Foreign Exchange (forex 

or FX) is the trading of one currency for another. For example, one

can swap the U.S. dollar for the euro. Foreign exchange transactions can take place on the

foreign exchange market, also known as the Forex Market.

The forex market is the largest, most liquid market in the world, with trillions of

dollars changing hands every day. There is no centralized location, rather the forex market is

an electronic network of banks, brokers, institutions, and individual traders (mostly trading

through brokers or banks).

The market determines the value, also known as an exchange rate, of the majority of

currencies. Foreign exchange can be as simple as changing one currency for another at a local

bank. It can also involve trading currency on the foreign exchange market. For example, a

trader is betting a central bank will ease or tighten monetary policy and that one currency will

strengthen versus the other.

When trading currencies, they are listed in pairs, such as USD/CAD, EUR/USD, or

USD/JPY. These represent the U.S. dollar (USD) versus the Canadian dollar (CAD), the Euro

(EUR) versus the USD and the USD versus the Japanese Yen (JPY).

There will also be a price associated with each pair, such as 1.2569. If this price was

associated with the USD/CAD pair it means that it costs 1.2569 CAD to buy one USD. If the

price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has

increased in value (CAD decrease) because it now costs more CAD to buy one USD.

In the forex market currencies trade in lots, called micro, mini, and standard lots. A micro lot

is 1000 worth of a given currency, a mini lot is 10,000, and a standard lot is 100,000. This is

different than when you go to a bank and want $450 exchanged for your trip. When trading in
the electronic forex market, trades take place in set blocks of currency, but you can trade as

many blocks as you like. 

Advantages of Forex Market

The biggest financial market in the world is the biggest market because it provides some advantages
to its participants. Some of the major advantages offered are as follows:

1. Flexibility

Forex exchange markets provide traders with a lot of flexibility. This is because there is no
restriction on the amount of money that can be used for trading. Also, there is almost no
regulation of the markets. This combined with the fact that the market operates on a 24 by 7
basis creates a very flexible scenario for traders. People with regular jobs can also indulge in
Forex trading on the weekends or in the nights. However, they cannot do the same if they are
trading in the stock or bond markets or their own countries! It is for this reason that Forex
trading is the trading of choice for part time traders since it provides a flexible schedule with
least interference in their full time jobs.

Transparency: The Forex market is huge in size and operates across several time zones!
Despite this, information regarding Forex markets is easily available. Also, no country or
Central Bank has the ability to single handedly corner the market or rig prices for an extended
period of time. Short term advantages may occur to some entities because of the time lag in
passing information. However, this advantage cannot be sustained over time. The size of the
Forex market also makes it fair and efficient!

2. Trading Options

Forex markets provide traders with a wide variety of trading options. Traders can trade in
hundreds of currency pairs. They also have the choice of entering into spot trade or they
could enter into a future agreement. Futures agreements are also available in different sizes
and with different maturities to meet the needs of the Forex traders. Therefore, Forex market
provides an option for every budget and every investor with a different appetite for risk taking.

Also, one needs to take into account the fact that Forex markets have a massive trading
volume. More trading occurs in the Forex market than anywhere else in the world. It is for this
reason that Forex provides unmatched liquidity to its traders who can enter and exit the
market in a matter of seconds any time they feel like!

3. Transaction Costs

Forex market provides an environment with low transaction costs as compared to other
markets. When compared on a percentage point basis, the transaction costs of trading in
Forex are extremely low as compared to trading in other markets. This is primarily because
Forex market is largely operated by dealers who provide a two way quote after reserving a
spread for themselves to cover the risks. Pure play brokerage is very low in Forex markets.

