The foreign exchange is an exchange where different currencies are traded. This exchange is essential in commodity trade, due to the international nature of the commodity market. This may require traders to purchase commodities and derivatives in a currency that is not their own currency. On the foreign exchange they can acquire all currencies required to successfully operate on the commodity market. The foreign exchange is however also a market on itself, where speculative traders trade different currencies with the intention of making a profit on price fluctuations between currencies.
The foreign exchange market, often referred to as the Forex or simply FX, is the market where one currency is traded against another currency. With the increasing globalization of the world economy and the international character of the commodity market, FX trading activity is continuously increasing. The trade takes place in a number of trade centers around the world, with the most important centers based in New York, Tokyo, Sydney, Hong Kong, Frankfurt and London. The FX has similar features to the commodity market, such as forwards, swaps, futures, options and spot trading.
These different trade centers all have their own exchange rate, which are very close to each other. With the London exchange rate serving as a benchmark. The exchange rate between two currencies is composed of the so-called base currency, which is the currency paid with and the counter currency, which is the currency received in return. The exchange rate is quoted to four decimal places except for the Yen which is limited to two decimal places and consists of two currency codes which determine the involving currencies. For example EUR/USD 1,4567 means the base, in this case the Euro, is worth 1,4567 United States Dollars, the counter. The fluctuation in an exchange rate is quoted in a so-called pip, which is short for percentage in point. A single pip is a change in the fourth decimal of an exchange rate.
There are a number of different participants active on the Forex market. They consist of both national banks and regular banks. Where the national banks have huge reserves which they tend to use to influence money supply and inflation or their currency. Whereas regular banks mostly fulfill a speculative role on the Forex market. Another group of participants are commercial companies who trade currency to finance their international payments for goods and services. Lastly are the speculators on the Forex market. They consist of hedging funds, retail traders and as mentioned before banks. Speculative trading accounts for most of the trading activity on the Forex market.
Advantages of Foreign Exchange
FX trading offers a number of advantages over futures or stock trading, which makes the market especially attractive for speculative trading.
The Forex market is the most liquid market in the world. This high liquidity minimizes the risk for slippage, which is the difference between expected transaction costs and the actual paid costs. This difference can occur due to the ineffective order execution of a broker or changes in commission costs. The high liquidity also ensures traders there is always a counter party to be found for their trading activity.
FX trading takes place twenty-four hours a day, except for the weekends. This helps traders take advantage of developments on the market immediately. Furthermore a trader can engage in FX trading from virtually anywhere on earth, as long as they have an account and an internet connection.
The margin on FX trading is very low which results in traders being able to trade large amount of currency with only a small required start capital. Thus it is very attractive to many traders, who hope to make large profits with limited starting capital. This also creates a threat because FX trading can also turn against you resulting in the loss being substantially bigger than your initial margin. Thus this high leverage is considered double-edged sword because it can generate significant losses and profits.
Determinants of Exchange Rates
There are a number of factors influencing the exchange rates. Similar to commodities the price for a currency is influenced by the market forces of supply and demand. The supply and demand for a currency can be influenced by the following factors.
The inflation in one country compared to other countries can influence the demand for a currency greatly. When inflation is low in one country, foreign investors will be encouraged to buy their products in low inflation countries. This will increase demand for the low-inflation currency.
The interest rate in a country will influence the exchange rate. Investors, planning to invest their money will usually do this in a situation where they expect to receive the highest return value. These investments must be done in the nation’s currency and thus will increase demand for the currency.
High inflation in a country can cause governments to increase interest rates to reduce the inflation. This results in an increase in currency demand, because investors want to take advantage of the high interest rates. Thus the relationship between inflation and interest rates can be an indicator for traders I which way a market will move.
The trade balance of a country can be an influencing factor for the exchange rate. If the trade balance is running an account surplus the export exceeds the import of a country. This causes the foreign demand for this country’s currency to be higher than those countries with a trade balance deficit.
The economic growth and stability in a country will have a positive effect on the value of a nation’s currency. Investors are more likely to invest their money in an economy that they predict will have the most chance of earning them a solid profit. Therefore the countries with a stable economy will likely see an increasing demand in their currency.