Foreign Currency Market

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi riyals, even though the United States is not involved in the transaction.

The foreign exchange market, or the FX market, is where the buying and selling of different currencies takes place. The price of 1 currency in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer networks—there is no central headquarters. There are 3 main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan. Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market.

Trading goes on 24 hours a day during the weekdays. In the United States, trading begins Sunday evening and ends on Friday evening. From Friday evening to Sunday evening, most banks are closed throughout the world, and since banks are the main traders and dealers of currency, there is very little activity over the weekends. Indeed, trading activity in a particular currency and, hence, its liquidity, is largely determined by how many banks are open that trade in that currency.

During the weekdays, trading progresses in waves as major banks open and close. At 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day. The foreign exchange market is a 24/5 market—most currency trading occurs 24 hours per worldwide business day.

The trading week starts when Monday morning first arrives in New Zealand and ends when it is late afternoon on Friday in San Francisco. Since New Zealand is just across the International Dateline, it is still Sunday in most of the world when it is Monday morning in New Zealand. So, for someone living on the east coast in the United States, the currency markets start opening about 5 p.m. Eastern Standard Time on Sunday.

The International Dateline is where, by tradition and fiat, the new calendar day starts. Since New Zealand is a major financial center, the forex markets open there on Monday morning, while it is still Sunday in most of the world.

Source: United States Naval Observatory.

The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1.21 trillion was traded each day—roughly equivalent to every person in the world trading $195 each day.

More statistics on the foreign exchange market: Bank for International Settlements: International Financial Statistics.

Percentages of FX Transactions by Country for April, 2001. (Countries with less than 1% are not shown in the chart.)

Source: New York Federal Reserve Bank.

Foreign Exchange Market Participants

There are 5 types of market participants—banks, brokers, customers, retail forex traders, and central banks.

1. Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies among themselves. Roughly 2/3 of all FX transactions involve banks dealing directly with each other.
2. Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profits by charging a commission on the transactions they arrange.
3. Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.
4. The Internet has allowed individuals to trade currencies using their home computers, hoping to make a profit from speculation, and this is a growing, albeit small, percentage of the trading volume.
5. Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands every day, the activity of these participants constantly affects the value of every currency in terms of every other.

Foreign Exchange Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

• For the import and export needs of companies and individuals;
• to hedge existing positions;
• to profit from the short-term fluctuations in exchange rates;
• for direct foreign investment;
• and to purchase foreign financial securities.

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they predict the market correctly, they can profit from it; otherwise, they'll probably lose.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating that a currency is heading down, selling it short, then buying it back at a lower price later.

To predict long-term movements of currencies, traders often use fundamental analysis to try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions of the involved countries and how those economic conditions are changing. Examining inflation, interest rates, and the relative strength of the countries' economies helps them make a determination. If they determine that a currency is underpriced, then the trader will expect the price to rise, but if it is overpriced, then the currency will probably decrease in value with respect to another currency.

However, fundamentals are difficult to quantify and there are many variables to consider, especially when the fundamentals of both countries of the currency pair must be examined, which must be done to forecast their relative value. Furthermore, fundamentals have a limited effect on price in the short term of most speculative forex trades, which is measured in minutes or hours between the time when a trader buys or sells and when she closes out her position. Hence, many traders use technical analysis to try to determine future prices in the next few minutes or hours, or sometimes, days. Technical analysis is the examination of recent prices and trading volumes in the hope of seeing a chart pattern that, in the past, has led to a certain change in prices more often than not. Although some traders use technical analysis to predict long-term prices, long-term changes in prices will be dictated by fundamentals.

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in 2 ways—through a broker or directly with each other.

Brokers

If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About 1/3 of transactions are arranged in this way.

Direct

Mostly, banks deal with each other directly. A trader makes a market for another by quoting 2 prices: the price at which he is willing to buy and the price at which he is willing to sell. The difference between the 2 price quotes is the spread, and is usually less than 10 pips. (1 pip = 1/10,000th of a currency unit for most currencies.)

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal 1 unit of those currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by 4 currencies: the U.S. dollar, the Euro, the Japanese yen and the British pound. Together these account for over 80% of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Types of Transactions

There are different types of FX transactions: spot transactions, forwards, futures, swaps, and options. Spot transactions are an immediate trade, while forwards, futures, swaps, and options allow traders to manage risk or to profit from speculation over an extended time period.

Spot Transactions

This type of transaction accounts for almost 1/3 of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.

By convention the payment is actually made 2 days later, but next day settlements are used as well, especially for the Canadian and U.S. dollar pair.

Although spot transactions are popular, they leave the currency buyer exposed to some financial risks. Exchange rate fluctuations can effectively raise or lower prices, making financial planning difficult for both companies and individuals.

One alternative for a company is to pay for the foreign goods right away to avoid the exchange rate risk, but this creates an opportunity cost equal to the interest that could be earned on the money during the interim.

Forward Transactions

One way to deal with FX 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 calculate a forward exchange rate that depends on the current exchange rate, the difference in interest rates between the 2 countries, and the date on which the exchange will take place. The date can be a few days, months, or years in the future, but in most cases, the time period is less than 1 year. Because a forward contract is negotiated between the parties, it is customized to their needs, especially in regard to the amounts involved and the date of settlement. Since a forward transaction is a direct transaction between the buyer and seller of currency in the over-the-counter (OTC) market, there is some credit risk that one of the parties will default on the transaction.

Futures

Foreign currency futures are forward transactions with standard contract sizes and maturity dates and are traded on organized exchanges. The buyer and seller of the futures contract does not have to be concerned about the creditworthiness of the other party, because the exchange becomes the intermediary of the transaction with the seller selling to the exchange and the buyer buying from the exchange. The exchange takes on the credit risk of the transaction. There is also greater price transparency and liquidity, because there are many more traders for the standardized contracts. Another advantage of futures over forwards is that a position in a futures contract can be closed out before the settlement date by buying or selling the offsetting contract. Because forwards are individually negotiated contracts, it would be difficult for either party to offset their position.

Currency Swaps

The most common type of forward transaction is the currency swap. In a swap, 2 parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that is not affected by any changes in the market rates. A currency swap allows the market participants to plan more safely, since they know in advance what their currency exchange will cost. It also allows them to avoid an immediate outlay of cash.

Options

Most forwards and futures require performance at a specified time. An option is similar to a forward or futures transaction, but it gives its owner the right, but not the obligation, to buy or sell a specified amount of foreign currency at a specified price, called the strike price, at any time up to a specified expiration date. Options differ from currency futures because the option holder can just let the option expire if, on the expiration date of the option, it is out of the money. At the expiration of a futures contract, the futures buyer would have to accept delivery of the currency, and the futures seller would have to actually deliver the currency, unless it is a cash-settled contract, in which case the seller would have to pay to the buyer the equivalent value in a specified currency.

A call option allows the holder to buy currency at the strike price. A put option allows the holder to sell currency at the strike price.

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