Forex is an acronym for foreign currency exchange. Currency exchange is the process of changing one currency to another for a variety of reasons, usually for commerce, commerce or tourism. According to the 2016 triennial report of the Bank for International Settlements (a global bank for national central banks), the average was more than $ 5.1 billion in daily volume of exchange operations.
The currency market is the "place" where currencies are traded. Currencies are important for most people around the world, whether they realize it or not, because the currencies must be exchanged for business and foreign trade. If you live in the USA UU. And you want to buy cheese from France, you or the company from which you buy the cheese have to pay the French cheese in euros (EUR). This means that the US importer. UU. You would have to change the equivalent value of US dollars (USD) in euros. The same goes for traveling. A French tourist in Egypt cannot pay in euros to see the pyramids because it is not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.
A unique aspect of this international market is that there is no central market for currencies. On the contrary, currency trading is done electronically without a prescription (OTC), which means that all transactions are made through computer networks between merchants around the world, rather than in a centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the main financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney, in almost every time zone This means that when the trading day in the US ends. In the US, the foreign exchange market starts again in Tokyo and Hong Kong. As such, the currency market can be extremely active at any time of the day, with quotes that change constantly.
After the agreement at Bretton Woods in 1971, more important currencies were allowed to float freely against each other. The values of individual currencies vary, which has led to the need for currency exchange and trade services.
Commercial and investment banks do most of the trade in the currency markets on behalf of their clients, but there are also speculative opportunities to trade one currency against another for professional and individual investors.
Cash market and futures and futures markets
In reality, there are three ways in which institutions, corporations and individuals trade with currencies: the spot market, the forwards market and the futures market. Currency trading in the spot market has always been the largest market because it is the "underlying" real asset on which the forwards and futures markets are based. In the past, the futures market was the most popular place for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic commerce and numerous currency brokers, the spot market has witnessed a large increase in activity and now outperforms the futures market as the preferred commercial market for individual investors and speculators. When people refer to the currency market, they generally refer to the spot market. Forwards and futures markets tend to be more popular among companies that need to cover their currency risks on a specific date in the future.
More specifically, the spot market is where coins are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, the feeling of ongoing political situations (both locally and internationally), as well as the perception of future performance. of one currency against another. . When an agreement is finalized, this is known as a "spot agreement." It is a bilateral transaction whereby one of the parties delivers an agreed amount of currency to the counterparty and receives a specified amount of another currency at the value of the agreed exchange rate. After closing a position, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than in the future), these operations actually take two days to settle.
Unlike the spot market, futures and futures markets do not operate with real currencies. Instead, they negotiate contracts that represent claims to a certain type of currency, a specific unit price and a future settlement date.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between them.
In the futures market, futures contracts are bought and sold based on a standard size and a settlement date in public commodity markets, such as the Chicago Mercantile Exchange. In the USA UU., The National Futures Association regulates the futures market. Futures contracts have specific details, which include the number of units that are traded, the dates of delivery and settlement, and the minimum price increases that cannot be customized. The exchange acts as the merchant's counterpart, providing authorization and settlement.
Both types of contracts are binding and are generally settled in cash for the exchange in question at maturity, although contracts can also be bought and sold before they expire. Forwards and futures markets can offer protection against risk when trading currencies. In general, large international corporations use these markets to protect against future fluctuations in the exchange rate, but speculators also participate in these markets.
Note that you will see the terms: FX, forex, currency market and currency market. These terms are synonyms and all refer to the currency market.
Forex as coverage
Companies that do business in foreign countries are at risk due to fluctuations in currency values when they buy or sell goods and services outside their domestic market. Currency markets offer a way to hedge currency risk by setting a rate at which the transaction will be completed.
To achieve this, an operator can buy or sell currencies in the forward or exchange markets in advance, which blocks an exchange rate. For example, imagine that a company plans to sell blenders made in the USA. UU. In Europe when the exchange rate between the euro and the dollar (EUR / USD) is 1 to 1 dollar at par.
The blender costs $ 100 and the US company plans to sell it for € 150, which is competitive with other blenders that were manufactured in Europe. If this plan is successful, the company will get $ 50 in profits because the EUR / USD exchange rate is uniform. Unfortunately, the USD begins to increase in value against the euro until the EUR / USD exchange rate is .80, which means that it now costs $ 0.80 to buy € 1.00.
