Foreign Exchange Market (Forex)

The foreign exchange market is a decentralized global market for trading in currencies. It is also referred to as currency, forex or FX market. Trading occurs between different types of buyers and sellers that include banks, large financial institutions and retail traders and is anchored by a wide range of financial centers around the globe. The foreign exchange market works 24/7 for five days a week and is the determining market for relative currency values.

The foreign exchange market is the place for currency conversion for international trade. Businesses who want to convert home currency to a foreign currency for importing goods or services must do so in foreign exchange market through an intermediary. Similarly, businesses who export goods to foreign countries must exchange receipts into home currency. A lot of speculation also takes place in the foreign exchange market where traders speculate directly on currency values or invest for short or long term to take advantage from differences in interest rates in different countries. Currency trading is done in pairs, meaning that a trader buys a specific number of units of one currency and pays in another.

For almost three decades since July 1944 when 44 nations signed the Bretton Woods Agreement to agree on a system of monetary management, currency trade was restricted by governments in one way or the other. As per the Bretton Woods system, exchange rates were to remain fixed. Things changed during the 1970s when nations slowly started changing over from fixed to a floating exchange rate regime.

The foreign exchange market is different in many ways from other markets. For one it is a highly liquid market as traded volumes are exceptionally large. It is a global market that knows no geographical boundaries and is open around the clock from 20:15 GMT Sunday until 22.00 GMT Friday. Margins of profit is low but can be enhanced with the use of leverage.

With daily turnover in global foreign exchange markets averaging around $4 trillion, it is the largest financial market in the world that allows all types of transactions including spot, forwards and swaps and options and derivative trading. Despite the fact that central banks do intervene occasionally to restore parity, the foreign exchange market is the closest to the concept of perfect competition where no participant is large enough to manipulate prices.

The Largest and the Most Liquid Market

As per the 2010 Triennial Central Bank Survey, a coordinated survey by the Bank of International Settlements, the average daily turnover in April 2010 was to the tune of US$ 3.98 trillion. The comparable figure for 1998 was US$ 1.7 trillion and US$ 3.21 in April 2007. Of the 2010 figure of US$ 3.98 trillion, spot transactions accounted for only $ 1.5 trillion and the rest ($ 2.5 trillion) comprised of forwards, swaps and derivatives.

The main hub of foreign exchange trading is United Kingdom, which accounted for 36.7% of the traded volume, with USA a poor second (17.9%). Japan accounted for 6.2%.

Ever since the Chicago Mercantile Exchange introduced foreign exchange futures and options trading in 1972, foreign exchange futures are more actively traded than any other derivative product. Exchange-traded foreign exchange futures trading doubled in the period of three years (April 2007 to April 2010) when it reached $166 billion.

Trading in derivative products such as futures and options are allowed in exchanges of almost all developing countries that have fully convertible currencies on capital accounts. Derivative trading is not allowed in some emerging economies that have partially convertible currencies and have capital controls. But the reality is that trading in foreign exchange derivates is growing in popularity even in emerging economies that do have capital controls over their currencies. Examples are South Africa, South Korea and India. These nations have founded exchanges for trading in currency futures and options even though their currencies are not fully convertible on the capital account.

There are certain very cogent reasons behind the growing popularity and increase in trade volumes in the foreign exchange market; volumes in 2010 were more than double than in 2004 and 20% more than 2007. Factors that have contributed to this growth are retail participation and increase in the number of traders who rapidly trade in and out of positions using sophisticated technological tools. In recent years, retail trading in foreign exchange has emerged as a significant market segment. In addition, substantial decrease in transaction cost due to the growth of online trading platforms and other venues for executing trades has allowed participation from traders of all types.

In short, electronic trading on online trading platforms has made foreign exchange trading extremely convenient for retail traders, including part time traders who are otherwise gainfully employed. It is estimated that in 2010, retail participation accounted for almost 10% of turnover in spot transaction.

