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Market Participants
Unlike the equity market - where investors often only trade with institutional
investors (such as mutual funds) or other individual investors - there are
additional participants that trade on the forex market for entirely different reasons
than those on the equity market. Therefore, it is important to identify and
understand the functions and motivations of the main players of the forex market.
Governments and Central Banks
Arguably, some of the most influential participants involved with currency
exchange are the central banks and federal governments. In most countries, the
central bank is an extension of the government and conducts its policy in tandem
with the government. However, some governments feel that a more independent
central bank would be more effective in balancing the goals of curbing inflation
and keeping interest rates low, which tends to increase economic growth.
Regardless of the degree of independence that a central bank possesses,
government representatives typically have regular consultations 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 manipulating 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. With
extremely deep pockets, they yield significant influence on the currency markets.
Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants
involved with forex transactions are banks. Most individuals who need foreign
currency for small-scale transactions deal with neighborhood banks. However,
individual transactions pale in comparison to the volumes that are traded in the
interbank market.
The interbank market is the market through which large banks transact with each
other and determine the currency price that individual traders see on their trading
platforms. These banks transact with each other on electronic brokering systems
that are based upon credit. Only banks that have credit relationships with each
other can engage in transactions. The larger the bank, the more credit
relationships it has and the better the pricing it can access for its customers. The
smaller the bank, the less 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 premium to the price they paid to obtain it.
Since the forex market is a decentralized market, it is common to see different
banks with slightly different exchange rates for the same currency.
Hedgers
Some of the biggest clients of these banks are businesses that deal with
international transactions. Whether a business is selling to an international client
or buying from an international supplier, it will need to deal with the volatility of
fluctuating currencies.
If there is one thing that management (and shareholders) detests, it is
uncertainty. Having to deal with foreign-exchange risk is a big problem for many
multinationals. For example, suppose that a German company orders some
equipment from a Japanese manufacturer to be paid in yen one year from now.
Since the exchange rate can fluctuate wildly over an entire year, the German
company has no way of knowing whether it will end up paying more euros at the
time of delivery.
One choice that a business can make to reduce the uncertainty of foreignexchange
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 spot
transactions or may not want to hold massive amounts of foreign currency for
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long periods of time. Therefore, businesses quite frequently employ hedging
strategies in order to lock in a specific exchange rate for the future or to remove
all sources of exchange-rate risk for that transaction.
For example, if a European company wants to import steel from the U.S., it would
have to pay in U.S. dollars. If the price of the euro falls against the dollar before
payment is made, the European company will realize a financial loss. As such, it
could enter into a contract that locked in the current exchange rate to eliminate
the risk of dealing in U.S. dollars. These contracts could be either forwards or
futures contracts.
Speculators
Another class of market participants involved with foreign exchange-related
transactions is speculators. Rather than hedging against movement in exchange
rates or exchanging currency to fund international transactions, speculators
attempt to make money by taking advantage of fluctuating exchange-rate levels.
The most famous of all currency speculators is probably George Soros. 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 derivatives 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 company.
Some of the largest and most controversial speculators on the forex market are
hedge funds, which are essentially unregulated funds that employ
unconventional investment strategies in order to reap large returns. Think of
them as mutual funds on steroids. Hedge funds are the favorite whipping boys of
many a central banker. Given that they can place such massive bets, 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, but others have
pointed out that the real problem was the ineptness of Asian central bankers.
(For more on hedge funds, see Introduction To Hedge Funds - Part One and Part
Two.) Either way, speculators can have a big sway on the currency markets,
particularly big ones.
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.
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