What is Forex?
Forex (FOReign EXchange, FX) market is an inter-bank currency exchange market. In 1971 Forex market replaced the Bretton Woods system – rates were no longer fixed but floating. Basically Forex is a multitude of currency exchange transactions when counter-parties exchange specified sums of one currency to another at an agreed rate on a certain date. The exchange rate is determined by market forces – offer and demand.
The overall volume of transactions in the global currency market is constantly growing. This is due to the development of international trade and abolition of currency restrictions in many countries. Daily turnover of conversion transactions in the world is estimated at $4 trillion. About 80% of all transactions are speculative transactions with intention to derive profit from jobbing on the exchange rate differences. Jobbing attracts numerous participants, both financial institutions and individual investors.
With the highest rates of information technologies and communications in the past two decades, the market itself has changed beyond recognition. Once surrounded with a halo of caste mystique, the profession of currency trading has become almost a mass. Currency transactions, which were recently privilege of the biggest monopolist banks are now publicly accessible thanks to e-commerce systems. And the foremost banks themselves also prefer trading via electronic systems rather than individual bilateral transactions. Daily transaction volumes of the largest international banks – Deutsche Bank, Barclays Bank, Union Bank of Switzerland, Citibank, Chase Manhattan Bank, Standard Chartered Bank are estimated at billions of U.S. dollars.
An important feature of the Forex market, however strange it may seem is its stability. Everyone knows that one of the properties of the stock market – its sudden falls, which has been proved very clearly during the recent crisis. Unlike the stock market, Forex is not falling. If the shares become worthless – it’s a catastrophe for the both – issuer and investors. If one currency collapses, it only means that another one gets stronger. In late 2008 – early 2009 for instance, the Dollar has risen by tens of percent against all currencies. Still the market did not collapse and trade continues as usual. This is the stability of the market and related business – currency is an absolutely liquid commodity and will always haggle. The main advantage of the currency market is that one can achieve a sustained success with the power of intellect.
Forex is around the clock. It is not related to any specific timetables as trade takes place among banks located in different parts of the World. The mobility of exchange rates is such that significant changes happen quite frequently, which enables to make several transactions every day. If you have an elaborate and reliable trading technology this can be turned into a business no other will be able to compete with. No wonder why banks buy expensive electronic equipment and maintain hundreds of staff of traders, working in different segments of the currency market.
Initial cost of getting into the business is extremely low. One needs to undergo a basic training, to buy a computer, to open an account and make a deposit – everything under several thousand dollars. You will never ever be able to start up any other business with such money. It is more than easy to find a reliable broker too. The rest of course depends on the trader only. Just like any other activity nowadays you are getting yourself into – it all depends on your personally. International monetary system has gone a long way over the millennium of human history, but there are no doubts we have seen it changing in the most interesting and previously unthinkable way. There are two main changes determining a new image of the World’s monetary system:
The money is fully separated from any tangible media or equivalent.
Powerful information and telecommunications technologies made it possible to combine monetary and banking systems of different countries into a single global financial system that has no boundaries.
Advantages of Forex.
Liquidity. Forex operates enormous amounts of money and gives an utmost freedom of opening and closing trading positions at current market quotations. High liquidity is highly attractive side for every investor because it enables the possibility of entering and exiting the market with any volume.
Promptness. Due to 24 hours a day working pattern, Forex traders do not need to wait to react on an event as it happens in other markets.
Availability. A possibility to trade 24 hours a day, regardless a geographical location: you only have to have a computer connected to the Internet. You will do perfectly fine even with a pocket PC, PDA or a mobile phone.
Flexible Management of a Trading Process. A trading position can be open for a pre-set period of time according to the investor’s needs, which allows to organize a trading process in advance.
Cost. Traditionally Forex has no commission charges apart from the natural Bid/Ask price differential (Spread).
Execution Price Guarantee. Unlike futures or other currency investments, Forex guarantees order execution at the current market price no matter the volume you trade.
Market Trend. Currency fluctuations have a certain overall direction seen even per a short period of time. Each given currency has its own definite fluctuations in time which enables speculations in Forex.
