The Foreign Currency Exchange Market

Also known as the spot currency or forex market, the foreign currency exchange market is the largest market in the world, consisting of about $1.9 trillion in transactions every day. It is different from other markets not only because of its tremendous volume but also because of its extreme liquidity. The forex market is an over the counter, or decentralized market. This means that traders may choose from a number of dealers to make a trade with, as opposed to the stock market for example, in which all trades of a particular stock must pass through one point. This allows for much more price competition. The market is essentially composed of six types of participants: commercial and investment banks, central banks, corporations, global funds, and retail clients (individual traders). Commercial and investment banks trade on what is known as the interbank market and make up the largest portion of forex trading. They trade for themselves as well as for their customers, and balance accounts by trading with each other. Central banks, large corporations, and hedge funds all trade on the interbank system as well. As the largest investors in forex, and with their well-established credit relationships, the members of the interbank system trade with the best rates. About three quarters of the daily volume of the forex market is exchanged in the interbank system. Central banks function in the forex market as regulatory agencies with the responsibility of maintaining their countrys money supply, and therefore do not speculate. Some directly influential actions they take include setting overnight lending rates, buying and selling government securities to adjust the size of the money supply, and buying/selling their own currency in the open market to influence interest rates. The main uses of the forex market for corporations are hedging against currency depreciation to protect future transactions and buying/selling currencies to pay international employees. Global managed profit-seeking funds generate a lot of volume in the forex market through foreign financial investments. They constitute about 20% of total market volume. Individuals account for the rest, using the forex market mostly for speculative purposes and sometimes to hedge. Because of online retail dealers, individuals can participate in forex trading under similar conditions as those on the interbank level; spreads are only slightly wider and execution is just as easy and effective. Foreign currency trading on the retail level is based on speculation on changes in the exchange rate between two currencies. Changes in the exchange rate are due to changes in the value of each currency relative to the other in the pair, and are measured in points in percentage, or pips. The foreign currency exchange market is a global market, in operation every week from Sunday at 5:00pm EST to Friday at 4:00pm EST. In every trade, one currency in the pair is borrowed in order to buy the other, typically in lots of 100,000 units each. Currencies and actions are chosen in expectation of a particular outcome. This expectation is usually derived using two kinds of analysis of the market: technical and fundamental. Technical analysis refers to the use of various statistical studies of charts of the past behavior of any currency pair in order to predict future movement. Fundamental analysis involves the use of different economic indicators as well as all

news with the potential of influencing the forex market to predict future movements of exchange rates. The chances for profit are equal regardless of whether an exchange rate is increasing or decreasing, as long as the appropriate corresponding action is taken. For every currency pair there is a bid and an ask price. The bid is the price at which a trader can sell the currency pair, and the ask is the price at which the trader can buy it. The difference between the bid and the ask is known as the spread, and is the cost of the trade, or the amount that the trade will have to make to break even. Trades are made on margin, with a minimum requirement of 1%. This allows for much more leverage than other markets, as well as security against losses. It may be said that the history of the forex market began with the origin of the global freefloating currency system. This originated with the Bretton Woods Accord, held in 1944 in New Hampshire, attended by delegates from Great Britain, France, and the United States. The conference was held with the intention of creating a post-World War II global environment in which all the ravaged economies of Europe could rebuild. The outcome of the accord was the International Monetary Fund (IMF), an aid agency, and the pegging of the major currencies to the US dollar, the only major currency left unharmed by the war. This action did bring stability back to Europe, although it ultimately collapsed. Similar agreements were made in its place, though with the new intention of ending the dependence of European currencies on the US dollar. By 1973 these too had failed, marking the conversion to a free-floating system, which was mandated in 1978. By 1993 there were no longer any agreements at all, allowing all currencies to move independently. During the 1980s computers and other technology made substantial new developments that had a significant impact on the forex market, for example by increasing the speed with which international transactions could be made. Jumping from nearly a billion dollars a day in the 1980s to almost $1.9 trillion a day now, the forex market has experienced major growth in recent years. Subsequent progression in the process of globalization has also been influential, as large corporations employ more people internationally (and therefore must exchange currency to pay them) and the economic policy of different nations becomes increasingly interrelated.

