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Foreign exchange market Wikipedia

Currency market

The international currency market, also known as the forex market, is a worldwide decentralized or over-the-counter (OTC) marketplace where currencies are bought, sold, and exchanged. This marketplace establishes exchange rates for all currencies, encompassing all activities associated with buying, selling, and exchanging currencies at current or predetermined prices. It is the most extensive market globally in terms of trading volume, surpassing even the credit market.

Major global banks are the primary players in this market. Financial hubs across the globe act as focal points for trading among a diverse range of buyers and sellers around the clock, excluding weekends. As currencies are traded in pairs, the forex market establishes a currency's relative value rather than its absolute worth by setting the market price of one currency in terms of another. For instance, 1 USD is equivalent to X CAD, CHF, JPY, and so on.

The currency exchange market operates through financial institutions and functions on various tiers. Banks rely on a smaller group of financial firms referred to as "dealers," who engage in significant amounts of foreign exchange trading behind the scenes. Although a few insurance companies and other types of financial institutions participate, most Forex dealers are banks. This concealed market is sometimes referred to as the "interbank market." Transactions between Forex dealers can be extremely large, amounting to hundreds of millions of dollars. Due to the jurisdictional complexities involved when dealing with two currencies, the Forex market is subject to little regulatory oversight.

The currency exchange market facilitates international trade and investments by enabling the conversion of currencies. This permits a US-based company, for example, to purchase goods from European Union (EU) member states, particularly those in the Eurozone, and pay in Euros, despite earning revenue in US dollars. The Forex market also supports direct speculation and evaluation of currency values, as well as carry trade speculation, which is based on the difference in interest rates between two currencies.

In a regular foreign exchange transaction, one party purchases a specific amount of one currency in exchange for a specific amount of another currency.

The contemporary Forex market began taking shape during the 1970s, following three decades of government constraints on foreign exchange transactions under the Bretton Woods system of monetary management, which established the regulations for commercial and financial interactions among the world's leading industrialized nations after World War II. Countries gradually shifted from the earlier exchange rate system, which was fixed according to the Bretton Woods system, to floating exchange rates.

The Forex market has the following distinctive characteristics:
A massive trading volume, making it the world's biggest asset class and leading to significant liquidity.
Geographical dispersion.
Continuous operation: 24 hours a day, with the exception of weekends, i.e., trading from 22:00 UTC on Sunday (Sydney) until 22:00 UTC on Friday (New York).
A range of factors affecting exchange rates.
Low relative profit margins compared to other fixed-income markets.
The use of leverage to increase profit and loss margins relative to account size.

Therefore, it has been described as the market that is closest to achieving perfect competition, despite currency intervention by central banks.

As per the Bank for International Settlements, the initial global findings from the 2022 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity reveal that the average daily trading in Forex markets was US$7.5 trillion in April 2022. This represents an increase from US$6.6 trillion in April 2019. In terms of value, Forex swaps were the most commonly traded instrument in April 2022, with an average daily trade of US$3.8 trillion, followed by spot trading at US$2.1 trillion.

The breakdown of the $7.5 trillion figure is as follows:
$2.1 trillion in spot transactions
$1.2 trillion in outright forwards
$3.8 trillion in Forex swaps
$124 billion in currency swaps
$304 billion in options and other products

History

Ancient

In ancient times, currency trading and exchange were already happening. People known as "money-changers" helped others to exchange money and charged a commission or fee for their services. They operated from city stalls or the Temple's Court of the Gentiles during feast times. Money-changers were also goldsmiths or silversmiths.

In the 4th century AD, the exchange of currency was monopolized by the Byzantine government.

Papyri PCZ I 59021 (c.259/8 BC) provides evidence of coinage exchange in ancient Egypt.

Currency and exchange played a crucial role in trade in the ancient world, allowing people to buy and sell various items such as food, pottery, and raw materials. If a Greek coin had more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. Therefore, many world currencies had a value fixed to a recognized standard such as silver and gold at some point in history.

Medieval and later

During the 15th century, the Medici family had to establish banks in foreign locations to exchange currencies for textile merchants. They created the nostro account book, which contained entries showing amounts of foreign and local currencies, to facilitate trade. Amsterdam maintained an active Forex market during the 17th century, and in 1704, foreign exchange transactions occurred between agents of the Kingdom of England and the County of Holland.

