The trading in forex is done in three differnet ways viz. the Spot market, the Forwards market and the Futures market.
In the past, the Futures market was the most popular among individual investors because it was available for a longer period of time. However, with the advent of electronic trading, the spot market has grown rapidly and now surpasses the futures market as the preferred trading market for individual investors and speculators. The Forwards and Futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.
In the spot market currencies are bought and sold according to the current price. The price is determined by supply and demand and is a reflection of many factors such as current interest rates, economic performance, local and internation political situations, perception of the future movement of one currency against another. When a deal is finalized in Spot market, it is known as a “spot deal”. It is a bilateral transaction by which one party delivers the agreed amount of the agreed currency to the counter party and receives the specified amount of another currency at the agreed exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), the trades actually take two days for settlement.
Forwards and Futures Markets
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency at an agreed price per unit on a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.
Both Forward and Futures contracts are binding and are typically settled for cash for the exchange in question upon expiry. The contracts can also be bought and sold before they expire. The forwards and futures markets offer protection against risk when trading currencies. Usually, big financial institutions and banks use these markets to hedge against future exchange rate fluctuations. Speculators also take part in these markets.
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