6 Forex Financial Instruments to Understand

By: Justin Stewart

What is the definition of a financial instrument where the forex market is concerned? Simply stated, it is any type of a financial medium such as bills of exchange, bonds, currencies, stocks, etc., that are used for borrowing purposes in financial markets. When you are discussing the forex market, the following six entities are designated as financial instruments:

1.Exchange-traded fund
2.Forward
3.Future
4.Option
5.Spot
6.Swap

Exchange-traded Fund - referred to as ETF's. These are open-ended investment companies that have the characteristic of being traded at any time throughout the day. These will oftentimes attempt duplicating stock market indices such as the S&P 500. The ETF's gain strength as the United States Dollar (USD) weakens against a different currency and therefore replicate currency market investments. Certain funds can track the price fluctuations of the various world currencies as they compare to the USD, and will oftentimes increase in value to counter the direction that the USD moves in. This creates increased interest in the USD for investors and speculators.

Forward - the agreement established between two parties wherein they purchase, sell, or trade an asset at a pre-agreed upon price is called a forward or a forward contract. Normally, there is no exchange of money until a pre-established future date has been arrived at. Forwards are normally performed as a hedging instrument used to either deter or alleviate risk in the investment activity.

Future - a forward transaction that contains standard contract sizes and maturity dates are considered futures. Futures are traded on exchanges that have been created for that purpose exclusively. Just like with commodity markets, a future in the forex market normally designates a contract length of 3 months in duration. Interest amounts are also included in a futures contract.

Option - commonly shortened to FX option from foreign exchange option. Options are derivatives (financial instruments whose values fluctuate based on underlying variables) wherein the owner has the right to, but is not necessarily obligated to, exchange one currency for another at a pre-agreed upon rate and a specified date. When you talk about options in any form (stock market, forex, or any other market), the forex market is the deepest and largest, as well as the most liquid market of any options in the world.

Spot - where futures contracts normally employ a 3-month timeframe, spot transactions encompass a 48-hour delivery transaction period. There are four characteristics that all spot transactions have in common, namely:

1. A direct exchange between two currencies
2. Involves only cash, never contracts
3. No interest is included in the agreed upon transaction
4. Shortest of all transaction timeframes

Swap - currency swaps are the most common type of forward transactions. A swap is a trade between two parties wherein they exchange currencies for a pre-determined length of time. The transaction then is reversed at a pre-agreed upon future date. Currency swaps can be negotiated to mature up to 30 years in the future, and involve the swapping of the principle amount. Interest rates are not "netted" since they are denominated in different currencies.

Foreign Exchange
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