What Are the Major Foreign Exchange Markets?
Transacting over a trillion dollars worth of business everyday, the foreign exchange system is the largest market in the world. Although highly consolidated, and dominated by large institutions like central banks and commercial financial institutions, Forex is actually more diverse than it appears at first glance.
Other People Are Reading
-
History
-
The contemporary Forex market has its roots in the 1944 Bretton Wood Agreement, signed by the soon-to-be victorious Allied powers to create a new global system of exchange for currencies, debt, and other trade items.
Spot Contracts
-
Spot Forex contracts account for the bulk of volume transacted on any given day, and are the most common instruments used by all currency speculators, from multi-billion dollar macro hedge funds to small-scale traders. In the spot market, units of currency are exchanged on the following settlement day, in contrast to futures and options where settlement only occurs when the contract expires. The Forex spot price is the immediate value of any currency in relation to another one, for instance, the Euro/U.S. dollar, and is used by banks and money centers when exchanging money for retail customers.
-
Currency Futures
-
Currency futures are contracts that specify a specific date and price for buying or selling the underlying currency units. A major advantage of foreign exchange futures is that many currencies are traded as indexes against a basket of other currencies, rather than against one individual currency. For example, if someone considered the Japanese yen undervalued and wanted to buy it, but didn't want to simultaneously sell short the U.S. dollar by selling U.S. dollar/Japanese yen contracts in the spot market, she could purchase Japanese yen index futures, and thus would stand to benefit from yen performance against several different currencies, rather than just the U.S. dollar.
Forex Options
-
Forex options can either exist on individual Forex pairs, like the Australian dollar/U.S. dollar, or on currency index futures products, like the Chicago Mercantile Exchange's U.S. dollar index. The major advantages are that they're cheaper than futures, and provide buyers with a specifically-defined downside risk potential. Their disadvantages are that they are vulnerable to time decay and volatility fluctuations, like almost all standard options.
Exotic Products
-
Exotic Forex products are usually over-the-counter investment instruments that are more complicated and less standardized than conventional futures and options contracts. This includes barrier options, knockout options, quanto options, and a variety of custom-made products set up between a small number of financial institutions and multinational corporations, usually for purposes of dynamic currency hedging and insurance.
-
References
- Photo Credit Image by Flickr.com, courtesy of Karen
