global linkage of forex markets
TRANSCRIPT
M.K.S College of Commerce
M.com part 1
Semester: 2
Name: Dinesh Ramesh Chotrani
Roll no: 10
Subject: Economics
Topic: Global Linkage of Foreign Exchange Markets
Faculty Name: Dr. Sujata Dhopte
Definition and characteristics of the foreign exchange market
The foreign exchange market is the market in which national currencies are bought and sold
against one another. This market is called the ‘foreign exchange’ market and not the ‘foreign
currency’ market because the ‘commodity’ that is traded on the market is more appropriately
called ‘foreign exchange’ than ‘foreign currency’: the latter is only a small part of what is
traded. Foreign exchange consists mainly of bank deposits denominated in various
currencies. Still, the term ‘foreign currency’ will be used interchangeably with the term
‘foreign exchange’. The foreign exchange market is the largest and most perfect of all
markets. It is the largest in terms of trading volume (turnover), which currently stands at over
one trillion US dollars per day. It is the most perfect market because it possesses the
requirements for market perfection: a large number of buyers and sellers; homogenous
products; free flow of information; and the absence of barriers to entry. The foreign exchange
market is made up of a vast number of participants (buyers and sellers). The products traded
on the foreign exchange market are currencies: no matter where you buy your yens, Euros,
dollars or pounds they are always the same. There is no restriction on access to information,
and insider trading is much less important than, for example, in the stock market. Finally,
anyone can participate in the market to trade currencies.
The importance of the foreign exchange market stems from its function of determining
crucial macroeconomic variable, the exchange rate, which affects to a considerable extent the
performance of economies and businesses. This market is needed because every international
economic transaction requires a foreign exchange transaction. Unfortunately, however, its
function of exchange rate determination is not very well understood in the sense that
economists are yet to come up with a theory of exchange rate determination that appears
empirically valid.
Unlike the stock market and the futures market, which are organised exchanges, the foreign
exchange market is an over-the-counter (OTC) market, as participants rarely meet and actual
currencies are rarely seen. There is no building called the ‘Sydney Foreign Exchange
Market’, but there are buildings called the ‘Sydney Stock Exchange’ and the ‘Sydney Futures
Exchange’. It is an OTC market in the sense that it is not limited to a particular locality or a
physical location where buyers and sellers meet. Rather, it is an international market that is
open around the clock, where buyers and sellers contact each other via means of
telecommunication. The buyers and sellers of currencies operate from approximately 12
major centres (the most important being London, New York and Tokyo) and many minor
ones. Because major foreign exchange centres fall in different time zones, any point in time
around the clock must fall within the business hours of at least one centre. The 24 hours of a
day are almost covered by these centres, starting with the
Far Eastern centres (Sydney, Tokyo and Hong Kong), passing through the Middle East
(Bahrain), across Europe (Frankfurt and London), and then passing through the US centres,
ending up with San Francisco. This is why the first task of a foreign exchange dealer on
arrival at work in the morning is to find out what happened while he or she was asleep
overnight. Some banks and financial institutions may for this reason operates a24-hour
dealing room or install the necessary hardware (Reuters’ screen, etc.) in their dealers’ homes.
Others may delegate the task to foreign affiliates or subsidiaries in active.
History of Foreign Exchange Market
The foreign exchange market as we know it today originated in 1973. However, money has
been around in one form or another since the time of Pharaohs. The Babylonians are credited
with the first use of paper bills and receipts, but Middle Eastern moneychangers were the first
currency traders who exchanged coins from one culture to another. During the middle ages,
the need for another form of currency besides coins emerged as the method of choice. These
paper bills represented transferable third-party payments of funds, making foreign currency
exchange trading much easier for merchants and traders and causing these regional
economies to flourish. From the infantile stages of forex during the Middle Ages to WWI, the
forex markets were relatively stable and without much speculative activity. After WWI, the
forex markets became very volatile and speculative activity increased tenfold. Speculation in
the forex market was not looked on as favourable by most institutions and the public in
general. The Great Depression and the removal of the gold standard in 1931 created a serious
lull in forex market activity. From 1931 until 1973, the forex market went through a series of
changes. These changes greatly affected the global economies at the time and speculation in
the forex markets during these times was little, if any.
The Bretton Woods Accord
The first major transformation, the Bretton Woods Accord, occurred toward the end of World
War II. The United States, Great Britain and France met at the United Nations Monetary and
Financial Conference in Bretton Woods, N.H. to design a new global economic order. The
location was chosen because, at the time, the U.S. was the only country unscathed by war.
