The foreign exchange market, also called Forex, is the largest market in the world. The dailyvolume of transactions exceeds the total volume of all the equity markets. Only recently, thanks to the internet, private investors have had the opportunity to invest in this sector.
The Forex is defined as OTC market (Over The Counter), which is an unregulated market. It represents one of the most attractive markets. Only 15% of the daily trading volume comes from companies or governments that buy and sell products in a foreign country. The remaining 85% comes from speculation.
The currencies allow you to diversify your investment portfolio. A big advantage is the leverage, which allows you to move sums of money equal to one hundred times the real capital. The Forex is characterized by a huge liquidity, is open 24 hours a day, has very low transaction costs. For all these reasons, it is an extremely convenient market for both speculators and investors.
Today, currencies are no longer tied to a fixed rate, but are subject to the law of supply and demand. The foreign exchange market has developed fully only after the agreements of Jamaica (1976), in which was enshrined the principle of “floating exchange rates“. Currency prices are no longer tied to gold, or to a single reference currency, but depend on a multitude of economic factors (interest rates, volumes of international trade, inflation) and political (stability of the government in office). This justifies the high sensitivity of this market.
Thanks to the Internet, on-line trading services have multiplied, facilitating access to the Forex market through platforms easy to use. Speculators appreciate the Forex for a variety of reasons, such as the availability of information, the ability to open mini accounts, low transaction costs, the use of leverage. Today, the Forex has a daily trading volume of 4,000 billion dollars. The most treated currencies are the U.S. dollar, the Japanese yen, the British pound, the Swiss franc, the Canadian dollar, the Australian dollar and the euro.
The foreign exchange market has a large liquidity thanks to the diversity of the participants. Any participant has his own objective, his inclination to risk, his time horizon. The main participants in the foreign exchange market are as follows:
Central Banks. The transactions represent 5-10% of the total volume of the Forex market. Central banks intervene to manage their currency reserves and government bonds. Their intervention has the objective to regulate the market. For example, if a strong euro threatens the economic policy of the European Central Bank, the latter will sell a large amount of the euro with the aim of lowering the price of the currency. Sometimes, however, the market is stronger than the banks.
The interbank market. It is the market of commercial banks. They control in advance the whole market as they are the only ones to be able to communicate between them in real time. Today, approximately half of the trade passes through the interbank market, as banks are the final interlocutor of the other participants. The operators of commercial banks seek to make a profit from the transactions executed for their customers. They search the gain in the so-called “market-making“: they propose themselves to their customers as buyers or sellers, regardless of the price of the moment. Traders of a bank “make leeway” on transactions executed for their customers, that is, conduct a transaction at a better price than that offered to the customers, in order to create a surplus value.
Multinational companies. Firms have the need to intervene in the market, for example because they need dollars to pay a foreign supplier. Their purpose, in most cases, is to neutralize the exchange rate risk. Large corporations, however, manage veritable trading rooms. The purpose is not only to cover the exchange rate risk of the company, but also to earn on the market. Multinational companies thus become good customers of commercial banks.
Institutional investors. They intervene in the market to cover their positions on the equity and bond portfolio. For example, a fund manager will take a position on the dollar, if he has shares in portfolio in this currency.
Private investors. They are constantly increasing thanks to the internet and online platforms. The transaction volume of private investors now represents 10% of the total volume.
Brokers, market makers, aggregators. These operators allow access to the market. Commercial banks take a commission on every transaction that passes through them. Even the objective of market makers is to gain from operations of their customers. The gain is represented by the spread, that is the difference between purchase price and the selling price. Aggregators are computer systems that display stock prices of banks and brokers.
Because of the decentralized structure of the foreign exchange market, brokers play a vital role, as they ensure the proper functioning of the market and its liquidity.