Introduction to Fx Market, & Spot Contracts for Fx
Foreign exchange market (FX market) is a global market where currencies are traded. The fx market is an over the counter market. Trade is done directly between the two parties, as opposed the exchange traded market where trade is done on the floor of the exchange (although some exchanges are being conducted entirely electronically), and regulated by an exchange commission.
The over the counter method avails the investor the opportunity to trade his stock exchange at any given time since they operate on a 24 hour basis. The defining characteristic of an over the counter market is that they are less formal, but very organized networks of trading relationship centered around one or more dealers, also called the market makers.
The market makers (dealers) quote their prices for selling or buying. The price for selling is called the ask or offer price, while the price for buying is known as the bid price. The advantage an exchange traded market has over an over the counter market is that regulations are put in place to protect the interest of investors. The exchange traded market is very transparent and liquid, with buy and sell orders as well as execution orders being revealed to one another. Also, there is no risk of a market maker pulling out as it is inherent in the over the counter market where dealers in an over the counter security can pull out from the market, thereby making life difficult for market participants relying on them to buy or sell. The reason why there is an absence of this risk for an exchange traded market is that some exchanges designate certain participants as dedicated market makers and require them to maintain bid and ask quotes throughout the trading day. Over the counter markets are less transparent and are not regulated; this means that quotes offered by dealers may differ depending on other dealers and individuals looking to buy from them or sell to them.
Bid and ask quotes are announced informally, it could be through an email, telephone conversation, messaging or an electronic bulletin board. Sorry for drifting away…lol… but enough about OTCs and Exchange traded markets, let us go back to the business of the day; the foreign Exchange Market.
Trades in the foreign exchange market are done based on the foreign exchange rate for various currencies. Foreign exchange rates list a currency in relation to another; it is simply the price of one currency in relation to another. There are two key terms to take note of in the foreign exchange rate. They are the base currency and the numeraire currency. The numeraire currency is the domestic currency, while the base currency is the currency which generates an asset in terms of the domestic currency when it is traded. An example is this: USDNGN. This denotes the amount of Naira worth 1 US dollar. The numeraire currency is the Naira, and the base currency is the Dollar.
A spot contract is a contract between two parties for immediate exchange of funds. It is a binding obligation by two willing parties to buy or sell a certain amount of foreign exchange at the current market price, to be settled in usually two business days after the transaction date. A spot contract can used to hedge the risk of foreign exchange rate fluctuations if the buyer is certain of predicts that the exchange rate would rise in the future. If the exchange rate falls, then the buyer loses while the seller gains. They are two days to note during a spot contract; they are the trade day and settlement day. Trade day is the day on which a spot contract is executed, while the settlement date is the day on which funds are physically exchanged as per market convention for “spot delivery”.
The price of a spot exchange rate is determined by the demand and supply of the currencies in the market. Various economic conditions influence the demand. Such economic conditions include: inflation rate of the country, monetary and fiscal policies of the government, balance of payment condition (ie surplus or deficit), differences between foreign and domestic interest rates and other economic indicators that create expectations about the country’s economic health.
Andrea Roncoroni., Gianluca Fusai., Mark Kummins., Handbook of multi commodity markets and products