Forex Investment and Currency Trading

Every day, financial instruments are bought and sold on securities exchanges and off-exchange trading venues. These includes securities such as

• Shares in companies (equities) and
• Interest-bearing obligations (bonds),

As well as

• Foreign currencies.

These transactions are settled immediately, meaning that the buyer must pay the purchase price right away – within a settlement period of a few days as determined by market practice – and the seller must likewise deliver the shares, bonds or foreign currency right away, i.e. transfer ownership of them to the buyer. Because the seller is paid the full amount in “cash”, this is alternatively referred to as the “cash market” or “spot market”, and the transactions are called spot transactions.

In contrast to these, there are other financial transactions which are not immediately settled. These can likewise be based on shares, bonds or currencies, known as the “underlying” asset or instrument. Their peculiarity is that the underlying assets are only delivered and paid for on a “future” or “forward” date, or that there is no actual exchange of the full purchase price against the assets but rather – likewise on this “future” or “forward” date – only a net settlement payment in the amount of the difference in rates. Because these transactions settle on a date in the future which is forward with respect to the spot settlement date, one refers to these generally as forward transactions. These may also be referred to as derivatives or derivative transactions because they are not outright spot trading of the equities, bonds or currencies themselves but rather are distinct financial instruments which “derived” from these underlying assets.

Currency forwards

An illustrative example of a transaction with an extended maturity date is the currency forward. The parties to this contract agree that on a specific date in the future, they will exchange one currency against another. As an example, in the case of a dollar/euro forward, the seller of the forward obligates himself at the time of the contract to subsequently deliver a specific amount in U.S. dollar against payment of a specific amount in euros. The size of the transaction (i.e. the amount in dollars), the date of the exchange (settlement date) and the exchange rate (the “forward rate”) are thus all determined now, at the time of the contract. For example, the parties may agree on March 1st that they will exchange Euro 100,000 for USD 130,000 on September 1st. In this case, the forward rate would be Euro 1 = USD 1.30.

The subsequent value of this contract depends decisively on how the spot exchange rate develops until its maturity date, along with how the levels of interest rates in each of the respective currencies change. For example, if the value of the euro rises to 1 EURO = 1.35 USD by September 1st, then the transaction turns out to be favorable for the party to the contract who sold dollars forward. Under the terms of the forward contract, he pays precisely USD 130,000 for the EURO 100,000. If, instead of executing a forward contract on March 1st, he had executed this transaction on September 1st as a spot transaction, he would have had to pay USD 135,000 on September 1st to receive the same Euro amount. It should be clear that the value and net result of a forward transaction depends decisively on changes in the price of the underlying asset or instrument between the time the forward contract is executed and its maturity (final settlement) date.

An essential feature of the forward transaction just described is that it is a fixed contract which is binding on both parties. The seller must deliver the underly8ing asset (e.g. in this currency forward, an amount in U.S. dollars) on the settlement date, and the buyer must pay the pre-agreed price. This is one of the basic forms of forward transactions, and because it is a fixed contract which is binding on both parties, this is referred to as a “forward contract”.