Early modern

Around 1850, Alex. Brown & Sons was a major currency trader in the USA. In 1880, Banco Espírito Santo was given permission to engage in a Forex trading business. This year is regarded as the beginning of modern foreign exchange, as the gold standard began in that year.

Before the First World War, there was limited control of international trade. The onset of war caused countries to abandon the gold standard monetary system.

Modern to post-modern

Between 1899 and 1913, the annual rate of growth for countries' foreign exchange holdings was 10.8%, while gold holdings increased at a rate of 6.3% per year from 1903 to 1913.

By the end of 1913, the British pound was used for almost half of the world's foreign exchange transactions. The number of foreign banks in London grew from three in 1860 to 71 in 1913. In 1902, there were only two Forex brokers in London. Paris, New York City, and Berlin were the most active centers for currency trades at the beginning of the 20th century, and Britain remained largely uninvolved until 1914. The number of Forex brokers in London increased to 17 between 1919 and 1922, and by 1924, 40 firms were involved in Forex trading.

During the 1920s, the Kleinwort family led the Forex market, while Japheth, Montagu & Co. and Seligman were also significant FX traders. The Forex market in London started to take on its modern form. By 1928, Forex trading was a vital component of the city's financial system. Various factors, such as continental exchange controls and issues in Europe and Latin America, prevented widespread prosperity in London's trade during the 1930s.

After World War II

In 1944, the Bretton Woods Agreement was signed, permitting currencies to fluctuate within a range of ±1% from the currency's par exchange rate. The Foreign Exchange Bank Law was implemented in Japan in 1954, allowing the Bank of Tokyo to become a center of foreign exchange. In the following years, Japanese law was altered to allow foreign exchange dealings in a broader range of Western currencies.

Richard Nixon, the U.S. President, is credited with terminating the Bretton Woods Agreement and fixed exchange rates, which ultimately resulted in a free-floating currency system. After the Accord ended in 1971, the Smithsonian Agreement permitted rates to fluctuate by up to ±2%. The volume of foreign operations by the U.S. Federal Reserve was relatively low in 1961-62. The Agreement's limitations were not considered feasible by those in charge of regulating exchange rates, and this practice was halted in March 1973. Organizations relied on reserves of currency instead of keeping major currencies with the ability to be converted to gold. From 1970 to 1973, trading volume in the market tripled. During February-March 1973, some markets were "split," and a dual currency rate was introduced. However, this was abolished in March 1974.

In June 1973, Reuters introduced computer monitors to replace telephones and telexes previously used for trading quotes.

Markets close

The forex markets were forced to close sometime between 1972 and March 1973 due to the ineffective Bretton Woods Accord and the European Joint Float. In 1976, the West German government made the largest purchase of US dollars in history, acquiring almost $3 billion (according to The Statesman: Volume 18, 1974, the figure was given as $2.75 billion in total). This event highlighted the impossibility of balancing exchange rates through the control measures in use at the time, leading to the closure of the monetary system and Forex markets in West Germany and other European countries for two weeks in February and/or March 1973 (according to Giersch, Paqué, & Schmieding, they closed after the purchase of "7.5 million Dmarks." Brawley states that the exchange markets had to be closed, and after they reopened, the large purchase occurred on March 1).

After 1973

In developed countries, government intervention in Forex trading ceased in 1973, marking the start of modern free market conditions. Other sources suggest that U.S. retail customers first traded currency pairs in 1982, with more pairs becoming available the following year.

On January 1, 1981, the People's Bank of China allowed certain domestic "enterprises" to participate in Forex trading, and in 1981, the South Korean government ended Forex controls and allowed free trade for the first time. In 1988, South Korea's government accepted the IMF quota for international trade.

On February 27, 1985, intervention by European banks (especially the Bundesbank) had an impact on the Forex market. The largest proportion of all trades worldwide in 1987 occurred in the United Kingdom (slightly over one quarter), with the United States having the second highest involvement in trading.

In 1991, Iran changed some international agreements from oil-barter to foreign exchange.

Market size and liquidity

The forex market is the most liquid financial market globally. It includes traders such as governments, central banks, institutional investors, commercial banks, currency speculators, corporations, and individuals. According to the 2019 Triennial Central Bank Survey conducted by the Bank for International Settlements, the average daily turnover was $7.5 trillion in April 2022, a significant increase from $1.9 trillion in 2004. Out of this, $2.1 trillion accounted for spot transactions and $5.4 trillion traded in other derivatives, swaps, and outright forwards.

