forex

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex and related markets currently is over US$ 3 trillion.Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks, and are subject to forex scams

Market participants

nlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, 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 (from 0-1 pip to 1-2 pips only for major currencies like the Euro). This is due to 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 determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade surplus and consists of exporting more than is imported; a negative balance of trade is known as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance; especially in the United Kingdom the terms visible and invisible balance are used.

Definition

The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stocks, nor does it factor the concept of importing goods to produce for the domestic market).

Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely to be good.

Factors that can affect the balance of trade figures include:

• Prices of goods manufactured at home (influenced by the responsiveness of supply)
• Exchange rates
• Trade agreements or barriers
• Other tax, tariff and trade measures
• Business cycle at home or abroad.

The balance of trade is likely to differ across the business cycle. In export led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

foreign currency mortgage is a mortgage which is repayable in a currency other than the currency of the country in which the borrower is a resident. Foreign currency mortgages can be used to finance both personal mortgages and corporate mortgages.

The interest rate charged on a Foreign currency mortgage is based on the interest rates applicable to the currency in which the mortgage is denominated and not the interest rates applicable to the borrowers own domestic currency. Therefore, a Foreign currency mortgage should only be considered when the interest rate on the foreign currency is significantly lower than the borrower can obtain on a mortgage taken out in his or her domestic currency.

Borrowers should bear in mind that ultimately they have a liability to repay the mortgage in another currency and currency exchange rates constantly change. This means that if the borrowers domestic currency was to strengthen against the currency in which the mortgage is denominated, then it would cost the borrower less in domestic currency to fully repay the mortgage. Therefore, in effect, the borrower makes a capital saving.

Conversely, if the exchange rate of borrower’s domestic currency were to weaken against the currency in which the mortgage is denominated, then it would cost the borrower more in their domestic currency to repay the mortgage. Therefore, the borrower makes a capital loss.

When the value of the mortgage is large, it may be possible to reduce or limit the risk in the exchange exposure by hedging

Managed currency mortgages can help to reduce risk exposure. A borrower can allow a specialist currency manager to manage their loan on their behalf (through a limited power of attorney), where the currency manager will switch the borrower's debt in and out of foreign currencies as they change in value against the base currency. A successful currency manager will move the borrower's debt into a currency which subsequently falls in value against the base currency. The manager can then switch the loan back into the base currency (or another weakening currency) at a better exchange rate, thereby reducing the value of the loan. A further benefit of this product is that the currency manager will try to select currencies with a lower interest rate than the base currency, and the borrower therefore can make substantial interest savings.

There are risks associated with these types of mortgages and the borrower must be prepared to accept an (often limited) increase in the value of their debt if there are adverse movements in the currency markets.

A successful currency manager may be able to use the currency markets to pay off a borrower's loan (through a combination of debt reduction and interest rate savings) within the normal lifetime of the loan, while the borrower pays on an interest only basis.

A currency pair depicts a quotation of two different currencies. The first currency in the pair is the base currency. The second currency in the pair is labelled quote currency or counter currency. Such a quotation depicts how many units of the counter currency are needed to buy one unit of the base currency.

For example the quotation EUR/USD 1.2500 means that one euro is exchanged for 1.25 US dollar. If the quote moves from EUR/USD 1.2500 to EUR/USD 1.2510, the euro is getting stronger and the dollar weaker. On the other hand if the EUR/USD quote moves from 1.2500 to 1.2490 the euro is getting weaker while the dollar is getting stronger.

Majors

Majors are the most liquid and widely traded currency pairs in the world. Trades involving majors make up about 90% of total Forex trading.

The Majors are:

EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD and USD/CAD.

