The Spot Market in Foreign Exchange

November 11, 2012 in Forex Articles

A ‘spot’ transaction in foreign exchange refers an exchange of currencies between the buyer and seller that is immediate and ‘on the spot.’

Actually, however, the transaction concludes after two business days when the buyer and seller deliver their respective currencies to the other party. The date is known as the spot value date. (However, by convention, the currency pair USD/CAD delivers in one business day). In settlement terminology USD/CAD would settle at T+1 day, whereas other pairs would do so at T+2 days.

The Spot Forex Market

The spot foreign exchange market is a very large, liquid and global market that trades practically round the clock. At one time it used to be the preserve of large banks, forex dealers, corporates and other entities that needed to have a supply of different currencies for their operations. With the advent of technology and computerization, trading platforms now enable almost anybody to trade forex from almost anywhere. As a result even small retail investors and speculators can now participate in this market.

Note that unlike stocks, the spot forex market is an OTC (over-the-counter) market, and does not have a centralized exchange for conducting trades. It may roughly be categorized into two large segments – the inter-bank market (with banks being the major players) and the retail market (constituting brokers, corporates, speculators and basically all other entities).

Size of the Spot Forex Market

According to statistics available from the triennial survey conducted by the Bank for International Settlements, the global average daily turnover during April 2010 was $4.0 trillion. Of this, spot transactions represent almost 37%, or about $1.5 trillion.

The Spot Forex Transaction

A spot transaction involves two currencies, one of which is fixed and is known as the base currency, while the other is called the counter-currency and is calculated from the exchange rate. The base currency is the one intended to be traded (bought or sold).

For example, a business concern may have imported goods from say, Germany, and needs to pay for them in euros. Since the firm generates its own revenues in dollars, it would have to convert its dollars into the euros, i.e. it would sell its dollars and buy euros. This it would do in the spot foreign exchange market where the quote (the prevailing exchange rate) might show as follows:

EUR/USD = 1.3000

In the quote, the EUR is the base currency and the USD is the counter-currency. The quote means that $1.30 would get 1 euro in two business days. Here, the euro, the base currency, is fixed at 1, while the counter-currency changes in accordance with fluctuations in the market. Therefore, if the business concern’s import bill was for €10,000, it would have to spend $13,000 (10,000 x 1.3000) to procure the euros in exchange for its dollars. On the spot value date, two business days hence, the firm would deliver its $13,000 dollars and would receive €10,000 in return. These euros would then be paid over to the German creditor.

What did the firm do? It sold its dollars and bought euros. Therefore, a purchase of the base currency implies a simultaneous sale of the counter-currency and a sale of the base currency implies a purchase of the counter-currency.

 

 

 

 

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