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The
Structure of Foreign Exchange Markets
The
purpose of the foreign exchange market is to facilitate
the trading of various currencies around the
world. Although many different types of currency are exchanged,
the majority of trades involve only a small number of them,
including the U.S. Dollar, Yen, Euro, Swiss Franc, Pound Sterling,
Australian Dollar, and Canadian Dollar. The U.S. Dollar is
involved in over 90% of all exchanges on the forex markets.
Contrary to popular belief, there is no one centralized market
in which all currency trading occurs; rather, the foreign exchange
is a loose conglomerate of several different markets, each
of which has its own rules and regulations. Major markets are
located in the U.S., London, and Tokyo, and each is open during
different hours according to their time zones. Naturally, trading
is heaviest when the market hours overlap, and almost two thirds
of the trading activity at the New York market takes place
during the morning while the European markets are still open.
Because there is no
centralized market, a single exchange
rate for a given currency does not exist. Because of the over-the-counter
(OTC) nature of the markets, the bid and ask rates for a currency
can vary among different geographic markets and market makers,
although they are usually fairly close to each other. Since
the price of a currency must be given in relation to another
currency, it is expressed in the form XXX/YYY, where each trio
of letters represents the international currency code. For
example, the price of Euros in U.S. Dollars is written as EUR/USD.
Traditionally, the first currency in the pair, called the base
currency, is always the one that was strongest when the pair
was created, and the other currency is known as the counter
currency. The actual prices themselves are in decimal form,
typically rounded to the nearest ten-thousandth of a unit.
The
forex markets make up the largest marketplace in the world,
with the equivalent of $1.9 trillion changing hands every 24
hours. It is largely a short term, speculative market, with
more than 40% of positions closed out before two days, and
nearly 4 out of 5 lasting less than a week. It is an extremely
liquid market, much more so than equities, due to the many
participants throughout the world and the very high daily turnover.
The top ten most active traders, however, account for nearly
73% of total trading volume. Made up of international banks,
these huge players provide the market with bid and ask prices
that are far tighter than retail customers can expect, and
trading activity that occurs between them is known as the “interbank
market”.
Introduced in 1972 at the Chicago Mercantile Exchange, forex
futures contracts are derivative instruments that are actively
traded as well, as they account for around seven percent of
total foreign exchange volume. In addition, foreign exchange
options have taken hold as a popular hedging strategy. They
represent contracts to buy currency at a certain price on a
set day in the future, and investors often purchase these derivatives
to offset any potential losses they may suffer due to the decline
in price of a currency. Another way traders are able to mitigate
risk is through a swap, in which both parties agree to exchange
one currency for another for a set period of time, and will
then reverse the transaction after the period expires.
The foreign exchange market is a fast-paced, international
currency exchange that is without rival among financial markets.
Its immense popularity among large banks, financial institutions,
international companies, and even retail investors ensures
that its growth will continue into the future.
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