Foreign Exchange Markets A General Overview and Structure of the Forex Market

In the beginning countries would trade with each other using the barter system. If one nation needed lumber but had cattle, they would trade one product for another. This was pure trading. This type of economy has many limitations, but served ankind well for many centuries. However, nations quickly saw the benefit of having a system of exchange, and while some cultures used pretty rocks, or animal teeth, precious metals quickly became established methods of exchange. God and silver were the most popular. Initially gold and silver coins were used, and in fact the name of the British standard currency, the pound sterling, came from the Hasterling region where gold coins were made, and originally meant coins of the Hasterling’s. Up until World War I most nations had central banks that supported the value of their currencies and most used gold as the standard. Paper money was printed and it legally could be exchanged for gold but this did not often happen. Since it was rarely converted, some banks and some nations believed they no longer needed to keep reserves of gold in their vaults, as the US once did with Fort Knox. Inflation then occurred.


Near the end of World War II a conference known as Bretton woods had many nations reach an agreement on a reserve currency system based on the US dollar. The World Bank and other organizations agreed, and a fixed exchange rate system was reached. The value of the dollar was fixed on a certain amount of gold, and other currencies were fixed on value to the dollar. Currency trading after this however has evolved and currencies have grown in value, and gone down in value, leading to fluctuation. Today traders take advantage of the fluctuation in value among currencies through the forex or foreign currency markets. It is quite common to see a trader who suspects that the value of the Euro will go up against the yen or the dollar and follow the old axiom of “buy low and sell high.” On of the ways this is done is through margin trading. With margin trading a trader doesn’t have to have all the money in an account that is being traded. If a trader has 10,000 and works with a one percent margin, he is able to trade $100,000 in currency. This adds great leverage to the trade and makes forex trading very attractive to many who are looking for a large and quick return on their investments. Forex traders are also attracted to the low costs associated with trading since most trades are without commission.

The fact that there is a 24 hour trading cycle is also attractive to many. Traders have opportunities for large profit, but they also have risk inherent. An aggressive trader may experience profit and loss swings of up to 30% in a day. This can be 30% to the good, or to the bad, so forex trading requires education and courage as well as capital. However there are no daily limits and no restrictions on trading hours other than the weekend when markets are closed. For this reason there are always opportunities. Money will always be made.

Much of the forex trading that occurs however is not with individual investors or speculators. Many commercial organizations have currency exposures that are created due to import and export activities. This is reason enough for many to engage in forex trading. However, financial
institutions remain the biggest players in the forex market. Banks, brokers, mutual funds and other major financial institutions are actively involved in forex trading.

Some nations in the past have complained about hedge funds and other large institutions involved in forex trading, saying that they have intentionally devalued their currencies to make quick profits. George Soros, the famous billionaire who is involved in politics, has been accused of
this practice by the government of Indonesia. Whether it is true or not, and if true whether it should or should not be done is not for this article. However, when institutions control such large amounts of money, the chance of manipulation does exist. As long as foreign currency is traded, there will be such accusations. However, the forex market remains a way to achieve substantial financial gain.

Who are the participants in today’s Forex market?

In general, there are two main groups in the Forex marketplace:
Hedgers account for less than 5% of the market, but are the key reason futures and other such financial instruments exist. The group using these hedging tools is primarily businesses and other organizations participating in international trade. Their goal is to diminish or neutralize the impact of currency fluctuations. Speculators account for more than 95% of the market. This group includes private individuals and corporations, public entities, banks, etc. They participate in the Forex market in order to create profit, taking advantage of the fluctuations of interest rates and exchange rates. The activity of this group is responsible for the high liquidity of the Forex market. They conduct their trading by using leveraged investing, making it a financially efficient source for earning.

Types of exchange rate systems

An exchange can operate under one of four main types of exchange rate systems:
Fully fixed exchange rates In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate. Semi-fixed exchange rates Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making. Interest rates are set to meet the target exchange rate.

