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Forex Trading

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Foreign Exchange Market Major Players

FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe. The major players are:

 

Deutsche Bank
UBS AG
Barclays Capital
Citi Bank
Royal Bank of Scotland
JPMorgan
HSBC
Credit Suisse
Goldman Sachs
Morgan Stanley
 
 
Market size and liquidity
 

Main foreign exchange market turnover, 1988–2007, measured in billions of USD. The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions, and the average daily volume in the global foreign exchange and related markets is continuously growing.

 

Exchange-traded FX futures contracts were introduced in the Chicago Mercantile Exchange in 1972 and are actively traded relative to most other futures contracts. Several other developed countries also permit the trading of FX derivative products on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, countries such as India Korea, and South Africa have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.

Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues have made it easier for retail traders to trade in the foreign exchange market. In 2006, retail traders constituted over 2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion. Because foreign exchange is an OTC market where brokers and dealers negotiate directly with one another, there is no central exchange or clearing house, and the biggest geographic trading centre is the UK, primarily London.

Due to London's dominance in the market, a particular currency's quoted price is usually the London market price.The ten most active traders account for 77% of trading volume, according to the 2010 Euromoney FX survey. These huge international banks continually provide the market with both bid and ask prices or buy and sell.

Customer will buy from the market at the higher "ask" price, and sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade. Minimum trading size for most deals is usually 100,000 units of base currency, which is a standard "lot". The spread is minimal for actively traded pairs of currencies, usually 0–3 pips.

Market Players

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. The term “better spread” occurs when a trader can guarantee large numbers of transactions for large amounts, they can demand a lesser difference between the bid and ask price.

 Access levels that make up the foreign exchange market are determined by the size of the "line" that is, the amount of money which is being traded. According to Galati and Melvin, pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and particularly in FX markets.
 
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Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Commercial Companies

The financial activities of companies seeking foreign exchange to pay for goods or services, play an important part in this market. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central Banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market.

 

It is said that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives.

Hedge Funds as Speculators
About 70% to 90%[ of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996.

Investment management firms

Investment management firms, who typically manage large accounts on behalf of customers  use the foreign exchange market to make transactions in foreign securities. An investment manager for example, bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist Currency Overlay operations, which manage clients currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms are usually small, many have a large value of assets under management (AUM), and hence can generate large trades.

Retail foreign exchange brokers

Both in size and importance, retail traders (usually individuals) constitute an ever growing segment of this market. Currently, they participate indirectly through brokers or banks. While largely controlled and regulated in the USA by the CFTC and NFA, retail brokers, have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began in 2009 imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are gone now.

 

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at-the customer has the choice whether or not to trade at that price.

Non-Bank Foreign Exchange Companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offers an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.It is estimated that in the UK, 14% of currency transfers/payments  are made via Foreign Exchange Companies. These companies selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services

Money Transfer/Remittance Companies

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange & Financial Services Ltd.

Trading Caracteristics

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates, depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously.

 

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are important centers as well. Exchange rates fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product growth, inflation, interest rates, budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions.

Determinants of FX Rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

 

  • International parity conditions: Relative Purchasing Power Parity interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions i.e. free flow of goods, services and capital which seldom hold true in the real world.
  • Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows.

  •  Asset market model: views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”  

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply.

Economic Factors

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.

 

  • The increase is in Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).  
  • Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.  
  • Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.  
  • Inflation levels and trends:Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.  

  • Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.  
  • Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the traded sector.

Political Conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies.

 

Generally if a country is experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market Psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

 

  • Flights to equality: Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.  
  • Long-term trends: Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. Currency markets often move in visible long-term trends.
  • "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".  To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

  • Economic numbers: Because economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time.
  • Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.
 
 
 
 

 

 

 

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