Introduction to Forex
Foreign exchange (aka forex) is an off-exchange retail foreign currency market where participants purchase currency in exchange for another (at the current exchange rate). Compared to the measly $22.4 billion a day volume of the New York Stock Exchange, the foreign exchange market looks absolutely with its $5 TRILLION a day trade volume.
Forex can affect the lives of everyone, regardless if you don't travel overseas or don't invest in currency. Today's world of commerce is such an international one that happenings on the other side of the world can ripple out to all nations.
China is a perfect example of this. The government in China regulates the exchange rate of their currency, and many believe the currency to be undervalued. A undervalued currency means Chinese made goods can be purchased for "less" on the international market. Were the Chinese government to allow the market to dictate the exchange rate the effects would definitely be felt across the globe, even for Americans who've never left America.
The reasons why an individual - or institution - would want to exchange money range to a myriad of different reasons, but the 3 main demographics include large corporations and institutions, speculators (investors) and tourists.
A tourist traveling from the United States to Germany, for example, will need the local currency (EURO), as common shops, taxi cabs, etc. will most likely not accept US Dollars. Typically the airport, hotels and other tourist destinations will have services to exchange just about any currency into the local tender.
Investors are attracted to the forex market because of its possibilities and advantages (which will be discussed in more detail in the 3rd email of this series). For example, investors enjoy the added liquidity and volume forex has to offer.
A large portion the global foreign exchange market consists of corporations and institutions, who often exchange currency for non-investment purposes: the need to meet payroll in other countries, to pay for services from a foreign factory, mergers and acquisitions, etc.
The FOREX (FOReign EXchange) Market is a cash-bank market established in 1971 when the US went off the gold standard adopted in the 1930's. At that time the US had to drop the gold standard after the 1929 crash and the British Pound became the currency of choice and the world's currency.
There have been other times before in Western History when paper money could be exchanged for gold. Throughout most of the 19th century and up to the outbreak of WW1, the world was on so-called "Classical Gold Standard" with all major countries participating in it. A gold standard meant that the value of a local currency was fixed at a set exchange to gold ounces (1 Troy ounce = 31.1 Grams).
After WW II the world needed a stable currency and a monetary agreement was reached by July 1944: seven hundred and thirty delegates from forty-four allied nations came together in Bretton Woods, NH, US The reason for the gathering was the United Nations Monetary and Financial Conference. For the first time in history monetary relations amongst the world's major industrial states were governed; it was the first time a system was implemented, in which the rules for commercial and financial relations were negotiated and agreed upon. The dollar's role was formalized under the Bretton Woods monetary agreement and other nations set official exchange rates against the Dollar, while the US agreed to exchange Dollars for gold at a fixed price on demand by central banks.
In 1971 Aug 15 after the collapse of Bretten Woods, the pegged exchange rates on US dollar if abanded and the it give birth to floating exchange rate as forex into speculation.
The main participants in the Forex market are: central banks, commercial banks, financial institutions, hedge funds, commercial companies and individual investors. The main reasons they participate in the Forex market are: Profit from fluctuations in currency pairs (speculating) Protection from fluctuating currency pairs which is derived from trading goods and services (Hedging) With technological development, the World Wide Web has become a great trading facilitator, as it can provide individual investors and traders with access to all the latest Forex news, technology and tools.
|EUR||Euro zone members||Euro||Fiber|
Currency symbols always have three letters, where the first two letters identify the name of the country and the third letter identifies the name of that country's currency also called as ISO CODE.
The currency pairs listed below are considered the "majors". These pairs all contain the U.S. dollar (USD) on one side and are the most frequently traded. The majors are the most liquid and widely traded currency pairs in the world.
|EUR/USD||Euro zone / United States||"euro dollar"|
|USD /JPY||United States / Japan||"dollar yen"|
|GBP/USD||United Kingdom / United States||"pound dollar"|
|USD/CHF||United States/ Switzerland||"dollar swissy"|
|USD/CAD||Australia / United States||"dollar loonie"|
|AUD/USD||Australia / United States||"aussie dollar"|
|NZD/USD||New Zealand / United States||"kiwi dollar"|
Forex is De-centralized market with Interbank quotes. It means that it is a decentralized, self-regulated market with no central exchange or clearing house, unlike stocks and futures markets. This structure eliminates fees for exchange and clearing, thereby reducing transaction costs.
The Interbank Market
The interbank market designates Forex transactions that occur between central banks, commercial banks and financial institutions. Central Banks - National central banks (such as the US Fed and the ECB) play an important role in the Forex market. As principal monetary authority, their role consists in achieving price stability and economic growth. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country's foreign exchange reserves that they can use in order to influence market conditions and exchange rates. Commercial Banks - Commercial banks (such as Deutsche Bank and Barclays) provide liquidity to the Forex market due to the trading volume they handle every day. Some of this trading represents foreign currency conversions on behalf of customers' needs while some is carried out by the banks' proprietary trading desk for speculative purpose. Financial Institutions - Financial institutions such as money managers, investment funds, pension funds and brokerage companies trade foreign currencies as part of their obligations to seek the best investment opportunities for their clients. For example, a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks.
The retail market designates transactions made by smaller speculators and investors. These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. The participants of the retail market are hedge funds, corporations and individuals. Hedge Funds - Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a country and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a major contributor to the dynamic of Forex Market. Corporations - They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for goods, exposing them to currency risks. Through the Forex market, they convert currencies and hedge themselves against future fluctuations. Individuals - Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates. They mainly operate through Forex platforms that offer tight spreads, immediate execution and highly leveraged margin accounts.
Compiled below are Forex trading examples. Please note that these are just examples; be aware that trading Forex is speculative and involves significant risk.
|Account Name||Credit/Debit||Day 1||Comment|
|USD Account||C||USD +100,000||$100,000 Investment|
|EUR Account||D||EUR -125,020||# lots (20) x lot value ($5,000) x EURUSD Quote (1.2502)|
|Balance (USD)||Equity (USD)||Lots Open||Used Margin (USD)||Usable Margin (USD)|
(1) Balance = Deposit ($10,000) + Sum of Realized Profit & Loss ($0) = $10,000
(2) Equity = Balance ($10,000) + Sum of Unrealized Profit & Loss ($0) = $10,000
(3) # Lots open = Investment ($100,000) / Value of one lot ($5,000) = 20 lots
(4) Used Margin = # Lots open (20) x Value of one lot ($5,000) x Margin (0.5%) = $500
(5) Usable Margin = Equity ($10,000) – Used Margin ($500) = $9,500