The forex market has been in existence for centuries, as people have been exchanging or bartering goods since the earliest times. However, the modern forex market is a lot more complicated than the ancient barter system.
What is Forex?
Forex was one of the original financial markets developed to provide structure to a growing economy. It provides a venue for buying, selling, exchanging, and speculation of currencies, enabling currency conversion for international trade. It decides foreign exchange rates for every currency and facilitates currency trading at current or determined prices.
The foreign exchange market is by far the largest global market in terms of trading volume. It is composed of a global network of financial centers that conduct transactions 24 hours a day. The market only closes on the weekends. However, as one hub of forex closes, another hub in a different part of the world remains open for trading. The round-the-clock availability of the forex market increases the liquidity available in currency markets.
Currency Values Controlled by Free Float & Fixed Float
There is no absolute value for a currency in the forex market and currencies are always traded in pairs. However, it determines the relative value of every currency by setting the market price of one currency when exchanged with another. The establishment of this relationship is the main function of the forex market. Price relationships between currencies improve liquidity in financial markets and promote overall stability.
A currency’s value is dependent on whether it is a ‘free-float’ or a ‘fixed-float’. The former’s relative value is determined by free-market forces like supply-demand relationships. The relative value of the latter is determined by the country’s governing body.
A country’s monetary authority of the central bank regulates and stabilizes the value of the currency by buying or selling its reserves in return for the currency to which it is fixed. Free-floating currencies include the U.S. dollar, British pound, and Japanese Yen. Fixed-floating currencies include the Indian Rupee and the Chinese Yuan.
For example, US$1 is equal to X AUD, CAD, or CHF, etc. The market works through financial institutions and larger international banks are the primary participants in the forex trading markets. The forex market operates on two levels, namely the interbank market and the over-the-counter (OTC) market.
The interbank market runs behind the scenes and is composed of ‘dealers’ or a smaller number of financial firms that are involved in large quantities of foreign exchange trading. While most foreign exchange dealers are banks, a few insurance companies and other kinds of financial firms are also involved.
Trades between foreign exchange dealers involve hundreds of millions of dollars. Forex also has a little supervisory entity to regulate exchanges as sovereignty issues may arise when involving two currencies. The market enables currency conversion to facilitate international trade and investments. For example, a U.S. business imports goods from the member states of the European Union and pays Euros for that, although its income is in U.S. dollars.
The market also supports direct speculation and evaluation relative to the currencies’ value and carries trade speculation, on the basis of the differential rate of interest between two currencies.
The OTC market allows transactions to be executed without a centralized exchange. Unlike the interbank market, OTC trading is done directly between the parties without the supervision of an intermediary. Click here for an example of an OTC forex trading provider.
The OTC market also does not require exchangeable deliverables to match a narrow range of quality, quantity, and identity defined by the exchange. Instead, the parties may agree on an unusual quantity. As market contracts are bilateral in over-the-counter trading, parties could have credit risk concerns with respect to each other.