“Forex” is shorthand for “foreign currency and exchange,” and forex trading refers to exchanging one currency for another. Forex traders typically do this in anticipation of profit, but other reasons for changing currency include commercial, trade, and tourism purposes. Foreign exchange trade is a massive industry. As of April 2019, the daily trading volume of forex trading was at $6.6 trillion.
Currencies are traded over the counter (OTC) with no central marketplace, and forex trading happens 24 hours a day, 5.5 days a week. As the day progresses, trading moves across global financial centers such as Hong Kong, London, New York, Paris, Singapore, and many others.
Commercial banks and investment banks engage in forex trading for their clients, and individual traders and investors also speculate on currency prices. The incentive to trade and speculate is the fact that it is possible to earn a profit from the movement of exchange rates. It is also possible to earn a profit from the interest rate differences between two currencies.
Profiting from interest rate differences is known as carry trade. It is accomplished by buying the currency with the higher rate and shorting the currency with the lower interest rate.
Forex trading for individual investors is largely powered by the Internet. Prior to the Internet, a substantial amount of capital was required for currency trading, so only hedge funds, big companies, and wealthy individuals could participate. Today, there is a robust retail market for forex trading that welcomes individual traders with modest trading capital.
Even though currencies are attached to national entities or countries, it is somewhat surprising to note that the economic situation of a particular country is not the main factor that impacts the behavior of its currency in the forex market. Rather, the primary factor that determines currency price is the movements of the large institutional investors in the forex market.
The three main ways to trade in the forex market are spots, forwards, and futures. The spot market is the largest of the three, and this is where currencies are bought and sold based on their trading (or current) price. Factors that impact currency trading prices include interest rates, economic performance of the country of origin, political situation of the country of origin, local and international sentiment regarding the currency, and the perceived future prospect of the currency. A spot deal is a completed trade where one party gives a specified amount of a currency to the other party in exchange for another currency, also in a specified amount.
In the forward market, no currency is traded. Instead, the exchange involves contracts. Each contract specifies a future date in which a currency is to be bought at a predetermined price. This is an over-the-counter market, with the deal undertaken by two parties who determine the terms of the contract.
Like the forward market, the futures market also trades in contracts. The difference is that, in the futures market, the trading is done in public commodities markets rather than over the counter. An example of a public commodities market is the Chicago Mercantile Exchange.
Both the futures market and forward market are used by companies to hedge foreign exchange risks. Hedging is a risk management strategy used to reduce the impact of a negative event. In the case of forex trading, a date and price is identified and a contract created indicating the specified date and trading price. With the contract, any possible losses in forex positioning can be limited or offset by the contract price and limited by the contract date. The contract effectively acts as an exit point from a bad trade.
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