The Foreign Exchange Market Explained
The foreign exchange market, also known as the Forex market, is where countries, nations or businesses exchange foreign currency. For instance, an investor wishing to swap euros for pounds would do so by placing an order with a trader, who buys the pounds at the market rate.
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Characteristics
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The New York Federal Reserve says that in 2009, the average daily Forex trading volume was $675 billion, up 28 percent from the year prior. The Fed lists banks as the largest player in market transactions, though brokers, private customers and central banks also engage in transactions. In 2001, the countries that participated most in the exchange market included the United Kingdom, which accounted for 33 percent of all transactions; the United States, which accounted for 17 percent; and Japan, at 10 percent.
Features of Foreign Exchange Transactions
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Transactions on the foreign exchange market generally fall into two categories: spot and forward rate transactions. The spot rate is the current exchange rate. Tourists exchanging their home currency for their vacation destination's currency typically engage in this type of transaction. On the other hand, a forward transaction is the exchange of money at a later date in time based on a predetermined rate. This type of transaction is taken by institutions that wish to avoid risk, Because the exchange rate is already established, the natural daily currency fluctuations do not impact the transaction.
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Considerations
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Governments and central banks are large players in the foreign exchange market. Nations use the exchange market as a way to regulate and implement monetary policy. For instance, if the United Kingdom wants to encourage exports, the country's central bank will weaken its currency by selling pounds on the exchange market. This makes British goods cheaper and more attractive to countries wishing to import British products. Likewise, the government can strengthen its currency and increase its purchasing power by buying its currency off the market.
Benefits
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The Forex market provides investors with the opportunity to safeguard assets when their host country is unstable. For instance, investors wary of their country's rising prices can swap their national currency for a more stable one, such as the euro or dollar. The opportunity to reap large sums of money through arbitrage is also a possibility. Michael Duane Archer and Jim Bickford, authors of "Getting Started in Currency Trading," define arbitrage as earning money on the rate discrepancy between two currencies. Speculators trade millions of dollars in just a few seconds in hopes of profiting on the rate differences.
Warning
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Losing large sums of money on the Forex market is a realistic possibility for investors. Likewise, countries can experience disastrous consequences when their currency is dumped or bought in large quantities. The United States is an example of an economy that relies on the investment of other countries, particularly China. Adam Parfrey, author of "Secret and Suppressed II," states China has the power to exert what the media dubs the "nuclear option," which is the mass sell-off of U.S. dollars. The results would be catastrophic to the American economy. Thus, both individuals and governments can have much to lose on the foreign exchange market.
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References
- Photo Credit Currency image by Alhazm Salemi from Fotolia.com
