How do the foreign exchange and derivative markets differ?

Answer 1

The foreign exchange market involves only the transfer of money across country lines, i.e. trading Euros for US dollars. This is a "cash" transaction. A derivative is any transaction which has a price determined by an underlying unit or security. So there are derivatives in foreign exchange, but there are also derivatives in equities and fixed income. So think of a derivative as a special product based on FX.

Answer 2

If you buy currency on the FX market you are buying currency for cash. For example you buy 100 euros and pay $150 at an exchange rate of $1.50 per euro. However, a derivative is a contract to buy the currency (or stock, or bond, or commodity). This may allow you to have better leverage, especially if you are hedging or speculating. For example, lets say you can buy an option to purchase 100 euros @ $1.55 for $5 per 100 euro contract. What this means is you pay someone $5 now and they will give you 100 euros for $1.55, up to an expiration date stated on the contract. If the price of euros goes to $1.65, you can execute your contract for $155, and than sell the euros for $165 for a tidy little profit.

Looking at this further, if you spent the $150 to purchase them on a cash market, you made $10. If you spent $150 to purchase 30 contracts as described above...you make $150, 15 X the cash market profit. The downside to the derivative is the expiration data. If the price doesn't move to a level that has the contract "in the money" before the contract expiration, you are left holding nothing.

Answer 3

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency.