The term foreign exchange market refers to the world’s largest financial market where world currencies are bought and sold against one another. Unlike the commodity and stock markets, it is not a physical market based in one building or location. Rather, it is an organizational framework, within which participants linked by telephone and computers buy and sell currencies. The most popular definition of foreign exchange market is: “an inter-bank and an inter-dealer market for exchange of national currencies between different countries”. With the advent of international trade and the absence of an international monetary unit, one of a nation’s prime concerns is the rate at which its own local currency can be exchanged for units of a foreign currency. This system of global trading in foreign currency is known as the Foreign Exchange Market, or Forex.
In comparison to the average daily trading volume of $300 Billion in the US Treasury Bond market and the less than $10 Billion exchanged in the US stock markets, the Forex market trades to the tune of more than $1.6 Trillion a day. It is by far the largest and most liquid market in the world.
Most Forex transactions occur via telephone links and computer terminals located in and out of the world’s major financial centers. Traditional participants in the entire process are financial institutions, banks, corporate customers, brokers, etc. Forex is a global market and it is unlike any other market. It operates on a 24-hour basis with a break during the weekend.
The major traded currencies on the foreign exchange market are Euro, Swiss Franc, US Dollar, Sterling, Japanese Yen, and Australian Dollar. Using technical and fundamental analyses the investor can make large profits by participating on this global market.
The market runs 24 hours a day in the major financial centers around the world. Actual currency is not seen; instead, it is transferred electronically from one bank deposit account to another. The Forex market is an over-the-counter (OTC) market. This means that all of the following are negotiable between the two counterparties in the market:
What is an Exchange Rate ?
As in other markets, the interaction of sellers and buyers (supply and demand) establishes the market price of a currency. The market price of a currency is its exchange rate, the price of one currency expressed in terms of another currency.
Any foreign exchange transaction involves the purchase and sale of two currencies. An exchange rate is interpreted as the price of one currency in terms of another, as well as the reverse. When you buy currency A against currency B, you also sell currency B against currency A. Let’s say, for example, that the US dollar/euro exchange rate is at 1.05, that is, one dollar is worth 1.05 euros. This means that for every dollar sold, you can buy 1.05 euros. The reverse is also true: 1.05 euros buys one dollar.
The Importance of the FX Market
There are two main reasons why the FX market exists today: international trade and hedging, and speculative dealing.
International Trade and Hedging
Companies involved with the movement of goods and services across national boundaries are active in the foreign exchange market. They need to exchange currencies, and to protect themselves from exchange rate movements. This is known as hedging your FX exposure. Such companies may also use the foreign exchange market to repatriate profits from other currencies to their home or base currency.
Speculative dealing occurs when dealers believe opportunities exist to make profits from exchange rate movements. For example, if a speculator expects the US dollar to appreciate against the Japanese yen, he will buy the US dollar against the yen and then try to sell it at a higher price, thus making a profit. In a dealing room, aside from quoting to customers, dealers speculate on exchange rates with a view to making profits for the bank.
The greatest percentage of all deals on the foreign exchange market is of a speculative nature.
The Size of the Foreign Exchange Market
The foreign exchange market is enormous. In terms of size and liquidity, the FX market far exceeds even the largest domestic markets such as the US stock market or the US futures market. The size of the market is determined every three years. Central banks and monetary authorities around the world measure the activity in the foreign exchange market during the month of April. They submit their findings to the Bank for International Settlements (BIS), which then produces the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity.
The most recent analysis conducted in April 2001 found that the average daily turnover in the FX market was almost USD 1,200 billion. Compared to activity of USD 1,490 billion recorded in April 1998, this represents a 19% decline at current exchange rates.