The Forex Market

Forex market description

What is the Forex Market?

The word Forex stands for Foreign Exchange and it refers to the Foreign Exchange Market. The Forex is a decentralized market which exists wherever one currency is traded against another such as financial centers worldwide, banks or any financial institution or company where currency transactions are conducted. Therefore it is the largest financial market in the world, especially in terms of daily trading volume.

In this market participate central banks, major financial banks and similar institutions, multinational corporations, governments, currency speculators (large, medium and small investors) and other market participants and institutions of all kinds. Small investors (those who speculate with relatively small amounts of money) are a small part of this market and they can participate directly by companies dedicated to providing trading services or indirectly through banks or brokers.

One of the most important characteristics of the Forex market is the huge volume of transactions that take place daily in this financial market. In fact each day the Foreign Exchange move about 4 billion U.S. dollars, which is substantially higher than the trading volume of any other financial market.

This has allowed that an entire industry has arisen around the Forex which produce many millions of dollars a year, which has contributed to making Forex the financial market with the greatest potential and growth in the financial world today. Thanks to advances in modern technology, particularly the Internet, Forex has gained increasing popularity among small and large private investors. This has caused that this market is no longer an exclusive domain for large companies. This is due in part to the high leverage that this market usually offers for traders (a high leverage allows large investments with little capital) and the possibility to profit from both rises and falls in currency prices.

Also the largest brokers which are established in this sector offer many advantages and services to their customers like free practice accounts or demo accounts, which enable customers to learn how to trade, practice strategies and gain confidence before risking real money in the market. Of course, as in any financial market, the risk of loss is quite high, so before investing any money is necessary to understand how work the financial instruments offered by Forex brokers. In this case the investors must identify and decide what level of risk they are willing to accept for their trades.

Unlike the stock market, the Forex market has no centralized location. By contrast, it operates through a fully globalized network of banks, financial institutions and individual speculators which operates 24 hours a day. All these big and small investors are focused on the purchase and sale of foreign currencies relative to its volatile exchange rate that varies constantly and whose movements these investors try to anticipate for profit.

Size and liquidity of the Forex market

Thus, the Forex market is unique compared to others because of the following features:

  • The extreme liquidity of the market which is superior than any other.
  • The variety and number of investors involved in this market.
  • It is geographical spread covering virtually the entire planet.
  • The extended period in which this market keeps operating, which covers 24 hours a day from Monday to Friday.
  • The wide variety of factors involved  that generate changes in the market behavior.
  • The sheer volume that is traded globally in foreign exchange, which daily average is equivalent to the total  that takes place in a month in the stock market on Wall Street.

The Forex market as such, works from the mid-70s. The currency futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and is one of the most active contracts traded. The volume of currency futures has grown rapidly in recent years, but it accounts for only about 7% of total foreign exchange market, according to The Wall Street Journal Europe (05/05/2006, P. 20).

Most of the trading volume in this market consists of direct buy/sale transactions of foreign exchange. In the Forex market, major international banks provide the market with a purchase price (bid) and a sale price (ask). The difference between these prices is called the spread and it generally constitute the fee charged by the banks or other companies to act as an intermediary between investors buying and selling currencies using their channels. Normally, the spread of the most traded currencies and under normal market conditions is only 1-3 pips or points. This value is usually higher for currencies that are less traded. Thus, if we want to negotiate with the EUR/USD and the buy price (bid) is 1.3200 and the selling price (ask) is 1.3203, we can determine that in this case the spread is 3 pips .

Forex Market Main Features

Among the implications produced for the fact that Forex is not a centralized market is that there is no single price or quote for the instruments traded in this market. Currency quotes are directly dependent on the various players that participate in the market.

While the Forex market operates and offers investors access 24 hours a day in practice it is limited by a break in operations that occurs on weekends, but even in those periods of recess, any trader can place buy or sale positions that will be activated once the market begins to work again, at the beginning of the week. An important aspect to consider when trading in the Forex market, is that the time of day in which the speculator access and trades in this market has a direct impact on the liquidity available for trading in one or more currencies. This is because during periods in which the major world markets begin to operate, is when there is greater liquidity, price movement and trading volume, although Forex is not linked directly to the nature of these stock negotiations centers since in this case it is basically an Over The Counter market. But either way, the Forex market traders should always consider the time before opening positions especially in relation to the major exchanges in the world.

