Theory Of Economic Cycle

What is Forex?

What is the Foreign Exchange Market and Who are the Participants?

What are the Unique features of Forex Market?

What is Forex?

The foreign exchange market is where currency trading takes place. Forex market is the largest market in the world and it is also the most liquid, differentiating it from the other markets. There is no central market place for the exchange of currency, but instead the trading is conducted over-the-counter.

Fx transactions typically involve one party purchasing a quantity of one currency in exchange of paying a quantity of another. The Foreign Exchange Market that we see today started evolving during the 1970s when world over countries gradually switched to floating exchange rate from their erst while exchange rate regime, which remained fixed as per the Breton Woods system till 1971.

Today FX market is one of the largest and the most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. Traditional daily turnover was reported to be over US$ 3.2 trillion in April 2007 by the Bank for International Settlements. Since then, the market has continued to grow.

The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Euro, Pound Sterling, Yen, etc., and the need for trading in such currencies.

Top

What is the Foreign Exchange Market and Who are the Participants?

The foreign exchange market is the market for buying and selling different currencies. It is primarily an over-the-counter market with trades between large commercial banks accounting for most foreign currency transactions. The main participants are:

Inter-Bank Market

Inter bank Market is at the top, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems.

Federal / Central banks

Central banks play an important role in the foreign exchange markets. All Central and federal banks have the monetary tools to maintain economic stability to maintain inflation target and price stability. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Usually, Central/Federal banks do not interfere with the market directly but can intervene to maintain its economic objectives. The mere expectation or rumor of central bank intervention might be enough to stabilize a currency.

Other participants in the foreign exchange market include:

Commercial Companies

Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. A big Chunk of market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants

Hedge Funds

Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. 70% to 90% of the forex market transactions are speculative. i.e., the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds participates aggressively in FX market.

Forex Brokers

These Brokers basically focus on individual traders and retail brokers, who match buyers and sellers in the market. They offer the opportunity for speculative trading. Retail traders, i.e., individuals are a small fraction of this market and may only participate indirectly through brokers or banks. These forex Brokers are largely controlled and regulated by the CFTC and NFA. At present, the NFA and CFTC are imposing stricter requirements, particularly in relation to the amount of Net capitalization required of its members. This activity is moving toward NDD (No Dealing Desk) and STP (Straight Through Processing) to improve the security in the forex market.

Other : Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as Foreign Exchange Brokers but are distinct from Forex Brokers as they do not offer speculative trading but currency exchange with payments, i.e., there is usually a physical delivery of currency to a bank account.

Top

What are the Unique features of Forex Market?

The foreign exchange market is unique because of following Features:

Over-the-counter (OTC) :

Forex market has no specific Exchange as the the trading is OTC based. Rather, there are a number of interconnected market places, where different currencies instruments are traded. Forex market allows trading in all major world currencies seamlessly. US Dollar, Euro, Japanese Yen and Great Britain Pound are a few currencies that account for over 80% of the daily forex trade.

'Over The Counter' trading also brings in the benefit of arbitrage (overnight differential interest) since there is no single dollar rate over the world depending on significantly great number of factors that affect the local Dollar demand and the local economy. Beginners need to understand the mechanics of economy that play roles here. These factors include the GDP, budget, trade deficits, rate of interests and inflation amongst other macro economic issues.

Continuity in Trading 24/5:

Forex market has a continuous nature. Global time zones and universal nature of currencies have facilitated the continuous nature of this. When markets in Asia close, European markets open and when they close, American market takes over. The next cycle begins with the Asian markets taking over from American markets. Although trading is 24/7 major brokers are open 24 hours a day from Sunday evening 17:00 to Friday 17:00 hours.

Commission free:

There is no commission involved in the foreign exchange trading. Although there is low transaction cost involved. One reason for this feature is you are trading currencies and not negotiable instruments which are always virtual in nature at the point of trade time.

Highest Volume amongst all Industries :

Largest daily turnover- Over 3 Trillion USD, which is ten times bigger than turnovers for all equity exchange markets put together. Pondering the point number 1, once again; London, New York and Tokyo are the top trading markets with many smaller markets and countless banks and operators functioning across the globe in relativity and interconnection to these big three. Thanks to the continuous nature of 'Over The Counter' trading, that it facilitates quick decision making for traders without waiting for the markets to open the next day.

USD Base currency:

US Dollar is involved in about 90% of transactions and is considered as universal currency.

Top