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What Is Forex?
The
foreign exchange market is the "place" where currencies are traded.
Currencies are important to most people around the world, whether they
realize it or not, because currencies need to be exchanged in order to
conduct foreign trade and business. If you are living in the U.S. and
want to buy cheese from France, either you or the company that you buy
the cheese from has to pay the French for the cheese in euros (EUR).
This means that the U.S. importer would have to exchange the equivalent
value of U.S. dollars (USD) into euros. The same goes for traveling. A
French tourist in Egypt can't pay in euros to see the pyramids because
it's not the locally accepted currency. As such, the tourist has to
exchange the euros for the local currency, in this case the Egyptian
pound, at the current exchange rate.
The
need to exchange currencies is the primary reason why the forex market
is the largest, most liquid financial market in the world. It dwarfs
other markets in size, even the stock market, with an average traded
value of around U.S. $2,000 billion per day. (The total volume changes
all the time, but as of August 2012, the Bank for International
Settlements (BIS) reported that the forex market traded in excess of
U.S. $4.9 trillion per day.)
One
unique aspect of this international market is that there is no central
marketplace for foreign exchange. Rather, currency trading is conducted
electronically over-the-counter (OTC), which means that all transactions
occur via computer networks between traders around the world, rather
than on one centralized exchange. The market is open 24 hours a day,
five and a half days a week, and currencies are traded worldwide in the
major financial centers of London, New York, Tokyo, Zurich, Frankfurt,
Hong Kong, Singapore, Paris and Sydney - across almost every time zone.
This means that when the trading day in the U.S. ends, the forex market
begins anew in Tokyo and Hong Kong. As such, the forex market can be
extremely active any time of the day, with price quotes changing
constantly.
Spot Market and the Forwards and Futures Markets
There
are actually three ways that institutions, corporations and individuals
trade forex: the spot market, the forwards market and the futures
market. The forex trading in the spot market always has been the largest
market because it is the "underlying" real asset that the forwards and
futures markets are based on. In the past, the futures market was the
most popular venue for traders because it was available to individual
investors for a longer period of time. However, with the advent of
electronic trading and numerous forex brokers, the spot market has
witnessed a huge surge in activity and now surpasses the futures market
as the preferred trading market for individual investors and
speculators. When people refer to the forex market, they usually are
referring to the spot market. The forwards and futures markets tend to
be more popular with companies that need to hedge their foreign exchange
risks out to a specific date in the future.
What is the spot market?
More
specifically, the spot market is where currencies are bought and sold
according to the current price. That price, determined by supply and
demand, is a reflection of many things, including current interest
rates, economic performance, sentiment towards ongoing political
situations (both locally and internationally), as well as the perception
of the future performance of one currency against another. When a deal
is finalized, this is known as a "spot deal". It is a bilateral
transaction by which one party delivers an agreed-upon currency amount
to the counter party and receives a specified amount of another currency
at the agreed-upon exchange rate value. After a position is closed, the
settlement is in cash. Although the spot market is commonly known as
one that deals with transactions in the present (rather than the
future), these trades actually take two days for settlement.
What are the forwards and futures markets?
Unlike
the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a
certain currency type, a specific price per unit and a future date for
settlement.
In
the forwards market, contracts are bought and sold OTC between two
parties, who determine the terms of the agreement between themselves.
In
the futures market, futures contracts are bought and sold based upon a
standard size and settlement date on public commodities markets, such as
the Chicago Mercantile Exchange. In the U.S., the National Futures
Association regulates the futures market. Futures contracts have
specific details, including the number of units being traded, delivery
and settlement dates, and minimum price increments that cannot be
customized. The exchange acts as a counterpart to the trader, providing
clearance and settlement.
Both
types of contracts are binding and are typically settled for cash for
the exchange in question upon expiry, although contracts can also be
bought and sold before they expire. The forwards and futures markets can
offer protection against risk when trading currencies. Usually, big
international corporations use these markets in order to hedge against
future exchange rate fluctuations, but speculators take part in these
markets as well.
Note that you'll see the terms: FX, forex, foreign-exchange market an
