FOREX Meaning and Significance

Meaning And Significance of Foreign Exchange

WHAT IS FOREX?

• Forex is a commonly used abbreviation for “Foreign Exchange,” and it is typically used to describe trading in the foreign exchange market by investors and speculators.
• The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices.
• In terms of volume of trading, it is by far the largest market in the world.

EXCHANGE RATE

• Exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
• Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day.
• In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency.

WHO TRADES CURRENCIES?

• Daily turnover in the world’s currencies comes from two sources:
• Foreign trade (5%). Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency.
• Speculation for profit (95%).
• Most traders focus on the biggest, most liquid currency pairs. “The Majors” include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily forex trading happens in the major currency pairs.

WHY DO EXCHANGE RATES CHANGE?

• Currencies trade on an open market, just like stocks, bonds, computers, cars, and many other goods and services. A currency’s value fluctuates as its supply and demand fluctuates, just like anything else.
• An increase in supply or a decrease in demand for a currency can cause the value of that currency to fall.
• A decrease in the supply or an increase in demand for a currency can cause the value of that currency to rise.
• A big benefit to forex trading is that one can buy or sell any currency pair, at any time subject to available liquidity. So if one think the Eurozone is going to break apart, he can sell the euro and buy the dollar (sell EUR/USD). If he think the price of gold is going to go up, based on historical correlation patterns he can buy the Australian dollar and sell the U.S. dollar (buy AUD/USD).

CENTRAL BANKS

• National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies.
• They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank “stabilizing speculation” is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

FOREIGN EXCHANGE FIXING

• Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behaviour of their currency.
• Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a market trend indicator.
• The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime.
• Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.

UNIQUENESS OF THE FOREX MARKET

• Its huge trading volume representing the largest asset class in the world leading to high liquidity;
• its geographical dispersion;
• its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed income; and
• the use of leverage to enhance profit and loss margins and with respect to account size.

DETERMINANTS OF EXCHANGE RATES

1. Economic Factors

• Economic policy- Monetary policy, fiscal policy
• Economic conditions – Balance of Trade trends, inflation level trends, economic growth and health, productivity of economy

2. Political conditions

• Internal, regional and international political conditions

3. Market psychology

• Long term trends
• Technical trading considerations
• Flights to quality – a type of capital flight whereby investors move their assets to a perceived “safe haven”

FINANCIAL INSTRUMENTS OF FOREX

1. Spot: is a two-day delivery transaction and it represents a “direct exchange” between two currencies
2. Forward: One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date.
3. Swap: In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
4. Futures: Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
5. Option: A foreign exchange option (FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.