The
foreign exchange (
currency or
forex or
FX)
market exists wherever one
currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency
speculators, multinational corporations,
governments, and other
financial markets and institutions. The trade happening in the forex markets across the globe currently exceeds $1.9 trillion/day (on average). Retail traders (individuals) are currently a very small part of this market and may only participate indirectly through brokers or banks and may be targets of
forex scams.
Market size and liquidity
The foreign exchange market is unique because of:
-
- its trading volume,
- the extreme liquidity of the market,
- the large number of, and variety of, traders in the market,
- its geographical dispersion,
- its long trading hours - 24 hours a day (except on weekends).
- the variety of factors that affect exchange rates,
According to the BIS study Triennial Central Bank Survey 2004, average daily turnover in traditional foreign exchange markets was estimated at $1,880 billion. Daily averages in April for different years, in billions of US dollars, are presented on the chart below:
Global foreign exchange market turnover:
-
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex futures volume has grown rapidly in recent years, but only accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Average daily global turnover in traditional foreign exchange market transactions totalled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including non-traditional foreign exchange derivatives and products traded on exchanges, averaged around $2.9 trillion a day. This was more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market.[1]
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in April 2006. Other large centres include the US (with a 18.2% global share), Japan (7.6%) and Singapore (5.7%) (Chart 2). Most of the remainder was accounted for by trading in Germany, Switzerland, Australia, Canada, France and Hong Kong.
The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer. This spread is minimal for actively traded pairs of currencies, usually only 0-3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is usually $100,000.
These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 5 pips wide (i.e. 0.0005). Competition has greatly increased with pip spreads shrinking on the major pairs to as little as 1 to 1.5 pips.
Trading characteristics
There is no single unified foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is no such thing as a single dollar rate - but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs.
The main trading centers are in London, New York, Tokyo, and Singapore, but banks throughout the world participate. As the Asian trading session ends, the European session begins, then the US session, and then the Asian begin in their turns. Traders can react to news when it breaks, rather than waiting for the market to open.
There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.
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 is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.
On the spot market, according to the BIS study, the most heavily traded products were:
-
- EUR/USD - 28 %
- USD/JPY - 18 %
- GBP/USD (also called sterling or cable) - 14 %
and the US currency was involved in 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). (Note that volume percentages should add up to 200% - 100% for all the sellers, and 100% for all the buyers).
Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus far 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.
Market participants
Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. As you descend the levels of access, the difference between the bid and ask prices widens. 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 forex market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment 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 forex market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001-2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs.
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems, such as EBS, Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange, Bloomberg and TradeBook(R). The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
[edit] Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.
[edit] Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high — that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives, however. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse, and in more recent times in Southeast Asia.
[edit] Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximization.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
[edit] Hedge funds
Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive currency speculation since 1990. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
[edit] Retail forex brokers
Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25-50 billion daily, which is about 2% of the whole market.
Factors affecting currency trading
- See also: Exchange rates
Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
[edit] Economic factors
These include economic policy, disseminated by government agencies and central banks, and economic conditions, generally revealed through economic reports.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a governments'central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
Economic conditions include:
Government budget deficits or surpluses: The market ususally reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's curency.
Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency.
Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
[edit] Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
For instance, political upheaval and instability can have a negative impact on a nation's economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.
[edit] Market psychology
Perhaps the most difficult to define (there are no balance sheets or income statements), market psychology influences the foreign exchange market in a variety of ways:
Flights to quality: Unsettling international events can lead to a "flight to quality" -with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts.
Long-term trends: Very often, currency markets move in long, pronounced trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-trem price trends that may rise form economic or political trends.
"Buy the rumor, sell the fact:" This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".
Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect - the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical analysis: May be at odds with fundamental analysis. Fundamental analysis maintains that markets may misprice a currency pair and, through various methods of fundamental analysis, the "correct" price can be calculated. Profits can be made by trading the mispriced currency and then waiting for the market to recognize its "mistake" and reprice the currency. In contrast, a technical analyst is not interested in a currency's "correct" price, only in price movement.
[edit] Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, many economists (e.g. Milton Friedman) argue that speculators perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists (e.g. Joseph Stiglitz) however, may consider this argument to be based more on politics and a free market philosophy than on economics.
Large hedge funds and other well capitalized "position traders" are the main professional speculators.
Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not, according to this view; it is simply gambling, that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 150% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators. [1]
Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and forex speculators only made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.
[edit] History
The forex market is a cash inter-bank or inter-dealer market, which was established in 1971 [citation needed] when floating exchange rates began to appear. The foreign exchange market is huge in comparison to other markets. For example, the average daily trading volume of US Treasury Bonds is $300 billion and the US stock market has an average daily volume of less than $10 billion. Ten years ago the Wall Street Journal estimated the daily trading volume in the forex market to be in excess of $1 trillion. Today that figure has grown to exceed $1.8 trillion a day.
Prior to 1971 an agreement called the Bretton Woods Agreement prevented speculation in the currency markets. The Bretton Woods Agreement was set up in 1945 with the aim of stabilizing international currencies and preventing money fleeing across nations. This agreement fixed all national currencies against the dollar and set the dollar at a rate of $35 per ounce of gold. Prior to this agreement the gold exchange standard had been used since 1876. The gold standard used gold to back each currency and thus prevented kings and rulers from arbitrarily debasing money and triggering inflation. Institutions like the Federal Reserve System of the United States, or the Bank of England in the United Kingdom, have this kind of power.
