Foreign exchange market (an Introduction)                           

The foreign exchange market or currency market or Forex is the market where one currency is traded for another. It is one of the largest markets in the world.

Market participants

Some of the participants in this market are simply commercial users with cross-border transactions in international trade seeking to exchange a foreign currency for their own, like multinational corporations that must pay wages and other expenses in different nations than they sell products in. Investors with securities investment portfolio involving multi-currency securities assets are also exposed to currency exchange rate fluctuations and thus seek to enter into foreign exchange transactions to manage and protect their portfolio assets against risks arising from exchange rate fluctuations. However, a large part of the market is made up of currency traders, who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency traders try to take advantage of even small fluctuations in exchange rates. Sometimes they are able to profit from arbitrage.

According to the Bank for International Settlements' last triennial study (April 2004) (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results), transactions that were:

??nbsp;strictly inter-dealer (i.e. inter-bank) accounted for 53%;
??nbsp;involved a dealer (i.e. a bank) and a fund manager or some other non-bank financial institution accounted for 33%; and
??nbsp;between a dealer and a non-financial company accounted for 14%.

Market liquidity

Foreign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) quotations.

In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.

On the spot market, according to the BIS study, the most heavily traded products were:

EUR/USD - 28 %
USD/JPY - 17 %
GBP/USD (also called cable) - 14 %

and the US dollar was involved 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus still overwhelmingly dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The only exception to this is EUR/JPY, which is an established traded currency pair in the inter-bank spot market.

Around-the-clock market

Market Size

Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the above-mentioned BIS study:

??nbsp;$600 billion spot
??nbsp;$1,300 billion in derivatives
??nbsp;$200 billion in outright forwards
??nbsp;$1,000 billion in forex swaps
??nbsp;$100 billion in options.

For various reasons, exchange-traded derivatives never caught on the Forex market as they did on all other financial markets (although attempts to launch currency futures in the early 1970s actually predate interest rate or stock index futures).

Other useful links to officially published information about the foreign exchange markets:

Full report of the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 (pdf).




Bid/Offer spread

Like any market there is a bid/offer spread (difference between buying price and selling price). On major currency crosses, the difference between the price at which a market maker will sell ("ask", or "offer") to a customer and the price at which the same market-maker will buy ("bid") from the same customer is called the quoted market bid/offer spread. In the EUR/USD price of 1.4238 a pip would be the smallest decimal change from '8' at the 4th decimal place. So the bid/ask quote of EUR/USD might be 1.4238/1.4239 for a bid/ask spread of 10 pips.

This, of course, does not apply to retail customers. To individuals, banks routinely mark up the difference to say 1.4140 / 1.4340 for transfers, or say 1.3740 / 1.4740 for banknotes or travelers' cheques.

Currency speculation

In our floating point system every cash flow in the world is calculated in some domestic currency. Any currency mismatch in cash flows, whatever they be, will thus generate foreign-exchange risk.

The most widespread speculation is of the passive kind. Most people and firms simply do not hedge foreign exchange risk on future cash flows, which amounts to ... reckless gambling, although it is generally not perceived as such.

Semi-passive speculation is the next most frequent kind. Investors will routinely speculate on currency fluctuations and realize profits by parking funds in one currency, and after it appreciates in value, switching to another. However, a Japanese investor who makes a profit of 20% in U.S. dollar term on an investment in a securities investment on United States stocks, has to realize that if the U.S. dollar has gone down by 40% versus the Japanese Yen, then he has actually lost money in terms of his domestic currency, the Japanese Yen.

Active speculation is in fact of a less significant amount when compared to the above, since it involves setting up both a foreign currency account and a credit line.

Individual currency speculators

Most individual currency speculators will trade using a broker which will typically have a spread marked up to say 10-20 pips from the inter-dealer bid/offer spread (so in our example from 1.4237/1.4239 to 1.423/1.425). The broker will often give their clients huge amounts of margin, thereby facilitating clients spending more money on the bid/ask spread. In some jurisdictions (including the United States of America), foreign exchange brokers are not regulated by the regulatory authorities (and in the case of the US, not regulated by the Securities and Exchange Commission nor the CFTC, since they do not sell neither securities nor futures contracts), so they are not bound by the same margin limits as stock brokerages. They do not typically charge margin interest, however since currency trades must be settled in 2 days, they will "resettle" open positions (again collecting the bid/ask spread).

Individual currency speculators can work during the day and trade in the evenings, taking advantage of the market's 24-hour long trading day.

Trading in foreign exchange contracts with Tokiwa

Tokiwa is a registered financial futures firm that focuses on over-the-counter foreign exchange transactions. Tokiwa acts as an inter-dealer who is actively making market quotes on currency pairs in bid/offer spreads to the customers for direct and actual dealing as the final counter-party to the customer on all foreign exchange transactions.

Tokiwa makes market bid/offer quotes for dealing on the following major currency pairs: