Foreign Exchange as a Financial Market

The international currency market Forex is a special kind of the world financial market. A trader’s purpose in foreign exchange is to buy and sell foreign currencies.

The exchange rates of all currencies being in the market turnover are permanently changing under the action of the demand and supply alteration. The latter is a strong subject to the influence of any important human society event in the sphere of economy, politics, and nature. 

Consequently, current prices of foreign currencies evaluated for instance in the US dollars fluctuate towards their higher and lower meanings. Using these fluctuations in accordance with a known and lower principle “buy cheaper – sell higher” traders obtain gains. 

How Forex is different from other financial markets

Forex is different in comparison to all other sectors of the world financial system thanks to its heightened sensibility to a large and continuously changing number of factors, accessibility to all individual and corporative traders, and exclusively high trade turnover.

It creates ensured liquidity of traded currencies and the round-clock business hours which enable traders to deal after normal hours or during national holidays in their country finding markets abroad open. 

Just as on any other market the trading on Forex, along with an exclusively high potential profitability, is a proportionately high level of risk.

It is possible to gain success on it only after a certain training including a familiarization with the structure and kinds of Forex, the principles of currencies price formation, the factors affecting prices alterations and trading risks levels, and sources of the information necessary to account for all those factors, techniques of the analysis and prediction of the market movements as well as with the trading tools and rules. 

An important role in the process of the preparation for the trading on Forex belongs to the demo trading (that is to trade using a demo account with some virtual money), which allows to testify all the theoretical knowledge and to obtain a required minimum of the trade experience not being subjected to material damage, aka using fake money to trade.

Main features of Forex

Currency exchange is very attractive for both the corporate and individual traders on the Forex – a special financial market assigned for foreign exchange. The following features make this market different in comparison to all other sectors of the world financial system: 

✓heightened sensibility to a large and continuously changing number of factors;

✓accessibility to all traders in the major currencies;

✓guaranteed quantity and liquidity of the major currencies; 

✓increased consideration for several currencies;

✓round-the-clock business hours which enable traders to deal after normal hours or during national holidays in their country finding markets abroad open and

✓extremely high efficiency relative to other financial markets. 

The goal of this blog post is to introduce beginning traders to all the essential aspects of foreign exchange in a practical manner and to be a source of the best answers to the typical questions such as:

  • why are currencies being traded
  • who are the traders
  • what currencies do they trade
  • what makes rates move
  • what instruments are used for the trade
  • how a currency behavior can be forecasted and where the pertinent information may be obtained from. 

Mastering the content of an appropriate section the user will be able to make his/her own decisions, test them, and ultimately use recommended tools and approaches for his/her own benefit.

In this blog post, we’ll be talking about different FOREX topics in general:

FOREX in a Historical Perspective

Currency trading has a long history and can be traced back to the ancient Middle East and Middle Ages when foreign exchange started to take shape after the international merchant bankers devised bills of exchange, which were transferable third-party payments that allowed flexibility and growth in foreign exchange dealings.

The modern foreign exchange market characterized by the consequent periods of increased volatility and relative stability formed itself in the twentieth century.

 By the mid-1930s London became to be the leading center for foreign exchange and the British pound served as the currency to trade and keep as a reserve currency. Because in the old times, foreign exchange was traded on the telex machines, or cable, the pound has generally the nickname “cable”. 

In 1930, the Bank for International Settlements was established in Basel, Switzerland, to oversee the financial efforts of the newly independent countries, that emerged after World War I, and to provide monetary relief to countries experiencing temporary balance of payments difficulties.

After World War II, when the British economy was destroyed and the United States was the only country unscarred by war, the U.S. dollar became the prominent currency of the entire globe. Nowadays, currencies all over the world are generally quoted against the U.S. dollar.

Main Stages of Recent FOREX Development

foreign exchange

The main phases of the further development of the Forex in modern times were:

✓ the signing of the Bretton Woods Accord;

✓constitution of the international monetary fund (IMF);

✓the emergency of the free-floating foreign exchange markets;

✓creation of currency reserves; constitution of the European Monetary Union and the European Monetary Cooperation Fund;

✓ introduction of the Euro as a currency.

Bretton Woods Accord

The Bretton Woods Accord was signed in July 1944 by the United States, Great Britain, and France which agreed to make the currency market stable, particularly due to governmental controls on currency values. In order to implement it, two major goals were: emphasized: to provide the pegging (backing of prices) of currencies and to organize the International Monetary Fund (IMF).

In accordance with the Bretton Woods Accord, the major trading currencies were pegged to the U.S. dollar in the sense that they were allowed to fluctuate only one percent on either side of that rate. When a currency exceeded this range, marked by intervention points, the central bank in charge had to buy it or sell it, and thus bring it back into range. In turn, the U.S. dollar was pegged to gold at $35 per ounce. Thus, the U.S. dollar became the world’s reserve currency.

