Also known as the spot currency or forex market, the foreign currency exchange market is the largest market in the world, consisting of about $1.9 trillion in transactions every day. It is different from other markets not only because of its tremendous volume but also because of its extreme liquidity. The forex market is an over the counter, or decentralized market. This means that traders may choose from a number of dealers to make a trade with, as opposed to the stock market for example, in which all trades of a particular stock must pass through one point. This allows for much more price competition.
The market is essentially composed of six types of participants: commercial and investment banks, central banks, corporations, global funds, and retail clients (individual traders). Commercial and investment banks trade on what is known as the ‘interbank’ market and make up the largest portion of forex trading. They trade for themselves as well as for their customers, and balance accounts by trading with each other. Central banks, large corporations, and hedge funds all trade on the interbank system as well. As the largest investors in forex, and with their well-established credit relationships, the members of the interbank system trade with the best rates. About three quarters of the daily volume of the forex market is exchanged in the interbank system.
Central banks function in the forex market as regulatory agencies with the responsibility of maintaining their country’s money supply, and therefore do not speculate. Some directly influential actions they take include setting overnight lending rates, buying and selling government securities to adjust the size of the money supply, and buying/selling their own currency in the open market to influence interest rates.
The main uses of the forex market for corporations are hedging against currency depreciation to protect future transactions and buying/selling currencies to pay international employees. Global managed profit-seeking funds generate a lot of volume in the forex market through foreign financial investments. They constitute about 20% of total market volume. Individuals account for the rest, using the forex market mostly for speculative purposes and sometimes to hedge. Because of online retail dealers, individuals can participate in forex trading under similar conditions as those on the interbank level; spreads are only slightly wider and execution is just as easy and effective.
Foreign currency trading on the retail level is based on speculation on changes in the exchange rate between two currencies. Changes in the exchange rate are due to changes in the value of each currency relative to the other in the pair, and are measured in points in percentage, or pips. The foreign currency exchange market is a global market, in operation every week from Sunday at 5:00pm EST to Friday at 4:00pm EST. In every trade, one currency in the pair is borrowed in order to buy the other, typically in lots of 100,000 units each. Currencies and actions are chosen in expectation of a particular outcome. This expectation is usually derived using two kinds of analysis of the market: technical and fundamental. Technical analysis refers to the use of various statistical studies of charts of the past behavior of any currency pair in order to predict future movement. Fundamental analysis involves the use of different economic indicators as well as all news with the potential of influencing the forex market to predict future movements of exchange rates. The chances for profit are equal regardless of whether an exchange rate is increasing or decreasing, as long as the appropriate corresponding action is taken. For every currency pair there is a ‘bid’ and an ‘ask’ price. The bid is the price at which a trader can sell the currency pair, and the ask is the price at which the trader can buy it. The difference between the bid and the ask is known as the ‘spread,’ and is the cost of the trade, or the amount that the trade will have to make to break even. Trades are made on margin, with a minimum requirement of 1%. This allows for much more leverage than other markets, as well as security against losses.
It may be said that the history of the forex market began with the origin of the global free-floating currency system. This originated with the Bretton Woods Accord, held in 1944 in New Hampshire, attended by delegates from Great Britain, France, and the United States. The conference was held with the intention of creating a post-World War II global environment in which all the ravaged economies of Europe could rebuild. The outcome of the accord was the International Monetary Fund (IMF), an aid agency, and the pegging of the major currencies to the US dollar, the only major currency left unharmed by the war. This action did bring stability back to Europe, although it ultimately collapsed. Similar agreements were made in its place, though with the new intention of ending the dependence of European currencies on the US dollar. By 1973 these too had failed, marking the conversion to a free-floating system, which was mandated in 1978. By 1993 there were no longer any agreements at all, allowing all currencies to move independently.
During the 1980s computers and other technology made substantial new developments that had a significant impact on the forex market, for example by increasing the speed with which international transactions could be made. Jumping from nearly a billion dollars a day in the 1980s to almost $1.9 trillion a day now, the forex market has experienced major growth in recent years. Subsequent progression in the process of globalization has also been influential, as large corporations employ more people internationally (and therefore must exchange currency to pay them) and the economic policy of different nations becomes increasingly interrelated.