4. Leverage

Forex markets provide the most leverage amongst all financial asset markets. The
arrangements in the Forex markets provide investors to lever their original investment by as
many as 20 to 30 times and trade in the market! This magnifies both profits and gains.
Therefore, even though the movements in the Forex market are usually small, traders end up
gaining or losing a significant amount of money thanks to leverage!
Disadvantages of Forex Market
It would be a biased evaluation of the Forex markets if attention was paid only to the advantages
while ignoring the disadvantages. Therefore, in the interest of full disclosure, some of the
disadvantages have been listed below:

1. Counterparty Risks

Forex market is an international market. Therefore, regulation of the Forex market is a difficult
issue because it pertains to the sovereignty of the currencies of many countries. This creates
a scenario wherein the Forex market is largely unregulated. Therefore, there is no centralized
exchange which guarantees the risk free execution of trades. Therefore, when investors or
traders enter into trades, they also have to be cognizant of the default risk that they are facing
i.e. the risk that the counterparty may not have the intention or the ability to honor the
contracts. Forex trading therefore involves careful assessment of counterparty risks as well as
creation of plans to mitigate them.

2. Leverage Risks

Forex markets provide the maximum leverage. The word leverage automatically implies risk
and a gearing ratio of 20 to 30 times implies a lot of risk! Given the fact that there are no limits
to the amount of movement that could happen in the Forex market in a given day, it is
possible that a person may lose all of their investment in a matter of minutes if they placed
highly leveraged bets. Novice investors are more prone to making such mistakes because
they do not understand the amount of risk that leverage brings along!

3. Operational Risks

Forex trading operations are difficult to manage operationally. This is because the Forex
market works all the time whereas humans do not! Therefore, traders have to resort to
algorithms to protect the value of their investments when they are away. Alternatively,
multinational firms have trading desks spread all across the world. However, that can only be
done if trading is conducted on a very large scale.

Therefore, if a person does not have the capital or the know how to manage their positions
when they are away, Forex markets could cause a significant loss of value in the nights or on
weekends.

The Forex market caters to different types of investors with different risk appetites.

1. LOWER TRADING COST

In the forex market, the lower trading cost has made it possible for even small,
individual investors to make the decent profits from trading. With lower costs, the
possible losses are much lower. You will discover that forex trading has no
commission fees unlike in other investments. The forex trading cost is limited to the
spread or the difference between the buying and selling prices for a
particular currency pair.

2. 24 HOUR TRADING OPPORTUNITY 5 DAYS A WEEK

You have plenty of opportunities to execute trades and sufficient time to make
adjustments whenever and where ever such opportunities present themselves.
Trading the foreign currency exchange market opening on Monday, 8 am Australian
time (which is 5 pm Sunday New York time). It continues nonstop until Friday, 4 pm
New York time.

3. HIGHLY LEVERAGED MARKET

You are allowed to trade on margins or technically on borrowed money with forex.
You get more value for your money as the returns can be magnified a hundredfold.
However, always remember that there always two sides of the coin when it comes to
leverage meaning it can also increase your losses.

4. EXCELLENT TRANSPARENCY
Forex trading is a transparent process because the forex trader has full access to
market data and information that are necessary to achieve successful transactions.
The excellent transparency that traders have more control over investments and
decide what to do based on the available information.

5. ACCESS ADVANTAGE IN FOREX

You can access the foreign currency exchange market and your trading
account from anywhere using internet connection without difficulty and trade from
anywhere you may happen to be. With other financial markets, you need to be
physically present to execute a trade.

6. SUPERIOR LIQUIDITY
In a forex market, traders are free to buy and sell currencies of their choosing. The
superior liquidity of the forex market allows traders to easily exchange currencies
without affecting the prices of currencies being traded.

Whether you trade a thousand dollars or millions, you can be assured of same
currency prices during the time an order was placed and executed. The forex
market’s superior liquidity allows you to get the profits you expect at the time you
made the trade.