GBP/USD is the only currency pair with its own name. It is known as "Cable", which has its origins from the days when a cable under the Atlantic synchronized the GBP/USD rate between the London and New York markets. But there are also lots of abbreviations for other currency pairs such as:
AUD/USD ... "Aussie"
EUR/USD ... "Euro"
GBP/JPY ... "Geppy"
GBP/USD ... "Cable"
NZD/USD ... "Kiwi"
USD/CAD ... "Loonie"
USD/CHF ... "Swissy"
USD/JPY ... "Gopher"
USD/CAD ... "Beaver"

Cross Rates

Cross rate is a currency pair that does not include USD, such as GBP/JPY. Pairs that involve the EUR are called euro crosses, such as EUR/GBP. All other currency pairs (those that don't involve USD or EUR) are generally referred to as cross rates.

Pips

A pip is the smallest number in a quotation of a currency. For example if the quotation of EUR/USD is 1.2025, a pip is represented by EUR 0.0001. EUR/GBP has half pips, in that it is quoted to a fifth decimal place which can only be 0 or 5. This is because one pip in EUR/GBP is equal to four pips in its predecessor, GBP/DEM, and one pip in EUR/GBP would be too large an increment.

In order to calculate the pip value or how much is one pip, you have to know some additional information such as: trading size, leverage used, and of course the actual rate of the pair for which you want to calculate the pip value. For example in case of US Dollar

Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

Changes in reserves

The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized^[clarify]) to maintain the targeted exchange rate within the prescribed limits.

Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.

To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).

Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.

In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.

Costs and benefits

Large reserves enhance a government's ability to amanipulate exchange rates -- but they carry an opportunity cost. The "quasi-fiscal costs" of holding reserves are the gap between the low-yield assets that asset managers typically hold, and the average cost of government debt in the country. In addition, governments can suffer losses from management of reserves - all of which is ultimately fiscal. Even in absence of a currency crisis, there can be a fiscal cost. China, for example, holds huge U.S. dollar-denominated assets, but the greenback has been weakening

A forex swap (or FX swap) is an over-the-counter short term interest rate derivative instrument. In emerging money markets, forex swaps are usually the first derivative instrument to be traded, ahead of forward rate agreements.

Structure

A forex swap consists of two legs:

• a spot foreign exchange transaction, and
• a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other.

Uses

Forex swaps are used for hedging currency positions and for speculation.

Hedging

Investors use forex swaps to hedge their existing forex exposures by swapping temporary surplus funds in one currency into another currency for better use of liquidity. Doing so protects against adverse movements in the forex rate, but favourable moves are renounced.

Speculation

Investors use forex swaps to speculate on changes in the interest rate differentials between two currencies.

The relationship between spot and forward is as follows:

where:

• F = forward
• S = spot
• r_T = interest rate of the term currency
• r_B = interest rate of the base currency
• T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

where r_T and r_B are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.

Related instruments

A forex swap should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.

retail forex (retail currency trading or retail FX) market is a subset of the larger foreign exchange market. This "market has long been plagued by swindlers preying on the gullible," according to The New York Times. It's commonly thought that about 90% of all retail FX traders lose money.

Currency Pairs

Currency prices can only fluctuate relative to another currency, so they are traded in pairs. Take two of the most common currency pairs, the EUR/USD (the price for euros in US dollars) and the GBP/USD (the price for the British pound in US dollars).

High Leverage

The idea of margin (leverage) and floating loss is another important trading concept and is perhaps best understood using an example. Most retail Forex market makers permit 100:1 leverage, but also, crucially, require you to have a certain amount of money in your account to protect against a critical loss point. For example, if a $100,000 position is held in Eur/USD on 100:1 leverage, the trader has to put up $1,000 to control the position. However, in the event of a declining value of your positions, Forex market makers, mindful of the fast nature of forex price swings and the amplifying effect of leverage, typically do not allow their traders to go negative and make up the difference at a later date. In order to make sure the trader does not lose more money than is held in the account, forex market makers typically employ automatic systems to close out positions when clients run out of margin (the amount of money in their account not tied to a position). If the trader has $2,000 in his account, and he is buying a $100,000 lot of EUR/USD, he has $1,000 of his $2,000 tied up in margin, with $1,000 left to allow his position to fluctuate downward without being closed out.

