What is the Forex Market 1

Currency market

Definition: foreign exchange market

On the Currency market various actors trade in foreign currencies. The individual foreign currencies are not bought or sold, but traded.

In the foreign exchange market, the foreign exchange market equilibrium and the foreign exchange market interventions must be observed.

The currency market equilibrium distinguishes two different perspectives. One approach is flow-oriented. The currency market equilibrium accounts for current account surpluses after deducting net capital exports. The foreign exchange market sees the result as an excess supply of domestic currency. The currency market is in equilibrium when this excess supply is not greater than zero.

The second way of looking at the forex market measures its holdings. According to this, the equilibrium of the foreign exchange market is preserved when the current account is balanced and international investors hold their holdings in foreign currencies.

With fixed exchange rates, the foreign exchange market interventions come into play. In the case of foreign exchange market interventions, the central bank intervenes in foreign exchange trading in order to influence the current exchange rate. This action has a direct effect on the money supply.

What is foreign exchange?

On the foreign exchange market, foreign exchange is traded. Foreign currencies are made up of credit balances or claims that traders value in a foreign currency.

Example 1: Forex trading on the Forex market

A foreign exchange dealer offers balances and receivables in US dollars on the German foreign exchange market.

Other examples of foreign exchange are foreign securities, foreign checks, or balances deposited in foreign banks. Foreign currencies are not banknotes or coins in foreign currency. Cash is only considered foreign currency when it is transferred to a foreign currency account.

Foreign exchange can have a dual function. On the one hand, they serve as legal tender abroad. On the other hand, investors also use foreign currency as an investment. This is particularly interesting for foreign investors when they no longer have confidence in their own currency. In order to avoid inflation in their own currency, the investor invests his assets in a foreign currency.

Another reason for investing in a foreign currency could be that the investor expects the foreign currency to rise sharply. The investor buys the currencies before the rise. As soon as the currency has risen, he sells the currency again. In this way, a very respectable profit can be realized under certain circumstances.

Trading in foreign currencies poses a risk for the investor if other investors invest their money in the same foreign currency at the same time. In this case, the risk of inflation increases automatically. Speculators must therefore take into account that trading in foreign exchange is not without risk. A high gain is just as conceivable as a total loss.

Who are the trading partners in a foreign exchange market?

The following groups are involved in trading in the foreign exchange market:

  • Private credit institutions
  • International corporations
  • Investors
  • Central banks
  • Forex trader

Private credit institutions

The private credit institutions trade in foreign currencies with one another. The interbank rate plays a decisive role in this. This is a separate exchange rate that the private credit institutions use in their foreign exchange trading.

International corporations

International corporations pursue a specific goal with their presence in the foreign exchange market. You want to protect yourself against a loss due to currency fluctuations.

Investors

With their investments, investors can have a decisive influence on the foreign exchange market.

Central banks

The central banks want to have a decisive influence on market events through their actions on the foreign exchange market.

Forex broker

The forex broker act on behalf of the investors. You look specifically for interesting foreign currencies and complete the trade for the investors. They involve them if they can realize a profit from the forex trading.

How does foreign exchange trading work?

In 1880 it was possible for the first time to open an account abroad in foreign currency. This was basically the birth of Forex trading. However, one only speaks of a real foreign exchange market after the International Monetary Fund (IMF) and the World Bank were founded in 1944.

Trading in forex doesn't work without the foreign exchange market. Trading in foreign exchange does not take place on an exchange. The market participants negotiate their foreign exchange over the counter. The place where this takes place is known as direct trading or OTC trading.

The opening of foreign exchange trading takes place when internationally operating companies, central banks or private investors offer foreign currencies or speculate in the foreign exchange. It should always be noted that the foreign currency cannot be bought or sold. Foreign exchange trading takes place exclusively through the exchange of various foreign currencies and in fixed currency pairs.

Example 2: Forex trading with fixed currency pairs

Various market participants - e. B. Central banks, international companies and private investors - to exchange their foreign currencies. Trading is done with fixed currency pairs. For example, foreign currencies in euros can only be exchanged for foreign currencies in US dollars, British pounds or Swiss francs.

The basis for foreign exchange trading is the exchange rate. This develops from the economic principle that a certain supply meets a certain demand.

The supply and demand for foreign currency are subject to constant change. For example, there can be the following reasons for this interplay:

  • Due to the payment of American punitive tariffs, American consumers are asking fewer products from European car manufacturers. The euro is automatically revalued. This triggers increased demand in the foreign exchange market.
  • The American central bank influences the business policy of the commercial banks by lowering the key interest rate. This forms the basis for the banks to be able to borrow money themselves. The central bank is thereby pursuing the goal of strengthening the domestic economy. This has a direct effect on the demand for one's own currency. The result is an appreciation of the euro, which extends to foreign exchange trading.
  • In order to contain an excessively expensive euro, the European Central Bank (ECB) steps in and buys US dollars as a foreign currency. The ECB wants to achieve two things with this trade: the dollar is to be appreciated and the euro to be devalued. This also affects the relationship between supply and demand when the euro is exchanged for American dollars on the foreign exchange market.

Which foreign exchange transactions are made in the foreign exchange market?

In a foreign exchange market, the different market participants conduct the following foreign exchange transactions:

  • Spot foreign exchange transactions
  • Forward foreign exchange transactions
  • Foreign exchange swaps
  • Currency option transactions

Spot foreign exchange transactions

In foreign exchange trading, market participants operate numerous spot currency transactions. This is characterized by the fact that the two contractual partners of a foreign exchange spot transaction exchange the foreign currencies at the point in time at which they conclude the exchange transaction. As a rule, market participants exchange their currencies within 48 hours. The market participants have fulfilled the conditions of the foreign exchange spot transaction when the foreign exchange has been booked on the account of the buyer and the buyer has received the agreed consideration.

