The Forex Market Explained

What is the forex market? 

Simply put, the forex market is a global financial market where the currencies of countries are traded. Put differently, it is a global market where forex trading – the selling and buying of national currencies – takes place. 

The term forex is derived from the blending of the parts ‘for’ and ‘ex’ in the words ‘forex’ and ‘exchange’ respectively. 

Other names used to refer to the forex market are the currency market, FX market, foreign exchange currency market, or foreign currency market. It is also commonly referred to as forex or FX. 

Features of the forex market 

• It is the largest and most liquid financial market in the world. It is estimated that daily trades on the forex market amount to approximately 6.6 trillion US dollars. 
• It is a decentralised global market, implying it has no physical location. 
• The forex market is a global online network (computer networks) where traders, investors, banks, and governments purchase and sell currencies. 
• The forex market does not close overnight, operating 24 hours a day from Monday morning in Asia to Friday afternoon in New York. In terms of Eastern Standard Time (EST) in the USA, the forex market operates from 17:00 on Sunday to 16:00 on Friday. 
• Exchange rates of national currencies are determined by the forex market. 

Types of forex market 

There are primarily three different types of forex market: the spot forex market, the forward forex market, and the future forex market.  

• The spot forex market is the largest of all three types of markets, used as the underlying asset on which the forward and future forex markets are based. Typically, when traders refer to the forex market, they usually refer to the spot forex market. 

The spot market is where currencies of countries are purchased and sold, based on their trading price, which is determined by supply and demand, based on various factors such as a country’s current interest rates, economic wealth, and political situations. 

The term ‘spot’ indicates that the exchange of a currency pair takes place at the ‘exact point the trade is settled’, that is ‘on the spot,’ or within a short period of two days. A finalised deal is called a spot deal. 

• In the forward forex market, two parties agree to trade a currency in over-the-counter market (OTC) at a specified price and quantity at a date in the future, or within a range of future dates. The terms of the agreement are set between the two parties themselves. The parties involved can be individuals, companies, and governments, to name a few. 

No currency is exchanged when the trade is set up. 

The forward market is helpful for hedging. However, it can be somewhat illiquid because only two parties are involved in the transaction. There is also a counterparty risk, implying that the other party will fail to honour the agreement.  

• The future forex market refers to a standardised contract in which two parties agree to buy or sell a given currency at a predetermined price at a date in the future. Contrary to a forward contract, a futures contract is legally binding. 

Future contracts trade on exchanges and not in the over-the-counter (OTC) market. 

Typically, forward and future contracts are settled for cash upon expiry. Although, these contracts can also be bought and sold before the expiry date. 

Furthermore, there is also an option forex market where certain currency pairs can be traded. Forex options allow option holders the right – but not the obligation – to enter into a currency trade at a specified future date and for a predetermined exchange rate, before the option expires.   

Tiers of the Forex market  

The forex market comprises two tiers (levels): the interbank market and the over-the-counter (OTC) market. 

• Interbank market 

The interbank market refers to a network of large banks that trade currencies of countries with each other. For this purpose, each bank has a forex (currency) trading desk, referred to as a dealing desk, which is continuously in contact with other banks. 

Reasons why the banks trade currencies are, amongst other reasons: balance sheet adjustments, hedging, and for the bank’s own account. When banks trade to generate profits for themselves, it is referred to as proprietary trading. They also trade on behalf of clients such as governments, hedge funds, large companies and corporations, and wealthy individuals.  

Some large banks will trade billions of currencies on a daily basis, with the result that exchange rates are determined by the interbank market.  

• Over-the-counter (OTC) market 

The OTC market refers to a network of trading relationships which are centred around forex dealers who act as market makers by quoting prices at which they are willing to sell or buy currencies to other dealers and to their clients. Furthermore, forex trading takes place via online platforms and forex brokers (dealer networks) – usually between two parties.  

Put differently, over-the-counter trading (OTC trading) refers to trading that is not executed on a formal exchange. OTC trading is less regulated than trades on exchanges, allowing for more opportunities for traders, but also poses some risks. 

Participants in the forex market 

Participants in the forex market include, inter alia: 

• Commercial banks 
• Governments 
• Central banks of countries and regions 
• Hedge funds 
• Brokers 
• Commercial companies 
• Hedge funds 
• Sovereign wealth funds, also known as state-owned investment funds 
• Retail traders, who buy and sell currencies for their own accounts 
• Individuals visiting foreign countries for business or vacation 

Advantages of the forex market 

The following advantages are some of the advantages of the forex market: 

• It is a decentralised market, meaning it is not bound to any single location or affiliated with a specific authority. 
• Numerous trading options with hundreds of currency pairs and different agreements such as spot, forward, and future. 
• Allows access 24 hours a day, 7 days a week. Investors and traders can trade without any time bound, allowing them to execute trades at night or during weekends. 
• High amount of liquidity and flexibility.  
• Lack of restrictive rules. 
• Suitable for different trading styles, ranging from investors to speculators. 
• Low transactions costs compared to other financial markets. 
• Allowing trades with low capital due to limited spreads, referred to as pips in the forex market. 
• Traders can easily enter or exit the forex market. 
• High leverage for traders can magnify profits. (Although, it can also magnify losses.)  

Disadvantages of the forex market 

Disadvantages of the forex market include, amongst other cons: 

• High leverage poses also a high risk which can quickly turn a trader’s forex trading into a financial disaster if a trader lacks a good understanding of leverage. 
• The forex market is not completely transparent because with a forex broker, a trader may not have enough knowledge and ability to decide how to trade. 
• The forex market poses counterparty risk because there is no central exchange that guarantees a trade, implying there could be a default risk. 
• Global and economic factors can influence the values of currencies, causing price fluctuations. 

Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional and regulated commodity broker before making trading and investment decisions.