Added for discussion
Foreign exchange market (FOREX)
The foreign exchange (currency or forex or FX) market
exists wherever one currency is traded for another. It
is by far the largest financial market in the world, and
includes trading between large banks, central banks,
currency speculators, multinational corporations,
governments, and other financial markets and
institutions. The average daily trade in the global
forex markets currently exceeds US$ 2 trillion. Retail
traders (individuals) are a small fraction of this
market and may only participate indirectly through
brokers or banks.
Financial markets
Unlike a stock market, where all participants have
access to the same prices, the forex market is divided
into levels of access. At the top is the inter-bank
market, which is made up of the largest investment
banking firms. Within the inter-bank market, spreads,
which are the difference between the bid and ask prices,
are razor sharp and usually unavailable, and not known
to players outside the inner circle. As you descend the
levels of access, the difference between the bid and ask
prices widens. This is due to volume. If a trader can
guarantee large numbers of transactions for large
amounts, they can demand a smaller difference between
the bid and ask price, which is referred to as a better
spread. The levels of access that make up the forex
market are determined by the size of the “line” (the
amount of money with which they are trading). The
top-tier inter-bank market accounts for 53% of all
transactions. After that there are usually smaller
investment banks, followed by large multi-national
corporations (which need to hedge risk and pay employees
in different countries), large hedge funds, and even
some of the retail forex market makers. According to
Galati and Melvin, “Pension funds, insurance companies,
mutual funds, and other institutional investors have
played an increasingly important role in financial
markets in general, and in FX markets in particular,
since the early 2000s.” (2004) In addition, he notes,
“Hedge funds have grown markedly over the 2001-2004
period in terms of both number and overall size” Central
banks also participate in the forex market to align
currencies to their economic needs.
Banks
The interbank market caters for both the majority of
commercial turnover and large amounts of speculative
trading every day. A large bank may trade billions of
dollars daily. Some of this trading is undertaken on
behalf of customers, but much is conducted by
proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large
amounts of business, facilitating interbank trading and
matching anonymous counterparts for small fees. Today,
however, much of this business has moved on to more
efficient electronic systems, such as EBS (now owned by
ICAP), Reuters Dealing 3000 Matching (D2), the Chicago
Mercantile Exchange, Bloomberg, and TradeBook(R). The
broker squawk box lets traders listen in on ongoing
interbank trading and is heard in most trading rooms,
but turnover is noticeably smaller than just a few years
ago.
Commercial companies
An important part of this market comes from the
financial activities of companies seeking foreign
exchange to pay for goods or services. Commercial
companies often trade fairly small amounts compared to
those of banks or speculators, and their trades often
have little short term impact on market rates.
Nevertheless, trade flows are an important factor in the
long-term direction of a currency's exchange rate. Some
multinational companies can have an unpredictable impact
when very large positions are covered due to exposures
that are not widely known by other market participants.
Central banks
National central banks play an important role in the
foreign exchange markets. They try to control the money
supply, inflation, and/or interest rates and often have
official or unofficial target rates for their
currencies. They can use their often substantial foreign
exchange reserves to stabilize the market. Milton
Friedman argued that the best stabilization strategy
would be for central banks to buy when the exchange rate
is too low, and to sell when the rate is too high — that
is, to trade for a profit based on their more precise
information. Nevertheless, the effectiveness of central
bank "stabilizing speculation" is doubtful because
central banks do not go bankrupt if they make large
losses, like other traders would, and there is no
convincing evidence that they do make a profit trading.
The mere expectation or rumor of central bank
intervention might be enough to stabilize a currency,
but aggressive intervention might be used several times
each year in countries with a dirty float currency
regime. Central banks do not always achieve their
objectives, however. The combined resources of the
market can easily overwhelm any central bank. Several
scenarios of this nature were seen in the 1992-93 ERM
collapse, and in more recent times in Southeast Asia.
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Investment management firms
Investment management firms (who typically manage large
accounts on behalf of customers such as pension funds
and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For
example, an investment manager with an international
equity portfolio will need to buy and sell foreign
currencies in the spot market in order to pay for
purchases of foreign equities. Since the forex
transactions are secondary to the actual investment
decision, they are not seen as speculative or aimed at
profit-maximization.
Some investment management firms also have more
speculative spe******t currency overlay operations,
which manage clients' currency exposures with the aim of
generating profits as well as limiting risk. Whilst the
number of this type of spe******t firms is quite small,
many have a large value of assets under management
(AUM), and hence can generate large trades.
Hedge funds
Hedge funds, such as George Soros's Quantum fund have
gained a reputation for aggressive currency speculation
since 1990. They control billions of dollars of equity
and may borrow billions more, and thus may overwhelm
intervention by central banks to support almost any
currency, if the economic fundamentals are in the hedge
funds' favor.
Retail forex brokers
Retail forex brokers or market makers handle a minute
fraction of the total volume of the foreign exchange
market. According to CNN, one retail broker estimates
retail volume at $25-50 billion daily, which is about 2%
of the whole market and it has been reported by the CFTC
website that unexperienced investors may become targets
of forex scams.
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