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Foreign Exchange Market - Get The Basic Education Now
The foreign exchange market, also called foreign exchange currency, forex or simply FX, is the biggest and busiest financial commodity market in the world. Basically, any time one type of currency is traded for another, foreign exchange is put into use. The main players in the game are central banks, large banks, currency speculators, governments, multinational corporations, and other types of financial markets and institutions. Individual retail traders take up the smallest percentage of this group, and they typically participate in the process through brokers or banks. They are also particularly at risk to forex scams.
Currently, the average trade in the worldwide foreign exchange and related markets reaches over a whopping US$ 3 trillion daily.
There are many factors that make the forexmarket unique, not the least of which are its large trading volumes and the extreme liquidity of the market at any given time. There are also a many traders in the market covering a large variety and spread out over a large geographical area. Of course the long trading hours of the foreign-exchange market is well known and trading hours typically lasts 24 hours a day, all through the week, except on the weekends. The exchange rates of the foreign exchange market also depend heavily on many factors which are constantly changing. This means that profit margins are typically much lower than other markets of fixed income, but because of very large trading volumes, there is also the possibility of large profits on occasion.
The Bank for International Settlements or BIS, recently estimated that an average of $3.21 trillion changes hands daily in traditional foreign exchange markets. This estimated total has been broken down as follows:
$1,005 billion in spot transactions
$362 billion in outright forwards
$1,714 billion in forex swaps
$129 billion estimated gaps in reporting
$2.1 trillion was also traded aside from these “traditional” avenues of turnover.
In 1972, exchange-traded forex futures contracts began to be traded at the Chicago Mercantile Exchange. Today, these are actively traded in relation to most other futures contracts. The volume of these types of futures has grown considerably since then and the Wall Street Journal Europe estimates that these accounts for about 7% of the total foreign exchange market volume.
Drawing from data gathered semi-annually from London, New York, Tokyo and Singapore Foreign Exchange Committees, the IFSL has estimated that the average daily global turnover in traditional foreign exchange market transactions registered around $2.7 trillion in April 2006. If non-traditional foreign exchange derivatives and products traded on exchanges were included, the overall turnover would reach to an average of $2.9 trillion a day. This figure is more than ten times the combined size of the daily turnover of the equity markets around the world.
Foreign exchange trading has more than doubled in size since 2001. Between April 2005 and April 2006 alone trading increased by 38%. One of the main reasons for this growth is that foreign exchange as an asset class has been growing in importance and many types of fund management assets, namely hedge funds and pension funds have greatly increased. Another important factor in this growth is the rise of a diverse selection of execution venues such as internet trading platforms, which has made it easier for retail traders to trade in the foreign exchange market.
There is no central exchange or clearing house in the foreign exchange-rate market. The primary reason for this is that foreign exchange is primarily an OTC market where brokers and dealers negotiate directly with each other. Today, the largest geographic trading center in the world is the UK, particularly the city of London. The IFSL estimates that the city has increased its contribution to the world turnover from 31.3% in April 2004 to 32.4% in April 2006 in traditional transactions.
According to The Wall Street Journal Europe, 73% of the world’s trading volume is accounted for by the ten most active traders. These are mostly large international banks which continually provide the market with both bid or buying and ask or selling prices. The bidding and asking gap is the difference between the price at which a particular bank or market maker will sell and the actual price at which a market-maker will buy from a wholesale customer. This difference is typically minimal for actively traded pairs of currencies, averaging around 0–3 pips. For example, Euros and US dollars are usually bid/ asked at 1.2200/1.2203, with minimum trading size for most deals usually coming in at around $100,000.
These figures may not necessarily apply to bank’s retail customers, who will often be subjected to markups to 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers’ checks. While spot prices of market makers will vary, prices on Euros and US dollars do not typically go beyond 3 pips wide or 0.0003. With increased competition, pip spreads have even begun to shrink considerably on major pairs, sometimes to as low as 1 to 2 pips.
Market participants
Unlike in the stock market, where all participants typically have access to the same prices and rates, the foreign exchange market is divided into varying levels of access. At the top of the hierarchy is the inter-bank market, which is comprised by largest investment banking firms. Within this group, spreads not usually made known to traders outside the inner circle. Going down the ladder of the levels of access, the spread widens markedly from 0-1 pip to 1-2 pips for major currencies like the Euro. This is due mostly to the volume of trading account. If a particular broker can guarantee large numbers of transactions for large amounts, they will be in a better position to demand a smaller difference between the bid and ask price, or what is known in the industry as a “better spread”. It is the amount of money or the size of the “line” that the traders exchange which determines the levels of access that make up the forex market. 53% of all transactions is accounted for by the top-tier inter-bank market. Further down there are the smaller investment banks, and still lower down are the large multi-national corporations. These multi-national corporations generally need to hedge risk and pay employees in different countries, in addition to large hedge funds and in some cases even some of the retail forex market makers. Galati and Melvin, has stated that an increasingly important role in financial markets is being played by pension funds, insurance companies, mutual funds, and other institutional investors. Their role is also particularly crucial in FX markets since the early 2000s. They go on to say that hedge funds have grown exponentially during the 2001 to 2004 period, both in terms of numbers and in overall size. Central banks are also becoming more heavily involved in the forex market in order to align currencies to their economic needs.
