Foreign Exchange, often referred to as Forex, is the exchange which takes place between two currencies, also known as the trading of currencies. The Forex market is by far the largest financial market one may come across. Trade generally takes place between National Banks, Central Banks, currency speculators, corporations, financial institutions, individuals and Governments.
The Forex market is one where currency trading takes place and its purpose is to facilitate trade and investment. The foreign exchange (Forex or FX) market is an over-the-counter (OTC) market. This means that it does not have a central exchange or clearing house that matches orders. There is no single exchange where all the trades are recorded. Instead, every market maker records its own transactions. The FX market is a means for companies to hedge currency risk, or to protect themselves against volatility in currency values.
Purchasing a quantity of one currency in exchange for a quantity of another is generally termed as Forex. Buying Euros when USD is stronger in value and then selling the Euro when it strengthens is a typical example of how a trade takes place. Not all benefit from this trade. It depends on how well one understands the markets and how well a strategy is planned. There are various indicators which help one analyse the Forex market. A thorough analysis of the past and present economic & political scenarios of the countries involved, also analysing the price trends and the volume of transactions helps one develop successful trading strategies.
Types of Foreign Exchange Markets
There are various types of Foreign Exchange markets depending on the type of trading activity.
Spot Market – a Foreign Exchange spot market usually refers to teh trading of securities or commodities (perishable and Non-perishable) for cash (price at the time of transaction) usually delivered immediately or within a short period of time. A spot Market for Forex has a delivery time of around 2 days.
Currency Arbitrage is making the most of the price differentials in various money markets by purchasing one currency in one market and selling it in another market.
Currency Speculation – holding a currency back after the purchase, speculating a price rise in the impending future.
Currency trading of Foreign Exchange Forward Contracts (cash market transaction with a post dated delivery) taking place ‘over the counter’ is known as a Forward Market.
A Foreign Exchange Futures market is actually an auctions market where the buyers and sellers trade contracts on a specified future date. Price is determined by the demand & supply conditions competing against buy and sell orders at the day and time of activity. This date is also know as the Delivery Date or the Final Settlement Date. The contract is obligatory to the trader of the delivery under the terms of the contract. A futures Market is also know as a derivatives market.
Forex Interbank Market
The primary market makers in the currency markets, who make bid and ask spreads, are the largest banks in the world. These banks deal with each other on a constant basis, via the Electronic Brokerage System (EBS), on behalf of their customers or themselves. Banks make their quotations available in this market to only those banks with which they trade and this market is not accessible to individual investors. The stiff competition between banks ensures fair pricing and tight spreads.
Although retail investors are not involved in the Interbank market, it is critical to understand the functioning of one, so as to determine that a broker is offering fair prices and to gain a better understanding of the pricing of retail spreads.
Pricing by Banks – How is it Done?
The factors that currency dealers consider to determine prices include volume available at the current price level, the current market rate, their account positions and their opinions on the direction of a specific currency pair. For example, if a bank dealer opines that the US dollar is likely to decline, they reduce the price at which they are willing to purchase dollars.
Forex Online Market Makers
Retail traders may access the FX market via online market makers that trade largely from the US and the UK. These market makers have a relationship with a number of banks on an EBS. Higher the trading volume of a market maker, greater the likelihood of it having an association with a larger number of banks and, consequently, more competitive are the quotations. Thus, it is extremely important for an individual investors to conduct an extensive analysis of a forex broker before making a choice.