Tuesday, April 21, 2015

Spot Market

Currency spot trading is the most popular foreign currency instrument
around the world, making up 37 percent of the total activity

The fast-paced spot market is not for the fainthearted, as it features
high volatility and quick profits (and losses). A spot deal consists of a bilateral
contract whereby a party delivers a specified amount of a given currency
against receipt of a specified amount of another currency from a
counterparty, based on an agreed exchange rate, within two business days of
the deal date. The exception is the Canadian dollar, in which the spot delivery
is executed next business day.

The name "spot" does not mean that the currency exchange occurs the
same business day the deal is executed. Currency transactions that require
same-day delivery are called cash transactions. The two-day spot delivery for
currencies was developed long before technological breakthroughs in
information processing.
This time period was necessary to check out all transactions' details
among counterparties. Although technologically feasible, the contemporary
markets did not find it necessary to reduce the time to make payments.
Human errors still occur and they need to be fixed before delivery. When
currency deliveries are made to the wrong party, fines are imposed.
In terms of volume, currencies around the world are traded mostly
against the U.S. dollar, because the U.S. dollar is the currency of reference.
The other major currencies are the euro, followed by the Japanese yen, the
British pound, and the Swiss franc. Other currencies with significant spot
market shares are the Canadian dollar and the Australian dollar.
In addition, a significant share of trading takes place in the currencies
crosses, a non-dollar instrument whereby foreign currencies are quoted
against other foreign currencies, such as euro against Japanese yen.

There are several reasons for the popularity of currency spot trading.
Profits (or losses) are realized quickly in the spot market, due to market
volatility. In addition, since spot deals mature in only two business days, the
time exposure to credit risk is limited. Turnover in the spot market has been
increasing dramatically, thanks to the combination of inherent profitability and
reduced credit risk. The spot market is characterized by high liquidity and
high volatility. Volatility is the degree to which the price of currency tends to
fluctuate within a certain period of time. Free-floating currencies, such as the
euro or the Japanese yen, tend to be volatile against the U.S. dollar.
In an active global trading day (24 hours), the euro/dollar exchange
rate may change its value 18,000 times. An exchange rate may "fly" 200 pips
in a matter of seconds if the market gets wind of a significant event. On the
other hand, the exchange rate may remain quite static for extended periods
of time, even in excess of an hour, when one market is almost finished
trading and waiting for the next market to take over. This is a common
occurrence toward the end of the New York trading day. Since California
failed in the late 1980s to provide the link between the New York and Tokyo
markets, there is a technical trading gap between around 4:30 pm and 6 pm
EDT. In the United States spot market, the majority of deals are executed
between 8 am and noon, when the New York and European markets overlap

The activity drops sharply in the afternoon, over 50 percent
in fact, when New York loses the international trading support. Overnight
trading is limited, as very few banks have overnight desks. Most of the banks

send their overnight orders to branches or other banks that operate in the
active time zones.
The major traders in the spot market are the commercial banks and the
investment banks, followed by hedge funds and corporate customers. In the
interbank market, the majority of the deals are international, reflecting
worldwide exchange rate competition and advanced telecommunication
systems. However, corporate customers tend to focus their foreign exchange
activity domestically, or to trade through foreign banks operating in the same
time zone. Although the hedge funds' and corporate customers' business in
foreign exchange has been growing, banks remain the predominant trading
The bottom line is important in all financial markets, but in currency
spot trading the antes always seem to be higher as a result of the demand
from all around the world.
The profit and loss can be either realized or unrealized. The realized
profit and loss is a certain amount of money netted when a position is closed.
The unrealized profit and loss consists of an uncertain amount of money that
an outstanding position would roughly generate if it were closed at the
current rate. The unrealized profit and loss changes continuously in tandem
with the exchange rate.

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