Let's take a look at the range of instruments available to FX market participants and their specific characteristics. The first instrument is spot transactions, which are FX trades settled for immediate delivery. However, the term immediate typically refers to settlement two business days after the transaction is agreed, called T plus two. But there are some exceptions to this depending on the currency pair. For example, a Euro, US Dollar spot transaction where a European importer purchases US Dollars to pay a US supplier. This would typically settle T plus two. However, US Dollar Canadian dollar transactions settle in just one business day, T plus one. Reflecting the market conventions for this currency pair.
Moving beyond immediate settlement, we have outright forwards, which are agreements to exchange currencies at a pre-agreed price on a future date.
For instance, a European exporter looking to hedge the FX risk on a payment they expect to receive in three months might enter into an FX forward where they agree today to sell US Dollars and receive Euros at a rate also agreed today, but where the currencies are actually exchanged in three months time. This allows the exporter to lock in a Euro US Dollar rate today, protecting them against unfavorable exchange rate movements.
FX swaps combine a spot trade with a forward transaction. They involve the simultaneous purchase of a currency at the spot rates and the sale of the same currency at a forward rate or vice versa. For example, a bank might enter into a six month Euro US Dollar FX swap, buying Euros at today's spot rate, and simultaneously selling the same Euros six month forward at a fixed forward rate. This type of transaction is commonly used for liquidity management or funding purposes.
It's important to distinguish FX swaps from cross currency swaps, while FX swaps only involve the exchange of principle cross currency swaps go further. They do involve the exchange of principal amounts in the two different currencies, but also add in the exchange of interest payments over the life of the swap. By way of an example of how the cash flows would work, let's look at a multinational corporation entering into a five year Euro US Dollar cross currency swap. Exchanging Euros for US Dollars at an initial exchange rate. Over the five years the corporation would also exchange interest payments in Euros for corresponding payments in US Dollars. At the end of the swaps term, the principle amounts are exchanged back at the initial rate, not the open market FX rate at that time. Effectively reversing the original transaction. This structure can be used to manage both currency and interest rate risk.
Lastly, there are options which offer flexibility by providing the right but not the obligation to exchange currencies at a specified price and date. For instance, an investor might purchase a three month Euro US Dollar call option with a fixed strike price. This gives them the right to buy Euros at the strike price, if the market Euro, US Dollar exchange rate rises above that level within the next three months. Allowing them to benefit from the currency's appreciation while limiting downside risk to just the premium paid to buy the option initially.
Turning to the charts, which is based on data from the BIS Triennial Central Bank survey, we can see that while the overall FX market volume has grown significantly over the years, the volume distribution among these instruments has remained relatively consistent. FX swaps account for the largest share of daily trading volume, followed by spot transactions and outright forwards cross currency swaps and FX options make up smaller, but still important parts of the markets.
