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Foreign Exchange Market

This or currency market or Forex is the market where one currency is traded for another. It is one of the largest markets in the world.

Some of the participants in this market are simply seeking to exchange a foreign currency for their own, like multinational corporations which must pay wages and other expenses in different nations than they sell products in. However, a large part of the market is made up of currency traders, who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency traders try to take advantage of even small fluctuations in exchange rates. Sometimes they are able to profit from arbitrage.

According to the Bank for International Settlements' last triennal study (April 2004) (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results), transactions :
• were strictly interdealer (ie interbank) for 53 % ;
• for 33 % involved a dealer (ie a bank) and a fund manager or some other non-bank financial institution;
• and for only 14 % were between a dealer and a non-financial company.

Market liquidity

Foreign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) offers.

Top 5 Most Traded Currencies
Rank Currency ISO 4217 Code Symbol
1 United States Dollar USD $
2 Eurozone Euro EUR €
3 Japanese Yen JPY ¥
4 British Pound Sterling GBP £
5 Swiss Franc CHF

In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.

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 currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.

On the spot market, according to the BIS study, the most heavily traded products were :
• EUR/USD - 28 %
• USD/JPY - 17 %
• GBP/USD (also called cable) - 14 %
and the US currency was involved 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus 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.

The foreign exchange market is open 24 hours per day throughout the week (closing worldwide Friday afternoon at 5pm New York time, ie 2100 GMT, and reopening Sunday 1900 GMT when Wellington, New Zealand opens on their Monday morning). If the European Market is closed the Asian Market or US will be open on the other hand and so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets.

Market Size

Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the above-mentioned BIS study :
$600 billion spot
$1,300 billion in derivatives, ie
$200 billion in outright forwards
$1,000 billion in forex swaps
$100 billion in options.

For various reasons, exchange-traded derivatives never caught on the Forex market as they did on all other financial markets (although attempts to launch currency futures contracts in the early 70s actually predate interest rate or stock index futures).

Bid/Offer spread

Like any market there is a bid/offer spread (difference between buying price and selling price). On major currency crosses, the difference between the price at which a market maker will sell ("ask", or "offer") to a wholesale customer and the price at which the same market-maker will buy ("bid") from the same wholesale customer is minimal, usually only 1 or 2 pips. In the EUR/USD price of 1.4238 a pip would be the '8' at the end. So the bid/ask quote of EUR/USD might be 1.4238/1.4239.

This, of course, does not apply to retail customers. To individuals, banks will routinely mark up the difference to say 1.4140 / 1.4340 for transfers, or say 1.3740 / 1.4740 for banknotes or travellers' cheques.

Currency speculation

In our floating point system every cash flow in the world is calculated in some domestic currency. Any currency mismatch in cash flows, whatever they be, will thus generate foreign-exchange risk.
The most widespread speculation is of the passive kind. Most people and firms simply do not hedge foreign exchange risk on future cash flows, which amounts to ... reckless gambling, although it is generally not perceived as such.
Semi-passive speculation is the next most frequent kind. Investors will routinely speculate on currency fluctuations and realize profits by parking funds in one currency, and after it appreciates in value, switching to another. However, a Belgian dentist who makes 20% in U.S. dollar term on an investment in the DJIA, has to realize that if the U.S. dollar has gone down by 40% versus the Euro, then he has actually lost money in terms of his domestic currency, the Euro.
Active speculation is in fact rarer, since it involves setting up both a foreign currency account and a credit line.

Individual currency speculators

Most individual currency speculators will trade using a broker which will typically have a spread marked up to say 3-20 pips (so in our example 1.4237/1.4239 or 1.423/1.425). The broker will give their clients often huge amounts of margin, thereby facilitating clients spending more money on the bid/ask spread. The brokers are not regulated by the U.S. Securities and Exchange Commission (since they do not sell securities), so they are not bound by the same margin limits as stock brokerages. They do not typically charge margin interest, however since currency trades must be settled in 2 days, they will "resettle" open positions (again collecting the bid/ask spread).
Individual currency speculators can work during the day and trade in the evenings, taking advantage of the market's 24h long trading day. Many firms offer online FX trading allowing individuals to trade currencies between foreing accounts (such as FXCM, XE.com and others).
oreign, foriegn, foregn, foregin, froeign, forin, foreing, excnage, exchaneg, exchnge, exchnage, ecxhange, exhcange, mreket, markte, mrket

See also
• Currency
• Dividends
• Euro
• Exchange Rate
• Foreign Exchange Options
• Currency Future
• Futures Contract
• Futures Exchange
• Basis Point
• Interest Rate
• Investment
• Forex Scams
• Bid/offer spread

• Summary Measures of the Foreign Exchange Value of the Dollar

• Forex and Commodities Futures and Options. What to know before you trade

Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate
Markets
Futures exchange
Products
Currency future
Forex swap
Currency swap
Bretton Woods system
Balance of trade
Balance of Payments
Base currency

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Foreign Exchange Market".