The purpose of the IMF is to consult with one another to maintain a stable system of buying and selling the currencies so that payments in foreign money can take place between countries smoothly and timely.

The IMF lends money to members who have trouble meeting financial obligations to other members, on the condition that they undertake economic reforms to eliminate these difficulties for their own good and the good of the entire membership. In total the main tasks of the IMF are:

  • to promote international cooperation by providing the means for members to consult and collaborate on international monetary issues; 
  • to facilitate the growth of international trade and thus contribute to high levels of employment and real income among member nations; 
  • to promote stability of exchange rates and orderly exchange agreements, and [to] discourage competitive currency depreciation; 
  • to foster a multilateral system of international payments, and to seek the elimination of exchange restrictions that hinder the growth of world trade;
  • to make financial resources available to members, on a temporary basis and with adequate safeguards, to permit them to correct payments imbalances without resorting to measures destructive to national and international prosperity.

Credit Tranche Drawing

To execute these goals the IMF uses such instruments as the Reserve tranche which allows a member to draw on its own reserve asset quota at the time of payment, Credit tranche drawings and stand-by arrangements are the standard forms of IMF loans. T

The compensatory financing facility extends financial help to countries with temporary problems generated by reductions in export revenues, the buffer stock financing facility is geared toward assisting the stocking up of primary commodities in order to ensure price stability in a specific commodity, and the extended facility designed to assist members with financial problems in amounts or for periods exceeding the scope of the other facilities.

Floating Exchange Rate

Since 1978, the free-floating of currencies was officially mandated by the International Monetary Fund. That is the currency may be traded by anybody and its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. Of course, the Federal Reserve Bank irregularly intervenes to change the value of the U.S. dollar, but no specific levels are ever imposed.

Naturally, free-floating currencies are in the heaviest trading demand. Free-floating is not the sine qua noncondition for trading. Liquidity is also an indispensable condition.

A tool for people and corporations to protect investments in times of economic or political instability is currency reserves for international transactions. Immediately after World War II the reserve currency worldwide was the U.S. dollar.

Currently, there are other reserve currencies: the euro and the Japanese yen. The portfolio of reserve currencies may change depending on specific international conditions, for instance, it may include the Swiss franc.

photo by: European Movement International

The creation of the European Monetary Union was the result of a long and continuous series of post-World War II efforts aimed at creating closer economic cooperation among the capitalist European countries. The European Community (EC) commission’s officially stated goals were to improve inter-European economic cooperation, create a regional area of monetary stability, and act as “a pole of stability in world currency markets.”

The first steps in this rebuilding were taken in 1950 when the European Payment Union was instituted to facilitate the inter-European settlements of international trade transactions. The purpose of the community was to promote inter-European trade in general and to eliminate restrictions on the trade of coal and raw steel in particular. 

In 1957, the Treaty of Rome established the European Economic Community, with the same signatories as the European Coal and Steel Community. The stated goal of the European Economic Community was to eliminate customs duties and any barriers against the transit of capital, services, and people among the member nations. The EC also started to raise common tariff barriers against outsiders.

The European Community consists of four executive and legislative bodies:

1. The European Commission: The executive body in charge of making and observing the enforcement of the policies. Since it lacks an enforcement arm, the commission must rely on individual governments to enforce the policies. There are 23 departments, such as foreign affairs, competition policy, and agriculture. Each country selects its own representatives for four-year terms. The commission is based in Brussels and consists of 17 members.

2. The Council of Ministers. Makes the major policy decisions. It is composed of ministers from the 12 member nations. The presidency is held for six months by each of the members, in alphabetical order. The meetings take place in Brussels or in the capital of the nation holding the presidency.

3. The European Parliament. Reviews and amends legislative proposals and has the power to adopt or reject budget proposals. It consists of 518 elected members. It is based in Luxembourg, but the sessions take place in Strasbourg or Brussels.

4. The European Court of Justice. Settles disputes between the EC and the member nations. It consists of 13 members and is based in Luxembourg. In 1963, the French-West German Treaty of Cooperation was signed. This pact was designed not only to end centuries of bellicose rivalry but also to settle the postwar reconciliation between two major foes. The treaty stipulated that West Germany would lead economically through the cold war, and France, the former diplomatic powerhouse, would provide the political leadership.

The premise of this treaty was obviously correct in an environment defined by a foreseeable long-term continuing cold war and a divided Germany. Later in this topic, we discuss the implications for the modem era of this enormously expensive pact.

A conference of national leaders in 1969 set the objective of establishing a monetary union within the European Community. This goal was supposed to be implemented by 1980 when a common currency was first to be used in Europe.

