Today, the “Forex” market is a nonstop cash market where currencies of nations are traded, typically via brokers. Foreign currencies are continually and simultaneously bought and sold across local and global markets. The value of traders’ investments increases or decreases based on currency movements.
Foreign exchange market conditions can change at any time in response to real-time events.
The main attractions of short-term currency trading to private investors are:
- 24-hour trading, 5 days a week with nonstop access (24/7) to global Forex dealers.
- An enormous liquid market, making it easy to trade most currencies.
- Volatile markets offering profit opportunities.
- Standard instruments for controlling risk exposure.
- The ability to profit in rising as well as falling markets.
- Leveraged trading with low margin requirements.
- Many options for zero commission trading.
A brief history of the Forex market
The following is an overview into the historical evolution of the foreign exchange market and the roots of the international currency trading, from the days of the gold exchange, through the Bretton-Woods Agreement, to its current manifestation.
The Gold exchange period and the Bretton-Woods Agreement
The Bretton-Woods Agreement, established in 1944, fixed national currencies against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had intended to use the funds to short the British currency. The bank’s refusal to grant the loan was due to the Bretton-Woods Agreement.
Bretton-Woods was aimed at establishing international monetary stability by preventing money from taking flight across countries, thus curbing speculation in foreign currencies. Between 1876 and World War I, the gold exchange standard had ruled over the international economic system. Under the goldstandard, currencies experienced an era of stability because they were supported by the price of gold.
However, the gold standard had a weakness in that it tended to create boom bust economies. As an economy strengthened, it would import a great deal,
running down the gold reserves required to support its currency. As a result, the money supply would diminish, interest rates would escalate and economic
activity would slow to the point of recession. Ultimately, prices of commodities would hit rock bottom, thus appearing attractive to other
nations, who would then sprint into a buying frenzy. In turn, this would inject the economy with gold until it increased its money supply, thus driving down
interest rates and restoring wealth. Such boom-bust patterns were common throughout the era of the gold standard, until World War I temporarily
discontinued trade flows and the free movement of gold.
The Bretton-Woods Agreement was founded after World War II, in order to stabilize and regulate the international Forex market. Participating countries
agreed to try to maintain the value of their currency within a narrow margin against the dollar and an equivalent rate of gold. The dollar gained a premium
position as a reference currency, reflecting the shift in global economic dominance from Europe to the USA. Countries were prohibited from devaluing
their currencies to benefit export markets, and were only allowed to devalue their currencies by less than 10%. Post-war construction during the 1950s,
however, required great volumes of Forex trading as masses of capital were needed. This had a destabilizing effect on the exchange rates established in
Bretton-Woods.
In 1971, the agreement was scrapped when the US dollar ceased to be exchangeable for gold. By 1973, the forces of supply and demand were in
control of the currencies of major industrialized nations, and currency now moved more freely across borders. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s. New financial instruments, market deregulation and trade liberalization emerged, further
stoking growth of Forex markets.
The explosion of computer technology that began in the 1980s accelerated the pace by extending the market continuum for cross-border capital
movements through Asian, European and American time zones. Transactions in foreign exchange increased rapidly from nearly $70 billion a day in the
1980s, to more than $2 trillion a day two decades later.
The explosion of the euro market
The rapid development of the Eurodollar market, which can be defined as US dollars deposited in banks outside the US, was a major mechanism for
speeding up Forex trading. Similarly, Euro markets are those where currencies are deposited outside their country of origin. The Eurodollar market came
into being in the 1950s as a result of the Soviet Union depositing US dollars earned from oil revenue outside the US, in fear of having these assets frozen
by US regulators. This gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government reacted by imposing laws to
restrict dollar lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the
late 1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short-
term loans and financing imports and exports.
London was and remains the principal offshore market. In the 1980s, it became the key center in the Eurodollar market, when British banks began
lending dollars as an alternative to pounds in order to maintain their leading position in global finance. London’s convenient geographical location
(operating during Asian and American markets) is also instrumental in preserving its dominance in the Euro market. Euro-Dollar currency exchange The euro to US dollar exchange rate is the price at which the world demand for US dollars equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro.
Factors affecting the Euro to US dollar exchange rate
Four factors are identified as fundamental determinants of the real euro to US
dollar exchange rate:
- The international real interest rate differential between the Federal Reserve and European Central Bank
- Relative prices in the traded and non-traded goods sectors
- The real oil price
- The relative fiscal position of the US and Euro zone
The nominal bilateral US dollar to euro exchange is the exchange rate that
attracts the most attention. Notwithstanding the comparative importance of
bilateral trade links with the US, trade with the UK is, to some extent, more important for the euro. The following chart illustrates the EUR/USD exchange rate over time, from the inauguration of the euro, until mid 2006. Note that each line (the EUR/USD, USD/EUR) is a “mirror” image of the other, since both are reciprocal to one another. This chart is illustrates the steady (general) decline of the USD (in terms of euro) from the beginning of 2002 until the end of 2004.
In the long run, the correlation between the bilateral US dollar to euro exchange rate, and different measures of the effective exchange rate of
Euroland, has been rather high, especially when one looks at the effective real exchange rate. As inflation is at very similar levels in the US and the Euro
area, there is no need to adjust the US dollar to euro rate for inflation differentials. However, because the Euro zone also trades intensively with
countries that have relatively high inflation rates (e.g. some countries in Central and Eastern Europe, Turkey, etc.), it is more important to downplay
nominal exchange rate measures by looking at relative price and cost developments.
The fall of the US “dollar”
The steady and orderly decline of the US dollar from early 2002 to early 2004 against the euro, Australian dollar, Canadian dollar and a few other currencies
(i.e. its trade-weighted average, which is what counts for purposes of trade adjustment), while significant, has still only amounted to about 20 percent.
There are two reasons why concerns about a free fall of the US dollar may not be worth considering. Firstly, the US external deficit will stay high only if US
growth remains vigorous, and if the US continues to grow strongly, it will also retain a strong attraction for foreign capital which, in turn, should support the US “dollar”. Secondly, attempts by the monetary authorities in Asia to keep their currencies weak will probably not work in the long run.
The basic theories underlying the US dollar to euro exchange rate
Law of One Price: In competitive markets, free of transportation cost barriers to trade, identical products sold in different countries must sell at the same
price when the prices are stated in terms of the same currency. Interest rate effects: If capital is allowed to flow freely, exchange rates become stable at a point where equality of interest is established.
The dual forces of supply and demand
These two reciprocal forces determine euro vs. US dollar exchange rates. Various factors affect these two forces, which in turn affect the exchange
rates:
The business environment: Positive indications (in terms of government
policy, competitive advantages, market size, etc.) increase the demand for the currency, as more and more enterprises want to invest in its place of
origin.
Stock market: The major stock indices also have a correlation with the
currency rates, providing a daily read of the mood of the business environment.
Political factors: All exchange rates are susceptible to political instability and anticipation about new governments. For example, political instability in
Russia is also a flag for the euro to US dollar exchange, because of the substantial amount of German investment in Russia.
Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), consumer price indices (CPI), producer
price indices (PPI), gross domestic product (GDP), international trade, productivity, industrial production, consumer confidence etc., also affect
currency exchange rates.
Confidence in a currency is the greatest determinant of the real euro to US dollar exchange rate. Decisions are made based on expected future
developments that may affect the currency.
Types of exchange rate systems
An exchange can operate under one of four main types of exchange rate
systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange
rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making. Interest rates are set to meet
the target exchange rate.
Free floating
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the
main factors affecting the exchange rate. The definition of a floating exchange rate system is a monetary system in
which exchange rates are allowed to move due to market forces without intervention by national governments. The Bank of England, for example,
does not actively intervene in the currency markets to achieve a desired exchange rate level. With floating exchange rates, changes in market supply and demand cause a currency to change in value. Pure free floating exchange rates are rare - most governments at one time or another seek to “manage” the value of their currency through changes in interest rates and other means of controls.
Managed floating exchange rates
Most governments engage in managed floating systems, if not part of a fixed exchange rate system.
The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity - though this depends
on whether dealers in foreign exchange markets regard a given fixed exchange rate as appropriate and credible.
The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating exchange rates is that it allows the government/monetary authority flexibility in determining interest rates as they do not need to be used to
influence the exchange rate.
The EUR-USD has dropped? So what!
(you can profit in any direction it takes, provided you chose the winning direction…)
Who are the participants in today’s Forex market?
In general, there are two main groups in the Forex marketplace:
Hedgers account for less than 5% of the market, but are the key reason futures and other such financial instruments exist. The group using these
hedging tools is primarily businesses and other organizations participating in international trade. Their goal is to diminish or neutralize the impact of
currency fluctuations.
Speculators account for more than 95% of the market.
This group includes private individuals and corporations, public entities, banks, etc. They participate in the Forex market in order to create profit,
taking advantage of the fluctuations of interest rates and exchange rates.
The activity of this group is responsible for the high liquidity of the Forex market. They conduct their trading by using leveraged investing, making it a
financially efficient source for earning.
Market making
Since most Forex deals are made by (individual and organizational) traders, in conjunction with market makers, it’s important to understand the role of the
market maker in the Forex industry. Questions and answers about ‘market making’
What is a market maker?
A market maker is the counterpart to the client. The Market Maker does not operate as an intermediary or trustee. A Market Maker performs the hedging
of its clients’ positions according to its policy, which includes offsetting various clients’ positions, and hedging via liquidity providers (banks) and its
equity capital, at its discretion.
Who are the market makers in the Forex industry?
Banks, for example, or trading platforms (such as Easy-Forex™), who buy and sell financial instruments “make the market”. That is contrary to
intermediaries, which represent clients, basing their income on commission.
Do market makers go against a client’s position?
By definition, a market maker is the counterpart to all its clients’ positions, and always offers a two-sided quote (two rates: BUY and SELL). Therefore,
there is nothing personal between the market maker and the customer. Generally, market makers regard all of the positions of their clients as a
whole. They offset between clients’ opposite positions, and hedge their net exposure according to their risk management policies and the guidelines of
regulatory authorities.
Do market makers and clients have a conflict of interest?
Market makers are not intermediaries, portfolio managers, or advisors, who represent customers (while earning commission). Instead, they buy and sell
currencies to the customer, in this case the trader. By definition, the market maker always provides a two-sided quote (the sell and the buy price), and
thus is indifferent in regards to the intention of the trader. Banks do that, as do merchants in the markets, who both buy from, and sell to, their
customers. The relationship between the trader (the customer) and the market maker (the bank; the trading platform; Easy-Forex™; etc.) is simply
based on the fundamental market forces of supply and demand.
Can a market maker influence market prices against a client’s position?
Definitely not, because the Forex market is the nearest thing to a “perfect market” (as defined by economic theory) in which no single participant is
powerful enough to push prices in a specific direction. This is the biggest market in the world today, with daily volumes reaching 3 trillion dollars. No
market maker is in a position to effectively manipulate the market.
What is the main source of earnings for Forex market makers?
The major source of earnings for market makers is the spread between the bid and the ask prices. Easy-Forex™ Trading Platform, for instance, maintains neutrality regarding the direction of any or all deals made by its traders; it earns its income from the spread.
How do market makers manage their exposure?
The way most market makers hedge their exposure is to hedge in bulk. They aggregate all client positions and pass some, or all, of their net risk to their
liquidity providers. Easy-Forex™, for example, hedges its exposure in this fashion, in accordance with its risk management policy and legal
requirements. For liquidity, Easy-Forex™ works in cooperation with world’s leading banks providing liquidity to the Forex industry: UBS (Switzerland) and RBS (Royal Bank of Scotland).
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