The Forex market is traded over-the-counter, and there is no central exchange or clearinghouse as brokers and dealers negotiate directly with one another. The United Kingdom, primarily London, is the most prominent trading center, accounting for 38.1% of the total in April 2022. Therefore, the quoted price for a particular currency is usually based on London market prices. In the US, trading accounts for 19.4% of the total, while Singapore, Hong Kong, and Japan account for 9.4%, 7.1%, and 4.4%, respectively.

Exchange-traded currency futures and options turnover were growing rapidly from 2004 to 2013, reaching $145 billion in April 2013, double the turnover recorded in April 2007. As of April 2022, exchange-traded currency derivatives accounted for 2% of OTC foreign exchange turnover. The Chicago Mercantile Exchange introduced Forex futures contracts in 1972, and they are now traded more than most other futures contracts.

The majority of developed nations allow the trading of derivative products on their exchanges, including futures and options on futures. Such countries already have fully convertible capital accounts. However, some emerging market governments prohibit Forex derivative products on their exchanges due to capital controls. Despite these controls, the use of derivatives is growing in many emerging economies, such as South Korea, South Africa, and India, which have established currency futures exchanges.

Between April 2007 and April 2010, Forex trading increased by 20%, and has more than doubled since 2004. The growth in turnover is attributed to several factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. Transaction costs have decreased and market liquidity has increased due to the growth of electronic execution and a variety of execution venues, attracting a wide range of customers. Online portals, in particular, have made it easier for retail traders to participate in the Forex market. By 2010, retail trading made up an estimated 10% of spot turnover, or $150 billion per day (refer to: Retail Forex traders).

Market participants

The Forex market has different levels of access, unlike the stock market. The top level is the interbank Forex market, consisting of large commercial banks and securities dealers. Spreads, which are the difference between the bid and ask prices, are very narrow in the interbank market and not disclosed to outsiders. Spreads increase as we go down the levels of access due to the volume of transactions. Larger transactions allow traders to demand a smaller difference between the bid and ask price, known as a better spread. The levels of access are determined by the size of the "line" (the amount of money involved in the trade). The interbank market accounts for the majority of transactions, followed by smaller banks, large multinational corporations, hedge funds, and retail market makers. Institutional investors like pension funds, insurance companies, and mutual funds have played a significant role in the FX market since the early 2000s, as have hedge funds. Central banks also participate in the Forex market to align currencies with their economic requirements.

Commercial companies

A significant portion of the Forex market is driven by the financial transactions of companies aiming to acquire foreign currency for payment of goods or services. Compared to banks or speculators, commercial companies typically engage in smaller trades that have minimal immediate effects on market rates. However, trade flows play a crucial role in determining the long-term trajectory of currency exchange rates. In certain cases, multinational corporations (MNCs) can have an unforeseen impact on the market, especially when they cover substantial positions based on exposures that are not widely known by other participants.

Central banks

National central banks have a significant impact on the Forex markets. They aim to manage the money supply, inflation, and/or interest rates, and typically have established target rates for their currencies, whether officially or unofficially. These banks utilize their considerable foreign exchange reserves to stabilize the market. However, the effectiveness of central bank efforts in "stabilizing speculation" is uncertain since central banks do not face the risk of bankruptcy in the same way as other traders do when experiencing substantial losses. Furthermore, there is no compelling evidence to suggest that central banks consistently generate profits from trading activities.

Foreign exchange fixing

Each country's national bank sets the foreign exchange fix, which represents the daily monetary exchange rate. The purpose is for central banks to assess their currency's performance based on the fix time and exchange rate. Fixing rates serve as a reflection of the market's genuine equilibrium value. Market participants, including banks, dealers, and traders, utilize these rates as an indicator of market trends.

Merely the anticipation or speculation of central bank intervention in foreign exchange can be sufficient to stabilize a currency. However, countries with a floating currency regime that is prone to fluctuations may resort to frequent and forceful interventions. Despite their efforts, central banks do not always achieve their desired outcomes. The collective power of the market can easily overpower any central bank. Instances of such scenarios were observed during the collapse of the European Exchange Rate Mechanism in 1992-93 and more recent episodes in Asia.

Investment management firms

Asset management companies (which commonly handle substantial portfolios for clients like pension funds and endowments) utilize the Forex market to execute transactions involving foreign securities. For instance, an asset manager handling an international equity portfolio must buy and sell various currency pairs to facilitate the purchase of foreign securities.