Free floating
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate. The definition of a floating exchange rate system is a monetary system in which exchange rates are allowed to move due to market forces without intervention by national governments. The Bank of England, for example, does not actively intervene in the currency markets to achieve a desired exchange rate level. With floating exchange rates, changes in market supply and demand cause a currency to change in value. Pure free floating exchange rates are rare most

governments at one time or another seek to “manage” the value of their currency through changes in interest rates and other means of controls. Managed floating exchange rates Most governments engage in managed floating systems, if not part of a fixed exchange rate system.

The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity - though this depends on whether dealers in foreign exchange markets regard a given fixed exchange rate as appropriate and credible.

The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating exchange rates is that it allows the government/monetary authority flexibility in determining interest rates as they do not need to be used to influence the exchange rate.

The fall of the US dollar

The steady and orderly decline of the US dollar from early 2002 to early 2004 against the euro, Australian dollar, Canadian dollar and a few other currencies (i.e. its trade-weighted average, which is what counts for purposes of trade adjustment), while significant, has still only amounted to about 20 percent. There are two reasons why concerns about a free fall of the US dollar may not be worth considering. Firstly, the US external deficit will stay high only if US growth remains vigorous, and if the US continues to grow strongly, it will also retain a strong attraction for foreign capital which, in turn, should support the US dollar. Secondly, attempts by the monetary authorities in Asia to keep their currencies weak will probably not work in the long run. The basic theories underlying the US dollar to euro exchange rate Law of One Price: In competitive markets, free of transportation cost barriers to trade, identical products sold in different countries must sell at the same price when the prices are stated in terms of the same currency.
Interest rate effects: If capital is allowed to flow freely, exchange rates become stable at a point where equality of interest is established.


The dual forces of supply and demand
These two reciprocal forces determine euro vs. US dollar exchange rates. Various factors affect these two forces, which in turn affect the exchange rates: The business environment: Positive indications (in terms of government policy, competitive advantages, market size, etc.) increase the demand for the currency, as more and more enterprises want to invest in its place of origin.
Stock market: The major stock indices also have a correlation with the currency rates, providing a daily read of the mood of the business environment. Political factors: All exchange rates are susceptible to political instability and anticipation about new governments. For example, political instability in Russia is also a flag for the euro to US dollar exchange, because of the substantial amount of German investment in Russia. Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), consumer price indices (CPI), producer price indices (PPI), gross domestic product (GDP), international trade, productivity, industrial production, consumer confidence etc., also affect currency exchange rates. Confidence in a currency is the greatest determinant of the real euro to US dollar exchange rate. Decisions are made based on expected future developments that may affect the currency.

Euro-Dollar currency exchange

The euro to US dollar exchange rate is the price at which the world demand for US dollars equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro.
Factors affecting the Euro to US dollar exchange rate Four factors are identified as fundamental determinants of the real euro to US dollar exchange rate:

• The international real interest rate differential between the Federal Reserve and European Central Bank
• Relative prices in the traded and non-traded goods sectors
• The real oil price
• The relative fiscal position of the US and Euro zone

The nominal bilateral US dollar to euro exchange is the exchange rate that attracts the most attention. Notwithstanding the comparative importance of bilateral trade links with the US, trade with the UK is, to some extent, more important for the euro. The following chart illustrates the EUR/USD exchange rate over time, from the inauguration of the euro, until mid 2006. Note that each line (the EUR/USD, USD/EUR) is a “mirror” image of the other, since both are reciprocal to one another. This chart is illustrates the steady (general) decline of the USD (in terms of euro) from the beginning of 2002 until the end of 2004.

In the long run, the correlation between the bilateral US dollar to euro exchange rate, and different measures of the effective exchange rate of Euroland, has been rather high, especially when one looks at the effective real exchange rate. As inflation is at very similar levels in the US and the Euro area, there is no need to adjust the US dollar to euro rate for inflation differentials. However, because the Euro zone also trades intensively with countries that have relatively high inflation rates (e.g. some countries in Central and Eastern Europe, Turkey, etc.), it is more important to downplay nominal exchange rate measures by looking at relative price and cost developments.

