Those wanting to get involved in trading currencies turn to the foreign exchange market, or forex. The role that currencies play in the world business and trade markets is extremely important. Currency exchanges occur every second of every day. For example, products purchased in Italy are normally paid for in Euros, the country’s recognized currency. However, Italians visiting the United States cannot use Euros and, therefore, must exchange them for US dollars if they want to make purchases within the country. Such exchanges are conducted by using rates established for each particular day.
Forex was created so that world currency exchanges could occur more easily and by more people. The forex market is the world’s largest and most liquid, outperforming even the stock markets with trades that exceed $5 billion daily on average (although trading amounts vary continuously).
Another unique aspect of the forex is that there is not a centralized marketplace where currency exchanges occur. All global trading is carried out via electronic sources such as computer networks in what are known as over-the-counter trades, or OTC. An appealing aspect of the forex market is that currencies can be traded five full days and one half day every week and for 24 hours except on the partial day. Practically every time zone is covered because trading takes place via major trading centers around the globe such as New York, Paris, Frankfurt, London, Singapore, Hong Kong and Tokyo. Because these financial centers span the globe, one location may end its day of trading while another location begins. This constant trading potential can produce extreme bouts of activity regardless of the time of day in which trades are being conducted. Quotes on currencies are ever changing throughout the day as well.
The Three Markets of Forex Trading
The forex actually consists of three different markets in which trades can be made by individual investors or those of a corporate or institutional nature. These markets are the spot market, which is largest of the three, the futures market and the forwards market. Both the futures and forwards markets are established on spot market trading. The futures market enjoyed top place in trading popularity prior to electronic trading due to it being available for an extended period to individual traders. With the rise of computers and making trades electronically, large numbers of investors and speculators alike have turned to the spot market as their vehicle of choice for trading currencies. Today, the spot market makes up the majority of activity known as forex with the markets of futures and forwards used mainly by companies that require hedging for their other trade risks.
Spot Market Explained
Foreign currencies that are traded are done so through the spot market. Trades are carried out based on current evaluations of daily prices that rise and fall, sometimes abruptly, due to each currency’s particular supply and demand. Elements that affect price rates include speculations of future performance of currencies, interest rate changes, political actions (both positive and negative) that occur on both a local or international level, and how economies perform according to their currencies. Trades that are conducted and finalized are called ‘spot deals’ which is where the market derives its name. Spot deals consist of one trading person or entity delivering a particular amount that has been agreed upon to another person or entity at a specified exchange currency value. Once these deals are closed, a process which occurs over two days, settlements are distributed in the select currency.
Futures Market and Forwards Market Explained
The futures and forwards markets are somewhat different than the spot market in that actual currencies are not traded, but rather they utilize contracts between various types of currencies that have specified unit prices and dates of settlement occurring sometime in the future.
Contracts are traded on the futures market pertaining to various trade sizes and dates of settlement that are standard in nature and which occur on markets trading in public commodities. Contracts traded on the futures market are based on specific information such as traded unit numbers, settlement dates, delivery dates, and minimum price amounts.
Pertaining to the forwards market, the individuals involved in trade do so according to contracts made OTC. The agreements outlining the deal are arranged by the individuals involved.
Regardless of whether contract trades are made via the futures market or forwards market, deals are final and settlements are normally made in cash according to their determined expiration dates. Traders do, however, have the option of purchasing or selling contracts before expiry. Deals that are made through the futures market and forwards market are often used as hedge protection for currency trades made on the spot market. Large corporations are the most common users of these two markets, using them as hedges to protect other investments from future fluctuations in exchange rates, but these markets are also often used by speculators as well.
The foreign exchange market, or forex, is also often called FX or simply currency market, but all of these terms represent the same market.
