You come back from a hectic day at the office, tired and want nothing else but to relax. You pour yourself wine while listening to the soothing sounds of classical music. You ask yourself, how such a complex musical genre became so soothing. Like other forms of art, “Music washes away from the soul the dust of everyday life. Berthold Auerbach”. You lie down on the couch and sleep the night away.
The question arises: how can we simplify complexity? The answer to this is knowledge. Understanding the basics of a complex world will open a new way of seeing difficult situations.
What is the Forex Market?
Like classical music, the Forex market is a complex place, which needs understanding in order to grasp and enjoy its beauty. The Forex Market or formally known as the Foreign Exchange Market, is a place where you exchange one currency for another. The Forex Market is a mechanism used in everyday life by everyone not just traders. This market covers any transaction that converts one unit of currency into a number of units of a different currency based on a certain ratio.
Besides the transactions of travelers, foreign exchange transactions include the following, to mention a few:
- The transactions performed by companies and individuals in order to purchase goods and services abroad.
- The flow of funds between reserve banks in order to bolster reserves of foreign currency and gold.
- And most importantly for our purposes, the financial market in which foreign exchange is traded for speculative and hedging purposes using a wide range of easily accessible instruments.
The foreign exchange market is the biggest financial market in the world. With an estimated 4 trillion dollars being traded daily in the Forex market, it absolutely dwarfs even the biggest stock exchanges. According to the Bank for International Settlements (in Forex Market Overview 2010) that is roughly 12.5 times higher than the average daily turnover of all the world’s equity exchanges. These high levels of daily volume bring the benefit of increased market liquidity. In fact, the foreign exchange market is the most liquid market in the world. The benefits are significant since positions can be opened and closed almost immediately and without large discrepancies between the quoted price and the actual price of execution, even in times of high volatility (Forex vs Equities [Sa]).
Forex markets can be traded at any time during the day or night. This is due to the level of global integration of the foreign exchange market. When the Asian foreign exchange market closes the European one opens, followed by the American market. All these markets trade all the main currency pairs so a trader can cater his trading times to his personal preference from any location in the world (Forex vs Stocks [Sa]).
When Was the Giant Born?
Referring to the trade of one monetary unit for another, the forex market can be seen as a mature market that has undergone various developments during the years – from an instrument that can be used to conduct international trade to a market that can be exploited for speculative purposes.
During the Second World War, a need for stability in the financial markets developed. Twenty-nine countries convened and came to an agreement to establish fixed exchange rates, which led to the formation of the International Monetary Fund (IMF) in 1949. Exchange rate changes exceeding 1% had to gain approval from the IMF before implementation. Nearing 1960, the fixed exchange rate system started showing signs of fragmentation due to various reasons.
In 1971, US President Nixon severed the link between the US dollar and the value of gold: an event known as the Nixon Shock. Subsequently, open market forces of supply and demand determined the value of the US dollar. By 1973, most the major currencies were at that stage determined by floating rates. This signified the start of the forex market, as we know it today.
Until the late 1990s, only large institutions – such as banks and governments – were allowed access to the forex market for speculative purposes. This was mainly due to the fact that in order to be able to trade within this market, a large amount of money was required. However, internet developments have enabled online forex trading firms to provide the opportunity for retail traders to gain access to the forex market despite the relatively small amounts of money with which they speculate. Although these online firms provide their clients with access to forex, it is important to note that forex is a decentralised market with various gateways.
Achieving greater accessibility and recognition, forex continued to grow and came to be the world’s most liquid market.
The determination of an exchange rate
It is an easy concept to grasp that an amount of one currency can be exchanged for another based on an already determined ratio. The determination of that ratio is a little less intuitive though. There are three methods that the government of a country can set in place to determine and administer the exchange rate of their currency relative to all other currencies, namely: a floating rate, a fixed rate and a managed exchange rate (Edge 1999).
The floating rate:
Figure 1: The supply (Line S) and demand (Line D) curves are the theoretical basis for the floating rate method.
The first method of exchange rate determination is based on the concept of supply and demand. The equilibrium point that determines the exchange rate is influenced by the same factors as the equilibrium point of any product. The demand curve for a currency (As represented by the line labelled D in Figure 1) moves upward and downward due to three main factors:
- The demand for local goods and services. When the foreign demand for these rises then the demand for the local currency will rise since these transactions are settled in the local currency.
- When foreign traders and speculators feel that the local currency is going to gain in value they will purchase more units of the local currency and thus increase demand.
- The last factor relates to the transactions of local and foreign reserve banks. In the course of their actions to bolster and reduce the levels of gold and foreign exchange held in their reserves they can influence the supply and demand of a currency.
These factors also influence the supply curve (Labelled S in Figure 1) in similar ways when the actions are performed by foreign entities instead of local ones. The exchange rate is then found at the point where the supply and demand curves intersect. In practise, however, the exchange rate isn’t determined by a graph consisting of two curves. It is determined intuitively in the market depending on the prices that the different market participants are willing to pay in order to buy and sell a certain currency (Moffatt [Sa]).
