Foreign exchange market

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the Credit market.[1]

The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency's absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: 1 USD is worth X CAD, or CHF, or JPY, etc..

The foreign exchange market works through financial institutions, and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as "dealers", who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the "interbank market" (although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.[2]

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.

The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, who set out the rules for commercial and financial relations among the world's major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements, the preliminary global results from the 2016 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $5.09 trillion per day in April 2016. This is down from $5.4 trillion in April 2013 but up from $4.0 trillion in April 2010. Measured by value, foreign exchange swaps were traded more than any other instrument in April 2016, at $2.4 trillion per day, followed by spot trading at $1.7 trillion.[3]

The $5.09 trillion break-down is as follows:

History

Ancient

Currency trading and exchange first occurred in ancient times.[4] Money-changers (people helping others to change money and also taking a commission or charging a fee) were living in the Holy Land in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybistẻs") used city stalls, and at feast times the Temple's Court of the Gentiles instead.[5] Money-changers were also the silversmiths and/or goldsmiths[6] of more recent ancient times.

During the 4th century AD, the Byzantine government kept a monopoly on the exchange of currency.[7]

Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of coinage in Ancient Egypt.[8]

Currency and exchange were important elements of trade in the ancient world, enabling people to buy and sell items like food, pottery and raw materials.[9] If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of a recognized standard like silver and gold.

Medieval and later

During the 15th century, the Medici family were required to open banks at foreign locations in order to exchange currencies to act on behalf of textile merchants.[10][11] To facilitate trade, the bank created the nostro (from Italian, this translates to "ours") account book which contained two columned entries showing amounts of foreign and local currencies; information pertaining to the keeping of an account with a foreign bank.[12][13][14][15] During the 17th (or 18th) century, Amsterdam maintained an active Forex market.[16] In 1704, foreign exchange took place between agents acting in the interests of the Kingdom of England and the County of Holland.[17]

Early modern

Alex. Brown & Sons traded foreign currencies around 1850 and was a leading currency trader in the USA.[18] In 1880, J.M. do Espírito Santo de Silva (Banco Espírito Santo) applied for and was given permission to engage in a foreign exchange trading business.[19][20]

The year 1880 is considered by at least one source to be the beginning of modern foreign exchange: the gold standard began in that year.[21]

Prior to the First World War, there was a much more limited control of international trade. Motivated by the onset of war, countries abandoned the gold standard monetary system.[22]

Modern to post-modern

From 1899 to 1913, holdings of countries' foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between 1903 and 1913.[23]

At the end of 1913, nearly half of the world's foreign exchange was conducted using the pound sterling.[24] The number of foreign banks operating within the boundaries of London increased from 3 in 1860, to 71 in 1913. In 1902, there were just two London foreign exchange brokers.[25] At the start of the 20th century, trades in currencies was most active in Paris, New York City and Berlin; Britain remained largely uninvolved until 1914. Between 1919 and 1922, the number of foreign exchange brokers in London increased to 17; and in 1924, there were 40 firms operating for the purposes of exchange.[26]

During the 1920s, the Kleinwort family were known as the leaders of the foreign exchange market, while Japheth, Montagu & Co. and Seligman still warrant recognition as significant FX traders.[27] The trade in London began to resemble its modern manifestation. By 1928, Forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930s London.[28]

After World War II

In 1944, the Bretton Woods Accord was signed, allowing currencies to fluctuate within a range of ±1% from the currency's par exchange rate.[29] In Japan, the Foreign Exchange Bank Law was introduced in 1954. As a result, the Bank of Tokyo became the center of foreign exchange by September 1954. Between 1954 and 1959, Japanese law was changed to allow foreign exchange dealings in many more Western currencies.[30]

U.S. President, Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually resulting in a free-floating currency system. After the Accord ended in 1971,[31] the Smithsonian Agreement allowed rates to fluctuate by up to ±2%. In 1961–62, the volume of foreign operations by the U.S. Federal Reserve was relatively low.[32][33] Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organizations relied instead on reserves of currency.[34][35] From 1970 to 1973, the volume of trading in the market increased three-fold.[36][37][38] At some time (according to Gandolfo during February–March 1973) some of the markets were "split", and a two-tier currency market was subsequently introduced, with dual currency rates. This was abolished in March 1974.[39][40][41]

Reuters introduced computer monitors during June 1973, replacing the telephones and telex used previously for trading quotes.[42]

Markets close

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float, the forex markets were forced to close sometime during 1972 and March 1973.[43][44] The very largest purchase of US dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure given as 2.75 billion in total by The Statesman: Volume 18 1974), this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks (during February and, or, March 1973. Giersch, Paqué, & Schmieding state closed after purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened ... March 1 " that is a large purchase occurred after the close).[45][46][47][48]

After 1973

In developed nations, the state control of the foreign exchange trading ended in 1973 when complete floating and relatively free market conditions of modern times began.[49] Other sources claim that the first time a currency pair was traded by U.S. retail customers was during 1982, with additional currency pairs becoming available by the next year.[50][51]

On 1 January 1981, as part of changes beginning during 1978, the People's Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading.[52][53] Sometime during 1981, the South Korean government ended Forex controls and allowed free trade to occur for the first time. During 1988, the country's government accepted the IMF quota for international trade.[54]

Intervention by European banks (especially the Bundesbank) influenced the Forex market on 27 February 1985.[55] The greatest proportion of all trades worldwide during 1987 were within the United Kingdom (slightly over one quarter). The United States had the second amount of places involved in trading.[56]

During 1991, Iran changed international agreements with some countries from oil-barter to foreign exchange.[57]

Market size and liquidity

Main foreign exchange market turnover, 1988–2007, measured in billions of USD.

The foreign exchange market is the most liquid financial market in the world. Traders include governments and central banks, commercial banks, other institutional investors and financial institutions, currency speculators, other commercial corporations, and individuals. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was $3.98 trillion in April 2010 (compared to $1.7 trillion in 1998).[58] Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps, and other derivatives.

In April 2010, trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading in the world. Trading in the United States accounted for 17.9% and Japan accounted for 6.2%.[59]

For the first time ever, Singapore surpassed Japan in average daily foreign-exchange trading volume in April 2013 with $383 billion per day. So the order became: United Kingdom (41%), United States (19%), Singapore (5.7%), Japan (5.6%) and Hong Kong (4.1%).[60]

Turnover of exchange-traded foreign exchange futures and options has grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). As of April 2016, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are traded more than to most other futures contracts.

Most developed countries permit the trading of derivative products (such as futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies.[61] Countries such as South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.

Foreign exchange trading increased by 20% between April 2007 and April 2010, and has more than doubled since 2004.[62] The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading was estimated to account for up to 10% of spot turnover, or $150 billion per day (see below: Retail foreign exchange traders).

Foreign exchange is traded in an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London. According to TheCityUK, it is estimated that London increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day.

Market participants

Top 10 currency traders [63]
% of overall volume, May 2016
Rank Name Market share
1 United States Citi 12.9 %
2 United States JP Morgan 8.8%
3 Switzerland UBS 8.8%
4 Germany Deutsche Bank 7.9%
5 United States Bank of America Merrill Lynch 6.4%
6 United Kingdom Barclays 5.7%
7 United States Goldman Sachs 4.7%
8 United Kingdom HSBC 4.6%
9 United Kingdom XTX Markets 3.9%
10 United States Morgan Stanley 3.2%

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0 to 1 pip to 1–2 pips for currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 51% of all transactions.[64] From there, smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”.[65] Central banks also participate in the foreign exchange market to align currencies to their economic needs.

Commercial companies

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short-term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational corporations (MNCs) can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

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. There is also no convincing evidence that they actually make a profit from 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 the behavior of their currency. Fixing exchange rates reflect 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. However, 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.[66] Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and can therefore generate large trades.

Retail foreign exchange traders

Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange trading, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association, have previously been subjected to periodic foreign exchange fraud.[67][68] To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes contracts for difference and financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or "mark-up" in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principals in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as "foreign exchange brokers" but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies.[69] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank.[70] These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. The volume of transactions done through Foreign Exchange Companies in India amounts to about USD 2 billion [71] per day This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing . Around 25% of currency transfers/payments in India are made via non-bank Foreign Exchange Companies.[72] Most of these companies use the USP of better exchange rates than the banks. They are regulated by FEDAI and any transaction in foreign Exchange is governed by the Foreign Exchange Management Act, 1999 (FEMA).

Money transfer/remittance companies and bureaux de change

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally, followed by UAE Exchange. Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange companies.