Most of the major European countries were in shambles. Up until WWII, Great Britain‘s
currency, the Great British Pound, was the major currency by which most currencies were
compared. This changed when the Nazi campaign against Britain included a major
counterfeiting effort against its currency. In fact, WWII vaulted the U.S. dollar from a failed
currency after the stock market crash of 1929 to benchmark currency by which most other
international currencies were compared. The Bretton Woods Accord was established to create
a stable environment by which global economies could restore themselves. The Bretton
Woods Accord established the pegging of currencies and the International Monetary Fund
(IMF) in hope of stabilizing the global economic situation. The Bretton Woods Accord lasted
until 1971. Ultimately, it failed, but did accomplish what its charter set out to do, which was
to re-establish economic stability in Europe and Japan.
The Beginning of the free-floating system
After the Bretton Woods Accord came the Smithsonian Agreement in December of 1971.
This agreement was similar to the Bretton Woods Accord, but allowed for a greater
fluctuation band for the currencies. In 1972, the European community tried to move away
from its dependency on the dollar. The European Joint Float was established by West
Germany, France, Italy, the Netherlands, Belgium and Luxemburg. The agreement was
similar to the Bretton Woods Accord, but allowed a greater range of fluctuation in the
currency values. Both agreements made mistakes similar to the Bretton Woods Accord and in
1973 collapsed. The collapse of the Smithsonian agreement and the European Joint Float in
1973 signified the official switch to the free-floating system. In 1978, the free-floating system
was officially mandated. In a final effort to gain independence from the dollar, Europe
created the European Monetary System in July of 1978. Like all of the previous agreements,
it failed in 1993.
Why do we make use of the Foreign Exchange Market?
Trading in a domestic market is substantially different from doing business in an offshore
market. In the complex world of international trade, merchants face a number of risks that
need to be managed in order to ensure the success of their cross–border transactions. In order
to protect themselves, these corporations apply hedging techniques using various foreign
exchange instruments and products in order to negate the impacts of exchange rate
fluctuations. Successful companies employ effective risk management techniques when
making business decisions, and evaluate commercial risk in an explicit and logical manner in
order to offset financial loss occasioned by the volatility in exchange rates (currency risk).
Market Size and Liquidity
Liquidity in the forex market is the highest among other financial markets in the world. The
market comprises central banks, currency speculators, organizations, governments, retail
investors and international investors. Over the years, the size of the FX market has been
constantly increasing. In 2010, The Triennial Survey by the Bank of International Settlements
reported that the average daily transaction in the US for the month of April was $3.98 trillion.
This was much greater than the $1.7 trillion recorded in 1998. The UK had about 36.7% of
the traders in the market to make it the highest contributor in foreign exchange trading.
Second on the list was USA, which had about 17.9% traders while Japan was third with 6.2%
of the total exchangers from the country. Turnover of exchange-traded foreign exchange
futures and options have grown rapidly in recent years, reaching $166 billion in April 2010
(double the turnover recorded in April 2007). Exchange-traded currency derivatives represent
4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced
in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other
futures contracts. Most developed countries permit the trading of derivative products (like
futures and options on futures) on their exchanges. All these developed countries already
have fully convertible capital accounts. Some governments of emerging economies do not
allow foreign exchange derivative products on their exchanges because they have capital
controls. The use of derivatives is growing in many emerging economies. Countries such as
Korea, South Africa, and India have established currency futures exchanges, despite having
some capital controls. Foreign exchange trading increased by 20% between April 2007 and
April 2010 and has more than doubled since 2004. The increase in turnover is due to a
number of factors: the growing importance of foreign exchange as an asset class, the
increased trading activity of high-frequency traders, and the emergence of retail investors as
an important market segment. The growth of electronic execution and the diverse selection of
execution venues have lowered transaction costs, increased market liquidity, and attracted
greater participation from many customer types.
Market participants
There are three types of participants in the foreign exchange market. These are: central banks,
global funds, retail clients (or individual retailers) and corporations. The commercial and
investment banks belong to the group known as ―Interbank market. The interbank market is
the largest market that operates in the foreign exchange market. Corporations, central banks
and global funds also operate at this level. Being the highest traders in the market,
participants in the interbank level are given the best rates. This level constitutes about seventy
five percent of the total volume available each day. The foreign exchange market consists of
two tiers: the interbank or wholesale market, and the client or retail market. Individual
transactions in the interbank market usually involve large sums that are multiples of a million
USD or the equivalent value in other currencies. By contrast, contracts between a bank and
its client are usually for specific amounts, sometimes down to the last penny.
Foreign Exchange Dealers:
Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client
markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly
higher ask price. Worldwide competitions among dealers narrows the spread between bid and
ask and so contributes to making the foreign exchange market efficient in the same sense as
securities markets.
Participants in Commercial and Investment Transactions:
Importers and exporters, international portfolio investors, multinational firms, tourists, and
others use the foreign exchange market to facilitate execution of commercial or investment
transactions. Some of these participants use the foreign exchange market to hedge foreign
exchange risk.
Speculators and Arbitragers:
Speculators and arbitragers seek to profit from trading in the market. They operate in their
own interest, without a need or obligation to serve clients or to ensure a continuous market.
Speculators seek all of their profit from exchange rate changes. Arbitragers try to profit from
simultaneous exchange rate differences in different markets.
Central Banks and Treasuries:
Central banks and treasuries use the market to acquire or spend their country‘s foreign
exchange reserves as well as to influence the price at which their own currency is traded. In
many instances they do best when they willingly take a loss on their foreign exchange
transactions. As willing loss takers, central banks and treasuries differ in motive and
behaviour form all other market participants.
Foreign Exchange Brokers:
Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction. For this service, they charge a small
commission, and maintain access to hundreds of dealers worldwide via open telephone lines.
It is a broker‘s business to know at any moment exactly which dealers want to buy or sell any
currency. This knowledge enables the broker to find a counterpart for a client quickly without
revealing the identity of either party until after an agreement has been reached.
Functions of the Foreign Exchange Market:
The foreign exchange market performs the following important functions:
(i) To effect transfer of purchasing power between countries- transfer function;
(ii) To provide credit for foreign trade - credit function; and
(iii) To furnish facilities for hedging foreign exchange risks - hedging function.
Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another, i.e., to accomplish transfers of purchasing power between two
countries. This transfer of purchasing power is effected through a variety of credit
instruments, such as telegraphic transfers, bank drafts and foreign bills.
In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to domestic
clearings.
Credit Function:
Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.
Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks. In a free
exchange market when exchange rates, i.e., the price of one currency in terms of another
currency, change, there may be a gain or loss to the party concerned. Under this condition, a
person or a firm undertakes a great exchange risk if there are huge amounts of net claims or
net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or liabilities through forward contracts in
exchange. A forward contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the future at a price agreed
upon now. No money passes at the time of the contract. But the contract makes it possible to
ignore any likely changes in exchange rate.
Kinds of Foreign Exchange Markets
The foreign exchange currency markets allow buying and selling of various currencies all
over the world. Business houses and banks can purchase currency in another country in order
to do business in that particular company. Since the foreign exchange currency market is one
of the biggest markets of the world, the market is sub divided into different kinds of foreign
exchange market. The main three types of foreign exchange markets- the spot foreign
exchange market, the forward foreign exchange market and the future foreign exchange
market are discussed below.
Spot Market
The term spot exchange refers to the class of foreign exchange transaction which requires the
immediate delivery or exchange of currencies on the spot. In practice the settlement takes
place within two days in most markets. The rate of exchange effective for the spot transaction
is known as the spot rate and the market for such transactions is known as the spot market.
Forward Market
The forward transactions is an agreement between two parties, requiring the delivery at some
specified future date of a specified amount of foreign currency by one of the parties, against
payment in domestic currency be the other party, at the price agreed upon in the contract. The
rate of exchange applicable to the forward contract is called the forward exchange rate and
the market for forward transactions is known as the forward market. The foreign exchange
regulations of various countries generally regulate the forward exchange transactions with a
view to curbing speculation in the foreign exchanges market. With reference to its
relationship with spot rate, the forward rate may be at par, discount or premium. If the
forward exchange rate quoted is exact equivalent to the spot rate at the time of making the
contract the forward exchange rate is said to be at par. The forward rate for a currency, say
the dollar, is said to be at premium with respect to the spot rate when one dollar buys more
units of another currency, say rupee, in the forward than in the spot rate on a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with respect to the
spot rate when one dollar buys fewer rupees in the forward than in the spot market. The
discount is also usually expressed as a percentage deviation from the spot rate on a per annum
basis.
Futures Market
Future Forex currency markets types are specific types constitute the forward outright deals
which in general take up small part of the foreign exchange currency trading market. Since
future contracts are derivatives of spot price, they are also known as derivative instruments.
