Advantages and Disadvantages (forex)

There are some significant differences between Forex and other markets like the equity markets or futures. While a good trader may be able to handle any market, structural differences in Forex can force a different approach. Moreover many of the so called "advantages" bring some inherent risks with them.
Superior Liquidity

With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time, New York and Tokyo (in this descending order).

There are always participants willing to buy or sell currencies in the Forex markets. Its liquidity, particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always open or close a position at a fair market price.

While it is true that currency markets have superior liquidity, it is also a fact that there are periods when liquidity dries up. This can happen during very volatile times or periods of market uncertainty. A volatile movement in price does not necessary mean a lot of volume, it can be just the opposite: fewer traders in the market means a thiner liquidity, which can lead to a big imbalance between buyers and sellers, resulting in a quick price movement in form of a spike or gap.

Because of the lower trade volume during the Asian session or even more during holiday seasons, investors in the Forex market are also vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transaction happening during these times.
High Leverage

The subject on leverage will thoroughly explained in chapter 3 and you will be taught how to take advantage of it. Leverage trading means, in short, that you are permitted to trade up to 100 times your margin deposit. This is primarily attributed to the higher levels of liquidity explained before.

A leverage of 1:100 means: in order to buy and benefit from one lot of 10,000 US Dollars you only have to commit your 100 Dollars, the rest of the amount is leveraged by the market maker/broker.

While certainly not for everyone, the substantial leverage available with most online retail brokers in the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.

A 100:1 leverage is commonly available from online Forex dealers, and sometimes even higher. This is a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but that's not all: a too small leverage can be equally dangerous as you will learn in chapter 3.

The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement a risk management in your trading plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.
Margin Trading

The Forex market is a 100% margin-based market. This concept is strongly associated with the previous one of leverage. Online Forex brokers offer many opportunities to open smaller accounts than in other markets. That sort of flexibility opens the door to essentially anyone who wants to explore financial trading. This isn't to say that all brokers are that flexible. There are, however, a great many which offer so-called mini-contracts and even smaller accounts traded with micro-lots.

In fact, spot Forex trading is essentially trading a 2-day delivery transaction. This trade involves a cash exchange between two currencies rather than a contract. For that, your broker requires a capital deposit to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will ask for as little as 0,5%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.

Note that margin trading does not mean margin loans. Your broker will not be lending you money to trade currencies (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds. This is what is referred to as the interest rate carry (or rollover).

When opening a position, one is essentially borrowing a currency, exchanging it for another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held.
If you are holding your position longer than one day, your broker rolls you forward into a new position for the next trading day. This is generally done transparently and automatically, but it also means that at the end of each day you will either pay or receive the interest differential on your position.
Some brokers will not apply the day's interest differential value on positions closed out during the trading day. In this case, if you open a position with a negative interest rate differential, but you close it during the same day, the differential is not applied.
Lower Transaction Costs

The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in turn lowers transaction costs. There are usually no commissions in Forex retail trading because the trader deals directly with a market maker.
You may ask, if Forex brokers don't charge commissions, how do they make money?
The broker makes money from the spread, which is the difference between what he pays for a currency and the higher price at which he sells it. In other words, the spread is the width between the bid and ask prices, which can be quite small in the major currency pairs, ranging between 2 and 5pips.

Because of the currency market round-the-clock liquidity and the competition among market makers, you receive tight, competitive spreads both intra-day and night.

The question if it is more cost-efficient to trade Forex in terms of both commissions and transaction fees depends not only on your broker's conditions but also on your trading style. Forex is more efficient if you know how to balance the number of trades and the earnings ratios. The usual lack of commissions is another factor that, despite being an advantage, has to be well understood to make it work in your benefit.
Profit Potential in Both Rising and Falling Markets

Every open Forex position has two sides because currencies are quoted in terms of their value against each other. This is because currencies are traded in "pairs" (for example, US Dollar vs. Yen or US Dollar vs. Swiss franc), one side of every currency pair is constantly moving in relation to the other.
When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as in a falling market.
some of the equity markets it is much more difficult to establish a short position due to the zero uptick rule, which prevents traders from shorting a stock unless the immediately preceding trade was equal to or lower than the price of the short sale.
This ability to sell currencies without any limitations can be seen as another distinct advantage of the Forex market. You have equal potential to profit in both a rising or falling market, as there is no structural bias to the market. Previous

Advantages and Disadvantages

Advantages and Disadvantages

There are some significant differences between Forex and other markets like the equity markets or futures. While a good trader may be able to handle any market, structural differences in Forex can force a different approach. Moreover many of the so called "advantages" bring some inherent risks with them.
Not Regulated
The global nature of the interbank market, without an unified or centrally cleared market for the majority of FX trades, make difficult to apply a cross-border regulation.