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The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.[1] The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.[2]

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of

its huge trading volume, leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit margins with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements,[3] as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. The $3.98 trillion break-down is as follows:

$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

Top 10 currency traders [6]

% of overall volume, May 2010 Rank Name Market share 1

11.30% 3

Barclays Capital 11.08% 4 HSBC 4.55% 8

Citi 7.69% 5

Deutsche Bank 18.06% 2 UBS AG Royal Bank of Scotland 6.50% 6 Goldman Sachs 4.28% 10 Morgan

JPMorgan 6.35% 7 Stanley 2.91%

Credit Suisse 4.44% 9

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Foreign Exchange Market
Need of Foreign Exchange: 1. Consumers generally come into the fray to foreign exchange when they travel one place to another. They either go to bank or a foreign exchange bureau to exchange one currency into another currency.

2. When there is some business which needs to operate from other countries too than this type of foreign exchange system comes into play. 3. Sometimes investors require currency exchange whenever they are doing any foreign investment or any real state investment. 4. All banks i.e. Commercial and Investment Banks trade currencies as a service for their commercial banking, deposit and lending customers base. The main participants of the foreign exchange market are listed below: Commercial banks Exchange markets Central banks Firms engaged in foreign trade transactions Investment funds Broker companies Private persons Commercial banks play an important role in exchange currency transactions. Other participants of the market have their accounts in the commercial banks which conduct necessary conversion transitions. Banks fulfills the need of market in exchange of distributing and calling money, breaking with it into new banks. Exchange markets do not have definite space and also do not have definite working hours. with the development of telecommunications most of the leading financial institutions of the world use services of exchange markets directly and via mediators 24 hours a day. Central banks control the currency exchange rate and regulate the interest investment rate in the national currency. US Central bank , FED has the greatest influence in the foreign exchange market. Firms which engaged in foreign exchange business have a stable demand of foreign currency and supply. According to rule imposed they do not have direct access to the foreign exchange market. They conduct their business through commercial banks. Investment funds- These companies, represented by various international investment,

mutual funds, insurance companies, and trusts, realize the policy of diversified management of portfolio of assets by placing there money in securities of the governments and corporations of different countries. Broker companies bring together buyers and sellers of foreign currency and start a conversion process after dealing with them. According to rule, in the foreign exchange market there is no fee as a per cent on the sum of a transaction, or as a sum agreed in advance. A broker company, which contains sound information about the rates, is a place where the real exchange rate is formed according to closed deals. Private persons realize a wide range of transactions in the area of foreign trade, tourism, pension, royalities etc. this is also the biggest group involved into such transactions. Foreign Exchange Rates: relative value between the two currencies is termed as foreign exchange rate. It is the quantity of one currency required to buy or sell one unit of the other currency. There are two common methods to express a foreign exchange rate. The most important method to expresses the amount of any currency is to buy one U.S. dollar. For example, a foreign exchange quote expressed as USD/CND at 1.5300 means that one U.S. dollar can be exchanged for 1.53 Canadian dollars. Another method is just the reverse of first one. Any foreign exchange rate is expressed as a whole number integer followed by four decimal points. In order to purchase some land or to buy a specific products from other firms residing in other countries, you need foreign currency. The Foreign Exchange Market, or "Forex" market, is where the most of buying and selling activity of currencies takes place. The Forex market is by far the largest financial market in the world with trading volumes surpassing USD 1.4 trillion on an average. The very large commercial banks are the major traders in this market. There are various online resources available through which you can gather information about foreign exchange. Also foreign exchange market is unique because of its volume, liquidity of market, large number of traders , long trading hours and variety of factors that affects foreign exchange rates. The foreign exchange market was originated in year 1973. Prior to first World War the Foreign exchange markets were stable .After World War I, the Foreign exchange markets increased tenfold with speculative activity. The biggest counter attack and the removal of the gold standard in 1931 created a serious problem in Foreign exchange market activity. From 1931 till 1973, the Foreign exchange market went through many changes as we observed today. As there are a lot of advantages of using foreign exchange market for their own purpose but still it has some risk as well. However, for an educated and experienced investor, foreign exchange markets proved to be a great way to diversify your portfolio and enjoy trading gains.

