This article is going to examine Forex, the foreign exchange market and the reasons Forex market exists in the first place. It will explain which factors make the Forex market the most liquid financial market there is. It will talk about what influences the currency fluctuations, as well as benefit and risks of the Forex trading. This beginners guide that will answer the question: What is the foreign exchange market about and explain why anyone interested in Forex trading should read it, before investing into this lucrative but constantly fluctuating market!
The foreign exchange market, or short Forex is in fact the place where these currencies are traded. Synonyms are FX, foreign exchange market and currency market. Countries or economical areas have their own monetary units that work locally, but if a person or a company want to purchase or sell a product from somewhere else, they need to perform a currency exchange.
Let’s say that you own a vineyard in Spain and your local currency is Euros, you want to export your wine to US, where they use US dollars. You will need to accept US dollars for payment. Or lets say you are an American tourist taking a trip to Japan, you need to purchase some local valuta Yen, do a currency exchange, to be able to pay for your local purchases.
The constant need to exchange currencies to fulfill todays business demands, makes the Forex the world’s largest financial market, even bigger than the stock market. Bank for International Settlements (BIS) reports that the average daily trade value of Forex is around 5 trillion USD.
What makes Forex unique is that is completely decentralized, there is no central foreign exchange market place. Instead the currency trading happens completely online, using a over-the-counter (OTC) methods, happening between the traders themselves around the world. This is the only market open 24h hours a day, 5.5 days a week!
How is that possible you might ask? Well, the financial centers all over the world, which include London, Zurich, Frankfurt, Paris, Singapore, Hong Kong, Sydney and New York cover almost all the time zones. When trading in one place ends, it opens in the next place. This means the markets are constantly active and the price quotes change all the time.
Three Forest Markets
Companies and individuals can exchange currency using 3 different methods:
- Spot Market
- Forwards Market
- Futures Market
This is where the currencies are exchanged for the ‘On the Spot’ or current price. The price is reflection of the supply and demand and determined by many things such as economic situation, interest rates, political situations and future predictions. After the deal is strike and position is closed, the transaction is settled in cash in 2 days time. This is the largest market and is the favorite of speculators and investors.
Forward And Future Markets
The futures markets are dealing with contracts, setup and agreed upon by two parties, representing claims to certain currency types, the price and future settlement date. Contracts and binding and settled upon expiry in cash, but can also be bought or sold before expiry. They can also offer risk protection and are therefore the favorite of corporations.
Above is an example of a currency pair. EUR is the base currency worth 1 unit (1EUR) and the USD is the counter currency it’s equivalent in foreign currency. This quote reads 1EUR=1.0450USD. It’s indirect quote would be USD/EUR =0.9568.
As with other trading market, there is a bid price (buy) and ask price (sell). It indicates how much the market pays for the quoted currency in relation to the base currency. In case of EUR/USD this would be 1.0449/1.0451 the bid being 1.0449 and ask being 1.0451. Bid price is always lower than the asking price.
Spread is the difference between bid price and asking price. In our example that’s 2 points, which might seem very small, can bring huge profits or losses. This is the reason speculators love the Forex market.
Pip indicate the smallest amount of points currency can fluctuate, for most currencies it is 0.001, as they are presented with 4 decimals such currencies are USD, GBP, EUR and so forth: For some other currencies it is 0.01, because the currency is quoted with 2 decimals only, like JPY.
Because of the size of the Forex market, investors can easily place very large trades without actually affecting the price of the currency itself. How can they do this without investing large amounts of money you might wonder? Well for instance to control a position for 200.000EUR, they simply put a small amount of money up front, let’s say 2000EUR and borrow the rest from the Forex broker.
This high leverage means that you can make huge profit, but also suffer really big losses in the matter of minutes eliminating your funds totally. This large risk taking is exactly what makes Forex market so attractive for speculators. You can also trade 24h a day which is very attractive for people with day jobs and busy lives.
Some of biggest know speculators are the billionaire George Soros and England’s Barings Bank’s derivatives trader Nick Leeson, each know respectively billion GBP gain and loss.
It can be very intimidating for new investors to enter this market as the huge amounts of funds and large number of trades made, any information or rumors regarding the traded currency will influence the price fast and sharp. Although forex market is less vunerable than equities, where the company’s stocks can loose or gain a large portion of its value as soon as news, such as quarterly results, are released, pros in fact often sit and wait for these exact moments to speculate large amounts of money.
