What is the global Forex market?

Today, the Forex market is a nonstop cash market where currencies of nations are  traded,  typically  via  brokers.  Foreign  currencies  are  continually  and simultaneously bought and sold across local and global markets.   The value of traders' investments increases or decreases based on currency movements. Foreign exchange market conditions can change at any time in response to real-time events.
The main attractions of short-term currency trading to private investors are:
    • 24-hour trading,  5 days a week with nonstop access  (24/7) to global
    Forex dealers.
•    An enormous liquid market, making it easy to trade most currencies.
•    Volatile markets offering profit opportunities.
•    Standard instruments for controlling risk exposure.
•    The ability to profit in rising as well as falling markets.
•    Leveraged trading with low margin requirements.
•    Many options for zero commission trading.

A brief history of the Forex market
The  following  is  an  overview  into  the  historical  evolution  of  the  foreign exchange market and the roots of the international currency trading, from the days  of  the  gold  exchange,  through  the  Bretton-Woods  Agreement,  to  its current manifestation.


The Gold exchange period and the Bretton-Woods Agreement
The Bretton-Woods Agreement, established in 1944, fixed national currencies against the US dollar, and set the dollar at a rate of USD 35 per ounce of gold. In 1967, a Chicago bank refused to make a loan in pound sterling to a college professor by the name of Milton Friedman, because he had intended to use the funds to short the British currency. The bank's refusal to grant the loan was due to the Bretton-Woods Agreement.
Bretton-Woods was aimed at establishing international monetary stability by
preventing money from taking flight across countries, thus curbing speculation
in  foreign  currencies.  Between  1876  and  World  War  I,  the  gold  exchange
standard had ruled over the international economic system. Under the gold

standard,  currencies  experienced  an  era  of  stability  because  they  were supported by the price of gold.
However, the gold standard had a weakness in that it tended to create boom-
bust economies. As an economy strengthened, it would import a great deal,
running down the gold reserves required to support its currency. As a result,
the money supply would diminish, interest rates would escalate and economic
activity  would  slow  to  the  point  of  recession.  Ultimately,  prices  of
commodities  would  hit  rock  bottom,  thus  appearing  attractive  to  other
nations, who would then sprint into a buying frenzy.   In turn, this would inject
the economy with gold until it increased its money supply, thus driving down
interest rates and restoring wealth. Such boom-bust patterns were common
throughout  the  era  of  the  gold  standard,  until  World  War  I  temporarily
discontinued trade flows and the free movement of gold.
The Bretton-Woods Agreement was founded after World War II, in order to
stabilize and regulate the international Forex market. Participating countries
agreed to try to maintain the value of their currency within a narrow margin
against the dollar and an equivalent rate of gold. The dollar gained a premium
position  as  a  reference  currency,  reflecting  the  shift  in  global  economic
dominance from Europe to the USA. Countries were prohibited from devaluing
their currencies to benefit export markets, and were only allowed to devalue
their currencies by less than  10%. Post-war construction during the  1950s,
however, required great volumes of Forex trading as masses of capital were
needed.   This had a destabilizing effect on the exchange rates established in
Bretton-Woods.
In     1971,  the  agreement  was  scrapped  when  the  US  dollar  ceased  to  be
exchangeable for gold. By  1973, the forces of supply and demand were in
control of the currencies of major industrialized nations, and currency now moved more freely across borders. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s.   New financial instruments, market deregulation and trade liberalization emerged, further stoking growth of Forex markets.
The explosion of computer technology that began in the  1980s accelerated the  pace  by  extending  the  market  continuum  for  cross-border  capital movements through Asian, European and American time zones. Transactions in foreign exchange increased rapidly from nearly  $70 billion a day in the 1980s, to more than $2 trillion a day two decades later.

The explosion of the euro market
The rapid development of the Eurodollar market, which can be defined as US dollars  deposited  in  banks  outside  the  US,  was  a  major  mechanism  for speeding up Forex trading. Similarly, Euro markets are those where currencies are deposited outside their country of origin. The Eurodollar market came into being in the 1950s as a result of the Soviet Union depositing US dollars earned from oil revenue outside the US, in fear of having these assets frozen by US regulators. This gave rise to a vast offshore pool of dollars outside the control of US authorities. The US government reacted by imposing laws to restrict dollar lending to foreigners. Euro markets were particularly attractive because they had far fewer regulations and offered higher yields. From the late  1980s onwards, US companies began to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing shortterm loans and financing imports and exports.
London  was  and  remains  the  principal  offshore  market.  In  the  1980s,  it became the key center in the Eurodollar market, when British banks began lending dollars as an alternative to pounds in order to maintain their leading position   in   global   finance.   London's   convenient   geographical   location (operating  during  Asian  and  American  markets)  is  also  instrumental  in preserving its dominance in the Euro market.


