Traded Instruments

The trading departments in larger banks consider various factors when determining exchange rates: besides taking into account their inventory positions, they also watch for volumes and recent price action and apply their particular analysis to see where each currency is headed. Usually they will quote more favorable rates to their counter-parties in the opposite direction they think the price is going for any particular currency.

They do this trading several Forex financial instruments. A financial instrument is a medium which can be traded, commonly categorized into two categories: cash instruments and derivative instruments. The first being such financial instruments like securities, loans, and deposits. These are readily transferable and their value is determined directly by the market. And the later, the derivatives, can be divided into two further categories: over the counter (OTC) derivatives and exchange-traded derivatives.

Foreign Exchange instruments and transactions have their own category in which: standard derivatives are Foreign Exchange futures; main OTC derivatives are Foreign exchange options, forwards and swaps; and cash instruments is the spot.

Many folks tend to think strictly of the spot market, but it is not the only one. An array of other investment vehicles have been popping up in the Forex world, providing traders even more ways to take positions in this market. These are the most traded ones:

and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.

The most common type of a foreign exchange forwards transaction is a currency swap. At the end of which the transaction is reversed. Currency swap is not traded via an exchange.

Futures
The currency futures are transactions with standard contract sizes and a maturity date (usually of three months). Futures are standardized and are usually traded via an exchange created for this purpose and usually include an interest amount. The futures market has become a bit more attractive for small speculators with the expansion of e-mini currency contracts.

It should also be noted that although some folks will claim there is no rollover in Forex futures, the interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot market rates. As the futures contracts approach their delivery date their prices will converge with the spot rate so that the holders will pay or receive the differential just as if they had been in a spot position.

Currency Options/Warrants
A foreign exchange option is another Forex instrument belonging to the derivatives, where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. This category also includes exotic foreign exchange options such as average rate options and barrier options.

Currency Swaps
This is the most common type of forward transaction. In a currency swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at an pre-agreed maturity. These are not standardized contracts nor traded through an exchange. Currency swaps can be used to secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan), or to hedge against (reduce exposure to) exchange rate fluctuations.