Pages

What is the global Forex market?

2:13 PM | , , , , ,

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 investment 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 marketi 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  US 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 boombust 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 naions, 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 throught Asian, European and American time zones.  Transactions in foreign exchange increased rapidly from nearly $70 bilion a day in the 1980s , to more than $3 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 dposited 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 bagan to borrow offshore, finding Euro markets an advantageous place for holding excess liquidity, providing short term 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 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.

EUR-USD rates 1998-2008

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 hight, 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 importand to downplay nominal exchange rate measures by looking at relative price and cost developments.