Currencies, or legal tender, are necessary to the majority of people around the world. Without it, even the purchase of simple staples like bread and milk, in either country, would be impossible. Currencies are also important to conduct foreign business or trade. For example, if you reside in Canada and would like to purchase shoes from Italy, either you or the company that you purchase the shoes from has to pay the Italian for the shoes in Euros (EUR). In other words, the Canadian importer would need to exchange the equivalent value of Canadian dollars into Euros. It is the same for travelers. A U.S. tourist in Mexico can’t pay to attend the Mexico City Metropolitan Cathedral in U.S. dollars (USD), because it is not the locally accepted currency. Therefore, the U.S. tourist would have to exchange their U.S. dollars for the local equivalence, which in this case would be the Mexican peso, at the current exchange rate.
What is Forex?
Forex, or the foreign exchange market, is the entity where currencies are traded. Because the need to exchange currencies is so inevitable, it results in forex being the most expansive, most liquid financial market worldwide, even surpassing the stock market, which reports show trades an average of $2,000 billion in U.S. dollars, per day. The forex tops that with approximately 4.9 trillion, in U.S. dollars, a day.
How It Works
The forex market differs from other financial markets in that there is no main or central marketplace for foreign exchange. Instead, currency trading is performed electronically via computer networks amidst traders around the globe. The forex market is open 24 hours a day and 5 1/2 days a week. Currencies are traded around the world in the 9 major financial centers which includes New York, Tokyo, London, Singapore, Hong Kong, Paris, Frankfurt, Zurich and Sydney. So when the trading day in the U.S. has come to an end, the forex market is just beginning fresh and new in Hong Kong and Tokyo. In other words, the forex market is active all hours of the day, with price quotes changing constantly.
How to Trade on Forex
There are essentially three ways individuals, corporations and institutions alike can trade on forex: the spot market and the futures market and forwards market.
The Spot Market
When people mention the forex market, they are usually referring to the spot market, which tends to be the most popular choice among spectators and individual investors. The spot market is where currencies are sold and bought in relation to current price. Currency price is set by supply and demand and includes a reflection of many factors including economic performance, current interest rates, the perception of future performance and the overall attitude towards continuing political situations, both internationally and locally.
Trading on the Spot Market
Once a transaction is complete, it is known as a “spot deal”. A spot deal is a two-way transaction in which one party transfers an agreed-upon currency amount to the other participating party in the financial transaction and in turn receives a specified amount of another currency at the agreed upon exchange rate value. Once the orientation is completed, the settlement is provided in cash.
The Forwards and Futures Markets
The forwards and futures markets differ from the spot market in that these markets do not trade actual currencies, but rather deal in contracts that provide rights to a specific currency type, a certain price per unit and a future date for settlement.
Trading on the Futures and Forwards Markets
In the futures market, futures contracts are sold and bought based upon specific size and settlement date on public commodities markets. Futures contracts contain a wide range of details including delivery and settlement dates, the number of units being traded and minimum price increments.
On the other hand, in the forwards market, contracts are sold and bought over the counter between two parties, who share authorization over the details of the agreement between themselves.
Both futures and forwards contracts are binding, and they are generally completed upon the exchange of cash when they expire. However, contracts can be sold and bought before they expire. The futures and forwards markets are commonly used to provide protection against the risks associated when trading currencies. In fact, major international companies often use forwards and futures markets to hedge against future exchange rate variations, however, spectators have been known to take part also.
Other modes of investing in the forex market include foreign currency CDs, foreign currency options, exchange-traded funds and exchange-traded notes and foreign bond funds. For more questions concerning the forex market, contact your AlfaTrade investment specialist who will be more than delighted to aid you.