The problem facing the company is that, although it still costs $ 100 to make the blender, the company can only sell the product at the competitive price of € 150, which when translated back to dollars is only $ 120 (€ 150 X .80 = $ 120). A stronger dollar resulted in a much smaller gain than expected.
The blender could have reduced this risk by shortening the euro and buying the USD when they were in parity. That way, if the value of the dollar increases, the profits from the trade would compensate for the reduced profit from the sale of blenders. If the USD fell in value, the more favorable exchange rate will increase the profits from the sale of blenders, which compensates for trade losses.
The coverage of this type can be done in the currency futures market. The advantage for the trader is that futures contracts are standardized and authorized by a central authority. However, currency futures may be less liquid than term markets, which are decentralized and exist within the interbank system worldwide.
Forex as speculation
Factors such as interest rates, trade flows, tourism, economic strength and geopolitical risk affect the supply and demand of currencies, which creates daily volatility in the currency markets. There is an opportunity to benefit from changes that can increase or reduce the value of one currency compared to another. A forecast that one currency will weaken is essentially the same as assuming that the other currency of the pair will be strengthened because the currencies are traded as pairs.
Imagine a merchant who expects interest rates to increase in the US. UU. Compared to Australia, while the exchange rate between the two currencies (AUD / USD) is .71 ($ .71 USD is needed to buy $ 1.00 AUD). The merchant believes that the highest interest rates in the US UU. They will increase the demand for USD and, therefore, the AUD / USD exchange rate will fall because it will require less USD, stronger, to buy an AUD.
Assume that the operator is correct and that interest rates rise, which decreases the AUD / USD exchange rate to .50 This means that $ .50 USD is required to buy $ 1.00 AUD. If the investor had shortened the AUD and extended the USD, he would have benefited from the change in value.
Currency as asset class
There are two different characteristics for currencies as an asset class:
You can earn the interest rate differential between two currencies.
You can benefit from changes in the exchange rate.
An investor can benefit from the difference between two interest rates in two different economies by buying the currency with the highest interest rate and shortening the currency with the lowest interest rate. Before the financial crisis of 2008, it was very common to reduce the Japanese yen (JPY) and buy British pounds (GBP) because the interest rate differential was very large. This strategy is sometimes called "carry trade".
Why we can trade currencies
Currency trading was very difficult for individual investors before the internet. Most of the currency traders were large multinational corporations, hedge funds or high-equity individuals because currency trading required a lot of capital. With the help of the Internet, a retail market has emerged aimed at individual traders, which provides easy access to currency markets, either through banks themselves or brokers that create a secondary market. Most online brokers or distributors offer very high leverage to individual merchants who can control a large transaction with a small account balance.
Forex Trading Risks
Currency trading can be risky and complex. The interbank market has varying degrees of regulation, and forex instruments are not standardized. In some parts of the world, currency trading is not regulated almost completely.
The interbank market is made up of banks that negotiate with each other worldwide. The banks themselves have to determine and accept sovereign risk and credit risk, and have established internal processes to stay as safe as possible. Regulations like this are imposed by the industry for the protection of each participating bank.
Since each of the participating banks performs the market by offering offers and offers for a particular currency, the market pricing mechanism is based on supply and demand. Because there are such large trade flows within the system, it is difficult for dishonest traders to influence the price of a currency. This system helps to create transparency in the market for investors with access to interbank operations.
Most small retail merchants trade with relatively small and unregulated forex brokers / brokers, who can (and sometimes do) re-quote prices and even trade with their own customers. Depending on where the distributor exists, there may be some government and industrial regulation, but those safeguards are inconsistent throughout the world.
Most retail investors should take time to investigate a currency dealer to find out if it is regulated in the US. UU. Or the United Kingdom (distributors in the US and the United Kingdom have more supervision) or in a country with lax rules and supervision. It is also a good idea to find out what type of account protections are available in the event of a market crisis, or if a distributor declares itself insolvent.
Pros and challenges of trading Forex
Pro: Currency markets are the largest in terms of volume of daily operations in the world and, therefore, offer the highest liquidity. This facilitates the entry and exit of a position in any of the major currencies in a fraction of a second for a small differential in most market conditions.
Challenge: Banks, brokers and distributors in the currency markets allow a great deal of leverage, which means that traders can control large positions with relatively little money of their own. Leverage in the 100: 1 range is a high ratio, but it is not uncommon in forex. A trader must understand the use of leverage and the risks that leverage introduces into an account. Extreme amounts of leverage have led many dealers to become insolvent unexpectedly.