Typically a trader's trading platform will show him three important numbers associated with his account: his balance, his equity, and his margin remaining. If trader X has two positions: $100,000 long (buy) in EUR/USD, and $100,000 short (sell) in GBP/USD, and he has $10,000 in his account, his positions would look as follows: Because of the 100:1 leverage, it took him $1,000 to control each position. This means that he has used up $2,000 in his margin, out of a $10,000 account, and thus he has $8,000 of margin still available. With this margin, he can either take more positions or keep the margin relatively high to allow his current positions to be maintained in the event of downturns. If the client chooses to open a new position of $100,000, this will again take another $1,000 of his margin, leaving $7,000. He will have used up $3,000 in margin among the three positions. The other way margin will decrease is if the positions he currently has open lose money. If his 3 positions of $100,000 decrease by $5,000 in value (which is fairly common), he now has, of his original $7,000 in margin, only $2,000 left.

If you have a $10,000 account and only open one $100,000 position, this has committed only $1,000 of your money plus you must maintain $1,000 in margin. While this leaves $9,000 free in your account, it is possible to lose almost all of it if the speculation loses money.

A forex scam is any trading scheme used to defraud individual traders by convincing them that they can expect to gain an unreasonably high profit by trading in the foreign exchange market. "The average individual foreign-exchange-trading victim loses about $15,000, according to CFTC records" according to The Wall Street Journal. This market would be a zero-sum game were it not for the fact that there are brokerage commissions, which technically make forex a "negative-sum" game. "The market has long been plagued by swindlers preying on the gullible," according to the New York Times .

These scams might include churning of customer accounts for the purpose of generating commissions, selling software that is supposed to guide the customer to large profits, improperly managed "managed accounts", false advertising, Ponzi schemes and outright fraud. It also refers to any retail forex broker who indicates that trading foreign exchange is a low risk, high profit investment.

The U.S. Commodity Futures Trading Commission (CFTC), which loosely regulates the foreign exchange market in the United States, has noted an increase in the amount of unscrupulous activity in the non-bank foreign exchange industry.

An official of the National Futures Association was quoted as saying, "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically..." Between 2001 and 2006 the U.S. Commodity Futures Trading Commission has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $350 million, mostly in managed accounts. CNN also quoted Godfried De Vidts, President of the Financial Markets Association, a European body, as saying, "Banks have a duty to protect their customers and they should make sure customers understand what they are doing. Now if people go online, on non-bank portals, how is this control being done?"

The highly technical nature of retail forex industry, the OTC nature of the market, and the loose regulation of the market, leaves retail speculators vulnerable. Defrauded traders and regulatory authorities can find it very difficult to prove that market manipulation has occurred since there is no central currency market, but rather a number of more or less interconnected marketplaces provided by interbank market makers.

Why retail speculators shouldn't be able to beat the market

The foreign exchange market is a zero sum game in which there are many experienced well-capitalized professional traders (e.g. working for banks) who can devote their attentions full time to trading. An inexperienced retail trader will have a significant information disadvantage compared to these traders.

Retail traders are - almost by definition - undercapitalized. Thus they are subject to the problem of Gambler's Ruin. In a fair game (one with no information advantages) between two players that continues until one trader goes bankrupt, the player with the lower amount of capital has a higher probability of going bankrupt first. Since the retail speculator is effectively playing against the market as a whole - which has nearly infinite capital - he will almost certainly go bankrupt.

The retail trader always pays the bid/ask spread which makes his odds of winning less than those of a fair game. Additional costs may include margin interest, or if a spot position is kept open for more than one day the trade must be "resettled" each day, each time costing the full bid/ask spread.

According to the Wall Street Journal (Currency Markets Draw Speculation, Fraud July 26, 2005) "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.'