Central banks such as the Federal Reserve Bank of the US or the European Central Bank provide to some degree oversight. But in general, the currency markets are much more lightly regulated than equity or bond markets.
There are, nevertheless, several associations and institutions which supervise and regulate key players at a national level. We will cover these subject in the next chapter.

No Exchanges
While it is true that there is exchange-based Forex trading in the form of futures, the opposite condition occurs in the OTC market via the spot market.

Trading in a decentralized environment may be seen as having advantages or not:
In a decentralized market, trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no structured clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest and most liquid market in the world depends on the so called "margin" accounts, a concept similar to good faith deposits. This fact can be considered as a disadvantage, while the lack of clearing fees or other exchange fees can be seen as an advantage. Most brokers don't make you pay fees to maintain an account regardless of your account balance or trading volume.

Besides, the lack of an exchange means a difference in how the exchange is actually done. In spot Forex much of the trading done by individuals is actually directly executed with their broker/dealer. That means the broker takes the other side of the trade. This is not always the case but it is the most common approach.

This doesn't mean the broker is deliberately trading against you - he still has to offset his risk in the overall market. We will talk extensively on false and true myths about brokers in the next chapter.

In a centralized market, you have the benefit of seeing real volume information, for example, and you might find comfort in knowing that there is a regulated mechanism backing your market participation.
Besides, the lack of a centralized exchange can lead to a discrepancy among price information from one market maker to the next, leading to the possibility of unfair trading activities.

At first glance, this ad-hoc arrangement can look like the wild west to investors who are used to organized exchanges. But be reassured, this arrangement works exceedingly well in practice: because participants in Forex must both compete and cooperate with each others, self regulation provides very effective control over the market.

Furthermore, reputable retail Forex broker/dealers in many countries are supervised by their national financial authorities, and agree to binding arbitration in the event of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies do so only through a regulated firm.
We will extensively talk about broker/dealers in the next chapter and how to inform and protect yourself.

Instantaneous Order Execution and Market Transparency
In the Forex world, fast order execution and instant fill confirmation is usually routine because you'll be trading via an Internet-based platform. Market transparency is highly desired in any trading environment. With no exchanges, there are no traditional open-outcry pits, no floor brokers and, consequently, no delays. Obviously, you might have to absorb some slippage if you trade during news announcements or if you trade a high volume, but normally all the prices on your broker platform are executable and your profit potential is not compromised.

Given the multi million-Dollar exchange that takes place every day in the currency markets, manipulation of the price is rather inexistent compared to other less liquid markets. However combined actions may occur in which several of the major participants - like central banks - force the market in a certain direction. That being said, this is not a rule but rather an exception.

In this regard, you should be informed of the market hours that tend to be more or less liquid as well as of the dates and times of the year in which the major trading places are less active. During low liquidity times the market is more vulnerable to erratic volatility or manipulation, like during the Asian session, or during longer periods such as holiday seasons.

In the stock market there are restrictions imposed on selling short that you don't have in the Forex. It is just as easy to take a short position as it is to take a long one. In chapter 3 you will learn the mechanics to trading.

24-Hour Trading
The Forex is the only market which can truly be viewed as a 24-hour market, which is one of the notorious differences you will notice if you came from another market. There is trading activity in all time zones during the week, and sometimes even on the weekends as well. In other markets traders must wait until the market opens the following day in order to open a new position.

However each hour of the day has a certain level of liquidity and each currency is associated with the trading session normally corresponding to its time zone and business hours. The Yen, for example, may show a greater liquidity during the Asian session. In contrast, a currency outside of its normal business hours can display more erratic movements in a chart.
A market operating 24 hours is surely attractive but you can easily fall into overtrading, taking far too many trades. Exercising some discipline will help you avoid falling into this trap. This 24 hour nature is an attribute you want to transform into an edge in your favor. As a trader, you can put on or take off positions literally any time of the day or night. That opens the game up to you if you don't have otherwise available time to trade. next, forex history, time session

Traded Instruments

The trading departments in larger banks consider various factors when determining exchange rates: besides taking into account their inventory positions, they also watch for volumes and recent price action and apply their particular analysis to see where each currency is headed. Usually they will quote more favorable rates to their counter-parties in the opposite direction they think the price is going for any particular currency.

