Foreign Exchange Markets (FX)
The Foreign Exchange Market (commonly referred to as the Forex Market or FX) is the marketplace for global currency deals and is the largest and most liquid market globally. The Forex market provides a vehicle where one country’s currency can be exchanged for that of another country through a floating exchange rate system. The Forex market, unlike many other assets, has no fixed location, so as such, it is not a market in the traditional sense. Instead, the Forex market is an electronically run market based on the extensive network of hundreds of major banks and their global offices.
The foreign exchange market is a decentralized and over-the-counter market where all currency exchange trades occur. It is the largest (in terms of trading volume) and the most liquid market globally. The forex market’s major trading centres are located in major financial hubs worldwide, including New York, London, Frankfurt, Tokyo, Hong Kong, and Sydney. Despite the decentralized nature of forex markets, the exchange rates offered in the market are the same among its participants, as arbitrage opportunities can arise otherwise.
The foreign exchange market is probably one of the most accessible financial markets. Market participants range from tourists and amateur traders to large financial institutions (including central banks) and multinational corporations.
Also, the forex market does not only involve a simple conversion of one currency into another. Many large transactions in the market affect the application of a wide variety of financial instruments, including forwards, swaps, options, etc.
CENTRAL BANKS
Despite the size and importance of the foreign exchange market, it remains largely unregulated. No international organisation supervises it, not any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks occasionally intervened to maintain stability in the FX market.
ROLE OF CENTRAL BANKS
There is no standard definition for instability or a disorderly market – circumstances must be evaluated on a case-by-case basis. Sharp rapid fluctuation of exchange rates and traders’ reluctance to be ready to either buy or sell currencies may be signs of a disorderly market. To restore stability, the central banks often work together.
FACTORS AFFECTING FX RATES
Many factors can potentially influence the market forces behind foreign exchange rates. The factors include various economic, political, and even psychological conditions. The economic factors include a government’s economic policies, trade balances, inflation, and economic growth outlook.
Political conditions also significantly impact the forex rate, as events such as political instability and political conflicts may negatively affect the strength of a currency. The psychology of forex market participants can also influence exchange rates.
THE DIFFERENT TYPES OF FX TRADING?
Forex traders access the markets through financial products. Spot Forex, CFDs, futures and Spread Bets are the three main products traders use to access markets. For example, a trader can trade the EUR/USD market with a CFD product. The three products are similar as they all offer comparable margin levels and can be used to access nearly all currency pairs, but they have a few differences that we will explain below.
Spot Forex
Spot Forex is the name of the market and product, which are used interchangeably. This is simply the trader buying one currency and selling the other; 2 days later, the currencies settle into their accounts.
Spot vs cash Forex
You’ll hear the terms cash and spot Forex used regularly. They are very similar, but there is a slight difference. Cash Forex is the rate right now; spot Forex is the rate for delivery in 2 days. The latter factors in the cost of financing the respective currencies for 2 days. Forex traders will nearly always be trading the spot market’s price.
Traders will do this through their Forex broker or service provider. As part of its service, almost all Forex brokers will provide the trader with leverage; it will only require the trader to fund a small percentage of the currency positions taken on in their trading account.
Compared to the other two product types we’re about to introduce you to, the distinguishing feature of trading spot Forex is it is not a derivative. The trader is trading the underlying asset – the two currencies need to settle 2 days after the transaction (the broker will do this for you). This means that there does not need to be two legs of the trade (we did in our GBP/USD example). For instance, our trader going short £50,000 can cover this by buying £50,000 using another, better-priced currency pair.
The other reason to trade using spot Forex, not the other products, is scale. Big volume traders, we’re talking hedge funds here and not private traders, like to transact in the underlying market. That way, they know the price they got was ‘on market’ and not impacted by the trade size relative to the derivative product provider. Retail derivative brokers are set up to cater for flow business (lots of small trades) and not large lumpy transactions.
CONTRACTS FOR DIFFERENCE
Contracts for Difference (CFDs) represent a financial contract between a trader and their broker to exchange the difference between an asset’s opening price and the closing price. No underlying assets, in our case currencies, are exchanged. It is simply an agreement to exchange the price difference.
The real benefit traders get from trading CFDs is they can trade the price of pretty much anything with a verifiable price, including shares, indices, commodities, profit and the currency markets, all from one trading account.
SPREAD BETTING
A financial spread bet is a CFD wrapped up as a bet for tax reasons. With financial spread betting in the UK and Ireland, profits are generally tax-free.
There are some differences. Instead of trading contracts, traders specify an amount per point they want to bet on the price of an underlying asset. This is done in the account’s base currency, so the currency risk CFDs bring now gone – traders set their base currency when they open the account. Every time the price of the selected currency pair moves in your direction, you will gain your stake times the number of points by which the pair has moved in your favour and vice-versa.
A spread bet is an OTC derivative, and the trader does not own the underlying asset like with CFDs. To trade, the broker needs the trader to place a margin on the account, not requiring the trader to fully fund the value of the underlying asset being bet on creates leverage.
WHAT IS A FOREIGN EXCHANGE FUTURE?
Forex futures (unlike Forex spot transactions) are traded on regulated exchanges, and all transactions have standard contract sizes and maturity dates. Forex futures buyers and sellers must post initial margin or security deposits for each contract. Like all futures contracts, currency futures are defined as a standardised contract/agreement to buy or sell a specific amount of a currency at a particular price on a stipulated future date. As with all futures, the currency future is derived from the underlying product, which in this case is the currency cash market. Click on the toggles to learn more.
