Spot Transaction and Forward Transaction in Foreign Exchange
In foreign exchange transactions, spot and forward transactions refer to different prices or quotes for different contracts. According to Shenkar and Luo (2008), a spot transaction includes banknote transactions for individuals and between banks. Usually, spot transactions for individuals are completed over the counter and instantaneously. Contrary to individual spot transactions, transactions between banks are settled on the second day of working after concluding the transactions. Notably, the interbank foreign exchange market is one of the largest financial markets and most dollar transactions settlements are through computerized Clearing House Interbank Payments Systems (CHIPS). On the other hand, a forward transaction occurs between a customer and a bank. The customer contacts the bank for a specific delivery of a specified foreign exchange amount at a fixed forward exchange rate, to be delivered at a fixed date. Consequently, as compared to a spot transaction that requires the immediate establishment of payment, in forward transaction payment is not necessary until maturity.
Forward and Future Contracts in Foreign-exchange
Fundamentally, forward and futures contracts in foreign exchange allow people to buy or sell certain types of an asset at a specific period and in a fixed price. As Ajami and Goddard (2014), while futures and forward contracts are similar in that they allow market participants to manage their forward liability by locking a future exchange rate, key differences exist between the two. Firstly, forward contracts can be any size, but futures contracts can only be of specific sizes. Secondly, forward contracts are available in multiple currencies, while futures contracts are only limited in certain currencies such as industrialized countries currencies. Thirdly, forward contracts have a wide range of maturity, while futures contracts have standardized maturity dates, often regulated by authorities. The other key difference is that forward contracts are negotiable, while futures contracts stipulate certain preliminary and maintenance margins. Operationally, they key difference in the two contracts is that, in the futures contract, individuals or companies can liquidate their position making it easy to cut their losses or take profits. Unfortunately, in forward contracts, individuals or corporations must wait for the contract to expire.
Why are Forward Contracts widely used than Futures Contracts in Foreign-exchange Market?
Although both forward and futures contracts are used in the foreign-exchange market, forward contracts are widely preferred as compared to futures contracts. Most probably, one of the reasons why forward contracts are preferred is due to the non-existence of regulations and variance in commissions (Ajami & Goddard, 2014). Ideally, in futures markets, prices are highly regulated and brokers are only allowed to charge specific commissions. Along with that, in forward markets, multiple currencies are included, which makes the foreign-exchange process easy as compared to futures markets that restrict traders to only a few select currencies. The other element that makes forward contracts more favorable is because they have a wide range of maturities as compared to future contracts that have standardized maturity date. In foreign-exchange markets, standardization affects the future margin requirements, making it unfavorable with the clients and banks.
Ajami, R., & Goddard, J. G. (2014). International Business: Theory and Practice. Florence: Taylor and Francis.Shenkar, O., & Luo, Y. (2008). International business. Thousand Oaks, Calif: Sage Publications.
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