Foreign Exchange Market Basics Explained

Foreign-Exchange-ExplainedForeign exchange is more commonly known as FOREX (FOReign + Exchange).

In it’s most simplistic statement foreign exchange is the sale of one country’s currency for that of another.

The FX market is an over the counter (OTC) with no centralised exchange. Traders have a choice between firms that offer trade-clearing services.

The structure of the forex exchange market is highly decentralised, which basically means there is no central location where trades occur. The NYSE (New York Stock Exchange), for example, is a centralised exchange. All orders relating to the purchase or sale of a stock listed on the NYSE are routed to the same dealer and pass through the hands of a single clearing firm. This structure requires buyers and sellers to meet at the NYSE to trade a stock that is listed on this exchange. It is for this reason that there is one universally quoted price a stock at any given time.

Not all the world’s currencies are traded. There are a number which cannot be traded without satisfying official exchange control regulations and are not in high enough demand to ensure liquidity and a viable market. The range of currencies that are traded includes the currencies of all major developed countries. Those that are less frequently traded are known as “exotic” currencies.

In the foreign exchange market there are multiple dealers whose business is to unite buyers and sellers.

Each dealer has the authority to execute trades independently of each other. Traders are faced with a choice between a variety of firms with an equal ability to execute their trades. The firm that offers the best services and execution will capitalise on this market efficiency by attracting the most traders. Established in 1971 when floating exchange rates began to develop, the Foreign Exchange also referred to as the “forex” or “spot fx” market is the largest financial market in the world.

In 2007, an estimated $3.2 trillion worth of foreign currencies were traded back and forth every day on which governments, banks, international corporations, hedge funds, and individual investors have a stake. If you compare that to the $25 billion a day volume that the NYSE trades, you can begin to imagine just how big the FX market really is. Single transactions worth between $200 million and $500 million are not uncommon in the forex market and even those large transactions don’t affect a currency’s price. This enormous market can be volatile although the allure is where two weeks of trading can hypothetically bring you $1 million out of the $1 thousand of initial investment.

Historically, the Forex market was not available to the small investor / trader but thanks to recent changes in the regulations, it is now available to all. Previously, there was a minimum transaction size and traders were required to meet strict financial requirements due to the higher degree of risk. Today market maker brokers are allowed to break down the large interbank units and offer small traders the opportunity to buy or sell and number of these smaller units (lots). Each lot is worth around $100,000 and is accessible to the individual investor through ‘leverage’ of 50:1 meaning that US$ 2,000 will allow you to control a $100,000 currency exchange. Some brokerages offer 100:1 and has high as 500:1 if you’re confident enough as a trader and have a proven track record of success with that broker.

The FOREX market is the LARGEST financial market in the world!

When you fly to another country, one of the first things you do when you get off the plane is look for a currency exchange counter where you can exchange your currency for whatever currency is used in the country you are visiting. You can also do this at any international airport or major city in your home country before leaving. Whether you exchange currency in your home country or in the country you arrive in, you actively participate in the largest financial market in the world. If you stop and think about the amount of tourists each country accepts and think about how many companies in the world have offices in multiple countries, you can begin to appreciate the size of the market.

The forex market is a group of around 5,000 currency trading institutions, including international banks, government central banks, and commercial companies. Currency trading has been thought of as a ‘professionals only’ market available exclusively to large institutions, however, because of the rise of the E-economy, online forex trading firms are now available to the average traders like you and I. During past decade, most interbank dealing was conducted using electronic platforms and now dominates trading flows. These trading platforms have now dramatically reduced trading costs for all participants in the FX market. The internet has provided the way for the exponential growth of the Forex market and it is still evolving to this day.

All Currencies Trade in Pairs

Forex trading is always traded in pairs. The most commonly traded pairs are traded against the US dollar USD. They are called ‘the Majors’ and are considered as Forex market’s “blue chips”.

The major currency pairs are the:

  • Euro (EUR/USD);
  • British Pound (GBP/USD);
  • Japanese Yen (USD/JPY);
  • Swiss Franc (USD/CHF), and;
  • Australian Dollar (AUD/USD).

What controls the Forex Market?

Supply and demand create volatility and is the key reason why exchange rates are permanently changing.

The foreign exchange market is often controlled by expectation of changes, rather than the changes themselves. Changes in expectations are almost immediately noticeable on the fx market are rate realignments.

Take for example how an increase in the oil price can affect the value of the Japanese Yen. As oil becomes more expensive, Japan needs to convert more of their Yen currency into U.S dollars because oil can only be bought using U.S dollars. This conversion of Yen into U.S dollars increases the amount of Yen into the forex market, which subsequently lowers it’s value. Additionally, as Japanese goods become more expensive, and fewer consumers are able to afford them, the demand for Yen falls. The fewer Japanese products that are bought, which must be bought with Yen, the fewer currency conversion to Yen occur. With rising supply of Japanese products combined with falling demand, the value of the Yen decreases.

Other important factors that cause currency rates to change are economical forces as well as political and psychological factors.

Basic limits of economy such as inflation, interests rates, unemployment, and many others affect exchange rates too. Competence of the government in maintaining the currency is conducive for its rate increase. Decreasing interest rates stimulates decreased demand for the currency and, thus, depresses its value the exchange operations. A decision of the Central bank of a country to buy or sell the currency may strengthen or undermine its rate significantly.

Activity of professional currency exchange managers is another important market force. In many cases, the managers may act independently and use the market as a unique instrument to achieve their goals of changing major rates. Most, if not all of them, could not care less about the adequacy of charts used for technical analysis. Though, as major levels of resistance and support are approached, the behaviour of the market becomes increasingly “technical”, and the reactions of large numbers of traders often become similar and predictable. Such periods in the market may lead to dramatic rate fluctuations, because significant funds happen to invested in similar positions.

The role of Government and Central Banks on Forex

If we use the Bank of England as an example, the bank has a number of means of influencing the exchange rate of the Great British Pound (GBP). The BOE can intervene in the foreign exchange market by buying or selling pounds which would alter the supply of pounds sterling relative to other currencies.

However, although intervention could be effective in smoothing short-term fluctuations in the value of the pound, it cannot resolve underlying economic problems, which have to be addressed by more fundamental policy measures. Although monetary policy in the UK is the achievement of domestic price stability, as defined by the inflation target set by the Government.

The exchange rate is influenced by real economic variables, but its level and volatility also have an impact on these same economic factors. Modest changes in the value of a currency can have significant effects on business and the national economy more generally. If a currency were to weaken excessively, it would put upward pressure on domestic inflation as imports and internationally tradable goods produced domestically rose in price: the cost, in terms of the domestic currency, of buying foreign currency is higher at a weaker exchange rate.
Conversely, a strengthening currency might lead to a fall in import prices and lower domestic inflation: the cost of buying foreign currency in terms of the domestic currency is lower at a stronger exchange rate. Domestic producers and exporters would need to contain and manage their costs to remain internationally competitive. Otherwise their profitability and the level of growth and employment in the economy might fall.

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