Is Forex a Derivative?

Currencies can be traded in spot, futures, options (vanilla), binary options, and CFD (contracts for difference) market. While currency futures and options (vanilla) are offered only by regulated exchanges, binary options are offered by both regulated exchange and OTC binary brokers. The other two kinds of currency trading (CFDs and spot Forex) are only offered on an OTC basis. Due to this complex structure, there is a considerable degree of doubt among beginner traders regarding the instruments, i.e., which of them are derivatives and which of them are not? A derivative is a financial contract whose value changes with the changes in the value of an underlying asset. By purchasing a derivative contract, a buyer agrees to purchase the underlying asset on a specific date and at a specific price. However, it is quite difficult to categorize all forms of currency trading purely by this definition. Therefore, let us examine various aspects pertaining to different kinds of Forex trading and determine which of them can be categorized as derivatives.

Settlement

The settlement process varies widely between different kinds of Forex trading. Let us review the process in each case to sort out derivatives from non-derivatives. If the settlement is based on the exchange rate of a currency traded in a different market, then the market being studied can be categorized as a derivative.

Spot

In case of spot Forex trading, a T+2 settlement is followed. This means, all transactions are settled (exchange of underlying currencies) within two business days from the date of execution. Notable exceptions to this rule are currency pairs such as USD/CAD, USD/TRY, USD/PHP, USD/RUB, USD/KZT and USD/PKR, which settle at T+1. Therefore, short-term settlement period and actual exchange of underlying assets (even though a Forex broker uses rollover mechanism to avoid delivery of assets) indicates that spot Forex is not a derivative.

Futures

Currency trades executed in a futures market are settled after a period of 30 days. Contracts with even longer settlement periods are also sometimes available. The currencies also derive their exchange rate from the prices quoted in the spot market. Generally, there would be a slight difference in the exchange rate of a currency in the futures market, compared with the prices quoted in the spot Forex market, as interest rate differentials are factored into the price. Therefore, longer settlement period and the price identification mechanism indicate that currency futures is a derivative market.

Vanilla options

Currency options usually have longer settlement cycles. For example, NASDAQ FX options expire on the third Friday of the expiration month. There is no compulsory delivery. Furthermore, the settlement of currency option contracts in all the exchanges are based on the price traded in the spot market. In case of NASDAQ FX options, the last traded price at 12:00 EST (noon) is used for settlement of the currency options contract. Therefore, longer settlement cycle and price identification mechanism indicate that traditional Forex option contracts are derivative products.

Binary options

Binary brokers offer a range of binary options contracts. Some of them expire in a matter of few minutes. However, none of them leads to the delivery of assets. Furthermore, the settlement is based on the price traded in the spot Forex market. Therefore, lack of delivery of assets and price identification (and settlement) mechanism indicate that binary options are derivative products.

CFDs

There are many similarities between currency CFDs and spot Forex trading. A trader could use the same charting platform, receive same quotes, etc. However, CFDs are mere contracts that allow a trader to bet on the price change in an asset. It does not result in delivery as in the case of a spot Forex market. The price of a currency in a CFD market follows the price in a spot market. Therefore, lack of delivery of assets and price identification (and settlement) mechanism indicate that currency CFDs are pure derivative products.

Price

If the price of a trading instrument in a particular market is dependent on the traded price in another market, then the market being studied can be categorized as a derivative.

Spot

The exchange rate of a currency in a spot market is influenced by several factors such as unemployment rate, inflation, GDP, PMI, and others. However, the exchange rate is not derived from any of these data. The data only has a strengthening or weakening effect on the exchange rate. For example, an increase in unemployment beyond a central bank’s target level will have a negative effect on a currency’s exchange rate. Instead, an increase in inflation will strengthen the currency if the central bank is expected to raise the interest rates to curb the rising prices. Since the exchange rate of a currency is not derived from any particular data, spot Forex does not fit into derivatives category.

Futures

The exchange rate of a currency in the futures market is derived from the price traded in the spot market. Usually, for the same currency, prices traded in the futures market will be a little higher than prices traded in the futures market. As we get closer to the settlement date, the price gap between the futures market and spot market will narrow. The price gap seen at the beginning of a new contract is due to the risk premium, which is added by the market participants to protect themselves. Therefore, the exchange rate calculation indicates that currency futures are derivatives.

Vanilla options

The premium changes in a traditional options market are reflecting changes in the currency’s exchange rate in the spot FX market. The time left for expiry and the overall sentiment towards a currency also influences the premium. Theoretically, the value of a call or put option is calculated using the Black-Scholes pricing model, which uses six variables, namely volatility, type of option, underlying price of currency or any other asset, time, strike price, and risk-free rate. As the premium is calculated from the underlying price of the currency in the spot market, options are obviously derivatives.

Binary options

Similar to traditional options, binary options also use spot currency exchange rates to settle a contract at expiry. The value of a currency binary options contract would be theoretically equal to zero or 100 based on the corresponding price of the currency traded in the spot market. Therefore, based on the exchange rate identification mechanism, binary options should be categorized as derivatives.

CFDs

Similar to futures and options, CFDs use spot market prices for trade execution and settlement. Since the price of a currency CFD is directly derived from the spot Forex market prices, we can categorize Forex CFDs as derivatives.

Trading time, order size, and volume

Derivative markets generally use standardized contracts or lay down restrictions on order size and volume. We shall categorize the different kinds of currency markets based on this fundamental difference.

Spot

Currencies can be traded on a 24/5 basis in a spot market. There are no trade time restrictions. Furthermore, Forex brokers do not specify any standard order size in spot Forex trading. Some online brokers allow traders to trade positions as small as 1 currency unit. Furthermore, Forex brokers do not restrain traders from placing huge orders. If at all there is any restriction, it may be only due to the size of a given broker and its liquidity providers. Therefore, lack of restrictions on trade timings, lot size, and order volume indicates that spot Forex trading is not a derivative.

