FX, or
currency market
is a global, worldwide-decentralized financial market for trading
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.
The foreign exchange market assists international trade and investment, by enabling
currency conversion. For example, it permits a business in the
United States to import goods from the
United Kingdom and pay
pound sterling, even though its income is in
United States dollars. It also supports direct speculation in the value of currencies, and the
carry trade, speculation on the change in interest rates in two currencies.
In a typical foreign exchange transaction, a party purchases a
quantity of one currency by paying a quantity of another currency. The
modern foreign exchange market began forming during the 1970s after
three decades of government restrictions on foreign exchange
transactions (the Bretton Woods system of monetary management
established the rules for commercial and financial relations among the
world's major industrial states after World War II), when countries
gradually switched to
floating exchange rates from the previous
exchange rate regime, which remained
fixed as per the
Bretton Woods system.
The foreign exchange market is unique because of
- its huge trading volume representing the largest asset class in the world leading to high liquidity;
- its geographical dispersion;
- its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;
- the variety of factors that affect exchange rates;
- the low margins of relative profit compared with other markets of fixed income; and
- the use of leverage to enhance profit and loss margins and with respect to account size.
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,
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. Some firms specializing on foreign exchange market had put
the average daily turnover in excess of US$4 trillion.
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 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).
Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other
derivatives.
Trading in the
United Kingdom accounted for 36.7% of the total, making it by far the most important center for foreign exchange trading. Trading in the
United States accounted for 17.9%, and
Japan accounted for 6.2%.
Turnover of exchange-traded foreign exchange futures and options have
grown rapidly in recent years, reaching $166 billion in April 2010
(double the turnover recorded in April 2007). Exchange-traded currency
derivatives represent 4% of OTC foreign exchange turnover. Foreign
exchange
futures contracts were introduced in 1972 at the
Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Most developed countries permit the trading of derivative products
(like futures and options on futures) on their exchanges. All these
developed countries already have fully convertible capital accounts.
Some governments of
emerging economies 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.
Countries such as 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.
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 is estimated to account for up
to 10% of spot turnover, or $150 billion per day (see
retail foreign exchange platform).
Foreign exchange is 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, which according to
TheCityUK
estimates has 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
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank 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 0-1 pip
to 1-2 pips for a 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 53% of all transactions. 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”
Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial
turnover and large amounts of speculative trading every day. Many large
banks may trade billions of dollars, daily. Some of this trading is
undertaken on behalf of customers, but much is conducted by proprietary
desks, which are trading desks for the bank's own account. Until
recently, foreign exchange brokers did large amounts of business,
facilitating interbank trading and matching anonymous counterparts for
large fees. Today, however, much of this business has moved on to more
efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies
An important part of this 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 companies 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,
and there is no convincing evidence that they do make a profit trading.
Foreign exchange fixing
Foreign exchange fixing is the daily monetary exchange rate fixed by
the national bank of each country. The idea is that central banks use
the fixing time and exchange rate to evaluate behavior of their
currency. Fixing exchange rates reflects the real value of equilibrium
in the market. Banks, dealers and traders use fixing rates as a trend
indicator.
The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float
currency regime. Central banks do not always achieve their objectives.
The combined resources of the market can easily overwhelm any central
bank.Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions are speculative. In other words,
the person or institution that bought or sold the currency has no plan
to actually take delivery of the currency in the end; rather, they were
solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity
and may borrow billions more, and thus may overwhelm intervention by
central banks to support almost any currency, if the economic
fundamentals are in the hedge funds' favor.
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. Whilst the number of this
type of specialist firms is quite small, many have a large value of assets under management), and hence can 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 platforms, 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 in the past been subjected to periodic Foreign exchange fraud.To deal with the issue, the NFA and CFTC began (as of 2009) imposing
stricter requirements, particularly in relation to the amount of Net
Capitalization required of its members. As a result many of the smaller
and perhaps questionable brokers are now gone or have moved to countries
outside the US. 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 Contract for differences 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 principal 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.These companies' selling point is usually that they will offer better
exchange rates or cheaper payments than the customer's bank. These
companies differ from Money Transfer/Remittance Companies in that they
generally offer higher-value services.
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
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 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. Major
trading exchanges include EBS and Reuters, 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 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
(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 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 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):
- 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.
- 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.
- 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 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.
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", a type of capital flight whereby investors move their assets to a perceived "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.
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
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.
Future
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.
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 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
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.
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.
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 it
happened despite the strong focus of the crisis in the USA.
)