The Foreign Exchange Market
With international trade, the currency of one country must be exchanged for that of another for settlement of a transaction. Institutions and corporations in the international market place oftentimes need a certain currency to complete a deal, or to guard themselves from the effects of currency swings and rate changes. This system involving the exchange of different currencies has created the Foreign Exchange market, or FOREX, or FX and more correctly known as the Global Interbank Currency Exchange Market.
Like stocks, gold and real estate investments, Foreign Exchange has become a very important tool for the investment community. Trading in FOREX provides certain additional advantages:
Margin System
You can enjoy the benefits of leverage on contracts up to one hundred times your margin deposit. That is, with 1% of the absolute value of contracts, you can enter the largest marketplace in the world. As long as you are able to maintain your margin requirements on the full contract value, you can remain indefinitely in the market.
Maximum Liquidity
Being the largest market in the world with over $1.6 Trillion bought and sold daily, huge volume of transactions are readily executed and cleared. Unlike futures or the stock market, there is almost never a lack of buyers or sellers. Therefore, it gives the investor the prerogative to open or close a position virtually at will.
Attractive Pricing
Foreign Exchange quotes are based on spot prices regardless of the transaction size. Prices are quoted on a net basis.
Effective Execution
Orders are executed and confirmed online or manually via a recorded phone call. Customers know immediately the rate at which the order is executed. Confirmed orders will always receive a single price execution.
Flexible Settlement
Foreign Exchange contracts opened can be rolled over daily for an indefinite period subject to roll-over fees.
Hedging Tool
Investors involved in international trade can minimize their currency exposure risks by trading in Forex.
Operation of the Forex Market
The International Foreign Exchange Market is an off-exchange non-physical market. The major participants in this market are Central Banks, prime multinational banks, large corporations, brokerage houses and individual investors. Forex agents offer various services to investors, including financial analysis, information gathering and market situation updates. Most transactions are conducted via the telephone or through online trading systems.
The high liquidity in the forex market is due to the enormous volume of transactions generated by the primary market called the “interbank market” where banks, large financial institutions, insurance companies and other large corporations deal with each other in huge quantities to manage their own currency risks. The secondary over-the-counter market, where retail clients participate in forex transactions, has benefited from this liquidity provided by the big institutions.
Market Size and Composition
The growth of the average daily volume of Forex has been phenomenal and is now currently trading to the tune of $3.2 trillion a day, having grown 50% in the last decade from an already large $1.6 trillion a day in 1997
Daily Forex Volume, in Billions
The Traded Currencies
The six major currencies of Forex dominate the overall market share. 76% of all trades have both currencies in the currency pair as a major, and more than 98% of all trades involve at least one major.
Both of these figures are well beyond what would be expected if currency trading were based solely on the majors' share of world GDP (74.5%), demonstrating the value the majors command abroad relative to other currencies. Another way of thinking about the majors' predominance in the currency markets is to compare the rest of the world's economic output (25.5%), to the less than 2% share of Forex speculation that does not have a major on either side of the currency pair.
The most common currency pairs are EUR/USD (30%), USD/JPY (20%), GBP/USD (11%), and USD/CHF (5%), which together totals 66% (two-thirds) of all Forex spot trades.
The Dollar, Euro, Yen, and Pound are the most traded currencies. The six majors combine for a huge bulk of the trading transactions in a single day. Corporations and banks have known this for years, and have often used Forex for hedging purposes. With the increase in global trade, multinational corporations have likewise used the forex market to manage their risk in changes in currency rates.
Source: Bank of International Settlements, Triennial Central Bank Survey.
Forex Trading
Forex Trading in recent years has been widely accepted by many corporations, institutions and individuals as an effective and efficient investment tool. It is also considered a vital hedging tool against currency exposure with flexibility and liquidity. Trades are executed in standard contract sizes and most currencies can be traded in any matched pair.
Each contract can be traded by depositing a fraction of the contract value, referred to as a Margin Deposit. Profit/Loss is realized through the fluctuation of the Foreign Currencies which allows investors to reap a high return with a minimum capital exposure. However, like all speculative investments, there is a potential risk for loss under unfavorable market conditions.
Margin Requirement
The margin (also called security deposit) required to cover a particular trade is pegged at $1,000 per lot (100,000 standard contract size) and $50 per lot (10,000 mini contract sixe). Hence, an open position of 5 lots will have a $5,000 margin requirement for a standard contract and $250 for a mini contract.
Sample Trade
- Bought 5 contracts of EURO at 1.5700
- Current selling price is at 1.5800
- Profit/loss calculation would be done as follows:
(Selling Price – Buying Price) x Contract Size x No. of Contracts
Current Selling Price : 1.5800
Buying Price : 1.5700
Contract Size of EURO : 100,000
No. of Contracts : 5
By putting the values in the formula:
(1.5800 – 1.5700) x 100,000 x 5
= 0.0100 x 100,000 x 5
= $5,000 (realized profit)Therefore, $5,000 is the realized profit. On the other hand, a market movement against the
open position will result in a loss. Actual profit/loss is realized upon liquidation of the open position.
