The foreign exchange market is a market in which trading occurs between two different currencies, and the rate applied between the two currencies is the exchange rate. To accurately understand 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 are very diverse and extensive. If an individual travels abroad, the person must exchange the local currency for foreign currency. For exporting company that sells the product in US dollars will eventually exchange it for domestic currency, resulting in forex trading.
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 international currency. If a foreigner purchases stocks or government bonds, they must convert the foreign currency into domestic currency, which must go through the foreign exchange market. Thus, economic entities can engage in economic activities between the two different currencies via the foreign exchange market.
Characteristics of the FX Market
1. 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.
2. 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 trading between the USD & JPY 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 again, New York foreign exchange market the following day.
3. Transactions in the foreign exchange market mainly have the nature of over-the-counter trades.
– Over-the-counter transaction means that an individual customer buys or sell foreign currency at the bank’s counter. The bank decides the transaction price individually, considering the counterparty’s offering price or credit. Usually, banks 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.
4. 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 JPY/USD 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.
5. 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.
Structure of Forex Market
The foreign exchange market consists of an interbank market and a customer market. Economic players participating in the foreign exchange market are customers who do business with banks and companies, non-banking financial institutions, individuals, governments and foreigners.
An Interbank Market
The interbank market is a wholesale market where large amounts of money are usually traded among banks participating in the foreign exchange market, playing a pivotal role in the foreign exchange market. The interbank market also functions as a link between the domestic foreign exchange market and the international financial market. The interbank market plays a central role in the foreign exchange market because banks traditionally have the following foreign exchange incentives.
1. Banks handle FX transaction of importing and exporting companies.
If an exporter sells U.S. dollars earned from exports to its main trading bank, the bank will sell foreign exchange in interbank markets using exchange rates designated by the exporter and pay local currency to the exporting company. As a result of these foreign exchange transactions, banks will bear the risk of exchange rate fluctuations.
2. Banks avoid currency risks by interbank transactions and seek profit through active FX trading.
When the exporter sells the foreign currency, banks will have increased exposure to foreign currency. To hedge the volatility of the exchange rate, banks tend to sell the foreign currency in the interbank market.
Banks also seek gains by actively trading on their own exchange rate forecasts. If banks expect the exchange rate to rise (fall) in the future, they would buy(sell) foreign currency in the interbank market to gain profits from exchange rate fluctuations.
3. Market makers provide liquidity to the FX market.
Market maker means an institution that presents two-way quotes to the FX market and supplies liquidity. In other words, market makers increase the efficiency and stability of the foreign exchange market by reducing the ask-bid spread.
Most of the interbank transactions go through FX broker for efficient transactions. This is because the cost to find the best selling price is high. The brokerage serves as an intermediary who earns only brokerage commission income for banks by providing real-time buying & selling prices and volume information to participating banks through trading platforms.
Customer Market
The customer market is a retail market in which FX transactions are made between banks and customers. The exchange rate is determined in the interbank with the commission added. Here are the 4 major fun facts about the customer market!
1. Banks charge different fees for different customers.
Banks charge transaction fees incrementally for each customer depending on the counterparty’s creditworthiness, size, or type of transaction, and they usually receive more commissions for individuals than for companies.
2. Customer market is expanding rapidly after the year 2000.
Customers participating in the global FX market greatly expanded since the 2000s. Global hedge funds, mutual funds, public pension funds, and insurance companies are the major non-banking financial institutions that increased global portfolio investment. Recently, more individuals are professionally trading in the FX market and online brokers are the catalyst to this phenomenon.
3. Technology development provoked various form of market.
Due to the steady development of computer technology, the form of the FX market also evolved. For example, the International Investment Bank and Reuters are increasingly developing and distributing independent brokerage systems to institutional investors and performing the function of the prime broker.
Thus, traditional customers such as hedge funds can access the interbank market directly using the bank’s ID. Also, individual investors use retail FX brokerage platforms, which greatly reduced transaction costs and improved convenience.
4. Algorithm trading takes a big part in the market.
As artificial intelligence are actively participating in the FX market, most of the trading volumes are generated via high-frequency trading. The orders are automatically executed according to pre-designed trading strategies without human emotions. This has lowered the ask-bid spread and increased efficiency and transparency.
Exchange Market and Exchange Rate
Swap is a transaction representative of exchange swap forward and foreign exchange swap X swap transaction. Futures exchange transactions occur on certain future days, while the exchange rate is fixed at the forward rate. For example, in the case of traders who need foreign exchange at a certain point in the future, foreign exchange can be secured in advance at a fixed price (gift exchange rate) through forwarding exchange transactions. Conversely, if you want to sell foreign exchange in the future, you can sign a contract to buy a foreign exchange using the current exchange rate. In both cases, fixed futures exchange rates can avoid the risk of future exchange rates fluctuating.
Exchange swap transactions are transactions in which two traders exchange two different currencies at the current contract rate and re-exchange principal at the time of maturity, such as spot exchange and futures exchange at the same time. The exchange swap market is different from the spot exchange market, judged through the spot exchange rate. It understands the supply and demand of foreign currency and liquidity through the swap rate, which is the difference between the futures exchange rate and the spot exchange rate.
Other foreign exchange market transactions include currency swap, CRS currency swap, and currency option exchange options. Over-the-counter derivatives market transactions such as gold lease swap can also be seen as broad foreign exchange transactions. The main reason for various foreign exchange derivatives transactions other than spot exchange transactions is to hedge the risk of exchange rate fluctuations or actively increase the return rate by investing in foreign exchange-related products. Banks often seek to maintain main trading relationships with customers by becoming counterparts to the demand for exchange hedge trading by companies.
