Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the Forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the Forex market.
Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.
Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the Yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the Yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.
Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with Forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.
The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers.
Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the Forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the Forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.
Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.
If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more Euros at the time of delivery.
One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.
Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.
For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.
Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.
Some of the largest and most controversial speculators on the Forex market are hedge funds, which are essentially employ unconventional investment strategies in order to reap large returns. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy.
Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.
Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the Yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the Yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.
Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with Forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.
The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers.
Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the Forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the Forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.
Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.
If there is one thing that management (and shareholders) detests, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more Euros at the time of delivery.
One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.
Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.
For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.
Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.
Some of the largest and most controversial speculators on the Forex market are hedge funds, which are essentially employ unconventional investment strategies in order to reap large returns. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy.
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