Currency Futures vs. Spot FX: An Overview
The foreign exchange (Forex) market is a very large market with many different features, advantages, and pitfalls. Forex investors may engage in trading currency futures (also known as an FX future or foreign exchange future), as well as trade in the spot Forex (Spot FX) market. The difference between these two investment options is subtle but worth noting.
- A currency future is a futures contract stipulating an exchange of one currency for another at a future date and at a fixed purchase price.
- A spot FX contract stipulates that the delivery of the underlying currencies occur promptly (usually 2 days) following the settlement date.
- The main difference between the contracts is when the trading price is determined and when the physical exchange of the currency pair occurs.
A currency futures contract is a legally binding contract that obligates the involved parties to trade a particular amount of a currency pair at a predetermined price (the stated exchange rate) at some point in the future. Assuming the seller does not prematurely close out the position, they can either own the currency at the time the future is written or may "gamble" that the currency will be cheaper in the spot market before the settlement date. Oftentimes, one of the currencies is the U.S. dollar. Currency futures are mainly used by global firms that seek protection against movements in foreign exchange rates.
With the spot FX, the underlying currencies are physically exchanged following the settlement date. Delivery usually occurs within 2 days after execution as it generally takes 2 days to transfer funds between bank accounts. In general, any spot market involves the actual exchange of the underlying asset. This is most common in commodities markets. For example, whenever someone goes to a bank to exchange currencies, that person is participating in the Forex spot market. As the largest market in the world, the foreign exchange spot market realizes about $1 trillion (USD) per day in transactions.
So, the main difference between currency futures and spot FX is when the trading price is determined and when the physical exchange of the currency pair takes place. With currency futures, the price is determined when the contract is signed and the currency pair is exchanged on the delivery date, which is usually in the distant future.
In the spot FX, the price is also determined at the point of trade, but the physical exchange of the currency pair takes place right at the point of trade or within a short period of time thereafter. However, it is important to note that most participants in the futures markets are speculators who usually close out their positions before the date of settlement and, therefore, most contracts do not tend to last until the date of delivery.