The
foreign exchange market (
forex,
FX, or
currency market) is a worldwide decentralized
over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007.
The $3.98 trillion break-down is as follows:
$1.490 trillion in spot transactions
$475 billion in outright forwards
$1.765 trillion in foreign exchange swaps
$43 billion currency swaps
$207 billion in options and other products
Market size and liquidity
The foreign exchange market is the largest and most
liquid financial market in the world. Traders include large banks,
central banks,
institutional investors, currency
speculators, corporations,
governments, other
financial institutions, and retail investors. 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
US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).Currency distribution of reported FX market turnover(Symbol) !! % daily share(April 2010)
|-
| || align="left"|
United States dollar || || align="right"| 84.9%
|-
| || align="left"|
Euro || || align="right"| 39.1%
|-
| || align="left"|
Japanese yen || || align="right"| 19.0%
|-
| || align="left"|
Pound sterling || || align="right"| 12.9%
|-
| || align="left"|
Australian dollar || || align="right"| 7.6%
|-
| || align="left"|
Swiss franc || || align="right"| 6.4%
|-
| || align="left"|
Canadian dollar || || align="right"| 5.3%
|-
| || align="left"|
Hong Kong dollar || || align="right"| 2.4%
|-
| || align="left"|
Swedish krona || || align="right"| 2.2%
|-
| || align="left"|
New Zealand dollar || || align="right"| 1.6%
|-
| colspan=3 align="center"|
Other Currencies || align="right"| 18.6%
|-
| colspan=3 align="right"|
Total || align="right"|
200%
|}
There is no unified or centrally cleared market for the majority of FX 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 often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. 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 center is London, but New York, 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, excluding weekends.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows 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. 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 (eg 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 (eg 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 2010 Triennial Survey, the most heavily traded bilateral currency pairs were:
EURUSD: 28%
USDJPY: 14%
GBPUSD (also called cable): 9%
and the US currency was involved in 84.9% of transactions, followed by the euro (39.1%), the yen (19.0%), and sterling (12.9%) (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. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
The following theories explain the fluctuations in FX rates in a
floating exchange rate regime (In a
fixed exchange rate regime, FX rates are decided by its government):
:(a) 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.
:(b) Balance of payments model (see exchange rate): 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 continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.
:(c) Asset market model (see exchange rate): 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 FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from 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.
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.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector .
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:
Flights to quality: Unsettling international events can lead to a "
flight to quality," with investors seeking a "
safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The
U.S. dollar,
Swiss franc and
gold have been traditional safe havens during times of political or economic uncertainty.
Long-term trends: Currency markets often move in visible long-term
trends. Although currencies do not have an annual growing season like physical commodities,
business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the
cognitive bias known as
anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.
Algorithmic trading in foreign exchange
Electronic trading is growing in the FX market, and
algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.
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.
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.
Swap
The most common type of forward transaction is the
FX swap. In an FX 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.
Future
Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate
,
. Futures are standardized 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.
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. Nevertheless, economists including
Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform 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. Other economists such as
Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.
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.
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 Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad 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 J. 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.
In this view, countries may develop unsustainable financial 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 in forex
Risk aversion in the forex 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.
In the context of the forex market, traders liquidate their positions in various currencies to take up positions in safe haven currencies, such as the US Dollar. 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 world fell while the US Dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA.
See also
Balance of trade
Bretton Woods system
Currency pair
Currency strength
Foreign currency mortgage
Foreign exchange controls
Foreign exchange hedge
Foreign exchange reserves
Foreign exchange scam
Foreign exchange swap
Nonfarm payrolls
Special Drawing Rights
Tobin Tax
World currency
Currency codes
money market
Notes
External links
A user's guide to the Triennial Central Bank Survey of foreign exchange market activity, Bank for International Settlements
London Foreign Exchange Committee with links (on right) to committees in NY, Tokyo, Canada, Australia, HK, Singapore
United States Federal Reserve daily update of exchange rates
Bank of Canada historical (10-year) currency converter and data download
Microstructure effects, bid-ask spreads and volatility in the spot foreign exchange market pre and post-EMU
OECD Exchange rate statistics (monthly averages)
"Lessons for the foreign exchange market from the global financial crisis" Two experts review how global FX markets coped after Lehman's bankruptcy in Sept 2008