They do this trading several Forex financial instruments. A financial instrument is a medium which can be traded, commonly categorized into two categories: cash instruments and derivative instruments. The first being such financial instruments like securities, loans, and deposits. These are readily transferable and their value is determined directly by the market. And the later, the derivatives, can be divided into two further categories: over the counter (OTC) derivatives and exchange-traded derivatives.

Foreign Exchange instruments and transactions have their own category in which: standard derivatives are Foreign Exchange futures; main OTC derivatives are Foreign exchange options, forwards and swaps; and cash instruments is the spot.

Many folks tend to think strictly of the spot market, but it is not the only one. An array of other investment vehicles have been popping up in the Forex world, providing traders even more ways to take positions in this market. These are the most traded ones:

Outright Forwards
In the case of forwards it is a transaction in which money does not actually change hands until a specific (and a previously agreed-upon) future date. In this case, the exchange rate is one which the buyer and the seller have agreed upon any future date, and it is not necessarily based on current market rates, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.

The most common type of a foreign exchange forwards transaction is a currency swap. At the end of which the transaction is reversed. Currency swap is not traded via an exchange.

Futures
The currency futures are transactions with standard contract sizes and a maturity date (usually of three months). Futures are standardized and are usually traded via an exchange created for this purpose and usually include an interest amount. The futures market has become a bit more attractive for small speculators with the expansion of e-mini currency contracts.

It should also be noted that although some folks will claim there is no rollover in forex futures, the interest rate spread is definitely factored in. You can see this when comparing the futures prices with the spot market rates. As the futures contracts approach their delivery date their prices will converge with the spot rate so that the holders will pay or receive the differential just as if they had been in a spot position.

Currency Options/Warrants
A foreign exchange option is another Forex instrument belonging to the derivatives, where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Currency Swaps
Contract which commits two counter parties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

ETFs
Among the Forex instruments you can also find the exchange traded funds (ETFs) typically traded on an exchange as baskets of securities with an underlying index. ETFs are open ended investment companies that can be traded now replicating investments in the currency markets. These funds track the price movements of world currencies versus the US dollar, and increase in value directly counter to the US dollar, allowing for speculation.
As an investment, currency ETFs closely resemble savings accounts; the ETFs hold cash and invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are unlikely to gain or lose much value -- a share worth 100 Euro now will probably be worth 100 Euro next month or 10 years from now. Each deposit account will pay slightly less than the currency overnight interest rate, and is subject to fund expenses.

Spot
Finally, the currency spot, the instrument most covered in the Education Center: In the spot market currencies are sold for cash and delivered immediately and prices reflect what one currency is currently worth in terms of another currency. In the most cases it's technically a two-day "maturity" transaction, in which two currencies are traded with cash (rather than a contract). Spot has the second largest share by volume in FX transactions among all instruments accounting for an average daily turnover of 1.005 trillion. The spot is traded over-the-counter, meaning it is traded through a dealer network and not through an exchange.

There are many currencies traded on a day-to-day basis on the spot market. You will notice that is always a currency moving up or down. From a price-action perspective, currencies rarely spend much time in tight trading ranges and tend to develop strong trends. Remember, most of the currency trading volume is speculative in nature and, as a result, the market frequently overshoots and then corrects.

This volatility will assure endless short-term and long-term cashing opportunities, allowing you to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to equity markets. We will cautiously consider all the so-called "advantages" of currency trading in more detail below.
Many of the instruments utilized in Forex will appear similar to those used in the equity markets. Since the instruments on the Forex often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments.
The growth in retail Forex has been very rapid, especially as equity and futures traders realized the approaches they've been using for years in their respective markets, particularly price-based techniques based on technical and quantitative analysis are equally applicable to Forex.

History, structure, time session.