Banks and large financial houses account for the majority of transactions in the foreign exchange market, with the Deutsche Bank leading with 15.64% (2011). The next five top participants in 2011 were Barclays Capital (10.75%), UBS AG (10.59%), Citi (8.88%), JP Morgan (6.43%) and HSBC (6.26%).

The foreign exchange market is an over-the-counter market, meaning that there is no central clearing house the way it is in stock markets world over. Trading is directly between brokers/dealers and traders. In every contract, the broker or dealer is the counterparty who stands to gain or lose just the way the trader does.

Geographically, London is the biggest trading center and prices quoted in the foreign exchange market are usually those that prevail in the London market. The International Monetary Fund also uses London prices at noon while calculating special drawing rights every day.

Market Participation

The foreign exchange market is not a composite single centralized market. It has different levels of access for different participants. At the top rung is the interbank market, which comprises of the largest commercial banks in the world and institutions dealings in securities. Next in line are smaller banks and then large multinational corporations, large hedge funds and a few top market makers for the retail market. Levels of access are primarily determined by ‘line’ size or the amount of money a participant is trading with.

• The interbank market is an exclusive club of world’s top most commercial banks and securities dealers. Spreads, the difference between bid and ask price, are extremely in the interbank market and not available, nor known to those who not belong to this inner circle. As you go down to the lower levels of access, spreads start getting bigger. However, traders who can guarantee large transactions and large volumes can negotiate for better spreads or getting the between bid and ask price difference reduced. The interbank market accounts for 53% of the total turnover. Central banks also participate in the currency market whenever they perceive that speculative activity has created an imbalance in demand and supply and adversely effected currency value.
• At the next level are smaller banks that need to buy or sell foreign currencies on behalf of their customers or for investment purposes. Many smaller banks prefer to deal through larger banks for getting better rates.
• The next level belongs to large multinational companies who need to pay employees abroad or for hedging risks. Large hedge funds, pension and mutual funds, insurance companies, and other institutional investors including retail market makers are included in this level. Participation by hedge funds has increased dramatically in the last decade.
• At the lowest rung of the ladder is the retail trader who trades through a market maker or direct market access broker.

Business Houses

Import and export business houses form an important segment of the foreign exchange market. These companies need to exchange currency for paying for goods and services or bring in proceeds of exports sales. The amounts traded are quite small and have little impact in the short term. However, trade flows have a significant effect on the direction of currency value in the long term. At times, when large positions, exposure to which is not widely known to other participants, are closed by multinational corporations can have an unpredictable but significant impact.

The Role of Participation by Central Banks

In most countries, monetary authority vests with the country’s central bank. Central banks need to manage money supply to control inflationary trends and interest rates. Central banks usually have unofficial targets for the value of their currencies, a goal that they try to achieve by using their substantial reserves of foreign currencies. Central bank participation is not for profit or loss but for stabilizing home currencies, an activity that anyways does not always succeed in its intended purpose.

The national central bank of the country fixes the daily exchange rate for its currency. The purpose behind it is to assess the behavior of the currency. Rate fixing is basically a trend indicator and a reflection of the market equilibrium.

Many times, all it takes to stabilize currency is only a rumor that the central bank will intervene. However, at times central banks of countries with managed floating exchange rate regime may need to intervene aggressively. Nevertheless, success is not guaranteed and there are enough instances to support the contention that the combined market resources can bring the efforts of a central bank to a naught.

Role of Speculative Activities

On an estimate, more than 70% of all transactions in the foreign exchange market are speculative. A speculator has no intention of taking delivery but is interested only in the movement of the exchange rate of currencies they have betted on. Large hedge funds have earned an enviable reputation of indulging in aggressive speculation in foreign exchange market. They have the financial capacity and wherewithal to support any currency and negate the efforts of central banks if they perceive that the fundamentals are in their favor.

