Forex/Currency Basics

What is currency market #

  • The currency market (foreign exchange market/Forex market/FX market) is the market for trading currencies.
  • In a currency transaction, a party purchases some quantity of one currency by paying for some quantity of another currency.
  • The currency market determines the relative values of currencies.

Market size and liquidity #

The foreign exchange market, also known as FOREX, is a highly traded market with an average daily volume of over $5 trillion.

A large portion of the FOREX market is driven by speculative activity, particularly by institutional traders such as hedge funds, investment banks, and proprietary trading firms, as well as by retail traders.

Largest and most liquid financial market in the world. (volume of trading) #

  • According to the Bank for International Settlements
    • In 1998, average daily turnover was 1.7 trillion.
    • As of April 2007 daily volume was 3.21 trillion.
    • As of April 2010, average daily turnover was estimated at $3.98 trillion,
      • $1.490 trillion in spot transactions
      • $475 billion in outright forwards
      • $1.765 trillion in foreign exchange swaps
      • $43 billion currency swaps
      • $207 billion in options and other products
    • Trading in forex markets averaged $5.3 trillion per day in April 2013.(Foreign exchange swaps, $2.2 trillion per day; spot trading $2.0 trillion per day in April 2013)

Foreign exchange trading volume by country #

  • Rank in 2010: UK(36.7%),US(17.9%),Japan(6.2%)
  • Rank in 2013: UK(41%), US(19%),Singapore(5.7%),Japan(5.6%),Hong Kong(4.1%)
  • Currently The biggest geographic trading center is UK, primarily London.

Trading characteristics #

Uniqueness of forex market #

  • Largest financial market & Largest asset class in the world with huge trading volume, therefore highest liquidity
    • liquidity means how quick an asset can be converted into cash)
      • This means 1 a trader can enter or exit the market easily in almost any market condition.
      • 2 Almost instantaneous transactions.
    • Almost impossible to manipulate. No one can corner the market.
  • 24 hours continuous operation except weekends,from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
  • A large part of trading volume come from real world demand. Countries/Institutions/Corporations need to trade currencies regularly for various reasons.
  • Low Barriers to Entry
    • Free demo account
    • Very low minimum deposit
    • Micro Accounts
  • Low transaction cost
  • Allow very low Margin & high leverage
    • High leverage is a sword that may cut both ways
      • It can increase profit potential but is at the same time dangerously risky.
      • Risk can be managed and reduced. Forex can be less riskier than other market, if you choose lower leverage and learn how to manage risk.
  • Geographically decentralized; No central exchange or clearing house. An over-the-counter(OTC) market where brokers/dealers negotiate directly with one another
  • Limited cross-border regulation.
    • because there is no centralized location or exchange
  • No insider trading. Major news that affect the exchange rates is released publicly(often on scheduled dates). Traders receive the same news at the same time.
  • Trading opportunities. You can long or short a currency pair as per the market movement

Market participants #

  • Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail traders.
  • It is important to note that the behavior and agendas of these different participants and owners of the infrastructure can vary significantly.

Forex market have several levels depend on the amount of money traded. #

  • The higher the level, the lower the spreads(bid ask difference).
  • At The top level is the interbank market(which consists of largest commercial banks and securities dealers, and accounts for 39% of all transactions in 2010).
  • At the relatively lower level are smaller banks, large multi-national corporations , large hedge funds, and some retail market makers.
  • Retail traders are at the lowest level.

Central banks and governments #

  • Central banks and governments also play a role in the FOREX market through their monetary policies and regulations.
  • They are entities that become involved in the market mainly for political and stabilization purposes.

National Central banks #

  • Have substantial foreign exchange reserves to stabilize the market.
  • Have target rates for their currencies.
  • Will try to control the money supply, inflation, interest rates.
  • Often, the rumor of a central bank foreign exchange intervention might be enough to stabilize a currency. Aggressive intervention might be used when needed.
  • The effectiveness of their intervention is uncertain. The market can easily overwhelm any central bank.

Businesses/corporations, pension funds & hedge funds #

Businesses and corporations, as well as pension funds and hedge funds, are considered fundamental participants in the FOREX market. These entities make investment decisions based on fundamental economic reasons and for genuine business purposes.

Commercial companies / Exporters and Importers #

  • Any firm that partakes in exports or imports
  • Commercial companies and multinational corporations need foreign exchange to pay for goods or services.
  • Multinational corporations also need to hedge risk and pay employees in different countries.

Hedge funds #

  • Hedge funds have a reputation for aggressive currency speculation. They control and borrow billions of dollars, which may overwhelm intervention by central banks.

Investment management firms #

  • They need to acquire the currency of the foreign country to makes investments in a foreign country.
  • For example, an investment manager having an international equity portfolio might need foreign currencies to pay for foreign securities purchases.

Investment banks & retail banks #

Investment banks and retail banks also play a significant role in the market as owners of the infrastructure, facilitating transactions for the main participants.

Investment banks, retail banks, and retail brokers are considered the owners of the market infrastructure. These entities facilitate transactions for the fundamental participants.

Retail brokers & exchanges #

  • Their primary role is to facilitate transactions for retail traders.
  • While they may also conduct some institutional business with hedge funds, this represents a very small portion of their overall activity.
  • It is common for retail brokers to clear the majority of their business through investment banks.
  • Retail brokers facilitate the trades of retail traders and may provide them with access to leverage and other resources.

Non-bank foreign exchange companies, Money transfer/remittance companies and bureaux de change #

  • Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country.
  • Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.
  • Money transfer/remittance companies and bureaux de change can be considered as a subcategory of retail participants in the foreign exchange market.
  • These entities typically facilitate small-scale foreign currency transactions for individuals and small businesses, such as sending money abroad or converting currency for travel purposes.

Retail traders & speculators #

  • Retail traders participate in the forex market for speculative reasons, typically with the goal of making a profit through buying and selling currencies.
  • In contrast, businesses and corporations, pension funds, and hedge funds participate in the market for fundamental reasons, such as to hedge currency risk or to facilitate international trade and investment.
  • Retail traders often have less capital and less knowledge of the market compared to these other types of participants.