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The foreign exchange spot market (forex, FX, or currency market) is a worldwide decentralised over-the-counter financial market for the trading of currencies. Financial centres around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange spot market determines the relative values of different currencies.
The primary purpose of the foreign exchange spot market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits an Australian business to import British goods and pay Pound Sterling, even though the business's income is in Australian dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies (such as the US & Japan) and lend/ invest in high-yielding currencies (such as Australia & New Zealand).
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency.
The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange spot market is unique because of
- its huge trading volume, leading to high liquidity;
- its geographical dispersion;
- its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;
- the variety of factors that affect exchange rates; and
- the use of leverage to enhance profit margins with respect to actual capital invested - typical leverage is 1:50.
As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007.
Unlike a stock market, the foreign exchange spot market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. 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. 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 (spread). The levels of access that make up the foreign exchange spot 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 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 FX market makers. Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in FX since the early 2000s. In addition, hedge funds have grown markedly since the mid 1990s in terms of both number and overall size.
National central banks play an important role in the foreign exchange spot markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilise the market by buying their own currency when the value is falling and selling when it is rising.
A sizeable proportion of foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favour. George Soros raised the ire of the Bank of England on 16 September 1992 when his hedge fund sold short more than US$10 billion worth of British Pounds, aiming to profit from the Bank of England's reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency. Finally, the Bank withdrew the currency from the European Exchange Rate Mechanism, devaluing the Pound, earning Soros an estimated US$1.1 billion. He was dubbed "the man who broke the Bank of England", costing the UK Treasury approximately £3.4 billion.
Investment management firms (who typically manage accounts on behalf of customers or manage large internal mandates) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage leverage currency exposures with the aim of generating profits as well as limiting risk.
Retail traders (individuals) constitute a growing segment of the market, both in size and importance. Currently, they participate indirectly through brokers or banks. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.
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