FOREX Market

FOREX market (FOReign EXchange Market) is the market where currency dealings through banks and other credit and financial institutions take place. The core of this market is money. Foreign exchange market provides the mechanism of money distribution and redistribution between lenders and borrowers with the help of intermediaries based on demand and supply. Its main function is the transformation of cash into loan funds. Also the dealings are made for currency rates speculations.

Lately, speculations in particular have been attracting more investors to this market.

Currency speculations are the deals of buying-selling one currency for different one with the aim of getting the speculation profit due to the rate difference. In currency speculation deals the parties, as a rule, buy and sell currency for a certain time period and one of them hopes for currency appreciation and the other one for devaluation of currency. At the end of the deal time period it is usually finished by the payment of the rate difference not the valid transfer of currency.

The main trade parties are the central and commercial banks of the country, major transnational companies and corporations, hedge and mutual funds, investment companies (brokers, dealers, company managers) and private traders.

The ratio of one currency to a different one is called a currency pair and defines its rate (the cost of one currency expressed in the money units of a different currency). For example, the ratio of euro (EUR) to US dollar (USD) is presented by the rate 1.3615 or EUR/USD – 1.3615. It means that one EUR costs 1.3615 USD.

The currency that means a unit of currency (EUR) is base currency, the other currency (USD) which defines the value of the base currency is called quoted currency. The currency rate is called the quote or the price of the currency pair.

The price of the currency pair changes in paragraphs. The minimum price change is 1 paragraph or 0.0001 of the quoted currency; it can also be 0.01 if the quoted currency is the national currency of Japan – Yen (JPY). If the price of a currency pair changes from 1.3615 to 1.3620, it means that the price increased by 5 paragraphs.

The price of the currency depends on demand and supply for the base currency. If most trade participants in a particular time period buy EUR for USD, then the demand for the base currency will increase and thus will lead to the price increase, the quotation of the currency pair will go up. If most trade participants sell EUR for USD, then the demand for the base currency will decrease due to increased supply and surely to price decrease, the quotation will go down.

In world practice, there are the cases when currency speculations take place in connection to trade operations and are carried out through the illegal import and further sale of the merchandise which prices in the exporting and importing countries substantially deviates from the general buying ability of the currencies of these countries. Gained this way, profit is used to pay the expenses in the countries where the merchandise was taken or for buying and exporting of the merchandise which prices are significantly higher abroad.

 In all the cases, the actions of the foreign exchange market trade participants with speculation operations lead to the increase of currency fluctuations relative to the trend, i.e. main tendency (movement direction) of rate change. The currency is bought by the trade participants when the exchange rate is at high level thus increasing the currency rate due to the increased rate as compared to trend. Respectively, the currency is sold to the participants when its price drops significantly, thus lowering the exchange rate even more drastically due to decreasing demand and increasing supply as compared to trend.

The idea of getting profit from speculations is to buy the base currency at a lower price and sell it later at a higher price, as well as to sell at a higher price and later buy at a lower price, where the price difference is the profit (appreciation). Any deal is presented by two transactions (buy + sell, where buy is opening transaction, and sell is closing transaction; sell + buyback, where sell is opening transaction, and buyback is closing transaction).

Buy/sell of base currency is carried out in amounts (lots). The minimum amount at currency tenders is 0.01 lot. 1 lot = 100,000 units of base currency. Opening transaction of Buy type of 1 lot of a pair EUR/USD is buying of 100,000 EUR with USD, if the pair quotation is 1.3615, then 1 lot costs 136,150 USD (1.3615*100,000). These numbers show that sufficient funds are needed for direct participation at currency tenders. That is why such financial intermediaries as brokers suggest using leverage (margin trading) for trade operations thus bringing trader's transactions directly onto the interbank market (FOREX market) to counterparty bank liquidity provider (bank through which the trader's transactions are carried out).

Leverage is the ratio of trader's cash to broker's credit, i.e. the leverage 1/100 allows carrying out the trade operations using 100 times smaller capital. To each 1 USD of the trader the broker gives 100 USD from their own reserve. Broker does not risk these funds, if trader's deposit is 10,000 USD, the trader can make trade transactions using 1,000,000 USD risking their funds only. The broker forcefully closes trader's transactions when the deposit balance is zero in order not to lose their loaned funds.

Let us say a trader is opening transaction buying 1 lot EUR/USD at the price 1.3615, i.e.

                       1 lot EUR costs 136,150 USD (100,000*1.3615).  

At the same time the sufficient deposit will be 100 times smaller than 136,150 USD since the leverage 1/100 is being used, i.e. 1,361.5 USD (136,150/100).

The price increases and reaches 1.3715, i.e. it has increased by 100 paragraphs, and now

                        1  lot EUR costs 137,150 USD (100,000*1.3715).

Closing transaction at this price means selling 1 lot bought earlier and getting the profit of 1,000 USD (137,150-136,150).

Having a deposit of 1,500 USD and using the leverage 1/100, it is possible to open transaction of 1 lot for the currency pair EUR/USD. If the price goes towards the opening of the transaction by 100 paragraphs, the profit will be 1,000 USD.

A broker's goal, when providing a trader with an opportunity to do the margin trading, is to put out a small trader's deposit onto the interbank market and get the difference between buy price (ASK) and sell price (BID) if the trader closes transaction with the positive outcome.

At foreign exchange market, there are always two prices for any currency pair. That is the essence of broker's job. The broker suggests that the trader buy base currency at a higher price and sell at a lower price. Let us say that the price for the currency pair EUR/USD is 1.3615, broker is ready to open transaction Sell at this price for trader. Accordingly, there is a price for the broker to open Buy transaction and at this moment it is a few paragraphs higher than Sell price. So price BID is 1.3615, price ASK is 1.3617. In this case the price difference is 2 points.

The difference between prices ASK and BID expressed in points is called spread. If a trader closes their transaction with profit, then the broker gets a spread. If a trader closes the transaction with loss, then spread stays at the interbank market, counterparty bank – liquidity provider.

Broker is directly interested in profitable traders' trading since they earn in this particular case.