Foreign Exchange Market

Foreign exchange market can be described as a network that allows buyers and sellers to exchange currency at a fixed price. Foreign exchange is the process by which individuals, businesses, and central banks convert one currency to another. If you’ve ever traveled abroad, it’s likely that you have done a forex transaction.

Geopolitical, economic conditions, and trade flows, can influence the value of currency pairs. Forex traders may be able to take advantage of this volatility by identifying new opportunities.

Forex trading is pure speculation. You are speculating on currencies from different countries. Currency trading involves both the dynamics of trading or market speculation and the factors that influence the currency’s value.

Foreign exchange is one of the most liquid and largest international financial markets. It is the crossroads of international capital and the intersection through which global investment and commercial flows move.

Key Players in Foreign Exchange Market

The foreign exchange market is primarily used by central banks, retail banks, corporations, and retail traders. Fundamental analysis can help you determine market trends by understanding how these players interact with Forex markets.

• The nation’s central banks manage its currency, money supply, and interest rates. Central banks usually take action to stabilize the currency.
• Large volumes of currency are traded on the interbank markets by retail banks. Banks can exchange currencies for large organizations and their accounts.
• Companies who have dealt with overseas companies must participate in the foreign currency market to transfer funds to imports and exports services.
• Forex transactions are handled by retail traders at a lower volume than banks and other organisations. Retail traders can profit from fluctuations in forex markets by using both fundamental and technical analysis.

Types of Foreign Exchange Market

There are three types of forex markets:

Spot forex Market: The physical exchange of currency pairs takes place at the exact moment the trade is settled, ie “on the spot” or within a brief period of time.

Forward forex Market: A contract to buy or sell a certain amount of currency at a specific price. The settlement is made at a fixed date in the future, or within a range.

The future forex market is a contract to buy or sell a certain amount of a currency at a fixed price and date in the future. A futures contract, unlike forwards, is legally binding

Many traders who speculate on forex prices won’t plan to take delivery of the currency; they will instead make exchange rate predictions in order to profit from price movements.

The Forces Behind Forex Rates

Foreign currency traders must analyze a variety of economic reports daily, interpret comments from financial and political officials around the globe, assess financial market movements, and take stock of geopolitical developments. All this is done to determine the direction in which major currencies move.

Interest Rates

Because they have an impact on global capital flows, interest rates are crucial to currencies. They also serve as benchmarks for investors’ expectations of what they can earn from investing in a country. Higher-yielding currencies (lower interest rates) tend to be stronger than lower-yielding currencies.

Interest Rate Expectations

Forex markets tend to be more concerned about the future direction of interest rates than the current levels. A currency might have a low rate of interest, but market expectations of higher rates in the future will often cause it to appreciate. It is also true that a currency with a high-interest rate often weakens when the market expects lower interest rates in the future.

An outlook period is a timeframe in which markets expect interest rates to change. It can be several months or quarters out. However, the longer the changes are expected to occur, the less impact they will have on currencies right now.

Relative interest rates

Currency traders tend to pay little attention to absolute rates and instead focus on the interest rate of one currency relative to other currencies.

Interest-rate Differentials

The interest-rate differential is the most important spread to monitor. It is the difference in interest rates between two currencies. A narrower interest-rate difference favors the lower-yielding currencies. An increase in the interest-rate differential favors the higher-yielding one.

Real and Nominal Interest Rates

It is not just the nominal interest rate that you should be focusing on. The real interest rates that markets focus on are inflation-adjusted or nominal rates minus inflation.

Monetary Policy

The nature and direction in which a country’s central banks set monetary policy is the most important determinant of a currency’s value relative to other currencies. The set of policies that central banks take to fulfill their legal mandates is called monetary policy.

The legislative mandates of most central banks are to promote price stability, also known as restraining inflation, and promote sustainable economic growth. Sometimes there is an explicit goal to encourage maximum employment.

The primary focus of central bankers is inflation. They are keen to change benchmark interest rates such as the Federal Funds Rate in the United States and refinance rate in Eurozone. The cost of money is affected by changes in interest rates. Higher interest rates mean that borrowing costs will rise, while lower interest rates will reduce borrowing costs.

Identifying Monetary Policy Cycles

Because central bankers are less likely to shock an economy by raising interest rates too dramatically, changes in monetary policy tend to involve small shifts of interest rates that last for a long time.

Currency traders pay a lot of attention to the intentions of central bankers, despite the importance of monetary policy to currencies. The good news is that central bankers can communicate with markets in many ways. Rate decisions, policy statements, guidance, and public speeches.

