Understanding the FOREX Market

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What are currency rates and why do they exist

When an American owned Toyota dealership in the United States buys cars from the manufacturer – Toyota, Japan the price is in Japanese Yen. The American dealership checks the current exchange rate of U.S. dollars for Japanese Yen and figures out how many U.S. dollars each car will cost. If the dealer chooses to do so he can call a Bank and enter into a foreign exchange contract. The Bank will give him the Japanese Yen he needs to buy the cars and in exchange the dealer will give the Bank the U.S. dollars. The number of Yen the dealer receives for those U.S. dollars is the exchange rate. For example, if the dealer received 112,000,000 yen for $1,000,000; the exchange rate would be 112.00 (112,000,000 Yen/ $1,000,000).

To do this identical transaction on the FXCM platform, the dealer would wait until the quoted price was 112 00-04. The dealer would sell 100 lots at 112.00; thereby selling U.S. dollars and buying Japanese Yen. We refer to this as selling USDJPY.

Without a reference exchange rate that the dealer could rely on and be able to transact at, he could not do business with Toyota, Japan. Foreign exchange rates therefore exist to facilitate trade between different countries that use different monies.

History and evolution of foreign exchange rates

From 1944 to 1971 the world operated under a system of fixed exchange rates. The U.S. dollar was convertible into gold at a set rate and all the countries fixed their currencies to the U.S. dollar at a set rate. There was no need for a foreign exchange market.
On August 15, 1971 all that changed. President Nixon announced that the U.S. dollar could no longer be cashed in for gold. In 1973 the U.S. formally announced the permanent floating of the U.S. dollar thereby officially ending the system of fixed exchange rates.

Exchanges rates between different countries began to fluctuate widely; creating the need for a foreign exchange market where exporters and importers could lock in rates; clearly a prerequisite for doing business. Simply put, an American Hondo dealer is quoted a price per car in Japanese Yen from Honda, Japan. If the dealer could call a Bank and get a current dealable price for USDJPY, then the dealer would know for sure how much those cars were costing him and whether or not he could sell them profitably in his dealership.

And this is exactly what began happening. U.S. importers bought their Yen when they signed a contract to buy Hondos; then they left the Yen in the Bank earning interest until contract payment date. It didn’t take long for the Banks to figure out they could provide value added service by quoting the importer a price for the contract date. The Bank did this by simply starting with the current rate and adjusting the current rate to account for the net interest earned or paid from trade date to contract date. This became known as the forward rate.

History and evolution of the foreign exchange market

Because there was no central marketplace for transacting foreign exchange in the early 1970s, exporters and importers could not accurately track daily movements in the currencies. In fact, they had no prior experience with floating exchange rates and therefore no in-house expertise. They were at the mercy of the moneychangers, the Banks. Overnight foreign exchange became a huge source of bottom revenue to the banking industry.

To offset the risks of holding currency positions taken as a result of customer transactions, the major banks entered into informal reciprocal agreements to quote each other throughout the day on preset amounts. It was understood that a certain maximum spread would be upheld, except under extreme conditions. It was further agreed that the rate would be supplied in a reasonable amount of time. Generally this meant the FX dealer made the price within seconds, and therefore without calling another bank for a second opinion. This was called direct dealing and all the major banks participated.

In the beginning, banks were quoting customers one-way prices. The customer would say where could I sell $10M USDJPY and the bank set a rate. The bank left itself plenty of room for error, oftentimes quoting as much as 50 points below the current market. This was a bonanza for the banks. However, a lot of money was lost when other banks called for a rate.

Description and evolution of the FX brokers

The first foreign exchange brokers came on the scene in the mid 1970s to satisfy the demand for continuous price quotes in the major currencies from the thousands of medium and small banks with significant customer foreign exchange business to offset. These banks were unwilling to be in the direct market because providing competitive rates to the large banks was costing them more money then they were making from their customers.

Initially the foreign exchange brokers installed direct lines to all the banks willing to participate. Generally a major bank made a rate and the brokers showed the rate to all the banks at about the same time. The first bank to deal on the rate completed a transaction. The others waited for the next rate. Any bank could make a rate; show a bid or an offer. Soon the brokers became quite efficient at putting together a continuous two-way price.

Reuters introduced a web based dealing system for banks 1992, followed by a similar web based system introduced by EBS (Electronic Brokerage System) for banks in 1993; although it took some time, by 1996 it was clear the voice broker was being replaced by the electronic broker.

Around the same time web based dealing systems that corporations could use in lieu of calling banks on the phone began to appear. Followed by the first web based dealing systems for individuals. Today there are hundreds of online FX brokers fighting for the business of the small trader or investor. Some are good; some are not (more on this later).

The movers and the shakers in the FX market

It is widely understood that day traders in the aggregate do not move the currency market much. They buy and sell and at the end of the day they have no net long or short position. Therefore they have not changed the demand/supply equilibrium and accordingly have not in the aggregate had a lasting effect on the price of a currency.

What moves the currency market is the other time frame; central banks, hedge funds, financial institutions, and corporations. These guys buy or sell huge amounts and their time frame is generally weeks to months, possibly years. Their transactions unbalance the market, requiring price adjustment to rebalance demand and supply.

Furthermore, changing fundamentals or longer-term technicals generally triggers the actions of the other time frame. Their affect on the price is therefore two-fold; in addition to causing a demand/supply imbalance, their actions generally reflect a price change that may have needed to occur even if they did not get the ball rolling through large transactions.

Evidence that this is so can be found in the unusually large price moves that often occur after significant scheduled economic news releases. Oftentimes the move is much greater than what would appear necessary given the deviation of the expected versus actual number (more on this later).