MUSIC MASTI

Foreign exchange market
From Wikipedia, the free encyclopedia
Jump to: navigation, search
This article needs additional citations for verification.
Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (July 2008)
Foreign exchange


Exchange rates
Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate

Markets
Foreign exchange market
Futures exchange
Retail forex

Products
Currency
Currency future
Non-deliverable forward
Forex swap
Currency swap
Foreign exchange option

See also
Bureau de change

The foreign exchange market (currency, forex, or FX) is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. [1]FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. The foreign exchange market that we see today started evolving during the 1970s when worldover countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971.

Presently, the FX market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Traditional daily turnover was reported to be over US$3.2 trillion in April 2007 by the Bank for International Settlements.[2] Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008.[3]

The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Pound Sterling, etc., and the need for trading in such currencies.
Contents
[hide]

* 1 Market size and liquidity
* 2 Market participants
o 2.1 Banks
o 2.2 Commercial companies
o 2.3 Central banks
o 2.4 Hedge funds as speculators
o 2.5 Investment management firms
o 2.6 Retail foreign exchange brokers
o 2.7 Non-bank Foreign Exchange Companies
o 2.8 Money Transfer/Remittance Companies
* 3 Trading characteristics
* 4 Determinants of FX Rates
o 4.1 Economic factors
o 4.2 Political conditions
o 4.3 Market psychology
* 5 Algorithmic trading in foreign exchange
* 6 Financial instruments
o 6.1 Spot
o 6.2 Forward
o 6.3 Future
o 6.4 Swap
o 6.5 Option
o 6.6 Exchange-Traded Fund
* 7 Speculation
* 8 References
* 9 See also
* 10 External links

[edit] Market size and liquidity

The foreign exchange market is unique because of

* its trading volumes,
* the extreme liquidity of the market,
* its geographical dispersion,
* its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),
* the variety of factors that affect exchange rates.
* the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
* the use of leverage

Main foreign exchange market turnover, 1988 - 2007, measured in billions of USD.

As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. According to the Bank for International Settlements,[2] average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows:

* $1.005 trillion in spot transactions
* $362 billion in outright forwards
* $1.714 trillion in foreign exchange swaps
* $129 billion estimated gaps in reporting

Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York accounted for 16.6%, and Tokyo accounted for 6.0%.[4] In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.

Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.

Several other developed countries also permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, a few select emerging countries (e.g., Korea, South Africa, India—[1]; [2]) have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.

FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
Top 10 currency traders [5]
% of overall volume, May 2008 Rank Name Volume
1 Flag of Germany Deutsche Bank 21.70%
2 Flag of Switzerland UBS AG 15.80%
3 Flag of the United Kingdom Barclays Capital 9.12%
4 Flag of the United States Citi 7.49%
5 Flag of the United Kingdom Royal Bank of Scotland 7.30%
6 Flag of the United States JPMorgan 4.19%
7 Flag of the United Kingdom HSBC 4.10%
8 Flag of the United States Lehman Brothers 3.58%
9 Flag of the United States Goldman Sachs 3.47%
10 Flag of the United States Morgan Stanley 2.86%

Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues have made it easier for retail traders to trade in the foreign exchange market. In 2006, retail traders constituted over 2% of the whole FX market volumes with an average daily trade volume of over US$50-60 billion (see retail trading platforms).[6] Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 34.1% in April 2007. The ten most active traders account for almost 80% of trading volume, according to the 2008 Euromoney FX survey.[3] These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer. This spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a retail broker. Minimum trading size for most deals is usually 100,000 units of base currency, which is a standard "lot".


These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100/1.2300 for transfers, or say 1.2000/1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide (i.e., 0.0003). Competition is greatly increased with larger transactions, and pip spreads shrink on the major pairs to as little as 1 to 2 pips.

[edit] Market participants
Financial markets

Bond market
Fixed income
Corporate bond
Government bond
Municipal bond
Bond valuation
High-yield debt

Stock market
Stock
Preferred stock
Common stock
Registered share
Voting share
Stock exchange

Foreign exchange market

Derivatives market
Credit derivative
Hybrid security
Options
Futures
Forwards
Swaps

Other Markets
Commodity market
Money market
OTC market
Real estate market
Spot market

Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
v • d • e

Unlike a stock market, where all participants have access to the same prices, 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 investment banking firms. 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. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). 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, which is referred to as a better spread. The levels of access that make up the foreign exchange 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 investment 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-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.