Role of Portfolio Management Firms

Portfolio management firms, particularly those who manage funds of pension funds, insurance companies and endowments and high net worth individuals need to buy or sell currency pairs in order to facilitate transactions for purchasing and selling foreign securities. Some portfolio management firms however specialize in speculation and participate actively to manage their clients’ exposures in currencies with the ultimate aim of generating profits. Such investment firms are small in number but assets under management of some of the firms are large enough for generating fairly large trades.

Retail Brokers and Traders

This segment of foreign exchange market is growing at a fairly rapid pace due to the coming of online trading platforms. Presently, retail participation is indirect, through brokers or banks. Despite the fact that forex brokers are largely regulated by domestic regulatory authorities for futures trading there have been a fairly large number of frauds in the retail foreign exchange market. In USA forex brokers are regulated and controlled by Commodity Futures Trading Commission and National Futures Association and from 2010, members dealing in forex are required to be registered specifically as a forex brokers or dealers. The capital adequacy requirements of forex brokers and dealers have also been fixed at a higher level. A large number of forex brokers are registered with Financial Services Authority of UK, where margin trading is a part of the overall over-the-counter market for derivatives trading including contracts for difference (CFD) and spread betting.

Retail participation in the forex market is by nature speculative. Retail traders may approach the market through forex brokers or dealers. A forex broker is primarily a trader’s agent who strives to get the best price for the client and deals on the client’s behalf and charges a commission or a mark-up for the service rendered.   In contrast, forex dealers or market makers typically act as counterparty in transactions with clients and quote currency exchange rates at which they are ready to buy or sell.

Role of Non-Banking Foreign Exchange Institutions

This relates to non-speculative transactions. A non-banking foreign exchange firm services individuals and businesses. Although termed as foreign exchange brokers, these firms do not indulge in speculative transactions. Their primary function is to exchange currencies and facilitate international payments. There is always a physical delivery of currency involved, either in cash or to a bank account.

The USP of non-banking foreign exchange companies is better exchange rates at lower cost as compared to banks. On a rough estimate such companies handle 14% of international payments and transfers in UK. Non-banking foreign exchange companies are different from companies that facilitate money transfer or foreign remittances inasmuch as they handle high value transactions.

Money Transfers and Currency Kiosks

Money transfer or remittance companies are primarily involved in currency exchanges required by migrant workers for sending money back home. Transfers are generally of low value but volumes are high. There is a huge market for money transfers and estimated money transfers in 2007 were in the range of $369 billion, 8% more than what it was in the year before that. India, Philippines, Mexico and China are the largest markets and accounted for money transfers amounting to $95 billion. The best known money transfer company, which is also the largest, is Western Union with 345,000 outlets worldwide.

Currency exchange companies or bureaux de change have outlets at tourist locations, airports and railway stations for the convenience of travelers wanting to change physical banknotes into local currency. These companies approach banks and non-banking foreign exchanges companies to access the forex market for reconversion of the foreign currency held by them.

Typical Features of Foreign Exchange Market

Majority of trades in foreign exchange market are between two principals without a central clearing house through which trades may be routed. Being an over-the-counter market, there are numerous interconnected markets offering several forex related financial instruments. As such, prices differ and depend upon the bank or market maker one is trading with. London being the dominant market, exchange rates (prices) usually follow the London price. Prices offered by various intermediaries (banks, market makers etc) may differ but are close to the London rates so as to deny traders the opportunity of benefitting from arbitrage. Electronic Broking Services and Reuters are major currency trading exchanges. In 2007, Reuters and Chicago Mercantile Exchange collaborated to form a central clearing mechanism for foreign exchange by the name of Fxmarketspace but failed.

The forex market is open all through the day for five days a week. It starts with the Asian sessions and when it ends, the European Session starts, followed by the American session and then back to where it started, the Asian session. Major trading centers are London and New York followed by Singapore, Tokyo and Hong Kong.

Currency values are affected by real monetary flows and also on market sentiment based on economic indicators including:

• Changes in gross domestic product (GDP), inflation and interest rates.
• National budget and trade deficit or surplus.
• High value cross border mergers and acquisitions.
• Overall working of a nation’s economy.

