Profile of Forex Marketplace

Foreign Currency and the Interbank Market

The world’s borders are open to individual, corporate and government commerce and are becoming more so every year. The trades and financial dealings that take place across international lines often result in vast amounts of foreign currencies flowing into other countries’ banks. Transacting business in trading and lending and consolidating deposits of foreign currencies, as a means of handling the interbank market was developed.

Global Operation

Central Banks like the Federal Reserve, Bank of Japan, Bank of England and European Central Bank play a major role in keeping currency fluctuations at equiibrium. World exchange rates have been permitted to operate in a floating rate mechanism since 1971 (sometimes referred to as the “dirty float” due to the nature of governmental intervention). Although some entities such as the European Economic Community have attempted to loosely maintain currency alignment amongst them, this has been done with little genuine success. The recent devaluations and revaluations of the various European currencies under the European Rate Mechanism are evidence of the might of the market forces operating in a global arena. In simple terms, the FOREX market operates as the purest democratic form of supply and demand for currencies as a tradable commodity.

This does not mean that world governments are not interested in the actions of the interbank market. Each government has its own monetary and currency policies, and through these policies each country can indirectly affect the trading and markets for its own currency.

As an example, the U.S. Treasury department can and does, buy and sell U.S. dollars in an attempt to influence the dollar’s exchange rate in the interbank market. The money for these transactions comes from the Treasury’s exchange stabilization fund, a fund established in 1934 and purposely created free from Congressional intervention or audit.

Trading

If Treasury officials decide that the U.S. dollar is priced too high in the interbank market, it can sell U.S. dollars in the market. As the supply of dollars in the market increases, the value should decrease and the exchange rate should drop. Conversely, if the Treasury decides that exchange rates for the U.S. dollar are too low, it can buy dollars in the market. As the supply of available dollars shrinks, the price of dollars should increase against other currencies in compensation. Stabilization of a currency through the purchase and sale of a country’s currency by its central bank is sometimes referred to as intervention.

The interbank market for foreign currencies functions efficiently as an open market conducting international monetary business and exchange from bank trading rooms around the world.

Most interbank trades occur to fulfill foreign currency contracts or commitments between two or more parties, each of which has negotiated the terms of the contract until all parties’ needs are met. Banks and multinational corporations entering into multi-million dollar foreign currency contracts must negotiate price, delivery and settlement terms in much the same manner as do investors in many U.S. securities.

Trading in currencies takes place around the clock, with most trades conducted in units valued from $1 million to $5 million (U.S.) and up. Foreign currency transactions are usually settled in one of two ways: spot trades settle with no fixed delivery date, yet have roll-over capabilities, (sometimes referred to as the spot market). Forward trades settle in more than two business days, with settlement dates normally set from I to 18 months out (sometimes referred to as the forward market).

Exchange Rates

It is the Interbank market that yields the familiar foreign exchange rates. An exchange rate is the rate at which one currency (such as U.S. dollars) can be converted into another (such as the Swiss franc or Japanese yen). Exchange rates change constantly, affected by hundreds of market- influencing factors (including political, economic, social and market conditions).

Exchange rates are usually quoted in terms of the currency of the country in which the quote is published. As an example, a quotation published in a British newspaper might put the exchange rate for the U.S. dollar to the British pound at 1.9135, which means that one British pound would buy 1.9135 U.S.dollars. The same exchange rate in a U.S. newspaper would be quoted at 0.5226, which means that one U.S. dollar would buy 0.5226 British pounds.

At one time, a fixed exchange rate set by international agreement existed between foreign currencies. This was changed in the 1970s to the current floating exchange rate system, in which foreign currency markets set the exchange rates. In a limited number of cases, the exchange rate of one currency to another is set by agreement between the countries involved, and in other cases, there is no exchange rate because the local government does not want its currency exchanged into that of another country.

Appreciation. A currency is said to be appreciating if it is rising in value compared to other currencies on the foreign exchange market (if it buys more units of foreign currencies). U.S. Currency is appreciating, for example, if it buys more British pounds now than it did at some point in the past. If the exchange rate is 1.58 dollars to the pound, for example, U.S. tourists need $1.58 to purchase one British pound. If the exchange rate moves to 1.50 dollars to the pound, Americans will need only $1.50 to purchase one British pound.

Depreciation. If a currency falls in value in the foreign exchange market (like the British pound in the preceding example), it is depreciating. In this case, it will buy fewer units of another country’s currency. Depreciation of the U.S. dollar means that U.S, dollars are becoming cheaper for citizens of other countries and the American goods and services are becoming less expensive abroad. Other countries might import more U.S. grain, tobacco, computers and other commodities, giving the United States a positive trade balance.

If U.S. dollars are depreciating, goods produced by other countries are becoming more expensive in the United States as those countries’ currencies appreciate relative to the dollar, This might discourage Americans from buying Japanese cars, Swiss watches or Brazilian coffee, reducing the United States’ debit items. Therefore, depreciation of the dollar tends to lead to an improved balance of payments.

Valuation. The rate of exchange between currencies is by no means fixed or set. The financial papers often site instances when the currencies of various countries have undergone devaluation or revaluation in relationship to the currencies of other countries. Changes in valuation can be results of either market factors or governmental decisions.

Devaluation. Devaluation occurs when the value of a currency drops substantially in comparison to the value of gold or to the value of another country’s currency. The devaluation of a currency is usually market driven and can be affected by that country’s international trade balance, reserves of gold, rate of inflation and general economic health.

Revaluation. Revaluation is a change in the relative value of a country’s currency and represents either an increase or decrease in that value. The revaluation of a currency usually occurs as the result of a decision by the government of that country and is implemented by its central bank (the United States’ central banking system is the Federal Reserve).

As an example of a revaluation, assume that high inflation in the country of Porsha has caused such a drop in the value of Porsha’s currency that a loaf of bread is priced at 100,000 Dranzuls. The citizens of Porsha must carry around a large bag of their country’s currency just to make everyday purchases. Rather than let the situation continue, the government of Porsha revalues the country’s currency and declares that one new Drazul will have the same value as 10,000 old Drazuls ( a 10,000 to I revaluation). The loaf of bread that cost 100,000 old Drazuls can now be purchased for ten new Drazuls. The interbank market had set it at 125,000 to I U.S. dollar. After the revaluation, one U.S. dollar is now worth 12.5 new Drazuls, and other currency exchanges are adjusted accordingly.

Speculating in Foreign Currencies

While foreign currencies do provide speculative opportunities for sophisticated (and highly liquid) investors, they carry their own set of risks. Because the interbank market is decentralized, any institution can provide investors with reliable, timely quotations on foreign Currency values. Some organizations and news sources are able to provide quotations that reflect the values of currency transactions that occurred 24 hours or more in the past, but even under the most favorable of circumstances, these figures represent only approximations and not actual trades. In the intervening period, changes in a country’s economic, governmental and social policies not to mention those of other major countries could have significant impact on the current price of its currency in the market, and an investor could be taking on substantial risk by trading without having real-time up-to-the minute information on all major markets.

Participants In The Forex Market

There is a wide range of players in this marketplace. According to the Federal Reserve Bank, nearly 80% of trading is controlled by major banks (commercial and international). The remainder of the market’s participants range from large multinational corporations, financial cartels, global money managers, registered dealers, international money brokers, futures and options traders, down through private speculators, import/export companies, international travelers and users of international money orders. Among these categories, only a very limited amount of trading is used for physical delivery or non-speculative purposes (less than 5%).

Banks

They are active in Forex, both on behalf of their customers (exporters and importers, borrowers and lenders) and on their own accounts. They are both intermediary and principal.

Merchant Banks

They participate on behalf of clients and on their own account. They exchange with each other and with the banks, either directly or through a Forex broker.

Other Financial Institutions and Corporations

Central Banks

From time to time central banks are key players in Forex markets.

Forex Brokers

The brokers in the Forex market act as middlemen in a role that is broadly similar to money and stock brokers, who stand between buyer and seller, and execute deals in return for a commission.

Forex  Market Composition

A. Market for Bank Notes

Bank notes are instruments payable on demand by issuing banks and their agents. It is an over-the-counter market and is characterized by high transaction costs. Actual physical delivery of currency occurs.

B. Interbank Market

This is one of the largest in the overall foreign exchange marketplace, as measured by trading volume. This global network of large commercial banks acting as dealers trades hundreds of billions of dollars daily and operates twenty-four hours a day. The foundation of the interbank market is its price continuity, which rests on the principle and spirit of reciprocity that exists among the market makers – their willingness to supply quotes and honor them if accepted by another participant. Reciprocity is the essential ingredient that supports the market’s liquidity and efficient operation. The market’s existence is further aided by generally recognized, informally set standards (dealing parameters) which help define the nature and conduct of transactions.

These rules pertain to:
1) Currencies to be traded
2) How currencies are to be quoted
3) Actual trading hours within a time zone
4) Standard transaction amounts

C. Forex Brokers Market

This market is substantially as large as the direct – dealing interbank market in transaction volume. Both interbank participants and the smaller banks, which are not active in the interbank market, often use the services of one or more Forex brokers. The brokers market has the potential to provide the best bids and offers available on the interbank market. The use of a broker as an intermediary also permits a bank to deal with other banks indirectly. Brokers provide anonymous importance. Only a party with a trade has the right to know the identity of the broker’s principal.

D. Forex Futures Market

As an action market, the IMM differs from the interbank and brokers market. The futures contracts traded on the IMM consist of fixed quantities of foreign currencies for future delivery.

E. Forex Options Market

Options are traded not only in the over-the-counter interbank market, but also on several open-auction exchanges.

Live Chat