8 minute read
Financial markets are big, complex, and intertwined. The size and breadth of the markets and how they interact with real-life is what keeps things interesting and challenging for me.
But for those operating outside of financial markets, for whom foreign exchange is a by-product of their operations, you might not be too interested, but you really need to know the basics!
In this short-ish article, we'll take a look at:
- FX quotes
- Spot contracts
- Forward contracts
- Option contracts
When we look at an FX quote we are looking at the value of one currency compared to another. In this way, foreign exchange is different to other markets.
A Currency Pair is the quotation of two currencies: for example, GBPUSD is the pound's value compared to the dollar. It specifically shows you how many dollars £1 will buy, that's because the pound (GBP) is listed first in the currency pair.
- Base Currency: the first currency in the quote/pair
- Counter Currency: the second currency in the quote/pair (AKA "quote" currency)
If GBPUSD is listed at 1.3500 then £1 buys $1.35
Converting between the Base and Counter currencies is easy...
- Base Currency amount x Rate = Counter Currency amount
- Counter Currency amount ÷ Rate = Base Currency amount
OK so that's easy enough, but there are actually two prices to think about 🤔... It's easiest to think about this in terms of the bank/broker that's providing the price to you. We'll call them the "price maker" (stick with me on this):
- Bid Price = rate the Price Maker will buy the Base Currency from you (hence, "bid")
- Ask Price = rate the Price Maker will sell the Base Currency to you (hence, "ask")
So in terms of GBPUSD and using the image above...
You can SELL GBP at 1.35101 or you can BUY GBP at 1.35116. Don't forget that if you buy or sell GBP you are doing the opposite in USD.
This kind of pricing is called two-way pricing and it shows the difference in the buy/sell rates, known as the "spread".
💡 Fear not – when you deal with Oku Markets we will keep things simple and show you a one-way rate in the direction that you need it, at a fixed and transparent price that we've agreed 👏
And finally, when it comes to FX Quotes there are particular market conventions as to which currencies are used as the base currency in order of preference. Most readers will be based in the UK, so it's nice to know that the pound is always the base currency except against the euro, but domestically many prefer to show GBPEUR (as opposed to EURGBP) so that's completely fine!
A spot contract is a trade for immediate settlement. The rate is agreed at the point of execution and delivery of currencies is made straight away, usually with a two-day delivery period. It's basically buy now, pay now, and it uses the current market price you see quoted online etc.
The majority of spot FX contracts will deliver in "T+2" (Trade plus two) although it is increasingly more common to enter into same-day or next-day delivery trades due to the increased speed and efficiency of global payments networks.
If a spot contract can be thought of as buy now, pay now, then forward contracts can be thought of as buy now, pay later.
You select the currency you wish to sell (and buy), the date in the future, and you're given the forward rate. We'll come onto what drives the forward rate in a future article, but for now here are some important notes on forward contracts:
- The forward rate might be higher or lower than the spot rate
- You might need to place a cash deposit as collateral against the trade
- Once agreed, you're obliged to transact at the future date and at the agreed rate, even if the market moves for or against you by that time
- You can opt for a forward contract which allows you to deliver (draw down) against the contract before the final delivery date, either within a window of dates or fully flexible throughout the time period
Forward contracts are primarily used by businesses as a tool to secure exchange rates, give protection, and hedge against adverse currency movements. They are similar to currency futures which are traded on-exchange and in fixed amounts and to fixed dates. Forward contracts are traded "over the counter" (off-exchange) so you can specify the amounts and dates, making them much more flexible.
The market for currency options is exploding! There are hundreds of variations and types of products, but for this article we'll look at the Vanilla Option.
The vanilla option is the simplest type of option instrument, and indeed is the foundation stone for a large number of those variations of products, often called "structured" or "multi-leg" products. Don't worry about those for now...
It is a tool for protection, for hedging, but it has a few key differences to forward contracts that make it unique and highly flexible:
- You choose the currency you're buying (and selling), the amount, the future date, and you choose the rate (that's a key difference right there)
- You are then quoted a "premium" much like an insurance contract. This premium is your cost of purchasing the option contract and it is non-refundable
- Vanilla options give the right but not the obligation to exchange one currency for another at an agreed rate and on an agreed future date
- This means that if the spot rate is better, or if I just don't want to use the hedge, I can walk away without any cost other than the premium I've already paid
Let's look at an example:
- I sell GBP 1million to buy USD in six months' time at $1.35
- I am quoted a premium of 3%, so I must pay £30K for this hedge
- In six months' time if the spot rate is $1.40 then I'll walk away from the option and trade at the better spot rate.
- If however the spot rate is $1.30 then I"ll "exercise" my option and buy the dollars at the agreed "Strike" rate of $1.35, which is 5-cents better than the spot rate...
- Easy peasy, right? 🤓
Businesses tend to like the balance of Protection and Participation that vanilla options provide: If the market moves against you then you're protected, if it moves in your favour then you can walk away from the hedge and benefit from the upside. But bear in mind that the premium you pay is non-refundable and you must factor that cost into your overall position.
In future articles, we'll take a look at some of the types of vanilla options and then move on to some multi-leg products.
FX can be complex and confusing, and we really don't help matters with the language and terminology we use day-to-day in markets.
Our philosophy at Oku Markets is to educate our customers and democratise solutions. This means no smoke and mirrors, and complete transparency with pricing and how markets operate.
We've learned over the years that if something seems too good to be true, then it is. We hope that this short introduction to FX has cleared up a few things and that you've maybe learned something new. Either that or it's been a useful aid for getting off to sleep!
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
Thanks for reading 👋