Major news that have a potential of affecting currency values in the short or medium term are released on predetermined dates and accessible to all at the same time. However, banks have a major advantage over others as only they have access to orders being placed with them.

Currency quotations follow a globally accepted convention. Since a currency must necessarily be bought by paying in another currency, currencies are traded in pairs; one against the other. This indirectly means that if you are buying one currency, you are selling the other in the pair. To avoid confusion as there are many currencies that go by the name of dollar, pound and franc, a three letter code is used where the first two letters denote the country’s name and the third is the name of the currency. The US dollar is thus USD and the Australian dollar is AUD.

The first currency in the pair is the base currency and the second is the counter or quote currency. Thus if EUR/USD pair is quoted at 1.0245, it means that one euro is equal to 1.0245 USD. The market convention is that the USD is the base currency in most pairs involving the US dollar. The Great Britain Pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) are exceptions to the rule. Where the US dollar is paired with these currencies, the USD is the quote currency.

Positive currency correlation is maintained because the factors that influence a specific currency will affect exchange rates of all currency pairs involving that particular currency.

The foreign exchange market is centered on the US dollar. The Triennial survey of 2010 reveals that the USD was involved in 84.9% of transactions. The euro is a poor second accounting for 39.1%, followed by Yen (19.0%) and the British pound (12.9%)

The EUR/USD was the most heavily traded currency pair accounting for 28% of traded volumes followed by USD/JPY (14%) and GBP/USD (9%).

Ever since the creation of euro in January 1999, trading in the euro has been growing constantly. It is anybody’s guess whether or not it will challenge the dominance of the US currency in the forex market. For some time it seemed likely when the value of the dollar eroded in during 2008. A lot of interest was shown by traders and banks to use the euro as the reference currency in international trade particularly for prices of commodities, including oil. The euro also became a major component of foreign reserves of banks. It is yet to be seen what affect the recent financial crisis in the Eurozone has on the euro’s challenge to the US dollar.

Exchange Rates: Determining Factors

In a fixed exchange rate regime exchange rates between currencies are determined and fixed by governments. In floating exchange rate regime, the currency is at the mercy of market forces (unless the central bank intervenes and succeeds). There are a few theories that try to explain the fluctuations in exchange rates.

• The theory that comes the nearest to explain exchange rate fluctuations pertains to international parity conditions such as relative purchasing power parity, interest rate parity, Fisher hypothesis and international Fisher effect. There is a lot of logic in these theories and they do explain exchange rate fluctuations to some extent. However, the assumptions made by them, free flow of goods and services and capital, are farfetched and not possible in the real world.
• Balance of payments model that considers the net effect of trade between two countries takes into account only tradable goods and services, ignoring the fact that huge amounts of capital flows also occur. This model also failed to explain how come the US dollar kept appreciating to new highs in the 1980s and most of 1990s despite the fact of a very high level of current account deficit.
• The asset market model, on the other hand, focuses on currencies being an important asset class for creating investment portfolios; it is people’s willingness to hold existing assets that determines asset prices. Decisions regarding maintaining or shuffling existing portfolios, in turn, depends upon the expectations of asset appreciation in future. This theory suggests that exchange rate between two currencies is the “price that just balances the relative supplies of and demand for assets denominated in those currencies”.

While none of them have been able to explain long term volatility in exchange rates, algorithmic programs can be prepared for short term predictions, a few days in advance.

It must thus be understood that there are many variables that determine exchange rate movements and like most other traded products, it is demand and supply that proves to be the final determining factor. Exchange rate volatility is the result of constantly changing demand and supply situation due to macroeconomic factors and current political events. The foreign exchange market is the only financial market that covers so much of what is happening in the world at any given point in time.

No single factor influences demand and supply for a specific currency but a combination of several economic and political factors along with behavioral economics or market sentiment.

