What is Foreign Exchange Market

The foreign exchange market, also referred to as the “forex” or “FX” market, is the market in which currencies are traded and exchange rates are determined. The forex market as we know it today can be dated back to 1971 when the Bretton Woods Agreement ended. This agreement had pegged the worlds major currencies to the U.S. dollar from 1944 until 1971. Its demise ushered in the era of floating exchange rates and currency volatility.
The forex market is open 24 hours a day, five days a week, with currencies traded in all of the world’s major financial centers. As the Asian centers close, the European centers open, and as they close the North American centers open, and eventually the Asian centers open again. The main centers for forex trading are London, New York, and Tokyo. The forex market is the largest and most liquid financial market in the world, with a daily average turnover of approximately US$3.2 trillion, according to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivative Market Activity, conducted by the Bank for International Settlements (BIS).
The forex market is classified as an “over-the-counter” (OTC) market, as most transactions are facilitated via a global network of dealers, communicating through connected computer terminals and by telephone rather than on a centralized exchange (though a segment of the foreign exchange market comprises currency futures and options, which are traded on exchanges). These dealers mostly work for the world’s major banks and so the forex market is also referred to as an “interbank” market. The rates quoted in the market are visible to all banks, although each bank must have established a credit relationship with another in order to transact at the rates quoted. Some deals in the forex market are facilitated by forex brokers who match counterparties for a fee. These brokers have been adversely affected by the increased use of the internet since the mid-1990s, which has resulted in much of their business migrating to more efficient online broking systems used only by banks. Retail traders (individual investors) comprise a small part of the forex market and may only participate indirectly through brokers or banks.
Transactions in the forex market can be undertaken on a spot, forward, or swap basis. A spot trans-action requires almost immediate delivery of foreign exchange (in practice, the delivery date, or “value date,” is normally the second business day following the transaction). A forward transaction requires delivery at some future date. The exchange rate is determined at the time of the transaction but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six, and twelve months. They are often used by companies that wish to lock in an exchange rate today for future delivery of a currency in order to hedge against foreign exchange risk. A swap transaction is another way of locking in a forward rate and involves the simultaneous exchange of one foreign currency for another, with both purchase and sale conducted with the same counterparty. A common type of swap is a “spot-against-forward” swap in which a dealer buys a currency in the spot market and simultaneously sells the same amount back to the same counterparty in the forward market. According to the 2007 BIS Survey, spot transactions account for less than one-third of global forex turnover, while forwards represent 11 percent and swaps more than 50 percent of all transactions. The four most commonly traded currencies in the forex market are the U.S. dollar, the euro, the Japanese yen, and the British pound.
Banks execute trades on behalf of their clients principally companies seeking foreign exchange to pay for goods or services, other banks, central banks, mutual funds, and hedge funds but they also trade a large amount of currency on their own account, via “proprietary desks,” in an attempt to profit from currency movements. This speculative activity, which accounts for the bulk of turnover in the forex market, involves buying currencies that are expected to appreciate in the hope of selling them at a future profit and selling currencies that are expect to depreciate in the expectation of buying them back at a cheaper price. Although sometimes controversial, many economists argue that speculators perform an important function by providing a market for hedgers and transferring risk. Banks also engage in arbitrage transactions which produce profits from temporary discrepancies between the exchange rates quoted by competing dealers.
There is virtually no forex trading based on inside information. Currency fluctuations are usually caused by actual monetary flows as well as by expectations of changes in these flows caused by macroeconomic factors such as changes in GDP growth, interest rates, inflation, and budget and trade deficits or surpluses. Major macroeconomic news is released publicly, usually on scheduled dates, so all dealers have access to this news at the same time. However, larger banks may have an advantage through knowledge of their customers’ order flow, which may provide insights into likely market reaction to particular announcements.