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Foreign Currency Market Tools
Spot Contract
The Spot Contract is the most simple and commonly used foreign exchange tool. It allows you to buy or sell one currency in exchange for another with settlement usually taking place within 2 days. The price of a spot contract is based on the prevailing market exchange rate on the day the contract is entered into.
While spot contracts are designed to supply currency for immediate use, spot exchange rate movements are very volatile. Relying on the spot market for future currency transactions is extremely risky and can expose you to unfavourable changes in the foreign exchange rate.
The spot rate of a currency is largely determined by:
- a country's current and future expected rates of inflation.
- a country's balance of foreign currency payments.
- the monetary and fiscal policies of the country's government.
- economic indicators which generate expectations about a country's economic well being.
- the interest rate differential between foreign and domestic interest rates.
Forward Contracts
A Forward Contract enables you to buy or sell one currency against another with settlement taking place on the expiry date of the contract. Forward contracts are different to spot contracts in that they eliminate the risk of a negative movement in exchange rates by securing a price today for a transaction that will take place in the future. Forward contracts protect your future cash flows against adverse currency movements eliminating the currency risk when you have payments to make in foreign countries.
The exchange rate in a forward contract reflects the difference in interest rates between countries. For example, when buying currency for a country with lower interest rates, the exchange rate will be lower than the spot rate. Forward contracts will usually require a deposit of about 10% of the value of the contract.
Limit Order
A limit order is an instruction to buy currency at a price that is above the current market price that gets executed when the specified price is reached. These can be used to buy currency at better rates when the market is perceived to be rising.
Stop Loss
A stop loss is an instruction to buy or sell currency at a price that is below the current market price that gets executed when the specified price is reached. These can be used to close out risk when the market is falling.