Banks
The interbank market is responsible not only for the majority of commercial forex turnover, but also considerable amounts of speculative trading daily. A typical large bank for example, may trade in billions of dollars daily. A small percentage of this trading is done on behalf of bank customers of course, but the majority of it is conducted by proprietary desks, who are involved in trading for the benefit of the bank’s own account.
Until fairly recently, foreign exchange brokers were involved in vast areas of the business, assisting in interbank trading and matching anonymous counterparts in exchange for small fees. With the changing times however, a lot of this business has been relegated to more efficient electronic systems. The broker squawk box, which was a recognizable aspect of many trading rooms for years, lets traders listen to ongoing interbank trading. Today, turnover is a lot smaller than it was just a few years ago.
Commercial companies
Commercial companies are an integral part of the forex market and much of their activities in this area are centered on seeking foreign exchange to pay for goods or services. Commercial companies generally trade in much smaller amounts compared to banks or speculators, and their trade activities do not usually have any short term effect on market rates. In any case, trade flows are important factor in the long-term direction of a particular currency’s exchange rate. This is why some multinational companies can have an unexpectedly significant impact on the market when very large positions are covered due to exposures that other market participants are not aware of.
Central banks
Country’s central banks have an important role to play in the foreign exchange markets as well. These institutions primarily try to control the country’s money supply, as well as inflation and interest rates. They will often have official or unofficial target rates for their particular currencies. They also have the ability to use their substantial foreign exchange reserves in order to stabilize the market. Milton Friedman has suggested that the best stabilization strategy for central banks to take would be to buy when the exchange rate is too low, and to sell when the rate is too high. In this way, they would be trading for a profit based on their more precise information. This type of “stabilizing speculation” is thought by many to be ineffective however, as central banks do not go bankrupt if they make large losses. Other traders are under no such protection from that risk, and furthermore, there is no evidence that supports the idea that central banks do make a profit by trading.
Oftentimes, the existence of a rumor or mere speculation of intervention by a central bank will cause enough of an effect to stabilize a country’s currency. Some countries with a dirty float currency regime however, have been known to aggressively intervene several times each year. Even then, central banks may not always achieve their goals. With the combined resources of the entire market, any central bank–no matter how powerful–can easily be overwhelmed. This was the case in the 1992 to 1993 ERM collapse, and more recently in Southeast Asia.
Investment management firms
Investment management firms typically use the foreign exchange market in order to facilitate trades in foreign securities. These firms usually manage large accounts for customers such as pension funds and endowments. An investment manager who has an international equity portfolio for example will generally need to buy and sell foreign currencies in the spot market to pay for the purchase of foreign equities. Since these foreign exchange transactions are not the primary purpose of the actual investment decision, they are not considered speculative or geared for profit-maximization.
Some investment management firms however, are also involved in more speculative specialist currency overlay operations. These operations are intended primarily to manage their clients’ currency exposures with the goal of profit generation as well as risk limitation. These types of specialist firms are quite small in number, although many of them have a large value of assets under management (AUM). This allows them to generate larger trades.
Hedge funds
Since 1990, hedge funds have gained a reputation for aggressive currency speculation. The most notable of these was the George Soros Quantum fund. Theses types of funds control billions of dollars in equity and often they may even borrow billions more. In this way, they can overwhelm intervention by central banks in order to support any currency that they wish, if the economic fundamentals will favor the hedge funds.
Retail forex brokers
A very small part of the total volume of the foreign exchange market is handled by retail forex brokers or market makers. CNN has stated that one retail broker has estimated a retail volume of $25 to 50 billion daily. This figure accounts for about 2% of the entire market and the CFTC website reports that inexperienced investors are particularly vulnerable targets of forex scams.
Trading characteristics
For the majority of FX trades, there is no unified or centrally cleared market and very little cross-border regulation. Because of the over-the-counter nature of most currency markets, there are instead a number of interconnected marketplaces, wherein different currency instruments are traded. This gives the impression that there are implies that there a number of different dollar trading rates or prices, depending on the particular bank or market maker that is doing the trading. In actual practice however, the rates are usually very close, or else they could be exploited almost instantly. In 2007, FxMarketSpace which is a joint venture of the Chicago Mercantile Exchange and Reuters was established with the primary role of being a central market clearing mechanism.
Today, the main trading centers of the world are located in London, New York, Tokyo, and Singapore, although other banks throughout the world also participate actively. The trading in currency happens nonstop throughout the day with the European session beginning as soon as the Asian trading session ends. The North American session follows quickly after and then the Asian session starts once again. This goes on through the week except for weekends.
It is often very difficult and even impossible to gain any type of “inside information” on the foreign exchange markets. Fluctuations in the exchange rates are usually caused by actual monetary flows in addition to expectations of changes in monetary flows. These changes are most often caused by changes in inflation, GDP growth, interest rates, large cross-border M&A deals, deficits or surpluses in budget and trade, and other market conditions. Any news of these developments is typically released publicly, sometimes at different dates, so that almost everyone can have access to the same news at the same time. Large banks have an important advantage however, in that they can see the order flow of their customers.
When currencies are traded for another, each pair of currencies is considered an individual product and is given the designation XXX/YYY, where YYY stands for the three-letter ISO 4217 international code of the currency into which the price of one unit of XXX is measured, called the base currency.
For example, Euro/US Dollar is the price of the euro against the US dollar, in this case, 1 euro = 1.3045 dollar. Following that convention, the first currency or the base currency of the pair, was the stronger currency at the creation of the pair. The second currency or counter currency was the weaker one at the creation of the pair.
Any factor that affects XXX will affect XXX/YYY and XXX/ZZZ as well. This will cause a positive currency correlation between XXX/YYY and XXX/ZZZ.
According to the BIS study, the most heavily traded products on the spot market, were:
EUR/USD: 28 %
USD/JPY: 18 %
GBP/USD (which is also called sterling or cable): 14 %
The US currency was involved in 88.7% of the total transactions, followed by the euro, which came in at 37.2%, the yen, which registered 20.3%, and the sterling, which came in at 16.9%. You will notice that the volume percentages add up to 200%. This accounts for 100% for all the sellers and 100% for all the buyers.
Since its creation in January 1999, trading in the Euro has grown considerably. Because of this, the foreign exchange market today is still far from being centered on the US Dollar. Trading the euro against a non-European currency for example–in this case designated ZZZ–will normally entail two trades: first a EUR to USD conversion and then a USD to ZZZ. The EUR to JPY is an exception to this rule, the pair being an established traded currency in the interbank spot market.
Factors affecting currency trading
While many factors affect exchange rates, the bottom line is that currency prices are still largely a result of supply and demand forces. The currency markets of the world can in essence be seen as a huge melting pot, in which a large and constantly fluctuating series of current events, supply and demand factors are constantly shifting. This of course means that the price of one currency shifts accordingly in relation to another. Because of this, no other market covers as much of what is going on in the world at any given time as the foreign exchange does.
Several factors influence the supply and demand–and therefore the value–of any given currency. There are three broad categories that these factors fall under, namely: economic factors, political conditions and market psychology.
Economic factors
One of the main economic factors is economic policy, which is typically disseminated by government agencies and central banks. Another one is economic conditions, which are generally revealed via economic reports. In addition, there are also other economic indicators.
Economic policy is comprised by government fiscal policy, under which is budget and spending practices, and monetary policy, which is the means by which a government’s central bank influences the supply and “cost” of money. This in turn is reflected by the level of interest rates.
Under economic conditions fall: government budget deficits or surpluses, balance of trade levels and trends, inflation levels and trends, and economic growth and health.
In government budget deficits or surpluses, the market typically reacts negatively to widening government budget deficits, and conversely, reacts positively to narrowing budget deficits. The value of a country’s currency directly reflects this impact.
In balance of trade levels and trends, the trade flow between countries reflects their demand for goods and services and this in turn reflects the demand to conduct trade for a country’s currency. The competitiveness of a nation’s economy is reflected in the country’s surpluses and deficits in trade of goods and services. Trade deficits for example may have an adverse impact on a nation’s currency.
Inflation levels and trends refer to the fact that a currency will typically lose value if there is already a considerable level of inflation in the country or if even if inflation levels are merely perceived to be rising. The primary reason for this is because inflation serves to erode purchasing power, and in effect demand, for that particular currency.
In terms of economic growth and health, these are detailed by reports such as gross domestic product or GDP, retail sales, employment levels, capacity utilization and many other occurrences. In general, the more healthy and robust a country’s economy is, the greater the demand for it will be and its performance will greatly improve as well.
