Globally, different currencies are traded for one another in the foreign exchange market (Forex). It is held to be the biggest financial market in the world, and which is closest to the ideal of “perfect competition” held by all the economists. The traders in include currency speculators, banks, central banks, governments, multinational corporations, and other financial organizations.
The forex market is characterized by:
- Huge trading volumes
- 24 hour trading
- Geographical diversity
- Large variety and number of traders
The trading volumes exceed billions of dollars, and the market is open throughout the day, as currency is traded across the globe. This geographical diversity is the reason that a large variety of traders exist in this market. Also, the capability of different platforms such as Internet trading, creates a diverse trader base in this market. Trade in this market consists of currency or foreign exchange also creates a very high amount of liquidity.
The main feature includes the absence of a central marketplace for trading purposes. As such, the trade is carried out OTC or “Over The Counter”. Depending upon the kind of foreign exchange or currency instrument that is being traded, and the kind of trade being conducted, the prices vary. For example, the price for buying currency notes would be different from the price for buying checks. Similarly, a buy transaction exchange rate will differ from a sell transaction exchange rate.
The Top 5 currencies that are traded in this market are:
- US Dollar (USD)
- Eurozone Euro (EUR)
- Japanese Yen (JPY)
- British Pound Sterling (GBP)
- Swiss Franc (CHF)
Currency rates are always expressed in terms of another currency, which is popular and more stable than the former one. For example, the exchange rate of the Indian Rupee is always expressed in comparison with the USD.
Factors Affecting Trade
Due to its particular features, forex rates and trading are primarily the result of the demand and supply functions of the currency.
Other than this view, the forex market is also affected by factors, which can be broadly classified into:
- Market Psychology
Political conditions of a country can affect the currency rates. Growth and economic prosperity can have a positive effect, while political upheaval like civil war can negatively affect these rates. Economic factors include things such as the budget deficit or surplus conditions, the balance of trade situation, levels of inflation, and the general trend of economic growth in that nation.
Market psychology includes the susceptibility of the forex market to rumors, perceptions of the market regarding the safety of a particular currency, and the definitive long term trends of a currency in the market.
These are different types of financial instruments or trading systems, which are followed commonly in this market.
The transaction has a two day delivery date. This is a direct exchange between two currencies, often involves cash, and does not include any interest. This is the most voluminous trade that is carried out in the market.
Currencies are exchanged on a future date, which is decided by the buyer and seller. This is undertaken depending on the rate of exchange that is prevalent on that day.
This is similar to the Futures trade that takes place in the stock market. This involves standard contracts, which often have maturity dates. The contract will state how much currency is to be exchanged at a specific rate and on a particular day. There often are special exchanges for this type of trading, and often includes interest costs.
This is a very unique type of transaction. In this way, two parties decide to exchange currencies with each other for an agreed length of time, and then decide to reverse the transaction at a future date.
This is similar to the Options trade in the stock market. The owner of the transaction can exchange currency at a pre-agreed rate on an already decided date. This is an option or a right, but not an obligation of the Option owner.
Thus, the foreign exchange market is a very important aspect of the measurement of the financial situation of a particular country, in the global marketplace.