Euro-Dollar currency exchange
The euro to US dollar exchange rate is the price at which the world demand
for US dollars equals the world supply of euros. Regardless of geographical
origin, a rise in the world demand for euros leads to an appreciation of the
euro.
Factors affecting the Euro to US dollar exchange rate
Four factors are identified as fundamental determinants of the real euro to US dollar exchange rate:
•    The international real interest rate differential between the Federal
    Reserve and European Central Bank
•    Relative prices in the traded and non-traded goods sectors
•    The real oil price
•    The relative fiscal position of the US and Euro zone
The nominal bilateral US dollar to euro exchange is the exchange rate that
attracts the most attention. Notwithstanding the comparative importance of

bilateral trade links with the US, trade with the UK is, to some extent, more important for the euro.
The following chart illustrates the EUR/USD exchange rate over time, from
the  inauguration  of  the  euro,  until  mid 2006.  Note  that  each  line (the
EUR/USD,  USD/EUR)  is  a     “mirror”  image  of  the  other,  since  both  are
reciprocal to one another. This chart is illustrates the steady (general) decline
of the USD  (in terms of euro) from the beginning of  2002 until the end of
2004.

In  the  long  run,  the  correlation  between  the  bilateral  US  dollar  to  euro
exchange  rate,  and  different  measures  of  the  effective  exchange  rate  of
Euroland, has been rather high, especially when one looks at the effective
real exchange rate. As inflation is at very similar levels in the US and the Euro
area,  there  is  no  need  to  adjust  the  US  dollar  to  euro  rate  for  inflation
differentials.   However, because the Euro zone also trades intensively with
countries  that  have  relatively  high  inflation  rates (e.g.  some  countries  in
Central and Eastern Europe, Turkey, etc.), it is more important to downplay nominal  exchange  rate  measures  by  looking  at  relative  price  and  cost developments.

The fall of the US dollar
The steady and orderly decline of the US dollar from early 2002 to early 2004
against the euro, Australian dollar, Canadian dollar and a few other currencies
(i.e. its trade-weighted average, which is what counts for purposes of trade
adjustment), while significant, has still only amounted to about 20 percent.
There are two reasons why concerns about a free fall of the US dollar may not be worth considering. Firstly, the US external deficit will stay high only if US growth remains vigorous, and if the US continues to grow strongly, it will also retain a strong attraction for foreign capital which, in turn, should support the US dollar. Secondly, attempts by the monetary authorities in Asia to keep their currencies weak will probably not work in the long run.

The basic theories underlying the US dollar to euro exchange rate
Law of One Price: In competitive markets, free of transportation cost barriers to trade, identical products sold in different countries must sell at the same price when the prices are stated in terms of the same currency.
Interest  rate  effects:  If  capital  is  allowed  to  flow  freely,  exchange  rates become stable at a point where equality of interest is established.


The dual forces of supply and demand
These two reciprocal forces determine euro vs. US dollar exchange rates.
Various factors affect these two forces, which in turn affect the exchange
rates:
The  business  environment:  Positive  indications     (in  terms  of  government
policy, competitive advantages, market size, etc.) increase the demand for
the currency, as more and more enterprises want to invest in its place of
origin.
Stock  market:  The  major  stock  indices  also  have  a  correlation  with  the currency  rates,  providing  a  daily  read  of  the  mood  of  the  business environment.

Political factors: All exchange rates are susceptible to political instability and anticipation  about  new  governments.  For  example,  political  instability  in Russia  is  also  a  flag  for  the  euro  to  US  dollar  exchange,  because  of  the substantial amount of German investment in Russia.
Economic data: Economic data such as labor reports (payrolls, unemployment
rate  and  average  hourly  earnings),  consumer  price  indices  (CPI),  producer
price  indices (PPI),  gross  domestic  product (GDP),  international  trade,
productivity,  industrial  production,  consumer  confidence  etc.,  also  affect currency exchange rates.
Confidence in a currency is the greatest determinant of the real euro to US dollar  exchange  rate.  Decisions  are  made  based  on  expected  future developments that may affect the currency.


Types of exchange rate systems
An  exchange  can  operate  under  one  of  four  main  types  of  exchange  rate systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making.   Interest rates are set to meet the target exchange rate.
Free floating
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate.
The definition of a floating exchange rate system is a monetary system in which  exchange  rates  are  allowed  to  move  due  to  market  forces  without intervention by national governments.    The Bank of England, for example, does  not  actively  intervene  in  the  currency  markets  to  achieve  a  desired exchange rate level.
With floating exchange rates, changes in market supply and demand cause a
currency to change in value. Pure free floating exchange rates are rare - most

governments at one time or another seek to  “manage” the value of their currency through changes in interest rates and other means of controls.
Managed floating exchange rates
Most governments engage in managed floating systems, if not part of a fixed exchange rate system.


The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under normal circumstances, there is less speculative activity - though this depends on  whether  dealers  in  foreign  exchange  markets  regard  a  given  fixed exchange rate as appropriate and credible.
The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. A second key advantage of floating exchange rates is that it allows the government/monetary authority flexibility in determining interest rates as they do not need to be used to influence the exchange rate.

Who are the participants in today’s Forex market?
In general, there are two main groups in the Forex marketplace:
Hedgers  account  for  less  than  5%  of  the  market,  but  are  the  key  reason futures and other such financial instruments exist.    The group using these hedging tools is primarily businesses and other organizations participating in international trade.    Their goal is to diminish or neutralize the impact of currency fluctuations.
Speculators account for more than 95% of the market.
This  group  includes  private  individuals  and  corporations,  public  entities,
banks, etc. They participate in the Forex market in order to create profit,
taking advantage of the fluctuations of interest rates and exchange rates.

The activity of this group is responsible for the high liquidity of the Forex market. They conduct their trading by using leveraged investing, making it a financially efficient source for earning.

Market making
Since most Forex deals are made by (individual and organizational) traders, in conjunction with market makers, it’s important to understand the role of the market maker in the Forex industry.

Questions and answers about 'market making'

What is a market maker?
A market maker is the counterpart to the client. The Market Maker does not operate as an intermediary or trustee. A Market Maker performs the hedging of  its  clients'  positions  according  to  its  policy,  which  includes  offsetting various clients' positions, and hedging via liquidity providers  (banks) and its equity capital, at its discretion.

Who are the market makers in the Forex industry?
Banks, for example, or trading platforms (such as Easy-Forex™), who buy and
sell   financial   instruments “make   the   market”.   That   is   contrary   to
intermediaries, which represent clients, basing their income on commission.

Do market makers go against a client's position?
By definition, a market maker is the counterpart to all its clients' positions, and always offers a two-sided quote  (two rates: BUY and SELL). Therefore, there  is  nothing  personal  between  the  market  maker  and  the  customer. Generally, market makers regard all of  the  positions  of  their  clients  as  a whole. They offset between clients' opposite positions, and hedge their net exposure according to their risk management policies and the guidelines of regulatory authorities.

Do market makers and clients have a conflict of interest?
Market makers are not intermediaries, portfolio managers, or advisors, who
represent customers (while earning commission).   Instead, they buy and sell
currencies to the customer, in this case the trader. By definition, the market
maker always provides a two-sided quote  (the sell and the buy price), and
thus is indifferent in regards to the intention of the trader.   Banks do that, as
do  merchants  in  the  markets,  who  both  buy  from,  and  sell  to,  their

customers.  The  relationship  between  the  trader     (the  customer)  and  the
market maker  (the bank; the trading platform; Easy-Forex™; etc.) is simply based on the fundamental market forces of supply and demand.

Can a market maker influence market prices against a client’s position?
Definitely not, because the Forex market is the nearest thing to a “perfect
market”  (as defined by economic theory) in which no single participant is
powerful enough to push prices in a specific direction. This is the biggest
market in the world today, with daily volumes reaching 3 trillion dollars.   No
market maker is in a position to effectively manipulate the market.

What is the main source of earnings for Forex market makers?
The major source of earnings for market makers is the spread between the bid and  the  ask  prices.  Easy-Forex™  Trading  Platform,  for  instance,  maintains neutrality regarding the direction of any or all deals made by its traders; it earns its income from the spread.

How do market makers manage their exposure?
The way most market makers hedge their exposure is to hedge in bulk. They aggregate all client positions and pass some, or all, of their net risk to their liquidity  providers.  Easy-Forex™,  for  example,  hedges  its  exposure  in  this fashion,   in   accordance   with   its   risk   management   policy   and   legal requirements.