Foreign Exchange Market

A Global Market is where Prices are established by the Millisecond

The Foreign Exchange Market (Forex) is the global financial market where currencies are bought and sold. In a typical transaction, one party will purchase a quantity of a currency by paying with a quantity of another currency. Therefore the Forex determines the relative values of different currencies. For example, how many US dollars you can buy in exchange for one pound sterling.

Financial centres around the world function as trading points, allowing a wide range of different types of buyers and sellers to operate around the clock. Companies, banks and institutional investors all need to change currencies when they conduct business overseas. Central banks are also big users of the Forex.

 

Main points about the Forex:

The primary purpose of the Forex is to assist international trade and investment, by allowing businesses to convert one currency to another currency.
The Forex market is huge. In April 2010, the average daily turnover was estimated at $3.98 trillion. Trading in the UK accounted for 36.7% of the total, making the UK the most important global centre for foreign exchange trading.
The Forex’s huge trading volume makes it the most liquid financial market in the world (see section on Markets Overview for more about the importance of liquidity).
It is an over the counter (OTC) market. It does not have a central exchange or clearing house. Forex brokers or traders call each other up to trade and negotiate directly with one another, using online trading platforms.
The biggest users of the Forex are the banks, because they operate all over the world and have to make loans in many different currencies. Most Forex trade is between either companies and banks or institutional investors and banks. Therefore banks act as the intermediaries in most transactions.
Currency trading happens continuously throughout the day and night, excluding weekends. All the major banks that make up the Forex have offices across the world, in London, New York, Tokyo and Hong Kong, so as one city closes for business, the banks transfer their ‘books’ (actually an electronic register) to another city that remains open.
An important part of the Forex market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. This is known as direct investment. For example, a British business importing US goods will need to buy US dollars to pay for the goods.
The Forex is also used by institutional investors for indirect investment. They invest in companies all over the world by buying stock and shares. If an investor is buying shares in a company listed on a foreign exchange, it will need to change currency in order to buy those shares locally.
Central banks are also big users of the Forex market. They amass reserves in a combination of currencies. Governments may use those reserves, for instance, to intervene and buy their own currency in the market if it weakens.
Prices are established by the millisecond with each successive trade. Currencies are traded against one another. Each currency pair therefore constitutes an individual trading product. Forex traders tend to specialise in particular trades. The most common one in London is the $/£ - trade exchanging dollars for sterling or vice versa.
Trading in the Forex may be for immediate delivery (buying or selling currencies now), which is called the spot or cash market, or for delivery at an agreed price at a later date, called the forward market (the derivatives market), which can be used to protect institutions against short-term changes in currency and interest rates.
Of the $3.98 trillion traded, $1.5 trillion is in spot transactions and $2.5 trillion is in forwards and other currency derivatives. The most common type of forward transaction is the FX swap, where two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.
An FX option is a derivative where the owner has the right, but not the obligation, to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the largest market for options of any kind in the world.
The Forex is also used by banks and hedge funds to speculate on the value of different currencies and the change in interest rates. They do this by buying and selling derivatives. Those speculating have no interest in actually taking delivery of the currency they have bought, they are just betting on the price movements.
There is a lot of speculative trading every day. Over 70% of transactions may be speculative. For a full account of this, see the sections on Futures and Options.
 
 

A Self-regulating Market with Constantly Changing Exchange Rates

The Forex market is self regulating. There is no government or regulatory body in control of it and no unified or centrally cleared market for the majority of FX trades.

The modern foreign exchange market began forming during the 1970s, when countries gradually switched to floating exchange rates from the previous fixed exchange rate regime.

As it is unregulated, in theory it is possible for anyone to trade, so long as they can find someone to trade with. However, no bank or financial institution is going to trade with someone they do not think is creditworthy (that is, big enough and safe enough to keep their side of the deal and pay over the money they have agreed to exchange). They will only trade with well known institutions that have been thoroughly checked out.

Unlike a stock market, the foreign exchange market is divided into levels of access. Not all users of the Forex can trade at the same rate. The levels of access that make up the foreign exchange market are determined by the amount of money which is traded by an institution.

The top level of trading is the interbank market, which accounts for 53% of all transactions. It is made up of the largest banks and securities dealers. Many large banks trade billions of dollars daily and so they can demand a smaller difference between the ‘bid’ and ‘ask’ price. This is referred to as a better spread. These prices are unknown outside the inner circle.

Next in level of access come the smaller banks followed by large multi-national corporations, large pension funds, insurance companies and other institutional investors. At the bottom are the smaller investors and traders.

Due to the over the counter (OTC) nature of currency markets, there are a number of interconnected marketplaces, where different currencies' instruments are traded. The prices of these are fluctuating all the time.

Currency prices are a result of the dual forces of demand and supply. These are influenced by a number of things - political conditions, economic factors, current events and by actual monetary flows in the market itself. All of these factors can affect the exchange rates. Factors are constantly shifting, and the price of one currency in relation to another shifts accordingly.

Economic factors that may cause fluctuations include changes in gross domestic product (GDP) growth, inflation, interest rates, budget and trade deficits or surpluses and large cross-border merger and acquisition deals. Political factors may include elections, the stability of a government etc.

Central banks play an important role in the foreign exchange markets; they try to control the money supply, inflation, and/or interest rates of their own country by using their, often substantial, foreign exchange reserves to stabilise the market. They do not always achieve their objectives: the combined resources of the market can easily overwhelm any central bank.

Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have one important advantage: they can see their customers' order flow.