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The foreign exchange market ( forex, FX, or currency market) is a global decentralization or over-the-counter (OTC) market for the trading of currency. This market determines Exchange rate for every currency. By trading volume, it is by far the largest market in the world, followed by the Bond market.Neil Record, Currency Overlay (Wiley Finance Series)
The main participants are the larger international banks. function as anchors of trading between a range of multiple types of and sellers around the clock, with the exception of weekends. As currencies are always traded in pairs, the 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. Example: 1 USD is worth 1.1 Euros or 1.2 Swiss Francs etc. The 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 trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the "interbank market". Trades between dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little supervisory entity regulating its actions. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.
The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the US to import goods from European Union member states, and pay , 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. Global imbalances and destabilizing speculation (2007), UNCTAD Trade and development report 2007 (Chapter 1B).
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 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. The foreign exchange market is unique because of the following characteristics:
Trading in foreign exchange markets averaged per day in April 2022, up from in 2019. Measured by value, foreign exchange swaps were traded more than any other instrument in 2022, at per day, followed by spot trading at .
During the 4th century AD, the Byzantine government kept a monopoly on the exchange of currency.J Hasebroek – Trade and Politics in Ancient Greece Biblo & Tannen Publishers, 1 March 1933 Retrieved 14 July 2012
Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of coinage in Ancient Egypt.S von Reden (2007 Senior Lecturer in Ancient History and Classics at the University of Bristol, UK) - Money in Ptolemaic Egypt: From the Macedonian Conquest to the End of the Third Century BC (p.48) Cambridge University Press, 6 December 2007 Retrieved
Currency and exchange were important elements of trade in the ancient world, enabling people to buy and sell items like food, pottery, and raw materials. If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of a recognized standard like silver and gold.
The year 1880 is considered by at least one source to be the beginning of modern foreign exchange: the gold standard began in that year.S Shamah – A Foreign Exchange Primer "1880" John Wiley & Sons, 22 November 2011 Retrieved 27 July 2102
Prior to the First World War, there was a much more limited control of international trade. Motivated by the onset of war, countries abandoned the gold standard monetary system.T Hong
– [https://books.google.com/books?id=iS1R27V7WUkC&dq=history+of+foreign+exchange&pg=PA4 Foreign Exchange Control in China: First Edition (Asia Business Law Series Volume 4)] Kluwer Law International, 2004 Retrieved 12 January 2013
At the end of 1913, nearly half of the world's foreign exchange was conducted using the pound sterling.S Misra, PK Yadav International Business: Text And Cases PHI Learning Pvt. Ltd. 2009 Retrieved 27 July 2012 The number of foreign banks operating within the boundaries of London increased from 3 in 1860, to 71 in 1913. In 1902, there were just two London foreign exchange brokers.P. L. Cottrell – Centres and Peripheries in Banking: The Historical Development of Financial Markets Ashgate Publishing, Ltd., 2007 Retrieved 13 July 2012 At the start of the 20th century, trades in currencies was most active in Paris, New York City and Berlin; Britain remained largely uninvolved until 1914. Between 1919 and 1922, the number of foreign exchange brokers in London increased to 17; and in 1924, there were 40 firms operating for the purposes of exchange.P. L. Cottrell (p. 75)
During the 1920s, the Kleinwort Benson family were known as the leaders of the foreign exchange market, while Japheth, Montagu & Co. and Seligman still warrant recognition as significant FX traders.J Wake – Kleinwort, Benson: The History of Two Families in Banking Oxford University Press, 27 February 1997 Retrieved 13 July 2012 The trade in London began to resemble its modern manifestation. By 1928, Forex trade was integral to the financial functioning of the city. However, during the 1930s, London's pursuit of widespread trade prosperity was hindered by continental exchange controls and additional factors in Europe and Latin America.J Atkin – The Foreign Exchange Market Of London: Development Since 1900 Psychology Press, 2005 Retrieved 13 July 2012 Some of these additional factors include tariff rates and quota, protectionist policies, trade barriers and taxes, economic depression and agricultural overproduction, and impact of protection on trade.
U.S. President Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually resulting in a free-floating currency system. After the Accord ended in 1971,RC Smith, I Walter, G DeLong (p.4) the Smithsonian Agreement allowed rates to fluctuate by up to ±2%. In 1961–62, the volume of foreign operations by the U.S. Federal Reserve was relatively low.AH Meltzer – A History of the Federal Reserve, Volume 2, Book 1; Books 1951–1969 University of Chicago Press, 1 February 2010 Retrieved 14 July 2012 (page 7 "fixed exchange rates" of) DF DeRosa – Options on Foreign Exchange Retrieved 15 July 2012 Those responsible for managing exchange rates then found the boundaries of the Agreement unrealistic. As a result, it led to its discontinuation in March 1973. Afterwards, none of the major currencies (such as the US dollar, the British pound, or the Japanese yen) were maintained with a capacity for conversion to gold. Instead, organizations relied on reserves of currency to facilitate international trade and back the value of their own currency.K Butcher – Forex Made Simple: A Beginner's Guide to Foreign Exchange Success John Wiley and Sons, 18 February 2011 Retrieved 13 July 2012 J Madura – International Financial Management, Cengage Learning, 12 October 2011 Retrieved 14 July 2012 From 1970 to 1973, the volume of trading in the market increased three-fold.N DraKoln – Forex for Small Speculators Enlightened Financial Press, 1 April 2004 Retrieved 13 July 2012 SFO Magazine, RR Wasendorf, Jr.) (INT) – Forex Trading PA Rosenstreich – The Evolution of FX and Emerging Markets Traders Press, 30 June 2009 Retrieved 13 July 2012 J Jagerson, SW Hansen – All About Forex Trading McGraw-Hill Professional, 17 June 2011 Retrieved 13 July 2012 At some time (according to Gandolfo during February–March 1973) some of the markets were "split", and a two-tier currency market was subsequently introduced, with dual currency rates. This was abolished in March 1974.Franz Pick Pick's currency yearbook 1977 – Retrieved 15 July 2012G Gandolfo – International Finance and Open-Economy Macroeconomics Springer, 2002 Retrieved 15 July 2012
Reuters introduced computer monitors during June 1973, replacing the telephones and telex used previously for trading quotes. City of London: The History Random House, 31 December 2011 Retrieved 15 July 2012
On 1 January 1981, as part of changes beginning during 1978, the People's Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading.JA Dorn – China in the New Millennium: Market Reforms and Social Development Cato Institute, 1998 Retrieved 14 July 2012 B Laurens, H Mehran, M Quintyn, T Nordman – Monetary and Exchange System Reforms in China: An Experiment in Gradualism International Monetary Fund, 26 September 1996 Retrieved 14 July 2012 Sometime during 1981, the South Korean government ended Forex controls and allowed free trade to occur for the first time. During 1988, the country's government accepted the IMF quota for international trade.Y-I Chung – South Korea in the Fast Lane: Economic Development and Capital Formation Oxford University Press, 20 July 2007 Retrieved 14 July 2012
Intervention by European banks (especially the Bundesbank) influenced the Forex market on 27 February 1985.KM Dominguez, JA Frankel – Does Foreign Exchange Intervention Work? Peterson Institute for International Economics, 1993 Retrieved 14 July 2012 The greatest proportion of all trades worldwide during 1987 were within the United Kingdom (slightly over one quarter). The United States had the second highest involvement in trading.(page 211 – source) H Van Den Berg – International Finance and Open-Economy Macroeconomics: Theory, History, and Policy World Scientific, 31 August 2010 Retrieved 14 July 2012
During 1991, Iran changed international agreements with some countries from oil-barter to foreign exchange.PJ Quirk Issues in International Exchange and Payments Systems International Monetary Fund, 13 April 1995 Retrieved 14 July 2012
Foreign exchange is traded in an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London. In April 2022, trading in the United Kingdom accounted for 38.1% of the total, making it by far the most important center for foreign exchange trading in the world. Owing to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day. Trading in the United States accounted for 19.4%, Singapore and Hong Kong account for 9.4% and 7.1%, respectively, and Japan accounted for 4.4%.
Turnover of exchange-traded foreign exchange futures and options was growing rapidly in 2004–2013, reaching in April 2013 (double the turnover recorded in April 2007). As of April 2022, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover. Foreign exchange were introduced in 1972 at the Chicago Mercantile Exchange and are traded more than to most other futures contracts.
Most developed countries permit the trading of derivative products (such as futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have . The use of derivatives is growing in many emerging economies. "Derivatives in emerging markets", the Bank for International Settlements, 13 December 2010 Countries such as South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.
Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. "The $4 trillion question: what explains FX growth since the 2007 survey?'', the Bank for International Settlements, 13 December 2010 The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading was estimated to account for up to 10% of spot turnover, or $150 billion per day (see below: Retail foreign exchange traders).
| + Top 10 currency traders % of overall volume, June 2020 |
| 10.78% |
| 8.13% |
| 7.58% |
| 7.38% |
| 5.50% |
| 5.33% |
| 5.23% |
| 4.62% |
| 4.61% |
| 4.50% |
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. After that, smaller banks, large multinational corporations (requiring risk hedging and cross-border payroll), major hedge funds, and even a few retail come into play. According to Galati and Melvin, “, insurance companies, , 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.
The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize the currency. However, aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.Alan Greenspan, The Roots of the Mortgage Crisis: Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own. , the Wall Street Journal, 12 December 2007 Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and can, therefore, generate large trades.
There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or "mark-up" in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principals in the transaction versus the retail customer, and quote a price they are willing to deal at.
It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. The Sunday Times (London), 16 July 2006 These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services. The volume of transactions done through Foreign Exchange Companies in India amounts to about US$2 billion per day. This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing. Around 25% of currency transfers/payments in India are made via non-bank Foreign Exchange Companies. Most of these companies use the USP of better exchange rates than the banks. They are regulated by FEDAI and any transaction in foreign Exchange is governed by the Foreign Exchange Management Act, 1999 (FEMA).
Bureaux de change or currency transfer companies provide low-value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access foreign exchange markets via banks or non-bank foreign exchange companies.
The main trading centers are London and New York City, though Tokyo, Hong Kong, and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows. These are caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, large banks have an important advantage; they can see their customers' order flow.
Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the Currency pair that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).
The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes a positive currency correlation between XXXYYY and XXXZZZ.
On the Spot price market, according to the 2022 Triennial Survey, the most heavily traded bilateral currency pairs were:
Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market.
None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days), algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of supply and demand. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. The Microstructure Approach to Exchange Rates, Richard Lyons, MIT Press (pdf chapter 1)
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions, and market psychology.
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
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.
Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "" and have a more destabilizing role than larger and better informed actors.Lawrence Summers and Summers VP (1989) 'When financial markets work too well: a Cautious case for a securities transaction tax' Journal of financial services
Currency speculation is considered a highly suspect activity in many countries, such as Thailand. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced Sweden's central bank, the Riksbank, to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Mahathir Mohamad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York, 1995. In this view, countries may develop unsustainable or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.
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