Types of Transactions

Foreign Exchange Basics
Financial institutions, investment managers, corporations and private investors trade foreign exchange (forex) markets to manage the risks and capture potential opportunities associated with currency rate fluctuations.
Trading a nation’s currency doesn’t occur in a vacuum; you don’t actually trade one currency but a pair based on its relationship to another currency. A number of factors go into determining the “strength” or “weakness” of a currency vs. another, but it usually comes down to comparing one nation's economy to another's. Generally, expanding economies have stronger currencies while recessionary economies have weaker currencies. Fundamentals influencing a currency’s value include the nation’s gross domestic product (GDP) as well as the trade balance between countries, interest rates, and other macroeconomic factors.


Types of Transactions
There are several types of financial instruments commonly used for currency trading.
Spot: A spot transaction is a two-day delivery transaction. 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. Spot transactions were developed for actual cash deliveries, but each day, they can be closed and reopened the same day to postpone the delivery date indefinitely.

Forward transaction: In this transaction, money does not actually change hands until an 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 December at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly three months. Futures contracts are usually inclusive of any interest amounts.

Swap: 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 standardized contracts and are not traded through an exchange.

Options: A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.


Types of Markets
As a trader, you have a variety of ways to participate in trading global foreign exchange. There are three main markets you can choose, with different characteristics—cash forex, currency futures, and the newest, spot equivalent futures.

Cash Forex. The cash forex market provides a mechanism for transferring funds globally, and determining the currency exchange rate. Trading occurs primarily between large banks, central banks, speculators, multinational corporations, governments, and other financial institutions. Individual traders can participate in cash forex trading via a broker or bank. This market is typically called an “over-the-counter” (OTC) market, as there is direct negotiation between parties without a central exchange or centralized clearing. The parties involved take on the risk, and they may or may not be creditworthy. As the market is made up of interconnected participants, there may not be unified rate for a particular currency at any given time. And, there are different levels of access, and pricing. The inter-bank market is at the top of the ladder, made up of the world’s largest investment banks. The tightest bid/ask spreads are generally within this tier. The retail cash forex market is only loosely regulated, so individual traders wishing to participate should be cautious.

Currency Futures. CME Group is the leader for currency futures trading in the United States. Currency pairs are also available at ICE Futures U.S. You can trade a variety of foreign exchange futures contracts in a fully regulated and transparent marketplace, with pricing based on a nation’s respective currency value vs. the U.S. dollar, or another currency. For example, you can trade futures on the Australian dollar vs. the Canadian dollar, or British pound vs. the Japanese yen. Unlike the cash forex market, institutional and retail traders alike have access to the same prices, the same pool of liquidity, and a central clearing mechanism to eliminate counterparty risk. CME Group offers 41 individual FX futures and 31 options products, covering major currency pairs as well as an array of emerging market currencies.

Spot Equivalent Futures
Individuals wishing to participate in foreign exchange trading now have a new choice that blends the characteristics of the cash futures market with the futures market. These products offer a level playing field for participants of any size with no hidden costs—unlike cash forex. Spot equivalent futures, traded at the U.S. Futures Exchange, replicate spot markets on a regulated, exchange environment backed by a clearinghouse. USFE’s spot equivalent futures automatically allocate the cost-of-carry in holding a spot position overnight via an end-of-day cash payment, making an SEF position economically similar to a spot position. This differs from traditional FX futures contracts, which have quarterly expiries and include cost-of-carry basis in the price of the contracts. Six currency pairs are currently available for trading electronically 23 hours a day. Most common futures order types are supported, including stops Learn more at www.usfe.com.

I feel the Spot Equivalent Futures contracts listed exclusively on the USFE provide currency traders a smooth transition into the futures markets. Cash currency traders often have difficulty adapting to the quotation system used on other FX futures contracts. The USFE contracts are quoted as spot prices. Because all the major seven currency contracts are traded in this format, one can use either outrights against the U.S. dollar, or trade crosses by executing spread orders. Spread orders allow a trader to eliminate the U.S. dollar from the equation and trade the relative value of the cross pair.

Many traders ask what benefits they would receive by trading these contracts as spreads ran than staying in the OTC cash forex market. The major benefit is the fact that futures contracts are regulated. Customer accounts are segregated, and no customer has ever lost money due to company default. There have been many instances of improprieties by FX firms. The OTC market is unregulated and not subject to the strict law the Commodity Futures Trading Commission imposes on futures brokerage firms.

Another benefit to traders is the fact that you can hedge your currency risk by using other futures products. Position enhancement techniques can be held in one futures account, making it much simpler to track the performance of each position and accounts as a whole.

As currency markets continue to gain in popularity, I believe traders will turn to regulated markets for the ease of execution, the secure nature of futures markets, and the ease of transition.

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