The Forex Market Explained

book-threedimensionalapproachOf all the four principle capital markets, currencies and currency exchange sit at the heart of every decision, whether this is a government, a central bank, a financial institution, or a private investor or trader. Every decision, whether in bonds, commodities or equities, will inevitably be a decision on the best return available on a particular asset class, and an assessment of the likely risk associated with that return. Each decision is therefore about money, and in buying or investing in an asset, we are giving up short term liquidity in return for a longer term gain.

Consequently the foreign exchange market sits at the heart of all the financial markets. It is represented by the continual movement of one currency against another. This is why the forex market is the largest financial market in the world, representing as it does, market sentiment and risk appetite on both a global and local scale.

History of foreign exchange

The modern era of foreign currency exchange can essentially be traced back to the early 1970’s following the collapse of the Bretton Woods agreement which until then had seen currencies pegged to the price of gold, a system which had been in place since the end of the second world war. Under the system, countries around the world settled their international trade balances in US dollars, and in return the US government promised to redeem other central bank’s holdings of dollars for gold at a fixed rate of $35 per ounce.

This created price stability across the currency markets, with currencies moving in step with fluctuations in the price of gold. All this finally came to an end in 1971, when persistent and growing payments deficits reduced confidence around the world in the ability of the US to redeem it’s currency in gold. As a result the US president, Richard Nixon was forced to abandon the gold standard, with currencies allowed to float freely in the open market. By March 1973, the Bretton Woods agreement was effectively dead and the free floating foreign exchange market was borne, and remains in place to this day. While some still advocate a return to some form of gold standard, this seems unlikely to happen in the future, and despite continued intervention from some of the principle central banks, currency exchange rates are largely dictated by market forces, other than those currencies which are pegged to the US dollar.

Following the demise of the gold standard two distinct markets for trading in forex were created, namely the spot market and the futures market. The CME lead the way in 1972 introducing futures trading on seven major currency pairs, underpinned by the OTC interbank spot market which flourished in tandem.

Spot currency market

The spot market is often also referred to as the cash market or the physical market. It is here that prices are settled in cash at the prevailing exchange rates for delivery of the underlying cash equivalents, with settlement generally taking place within two days. The two day settlement periods allows for different time zones around the world, with the USD/CAD the only currency pair to settle within a day, due to the close proximity and time difference between the two countries.

Historically Forex was typically the market of the big banks, where large transactions for real cash amounts were executed on behalf of their clients, who would typically be buying and selling currencies, either to pay for, or purchase goods and services overseas, or for investment in overseas projects. As such, the market was generally considered a professional one, and the preserve of the major banks, who were either executing orders for their clients, or speculating through their own proprietary trading desks.

Interest in the foreign exchange market was limited, and indeed even up to the late 1990’s you would have been hard pressed to find the foreign exchange desk in any of the major banks, as this was considered to be a dead end job, and simply a service that was offered by the bank to retain larger clients. All this changed with the advent of electronic trading, and suddenly what had once been considered a specialist market, was opened to the retail trader and investor, creating plethora of electronic FX brokers, offering OTC contracts ( over the counter ) to meet the increasing demand.

The spot currency market is now the largest asset class in the world, and with twenty four hour electronic trading, is a market which is available to all traders and speculators, allowing small traders to speculate on the same markets and on a equal playing field with the large corporate investor or speculator.

book-volumepriceanalysisOne of the unique aspects of this market is that there is no central exchange. All transactions are executed over the counter through one of the many FX brokers around the world. This creates one major problem, which is that with no central exchange, there is no trading volume reported.

Volume is the only true leading indicator( see Indicators), and until now unavailable to the spot forex trader. The MT4 platform solves this problem at a stroke giving the forex trader access to this powerful indicator – FREE!

Quotes in the currency markets are always in terms of pairs, so that one currency is always quoted against another, and in general there are two quote conventions. The first is the American system and the second is the European system. Since 1978 the convention has been to quote using the European style, with some exceptions including the euro, the UK pound, and the commonwealth currencies, which are generally quoted in the American format. However, it is important to note that when trading in currency futures, the format here is to quote against the US dollar.

Currency futures

So for example in the spot market the USD/CAD is the the format for the US dollar against the Canadian dollar, but in the futures market, it is the reverse and appears as the CAD/ USD, an important point, particularly when trading in both markets when using a hedging strategy. Some currency pairs will remain the same. So for example the GBP/USD is the same format in both markets, as is the AUD/USD, but the USD/JPY is reversed, as for the USD/CAD.

Currency futures differ in several key respects from their spot market equivalent, both in terms of quotation format, as well as how the underlying markets work and trades are executed. The first primary difference is that currency futures are bought and sold through a central exchange, such as the CME, either using the open outcry system or increasingly using an electronic platform such as Globex, which provides virtual twenty four hour access to the market, and mirrors the spot market in this respect.

The second major difference is that these contracts are not settled immediately. The futures contract may become due for delivery in days, weeks or even months ahead. So when a futures contract is bought or sold, the physical delivery only takes place when the contract expires at the due date. This gives rise to the difference in quote values between the futures contract and the underlying spot market exchange rates on which the quotes are based.

There is inevitably a cost to hold the currency for the the period of the contract, and this is generally referred to as the basis. In the case of the spot market and the equivalent futures market, then the basis in this case is simply the difference between the two quotes, which then unwinds as the contract reaches expiry. The basis can be positive or negative depending on the relationship between short term interest rates. You can read more about this in ‘Futures explained’.

Finally a currency futures contract is a fungible instrument, which means that since it is a standard contract, it can be easily traded on the exchange, and bought and sold many times over the life of the contract. This is not the case in the spot market, where an OTC contract can only be traded with the broker.

Since their introduction in 1972, currency futures have grown dramatically in popularity and over the years many contracts have been added to the original seven which began life on the CME. The list now includes contracts on all the major currencies around the world including both majors and exotics. In the last few years the CME along with other exchanges have introduced both mini and micro contract sizes to allow smaller retail traders access to the futures market, with small contract sizes which are more akin to the mini lot size so popular in the spot market.

So for example the CME quotes an emicro EUR/USD contract which has an underlying contract size of 12,500 euros, and a minimum price fluctuation of 0.0001 or 1 pip, making each pip movement equivalent to $1.25. This is virtually on a par with a mini lot size in the spot market which has an underlying of 10,000 units and therefore equivalent to $1.00 per pip movement in the market. These e-micro size futures contracts are now widely available across all the majors and even most of the cross pairs, opening up currency futures trading to all traders and speculators, and creating a level playing field in which to trade the forex markets.

That said, the forex spot market is still by far the fastest growing financial trading market in the world and more than half of all new retail traders are opting to trade spot forex.