What is Forex?

Razvan Mihai

Analyst

A market where individuals or a collective have the ability to buy, sell, exchange and speculate on currencies.  You can also define it this way: The Forex Market (Forex, FX, currency market or Foreign Exchange Market) is a global decentralized market for the trading of currencies. 

The main participants in the market are the large international banks, commercial companies, central banks, investment management firms, hedge funds, retail Forex brokers and investors.

The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states. Especially Eurozone members, and pay Euros, even though its income is in United States dollars.  It also supports direct speculation based on the interest rate differential between the two currencies.

Sometimes trading in the Forex Market is confused with trading a CFD (check what is a CFD here) based on the Forex Market. To be an active trader in the currency exchange market, you should own currency in order to buy and own another.

Let us take a look at an example: a US citizen would like to visit France. In order for that individual to be able to buy food, pay accommodation and souvenirs, they would need to exchange United States dollars to euros at a bank or exchange booth.

Let us consider another example: Apple Inc. would like to invest in a factory in Japan. The company owns US dollars since its main revenue is made in the United States. To open this factory, they would need to change the US dollars to Japanese yen. And the examples could continue.

The modern foreign exchange market was established during the 1970s after three decades of government restrictions on foreign exchange transactions. This was the time when countries gradually switched to floating exchange rate from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying for some quantity of another currency. This is why a currency by itself is neither stronger or weaker unless it is compared to another.

In the Forex Market the instruments traded are called currency pairs. The symbol for a currency pair will appear like this: EUR/USD. 

It is followed by two quotations like the example shown below.

Symbol             Bid       Ask

EUR/USD         1.3300            1.3302

The first quotation is the price at which an investor sells (Bid) and the second one is the price at which the investor buys (Ask). The difference between them is called the spread. It is the cost of trading in the forex market through a brokerage house, exchange booth or a bank.

Using the same example, but applied as a general rule, the EUR/USD can be read by: how many units of the second currency (USD) should be paid for one unit of the first currency (EUR).

 

Majors

In the forex market, there are four currency pairs considered to be the most heavily traded: EUR/USD, USD/JPY, GBP/USD, USD/CHF. Some people consider the major pairs are those that are made from the following currencies:

 

EUR – Euro Area single currency

GBP – Great Britain Pound (Cable)

AUD – Australian Dollar (Aussie)

NZD – New Zealand Dollar (Kiwi)

USD – United States Dollar  (Greenback)

JPY – Japanese Yen

CHF – Swiss Franc

CAD – Canadian Dollar (Loonie)


Carry Currency Pairs

Carry pairs, are currency pairs formed by a country whose currency has high interest rate and one that has low interest rate.  Their major characteristic is that they are traded all over the world and are very volatile.

It is easier to grasp if you remember that these are not stable pairs. But their evolution depends on the evolution of the interest rate. 

The basic idea of carry trading was to get a loan in a country’s currency with a very small interest rate, then exchange it for another’s with high interest rate in order to deposit for a higher interest rate. In practice the difference between the interest should be big enough to cover the exchange costs, the paid interest, other commissions and to still remain with a profit.

For the moment, the most important examples in the category are: USDJPY, EURUSD, AUDJPY, NZDJPY, USDCHF. But these pairs will change according to the interest rate posted by each Central Bank.

It is important to point out that it is not advisable for beginners to scalp with carry pairs because at times spreads widen very quickly and even with a stop-loss order it is not enough to avoid loss. Experienced scalpers are also advised to trade those using typical trends, following strategies to exploit breakouts and other sharp movements.

Exotic currencies

 

Exotic currencies are those formed by at least one exotic country’s currency. Their important characteristic is that they are rarer, less liquid and less well-known forex pairs than the other two previous categories of currency pairs. We can enumerate the pairs: USDSEK, USDZAR, USDTRY, USDNOK and USDBRL or the Russian ruble.


The Forex Market is unique because of the following characteristics:

·        Its huge trading volume representing the largest asset class in the world, leading to high liquidity;

·        Its geographical dispersion;

·        Its continuous operation: 24 hours a day except weekends;

·        The variety of factors that affect exchange rates;

          Low margins of relative profit in comparison to other markets of fixed income, and

·        The use of leverage to enhance profit and loss margins with respect to account size.

 

According to the Bank of International Settlements, the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity shows that trading in foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. Foreign exchange swaps were the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion.


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