Forex market: Who trades currency and why

The foreign exchange market (or forex market) is the largest financial market in the world. In fact, the market for currencies is several times larger than the stock market.

TUTORIAL: Forex Tutorial: The Forex Market

The forex market is where one currency is exchanged for another, and it has a lot of unique attributes that may come as a surprise for new traders. In this article we will take an introductory look at the forex market and how and why traders are increasingly flocking toward this type of trading.

What Is Forex?

An exchange rate is the price paid for one currency in exchange for another. It is this type of exchange that drives the forex market.

There are more than 100 different kinds of official currencies in the world. However, most international forex trades and payments are made using the U.S. dollar, yen and euro. Other popular currency trading instruments include the British pound, Australian dollar, Swiss franc, Canadian dollar and Swedish krona.

Currency can be traded through spot transactions, forwards, swaps and option contracts where the underlying instrument is a currency. Currency trading occurs continuously around the world, 24 hours a day, five days a week. (For further reading on setting up a forex account, see "Forex Basics: Setting up an Account.")

Who Trades Forex?

There are many players in the forex market:

Banks
The greatest volume of currency is traded in the interbank market. This is where banks of all sizes trade currency with each other and through electronic networks. Big banks account for a large percentage of total currency volume trades. Banks facilitate forex transactions for clients and conduct speculative trades from their own trading desks.

When banks act as dealers for clients, the bid-ask spread represents the bank's profits. Speculative currency trades are executed to profit on currency fluctuations. Currencies can also provide diversification to a portfolio mix. (For further reading on the types of currencies available to traders, see "Top 8 Most Tradable Currencies.")

Central Banks
Central banks are extremely important players in the forex market. Open market operations and interest rate policies of central banks influence currency rates to a very large extent.

Central banks are responsible for forex fixing. This is the exchange rate regime by which a currency will trade in the open market. Exchange rate regimes are divided into floating, fixed and pegged types.

Any action taken by a central bank in the forex market is done to stabilize or increase the competitiveness of that nation's economy. Central banks (as well as governments and speculators) may engage in currency interventions to make their currencies appreciate or depreciate. For example, a central bank may weaken its own currency by creating additional supply during periods of long deflationary trends, which is then used to purchase a foreign currency. This effectively weakens the domestic currency, making exports more competitive in the global market.

Central banks use these strategies to calm inflation, but this also serves as a long-term indicator for forex traders. (For more on this topic, see "How Inflation-Fighting Techniques Affect the Currency Market.")

Investment Managers and Hedge Funds
Portfolio managers, pooled funds and hedge funds make up the second-biggest collection of players in the forex market next to banks. Investment managers trade currencies for large accounts such as pension funds, foundations and endowments.

An investment manager with an international portfolio will have to purchase and sell currencies to trade foreign securities. Investment managers may also make speculative forex trades, while some hedge funds execute speculative currency trades as part of their investment strategies.

Corporations
Firms engaged in importing and exporting conduct forex transactions to pay for goods and services. Consider the example of a German solar panel producer that imports American components and sells the final goods in China. After the final sale is made, the Chinese yuan must be converted back to euros. The German firm must then exchange euros for dollars to purchase the American components.

Companies trade forex to hedge the risk associated with foreign currency translations. The same German firm might purchase American dollars in the spot market, or enter into a currency swap agreement to obtain dollars in advance of purchasing components from the American company in order to reduce foreign currency exposure risk.

Additionally, hedging against currency risk can add a level of safety to offshore investments. (For more on this topic, see "Protect Your Foreign Investments From Currency Risk.")

Individual Investors
The volume of trades made by retail investors is extremely low compared to banks and other financial institutions. However, forex trade is growing rapidly in popularity. Retail investors base currency trades on a combination of fundamentals (i.e., interest rate parity, inflation rates and monetary policy expectations) and technical factors (i.e., support, resistance, technical indicators, price patterns).

The reasons for forex trading are varied. Speculative trades – executed by banks, financial institutions, hedge funds and individual investors – are profit motivated. Central banks move forex markets dramatically through monetary policy, exchange regime setting, and, in rare cases, currency intervention. Corporations trade currency for global business operations and to hedge risk.

How Forex Trade Shapes Business

The resulting collaboration of the different types of forex traders is a highly liquid, global market that impacts business around the world. Exchange rate movements are a factor in inflation, global corporate earnings and the balance of payments account for each country.

For instance, the popular carry trade highlights how market participants influence exchange rates that, in turn, have spillover effects on the global economy. The carry trade, executed by banks, hedge funds, investment managers and individual investors, is designed to capture differences in yields across currencies by borrowing low-yielding currencies and selling them to purchase high-yielding currencies. For example, if the Japanese yen has a low yield, market participants would sell it and purchase a higher yield currency. (For background reading on this strategy, check out "Currency Carry Trades 101.")

When interest rates in higher yielding countries begin to fall back toward lower yielding countries, the carry trade unwinds and investors sell their higher yielding investments. An unwinding of the yen carry trade may cause large Japanese financial institutions and investors with sizable foreign holdings to move money back into Japan as the spread between foreign yields and domestic yields narrows. This may result in a broad decrease in global equity prices.

The Bottom Line

There is a reason why forex is the largest market in the world – it empowers everyone from central banks to retail investors to potentially see profits from currency fluctuations related to the global economy. There are various strategies that can be used to trade and hedge currencies, such as the carry trade, which highlights how forex players impact the global economy. Overall, investors can benefit from knowing who trades forex and why they do so.