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Different Types Of FX Trading Markets

FX Trading Markets is a global online network where currency traders and investors may buy and sell. It has no bodily site and runs for 5 1/2 days a week, 24 hours a day.

FX Trading Markets are one of the most significant financial marketplaces in the world. It is hard to underestimate their role in the global payment system. Their operations/dealings must be trustworthy for them to fulfil their role effectively. Trustworthiness refers to the fulfilment of contractual commitments. For example, if two parties have engaged in a forward contract for a currency pair (meaning one is buying and the other is selling), both parties should be willing to keep their part of the contract as the case may be.

Following are the major FX Trading Markets

  • Spot Markets
  • Forward Markets
  • Future Markets
  • Option Markets

Futures & Options are called the derivative because they derive their value from the underlying exchange rates.

Spot Market

In FX trading markets, these are the fastest currency transactions. This market enables buyers and sellers with instant payment based on the current exchange rate. The spot market accounts for about a third of all currency exchange, and trades typically settle in one or two days. This certifies traders to be observable to the currency market’s instability, which can source the price to rise or fall between the contract and the trade.

The amount of spot transactions in the FX trading market is increasing. The majority of these transactions take the form of purchasing and selling currency notes, cashing in traveller’s cheques, and banking transfers. The last category accounts for about 90% of all spot transactions, which are conducted solely for the benefit of banks.

According to the Bank of International Settlements (BIS), spot transactions account for around half of all FX trading market transactions daily. The FX trading market is centred on London. It has the largest volume and is the most diverse in terms of the currencies traded.

Major Participants in the Spot Exchange Market

Commercial Banks

These banks are the market’s key participants. The primary players in the FX trading markets are commercial and investment banks, which not only trade on their behalf but also for their clients. The bank engages in forex trading to profit from exchange fluctuations, which accounts for a significant portion of the transaction. If the transaction volume is large, an interbank transaction is carried out. A broker may be recruited for small-volume foreign exchange intermediation.

Central Banks

Central banks, such as the Reserve Bank of India (RBI), intervene in the market to limit currency volatility and guarantee an exchange rate that is commensurate with the needs of the national economy. If the rupee starts to depreciate, for example, the RBI (central bank) may release (sell) a specific amount of foreign currency (like a dollar). The rupee’s devaluation will be halted as a result of the enhanced foreign currency supply. To prevent the rupee from appreciating too much, the reverse process might be used.

Dealers, Brokers, Arbitrageurs & Speculators

Dealers engage in the practice of buying low and selling high. These dealers’ activities are primarily focused on wholesale, with interbank transactions accounting for the majority of their transactions. Dealers may occasionally have to deal with corporations and central banks. They provide minimal transaction costs and a relatively narrow spread. 90 per cent of the total amount of foreign exchange transactions is made up of wholesale transactions.

Forward Market

A forward contract is an agreement between two parties (two firms, individuals, or government nodal agencies) to conduct business at a certain price and quantity at a future date. Because no money is transferred when the contract is signed, there is no requirement for a security deposit.

Is Forward Contracting Useful?

Hedging and speculating benefit greatly from forwarding contracts. A wheat farmer forwards his crop at a known set price to avoid price risk is the typical case of hedging application through forwarding contracts. Similarly, a bakery needs to order bread in advance to help with production planning while avoiding price changes. Speculators predict an increase in price based on their expertise or information. In its place of going long (buying) on the cash market, they go long (purchase) in the forward market. This speculator would then go long on the forward market, wait for the price to rise, and then sell it at a higher price, profiting.

Drawbacks Of Forwarding Markets

The forward markets come with a few drawbacks. The drawbacks are briefly mentioned below:

  • There is a lack of trade centralization.
  • Illiquid (only 2 parties are involved).
  • The risk posed by a third party (risk of default is always there).

The underlying concern with the first two issues is that there is a lot of flexibility and generality. The forward market is similar to two people negotiating a real estate transaction (there are two parties involved: the buyer and the seller). The contract conditions of the agreement are now set according to the convenience of the two people participating in the deal, but if additional people are involved, the contracts may become non-tradeable. In the forwarding market, counterparty risk is always there; if one of the two parties to the transaction declares bankruptcy, the other suffers.

Another typical issue in the forward market is that the longer a forward contract is open, the greater the possible price fluctuations and, as a result, the greater the counter-party risk.

Even in forwarding markets, trading has standardised contracts, which eliminates the problem of illiquidity, but the counterparty risk always exists.

Future Markets

Future markets can help with many of the issues that arise in forwarding markets. In terms of core principle, future markets are comparable to forward markets. Contracts, on the other hand, are standardised, and trading is centralised (on a stock exchange like NSE, BSE, KOSPI). Because exchanges have a clearing business that acts as the counterparty to both sides of each transaction and guarantees the trade, there is no counterparty risk. When compared to forwarding markets, the futures market is far more liquid since it allows an unlimited number of people to participate in the same trade (like, buy FEB NIFTY Future).

Option Market

An option is a contract that allows the option buyer the right, but not the responsibility, to purchase or sell the underlying at a future specified date (and time) and a defined price. A call option allows you to purchase, while a put option allows you to sell. Because currencies are exchanged in pairs, one is purchased and the other is sold.

Currency Options

Currency options are a subset of currency derivatives, which have risen to prominence as a crucial and intriguing new asset class for investors. The currency option allows you to take a position on the exchange rate and achieve both investing and hedging goals.