The foreign exchange market is the world’s most traded financial market. Forex (FX) is a blend of foreign currency and exchange, while foreign exchange is the process of changing currencies. People engage in foreign exchange for several reasons – trading, commerce, and tourism. Because of large trade flows within the system, trading currency is complex and risky, especially if you don’t know how to interpret the markets. The good news is that there are already systems that help create transparency for all investors.
Currencies are vital in helping us purchase goods and services locally and beyond our borders. The foreign exchange market is where currency trading happens. International currencies have to be exchanged to conduct foreign business and trade.
This is the whole concept of forex trading. The best thing about the international market is that currency trading is conducted electronically over the counter rather than in one centralized marketplace. As a result, all transactions occur through computer networks among the various traders worldwide. The forex exchange market is open 24 hours a day for five and a half days a week.
Currencies are traded across almost every time zone in major financial centers of London, New York, Frankfurt, Paris, Singapore, Hongkong, Tokyo, Sidney, and Zurich. Based on that logic, when the US trading day ends, the forex market begins afresh in other time zones like Hong Kong and Tokyo. So, the forex market can be tremendously active at any time, with the price quotes changing constantly.
So, what is forex trading? Simply put, this is the process through which traders speculate on currency prices to make a profit. Usually, currencies are traded in pairs. When a trader exchanges one currency for another, they are speculating on whether one of the currencies will fall or rise in value against the other.
What influences the currency value? Trade flows and political, economic, and geographical events affect forex supply and demand. This ends up creating daily volatility that offers new opportunities to forex traders.
The forex market has existed for centuries as people bartered goods and currencies to make purchases. Today’s forex market is a relatively modern invention, all thanks to the collapse of what is known as the Bretton Woods accord. This collapse began in 1971, after which more and more currencies were allowed to float freely against each other. The values of currencies vary based on demand and circulation.
Various foreign exchange trading services monitor them. For a long time, the forex market was heavily dominated by institutional firms and commercial and investment banks. These acted on behalf of their clients. While an aspect of that remains, forex trading has become more retail-oriented. As a result, traders and investors of many holding entities have begun participating in forex trading.
Today, there are speculative opportunities for professional and individual investors to trade one currency against another. Usually, there are two unique features of currency as an asset class – one can earn an interest rate differentiation between different currencies, and you can also profit from changes in the currency exchange rate, a strategy referred to as carry trade.
Forex traders primarily transact in three distinct marketplaces – spot, forward, and future markets. The spot market is the largest and is what you’re probably referring to when you refer to the forex market. Forwards and futures markets are more popular with financial firms and companies looking to hedge out their foreign exchange risks to a specific date in the future.
The spot market is the largest since it trades in the biggest underlying real asset for the futures and forwards markets. In the past, forwards and futures markets volumes surpassed those of the spot markets. However, that changed with the advent of electronic trading and forex brokers’ proliferation, boosting volumes for forex spot markets. The spot market is where traders buy and sell currencies based on their trading price.
This price is usually determined by supply and demand. It is calculated based on factors like economic performance, current interest rates, ongoing political situations locally and internationally, and the future perception of the performance of different currencies against one another. A spot deal is a bilateral transaction where one party delivers an agreed-upon currency amount to a counterparty and, in return, receives a specific amount of another currency based on the agreed-upon exchange rate value. Once the position has been closed, the settlement is usually in cash. While transactions in the spot market are in the present, the traders typically take about two days to finalize and make a settlement.
A forward contract is usually a private agreement between two principles to buy currency at a predetermined price at a future date. Two parties buy and sell contracts in the forward markets and determine an agreement. Future contracts are bought and sold based on a standard size and settlement date on public commodities markets.
A future contract is an agreement between two parties to deliver a currency at a predetermined price at a future date. The difference between futures and forward markets is that future markets trade on exchanges rather than OTC. Future contracts have precise details, including the number of units sold, settlement and delivery dates, and the minimum price increments one can’t customize. The exchange, in the end, acts as a counterparty to the trader, providing settlement and clearance services.
Both forward and future contacts are binding and settled for cash upon the expiry of the exchange. However, the contracts can always be bought and sold before they expire. The forwards and futures markets offer something spot markets don’t – protection against risk when trading currencies. Big international entities use these markets to hedge against exchange rate fluctuations in the future, although even speculators take part in these markets.
There are two main reasons – speculation and hedging.
Forex For Speculation
As mentioned earlier, the supply and demand of currencies are affected by factors like trade flows, interest rates, economic strength, and geopolitical events. This creates daily volatility in forex trading markets. Therefore, an opportunity arises for traders to profit from the changes that may cause one currency to increase or decrease in value against another. The whole thing relies on speculation, where one forecasts one currency weakening and the other strengthening since currencies are traded as pairs.
Forex For Hedging
Companies that do business in foreign countries are at increased risk due to currency value fluctuations when they buy and sell goods or services outside their domestic markets. Therefore, companies use forex to hedge currency risk by fixing a specific rate at which each transaction is completed. They do this by buying and selling currencies in advance in the forward and swap markets, thus locking in an exchange rate. The main advantage of hedging is that future contracts are cleared and standardized by a central authority.
In a nutshell, traders use speculation to make profits off the rise and fall of currency prices. Hedging is used to lock in prices for sales and manufacturing in overseas markets.
Forex trading is similar to trading equity. So, where do you begin with forex trading for the first time?
Forex trading is the process of speculating currency prices in a bid to make a profit. However, this is easier said than done for many people, mainly because forex trading is hard to understand. That’s why we’ve created this guide to help debunk the “complexity” of forex trading. Also, there are online courses you can take to familiarize yourself with the ins and outs of forex trading. Understanding the macroeconomic fundamentals that drive forex can help beginner forex traders become more profitable.
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