Spot, Swap, Spread: Foreign Exchange Terms Defined

by Christopher Chen

The foreign exchange market has a trading volume of $5.3 trillion per day. The market functions like any other market – buyers and sellers of a commodity meet and trade. In the case of a foreign exchange market, as demand exceeds supply, the currency’s value will go up. The most traded currencies are the US dollar, Euro, Japanese yen, Pound sterling, and the Australian dollar. The top three countries where trading most occurs are New York City, London, and Singapore.

Instruments

There are four main instruments (products) used in foreign exchange trading. They are: spot, forward, and future contracts as well as options.

  1. Spot Contract: A spot contract is when a settlement occurs typically two business days after the trade date. This is done when traders want to exchange their currency to another at a particular point in time.
  2. Forward Contract: A forward contract is to be settled farther than two business days. For instance, forward contracts help market participants protect themselves from adverse exchange-rate developments. For instance, a Japanese car exporter to Europe expects to be paid in Euros, two months in advance. To eliminate currency risk, a company may purchase a forward contract and lock itself into a euro-yen exchange rate.
  3. Future Contract: A future contract is similar to a forward contract in that they involve an agreement to trade specific amounts of currencies at a future date. However, the difference between the two is when a price is agreed with another futures participant, the exchange’s “clearing house” steps into the trade to serve as each trader’s counterparty. These future contracts are used for small companies.
  4. Options: An option is a contract which offers the buyer the risk, but not the obligation to buy or sell a security or another financial asset at an agreed-upon price during a certain period of term or a specific date (exercise date). There are two types of options, a call and a put. Purchasing a “call” option gives the buyer the opportunity to exchange his currency at a rate by a certain date. On the other hand, purchasing a “put” option gives the buyer the opportunity to sell a particular currency at a rate by a certain date. Options were originally designed to reduce currency risk, but also may be used to leverage the gains (and losses) of traders and thus dramatically increase risk.

Dealing Room (Trading Room) Structure

  1. Interbank Traders: Interbank traders deal exclusively with other market-makers (a dealer that buys or sells a financial instrument or commodity on a continuous basis at a publicly quoted price). Different traders are in charge of spot and forward transactions and focuses on one of the major currency pairs. Their job is to provide liquidity for the banks. Spot interbank traders focus on short-term market opportunities produced by large customer transactions, while forward traders take a longer term view of the market and pay specific attention to interest-rate differentials.
  2. Foreign Exchange Salespeople: Foreign exchange sales people manage the banks’ relationship with customers. Their first responsibility is to provide quotes to existing customers. When customers request a quote for a particular amount in a given currency pair, without indicating direction, the salesperson asks the relevant interbank for an indicative quote to this customer, which may be passed on directly to the customer, or in most cases, marked up.
  3. Proprietary Trader: Proprietary traders undertake speculative trades with a medium to long horizon in a variety of financial markets. Their positions are larger than those of interbank traders and last much longer.

Market Players

  1. Commercial and Investment Banks: Examples of commercial and investment banks are UBS, Deutsche Bank, Citigroup, JP Morgan Chase, HSBC, Goldman Sachs, and Barclays Capital. Commercial and investment banks are where the bank traders work at as well as the foreign exchange salespeople.
  2. Central Banks: Examples of central banks are the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England. Central banks do not speculate in the foreign exchange market (the most notable exception is Malaysia’s Bank Negara in the mid-1990) and issue their respective national currencies and control the currencies’ supply and demand.
  3. Broker: Foreign exchange brokers do not take active trading positions; instead they find the best available rates, and link matching requests for currency purchases and sales among dealers. Brokers protect the anonymity of the involved parties until just before a trade is executed to ensure fair trading. For their services, brokers get a commission paid in equal parts by both parties to a transaction.
  4. Investment Companies, Pensions, and Hedge Funds: Investment companies manage and invest the pooled funds of their clients. Pension funds manage and invest money from pension plans at a very low risk. Hedge funds are partnerships of a limited number of wealthy investors. These three types of institutions trade foreign currencies on behalf of their clients.
  5. Corporations: Corporations and multinational companies who are involved in the foreign exchange market see foreign exchanges as perhaps an unwanted necessity of doing business internationally. The traders who work in these banks are mainly hedgers.
  6. Individuals: Individual players in the foreign exchange market are usually day traders.

Fundamental & Technical Analysis

In the literature of financial markets, participants are classified into groups according to two different approaches as to how they form their expectations: “fundamental analysis” and “technical/chartist analysis”.

Fundamental: Fundamental analysis is used by market participants who form their expectations about currencies by considering the economic conditions on which they believe exchange rates rest. These market forecasters assume that superior understanding of relevant economic conditions allows one to successfully predict exchange rates.

Technical:  Technical analysis is used by market participants who based their expectations solely on exchange rates themselves and on patterns of previous exchange-rate developments. Traders who use technical analysis do not rely on any assumptions about the economic basis of exchange rates. Rather, participants use technical analytics assume all underlying economic and financial information relevant to exchange rates is already incorporates into exchange rates and therefore analyzing this information does not help win predictions.

Foreign Exchange Terminology:

  1. Arbitrage: The purchase or sale of a financial product to take advantage of small price discrepancies in the market.
  2. Ask (Offer) Price: The lowest price at which a seller of a currency is willing to sell.
  3. Bid/Ask Spread: The difference between the bid and the ask price.
  4. Bid Price: The price a buyer is willing to pay for a good (in the base currency).
  5. Broker: When an individual or firm acts as an intermediary between a buyer and a seller.
  6. Currency Swap: Contract which commits two counterparties to exchange two streams of interest payments for an agreed amount of time and principle amounts at a previously agreed exchange rate at maturity for two different currencies.
  7. Currency Option: Option contract which gives the right to buy or sell a currency with another currency at a specific exchange rate during a particular time interval.
  8. Dealer: An individual or firm which acts as a principal or counterpart to a transaction. A dealer takes the counter-position of the trader, hoping to earn a profit when closing out the position of the trade.
  9. Fill: When an order has been fully executed.
  10. Fill or Kill: An order that, if cannot be filled, will be cancelled.
  11. Foreign Exchange Swap: Transaction which involves the exchange of two currencies at a specific date and a reverse exchange of the two currencies at a date future than the original exchange date.
  12. Forward: Pre-specified exchange rate between two currencies, based on their interest rate differential.
  13. Futures Contact: Obligation to exchange a good or instrument at a set price and specified quantity at a future date.
  14. Hedge: A combination of positions that reduces the risk of your primary position.
  15. Hit the bid: To sell the current market bid.
  16. Offer/Ask Price: This is the price the market is prepared to sell the product. In this case, it is currency.
  17. Spot Price: The product or sale of a product for immediate delivery.
  18. Spot Trade: Single outright transaction involving the exchange of two currencies at the agreed-on the date of the contract.