[edit] Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

[edit] Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

[edit] Central banks

National central banks play an important role in the foreign exchange 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 stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[7] Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.

[edit] Hedge funds as speculators

About 70% to 90% of the 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' favor.

[edit] Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) 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 clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

[edit] Retail foreign exchange brokers

There are two types of retail brokers offering the opportunity for speculative trading: retail foreign exchange brokers and market makers. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated by the CFTC and NFA might be subject to foreign exchange scams.[8][9] At present, the NFA and CFTC are imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone. It is not widely understood that retail brokers and market makers typically trade against their clients and frequently take the other side of their trades. This can often create a potential conflict of interest and give rise to some of the unpleasant experiences some traders have had. A move toward NDD (No Dealing Desk) and STP (Straight Through Processing) has helped to resolve some of these concerns and restore trader confidence, but caution is still advised in ensuring that all is as it is presented.

[edit] Non-bank Foreign Exchange Companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account.

It is estimated that in the UK, 14% of currency transfers/payments[10] are made via Foreign Exchange Companies.[11] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.

[edit] Money Transfer/Remittance Companies

Money transfer/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally.

[edit] Trading characteristics
Most traded currencies[2]
Currency distribution of reported FX market turnover Rank Currency ISO 4217 code
(Symbol) % daily share
(April 2007)
1 Flag of the United States United States dollar USD ($) 86.3%
2 Flag of Europe Euro EUR (€) 37.0%
3 Flag of Japan Japanese yen JPY (¥) 17.0%
4 Flag of the United Kingdom Pound sterling GBP (£) 15.0%
5 Flag of Switzerland Swiss franc CHF (Fr) 6.8%
6 Flag of Australia Australian dollar AUD ($) 6.7%
7 Flag of Canada Canadian dollar CAD ($) 4.2%
8-9 Flag of Sweden Swedish krona SEK (kr) 2.8%
8-9 Flag of Hong Kong Hong Kong dollar HKD ($) 2.8%
10 Flag of Norway Norwegian krone NOK (kr) 2.2%
11 Flag of New Zealand New Zealand dollar NZD ($) 1.9%
12 Flag of Mexico Mexican peso MXN ($) 1.3%
13 Flag of Singapore Singapore dollar SGD ($) 1.2%
14 Flag of South Korea South Korean won KRW (₩) 1.1%
Other 14.5%
Total 200%

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed (called base currency). For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.5465 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

* EUR/USD: 27%
* USD/JPY: 13%
* GBP/USD (also called sterling or cable): 12%

and the US currency was involved in 86.3% of transactions, followed by the euro (37.0%), the yen (17.0%), and sterling (15.0%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

[edit] Determinants of FX Rates
See also: exchange rates

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions viz; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model (see exchange rate). This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

(c) Asset market model (see exchange rate) views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

[edit] Economic factors

These include: (a)economic policy, disseminated by government agencies and central banks, (b)economic conditions, generally revealed through economic reports, and other economic indicators.

1. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
2. Economic conditions include:

Government budget deficits or surpluses
The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
Balance of trade levels and trends
The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
Inflation levels and trends
Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
Economic growth and health
Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
Productivity of an economy
Increasing productivity in an economy should positively influence the value of its currency. It affects are more prominent if the increase is in the traded sector [3].

[edit] Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in India, Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

[edit] Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality
Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc has been a traditional safe haven during times of political or economic uncertainty.[12]
Long-term trends
Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [13]
"Buy the rumor, sell the fact"
This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[14] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
Economic numbers
While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations
As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[15]

[edit] Algorithmic trading in foreign exchange

Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.[citation needed]

An algorithmic trader needs to be mindful of potential fraud by the broker. Part of the weekly algorithm should include a check to see if the amount of transaction errors when the trader is losing money occurs in the same proportion as when the trader would have made money.

[edit] Financial instruments

[edit] Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot transactions has the second largest turnover by volume after Swap transactions among all FX transactions in the Global FX market. NNM

[edit] Forward
See also: forward contract

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years. Usually the date is decided by both parties.

