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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.
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.
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
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, 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
size and liquidity
foreign exchange market is the largest and most liquid
financial market in the world. Traders include large
banks, central banks, institutional investors, currency
speculators, corporations, governments, other financial
institutions, and retail investors. The average daily
turnover in the global foreign exchange and related
markets is continuously growing. According to the
2010 Triennial Central Bank Survey, coordinated by
the Bank for International Settlements, average daily
turnover was US$3.98 trillion in April 2010 (vs $1.7
trillion in 1998). Of this $3.98 trillion, $1.5 trillion
was spot foreign exchange transactions and $2.5 trillion
was traded in outright forwards, FX swaps and other
in London accounted for 36.7% of the total, making
London by far the most important global center for
foreign exchange trading. In second and third places
respectively, trading in New York City accounted for
17.9%, and Tokyo accounted for 6.2%.
of exchange-traded foreign exchange futures and options
have grown rapidly in recent years, reaching $166
billion in April 2010 (double the turnover recorded
in April 2007). Exchange-traded currency derivatives
represent 4% of OTC foreign exchange turnover. FX
futures contracts were introduced in 1972 at the Chicago
Mercantile Exchange and are actively traded relative
to most other futures contracts.
developed countries permit the trading of FX derivative
products (like currency futures and options on currency
futures) on their exchanges. All these developed countries
already have fully convertible capital accounts. A
number of emerging countries do not permit FX derivative
products on their exchanges in view of controls on
the capital accounts. The use of foreign exchange
derivatives is growing in many emerging economies.
Countries such as Korea, South Africa, and India have
established currency futures exchanges, despite having
some controls on the capital account.
exchange trading increased by 20% between April 2007
and April 2010 and has more than doubled since 2004.
The increase is turnover is due to a number of factors:
the growing importance of foreign exchange as an asset
class, the increased trading activity of high-frequency
traders, and the emergence of retail investors as
an important market segment. The growth of electronic
execution methods and the diverse selection of execution
venues have lowered transaction costs, increased market
liquidity, and attracted greater participation from
many customer types. In particular, electronic trading
via online portals has made it easier for retail traders
to trade in the foreign exchange market. By 2010,
retail trading is estimated to account for up to 10%
of spot FX turnover, or $150 billion per day (see
retail trading platforms).
foreign exchange is an OTC market where brokers/dealers
negotiate directly with one another, there is no central
exchange or clearing house. The biggest geographic
trading centre is the UK, primarily London, which
according to TheCityUK estimates has increased its
share of global turnover in traditional transactions
from 34.6% in April 2007 to 36.7% in April 2010. Due
to London's dominance in the market, a particular
currency's quoted price is usually the London market
price. For instance, when the IMF calculates the value
of its SDRs every day, they use the London market
prices at noon that day.
OTC, non organized
Real estate market
Banks and banking
v d e
a stock market, the foreign exchange market is divided
into levels of access. At the top is the inter-bank
market, which is made up of the largest commercial
banks and securities dealers. Within the inter-bank
market, spreads, which are the difference between
the bid and ask prices, are razor sharp and usually
unavailable, and not known to players outside the
inner circle. The difference between the bid and ask
prices widens (from 0-1 pip to 1-2 pips for some currencies
such as the EUR). This is due to volume. If a trader
can guarantee large numbers of transactions for large
amounts, they can demand a smaller difference between
the bid and ask price, which is referred to as a better
spread. The levels of access that make up the foreign
exchange market are determined by the size of the
"line" (the amount of money with which they
are trading). The top-tier inter-bank market accounts
for 53% of all transactions. After that there are
usually smaller banks, followed by large multi-national
corporations (which need to hedge risk and pay employees
in different countries), large hedge funds, and even
some of the retail FX-metal market makers. According
to Galati and Melvin, Pension funds, insurance
companies, mutual funds, and other institutional investors
have played an increasingly important role in financial
markets in general, and in FX markets in particular,
since the early 2000s. (2004) In addition, he
notes, Hedge funds have grown markedly over
the 20012004 period in terms of both number
and overall size Central banks also participate
in the foreign exchange market to align currencies
to their economic needs.
interbank market caters for both the majority of commercial
turnover and large amounts of speculative trading
every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf
of customers, but much is conducted by proprietary
desks, trading for the bank's own account. Until recently,
foreign exchange brokers did large amounts of business,
facilitating interbank trading and matching anonymous
counterparts for large fees. Today, however, much
of this business has moved on to more efficient electronic
systems. The broker squawk box lets traders listen
in on ongoing interbank trading and is heard in most
trading rooms, but turnover is noticeably smaller
than just a few years ago.
