The foreign exchange market is a market in which trading occurs between two different currencies, and the exchange rate applied to trading between the two currencies is the exchange rate. To accurately understand and predict the exchange rate, it is necessary to look at the structure of the foreign exchange market and the trading mechanism.
In most countries worldwide, under an open economy, the need for foreign exchange trading for foreign exchange has grown as various forms of financial transactions have expanded compared to the past. This is because cross-country or cross-border physical and financial transactions require internationally widely used foreign exchange, mainly the U.S. dollar.
The examples of foreign exchange trading taking place in foreign transactions are very diverse and extensive. If an individual travels abroad, we must exchange the local currency for local currency, and export proceeds earned by an exporting company in US dollars will eventually be exchanged for domestic currency, resulting in the exchange market.
In the case of financial transactions, direct investment in foreign companies, securities investment in overseas stock markets, and purchases of overseas real estate will require local currency or international currency. If a foreigner purchases stocks or government bonds, the foreign exchange must be converted into domestic currency and invested, so it must go through the foreign exchange market.
Thus, for a country’s economic entity to engage in economic activities between the two different currencies, trading places, or trading mechanisms between the two currencies can be used in the foreign exchange market. Also, the exchange rate represents the relative price of the two currencies as an exchange rate that applies in the event of trading between the two currencies in the foreign exchange market.
Characteristics of the FX Market
First, the foreign exchange market is much larger than other financial markets such as the stock market and derivatives market.
– The average daily foreign exchange transactions worldwide surveyed by the Bank for International Settlements were about $5 trillion in 2016, about 170 times the daily average trading volume of the New York Stock Market.
– This is due to the rapid expansion of cross-border trade and financial transactions over the past few decades, which has necessarily increased the size of foreign exchange transactions.
Secondly, the foreign exchange market has the property of continuous 24-hour trading as a global market.
– This is because foreign exchange markets in New York, Tokyo and London, the world’s major financial centres, will open continuously over time.
– For example, before the end of trading between the U.S. dollar and the yen in the New York foreign exchange market, these currencies will begin trading in the Tokyo foreign exchange market, followed by the London foreign exchange market and the New York foreign exchange market following day.
– Therefore, the exchange rates determined in the world’s major left- currency markets have continuous properties worldwide.
Third, transactions in the foreign exchange market mainly have the nature of over-the-counter trades.
– Over-the-counter transaction means that if an individual customer requests foreign exchange sales at a bank’s transaction counter, which serves as the main window for foreign exchange transactions, the bank decides the transaction price individually considering the counterparty’s offer price or credit.
– Usually, banks are distinguished from stock market transactions participating through exchanges. They apply exchange rates differently in consideration of differences in the creditworthiness of companies or individuals who are customers of foreign exchange transactions.
– In other words, in-stock transactions through exchanges, a relatively more tightly defined trading mechanism is applied equally to many participants. In contrast, foreign exchange market transactions are based on individual characteristics such as a customer.
Fourth, the foreign exchange market is very efficient.
– The exchange rate, which is the price formed in the foreign exchange market, will be adjusted quickly in the event of a disturbance between each market.
– For example, if the Y/D exchange rate differs between New York and Tokyo, foreign exchange traders may benefit from arbitrage by purchasing relatively cheaper currencies in one market and selling them in another.
– The arbitrage of these two currencies will continue until the exchange rate in the two markets is about the same level. Recently, as the development of computer transaction techniques and the proportion of program sales have increased, even if the exchange rate between the two markets is slightly different, the efficiency of the market has been increased.
Fifth, the three major currencies – the U.S. dollar, the euro and the yen – are very high in the global foreign exchange market.
– According to a survey conducted by the International Payment Bank, the three major currencies account for about 70 per cent of foreign exchange transactions worldwide.
– This is because the currencies used in international trade settlements, overseas bond issuance, and foreign exchange reserves are concentrated in these three major currencies, meeting the essential functions of the currency’s value, exchange, and value storage.