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Foreign Exchange

What is Foreign Exchange

Foreign Exchange (FX or Forex) is one of the largest and most liquid financial markets in the world. According to the authoritative Triennial Central Bank Survey from Bank for International Settlements, Basel, average daily turnover in April 2007 exceeded US $3.2 trillion, and evidence suggests that the market is still expanding. The spot market accounts for around a third of activity in the FX market.

FX is simple to understand once it is realized that a currency is effectively a commodity whose value can change against other currencies, as well as other assets, such as gold and oil.

Foreign Exchange Rate Systems:

There are basically two types of exchange rate systems:

Flexible Exchange Rate System:

In a flexible exchange rate system, a currency is ‘free’ to float and its value is determined by market forces.
Fixed Exchange Rate System:

In a fixed exchange rate system, a currency is not allowed to fluctuate freely. Instead, its value is fixed either against a single currency, such as the USD, at a specific rate, or a basket of currencies. In a fixed system, the local central bank will use its currency reserves to prevent rate movements.

Major Influences on FX Prices

There are numerous factors that determine a free floating currency’s worth in the market, from international trade flow, economic and political conditions, the level of interest rates to simple short-term supply and demand. Unlike many other assets, FX is a pure market and rates move freely both up and down.

Advantage of FX Trading

24 Hour Market

FX is a global market that never sleeps. It is active 24-hours a day for almost 5-days a week. Most activity takes place between the time the New Zealand market opens on Monday, which is Sunday evening in Europe, until the US market closes on Friday evening.

Liquidity

The FX market is huge and it is still expanding. Daily average volume now exceeds US$ 3.2 trillion. Technology has made this market accessible to almost anyone and retail traders have flocked to FX.

Leverage

FX margin ratios tend to be higher than those available in equity because it is more liquid – there is nearly always a price in FX ­– and it tends to be less volatile.

Narrow Spreads

Spreads, the difference between the bid and offer price, in FX are miniscule. Just compare a 2-pip price in EUR/USD with a price in even the most active and liquid equity issue. Furthermore, FX prices are typically ‘good’ for far larger amounts than in equity. The spread is the hidden, ‘intrinsic’ cost of dealing and in FX it is minimal. Technology has made these tight prices available to almost everyone.

No Commission or Transaction Costs

The majority of OTC FX business is commission free and with such narrow spreads, the intrinsic cost of trading is far lower than in other assets, such as equity.

Profit potential regardless of market direction

FX is a pure market. Prices can just as easily go up as down. If a trader believes a currency is about to depreciate, there are seldom restrictions on selling it although if the position is held for more than one day, there is a cost of carry to consider. Profit potential exists in FX regardless of whether a trader is buying or selling and regardless of whether the market is moving up or down.

Equal Access to Market Information

Despite the introduction of best execution regulations in Europe and the US, few would disagree that professional traders and analysts in the equity market have a huge competitive advantage in comparison to individual traders. In FX, perhaps the only advantage the big banks have is flow information. But FX is a democratic market where virtually all participants have access to the same market moving information as everyone else.

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