Forex Trading and How It Works

Effect on the Dollar and the U.S. Economy

Forex trading is a $5.3 trillion a day business.

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Foreign exchange trading (forex trading) is an international market for buying and selling currencies. At $6.6 trillion, it is 25 times larger than all the world's stock markets.

Forex trading dictates the exchange rates for all flexible-rate currencies. As a result, rates change constantly for the currencies that Americans are most likely to use. These include Mexican pesos, Canadian dollars, European euros, British pounds, and Japanese yen. 

Key Takeaways

  • Foreign exchange trading (forex trading) is an international market for buying and selling currencies.
  • There are four ways to engage in forex trading: spot contracts, swaps, forward trades, and options.
  • Forex trading affects the dollar's value directly; when traders demand a higher price for the dollar, its value rises.

How Forex Works

The foreign exchange market is primarily over-the-counter (OTC.) It occurs either via electronic platforms or on the phone between banks and other participants. Only 3% of trades, mostly futures and options, is done on exchanges.

All currency trades are done in pairs. When you sell your currency, you receive the payment in a different currency.

Every traveler who has gotten foreign currency has done forex trading. For example, when you go on vacation to Europe, you exchange dollars for euros at the going rate. You sell U.S. dollars and buy euros. When you come back, you sell euros and buy U.S. dollars.

Types of Trades

There are four ways to engage in forex trading: spot contracts, swaps, forward trades, and options. Half of all trades done are swaps, while 30% are spot trades. Another 15% are forward contracts, while only 5% are options.

Foreign Exchange Turnover April 2019
Type Amount Percent
Swaps $3.31  50%
Spot $1.99  30%
Forwards $0.99  15%
Options $0.29    5%
Total $6.59 100%

These are the types of trades done by banks, corporate treasurers, or finance specialists. Each has its own favorite type of trade.

Spot Transactions

The most familiar type of forex trading is spot trading. It's a simple purchase of one currency using another currency. You usually receive the foreign currency immediately. 

Spot transactions are similar to exchanging currency for a trip abroad.

Spots are contracts between the trader and the market maker, or dealer. The trader buys a particular currency at the buy price from the market maker and sells a different currency at the selling price. The buy price is somewhat higher than the selling price. The difference between the two is called the spread. This is the transaction cost to the trader, which in turn is the profit earned by the market maker.

You paid this spread without realizing it when you exchanged your dollars for foreign currency. You would notice it if you made the transaction, canceled your trip, and then tried to exchange the currency back to dollars right away. You wouldn't get the same amount of dollars back.

Foreign Exchange Swaps

Half of all currency trades are foreign exchange swaps. Two parties agree to borrow currencies from each other at the spot rate. They agree to swap the currencies back on a certain date at the future rate. Most swaps are short-maturity, between one to seven days.

Central banks use swaps to keep foreign currencies available for their member banks.

The banks use it for overnight and short-term lending only. Most swap lines are bilateral, which means they are only between two countries' banks. Importers, exporters, and traders also engage in swaps.

Forward Trades

Many businesses purchase forward trades. It's like a spot trade, except the exchange occurs in the future. You pay a small fee to guarantee that you will receive an agreed-upon rate at some point in the future. Most forward trades are between seven days and three months.

A forward trade hedges companies from currency risk. It protects them from the risk that their currency’s value will rise by the time they need it.

A short sale is a type of forward trade in which you sell the foreign currency first. You do this by borrowing it from the dealer. You promise to buy it in the future at an agreed-upon price. You do this when you think the currency's value will fall in the future.

Businesses short a currency to protect themselves from risk. But shorting is very risky. If the currency rises in value, you have to buy it from the dealer at that price. It has the same pros and cons as short-selling stocks.

FX Options

Foreign exchange options give you the right to buy foreign currency at an agreed-upon date and price. Unlike a forward contract, you are not obligated to buy it. Like insurance, your only cost is the premium paid to purchase the option.

Multinational corporations are most likely to use options. They can protect themselves from sudden currency volatility at a low cost.

Forex Trading Is Growing

The Bank for International Settlements surveys average daily forex trading every three years. In April 2019, it was $6.6 trillion. Trading was up significantly from the $5.1 trillion traded in April 2016. It also surpassed the prior record of $5.4 trillion traded in 2013.

Forex trading kept growing right through the 2008 financial crisis. In 2007, the pre-recession high was $3.3 trillion traded per day. By 2010, $3.97 trillion was traded per day.

The Most Traded Currencies

In April 2019, 88% of trades were between the U.S. dollar and other currencies. The dollar is involved because it is the world's reserve currency. Most international transactions are paid in dollars.

The euro is next at 32%, a slight rise from 2016. The yen carry trade came in third in 2019, at 17%. The chart below shows the top eight currencies and their percentages of global currency trades. The percentages add up to 200%, due to being traded in pairs.

Currency % of World Trade
USD (U.S. Dollar) 88
EUR (Euro) 32
JPY (Yen) 17
GBP (Pound) 13
AUD (Australian Dollar)   7
CHF (Swiss Franc)   5
CAD (Canadian Dollar)   5
CNY (Chinese Yuan)   4
Other 25

The Biggest Forex Traders

Central banks and large private banks are the biggest traders, accounting for 38% of daily turnover. Forex trade is a primary source of revenue for banks. Smaller regional banks are the next largest, at 13% of total trades. They are more likely to use forex swaps.

Corporations engage in 7% of total trades. Multinationals must trade foreign currencies to protect the value of their sales to other countries. Otherwise, if a particular country's currency value declines, the sales will too. Forex trades protect them against this loss.

Pension funds and insurance companies are responsible for another 6.6% of the total turnover.

Hedge funds and proprietary trading firms engage in 5% of forex trade. They are more likely to use forwards. Although they represent a smaller proportion, their trading is increasing for the same reason as the banks.

The Effect on the Dollar's Value

Forex trading affects the dollar's value directly. When traders demand a higher price for the dollar, its value rises. This often happens when other countries are perceived as a greater risk. The dollar becomes a safe haven currency if it seems the value of foreign currencies will decline.

The dollar also increases in value when interest rates rise in the United States. Traders who have dollars could make more money putting their money in the banks and receiving higher rates. As a result, they charge more for dollars when trading them for foreign currency.

Forex's Effect on an Economy

strong dollar makes U.S. exports less competitive. Their goods will seem expensive for foreigners. For that reason, a strong dollar can slow economic growth.

Another effect is the decline of the stock market. Foreigners will think U.S. stocks are more expensive compared to local stocks when the dollar is strong.

On the other hand, imports will be cheaper. This will lower the cost of most consumer goods, since so much is imported. Inflation is less of a threat as prices come down.

The most important import is oil, which is priced in U.S. dollars. A strong dollar allows oil-producing countries to reduce the price of oil.

If you're traveling overseas to another country that uses a different currency, you must plan for changing exchange rate values. When the U.S. dollar is strong, you can buy more foreign currency and enjoy a more affordable trip. If the U.S. dollar is weak, your trip will cost more because you can't buy as much foreign currency. 

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