What is Forex Market and How Can We Trade It?

The Foreign Exchange Market (currency, Forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.

The purpose of the Forex market is to help international trade and investment. A Forex market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars.

In a typical Forex transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern Forex market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The market is unique because of:

-          Forex trading volumes,

-          The extreme liquidity of the Forex market,

-          Forex geographical dispersion,

-          Long Forex trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),

-          The variety of factors that affect Forex currency exchange rates.

-          The low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

-          The use of leverage by Forex brokers

-          Forex markets trend well when liquidity is good.

As such, Forex has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements, average daily turnover in global Forex markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main Forex market turnover was broken down as follows:

-          $1.005 trillion in spot transactions

-          $362 billion in outright forwards

-          $1.714 trillion in Forex swaps

-          $129 billion estimated gaps in reporting

There is no unified or centrally cleared market for the majority of Forex trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded.

This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London Forex market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main Forex trading centre is London, but New York, Tokyo, Hong Kong and Singapore are all important centres as well. Banks throughout the world participate. Forex currency trading happens continuously throughout the day; as the Asian trading session ends, the European and London Open sessions begin, followed by the US Open/North American session and then back to the Asian session, excluding weekends.

Fluctuations in Forex rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major Forex news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies in Forex thus constitutes an individual product and is traditionally noted XXXYYY or YYY/XXX, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EURUSD or USD/EUR is the price of the Euro expressed in US dollars, as in 1 Euro = 1.5465 Dollar. Out of convention, the first currency in the pair, the "base" currency, was the stronger currency at the creation of the Forex pair. The second currency, counter currency or "term" currency, was the weaker currency at the creation of the pair. Currencies are occasionally incorrectly quoted with the pairs inverted e.g. EUR/USD but this is incorrect. The "/" acts the same as the divide mathematical operator and derives the actual exchange rate. e.g. an amount of $140,000 equates to €100,000. $140,000/€100,000 = $/€ = USD/EUR = a rate of 1.4 hence EURUSD or USD/EUR.

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.

On the spot Forex market, according to the BIS study, the most heavily traded products were:

-          EURUSD: 27%

-          USDJPY: 13%

-          GBPUSD (also called Sterling or Cable): 12%

The US currency was involved in 86.3% of Forex transactions, followed by the Euro (37.0%), the Yen (17.0%), and Sterling (15.0%). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.

Forex trading in the Euro has grown considerably since the currency's creation in January 1999, and how long the Forex market will remain dollar-centered is open to debate. Until recently, trading the Euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot Forex market. As the Dollar's value has eroded during 2008, interest in using the Euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

A spot Forex transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot Forex market. Spot Forex transactions have the second largest turnover by volume after Swap transactions among all Forex transactions in the Global Forex market.

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