On the other hand the traders focus trading on few currencies, instead of thousands of different stocks, traders have less financial and political news to follow. The following currency pairs: EUR/USD, USD/JPY, GBP/USD, USD/CHF and commodity pairs: USD/CAD, AUD/USD, NZD/USD are been traded o the currency market. On the equity markets the gain cannot be easily made when the economy is in decline, but on forex market you can gain both on raising and declining values, since you are trading in pairs and hence making comparisons in relation to these two traded currencies only. Additionally the low entrance, 1% value of investment in the Forex compared to 50% on the stock market, makes it attractive for beginners.
Besides individual and corporate currency traders, there are also other major forces at work. Central banks and federal governments play a huge role on the Forex market, due to the massive amounts reserves they poses. They are often trying to meet economical objective by manipulating the reserve volumes. This an happen for instance by one country buying massive amounts of other countries currency in order to keep their own currency stable.
Additionally banks and other financial institution are constantly transacting with each other on the interbank market. Because it’s a credit based systems, where the relationships are setup on individual basis, larger the bank or the financial institution, bigger the influence. This is the mayor reason the banks offer foreign currency at different rates, normally bigger the bank, better the rate.
Large corporations also play a role on the currency market, due to their large international trade. In order to regulate their prices, they purchase foreign currency they need for their transactions. They also tend to use a strategy called hedging, where they lock the exchange rate for the certain deal or time frame with their trading partner to avoid losses due to currency fluctuations. However hedging can also cause huge losses for banks, some have been even forced to close due to entering an long term contract, which have turned unfavorable.
Economical Theories That Influence The Currency Fluctuations
Inflation and interest rates are the main factors influencing the parity condition, the explanation from the economics point of view on the currency pair exchange price. If the parity condition, in the other words theory, does not hold, an arbitrage opportunities exists for all the market participants, which are often taken advantage of by individual investors for gain. There are additional theories based on financial circumstances, such as capital flows, trade conditions and internal politics and economical situation of the given country. The major theories are:
- Purchasing Power Parity (PPP) – After exchange rate adjustment the price levels in two countries should be the same.
- Interest Rate Parity (IRP) – After exchange rate adjustment the price of the same asset in two countries should be the same.
- International Fisher Effect (IFE) – After exchange rate adjustment the nominal rate in two countries should be the same.
- Balance of Payments Theory – The exchange rate should adjust the current accounts surplus or deficit between two countries.
- Real Interest Rate Differentiation Model – The exchange rate should adjust the real interest rates between two countries.
- Asset Market Model – The exchange rate should adjust based on the trade rate, flow of currency into the country by foreign investors, between two countries.
- Monetary Model – The exchange rate should adjust to the monetary policies, which include the interest rate set by the central banks and the amount of printed currency, between two countries.
These fundamentals of economical theories are the basis for determining the currency value, but the fact that there are so many theories, which are based on assumptions and perfect world, it is not possible to completely predict the fluctuations of currency.
Economic Data That Influence The Currency Fluctuations
While the economical theories can be used to predict and model the currencies on long term, on the short term, a more significant impact is achieved from the economical data. To understand the economic data better, we need to use an analogy.
If you think countries as large corporations and the currency as stock market shares in the county, the economic data can be seen as the corporations quarterly results. The same way current events and news about the company deals and its internal staffing effects its stock value, political climate, currency inflation, interest rate fluctuations, GDP, unemployment, natural disasters and consumer behavior can greatly influence the currency value.
It can be difficult to follow up on all the economical news world wide on the daily basis, but this is really a key to understanding Forex market and how these events fluctuate the exchange rates. The following are the largest indicators for influencing the economy:
- Employment Data
- Interest Rates
- Gross Domestic Product
- Retail Sales
- Durable Goods
- Trade and Capital Flows
I am happy you took time to read this article, instead of just rushing into the trading, like so many others. The reasons who most people never make money on the Forex market, is that they don’t understand it, but instead rely on other peoples analyses and trading signals.
Now that you have learned the basics about Forex markets, you are ready to move on and learn the basics about how to do Forex trading online.
If you want to try some other options to make money online legally, take a look at here for my recommendations: Start Making Money Online