6.1 Structure and functions of forex markets

The foreign exchange market is a complex ecosystem of participants and transactions. Banks, central banks, corporations, and investors all play crucial roles in this global marketplace, engaging in spot, forward, and swap transactions to meet their financial needs.

Forex trading involves bid-ask spreads, which impact costs and profitability. Major trading centers like London, New York, and Tokyo form a continuous 24-hour market, ensuring liquidity and efficient price discovery around the clock. Understanding these elements is key to navigating the forex landscape.

Key Participants and Transactions in Forex Markets

Key participants in forex markets

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• Commercial banks
  • Function as dealers, executing trades for clients and their own accounts
  • Supply liquidity to the market by consistently buying and selling currencies
  • Participate in interbank trading, exchanging currencies with other banks to manage risk and facilitate client transactions
• Central banks
  • Oversee and maintain their country's foreign exchange reserves
  • Conduct market interventions to stabilize their currency's value when necessary (Bank of Japan, European Central Bank)
  • Implement monetary policies that can influence exchange rates, such as adjusting interest rates or engaging in quantitative easing
• Corporations
  • Undertake forex transactions to facilitate international trade and investment activities (Microsoft, Toyota)
  • Employ hedging strategies to mitigate exposure to currency risk, such as using forward contracts or options
• Institutional investors
  • Comprise mutual funds, pension funds, and insurance companies that invest in foreign assets
  • Require currency conversion to purchase and sell foreign securities or assets (BlackRock, Vanguard)
• Retail traders and investors
  • Consist of individuals who speculate on currency price movements to generate profits
  • Access the forex market through online trading platforms offered by brokers (MetaTrader, TradingView)

Types of forex transactions and orders

• Spot transactions
  • Involve the immediate exchange of currencies at the prevailing market rate
  • Require settlement within two business days after the trade date
• Forward transactions
  • Establish an agreement to exchange currencies at a predetermined rate on a specific future date
  • Employed for hedging against currency risk or speculating on future price movements
• Swap transactions
  • Entail the simultaneous buying and selling of currencies
  • Combine a spot transaction and a forward transaction to manage short-term liquidity or hedge interest rate risk
• Market orders
  • Direct the immediate execution of a trade at the best available current market price
• Limit orders
  • Specify a desired price or better at which to buy or sell a currency pair
• Stop orders
  • Trigger a buy or sell order when the currency pair's price reaches a predetermined level, serving as a risk management tool

Spreads, Trading Centers, and Global Forex Market

Bid-ask spreads in forex trading

• Bid price
  • Represents the price at which a dealer is prepared to purchase a currency pair
• Ask price
  • Indicates the price at which a dealer is willing to sell a currency pair
• Bid-ask spread
  • Constitutes the difference between the bid and ask prices quoted by a dealer
  • Reflects the cost of executing a trade and the dealer's profit margin (2-5 pips for major currency pairs)
• Spread impact on trading
  • Higher spreads result in increased transaction costs and reduced potential profitability for traders
  • Tighter spreads are more favorable for traders as they minimize trading costs
• Factors influencing spreads
  • Market liquidity: higher liquidity typically leads to tighter spreads (EUR/USD, USD/JPY)
  • Currency pair: more actively traded pairs generally have tighter spreads compared to less liquid pairs
  • Market volatility: periods of heightened volatility can cause spreads to widen as dealers manage increased risk

Major global forex trading centers

• London
  • Stands as the world's largest forex trading hub, responsible for a substantial portion of global turnover
  • Serves as a bridge between the Asian and North American trading sessions, contributing to its high liquidity
• New York
  • Ranks as the second-largest forex trading center globally
  • Benefits from overlapping trading hours with the European session, facilitating active market participation
• Tokyo
  • Operates as the primary trading center in Asia, with a significant influence on the Japanese Yen and other Asian currencies
  • Experiences high trading volume during the Asian trading session (USD/JPY, AUD/JPY)
• Singapore and Hong Kong
  • Emerge as rapidly growing trading centers in the Asian region
  • Leverage their strategic geographic locations and accommodative financial regulations to attract forex market participants
• Continuous 24-hour market
  • Trading activity seamlessly transitions from one major center to another as the global business day progresses
  • Ensures consistent high liquidity and efficient price discovery throughout the 24-hour trading cycle