• Monetary and Fiscal Policies:

The state of national economy along with the economic policy plays a major role in determining currency value. Economic policy is a combination of monetary policy and fiscal policy. Monetary policy comprises of measures such as interest rates that governments and central banks take to control money supply by increasing or decreasing ‘cost’ of money. High interest rates normally increase demand for the currency provided other economic factors are favorable. Fiscal policy is primarily the spending practices adopted by governments.

• Budget

The manner in which governments make use of available resources has a telling effect on currency policy. Budget deficits, spending more than income, are usually looked upon as a negative, while budget surpluses are viewed positively.

• Trade Balance

Trade balance between countries is a reflection of demand for goods and services. This has a direct impact on the demand for currencies. Trade surplus or deficit is an indication of competitiveness of a country’s economy. A favorable trade balance or trade surplus means more demand for the country’s currency.

• Inflation and Inflationary Trends

As a general rule, high inflation means loss in currency value. Inflation reduces the currency’s purchasing power. As goods and services become more expensive, there is a concomitant reduction in demand for the currency. However, sometimes inflation may become a cause for a currency’s strength on the hopes that interest rate will be raised by the central bank for bringing inflation down.

• Overall Economic Health

The overall health and the rate of growth of an economy indicate the strength of the country’s currency. A robust economy means a strong currency. Nation’s overall economic health is reflected by figures such as its gross domestic product (GDP), employment /unemployment levels, capacity utilization (level of use of installed productive capacity), domestic retail sales and other economic indicators.

• Production

Increase in production is necessarily an indication of increase in domestic or overseas demand. More productivity means increase in exports sales as well as retail sales, which in turn is a positive for the nation’s overall economy and consequently, currency value.

• Political Factors

Currency markets are particularly sensitive to political developments in a country. This has as much to do with political stability of the present government as well as how the world perceives a new party that may have come to power. Whereas an unstable government has a negative impact, the rise of a political party that is believed to be fiscally more responsible can improve market sentiment. Sometimes political unrest in a neighboring country can also have a negative impact on a country’s currency.

Behavioral economics

• This has more to do about psychology than facts. In this context, it is the positive or negative effect on the value of a currency due to cognitive, emotional and social factors. Sometimes market participants take economic decisions based on perceptions rather than pure logic. For example, US dollar and the Swiss franc have traditionally been considered as ‘safe havens’. These currencies thus demand a higher price because investors ‘think’ that it is safe to invest in these currencies. It is easier to understand this concept when we see the price of gold rising beyond expectations of analysts, not because of shortage but because gold is perceived to be a safe investment.
• There are no growing seasons for currencies as there are for agricultural commodities. Nor do they have business cycles. Yet, currency values often follow visible long term trends.
• Like any other market, currency markets too react to rumors. A rumor that a particular event is to take place often reflects in the price of a currency before the event actually takes place. On the strength of the anticipated affect of the rumored event, the market becomes overbought or oversold as the case may be. However, when the anticipated event actually takes place the market reacts in the opposite direction. In market terminology this is often referred to as buy the rumor, sell the fact. It is a cognitive bias, a deviation in judgment leading to perceptual distortion and illogical interpretation. Simply stated, it is decisions taken by giving undue importance to the relevance of events on currency prices.
• Sometimes a particular number related to economic health becomes more important than others; a sort of an amulet that will ward off all evils faced by a currency. When a particular economic number in trending, it becomes crucial to market psychology and has an immediate short term impact on movement in currency market. In the past couple of years, employment numbers, money supply, trade balance numbers and inflation, all have taken turns and been in spotlight one after the other.
• Trading on technical charts, technical analysis of historical prices for looking at patterns is a popular method of trading in financial instruments including foreign currency. Analysts study these charts to identify patterns and predict exchange rate movements.

Transaction Types

• Spot Transaction

This is the simplest of all trades possible in the foreign exchange market. Spot transaction is an agreement between the trader and the dealer to buy one currency and pay in another currency in the pair at the prevailing rate. Settlement is done in two days, meaning that the delivery and payment procedure is completed in two working days. This is true for all currency pairs barring trades between the US dollar, Canadian dollar, Euro, Turkish Lira and Russian Ruble, which are settled on the next working day.

