Forex glossary of terms
The following Forex types will be reviewed in this part:
A derivative is a financial agreement that has its value determined from the price of a certain asset, commodity, rate, index or the happening or significance of an event. The meaning of the word derivative itself comes from the way in which the value of these agreements are derived from the price of the item of significance. There are many known examples of derivatives such as futures, swaps, forwards, and options, all of which can be joined with traditional securities and loans thus creating structured securities, also commonly referred to as hybrid instruments.
Forward deals are provide insurance against the possibility that exchange rates will fluctuate and ultimately differ from what they are between the present and the delivery date of the contract. A forward is also a simple common derivative because simply stated, it is a financial agreement with its price rooted in another asset. The delivery price is the price in a forward contract. This gives the investor the permission to fix the current exchange rate thus avoiding changes in the forex exchange rates.
Futures contracts are similar in many ways to forwards, with the exception that they are very standardized. The future contracts which are commonly traded on the majority of organized exchanges are so highly standardized that they are given the label of fungible - which means that they can be easily substitutable for one for another. Fungibility is advantageous in that it promotes trading and yields a larger trading volume in addition to greater market liquidity.
While futures and forward contracts are extremely similar in nature some key differences between the two include:
- Forwards are always traded over-the-counter whereas futures are always traded on an exchange.
- Each forward is unique in its composition whereas as previously stated futures are highly standardized
- In addition to these details, the price at which the final contract is determined differ in the following ways:
- Forwards are determined when the forward price is agreed upon on the trade date (at the beginning) whereas futures are determined at the settlement price which is only determined and fixed on the very last trading date of the contract (i.e. at the finish)
- The credit risk of forwards is much higher than that of futures:
- The financial gain or loss on a forward contract can only be determined at the time of settlement thus credit exposure can drastically be elevated.
- The financial gain or loss on a futures position is calculated in cash on a daily basis. After each day one's credit exposure can return to zero.
- If physical delivery has been chosen as an option the forward agreement will always dictate whom should be receiving the delivery. The person who is receiving the delivery of a future contract may be anyone chosen by the exchange.
- In future agreements margin requirements and periodic margin calls may occur whereas with forward agreements no cash flows exist until the day of delivery.
Foreign currency exchanged occur when a financial foreign currency agreement is in place stipulating that both the buyer and seller plan to change the same immediate principal amounts of the two different currencies they are representing at a specific spot rate. An important note to remember is that both the buyer and seller agree to swap either floating or fixed rate interest payments in there representative exchanged currencies over the duration of the accord.
Upon the maturity, or completion of the duration of the contract, the initial principal amount is then re-swapped at a an exchange rate that has been pre-negotiated thus the parties will eventually re-obtain their original currencies. Foreign currency swaps are generally used more by commercials trying to hedge foreign currency rather then by forex retail dealers.
Options are nice in that they allow investors increased flexibility. While options certainly cost more than futures contracts, an options' value lies in the fact that they allow investors whether to exercise a future contract or not. Call options permit the investor the right, without any obligation, to buy whatever asset at the exact price (strike price) on a specific date. Again the option holder inherets no obligation to buy or sell the asset at stake.
The purchaser of a call option believes firmly that the price of the asset will eventually be higher than that of the original strike price. The option holder then has the right, without any obligation to sell the security by some specified date (known as a put option). An investor of a put option believes that the price of the asset will eventually be lower than that of the original strike price. With an option contract, the holder maintains the exclusive right to either buy or sell the security at a pre-negotiated place and time in the future. Again there are two different types of options. A put option permits the purchaser to sell the asset whereas a call option permits the purchaser the right to buy an asset.
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