Foreign exchange

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Revision as of 18:04, 27 July 2005 by Sharky (Talk | contribs)

The foreign exchange market (also referred to as forex or fx) is the market of currencies. Trade takes place when one country's currency (such as the Swiss Franc) is exchanged for the currency of another country (say the Japanese Yen). The market exists to facility the exchange of money around the globe for business and travel purposes, though speculation has become increasingly popular over the years.

Contents

Market Structure

Foreign Exchange transactions take place 24 hours per day, around the world through a combination of inter-bank and futures andoptions markets, though the inter-bank market far surpases the others in volume. In fact foreign exchange is the largest of the financial markets, dwarfing all others.

Participants

The Forex market is called an 'Inter-bank' market due to the fact that historically it has been dominated by banks, including central banks, commercial banks, and investment banks. However, the percentage of other market participants is rapidly growing, and now includes large multinational corporations, global money managers, registered dealers, international money brokers, futures and options traders, and private speculators. The total daily value of foreign exchange transactions currently stands at around $1.9 Trillion.

Brief History of Forex

Forex is the largest market in the world, with an average of $1.9 trillion U.S. dollars traded daily, driven by the supply and demand of currencies. The volume of forex causes significant liquidity, which means it’s less influenced by large buy and sell orders that can cause unwarranted price manipulation. This means a person or a company can’t enter the market to influence it based strictly off reputation or the volume of a transaction.

In the past, the only way to gain access to the forex market was through banks that moved large amounts of currencies for commercial and investment purposes (known as the interbank market) making it unavailable to all but the wealthiest individuals. In addition to the buying and selling of foreign currencies, interbank market banks compete with each other for corporate customers, most of which, seek to capitalize on the best exchange rates possible (hedging).

One of the largest influencers of the interbank market are the world’s central banks. Central banks are the principle government–run banks of the major countries of the world, such as the United States’ Federal Reserve Bank or Japan’s Bank of Japan. These central banks often intervene in the forex market to carry out their countries’ monetary policy. At times, central bank activity can be extremely disruptive to currency markets as governments maneuver to change the level of their currency rates. These interventions can often create great opportunity as well as risk for speculators.

Third-party brokerage firms called primary market–makers provide another component of the forex market. These firms remain on the outer perimeter of the interbank market buying and selling currencies from multiple banks making them very appealing to individual speculators because of the prices they quote. Interbank prices sometimes have large price gaps, but market–makers assume this risk to give consistent, competitive pricing to individuals at a retail level.

Primary market–makers offer prices based on interbank prices to make currency trading available to individuals to trade. These are based upon the exchange rates as they are quoted by banks to each other. Furthermore, primary marketmakers provide a two–sided market and add overall liquidity to the forex market. Because forex trading is not centralized on an exchange as with the stock and futures markets, it’s considered an over–the–counter (OTC) market. Most forex transactions are conducted between two parties via a telephone or the Internet. Like other financial instruments, forex firms make a small profit from the differences between the buy and sell prices, thus offering commission–free trading.

Most forex trading firms make third–party software available to traders while others develop their own proprietary trading software. Real–time currency prices and data are fed into the software via a dealing desk so traders can make decisions or predictions in an effort to make a profit. Some of the most advanced forex trading software today includes real–time charting, technical indicators and up-to-the-minute news. These resources used to be only available to professional traders in the interbank market.

Currency Prices

Currency abbreviations

Currency references use standardized three character abbreviations known as SWIFT or ISO codes. The codes for the major (most active) currencies are:

  • AUD - Australian Dollar
  • CAD - Canadian Dollar
  • EUR - Euro
  • JPY - Japanese Yen
  • GBP - British Pound
  • CHF - Swiss Franc
  • USD - U.S. Dollar

Currency pairs

The forex market trades in currency pairs. These pairs use a standardized quote structure of Base/Quote with the above mentioned abbreviations in an XXX/YYY format. The pair can be thought of in terms of how much of the Quote currency it takes to make one unit of the Base currency.

Putting this together, EUR/USD is the number of U.S. Dollars it takes to equate to 1 Euro. This is the exchange rate.

It should be noted that a cross-rate or cross currency pair (often just called a cross) is the term used in common market parlance for a currency pair which does not include the USD. An example would be EUR/GBP.

In some trading circles you may hear the term 'Cable' referred to when talking about the GBP/USD. This refers to the transatlantic cable which when laid opened up a whole new area of currency specualtion.

Quotes

Currency market quotes are displayed in a standard bid/offer set-up. Among the major currency pairs (pairs which include two of the major currencies as listed above), most are quoted to 4 decimal places with a pip equal to 1/10,000th of a point. Where the Japanese Yen is included as the Quote currency, the standard is 2 decimal places, with a pip being 1/100th of a point.

With increased volume in forex trading, the quotes have actually been extended an additional decimal point, at least in the major currency pairs. This has created what are referred to as pippettes, fractions of a pip.

Currency Exchange Rate Influences

The rate of exchange between one country's currency and those of other countries both impacts a given economy and is impacted by it, and similarly ties in with interest rates. A currency will tend to be stronger when the economy is strong in comparisson to others and weaker when the economy is comparatively less strong. At the same time, exchange rates directly impact trade and investment.

Trade is often spoken about as the primary factor in foreign exchange. Also important are:

  • Interest rate spreads
  • Comparative prices
  • Inflation
  • GDP growth

Currency Index

There is really only one major currency index which is actively trade. That is the US Dollar Index (USDX), which is traded via the futures and futures options market on the New York Board of Trade (NYBOT).

Related T2W Resources

Other Resources

Live charts for usdx are available at www.netdania.com