 Functions of foreign exchange market

1. 1. Functions of Foreign Exchange Market Meaning: Foreign exchange market is the market in
which foreign currencies are bought and sold. The buyers and sellers include individuals, firms,
foreign exchange brokers, commercial banks and the central bank. Like any other market, foreign
exchange market is a system, not a place. The transactions in this market are not confined to only
one or few foreign currencies. In fact, there are a large number of foreign currencies which are
traded, converted and exchanged in the foreign exchange market. Functions of Foreign Exchange
Market: Foreign exchange market performs the following three functions: 1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one currency
into another, i.e., to accomplish transfers of purchasing power between two countries. This
transfer of purchasing power is effected through a variety of credit instruments, such as
telegraphic transfers, bank draft and foreign bills. In performing the transfer function, the foreign
exchange market carries out payments internationally by clearing debts in both directions
simultaneously, analogous to domestic clearings. 2. Credit Function: It provides credit for foreign
trade. Bills of exchange, with maturity period of three months, are generally used for international
payments. Credit is required for this period in order to enable the importer to take possession of
goods, sell them and obtain money to pay off the bill.
2. 2. 3. Hedging Function: A third function of the foreign exchange market is to hedge foreign
exchange risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange
market when exchange rate, i. e., the price of one currency in terms of another currency, change,
there may be a gain or loss to the party concerned. Under this condition, a person or a firm
undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which
are to be met in foreign money. Exchange risk as such should be avoided or reduced. For this the
exchange market provides facilities for hedging anticipated or actual claims or liabilities through
forward contracts in exchange. A forward contract which is normally for three months is a
contract to buy or sell foreign exchange against another currency at some fixed date in the future
at a price agreed upon now. No money passes at the time of the contract. But the contract makes it
possible to ignore any likely changes in exchange rate. The existence of a forward market thus
makes it possible to hedge an exchange position. Foreign bills of exchange, telegraphic transfer,
bank draft, letter of credit, etc., are the important foreign exchange instruments used in the foreign
exchange market to carry out its functions. 4. Minimizing Foreign Exchange Risk: The foreign
exchange market provides "hedging" facilities for transferring foreign exchange risk to someone
else.
3. 3. Conclusion The foreign exchange market is merely a part of the money market in the financial
centers. It is a place where foreign moneys are bought and sold. The buyers and sellers of claim on
foreign money and the intermediaries together constitute a foreign exchange market. It is not
restricted to any given country or a geographical area. Thus, the foreign exchange market is the
market for a national currency (foreign money) anywhere in the world, as the financial centers of
the world are united in a single market. There is a wide variety of dealers in the foreign exchange
market. The most important among them are the banks. Banks dealing in foreign exchange have
branches with substantial balances in different countries. Through their branches and
correspondents, the services of such banks, usually called “Exchange Banks,” are available all
over the world.
 Dete
rminants of Exchange Rates
Numerous factors determine exchange rates. Many of these factors are
related to the trading relationship between the two countries. Remember,
exchange rates are relative, and are expressed as a comparison of the
currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these
factors are in no particular order; like many aspects of economics, the relative
importance of these factors is subject to much debate.

1. Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies.
During the last half of the 20th century, the countries with low inflation
included Japan, Germany, and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation typically
see depreciation in their currency about the currencies of their trading
partners. This is also usually accompanied by higher interest rates.
 2. Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation
and exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign
capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates – that is, lower interest rates
tend to decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services,
interest, and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's exchange rate
until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the
domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. The reason? A large debt encourages inflation,
and if inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a
large debt, but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through domestic
means (selling domestic bonds, increasing the money supply), then it must
increase the supply of securities for sale to foreigners, thereby lowering their
prices. Finally, a large debt may prove worrisome to foreigners if they believe
the country risks defaulting on its obligations. Foreigners will be less willing to
own securities denominated in that currency if the risk of default is great. For
this reason, the country's debt rating (as determined by Moody's or Standard
& Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related
to current accounts and the balance of payments. If the price of a country's
exports rises by a greater rate than that of its imports, its terms of trade have
favorably improved. Increasing terms of trade shows' greater demand for the
country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the
currency's value). If the price of exports rises by a smaller rate than that of its
imports, the currency's value will decrease in relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can
cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries

TYPES OF FOREIGN EXCHANGE MARKET.

