Life Cycle – Foreign Exchange Transactions
Before we get into the details of the foreign exchange life cycle lets discuss foreign exchange tenors. The FX rates we see on websites like Yahoo finance are for value spot. Spot rates imply that the FX transaction will be settled for delivery spot.
For most currencies spot rate is a rate for delivery t+2 with t being today, with the exception of the CAD where spot for CAD is t+1. However with the introduction of CLS (continuous Linked Settlements) CAD, MXN, USD are looking at same day settlement. Since USD, Mexico and CAD share roughly the same timezone FX deals between the 2 currencies can be settled in one day.
Figure: The Foreign Exchange Lifecycle (Source – The Federal Reserve Bank)
To understand why transactions take place on spot and how to derive transactions on different maturities we need to briefly understand the way clearing and settlement works in the foreign exchange markets.
Let us understand the first step of the FX transaction cycle – Pre-Trade Preparation