The global foreign exchange market is the biggest market in the world: Its 3.2 trillion USD daily turnover exceeds the combined turnover of the entire world’s stock and bond markets.
There are many reasons for the popularity of foreign exchange trading, but the most important are the availability of leverage, the high liquidity 24 hours a day and the low dealing costs associated with trading spot FX.
Unlike many other securities (any financial instrument that can be traded) the FX market does not have a fixed exchange. It is primarily traded through banks, brokers, dealers, financial institutions and private individuals. Trades are executed via telephone and increasingly through the Internet. It is only in the last few years that the smaller investor has been able to gain access to this market. Previously the large amounts of deposits required were beyond the reach of many smaller investors. With the advent of the Internet and growing competition it is now easily in the reach of most investors.
It is estimated that anywhere from 70%-90% of the spot FX market activity is speculative. In other words the person or institution that bought or sold the currency has no intention of actually taking delivery of the currency. Instead, they are speculating on the movement of that particular currency. Data from the Bank of International Settlements suggests that 90% of all currencies are traded against the US Dollar. The four next most traded currencies are the Euro (EUR), Japanese Yen (JPY), Pound Sterling (GBP) and Swiss Franc (CHF). As currencies are traded in pairs and exchanged one for the other when traded, the rate at which they are exchanged is called the exchange rate.
The Main Players in the FX Market
- Central Banks and Governments – Policies that are implemented by governments and central banks can play a major role in the FX market, particularly in the setting of interest rates. Central banks can play an important part in controlling the country’s money supply to insure financial stability.
- Banks – a large part of FX turnover is from banks. Large banks can literally trade billions of dollars daily. This can take the form of a service to their customers or they themselves speculate on the FX market.
- Hedge Funds – as we know the FX market is extremely liquid which is why it can be desirable to trade. Hedge Funds have increasingly allocated portions of their portfolios to speculate on the FX market. Another advantage Hedge Funds can utilize is a much higher degree of leverage than would typically be found in the equity markets.
- Corporate Businesses – International trade transactions are the backbone of the FX markets. Many companies have to import or exports goods to different countries all around the world. Payment for these goods and services may be made and received in different currencies. Many billions of dollars are exchanges daily to facilitate such trade.
- Retail Currency Transactions – the ordinary individual now plays a part in today’s FX market. Every time he goes on holiday overseas, he normally need to purchase that country’s currency and again change it back into his own currency once he returns. He may also purchase goods and services whilst overseas or on the internet and his credit card company has to convert those sales back into his base currency in order to charge him.
- Speculators and Investors – usually an Investor has a much longer time horizon in which he expects his investment to yield a profit whereas the speculator has a shorter time horizon.. Regardless of this difference, both speculators and investors approach the FX market to profit from the movement in currency pairs. They both will have their reason for believing a particular currency will perform better or worse than another and will buy or sell an FX pair accordingly: They may decide that the Euro will appreciate against the US Dollar and buy the Euro vs. the US dollar (EURUSD), to create a long position. If the Euro actually strengthens against the US Dollar, then long positions in the EURUSD will see a profit.
Spot and forward trading
When you trade foreign exchange, you are normally quoted the spot exchange rate for the currency pair you are interested in. This is called the spot fx rate. This means that if you take no further steps, your trade will be settled after two business days i.e. T+2. However, many investors and speculator’s want to roll their trades forward to a later date and avoid settlement after 2 days. This forward trading can be undertaken on a daily basis or for longer periods of time. The FX position can be closed at any time and the net gain or loss on the trade is taken. Your broker will automatically roll any open spot position to the next day unless you provide some other instruction. This rollover takes place at 21:59 London, UK time and the forward rate is debited or credited to your account according to your position. Forward rates are calculated from the interest rate differential between the pair of currencies.
Interest Rate Differentials
Different currencies pay different interest rates which are determined by the Central Bank rates for each currency. The difference between these Central Bank rates acts as the main driver of the trend in an FX pair’s exchange rate. It is clearly attractive to be a buyer (long) of a currency that pays a high interest rate while being Seller (short) a currency that has a low interest rate. Although such interest rate differentials are small, they can be amplified by the use of leverage. For example, the interest rate differential between the US dollar and the Australian dollar is currently 4%. In a position that can be supported by a 5% margin deposit, this results in an 80% profit on capital per annum when you buy the Australian dollar.
Such a situation clearly benefits the high interest rate currency and as result, the Australian dollar has strengthened versus the US dollar. But it is not certain that the currency with the higher interest rate will be strongest. If the reason for the high interest rate is rapidly rising inflation, this may undermine confidence in the currency more than the benefits perceived from the high nominal interest rate and the exchange rate could decline.
In summary, the spot FX market is large and liquid and trades 24 hours a day, 6 days a week. There is a large variation in the size of participants in this market – from Central Banks to individuals but the FX market is dominated by speculators and investors who seek to profit from forecasting the direction of spot FX rates. Exchange rates are provided for pairs of currencies and investors and speculators take positions in those pairs, either long or short, depending on their view of which way the exchange rate is likely to move. Usually the rate quoted for a currency pair is the spot FX rate which settles 2 business days after being traded. However, most positions are rolled forward on a daily/weekly or even monthly basis and a forward rate is applied to account for the interest rate differential between the two currencies. For spot FX positions, this rollover takes place daily at 21:59 London, UK time. The interest rate differential between two currencies is the main driver of the trend in their exchange rate but a high interest rate alone does not determine a currency’s strength relative to other currencies.