Spot Market
These are the quickest transactions involving currency in foreign markets. These
transactions involve immediate payment at the current exchange rate, which is also
called the spot rate. The Federal Reserve says the spot market accounts for one-
third of all currency exchange, and trades usually take place within two days of the
agreement. This does leave the traders open to the volatility of the currency market,
which can raise or lower the price between the agreement and the trade.
Futures Market
As the name implies, these transactions involve future payment and future delivery
at an agreed exchange rate, also called the future rate. These contracts are
standardized, which means the elements of the agreement are set and non-
negotiable. It also takes the volatility of the currency market, specifically the spot
market, out of the equation. These are popular among traders who make large
currency transactions and are seeking a steady return on their investments.
Forward Market
These transactions are identical to the Futures Market except for one important
difference—the terms are negotiable between the two parties. This way, the terms
can be negotiated and tailored to the needs of the participants. It allows for more
flexibility. In many instances, this type of market involves a currency swap, where
two entities swap currency for an agreed-upon amount of time, and then return the
currency at the end of the contract.
PARTICIPANTS IN FOREIGN EXCHANGE MARKET
Forex Dealers

Forex dealers are amongst the biggest participants in the Forex market. They are also known as
broker dealers. Most Forex dealers in the world are banks. It is for this reason that the market in which
dealers interact with one another is also known as the interbank market. However, there are some
notable non-bank financial institutions also that deal in foreign exchange.

These dealers participate in the Forex markets by providing bid-ask quotes for currency pairs at all
times. All brokers do not participate in all currency pairs. Rather, they may specialize in a specific
currency pair. Alternatively, a lot of dealers also use their own capital to conduct proprietary trading
operations. When both these operations are combined, Forex dealers have a significant participation
in the Forex market.

Brokers

The Forex market is largely devoid of brokers. This is because a person need not deal with brokers
necessarily. If they have sufficient knowledge, they can directly call the dealer and obtain a favorable
rate. However, there are brokers in the Forex market. These brokers exist because they add value to
their clients by helping them obtain the best quote. For instance, they may help their clients obtain the
lowest buying price or the highest selling price by making available quotes from several dealers.
Another major reason for using brokers is creating anonymity while trading. Many big investors and
even Forex dealers use the services of brokers who act as henchmen for the trading operations of
these big players.

Hedgers

There are many businesses which end up creating an asset or a liability priced in foreign currency in
the regular course of their business. For instance, importers and exporters engaged in foreign trade
may have open positions in several foreign currencies. They may therefore be impacted if there is a
fluctuation in the value of foreign currency. As a result, to protect themselves against these losses,
hedgers take opposite positions in the market. Therefore if there is an unfavorable movement in their
original position, it is offset by an opposite movement in their hedged positions. Their profits and
losses and therefore nullified and they get stability in the operations of their business.

Speculators

Speculators are a class of traders that have no genuine requirement for foreign currency. They only
buy and sell these currencies with the hope of making a profit from it. The number of speculators
increases a lot when the market sentiment is high and everyone seems to be making money in the
Forex markets. Speculators usually do not maintain open positions in any currency for a very long
time. Their positions are transient and are only meant to make a short term profit.

Arbitrageurs

Arbitrageurs are traders that take advantage of the price discrepancy in different markets to make a
profit. Arbitrageurs serve an important function in the foreign exchange market. It is their operations
that ensure that a market as large, as decentralized and as diffused as the Forex market functions
efficiently and provides uniform price quotations all over the world. Whenever arbitrageurs find a price
discrepancy in the market, they start buying in one place and selling in another till the discrepancy
disappears.

Central Banks

Central Banks of all countries participate in the Forex market to some extent. Most of the times, this
participation is official. Although many times Central Banks do participate in the market by covert
means. This is because every Central Bank has a target range within which they would like to see
their currency fluctuate. If the currency falls out of the given range, Central Banks conduct open
market operations to bring it back in range. Also, whenever the currency of a given nation is under
speculative attack, Central Banks participate extensively in the market to defend their currency.

Retail Market Participants

Retail market participants include tourists, students and even patients who are travelling abroad. Then
there are also a variety of small businesses that indulge in foreign trade. Most of the retail participants
participate in the spot market whereas people with long term interests operate in the futures market.
This is because these participants only buy/sell currency when they have a personal/professional
requirement and dealing with foreign currencies is not a part of their regular business.
The participants have been listed in descending order. This means that dealers are the most
active traders in the Forex markets, followed by brokers and so on.