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Home > Financial Risk Management Checklists > The Foreign Exchange Market: Its Structure and Function

Financial Risk Management Checklists

The Foreign Exchange Market: Its Structure and Function


Checklist Description

This checklist describes how the foreign exchange market works and the types of transactions conducted on it.

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Definition

The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for another. Prior to 1996 the market was confined to large corporate banks and international corporations. However it has since opened up to include all traders and speculators. The average daily turnover in forex markets is US$4.0 trillion, according to the Bank of International Settlements’s Triennial Survey from 2010. The market is growing rapidly as investors gain more information and develop more interest.

In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they bet correctly and collect the profit in the form of an interest rate spread when they return to the original currency. The profit margins are low compared with other fixed-income markets. Large trading volumes can, however, result in very high profits. Over half of all forex trading takes place in London and New York, with London dominating the market at 37% of all transactions. New York’s market share is 18%, with Tokyo ranked third at 6%. Singapore, Switzerland, and Hong Kong are the next-largest forex markets globally with approximately 5% market share each.

One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using cash as opposed to a contract.

In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in advance. The time period ranges from days to years. Currency swaps are a popular type of forward transaction; these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later date. Another type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up and a maturity date arranged. The time schedule is about three months.

In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction depends on the availability of option contracts on an organized exchange. Otherwise, such forex deals may be carried out using an over-the-counter (OTC) contract.

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Advantages

  • The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when bought or sold without causing too much movement in the price and keeping losses to a minimum.

  • As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart from weekends.

  • An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in this regard.

  • It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no restrictions on trade.

  • In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is an attractive advantage.

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Disadvantages

  • The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at least, such a failure could bring ruin to the forex market as a whole.

  • Investors need a lot of capital to make good profits because the profit margins on small-scale trades are very low.

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Action Checklist

  • Be alert for unanticipated corrections and wild fluctuations in currency exchange rates.

  • Look for volatile markets that offer opportunities for quick profit.

  • Watch out for lost payments, and be aware of delays in payments and money received. There may also be discrepancies between bank drafts received and the original price of the contract.

  • It is wise to exit from the forex market at the point when your profit targets have been achieved as this ensures that you stay within the profit zone.

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Dos and Don’ts

Do

  • Make sure when you pick a pair of currencies that you understand their relationship.

  • Use a trading system that you can trust with your money.

Don’t

  • Don’t be greedy: take your profits at the right time.

  • Don’t be emotional when you trade.

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Further reading

Books:

  • Archer, Michael Duane. Getting Started in Currency Trading: Winning in Today’s Market. 4th ed. Hoboken, NJ: Wiley, 2012.
  • Chen, James. Essentials of Foreign Exchange Trading. Hoboken, NJ: Wiley, 2009.

Report:

  • Bank for International Settlements. “Triennial central bank survey: Report on global foreign exchange market activity in 2010.” December 2010. Online at: www.bis.org/publ/rpfxf10t.htm

Website:

  • Forex on Top, provides a ranked list of the most visited forex websites including trading platforms: www.forexontop.com

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