Forex Walkthrough


Level 2 Markets - Market Participants

Unlike the stock market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are more parties that trade on the forex market for completely different reasons than those in the stock market. Therefore, it is very important to identify and understand the functions and motivations of these main players in the forex market.

Governments and Central Banks
Probably the most influential participants involved in the forex market are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in unison with the government. However, some governments feel that a more independent central bank is more effective in balancing the goals of managing inflation and keeping interest rates low, which usually increases economic growth. No matter the degree of independence that a central bank may have, government representatives usually have regular meetings with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in maintaining foreign reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S.Treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. They have extremely deep pockets, which allow them to have a significant impact on the currency markets.

Banks and Other Financial Institutions
Along with central banks and governments, some of the largest participants involved with forex transactions are banks. Most people who need foreign currency for small-scale transactions, like money for travelling, deal with neighborhood banks. However, individual transactions pale in comparison to the dollars that are traded between banks, better known as the interbank market. Banks make currency transactions with each other on electronic brokering systems that are based on credit. Only banks that have credit relationships with each other can engage in transactions. The larger banks tend to have more credit relationships, which allow those banks to receive better foreign exchange prices. The smaller the bank, the fewer credit relationships it has and the lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a higher price than they paid to obtain it. Since the forex market is a world-wide market, it is common to see different banks with slightly different exchange rates for the same currency.

Some of the biggest clients of these banks are international businesses. Whether a business is selling to an international client or buying from an international supplier, it will inevitably need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) hates, it's uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinational corporations. For example, suppose that a German company orders some equipment from a Japanese manufacturer that needs to be paid in yen one year from now. Since the exchange rate can fluctuate in any direction over the course of a year, the German company has no way of knowing whether it will end up paying more or less euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make such transactions in the spot market or may not want to hold large amounts of foreign currency for long periods of time. Therefore, businesses quite often employ hedging strategies in order to lock in a specific exchange rate for the future, or to simply remove all exchange-rate risk for a transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay for this steel in U.S. dollars. If the price of the euro falls against the dollar before the payment is made, the European company will end up paying more than the original agreement had specified. As such, the European company could enter into a contract to lock in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Another class of participants in forex is speculators. Instead of hedging against changes in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

George Soros is one of the most famous currency speculators. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a trader with England's Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the entire company. (For more on these investors, see George Soros: The Philosophy Of An Elite Investor and The Greatest Currency Trades Ever Made.)

The largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that use unconventional and often very risky investment strategies to make very large returns. Think of them as mutual funds on steroids. Given that they can take such large positions, they can have a major effect on a country's currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, while others have pointed to the ineptness of Asian central bankers. Either way, speculators can have a big impact on the forex market.

Now that you have a basic understanding of the forex market, its participants and its history, we can move on to some of the more advanced concepts that will bring you closer to being able to trade within this massive market. The next section will look at the main economic theories that underlie the forex market.

Trading Currencies
Related Articles
  1. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  2. Mutual Funds & ETFs

    Mutual Funds Millennials Should Avoid

    Find out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
  3. Bonds & Fixed Income

    High Yield Bond Investing 101

    Taking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
  4. Mutual Funds & ETFs

    Top 3 Commodities Mutual Funds

    Get information about some of the most popular and best-performing mutual funds that are focused on commodity-related investments.
  5. Stock Analysis

    What Seagate Gains by Acquiring Dot Hill Systems

    Examine the Seagate acquisition of Dot Hill Systems, and learn what Seagate is looking to gain by acquiring Dot Hill's software technology.
  6. Chart Advisor

    Agriculture Commodities Are In The Bear's Sights

    Agriculture stocks have experienced strong moves higher over recent weeks, but chart patterns on sugar, corn and wheat are suggesting the moves could be short lived.
  7. Investing Basics

    Investing $100 a Month in Stocks for 30 Years

    Find out how you could potentially earn hundreds of thousands of dollars by just investing $100 a month in stocks during your working years.
  8. Professionals

    Top Stocks to Short, Go Long On to Beat the Market

    A long/short portfolio can help weather a variety of market scenarios. Here's how to put one together.
  9. Mutual Funds & ETFs

    Top 4 Asia-Pacific ETFs

    Learn about four of the best-performing exchange-traded funds, or ETFs, that offer investors exposure to the Asia-Pacific region.
  10. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  1. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Liquidity

    The degree to which an asset or security can be quickly bought ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  1. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  2. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
  3. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  4. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  5. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  6. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!