Certain asset management firms also engage in specialized currency overlay operations, which involve managing clients' currency exposures with the goal of generating profits and mitigating risks. Although the number of firms specializing in this area is relatively limited, many of them manage significant assets under their supervision, enabling them to execute substantial trades.

Retail Forex traders

The retail segment of speculative traders in the Forex market is experiencing growth. Currently, these traders participate indirectly through intermediaries such as brokers or banks. In the United States, retail brokers are subject to strict regulation and oversight by the Commodity Futures Trading Commission and National Futures Association. However, there have been occasional instances of Forex fraud involving retail brokers in the past. To address this issue, the NFA implemented a requirement in 2010 for its members engaged in Forex trading to register specifically as Forex CTA (Commodity Trading Advisor) instead of a general CTA. Members of the NFA who are traditionally subject to minimum net capital requirements, such as FCMs (Futures Commission Merchants) and IBs (Introducing Brokers), face higher minimum net capital requirements if they engage in Forex trading. Some Forex brokers operate under the regulations of the Financial Services Authority in the UK, where Forex trading with margin is part of the broader over-the-counter derivatives trading industry, including contracts for difference and financial spread betting.

There are two primary types of retail FX brokers that offer speculative currency trading opportunities: brokers and market makers. Brokers act as intermediaries between the customer and the wider FX market. They aim to obtain the best price for a retail order and execute trades on behalf of the retail customer. In addition to the market price, brokers charge a commission or mark-up. On the other hand, market makers or dealers usually act as principals in transactions with retail customers. They quote prices at which they are willing to transact with the retail customer.

Non-bank foreign exchange companies

Currency exchange and international payment services are provided by non-bank foreign exchange companies to individuals and businesses. These companies, also known as "Forex brokers," focus on currency exchange and payments rather than speculative trading. Typically, they facilitate physical delivery of currency to a designated bank account.

In the United Kingdom, approximately 14% of currency transfers and payments are conducted through Foreign Exchange Companies. These companies differentiate themselves by offering better exchange rates or lower payment fees compared to traditional banks. Unlike Money Transfer/Remittance Companies, Foreign Exchange Companies generally cater to higher-value transactions. In India, the daily volume of transactions through Foreign Exchange Companies amounts to around US$2 billion. Although this figure falls short of established international Forex markets, the market is experiencing steady growth with the emergence of online Foreign Exchange Companies. Approximately 25% of currency transfers and payments in India are conducted through non-bank Foreign Exchange Companies, which often highlight competitive exchange rates as their unique selling proposition. These companies operate under the regulation of FEDAI (Foreign Exchange Dealers' Association of India), and any foreign exchange transaction is subject to the provisions of the Foreign Exchange Management Act, 1999 (FEMA).

Money transfer companies and bureaux de change

Money transfer companies specialize in facilitating high-volume, low-value transfers, primarily made by economic migrants to their home countries. According to a 2007 estimate by the Aite Group, the total value of remittances reached $369 billion, representing an 8% increase compared to the previous year. The top four recipient countries, namely India, China, Mexico, and the Philippines, received a combined total of $95 billion. Among the prominent providers in this industry, Western Union is widely recognized as the largest, boasting a global network of 345,000 agents, closely followed by UAE Exchange. Bureaux de change and currency transfer companies focus on offering foreign exchange services for travelers, typically catering to low-value transactions. These establishments are commonly found at airports, train stations, tourist destinations, and similar locations, providing the convenience of exchanging physical currency notes from one denomination to another. They gain access to Forex markets through collaborations with banks or non-bank foreign exchange companies.

Most traded currencies by value

There is no centralized or standardized market for the majority of trades, and cross-border regulation is minimal. Given the decentralized nature of currency markets, multiple interconnected marketplaces exist where various currency instruments are traded. As a result, there isn't a single exchange rate but rather multiple rates or prices depending on the participating bank or market maker and their location. However, due to the presence of arbitrage, these rates remain relatively close to one another. Typically, the quoted price of a specific currency reflects the prevailing London market price, given the city's dominant role in the market. Key trading platforms include Electronic Broking Services (EBS) and Thomson Reuters Dealing, alongside trading systems provided by major banks. Fxmarketspace, a collaborative effort between the Chicago Mercantile Exchange and Reuters, was launched in 2007 with the aim of establishing a central market clearing mechanism but fell short of achieving that goal.