Because of the strong correlation between currency values and interest rates, foreign currency traders must be aware of the market’s current thinking and follow it closely. This can be done by following market commentary in print and online media. However, it is important to remember that these outlets (especially print) often fall one step behind the current market.

Evaluation of Official Currency Policies and Rhetoric

After monetary policy and interest rates, the next largest influence on currency values is government policies and official stances about the value of individual currencies. The value of their currencies is a matter of national governments.

In a sense, the currency of a country is the main entry point to its economy and financial market. It’s equivalent to closing the front door if the currency is seen as volatile or unstable. That’s something that no major economy can afford today.

Types of Foreign Currency Market Intervention

Central banks can buy or sell currencies on the open market in order to influence currency rates in the desired way. Direct intervention in the markets is rarely used as a last resort.

This may also be used as a temporary measure to stabilize markets that are affected by extreme events such as a terrorist attack, or rumors about a financial institution going under. Markets are usually aware of the growing risks of intervention, even if it isn’t necessary for emergency situations.

Financial Stability

The 2008-2009 Great Financial Crisis triggered a global recession unlike anything since the Great Depression in the 1930s. Major governments’ finances became a mess as tax revenues plummeted and spending was increased or maintained through fiscal stimulus. Global markets began to question the financial stability and creditworthiness of major national governments.

The perception of a currency’s value is directly related to the level of faith that investors have in the financial stability and soundness of the country(s) backing it. Investors who fear that sovereign debt default will result in government bonds not being paid back will likely sell the bonds and the currency.

This can lead to panic in the market, with government bond prices plummeting, causing yields to rise and increasing borrowing costs. It could also result in the government being forced out of the global capital markets, leading ultimately, to default.

The most recent example is the Eurozone debt crisis in 2009-2012. This was when bond investors fled Greek or Irish government debt. This raised borrowing costs to unaffordable amounts and forced those governments to seek bailouts from richer Eurozone members.

Between November 2009’s start of the Greek debt crisis and the establishment of a temporary bailout in May 2010, the euro fell by more than 20% against the USD, while falling even further against other currencies.

Debts, Deficit, and Growth

Investors are questioning the financial stability of high-debted European countries after the Great Financial Crisis. The US and Japan have high levels of debt, which can impact sentiment in these currencies. You should also consider the financial stability of key currencies as part of your analysis.

Credit risk

Financial stability is a dynamic process that happens over time, just like monetary policy or interest rate changes. However, markets view individual countries’ financial stability differently each day. How can you monitor the market’s current view of a country’s creditworthiness and how can you keep an eye on it? Market news reports and economic commentary will help you keep an eye on these credit risk measures.

Credit Ratings

Moody’s, Standard & Poor’s (S&P), and Fitch give sovereign debt ratings a lot of weight. Credit rating agencies often indicate that a nation’s debt ratings are under investigation and provide a bias to that evaluation, such as “Portugal sovereign debt placed on review; outlook negative,” prior to a rating change. These kinds of announcements can have a big influence on the currency in question.

Yield Spreads

These are the differences in the yields (interest rate) of bonds issued by one government relative to bonds issued by a more secure country. An increasing spread means that credit risks are growing.

The yields (interest rates) of bonds issued by a weak country are sold to make yields higher while bonds issued by a safe country are purchased to lower yields. Yield spreads change on a daily basis and intra-day basis. Widening spreads indicate a worsening credit risk while narrowing spreads indicate greater relief.

Credit Default Swaps (CDS)

These derivatives can be thought of as an insurance policy for default. The buyer pays a premium, and the seller is required to pay the bond back in default. CDS can be used to lead bond market movements and are an active speculative counterpart of the underlying bonds. Rising CDS rates indicate increased credit risk. Falling CDS rates are expressed in basis points (bps) and signal less concern.

Debt Auction Results

Governments can borrow money through regular auctions or issuances. This is where the government sells its debt to international investors. These key indicators are the extent of demand as well as the yield (the price that investors will pay).

The bid/cover ratio is used to measure the demand. This is the ratio of the amount that is being offered to the amount that is being bid. The bid/cover ratio is a measure of perceived security and demand.

Geopolitical Events and Risks

Geopolitics is often focused on geopolitical, military/security, or natural disruptions to the global economic system or specific regions or countries. Geopolitical risks also include elections in individual countries, such as by-elections or legislative referenda.

This is especially true if the outcome could lead to a change of government or economic policy. As the main conduits of international capital flows, currency markets are often the first to respond to international developments, as global investors shift assets to meet geopolitical developments.

Frequently Asked Questions (FAQs)