Question

The foreign exchange market is a market in which foreign exchange transactions take place. The Primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital movement. Certain important types of transactions conducted in the foreign exchange market occurs via the Spot and Forward markets.

• Describe the spot market
• Describe the forward market

Answer 1

In simple words:

In a spot market a product is transferred or exchanged for a price immediately but the official transfer (formalities) takes some time. In a forward market price is decided now but actual transfer takes place later.

a) Spot Market:

Here trades are done immediately but official transfer of funds take some time. The current price of a financial instrument is called the spot price. It is the price at which an instrument can be sold or bought at immediately.

Let’s say an online furniture store in Germany offers a 30% discount to all international customers who pay within five business days after placing an order.

Jessy James, who operates an online furniture business in the US, sees the offer and decides to purchase $10,000 worth of tables from the online store. Since she needs to buy euros for (almost) immediate delivery and is happy with the current EUR/USD exchange rate of 1.1233, Danielle executes a foreign exchange transaction at the spot price to buy the equivalent of $10,000 in euros, which works out to be €8,902.34 ($10,000/1.1233). The spot transaction has a settlement date of T+2, so Jessy James receives her euros in two days and settles her account to receive the 30% discount.

b) Forward Market:

It is a market that facilitates foreign exchange transactions that involve the future exchange of currencies. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called forward rate. This rate is settled immediately but actual transaction of foreign exchange takes place in the future. This rate may be at a premium or discount or spot rate.

A forward contract can have 2 participants, and these may be Arbitrageurs, Traders, Hedgers and Speculators. A forward contract benefits both the parties. One party may use a forward contract to minimize risk and other party may want to make a profit. Suppose you need 100 Euros next month for some reason and current price of one Euro is $1.2 and you fear that the price of 100 Euros will go up to $1.5. Now you will approach a forward market and find a person who will agree to sell you 100 Euros at less than $1.5. Now that other person being an expert knows that it will not fluctuate that much in 1 month will agree to sell you 100 Euros at $1.3. Now you have reduced your risk by $0.2 per Euro and can sleep well. After 1 month you have to purchase the Euros at $1.3 irrespective of the spot rate at that time. That other person might be in Profit or Loss depending upon the exchange rate of that time.