Futures

Currency futures are traded in set hours. Although, the all-night derivative market does exist, it is largely illiquid and cannot be accessed easily by retail traders. There is also a standard lot size in currency futures trading. Furthermore, the exchange specifies a maximum position size for small and large (institutional) traders. In the USA, the Commodity Futures Trading Commission determines the position limit in futures and options contracts. A penalty is also slapped for position limit violation. Based on these restrictions, we can classify currency futures as derivatives.

Vanilla options

Similarly to currency futures, traditional currency option contracts are traded only during set hours. There is also a standard lot size, and position limits for small and large traders mandated by the market regulators. Therefore, currency options are derivatives too.

Binary options

Binary options can be traded at any time (some brokers allow even weekend orders). Binary brokers usually set some minimum and maximum order volume levels. However, these restrictions are not set in stone unless the given binary option contract is traded on a regulated exchange. Therefore, it is impossible to classify binary options as a derivative purely by looking at the market’s restrictions on trading time, order size, and volume.

CFDs

Most currency CFDs are traded during the same hours as spot Forex. Also, similarly to spot FX, there will rarely be a meaningful order size and number restriction. Many CFD brokers allow fractional position sizing and flexible high limit on the number of trades when it comes to currency pairs. Therefore, we cannot say that CFDs are derivative contracts just by looking at this parameter.

Trading capital

The margin money required to open a position is usually standardized in a derivative market. We shall categorize different kinds of Forex trading based on that rule.

Spot

In spot Forex trading, the average leverage offered by online brokers is higher than 1:100. Furthermore, there is no definite rule regarding the minimum capital that needs to be maintained to open a trade. As long as a trader maintains the minimum margin amount specified by a Forex broker, the position will remain open. Spot Forex brokers generally decrease the leverage on weekends. This is done based on particular broker’s judgment and for their own protection – no standard market-wide rule exists to regulate the necessary margin size. Such a lack of definite rules indicates that spot Forex is not a derivative.

Futures

In the currency futures market, all traders have to maintain a standard minimum margin stipulated by the exchange. An additional amount, as dictated by the exchange, needs to be set aside to carry forward the position overnight. There are no variations in the rules. Therefore, margin rules indicate that currency futures are derivative products.

Vanilla options

Traditional currency option trades involve buying or selling a call or put option. To buy a call or put option, a trader should have an amount equal to the lot size multiplied by the premium for a strike price. Likewise, to sell a call or put option (writing an option) a trader should have an amount equal to the lot size multiplied by the premium for a strike price, plus the risk margin (writing an option involves unlimited risk). All margin details are standardized by the exchange, indicating that traditional currency options are derivatives.

Binary options

A binary broker determines the minimum investment that can be made in a currency options contract. Some binary brokers allow additional investments (double up) after a contract turns active. The minimum and maximum additional investment that can be added is also determined by the binary broker and is not left to the trader. Therefore, currency binary options are derivatives.

CFDs

Similarly to currency futures, the broker determines the margin money required to open a CFD contract. The margin terms are standardized and determined by the broker. Therefore, based on capital requirements, we can categorize CFDs as derivatives.

Swaps

A swap rate (overnight interest or rollover fee) is applied for holding a position in a currency pair to compensate each party (a trader and a market maker) for the lack of physical delivery of cash. If there is no exchange of assets, there will be no rollover interest (earned or paid) and that kind of trading would fall under derivatives. We shall apply the rule to categorize different kinds of trading.

Spot

When a long or short position in a currency pair is left open overnight by a trader, a Forex broker will apply a rollover or swap fee to the trading account. Depending on the interest rate differentials between the currencies, a trader may receive or pay a swap fee. For example, when a short position is opened in the EUR/USD pair, a trader will receive the overnight interest for purchasing the greenback, while paying an overnight interest for selling the euro. Ultimately, the interest rate differential (and the broker’s commission) will decide whether the swap is positive or negative. Unless a trader opens a special swap-free account, this fee is applied by all foreign exchange brokers. Thus, we cannot categorize spot Forex as derivative trading.

Futures

There is no swap or rollover fee involved in currency futures trading. Therefore, we can categorize currency futures as derivatives.

Vanilla options

Similar to currency futures, traditional currency options do not carry an overnight rollover fee. Therefore, traditional options can be called derivative trading.

Binary options

Binary options are nothing but bets on the direction of price movement of an asset. As there is no real exchange of assets involved, binary options traders do not incur a swap fee when trading currencies. Therefore, we can categorize them as derivatives.

CFDs

Currency CFDs do not involve any swap fee as there is no settlement or exchange of assets. There are brokers who charge an overnight interest rate. However, it is not standardized. Furthermore, a currency CFD trader may always have to pay an overnight interest fee, but will not earn any kind of interest for keeping a position open, as in the case of spot Forex market. The broker will hedge its risk using a variety of strategies while acting as the counter party to the trade. Therefore, CFDs can be categorized as derivatives.

Based on settlement mechanism, exchange rate identification process, trading time, order size, volume, trading costs, and swaps, it is clear that spot Forex trading is not a derivative. All other forms of currency trading such as futures, vanilla options, binary options, and CFDs can be categorized as derivatives. According to the report by the Bank for International Settlements, in April 2016, the total Forex market turnover was $5.1 trillion per day, of which spot Forex trading accounted for 33% or $1.7 trillion. Options and other products contributed only 5% of the total turnover. Therefore, it can be understood that Forex derivatives (futures, options, binaries, and CFDs) market is small if compared to the spot Forex market.


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