FX markets — spot, forward, swap

Foreign exchange is the largest market in the world by daily volume — about $7.5 trillion in 2024 per BIS. It's structurally unlike any other market: 24-hour trading, no central exchange, dominated by a handful of major banks, with prices set primarily through bilateral OTC transactions and electronic communication networks. Every analyst working in international finance lives in this market.

The three main FX product types

• Spot: agreement to exchange currencies at the current rate, typically with settlement T+2 (two business days later). The 'spot rate' you see quoted on Reuters or Bloomberg.
• Forward: agreement to exchange currencies at a future date at a rate agreed today. Used for hedging known future cash flows. Pricing relates to the interest-rate differential between the two currencies (covered interest parity).
• FX swap: combination of a spot transaction in one direction and a forward in the reverse direction. Used by banks for funding management.
• NDF (Non-Deliverable Forward): same as a forward but settled in cash in a major currency (typically USD) rather than physical delivery. Used for currencies with capital controls.
• Options and exotic derivatives: more complex structures for hedging and speculation.

Currency-pair categories

• Majors: pairs involving USD and the next-tier currencies (EUR, JPY, GBP, CHF, CAD, AUD, NZD). Tightest spreads, deepest liquidity, 24-hour trading.
• Crosses: pairs not involving USD (EUR/GBP, EUR/JPY, GBP/JPY). Slightly wider spreads than majors but generally liquid.
• Emerging-market: USD/KES, USD/NGN, USD/ZAR, USD/EGP, USD/INR, USD/BRL, USD/MXN. Wider spreads, lower liquidity in some, central-bank intervention common.
• Exotic: USD/SOS, USD/ETB, USD/MWK. Very wide spreads, sometimes traded only as NDFs.

How the CBK FX market actually works

Kenya's FX market structure has evolved significantly. Pre-2023 it was effectively pegged via informal CBK guidance. Reforms have moved it toward a more market-determined exchange rate. Daily structure:

• Interbank market: 14 banks transact OTC with each other at quoted rates. CBK observes; the daily 'mean rate' is computed from this trading.
• CBK reference rate: published daily based on interbank trades, used for accounting and reporting purposes.
• Customer rates: banks quote to customers (importers, exporters, individuals) with a spread above their interbank costs. Retail spreads can be 100-300 bps; corporate spreads 30-100 bps for large counterparties.
• Central bank intervention: CBK can buy or sell USD to manage the rate — done discretely, sometimes via state-owned banks. The market watches reserves for signs of intervention.

Covered Interest Parity — the FX pricing identity

FX forwards are not predictions of where the spot rate will end up. They are arbitrage-priced, with their level pinned to the interest-rate differential between the two currencies. The relationship is called Covered Interest Parity, and it is one of the cleanest, most-tested no-arbitrage results in finance — and the source of the most common retail-trader misconception about how forwards work.

                       1  +  r_quote  ×  T
  F   =   S   ×   ─────────────────────────────
                       1  +  r_base   ×  T

where:
  F        =  the forward exchange rate, quoted in quote currency per
              unit of base currency. For USD/KES, this is KES per USD.
  S        =  the spot exchange rate today, same quoting convention as F
  r_quote  =  the annualised interest rate in the quote currency,
              expressed as a decimal. For USD/KES, this is the
              KES interest rate (the higher-yielding side here).
  r_base   =  the annualised interest rate in the base currency,
              expressed as a decimal. For USD/KES, this is the
              USD interest rate.
  T        =  the forward tenor in years (90 days = 0.25, 1 year = 1.0)
  1 + r·T  =  the simple-interest accumulation factor over the tenor
              for each currency — what 1 unit grows to over T years

Variable glossary — why each input matters

• F is what you can lock in today for a settlement at time T. It is not the market's prediction of S at time T; it is the rate that prevents arbitrage between borrowing in one currency and lending in the other.
• S is the observable spot rate, the anchor everything builds from. A 1% change in S translates directly into a 1% change in F at any tenor — spot moves dominate forward moves at short horizons.
• r_quote and r_base are the two interest rates that drive the forward curve's slope. The currency with the higher interest rate trades at a forward 'premium' (above spot for a quote-currency view); the currency with the lower rate trades at a forward 'discount'. This is mechanical, not directional.
• T determines how much of the interest-rate differential accumulates. A 7% differential over 0.25 years (90 days) means F sits about 1.75% above S; over 1 year, ~7%; over 5 years, ~35% (with compounding).
• The (1 + r·T) accumulation factor is simple-interest convention used in the FX market; for cleaner math, longer tenors, or option pricing, the formula's continuous-compounding form F = S × exp((r_quote − r_base) × T) is used instead. The two forms agree to several decimal places for short tenors and standard rates.

A worked CIP example, end to end

Quote: USD/KES, 90-day tenor
  Spot S:        130.00 KES per USD
  USD rate:      5.0% (the base currency rate)
  KES rate:     14.0% (the quote currency rate)
  T:             90 / 360 = 0.25 years (FX market convention)

Applying CIP:
                  1 + 0.140 × 0.25     1 + 0.0350
  F  =  130  ×  ──────────────────  =  130  ×  ──────────  =  132.83
                  1 + 0.050 × 0.25     1 + 0.0125

Reading: the 90-day forward is 132.83 KES per USD — about 2.18% above spot,
because KES rates exceed USD rates by 900 basis points annualised and 90 days
is a quarter of a year (so roughly 9% / 4 ≈ 2.25%, in line with the precise 2.18%).

This is NOT a forecast that the shilling will weaken to 132.83 in 90 days.
It is the no-arbitrage forward rate. A Kenyan exporter selling forward at 132.83
is locking in their KES per USD; a Kenyan importer buying forward at 132.83 is
locking in their cost. Whether either decision is 'good' depends on where spot
actually ends up — but the forward rate is not the market's bet on that
location. It is purely the interest-rate-differential-implied price.

EM currency trading characteristics

• Lower liquidity outside business hours — USD/KES is essentially closed when London and New York are closed.
• Wider bid-ask spreads — 20-100 bps for major EM currencies vs 1-5 bps for majors.
• Higher volatility — annualised vol of 8-15% for EM currencies vs 5-10% for majors.
• Carry trade dynamics — high-yielding EM currencies attract foreign capital seeking yield; reversals can be brutal (Turkish lira 2018-2022, Argentine peso repeatedly).
• Central-bank intervention risk — EM central banks intervene more often and less predictably than developed-market central banks.