important part of this market comes from the financial
activities of companies seeking foreign exchange to
pay for goods or services. Commercial companies often
trade fairly small amounts compared to those of banks
or speculators, and their trades often have little
short term impact on market rates. Nevertheless, trade
flows are an important factor in the long-term direction
of a currency's exchange rate. Some multinational
companies can have an unpredictable impact when very
large positions are covered due to exposures that
are not widely known by other market participants.
central banks play an important role in the foreign
exchange markets. They try to control the money supply,
inflation, and/or interest rates and often have official
or unofficial target rates for their currencies. They
can use their often substantial foreign exchange reserves
to stabilize the market. Nevertheless, the effectiveness
of central bank "stabilizing speculation"
is doubtful because central banks do not go bankrupt
if they make large losses, like other traders would,
and there is no convincing evidence that they do make
a profit trading.
fixing is the daily monetary exchange rate fixed by
the national bank of each country. The idea is that
central banks use the fixing time and exchange rate
to evaluate behavior of their currency. Fixing exchange
rates reflects the real value of equilibrium in the
forex market. Banks, dealers and online foreign exchange
traders use fixing rates as a trend indicator.
mere expectation or rumor of central bank intervention
might be enough to stabilize a currency, but aggressive
intervention might be used several times each year
in countries with a dirty float currency regime. Central
banks do not always achieve their objectives. The
combined resources of the market can easily overwhelm
any central bank. Several scenarios of this nature
were seen in the 199293 ERM collapse, and in
more recent times in Southeast Asia.
funds as speculators
70% to 90% of the foreign exchange transactions are
speculative. In other words, the person or institution
that bought or sold the currency has no plan to actually
take delivery of the currency in the end; rather,
they were solely speculating on the movement of that
particular currency. Hedge funds have gained a reputation
for aggressive currency speculation since 1996. They
control billions of dollars of equity and may borrow
billions more, and thus may overwhelm intervention
by central banks to support almost any currency, if
the economic fundamentals are in the hedge funds'
management firms (who typically manage large accounts
on behalf of customers such as pension funds and endowments)
use the foreign exchange market to facilitate transactions
in foreign securities. For example, an investment
manager bearing an international equity portfolio
needs to purchase and sell several pairs of foreign
currencies to pay for foreign securities purchases.
investment management firms also have more speculative
specialist currency overlay operations, which manage
clients' currency exposures with the aim of generating
profits as well as limiting risk. Whilst the number
of this type of specialist firms is quite small, many
have a large value of assets under management (AUM),
and hence can generate large trades.
foreign exchange brokers
traders (individuals) constitute a growing segment
of this market, both in size and importance. Currently,
they participate indirectly through brokers or banks.
Retail brokers, while largely controlled and regulated
in the USA by the CFTC and NFA have in the past been
subjected to periodic foreign exchange scams. To deal
with the issue, the NFA and CFTC began (as of 2009)
imposing stricter requirements, particularly in relation
to the amount of Net Capitalization required of its
members. As a result many of the smaller, and perhaps
questionable brokers are now gone.
are two main types of retail FX brokers offering the
opportunity for speculative currency trading: brokers
and dealers or market makers. Brokers serve as an
agent of the customer in the broader FX market, by
seeking the best price in the market for a retail
order and dealing on behalf of the retail customer.
They charge a commission or mark-up in addition to
the price obtained in the market. Dealers or market
makers, by contrast, typically act as principal in
the transaction versus the retail customer, and quote
a price they are willing to deal atthe customer
has the choice whether or not to trade at that price.
assessing the suitability of an FX trading service,
the customer should consider the ramifications of
whether the service provider is acting as principal
or agent. When the service provider acts as agent,
the customer is generally assured of a known cost
above the best inter-dealer FX rate. When the service
provider acts as principal, no commission is paid,
but the price offered may not be the best available
in the marketsince the service provider is taking
the other side of the transaction, a conflict of interest
foreign exchange companies
foreign exchange companies offer currency exchange
and international payments to private individuals
and companies. These are also known as foreign exchange
brokers but are distinct in that they do not offer
speculative trading but currency exchange with payments.