The gold exchange standard had its own problems however. As an economy grew it would import goods from overseas until it ran its gold reserves down. As a result the country’s money supply would shrink resulting in interest rates rising and a slowing of economic activity to the extent that a recession would occur.
Eventually the recession would cause prices of goods to fall so low that they appeared attractive to other nations. This in turn led to an inflow of gold back into the economy and the resulting increase in money supply saw interest rates fall and the economy strengthen. These boom-bust patterns prevailed throughout the world during the gold exchange standard years until the outbreak of World War I which interrupted the free flow of trade and thus the movement of gold.
After the war the Bretton Woods Agreement was established, where participating countries agreed to try and maintain the value of their currency with a narrow margin against the dollar. A rate was also used to value the dollar in relation to gold. Countries were prohibited from devaluing their currency to improve their trade position by more than 10%. Following World War II international trade expanded rapidly due to post-war construction and this resulted in massive movements of capital. This destabilized the foreign exchange rates that had been set-up by the Bretton Woods Agreement.
The agreement was finally abandoned in 1971, and the US dollar was no longer convertible to gold. By 1973, currencies of the major industrialized nations became more freely floating, controlled mainly by the forces of supply and demand. Prices were set, with volumes, speed and price volatility all increasing during the 1970’s. This led to new financial instruments, market deregulation and open trade. It also led to a rise in the power of speculators.
In the 1980’s the movement of money across borders accelerated with the advent of computers and the market became a continuum, trading through the Asian, European and American time zones. Large banks created dealing rooms where hundreds of millions of dollars, pounds and yen were exchanged in a matter of minutes. Today electronic brokers trade daily in the forex market, in London for example, single trades for tens of millions of dollars are priced in seconds. The market has changed dramatically with most international financial transactions being carried out not to buy and sell goods but to speculate on the market with the aim of most dealers to make money out of money.
London has grown to become the world’s leading international financial center and is the world’s largest forex market. This arose not only due to its location, operating during the Asian and American markets, but also due to the creation of the Eurodollar market. The Eurodollar market was created during the 1950’s when Russia’s oil revenue, all in US dollars, was deposited outside the US in fear of being frozen by US authorities. This created a large pool of US dollars that were outside the control of the US. These vast cash reserves were very attractive to foreign investors as they had far less regulations and offered higher yields.
Today London continues to grow as more and more American and European banks come to the city to establish their regional headquarters. The sizes dealt with in these markets are huge and the smaller banks, commercial hedgers and private investors hardly ever have direct access to this liquid and competitive market, either because they fail to meet credit criteria or because their transaction sizes are too small. But today market makers are allowed to break down the large inter-bank units and offer small traders the opportunity to buy or sell any number of these smaller units (lots).
[edit] Algorithmic trading in Forex
With steady growth of the FX markets and the increasing adoption of E-FX among the market participants, algorithmic trading is emerging as the next level of trading technology for market participants to contend with. Although there is much confusion about the technique, most market participants seem to agree that it will be used increasingly frequently. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be exectuded using algorithm, up from about 18% in 2005.
[edit] Financial instruments
There are several types of financial instruments commonly used.
Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market.
Forward transaction: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.
Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.
Options: A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.
[edit] The difference between spot and futures in forex
Before a description of retail trading, it is important to understand the difference between the spot and futures markets. Futures are generally based on contracts, with typical durations of 3 months. Spot, on the other hand, is a two-day cash delivery. While the futures markets were created to hedge out risks and speculate on future market conditions, spot was created to allow actual cash deliveries. Spot developed a two-day delivery date to give those transporting the actual cash a window of time to receive it. While in theory there still is a two-day delivery date imposed after a forex transaction, this is effectively no longer used. Every day, at 5 pm EST (the predetermined end of the trading day) spot positions are closed and then reopened. This is done to guarantee an unlimited timeline for delivery. For example, if a spot transaction occurs on a Monday, the delivery date is Wednesday. At 5 pm on Monday, the position is closed and then immediately re-opened; now this is a new position with the close date of Thursday. This daily process allows an investor to hold open a position indefinitely.
Another important difference between futures and spot is how interest is credited. Each currency in a forex transaction has an inherent interest rate attached to it. In the case of the US dollar, this is the Federal Funds Rate. This interest is added every day whether the market is trading or not. Interest cannot take a vacation; money and its loaning value are still important even if the financial world has stopped dealing. In futures, the interest is built into the price of the contract. In spot, however, interest is not taken into account in the offering price because the spot market is a cash market, not a contract market. There must be some mechanism for crediting interest, and various institutions have developed ways to do it. The most common method is to credit that day’s worth of interest at the same time they “flip” the position, or carry it over to the next day. This is important for later discussions and analysis because the transactions examined in this study had interest credited at the end of the business day at exactly 5 pm EST. If a position was held from 5:01 pm on Tuesday and closed at 4:59 pm on Wednesday, no interest would be credited for that day. If, on the other hand, a position was opened Tuesday at 4:59 pm and closed Tuesday 5:01 pm, a full day’s interest would be credited. This has interesting ramifications; traders who work intra-day, or “day traders,” often do not use interest for either gain or loss.
Courtesy : http://en.wikipedia.org
