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Foreign exchange market is also called the currency market as the transactions in this market typically involve one party purchasing a quantity of one currency and in exchange paying a quantity of another. The Forex market is the largest financial market in the world that gives rise to liquidity as well. The transactions can take place between large banks, currency traders, corporations, and other institutions as well as various governments. The average daily volume in the global Forex markets is steadily growing fast.

There are a few explanations and definitions that we need to understand for having a better grasp on the working of Forex market. These are briefly mentioned hereunder.

Size of the market and its liquidity content

The Forex market is always bubbling with activities because of the following unique features:

1. It has long trading hours: 24 hours a day except on weekends (from 5pm EST on Sunday until 4pm EST Friday),
2. Profits can be high due to very large trading volumes. However, margins of profit compared with other markets of fixed income are low
3. There are different kinds of traders in the market, having geographical dispersion.
   Forex market is liquid and use of “leverage” is frequently done here.

Because of the above and few other factors, Forex market has been referred as the ideal “open economy” market that’s closest to the competition involved.

Exchange-traded “Forex futures” contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded. As such Forex futures’ volume has grown rapidly in recent years. Because foreign exchange is an over the counter market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading center is the UK, mainly London.

Some large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell (”ask”, or “offer”) and the price at which a market maker will buy (”bid”) from a wholesale customer. This spread is minimal for actively traded pairs of currencies.

Participation in Forex market

There are different levels of access in the Forex market. It’d not like a stock market, where all participants have access to the same prices. At the top level, there is inter-bank market, which constitutes major investment banking firms. Within the inter-bank market, spreads are razor sharp and usually unavailable, and not known to players outside the inner circle.

As you descend the levels of access, the difference between the bid and ask prices widens. This is due to the existing volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are finalized by the size of the “line” (this is the amount of money with which they are trading). The top-tier inter-bank market accounts for majority of transactions.. After that there are usually smaller investment banks, followed by large multi-national corporations which hedge their risks, large hedge funds, and even some of the retail forex-market makers. Some funds like pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in forex markets in particular, during the current decade.

Trading characteristics

Because the currency market or Forex trade is done “over the counter”, there is no unified or centrally cleared market for the majority of Forex trades, and there is very little cross-border regulation. However, there are a number of interconnected marketplaces, where different currencies or other financial instruments are traded. This means that there is not a single exchange rate but rather a number of different rates, depending on what the market maker is trading, and where it is… Due to London’s dominance in the market, the price quoted for a particular currency is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, opened in 2007 and is called “FxMarketSpace”.

While the main trading center is London but other centers like Tokyo, New York, Singapore and Hong Kong are also important. The Banks throughout the world also participate in the Forex market activities. Currency trading happens continuously (except on weekends) throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, and so on so forth.

Exchange rate fluctuations are usually caused by actual monetary flows as well as the expectation of variation caused by changes in GDP growth, trade and budget deficits or surpluses, large cross-border merger or acquiring deals, inflation, interest rates and other macroeconomic conditions. Major news is released publicly, often on scheduled dates. As such many people have access to the same news at the same time.

Factors affecting currency trading

Currency prices are a result of supply and demand forces. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several of them. We can attribute the elements affecting the currency trading into three broad categories

1. Economic factors

   These factors include economic policy, disseminated by government agencies and central banks, other economic indicators and conditions, generally revealed through economic reports.

2. Political conditions

   Currency markets get widely affected by the internal or regional and international political events. For example, political upheaval and instability can have a negative impact on a nation’s economy. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency, also.

3. Market psychology

   This is perhaps the biggest factor, which affects the Forex market trading. As in all liquid exchanges and markets, the trader perception counts a lot.

   The above is just a brief on the Forex market working. However, as the saying goes, “The taste of pudding is known by eating it”; the best way to explore this is to participate on a retail level, through a small bank or corporation. A hand on experience reveals everything.

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   This entry was posted on Thursday, October 23rd, 2008 at 11:37 am and is filed under Forex. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.