An introduction to the FX spot market

The foreign exchange market is the largest financial market in the world, with a daily turnover of around 5 trillion USD according to the Bank for International Settlements. The spot FX market makes up the majority of daily trades and is the most common foreign exchange product. Most spot trades are conducted between two financial institutions, or a company and a financial institution, and are usually undertaken to pay for goods and services or for speculative purposes.

A spot trade is a binding obligation to buy or sell a foreign currency and is intended for immediate delivery at the current price, which is called the “spot exchange rate”. However, trades are usually completed with a slight delay of two days and the counterparties to the contract can agree that the price will be the exchange rate at the time of settlement. While the trade date is the date at which the spot trade is executed, the day on which the currencies are physically exchanged is called the “settlement date”. In the FX industry, this is referred to as “T+2”, which means “trade day plus two days” for the physical delivery of the currencies to be completed.

The “T+2” is a throwback to the days when trades were conducted over the phone or fax machine. Although this method allowed for the trading terms to be agreed on instantly, the actual physical delivery of the financial instruments could take several days.

Most spot trades on the foreign exchange market are settled two business days after the trade execution, with the exception of trades on the USDCAD currency pair, which are settled the following business day. Furthemore, holidays can also cause a delay in the trade settlement after execution, as the settlement date must be a regular working day in both countries whose currencies are involved in the spot trade.

Although spot trades are the most common and simplest FX product for immediate execution, they also have their drawbacks. As the FX market can be very volatile, even during a single trading day, the counterparties can put themselves at significant risk if they rely on the spot rate for future settlement.

The difference between the spot and futures markets

Aside from spot FX trades, investors in the Forex market can also engage in currency futures. A currency futures contract is a legally binding contract in which two parties agree to exchange a particular amount of a currency pair at a specified price at a future date. The main difference between the spot and futures FX markets is when the actual delivery of the currency takes place. While the physical delivery in a futures contract is usually a date in the future, the delivery in a spot FX contract takes place at the time of trade or shortly thereafter. However, it is important to note that the majority of futures market participants are speculators who close out their positions before the actual date of settlement. Both contracts are similar in that the price is determined when the contract is signed.

Pricing of spot and futures contracts

The exchange rate of a spot contract is determined by the supply and demand of the underlying currency. Supply and demand can be affected by a number of factors, such as the country’s current and expected interest rate, inflation rate, expected economic growth, monetary and fiscal policies, differences between domestic and foreign interest rates etc.

If a contract settles later than the spot contract, such as forwards and futures, their price is a combination of the spot price and the time value of money, i.e. the cost of interest up to the settlement date. In Forex, the difference between domestic and foreign interest rates is one of the most important factors that affect the pricing of forwards and futures. Traders also track the differences in interest rates and the price of futures to get a hint as to where spot prices may head in the future.

Other spot markets

Aside from the foreign exchange market, other financial markets also trade on the spot market. Interest rate products such as bonds and options are settled the following business day.

Although commodities can also be traded on the spot market, most commodities trading is for future settlement. Commodities are traded through regulated exchanges such as the CME Group and the Intercontinental Exchange. Futures contracts on commodities are usually not delivered, as the contracts are closed out before maturity, and the loss or gain is settled in cash. The Commitment of Traders report (COT), published by the US Commodity Futures Trading Commission, gives an overview of long and short futures positions on a number of securities and commodities undertaken by commercial and non-commercial traders, and is published each Friday at 2:30 PM EST.

The energy spot market connects producers of surplus energy with potential buyers and allows for the immediate negotiating of prices and delivering of energy within minutes. Some examples of energy spot markets are the Title Transfer Facility (TTF) in the Netherlands, and the National Balancing Point (NBP) in the United Kingdom.

Summary

The FX spot market accounts for the majority of daily turnover and is the most basic FX trading product. In essence, currencies, securities and commodities are traded for immediate delivery, in contrast to the futures market where delivery is scheduled for a date in the future. In the spot market, settlement usually takes place two business days after the trade execution due to the time it takes to move cash from one bank to another. An exception is the US dollar and Canadian dollar pair, which is settled the following business day.

Aside from the FX spot market, which trades over-the-counter, other spot markets that trade on exchanges include the bonds and futures market, commodities, and energy products. However, most commodities trade on the futures market for future delivery, with most of the contracts being closed out before maturity and settled in cash.

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