Foreign Exchange (Forex) Market

Foreign Exchange Market or Forex market is a place where international currencies are traded. It has emerged to be the largest and decentralized financial market operating globally. It does not have any central authority and hence it is called an “Over The Counter” (OTC) market. It allows the traders to buy, sell, exchange and speculate on currencies. The major determinant of the exchange rate is the monetary value of the currency.

Forex Market – A Global Entity:

It is after the breakdown of Bretton Woods system in 1971 and most of the economies shifting to managed exchange rate regime, when the forex market started operating globally in a major way. It is after the breakdown of Bretton Woods system in 1971 and most of the economies shifting to managed exchange rate regime, when the forex market started operating globally in a major way. The decade of 1990’s witnessed major policy changes thereby re-orienting markets which reflected a rapid expansion of forex market in terms of:
Increased number of participants
Increased transaction volumes
Decline in transaction costs
Efficient mechanisms of risk transfer

The forex market is the most liquid market in the world now and accounted for almost $4 trillion as daily turnover in 2010. The breakdown of this figure is as follows: 

 

Foreign Exchange swaps – $1765 billion
Spot Transactions – $1490 billion
Outright Forwards – $475 billion
Options and other products – $207 billion
Currency swaps – $43 billion

 

Forex Market Participants:

The Forex market is different from stock market in the sense that the former follows a hierarchical order in its level of access. At the apex is the Inter-Bank market, consisting of commercial banks and security dealers. They account for 53 % of all transactions.

Following Inter-Banks are the Smaller Banks, then the Multi National Corporations, large Hedge Funds and some Retail Forex market makers. Hence, the main participants are:
Banks
Forex fixing
Central banks
Retail forex traders
Commercial companies
Hedge funds as speculator
Non-banking forex companies
Investment management firms
Money transfer/Remittance companies

As the forex market follows OTC nature of market, the exchange rates (prices) of different currencies are not fixed. The price of a currency depends on the trading banks or market makers. The quoted price of any currency reflects London’s market price, as it is the main trading centre in the world.

Factors Influencing Forex Market:

The changes in the forex market are a cumulative effect of economic factors, political conditions and market psychology.

Economic factors: The economic policies, balance of trade as well as inflation and growth rates of an economy influence the exchange rate of a currency. An economy’s productivity also influences its exchange rates positively.

Political conditions: Political stability is one of the key factors operating behind forex market fluctuations. Also events in one country may affect the exchange rate of neighboring country’s currency.

Market psychology: Forex markets are highly responsive to expectations and market perceptions. The participants often rely their decisions on long term trends of economic indicators.

Currencies Traded:

The most traded currencies in the forex market are:

1. U.S Dollar (USD)
2. British Pound Sterling (GBP)
3. Euro (EUR)
4. Canadian Dollar (CAN)
5. Australian Dollar (AUD)
6. Swiss Franc (CHF)
7. New Zealand dollar (NZD)
8. Japanese Yen (JPY)

As measured by the volumes of trade, USD-GBP and USD-EUR are the most popular currency pairs. However, this does not imply that they are the most profitable currency pairs or best investment options. It is always advisable that any customer should analyze past data for the currency pair with greatest pip movement and least volatility before making investment decisions.