The foreign-exchange markets comprise four different markets, which function separately yet they are closely interlinked.
The Spot Market
Currencies for immediate delivery are traded on the spot market. A tourist’s purchase of foreign currency is a spot-market transaction, as is a firm’s decision immediately to convert the receipts from an export sale into its home currency. Large spot transactions among financial institutions, currency dealers and large firms are arranged mainly on the telephone, although electronic broking services have gained considerable importance. The actual exchange of the two currencies is handled through the banking system and generally occurs two days after the trade is agreed, although some trades, such as exchanges of US dollars for Canadian dollars, are settled more quickly. Small spot transactions often occur face to face, as when a moneychanger converts individuals’ local currency into dollars or euros.
The Futures Market
The futures markets allow participants to lock in an exchange rate at certain future dates by purchasing or selling a futures contract. For example, an American firm expecting to receive SFr10m might purchase Swiss franc futures contracts on the Chicago Mercantile Exchange. This would effectively guarantee that the francs the firm receives can be converted into dollars at an agreed rate, protecting the firm from the risk that the Swiss franc will lose value against the dollar before it receives the payment. The most widely traded currency futures contracts, however, expire only once each quarter. Unless the user receives its foreign-currency payment on the precise day that a contract expires, it will face the risk of exchange-rate changes between the date it receives the foreign currency and the date its contracts expire.
The Options Market
A comparatively small amount of currency trading occurs in options markets. Currency options, which were first traded on exchanges in 1982, give the holder the right, but not the obligation, to acquire or sell foreign currency or foreign-currency futures at a specified price during a certain period of time.
The Derivatives Market
Most foreign-exchange trading now occurs in the derivatives market. Technically, the term derivatives describes a large number of financial instruments, including options and futures. In common usage, however, it refers to instruments that are not traded on organised exchanges. These include the following:
- Forward contracts are agreements similar to futures contracts, providing for the sale of a given amount of currency at a specified exchange rate on an agreed date. Unlike futures contracts, however, currency forwards are arranged directly between a dealer and its customer. Forwards are more flexible, in that they can be arranged for precisely the amount and length of time the customer desires.
- Foreign-exchange swaps involve the sale or purchase of a currency on one date and the offsetting purchase or sale of the same amount on a future date, with both dates agreed when the transaction is initiated. Swaps account for about 56% of all foreign-exchange trading. Normally, these are short-term deals, lasting a week or less.
- Forward rate agreements allow two parties to exchange interest-payment obligations, and if the obligations are in different currencies there is an exchange-rate component to the agreement.
- Barrier options and collars are derivatives that allow a user to limit its exchange-rate risk.
Although large-scale derivatives trading is a recent development, derivatives have supplanted the spot market as the most important venue for foreign-exchange trading.