The FX market is decentralized or "over-the-counter" market, where trading occurs directly between two parties rather than via centralized exchanges. It is the largest financial market in the world, accounting for over $5 trillion in daily trading volume.In a typical corporate FX transaction, a contract is made to purchase one currency and sell another at a set rate. This contract is subsequently "settled" by physically delivering the currencies between parties.The key participants of the FX market are international banks, who act as "market makers" and trade significant volumes of currency, driving global price movements. Transactions between these major banks are referred to as the "interbank market", and represents the most efficient market (best pricing with smallest spread) for FX.The FX market operates 24 hours a day, except weekends. Trading may also be suspended in individual markets on public holidays, which can impact liquidity (for example, relatively little volume is trade on Christmas Day and New Year's Day).
The "bid" price is what the dealer is willing to pay for currency if the customer is selling, while the “ask” price is how much the dealer wants for a currency if the customer is buying. The ask price is also referred to as the "offer" price.The bid price is lower than the ask price, because you cannot sell currency at a higher price than you buy it. The difference between the bid and ask prices is referred to as the "spread".
Liquidity refers to the level of trading activity for a given currency pair at a point in time. High liquidity helps keep the market stable and avoid price volatility, and keeps spread tighter and hence pricing more favourable. It is therefore often more risky to trade at times when liquidity is reduced, such as major market holidays.
A "market maker" quotes prices at which currency can be bought and sold to the counterparties (other organizations) with which they have a relationship. Specifically, what identifies a market maker is that they always quote both bid and ask prices for a set of currencies.It is effectively the network of market makers around the world which drive foreign exchange pricing. Large international banks typically have market makers for every major currency pair.Market makers make money in two ways: firstly, through the bid/ask spread on the currencies they trade, and secondly (optionally) by taking positions themselves in the market by trading with other banks.
FX pricing is driven by market makers and due to the decentralized nature of the market, there is no single "source of truth" for pricing. In fact, pricing available to a trade is highly dependent on the counterparties with which they have a relationship.Typically market makers will consider several factors in setting pricing:1) Rates being quoted by other market makers - it is always desirable to attract FX "flow" (transaction volume) by offering competitive pricing.2) Positions they have taken in the market - for example, if they wish to adjust their risk profile they may offer pricing which enables them to rebalance their position.3) Their prediction of future direction for an exchange rate.
When market makers quote bid and ask pricing, they typically accompany this with a "volume". This is the size of trade for which the price will be honoured. At any one time, there may be multiple quotes in the market with different pricing at different volumes. This means that depending on the size of a trade, different prices may be available. The best pricing in the market ("top of book") may only be available for smaller volumes, and larger trades may be executed at a price further down the order book.
Banks make money on FX operations in several ways. The capital markets departments typically make money through market making and trading operations - collecting bid/ask spread and taking positions in the market.However, banks also generate profit through the corporate FX services they provide. Typically, the FX sales desk which quotes pricing to corporate customers will apply a margin or mark-up to the prices at which the bank's traders are dealing. This margin is not disclosed, and can differ wildly from customer to customer ("price discrimination").Just FX Analytics uses interbank top-of-book prices usually accessible only to professional traders to benchmark corporate FX rates and calculate this markup.
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.
- TOD (Today)
- TOM (Tomorrow)
- SN (Spot Next) - this is 1 day after a 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.
A Broken Tenor is a forward contract that is for a time period that falls in between the fixed FX tenors described above.
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