I.e., there is usually a physical delivery of currency
to a bank account. Send Money Home offers an in-depth
comparison into the services offered by all the major
non-bank foreign exchange companies.
is estimated that in the UK, 14% of currency transfers/payments
are made via Foreign Exchange Companies. These companies'
selling point is usually that they will offer better
exchange rates or cheaper payments than the customer's
bank. These companies differ from Money Transfer/Remittance
Companies in that they generally offer higher-value
transfer companies/remittance companies perform high-volume
low-value transfers generally by economic migrants
back to their home country. In 2007, the Aite Group
estimated that there were $369 billion of remittances
(an increase of 8% on the previous year). The four
largest markets (India, China, Mexico and the Philippines)
receive $95 billion. The largest and best known provider
is Western Union with 345,000 agents globally followed
by UAE Exchange & Financial Services Ltd.
Currency distribution of reported FX market turnover
Rank Currency ISO 4217 code
(Symbol) % daily share
?United States dollar
?Hong Kong dollar
?New Zealand dollar
Other Currencies 18.6%
is no unified or centrally cleared market for the
majority of FX trades, and there is very little cross-border
regulation. Due to the over-the-counter (OTC) nature
of currency markets, there are rather a number of
interconnected marketplaces, where different currencies
instruments are traded. This implies that there is
not a single exchange rate but rather a number of
different rates (prices), depending on what bank or
market maker is trading, and where it is. In practice
the rates are often very close, otherwise they could
be exploited by arbitrageurs instantaneously. Due
to London's dominance in the market, a particular
currency's quoted price is usually the London market
price. A joint venture of the Chicago Mercantile Exchange
and Reuters, called Fxmarketspace opened in 2007 and
aspired but failed to the role of a central market
main trading center is London, but New York, Tokyo,
Hong Kong and Singapore are all important centers
as well. Banks throughout the world participate. Currency
trading happens continuously throughout the day; as
the Asian trading session ends, the European session
begins, followed by the North American session and
then back to the Asian session, excluding weekends.
in exchange rates are usually caused by actual monetary
flows as well as by expectations of changes in monetary
flows caused by changes in gross domestic product
(GDP) growth, inflation (purchasing power parity theory),
interest rates (interest rate parity, Domestic Fisher
effect, International Fisher effect), budget and trade
deficits or surpluses, large cross-border M&A
deals and other macroeconomic conditions. Major news
is released publicly, often on scheduled dates, so
many people have access to the same news at the same
time. However, the large banks have an important advantage;
they can see their customers' order flow.
are traded against one another. Each currency pair
thus constitutes an individual trading product and
is traditionally noted XXXYYY or XXX/YYY, where XXX
and YYY are the ISO 4217 international three-letter
code of the currencies involved. The first currency
(XXX) is the base currency that is quoted relative
to the second currency (YYY), called the counter currency
(or quote currency). For instance, the quotation EURUSD
(EUR/USD) 1.5465 is the price of the euro expressed
in US dollars, meaning 1 euro = 1.5465 dollars. The
market convention is to quote most exchange rates
against the USD with the US dollar as the base currency
(eg USDJPY, USDCAD, USDCHF). The exceptions are the
British pound (GBP), Australian dollar (AUD), the
New Zealand dollar (NZD) and the euro (EUR) where
the USD is the counter currency (eg GBPUSD, AUDUSD,
The factors affecting XXX will affect both XXXYYY
and XXXZZZ. This causes positive currency correlation
between XXXYYY and XXXZZZ.
On the spot market, according to the 2010 Triennial
Survey, the most heavily traded bilateral currency
GBPUSD (also called cable): 9%
and the US currency was involved in 84.9% of transactions,
followed by the euro (39.1%), the yen (19.0%), and
sterling (12.9%) (see table). Volume percentages for
all individual currencies should add up to 200%, as
each transaction involves two currencies.
in the euro has grown considerably since the currency's
creation in January 1999, and how long the foreign
exchange market will remain dollar-centered is open
to debate. Until recently, trading the euro versus
a non-European currency ZZZ would have usually involved
two trades: EURUSD and USDZZZ. The exception to this
is EURJPY, which is an established traded currency
pair in the interbank spot market. As the dollar's
value has eroded during 2008, interest in using the
euro as reference currency for prices in commodities
(such as oil), as well as a larger component of foreign
reserves by banks, has increased dramatically. Transactions
in the currencies of commodity-producing countries,
such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
following theories explain the fluctuations in FX
rates in a floating exchange rate regime (In a fixed
exchange rate regime, FX rates are decided by its
(a) International parity conditions: Relative Purchasing
Power Parity, interest rate parity, Domestic Fisher
effect, International Fisher effect. Though to some
extent the above theories provide logical explanation
for the fluctuations in exchange rates, yet these
theories falter as they are based on challengeable
assumptions [e.g., free flow of goods, services and
capital] which seldom hold true in the real world.
