The ChoosaBroker Trading Academy

How the Foreign Exchange Market Works

It would be difficult to overstate the importance of foreign exchange markets for the global economy. They affect employment and output through real exchange rates; impact inflation through the cost of imports; and influence international capital flow through the returns and risks of the different assets. Justifiably, foreign exchange rates are a major focus for government policymakers, the general public, and of course the media. To understand currency exchange rates it is essential to know how the market operates and how these prices are determined. In this lesson, we will learn:

  • What is the Currency Exchange Market?
  • Functions of Currency Market
  • Participants in the Foreign Exchange Market
  • What Happens at the Foreign Exchange Market?

Foreign Currency Exchange Market Defined

The currency exchange market is a globally decentralized marketplace for trading foreign currencies. This includes buying, selling or exchanging the different currencies at ongoing or pre-determined rates. Currencies are traded in an “over the counter” market, where the brokers negotiate directly with one another, without the presence of any central exchange or clearing house. Federal governments and central banks, asset managers, multinational corporations and individual speculators are the various market participants. The main trading centres include London, New York, Tokyo, Singapore and Hong Kong.

The most popular currency market instruments are listed below:

1. Spot Currency

  • A spot currency trade represents a “direct exchange” between two underlying currencies. It is the most common type of currency transaction.

2. Currency Futures

  • Futures, in general, are contracts to buy or sell a specific asset at a pre-defined price on a future date. Currency futures are standardized financial instruments that are traded on a centralized exchange.

3. Currency Options

  • A currency option is another derivative instrument that gives the buyer the right but not the obligation to buy or sell an underlying currency at a defined price on the date of expiration of the options contract.

4. Currency ETF

  • Currency exchange traded funds are constructed and managed by financial institutions, which buy and hold the underlying assets in a fund. Shares of such ETFs are then listed on an exchange, where the public can buy and sell them just like stocks.

Functions of Currency Market

The three main functions of currency market are detailed below:

1. Transfer of Funds

  • – The most basic function of the currency market is to aid in the transfer of funds from one country to another for the settlement of payments. For example, if an importer in the United States buys crude oil from Canada and the payment is to be made in U.S. Dollars, then the conversion of Canadian Dollar to U.S. Dollar will be facilitated by the currency market. The market forces of demand and supply will decide what the exchange rate shall be, and the importer can then make the payment through the use of credit instruments such as bank drafts or bills of foreign exchange.

2. Facilitating Credit

  • – The foreign currency market provides short-term credit to importers and exporters. For example, a German importer wanting to buy electronic goods from Japan can pay for the purchase by issuing a bill of exchange in the foreign currency market, typically with a three-month maturity. The three-month window enables the importer to take possession of the goods, sell them and obtain money to pay the bill off.

3. Hedging Tool

  • – The currency market plays an important role in hedging foreign exchange risks. Suppose two parties enter in to a transaction that involves staggered payments in British Pounds. Since currency rates fluctuate in response to the demand-supply situation, both the parties are at risk that the Pound might move against them when the time comes to make the payments. To mitigate this risk, people or institutions that deal in foreign currencies, often shield themselves by buying or selling currency futures contracts that come inbuilt with an agreed upon price.

Players in the Foreign Exchange Market

The major participants in the currency market can be classified in to three broad categories:

1. Financial Institutions

  • Financial institutions are a disparate group that includes central banks, commercial banks, broker-dealers, hedge funds and other asset managers. Compared to the other market participants, financial institutions tend to trade larger amounts and hold their foreign currency positions for relatively longer periods of time. Since financial institutions use foreign currencies primarily as a store of value, they stand to gain or lose according to future fluctuations in the underlying currency’s value.

2. Corporates

  • Multinational corporations use the Forex markets to support the treasury operations related to their core business ventures. These corporates pre-dominantly use foreign currencies as a medium of exchange, because of which, they trade in relatively smaller amounts, with holding periods that are also brief. Most corporate participants do not engage in speculative trading – in fact some firms explicitly prohibit it. Multinational corporations typically only use the foreign currency markets for one side of each exposure. For example, a U.S. firm with operations in France will need EUR to pay taxes in that country. To do so, it will sell USD to buy EUR in the Forex market and then deliver the currency directly to the French government.

3. Speculators, Hedgers and Arbitrageurs

  • Speculators are traders who buy and sell foreign currency to earn profit by correctly forecasting the future movements in the currency. Speculators do not have any genuine requirement for holding on to foreign currencies. This is facilitated by Forex brokers who are often based accross the globe such as Interactive Brokers, IG markets and Pepperstone.

  • Hedgers are essentially traders who take part in currency trading because they have assets or liabilities in foreign currencies. Hedgers utilize the Forex market to hedge the risk associated with volatility in foreign exchange prices.

  • Arbitrageurs buy and sell the same currency at two different markets whenever there arises any price discrepancy, in anticipation that the “law of one price” will dissolve the differential. Arbitrageurs play a key role in ensuring that currency market prices move in tandem across the globe.

How Does the Forex Market Work?

The major participants in the currency market are the large international banks. Hubs like London and New York attract the widest range of sellers and buyers. Since a currency always trades in pair, the market doesn’t denote any absolute value to the currency. It instead determines its value relative to another currency. The first currency in any pair is the BASE CURRENCY, which is quoted relative to second currency, also known as the COUNTER CURRENCY. For example, the value of GBP/USD signifies how many U.S. Dollars are needed to purchase one British Pound.

The currency market functions on several tiers. At the very top is the inter-bank market, made up of the biggest commercial banks. These banks, in turn, rely on smaller financial firms called “dealers”, who themselves are involved in transacting huge volumes of the major currency pairs. Trades between these dealers can amount to billions of dollars. The dealers are connected to each other through electronic communication networks. Since currency trading is beyond the scope of geographical boundaries, there is no single regulatory authority supervising the activities in the market.

Key Facts

  • The U.S. Dollar is the most representative currency, with more than 60% of the reserves held by the world´s central banks being greenback-denominated.
  • The Dollar is followed by the Euro, the currency in which close to 24% of the world´s international reserves are denominated.
  • The Japanese Yen and the British Pound account for 5.40% and 5.60%, respectively.

Final Thoughts

  • The foreign exchange market is the world’s largest and most liquid financial market, with average daily turnover of US$ 3.20 trillion. The rapid growth of electronic trading networks has made currency trading more accessible than any time in the past, thereby offering a world of opportunities to both traders and investors who are willing to put the effort to understand its inner dynamics. If you are planning to start trading, there are a number of brokers who are best for beginner day traders.