate to reflect the one-month FX Forward price of EUR/USD.
This transaction, and the future exchange of currencies, would be determined by the FX Forward rate for one-month EUR/USD, which was agreed on the Trade Date (Near Date), Monday 8/28/23. This transaction would settle, and the currency payments by both parties would be exchanged one month forward from the original trade date of 8/28/23.
The spot rate and the forward rate differ in terms of their timing, calculation, and usage:
The spot rate is applicable for immediate transactions, while the forward rate is used for future transactions, typically beyond two business days.
The spot rate is determined by the forces of supply and demand in the currency market. On the other hand, the forward rate is calculated using the spot rate and the interest rate differentials between the two currencies.
The spot rate is commonly used for immediate currency conversions, international trade settlements, and day-to-day transactions. In contrast, the forward rate is utilized for long-term investments, hedging foreign currency risk, and planning future financial obligations.
The spot rate and forward rate have different applications in the financial world:
The main users of Spot FX are Commercial Banks, Non-Bank Financial Institutions (Asset Managers, Corporate Customers, High Frequency Trading Firms), Central Banks, Broker/Dealers and Speculators.
The largest users of Spot FX trading are Commercial and Investment Banks, trading for themselves and also for their customer base.
The majority of users of Forward FX contracts are Multinational companies that want to hedge their currency risk exposures against future price fluctuations, which can occur during the duration of the Forward FX agreement. Commercial banks, Central Banks, Broker/Dealers and Speculators are also users of FX Forwards.
Large commercial banks not only speculate, for profit, on future currency movements using FX Forwards, but they also trade on behalf of the customers. These customers have a pre-established Bi-lateral Credit relationship with their bank partners and transact directly with these bank partners, by requesting FX Forward pricing from them.
In conclusion, the spot rate and forward rate are crucial concepts in the realm of foreign exchange and risk management. The spot rate represents the current exchange rate, while the forward rate is a predetermined rate for future transactions. Understanding their differences and applications can help individuals and businesses make informed decisions regarding currency conversion, hedging strategies, and investment planning.