• Forward Contract

A forward contract is non-standardized contract between two parties where they agree to settle delivery and payment on a specified future date. Theoretically, the date may be a day, weeks, months or years from the contract date. The contract is negotiated by both parties outside of an exchange and money does not change hands until the agreed upon date. The contracting parties agree on the exchange rate today but deliver and pay at a future date regardless of the price at which the currency pair is traded on the settlement date. Traders use forward contracts to manage the risk associated with forex trading.

• Swap

A foreign exchange swap is buying and selling identical units of one currency for another at the same time with two different value dates. For example, one transaction may be a spot and the other forward. Swaps are non-standardized contracts, not traded through an exchange and require a deposit for the time till the position is open. The deposit is paid on closure after adjusting the profit or loss made on the transaction.

• Futures

A futures contract is a standardized forward contract. It is normally traded on a futures exchange specially created for trading in derivatives. A currency futures contract is for exchange of one currency for another on a specified future date at the exchange rate fixed for that date. A futures contract usually includes an interest element.

• Option

Foreign exchange option is a derivative product that provides the trader with the right but not the obligation of exchanging money denominated in one currency into another currency at an agreed exchange rate on a specified date.

The Role of Speculation in Foreign Exchange Market

A fair amount of debate has been going on the role of speculation and its effect on currency devaluations. As usual, there are two schools of thought. One school of thought believes that speculative activity eventually plays a stabilizing role by providing an opportunity to reduce or eliminate risk to those who do not want to bear it as they are able to transfer it to those who want to bear it. The other school of thought opines that this argument is more political than economic and meant for supporting free market philosophy.

Speculation also provides a market for hedgers. Actually, hedgers are the only main professional speculators along with other well capitalized traders. Most individual traders, according to some experts, trade irrationally and their presence acts as a destabilizing factor even if all other traders trade rationally.

Currency speculation is viewed differently from investment in stocks and bonds. Currency speculation is viewed as nothing more or less than simple gambling while investment in stocks and bonds is considered to be a positive factor that contributes to economic growth as it provides capital. Currency speculation, according to some economists, also interferes with economic policy. An often cited example is that of Sweden, when in 1992 due to currency speculation, its central bank had to raise interest rates temporarily for a few days to 500% and eventually devalue its currency. The Malaysian Prime Minister also blamed George Soros and other hedgers and speculators for forcing the government to devalue the Malaysian ringgit in 1997.

Proponents of free market however hold the view that currency speculators are plain and simple business minded people out to profit from the effects of government policy and domestic and international events on currency values.

Carrying the argument further, in case a country is mishandling its economy, currency speculators may hasten an inevitable collapse, which is anytime better than a continued financial bubble that may lead to an even bigger collapse. Critics like the Malaysian Prime Minister are seen as trying to blame others for their own follies.

Risk Appetite

In other markets, traders perceiving adverse behavior tend to close positions in risky assets and shift to other assets that are less risky. However, in the foreign exchange market, things are done differently. In anticipation of something happening that can has the potential of affecting the market adversely, forex traders tend close their positions in other currencies and take shelter in hard currencies or safe haven currencies. Foreign exchange reserves and gold, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions is one measure that distinguishes a hard currency from a soft currency. However, sometimes the choice of a hard currency may just be a matter of prevailing sentiment than that of statistics. A glaring example is that of the financial crisis of 2008 when despite the USA being the epicenter of the crisis, the US dollar strengthened in value against most other currencies.

Currency Carry Trade

A currency carry trade is a strategy focused on making a profit from uncovered interest arbitrage. In simple words, it is borrowing a low-yielding currency (currency that has a low interest rate) and investing in a high-yielding currency. Big interest rates differentials can be extremely profitable for the arbitrager who uses high level of leverage. However, it is a double-edged sword like all other leveraged trades as large fluctuations in exchange rates can easily turn it into a losing trade.

Forex Trade Alerts or Signals

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