They are specific with regard to the expiration date and the size of the trade amount. In
general, the forward outright deals which get mature past the spot delivery date will mature
on any valid date in the two countries whose currencies are being traded, standardized
amounts of foreign currency futures mature only on the third Wednesday of March, June,
September, and December. Future kinds of foreign exchange markets have many features,
which attracts traders to future markets. The first thing is that anyone can trade in future
market. It is open to all kind of traders in foreign exchange market including individual
traders. This is the difference between the future foreign exchange market and the spot
foreign exchange market, since spot market is closed to individuals traders except in case
there are deals of high net worth. The future forex currency market types are central markets,
just as efficient as the cash market, and whereas the cash market is a much decentralized
market, futures trading take place under one roof. The futures market provides various
benefits for currency traders because futures are special types of forward outright contracts
which corporate firms can use for hedging purposes.
Components of Foreign Exchange Trading
Trading Characteristics
Currencies that are often traded include the United States dollar, Euro, Japanese Yen, Pound
Sterling, Australian dollar, Swiss franc, Canadian dollar, Hong Kong dollar, Swedish krona,
New Zealand dollar, South Korean won, Singapore dollar, Norwegian krone, Mexican peso
and Indian rupee. There is no regulation for the traders on the kind of currencies to trade
since this is an over-the-counter market. However, there are different market places where the
participants can trade on the different currencies. Exchange rates among currencies are
affected by the growth of Gross Domestic Product (GDP), inflation, interest rates and balance
of trade. News about the foreign exchange market is given to the public on scheduled periods
so that every trader involved gets access to it at the same time. However, the big banks are
given higher priority by letting them see the operations of their customers.
Currencies Traded In FX Market
Currencies on the forex market are traded in pairs. A currency quote is made of these two
pairs of forex trading currencies, situated together and divided by a line (for example,
EUR/USD). The first currency is called as base currency and the second currency is known as
quote currency. The second currency shows your profits and losses for the forex trading
transactions. Many currencies are used all over the world, but there are only a few currencies
that are traded actively in the forex world. In forex trading, only the most economically stable
and liquid currencies are demanded in sufficient quantities. Get to know about the currencies
traded in forex world by reading through the article further. Forex currencies are divided into
major and minor currencies. The major currencies which are frequently traded in forex
market are USD, EUR, JPY, GBP, CHF, CAD, AUD and NZD. All the other currencies are
called minor currencies. However, there are about 18 currency pairs that are conventionally
quoted by forex market makers as a result of their overall liquidity. These pairs include
USD/CAD, EUR/JPY, EUR/USD, EUR/CHF, USD/CHF, EUR/GBP, GBP/USD,
AUD/CAD, NZD/USD, GBP/CHF, AUD/USD, GBP/JPY, USD/JPY, CHF/JPY, EUR/CAD,
AUD/JPY, EUR/AUD and AUD/NZD. These18 pairs represent the majority of the trading
volume in the forex world. You have a wide variety to choose from and this makes fx trading
less complicated.
FOREX Products
Cross trades: Trades that does not involve the USD. The Rate is calculated from the quote
rates of the individual currencies against the USD.
Non-Deliverable Forwards (NDF’s)
There are some currencies that cannot be physically delivered to the country of origin. For
example, due to currency restrictions in that country we are not therefore able to make a
physical payment of that currency. Typically, these tend to be Latin American, Asian or
Eastern European currencies. Customers may still wish to hedge/speculate against
movements in that Non deliverable Currency‘s exchange rate against other currencies. E.g.
BRL (non-deliverable) / USD (deliverable). Any profit / loss are cash-settled (payable) in
USD (the deliverable currency). An NDF is a short-term, cash-settled currency forward
between two counterparties. On the contracted settlement date, the profit or loss is adjusted
between the two counterparties based on the difference between the contracted NDF rate and
the prevailing spot FX rates on an agreed notional amount.
Exchange Rates & Its Uses
Exchange rates represent the linkage between one country and its partners in the global
economy. They affect the relative price of goods being traded (exports and imports), the
valuation of assets, and the yield on those assets. In the period of fixed or constant exchange
rates these prices, values, and yields were predictable over time. However, since 1973 we
have been living in a world of flexible rates where foreign exchange markets determine these
rates based on trade flows, interest rate differentials, differing rates of inflation, and
speculation about future events. Exchange rates can be expressed as the foreign price of a
domestic currency (i.e., the Euro price of a U.S. dollar) or its reciprocal -- the domestic price
of foreign currency. The spot exchange rate refers to the current exchange rate. The forward
exchange rate refers to an exchange rate that is quoted and traded today but for delivery and
payment on a specific future date. Fixed Exchange Rates A fixed exchange rate, sometimes
called a pegged exchange rate, is also referred to as the Tag of particular Rate, which is a type
of exchange rate regime where a currency's value is fixed against the value of another single
currency or to a basket of other currencies, or to another measure of value, such as gold. A
fixed exchange rate is usually used to stabilize the value of a currency against the currency it
is pegged to. This makes trade and investments between the two countries easier and more
predictable and is especially useful for small economies in which external trade forms a large
part of their GDP.A floating exchange rate or fluctuating exchange rate is a type of exchange
rate regime wherein a currency's value is allowed to fluctuate according to the foreign
exchange market. A currency that uses a floating exchange rate is known as a floating
currency.
