Foreign exchange (Forex) is a type of financial trading in which the currency of a country is exchanged for that of another. With a daily turnover of over $4.9 trillion, the Forex market is the largest financial trading market in the world.
One unique aspect of the Forex market today is the lack of a central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world. The market is open 24 hours a day, five and a half days a week across almost every time zone. For instance, when the trading day in the US ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.
The forex market started evolving in the 1970s when international trade switched from a fixed rate (set by the Bretton Woods agreement) to a floating exchange rate. Since then, the relative rates of currencies have been determined by buying and selling activity within the international foreign exchange market. When more of a currency is bought, its relative price goes up, and when more is sold its price goes down.
Evolution of Foreign Exchange
Forex history dates back to the ancient times of the Babylonians. Exchange as a medium was invented since the barter system. The first coins were used in ancient Egypt. Since then, foreign exchange has played a pivotal role in framing world politics and economy.
Here are some milestones in the history of Forex:
Change in gold standards (1816): The gold standard was used as standard trading unit and had a standard weightage. The British pound was defined as 123.27 grains of gold. The British pound was set as the fixed exchange currency. In 1879, the US adopted the gold standard and replaced the British pound as the new exchange currency.
Bretton-Woods agreement (1944): After WWII, the US emerged as the world’s only stable economy. As a result, the dollar emerged as the new standard of foreign exchange. At the Bretton-Woods conference (1944), the Forex framework agreed that the dollar would be the world’s new exchange unit. The Bretton Woods Accord established the World Bank and introduced the pegging of currencies and the IMF.
Floating exchange rates (1973): The Smithsonian agreement was a flexibility agreement, which was signed in 1971 at Bretton-Woods to let currencies fluctuate. This was a deliberate attempt by the European market to break-way from its dollar dependency. However, the Smithsonian Agreement and the European Joint Float failed in their efforts to do away with the US dollar. By 1972, most European countries initiated the floating value of their currencies. In 1978 and 1993, countries tried to peg their currencies freely but failed. The financial market then introduced a free-floating currency system.
Introduction of the Internet (1994): The forex market remained the prerogative of the banks but the Internet allowed small investors to enter the forex trading market. Online forex trading was introduced in 1994 and brought drastic changes to forex history. Today, the average daily trading volume of the forex market is $3.2 trillion.
Arrival of the Euro: In 2002, the Euro was introduced as the official currency of 12 European nations. The rapid development of the Euro-dollar market accelerated trading in the forex market. Today, the euro is the second most traded currency in the forex market.
How Currencies Are Traded
Currency trading is always done in forex pairs. Of the two currencies constituting a forex pair, one is bought and the other is sold. Together, these two currencies make the ‘exchange rate.’
The most traded currency pairs in the world are called the Majors. The top four currency pairs account for nearly 70 percent of the world's total daily trade in the forex market. They are: Euro/US Dollar - EUR/USD, Great Britain Pound/US Dollar - GBP/USD, US Dollar/Confoederatio Helvetica Franc - USD/CHF and US Dollar/Japanese Yen - USD/JPY.
A forex pair can be classified to have two components: The Base Currency & the Quote (Secondary) Currency.
In the currency pair EUR/USD, Euro is the base currency, while the US dollar is the secondary currency. If the exchange rate is 1.3214, one unit of Euros can be exchanged for 1.3214 US dollars. Suppose the quote for this pair is 1.3214/16. The first part of this quote is called the ‘bid’ price and the second part is known as the ‘ask’ price. While the former is the price at which traders are willing to purchase, the latter is the price at which they are willing to sell.
In this example, one unit of Euro can be sold to get 1.3214 units of the US dollar. However, one will have to pay 1.3216 units of the US dollar to buy one Euro. Forex pairs are typically traded in lots (the standard being 100,000 units) of the base currency. For the above example, $132,160 will have to be paid for buying €100,000.
The currencies are then traded in four different markets, which function separately yet are closely interlinked.
The Spot Market:
Forex spot-trading involves purchasing one currency with another for immediate delivery. Most of the forex spot transactions are completed within two days as the banks take around 48 hours to transfer the funds.
As the forex spot market functions on the current prices, profits can be made instantaneously by selling currency pairs. The market started initially as a platform for banks to buy and sell currencies. Gradually, individual traders also began to participate in it through brokers.
Additionally, tourists engage in the spot market transactions when they exchange foreign currency with a money-changer. A firm’s decision to immediately convert the receipts from an export sale into its home currency can also be considered as a spot market transaction.
The Futures Market:
Forex (currency) futures are exchange traded contracts to buy or sell a certain amount of any currency. The trading price of a currency is set according to a future price on a set date. A currency futures contract is traded with a specific termination date, after which a trader has to sell it.
Currency futures were developed after 1971, following the collapse of the Bretton Woods system of fixed exchange rates. The currency futures market is growing in popularity, as the main participants of this organized market comprise bankers, importers, exporters, multinational corporations and private speculators.
They are traded according to the rules and regulations that are drawn by the futures exchanges. The trading can be done either on the floors of these futures exchanges or these exchanges can facilitate electronic trading for its members. The Chicago Mercantile Exchange is the world’s largest and most successful exchange for trading in currency futures, with offices in Chicago, New York, Washington, London and Tokyo.
Forex futures serve the following purposes:
- Investors trade forex futures to hedge against the exchange-rate risk.
- Futures are used by forex traders as speculations to earn profit from currency rate fluctuations.
The Options Market:
Forex options are contracts between buyers and sellers whereby the buyer has the special power, of buying or selling forex at a predefined rate during a specified timeframe.
Forex options are of two types: call options and put options. The buyer of a call option has the right to buy the underlying currency at an agreed upon price at a future date. A put option provides the buyer the right to sell the underlying currency.
While currency options give the buyer the right to buy or sell the underlying currency, there is no obligation to do so. However, the seller of the currency options is obligated to buy or sell the underlying currency in case the buyer decides to exercise the option.
For exercising the right to trade the underlying asset, the seller of the option is paid a price, known as premium. The price that is specified for either buying or selling at the future date is known as the strike price.
When an investor believes that the US dollar will appreciate against the Euro, he purchases a currency call option on USD/EUR. If the value of the US dollar actually increases against the Euro, the buyer can exercise his right to earn a profit.
A comparatively small amount of currency trading occurs in options markets.
The Derivatives Market:
Derivatives are financial instruments, the price or value of which is derived from some other asset, index, value or condition known as underlying assets. Technically, the term can be used to described options and futures as well, however its most common usage for Forex refers to instruments that are not traded on organised exchanges. These include: Forward contracts, Foreign-exchange swaps, Forward rate agreements and barrier options.
Most foreign-exchange trading now occurs in the derivatives market (inclusive of options and futures). Options and Futures are traditionally refered to as Exchange Traded Derivatives, while Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary.
The main participants of the OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.
In contrast, exchange traded derivatives are traded on an exchange which acts as an intermediary and takes initial margin from both the parties.
Derivatives are used by investors to speculate and earn some profits if the value of the underlying assets moves in the direction perceived by them. Similarly, traders use derivatives to mitigate or hedge the risk in underlying assets by entering into a derivative contract whose value moves in the opposite direction to their underlying position.