Forex Basics

What is Forex #

  • The forex market (foreign exchange market or currency market) is a global decentralized market for currency trading.
  • The forex market determines the relative values of currencies.
  • In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency.

Market size and liquidity #

Largest and most liquid financial market in the world. (volume of trading) #

  • According to the Bank for International Settlements
    • In 1998, average daily turnover was 1.7 trillion.
    • As of April 2007 daily volume was 3.21 trillion.
    • As of April 2010, average daily turnover was estimated at $3.98 trillion,
      • $1.490 trillion in spot transactions
      • $475 billion in outright forwards
      • $1.765 trillion in foreign exchange swaps
      • $43 billion currency swaps
      • $207 billion in options and other products
    • Trading in forex markets averaged $5.3 trillion per day in April 2013.(Foreign exchange swaps, $2.2 trillion per day; spot trading $2.0 trillion per day in April 2013)

Foreign exchange trading volume by country #

  • Rank in 2010: UK(36.7%),US(17.9%),Japan(6.2%)
  • Rank in 2013: UK(41%), US(19%),Singapore(5.7%),Japan(5.6%),Hong Kong(4.1%)
  • Currently The biggest geographic trading center is UK, primarily London.

Trading characteristics #

Uniqueness of forex market #

  • 24 hours continuous operation except weekends,from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
  • Geographical dispersion;
  • The use of leverage
  • The low margins of relative profit
  • Largest asset class in the world with huge trading volume, high liquidity;
  • The market closest to the ideal of perfect competition
  • An over-the-counter market where brokers/dealers negotiate directly with one another
  • No central exchange or clearing house.
  • very little cross-border regulation.
  • Major news that affect the exchange rates is released publicly(often on scheduled dates). Traders receive the same news at the same time.

Forex spot market & futures market #

  • Forex spot market or forex cash market means the exchange rate right now. The trade occurs immediately, on the spot. Suppose you want to buy some foods, the store owner give you foods, right now , on the spot.

  • Futures market means the exchange rate in the future. Suppose you only need foods next week(future), you enter into a contract with the store owner to deliver foods to you in the future at a specified price.

Market participants #

Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail traders. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004)

Forex market have several levels depend on the amount of money traded. The higher the level, the lower the spreads(bid ask difference). At The top level is the interbank market(which consists of largest commercial banks and securities dealers, and accounts for 39% of all transactions in 2010). At the relatively lower level are smaller banks, large multi-national corporations , large hedge funds, and some retail market makers. Retail traders are at the lowest level.

National Central banks #

  • Have substantial foreign exchange reserves to stabilize the market.
  • Have target rates for their currencies.
  • Will try to control the money supply, inflation, interest rates.
  • Often, the rumor of a central bank foreign exchange intervention might be enough to stabilize a currency. Aggressive intervention might be used when needed.
  • The effectiveness of their intervention is uncertain. The market can easily overwhelm any central bank.

Commercial companies. #

  • Commercial companies and multinational corporations need foreign exchange to pay for goods or services.
  • Multinational corporations also need to hedge risk and pay employees in different countries.

Hedge funds as speculators #

Hedge funds have a reputation for aggressive currency speculation. They control and borrow billions of dollars, which may overwhelm intervention by central banks.

Investment management firms #

For example, an investment manager having an international equity portfolio might need foreign currencies to pay for foreign securities purchases. Some investment management firms also speculate in the forex market.

Non-bank foreign exchange companies #

They offer currency exchange and international payments to private individuals and companies. (They do not offer speculative trading services).

Money transfer/remittance companies and bureaux de change #

  • Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country.
  • Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.

Retail foreign exchange traders #

Individual investors participate indirectly through retail forex brokers or banks.