Exchange-rate regime:
An exchange-rate regime is the way an authority manages its currency in relation to other
currencies and the foreign exchange market. It is closely related to monetary policy and the
two are generally dependent on many of the same factors. The basic types are a floating
exchange rate, where the market dictates movements in the exchange rate; a pegged float,
where a central bank keeps the rate from deviating too far from a target band or value; and a
fixed exchange rate, which ties the currency to another currency, mostly more widespread
currencies such as the U.S. dollar or the euro or a basket of currencies.
Fluctuations in exchange rates
A market-based exchange rate will change whenever the values of either of the two
component currencies change. A currency will tend to become more valuable whenever
demand for it is greater than the available supply. It will become less valuable whenever
demand is less than available supply (this does not mean people no longer want money, it just
means they prefer holding their wealth in some other form, possibly another currency).
Increased demand for a currency can be due to either an increased transaction demand for
money or an increased speculative demand for money. The transaction demand is highly
correlated to a country's level of business activity, gross domestic product (GDP), and
employment levels. The more people that are unemployed, the less the public as a whole will
spend on goods and services. Central banks typically have little difficulty adjusting the
available money supply to accommodate changes in the demand for money due to business
transactions. Speculative demand is much harder for central banks to accommodate, which
they influence by adjusting interest rates. A speculator may buy a currency if the return (that
is the interest rate) is high enough. In general, the higher a country's interest rates, the greater
will be the demand for that currency.
Factors that affect foreign exchange market trends
The Foreign Exchange or Forex is the largest marketplace today for stock buying and selling,
and it is continually growing with more and more people investing in it. Nevertheless, as
promising as this marketplace might be when it comes to profit, like any other trade it can be
extremely volatile as well. It is therefore important to be familiar with particular factors that
affect developments within the Foreign exchange marketplace if you are made the decision in
joining this arena. After all, acquainting yourself using the many scenarios that can cause
currencies to go up or down can help you a great deal in generating decisions for when to buy
or sell. There are basically 3 main factors that affect the Foreign Exchange, a country‘s
economic system, political conditions and marketplace psychology.
Economic system
Financial factors are the most basic things that create changes inside a country‘s forex. When
such financial circumstances as a budget deficit or surplus is present inside a country, there
will surely be reactions in the marketplace and values will be reflected on currencies. Other
conditions may also include inflation trends, and also the general financial growth of the
country. The much more prosperous a country‘s economy is, the much more investors will be
able to adhere to doing trade in a more constructive perspective. Such indicators as a
development inside a nation‘s gross domestic product (GDP), employment levels and retail
sales among others will basically attract much more investors and that nation‘s forex value
will likely go up.
Political Circumstances
Another extremely essential factor that affect developments in Forex, are the conditions of a
country‘s political sector. This is simply because political instability or turmoil can generally
create negative fluctuations to an economic system. But if this kind of situations happens
wherein a country might rise above political obstacles, the opposite may happen and the
economic system might improve. Occasions inside a region can surely create damaging or
constructive interest among investors for a nation‘s forex. And so, such circumstances surely
influence the developments for demands and costs of a certain currency.
Marketplace Psychology
The perception of traders and investors will significantly affect the International Exchange
market in so several ways. After all, the marketplace is highly dependent on regardless of
whether or not individuals would want to make investments on a country‘s economic system
in order to determine whether forex prices will go up or down. For instance, such conditions
wherein unsettling worldwide occasions might occur, then under the ―flight of quality‖ rule,
people would generally want to search for a secure haven for their investments. Whenever
there is a higher demand to get a particular country‘s economy, then a higher price will
probably be given to buyers and the currency‘s worth will go up and turn out to be stronger.
Other occasions that contribute to traders‘ perceptions may be long-term developments where
people invest based on what they‘ve observed for a lengthy period and time, and even
economic numbers in which people may base their investments depending on what numbers
show a higher value.
Different Exchange Systems which links the Forex Market Globally
The foreign exchange currency trading market has various different foreign exchange
systems through which currencies can be traded. It is beneficial to understand various
exchange systems in forex as it helps while trading in forex markets.