[edit] Future
Main article: currency future

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate [4],[5]. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

[edit] Swap
Main article: foreign exchange swap

The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

[edit] Option
Main article: foreign exchange option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

[edit] Exchange-Traded Fund
Main article: exchange-traded fund

Exchange-traded funds (or ETFs) are open ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500 (e.g., SPY), but recently they are now replicating investments in the currency markets with the ETF increasing in value when the US Dollar weakens versus a specific currency, such as the Euro. Certain of these funds track the price movements of world currencies versus the US Dollar, and increase in value directly counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated investors and speculators.

[edit] Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[16] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.[17]

Large hedge funds and other well capitalized "position traders" are the main professional speculators.

Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[18] Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[19]

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators allegedly made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. Given that Malaysia recovered quickly after imposing currency controls directly against IMF advice, this view is open to doubt.

[edit] References

1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 551. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.
2. ^ a b c Triennial Central Bank Survey (December 2007), Bank for International Settlements.
3. ^ a b Annual FX poll (May 2008), Euromoney.
4. ^ BIS Triennial Central Bank Survey, published in December 2007.
5. ^ Source: Euromoney FX survey FX Poll 2008: The Euromoney FX survey is the largest global poll of foreign exchange service providers.'
6. ^ http://www.ifsl.org.uk/upload/CBS_Foreign_Exchange_2007.pdf (December 2007), International Financial Services, London.
7. ^ Alan Greenspan, The Roots of the Mortgage Crisis: Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own. , the Wall Street Journal, December 12, 2007
8. ^ McKay, Peter A. (2005-07-26). "Scammers Operating on Periphery Of CFTC's Domain Lure Little Guy With Fantastic Promises of Profits". The Wall Street Journal (Dow Jones and Company). http://online.wsj.com/article/SB112233850336095645.html?mod=Markets-Main. Retrieved on 2007-10-31.
9. ^ Egan, Jack (2005-06-19). "Check the Currency Risk. Then Multiply by 100". The New York Times. http://www.nytimes.com/2005/06/19/business/yourmoney/19fore.html?_r=2&adxnnl=1&oref=slogin&adxnnlx=1191337503-g1yHfewhqPWye0XtI+Eq0A&oref=slogin. Retrieved on 2007-10-30.
10. ^ The Sunday Times (UK), 16 July 2006
11. ^ The 5 largest in the UK are Travelex, Moneycorp, HiFX, World First and Currencies Direct
12. ^ Safe haven currency
13. ^ John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance, 1999), pp. 343–375.
14. ^ Investopedia
15. ^ Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York (1998), chapter 11, pp. 113–115.
16. ^ Michael A. S. Guth, "Profitable Destabilizing Speculation," Chapter 1 in Michael A. S. Guth, SPECULATIVE BEHAVIOR AND THE OPERATION OF COMPETITIVE MARKETS UNDER UNCERTAINTY, Avebury Ashgate Publishing, Aldorshot, England (1994), ISBN 1856289850.
17. ^ What I Learned at the World Economic Crisis Joseph Stiglitz, The New Republic, April 17, 2000, reprinted at GlobalPolicy.org
18. ^ But Don't Rush Out to Buy Kronor: Sweden's 500% Gamble - International Herald Tribune
19. ^ Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York, 1995.

[edit] See also

* Balance of trade
* Bretton Woods system
* Currency pair
* Double top
* Foreign currency mortgage
* Foreign exchange hedge
* Foreign exchange reserves
* Foreign exchange scam
* Foreign exchange swap
* Head and shoulders (chart pattern)
* Nonfarm payrolls
* Retail foreign exchange
* Special Drawing Rights
* Technical analysis
* Tobin Tax
* World currency
* Major inter-dealer FX brokers: EBS, Reuters
* Major retail FX brokers: FXCM, World First, HY Markets, Travelex, Henyep Investment, Varengold Bank FX, InstaForex

[edit] External links

* Benchmark Currency Rates from Bloomberg
* CFTC Commission Advisory Customer fraud Protection
* United States Federal Reserve daily update
* Microstructure effects, bid-ask spreads and volatility in the spot foreign exchange market pre and post-EMU Technical description of FX market workings.
* OECD Exchange rate statistics

Retrieved from "http://en.wikipedia.org/wiki/Foreign_exchange_market"
Categories: Foreign exchange market