Foreign exchange market and balance of payments
The average daily trading volume (including interbank and customer transactions) in the global foreign exchange market reached about $6.6 trillion as of 2019. Despite the global financial crisis in 2008, foreign exchange transactions accounted for the largest portion of traditional transactions (48.6 per cent), followed by spot exchange transactions (30.3 trillion dollars). The volume of currency swaps and currency options is relatively small.
1. Other foreign exchange derivatives included: Bank for International Settlements
Meanwhile, the volume of foreign exchange market transactions in Korea accounts for most traditional foreign exchange transactions, such as spot exchange, futures exchange, and foreign exchange swap transactions. Among them, spot exchange transactions steadily expanded due to the development of the real economy, such as Korea’s trade and the expansion of domestic and foreign securities investment funds, recording an average of 198.3 billion dollars per day as of 2019.
Futures exchange transactions have been the most widely used currency hedging instrument for Korean exporters such as shipbuilding and heavy industries. Also, since April 1999, when foreign exchange banks and non-residents were allowed to trade off-shore differential settlement futures, the portion of the transaction has accounted for a significant portion of the exchange transaction. However, the amount of exchange transactions in the interbank market is not large.
Foreign exchange swap transactions have been mainly used to address the excessive shortage of won and foreign currency funds or as a means of exchange hedging. In particular, foreign branches can raise foreign currency funds from their home countries without a currency risk and use them for financial arbitrage in Korea. Recently, as Korea’s overseas securities investment has steadily increased, investors have been widely used to raise foreign capital to avoid currency risks.
Other foreign exchange-related products such as currency swaps and currency options are traded, but the size is tiny.
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Foreign Exchange Market and Balance of Payments
Using the exchange rate information presented here, we should note that this price means nominal exchange rate. The nominal exchange rate is a concept that is relative to the real price of a currency and is independent of the actual change in value, such as the purchasing power of that country’s currency. Second, the proposed exchange rate results from foreign exchange trading by foreign exchange dealers who participate in interbank foreign exchange markets in a country or a particular foreign exchange market. Therefore, it is distinct from the customer exchange rate that banks apply to businesses or individuals by adding or subtracting a certain spread based on the interbank exchange rate. Third, information on exchange rates may vary slightly depending on the foreign exchange market in which banks made the transaction and the media that provided the information. Therefore, it is necessary to identify when the exchange rate presented is the transaction price entered into the foreign exchange market.
On the other hand, if there is no interbank foreign exchange market between the two currencies, banks can calculate the exchange rate indirectly. For example, Korea’s interbank foreign exchange market has only won/dollar market and won/yuan market, so there is no interbank market for won and yen directly traded. Therefore, there is no won/yen exchange rate determined as a result of the interbank market transaction. In this case, the won/yen exchange rate is calculated using the ratio of the won/dollar exchange rate determined in the Seoul foreign exchange market and the yen/dollar exchange rate formed in the Tokyo or New York foreign exchange market. For example, if the won/dollar exchange rate against the U.S. dollar is 1,100 won and the yen/dollar exchange rate formed in the Tokyo foreign exchange market at the same time is 105 yen, we can obtain the won/yen exchange rate at 1,047.6 won (=1,100/105). The exchange rate of the euro or other currencies against the 12th won is also determined in this way, called the arbitrage rate.
The exchange rate fluctuates from time to time due to short- and long-term factors.
The exchange rate fluctuates from time to time under various factors, such as the economic conditions of individual countries or global environmental changes. More directly, we can determine the exchange rate in real-time based on the asking price and trading results of foreign exchange dealers in the interbank foreign exchange market, determining the exchange rate by various economic or non-.
Various factors that cause exchange rate fluctuations can be classified as domestic and global factors and can be classified into mid-to-long-term and short-term factors depending on their characteristics. For example, if a country loses currency value due to deteriorating basic economic conditions such as worsening international balance, it can be said that the exchange rate changes due to domestic factors. There are also long-term factors such as changes in currency purchasing power, but there are also many short-term factors such as changes in investors’ risk preferences and expectations.
To reasonably predict exchange rates, it is important to understand the individual factors that affect them. In fact, the foreign exchange market is always mixed with the rising and falling factors of the exchange rate, and the long-term and short-term factors are also complicated. Besides, each country has a different impact on the exchange rate of certain factors, and in one country, the impact varies from time to time. Besides, if uncertainty in the international financial market increases, foreign exchange trading by participants in the foreign exchange market may be concentrated in a certain direction; therefore, it is imperative to understand various exchange rate fluctuations systematically and comprehensively analyse them based on the economic conditions of each country.
Summary
The foreign exchange market is a market in which trading occurs between the two currencies and can be classified as an interbank market and a customer market. The interbank market plays a pivotal role in the foreign exchange market. The global customer market has recently evolved rapidly due to the development of computing techniques and the participation of non-bank financial institutions. The volume of transactions is steadily increasing by type of foreign exchange transactions, mainly focusing on traditional foreign exchange transactions such as spot exchange, futures exchange, and foreign exchange swaps. The exchange rate can be defined as the exchange rate between the two currencies in the foreign exchange market, which is influenced by domestic and long-term factors and reflects currency-specific characteristics, so it is important to have a systematic understanding and comprehensive analysis.