(b) Balance of payments model (see exchange rate):
This model, however, focuses largely on tradable goods
and services, ignoring the increasing role of global
capital flows. It failed to provide any explanation
for continuous appreciation of dollar during 1980s
and most part of 1990s in face of soaring US current
(c) Asset market model (see exchange rate): views
currencies as an important asset class for constructing
investment portfolios. Assets prices are influenced
mostly by peoples willingness to hold the existing
quantities of assets, which in turn depends on their
expectations on the future worth of these assets.
The asset market model of exchange rate determination
states that the exchange rate between two currencies
represents the price that just balances the relative
supplies of, and demand for, assets denominated in
of the models developed so far succeed to explain
FX rates levels and volatility in the longer time
frames. For shorter time frames (less than a few days)
algorithm can be devised to predict prices. Large
and small institutions and professional individual
traders have made consistent profits from it. It is
understood from above models that many macroeconomic
factors affect the exchange rates and in the end currency
prices are a result of dual forces of demand and supply.
The world's currency markets can be viewed as a huge
melting pot: in a large and ever-changing mix of current
events, supply and demand factors are constantly shifting,
and the price of one currency in relation to another
shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world
at any given time as foreign exchange.
and demand for any given currency, and thus its value,
are not influenced by any single element, but rather
by several. These elements generally fall into three
categories: economic factors, political conditions
and market psychology.
include: (a)economic policy, disseminated by government
agencies and central banks, (b)economic conditions,
generally revealed through economic reports, and other
policy comprises government fiscal policy (budget/spending
practices) and monetary policy (the means by which
a government's central bank influences the supply
and "cost" of money, which is reflected
by the level of interest rates).
budget deficits or surpluses: The market usually reacts
negatively to widening government budget deficits,
and positively to narrowing budget deficits. The impact
is reflected in the value of a country's currency.
of trade levels and trends: The trade flow between
countries illustrates the demand for goods and services,
which in turn indicates demand for a country's currency
to conduct trade. Surpluses and deficits in trade
of goods and services reflect the competitiveness
of a nation's economy. For example, trade deficits
may have a negative impact on a nation's currency.
levels and trends: Typically a currency will lose
value if there is a high level of inflation in the
country or if inflation levels are perceived to be
rising. This is because inflation erodes purchasing
power, thus demand, for that particular currency.
However, a currency may sometimes strengthen when
inflation rises because of expectations that the central
bank will raise short-term interest rates to combat
growth and health: Reports such as GDP, employment
levels, retail sales, capacity utilization and others,
detail the levels of a country's economic growth and
health. Generally, the more healthy and robust a country's
economy, the better its currency will perform, and
the more demand for it there will be.
of an economy: Increasing productivity in an economy
should positively influence the value of its currency.
Its effects are more prominent if the increase is
in the traded sector.
Internal, regional, and international political conditions
and events can have a profound effect on currency
exchange rates are susceptible to political instability
and anticipations about the new ruling party. Political
upheaval and instability can have a negative impact
on a nation's economy. For example, destabilization
of coalition governments in Pakistan and Thailand
can negatively affect the value of their currencies.
Similarly, in a country experiencing financial difficulties,
the rise of a political faction that is perceived
to be fiscally responsible can have the opposite effect.
Also, events in one country in a region may spur positive/negative
interest in a neighboring country and, in the process,
affect its currency.
Market psychology and trader perceptions influence
the foreign exchange market in a variety of ways:
to quality: Unsettling international events can lead
to a "flight to quality," with investors
seeking a "safe haven." There will be a
greater demand, thus a higher price, for currencies
perceived as stronger over their relatively weaker
counterparts. The U.S. dollar, Swiss franc and gold
have been traditional safe havens during times of
political or economic uncertainty.
trends: Currency markets often move in visible long-term
trends. Although currencies do not have an annual
growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks
at longer-term price trends that may rise from economic
or political trends.
the rumor, sell the fact": This market truism
can apply to many currency situations. It is the tendency
for the price of a currency to reflect the impact
of a particular action before it occurs and, when
the anticipated event comes to pass, react in exactly
the opposite direction. This may also be referred
to as a market being "oversold" or "overbought".
