When most people talk or write about Forex, they are referring to the spot forex(See below). However, there are three different type of currency investing markets that you should be aware of:
The Spot Currency Market
The spot market (also known as cash currency market) is the current or actual price of a currency at that moment in time. It is the price at which you will get a currency for immediate delivery. Every time you go to a bank to exchange your Japanese yen for Canadian dollars, you are engaging in the spot currency market. For the spot forex trader, it is the price in which you contact your forex broker either by phone or through his trading platform and ask for the price you wish to trade a particular currency.
Most retail forex traders deal in the spot currency market which is the forex market. With the advent of new technology, transactions of this kind are normally concluded in seconds but the normal delivery time for spot forex contracts is two days with the exception of the Canadian dollar which is one day.
The Forwards Currency Market
A more complicated currency market is the forwards currency market. Forward trading is different from spot trading in that you must take into account the interest rate differences ,otherwise called the interest rate differential, between the countries currencies you are trading in. For example, when dealing with the currency pair GBP/USD (Great Britain Pound against the USA dollar), you must take into account the interest rate differences between Britain and the USA. If the interest rate in Britain is 5% and the interest rate in the USA is 3%, the interest rate differential is 2%.
A forward currency contract attempts to calculate the fair value of two currencies taking into account the interest rates of the two countries in the future. The future rate or the forward rate is normally 3 days to 3 years, but most such contracts are under 6 months. The forward rate is calculated as
Before you get your calculator out, note that the determination of the forward price is not a prediction of a future exchange rate but is merely a tool to allow parties to fix a rate in the future. Currency forwards are the domain of large financial institutions and corporations.
A currency swap is a combination of a spot currency trade and a forward contract. This type of contract is also very complicated and involves multinationals trying to get better rates in their trading activities.
For example, a car manufacturer in the USA makes a deal in Europe but believes it will get better interest rates in the USA because of better relationships in the USA. The manufacturer borrows funds in the USA over the next 5 years.
The USA manufacturer then makes a deal with European banks to trade it’s future dollar interest rate liability to the USA banks in Euros. As such the European bank agrees to pay the car manufacturer enough dollars to service it’s dollar loan and in return, the car manufacturer agrees to make payments to the European bank in Euros.