News: - Founded by a group of enthusiasts to promote financial literacy

Main Menu

Forex market: Forex features

Started by Admin, May 10, 2024, 10:55 AM

Previous topic - Next topic
Topic keywords [SEO] Forex


A foreign exchange market is a place where all participants come together to buy or sell one currency against another. In financial jargon, the foreign exchange market is often referred to as Forex, which is an abbreviation of the English term FOReign EXchange. Like all markets, it also determines exchange prices, which is the exchange rate between each currency pair.

The world's largest market

In 2019, according to the Bank for International Settlements (BIS) Triennial Central Bank Review report, the daily trading volume will be almost 6,590 billion dollars. Thus, trading volumes in this market have grown by almost 30% since the previous review (2016) and by more than 65% over the decade of 2010. This makes it the largest and most liquid market in the world in terms of transaction volume.

By comparison, the daily transaction volume in the FX market is more than twice the annual GDP of France!

The adoption of floating exchange rate regimes by many countries since the beginning of the 1970s, combined with technical advances (notably high-frequency trading software and virtually uninterrupted access to the FX market) goes a long way towards explaining why this market is now the most active and voluminous in the world.

London dominance

While coins and banknotes exist in every country, the foreign exchange market is completely dematerialized and decentralized. It is not tied to any particular exchange. Almost all transactions are done over-the-counter. This allows currency transactions to take place virtually around the clock, whereas other financial securities are often tied to a specific financial center with daily opening and closing hours.

Even though in theory the foreign exchange market is open all the time, in practice it closes once a week in the hours between the close of trading on Friday evening at 22:00 GMT on the West Coast of the EU and the opening of trading on Sunday evening at 22:00 GMT on the Wellington Stock Exchange in New Zealand, which is where the week begins. This is because the major banks are closed on weekends and trading volumes in this market are very low on Saturdays, Sundays and public holidays.

In 2019, the currency market is largely dominated by the City of London. This financial center accounts for more than 50% of all global foreign exchange transactions. Asian markets are growing in importance but remain lower than London's. France accounts for just 2% of global currency trading.

Who participates in the foreign exchange market

The foreign exchange market brings together a wide range of participants. These include:

  • individuals (very rare) and companies (SMEs and multinationals) who need to buy and sell different currencies depending on their activities;
  • commercial banks, investment banks and brokers, who fulfill their clients' orders and also act on their own behalf;
  • monetary authorities, particularly central banks, which are the main participants in the foreign exchange market. They manage their foreign exchange reserves and intervene when necessary on the exchange rates of the currencies for which they are responsible;
  • International organizations (such as the IMF and the World Bank);
  • investment funds, some of which specialize in foreign exchange operations.

Some characteristic features of the foreign exchange market

The foreign exchange market is a market in which almost all transactions are conducted over-the-counter. Brokers and banks negotiate directly with each other, without any exchange intermediaries. Both individuals and companies must use their banks to access the foreign exchange market. Thus, Forex is an unregulated Forex market. However, there are regulated segments of the Forex market - of very limited size - that offer derivatives (e.g. warrants) as hedging and speculation tools.

Since the liberalization of trading in the 1990s, Forex market participants have become highly concentrated, especially at the bank level. They provide other market participants with instruments to hedge or speculate on exchange rate fluctuations. They also play a role in setting a single exchange rate for each currency pair.

A market dominated by dollars

Interestingly, the dollars (USD) remains the base currency in the foreign exchange market. A BIS survey for 2019 showed that of all the trades made in the Forex market, 88.3% of all trades were made with the USD and 32.3% with the Euro.

Since two currencies are involved in each transaction, buying one currency necessarily sells the other. Since each currency (dollar, euro, yen...) is counted twice, the sum of the percentages of all the currencies in the transaction reaches 200%. On the other hand, when we consider pairs of currencies (euro/dollar, dollar/yen...), the double counting disappears and the sum of the percentages of all pairs in the trade reaches 100%. Thus, EUR/USD is the most widely traded currency pair in the world: in 2019, it accounted for 24% of all traded currency pairs.

Spot and forward trades

The simplest transaction in the foreign exchange market is a spot transaction. It consists of buying one currency against another at the current market price with delivery on D+2 day. The spot market accounts for 30.2% of daily transactions.

A forward transaction involves fixing the price, quantity and date of future exchange on the day of the transaction. Its usefulness is that it provides a hedge against currency fluctuations. In essence, whatever the price at maturity (i.e. the date set for the currency exchange), the transaction will be carried out in accordance with the terms of the contract fixed earlier.

Whatever the purpose of a foreign exchange market participant - hedging or speculation - various players meet daily in this market as "counterparties" in transactions. So, for example, to hedge against a fall in the euro against dollars, a bank of a French company needs to find someone in the foreign exchange market who at the same time wants to buy euros for dollars.

A producer in the eurozone buys oil in dollars with delivery and payment in three months. To hedge his currency risk, he buys forward dollars at a guaranteed exchange rate. This person can be either a speculator buying euros because he is betting on the appreciation of that currency, or a person wanting to hedge against the appreciation of the euro against the U.S. dollar.

It is easy to see why forward transactions are of interest to companies and institutions with international operations. Forward transactions carried out in the over-the-counter market are called forwards, while futures transactions are carried out in the organized market. There are other types of derivatives used to hedge against the effects of currency fluctuations: swaps, currency options and some more complex structured products. Of the 6,950 billion dollars traded daily in the foreign exchange market, swaps account for 3,310 dollars, or 50% of trading volume.

Access to the foreign exchange market allows most participants to protect themselves from currency risks associated with their income and expenses, particularly through the futures market, as shown in the example above. But it also provides an opportunity to speculate on the exchange rates of different currencies.

Hedging and speculation

While many companies and commercial banks participate in the foreign exchange market primarily for hedging purposes, other participants, notably hedge funds and investment banks acting on their own behalf, participate in the foreign exchange market to profit from daily changes in exchange rates.

Indeed, foreign exchange transactions have increased dramatically since the 1970s and the end of fixed exchange rates, although this growth has stagnated in recent years. Currency is seen as a common financial asset that can be used to generate gains or losses by speculating on currency fluctuations. Although the foreign exchange market is not a market in itself, the massive development of derivative products such as options and swaps has made it even more attractive to speculators.

Speculation can have positive consequences because it helps provide liquidity to the market. Indeed, if an investor wants to protect himself against the appreciation of a currency, he must buy that currency. This is only possible if there is a counterparty, that is, an investor betting on the fall of the currency, otherwise the market is blocked. But speculation can also provoke sharp up and down movements in some currencies. When volatility gets out of control, exchange rates become difficult to read, and this can trigger serious economic crises that require concerted intervention by Central Banks.

It is interesting to note that volatility (speed and amplitude of price fluctuations) in a market such as a foreign exchange market is beneficial to speculators because nothing can be gained in a sluggish market, while this volatility hurts monetary authorities and currency hedgers. At the same time, currency crises affecting one or more currencies very often indicate only the real weakness of the country(ies) concerned.