The foreign exchange or forex market is the largest financial market in the world, far larger than the stock market; with a daily volume of $5.1 trillion, compared to $84 billion for equities worldwide, according to the 2016 FX and OTC derivatives market Triennial Central Bank Survey. The digital platform where one currency is traded for another, the forex market has many unique attributes that may come as a surprise to new traders. In this article, we will take an introductory look at forex, and how and why traders are increasingly moving towards this type of trading.
- The foreign exchange market is also known as FX or forex. It is a global marketplace for the trade of national currencies against each other.
- Market participants use forex to hedge against international currency and interest rate risks, to bet on geopolitical events, and to diversify portfolios, among other factors.
- Financial institutions such as commercial banks, central banks, money managers, and hedge funds tend to be major players in this market.
- Global corporations use forex markets to hedge currency risks from foreign transactions.
- Individuals (retail traders) are a very small relative portion of all forex volumes, and they mainly use the market for speculation and day-to-day trading.
What’s the Forex?
The exchange rate is the price paid for one currency in exchange for another currency. It is this form of trade that drives the foreign exchange market.
There are more than 100 different types of official currencies in the world. However, most forex sales and transfers are done using the US dollar, the British pound, the Japanese yen, and the euro. Other common foreign currency trading instruments include the Australian dollar, the Swiss franc, the Canadian dollar, and the New Zealand dollar.
Currency may be exchanged by spot transactions, futures, swaps, and options contracts where the underlying instrument is a currency. Currency trading is underway around the world, 24 hours a day, five days a week.
Who’s selling Forex?
The forex market has not only many players, but also many types of players. Here we go through some of the major types of forex market institutions and traders:
Commercial and Investment Banks
The largest volume of currency is traded on the interbank market. This is where banks of all sizes are exchanging their currency with each other and through electronic networks. Big banks account for a large percentage of total currency transactions. Banks facilitate forex trades for customers and participate in speculative transactions from their own trading desks.
As banks act as dealers for customers, the distribution of the bid-ask reflects the bank’s profits. The speculation of currency transactions is carried out in order to benefit from currency fluctuations. Currencies may also diversify into a portfolio mix.
The Central Bank
Central banks, which serve the government of their country, are extremely important players in the forex market. Open market operations and central banks ‘ interest rate policies have a very large impact on currency rates.
The central bank is responsible for setting the price of its native currency on forex. This is the exchange rate regime that will allow its currency to trade in the open market. Exchange rate regimes are classified into floating, fixed, and fixed forms.
Any action taken by a central bank in the forex market shall be taken to stabilize or increase the competitiveness of that nation’s economy. Central banks (as well as speculators) can engage in currency intervention to make their currencies appreciate or depreciate. For example, a central bank may weaken its own currency by creating additional supplies during periods of long deflationary trends which are then used to purchase foreign currency. This effectively weakens the domestic currency, making exports more competitive on the global market.
Central banks are using these strategies to ease inflation. They often act as a long-term proxy for forex traders.
Investment directors and hedge funds
Portfolio managers, mutual funds, and hedge funds make up the second largest collection of forex market players alongside banks and central banks. Investment managers are exchanging currencies for large accounts, such as pension funds, foundations, and endowments.
An investment manager with an international portfolio will have to purchase and sell foreign currency to exchange foreign securities. Investment managers may also participate in risky forex trading, while some hedge funds engage in speculative currency trading as part of their investment strategies.
Firms engaged in importing and exporting forex transactions to pay for goods and services. Consider the example of a German manufacturer of solar panels that imports American components and sells its finished products in China. After the final sale has been made, the Chinese yuan obtained by the producer must be converted back to euros. The German company must then exchange euros for dollars in order to purchase more American components.
Companies trade forex to hedge the risk of foreign currency translation. The same German firm can purchase American dollars on the spot market or enter into a currency swap agreement to obtain dollars in advance of the purchase of components from the American company to reduce the risk of foreign currency exposure.
In addition, foreign currency risk hedges will add a level of security to offshore investment.
The number of forex transactions made by retail investors is extremely low in comparison to financial institutions and companies. It’s growing rapidly in popularity, however. Retail investors base currency transactions on a combination of fundamentals (i.e., interest rate convergence, inflation rate, and monetary policy expectations) and technical factors ( i.e. support, resistance, technical indicators, price patterns).
How Forex Trade Shapes Company
The resulting partnership between different types of forex traders is a highly liquid, global market that has an influence on business around the world. Exchange rate fluctuations are a factor in each country’s inflation, global corporate earnings, and balance of payments.
For example, the common currency’s trade strategy illustrates how market participants influence exchange rates. That, in turn, have spillover effects on the global economy. Trading carried out by banks, hedge funds, investment managers, and individual investors is designed to capture discrepancies in returns across currencies by borrowing low-yield currencies and selling them to buy high-yield currencies. If the Japanese yen had a low yield, market participants would sell it and purchase a higher yield currency.
When interest rates in higher-yielding countries begin to fall back to lower-yielding countries, trade is slowing and investors are selling their higher-yielding investments. Delaying trade in yen can cause large Japanese financial institutions and investors with large foreign holdings to move money back to Japan as the spread between foreign yields and domestic yields narrows. This strategy, in turn, may result in a large decline in global equity prices.
The Lower Line
There is a reason why forex is the largest market in the world. It empowers everyone, from central banks to retail investors; to potentially see profits from currency fluctuations linked to the global economy. There are a number of strategies to use to trade and hedge currencies. Such as carry trade, which highlights how forex players have an impact on the global economy.
The reasons for trade in forex are varied. Speculation transactions – carried out by banks, financial institutions, hedge funds, and individual investors – are profit-driven. Central banks are moving forex markets dramatically through monetary policy, exchange-rate arrangements, and, in rare cases, currency intervention. Corporations are trading currency for global business operations and risk hedges.
Overall, investors can benefit from knowing who trades forex and why.