Have you ever wondered what the difference was between the various ways of trading Forex?
This page will explain all the different types of contracts that you can order in Forex (including Swaps, Spot Trades and Futures) plus examples of how each trade works.
3 Types of Forex Contracts:
- Futures Contracts
- Currency Swaps
- Spot Trades
Right now, you can trade many different kinds of Forex contracts, from spot Forex, futures contracts and even currency swaps. There are certain subtle differences that set these different trading vehicles apart from each other, and yet still provide the same exposure to the currency markets.
Firstly, a currency futures contract is literally a contract that binds two parties together at a specific future date to perform a transaction of buying and selling a fixed amount of currency units for a predetermined price. This is different from a spot FX trade, where the actual currency itself is being transacted upon. A simple way to think of it is that the futures contract is settled at a specific future date, while a spot trade is settled immediately “on the spot”.
Currency Futures Vs Spot Forex
Essentially, the difference between currency futures and spot Forex is in the determination of the trade price and when the transaction takes place. When you take on a currency futures contract, you agree to the settlement price of a future date. That means that you have the obligation of transacting the agreed upon volume of currency at the agreed upon future date. On the other hand, with a spot Forex trade, you make the transaction immediately and actually hold the currency as your property.
Aside from the subtle differences mentioned above, you would essentially have the same exposure to whatever currency pair that you are trading regardless of whether you’re trading futures or spot. Of course, there are practical differences as well involved in these transactions, which affects the commissions or transaction fees that you would pay, and the leverage you are allowed to apply to your positions in both cases.
If you are trading futures, then you would have to do your trading through a futures exchange and pay your futures broker a commission on top of the spread. In addition, you would have to abide by the prevailing rules regarding leverage of the futures broker that you are trading through. In the same way, if you are trading spot Forex, then you would do so through a spot Forex broker and pay them a spread and accept whatever terms of leverage and margin they are willing to extend. Generally, the terms provided for trading spot Forex is better than that of trading futures, which is why people tend to trade spot.
What About Currency Swaps?
Currency swaps are a special agreement between two parties to exchange a fixed amount of a pair of currencies, one for the other, and then to return the original fixed amount swapped after a certain specified period has elapsed. The period or “maturity” as it is more commonly known can be negotiated up to 30 years. Now, you may be wondering, why would anyone want to put this kind of agreement in place?
Essentially, a currency swap is an extremely cheap way for banks and other financial institutions to fund their foreign exchange balances on a day to day basis. Instead of borrowing at the prevailing rate of interest in their country, they can secure cheaper debt by going overseas. A currency swap is one of the vehicles that facilitates the process of acquiring this “cheap debt” in a foreign currency.
Many businesses, banks and other institutions also use currency swaps to hedge against or reduce their currency risk. In cases where a company is holding a debt in a foreign currency, they can “lock it in” at the current rate by purchasing a swap to essentially convert the debt upon maturity at today’s price.