The foreign exchange market, also known as the Forex or FX market, is the largest financial marker in the world. Foreign exchange traders and investors use a number of instruments to take advantage of rising and falling exchange rates. Basically, a foreign exchange instrument is a standardized contract or security that has foreign exchange as the underlying asset.
The most popular foreign exchange instruments are the so-called major spots. A spot is essentially a contract for immediate delivery of currency at the current market Forex rate. For example, if you buy 1 million EUR/USD (euros vs. the U.S. dollar) at the exchange rate of 1.3, you will immediately get 1 million euros for your 1.3 million U.S. dollars.
There are five major currencies in the world, and, therefore, five major spots: U.S. dollar, euro, Japanese yen, Swiss franc and British pound sterling.
Minor and Exotic Spots
Minor currencies, or minor spots, are currencies that are freely convertible (have no capital controls) but are not as liquid as the majors. It may be difficult to immediately execute large transactions (for example, in excess of U.S. $50 million equivalent). Minor spots include currencies such as Canadian or Australian dollars.
Exotic spots, also known as emerging-market spots, are usually not freely convertible and are often illiquid. They can include currencies such as the South African rand, Turkish lira or Russian ruble.
Investors and traders trade minor and exotic currencies when they want exposure to certain countries. For example, they may want to take advantage of a national debt crisis in a developing country.
Another financial instrument that currency traders and investors employ is a foreign exchange option. An option is basically a standardized contract that gives the buyer the right (while no obligation) to buy or sell a given currency at a given exchange rate (strike price) by a certain date.
Options that give you the right to buy a currency are called call options, while those that allow you to sell it are named put options.
Investors who buy options limit their risk while leaving their profit potential unconstrained. Take the example of an investor who buys a one-month JPY/USD (yen vs. U.S. dollar) call option with a strike of 90.00 for $10,000. If the exchange rate goes down, all the investor loses is the price of the option; if the exchange rate moves above 90 yen per dollar, the investor will exercise the option and get the yen at a cheaper price, selling it immediately in the spot market, thus making a profit.
- exchange fluctuations image by Raimundas from Fotolia.com