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Within any economy, consumers and businesses use currency as a medium of exchange. In the UK, pound sterling is the national currency, while in the United States it is the US dollar. Modern economies now use paper money as a medium of exchange. However, in the past, physical commodities such as gold and silver were commonly used when payments needed to be made. FX markets Most currencies can be exchanged for others in the global currency market, also referred to as the foreign exchange market, forex or FX market. This market is open 24 hours a day, five days a week, and involves all of the major trading centres (London, New York, Singapore, Hong Kong, Tokyo). An exchange rate refers to the price at which one currency can be exchanged for another. For example, if the rate of exchange between the pound and the dollar is 1.55, then one pound can be exchanged for 1.55 dollars. The major international currencies are the US dollar, (USD), the euro (EUR), the Japanese yen, (JPY), pound sterling (GBP), the Swiss franc (CHF) and the Australian dollar (AUD). The FX market developed in the 1970s and is dominated by the large banks. Many different types of transactions are undertaken in the foreign exchange market. For example, it facilitates currency exchange for those who are travelling to another country. Currencies also play a critical role in international trade for instance, if a UK importer takes delivery of some shiny new BMWs, it can purchase the euros required to pay BMW in the FX market even though its revenues are in pound sterling. Currencies in international investment. If an American company decides to buy a British firm, the former will usually need to purchase pounds and sell dollars in the FX market to pay the UK company. Currency speculation. Speculators and traders can attempt to profit from changes in the value of currencies relative to one another. The FX market is the largest market in the world. According to the Bank for International Settlements (BIS), global currency transactions amount to around USD 4 trillion per day. This dwarfs other major asset classes such as stocks and bonds. As such, one of the appealing attributes of FX as an asset class is that it is highly liquid. 4500 FX Turnover (in US dollar billions) 4000 3500 3000 2500 2000 1500 1000 500 0 1998 2001 2004 2007 2010 Source: BIS/FxPro.au
Low transaction costs. Because of the huge trading volumes in FX markets, transaction costs are relatively low compared with other asset classes. A truly global asset class. One reason that FX markets are so liquid is because of the diversity and geographical dispersion of the users. The UK is the biggest market for foreign exchange, followed by America and Japan. Currencies are traded over-the-counter rather than on an exchange, usually with a large bank such as Deutsche Bank, Citigroup, Barclays, HSBC or JPMorgan, or with one of their agents. The most commonly traded currency pair in the world is the EUR/USD (which constitutes more than 25% of all FX trades), followed by USD/JPY (14%) and GBP/USD (9%). The USD is used in 85% of all FX transactions, with the euro involved in almost 40% of currency trades. 90 80 70 60 50 40 30 20 10 0 Currency distribution (% of average turnover) USD EUR JPY GBP AUD CHF CAD NZD Source: BIS/FxPro Currency markets are very diverse in terms of the main players. They include the major commercial banks, pension funds, insurance companies, asset managers, sovereign wealth funds, central banks, multi-national companies, hedge funds, high net worth investors, retail FX traders, currency exchange and money transfer companies. The bigger the player, the lower the spreads. The interbank market constitutes over one-half of the total volume of the FX market, and is made up of large commercial banks and investment banks. This segment of the currency market has the tightest spreads. Retail traders make up a growing market segment for three main reasons: The low level of returns from the other major assets classes over recent years (stocks, bonds, property); More advanced technology, and with it, lower transaction costs; The ability to use leverage to increase returns..au
Implications for trading The main points to remember about FX markets: Global FX is the largest, most liquid and most diverse market in the world. The US dollar is used in 85% of all currency transactions. The euro features in 39% of transactions, the Japanese yen in 19% and the pound in 13%. The most commonly traded currency pair in the world is the EUR/USD. London is the biggest market for foreign exchange, followed by New York. Retail trading is a growing market segment..au
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