The foreign exchange market or commonly known as FX or Forex or the currency market represents a global decentralized or over the counter (OTC) market for trading currencies. The foreign exchange rate depends upon this market. Forex market actually covers all aspects of buying, selling and exchanging of currencies at current or determined prices and that is what makes it the largest market in the world. This market works through many financial institutions and thus its main participant includes the large international banks. The Forex Market makes international trade and investments possible by enabling currency conversions. This market has a huge trading volume, geographical dispersion, continuous operations, low margin of relative profit and a variety of factors that affect exchange rate.
What do we mean by the term FOREX?
Forex is a term that represents foreign exchange market i.e. a “place” where currencies are traded. Currencies are the most vital sources for people across the globe as they are the essential requirement that are exchanged in order to conduct trade and business. Suppose a person living in US wants to buy cheese from France. In order to do so either he or the company, which is buying cheese from France, will be paying the French for the cheese in euros (EUR). In other words, we can say that the US importer would have to exchange the equivalent value of US dollars (USD) into euros. The same concept can be applied for travelling. Say we have a French tourist in Egypt he cannot pay in euros over there to see the pyramids because that is not the locally accepted currency. So first, the tourist would have to get the euros exchanged for the local currency that is Egyptian Pound in this case at the current exchange rate.
This kind of requirement of exchanging currencies is what makes Forex market, the largest and the most liquid financial market in the world. It makes all other markets look small in size. For example, the stock market, with an average traded value of around US $2,000 billion per day as compared to Forex market with an average traded value of US $4.9 trillion per day as per the reports of the Bank for International Settlements (BIS).
A unique feature of this international market that makes it different and immensely popular is that there is no central market place for foreign exchange. This method of currency trading is conducted electronically over the counter (OTC) i.e. the transactions rather than occurring on one centralized exchange occur via computer networks between traders around the world. This market is opened almost all the day i.e. 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney – across almost every time zone i.e. why we say that this market works under multiple operations. When the trading day in the US ends, the Forex market begins anew in Tokyo and Hong Kong. The Forex market is active at any time of the day with price quotes changing constantly.
Spot Market and the Forwards and Futures Markets
Spot Market, the Forwards and the Futures Markets comprise the three actual ways by which institutions, corporations and individuals trade Forex. It is well known that the Forward and Futures market is based upon Forex trading in spot market, as it is the “underlying” real asset and the largest market. Initially the availability of the futures market for a longer period to the individual investors made it the most popular venue for the traders. With the advent of electronic trading and numerous forex brokers, the spot market has surpassed the future market as it has witnessed a huge surge in activity making it the preferred trading market for individuals and speculators. Therefore, the term forex market simply implies spot market. Companies that need to hedge their foreign exchange risks out to a specific date in the future prefer forwards and futures market.
Defining the Spot Market:
The spot market is the place where currencies are bought and sold according to the current price. The current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another are the various factors that play a major role in determining the price by supply and demand. Another term here is “spot deal” which means to finalize a deal that is basically a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. The settlement is in cash once the position is closed. These trades take around two days for the settlement contrary to the fact the spot market is commonly known as the one, which deals with transactions in the present rather than the future.
Defining the Forwards and the Futures Markets:
Rather than dealing with the actual currency just as spot market, the forwards and futures markets deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement. The basic principle behind Futures markets comprises of buying and selling of contracts OTC between two parties, who determine the terms of the agreement between themselves. Just as the name suggests in the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized are the various details mentioned in the future contracts. This exchange is acting as a counterpart to the trader, providing clearance and settlement.
Although contracts can be bought and sold before they expire, yet a similarity between the two types of contract is that they are binding and are typically settled for cash for the exchange in question upon expiry. Merits of forwards and future markets is that they offer protection against the risk while trading currencies. Speculators and big international corporations use these markets in order to hedge against future exchange rate fluctuations.