While London and New York City are the primary trading centers, Tokyo, Hong Kong, and Singapore also hold significant importance. Banks from around the world actively participate in currency trading, which takes place continuously throughout the day. As one trading session ends, another begins, ensuring round-the-clock activity.

Fluctuations in exchange rates are primarily influenced by actual monetary flows and expectations of future changes in those flows. These changes can be attributed to factors such as gross domestic product (GDP) growth, inflation based on purchasing power parity theory, interest rates (including interest rate parity, Domestic Fisher effect, and International Fisher effect), budget and trade deficits or surpluses, significant cross-border mergers and acquisitions, and other macroeconomic conditions. Major news and economic indicators are released publicly, often on predetermined dates, allowing widespread access to the same information simultaneously. However, large banks possess an advantage as they have visibility into their customers' order flow.

Currencies are exchanged in pairs, with each pair representing a distinct trading product. Traditionally, these pairs are denoted as XXXYYY or XXX/YYY, where XXX and YYY are the three-letter codes according to ISO 4217 for the respective currencies. The first currency (XXX) is the base currency, quoted relative to the second currency (YYY), known as the counter currency or quote currency. For example, the quote EURUSD (EUR/USD) 1.5465 represents the price of one euro in terms of US dollars, indicating that 1 euro equals 1.5465 dollars. It is customary to quote most exchange rates against the US dollar, with the USD as the base currency (e.g., USDJPY, USDCAD, USDCHF). However, the British pound (GBP), Australian dollar (AUD), New Zealand dollar (NZD), and euro (EUR) are exceptions, where the USD serves as the counter currency (e.g., GBPUSD, AUDUSD, NZDUSD, EURUSD).

Factors influencing XXX will impact both XXXYYY and XXXZZZ, resulting in a positive currency correlation between XXXYYY and XXXZZZ.

In the spot market, based on the 2022 Triennial Survey, the most actively traded currency pairs were:
EURUSD: 22.7%
USDJPY: 13.5%
GBPUSD (also known as cable): 9.5%

The US dollar was involved in 88.5% of transactions, followed by the euro (30.5%), the yen (16.7%), and the pound (12.9%). The total volume percentages for individual currencies should sum up to 200% since each transaction involves two currencies.

Trading in the euro has significantly increased since its introduction in January 1999, and the future dominance of the US dollar in the Forex market is subject to debate. In the past, trading the euro against a non-European currency ZZZ typically required two trades: EURUSD and USDZZZ. However, an exception to this is EURJPY, which is an established currency pair traded in the interbank spot market.

Determinants of exchange rates

In a fixed exchange rate system, the government determines the exchange rates. In a floating exchange rate system, various theories have been proposed to explain and predict exchange rate fluctuations, including:
International parity conditions: These theories, such as relative purchasing power parity, interest rate parity, domestic Fisher effect, and international Fisher effect, offer logical explanations for exchange rate fluctuations. However, they are based on assumptions that are often not applicable in the real world, such as the free flow of goods, services, and capital.
Balance of payments model: This model primarily focuses on tradable goods and services, overlooking the growing significance of global capital flows. It fails to explain the sustained appreciation of the US dollar in the 1980s and most of the 1990s, despite the significant US current account deficit.
Asset market model: This model considers currencies as essential assets for constructing investment portfolios. Asset prices are primarily influenced by people's willingness to hold existing asset quantities, which is influenced by their expectations of future asset value. According to the asset market model, the exchange rate between two currencies represents the price that balances the relative supply and demand for assets denominated in those currencies.

None of the existing models have successfully explained long-term exchange rates and volatility. However, for shorter time frames, algorithms can be developed to predict prices. It is evident from the aforementioned models that various macroeconomic factors impact exchange rates, and ultimately, currency prices are determined by the interplay of supply and demand. The global currency markets can be likened to a vast melting pot, where an ever-changing mixture of current events constantly shifts supply and demand factors, consequently affecting the price of one currency relative to another. No other market encapsulates and distills as much of the world's happenings at any given time as the Forex market.

The value of a currency, determined by its supply and demand, is influenced by multiple factors rather than a single element. These factors generally fall into three categories: economic factors, political conditions, and market psychology.

Economic factors

Economic factors encompass various aspects, including:
(a) Government policies related to the economy, disseminated by government agencies and central banks.
(b) Economic conditions, typically revealed through economic reports and indicators.

Government policies consist of fiscal policy, involving budget and spending practices, and monetary policy, which involves the measures employed by a central bank to influence the supply and "cost" of money, reflected in interest rates.
Government budget deficits or surpluses: Wider budget deficits are generally viewed negatively by the market, while narrowing deficits are seen in a positive light. These perceptions impact the value of a country's currency.
Balance of trade levels and trends: The flow of trade between countries reflects the demand for goods and services, indicating the need for a country's currency to facilitate trade. Surpluses and deficits in trade demonstrate the competitiveness of a nation's economy. Trade deficits, for example, can have a negative impact on a country's currency.
Inflation levels and trends: High inflation or rising inflation levels typically lead to currency depreciation, as inflation erodes purchasing power and demand for the currency. However, in certain cases, a currency may strengthen when inflation rises due to expectations of the central bank raising short-term interest rates to counter inflation.
Economic growth and health: Reports such as GDP, employment levels, retail sales, and capacity utilization provide insights into a country's economic growth and health. A strong and healthy economy generally results in better currency performance and increased demand for the currency.
Productivity of an economy: Improved productivity within an economy can positively influence the value of its currency, particularly if the productivity increase occurs in the traded sector.

Political conditions

Political conditions and events, whether internal, regional, or international, can significantly influence currency markets.

All exchange rates are vulnerable to political instability and expectations surrounding a new ruling party. Political turmoil and instability can adversely affect a nation's economy. For instance, the destabilization of coalition governments in Pakistan and Thailand can have a negative impact on the value of their respective currencies. Similarly, in a country facing financial difficulties, the rise of a politically responsible faction can have the opposite effect. Additionally, events occurring in one country within a region can generate positive or negative interest in neighboring countries, thereby influencing their currencies.

Market psychology

Market sentiment and trader perceptions play a significant role in shaping the Forex market through various mechanisms:
Seeking safety: Uncertain international events can trigger a "flight-to-quality," wherein investors transfer their assets to perceived safe havens. Currencies considered stronger compared to their weaker counterparts experience increased demand and higher prices during such times of political or economic uncertainty. Traditional safe haven assets include the US dollar, Swiss franc, and gold.
Long-term patterns: Currency markets often exhibit observable long-term trends, influenced by economic and political factors. While currencies do not have seasonal cycles like physical commodities, business cycles can impact their value. Analyzing these cycles helps identify longer-term price trends.
"Buy the rumor, sell the fact": This common market phenomenon applies to various currency situations. It refers to the tendency of currency prices to reflect the expected impact of a specific event before it occurs. However, when the anticipated event materializes, the market reacts in the opposite direction. This behavior is sometimes attributed to market being "oversold" or "overbought." Such actions can also result from cognitive biases like Anchoring, wherein investors excessively focus on the relevance of external events to currency prices.
Economic indicators: While economic data can reflect economic policies, certain reports and numbers hold significant importance in market psychology and can immediately impact short-term market movements. The prominence of specific economic indicators may change over time. For instance, money supply, employment figures, trade balance, and inflation numbers have all taken turns in the spotlight in recent years.
Technical analysis considerations: Similar to other markets, currency pairs like EUR/USD can exhibit recognizable patterns formed by historical price movements. Traders often study price charts to identify and leverage such patterns in their decision-making process.

Financial instruments

Spot transactions

A spot transaction refers to a delivery transaction completed within two days (except for trades involving the US dollar, Canadian dollar, Turkish lira, euro, and Russian ruble, which settle on the next business day). In contrast, futures contracts typically have a three-month duration. This type of trade involves a direct exchange of two currencies, has a short time frame, entails cash rather than a contract, and does not include interest in the agreed-upon transaction. Spot trading is a commonly observed form of forex trading. In some cases, a forex broker may levy a small fee on the client to extend the expiring transaction into a new identical one, allowing the trade to continue. This fee is referred to as the "swap" fee.

Forward transactions

To mitigate foreign exchange risk, one approach is to participate in a forward transaction. In this type of transaction, actual money exchange does not take place until a predetermined future date. The buyer and seller reach an agreement on an exchange rate for a specific future date, and the transaction is executed on that date, irrespective of the prevailing market rates at that time. The duration of the trade can vary, ranging from a single day to several days, months, or even years. Typically, the date is mutually determined by both parties, and the terms of the forward contract are negotiated and agreed upon by both parties.

