Foreign Exchange Market

& Structure - Introduction

IBA - RAVI

Foreign Exchange
A foreign exchange transaction is an
agreement between a buyer and a
seller that a given amount of one
currency is to be delivered at a
specified rate for some other currency.
The foreign exchange market (forex,
FX, or currency market) is a form of
exchange for the global decentralized
trading of international currencies.

Foreign Exchange
Definition
Import
&
Export

Tourism,
Educatio
n, etc

Forex
Transacti
on
Investme
nt
Avenues
Abroad

Inter
bank
Settleme
nt

Features
Largest financial market
in the world with
average daily turnover
of approximately $5
trillion
The forex market is
greater than the stock
Dominated by large
market. It is 75 times
Multinational banks,
greater than the
Central banks, Hedge
combined volumes at
funds & Currency
New York Stock
Brokers
Exchange
Round the clock market
starting from Sydney,
Tokyo, Honk Kong,
Singapore, Bahrain,
London, New York.
Almost open 24hours x
5 days

FEX Market -Definition

The foreign exchange market, also
known as the forex, FX, or currency
market, involves the trading of one
currency for another.
Prior to 1996 the market was
confined to large corporate banks
and international corporations.

FEX Market -Definition

However it has since opened up to
include all traders and speculators.
The average daily turnover in forex
markets is over US$4.0 trillion, according
to the Bank of International Settlementss
Triennial Survey from 2010.
The market is growing rapidly as
investors gain more information and
develop more interest.

Forex market contd.

The foreign exchange market is a
decentralised, over-the-counter (OTC) global
market.
The daily volume of the Forex market surpasses
$4 trillion as day worldwide. To put this in
perspective the daily volume traded on the
New York stock exchange is $25 billion making
it the largest financial market in the world.
The total Forex volume is well over three times
the total amount of the stocks and futures
markets combined.

Forex Market contd.

The participants of the Forex market include banks,
corporations, institutional investors, hedge
funds and individuals. In simple terms Forex
trading is where you can buy and sell currencies,
simultaneously.
The way it works is much like the process of
currency exchange at airports or hotels where you
can exchange the currency you deal with for the
local currency.
The Forex market is open 24 hours a day 5 days a
week, enabling traders to buy and sell around the
clock acting on global news events as they happen.

 In trading foreign exchange, investors

bet that one currency will appreciate
over another; they profit when they
bet correctly and collect the profit in
the form of an interest rate spread
when they return to the original
currency.
The profit margins are low compared
with other fixed-income markets.

 Large trading volumes can, however,

result in very high profits. Over half of all
forex trading takes place in London and
New York, with London dominating the
market at 37% of all transactions.
New Yorks market share is 18%, with
Tokyo ranked third at 6%. Singapore,
Switzerland, and Hong Kong are the nextlargest forex markets globally with
approximately 5% market share each.

FEX types
One type of very short-term transaction is the spot
transaction between two currencies, delivering over two
days and using cash as opposed to a contract.
In a forward transaction, the money is not exchanged until
an arranged date and an exchange rate is agreed in
advance. The time period ranges from days to years.
Currency swaps are a popular type of forward
transaction; these involve the exchange of currency by two
parties for an agreed length of time and an arrangement to
swap currencies at an agreed later date.
Another type is a foreign currency future, which is inclusive
of interest. A standard contract is drawn up and a maturity
date arranged. The time schedule is about three months.

 In a foreign exchange option (FX option), the

most liquid and biggest options market in
the world, the owner may elect to exchange
money in a designated currency for another
currency at an agreed date in the future.
This type of transaction depends on the
availability of option contracts on an
organized exchange. Otherwise, such forex
deals may be carried out using an overthe-counter (OTC) contract.

Forex Market Structure

For most retail traders understanding

the structure of the Forex market is
something that is often overlooked.
This is a critical element that needs to
be considered when designing and
implementing any trading plan.
The forex market differs from other
global markets due to the way it is
structured.

Forex Market Structure

The main factors affecting the structure of the

Forex market are the ways Forex products are
traded, the participants and their motivation,
regulation and the sheer size of the market.
Since transactions in the Forex market are
done over-the-counter (OTC) and not through
a central exchange like futures or shares,
prices behave differently.
Understanding these differences is essential
to your development.

