Author: Matt Lee
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Currency Futures vs. Spot FX: An Overview
Foreign exchange is the largest and most liquid market in the world. This market sees trillions of dollars change hands each day. Forex investors may engage in trading currency futures (also known as a foreign exchange or FX future), as well as trade in the spot forex (spot FX) market. The difference between these two investment options is subtle but worth noting.
Key Takeaways
- A currency future is a futures contract stipulating an exchange of one currency for another at a future date and a fixed purchase price.
- A spot FX contract stipulates that the delivery of the underlying currencies occurs promptly following the settlement date.
- The main difference between the contracts is when the trading price is determined and when the physical exchange of the currency pair occurs.
Currency Futures
A currency futures contract is a financial contract that obligates the involved parties to trade a particular amount of a currency pair at a predetermined price (the stated exchange rate) at some point in the future. One of the currencies traded is often the U.S. dollar. These futures are traded on global derivatives exchanges, including the Chicago Mercantile Exchange (CME) and Euronext.
Traders use currency futures to lock in an exchange rate over a certain period. Many investors use them to hedge fluctuations in currency exchange rates. The seller of a currency future can either own the currency when the future is written or they may gamble that the currency will be cheaper in the spot market before the settlement date if they don’t close out their position before the expiry date.
Currency futures are also common in global trade and for large corporations. The goal is to seek protection against movements in foreign exchange rates.
Spot FX
Spot FX trades are the most common type of spot trades. As noted above, the foreign exchange market is the largest in the world. By 2022, daily global spot FX trading was valued at more than $2 trillion.
In this type, the underlying currencies are physically exchanged immediately following the settlement date. Settlement usually occurs two days from the trade date unless it involves certain currency pairs, including the CAD/USD pair.
Any spot market generally involves the actual exchange of the underlying asset. This is most common in commodities markets. For example, whenever someone goes to a bank to exchange currencies, that person is participating in the forex spot market.
Note
There is no central authority that governs the foreign exchange market and it has no centralized location. So it should come as no surprise that the foreign exchange market (known simply as the forex market) has many features, advantages, and pitfalls.
Key Differences
The main difference between currency futures and spot FX is when the trading price is determined and when the physical exchange of the currency pair takes place. With currency futures, the price is determined when the contract is signed and the currency pair is exchanged on the delivery date, which is usually in the distant future.
In the spot FX, the price is also determined at the point of trade, but the physical exchange of the currency pair takes place right at the point of trade or within a short period of time thereafter. However, it is important to note that most participants in the futures markets are speculators who usually close out their positions before the date of settlement and, therefore, most contracts do not tend to last until the date of delivery.
How Big Is the Foreign Exchange Market?
The foreign exchange or forex market is the world’s largest and most liquid market. There is no central authority that governs it and no central location. According to the Bank for International Settlements, daily trading in the global forex market averaged $7.5 trillion in April 2022.
What Is the Most Commonly Traded Currency Pair?
The EUR/USD (euro/U.S. dollar) is the most commonly traded currency pair in the foreign exchange market. This pair had almost 23% of the market share, according to the Bank for International Settlements. This is likely due to the strength of both the U.S. and European economies and their relative political stability.
What Is the Major Difference Between the Forex and Other Markets?
Unlike other markets, the foreign exchange market is decentralized. This means there is no central authority that oversees it and it isn’t bound by a physical location. Forex traders don’t have to abide by the same regulations or standards that traders do in other markets, such as the equity or options market.
The Bottom Line
The foreign exchange market is the largest in the world. Traders in this market can use different strategies to meet their needs, including currency and spot FX trading. Both involve using currencies as the basis for trading but are distinct in that they use different times to determine the trading price of currencies. Knowing the difference and understanding the nuances of these trading strategies can help you limit your losses and hopefully realize gains.
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