The concept of a forex exchange transaction is closely connected with financial conditions. We classify the precious metals market, the credit market, the stock market, and Forex as the financial markets where financial instruments are objects of forex exchange transactions. This article will cover only those financial instruments that are used in the forex market. A forex exchange transaction is an agreement between two parties to buy one currency against selling another currency. Such a transaction has a certain date and price. Forex transactions differ by the date when money is credited to the account (the value date). Therefore, foreign exchange transactions can be divided into two types: spot foreign exchange transactions and forward foreign exchange transactions.
The vast majority of forex deals are spot transactions. As a rule, the value date of the spot deal is the second working day after the transaction is closed. Such conditions are very convenient for the market participants as they have enough time to deal with documentation. The market where the currency is exchanged at spot quotes is called the spot market. It is a market with immediate payment.
Notably, this principle of mutual settlements for spot transactions is apt for large investors. For private investors (clients of various brokerage firms) who trade on the forex market via the Internet, the transaction is made immediately after the investor clicks on the button. For such transactions, the value date is not important since the client's account always reflects the current trading on the forex market.
Forward foreign exchange transactions include forwards, futures, options, and swaps. They are also called derivatives. Such financial instruments were created specifically for business as they help reduce the potential risks of price fluctuations. For a private investor who wants to make a profit on the forex market, these financial instruments are not so crucial. Nevertheless, we will provide an insight into these instruments to understand the overall picture.
Forward contracts are closed between the contractors under the conditions to exchange a certain amount of currency according to the agreed price and day (settlement date). The deal will be closed regardless of the current (or spot) price.
For example, a forward contract will be useful when a Russian company plans to buy foreign equipment for US dollars. Let us imagine that this company does not have enough money to close the deal but it expects that the rubles will be transferred to a settlement account within a month. Moreover, the company envisages that the rate slides into a negative zone for the company, i.e. the USD will grow. In this situation, it makes sense to conclude a forward contract with a bank on buying the necessary amount of USD with the settlement date of one month and at a profitable price for the company. Naturally, there may be difficulties in finding a contractor as banks also expect the US dollar to gain ground.
On the one hand, forward contracts lower risks but on the other hand, they can lead to a loss of profit. If the US dollar falls, the company loses the opportunity to pay less for equipment.
Unlike forward contracts, futures have standard maturity dates and fixed currency volumes. Thanks to this feature, they can be sold as common securities. Futures are traded in the futures market. The average time of a futures contract execution is about three months.
Options are similar to futures but options trading involves less risk. Thus, if you buy futures, you will have to close the trade on the agreed terms. If you buy options, you are allowed to refuse to close the trade. Options are traded in the options market.
A swap contract is an agreement between two parties to exchange assets at predetermined intervals. For example, a company buys from a bank $1,000 for rubles at spot price with the liability to sell $1,000 for rubles back to the bank in a month at spot price that will be in the Forex market in a month. Swaps are customized contracts. So, they are not traded on exchanges.
Among all the forex deals (financial instruments), spot transactions are the most important for an investor.