Is Forex Classified as a Financial Derivative? (Part 1)

You can trade currencies across multiple markets including spot, futures, (vanilla) options, binary options, and contracts for difference (CFD). Trading options and futures on currencies is just available on regulated exchanges, while binary options are available through official exchanges further as over-the-counter (OTC) options brokers. the opposite two varieties of currency trading markets i.e. contracts for difference and commodity exchange are only available on OTC platforms. This complex structure contributes to raising a sort of doubt among novice traders about the character of the financial instruments they’re managing, in addition because the difficulty of determining whether or not they fall within the financial derivatives or not. A derivative may be a financial contract whose value changes in parallel with the change within the value of the underlying asset. the acquisition of a financial derivative contract involves the client agreeing to get the underlying asset on a selected date and at a specified price. However, it’s difficult to classify all kinds of currency trading in line with this definition. within the following lines, we’ll discuss the various aspects related to the assorted models of forex trading and determine the extent to which each are often classified under financial derivatives.

Leveling

The settlement process varies greatly for various styles of forex trading. Let’s bear this process in each case to sort contracts that are a derivative from people who don’t seem to be during this asset class. If the settlement process is predicated on the charge per unit of the currency traded in another market, then the relevant market during this case are going to be classified under the financial derivatives markets.

Spot Market

The T+2 settlement rule applies when trading forex within the commodities exchange. this implies that every one trades (exchange of base currencies) are settled within two business days from the date of execution. There are important exceptions to the current rule with some currency pairs like USD/CAD, USD/TRY, USD/TRY, USD/PHP, USD/RUB, USD/KZT, and USD/PKR, that the T+1 rule applies. Thus it is said that the short settlement period and actual delivery of the underlying assets (even though forex brokers use a rollover mechanism to avoid asset delivery) clearly indicates that spot forex contracts aren’t classified as derivatives.

Futures Contracts

Currency trades within the commodities market are settled after 30 days have passed. Contracts with longer settlement terms are sometimes also available. The currencies traded derive their exchange rates from quotations within the commodities market. In general, we will observe a small difference within the rate of currencies within the commodities exchange compared to their prices within the commodities market, which is because of taking under consideration the difference in interest rates. Thus, it will be said that the length of the settlement period and therefore the price-determining mechanisms clearly indicate that future contracts on currencies fall within the financial derivatives.

Vanilla Options

Settlement cycles within the currency options markets are characterized by an extended period of your time. as an example, NASDAQ FX options expire on the third Friday of the expiration month. there’s also no obligatory obligation to deliver the underlying asset. Moreover, the settlement of currency options contracts on all exchanges is predicated on the quoted prices within the commodities market. as an example, the last traded price at 12:00 EST (noon) is employed to settle NASDAQ FX options contracts. Thus, it will be said that the length of the settlement cycle and therefore the price-setting mechanisms indicate that traditional forex options contracts are derivative products.

Binary Options

Binary options brokers offer a spread of digital options contracts. a number of these contracts expire within some minutes, but none of them end in the particular delivery of the present assets. additionally, options contract settlement is predicated on the value traded within the commodities market. Thus, it will be said that the absence of actual delivery of the traded assets and also the mechanisms of price setting and contract settlement clearly indicate that binary options are classified as financial derivatives.

Contracts For Difference

There are many similarities between CFDs on currencies and contracts traded within the spot forex market. The trader can use the identical charting platform, get the identical prices..etc. However, CFDs are nothing quite financial instruments that allow a trader to punt the change within the price of an asset. In other words, the CFD doesn’t result in the particular delivery of the asset because it does within the commodity exchange. The currency price in an exceedingly CFD follows the value quoted within the spot forex market. Thus, it may be said that the absence of physical delivery of assets and mechanisms of price discovery and settlement of trades clearly indicate that CFDs on currencies are pure financial derivatives.