What is The Foreign Exchange Market?

Foreign Exchange Market Analysis

Even though many people believe that their daily lives are not affected by currencies, foreign exchange is needed to enable trade and business between countries.  For example, if a company is based in the UK and wishes to purchase electronics from Japan, the UK company will have to exchange British Pounds for the amount payable in Japanese Yen.  The same rule applies to tourists.  If a German citizen visits South Africa, they cannot use their local currency to pay for consumables in South Africa.  The German will have to exchange Euros for the South African Rand to enable him to have purchasing power.

The foreign exchange market is unique in that it does not have a centralized marketplace.  Currency trading is carried out electronically, meaning that all the relevant transactions are conducted on computer networks by traders around the world, rather than from a centralized exchange like the stock market.  The foreign exchange market trades 24 hours a day, for 5½ days a week, in the main economic centres such as Tokyo, Hong Kong, Sydney, Paris, Singapore, Frankfurt, Zurich, New York and London.  This 24 hour trading window makes this a very active market, wherein pricing structures change constantly.

The Other Market that are Related to the Foreign Exchange Market

There are three essential ways in which individuals, corporations and other institutions trade foreign exchange, the spot, forwards and futures market.  The largest market is the spot market as it is the asset that the other two are based on.  Previously, the futures market held the place as the most popular because individual investors had availability to it for longer time periods.  However, due to electronic trading, the futures market has taken a back seat to the spot market as a preference for speculators and individuals in the trade.  The spot market is what most foreign exchange traders refer to.  The futures and forwards market are more popular with corporations as they need the facility to look at their risks at a particular date sometime in the future.

 Spot Market

This is the market where various currencies are sold and bought based on the current price.  The price, based on supply and demand, is an indication of events such as current interest rates, political stability, economic trading and the perceived performance of one currency to another.  A ‘spot deal’ happens upon the finalisation of a deal.  It is a two-way decision whereby one party provides a specific amount of one currency to another party for a specific amount of an alternate currency, at a mutually agreed exchange rate.  Once the position has closed, the settlement will be done in cash.  Even though the spot market deals with present, rather than future trades, it can take up to two days for the final settlement to take place.

Forwards Market

The forwards market involves the buying and selling of contracts between two consensual parties who mutually agree on the terms.

Futures Market

The futures market contains specific details relating to the contract, including the delivery and the settlement dates, the minimum price increments and the number of trading units that have been agreed upon.

Both forms of the contract are final and binding and are normally in the form of a cash settlement for the agreed upon exchange, upon expiry.  It is possible for contracts to be bought and sold prior to expiry date.



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