Trading with Brokers:
The Forex brokers are part of the one of the different exchange systems in forex. Their
primary function is to bring closer the buyers and the sellers in the forex market from around
the world. Also, the broker exchange systems in forex helps in the quick, accurate and
efficient execution of orders of various forex traders. The majority of transactions which are
completed through the brokers using different systems in forex are via phone. The phone
lines between brokers and banks are dedicated, or direct, and are usually in-stalled free of
charge by the broker. A foreign exchange brokerage firm has direct lines to banks around the
world. Most foreign exchange is executed through an open box system—a microphone in
front of the broker that continuously transmits everything he or she says on the direct phone
lines to the speaker boxes in the banks. This way, all banks can hear all the deals being
executed. Brokers communicate through Reuter, Phone or Bloomberg. Different Foreign
exchange systems used by brokers in doing the analysis of market trends. The Electronic
Trading system was introduced in 1992. Reuters, the news company introduced the screen
quotations which created screen-based market. Under this system, prices are visible to all
market participants. Traders enter buy and sell orders directly into their terminals on an
anonymous basis.
Direct Dealing:
Another most common exchange system in forex is direct dealing. These exchange systems
in forex are based on the principle of trading reciprocity. The market maker and the bank
making or quoting a price expects the bank that is calling to reciprocate with respect to
making a price when called upon. Direct dealing used to be conducted mostly on the phone.
Dealing errors were difficult to prove and even more difficult to settle. In order to increase
dealing safety, most banks tapped the phone lines on which trading were conducted. This
measure was helpful in recording all the transaction details and enabling the dealers to
allocate the responsibility for errors fairly. But tape recorders were unable to prevent trading
errors. With the introduction of dealing systems in 1980s, the direct dealing exchange
systems in forex were changed forever.
Dealing Systems:
These types of exchange systems in foreign exchange are actually online computer systems
which are linked to the contributing banks around the world on a one on one basis. These
exchange systems in forex are highly reliable and most preferred. The performance of dealing
systems greatly depends upon the speed, reliability, and safety. Accessing a bank through a
dealing system is much faster than making a phone call. There are continuous improvements
in dealing foreign exchange in order to offer maximum support to the dealer's main function.
Matching Systems:
This exchange system in forex is different from the other foreign exchange systems such as
the dealing systems. In the dealing system the currency trading is done directly and on a one-
on-one basis, however in matching systems the currency trading is done anonymously and
individual traders deal against the rest of the market. This is similar with other different
systems in forex such as the trading the market with the help of a broker. However, unlike the
brokers' market, there are no individuals to bring the prices to the market, and liquidity may
be limited at times. Matching Systems are well-suited for trading smaller amounts as well.
The dealing systems characteristics of speed, reliability, and safety are replicated in the
matching systems. In addition, credit lines are automatically managed by the systems.
Traders input the total credit line for each counter party. When the credit line has been
reached, the system automatically disallows dealing with the particular party by displaying
credit restrictions, or shows the trader only the price made by banks that have open lines of
credit. As soon as the credit line is restored, the system allows the bank to deal again. In the
interbank market, traders deal directly with dealing systems, matching systems, and brokers
in a complementary fashion.
Linkage of foreign exchange markets
How does the foreign-exchange market trade 24 hours a day?
The foreign exchange market is the largest financial market in the world, trading around $1.5
trillion each day. Trading in the forex is not done at one central location but is conducted
between participants through electronic communication networks (ECNs) and phone
networks in various markets around the world.
The market is open 24 hours a day from 5pm EST on Sunday until 4pm EST Friday. The
reason that the markets are open 24 hours a day is that currencies are in high demand. The
international scope of currency trading means that there are always traders somewhere who
are making and meeting demands for a particular currency.
Currency is also needed around the world for international trade, as well as central banks and
global businesses. Central banks have relied on foreign-exchange markets since 1971 - when
fixed-currency markets ceased to exist because the gold standard was dropped. Since that
time, most international currencies have been "floated", rather than pegged to the value of
gold.
At each second of every day, countries' economies are growing and shrinking because of
economic and political instability and infinite other perpetual changes. Central banks seek to
stabilize their country's currency by trading it on the open market and keeping a relative value
compared to other world currencies. Businesses that operate in many countries seek to
mitigate the risks of doing business in foreign markets and hedge currency risk.
