Foreign exchange market

Foreign exchange market (often abbreviated as 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.

Overview

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.

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 after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II).

Market Participants

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0 to 1 pip to 1–2 pips for currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 51% of all transactions. Then come the smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. Central banks also play a role in the foreign exchange market in their attempt to control money supply, inflation, and/or interest rates of their country.

Trading Characteristics

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 weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) to 22:00 GMT on 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.

Instruments

The foreign exchange market works through financial institutions and operates on several levels. Over-the-counter (OTC) derivatives are significant parts of this market. Instruments include:

• Spot transactions
• Forward transactions
• Swap transactions
• Option transactions
• Futures transactions

Major Currencies

The most traded currencies in the foreign exchange market are the United States dollar, the Euro, the Japanese yen, the British pound sterling, the Australian dollar, the Canadian dollar, and the Swiss franc.

Regulation

The foreign exchange market is largely unregulated; however, some countries like the United States have regulatory agencies that oversee the market to some extent. The Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) are the regulatory bodies in the United States.

Risks

Trading in the foreign exchange market can be challenging because of the risk of loss, especially due to leverage. Traders may use leverage to finance their trades. While this can increase profit potential, it also increases the risk of significant losses.

See Also

• International monetary systems
• Currency strength
• Foreign exchange fraud