How do Institutions, Corporations and Individuals Trade Forex (Market Participants)
The Forex would evolve from a need to manage exchange rate risk exposure after abandonment of the Bretton Woods agreement in 1971 meant the US Dollar was no longer tied to gold and its value would “float.” By the mid 1970s, currencies of the world’s major nations were primarily impacted by the forces of supply and demand with exchange rates growing ever-more volatile into the 1980s. This saw the introduction of new financial instruments, market deregulation and trade liberalization. Through the 80s, rapidly-advancing computerization was employed to meet the needs of governments, financial institutions, and corporations for managing the exchange rate risk of global financial transactions.
With full-featured electronic trading platforms and a wealth of research and information resources now readily available, the Foreign Exchange Forex market brings the global economy to the average trader’s computer screen.
Hedgers
A business transaction illustrates how FX Forward exchange rates can be used to try to manage risk. Let’s say a German manufacturer has agreed to sell a printing press to an American printing company. The contract terms require delivery and payment by a date six months in the future. The German manufacturer will calculate its production expenses in Euros, but has agreed to accept payment in US dollars from the American buyer. Should the US dollar decline in value by the time the press is to be paid in full, the German manufacturer’s profit margin would be adversely affected. If the Euro has been rising in value against the US dollar, it would take more US dollars to cover the press maker’s expenses, potentially cutting into the target profit margin threshold.
The German manufacturer may attempt to manage its exchange rate risk exposure with a contract that locks in a specific forward exchange rate for payment on the date, six months ahead. Interest rates in different countries will affect the degree of change in their respective currencies. An FX forward exchange rate will factor in interest rate parity to equalize the future values of the currencies being exchanged.
Banks
As banks around the world manage monetary transactions of all sizes, they are constantly exposed to exchange rate risk. Comprising the Inter-Bank Market, banks are primary participants in the Forex market; a large bank could be responsible for up to billions traded every business day. Trading such massive volume allows banks access to favorable trading terms; the “Inter-Bank Rate” may be the most favorable exchange rate available at any given time.
Financial Institutions
Financial institutions holding investments will utilize the Foreign Exchange to attempt to manage their own risk exposure and to speculate as part of an investment management program.
Speculators
Without a business interest in either side of a monetary transaction or investment holding, a speculator in the Forex market is free to research and trade any currency pair. Profit or loss is achieved solely on price movement, therefore trading is just as easily conducted to the downside as it is to the upside. There is risk of loss in currency trading.
