The forex market

What the market is 

Foreign exchange is the business of turning one currency into another. Every transaction in it is two transactions at once: a quantity of one currency is bought and, in the same instant and at the same agreed rate, a quantity of another is sold. There is no way to deal in a single currency on its own, because a currency has no price except in terms of something else. This is why the market's unit is not a currency but a pair, and why every price in it is a ratio rather than an amount.

The market has no building, no trading floor and no closing bell. It is over the counter, which means each transaction is a bilateral agreement between two named parties on terms the two of them settle, rather than an order matched anonymously on an exchange and cleared through a central counterparty. The consequence is structural rather than cosmetic: there is no single official price for a currency pair at any given moment, only the prices particular institutions are willing to deal at, which is why two quotations for the same pair at the same second can differ slightly.

What holds the market together instead of an exchange is the network at its centre. Large banks quote each other continuously in what is conventionally called the interbank market, and those quotations are the reference from which prices further out are derived.

Who deals in it, and why 

The participants have almost nothing in common except the instrument, and their reasons for being there differ so completely that the same price means different things to different desks. Grouping them by motive is the most useful way to read the market's behaviour.

• Commercial companies, which convert currency because their business requires it. An importer paying a foreign supplier and an exporter repatriating revenue both have to deal regardless of what they think of the rate.
• Institutional investors and asset managers, whose currency dealing is usually a by-product of a decision made elsewhere. Buying a foreign bond or share requires buying the currency it settles in, and hedging that exposure back requires selling it again.
• Banks, which quote two-way prices to their clients and to each other, and which carry inventory as a result of doing so.
• Central banks, which deal for policy reasons rather than commercial ones: managing reserves, defending a stated exchange-rate regime, or intervening in a market they judge to be disorderly.
• Speculative participants, from macro funds to individual traders, who hold a position in a pair for no reason other than an expectation about the rate itself.

Only the last of those groups is present because of the price. The rest are present in spite of it, and their flow arrives on a calendar of its own: month-end rebalancing, coupon and dividend dates, corporate settlement cycles. Much of what looks like inexplicable movement in a quiet hour is flow from a participant with no view at all.

How the price is written 

A quotation names two currencies in a fixed order. The first is the base currency and the second is the quote currency, and the number between them states how much of the second is required to obtain one unit of the first. The base is always one unit, never stated, and every movement in the number is a statement about the base currency measured in the quote currency, never the other way round.

The order is a market convention rather than a rule of arithmetic, and it is fixed by usage: a pair is quoted the way the market has always quoted it, so a rate for the reverse ordering is simply the reciprocal and is rarely written down. The smallest conventional increment of the rate is called a pip, which for most pairs is the fourth decimal place and for pairs quoted against the Japanese yen is the second. How a quotation is read in detail is set out in how a currency pair is quoted.

When it trades 

Because dealing is bilateral and the participants are distributed across every time zone, the market runs continuously from the opening of the Asia-Pacific session on Monday morning local time to the New York close on Friday afternoon. It does not open and it does not close during that window; what changes is which part of the world is awake, and with it which institutions are quoting and how much size they are willing to show.

Three broad sessions are conventionally distinguished. The Asia-Pacific session centres on Tokyo, Singapore, Hong Kong and Sydney. The European session centres on London, the largest single dealing centre by volume. The North American session centres on New York. Their edges overlap, and the London to New York overlap is conventionally described as the busiest period of the day, because two of the three largest concentrations of dealing are open at once.

Activity is uneven within that continuous week, and the unevenness is a property of the market rather than of any one venue. In the hours when a pair's home markets are closed, fewer institutions quote it, the size available at each price is smaller, and the same order can move the rate further than it would have moved earlier in the day.

What moves a rate 

An exchange rate is a relative price, so it responds to anything that changes the relative standing of the two economies behind it. Interest rate expectations are the most closely watched of those inputs, because a currency's rate of return relative to another currency's is the most direct comparison the market can make. Inflation feeds in through the same channel, since inflation is what central banks respond to, and growth data, external balances and the market's appetite for risk all contribute.

Two currencies are involved in every rate, which is the detail most often lost. A pair can move because the base currency has been repriced, because the quote currency has been repriced, or because both moved and one moved further. Reading the same currency against several counterparts is the conventional way practitioners separate those cases, and the drivers are set out in full in what moves a currency pair.

How a CFD on a currency pair settles 

A contract for difference written on a currency pair references the pair's rate without delivering either currency. Nothing is converted, nothing arrives in an account denominated in the base currency, and no value date for physical settlement exists. What settles is a cash difference: the change in the rate between opening and closing, multiplied by the size of the contract, expressed in the account's own currency.

Size is stated in lots, and a standard lot in currency CFDs is conventionally one hundred thousand units of the base currency. Rate multiplied by size gives the notional value of the contract, and the notional value is the figure profit and loss is calculated on. It is not the figure that has to be funded. The counterparty requires a percentage of the notional value to be posted as margin and held for as long as the contract is open, and because the difference is calculated on the whole contract while only a percentage of it has been posted, a loss is measured against the full notional value and is not limited to the amount deposited. A favourable move is measured on exactly the same basis and to the same degree.

The final row is the mechanism the risk statement above describes. The percentage move is a percentage of the notional value rather than of the margin, so the money amount it produces bears no fixed relationship to the size of the deposit. A position held past the daily cut also carries an overnight financing adjustment, a separate line calculated on the notional value in the same way.

Which pairs exist 

Currency pairs are conventionally sorted into three groups by how heavily they are dealt rather than by any formal definition. The majors are the handful of pairs that set the US dollar against the other most heavily dealt currencies. The minors sit a tier below them in turnover, pairing a heavily dealt currency with a smaller developed one. The exotics pair a heavily dealt currency with the currency of an emerging or tightly managed economy. Cutting across all three is the cross, any pair with no dollar leg at all. The boundaries are usage rather than law.

YAL lists 60+ currency pairs, spanning all three groups, including a cluster quoted against Gulf currencies. Each pair's own conditions are published per instrument rather than per group.