Who is Market Participants

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 (from 0-1 pip to 1-2 pips only for major currencies like the Euro). 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.

According to the Bank of International Settlement (BIS) study Triennial Central Bank Survey 2004

• 53% of the transactions were interbank or interdealer strictly
• 33% of the transactions dealt with a fund manager or an kind of financial institution not associated with banks and a dealer (like bank for instance).
• 14% were held between non financial organizations and dealers.

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market.

Central Banks

There are two main reasons why a central bank would participate in the forex market which are:

1. To fix the value of its currency to a particular level: Unlike the main currencies which we are going to be focusing on in this course, the currencies of many developing countries are fixed in value to the dollar or to some other currency or basket of currencies. This is done to try and promote international competitiveness in the market and a currency environment that is more conducive to economic stability.
   
   Probably the most talked about example of a country that does this is China who up until recently maintained a fixed value of their currency against the US Dollar. A central bank normally accomplishes this by buying their own currency when the value gets too weak creating more demand for the currency and therefore driving the value up, and selling their own currency when it gets to strong creating a greater supply of that currency and therefore lowering its value back to the desired level.
    
2. To protect the value of a floating currency from extreme movements: Unlike China and many other developing economies in the world, the US, The Euro Zone, Japan and the other major economies of the world have what is known as a floating exchange rate. Very simply what this means is that instead of having the value of the currency pegged to something else which therefore determines its value, the value of the currency is determined by market forces.

Although the values of these currencies float freely in the market most of the time, as a currency’s strength or weakness in the market has such a dramatic affect on a country’s international competitiveness, there are rare instances where a central bank will intervene in the market even with the major currencies. Normally this is only seen after large one directional moves in the market over a long period of time, to the point where the country’s stability or competitiveness is being severely damaged. As Japan’s economy relies heavily on exports the most notorious central bank for interventions is the Bank of Japan, however both the European Central Bank and the Federal Reserve have intervened in the currency markets in the pasts.

While some interventions have limited affect on exchange rates others, as you can see from the chart here of a past Bank of Japan intervention, can have a dramatic affect on the market.

Because of this often times a central bank can do what is termed a verbal intervention, where simply the talk of intervention is enough to have the desired affect on the market.

Banks and Other Financial Institutions

In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

Hedge Funds

Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators

Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company.

Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. Either way, speculators can have a big sway on the currency markets, particularly big ones.

Brokers

What a Forex Broker does? Brokers provide access to the FX market to individual traders. Typically banks and hedge funds have direct access to the market as they are a part of the market.

A broker will provide account keeping services, execute trades and usually provides some software to place orders and allow you to look at current prices and charts.

Brokers earn their profit by charging a spread. This is a difference between the buying and selling price. For example to buy EUR/USD, the price may be quoted 15/19, which means that the broker makes a spread of 4 basis points per trade. A trade is either buying or selling a foreign currency position.

Now that you have a basic understanding of the forex market, its participants and its history, we can move on to some of the more advanced concepts that will bring you closer to being able to trade within this massive market. The next section will look at the main economic theories that underlie the forex market.

Lastly are individuals such as you and I who participate in the forex market in three main areas.

1. As Investors Seeking Yield: Although not very popular in the United States, overseas and particularly in Japan where interest rates have been close to zero for many years, individuals will buy the currencies or other assets of a country with a higher interest rate in order to earn a higher rate of return on their money. This is also referred to as a carry trade, something that we will learn more about in later lessons.
    
2. As Travelers: Obviously when traveling to a country which has a different currency individual travelers must exchange their home currency for the currency of the country where they are traveling.
    
3. Individual speculators who actively trade currencies trying to profit from the fluctuation of one currency against another. This is as we discussed in our last lesson a relatively new phenomenon but most likely the reason why you are watching this video and therefore a growing one.

Individual traders are increasingly active in the FX markets. This is driven by the ready access to the market through the Internet and the opportunities available to earn significant profits with a relatively low capital investment.

These factors are a disadvantage, but the advantage is that the individual trader can choose whether to participate in the market at any given point in time. Professional traders are pretty much obliged to trade all the time by the nature of their jobs which means that they may not be able to be as selective about the trades that they enter.