Financial markets are, by and large, very similar in nature to any other market for goods and services. However, unlike the markets for things like clothing or smartphones, financial markets revolve around the exchange of instruments, products and securities. The absence of financial markets would result in the inefficient allocation of capital, in addition to significantly decreased economic activity in the forms of commerce, trade, and investments!
There exist a plethora of financial markets, together extensively covering every avenue of economic activity. Conventionally, there are four types of markets. First, there is the stock market, in which stocks of companies can be bought and sold. Then, there is the derivatives market, which is composed of financial instruments like futures contracts and options. That is followed by the commodity market, which includes houses and the buying and selling of raw products like oil and gold. Finally, the bond market allows for the purchase and sale of bonds from companies and the government.
All told, however, there is one financial market that stands apart from the rest. This would be the foreign exchange market - a decentralized financial market that is open for trade 24 hours a day Monday to Friday and is the largest financial market in the world. Indeed, this week’s edition of Finance from A to Z will dive into detail about the intricacies of the foreign exchange market!
F is for Forex:
The foreign exchange market, otherwise known as Forex or FX, is an international marketplace for the exchange of national currencies. When this exchange occurs, an exchange rate is enforced where there is a price to be paid when one currency is exchanged for another. Additionally, forex trading is conducted over the counter while being monitored by a global network of banks and financial institutions.
Of the 180 distinct official currencies currently in circulation across the globe, there are only a few in which the majority of forex trades and payments are made. In order of descending popularity, these currencies are the U.S dollar, the euro, the Japanese yen, the British pound, the Australian dollar and the Canadian dollar.
How exactly, then, are currencies traded?
All of the aforementioned currencies are assigned a three-letter code. For example, the U.S. dollar is USD whilst the British pound is GBP. When they are traded for one another, they are assigned a currency pair which would look something like this: GBP/USD. The currency on the left is known as the base currency, which gets traded for the currency on the right - known as the quote currency. It is important to note, however, that this ordering is not absolute, and there do exist some exceptions to the rule. Nevertheless, this ordering is the typical convention.
The forex market is largely driven by the supply and demand of sellers and buyers for particular currencies. The factors that affect the demand for some currencies over others determine why one currency may become more desirable than another. Such factors are generally macro in nature and include the respective interest rates, monetary policy, political climate and economic growth of a currency’s home. Indeed, for this reason, much of forex trading is based on speculation and hedging. Those who trade forex are purchasing currencies they believe will rise relative to others and they sell currencies they believe will decrease.
As with any financial market, there are risks associated with participating in the foreign exchange market. Principally, forex trading necessitates the use of leverage, which can either significantly enhance earnings or create catastrophic losses exceeding the amount one had originally borrowed. Given that the value of all currencies are in constant fluctuation and thereby require very large trades to make a positive return, the use of leverage in terms of forex is a high risk, high reward activity. Therefore, it is exceedingly important to exercise caution and be fully informed about the potential consequences of forex trading despite the allure of profit.
That's all for this week, folks.
Share your thoughts in the comments below and see you in the next edition!