The foreign exchange market or forex market is an international network on which traders and investors can buy and sell currencies. There is no physical location via which it operates and it remains functional 24 hours a day for 5 days a week.
Foreign exchange markets are one of the most liquid and most high volume financial markets in the world. They play an important role in carrying out payments globally and to be able to perform their role in an efficient manner, their operations/dealings must be reliable. They must be able to honor contractual obligations. For instance, when there are two different parties involved in a forward contract of a currency pair (where one buys and the other sells), neither of them should be defaulting on their commitment.
Here are the leading foreign exchange markets −
- Spot Markets
- Forward Markets
- Future Markets
- Option Markets
- Swaps Markets
Swaps, Future, and Options are known as derivatives as their value is drawn from the underlying exchange rates.
The transactions carried out in the spot market are the quickest when it comes to forex trading. Buyers and sellers are paid immediately in the spot market on the basis of the current exchange rate. The spot market covers nearly one-third of all currency exchanges where the trades are settled in no longer than a day or two. In this market, traders can open up to the volatile nature of the forex market which could lead to an increase or decrease in price between the agreement and the trade.
The volume of spot transactions has increased in the foreign exchange market. Typically, these transactions involve buying and selling of currency notes, encashing traveler’s cheques, and bank transfers. It is not surprising that bank transfers make up for nearly 90% of all spot transactions.
Major Participants in Spot Exchange
We will now explore all about the key participants in the spot exchange market.
- Commercial banks
Commercial banks are among the leading players in the market. Commercial and investment banks trade by themselves and also on behalf of their customers. A majority of the trades take place by working with currencies indulged by the bank so profit can be earned by exchange movements. Interbank transactions are carried out when the transaction volume is huge. If the volume of the forex exchange is small, you may have to reach out to a broker.
Central banks enter the market to stabilize the national currency by checking on fluctuations and also to make sure that the exchange rate remains compatible with the economic needs of the country.
- Dealers, brokers, arbitrageurs and speculators
Dealers prefer to buy when the rates are low and sell when the rates are high. These dealers lay more emphasis on wholesale and most of their transactions take place at the interbank level. Sometimes the dealers may also have to be involved with corporates and central banks. The transaction cost is low and even the spreads are quite narrow. Roughly 90% of their trades are wholesale in nature.
In the forward contract, there are typically two parties (two companies, individual or government nodal agencies)involved that mutually decide to carry out a trade on a certain date and time in the future. The price and the quantity for this trade are also pre-determined and the trade does not require any security deposit.
Why is forward contracting useful?
Forward contracting plays an important role in hedging and speculation. A typical example of hedging application via forward contract is that of a farmer who sells their harvest at a known fixed price to rule out any risk. It could also be seen in the functioning of a bread factory that wished to purchase bread in advance to help in production planning without worrying about the price fluctuations. There are speculators in the market who on the basis of their knowledge or information try to predict price rise. On the basis of their speculation they choose to buy or go long on the forward market instead rather than putting their money in the cash market.
Disadvantages of forward markets
The forward markets have some disadvantages that are listed below:
- Absence of centralized trading
- Poor liquidity (because only two parties are involved)
- Counterparty risk (one of the parties could default)
In the first two cases the key issue is that there is too much flexibility and generality. The forward market is similar to two people having a real estate contract against each other. The contract is drafted on the basis of the convenience of the two persons involved but in case there are more participants, the contracts could be non-tradeable. Counterparty risk is always something that needs to be taken into account in the forward market. If either of the two parties declares bankruptcy, the other would face the brunt of it.
Yet another issue in the forward market is that if the contract is open for a longer time period, the risk of being affected by potential price movements and counter-party troubles increases.
The future markets can assist by offering constructive solutions to several problems that one may come across in the forward markets. Future markets also operate in a similar fashion. This means that the basic principles on which they work remain essentially the same. But remember that contracts are standardized and trading is centralized. One does not have to worry about counterparty risks since exchanges have clearing corporations. They can turn into counterparty on either side and thus offer guarantees for the trades. Future market is much more liquid as compared to the forward markets since there is no limit to the number of people entering the same trade. Know more about metatrader 5 app
An option is a contract that allows the buyer the right to purchase or sell the underlying asset at a future fixed date (and time) and at a fixed price. Do remember that the buyer is not under any obligation to do so. They may choose to buy or sell on the basis of their will. A call option provides them with the right to purchase whereas a put option allows them to sell.