The foreign exchange market and its function:
The objective of the foreign exchange market, or Forex, is to fix the currency exchange rates or the exchange rates between the different currencies, and in fact the Forex is the largest financial market in the world. According to official figures, the official daily transaction volume of this market is higher than that of all the other markets combined. The foreign exchange market is therefore considered as the largest but also the most liquid worldwide in terms of the volume of transactions.
To understand the advantages and particularities of the foreign exchange market it is essential to understand the spread of the floating exchange rate system throughout the world since the 1970s, as well as the technical progress such as the arrival on the market of high frequency trading software and continuous access to this market that have contributed to making the Forex the important foreign exchange market that it has become today.
Marketplace and opening hours of the Forex:
Despite the number of currencies around the world that it manages and where it calculates the quotes, the currencies market, or Forex, is an entirely decentralised and dematerialised market. This means that that the foreign exchange market is not reliant on a particular stock market. All operations and transactions completed on this market are OTC, or ‘over the counter’.
It is also possible to complete transactions on the Forex almost continuously, 24/7, which is not the case with other assets such as shares that are generally geographically fixed to a particular financial marketplace such as the stock markets in New York, Tokyo or Paris where the opening hours are defined by the opening and closing times of the market concerned.
However, and although the idea exists that the Forex market is open continuously, in fact it closes once a week during the time between the closing of the stock market at 10 p.m. on Friday night of the West Coast of the United States and the opening at 10 p.m. on Sunday evening of the Wellington stock market in New Zealand that begins the financial week. As the majority of banks are closed over the weekend the amount of transactions on the Forex market are relatively low on Saturday, Sundays and Bank Holidays.
It can also be advantageous to note that the foreign exchange market is however largely dominated by the City of London as it is on this marketplace that over a third of the global foreign exchange transactions take place. However we would also note that in recent years, the Asian financial marketplaces have risen in stature but are still smaller than that of London at present.
The different players on the foreign exchange market and their roles:
On the foreign exchange market we find different entities, acting in different ways. Here are details of the major players:
- The individuals and companies, often the SMEs and multinationals are of course present for selling and buying currencies according to their activities requirements.
- The banks including the commercial banks, investment banks and brokers execute orders on behalf of their clients and on their own account.
- The Central Banks and other financial authorities are also major players in the foreign exchange market as it is they that manage the monetary reserves and can intervene in the currency exchange rates that they are responsible for.
- Certain international institutions are also represented such as the IMF, the World Bank and the OECD.
- Finally, the investment funds also play a significant role and some of these funds are even specialised in currencies trading.
The major currencies on the Forex market:
Although all the currencies around the world are of course quoted on the foreign exchange market it is still the American, or U.S. Dollar, or USD that retains its position as the major and reference currency of this market. In fact the largest part of the transactions completed on this market concern this particular currency. It should however be noted that the Euro is in second position in this classification and is therefore the second most traded currency, right behind the American Dollar.
To understand the operation of the foreign exchange market you will also need to take into account the fact that the currencies quoted are in fact in pairs. Two currencies are implicated in each transaction completed on this market. One currency is purchased through the sale of another.
The currency pairs thereby formed are named according the actual currencies represented, for example the EUR/USD pair is the exchange rate of one Euro expressed in U.S. Dollars which is in fact the most traded worldwide. In fact, each year, this particular currency pair alone accounts for a nearly a quarter of all global transactions on the Forex.
The type of transactions completed on the foreign exchange market:
On the foreign exchange market we can observe spot transactions as well as futures contracts. The spot transactions are the most common on the market. These consist of buying a particular currency against another at the market price with a D + 2 delivery. The Spot market here represents around a third of the daily transactions on the foreign exchange market.
Futures consist of fixing the price, the amount and the future trading date at the time of the order. The usefulness of this type of transaction is that it offers a cover against fluctuations in the exchange rate. In this type of operation, whatever the true rate on the trading date, the transaction is completed according to the terms agreed at the time of the contract.
The different parties of the Forex therefore meet every day on this market as counterparts in transactions relating to cover positions or speculative transactions. The cover operations notably enable bankers and other financial entities to cover themselves against a fall in the Forex rate. For the companies, the Forex enables them for example to purchase commodities in a currency different to their own and cover themselves against an unfavourable currency exchange rate.
Finally, for the speculative operations, this means above all the buying of the currencies that you consider will rise against the other and thereby gain profits by selling these currencies at a later time. Whether it is businesses or entities, we can thereby better understand the advantages of futures transactions for the companies and entities that complete their activities on an international level.
It should also be noted that the contracts completed on the over the counter market are commonly called ‘forwards’ whereas the transactions completed on the futures markets are, as indicated, called ‘futures’. Certain other derived products such as swaps, currency options and other more structurally complex products enable the protection from exchange rate movements. The Swaps represent approximately half the transaction volume traded on the foreign exchange market at present.
As you have undoubtedly realised, the foreign exchange market enables certain players to protect themselves against the risks related to the exchange rates on their profits and expenses with the futures market but it can also enable speculation on the exchange rates of different currencies.
Covering and speculation on the foreign exchange market:
Numerous banks, entities and commercial banks operate on the foreign exchange market, mainly with the aim of covering their positions but other entities such as investment funds or investment banks complete speculative operations on their own account with the aim of making profits from the movements and rate changes on the Forex.
In fact, since the end of the fixed exchange rates which occurred in 1970, the volume of daily transactions on the foreign exchange market boomed before stabilising a few years ago. Nowadays, the currency pairs are considered by investors as financial assets, although a little apart, that like other assets can be used to make profits, or lead to losses, depending on the movements and trends of this market. The foreign exchange market is not truly a stock market, the derived products that have developed are the options and swops that have made it more attractive and highly popular with the speculative investors.
But speculating on the foreign exchange market is also important for the latter as it enables the guarantee of liquidity on the market. An investor can thereby cover themselves against a rise in the exchange rate by buying this currency but cannot do so unless the market offers a balancing or countering trade, that is to say by a seller of this currency.
Of course, speculating on the foreign exchange market, or Forex, can also be at the origin of strong movements for certain currency pairs, leading even to the provocation of certain economic crises requiring the intervention of the Central Banks.