Spot foreign exchange transactions can also be concluded for commodities and goods. Foreign exchange spot transactions are legally anchored in Article 38, Paragraph 2 of the EU Regulation, which was dated August 10, 2006. According to this, both parties must agree that they have concluded a contract for a real delivery transaction that they both have to fulfill.

Forward foreign exchange transactions

Forward exchange transactions are differentiated from spot exchange transactions in that the contracting parties do not have to fulfill them within 48 hours. With forward exchange transactions, the parties involved fix the exchange rate for the foreign currency exchange on a certain date in the future. The parties are free to choose this date.

The aim of fixing the exchange rate at an early stage is to hedge future foreign currency exchanges against unwanted exchange rate fluctuations.

The fact that forward exchange transactions are not subject to the rules of a stock exchange is an advantage for both parties. The market participants are free to design the contract. The disadvantage is that a positive exchange rate development is also not taken into account.

Foreign exchange swaps

In a currency swap, the two contracting parties combine spot currency transactions and forward currency transactions. The swap partners agree that they will exchange the agreed amount in the selected foreign currency.

Example 3: The process of a foreign exchange swap

An American investor wants to sell $ 2 million at a daily rate of EUR 0.85. The current daily rate is identical to the spot rate. The investor would like to buy back the same amount in six months. His swap partner exchanges the 2 million US dollars at the spot rate of 0.85 euros. This is the prerequisite for the first part of the foreign exchange swap transaction (foreign exchange spot transaction). The regulation can only be deviated from if both swap partners agree on a different spot rate.

Half a year later, the swap partners complete the second part of the currency swap (currency forwards). The swap partner sells the 2 million US dollars back to the American investor at the previously agreed exchange rate.

Ultimately, both swap partners have the amount they had at the start of the forex deal. In practice, interest payments often still have to be made. It is also not uncommon for advance payments to be agreed in a forex swap transaction.

Currency option transactions

Currency options are used by the contracting parties involved to hedge a risk that may arise from fluctuations in the exchange rate. The buyer does not enter into any obligation with the purchase. He acquires the right to purchase a currency of his choice at an agreed rate. It is crucial that a certain date is agreed for the fulfillment of the right. The participating contracting parties refer to the time between the conclusion of the contract and the date of fulfillment as the option period.

The buyer protects himself against exchange rate fluctuations because the amount that he has to pay on the future date is already fixed when the contract is concluded.

The currency option transaction assures the seller that he can sell the currency amount for a predetermined amount within the option period. Here, too, the focus is on safeguarding against possible future price fluctuations.

What does forex trading mean?

Another word for currency market is forex. Forex stands for "Foreign Exchange". This is the English term for foreign exchange. Forex traiding is therefore trading in foreign currencies.

Example 4: How Forex Trading Works

An investor speculates that the euro will lose value. At the same time, he hopes that the rate for the US dollar will rise. The investor is investing $ 100,000 at a rate of $ 1.15 for the euro. If he sells the amount later at a higher exchange rate (e.g. 1.17 US dollars), the investor can realize a profit. However, if he has no other option to sell the amount at a lower exchange rate (e.g. 1.10 US dollars), the investor must accept a loss. To avoid such a scenario, the investor can, for example, conclude a forward exchange deal. Here he protects himself against an exchange rate fluctuation that is negative for him.

The other areas of the financial market

In addition to the foreign exchange market, the financial market can be divided into further sub-markets. Which includes:

  • Money market
  • Credit market
  • Capital market

Money market

In the money market, a short-term supply of money meets a demand for money. This is e.g. central bank money that is traded between two credit institutions. The interest that is used in trading is referred to by the credit institutions as money market interest.

Credit market

The credit market is the platform for trading finance. It is crucial that the market is neither limited in time nor place. The credit market is seen as an umbrella term for the money market and the capital market.

Capital market

The capital market is characteristic of medium and long-term investments. The term is more than a year.

Summary

  • The foreign exchange market forms the platform for trading foreign currencies. It is characteristic that the foreign currencies are exchanged.
  • A functioning foreign exchange market must respect the foreign exchange market equilibrium and foreign exchange market interventions.
  • Trading on the foreign exchange market takes place exclusively in foreign exchange. These are credit balances or claims that can be exchanged in a foreign currency.
  • Foreign currencies are considered a means of payment and are used by investors to invest money.
  • Every investor must be aware that he can not only suffer high profits, but also a total loss.
  • Different trading partners are active in the foreign exchange market. In addition to the central banks and investors, this also includes international corporations and forex traders.
  • Market participants do not need a stock exchange to trade forex. Trading takes place over the counter and is therefore also referred to as direct trading or OTC trading.
  • The foreign exchange transactions that are traded on the direct market can be differentiated, for example, into foreign exchange spot transactions and currency forwards. In addition, market participants also operate currency swaps and currency options.
  • The contractual partners in a foreign exchange spot transaction fulfill their obligations within 48 hours.
  • In forward exchange transactions, the parties set the exchange rate on any date in the future.
  • The core of a foreign exchange swap is the combination of foreign exchange spot and forward exchange.
  • Exchange rate fluctuations can be hedged with currency option transactions. Both the buyer and the seller of a currency option business benefit from this.
  • Forex Trading is the English term for currency trading.
  • In addition to the foreign exchange market, the financial market consists of the following sub-markets: money market, credit market and capital market.