Different people use the Forex Market for their varied personal intentions. There are multiple uses of the Forex Market. For instance, the hedge funds utilize the resources of the Forex market to generate profits from the fluctuating currency rates.
Commercial companies, on the other hand, use the Forex Market for their own dealings to exchange currencies across countries to enable various transactions to take place.
The Forex Market is broken down into numerous submarkets depending on the various kinds of applications that currency trading expedites. Each submarket is dedicated to a specific kind of application.
Let me give you a detailed tour of the three principle submarkets of the Forex system:
The Forex Spot Market
The Spot market is the largest of the Forex subtypes that incorporates the retail Forex traders like you and me. It is in this market where we retail traders make our trades. In the spot market, currency is exchanged in the hopes of instant returns or sometime in the near future. The market derives its name from the phrase “on the spot” which is the motto of this type of trading.
Let me make it easier with an example.
Aaron is travelling to Sydney from America. In the airport, he exchanges his US Dollars for Australian Dollars. Aaron gives the cashier his USD and the cashier instantaneously hands him back AUD of equal value.
This way, Aaron has made an “on the spot” exchange of currency with the cashier at the airport. This is one of the basic ways in which the Forex Market operates.
The Spot market consists of approximately 40% of the total trading activities that take place in the Forex Market.
The Futures Market
This kind of Forex Market is based on contracts. The contract mentions the price and the “future” date when currency or commodity will be delivered. The future date specified in the contract is also called the expiration price.
Owing to the fact that the Future market has a centralized nature, all the contracts open with a central exchange.
The main purpose of the Future market is for commercial purposes, however, retail traders and hedge funds too utilize the future market to make profits.
Situation 1: A farmer can decide to sell his produce with a future contract that will expire in 4 months. This way, after three months when the farm is ready to be harvested, the farmer has an assured buyer.
The future contract decides on a price that the buyer and seller both agree on. This provides a major advantage to the farmer who does not have to go through the hassle of searching for a new buyer while his “stocks go bad”.
Situation 2: The renowned technological company, Apple has plans to launch one of their new devices, an Apple iPhone in the market which is expected to be a big hit with the customers.
Apple cannot produce a huge lot of products alone in time. Hence, they allocate some of the manufacturing responsibility offshore to the Japanese manufacturing team and give a time frame of 3 months to do the job.
Now, Apple has found themselves in the need of converting USD to JPY to continue their business transactions.
Rather than waiting for 3 months and making the USD/JPY exchange at the time when the project is finished, Apple decides to purchase future contracts that will expire in 4 months.
In this way, Apple makes a profit by locking the exchange rate of the Japanese Yen instead of taking the chance of Japanese Yen increasing in value during the 3 months time span of the manufacturing process. This way they avoid the danger of the transaction becoming more expensive on their end.
This process is known as hedging. Most commercial companies engage in this process of trading to safeguard themselves against any currency fluctuation that might go against their favour.