Currently, the main financial centers in the world are the New York Stock Exchange, the London Stock Exchange and the Tokyo Stock Exchange. These exchanges operate daily from Monday to Friday with a fixed schedule. First the Asian markets start to operate followed by the European markets and finally the American markets.

The Forex market opens every Sunday in the afternoon (EST Time East Coast of the United States) and closes on Friday at 4:00 pm Eastern Time U.S. Thanks to this extensive schedule, investors have constant access to the market with the benefit of increased liquidity and the possibility to respond quickly to political and economic events that can positively or negatively impact the markets so that the trader can make a profit with any major event that cause movements in the Forex.

In Forex, usually the variations in the exchange rates of currencies are caused by actual monetary flows as well as the expectations of changes in these rates, due to fluctuations in economic variables of the major economies such as inflation, interest rates , GDP growth, trade deficits and surpluses, national budgets and other. In general, the major economic and political news are issued on scheduled dates, so that investors have access to the same information at the same time. However, the reality is that the big banks have a great advantage over other investors because they can see the order book of its customers, meaning that they can be aware of the market’s direction because they can check the buy /sale orders of the investors to whom they provide services.

Below are the most traded currencies in the Forex market along with its ISO 4217 code and its percentage of market share:

Currency
 ISO 4217 Symbol
% Participation in the FX Market
US Dollar
USD
86.3
Euro
EUR
37.0
Yen
JPY
17.0
Pound Sterling 
GBP
15.0
Swiss Franc
CHF
6.8
Australian Dollar
AUD
6.7
Canadian Dollar
CAD
4.2
Swedish Krona
SEK
2.8
Hong Kong Dollar
HKD
2.8
Norwegian Krone
NOK
2.2
New Zealand Dollar
NZD
1.9
Mexican Peso
MXN
1.3
Singapore Dollar
SGD
1.2
South Korean Won
KRW
1.1
Other currencies
14.5

In the Forex market, currencies are traded in pairs, each of which is a product or individual instrument to trade and is usually noted as XXX/YYY, where YYY is the international three-letter code ISO 4217 for a given currency , in which the price of one unit of XXX (another currency) is expressed. To better understand this, we can use as an example the EUR/USD = 1.3200 (Quote produced in early August of 2010), in which the price of the Euro (EUR) is expressed in U.S. dollars (USD), which means i in this case that the value of 1 euro equals  to 1.3200 U.S. dollars.

According to several studies, the most traded currency pairs in the Forex market are:

  • EUR/USD: 28%.
  • USD/JPY:  17%.
  • GBP/USD: 14%

While trading volumes in euros has increased significantly since its inception in 1999, the Forex market is still dominated by the U.S. dollar as shown in the table above, which shows how the dollar has an 87% on the market by far surpassing all others currencies.

Types of Forex market instruments

Today the total value of transactions in the Forex market is around $ 4 trillion a day, which is higher than traditional derivatives whose daily trading volume is 3.7 trillion. The most common instruments that are traded in the Forex market are:
  • Spot foreign exchange transactions (spot market): These operations are commonly known as Foreign Exchange Spot Trading. In this case, these trades consist of the purchase/sale of foreign currencies with a delivery that can last up to 2 business days of the transaction contract. These are the most common transactions in the Forex market.
  • Currency based financial options: These options also known as Foreign Exchange Options are contracts that give the buyer the right but not the obligation to purchase or sell one currency for another at a specified price or rate on a date established in the contract. It is a type derivative which is traded Over The Counter (No trades at a central market, transactions are made directly between the two parties).
  • Futures contracts based on currencies: These contracts, also known as Foreign Exchange Futures, consist of an agreement to exchange currencies at a predetermined date in the future at a price specified in the contract. Unlike transactions in options, futures transactions are not performed on Over The Counter markets.
  • Currency Forwards: These instruments are also called Outright Forward and basically consist of an exchange of one currency for another at a future date price preset.
  • Not traded currency contracts: These financial products are known as Non deliverable Forwards. These are contracts which  usually are traded offshore and where settlement is made based on different currencies. They offer the possibility for the investor to have exposure to a currency without having to pay or receive the currency.
  • Currency swaps: These instruments, also known as Foreign Exchange Swaps are agreements between two counterparts (buyer and seller) for the purchase and sale of a certain amount of currency (for the change of a future stream of payments of interest and principal) in which one of the counterparts pay in a currency while the other party pays in another currency. At present there are various types of currency swaps.

