The Structure and Function of the Foreign Exchange Market (CISI Exam Prep)
The Structure and Function of the Foreign Exchange Market
Relevant to the following CISI qualifications: IISI, Securities, Global Securities, ICWIM and ICAWM
The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for another. Prior to 1996 the market was confined to large corporate banks and international corporations. However it has since opened up to include all traders and speculators. Today, the average daily turnover in forex markets is US$1.9 trillion, according to the Bank of International Settlement’s Triennial Survey. The market is growing rapidly as investors gain more information and develop more interest.
In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they bet correctly and collect the profit in the form of an interest rate spread when they return to the original currency. The profit margins are low compared with other fixed-income markets. Large trading volumes can, however result, in very high profits. Most forex trading takes place in London, New York, and Tokyo, with most trading activity in London, which dominates the market at 30% of all transactions. New York’s market share is 16%, and Tokyo’s has fallen to 10% due to the growing prominence of Singapore and Hong Kong. Singapore has become the fourth largest exchange market globally, and Hong Kong is the fifth, having overtaken Switzerland. The various players in the foreign exchange market include bank dealers, 16% of which are international investors and speculators. Banks account for almost two-thirds of forex transactions; of the rest, about 20% is mainly attributable to securities firms that operate in the international debt and equity markets.
One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using cash as opposed to a contract.
In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in advance. The time period ranges from days to years. Currency swaps are a popular type of forward transaction; these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later date. Another type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up and a maturity date arranged. The time schedule is about three months.
In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction depends on the availability of option contracts on an organized exchange. Otherwise, such forex deals may be carried out using an over-the-counter (OTC) contract.
- The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.
- As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis part from weekends.
- An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.
- It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.
- In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.
- The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.
- Investors need a lot of capital to make good profits because the profit marginson small-scale trades are very low.
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