The fixed rate:
In a fixed exchange rate system, also referred to as a pegged currency system, the value of a local currency is tied (by the government) to the value of another currency, which is usually the US Dollar (Nicholson [Sa]). Under this system, a local currency is pegged in a ratio to the foreign currency. All other exchange rates with the local currency then depend on the exchange rates of the currency that it is pegged to. To illustrate this concept take an imaginary currency pegged to the US Dollar in a ratio of 1.5 units to every Dollar. If the Dollar is trading at two Dollars to the Pound then the exchange rate of the imaginary currency would be three units to a pound (Edge 1999).
The managed rate:
The last method used by governments to determine the exchange rates of a country is also the most intrusive in the functioning of foreign exchange as a free market. Under this system the government sets the exchange rate at a specific point in time and the rate remains fixed for a specific period. In general, exchange rates would be fixed by the reserve bank in the morning and would then be set at that level until the next morning when a new set of rates is announced (Edge 1999).
Out of the three methods that government can adopt, the most popular in modern times has been the floating rate. Not only does it give a true reflection of the value the international community places on a currency, but it also opens up the opportunity for traders to speculate on the daily price movements. Although the managed rate is no longer used, many other countries currently peg their exchange rates in a fixed rate system. Most notable under these are China, Syria and the Netherlands (Nicholson [Sa]).
What is traded on the Forex market?
The Forex market is the market of trading currency pairs. Every currency has a quoted exchange rate that determines in what ratio it can be converted to another currency. All these exchange rates are constantly adjusting themselves due to market participants taking advantage of opportunities for risk-free profit, also known as arbitrage, thus eliminating the existence of the price disparities between different exchange rates that lead to these arbitrage possibilities (Forex Arbitrage [Sa]).
Currencies are traded in the Forex market, point.
What does a currency pair mean?
A currency pair functions as a tool where the one currency is sold and the other bought simultaneously. Therefore, the pair currency is written: EUR/USD, The United States Dollar to the European Euro.
The final addition is written like this: EUR/USD= 1.2.
You will buy the first currency stated and sell the second. Therefore you will receive €1 if you sell $1.2.
You will sell the first currency stated and buy the second. Therefore you will receive $1.2 for every €1 you sell.
Currency pairs make it easier to interpret the net result when both the currencies fluctuate in value over the given period of time.
The first currency in a pair is called the base currency while the second currency (to the right of the pair) is called the counter currency. Example: EUR/USD, EUR is the base currency and USD is the counter currency.
The bid and an offer
The bid is the price at which someone is willing to buy currency at and an offer is the price someone is willing to sell the currency at.
There are many different instruments available to traders and other market participants who want to gain exposure to the foreign exchange markets. These four instruments are:
- Spot trades
- Forward and future contracts
A spot trade occurs when a certain amount of one currency is exchanged for another currency according to the exchange rate at that time. This rate is referred to as the spot rate. These transactions are settled electronically in most cases and as such are instantaneous. However, delivery does not necessarily have to take place immediately. When it does not, the spot rate at the time of the transaction will still apply. Spot transactions are also the type of transactions that occur when a tourist converts their cash at an airport foreign exchange kiosk (Kinds of Foreign Exchange Market [Sa]).
Forward and future contracts:
The main difference between these contracts and spot transactions is with regard to when the contract is settled and possession of the opposite side of the trade is affected. In the case of futures and forward contracts, the buyer and seller agree to exchange a certain amount of one currency for an amount of a different currency at an agreed upon point in the future based on the forward rate. This forward rate is set at the inception of the contract and is based on the expectations of future currency fluctuations.
Both of these contracts were designed to be used for hedging purposes by companies and individuals who, for many different reasons, need to protect themselves against movements in other underlying assets.
Forward contracts are agreements between two parties where all parameters are determined by the two parties. These parameters include such things as the amount of each currency that will be exchanged and the execution date of the trade. A futures contract, on the other hand, is traded on an exchange and due to this all the parameters are predetermined before the contract is posted on the exchange. This means that futures contracts are infinitely more liquid than forward contracts and they can be bought and sold without forcing the market participant to hold it until maturity (Common Financial Instruments of Forex 2011).
A currency swap is an agreement between two parties under which they exchange a principal amount of two different currencies for a set term. At the end of this period they exchange the principal amount of the swap again. These transactions usually occur at the prevailing spot rate at each point in time when an exchange takes place. Sometimes swap contracts include provision for the parties to make interest payments to each other on the principal amounts in the swap at either fixed or floating rates (Guinan 2009).
An options contract is similar to a futures contract in the sense that both are settled at a future date and both are standardized so they can be traded on an exchange. An options contract differs in the fact that it gives the holder of the option the right, but not the obligation, to exchange a specified amount of currency at the stated rate. This means that unlike a futures or forward contract, the holder of an option is partially protected from a massive unfavourable currency movement (Common Financial Instruments of Forex 2011).
The Forex market will continue to be a great platform for traders to practise their craft due to its enormity and high liquidity. There are also instruments to cater to a wide variety of market participants and with the increase in global integration, many more companies will turn to easily accessible futures and option contracts to hedge against exchange rate movements. Increased activity can signal higher volatility, which is ideal for a talented trader looking to make a profit from significant price movements.