Trading characteristics

Most traded currencies by value
Currency distribution of global foreign exchange market turnover[73]
Rank Currency ISO 4217 code
(symbol) 		% daily share
(April 2016)
1
  United States dollar
USD ($)
 80.6%
2
  Euro
EUR (€)
 37.4%
3
  Japanese yen
JPY (¥)
 21.6%
4
  Pound sterling
GBP (£)
 12.8%
5
  Australian dollar
AUD (A$)
 6.9%
6
  Canadian dollar
CAD (C$)
 5.1%
7
  Swiss franc
CHF (Fr)
 4.8%
8
  Renminbi
CNY (元)
 4.0%
9
  Swedish krona
SEK (kr)
 2.2%
10
  New Zealand dollar
NZD (NZ$)
 2.1%
11
  Mexican peso
MXN ($)
 1.9%
12
  Singapore dollar
SGD (S$)
 1.8%
13
  Hong Kong dollar
HKD (HK$)
 1.7%
14
 Norwegian krone
NOK (kr)
 1.7%
15
 South Korean won
KRW (₩)
 1.7%
16
  Turkish lira
TRY (₺)
 1.4%
17
  Russian ruble
RUB (₽)
 1.1%
18
 Indian rupee
INR (₹)
 1.1%
19
 Brazilian real
BRL (R$)
 1.0%
20
 South African rand
ZAR (R)
 1.0%
Other 7.1%
Total[74] 200.0%

There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice, the rates are quite close due to arbitrage. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. Major trading exchanges include Electronic Broking Services (EBS) and Thomson Reuters Dealing, while major banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading centers are London and New York City, though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows. These are caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the 2016 Triennial Survey, the most heavily traded bilateral currency pairs were:

The U.S. currency was involved in 87.6% of transactions, followed by the euro (31.3%), the yen (21.6%), and sterling (12.8%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market.

Determinants of exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):

  1. International parity conditions: Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
  2. Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for the continuous appreciation of the US dollar during the 1980s and most of the 1990s, despite the soaring US current account deficit.
  3. Asset market model: views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days), algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.[75]

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors

These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is not included in the agreed-upon transaction. Spot trading is one of the most common types of Forex Trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuation of the trade. This roll-over fee is known as the "Swap" fee.

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. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Non-deliverable forward (NDF)

Forex banks, ECNs, and prime brokers offer NDF contracts, which are derivatives that have no real deliver-ability. NDFs are popular for currencies with restrictions such as the Argentinian peso. In fact, a Forex hedger can only hedge such risks with NDFs, as currencies such as the Argentinian Peso cannot be traded on open markets like major currencies.[81]

Swap

The most common type of forward transaction is the foreign exchange 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. A deposit is often required in order to hold the position open until the transaction is completed.

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.

Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Thus the currency futures contracts are similar to forward contracts in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly used by MNCs to hedge their currency positions. In addition they are traded by speculators who hope to capitalize on their expectations of exchange rate movements.

Option

A foreign exchange option (commonly shortened to just 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.

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Economists, such as Milton Friedman, have argued that speculators ultimately are a stabilizing influence on the market, and that stabilizing speculation performs the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[82] Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market philosophy than on economics.[83]

Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.[84] Also to be considered is the rise in foreign exchange autotrading; algorithmic, or automated, trading has increased from 2% in 2004 up to 45% in 2010.[85]

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Swedish National Bank (the central bank of Sweden) to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[86] Mahathir Mohamad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[87]

In this view, countries may develop unsustainable economic bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.

Risk aversion

The MSCI World Index of Equities fell while the US dollar index rose

Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.[88]

In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US dollar.[89] Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across the world fell while the US dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA.[90]

Carry trade

Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate. A large difference in rates can be highly profitable for the trader, especially if high leverage is used. However, with all levered investments this is a double edged sword, and large exchange rate price fluctuations can suddenly swing trades into huge losses.

See also

References

  1. ↑ Record, Neil, Currency Overlay (Wiley Finance Series)
  2. ↑ Global imbalances and destabilizing speculation (2007), UNCTAD Trade and development report 2007 (Chapter 1B).
  3. ↑ "Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016".
  4. ↑ CR Geisst – Encyclopedia of American Business History Infobase Publishing, 1 January 2009 Retrieved 14 July 2012 ISBN 1438109873
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  6. ↑ T Crump – The Phenomenon of Money (Routledge Revivals) Taylor & Francis US, 14 January 2011 Retrieved 14 July 2012 ISBN 0415611873
  7. ↑ J Hasebroek – Trade and Politics in Ancient Greece Biblo & Tannen Publishers, 1 March 1933 Retrieved 14 July 2012 ISBN 0819601500
  8. ↑ S von Reden (2007 Senior Lecturer in Ancient History and Classics at the University of Bristol, UK) - Money in Ptolemaic Egypt: From the Macedonian Conquest to the End of the Third Century BC (p.48) Cambridge University Press, 6 December 2007 ISBN 0521852641 [Retrieved 25 March 2015](ed. daing of papyri - c.f.46)
  9. ↑ Mark Cartwright. "Trade in Ancient Greece". Ancient History Encyclopedia.
  10. ↑ RC Smith, I Walter, G DeLong – Global Banking Oxford University Press, 17 January 2012 Retrieved 13 July 2012 ISBN 0195335937
  11. ↑ (tertiary) – G Vasari – The Lives of the Artists Retrieved 13 July 2012 ISBN 019283410X
  12. ↑ (page 130 of ) RA De Roover – The Rise and Decline of the Medici Bank: 1397-1494 Beard Books, 1999 Retrieved 14 July 2012 ISBN 1893122328
  13. ↑ RA De Roover – The Medici Bank: its organization, management, operations and decline New York University Press, 1948 Retrieved 14 July 2012
  14. ↑ Cambridge dictionaries online – "nostro account"
  15. ↑ Oxford dictionaries online – "nostro account"
  16. ↑ S Homer, Richard E Sylla A History of Interest Rates John Wiley & Sons, 29 August 2005 Retrieved 14 July 2012 ISBN 0471732834
  17. ↑ T Southcliffe Ashton – An Economic History of England: The 18th Century, Volume 3 Taylor & Francis, 1955 Retrieved 13 July 2012
  18. ↑ (page 196 of) JW Markham A Financial History of the United States, Volumes 1–2 M.E. Sharpe, 2002 Retrieved 14 July 2012 ISBN 0765607301
  19. ↑ (page 847) of M Pohl, European Association for Banking History – Handbook on the History of European Banks Edward Elgar Publishing, 1994 Retrieved 14 July 2012
  20. ↑ (secondary) – Retrieved 13 July 2012
  21. ↑ S Shamah – A Foreign Exchange Primer ["1880" is within 1.2 Value Terms] John Wiley & Sons, 22 November 2011 Retrieved 27 July 2102 ISBN 1119994896
  22. ↑ T Hong – Foreign Exchange Control in China: First Edition (Asia Business Law Series Volume 4) Kluwer Law International, 2004 ISBN 9041124268 Retrieved 12 January 2013
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  30. ↑ M Sumiya – A History of Japanese Trade and Industry Policy Oxford University Press, 2000 Retrieved 13 July 2012 ISBN 0198292511
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  32. ↑ AH Meltzer – A History of the Federal Reserve, Volume 2, Book 1; Books 1951–1969 University of Chicago Press, 1 February 2010 Retrieved 14 July 2012 ISBN 0226520013
  33. ↑ (page 7 "fixed exchange rates" of) DF DeRosa –Options on Foreign Exchange Retrieved 15 July 2012
  34. ↑ K Butcher – Forex Made Simple: A Beginner's Guide to Foreign Exchange Success John Wiley and Sons, 18 February 2011 Retrieved 13 July 2012 ISBN 0730375250
  35. ↑ J Madura – International Financial Management, Cengage Learning, 12 October 2011 Retrieved 14 July 2012 ISBN 0538482966
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  37. ↑ (SFO Magazine, RR Wasendorf, Jr.) (INT) – Forex Trading PA Rosenstreich – The Evolution of FX and Emerging Markets Traders Press, 30 June 2009 Retrieved 13 July 2012 ISBN 1934354104
  38. ↑ J Jagerson, SW Hansen – All About Forex Trading McGraw-Hill Professional, 17 June 2011 Retrieved 13 July 2012 ISBN 007176822X
  39. ↑ Franz Pick Pick's currency yearbook 1977 – Retrieved 15 July 2012
  40. ↑ page 70 of Swoboda →
  41. ↑ G Gandolfo – International Finance and Open-Economy Macroeconomics Springer, 2002 Retrieved 15 July 2012 ISBN 3540434593
  42. ↑ City of London: The History Random House, 31 December 2011 Retrieved 15 July 2012 ISBN 1448114721
  43. ↑ C Robles – How To Profit From The Falling Dollar AuthorHouse, 2007 Retrieved 15 July 2012 ISBN 1434311023
  44. ↑ "Thursday was aborted by news of a record assault on the dollar that forced the closing of most foreign exchange markets." in The outlook: Volume 45, published by Standard and Poor's Corporation – 1972 – Retrieved 15 July 2012 →
