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| ==The nature of the market== | ==The nature of the market== | ||
| Viewed as a whole, the foreign exchange market is huge, probably the most liquid market in the world. It is, however, essential to understand that there is no such thing as ''the'' foreign exchange market. Due to the ] (]) nature of currency |
Viewed as a whole, the foreign exchange market is huge, probably the most liquid market in the world. It is, however, essential to understand that there is no such thing as ''the'' foreign exchange market. Due to the ] (]) nature of currency markets, there are rather a number of more or less interconnected market places, where different currency ] are traded. This implies that there is no such thing as ''a'' dollar rate - buth rather a number of different rates (prices), depending on what bank, broker or market maker is clearing the trade. However, in practice the rates are often very close or similar. Too wide differences could be exploited by traders in ] type of trades. | ||
| Most ] currency trades placed by retail clients are offset against the liquidity of the trader's own ] (or ]). Thus, most spot trades never makes it into any (coherent) marketplace, as it often is the broker taking the other side of a trade. | Most ] currency trades placed by retail clients are offset against the liquidity of the trader's own ] (or ]). Thus, most spot trades never makes it into any (coherent) marketplace, as it often is the broker taking the other side of a trade. | ||
Revision as of 21:47, 9 January 2006
| Foreign exchange |
|---|
| Exchange rates |
| Markets |
| Assets |
| Historical agreements |
| See also |
The foreign exchange market or currency market or Forex is the market where one currency is traded for another. It is the largest market in the world, in terms of cash value traded, and includes trading between large banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. Retail traders (small investors - speculators) may only participate in this market indirectly through brokers or banks.
Market participants
Some of the participants in this market are simply seeking to exchange a foreign currency for their own, like multinational corporations which must pay wages and other expenses in different nations than they sell products in. However, by far the largest volume of the market comes from speculative currency trades, executed by traders (speculators), who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency speculators try to take advantage of even small fluctuations in exchange rates. Sometimes they are able to profit from interest rate differentials too, in arbitrage type of trades. In these cases, most often no physical delivery of the currencies take place. Many trades are carried out using computer software or by placing orders over the phone.
In most countries speculative currency trading is widely considered highly suspect, due to the fact that speculative trading may have huge macroeconomical impact on a country's economy. However, as mentioned above, the markets are also to some extend used by participants in need of foreign currencies to pay for actual (foreign) goods or services.
According to the Bank for International Settlements' last triennal study (April 20y04) (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results), transactions :
- were strictly interdealer (ie interbank) for 53 % ;
- for 33 % involved a dealer (ie a bank) and a fund manager or some other non-bank financial institution;
- and for only 14 % were between a dealer and a non-financial company.
Market liquidity
Foreign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) offers.
The nature of the market
Viewed as a whole, the foreign exchange market is huge, probably the most liquid market in the world. It is, however, essential to understand that there is no such thing as the foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of more or less interconnected market places, where different currency instruments are traded. This implies that there is no such thing as a dollar rate - buth rather a number of different rates (prices), depending on what bank, broker or market maker is clearing the trade. However, in practice the rates are often very close or similar. Too wide differences could be exploited by traders in arbitrage type of trades.
Most spot currency trades placed by retail clients are offset against the liquidity of the trader's own broker (or market maker). Thus, most spot trades never makes it into any (coherent) marketplace, as it often is the broker taking the other side of a trade.
| Rank | Currency | ISO 4217 Code | Symbol |
| 1 | United States Dollar | USD | $ |
| 2 | Eurozone Euro | EUR | € |
| 3 | Japanese Yen | JPY | ¥ |
| 4 | British Pound Sterling | GBP | £ |
| 5 | Swiss Franc | CHF |
In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.
On the spot market, according to the BIS study, the most heavily traded products were :
- EUR/USD - 28 %
- USD/JPY - 17 %
- GBP/USD (also called cable) - 14 %
and the US currency was involved 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The only exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.
Around-the-clock market
Unlike stocks and futures exchange, foreign exchange is indeed an interbank, over-the-counter (OTC) market which means there is no single universal exchange for specific currency pair. The foreign exchange market operates 24 hours per day throughout the week between individuals with forex brokers, brokers with banks, and banks with banks. If the European session is ended the Asian session or US session will start, so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets.
Market Size
Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the above-mentioned BIS study :
- $600 billion spot
- $1,300 billion in derivatives, ie
- $200 billion in outright forwards
- $1,000 billion in forex swaps
- $100 billion in options.
For various reasons, exchange-traded derivatives never caught on the Forex market as they did on all other financial markets (although attempts to launch currency futures contracts in the early 70s actually predate interest rate or stock index futures).
Bid/Offer spread
Like any market there is a bid/offer spread (difference between buying price and selling price). On major currency crosses, the difference between the price at which a market maker will sell ("ask", or "offer") to a wholesale customer and the price at which the same market-maker will buy ("bid") from the same wholesale customer is minimal, usually only 1 or 2 pips. In the EUR/USD price of 1.2238 a pip would be the '8' at the end. So the bid/ask quote of EUR/USD might be 1.2238/1.2239.
This, of course, does not apply to retail customers. To individuals, banks will routinely mark up the difference to say 1.2140 / 1.2340 for transfers, or say 1.1940 / 1.2440 for banknotes or travellers' cheques.
Individual currency speculators
Currency speculation by small traders is fairly loosely regulated in the U.S. by the U.S. Commodity Futures Trading Commission (CFTC) and has become more prominent since the introduction of on-line trading. The CFTC has noted an increase in foreign exchange trading scams .
On-line traders may use a broker who typically quote a spread perhaps 3-20 pips wide (e.g. 1.2237/1.2240 or 1.2220/1.2240). The broker will often allow their clients to use a large amount of margin, increasing both the potential gains and losses, and increasing the brokers' profits on the bid/ask spread.
Brokers do not typically charge margin interest, but since currency trades must be settled in 2 days, they will "resettle" open positions (again collecting the bid/ask spread).
There have been several sucessful large individual currency speculators (e.g. George Soros), but since the foreign exchange market is a zero sum game, small speculators should carefully consider if they have a competitive advantage in this market, i.e. why they think they can beat this market. Considering the CFTC warning, retail traders should be aware of the possibility that retail forex brokers may manipulate quoted spot rates, improperly trigger their clients' stop-loss orders and charge hidden fees.
Forex Communities
- Forex Tsd Forex Trading System Development forum.
External links to educational resources
- CFTC fraud warning
- Disk Lectures MBA level audio lecture with slideshow on Foreign Exchange
- Federal Reserve educational material
- Foreign Exchange related material from the Federal Reserve
- Forex Magazine Online Forex Magazine
- London FX Ltd introduction to FX spot trading terminology and conventions
- Model Code from ACI - The Financial Markets Association, a Paris, France based industry association.