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Foreign Currency Market

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their countrys currency or in U.S. dollars, which are accepted all over the world. When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi riyals, even though the United States is not involved in the transaction. The foreign exchange market, or the FX market, is where the buying and selling of different currencies takes place. The price of 1 currency in terms of another is called an exchange rate. The market itself is actually a worldwide network of traders, connected by telephone lines and computer networksthere is no central headquarters. There are 3 main centers of trading, which handle the majority of all FX transactionsUnited Kingdom, United States, and Japan. Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day during the weekdays. In the United States, trading begins Sunday evening and ends on Friday evening. From Friday evening to Sunday evening, most banks are closed throughout the world, and since banks are the main traders and dealers of currency, there is very little activity over the weekends. Indeed, trading activity in a particular currency and, hence, its liquidity, is largely determined by how many banks are open that trade in that currency. During the weekdays, trading progresses in waves as major banks open and close. At 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day. The foreign exchange market is a 24/5 marketmost currency trading occurs 24 hours per worldwide business day. The trading week starts when Monday morning first arrives in New Zealand and ends when it is late afternoon on Friday in San Francisco. Since New Zealand is just across the International Dateline, it is still Sunday in most of the world when it is Monday morning in New Zealand. So, for someone living on the east coast in the United States, the currency markets start opening about 5 p.m. Eastern Standard Time on Sunday.
The International Dateline is where, by tradition and fiat, the new calendar day starts. Since New Zealand is a major financial center, the forex markets open there on Monday morning, while it is still Sunday in most of the world.

Source: United States Naval Observatory.

The FX market is fast paced, volatile and enormousit is the largest market in the world. In 2001 on average, an estimated $1.21 trillion was traded each dayroughly equivalent to every person in the world trading $195 each day. More statistics on the foreign exchange market: Bank for International Settlements: International Financial Statistics.

Percentages of FX Transactions by Country for April, 2001. (Countries with less than 1% are not shown in the chart.)

Source: New York Federal Reserve Bank.

Foreign Exchange Market Participants

There are 5 types of market participantsbanks, brokers, customers, retail forex traders, and central banks.
1. Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies among themselves. Roughly 2/3 of all FX transactions involve banks dealing directly with each other. 2. Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profits by charging a commission on the transactions they arrange. 3. Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries. 4. The Internet has allowed individuals to trade currencies using their home computers, hoping to make a profit from speculation, and this is a growing, albeit small, percentage of the trading volume. 5. Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands every day, the activity of these participants constantly affects the value of every currency in terms of every other.

Foreign Exchange Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

For the import and export needs of companies and individuals; to hedge existing positions; to profit from the short-term fluctuations in exchange rates; for direct foreign investment; and to purchase foreign financial securities.

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they predict the market correctly, they can profit from it; otherwise, they'll probably lose. Traders make money by purchasing currency and selling it later at a higher price, or, anticipating that a currency is heading down, selling it short, then buying it back at a lower price later. To predict long-term movements of currencies, traders often use fundamental analysis to try to determine whether the currencys price reflects its fundamental value in terms of current economic conditions of the involved countries and how those economic conditions are changing. Examining inflation, interest rates, and the relative strength of the countries' economies helps them make a determination. If they determine that a currency is underpriced, then the trader will expect the price to rise, but if it is overpriced, then the currency will probably decrease in value with respect to another currency. However, fundamentals are difficult to quantify and there are many variables to consider, especially when the fundamentals of both countries of the currency pair must be examined, which must be done to forecast their relative value. Furthermore, fundamentals have a limited effect on price in the short term of most speculative forex trades, which is measured in minutes or hours between the time when a trader buys or sells and when she closes out her position. Hence, many traders use technical analysis to try to determine future prices in the next few minutes or hours, or sometimes, days. Technical analysis is the examination of recent prices and trading volumes in the hope of seeing a chart pattern that, in the past, has led to a certain change in prices more often than not. Although some traders use technical analysis to predict long-term prices, long-term changes in prices will be dictated by fundamentals.

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in 2 waysthrough a broker or directly with each other.

Brokers

If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About 1/3 of transactions are arranged in this way.
Direct

Mostly, banks deal with each other directly. A trader makes a market for another by quoting 2 prices: the price at which he is willing to buy and the price at which he is willing to sell. The difference between the 2 price quotes is the spread, and is usually less than 10 pips. (1 pip = 1/10,000th of a currency unit for most currencies.) Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal 1 unit of those currencies. The currencies of the worlds large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by 4 currencies: the U.S. dollar, the Euro, the Japanese yen and the British pound. Together these account for over 80% of the market. It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Types of Transactions
There are different types of FX transactions: spot transactions, forwards, futures, swaps, and options. Spot transactions are an immediate trade, while forwards, futures, swaps, and options allow traders to manage risk or to profit from speculation over an extended time period.
Spot Transactions

This type of transaction accounts for almost 1/3 of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.
Example Spot Transaction 1. A trader calls another trader and asks for a price of a currency, say British pounds. This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell. Otherwise, the other trader may skew her price in her favor if she knew specifically what the other wanted.