The explosion of the euro market

The rapid development of the Eurodollar market, which can be defined as US dollars deposited in banks outside the US, was a major mechanism for speeding up Forex trading. Similarly, Euro markets are those where currencies are deposited outside their country of origin. The Eurodollar market came into being in the 1950s as a result of the Soviet Union depositing US dollars earned from oil revenue outside the US, in fear of having these assets frozen by US regulators. This gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government reacted by imposing laws to restrict dollar lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late 1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short term loans and financing imports and exports.

London was and remains the principal offshore market. In the 1980s, it became the key center in the Eurodollar market, when British banks began lending dollars as an alternative to pounds in order to maintain their leading position in global finance. London's convenient geographical location (operating during Asian and American markets) is also instrumental in preserving its dominance in the Euro market.

The Gold exchange period and the Bretton-Woods Agreement

The Bretton-Woods Agreement, established in 1944, fixed national currencies against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had intended to use the funds to short the British currency. The bank's refusal to grant the loan was due to the Bretton-Woods Agreement. Bretton-Woods was aimed at establishing international monetary stability by preventing money from taking flight across countries, thus curbing speculation in foreign currencies. Between 1876 and World War I, the gold exchange standard had ruled over the international economic system. Under the gold standard, currencies experienced an era of stability because they were supported by the price of gold.
However, the gold standard had a weakness in that it tended to create boombust economies. As an economy strengthened, it would import a great deal, running down the gold reserves required to support its currency. As a result, the money supply would diminish, interest rates would escalate and economic activity would slow to the point of recession. Ultimately, prices of commodities would hit rock bottom, thus appearing attractive to other nations, who would then sprint into a buying frenzy. In turn, this would inject the economy with gold until it increased its money supply, thus driving down interest rates and restoring wealth. Such boom-bust patterns were common throughout the era of the gold standard, until World War I temporarily discontinued trade flows and the free movement of gold.

The Bretton-Woods Agreement was founded after World War II, in order to stabilize and regulate the international Forex market. Participating countries agreed to try to maintain the value of their currency within a narrow margin against the dollar and an equivalent rate of gold. The dollar gained a premium position as a reference currency, reflecting the shift in global economic dominance from Europe to the USA. Countries were prohibited from devaluing their currencies to benefit export markets, and were only allowed to devalue their currencies by less than 10%. Post-war construction during the 1950s, however, required great volumes of Forex trading as masses of capital were needed. This had a destabilizing effect on the exchange rates established in Bretton-Woods.
In 1971, the agreement was scrapped when the US dollar ceased to be exchangeable for gold. By 1973, the forces of supply and demand were in control of the currencies of major industrialized nations, and currency now moved more freely across borders. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s. New financial instruments, market deregulation and trade liberalization emerged, further stoking growth of Forex markets. The explosion of computer technology that began in the 1980s accelerated the pace by extending the market continuum for cross-border capital movements through Asian, European and American time zones. Transactions in foreign exchange increased rapidly from nearly $70 billion a day in the 1980s, to more than $2 trillion a day two decades later.

is Forex trading? What is a Forex deal?

The investor's goal in Forex trading is to profit from foreign currency movements. More than 95% of all Forex trading performed today is for speculative purposes (e.g. to profit from currency movements). The rest belongs to hedging (managing business exposures to various currencies) and other activities. Forex trades (trading onboard internet platforms) are non-delivery trades: currencies are not physically traded, but rather there are currency contracts which are agreed upon and performed. Both parties to such contracts (the trader and the trading platform) undertake to fulfill their obligations: one side undertakes to sell the amount specified, and the other undertakes to buy it. As mentioned, over 95% of the market activity is for speculative purposes, so there is no intention on either side to actually perform the contract (the physical delivery of the currencies). Thus, the contract ends by offsetting it against an opposite position, resulting in the profit and loss of the parties involved.


