The Foreign Exchange Market

Definition

The Forex Market is HUGE

The US dollar is represented in about 85% of all forex market transactions, the euro in about 40% and the Japanese yen in about 20%. (Because there are always two currencies involved in a forex market transaction these percentages add up to 200%.)

The Forex Market is deep and very liquid

For this reason the forex market is also an ideal market for small investors and small speculators which gain access to this deep and liquid markets through retail forex brokers.

The Forex Market is Global

For example if my business has to pay a webhosting company in the United States, I have to pay them in US dollars. For that reason I have to exchange rands for US dollars. If someone in Australia would like to open a forex trading account with a well regulated spreadbetting company in, say, London, she may have to exchange Australian dollars for US dollars or British pound (GBP) to make the necessary margin trading investment.

These transactions, commercial or investment, are mostly done through a global network of banks, from very large with well-known names, to smaller regional and national banks.

The Forex Market is "always" open

The always open characteristic of the forex market is very nice for individual traders who can have very flexible trading hours, not being limited to the confinements of an organization / company and its business hours.

In comparison to stock, bond and some futures markets which are open only a few ours a day, the forex market offers with its deep liquidity 24 hours a day an ideal opportunity to speculate / trade in the short term with currencies.

The Forex Market is "virtual" & online

Unlike stock exchanges which have physical addresses, the exchange of currencies takes place in the online world of electronic networks and computers. Eventually, money end up in someone's bank account where it can be accessed, but remember we have said a vast majority of foreign exchange transactions do not involve physical handling of money or even commercial transactions.

This is the right time then to introduce a very important concept you need to understand, namely the difference between foreign exchange trading (as speculation) and other commercial and "real money flow" foreign exchange transactions.

There are some foreign exchange transactions that are "deliverable" and some that are "non-deliverable".

Deliverable foreign exchange refers to when you "take delivery" of the foreign currency exchanged. "Non-deliverable" foreign exchange means there are mechanisms in place to prevent the need to actually "pay" / "exchange" the value of the transaction in the currency you transact with. Instead you can just settle the difference in the value of the transactions.

Deliverable and non-deliverable forex transactions

It works like this:

A New York based investment fund manager in global equities receives $50 million from a large state government pension fund manager to invest in retail sector stocks in a foreign land, (say, Europe).

In order to do this transaction the investment manager takes the $50 million and exchange it for euro's. For this transaction to actually take place the $50 million is exchanged and delivered through the banking system to the clients' bank account of the global investment manager in Europe. According to international banking conventions within two days the bank account of the investment manager will be credited with the equivalent amount of euros needed to "buy" the $50 million. In practice the investment manager sold $50 million and received (delivered in his bank account in euro) the equivalent amount of euro based on the exchange rate of the transaction. Let's say it was EUR45 million.

The bottom line here is that it is "real money". $50 million has been exchanged for EUR 45 million which can be used to buy German, French, Italian and other stocks listed on the respective stock exchanges in Europe.

"Non-deliverable" foreign exchange is a mechanism in the forex market to ensure speculators don't have to actually deliver the real amount of currency in the counter party's bank account. Instead they only have to deliver the profit or loss of a transaction they have done. This is achieved by "rolling" the delivery date of the transaction every day to the next day. It sounds more complicated than it is.

What essentially happens is the speculator and his broker agree that he has no interest to deal in the large amounts of currency or at any stage accept the hundreds of thousands or millions of currency in his bank account or in notes but only wants to receive or pay the profits or losses of the transaction. The forex broker will then every day roll the transaction over to the next day, thereby postponing the delivery (supposed to happen in two days) until the speculator reverses the transaction, by doing the opposite of the initial transaction and thereby effectively cancel the need for delivery. At that point the forex broker and client settle the difference only, either as a profit or a loss for the client / trader.

This is important to grasp if you trade forex, or want to trade forex. You are likely to trade in larger amounts of currency than what you have in your account and, obviously, that would be problematic if you had to deliver the currency amount you trade with, if you don't have it! Luckily there is "non-deliverable" forex!

Today the foreign exchange market offers opportunities for trading not only to banks and institutions, but to individual investors, financial market speculators and a new breed of online trader. It is big business and very easy to become part of the most popular financial market in the world.