2. The second trader provides the first trader with prices for both buying and selling (2-way price). 3. When the traders agree to do business, one will send pounds and the other will send dollars.

By convention the payment is actually made 2 days later, but next day settlements are used as well, especially for the Canadian and U.S. dollar pair. Although spot transactions are popular, they leave the currency buyer exposed to some financial risks. Exchange rate fluctuations can effectively raise or lower prices, making financial planning difficult for both companies and individuals.
Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan. Tools will be ready in 6 months and will cost 120 million yen. At the time of the order, the yen is trading at 120 to a dollar. The U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,000 yen with 120 yen per dollar = $1,000,000) . However, the yen per dollar rate will almost certainly be different 6 months later. Suppose the yen per dollar drops to 100 yen per dollar: Cost in U.S. dollars would increase (120,000,000 / 100 = $1,200,000) by $200,000. Conversely, if the yen per dollar goes up to 140 yen to a dollar: Cost in U.S. dollars would decrease (120,000,000 / 140 = $857,142.86) by over $142,000. One alternative for a company is to pay for the foreign goods right away to avoid the exchange rate risk, but this creates an opportunity cost equal to the interest that could be earned on the money during the interim.

Forward Transactions
One way to deal with FX risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller calculate a forward exchange rate that depends on the current exchange rate, the difference in interest rates between the 2 countries, and the date on which the exchange will take place. The date can be a few days, months, or years in the future, but in most cases, the time period is less than 1 year. Because a forward contract is negotiated between the parties, it is customized to their needs, especially in regard to the amounts involved and the date of settlement. Since a forward transaction is a direct transaction between the buyer and seller of currency in the over-thecounter (OTC) market, there is some credit risk that one of the parties will default on the transaction.

Futures
Foreign currency futures are forward transactions with standard contract sizes and maturity dates and are traded on organized exchanges. The buyer and seller of the futures contract does not have to be concerned about the creditworthiness of the other party, because the exchange becomes the intermediary of the transaction with the seller selling to the exchange and the buyer buying from the exchange. The exchange takes on the credit risk of the transaction. There is also greater price transparency and liquidity, because there are many more traders for the standardized contracts. Another advantage of futures over forwards is that a position in a futures contract can be closed out before the settlement date by buying or selling the offsetting contract. Because forwards are individually negotiated contracts, it would be difficult for either party to offset their position.

Currency Swaps
The most common type of forward transaction is the currency swap. In a swap, 2 parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.
Example Currency Swap Transaction

Suppose a U.S. company needs 12 million Japanese yen for a 3 month investment in Japan. It may agree to a rate of 120 yen to a dollar and swap $100,000 with a company willing to swap 12 million yen for 3 months After 3 months, the U.S. company returns the 12 million yen to the other company and gets back $100,000, with adjustments made for interest rate differentials. In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that is not affected by any changes in the market rates. A currency swap allows the market participants to plan more safely, since they know in advance what their currency exchange will cost. It also allows them to avoid an immediate outlay of cash.
Percentages of FX Transactions by Type for April, 2001.

Source: New York Federal Reserve Bank.

Options
Most forwards and futures require performance at a specified time. An option is similar to a forward or futures transaction, but it gives its owner the right, but not the obligation, to buy or sell a specified amount of foreign currency at a specified price, called the strike price, at any time up to a specified expiration date. Options differ from currency futures because the option holder can just let the option expire if, on the expiration date of the option, it is out of the money. At the expiration of a futures contract, the futures buyer would have to accept delivery of the currency, and the futures seller would have to actually deliver the currency, unless it is a cashsettled contract, in which case the seller would have to pay to the buyer the equivalent value in a specified currency. A call option allows the holder to buy currency at the strike price. A put option allows the holder to sell currency at the strike price.
Example Option

Suppose a trader purchases a 6-month call on 1 million euros at 0.88 U.S. dollars to a euro. During the 6 months the trader can either purchase the euros at the 0.88 rate, or purchase them at the market rate. After 6 months, the option expires.

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