Currency market participants

According to various studies, at present over 50% of transactions in the foreign exchange market are solely between banks. Also, about 30% of trades are done between banks and other financial company while the rest of the transactions are made between a broker and a  non-financial entity (non-financial companies, individual investors and others).

Below we describe the main actors and participants involved in the Forex currency market:

Commercial Banks

The interbank market today represents a high percentage of speculative transactions in the financial market. In fact, a large financial bank can negotiate even billions of dollars daily in the Forex market. Some of this trading volume is done on behalf of their clients, however the other part is made by the bank to gain direct income with the price fluctuations of one currency against another.
Until relatively recently, many of the foreign currency negotiators actively involved in this type of market operations facilitated the parties that conducted a transaction the effective executions of the orders in exchange for a commission or fee as payment for their services.
However, today a large part of the trades in the Forex market is performed using more efficient electronic systems such as:
  • Chicago Board of Trade.
  • Tradebook.
  • Bloomberg.
  • EBS.

Central Banks

Central banks such as the Fed or the ECB sometimes operate in the foreign exchange markets in order to control the supply and demand for money, interest rates in the currency of its country and even inflation. These banks regularly impose exchange rates of currencies and often employ international reserves as a resource to stabilize the market when it threatens to spiral out of control. For these reasons, the expectation and even the rumor that a major central bank will intervene in the market can significantly alter the value of a currency. Despite this, central banks do not always achieve their goals because the market is too big and can be dominated by any bank. This happened recently in Asian markets and in the period between 1992-1993 with the collapse of the Exchange Rate Mechanism.

Commercial Companies

Firms that do not directly belong to the financial sector which operate both with international customers and suppliers are also involved in the Forex market. However, in this case the impact of these companies in the short term is small compared to other participants. Despite this, trade flows resulting from these companies are an important factor that can affect the behavior of a currency over time. Also, direct operations of some multinationals may affect significantly the currencies of countries with small economies.

Investment Funds Companies (Hedge Funds)

These are companies that operate in the foreign exchange market in order to gain access to the financial markets of different countries so that they can invest in other assets such as stocks, bonds and others on behalf of their clients and with the capital of them.

Investors (traders) through intermediaries (brokers)

Today there are companies that specialize in providing access and support services for private operators that are interested in the Forex market. These companies provide different types of services designed for this purpose. Thus, we have the brokers or financial intermediaries, which will provide traders with the possibility to open a trading account in a particular currency (usually USD or EUR) for the purchase and sale of foreign exchange through different channels (in most cases transactions are conducted using the Internet or by telephone), in order to earn income based on fluctuations in the exchange rate of various currencies against each other (eg Euro vs US Dollar, US Dollar vs. Yen, Euro vs. Yen, etc).

Because of its importance in the financial system and the seriousness of their work, these firms generally are subject to various controls and audits depending on country of origin. However, when choosing a broker to operate in the market, the trader must investigate its reputation, strength, quality of service and the legal framework by which it is governed.

Other companies involved in the Forex market

In addition to the direct participants in the Forex market, we have other companies that offer various services that relate directly or indirectly to this financial market. For example, there are companies dedicated to account management, among which we can include mutual funds, which basically are dedicated to raise capital from a number of investors to trade in the Forex with a strong capital , which is managed by the company’s expert investors.

In this case the firm through capital investment generates returns that are distributed among investors according to the amount of their investment. Of course, these companies are subject to the inherent risk derived from capital speculation, so they can lose partially or totally the capital invested. If the investor chooses an alternative of this type, it is essential to verify if the company meets certain criteria of professionalism, experience, transparency and risk policies especially for this type of investment. Today there are Forex brokers that offer a managed account service to their customers (PAMM accounts) in which the investor’s capital is managed by experienced traders in the market.

Finally, we have companies that provide education services to investors to participate successfully in the market and companies which develop computer type applications for Forex trading, such as those that design and sell automated trading systems. These systems are programs designed to make buy and sell transactions in the market according to various parameters that were programmed such as mathematical calculations or technical indicators designed from mathematical formulas, which help to read the movement of the market prices during certain periods. Besides these companies, there are others dedicated to Forex autotrading, Forex signals, platform development to invest in the market, etc.

Through the following link you can see a list of the main brokers that allow to trade in the Forex market: List of the main Forex Brokers

 

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