The forex market is the place where the world’s different currencies are traded. As anybody realizes, currencies are required to be exchanged for any business transaction to take place in the world. To understand the mechanism of trading different currencies and what forex denotes, let us assume the following situation: you are a resident of the United Kingdom and want to buy butter from a manufacturer in Switzerland. This is how the transaction would take place: if you are buying butter directly, you would have to pay the Swiss company in Euros. If another company is making the purchase on your behalf, they would also pay in euros. The importer of the cheese in the United Kingdom pays an amount equivalent to the exchange value of GBP for the Euros. However, a foreign tourist visiting the Pyramids would have to pay in the local currency (Egyptian pound) and not Euros. A European tourist would therefore exchange euros at the prevailing exchange rate for the Egyptian pound.
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This happens all the time and the primary as well as compelling need for the exchange of currencies makes the currency market an extremely volatile and liquid environment. The Bank for International Settlements reports that the total daily volume of the forex trades is more than 5 trillion dollars in comparison to the average value of the total daily trades in the stock market which is in the range of about 2 trillion dollars.
A very unique aspect of the forex market is the absence of a centralized exchange. All the trading in currencies that take place throughout the world from the various corners is executed through computers between the traders. This is to say that all transactions are electronic in nature. A second unique aspect is that trading takes place all through 24 hours in a day and for five and a half days in a week. Major financial markets in the world where trading takes place in large volumes include New York, Hong Kong, Zurich, Frankfurt, Singapore, Paris, Tokyo and London. The trades are executed across different time zones. As an example, at the time when currency trading draws to a close in the US markets, those in Hong Kong and Tokyo start operating. The price quotes of the different currencies are dynamic and are always changing.
Forex Markets – Spot, Forwards, and Futures
There are three methods by which forex trading is carried out by individuals and corporate institutions. They are the spot, forwards and futures market. The largest volume of trading happens in the spot market. This is because both the forwards as well as the futures market are based on the values of the underlying assets in the spot market. Till the recent past, the futures market was the most popular venue for traders as this market was available for longer periods of time. However, with the introduction of the electronic medium of trading, the trading activity in the spot market has seen an upward surge. It is now the most popular venue for trading for both speculators and individuals. The terms forex market and spot market are interchangeable and they mean the same. The other two markets, namely the futures and forwards markets, are popular with institutions and corporations that need to hedge their associated forex risks to a specific future date.
The spot market is also referred to as the forex market. This is where currencies are either bought or sold according to their current prices. The current price of any currency is dependent on its supply and demand status. The value of a nation’s currency is indicative of many factors such as international and local political scenario, economic indicators and performance, prevalent rates of interest, and the future performance f the currency with respect to another. A spot deal denotes a contract that is finalized in the currency market. The deal specifically denotes the amount of currency that would be delivered by one party to another in exchange for a specific amount of another currency. An exchange rate is agreed upon by both the parties. When a deal is closed in the spot market, the settlement is usually done in cash. However, it may take two days to complete the transaction.
Forwards and Futures Markets
Unlike in the spot market, there are no currencies that are traded in the forwards and futures markets. The deals are referred to as contracts. They represent claims of a specific type of currency at a specified price per unit at a future settlement date. The terms of the contracts are decided by the two parties involved in the deal. These currency contracts are purchased or sold over the counter in the forwards market.
However, in the futures market, the terms of the deal cannot be customized. In this market the size of the contracts are specified and so are the settlement dates. In the United States, the futures market complies with the regulations imposed by the National Futures Association. The contracts have specifications regarding settlement dates, the number of units that are being traded and minimum price increments. These cannot be changed by the parties involved in the deal. The clearance and the settlement are provided by the exchange which acts as the trader’s counterpart.
The terms are binding for both forwards and futures contracts. They can be purchased or sold before the expiration times and the settlement is in the form of cash on expiry of the contract. Typically, forwards and futures contract help institutions to hedge the risks they encounter in the forex market. Though individuals are also seen to take part in forwards and futures contracts, it is more commonly seen as a method to cut the risk due to fluctuations that may occur in the forex rates in the future by corporate institutions.
How Forex Trading Works
Forex trading is typically executed via a broker. The trader can choose the currency pair and then place the trade. The order placed by the trader for buying or selling is passed on by the broker to a partner in the Interbank Market. When the trader wants to close the trade, the corresponding position is closed in the Interbank Market. The trader’s account is then credited with the gain or loss from the deal. This whole process takes only a few seconds to complete.