Components of a Forex deal
A Forex deal is a contract agreed upon between the trader and the market maker (i.e. the Trading Platform). The contract is comprised of the following components:
• The currency pairs (which currency to buy; which currency to sell)
• The principal amount (or "face", or "nominal": the amount of currency involved in the deal)
• The rate (the agreed exchange rate between the two currencies).
Time frame is also a factor in some deals, but this chapter focuses on Day Trading (similar to “Spot” or “Current Time” trading), in which deals have a lifespan of no more than a single full day. Thus, time frame does not play into the equation. Note, however, that deals can be renewed (“rolled-over”) to the next day for a limited period of time. The Forex deal, in this context, is therefore an obligation to buy and sell a specified amount of a particular pair of currencies at a pre-determined exchange rate. Forex trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a “spot rate”, or just “rate”, for short). If

an investor had bought 1,000 euros on that date, he would have paid 1,199.00 US dollars. If one year later, the Forex rate was 1.2222, the value of the euro has increased in relation to the US dollar. The investor could now sell the 1,000 euros in order to receive 1222.00 US dollars. The investor would then have USD 23.00 more than when he started a year earlier. However, to know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the very minimum, the return on investment (ROI) should be compared to the return on a “risk-free” investment. Long-term US government bonds are considered to be a risk-free investment since there is virtually no chance of default - i.e. the US government is not likely to go bankrupt, or be unable or unwilling to pay its debts. Trade only when you expect the currency you are buying to increase in value relative to the currency you are selling. If the currency you are buying does increase in value, you must sell back that currency in order to lock in the profit. An open trade (also called an “open position”) is one in which a trader has bought or sold a particular currency pair, and has not yet sold or bought back the equivalent amount to complete the deal. It is estimated that around 95% of the FX market is speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency.

Exchange rate
Because currencies are traded in pairs and exchanged one against the other when traded, the rate at which they are exchanged is called the exchange rate. The majority of currencies are traded against the US dollar (USD), which is traded more than any other currency. The four currencies traded most frequently after the US dollar are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or “the Majors”. Some sources also include the Australian dollar (AUD) within the group of major currencies. The first currency in the exchange pair is referred to as the base currency. The second currency is the counter currency or quote currency. The counter or quote currency is thus the numerator in the ratio, and the base currency is the denominator. The exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain 1 euro.

Spreads
It is the difference between BUY and SELL, or BID and ASK. In other words, this is the difference between the market maker's "selling" price (to its clients) and the price the market maker "buys" it from its clients. If an investor buys a currency and immediately sells it (and thus there is no change in the rate of exchange), the investor will lose money. The reason for this is “the spread”. At any given moment, the amount that will be received in the counter currency when selling a unit of base currency will be lower than the amount of counter currency which is required to purchase a unit of base currency. For instance, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing a spread of 1,000 pips (percentage in points; one pip = 0.0001). Such a rate is much higher than the bid/ask currency rates that online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In general, smaller spreads are better for Forex investors since they require a smaller movement in exchange rates in order to profit from a trade.

Prices, Quotes and Indications
The price of a currency (in terms of the counter currency), is called “Quote”. There are two kinds of quotes in the Forex market: Direct Quote: the price for 1 US dollar in terms of the other currency, e.g. Japanese Yen, Canadian dollar, etc. Indirect Quote: the price of 1 unit of a currency in terms of US dollars, e.g. British pound, euro.
The market maker provides the investor with a quote. The quote is the price the market maker will honor when the deal is executed. This is unlike an “indication” by the market maker, which informs the trader about the market price level, but is not the final rate for a deal.
Cross rates – any quote which is not against the US dollar is called “cross”. For example, GBP/JPY is a cross rate, since it is calculated via the US dollar. Here is how the GBP/JPY rate is calculated:

GBP/USD = 1.7464;
USD/JPY = 112.29;
Therefore: GBP/JPY = 112.29 x 1.7464 = 196.10.

Margin
Banks and/or online trading providers need collateral to ensure that the investor can pay in the event of a loss. The collateral is called the “margin” and is also known as minimum security in Forex markets. In practice, it is a deposit to the trader's account that is intended to cover any currency trading losses in the future.
Margin enables private investors to trade in markets that have high minimum units of trading, by allowing traders to hold a much larger position than their account value. Margin trading also enhances the rate of profit, but similarly enhances the rate of loss, beyond that taken without leveraging.

