Understanding Foreign Exchange Market: The largest Financial Market

Foreign Exchange Market

Foreign exchange market or forex market is a worldwide decentralized over the counter financial market. Financial centers 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 trading starts at 10 am Monday as Australia Market opens and moves towards west as major financial centers such as Tokyo London, New York opens, finally the market closes on Friday at 5 pm in New York. The foreign exchange market determines the relative values of different currencies. 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 if I want to import goods from America then I have to make payment in terms of US dollars so I can exchange Indian rupees with US dollars through foreign exchange market. There is not a particular exchange for forex trading unlike equity and commodity exchanges but foreign exchange takes place through small financial institutions that are operating in different countries. Foreign exchange market is the largest and most liquid financial market with a daily turnover of $3.2 trillion. Foreign exchange trading takes place through spot, future, swap forward and options. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors

Major Currency Traders

All over the world there are various financial institutions that are involved in currency trading, majors being Deutsche Bank having 18.06%  share of total currency traded followed by UBS AG with 11.30%,Barclays Capital 11.08%, Citi 7.69% and JP Morgan having 6.35% of the currency traded. Trading in London accounted for 36.7% of the total, making London by far the most important global center for foreign exchange trading. In second and third places, respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%. More than 80% of the currency traded is for speculation purpose for earning profit from currency movement. US dollars is the most traded currency which accounts for 84.9% of daily currency traded followed by Euro 39.1%,Japnese  yen 19%, and pound sterling 12.9%.

Currency Trading

A currency is always traded in pairs, this is because when ever currency exchange takes place you are buying one currency and selling the other that you already hold. There are 6 major currency pairs which accounts for more than 95% of the total currency traded. The major currency pairs are:

EUR/USD: Euro and US dollar

GBP/USD: Pound Sterling and US dollar

USD/JYP:  US dollar and Japanese Yen

AUD/USD: Australian dollar and US dollar

USD/CAD: US dollar and Canadian dollar

USD/CHF: US dollar and Swiss currency.

All these major currency involves US dollars other currency which doesn’t involve US dollars are called minor currency.

Lots: In the past, spot forex was traded in specific amounts called lots. The standard size for a lot is 100,000 units. There is also a mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units respectively. Currencies are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments, one need to trade large amounts of a particular currency in order to see any significant profit or loss.

Let's assume we will be using a 100,000 unit (standard) lot size. We will now recalculate some examples to see how it affects the pip value.

USD/JPY at an exchange rate of 119.80 (.01 / 119.80) x 100,000 = $8.34 per pip

USD/CHF at an exchange rate of 1.4555 (.0001 / 1.4555) x 100,000 = $6.87 per pip

In cases where the U.S. dollar is not quoted first, the formula is slightly different.

EUR/USD at an exchange rate of 1.1930 (.0001 / 1.1930) X 100,000 = 8.38 x 1.1930 = $9.99734 rounded up will be $10 per pip

GBP/USD at an exchange rate or 1.8040 (.0001 / 1.8040) x 100,000 = 5.54 x 1.8040 = 9.99416 rounded up will be $10 per pip.

. As the market moves, so will the pip value depending on what currency you are currently trading.

Leverage

 It a extremely difficult for small investor like us to trade such large amounts of money. In forex trading your broker acts as your bank. He leverage your account deposit in the ratio of 100:1 and sometimes even 200:1 varying from broker to broker. All he asks from you is that you give it $1,000 as a good faith deposit, which he will hold for you but not necessarily keep. This is how forex trading using leverage works. The amount of leverage you use will depend on your broker and what you feel comfortable with.

Typically the broker will require a trade deposit, also known as "account margin" or "initial margin." Once you have deposited your money you will then be able to trade. The broker will also specify how much they require per position (lot) traded.

For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account. No problem as your broker would set aside $1,000 as down payment, or the "margin," and let you "borrow" the rest. Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.

The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a one percent margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.

PIP

A PIP stands for point in percentage. It is unit of measurement to express the smallest change in value between two currencies. A PIP is denoted by the 4 digit to the right of decimal in a currency pair however in pair involving Japanese Yen a PIP denotes 2 digit to the right of decimal. Every movement in pip in a currency pair involving US dollar  in a position of $100000 denotes $10 of profit or loss.

This is how a currency window looks like. Here the figure shows a currency pair of EURO and US dollar  The first currency in a pair is called base currency and the second is called counter currency. All the selling and buying of currency is done in term of the base currency. For example if are buying a currency pair involving EUR/USD then we are buying EURO and selling US dollar similarly if we are selling a currency pair EUR/USD we are selling EURO and buying US dollars. There is a difference in price that you pay to buy a currency and the price you get in selling the same currency this difference is known as spread this difference in price is kept by your broker as its profit.

Exchange Rate Determination

The exchange rates are determined completely on the principles of demand and supply, value of a currency having greater demand tends to appreciate and depreciates for currency with lesser demand. Besides this the market runs on fundamentals that is any national or international events having an impact on the economy will have a bearing on currency market. The market also runs on sentiments.

Analysis

On the whole a forex market gives us a good trading platform to earn a good return on our investment, since trading on forex market involves high leverage its can give a good return on the same time it can also wipe out your complete investment. Since it is difficult to analyze the changes  in forex market, factors that effects exchange rate, very few people tends to invest in foreign exchange market. Reports are published on daily basis analyzing the movement of market on a particular date so these reports can help you in investing, specially reports published by investments banks are more accurate the best being that of Goldman Sachs. Then you can also study the world economy and economic events in major developed nations as they have great impact on the exchange rate. Ex, right now due to the American debt crisis the demand for US dollars will be less thus the US dollar tends to depreciate in its value, similarly with European economy recovering the demand tends to increase. So if you properly analyze the market forex market can give you greater return than any other market.