Margin size. A level of margin required is only defined by terms of agreement between a client and a bank (broker firm) providing a client with an access to the market (normally constituting 1:100). This means that you can trade volumes of up to $100,000 only having deposited an sum of 1% of the volume ($1,000). Such an insignificant margin level (significant leverage) coupled with rapidly changing currency quotations makes Forex highly profitable (and highly risky). Although its up for trader to decide what leverage to use.
Popular Misconceptions about Forex
The first and the main misconception about Forex is that it is on a par with roulette games when players make their bets, then someone wins a lot and the rest ones lose. Forex is not a roulette because in the core of currency price fluctuations there are certain principles. First of all, currency price depends on its country’s economic performance. Secondly, it is linked to preferences and expectations of the market players. It is all a subject of prognosis which is proved by the market analysis containing objective factors rather than casuality.
It is commonly accepted nowadays that risk is an inherent part of any business activity. You may not always have the result you planned from a deal. But it is especially risky to be involved in financial markets trading. Due to the complexity and unpredictable nature of market’s behavior it is easy to suffer losses and there is never a 100% confidence that the result is going to be positive. Many are put off from work in the financial market despite the much easier access to it thanks to modern communication technologies and powerful analytical software packages.
It is also well known to everyone who has ever taken part in any of business activities that divergence between planned and actual results is inevitable. There are all sorts of unforeseen but still highly influential factors like economic or political changes, natural disasters, unfair business practice, default on commitments by your counter-agent � there are plenty � are all there to put your project down � not only to test your nerves. Risk is an inherent part of any activity. The only way to avoid risk � is to do nothing but even in this case there is a risk of some sort.
Second popular misconception and the most frequently asked question is that one trader’s win is another’s loss. By no means all players in the Forex market are seeking advantages in price fluctuations � there are large groups of players using currency exchange operations for other purposes (exporters, importers, large investors and others) to whom such a short-term changes are not significant. Exporters sell products for the currency of the country-importer, to invest into production they need currency of the country of location therefore broker companies execute currency exchange orders. It is because currencies can be converted one into another easily at the floating market rate, such operations may become a source of profit themselves. Nevertheless, financial markets are redeployment of resources site in the first place.
Market players are in the first place commercial banks executing orders from exporters, importers, investment institutions, insurance and retirement funds, hedgers and private investors. Commercial banks also perform trading operations in their own interests and at their own expenses. Daily turnover of the largest banks often exceeds several billion U.S. Dollars and many have their overall profit formed mostly by speculative currency exchange operations.
Brokerage houses are also playing an important role of contractor between large numbers of banks, funds, commission houses, dealing centers, etc.
Commercial Banks and Brokerage Houses do not only execute currency exchange operations at prices of other active players, but come out with prices of their own as well, therefore are actively influencing on the price formation process. We call them Market Makers.
In contrast to the above, passive players cannot set their own quotations and make trades at quotations offered by active market players. Passive market players are normally pursue the following aims: make payment under export or import contracts, invest or set up a branch overseas, create a joint venture, tourism, margin speculation, foreign currency hedging, etc.
The participants’ list witnesses that the market is widely used by big business and for serious matters. A change in currency rate may cause importers or exporters as well as other businesses incur significant losses which forces them to use a variety of risk hedging instruments such as forward deals, options, futures and so on. Forex is an important part of every successful business.
Market players can be divided into several groups:
Central banks. Their main task is exchange regulations in the foreign market, namely, the prevention of spike rates of national currencies in order to prevent economic crises, maintaining the exports and imports balance. Central banks have a direct impact on the currency market. Their influence can be direct – in the form of currency intervention, or indirect � via regulation of money supply and interest rates. Central bank may act in the market on their own to influence the national currency, or together with other central banks to conduct a joint monetary policy in the international market or for joint interventions. Central banks are normally entering the Forex market, not for profit, but to verify the stability or correct the existing national currency exchange rate for it has a significant impact on the home economy. Central banks may not be attributed to either “Bulls” or “Bears”, because they can play bullish as well as bearish depending on the particular challenges facing them at the moment. Central banks may also go on the currency market through commercial banks. Although profit is not the main purpose of these banks, they are not attracted to unprofitable operations neither, so the central banks’ intervention are normally disguised and carried out through several commercial banks at the same time. Central banks of different countries sometimes join together for coordinated interventions. The greatest influence on world currency markets were:
Central U.S. bank – US Federal Reserve (Fed),
the European Central Bank (ECB),
the Bank of England (also known as the Old Lady),
the Bank of Japan.