Over The Counter

The first thing to understand about the
structure of the forex market is the way in
which products are traded. Forex is for the
most part, an over the counter (OTC) market.
This means that there is no central exchange
through which instruments are traded.
When we refer to instruments, we are
referring to the different forex products
participants use to conduct transactions,
whether they be corporate, speculative or
hedging.

Over The Counter

These products include: Spot forex, outright
forwards, forex swaps, forex options. When a
product is traded OTC it is done so through a market
maker.
A market maker in forex is effectively a bank or
broker that facilitates currency trades by providing
buy and sell quotes and then taking orders.
Orders can be hedged or passed on so there is no
exposure/risk, matched within the internal order
book or held by the market maker, meaning they
take the other side of the order and take a position
against the client

 Other commonly traded instruments such

as shares and futures are exchange
traded products, this means that any
transaction involving these instruments is
done through an exchange such as the
New York Stock Exchange (NYSE) and
London Stock Exchange (LSE).
The points below highlight some features
of OTC and exchange traded markets.

 Lets expand on what OTC means in the

case of the Forex market.
Since there is no central exchange through
which to process orders and transactions, a
sophisticated network has been established
in order to allow participants to
communicate and transact.
This network has different levels, each with
its own institutions serving different
functions within the forex market.

 The interbank market is essentially a network between

larger banks. This network is made possible through EBS
(electronic broking services) and Reuters spot matching
systems.
These two applications effectively aggregate the order
books of the banks, showing the various bids, offers and
amounts that each is willing to transact at. This allows
proper market function to occur by providing sufficient
liquidity and efficient processing.
The interbank market is only accessible to larger banks with
the highest of credit standings, this is to eliminate any
counterparty risk and reduce competition. By restricting
access to the interbank market the big banks are continuing
to maintain their share of forex turnover and thus profits.

The Players
At the top of the food chain we have the
foreign exchange dealers. These are
the dealer banks which conduct foreign
exchange business for their clients or
themselves. The major banks include;
Deutsche Bank, UBS, Citigroup, Barclays
Capital, RBS, Goldman Sachs, HSBC,
Bank of America, JP Morgan, Credit
Suisse and Morgan Stanley

The Players
The dealer banks that form the
interbank market are effectively the
market makers of the forex market,
they set the prices and manage the
volume for the rest of the market to
feed off.

The Players
These banks handle approximately 2/3 of
the daily forex volume and along with
others form what is known as the
interbank market.
These banks deal with each other on
behalf of clients or for themselves,
providing much needed liquidity to the
market so large transactions whether
corporate or speculative can be facilitated
and proper market function can occur

The Players
On the next level of the forex market we have
the market that exists for financial and nonfinancial participants. This may include
smaller banks, businesses, hedge/mutual/pension
funds, CTAs and large investors.
Traditionally the majority of foreign exchange
turnover has been the result of international
trade flows, this trend has changed in recent
years with the majority of turnover being the
result of capital flows, speculative and hedging
activities.

The Players
This shift reflects the increasing
recognition of foreign exchange as a
means of generating returns by all
market participants, and the need to
manage foreign exchange risks
through hedging activities.

The Players
On the next level we have forex brokers
and retail ECNs (electronic communications
network). Traditionally forex brokers were
the intermediary party between buyers and
sellers, meaning they facilitated the
transaction between the end user and their
liquidity provider (market maker bank). For
the most part this is still the case today,
however, some brokers will run a book and
trade against their clients. .

The Players
Brokers and ECNs will usually have
an agreement with one or more
liquidity providers, through which
they can hedge positions on their
book and manage any exposure they
might have. A liquidity provider could
be any one of the above mentioned
major banks, or even another retail
broker depending on their needs.

The Players
In the background of all this we have the
central banks. The central banks follow
their respective currency, making sure its
price movements arent to erratic and
promoting stability. They are participants
in the market to diversify their currency
reserves, influence the value of their
exchange rate (less common nowadays)
and make international payments on
behalf of the government

The Players
To do all this the central bank has its own
dealers who use a number of larger banks
to help facilitate these flows of funds.
Central bank intervention used to be far
more common and have greater affect
than it has nowadays. Rather than
actively participating in the market
buying and selling their currency, central
banks instead use verbal intervention to
affect the value of their currency.

Liquidity in FEX market

Structure of Forex market