Trading in currency in other words also known as foreign exchange is the world’s largest financial market and was the area in which world’s largest financial institutions were involved. Earlier the Forex transactions were of biggest concern of the big corporate houses, however as the time changes the need for foreign currency has made its way through corporate houses to individuals who are involving in some sort of international transactions. Though the volume of transactions and the people involved in currency trading is increasing exponentially, still there is an information asymmetry between the investors and the marketAlthough we may not be aware of it, the currency market has a deep impact on our everyday life, from the most obvious currency exchange we have to do when visiting a foreign country, to the way our goods prices and sometimes even salaries fluctuate due to the variance of value of our currencies relative to those of foreign countries with which we do business. Even the money under your mattress is continually changing in value! What is the currency market?
We define a market as a place where people could meet each other for buying or selling things, be they tangible like in a food market, or virtual like web sites such as eBay.
But why is there a need for a foreign exchange market? The forex market is an important tool for allowing business transactions be done between different currencies. Imagine, for example, the Chinese manufacturer who has an order of ten thousand t-shirts from a European wholesaler. The Chinese manufacturer, most probably will want to be paid on US dollars from the European wholesaler, who will have to change its euros to US dollars to pay the Chinese manufacturer. At the same time the Chinese manufacturer will need to buy cotton on the cotton market, traded in US dollars. In the end, this manufacturer probably will change the US dollars of profit to Chinese yuans, to spend it on goods and salaries in China, or maybe he or she is thinking of opening a business on England, so will change some of his US dollars to British pounds. Without a currency market, none of these transactions could be made fairly. Having a free market where thousands of participants could decide on the value of an asset is the most logical and fair way to give anything a value.
The foreign exchange market provides the machinery for making international payments, for transferring purchasing power from one currency to another, and ensuring that the relative value of each currency is clear and universal.
There were even money changers in Ancient Greece, but the foreign exchange as we know it has evolved a lot since then. Since the 1970’s, deep structural changes have occurred in the world financial system and economy:
- A change in the international monetary system, from the fixed exchange rate specified on the Bretton Woods agreements, to the floating exchange rates in the early 70s ’til our days
- Financial deregulation through the world, resulting in higher freedom for financial transactions and increased competition among financial institutions.
- International trade liberalization, within multilateral trade agreements. Enormous expansion of international capital transactions.
- Huge advances in technology, allowing instantaneous transmission of market information, and fast and reliable execution of financial transactions.
- The development of new financial instruments and advances in the understanding of the financial system.