Foreign exchange market or Forex is the market for buying and selling currencies. Currencies from all over the word can be traded in Forex, which is an OTC (over the counter) market. It is loosely regulated by the Commodity Futures Trading Commission (CFTC).
The National Futures Association (NFA) has regulatory authority over retail brokers and market makers. Forex, the most liquid market in the world, operates round the clock.
In the Forex market, currencies are always quoted in pairs. For example .88415 EUR/USD means that 1$ = 0.88415 Euros. When USD is not one of the currencies whose exchange rate is being determined, the exchange rate is referred to as the cross rate.
The smallest price movement in a currency is called a pip (percentage in point). Profits are measured in terms of pips. For the EUR/USD pair, 1 pip = 0.0001. Hence if EUR/USD increases by 1%, it would mean an increase of 100 pips.
The difference between bid (trader's sale price or the dealer's cost price) and ask (trader's cost price or the dealer's sale price) is called spread. Bid and ask are quoted in pairs. For example .709474-71 EUR/USD would mean 0.709474 is the bid price and 0.709471 is the ask price. Market makers quote both bid and ask prices, and profit from bid ask spread.
Spot and Forward Rate
Spot rate is the price of a currency in the spot market. Forward rate is the predetermined rate at which a currency can be exchanged for another in the forward market.
Governments and Banks
Governments and central banks of various countries deal in Forex market with the intention of maintaining their foreign exchange reserves. At time, governments buy and sell currency with the intention of achieving a favorable balance of payment (BOP) situation. For instance, if a country is interested in increasing its exports, it might sell its currency.
This would increase supply of currency. An increase in supply would lead to currency depreciation. Once currency depreciates, exports increase; making the current account balance favorable and the BOP satisfactory. As governments and central banks have unlimited authority and access to money, they can have significant influence on the direction of market.
Firms deal in the Forex market mainly to hedge against unfavorable exchange rate movements. For example, a firm in the U.S. engaged in the business of supplying corn to Europe would receive payments in Euros. Suppose Euro depreciates, the U.S. based firm would suffer.
This is because, the firm can now buy fewer dollars with the euros. In order to avoid this situation, the firm can enter into a futures contract to lock in a favorable rate at which Euros can be exchanged for dollars. This process is known as hedging.
Banks and Financial Institutions
Banks and other financial institutions also participate in the Forex market. Banks profit from the bid-ask spread. They deal in a particular segment of the market known as the interbank market. In this market, banks who have credit relations with each other indulge in trading currencies.
The size of the bank in monetary terms would determine its credit relation and its importance in the interbank market. Individuals who need to exchange currency can approach their local banks.
Hedge funds indulge in speculation by trying to judge the direction of the market. They profit by buying low and selling high. Their intention is to profit from sales, and not take delivery of the currency.
Retail Forex Brokers
Retail brokers allow individuals who participate in the market with the intention of making money through speculation. There are many online retail brokers who allow people to create an account for the purpose of trading. They also allow people to trade on margin. This means that for every 1$ in their account, they are allowed to borrow up to 100$ (say).
Online brokers provide trading platforms. People are generally allowed a demo account to test the platform. The product can be customized to suit the needs of the user. The user is also provided with an e-book that provides training. The user has access to news, currency quotes, and technical analysis tools, and can buy and sell many currency pairs.
A wide selection of plotting tools are also provided to help the user plot his own charts. Many of these products automatically signal when to buy and sell. A good Forex platform will allow the trader to profit from market movements that are repetitive nature.
However, many of these products may not deliver. They might be useless or too complicated for the user. In order to avoid getting scammed, one should always look for a regulated broker before deciding to trade online.
Forex trading can be a great source of income for people comfortable with foreign exchange market, and know how to make the most of currency movements. One must remember that it involves substantial risk, especially if the trader is heavily leveraged. It is up to the trader to ensure to choose appropriate trading platform and exercise caution while trading.