The world’s largest financial market is the currency market. In fact, it is many times larger compared to the stock market. The forex market is where currencies are exchanged and offers a great deal of features. The aim of this article is to give you some idea as to who all involve in forex trading and why they trade currencies.
Forex – What Is It
The exchange rate can be defined as the price you pay for one currency in exchange for another. The driving force behind the forex market is exchange of currencies.
Though there are over 100 different currencies in the world, for most international trades payments are made in U.S. dollar, euro and yen. The British pound, Swiss franc, Australian dollar, Swedish krona and Canadian dollar are also widely exchanged.
Currencies can be exchanged in the spot market, forwards market, swaps market and options market. The forex markets are open for 24 hours in a day and for five days a week.
Forex – Who All Trade Currencies
There are a number of players in the currency market:
The currency trading volume is the highest in the Interbank market. All types of banks trade currencies with each other in the Interbank market through electronic networks. Larger banks carry out a larger percentage of the total currency being traded. Banks also facilitate currency transactions for their clients and involve in speculative trading on their own. Banks, when they act as dealers, they make profit through the bid-ask rate or spread. Banks carry out speculative currency trades in order to profit from fluctuations in currency prices.
Central banks in countries around the world are key players in the currency market. Their operations in the open market and interest rate decisions have a great impact on currency prices. Central banks are also responsible for forex fixing, which refers to the exchange rate regime. It determines as to at which price a currency will trade in the open market. The exchange rate regimes are of three types: fixed, floating and pegged.
Central banks intervene in the currency market for two reasons: stabilizing or increasing the competitiveness of the economy of the nation they represent. This is to say that central banks, and governments as well as speculators, often involve in currency interventions in order to make their country’s currencies depreciate or appreciate. When deflationary trends prevail for a long time, the central banks weaken their country’s currency by increasing its supply. This is then made use of to buy a foreign currency. This action by the central weakens the domestic currency and makes exports more competitive. Central banks make use of these strategies to tame inflation as well, but the actions taken by the central bank provide clues to forex traders as regards the direction of price of the country’s currency.
Hedge Funds and Investment Managers
After banks, pooled funds, portfolio managers and hedge funds form the second largest team of players in the currency market. Investment managers involve in currency trading for large accounts like endowments and pension funds. Investment managers who handle international portfolios will involve in purchasing and selling currencies of foreign securities. They may also often involve in speculative forex trading. In addition, hedge funds are seen to be involving in speculative currency trading.
Large companies that import and export goods and services carry out forex transactions in order to make payments. For example, a manufacturer of solar panels in Germany may be required to import American components and sell the finished goods in China. After completing a sale, the Chinese yuan has to be exchanged for euros. Prior to the sale the German manufacturer is required to exchange euros for US dollars in order to buy components from America.
Large corporations also involve in forex trading for the purpose of hedging the risk associated with foreign currency transactions. The German firm in the above example might buy US dollars in the currency spot market or execute a swap agreement for obtaining dollars ahead of buying components from the supplier in the US for the purpose of reducing the risk associated with exposure to a foreign currency. This is because hedging can add safety to offshore investments.
Individual or Retail Investors
In terms of volume, the trades executed by retail traders is very low when compared with that of banks and other institutions. However, the popularity of forex trading among retail investors is rapidly growing. Retail traders trade forex on the basis of fundamental and technical analyses. Fundamental analysis takes into consideration such factors as interest rate, inflation and GDP, among others. Technical analysis involves aspects like, price patterns and support and resistance levels.
The participants in the forex market trade currencies for different reasons as follows:
Banks, hedge funds, retail traders and other financial institutions involve in speculative trading to make profits.
Central banks impact currency prices through monetary policy, intervention to appreciate or depreciate domestic currencies, etc.
Large corporations trade currencies to hedge risk and as part of their global business operations.
Actions of Forex Traders Impact Businesses
The actions of the forex traders in the highly liquid currency market impacts businesses around the world. Exchange rate variations impact inflation, corporate earnings and the trade balance of countries.
The popular carry trade executed by the market participants greatly influences the currency exchange rates. This in turn impacts the global economy. The carry trade – borrowing and then selling low-yielding currencies to buy high-yielding currencies – is designed to generate profit from differences in yields among currencies.
As interest rates in countries with higher-yielding currencies start falling to that in countries with lower yielding currencies, traders involve in carry trades and sell off their higher yielding investments. A yen carry trade forces Japanese investors and large financial institutions to move their money back to the country because of the narrowing of the spread between domestic and foreign yields. This can lead to a broad decline in equity prices around the world markets.
The carry trade has an impact on the global economic situation. As a trader, you can benefit if you know who all trade forex and why.