Commercial banks. They execute most of foreign exchange operations. Other market participants carry out conversion and deposit-lending operations through accounts opened in commercial banks. Banks accumulate (via transactions with clients) the aggregate market demand for currency conversions as well as for fundraising or investment to fulfill them in other banks. Apart from dealing with clients’ requests, banks may operate independently and at their own expense.
Foreign exchange market in the end of the day is a market of interbank deals, therefore speaking of the movement of exchange or interest rates, we will have in mind the interbank foreign exchange market. International exchange markets are most of all affected by major international banks with daily volume of transactions estimating in billions of US dollars. These are: Deutsche Bank, Barclays Bank, Union Bank of Switzerland, Citibank, Chase Manhattan Bank, Standard Chartered Bank and others. Their main difference is large volume of transactions frequently causing significant changes in quotations.
Big players may act as either “Bulls” or “Bears”.
“Bulls” are those market participants who are interested in enhancing the value of currency.
“Bears” are interested in reduction of currency value.
The market is permanently in equilibrium between the bulls and the bears, so currency quotations fluctuate within fairly narrow limits. However, when either of the group prevails, exchange rates change in a rather dramatic and significant way.
Firms performing Foreign Trade Operations. Companies participating in international trade constantly demand foreign currency (importers) or supply foreign currency (exporters), as well as place or attract free currency volumes in form of short-term deposits. These participants don not have a direct access to the currency market and realize their conversion and deposit transactions via commercial banks.
Firms carrying out international investment: Investment Funds, Money Market Funds and International Corporations. These institutions and companies, represented by various international investment funds, implement the policy of diversified management of assets portfolios by placing money in securities of governments and corporations of different countries. They are simply called funds in dealer slang. The best known funds are “Quantum” of George Soros executing successful exchange speculations, or a “Dean Witter” fund. Major international corporations engaged in foreign industrial investments: creation of subsidiaries, joint ventures and the likes, such as, for example, Xerox, Nestle, GE (General Electric), BP (British Petroleum) and others are also a part of this group.
Currency exchange. In some countries with transition economies there are currency exchanges, whose functions include currency exchange for businesses and adjustment of market exchange rates. The state is usually actively regulating the exchange rate, taking the advantage of the exchange market size.
Brokerage firms are bringing together buyers and a sellers of foreign currency and conduct conversions between them, as well as dealing in deposit and loan operations. Brokers charge commission for their intermediary services in form of a percentage per transaction.
A so called ECN (Electronic Communication Network) brokers have been widely developing recently. ECN is an electronic platform where currency exchange requests from various contractors are brought together. Their clients are large banks, brokerage firms and private clients. Access limit in terms of deposit with such brokers are usually high which makes it unaffordable to most private investors. It is assumed that ECN brokers do not act as a counterparty to its clients and only charge commission.
Individuals. People who realize a wide range of non-trade transactions in the sphere of foreign tourism, transfers of salaries, pensions, royalties, buying and selling of cash.
With the introduction of margin trading individuals have received an opportunity to invest idle funds in the Forex market with a view to profit.
Typical transaction volume in the interbank trading estimates in millions of US dollars. It is clear that such level is unreachable to a private investor, well, at least, to the vast majority.
Small and medium investors are nowadays able to enter the Forex thanks to dealing or brokerage companies. People from all over the World are now accessing the currency market with sums of around 1,000-2,000 US dollars. Dealing companies provide clients with a credit line, a so-called “Dealing lever” or “Leverage”, several times the deposited sum. Deposit required by broker is a security sum, enabling client to purchase and sell amounts 50, 100 and sometimes 500 times greater than the deposit made. The client is exposed to risk of losses whereas deposit serves as a collateral insuring the broker. Such system of work through a dealing (brokerage) company using the leverage provided is called “Margin Trading”.