Forex – The Foreign Exchange Market

What is “Forex” ?

The Forex, short for Foreign Exchange (forex market) is the market where currencies from all over the world are traded against each other in the form of pairs. We call exchange rate the price of exchange between two currencies. Thus, if we take the example of EUR / USD rating at 1.50, it means that with 1 euro, you can get 1.50 dollars. Investors buy and sell currencies in real time and continuously. The exchange rate thus changes constantly based on supply and demand of a particular currency. This has not always been the case.

Before 1944, it was impossible to buy the dollar against the euro. The gold was used as reference in all exchanges (Currencies were only convertible in gold). Then, in 1944 took place the Bretton Woods conference in order to ensure economic stability after war. The key elements that resulted are: Creation of the IMF – Creation of the Central World Bank – Creation of the International Bank for Reconstruction and Development – The dollar has been designated as the single currency convertible into gold while other currencies have seen their rate fixate at + – 1% against the dollar.

Until 1992, the exchange rate remained fixed (or constant relative to a reference currency). The states controlled the price of their currency and made sure she never leaves the exchange rate band that was set (from + – 1% against the dollar at the beginning). The exchange then moved only if a state decides to devalue or revalue its currency by acting with its foreign exchange reserves. Technically, a currency could be attacked on the currency market if the price was too high or too low. That’s what happened in 1992, which was a major turning point for the foreign exchange market.

George Soros, seeing that the price of sterling was too high, decided to shorts it for $ 10 billion. The Bank of England not having enough foreign reserves to maintain its fixed exchange rate was forced to devalue its currency. George Soros has also won more than 1 billion dollar on this operation and was nicknamed ‘the man who broke the Bank of England’. Other currencies have also been attacked in the following years prompting the authorities to move on floating exchange rates, system that we know today.

The price of a currency on the Forex is now a balance between supply and demand of various stakeholders for a particular currency. Currencies fluctuate 24h/24 and 7d / 7. However, brokers do not allow you to trade the weekend (because of the low volatility), while the market remains wide open for central banks, commercial banks or hedge funds that are key investors on the Forex. Thus, many gaps appear at the opening of the market on Sunday evening.

The Forex market is highly liquid. The daily volume is today of 3.981 billion dollars, making it the second largest market behind the interest rate (8000 billions). There are no worries of counterparty (Especially since your broker is your guaranteed counterparty). The following chart shows the evolution of the daily volume ($ billion) transactions on the forex market:

These 3,981 billion dollars of transaction are composed as follow:

• 1 490 billion spot transactions
• 475 billion forward exchange
• 1 765 billion in swaps
• 475 billion of others transactions

Among these transactions, the most traded parities are the EUR / USD (about 28% of the total volume), the USD / JPY (about 14% of the total volume), the GBP / USD (about 9% of the total volume). The dollar is the most traded currency in the world, it represents more than 85% of trade on Forex, as shown in the graph below which shows the most traded currencies:

So I will now introduce you how the Forex is working…
The Forex, or Foreign exchange market, is i said before the market where currencies are quoted againt other currencies. Example: EURO against the DOLLAR, or more usually known as EUR/USD. So, the value of one euro in dollar is priced.  In our example, the EURO is the basic currency, the DOLLAR is the currency which makes you earn money on Forex or not in your trades. To sum up, whatever you do on EUR/USD parity, sell or buy, you win or lose dollars. When you close your position, the profit or loss is converted into basic currency of your account at the market price.

The parities on the Forex evolve according to the economic indicators of the countries involved in parity. For the EUR/USD it will thus be necessary to take into consideration all the economic news of the Euro area, as well as the United States. Each economic news is forecast, and news better than its forecast generally makes increase the currency concerned. Thus if good news on EURO is announced, EUR/USD parity will goes up and if a bad news comes out, EUR/USD will goes down.

Is it possible to make money on the Forex?

The answer is YES.
YES, if you don’t do anything. Not like “Toto gambles on Forex“. I invite you to consult advices on How to suceed on forex in order not to make as the majority of the particular who come to the Forex believing they know everything, being sure to  make money, and finally to get it wrong. (Stage by which I passed of course, otherwise I will not say it)

The Forex is a market that suits perfectly to technical analysis. Indeed, when no news comes out, the market will most likely follow his trend (this is why the Forex is also known as market trend), forming very often beautiful charts patterns. The most found pattern on the Forex is the channel (bullish or bearish), because there is mostly a trend, marked by corrections. In times of economic crisis, of course, the market loses its trend and it becomes more difficult to trade on the Forex.

