Forex

Financial Instruments

There are several types of financial instruments commonly used.

Forwards: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, 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.
Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swaps: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.
Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the Spot market.

The Difference between Spot and Futures in ForexBefore a description of retail trading, it is important to understand the difference between the Spot and Futures markets. Futures are generally based on contracts, with typical durations of 3 months. Spot, on the other hand, is a two-day cash delivery. While the Futures markets was created to hedge out risks and speculate on future market conditions, Spot was created to allow actual cash deliveries. Spot developed a two-day delivery date in order to give those transporting the actual cash a window of time to receive it. While in theory there still is a two-day delivery date imposed after a Forex transaction, this is effectively no longer used. Every day, at 5 pm EST (the predetermined end of the trading day) Spot positions are closed and then reopened. This is done in order to guarantee an unlimited timeline for delivery. For example, if a Spot transaction occurs on a Monday, the delivery date is Wednesday. At 5 pm on Monday, the position is closed and then immediately re-opened; now this is a new position with the close date of Thursday. This daily process allows an investor to hold open a position indefinitely.
Another important difference between Futures and Spot is how interest is credited. Each currency in a Forex transaction has an inherent interest rate attached to it. In the case of the US dollar, this is the Federal Funds Rate. This interest is added every single day whether the market is trading or not. Interest cannot take a vacation; money and its loaning value are still important even if the financial world has stopped dealing. In Futures, the interest is built into the price of the contract. In Spot, however, interest is not taken into account in the offering price because the Spot market is a cash market, not a contract market. There must be some mechanism for crediting interest, and various institutions have developed ways to do it. The most common method is to credit that day’s worth of interest at the same time they “flip” the position, or carry it over to the next day. This is important for later discussions and analysis because the transactions examined in this study had interest credited at the end of the business day at exactly 5 pm EST. If a position was held from 5:01 pm on Tuesday and closed at 4:59 pm on Wednesday, no interest would be credited for that day. If, on the other hand, a position was opened Tuesday at 4:59 pm and closed Tuesday 5:01 pm, a full day’s interest would be credited. This has interesting ramifications; traders who work intra-day, or “day traders,” often do not use interest for either gain or loss.

In finance, a forex swap (or FX swap) is an over-the-counter short term interest rate derivative instrument. In emerging money markets, forex swaps are usually the first derivative instrument to be traded, ahead of forward rate agreements.

Structure

A forex swap consists of two legs:
a spot foreign exchange transaction, and a forward foreign exchange transaction. These two legs are executed simultaneously for the same quantity, and therefore offset each other.
The fixed rate in this transaction is the forward rate that is locked in by the forward contract. The floating rate will be the overnight rate that is realized on a daily basis by the spot transaction. Typically, the floating side of these trades are indexed to the Overnight Index Swap (OIS) rate. This rate is an average of the rates that are paid based on a survey.
UsesForex swaps are used for hedging or speculation.
HedgingInvestors use forex swaps to hedge their existing forex exposures by swapping temporary surplus funds in one currency into another currency for better use of liquidity. Doing so protects against adverse movements in the forex rate, but favourable moves are renounced.
SpeculationInvestors use forex swaps to speculate on changes in the interest rate differentials between two currencies.
The relationship between spot and forward is as follows:

where:

F = forward

S = spot

rT = interest rate of the term currency

rB = interest rate of the base currency

T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

where rT and rB are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.
Related instrumentsA forex swap should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.

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