The Foreign Exchange "Forex" Market and the Two Main Purposes of Trade - Part 2
In part 1 we looked at the global nature of the forex market and that many of us may engage in forex deals without really being conscious of it. We took a look at what makes the price spread on rates and how this can vary depending on who we are doing our deal with. We looked at the speculative trader who is seeking to make profits on market value changes and so loves volatile markets that give opportunity. We also looked at the other type of trader being primarily business and corporate entities. These traders seek risk reduced business transactions across countries and different currencies. In part 2 we take a closer look at the two types of deal and trader.
The depth of the forex market is truly astonishing with a staggering average daily turnover of 1 Trillion US Dollars, making it by far the largest financial market in the world.
The market opens in Sydney and then follows the start of the new business day to other centre openings such as Tokyo, London, New York.
The huge diversity of traders and players in the market, both in terms of background and deal size, makes for a truly exciting market. This can be a real conundrum for governments seeking to control their country's currency exchange level in the market through central bank intervention - not always successfully. This liquidity and volatility is perfect for forex traders who want to make profitable forex trades on exchange differences and also ideal for the many automated trading systems now being used by lay traders and professionals. Before the development of internet trading access for the general population in the 1990's, bank dealing rooms and large brokerage firms developed computerized trading models to reliably control speculative risk in trading and reduce the reliance on human brokers. The recent rush to access the forex market, using similar tools by lay traders, has seen the development of forex robot trading systems that are modifications or facsimiles of the systems used by the larger institutions. Many of these automated trading systems that are offered on the internet are light weight, poor quality and don't reliably deliver the profitable trades that are promised, but some of the systems do - if set up and used correctly.
Most forex robot trading models use mathematical algorithms and precise programming to make trades in a controlled manner. Some forex robots are designed to perform many trades delivering small gains over very short trade time windows such as one minute. They can be set to stay on 24 hours and trade the full time of the world market with no need of a human broker. Other automated forex systems are designed to use much longer trade time windows such as 4 hour. The point here is that the trading robots and automated systems vary in the designed method of the trading system but all are intended to isolate human emotion, greed and error by automatically delivering the bulk of the trades made as profits against a smaller number of loss trades, thus incrementally growing a profitable account. The added advantage of these automated trading systems is that they take away the need for thorough knowledge of the market and forecast systems that broker and dealers once had to know and rely on. Obviously, knowledge and understanding is a huge benefit when trading the market for profit, even using a forex robot to do it for you. With little or no knowledge, the consumer is still left with the decision of choosing a forex trading robot that works and setting it up correctly. Some forex robots do have problems in that the trading system design is not flexible and sophisticated enough to cope with unusual market conditions and hence can fail when the market changes. Other forex robot systems are more robust and sophisticated in their programming design and they are able to detect market conditions where trades, using their particular method and model, must be avoided.
At its simplest, for business, foreign exchange is essentially about exchanging one form of currency for another. Complexity occurs due to three factors. Firstly what is the foreign exchange exposure (how much and what currencies?), secondly what will be the rate of exchange, and thirdly when does the actual exchange occur. It is through trying to control these factors that a trader or customer seeks the best advantage in making a deal.
Foreign exchange exposures come about in many diverse situations. A traveler has the risk that if that country's currency appreciates against their own, their trip will be more expensive.
An exporter, who sells product in foreign currency, has the risk that if the value of that foreign currency falls then the earning and profit in the exporter's home currency will be lower.
An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate causing the local currency cost to be greater than expected and so reducing profit.
Fund Managers and companies who own foreign assets are exposed to falls in the currencies where they own the assets and so are exposed. The exposure affect would occur if they were to sell the foreign assets in a falling market thus their exchange rate would have a negative effect on the home currency value that they would realize.
Other foreign exchange exposures are less obvious and relate to the exporting and importing activities in your home country where the negotiated price is being effected by exchange rate movements. The consumer would see this in retail where prices may gradually change, rising or falling, according to exchange rate variation and the retailers effort to maintain the margin, or offer a discount with no impact on his margin factor.
The aim of foreign exchange risk management is to stabilize a business cash flow against exchange exposure and reduce uncertainty from financial forecasts. Fortunately there are a range of hedging instruments that achieve exactly that, and two forms of the market that enable these instruments to work for the business person. One form of the market gives an immediate or 2 day deal maturity exchange price (spot price market) the other form is the forward or future market that enables an exchange deal to be locked in, months in advance of the exchange taking place, but takes into account a forward adjustment rate on the spot rate at the time the deal is arranged. The forward adjustments rate allows for interest rate changes on a forward 'future' contract where a future settlement date is agreed for the deal. It is a bit like taking out a loan at a fixed rate.
These are all issues of concern for standard business between currency types where seeking a reliable, predictable or stable exchange rate is the major concern for business. This is needed so that profits from business activities, unrelated to exchange rate issues and disconnected from them, can be relied on in the home currency.
We can now understand that the speculator trader is not as concerned about stability but relies on market volatility and movement between currency pairs to create a profit making market environment and so opportunity occurs via a rising or falling value in one currency against another. The business and corporation looks for the opposite to stabilize budgets and deals.
Banks, traders and even governments, trading to profit from value changes between currency pairs, can effect the market and speculators may abhor flat stable markets; but the market is really a barometer measuring the value of one currency relative to another as determined by a many complex economic and political factors in each country.
So it is that the trader must still, through prediction, try to ride changes in currency values to make profitable trades. The trader does so using brokerage, online trading or online automated trading and employing forex robot tools, technical or fundamental forecasting methods. The business person, looking for stability and reduced risk in his currency trading, tries to reduce his exposure to value changes via hedging and forward contracts.
Thanks for reading and see you again for the next article.
Eric Bray
