The currency market or exchange market is a market characterized by free currency exchange, that is, its main objective is to facilitate international trade and investment. It is also known as FOREX (Foreign Exchange, which translates as exchange of foreign currencies).
In this physical or virtual space, the price of each currency called the exchange rate is set. This quotation depends exclusively on the supply and demand of the participants.
It should be noted that only cash is traded in the exchange market. On the contrary, deposits registered in financial institutions or documents that grant the right to collect an amount of money are also marketed.
This market helps to make purchases and sales of companies from different countries without them sharing the same currency. For example, a US company is allowed to import European products and pay in euros even though the income of this company is in dollars. To find out the value of one currency with respect to another, the currency converter is used.
The foreign exchange market is relatively young, it began to form in 1970 at the time when floating exchange rates were established, abolishing the fixed rate established in 1944 in Bretton Woods that was based on the ounce of gold.
The foreign exchange market is unique due to the volume of transactions, the extreme liquidity of the market, the great number and variety of participants in the market, its geographical dispersion, the time in which it operates (24 hours a day except weekends ), the variety of factors that generate exchange rates and the volume of foreign currency traded internationally.
Most common currency market instruments
- Foreign currency spot operations: These are foreign currency purchases and sales in which the time that elapses do not exceed more than two business days.
- Forward currency transactions: These are currency purchase and sale transactions in which the quantity and price of the currency are set at the time of contracting but the delivery of the same is made at a time set in the contract. Term operations represent 70% of the total operations carried out.
- Financial derivatives: There are 5 within derivatives:
1. Foreign Exchange Options: A contract that gives the right (not the obligation) to exchange one currency for another at a specified rate on a specific date.
2. Currency futures (foreign Exchange futures): it is an exchange of currencies on a certain date under an already agreed rate.
3. Non-negotiated currency contract (non deliverable forwards): a contract generally negotiated extraterritoriality, which is settled on the basis of different currencies.
4. Forward futures (outright forward): It is an exchange of one currency for another at the rate of a predetermined future day.
5. Currency swap (foreign Exchange swaps): It is a contract that is characterized by the peculiarity of buying and selling a quantity of currencies, and of reselling and repurchasing currencies at a specific rate on a specific date.
Factors why exchange rates may vary
- Economic: Inflation (also underlying inflation), public deficit, GDP, unemployment, CPI, etc.
- Politicians: Monetary policy of a country.
- Psychological: Due to rumors. The latter seems to be of less importance, but it is not. For example: on 04/23/2013, a rumor of an attack on the White House via Twitter caused the Wall Street stock market to shake for a few minutes and the indices fell more than 1%.
Characteristics of the currency market
Among the characteristics of the forex market are:
- Large scale: A large number of currency exchange operations are reported around the world, configuring what is considered the largest financial market.
- Variety: Many types of actors participate, from international entities to natural persons who come to an exchange house. Likewise, a high range of financial assets is offered: Forwards, options, among others.
- Agility: It is easy to communicate the applicant with the offer. Transactions can be made through various means such as the bank window or through a computer.
- Utility: Allows you to satisfy the need of agents for a particular currency. This is important, for example, if the parties that have concluded a contract are not in the same country. In that case, the buyer will normally have to purchase a foreign currency.
Foreign exchange institutions
The main participants in the foreign exchange market are
- Commercial banks: These financial intermediaries allow their clients to trade currencies. In addition, they buy and sell coins in the administration of their deposits, seeking to maintain, for example, a percentage in dollars.
- Central banks: They are the monetary authorities of each country. These entities intervene to avoid strong fluctuations in the exchange rate. To do so, they have monetary policy instruments such as certificates of deposit. See relationship between monetary policy and foreign exchange market
- Companies: They go to the exchange market to buy and sell foreign currency. For example, they may be importers who need to purchase foreign currency to pay their suppliers.
- Exchange houses: They allow the public to exchange part of their capital from one currency to another. They carry out cash transactions.