Time (opening & end) Forex

Opening and end of trading sessions as per time zones:
GMT
Tokyo: 0.00 - 9.00
London: 8.00 - 17.00
New York: 13.00 - 21.00
Eastern Standard Time
Tokyo: 19.00 - 4.00
London: 3.00 - 12.00
New York: 8.00 - 16.00

The time zones, by stating:

Generally speaking, the first market to begin trading is in the Asia-Pacific zone with the New Zealand and Australian markets. Their opening is followed by Asian financial centers in Japan, Singapore, and Hong Kong. Then, the European markets open in Switzerland, Germany and London. When the Asia-Pacific and Asian markets end their business day, the market activity flows into the opening hours of Canada, followed by the New York session. Just before the New York session ends, another trading day begins in the Asia-Pacific zone.

Thus, it is important to strategize your local time according to the around-the-clock activities of the Forex markets, in order to maximize your potential profits from the market movements.

The two most active times through a full 24-hour market day are the London and New York sessions. The reason is that the major currencies like the Pound (GBP), Euro (EUR) and Dollar (USD) move most frequently in these two sessions. This coincides with the impact of each currency's regularly released of economic figures.

In summary, we may conclude that the first market to begin operation every week is the New Zealand market early Monday morning and the last market to close at the end of the week on Friday afternoon is the New York market. In Asia, this means that the weekly round-the-clock operation of the Forex market begins in the wee hours of Monday morning and runs to Saturday morning. Dar Wong comments fxstreet.com

Interbank Market

Interbank Market ; When speaking of Forex at a governmental level (central banks) and institutional level (commercial and investment banks), we refer to a market which, nowadays, negotiates over 3 trillion Dollars a day. At this level, exchanges of 5 to 10 million are frequent, but also amounts of 100 to 500 million are traded between major participants.

It's an interbank or over the counter market (OTC) and spot market, meaning it is not done through an exchange. Unlike most other exchanges, the Forex market is not a centralized market where each transaction is recorded by price dealt and volume traded. There is no central place back to which all trades can be traced and there is not onemarket maker but many.

Each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make bid and ask spreads in the currency market are the largest banks in the world. That literally means banks constantly dealing with each other either on behalf of themselves or their customers. This is why the market on which banks conduct transactions is called the interbank market.

Larger speculators also operate in the interbank market where they can execute multi-million Dollar trades with ease.
Individual traders, who generally trade in much smaller sizes, primarily do so through brokers and dealers.

The volume negotiated is particularly focused in London, but also in New York and Tokyo. These cities are also major trading and decision centers for monetary matters because of their sheer size in turnover and number market participants also because the happenings in these places tend to influence other dealing centers around the world. Other important locations at this level are Sydney, Switzerland, Frankfurt, Singapore and Hong Kong.

Many of today's major currencies fluctuate freely between each others and are negotiable virtually throughout the world. This has resulted in increased speculation by banks, hedge funds, brokers and individuals. Central banks occasionally intervene with the intention to move the currency towards desired levels, however, the underlying factor that leads the Forex market are the forces of supply and demand.

The lack of physical change enables the exchange market to operate 24 hours a day, 5 days a week, covering different areas across the most important financial centers. Its tremendous volume of transaction makes it very liquid and therefore highly desirable to trade. Currencies are the most traded assets in the world - any commercial or financial flow across borders may involve a currency exchange.

Until the popularization of Internet trading, Forex was primarily the domain of government central banks and commercial and investment banks. With the increasingly widespread availability of electronic trading networks and matching systems, trading on the foreign exchange is now more accessible than ever.

The market has been rendered feasible to non-banking international corporations like hedge funds, which can now trade via intermediaries thanks to those networks. They are the high level that really moves the currency market buying or selling huge amounts in the mid to long term: their time frame is generally weeks to months, possibly years. Their transactions unbalance the market, requiring price adjustment to rebalance demand and supply.

The volume negotiated is particularly focused in London, but also in New York and Tokyo. These cities are also major trading and decision centers for monetary matters. Other important locations at this level are Sydney, Switzerland, Frankfurt, Singapore and Hong Kong.

The presence of such heavy weight entities may appear rather discouraging to any aspiring trader. But the fact is that the presence of such powerful entities and their massive volume in transactions can also work to your benefit as a trader.

It is important to note that even high-level financial institutions are vulnerable to market movements and are also subject to market volatility as all the other smaller participants. In practical terms, this means that the market is too big for a single participant to control it and that the alleged insider information that large banks have is of very relative value compared to the size of the market.

Individual traders, in turn, do not move the currency market so much. Their time frame is usually much shorter and so is their investment horizon. Therefore they do not impact the demand/supply equilibrium in the aggregate in the same way, nor their positions have a lasting effect on the currency prices. But on the other hand, their trading models and lower volumes allow more flexibility to enter and exit the market.

