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What is Currency Exchange?
Currency exchange is the trading of one currency against another at a set price or rate, called an exchange rate. Currency exchange is synonymous with foreign exchange and is often referred to using the acronyms Forex or FX.
The FX Market
In terms of trading volume, daily FX turnover exceeds $1.5 trillion US dollars (source: Bank of International Settlements). This makes the FX market the world's largest, most efficient market, dwarfing both the US bond and equity markets. The New York Stock Exchange, for example, has a daily trading volume of approximately $30 billion. In turn, the FX market is by far the most liquid market in the world today. Due to the sheer size of the FX market, it is virtually impossible for individuals or companies to impact exchange rates. In fact, even central banks and governments find it increasingly difficult to affect the exchange rates of the most liquid currencies, such as the US dollar, Japanese Yen, Euro, Swiss Franc, Canadian Dollar or Australian Dollar.
The FX market was established in 1971 when floating exchange rates began to materialize. It is an inter-bank or inter-dealer market based on the vast network of hundreds of major banks across the globe. Additionally, it is an Over-The-Counter market (OTC), meaning that transactions are conducted between any counter parties that agree to trade via the telephone or an electronic network. The FX market is unique in that it has no fixed location or centralized exchange, as do many stock markets including the NYSE, ASE and CME. Dealers often advertise, negotiate and transact based upon exchange rates obtained directly or via distribution networks, such as Reuters or Bridge.
Typically, trades of $1 million and above constitute the institutional marketplace. Trades below this $1 million threshold constitute the retail marketplace.
The major dealing centers today are: London (with over 50% of the market), followed by New York, Tokyo, Zurich, Frankfurt, Hong Kong and Singapore, Paris and Sydney.
The FX market is a true 24-hour market, 5 days a week. With dealers in every major time zone. Trading begins Monday morning in Sydney (which corresponds to 7 PM EST, Sunday) and then moves around the globe through the various trading centers until the market closes at 4:30 EST in New York.
Today, over 85% of all FX transactions involve seven major currencies: the US Dollar (USD), Japanese Yen (JPY), Euro (EUR), Swiss Franc (CHF), British Pound (GBP), Canadian Dollar (CAD), and Australian Dollar (AUD). In the FX market, currencies are primarily traded against the US dollar. This means that most exchange rates are quoted with the US Dollar as the base or first currency quoted in a pair (i.e. USD/JPY). Exceptions to the rule are the GBP, NZD (New Zealand Dollar), AUD and the EUR (Euro).
The term cross rate refers to an exchange rate between two non-US Dollar currencies. Trading between two non-US Dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-US Dollar currency. There are a few non-US Dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.
Governments and Central Banks: Policies implemented by governments and national central banks play a significant role in the FX Market. Central banks control a country's money supply and are responsible for monetary policy and the maintenance of financial stability.
Banks and Investment Banks: A significant portion of FX turnover is derived from brokering/trading services performed by commercial and investment banks. In fact, large banks often trade billions of dollars daily. Banks trade currencies as a service for their commercial banking, deposit and lending customers. These institutions also conduct proprietary trading.
Hedge Funds: Given the size and liquidity of the market, hedge funds have begun to allocate increasing portions or their portfolios towards FX speculation. These funds are primarily attracted to the FX market because the ability to leverage their investments is typically much greater than it would be in the equity markets.
Businesses: International trade is the backbone of the FX market. Companies must convert currencies when they conduct business outside their home country. For example, if they export/sell goods in another country, they often receive payment in the currency of that foreign country and then must convert that currency back into their home currency. Similarly, if they import/buy foreign goods or services, they will have to pay in a foreign currency, requiring them to first convert their home currency into the foreign currency. Large companies convert huge amounts of currency each year. The timing of when they convert can have a large affect on their balance sheet and bottom line.
Consumers: Consumers typically come into contact with currency exchange when they travel. They go to a bank or a currency exchange bureau to convert one currency (typically, their "home currency") into another (i.e. the currency of the country they intend to travel to). Consumers may also purchase foreign goods while shopping in a foreign country or via the Internet with their credit card, in which case they will find that the amount they paid in the foreign currency will have been converted to their home currency on their credit card statement.
Investors and Speculators: Investors and speculators trade currencies in order to benefit from movements in the FX market. For example, if an investor believes that the Japanese economy is getting stronger and, as a result, the Japanese Yen will appreciate or rise in value relative to other currencies, then he/she may want to buy Japanese Yen and take what is referred to as a long position. Similarly, if an investor believes the Euro will depreciate or decline in value over time, then he/she may want to sell Euro to take a short position. Investors and speculators can profit from currencies becoming stronger (by taking a long position) and from currencies becoming weaker (by taking a short position). Speculators are often day traders, trying to take advantage of market movements in very short time periods -- buying a currency and then selling it again may happen within hours or even minutes. Day traders are attracted to currency trading because of the size, liquidity and volatility in the FX market. Participation in the FX market by individuals other than high net-worth individuals has been limited in the past. This is likely to be THE PLACE to learn trading in the future.