Political conditions
Currency markets can be significantly affected by internal, regional, and international political conditions and events. Political upheaval and instability in particular can affect a nation’s economy negatively. On the other hand, the rise of a political force that is perceived to be fiscally responsible can have quite the opposite effect. Even events in one country may bring about positive or negative interest in a neighboring country and thereby influence its currency.
Market psychology
Market psychology and trader perceptions can influence the market in any number of ways. For one thing, international events and signals may cause a “flight to quality,” with investors looking for a “safe haven”. Currencies that are perceived as being stronger will be in greater demand than their relatively weaker counterparts.
Currency markets also often move in long-term trends. Although they do not normally have annual growing seasons as physical commodities do, business cycles do have an impact on currencies. Longer-term price trends may also be affected by economic or political trends.
Many currency situations follow the “Buy the rumor, sell the fact” adage. This refers to the tendency for currency prices to reflect the impact of an action even before it occurs. When the anticipated event does come about, a reaction in exactly the opposite direction is typically observed. When this situation occurs, the market is sometimes said to be “oversold” or “overbought”. “Buying the rumor or selling the fact” is also a sign of the bias known as anchoring, wherein investors place undue focus on the relevance of outside events in relation to currency prices.
Economic numbers certainly reflect economic policy to some extent, but some reports and numbers also have an almost mystical effect. Often, the number itself may have an immediate impact on short-term market trades. Market indicators can change over time with employment, money supply, inflation numbers and trade balance figures having been important indicators in the past.
In terms of technical trading considerations, the accumulated price movements in a currency pair such as EUR/USD for example, can form patterns that traders may attempt to make use of. Many traders in fact identify such patterns by studying price charts.
Algorithmic trading in forex
Electronic or online trading has been used in the FX market for awhile and now, algorithmic trading - strategies developed by using automated software - is increasing in popularity. It has been estimated that by 2008, up to 25% of all trades by volume will be done using algorithm, compared to about 18% in 2005.
Examples of financial instruments
Spot: A spot is a transaction that takes two days to deliver, as opposed to futures contracts, which can take up to three months. This trade has the shortest time frame, and represents a “direct exchange” between two currencies. Spot transactions usually involve cash instead of a contract, and interest is typically not included. Of all the all instruments, spot has the largest share by volume in FX transactions.
Forward: One way that traders avoid some of the risk in Forex is by engaging in a forward transaction. In this type of transaction, money is not actually exchanged until an agreed upon date. Both the buyer and seller set a predetermined exchange rate, and when that date arrives, the transaction occurs regardless of what the actual market rates are. These trades can last anywhere from a few days, to months or even years.
Currency future: Foreign currency futures are simply forward transactions that come with standard contract sizes and maturity dates. An example would be 600,000 British pounds for next October at an agreed rate of exchange. Futures are often standardized and are typically traded using an exchange created for this very purpose. Contract lengths average roughly 3 months. Any interest amounts are usually included in futures contracts.
Forex swap: By far, the currency swap is the most common type of forward transaction. In this type of transaction, two parties exchange currencies for a certain period of time and agree to turn around the transaction at a future date. Typically not standardized, these contracts are not traded usually traded through an exchange.
Foreign exchange option: Foreign exchange options often referred to as FX options are offshoots wherein the owner has the option to exchange money in one currency into another currency at a previously-agreed upon exchange rate on a future date. The owner is under no obligation to do so however. Today, the FX options market is the largest and most liquid market for options all over the world.
Exchange-traded fund: Exchange-traded funds, also called ETFs are simply open end investment companies that can be traded at any time. ETFs typically try to replicate a stock market index such as the S&P 500. In recent years however, they are being used to replicate investments in the currency market, with the ETF increasing in value when the US Dollar weakens against a specific currency. Some of these funds track the price movements of world currencies against the US Dollar, and increase in value directly inversely to the US Dollar. This allows speculation in the US Dollar for both US and US Dollar denominated speculators and investors.
Speculation: Currency speculators and their effect on currency devaluations as well as national economies are a regular source of controversy. Many economists however have claimed that speculators perform an important function by providing a market for hedgers and also transferring risks from people who don’t want a part of it, to people who do. Still other economists have suggested that this statement is based more on politics and on a free market philosophy rather than on economics.
Today, the main professional speculators are the larger hedge funds and other similarly well capitalized “position traders”.
Currency speculation is treated with a fair amount of suspicion in many countries. While investing in traditional financial instruments such as bonds or stocks are often seen as positive contributors to economic growth, currency speculation does not enjoy this reputation. Many in fact believe that it is simply a form of gambling, that could actually interfere with economic policy.