The reasons for the proposed common currency unit were to stimulate inter-European trade and to weld together the individual member economies in order to compete successfully with the economies of the United States and Japan.

In 1978, the nine members of the European Community ratified a new plan for the stability of the European Monetary System. The new system was practically established in 1979. Seven countries were then full members-West Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and Ireland. Great Britain did not participate in all of the arrangements and Italy joined under special conditions. Greece joined in 1981, Spain and

Portugal in 1986. Great Britain joined the Exchange Rate Mechanism in 1990. The European Monetary Cooperation Fund was established to manage the EMS’ credit arrangements. In order to increase the acceptance of the ECU, countries that hold more ECU deposits, or accept as loan repayment more than their share of ECU, receive interest on the excess ECU deposits, and vice versa. 

The interest rate is the weighted average of all the EMS members’ discount rates. In 1998 the Euro was introduced as an all-European currency. Here are the official locking rates of the 11 participating European currencies in the euro (EUR). The rates were proposed by the EU Commission and approved by EU finance ministers on December 31, 1998, ahead of the launch of the euro at midnight, January 1, 1999.

The real starting date was Monday, January 4, 1999. The conversion rates are:

1 EUR =  40.3399 BEF 1 EUR = 1.95583 DEM

1 EUR = 166.386 ESP 1 EUR = 6.55957 FRF

1 EUR = 0.787564 IEP 1 EUR = 1936.27 ITL

1 EUR = 40.3399 LUF 1 EUR = 2.20371 NLG

1 EUR 13.7603 ATS 1 EUR = 200.482 PTE 

1 EUR = 5.94573 FIM

The euro bills are issued in denominations of 5, 10, 20, 50, 100, 200, and 500 euros. Coins are issued in denominations of 1 and 2 euros, and 50, 20,10, 5, 2, and 1 cent.

Factors that Caused FOREX Volume Growth

Foreign exchange trading is generally conducted in a decentralized manner, with the exceptions of currency futures and options. Foreign exchange experienced spectacular growth in volume ever since currencies were allowed to float freely against each other. While the daily turnover in 1977 was U.S. $5 billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark in September 1992, and stabilized at around $1,5 trillion by the year 2000.

The main factors that influence this spectacular growth in volume are indicated below. For foreign exchange, currency volatility is a prime factor in the growth of volume. In fact, volatility is a sine qua non condition for trading.

Interest Rate Volatility

Economic internationalization generated a significant impact on interest rates as well. Economics became much more interrelated, which exacerbated the need to change interest rates faster. Interest rates are generally changed in order to adjust the growth in the economy, and interest rate differentials have a substantial impact on exchange rates.

Business Internationalization

In recent decades the business world the competition has intensified, triggering a worldwide hunt for more markets and cheaper raw materials and labor. The pace of economic internationalization picked up even more in the 1990s, due to the fall of Communism in Europe and up-and-down economic and financial development in both Southeast Asia and South America.

These changes have been positive for foreign exchange since more transactional layers were added. 

Increasing Corporate Interest

Successful performance of a product or service overseas may be pulled down from the profit point of view by adverse foreign exchange conditions and vice versa. Accurate handling of foreign exchange may enhance the overall international performance of a product or service.

Therefore, interest in foreign exchange has increased in the past decade. Many corporations are using currencies not only for hedging but also for capitalizing on opportunities that exist solely in the currency markets.

Increasing Traders Sophistication

Advances in technology, computer software, and telecommunications and increased experience have increased the level of traders’ sophistication. This enhanced traders’ confidence in their ability to both generate profits and properly handle the exchange risks. Therefore, trading sophistication led to a volume increase.

Developments in Telecommunications

The introduction of automated dealing systems in the 1980s, matching systems in the early 1990s, and Internet trading in the late 1990s completely altered the way foreign exchange was conducted. The dealing systems are online computer systems that link banks on a one-to-one basis while matching systems are electronic brokers.

They are reliable and much faster, allowing traders to conduct more simultaneous trades. They are also safer, as traders are able to see the deals that they execute. The dealing systems had a major role in expanding the foreign exchange business due to their reliability, speed, and safety.

Computer and Programming development 

Computers play a significant role in many stages of conducting foreign exchange. In addition to the dealing systems, matching systems simultaneously connect all traders around the world, electronically duplicating the brokers’ market. The new office systems provide full accounting coverage, ticket writing, back-office processing, and risk management implementation at a fraction of their previous cost.

Advanced software makes it possible to generate all types of charts, augment them with sophisticated technical studies, and put them. at traders’ fingertips on a continuous basis at a rather limited cost.

If you like to start day trading crypto instead of forex trading, visit Martina’s Learn to Trade & Invest Crypto Academy platform to get access to all content and resources, our trading community, and 2 Zoom lives with her every month.

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