The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates
for every currency. It includes all aspects of buying, selling and
exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the Credit market.
The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers
and sellers around the clock, with the exception of weekends. Since
currencies are always traded in pairs, the foreign exchange market does
not set a currency's absolute value but rather determines its relative
value by setting the market price of one currency if paid for with
another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.
The foreign exchange market works through financial institutions
and operates on several levels. Behind the scenes, banks turn to a
smaller number of financial firms known as "dealers", who are involved
in large quantities of foreign exchange trading. Most foreign exchange
dealers are banks, so this behind-the-scenes market is sometimes called
the "interbank market"
(although a few insurance companies and other kinds of financial firms
are involved). Trades between foreign exchange dealers can be very
large, involving hundreds of millions of dollars. Because of the
sovereignty issue when involving two currencies, Forex has little (if
any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and
investments by enabling currency conversion. For example, it permits a
business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.
In a typical foreign exchange transaction, a party purchases some
quantity of one currency by paying with some quantity of another
currency.
The modern foreign exchange market began forming during the
1970s. This followed three decades of government restrictions on foreign
exchange transactions under the Bretton Woods system
of monetary management, which set out the rules for commercial and
financial relations among the world's major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system.
Market participants
the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers.
Within the interbank market, spreads, which are the difference between
the bid and ask prices, are razor sharp and not known to players outside
the inner circle. The difference between the bid and ask prices widens
(for example from 0 to 1 pip
to 1–2 pips for currencies such as the EUR) as you go down the levels
of access. This is due to volume. If a trader can guarantee large
numbers of transactions for large amounts, they can demand a smaller
difference between the bid and ask price, which is referred to as a
better spread. The levels of access that make up the foreign exchange
market are determined by the size of the "line" (the amount of money
with which they are trading). The top-tier interbank market accounts for
51% of all transactions.From there, smaller banks, followed by large multi-national
corporations (which need to hedge risk and pay employees in different
countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds,
and other institutional investors have played an increasingly important
role in financial markets in general, and in FX markets in particular,
since the early 2000s.” (2004) In addition, he notes, “Hedge funds have
grown markedly over the 2001–2004 period in terms of both number and
overall size”. Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Spot
A spot
transaction is a two-day delivery transaction (except in the case of
trades between the US dollar, Canadian dollar, Turkish lira, euro and
Russian ruble, which settle the next business day), as opposed to the futures contracts,
which are usually three months. This trade represents a “direct
exchange” between two currencies, has the shortest time frame, involves
cash rather than a contract, and interest is not included in the
agreed-upon transaction. Spot trading is one of the most common types
of forex trading. Often, a forex broker will charge a small fee to the
client to roll-over the expiring transaction into a new identical
transaction for a continuation of the trade. This roll-over fee is known
as the "swap" fee.
Forward
One way to deal with the foreign exchange risk is to engage in a
forward transaction. In this transaction, money does not actually change
hands until some agreed upon future date. A buyer and seller agree on
an exchange rate for any date in the future, and the transaction occurs
on that date, regardless of what the market rates are then. The duration
of the trade can be one day, a few days, months or years. Usually the
date is decided by both parties. Then the forward contract is negotiated
and agreed upon by both parties.
Non-deliverable forward (NDF)
Forex banks, ECNs, and prime brokers offer NDF contracts, which are
derivatives that have no real deliver-ability. NDFs are popular for
currencies with restrictions such as the Argentinian peso. In fact, a
forex hedger can only hedge such risks with NDFs, as currencies such as
the Argentinian peso cannot be traded on open markets like major
currencies.
Swap
The most common type of forward transaction is the foreign exchange
swap. In a swap, two parties exchange currencies for a certain length of
time and agree to reverse the transaction at a later date. These are
not standardized contracts and are not traded through an exchange. A
deposit is often required in order to hold the position open until the
transaction is completed.
Futures
Futures are standardized forward contracts and are usually traded on
an exchange created for this purpose. The average contract length is
roughly 3 months. Futures contracts are usually inclusive of any
interest amounts.
Currency futures contracts are contracts specifying a standard
volume of a particular currency to be exchanged on a specific settlement
date. Thus the currency futures contracts are similar to forward
contracts in terms of their obligation, but differ from forward
contracts in the way they are traded. In addition, Futures are daily
settled removing credit risk that exist in Forwards.
They are commonly used by MNCs to hedge their currency positions. In
addition they are traded by speculators who hope to capitalize on their
expectations of exchange rate movements.
Option
A foreign exchange option (commonly shortened to just FX option) is a
derivative where the owner has the right but not the obligation to
exchange money denominated in one currency into another currency at a
pre-agreed exchange rate on a specified date. The FX options market is
the deepest, largest and most liquid market for options of any kind in
the world.
Forex scandal
The forex scandal (also known as the forex probe) is a financial scandal that involves the revelation, and subsequent investigation, that banks colluded for at least a decade to manipulate exchange rates for their own financial gain. Market regulators in Asia, Switzerland, the United Kingdom, and the United States began to investigate the $4.7 trillion-a-day foreign exchange market (forex) after Bloomberg News reported in June 2013 that currency dealers said they had been front-running
client orders and rigging the foreign exchange benchmark WM/Reuters
rates by colluding with counterparts and pushing through trades before
and during the 60-second windows when the benchmark rates are set. The
behavior occurred daily in the spot foreign-exchange market and went on for at least a decade according to currency traders.( Information courtesy from wikipedia)