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Foreign exchange market
Foreign exchange market

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the Credit market.[1]

The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency's absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as "dealers", who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the "interbank market" (although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.

The modern foreign exchange market began forming during the 1970s.

The foreign exchange market is unique because of the following characteristics:

  • its huge trading volume, representing the largest asset class in the world leading to high liquidity;
  • its geographical dispersion;
  • its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
  • the variety of factors that affect exchange rates;
  • the low margins of relative profit compared with other markets of fixed income; and
  • the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements, the preliminary global results from the 2019 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $6.6 trillion per day in April 2019. This is up from $5.1 trillion in April 2016. Measured by value, foreign exchange swaps were traded more than any other instrument in April 2019, at $3.2 trillion per day, followed by spot trading at $2 trillion.[3]

The $6.6 trillion break-down is as follows:

History


Currency trading and exchange first occurred in ancient times.[4] Money-changers (people helping others to change money and also taking a commission or charging a fee) were living in the Holy Land in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybistẻs") used city stalls, and at feast times the Temple's Court of the Gentiles instead.[5] Money-changers were also the silversmiths and/or goldsmiths[6] of more recent ancient times.

During the 4th century AD, the Byzantine government kept a monopoly on the exchange of currency.[7]

Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of coinage in Ancient Egypt.[8]

Currency and exchange were important elements of trade in the ancient world, enabling people to buy and sell items like food, pottery, and raw materials.[9] If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of a recognized standard like silver and gold.

During the 15th century, the Medici family were required to open banks at foreign locations in order to exchange currencies to act on behalf of textile merchants.[10][11] To facilitate trade, the bank created the nostro (from Italian, this translates to "ours") account book which contained two columned entries showing amounts of foreign and local currencies; information pertaining to the keeping of an account with a foreign bank.[12][13][14][15] During the 17th (or 18th) century, Amsterdam maintained an active Forex market.[16] In 1704, foreign exchange took place between agents acting in the interests of the Kingdom of England and the County of Holland.[17]

Alex. Brown & Sons traded foreign currencies around 1850 and was a leading currency trader in the USA.[18] In 1880, J.M. do Espírito Santo de Silva (Banco Espírito Santo) applied for and was given permission to engage in a foreign exchange trading business.[19][20]

The year 1880 is considered by at least one source to be the beginning of modern foreign exchange: the gold standard began in that year.[21]

Prior to the First World War, there was a much more limited control of international trade.

From 1899 to 1913, holdings of countries' foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between 1903 and 1913.[23]

At the end of 1913, nearly half of the world's foreign exchange was conducted using the pound sterling.[24] The number of foreign banks operating within the boundaries of London increased from 3 in 1860, to 71 in 1913. In 1902, there were just two London foreign exchange brokers.[25] At the start of the 20th century, trades in currencies was most active in Paris, New York City and Berlin; Britain remained largely uninvolved until 1914. Between 1919 and 1922, the number of foreign exchange brokers in London increased to 17; and in 1924, there were 40 firms operating for the purposes of exchange.[26]

During the 1920s, the Kleinwort family were known as the leaders of the foreign exchange market, while Japheth, Montagu & Co. and Seligman still warrant recognition as significant FX traders.[27] The trade in London began to resemble its modern manifestation. By 1928, Forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930s London.[28]

In 1944, the Bretton Woods Accord was signed, allowing currencies to fluctuate within a range of ±1% from the currency's par exchange rate.[29] In Japan, the Foreign Exchange Bank Law was introduced in 1954. As a result, the Bank of Tokyo became the center of foreign exchange by September 1954. Between 1954 and 1959, Japanese law was changed to allow foreign exchange dealings in many more Western currencies.[30]

U.S. President, Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually resulting in a free-floating currency system. After the Accord ended in 1971,[31] the Smithsonian Agreement allowed rates to fluctuate by up to ±2%. In 1961–62, the volume of foreign operations by the U.S. Federal Reserve was relatively low.[32][33] Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organizations relied instead on reserves of currency.[34][35] From 1970 to 1973, the volume of trading in the market increased three-fold.[36][37][38] At some time (according to Gandolfo during February–March 1973) some of the markets were "split", and a two-tier currency market was subsequently introduced, with dual currency rates. This was abolished in March 1974.[39][40][41]

Reuters introduced computer monitors during June 1973, replacing the telephones and telex used previously for trading quotes.[42]

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float, the forex markets were forced to close sometime during 1972 and March 1973.[43] The largest purchase of US dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure is given as 2.75 billion in total by The Statesman: Volume 18 1974). This event indicated the impossibility of balancing of exchange rates by the measures of control used at the time, and the monetary system and the foreign exchange markets in West Germany and other countries within Europe closed for two weeks (during February and, or, March 1973. Giersch, Paqué, & Schmieding state closed after purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened... March 1 " that is a large purchase occurred after the close).[44][40][46][47]

In developed nations, the state control of the foreign exchange trading ended in 1973 when complete floating and relatively free market conditions of modern times began.[48] Other sources claim that the first time a currency pair was traded by U.S. retail customers was during 1982, with additional currency pairs becoming available by the next year.[49][50]

On 1 January 1981, as part of changes beginning during 1978, the People's Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading.[51][52] Sometime during 1981, the South Korean government ended Forex controls and allowed free trade to occur for the first time. During 1988, the country's government accepted the IMF quota for international trade.[53]

Intervention by European banks (especially the Bundesbank) influenced the Forex market on 27 February 1985.[54] The greatest proportion of all trades worldwide during 1987 were within the United Kingdom (slightly over one quarter). The United States had the second highest involvement in trading.[55]

During 1991, Iran changed international agreements with some countries from oil-barter to foreign exchange.[56]

Market size and liquidity


The foreign exchange market is the most liquid financial market in the world. Traders include governments and central banks, commercial banks, other institutional investors and financial institutions, currency speculators, other commercial corporations, and individuals. According to the 2019 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was $6.6 trillion in April 2019 (compared to $1.9 trillion in 2004).[3] Of this $6.6 trillion, $2 trillion was spot transactions and $4.6 trillion was traded in outright forwards, swaps, and other derivatives.

