FX Market Mechanics
Using Just FX Analytics
A spot FX transaction is the “simplest” trade and refers to an agreement between two parties to exchange currencies at an agreed price (the “spot rate”). The idea of a spot trade is that it is as close as is often practical to an “immediate” exchange of currencies, allowing for some time to physically deliver the currency (“settle" the trade). Spot transactions are typically settled (that is, funds are transferred between parties) two business days after the trade date (“T+2”). However, there are exceptions to this convention: most notably, USD/CAD settles on T+1. Spot trades are the most common type of FX trade, and account for more than 2 trillion USD of daily transactions.
An FX forward transaction (also referred to as a “forward outright”) is an agreement between two parties to exchange currencies at an agreed price on a future settlement date which is not the spot date. The purpose is to mitigate risk by guaranteeing an exchange rate between currencies for a future date. This might be used for a planned invoice payment in another currency, for example. The key difference between a forward and spot trade is that, due to the difference in settlement dates, forwards take into account the “time value of money". The rate for a forward contract (the “all-in rate”) is composed of the current spot price, plus a number of “forward points” which are determined by the interest rate differential between the two currencies (since this reflects the relative value of holding one over the other) and the length of the contract. Typically, the longer the contract, the greater the difference will be between the all-in rate and spot rate. It is important to note that the price of a forward contract is not a reflection of the future exchange rate between the currencies (expected future spot price). Forward contracts may settle on any day which is a valid business day in both currencies. The settlement date of a forward contract is referred to as the “value date”. There are commonly-used standard contract durations (“fixed tenors”), such as 1 week, 1 month, 1 year, etc., which are measured from the spot date. A value date which does not fall on a fixed tenor date is referred to as a “broken date”. See “Tenors” for more information. Forward contracts may also be “short-dated”, which means their value date falls before the spot date. In this scenario, the all-in rate moves in the opposite direction to the spot rate compared to post-spot forward contracts.
An FX swap is two agreements to exchange a pair of currencies with two different value dates, in opposing directions. These agreements are referred to as “legs” of the swap. The earlier leg is referred to as the “near leg”, and the latter is the “far leg”. For example, a swap contract might be created to buy currency on the spot date, and sell the same amount in 1 month. Commonly one leg of a swap is a spot transaction, in which case the swap is essentially the forward point component of a forward contract. However, it is also possible to execute a swap where both legs are forwards. Swaps are commonly used to allow the settlement date of a forward trade to be moved later (“rolled forward”) or earlier in time, by using one leg to cancel out an existing forward contract.
Tenors refer to the common standard contract durations for forward trades. Fixed FX tenors are: Pre-Spot ("short-dated" forwards): - TOD - Today - TOM - Tomorrow Post-Spot: - SN - Spot Next (1 day after spot) - 1 WEEK, 2 WEEK, 3 WEEK - number of weeks after the spot date - 1 MONTH, 2 MONTH, etc. - number of months after the spot date - 1 YEAR, 2 YEAR, 5 YEAR - number of years after the spot date If the date of a fixed tenor for a trade falls on a market holiday for either currency in the pair, the date is typically moved to the next business day.