Foreign Exchange (Forex)

The foreign exchange (Forex or FX) market is one of the most liquid exchange markets in the world. Similarly based on buying and selling at a profit as other trading mechanisms, the FX market is one of the largest exchange markets in the world with a daily trading total of approximately $3.9 trillion (AUD). Noted as reference points, the American stock exchanges trade less than $160 billion (AUD) per day, and bond market traffic tallies slightly over $296 billion (AUD) daily.

The foreign exchange market was developed in the 1970s with the intent to encourage and assist international trade and investment. Lightly regulated, the over-the-counter (OTC) currency exchange has grown in scope and popularity primarily from the 1990s on.

Because all currency is available for OTC trading, the Forex market is global in nature. Over 5000 trading institutions around the world compose the market base. Trading brokerages, domestic national banks, and international banks monitor and trade currency 24 hours a day, Monday through Friday. There is no centralised location for the FX—no building or street address. Major trading centres, however, are Paris, Frankfort, London, Singapore, New York City, Hong Kong, and Tokyo—where the majority of Forex trading is conducted via the telephone or the Internet. However, anyone anywhere on the planet can engage in Forex trading.

Forex Cornerstone Organisations

As noted above, major traders in the foreign exchange market are generally larger financial institutions or commercial enterprises. Through brokers and brokerage houses individual investors can engage in currency trading, but bulk purchase influence is generally claimed by a core group forming the foundation of this high-volume market. Unlike stock exchanges, the Forex market is divided into levels of access. The largest group comprises the larger commercial banks and securities dealers engaging in interbank market.

Central Banks
Central banks attempt to control the currency supply, inflation, and even interest rates; central banks may have unofficial target rates for their nations' currencies. Most central banks stockpile foreign currency and often attempt to stabilise exchange rates and trading volumes by withholding or releasing volumes of currency to best suit their needs. The actual end result of 'stabilising speculation' is debatable, because national banks do not go bankrupt as other trading institutions can; therefore, they have little at risk beyond a profit margin.

Commercial Companies
Commercial enterprises comprise only a small portion of actual trading entities, but they represent not other countries investing in countries but businesses—job, trade, import, and export of goods and services—that have potential economic impact overseas. While a commercial interest can invest in a foreign nation's currency, that trade or purchase does not guarantee that it will contract to purchase goods, it can indicate faith in that country's ability to deliver or absorb goods or services—its economy's future.

Commercial Banks
Large commercial banks can trade billions of dollars daily. Most of their trading revolves their own financial reserves and future, some trading is conducted on behalf of their own customers.

Commercial banks, like private trading houses or brokerages, that trade on behalf of customers gain revenue by transaction fees, either per currency unit traded or by a set charge per transaction. In those instances the banks gain, regardless of whether their customers follow suit. Obviously, however, the banks trading offices prefer to maintain their trading customers and endeavour to keep those accounts in the black.

Additional Traditional Investors
Several other groups or organisations invest heavily in the foreign exchange market. Their motivations may differ, but the goals are identical: Make the best, most profitable currency trade as possible. They include:

  1. Hedge Fund Speculators: A hedge fund manager speculates and invests based on what may happen to the invested currency within a particular time frame. Never intending to take possession of the purchased currency, the hedge fund speculator attempts to predict in what direction the exchange rate of the incoming currency will be and attempt to sell it before rates drop or hold until rates improve.
     
  2. Investment Management Firms: In a thumbnail explanation, investment management firms generally control large amounts of investment funds, such as pension funds or money market funds. They use the investment funds to invest in currency exchanges in hopes of growing the base funds amounts and paying profit dividends as determined by the funds' operating by-laws.
     
  3. Retail Brokers: The two types of retail foreign exchange brokers—brokers and dealers, also called market makers.
     
    Brokers serve the interests of individual investors, whether the investor is a single person or a single business. They charge a commission on each transaction, whether selling or buying and regardless of transaction profit or loss for the customer.
     
    Dealers or market makers, on the other hand, act on their own behalf and declare rates which they are willing to pay in sought-after transactions. Others have the choice of accepting or declining the transaction offer.
     
  4. Foreign Exchange Companies (Non-Bank): These organisations offer currency trades and international payments to companies and to private individuals. While called exchange brokers, they do not speculate on future currency prices or trading. They facilitate other-currency payments from entities in one country to entities in another country, often businesses, for a fee.
     
  5. Money Transfer/Remittance Companies: Money transfer companies rely on high-volume, low-balance money transfers from one country occupant to another. The transfer company invests in the receiving country's currency to enable remitting the transferred amount in local currency. One of the best known money transfer companies is Western Union.

Determining Currency Exchange Rates

Called Forex fixing, each nation's central or national bank, sets its country's exchange rate every weekday morning; that rate reflects the actual value of equilibrium of the country's currency and is often used to evaluate faith in the market. Foreign exchange traders use fixed rates as trend indicators and make investment decisions on those trends.

Several factors determine a nation's currency value. Ideally, a currency rests at its equilibrium—a stable currency balance. Every nation attempts to maintain a stable currency reserve. Those with trade deficits will spend more of its reserve to purchase needed goods and services. When the reserves drop, the currency value drops as well. Inflation rises as a result, and when inflation outstrips buying power, a country often prints more currency which may cause an additional drop in its exchange rate, however temporarily.

After an interim period expensive imports are forced to reduce which also reduces the amount of currency spent and which increases the nation's currency reserve. The country executes the import limitations in hopes of rebuilding its currency reserve, increasing its exchange value, and improving its equilibrium again.

Countries can gain what some consider an unfair advantage on the international market by deliberately undervaluing its currency. A low exchange rate reduces the cost of exports but raises the price of imports, requiring an increase in domestic spending.

Currency Pairs

All foreign exchange rates are based on two currencies—the base or home currency and the exchange currency of a different country. For example, the currency pair of American dollars to Australian dollars compose one currency pair. The Australian dollar to the Russian Ruble composes another currency pair. The British Pound and the Euro is yet another currency pair.

The difference in worth from one pair element to another composes the exchange rate between the two. On Monday, for example, the Australian dollar may be worth 1.2 American dollars or 5.6 Japanese yen, or 120 Mexican pesos. On Tuesday, the Australian dollar may be worth less or more against each other paired currency, depending on economy, interest rates, inflation, or any other aspect that influences exchange rate.

The currency pair is always rated in relation to only each other. The Australian dollar against the Japanese yen is not directly influenced by the Mexican peso against the Japanese yen.

Forex fixing by the central or national banks affect currency pairing exchanges, as noted above.

Foreign Exchange Options

A foreign exchange option is exactly that—a choice. The options holder holds the right to exchange currency at a contract rate at or by a designed time. The owner is by no means required to, however. If the option is activated, the terms have been predetermined and cannot be changed. Declining to activate the option has no directly assigned penalty.

Foreign Exchange Market Vocabulary

When researching and trading on the foreign exchange market, understanding the terminology is imperative. Some common terms and their definitions include:

  1. Cross: The standard of foreign exchange, cross trading is exchanging one currency for another.
  2. Pip or Point: Short for 'proportion in points,' a Pip equates to 0.0001 currency unit or one-hundredth of one percent. It is also considered the minimum amount for which a currency can be exchanged.
  3. Bid: The declared amount at which a buyer is willing to purchase currency.
  4. Ask: The price at which a buyer can purchase currency. Also called an offer price.
  5. Spread: The difference between a bid price and an asking price.
  6. Offset Currency: The second currency listed in a currency pair.
  7. Day Trade: Short-term purchasing and selling, not to exceed one day.
  8. Overseas Exchange: Alternate name for Foreign Exchange.
  9. Leverage: The relation of the deposited total to the quantity of currency it can purchase. Leverage figures adjust according to targeted currency and rate of exchange.
  10. Limit Array or Limit Orders: The predetermined minimum and maximum price limits for transactions. The orders list the minimum sell prices and the maximum purchase prices.
  11. Liquidity: The ability to sell currency assets in the Forex market. It is a benchmark of interest in trading that currency at any given moment.
  12. Margin: The smallest amount required before a depositor can start trading. It is also the minimum amount required to open a Forex account.
  13. Stop Loss Array or Order: A predetermined stop point for trading, intended to limit risk exposure.
  14. Spot Trading: Buying foreign currency for immediate delivery instead of a later delivery.
  15. Forward Contract: A non-standard contract between two parties to later purchase a specified quantity of a specific currency at a currently delineated price. The forward or delivery price is the predetermined purchase price.

    The advance arrangements require the buyer to take a long position, hoping that in the long run, the purchased currency will be worth more than the delivery price. The seller assumes a short position, hoping the later value of the currency will be lower than the delivery price.
  16. Forward Premium: Also called the Forward Discount, it is the difference between the spot price and the forward price or delivery price and is measured as a profit or loss from the buyer's standpoint.
  17. Forex Swap: A simultaneous transaction involving an immediate purchase of one currency and the delayed sale of another currency at two different value dates. A Forex swap most often involves a spot sale and a forward contract.

Trading Patterns

Although there are several trading centres in the world, three are considered peak interest locations—Tokyo, New York City, and London.

The Forex market consistently experiences fluxes in currency values and in trading cycles. Typically, the primary flux periods are during business hours for each city, and liquidity against those currencies within that global region is greater during the peak activity times for each.

Because trading is conducted over-the-counter and around the clock, an investor may miss peak opportunities presented when not monitoring the FX market. Understanding limitations in trading times may help plot trading forecasts and strategies.

Forex Market Summary

Once basic principles and terminology are understood, practice investing and market trend observations enable quick learning and boost an investor's chances of successfully trading foreign currency. However, as with other investment tools, currency trading encompasses risk, whether investing only minimal amounts or millions of dollars.

Whether engaging in FX trading for one importation of goods transaction or as a speculative investment venture, careful consideration of timing, pricing, conditions, value, and volume all play their parts in determining whether foreign exchange trading is a viable possibility or not. It can be highly profitable, but hesitating even a moment too long can cause financial disaster if highly invested.