To buy the rumor or sell the fact can also be an example
of the cognitive bias known as anchoring, when investors
focus too much on the relevance of outside events
to currency prices.
numbers: While economic numbers can certainly reflect
economic policy, some reports and numbers take on
a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate
impact on short-term market moves. "What to watch"
can change over time. In recent years, for example,
money supply, employment, trade balance figures and
inflation numbers have all taken turns in the spotlight.
trading considerations: As in other markets, the accumulated
price movements in a currency pair such as EUR/USD
can form apparent patterns that traders may attempt
to use. Many traders study price charts in order to
identify such patterns.
trading in foreign exchange
trading is growing in the FX market, and algorithmic
trading is becoming much more common. According to
financial consultancy Celent estimates, by 2008 up
to 25% of all trades by volume will be executed using
algorithm, up from about 18% in 2005.
A spot transaction is a two-day delivery transaction
(except in the case of trades between the US Dollar,
Canadian Dollar, Turkish Lira, EURO and Russian Ruble,
which settle the next business day), as opposed to
the futures contracts, which are usually three months.
This trade represents a direct exchange
between two currencies, has the shortest time frame,
involves cash rather than a contract; and interest
is not included in the agreed-upon transaction.
One way to deal with the foreign exchange 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 agree on an exchange
rate for any date in the future, and the transaction
occurs on that date, regardless of what the market
rates are then. The duration of the trade can be one
day, a few days, months or years. Usually the date
is decided by both parties. Then the forward contract
is negotiated and agreed upon by both parties.
The most common type of forward transaction is the
FX swap. In an FX swap, two parties exchange currencies
for a certain length of time and agree to reverse
the transaction at a later date. These are not standardized
contracts and are not traded through an exchange.
Foreign currency futures are exchange traded forward
transactions with standard contract sizes and maturity
dates for example, $1000 for next November
at an agreed rate ,. Futures are standardized
and are usually traded on an exchange created for
this purpose. The average contract length is roughly
3 months. Futures contracts are usually inclusive
of any interest amounts.
A foreign exchange option (commonly shortened to just
FX option) is a derivative where the owner has the
right but not the obligation to exchange money denominated
in one currency into another currency at a pre-agreed
exchange rate on a specified date. The FX options
market is the deepest, largest and most liquid market
for options of any kind in the world..
about currency speculators and their effect on currency
devaluations and national economies recurs regularly.
Nevertheless, economists including Milton Friedman
have argued that speculators ultimately are a stabilizing
influence on the market and perform the important
function of providing a market for hedgers and transferring
risk from those people who don't wish to bear it,
to those who do. Other economists such as Joseph
Stiglitz consider this argument to be based more on
politics and a free market philosophy than on economics.
hedge funds and other well capitalized "position
traders" are the main professional speculators.
According to some economists, individual traders could
act as "noise traders" and have a more destabilizing
role than larger and better informed actors.
speculation is considered a highly suspect activity
in many countries. While investment in traditional
financial instruments like bonds or stocks often is
considered to contribute positively to economic growth
by providing capital, currency speculation does not;
according to this view, it is simply gambling that
often interferes with economic policy. For example,
in 1992, currency speculation forced the Central Bank
of Sweden to raise interest rates for a few days to
500% per annum, and later to devalue the krona. Former
Malaysian Prime Minister Mahathir Mohamad is one well
known proponent of this view. He blamed the devaluation
of the Malaysian ringgit in 1997 on George Soros and
J. Millman reports on an opposing view, comparing
speculators to "vigilantes" who simply help
"enforce" international agreements and anticipate
the effects of basic economic "laws" in
order to profit.
this view, countries may develop unsustainable financial
bubbles or otherwise mishandle their national economies,
and foreign exchange speculators made the inevitable
collapse happen sooner. A relatively quick collapse
might even be preferable to continued economic mishandling,
followed by an eventual, larger, collapse. Mahathir
Mohamad and other critics of speculation are viewed
as trying to deflect the blame from themselves for
having caused the unsustainable economic conditions.
Risk aversion in forex
Chart showing MSCI World Index of Equities fell while
the US Dollar Index rose.
aversion in the forex is a kind of trading behavior
exhibited by the foreign exchange market when a potentially
adverse event happens which may affect market conditions.
This behavior is caused when risk averse traders liquidate
their positions in risky assets and shift the funds
to less risky assets due to uncertainty.
the context of the forex market, traders liquidate
their positions in various currencies to take up positions
in safe haven currencies, such as the US Dollar. Sometimes,
the choice of a safe haven currency is more of a choice
based on prevailing sentiments rather than one of
economic statistics. An example would be the Financial
Crisis of 2008. The value of equities across world
fell while the US Dollar strengthened (see Fig.1).
This happened despite the strong focus of the crisis
in the USA. (Credit: