What is FOREIGN exchange ?

          The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.

           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 in the value of currencies, and thecarry trade, speculation on the change in interest rates in two currencies.

          In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

          The foreign exchange market is unique because of

• 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, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;

• the variety of factors that affect exchange rates;

• the low margins of relative profit compared with other markets of fixed income; and

• the use of leverage to enhance profit and loss margins and with respect to account size.

         As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention bycentral banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.

Market size and liquidity

          The foreign exchange market is the most liquid financial market in the world. Traders include large banks,central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by theBank for International Settlements, average daily turnover was derivatives.

           Trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the United States accounted for 17.9%, and Japan accounted for 6.2%.

           Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.

          Most developed countries permit the trading of derivative products (like futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging economies do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies. Countries such as 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 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 ofretail investors 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 is estimated to account for up to 10% of spot turnover, or $150 billion per day (see retail foreign exchange platform).

          Foreign exchange is 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, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when theInternational Monetary Fund calculates the value of its Special Drawing Rights every day, they use the London market prices at noon that day.

Market participants

          Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank 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 0-1 pip to 1-2 pips for a 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 53% 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.

Foreign exchange

          Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator.

          The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but 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. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Southeast Asia.

Central banks

          National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/orinterest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

Investment management firms

          Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

          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 hence can generate large trades.

Determinants of exchange rates

        The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):

•  International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

• Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

• Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

           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 demand and supply. 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.

          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.

Economic factors

          These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.
Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

         Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

          Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

          Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector .

Financial

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.

Future

          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.

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.

Swap

          The most common type of forward transaction is the 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.

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 options market is the deepest, largest and most liquid market for options of any kind in the world.

Speculation

          Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists includingMilton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market forhedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.

          Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.

           Currency speculation is considered a highly suspect activity in many countries. 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 the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad 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 J. 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.

          In this view, countries may develop unsustainable financial bubbles 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.

Risk aversion

          Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.

          In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US Dollar. Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across the world fell while the US Dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA.