The foreign exchange or forex market, which has a daily volume of $6.6 trillion, is the largest financial market in the world, surpassing the stock market, according to the 2019 Triennial Central Bank Survey of FX and OTC derivatives markets.
The forex market, a virtual place where one currency is traded for another, has several distinctive features that may surprise beginner traders.
What is Forex?
An exchange rate is the cost involved in buying one currency for another. This kind of trading drives the forex market.
The world has 180 different kinds of official currencies. Most foreign exchange transactions and payments are made in the US dollar, British pound, Japanese yen, and euro. Some other popular currencies are the Canadian dollar, Australian dollar, Swiss franc, and New Zealand dollar.
Spot transactions, forwards, swaps, and options contracts using a currency as the underlying tool can all be used to trade currencies. Continuous currency trading takes place five days a week around the world.
Who Trades Forex?
The number of participants in the forex market is enormous, as are the types of players. Following, we will list some of the main categories of businesses and traders in the forex markets:
Commercial & Investment Banks
The interbank market is where the most currency is traded. Here, banks of all sizes exchange currency across electronic networks and with one another. Major banks account for a sizable portion of all currency transaction volume. Banks help customers with their foreign exchange transactions and manage their own trading desks for speculative trades.
The bid-ask spread is a representation of the bank’s earnings when it acts as a dealer for customers. To profit from currency volatility, speculative currency transactions are made. A portfolio’s mix of currencies can also add diversity.
Central Banks
Central banks are key participants in the FX market since they speak for their country’s government. Currency rates are significantly influenced by central banks’ open market activities and interest rate policy.
A central bank is in charge of setting the exchange rate for its native currency. Its currency will trade on the open market under this system of exchange rates. There are three different types of exchange rate regimes: floating, fixes, and pegged. Any action a central bank takes in the foreign exchange market is done to stabilize or boost that country’s economy’s level of competitiveness. Central banks and speculators may use currency interventions to make their currencies rise or fall.
For instance, during extended deflationary trends, a central bank may weaken its own currency by increasing supply, which is subsequently used to buy foreign currency. As a result, the native currency is effectively lower, increasing the competitiveness of exports on the international market.
Central banks employ these methods to reduce inflation. For forex traders, their actions also act as a long-term indication.
Individual Investors
The number of forex trades conducted by ordinary investors is incredibly small compared to financial institutions and businesses. However, its popularity is rising quickly. Fundamentals (such as interest rate parity, inflation rates, and expectations for monetary policy) and technical variables are the foundation upon which retail investors base their currency trading (i.e., support, resistance, technical indicators, price patterns).
How Does Central Bank Affect The Forex Market?
Forex traders usually analyze the central bank chairman’s language to determine if the central bank is going to increase or lower interest rates. Hawkish and Dovish terms relate to language that is taken to imply a rise or drop in rates. Known as “forward guidance,” these subtle clues have the power to influence the FX market.
Traders who believe the central bank is poised to raise interest rates will put a long bet in that currency’s favor, while those who believe the central bank will take a dovish position attempt to short the currency.
Changes in central bank interest rates provide traders the chance to engage in a carry trade based on the interest rate difference between the currencies of two countries. Carry traders trade a high-yielding currency against a low-yielding currency in an effort to earn overnight interest.
Takeaways
- The foreign exchange or forex market, which has a daily volume of $6.6 trillion, is the largest financial market in the world.
- An exchange rate is the cost involved in buying one currency for another. This kind of trading drives the forex market.
- Central banks are key participants in the FX market since they speak for their country’s government.
- Traders who believe the central bank is poised to raise interest rates will put a long bet in that currency’s favor.
- Those who believe the central bank will take a dovish position attempt to short the currency.