Foreign exchange is traded in an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London. In April 2019, trading in the United Kingdom accounted for 43.1% of the total, making it by far the most important center for foreign exchange trading in the world. Owing to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day. Trading in the United States accounted for 16.5%, Singapore and Hong Kong account for 7.6% and Japan accounted for 4.5%.[3]

Turnover of exchange-traded foreign exchange futures and options was growing rapidly in 2004-2013, reaching $145 billion in April 2013 (double the turnover recorded in April 2007).[57] As of April 2019, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover.

Most developed countries permit the trading of derivative products (such as futures and options on futures) on their exchanges.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004.[59] The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading was estimated to account for up to 10% of spot turnover, or $150 billion per day (see below: Retail foreign exchange traders).

Market participants


Unlike a stock market, the foreign exchange market is divided into levels of access.

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services.

National central banks play an important role in the foreign exchange markets.

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate the behavior of their currency. Fixing exchange rates reflect the real value of equilibrium in the market. Banks, dealers, and traders use fixing rates as a market trend indicator.

The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize the currency.

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and can, therefore, generate large trades.

Individual retail speculative traders constitute a growing segment of this market.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or "mark-up" in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principals in the transaction versus the retail customer, and quote a price they are willing to deal at.

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 in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies.[66] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank.[67] These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. The volume of transactions done through Foreign Exchange Companies in India amounts to about US$2 billion[68] per day This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing. Around 25% of currency transfers/payments in India are made via non-bank Foreign Exchange Companies.[69] Most of these companies use the USP of better exchange rates than the banks. They are regulated by FEDAI and any transaction in foreign Exchange is governed by the Foreign Exchange Management Act, 1999 (FEMA).

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest foreign markets (India, China, Mexico, and the Philippines) receive $95 billion. The largest and best-known provider is Western Union with 345,000 agents globally, followed by UAE Exchange. Bureaux de change or currency transfer companies provide low-value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access foreign exchange markets via banks or non-bank foreign exchange companies.

Trading characteristics


There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation.

The main trading centers are London and New York City, though Tokyo, Hong Kong, and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows.

Currencies are traded against one another in pairs.

The factors affecting XXX will affect both XXXYYY and XXXZZZ.

On the spot market, according to the 2019 Triennial Survey, the most heavily traded bilateral currency pairs were:

  • EURUSD: 24.0%
  • USDJPY: 13.2%
  • GBPUSD (also called cable

The U.S. currency was involved in 88.3% of transactions, followed by the euro (32.3%), the yen (16.8%), and sterling (12.8%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate.

Determinants of exchange rates


In a fixed exchange rate regime, exchange rates are decided by the government, while a number of theories have been proposed to explain (and predict) the fluctuations in exchange rates in a floating exchange rate regime, including:

  • International parity conditions: Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
  • Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for the continuous appreciation of the US dollar during the 1980s and most of the 1990s, despite the soaring US current account deficit.
  • Asset market model: views currencies as an important asset class for constructing investment portfolios.

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several.

Economic factors include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.

  • Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
  • Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
  • Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade.
  • Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising.
  • Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
  • Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency.

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party.

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

  • Flights to quality: Unsettling international events can lead to a "flight-to-quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The US dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.[74]
  • Long-term trends: Currency markets often move in visible long-term trends.
  • "Buy the rumor, sell the fact": This market truism can apply to many currency situations.
  • Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves.
  • Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[77]

Financial instruments


A spot transaction is a two-day delivery transaction (except in the case of trades between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is not included in the agreed-upon transaction. Spot trading is one of the most common types of forex trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuation of the trade. This roll-over fee is known as the "swap" fee.

One way to deal with the foreign exchange risk is to engage in a forward transaction.

Forex banks, ECNs, and prime brokers offer NDF contracts, which are derivatives that have no real deliver-ability.

The most common type of forward transaction is the foreign exchange swap.

Futures are standardized forward contracts and are usually traded on an exchange created for this purpose.

Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date.

A foreign exchange option (commonly shortened to just 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.

Speculation


Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Economists, such as Milton Friedman, have argued that speculators ultimately are a stabilizing influence on the market, and that stabilizing speculation performs the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[80] Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market philosophy than on economics.[81]

Large hedge funds and other well capitalized "position traders" are the main professional speculators.

Currency speculation is considered a highly suspect activity in many countries.

Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[84]

In this view, countries may develop unsustainable economic bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.

Risk aversion


Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions.

In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US dollar.[86] Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics.

Carry trade


Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate.[178] A large difference in rates can be highly profitable for the trader, especially if high leverage is used.

See also


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