To do this, they enter into currency swaps giving them the right, but not necessarily the
obligation to buy a set amount of a foreign currency for a set price in another currency at a
date in the future. By doing this, they are limiting their exposure to large fluctuations in
currency valuations. Due to the importance of currencies on the international stage there
needs to be round-the-clock trading at all times. Domestic stock, bond and commodity
exchanges are not as relevant, or in need, on the international stage and are not required to
trade beyond the standard business day in the issuer's home country. Due to the focus on the
domestic market, demand for trade in these markets is not high enough to justify opening 24
hours a day, as few shares would be traded at 3am, for example. The ability of the forex to
trade over a 24-hour period is due in part to different time zones and the fact it is comprised
of a network of computers, rather than any one physical exchange that closes at a particular
time. When you hear that the U.S. dollar closed at a certain rate, it simply means that that was
the rate at market close in New York. But it continues to be traded around the world long
after New York's close, unlike securities.
The forex market can be split into three main regions: Australasia, Europe and North
America. Within each of these main areas there are several major financial centres. For
example, Europe is comprised of major centres like London, Paris, Frankfurt and Zurich.
Banks, institutions and dealers all conduct forex trading for themselves and their clients in
each of these markets.
Each day of forex trading starts with the opening of the Australasia area, followed by Europe
and then North America. As one region's markets close another opens, or has already opened,
and continues to trade in the forex market. Often these markets will overlap for a couple
hours providing some of the most active forex trading. So if a forex trader in Australia wakes
up at 3am and decides to trade currency, they will be unable to do so through forex dealers
located in Australasia but they can make as many trades as they want through European or
North American dealers. With all of this action happening across borders with little attention
to time and space, the sum is that there is no point during the trading week that a participant
in the forex market can't potentially make a currency trade.
The foreign exchange market is open and active 24 hours a day from Monday morning in
New Zealand through Friday night in New York. At any given moment, currency trading
desks in dozens of global financial centres are open and active in the market.
Currency trading doesn't even stop for holidays when other financial markets, like stocks or
future exchanges, may be closed. Even though it's a holiday in Japan, for example, Sydney,
Singapore, and Hong Kong may still be open. About the only holiday in common around the
world is New Year's Day, and even that depends on what day of the week it falls on.
There is no officially designated starting time to the trading day or week, but for all intents
the market action kicks off when Wellington, New Zealand, the first financial centre west of
the International Dateline, opens on Monday morning local time. Depending on whether
daylight saving time is in effect, it roughly corresponds to early Sunday afternoon in the
Americas, Sunday evening in Europe, and very early Monday morning in Asia.
The Sunday open represents the starting point when currency markets resume trading after the
Friday close of trading in North America (5 p.m. Eastern time). This is the first chance for the
forex market to react to news and events that may have happened over the weekend. Prices
may have closed New York trading at one level, but depending on the circumstances, they
may start trading at different levels at the Sunday open. The risk that currency prices open at
different levels on Sunday versus their close on Friday is referred to as the weekend gap risk
or the Sunday open gap risk. A gap is a change in price levels where no prices are tradable in
between.
As a strategic trading consideration, individual traders need to be aware of the weekend gap
risk and know what events are scheduled over the weekend. There's no fixed set of potential
events, and there's never any way of ruling out what may transpire, such as a terror attack, a
geopolitical conflict, or a natural disaster. You just need to be aware that the risk exists and
factor it into your trading strategy.
On most Sunday opens, prices generally pick up where they left off on Friday afternoon. The
opening price spreads will be much wider than normal because only Wellington and 24-hour
trading desks are active at the time. When banks in Sydney, Australia, and other early Asian
centers enter the market over the next few hours, liquidity begins to improve and price
spreads begin to narrow to more normal levels.
Because of the wider price spreads in the initial hours of the Sunday open, most online
trading platforms don't begin trading until 5 p.m. ET on Sundays, when sufficient liquidity
enables the platforms to offer their normal price quotes. Make sure you know your broker's
trading policies with regard to the Sunday open, especially in terms of order executions.
NETWORK OF DEALERS
The Forex market consists of a network of dealers and traders grouped around the world.
These players are linked by a system of computers, phones, and the internet.
The Major Dealing Centres
While there is no true centre, the Forex market has major dealing centres located in London,
New York, and Tokyo. These are labelled 'major centres’ because the activity in these places
hold tremendous influence on the market. There are other centres labelled 'minor centres,'
which also play a significant, albeit smaller, role in the market. These 'minor centres’ Hong
Kong, Singapore, Sydney, Frankfurt and Zurich. The 8 regions are very influential when it
comes to the trading practice of the Forex market. Everyone from the day trader to the Hedge
Fund manager keeps an eye on the markets and their activities.
Central Banks
The majority of developed market economies have a central bank, whose role differs from
country to country. Central banks play an important role in the Forex market. They try to
maintain the money supply, interest rates, inflation, and other market factors. A nation's
central bank also has the fundamental responsibility of maintaining the market for its national
currency. This entails monitoring and checking the prices dealt in the Forex market.
Participants in the market all tend to respect the opinions of the central banks because of the
power and control they have over the value of their national currency.
Banks
Both small and large banks, working for themselves and their clients (institutions, individual
investors), participate in the Forex markets. According to the Bank for International
Settlements, approximately 50% of all Forex transactions are strictly interbank (See Key
terms section) trades. Some of the more active large banks may trade up to one billion dollars
daily. And while some of this trading is done for customers, most of it is for the bank's own
account.
In the past banks relied on Forex brokers to handle their accounts in the role of middlemen,
but with the emergence of technology in the Forex arena, they have been replaced by
computers and other devices. Today, transactions are made by telephone with brokers or by
an electronic medium, with the transaction time being between 5 and 10 seconds.
Market Makers
Forex market makers are the banks and brokerage companies that facilitate the 24 hour
trading capabilities of the Forex market. Market makers literally "make the market" for the
currencies. They ensure that the market is always functional and that the currencies in it will
always obtain the market rate. To achieve this level and efficiency of trading, Forex market
makers update their prices at least two times per minute allowing the trader to get the most
complete up to date price and information as possible.
Corporations
Small and large companies also play an important role in the Forex market. These companies
often use foreign exchange to pay for goods or services. Compared to banks and hedge funds,
corporations trade less amounts of currency. Although they also do not hold the influence of
banks and hedge funds, they keep the market strong through international trade and foreign
currency exchange between multinational companies.
Fund Managers
Forex fund manager are similar to money managers in the investment field. However, fund
managers do business in both the domestic and international arena for individual investors,
corporate pension funds, governments, and even central banks. Fund managers usually have a
large pool of investments to oversee for a wide variety of clients. Dealing with hundreds of
millions of dollars, they invest money across a range of countries to maximize returns.
Hedge Funds
Hedge funds have a reputation for aggressive currency speculation. Their influence in the
market over the past decade has increased immensely (FXBlog). Hedge funds oversee
billions of dollars of equity, and, due their tremendous borrowing power, may have rivaled
the power and influence of central banks, if investments and market rends are in their favor.
As opposed to banks and fund managers, hedge funds are primarily more concerned with
managing the total risk of their investment pools.
Investment Management Firms
Investment management firms typically manage large accounts on behalf of corporate
pension funds, trusts, charity organization and similar institutions. They use the Forex market
to facilitate transactions in foreign securities. An example of an investment firm's activity in
the Forex market is given by trading markets.com: an investment manager in charge of an
international equity portfolio needs to purchase and sell several pairs of foreign currencies to
pay for foreign securities purchases. Like hedge funds, investment firms are concerned with
limiting risk (while, of course, maximizing returns).
Brokers and Electronic Brokers
The Forex broker is very similar to a stockbroker. One difference, though, is that Forex
brokers only deal with banks. They, in a very efficient manner, act as the primary agent for
bank transactions of the Forex market. Due to technological innovations in the market, many
traditional brokering duties have been computerized, decreasing the need for human handling
of the orders.
This technological takeover of the brokerage aspect of the Forex market, has led to the
emergence of 'straight through processing.' Straight through processing is the automatic
processing of an order as soon as it becomes. This has opened up Forex trading to a new,
wide range of individuals and companies. Some of the most popular trading platforms include
Forex.com, FXconnect, and FX Solutions. These sights, and others like them, allow Forex
market participants, mostly the larger banks and corporations, to access the market directly,
instead of going through a broker or a middleman, ultimately cutting costs significantly.
Society for worldwide international financial communications (SWIFT)
The rapid improvement in communication and technology has enabled the foreign exchange
dealers worldwide to link together through telephone, telex and satellite communication
network called the Society for Worldwide International Financial Communications
(SWIFT).The communication system based in Brussels, in Belgium links banks and brokers
in every financial centre. It enables the dealers to have the information of all the events that
may have an impact on the exchange rate thus making the worldwide foreign exchange
centres to function as efficient as one single market.
Clearing House Interbank Payments System
In the United States, all foreign exchange transactions involving dollars are cleared through
the Clearing House Interbank Payments System (CHIPS). It is an electronic fund transfer
mechanism. It is a system developed by the New York clearing house association for transfer
of international dollar payments. It links about 150 depository institutions that have offices in
New York. It handles more than 100000 interbank transfers daily, valued about $500 billion.
It represents about 90 percent of all interbank transfers relating to international dollar
payments.
Bibliography
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