Trading Hours
The Forex market, in contrast to almost every other market in the world, can be accessed 24 hours a day from Sunday afternoon to Friday afternoon.
The major hubs of the Forex market are the leading financial cities of the world (London, New York, Tokyo and Sydney). As the world turns and traders in each city wake up and go to work, the Forex market shifts from Tokyo at the start of the calendar day, to London, to New York at the end of the calendar day, to Sydney and then back to Tokyo. This process is mirrored in nearly every major city in the world.
Modern telecommunication has been the key to the growth of Forex. It has allowed for an increased number of participants and liquidity (more speculators making more trades on more currency pairs); rapid execution (speculators can place and confirm an order within seconds); and rapid decentralization of the marketplace.
Why Trade Forex?
The transformation of the world economy into a global dimension and the dawn of technological advancement create unprecedented opportunities particularly with the emergence of new markets with considerable growth potential. This scenario likewise underscores the fact that up-to-date information in this modern age is a valuable commodity made possible by breakthroughs in information technology. Now world events are digested in a matter of seconds providing the backbone for vital investment decision making. Among the most dynamic of the markets which is highly sensitive to political and economic changes is the Spot Foreign Currency Market (FOREX).
Whether we like it or not, radical changes in foreign exchange rates affect an individual's or institution's overall investment portfolio. If your holdings are all in US Dollars, you have chosen to hold the dollar and give up other major currencies. Indirectly, this makes you a currency investor. By investing in, and with, the US currency, then your portfolio becomes dependent on the integrity and value of the US Dollar. Without realizing it, this may have worked against you due to the decline of the value of the US Dollar against other major currencies.
The FOREX market provides the investor a valuable tool in managing the effects of the foreign exchange risk by taking advantage of fluctuations in exchange rates. It is a means by which one can readily access this global market 24 hours a day and be able to hedge his/her outstanding US Dollar-based holdings.
In a time when the speed of business increases on a daily basis, you need the ability to react swiftly. This change has created a condition that may leave investors out of the game without being aware of lost opportunities or erosion in their capital assets.
How is Forex Trading Regulated?
The legal framework under which trading in off-exchange (also called over-the-counter or OTC) trading in foreign currencies is regulated by the Commodity Exchange Act as modified by the Commodity Futures Modernization Act of 2000 which was enacted into law in December 2000. Under these laws only regulated entities may serve as counterparties to off-exchange forex transactions with retail customers. The following are listed as regulated entities or legitimate counterparties in the Act:
- financial institutions, such as banks and savings associations,
- registered broker-dealers and certain of their affiliates
- registered futures commission merchants (FCMs) and certain of their affiliates
- certain insurance companies and their regulated affiliates
- financial holding companies, and
- investment bank holding companies.
The Commodity Futures Trading Commission (CFTC) exercises regulatory authority over retail off-exchange forex trading. As such, it has within its power petition a federal court to close down any unregulated entity that acts as a counterparty to forex transactions with retail customers. It can also take action against registered FCMs and their affiliates who are in violation of the anti-fraud and anti-manipulation provisions of the Commodity Exchange Act involving OTC forex transactions with retail customers.
The National Futures Association (NFA), a self-regulatory organization authorized by Congress, promulgates rules and regulations for the protection of investors and ensures market integrity in the U.S. futures industry including the retail off-exchange forex market. Among others, the NFA requires forex dealer FCMs to:
- observe high standards of commercial honor and just and equitable principles of trade in connection with the retail forex business;
- supervise the activities of their employees and agents as well as affiliates that act as counterparties to retail forex transactions;
- maintain a minimum net capital requirement on the value of open positions carried by customers; and
- require security deposits (margin) from customers.
Why choose FOREX over traditional investments?
The unparalleled growth of the FOREX Market over the past ten years is indicative of a major shift of investor funds from the traditional markets into the FOREX (spot currency markets). Many reasons explain this recent and accelerating phenomenon. Among other things, the Forex market brings unmatched liquidity. No other market can match the constant monetary flows being exchanged on the spot currency market on a daily basis.
In fact, Central Banks themselves realize it as they have not been able to manage the flows in or out of the major currencies (see the recent action by the Bank of Japan). FOREX is a much better TRADING market. To that extent, the Forex market offer the sophisticated investor more advantages:
- Long Trends associated with macro currency moves. It is well known that the best trading systems are based on taking optimal advantage of long powerful trends while controlling risks through reversal indicators. The currency market brings the most predictable trends to be found in any sizable market.
- No possible manipulation: the sheer size and internationalization of the market makes it virtually impossible for the FOREX markets to be manipulated. Unlike other markets which need to be checked daily to prevent unexpected cases of interference on price movements.
- Three times longer trading hours: the global FOREX market only closes for business once a week (From Friday evening to Sunday afternoon EST) while other markets have limited trading hours. FOREX traders are still taking advantage of potential trading opportunities when other markets are closed. To some extent, one can say that 1 year of FOREX trading is the equivalent of 2 years of Futures Trading.
No comments:
Post a Comment