The FX market trades over $7 trillion per day. Most of that volume is not driven by companies converting revenues or tourists buying currency — it is driven by banks, asset managers, and hedge funds managing cross-currency exposures, funding positions, and making markets for clients. To understand how the FX desk operates inside a bank, you need to understand three related but distinct products: spot, forwards, and FX swaps.
FX Spot: T+2 Settlement
An FX spot transaction is the purchase or sale of one currency against another for settlement in two business days — this is the T+2 convention for most major currency pairs, including EUR/USD, GBP/USD, and USD/JPY. USD/CAD settles in one business day (T+1), and a few exotic pairs settle on a different cycle.
The two-day settlement convention exists for operational reasons — it gives back-office teams time to process and confirm the exchange of currencies. But this creates a practical issue: if you agree to buy euros today and the rate moves before settlement, you have a two-day window of settlement risk.
The spot rate is quoted as a bid/offer: EUR/USD 1.0821/1.0822 means the dealer will buy euros at 1.0821 (you sell euros) or sell euros at 1.0822 (you buy euros). The spread of one pip (0.0001) is the dealer's income for making the market. For the most liquid pairs during active trading hours, spreads can be less than half a pip in interbank markets.
FX Forwards: Locking in a Future Rate
An FX forward is an agreement to exchange currencies at a specified rate on a future date beyond the spot settlement date. A UK company that knows it will receive $10 million from a US customer in three months can use a forward to lock in the exchange rate today, eliminating the uncertainty of where GBP/USD will be in three months.
The forward rate is not a forecast of where spot will be. It is determined mechanically by covered interest rate parity: the forward rate equals the spot rate adjusted for the interest rate differential between the two currencies over the forward period.
If GBP/USD spot is 1.2700 and UK rates are 4.5% while US rates are 5.25%, the three-month forward rate is calculated as:
Forward = Spot × (1 + US rate × days/360) / (1 + UK rate × days/365)
In this example, the forward rate would be slightly below 1.2700 because US rates exceed UK rates — meaning USD is at a forward premium relative to GBP. If the forward rate were different from this, arbitrageurs could borrow in one currency, invest in the other, and sell forward to lock in a risk-free profit — which would quickly push the forward back to parity.
Forward Points
In practice, FX forwards are quoted as a spot rate plus or minus forward points — the difference between the forward rate and the spot rate, expressed in pips. If spot EUR/USD is 1.0820 and the six-month forward points are −18 (meaning −0.0018), the six-month forward rate is 1.0802.
Forward points are derived entirely from the interest rate differential — specifically, from the FX swap market — and have nothing to do with anyone's view on where EUR/USD spot will go. When a client asks a bank for a forward, the FX desk prices the forward points off the swap curve and adds a bid/offer spread.
FX Swaps: The Most Traded FX Instrument
An FX swap combines a spot transaction with a simultaneous forward transaction in the opposite direction. A company that sells $10 million for pounds today (spot leg) and agrees to buy $10 million back in three months (forward leg) has done an FX swap. No currency exposure is created — this is purely a funding instrument.
FX swaps are the most traded FX instrument globally, accounting for roughly half of all FX market turnover. Banks use them to manage their currency funding positions: a bank that has excess dollars but needs pounds for three months will do a dollar/pound FX swap (sell dollars today, buy dollars back in three months) to fund its pound position without taking any currency risk.
The pricing of an FX swap is expressed in forward points. When the market refers to the "FX swap rate" it means the forward points on the swap — the difference between the near and far legs. This is driven by the short-term interest rate differential between the two currencies, as determined in the overnight and term money markets.
Cross-Currency Basis Swaps
In theory, covered interest rate parity should hold exactly — you should be able to borrow in dollars, swap into euros, invest at the euro rate, and swap back at no profit or loss. In practice, this breaks down because of supply and demand imbalances in cross-currency funding, bank credit risk, and regulatory constraints. The deviation is called the cross-currency basis.
During the 2008 financial crisis, euro-dollar basis swapped to −100 basis points, meaning European banks were paying an extra 100bp above what theory suggested to borrow dollars. Even in normal times, there is a persistent basis in major pairs like EUR/USD and USD/JPY. The cross-currency basis swap market allows institutions to express or hedge this basis — it is a longer-dated version of the FX swap that exchanges floating interest payments in two currencies along with the principal.
Non-Deliverable Forwards (NDFs)
Some currencies cannot be freely converted or delivered offshore — Chinese renminbi (CNH/CNY), Indian rupee, Korean won, and Brazilian real among others. For these currencies, companies and investors use non-deliverable forwards (NDFs). An NDF works like a forward but settles in a convertible currency (usually USD) based on the difference between the contracted forward rate and the official fixing rate at maturity. No physical exchange of the restricted currency takes place. NDF markets can be extremely liquid — the USD/CNH NDF is one of the most actively traded emerging market instruments globally.