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.
Hedgers 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.)
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.
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.