Foreign Currency Trading
The foreign exchange market is the largest and most liquid market in the world. The FX market is unique because of its (i) geographical dispersion (ii) its continuous 24 hours operation (iii) its huge daily trading volumes of over $4 trillion per day (iv) low margin requirements and (v) high liquidity. As such, it has been referred to as the market closest to the ideal of perfect competition, not withstanding currency intervention by global central banks.
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits an Australian manufacturer to import sugar from China and pay Yuan, even though the business is domiciled in Australia. Moreover, it provides businesses a synchronized avenue to sell their products globally, hence increasing their competitive advantage.
Unlike a stock market, the foreign exchange 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. Central banks may look to intervene in the currency markets if they believe that their currency is over/under valued. For instance, following the Japanese earthquake, the Bank of Japan sold the Yen (JPY) in order to make their exports more competitive. More recently, we saw the Swiss Central Bank peg the CHF against the EUR, in order to also devalue the currency to increase direct investment flows. Hedge funds and speculators also make up a large proportion of the market are an integral part of helping to determine foreign exchange prices.
The growth of the foreign exchange markets has also allowed investors to profit from movements in currencies. For example, an investor may speculate that the European Central Bank (ECB) is likely to reduce interest rates in Europe due to contagion fears in Germany, or that a default in Greece would be catastrophic for the European banking system. Accordingly, the investor may take a short position in the Euro against the US Dollar and profit if the euro depreciates in value. The use of leverage means that investors can only put a very small proportion of capital to manage a large position, hence magnifying their returns.
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