Introduction to the Foreign Exchange Market

The rationale behind this post is to break down the inner workings of the foreign exchange market and perhaps provide some enlightenment on the current situation, the forex market in general, the reason why we have and need forex brokers, and how forex brokers make their profit. More importantly, it aims to provide some understanding as to why we, as forex speculators, can and should, despite a very volatile market, continue to trade.

Rationale

Let’s start with a basic explanation of why the forex market came to be, and how it is used by its principal participants. We’ll continue the explanation into the structure of the market, and how it operates. In conclusion, we’ll look at the implications and how this affects speculators.


The forex market isn’t usually used as a medium for investments, unlike other markets, such as those that trade equity and bonds. While speculation plays a smaller, but nonetheless important role, the vast majority of forex trades are primarily made as a means to facilitate international business transactions.

An example might help to shed a little light on this. Let’s say you’ve got a guy in Detroit who decides he wants to buy a nice shiny new import. He’s got his eye on a Mitsubishi Eclipse and goes to the local Mitsubishi dealership, where he’ll naturally pay for his car with U.S. Dollars. That’s all well and good, but the Japanese workers in the Mitsubishi factory in Japan naturally want to get paid in their own currency, namely Japanese Yen. Somewhere along the line, the U.S. Dollar money from the car purchase has to be converted to Japanese Yen to pay those workers.

If you think about it, huge multi-nationals like Nestle, Exxon-Mobil, Microsoft, Honda, Sony, G-E and tens of thousands of other smaller global entities move nearly every single U.S. Dollar, Japanese Yen, Euro, Pound Sterling, Saudi Arabian Riyal, Brazilian Real and Russian Ruble plus dozens of other foreign currencies you’ve never even heard about, through the foreign exchange markets. In a single day, more than $2.3 trillion in foreign exchange is traded, and that figure is expected to rise to $3 trillion within two years time. It isn’t difficult to comprehend, then, how truly insignificant is the presence of the individual speculators.

The fact is, businesses don’t really care (much) about the variances and intricacies of the foreign exchange rates. They’re in the business to make a product, sell it and reap the profits.

A bank, as the central depository of a company’s cash, is naturally the facilitator of a company’s foreign exchange transactions. Decades ago, it was a matter of a simple telephone call from a banker in one country to another banker in a different country. Banks that had an international presence could merely do a branch to branch transfer.

Remember, banks are in the business to make money, just like any other business. So when a bank bought foreign currency at one price, they naturally added their margin to it before selling it to another customer. That margin is called the spread. For all intents and purposes, that was, and remains, a fairly reasonable cost.

From our earlier example, Mitsubishi gets Japanese Yen in payment for the Eclipse, and is now able to pay its workers who built the car. The car owner is happy, Mitsubishi is happy and the Mitsubishi factor workers are happy. The banks which facilitated the foreign exchange transaction are also happy, because they earned a tidy little profit (the spread) for handling the transaction, and for accepting the associated risks inherent with foreign exchange.

One of the consequences of transacting all this foreign exchange business is that bank traders soon developed an ability to speculate as to the direction of future currency rates. With a better grasp of how the market works, a bank could give a customer a quote adding a spread to the current rate but actually hold off or hedge until a better rate comes along. In so doing, the banks were able to dramatically increase their net income. One unfortunate end result, though, was that the method of redistributing the liquidity made it impossible to complete certain forex transactions.

For that reason alone, the foreign exchange market needed to be made available to non-bank participants. Naturally, the banks wanted to be able to execute more orders in the forex market which would allow them to profit from less experienced participants (who provided a better distribution of the liquidity) and which permitted them to execute their hedge orders from their international customers.