Maintenance Margin
Most trading platforms require a “maintenance margin” be deposited by the trader parallel to the margins deposited for actual trades. The main reason for this is to ensure the necessary amount is available in the event of a “gap” or “slippage” in rates. Maintenance margins are also used to cover administrative costs. When a trader sets a Stop-Loss rate, most market makers cannot guarantee that the stop-loss will actually be used. For example, if the market for a particular counter currency had a vertical fall from 1.1850 to 1.1900 between the close and opening of the market, and the trader had a stop-loss of 1.1875, at which rate would the deal be closed? No matter how the rate slippage is accounted for, the trader would probably be required to add-up on his initial margin to finalize the automatically closed transaction. The funds from the maintenance margin might be used for this purpose. Important note: Easy-Forex™ does NOT require that traders deposit a maintenance margin. Easy-Forex™ guarantees the exact rate (Stop-Loss or other) as pre-defined by the trader.

Leverage
Leveraged financing is a common practice in Forex trading, and allows traders to use credit, such as a trade purchased on margin, to maximize returns. Collateral for the loan/leverage in the margined account is provided by the initial deposit. This can create the opportunity to control USD 100,000 for as little as USD 1,000.
There are five ways private investors can trade in Forex, directly or indirectly:
• The spot market
• Forwards and futures
• Options
• Contracts for difference
• Spread betting
Please note that this book focuses on the most common way of trading in the Forex market, “Day-Trading” (related to “Spot”). Please refer to the glossary for explanations of each of the five ways investors can trade in Forex.

A spot transaction
A spot transaction is a straightforward exchange of one currency for another. The spot rate is the current market price, which is also called the “benchmark price”. Spot transactions do not require immediate settlement, or payment “on the spot”. The settlement date, or “value date” is the second business day after the “deal date” (or “trade date”) on which the transaction is agreed by the trader and market maker. The two-day period provides time to confirm the agreement and to arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.

Risks
Although Forex trading can lead to very profitable results, there are substantial risks involved: exchange rate risks, interest rate risks, credit risks and event risks. Approximately 80% of all currency transactions last a period of seven days or less, with more than 40% lasting fewer than two days. Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.

Forex? What is it, anyway?

The market
The currency trading (foreign exchange, Forex, FX) market is the biggest andfastest growing market on earth. Its daily turnover is more than 2.5 trilliondollars. The participants in this market are central and commercial banks, corporations, institutional investors, hedge funds, and private individuals likeyou.

What happens in the market?
Markets are places where goods are traded, and the same goes with Forex. InForex markets, the “goods” are the currencies of various countries (as well as gold and silver). For example, you might buy euro with US dollars, or youmight sell Japanese Yen for Canadian dollars. It’s as basic as trading one currency for another. Of course, you don’t have to purchase or sell actual, physical currency: you trade and work with your own base currency, and deal with any currency pair
you wish to.


“Leverage” is the Forex advantage
The ratio of investment to actual value is called “leverage”. Using a $1,000 to buy a Forex contract with a $100,000 value is “leveraging” at a 1:100 ratio. The $1,000 is all you invest and all you risk, but the gains you can make may be many times greater.

How does one profit in the Forex market?
Obviously, buy low and sell high! The profit potential comes from the fluctuations (changes) in the currency exchange market. Unlike the stock market, where share are purchased, Forex trading does not require physical purchase of the currencies, but rather involves contracts for amount and exchange rate of currency pairs. The advantageous thing about the Forex market is that regular daily fluctuations – in the regular currency exchange markets, often around 1% - are multiplied by 100! (Easy-Forex™ generally offers trading ratios from 1:50 to 1:200).

How risky is Forex trading?
You cannot lose more than your initial investment (also called your “margin”). The profit you may make is unlimited, but you can never lose more than the margin. You are strongly advised to never risk more than you can afford to lose.

How do I start trading?
If you wish to trade using the Easy-Forex™ Trading Platform, or any other, you must first register and then deposit the amount you wish to have in your margin account to invest. Registering is easy with Easy-Forex™ and it accepts payment via most major credit cards, PayPal, Western Union. Once your deposit has been received, you are ready to start trading.

How do I monitor my Forex trading?
Online, anywhere, anytime. You have full control to monitor your trading status, check scenarios, change some terms in your Forex deals, close deals, or withdraw profits.