The Foreign Exchange Market

The foreign exchange market, also known as the forex, FX, or currency market, involves trading one currency for another.

Prior to 1996 the market was confined to large corporate banks and international corporations. However, it has since opened up to include all traders and speculators. Today, the average daily turnover in forex markets is US $5.1 trillion, according to the Bank of International Settlement’s Survey.

In trading foreign exchange, investors bet that one currency will either appreciate or depreciate compared to another; they profit when they bet correctly and collect profit from the trade.

Most forex trading takes place in London, New York and Tokyo, with most trading activity in London, which dominates the market at 37% of all transactions. New York’s market share is 20% and Tokyo has fallen to 6% due to the growing prominence of Hong Kong at 7% and Singapore 8%.

The various players in the foreign exchange market include financial institutions, who account for 51%, reporting dealers account for 42% and non-financial customers account for 7%.

One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using cash as opposed to a contract.

In a forward transaction, the money is not exchanged until an arranges date and an exchange rate is agreed in advance. The time-period ranges from days to years.

Currency swaps are a popular type of forward transaction; these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later date.

Another type is a foreign currency future, which is inclusive of interest.

A standard contract is drawn up and a maturity date arranged. The time schedule is about three months.

In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction depends on the availability of option contracts on an organised exchange.

Otherwise, such forex deals may be carried out using an over-the -counter (OTC) contract.

Advantages

The forex market is extremely liquid, hence its rapid growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.

As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart from weekends.

An investor needs only a small amount of capital compared with other investments. Forex trading is outstanding in this regard.

It is an unregulated market, meaning that there is no trade commission over-seeing transactions and there are no restrictions on trade.

In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.

Disadvantages

The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.

Investors need a lot of capital to make good profits because the profit margins on small-scale trades are very low.