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Understanding the Different Types of Currency Exchange Contracts

The forex market is one of the biggest entities of its type anywhere in the world, with this global space worth a staggering $1.93 quadrillion and estimated to be around 2.5x larger than the world’s GDP.

As this market has continued to benefit from exponential growth, it has also diversified and seen a number of new investment vehicles developed to leverage its unique volatility. Currency exchange contracts offer a relevant case in point, as they provide a legal arrangement in which the parties agree to a future transfer at a predetermined rate of exchange.

However, there are several different types of currency exchange contracts available to investors, and we’ve highlighted some of these in more detail below.

  • The Spot Contract

We’ll start with the Spot Contract, which is the most straightforward and popular foreign exchange product.

This refers to an agreement to buy or sell one currency in exchange for another, while you’ll have a total of two days to settle the contract at a price based on the established ‘spot exchange rate’.

While this simple exchange contract offers convenience and flexibility to traders, it has been noted that spot exchange rate movements are notoriously unpredictable and volatile. This rule can apply even during a single trading day, so it’s crucial that you approach this type of agreement with inherent caution.

  • The Forward Contract

On a similar note, a Forward Contract allows you to buy or sell one currency against another, with the settlement due no later than the day the contract expires.

This type of agreement differs from Spot Contracts by eliminating the risk of fluctuating exchange rates, primarily because it locks in a fixed price for all future transactions (regardless of how the market changes during this period of time).

Forward Contracts can have a maximum time-frame of two years, so there’s a far greater window in which to exchange currencies and optimise profitability.

  • A Limit Order

A Limit Order is essentially an agreement to secure currency at a fixed price, and one that may not be available in real-time.

This type of contract is particularly useful when the markets are moving in a positive trajectory (from your perspective, at least), and in this respect it can help you to take advantage of a bullish climate.

This is also one of the two most common types of ‘orders’ in the foreign exchange, with the other detailed below.

  • A Stop Loss Order

A Stop Loss order is used when the market is shifting in a downward or negative direction from the perspective of your preferred currency, with this type of agreement helping to negate the risk posed by adverse price movements.

A stop loss order instructs a brokerage to buy when the currency hits a predetermined value, with a view to offloading the asset before further and potentially disproportionate losses are incurred.

This is an incredibly popular option for risk-averse investors, especially during periods of intense volatility or unpredictability.