Invest Finance

All about Forex

28.03.2024

3 min

History, participants, trading principles

Forex, short for “foreign exchange,” is the global marketplace where currencies are traded. It’s the largest and most liquid financial market in the world, with trillions of dollars in transactions occurring daily. Unlike other financial markets, the forex market has no centralized exchange; it operates 24 hours a day through a network of banks, corporations, and individuals trading currencies electronically around the world.

History of Forex

The history of the market began in 1971 when US President Richard Nixon announced the termination of the US dollar backing with gold. All this pushed the Bretton Woods monetary system to the final collapse and led to the possibility of free change in exchange rates. Thus began the era of the Forex market, which today is the largest financial market in the world with a turnover of more than 5 trillion US dollars per day. For comparison, on the NYSE, the average daily turnover is $22.5 billion, and on the London Stock Exchange, the average daily turnover exceeds $7 billion.

Market Participants

Until 1993, trading in this market took place exclusively between banks. That year, a consortium of the largest banks in the world, together with the company KUATRON, developed and implemented an automated system for currency dealing, which made it possible to create a worldwide network of currency trading. Today, this network unites the 13 largest banks in the world. about 900 banks from various parts of the world and about 3,000 dealing companies.

In general, the participants in the trading of the foreign exchange market are:

Commercial banks
Foreign trade firms
Investment companies and funds
Central banks.
Brokerage companies
And of course individual traders.

Trading principle

Trading in this market is conducted, of course, in currencies, but not only. There are many other interesting instruments, such as oil, gold, stocks, stock indices, and cryptocurrencies. The main feature of this market is that when you buy or sell any of these financial instruments, you do not receive them physically. Well, as if when buying a ton of oil, it would be brought to you at the door. No, it doesn’t work that way here. In this market, you do not buy an asset directly but enter into an instant contract with a broker for the difference in the price of this asset (the so-called CFD contract). Under this contract, the broker allocates you a certain amount of credit, and you only give a temporary deposit, which is 10, 100 or even 500 times less than the amount of the contract. When you close the deal, the loan is automatically returned to the broker, you release your collateral, and the financial result from your deal is added to or subtracted from the amount of your total deposit.

Currency pairs: types, quotes

In Forex trading, a currency pair is a quotation of two different currencies, with the value of one currency being quoted against the other. The first listed currency is called the base currency, and the second currency is called the quote currency. For example, in the currency pair EUR/USD, the EUR is the base currency and the USD is the quote currency. This indicates how many U.S. dollars (the quote currency) are needed to purchase one euro (the base currency)

Here are some common currency pairs:

EUR/USD: Euro/U.S. dollar
USD/JPY: U.S. dollar/Japanese yen
GBP/USD: British pound/U.S. dollar
USD/CHF: U.S. dollar/Swiss franc
AUD/USD: Australian dollar/U.S. dollar
NZD/USD: New Zealand dollar/U.S. dollar

They are also called “Majors. Major pairs are usually the most actively traded on the market, which means that they are the most liquid, so brokers may offer lower spreads for them.

In addition to “majors,” you may also hear traders discussing trades in minors, also called cross rates, as well as trading in “exotics.” Minors, or cross rates, are currency pairs not quoted with the U.S. dollar. These slightly less popular pairs often experience larger fluctuations due to less liquidity, and therefore their spreads will often be wider than those of the majors.

A couple of examples of minor currency pairs you see now.

GBP / JPY (British Pound / Japanese Yen)
EUR / GBP (Euro / British Pound)

Finally, sometimes you may see some minors, which are also called Exotics. This means that they are currency pairs that contain currencies from developing countries, such as the Turkish Lira, the Singapore dollar, or the Mexican peso.

Here are some examples of such currency pairs.

EUR / TRY (EUR/Turkish Lira)
EUR / MXN (euro/Mexican peso)

A quote is the value or price of a currency pair at a particular point in time. A quote always has two price values, depending on whether you’re buying or selling the financial instrument.

Here is an example. The currency pair is GBP/USD and the quote is 1.3089-1.3091. So here it shows how much of the quote currency (in this case the US dollar) is needed to buy 1 unit of the base currency, namely the British pound.
In this example, 1 pound can be bought for 1.3091 US dollars.

Direct quote – displays the amount of national currency for one unit of foreign currency. For example, a direct quote for the Swiss franc looks like this

U.S. dollar to Swiss franc (USD/CHF

The same for the Japanese Yen and Canadian Dollar

US Dollar Japanese Yen (USD/JPY)
US Dollar Canadian Dollar (USD/CAD)

The first currency will be the base one and the second one will be quoted. We can see that in all direct quotes the US dollar is first – in fact, this is how you define whether it is a direct or an indirect quote.

Point (pip), Spread, types of spread

Point (pip)

In Forex trading, a pip stands for “percentage in point” or “price interest point” and represents the smallest price move that a currency pair can make. A pip is typically the fourth decimal place in most currency pairs. For example, if the EUR/USD pair moves from 1.1050 to 1.1051, that 0.0001 USD change is one pip.For pairs involving the Japanese yen, a pip is the second decimal place, since these pairs are quoted only to two decimal places. The value of a pip varies depending on the currency pair and the size of the trade. It’s a crucial concept in Forex as it helps traders manage risk and calculate potential profits and losses.

Spread

It is the difference between the bid (sell) price and the ask (buy) price of a currency pair. It represents the broker’s fee for executing a trade and is usually measured in pips, which is the smallest unit of price movement in a currency pair.

For example, if the EUR/USD pair is quoted with a bid price of 1.1050 and an ask price of 1.1052, the spread would be 2 pips. The size of the spread can be influenced by various factors, including market liquidity, volatility, and the broker’s own policies.

There are two main types of spreads in Forex:

Fixed spreads remain constant regardless of market conditions.
Variable spreads can fluctuate based on market conditions, often widening during times of high volatility or low liquidity