What is Foreign Exchange

Foreign Exchange (FX or Forex) is one of the largest and most liquid financial markets in the world. According to the authoritative Triennial Central Bank Survey from Bank for International Settlements, Basel, average daily turnover in April 2007 exceeded US $3.2 trillion, and evidence suggests that the market is still expanding. The spot market accounts for around a third of activity in the FX market.

FX is simple to understand once it is realized that a currency is effectively a commodity whose value can change against other currencies, as well as other assets, such as gold and oil.

What is FX Trading

In an FX transaction, one currency is sold in exchange for another one. The rate expresses the relative value between the two currencies. Currencies are normally identified by a three-digit ‘Swift’ code. For instance, EUR = the euro, USD = the US dollar, CHF = the Swiss franc and so on. A full list of codes can be found here. A EUR/USD rate of 1.5000 means that €1 is worth $1.5.

Sometimes, EUR/USD is referred to as a currency pair. The rate can be inverted. So a EUR/USD rate of 1.5000 is the same as a USD/EUR rate of 0.6666. In other words, $1 is worth €0.6666. The market convention is that most currencies tend to be quoted against the dollar, but there are notable exceptions, such as with the EUR/USD already mentioned, GBP/USD (UK sterling) and AUD/USD (the Australian dollar). This is not as confusing as it may sound.

Foreign Exchange Rate Systems

There are basically two types of exchange rate systems:

Flexible Exchange Rate System

In a flexible exchange rate system, a currency is ‘free’ to float and its value is determined by market forces.

Fixed Exchange Rate System:

In a fixed exchange rate system, a currency is not allowed to fluctuate freely. Instead, its value is fixed either against a single currency, such as the USD, at a specific rate, or a basket of currencies. In a fixed system, the local central bank will use its currency reserves to prevent rate movements.

Major Influences on FX Prices

There are numerous factors that determine a free floating currency’s worth in the market, from international trade flow, economic and political conditions, the level of interest rates to simple short-term supply and demand. Unlike many other assets, FX is a pure market and rates move freely both up and down.

Over-the-Counter Market

The Forex market is an 'over the counter market' (OTC), which means that there is no physical location and no central exchange and clearing hours where orders are matched. Instead, it operates 24-hours a day via an electronic network of banks, corporations and individuals trading one currency for another.

FX traders constantly negotiate prices between one another and the resulting market bid/ask prices are then fed into computers and displayed on official quote screens. Forex exchange rates quoted between banks are referred to as Inter-bank Rates.

FX market participants

There are numerous different types of participants in the FX market and frequently they are looking for very different outcomes when they trade. This is why that although FX is often described as a ‘zero-sum’ game – what one investor makes is equal in theory to what another has lost – there are numerous opportunities to make money. FX can be thought of as a pie from which everyone can have a decent meal.

Traditionally, banks have been the main participants in the FX market. They still remain the largest players in terms of market share, but transparency has made the FX market far more democratic. Now virtually everyone has access to the same, extremely narrow prices that are quoted in the interbank market.

Banks remain the main players in the FX market, but a new breed of market makers, such as hedge funds and commodity trading advisors, has emerged over the past decade.

Central Banks can also play an important role in the FX market, while international corporations have a natural interest to trade on account of their exposure to FX risk.

Retail FX has expanded rapidly over the past decade and while precise figures are hard to come by, this sector is believed to represent as much as 20% of the FX market.

Spot FX versus Currency Futures

While most FX trading takes place OTC, there is also a quite vibrant and successful futures market. Turnover on the CME, based in Chicagois around US $85 billion a day. Several other exchanges also offer currency futures.

Typically, spot FX prices are for T+2 settlement. That means trades which are not closed out are settled in 2-working days. Futures tend to have a maturity of 3-months and so are settled quarterly, normally in March, June, September and December. This is why futures prices often look different from spot. In reality, they are almost 100% correlated. The FX market is too efficient not to arbitrage out any price discrepancies. The futures price includes the forward rates of currency pairs.

Generally, futures prices are quoted as the US dollar versus the currency – in other words, a futures price is the inversion of the spot rate, plus the swap price to the maturity date. Again, this is not as complicated as it sounds.

Where to trade is a matter of choice and both the OTC and the futures markets have their merits. But the OTC market does offer more flexibility and it is generally cheaper to trade in.

Advantage of FX Trading

24 Hour Market

FX is a global market that never sleeps. It is active 24-hours a day for almost 7-days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe, until the US market closes on Friday evening.

Liquidity

The FX market is huge and it is still expanding. Daily average volume now exceeds US$ 3.2 trillion. Technology has made this market accessible to almost anyone and retail traders have flocked to FX.

Leverage

FX margin ratios tend to be higher than those available in equity because it is more liquid – there is nearly always a price in FX ­– and it tends to be less volatile.

Narrow Spreads

Spreads, the difference between the bid and offer price, in FX are miniscule. Just compare a 2-pip price in EUR/USD with a price in even the most active and liquid equity issue. Furthermore, FX prices are typically ‘good’ for far larger amounts than in equity. The spread is the hidden, ‘intrinsic’ cost of dealing and in FX it is minimal. Technology has made these tight prices available to almost everyone.

No Commission or Transaction Costs

The majority of OTC FX business is commission free and with such narrow spreads, the intrinsic cost of trading is far lower than in other assets, such as equity.

Profit potential regardless of market direction

FX is a pure market. Prices can just as easily go up as down. If a trader believes a currency is about to depreciate, there are seldom restrictions on selling it although if the position is held for more than one day, there is a cost of carry to consider. Profit potential exists in FX regardless of whether a trader is buying or selling and regardless of whether the market is moving up or down.

Equal Access to Market Information

Despite the introduction of best execution regulations in Europe and the US, few would disagree that professional traders and analysts in the equity market have a huge competitive advantage in comparison to individual traders. In FX, perhaps the only advantage the big banks have is flow information. But FX is a democratic market where virtually all participants have access to the same market moving information as everyone else.