Forex is a loose acronym for Foreign Exchange Market that originated in
the 1970s around the time free currency exchange rates were introduced
in the world. In forex markets, market participants determine the price
of one currency against the other purely from market forces stemming
from supply and demand. There are no external controls in a forex market
and is perhaps the best example of a perfect market with free
competition. Forex is also the biggest liquid financial market in the
world, with market volumes ranging in 1-3 trillion US Dollars a day.
The US Dollar, Euro, Japanese Yen, British Pound and Swiss Francs are the major currencies traded in forex markets.
Little Bit Of History
The foreign exchange markets as we see today have evolved through the
gold exchange period, followed by the Bretton Woods Agreement, to its
current setting. Although by 1973, the major industrialized nations'
currencies were floated more freely across nations, coinciding with
currency prices being quoted daily, it was only due to the advent of
computers and technology in the 1980s that the market reaches for
cross-border forex trading gained momentum extending through Asian,
European and American time zones. Gradually over the years foreign
exchange transactions increased intensively to all the facets we see
today in forex markets worldwide.
Today advances in computer technology have permitted the instantaneous
transmission and receipt of currency prices across the world. These
technological advances in computer networks are the primary reason
behind the growth of forex trading amongst ordinary investors.
How Does Forex Market Works?
To understand how forex markets work, one has to understand what exactly
constitutes the forex market, the institutional framework that drives
this market, and importantly the process of currency price
determination.
Foreign exchange market is no different from any other market where
buyers and sellers meet to buy or sell a commodity for a specific price.
The only difference in forex markets being, it is the “currency” that
constitutes the commodity, and the price at which it is exchanged
conforms to the foreign exchange rate for that currency at that point in
time.
Export earnings of corporations, overseas remittances, and investment
flows (direct or borrowed capital) constitute the main sources of
foreign exchange. Individuals and entities who receive foreign currency
are the primary market suppliers and they may sell foreign currency to
licensed exchange dealers who in turn may pass it to other dealers in
need of foreign exchange. The Central banks may sell foreign reserves to
make market adjustments, and on the other side companies would need to
buy this foreign exchange to make overseas payments. This creates a
market for foreign exchange wherein a person may sell a currency today
and probably emerge as a buyer the very next day.
Forex Market Framework
The biggest foreign exchange markets are in Tokyo, London and New York
and they are networked with each other using modern technology creating a
seamless interface that transacts currency prices and deals almost
instantaneously across the world. The institutional framework that
drives the forex markets is perhaps the key to the market itself and
comprises the following:
- Commercial and Central banks in different countries
- Exchange markets and firms that conduct foreign exchange deals
- Investment funds
- Brokerages and individuals
By transacting with different clients in exchange conversions,
commercial banks accumulate a great chunk of forex market needs and are
often shared with other banks in interbank dealings. These banks (Union
Bank of Switzerland, Swiss Bank Corporation, Deutesche Bank, and
Citibank) with daily volume of transactions in billions of dollars
greatly influence forex markets. Central Banks as for example the US
Federal Reserve influence forex markets by regulating the investment
climate and making market interventions and so on.
Exchange Rate
Exchange rate is a market-determined phenomenon. In other words, the
exchange rate depends on supply and demand conditions in the market for
any particular currency. A currency exchange rate is derived from the
‘spot transactions’ (means foreign exchange trades that are initiated
and settled within two business days with the respective exchange) of
authorized dealers with the public.
This exchange rate that is reported in the price tickers that you see on
your trading screen reflect the cumulative transactions undertaken by
the major market makers (namely the institutions) with large value
transactions reflecting more on the currency prices than a small value
transaction. That’s probably one of the reasons why currency prices keep
changing on your screen reflecting the rate at which the major market
maker’s i.e. the institutions trade.
Advantages of Forex Over Other Markets
The Forex market offers many advantages, over stock market trading and
other forms of investment opportunity. In forex markets financial
reasons compel the execution of a forex deal and not commercial
considerations. Also as compared to stock markets, exchange markets do
not operate out of any specific building.
In forex it is not obligatory to buy a currency to sell it later but it
is enough to open buy/sell position for any currency without actually
possessing it, unlike stock trading where you are committed to have the
full face value of the stock before you can trade for that amount of
stock.
Although Forex markets can be volatile at times, it offers an advantage
over a declining stock market, in that with proper knowledge of forex
markets you could still key into profitable trades. On the contrary,
people tend to avoid stock markets when it is in a downward spiral as no
one really knows when it would start on an upward trend. In other words
forex trades can be made even if the markets were rising or falling.
The profits you could possibly make in stock markets pales into
insignificance in comparison to the windfall profits you could be making
in forex markets. For example proper leverage alone can make you huge
sums in a very short time and that too by making fewer trades.
The limited number of currencies traded in forex markets makes it easier
to monitor market trends that relate to those currencies, whereas in
the stock market a lot of factors could affect individual stocks, not to
mention the innumerable number of stocks (there are several thousand
stocks registered in most stock exchanges) that would have to be
monitored at any given point in time.
Although it has its own trends and cycles punctuated by high volatility,
forex markets don’t fit into the traditional Bull/ Bear market cycle
typical of stock trading. That is because currency rates always throw in
new intriguing ways of making profit. For example, interest rates do
not adversely affect currency markets as it would stock market indices
and stocks in general. When interest rates go up, that country’s
currency gets strengthened (giving profitable opportunities to the
discerning trader) whereas it would depress stock markets in that
country and probably cause losses to a stock trader having several open
positions.
Comparison of size and liquidity, and market time
It is impossible to quantify the exact amount of money traded in forex
markets worldwide since trading is not restricted to one single exchange
or location. But several estimates put it between 1-3 trillion US
Dollars a day. This is certainly lesser than the volume of stocks traded
in all the major stock exchanges around the world and also far less
than the gold and forex reserves of the developed world. It also far
exceeds the daily volume of foreign trade transactions between different
countries. Therefore in terms of size, number of participants and
liquidity, forex markets are huge and offer the best opportunities to
the investor.
This superior liquidity in forex markets allows traders to open and
close positions in a matter of a few seconds or keep that position going
on for several years or perhaps indefinitely which is not possible
while trading stocks.
Using networked computers, forex trading offers you a world wide market,
instantaneously available to you on 24/5 basis from 00:00 GMT on Monday
to 10.30 GMT on Friday covering all time zones. When the sun sets in
one trading center, it is dawn and the beginning of a trading day
somewhere else in the world. On the contrary, stock market in any major
country opens at 10 am local time and remains operative till 4p.m local
time restricting the possibility of indulging in round the clock
trading.
Forex trading is done strictly on your calling. Since forex trading goes
on 24 hours a day there is no need to have a fixed schedule, and even
if you set one, it’s purely your discretion based on your own trading
strategy and of course to your liking.