Non-deliverable forward (NDF) transactions

Foreign exchange banks, electronic communication networks (ECNs), and prime brokers provide non-deliverable forward (NDF) contracts, which are financial instruments that do not involve actual physical delivery. NDFs are commonly used for currencies with limitations, such as the Argentinian peso. In cases like these, forex hedgers can only protect themselves against such risks by using NDFs, since currencies like the Argentinian peso cannot be traded on open markets like major currencies.

Swap transactions

The prevalent form of forward transaction is known as a Forex swap. In a swap, two parties swap currencies for a specific duration and agree to reverse the exchange at a future date. These contracts are not standardized and are not conducted through an exchange. A deposit is typically necessary to maintain the position open until the transaction is finalized.

Futures transactions

Futures are standardized forward agreements and are typically traded on a dedicated exchange. The typical duration of a contract is approximately 3 months. Futures contracts usually include interest amounts.

Currency futures contracts are contracts that specify a fixed volume of a particular currency to be exchanged on a specific settlement date. Therefore, currency futures contracts bear similarities to forward contracts in terms of their obligations but differ in terms of their trading process. Moreover, futures contracts are settled daily, mitigating credit risk inherent in forwards. Multinational corporations commonly employ currency futures to hedge their currency positions. Additionally, speculators engage in trading currency futures in anticipation of exploiting exchange rate fluctuations.

Options transactions

A foreign exchange option, also known as an FX option, is a financial instrument that grants the holder the choice, but not the obligation, to convert money from one currency to another at a predetermined exchange rate on a specified date. The FX options market is globally recognized as the most extensive, significant, and fluid market for options across all categories.

Speculation

Debates surrounding currency speculators and their impact on currency devaluations and national economies resurface regularly. Economists, like Milton Friedman, contend that speculators ultimately play a stabilizing role in the market. They argue that speculative activities provide a necessary market for hedgers and enable the transfer of risk from those unwilling to bear it to those willing to do so. On the other hand, some economists, including Joseph Stiglitz, view this argument as more politically and philosophically driven rather than grounded in economic principles.

Prominent speculators in the market are typically large hedge funds and well-capitalized "position traders." While some economists suggest that individual traders may act as "noise traders" and potentially have a more destabilizing impact compared to larger and better-informed participants.

Currency speculation often carries a negative connotation in many countries. Unlike investment in traditional financial instruments that are seen as contributing to economic growth by providing capital, currency speculation is regarded as mere gambling and often interferes with economic policies. A notable example is the 1992 devaluation of the Swedish krona, which was attributed to currency speculation and led to Sweden's central bank temporarily raising interest rates to an unprecedented 500% per annum. Mahathir Mohamad, a former Prime Minister of Malaysia, is a well-known advocate of this perspective, blaming currency speculators, such as George Soros, for the devaluation of the Malaysian ringgit in 1997.

However, there is an opposing view presented by Gregory Millman, likening speculators to "vigilantes" who help enforce international agreements and anticipate the consequences of basic economic laws to profit. According to this viewpoint, countries may develop unsustainable economic bubbles or mishandle their national economies, and foreign exchange speculators expedite the inevitable collapse. In some cases, a swift collapse might be preferable to continued economic mismanagement followed by a larger-scale collapse. Critics, including Mahathir Mohamad, are seen as attempting to shift the blame away from themselves for the unsustainable economic conditions they created.

Risk aversion

Risk aversion refers to a type of trading behavior observed in the Forex market when there is an occurrence of a potentially unfavorable event that could impact market conditions. This behavior arises when cautious traders sell off their positions in high-risk assets and allocate their funds towards safer assets due to uncertainty.

Within the Forex market context, traders sell off their holdings in different currencies and opt for safe-haven currencies like the US dollar. Sometimes, the selection of a safe haven currency is more influenced by prevailing sentiments rather than economic indicators. An illustration of this can be seen during the 2008 financial crisis, where global equity values declined while the US dollar gained strength (refer to Fig.1). Interestingly, this occurred despite the crisis primarily affecting the US.

Carry trade

Carry trade involves borrowing a currency with a low interest rate to acquire another currency with a higher interest rate. When there is a substantial interest rate disparity, this strategy can be highly lucrative for traders, particularly when employing significant leverage. Nevertheless, as with any leveraged investments, this approach has both advantages and disadvantages, as significant fluctuations in exchange rates can swiftly turn profitable trades into substantial losses.