The Forex is not a really a volatile market. The average daily volatility of parity is about 1.0%. The Forex is made volatile by the leverage. Indeed, if we take the example of an individual investing 10,000 Euros with leverage up to 500, it can trade with 5 000 000 Euros on the Forex. Such a position on the EUR / USD will generate variations on its balance of plus or minus 500 USD per pip. So with a level of EUR / USD at 1.4000, a simple variation of 20 pips in the wrong side will make him lose everything on his account. (Conversely, in 20 pips, it doubles its capital …)

Currencies on Forex

How is the Forex Structured?

The forex market is decentralized, meaning that there is no central exchange. Additionally, there is no clearing house where buyers are matched with sellers. Instead the connections between dealers and market makers are done through such means as:

• Computers
• Telephones
• Fax machines

No monopolistic pricing strategies can be applied by market makers thanks to the mere nature of the forex. Since there are many market makers on the forex, traders can quickly move to another one if they are not satisfied with the pricing strategies of the market maker.

Through the close examination of spreads, market makers are deprived of the possibility of changing the costs that are incurred when a trade is made.

In contrast, equity market is centralized, meaning that there is a clearing house where buyers are matched with sellers.

Companies that are listed on the particular stock exchange are the only ones that can be traded there. They are operated by so called specialists.

In contrast to the equity market, the FX market can have many market makers, who can quote different prices.

In contrast to the decentralized markets where monopolistic strategies are not allowed, in centralized markets such practices are not excluded. This is caused by the fact that there is only one specialist responsible for the monitoring and control of the market.

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Thus, specialists have the opportunity to distort the prices in different ways in accordance with their own purposes.

The distortion of prices can be done by the specialist in the conditions of too many sellers and too few buyers. In such a case, the specialist will have to purchase from these sellers being the only buyer which can lead to a reduction on the value of the security.

The specialist may apply another tactic and widen the spread. This will lead to a barrier to other investors in the trading. Additionally, specialists can adjust the quotes in such a way, so that their investing purposes are met.

Types of Currency Exchange Markets: Spot and Forward Market Explained

There are several types of currency exchange markets. Two of them are the so called Spot Market and Forward Market.

Spot Market

Spot currency trading represents the most widely used foreign currency instrument. The spot foreign exchange market basic characteristics contributing to its popularity are:

• High volatility
  Volatility represents the degree of price fluctuation of a particular currency for a specific time period. This means that a particular currency pair may change its price with as many as 150 – 250 pips for as little as several seconds. This might represent a great opportunity for quick profits and yet, quick losses as well.
• High liquidity
• Short-term contract execution
  In a spot deal, the bilateral contract between two parties exchanging currencies is based on a predetermined exchange rate within two business days of the contract date. The only exception to the 2-day rule is the Canadian dollar since the spot delivery is done in the next business day.

Those three characteristics lead to minimization of the credit risk on the spot market.

After having a deal, the trader is informed of the quota by the bank, which serves him/her. The quota represents the evaluation of the target currency, which is done either against the US dollar or any other currency.

It has two components: the bid-price (the price which is wanted by the seller) and the ask-price (the price which the buyer is willing to pay for the currency pair).

The difference between the two prices and is measured in pips (points) and is called spread.

Forward Market

The basic characteristics of the forex forward market are:

• Decentralization
  This allows traders form all over the world to enter into different deals either by using the services of a broker or on one-on-one basis.
• No standard regarding the settlement dates
  The settlement dates that are established on the forward market can range from 3 days to 3 years. Currency swaps are rarely longer than a year but in principle no technical restrictions exist to execute such a deal. The only requirement is that the date is a valid business day for the currencies that are part of the deal.

There are two parts that make up the forward price:

• The spot exchange rate – the most important part of the forward price, which provides its foundations.
• The forward spread (also known as forward pips or forward points) – it is used for the adjustment of the spot rate when the settlement dates differ from the spot date. This implies that the maturity date is of significant importance in determining the value of the forward price.

The participants in the forward market typically apply two tools: forward outright deals and exchange deals (also known as swaps). The latter represents a combination between a forward outright deal and a spot deal.