The foreign-exchange market, also known as the currency market, is a worldwide financial market that trades 24 hours a day, Monday through Friday. With an average daily turnover of US$4 trillion, it is the largest financial market in the world, as well as the most liquid.
Currencies trade “over the counter”, meaning there is no central exchange or clearing house, and very little cross-border regulation. Market participants, substantially banks, brokers/dealers, commercial companies and hedge funds, negotiate transactions directly with each other.
The currency markets are globally intertwined, and there is no single exchange rate. The rates instead depend on where and at what price a market participant is trading a currency.
Given the uniqueness of the foreign exchange market’s geographic reach and diversity, unparalleled volume and liquidity, continuous trading, competitive pricing and the assortment of factors that affect rates, the market is thought to have achieved the ideal of perfect competition.
A currency, generally defined as a medium of exchange, can be fully convertible, partially convertible or non-convertible. A fully convertible currency has no restrictions on the amount that can be traded, and the rate is floating and not fixed by a government.
A partially convertible currency involves government control over international investments flowing in and out of the country, usually requiring approval for conversion. A non-convertible currency may not be converted into another currency and therefore not traded on the forex markets.
A foreign exchange transaction involves the simultaneous buying of one currency and the selling of another. A currency pair constitutes a first currency, which is the base currency, and a second currency, which is the counter currency and shows how much of the counter currency is needed to purchase one unit of the base currency.
In a currency pair, the base currency is being bought, while the counter currency is being sold. The market convention is to quote most exchange rates versus the US dollar as the base currency, the exceptions being the British pound, the euro and Australian and New Zealand dollar. The US dollar accounts for 85 per cent out of 200 per cent of daily volume, as there are two sides to a transaction. The euro is second with 39 per cent.
Exchange rates are quoted on a bid/offer basis, with the bid being the price that the market maker will buy and the offer being the price the market maker will sell. According to the ISO 4217 standard, currencies have three-letter codes, for instance KHR for the riel. Although there are no specific rules, currency pairs are generally quoted up to four decimal places, with the fourth decimal place referred to as a “pip”.
Trades are generally on a spot, forward or swap basis. A spot transaction is typically a two-day settlement period. The spot rate is utilised by most online trading platforms. In a forward forex contract, the parties agree on an exchange rate for a date in the future, and transaction settles on that date at the rate agreed.
The swap is the most prevalent forex transaction, representing 55 per cent of turnover. Spots represent 37 per cent and forwards 12 per cent. In a swap, two parties agree to exchange principal and interest in one currency for the same in another currency for a certain length of time.
The mantra in currency trading is “buy the strong currency and sell the weak currency”. As we cross into 2012, leaving a year with heightened political risk and extraordinary volatility, currencies will be an asset class that will be in the spotlight again and offer traders an interesting ride.
Anthony Galliano is chief executive of Cambodian Investment Management. [email protected]