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  48. ↑ "... forced to close for several days in mid-1972, ... The foreign exchange markets were closed again on two occasions at the beginning of 1973,.. " in H-J Rüstow New paths to full employment: the failure of orthodox economic theory Macmillan, 1991 Retrieved 15 July 2012 →
  49. ↑ Chen, James (2009). Essentials of Foreign Exchange Trading. ISBN 0470464003. Retrieved November 15, 2016.
  50. ↑ Hicks, Alan (2000). Managing Currency Risk Using Foreign Exchange Options. ISBN 1855734915. Retrieved November 15, 2016.
  51. ↑ Johnson, G. G. (1985). Formulation of Exchange Rate Policies in Adjustment Programs. ISBN 0939934507. Retrieved November 15, 2016.
  52. ↑ JA Dorn – China in the New Millennium: Market Reforms and Social Development Cato Institute, 1998 Retrieved 14 July 2012 ISBN 1882577612
  53. ↑ B Laurens, H Mehran, M Quintyn, T Nordman – Monetary and Exchange System Reforms in China: An Experiment in Gradualism International Monetary Fund, 26 September 1996 Retrieved 14 July 2012 ISBN 1452766126
  54. ↑ Y-I Chung – South Korea in the Fast Lane: Economic Development and Capital Formation Oxford University Press, 20 July 2007 Retrieved 14 July 2012 ISBN 0195325451
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  57. ↑ PJ Quirk Issues in International Exchange and Payments Systems International Monetary Fund, 13 April 1995 Retrieved 14 July 2012 ISBN 1557754802
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  59. ↑ BIS Triennial Central Bank Survey - Foreign exchange and derivatives market activity in April 2010, published in September 2010.
  60. ↑ "Singapore Overtakes Japan as Asia’s Top Foreign-Exchange Hub". Bloomberg. 6 September 2013.
  61. ↑ "Derivatives in emerging markets", the Bank for International Settlements, 13 December 2010
  62. ↑ "The $4 trillion question: what explains FX growth since the 2007 survey?, the Bank for International Settlements, 13 December 2010
  63. ↑ Source: Euromoney FX survey 2016 results revealed
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  66. ↑ Alan Greenspan, The Roots of the Mortgage Crisis: Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own. , the Wall Street Journal, 12 December 2007
  67. ↑ McKay, Peter A. (26 July 2005). "Scammers Operating on Periphery Of CFTC's Domain Lure Little Guy With Fantastic Promises of Profits". The Wall Street Journal. Retrieved 31 October 2007.
  68. ↑ Egan, Jack (19 June 2005). "Check the Currency Risk. Then Multiply by 100". The New York Times. Retrieved 30 October 2007.
  69. ↑ The Sunday Times (London), 16 July 2006
  70. ↑ Andy Kollmorgen. "Overseas money transfers". choice.com.au.
  71. ↑ http://www.pondiuni.edu.in/storage/dde/downloads/ibiv_forex.pdf
  72. ↑ http://nptel.ac.in/courses/110105031/pr_pdf/Module5-5.pdf
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  74. ↑ The total sum is 200% because each currency trade always involves a currency pair.
  75. ↑ The Microstructure Approach to Exchange Rates, Richard Lyons, MIT Press (pdf chapter 1)
  76. ↑ "To What Extent Does Productivity Drive the Dollar?". ssrn.com. SSRN 711362 Freely accessible.
  77. ↑ "Safe Haven Currency". Financial Glossary. Reuters. Retrieved 22 April 2013.
  78. ↑ John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance, 1999), pp. 343–375.
  79. ↑ "Overbought". Investopedia. Retrieved 22 April 2013.
  80. ↑ Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York (1998), chapter 11, pp. 113–115.
  81. ↑ Gelet, Joseph (2016). Splitting Pennies. Elite E Services. ISBN 9781533331090.
  82. ↑ Michael A. S. Guth, "Profitable Destabilizing Speculation," Chapter 1 in Michael A. S. Guth, Speculative behavior and the operation of competitive markets under uncertainty, Avebury Ashgate Publishing, Aldorshot, England (1994), ISBN 1-85628-985-0.
  83. ↑ What I Learned at the World Economic Crisis Joseph Stiglitz, The New Republic, 17 April 2000, reprinted at GlobalPolicy.org
  84. ↑ Lawrence Summers and Summers VP (1989) 'When financial markets work too well: a Cautious case for a securities transaction tax' Journal of financial services
  85. ↑ "Anatomy of the Forex Market". Pepperstone. Retrieved 22 April 2013.
  86. ↑ Redburn, Tom (17 September 1992). "But Don't Rush Out to Buy Kronor: Sweden's 500% Gamble". The New York Times. Retrieved 18 April 2015.
  87. ↑ Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York, 1995.
  88. ↑ "Risk Averse". Investopedia. Retrieved 25 February 2010.
  89. ↑ Moon, Angela (5 February 2010). "Global markets – US stocks rebound, dollar gains on risk aversion". Reuters. Retrieved 27 February 2010.
  90. ↑ Stewart, Heather (9 April 2008). "IMF says US crisis is 'largest financial shock since Great Depression'". The Guardian. London. Retrieved 27 February 2010.
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