DAY 2

How Does the Forex Market Work?

The FX market is the only truly continuous and nonstop trading market in the world. In
the past,the forex market was dominated by institutional firms and large banks, which
acted on behalf of clients. But it has become more retail-oriented in recent years—
traders and investors of all sizes participate in it.

Where Is It?

An interesting aspect of world forex markets is that no physical buildings function as

trading venues. Instead, it is a series of connected trading terminals and computer
networks. Market participants are institutions, investment banks, commercial banks,
and retail investors from around the world.

What Is It About?

Currency trading was very difficult for individual investors until it made its way onto the
internet. Most currency traders were large multinational corporations, hedge funds,
or high-net-worth individuals (HNWIs)  because forex trading required a lot of capital.

Commercial and investment banks still conduct most of the trading in forex markets on

behalf of their clients. But there are also opportunities for professional and individual
investors to trade one currency against another.

Types of Markets

Forex is traded primarily via spot, forwards, and futures markets.The spot market is the
largest of all three markets because it is the “underlying” asset on which forwards and
futures markets are based.When people talk about the forex market,they are usually
referring to the spot market.

The forwards and futures markets tend to be more popular with companies or financial
firms that need to hedge their foreign exchange risks out to a specific future date.

Spot Market

The spot market is where currencies are bought and sold based on their trading price.
That price is determined by supply and demand and is calculated based on several
factors, such as:

 Current interest rates

 Economic performance
  Geopolitical sentiment
 Price speculation

A finalized deal on the spot market is known as a spot deal. It is a bilateral transaction
in which one party delivers an agreed-upon currency amount to the counterparty and
receives a specified amount of another currency at the agreed-upon exchange rate
value. After a position is closed, it is settled in cash.

Although the spot market is commonly known as one that deals with transactions in the
present (rather than in the future), these trades take two days to settle.

Forwards and Futures Markets

A forward contract is a private agreement between two parties to buy a currency at a

future date and a predetermined price in the OTC markets. In the forwards market,
contracts are bought and sold OTC between two parties, who determine the terms of
the agreement between themselves.

A futures contract is a standardized agreement between two parties to take delivery of

a currency at a future date and a predetermined price. Futures trade on exchanges and
not OTC. In the futures market, futures contracts are bought and sold based on a
standard size and settlement date on public commodities markets, such as the Chicago
Mercantile Exchange (CME).

Futures contracts have specific details, including the number of units being traded,
delivery and settlement dates, and minimum price increments that cannot be
customized. The exchange acts as a counterparty to the trader, providing clearance
and settlement services.

Unlike the spot, forwards, and futures markets, the options market does not trade
actual currencies. Instead, it deals in contracts that represent claims to a certain
currency type, a specific price per unit, and a future date for settlement.
Both types of contracts are binding and are typically settled for cash at the exchange in
question upon expiry, although contracts can also be bought and sold before they
expire.These markets can offer protection against risk when trading currencies.

In addition to forwards and futures,options contracts are traded on specific currency

pairs.Forex options give holders the right,but not the obligation,to enter into a forex
trade at a future date.

Using the Forex Markets

There are two distinct features of currencies as an asset class:

 You can earn the interest rate differential between two currencies.

 You can profit from changes in the exchange rate.
So, you can profit from the difference between two interest rates in two different
economies by buying the currency with the higher interest rate and shorting the
currency with the lower interest rate. For instance, before the 2008 financial crisis,
shorting the Japanese yen (JPY) and buying British pounds (GBP) was common
because the interest rate differential was substantial. This strategy is sometimes
referred to as a carry trade.

Forex for Hedging

Companies doing business in foreign countries are at risk due to fluctuations in

currency values when they buy or sell goods and services outside of their domestic
market. Foreign exchange markets provide a way to hedge currency risk by fixing a
rate at which the transaction will be completed. A trader can buy or sell currencies in
the forward or swap markets in advance, which locks in an exchange rate.

Locking in the exchange rate helps them reduce losses or increase gains, depending
on which currency in a pair is strengthened or weakened.

Forex Speculation

Factors like interest rates, trade flows, tourism, economic strength,and geopolitical

risk affect the supply and demand for currencies, creating daily volatility in the forex
markets. This creates opportunities to profit from changes that may increase or reduce
one currency’s value compared to another. A forecast that one currency will weaken is
essentially the same as assuming that the other currency in the pair will strengthen.

So, a trader anticipating price movement could short or long one of the currencies in a
pair and take advantage of the movement.