What is the foreign exchange market?

foreign exchange

The foreign exchange market is a powerful and influential financial market that has made international headlines in recent years due to various currency crises. There was the crisis of the Turkish lira (2018), the Venezuelan bolivar (2008, 2018) or the Argentine peso (2017-2018). But so-called “strong” currencies, such as the Swiss franc (2015, so-called “franc shock”) or the US dollar (July 15, 2008, $ 16,083 per € 1, “World Bank predicts end of dollar rule” 2) also came up violently under pressure. The foreign exchange market is better known under the name Forex (Foreign Exchange Market).

where currency supply and demand meet

Let’s take a closer look at this definition:
• The foreign exchange market is a financial market. This is essentially divided in three markets: money market, capital market and foreign exchange market. In the money market loans are negotiated; the capital market offers investment opportunities in stocks. The respective currencies of the countries meet in the foreign exchange market.
• The “goods” that are “bought” and “sold” are foreign exchange, foreign currencies. Foreign exchange has no physical existence. They appear as foreign transfers or credit in a foreign currency in an account, so they have a purely electronic existence. Foreign currencies are transferred to accounts (book money). (The coins and banknotes of foreign currency
are referred to as currency.)
• The “price” at which the foreign exchange is traded is the exchange rate. This indicates how much currency we need to exchange it for another currency (more on that below).
• Supply and demand meet. Buy and sell the various participants in the forex market to meet certain economic and financial needs (at the end of this article we will look at the participants in the forex market in more detail)..
• The main features of the Forex compared to the other financial markets are:

  1. Highest volume of all financial markets.
  2. Open 24 hours.
  3. OTC market.
  1. Highest volume of all financial markets
    The Forex market is the largest and most actively traded financial market in the world in terms of volume. On average, more than $ 5000 billion traded (5 to the power of 12 or a 5 followed by 12 zeros): 5,000,000,000,000 A number that is very difficult to imagine (for comparison: in the Milky Way, our home galaxy, there are “only” between 100 and 300 billion stars.) What does that mean in terms of volume? Volume is the money that changes hands in a financial center in one day.
Forex

Forex daily average volume vs. Exchange daily average volume. (Source: Nasdaq and Bank for International Settlements, own presentation)

let’s compare the volume of the largest exchanges in the world to that Volume of forex trading. This volume exceeds the global trading volume for shares by 25 times. The huge amount of money traded in the forex market explains the powerful influence that the forex has on other financial markets, the real economy and politics.

  1. Open 24 hours The foreign exchange market is open 24 hours a day, five days a week. Trading begins on Sunday at 11:00 p.m. Central European Time (start of trading in Australia) and ends on Friday at 11:00 p.m. Central European Time (end of trading in the United States).

24h trading world map forex. (Source: own representation)

  1. OTC market
    The Forex is an OTC market. OTC stands for Over the Counter Market, because here
    there is no separate geographic marketplace as with the stock exchanges (New York, Frankfurt, London, etc.). It only works electronically

Foreign exchange trading takes place around the world via the networks of traders (banks and brokers); all transactions are processed online. The main foreign exchange centers are London, New York and Tokyo. Now after Brexit, Frankfurt will most likely take over from London.

Exchange rates and currencies


We deal with currencies every day. Whether on vacation in Turkey (Turkish Lira), in Argentina (Argentine peso) or Vietnam (Vietnamese dong). On all of these trips you have to buy the national currency to be able to pay for your purchase. Much of what you buy (for example, imports from your country) had to be paid for with foreign money, i.e. currencies. Around to make these payments, the importer first had to exchange his euros for the foreign currency (e.g. in US dollars). This currency exchange takes place, directly or indirectly (through the bank to which the importer is a customer) in the foreign exchange market. The “price” that the importer pays for US dollars (USD) is the exchange rate.

Exchange rate

The nominal exchange rate is the price of a currency in units of another currency.
The currencies are traded in pairs (the most important currency pairs are shown in the Table ). For example, a Forex terminal contains EUR / USD, USD / CHF (Swiss Franc) or USD / GBP (British Pound). The EUR / USD is the exchange rate of the euro and the US dollar, in this case you need 1.1234 US $ to buy 1 EUR.

currency pairs

What does these graphic mean?

  1. The currency pair being traded (EUR – USD)
  2. The exchange rates (“the prices”):
    a) Sell: You sell the currency on the left (EUR). The price is the so-called bid (“bid price”). This is the highest price that a bank or broker would pay.
    b) Buy: You buy the currency on the left (EUR). The price is the so-called ask (“ask price”). This is the selling price offers a bank or broker.
    c) Spread: This is the difference between Bid and Ask, the commission that you have to pay the broker for your service

More than 70% of all foreign exchange transactions involve the US dollar as a currency pair.
Majors are the main currency pairs. Minors are currencies that are a Pair with the USD but are rather illiquid (this means that they are little traded). Crosses are currency pairs without the USD (e.g. Euro and Japanese yen). Finally there are exotics (e.g. Tenge from Kazakhstan). The Foreign exchange market is a very risky financial market. Should you still invest,
it is advisable to focus on majors (and some of the crosses). There are three arguments in favor of majors:
• Majors are currency pairs from the world’s largest economies.
• These economies are characterized by political and economic ones Stability.
• They pay low interest on their government bonds due to their low Probability of becoming insolvent. (The interest rate of the European Central .Bank is 0%, that of Turkey 24%, which means that the Turkish lira is currently a risky currency) (maybe it’s already different now, things are changing realy fast in the financial world) Both EUR and USD have flexible exchange rates (free float or flexible floating system) A flexible exchange rate is determined by the market demand and supply are the forces that determine the exchange rate. A free market without any direct intervention from central banks. This is how we can graphically represent this free market. Is the most important graphic of this essential. We will use them to analyze and forecast changes in exchange rates. On the vertical axis, the exchange rate is in USD per EUR, the “price” in dollars for 1 EUR. On the horizontal axis is the amount in euros that is offered and demanded. The falling curve from left to right marks the demand for Euros (since we are in the American market from Euros comes from this demand from market participants in the USA). As with any other market, the lower the price, i.e. the fewer dollars per euro, the greater the demand. Therefore, the demand curve is falling.
The rising curve from left to right marks the supply in euros (the market participants in the eurozone are those who offer the euro). The opposite of the demand curve applies here: the higher the price (more US dollars per euro), the greater the quantity offered in euros.

Exchange rates and currencies

EURO market in the USA. (Source: own Presentation)

Where the supply and demand curves intersect, there is a balance.
the equilibrium exchange rate (€ / $) * and the equilibrium quantity Q * €. The Equilibrium states how many EUR and USD are traded at what exchange rate at that moment. But this is just the beginning. Later in the article we will consider the fact that the supply and demand curve can shift, which leads us to a new balance and a new one


Exchange rate leads


Important


The exchange rate can be expressed in two different ways:

  1. Quantity listing (indirect quotation)
  2. Price quotation (direct quotation)
  1. Quantity listing (indirect quotation)
    The exchange rate indicates how many units of the foreign currency it takes to buy one unit of the local currency.

For example, on June 7, 2019, you had to raise about $ 1.12 per EUR 1. In this case (quantity listing), an increase in the nominal exchange rate means that the domestic currency, in this case the euro, has gained in value; it is an appreciation.

2. Price quotation (direct quotation)
The exchange rate indicates how many units of domestic currency correspond to one unit of foreign currency.

For example, since we recorded an exchange rate of $ 1.12 per 1 EUR on June 7, 2019, we can also specify: 0.89 EUR per dollar (1 divided by 1.12; the price quotation is only the reciprocal of the quantity quotation) and would have determined the price quotation. In this case, an increase in the exchange rate means a devaluation of the domestic currency, in this case the euro

Appreciation (the domestic currency) increase in the value of the domestic currency (which is equivalent to a devaluation of the foreign currency). (Appreciation = “price” of the currency increases).

Devaluation (the domestic currency) decrease in the value of the
domestic currency (which is equivalent to an appreciation of the foreign currency). (Devaluation = “price” of the currency decreases).

This means that a change in the exchange rate always leads to the appreciation of one currency and at the same time to the devaluation of the other currency.
Important In this article, we will use quantity listing, that is, foreign currency units per unit of the domestic currency from the perspective of the euro zone (that is, the euro as the domestic currency).

Exchange rate systems


We can also speak of two types of exchange rates: Spot Exchange
Rate and forward exchange rate:
• The forward rate is the exchange rate, usually for
international trade, which is agreed today for a fixed date
in the future.
• The spot rate (Spot or Spot Exchange Rate) is the exchange rate for
Transactions that are carried out immediately (the delivery times are
Usually within two days).

So far we have only spoken of one currency pair (EUR – USD), that is completely flexible. But there are different exchange rate systems, and each country decides which one to adopt for its currency. The basic distinction is between systems of flexible and fixed exchange rates. Flexible stands for “free” and fx for “fixed” exchange rates. Between The two extremes (completely fx and completely flexible) have different exchange rate systems in which the exchange rates are fx but adaptable. The perfectly flexible exchange rate results from the supply and demand of the currency in the foreign exchange market without any intervention by the central bank. The exchange rate of the currency pair USD – CHF (US dollar / Swiss franc) in Forex is only determined by the forces of supply and demand.

If exchange rates are not fully flexible, the central bank sets an exchange rate or intervenes directly in the foreign exchange market. (We will focus on the flexible exchange rates in this essential). There are numerous intermediate forms between the two extremes, the completely flexible and the completely fixed exchange rates, which are often called managed floating systems.

How can a government or central bank set the exchange rate?


Not only the market can determine the exchange rate of a currency. Also the Central bank can opt for a fixed (stable) exchange rate. It is common for small countries to change their currency to that of a large country tie (usually US dollars) e.g. B. Belize, Panamá, Eritrea, Cuba. But also some large countries like China peg their currency, the Chinese yuan to the US dollar. Typically, a currency regime has a ceiling and a floor, which are called intervention points. Should if the exchange rate moves above or below these limits, the central bank would intervene to bring the exchange rate back between the limits.
So far we have talked about exchange rates, i.e. exchange rates, but there is an additional concept that we need to know: the cross rates. As we have seen, currencies are traded in pairs. If you were to trade all currency pairs, we would have 13,000 currency pairs. With only 15 currencies, we already have 105 possible currency pairs. However, most currencies are quoted in US dollars or euros. The exchange rates of other currency pairs can be calculated using these currency pairs, which are linked to the US dollar or the euro. These exchange rates, which result from other exchange rates, are called cross rates in technical jargon. The Concept becomes clearer with an example: The cross-rate exchange rate between the Canadian Dollar (CAD) and the British pound (GBP) can be determined from the pairs CAD – USD and USD – GBP:

  1. First we exchange 1 CAD for USD, where CAD – USD = 0.74 (more current
    Exchange rate); 1 CAD is exchanged for $ 0.74.
  2. In the second step we convert 0.74 US $ to GBP with the current exchange rate USD – GBP = 1.26 (1.26 US $ for 1 GBP)

These are combinations of two currencies in 15 different currencies. They are calculated using the binomial coefficient.

Since 1 CAD = 0.74 US $ and 1.26 US $ = 1 GBP, we only have to multiply 0.74 by 1.26 and get 1.70 CAD per 1 GBP as a cross rate.

Who are the participants (or players) in the Forex market?


To understand the changes in exchange rates, you need to know about the participants in the foreign exchange market, your teammates. These often pursue different interests, which can lead to the appreciation or devaluation of a currency. So for whom are currencies and the foreign exchange market relevant?

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  1. Banks: International banks have international customers who need different currencies. International loans also play a major role in the foreign exchange market, as many borrowers take out loans in a cheaper currency (e.g. the Swiss franc shock and the credit crisis). Speculation is, officially, not one of the activities of the. Banks in the foreign exchange market, but only officially. Important players are Deutsche Bank, UBS, HSBC, Citibank or JP Morgan. With large amounts, commercial banks usually do business among themselves. For smaller amounts, they also use the intermediation of the forex brokers
  2. Central bank: The central banks hold reserves of international currencies. If the exchange rate is not completely flexible, the intervention of the central bank is necessary to correct fluctuations in the exchange rate again and again.
  3. Foreign exchange brokers. Brokers act as intermediaries and bring buyers and sellers together for a fee (spread). Thanks to the expansion of the Internet in combination with the broker, even small investors can participate in the foreign exchange market.
  4. Speculators: As with any other market, you can speculate in the foreign exchange market. For example, you buy a currency that you think will appreciate in the near future and sell it when it actually happens (in another article, Factors influencing exchange rates , we’ll see how a speculative attack works).
  5. International companies rely on the Forex for their to be able to conduct business. International trade relations are the basis of foreign exchange trading. International companies have offices in different countries, so they have to protect themselves against possible currency crises, d.H. against the risk when trading foreign currencies to minimize their profits.
  6. Since the beginning of the internet era, even the small investor can play in forex. There are countless forex brokers who offer apps for smartphones and tablets to make it as easy as possible for small investors to speculate in forex. Why are the Forex brokers trying so hard for the little speculator? We will answer this question in another article Factors influencing exchange rates.

By S.van der Tap Pd.Internet Marketer Founder Of digitalstico.com

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