At this point it's interesting to note that the trading activity of each financial center will determine the behavior of the market. Thus when the London markets open and the session starts, it's still overlapped with the last two hours of activity in Tokyo. Position openings done by London traders and the closure of positions in Tokyo coinciding in a interval of two hours may explain the increase in activity and volatility around this time. Later the European and the US session match during 4 hours in a combination of players, significantly increasing liquidity.fxstreet.com . Market Structure, history

Market Structure (Forex)

Market Structure
Although we track the start of the Forex in the early 70's, the lack of a central marketplace for transacting foreign exchange made difficult for importers and exporters to accurately track daily movements in the currencies. In fact they had no prior experience with floating exchange rates and therefore no in-house expertise. They were at the mercy of the banking industry, specially the big banks for whom foreign exchange became a huge source of revenue.

The first foreign exchange brokers came on stage in the mid 70's to offset a significant customer foreign exchange business for medium and small banks, which needed continuous exchange rates in the major currencies.

Initially the foreign exchange brokers installed direct lines to all the banks willing to participate. Generally a major bank made a rate and the brokers showed the rate to all the banks at about the same time. The first bank to deal on the rate completed a transaction. The others waited for the next rate. Any bank could make a rate; show a bid or an offer. Soon, with the aid of new technologies, the brokers became quite sophisticated and efficient at putting together a continuous two-way price and using the banks as their primary liquidity providers. interbank market, history

Forex explaining

Introduces the Forex by explaining (Scott Owens):
Since currencies are valued differently, there is a market in place to set those values. Where a market exists speculation inevitably follows. In this case, the market is hyper-active. Banks sending deposits around the world, corporations hedging their exposure to currency risk in different countries, government banks forwarding national economic goals through monetary policy, and massive investment funds playing the role of speculator. Not long ago, that was the extent of the market. It was the domain of the professional trader or banker.

The word "market" usually invokes the idea of a central market place like the New York or London exchanges. This is not the case in forex. Instead, forex functions through what is known as the "interbank" market. Interbank is a fancy way of saying that banks trade with each other, absent a central market place. This is one major reason why volume data is not available for forex. It's also the reason why retail investors and smaller traders were left on the sideline for so long.

In the 90's, a series of events unfolded that made forex available to retail investors. Deregulation led many companies to form pools of liquidity where retail investors could take advantage of the huge speculative opportunity in forex. These dealers offered high leverage, low minimums, and a new way to trade - 24/7From:fxstreet.com
Forex History, etc

the Speculative

Speculative turnovers in currency exchange
The volume traded in Forex today is so high that no data is available, but every three years, the BIS (Bank of International Settlements) publishes the results of a survey made among major market participants and creates an estimate based on the responses obtained.
The most recent report, completed in 2007, estimated the average global daily volume at about 3.2 trillion traded in the world's main financial markets, of which an estimated 95% is speculative. Its daily transaction volume is about 100 times that of all the stock-exchanges together. The fact that 95% of the market is speculative means that most of the participants buying a currency really have no intention of receiving that particular currency. They're watching their price movement to sell it back for a profit when it has increased in value.

The other 5% of the daily turnover come from companies hedging their exposures and governments exchanging foreign currencies and reserves.
85% of the turnover is done in the major currencies against the Dollar where there is the most important liquidity, allowing fast fills in and out of the market. You can find just above a link to a table excerpted from the last Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity of 2007.

In the most recent results in which the BIS classifies exchange volume by country, London remains the capital of the FOREX market. The EUR/USD pair is the most traded, and it is not a coincidence that the pair has the lowest spreads - the width between bid and offer price. Generally, in the interbank market, the higher the volume, the lower the spreads are.

In the next chapters you will learn what spreads are and all about the market mechanics, but for now we will show you how this market is composed and who moves and shakes it!

page 1, 2, 3,,

Bye Bye Gold

2. Good Buy/ Bye Gold?
The most fundamental answer why gold was needed to establish an international monetary system is perhaps that even fluctuations in the value of money caused by the supply and demand of gold are better than experimenting hyperinflation or deep devaluation because of irresponsible monetary policy.

But history shows that there were serious problems associated with the gold-money peg and that it was impossible to keep the linkage. Difficulties arrived when the supply of gold oscillated, causing short term price fluctuations. Moreover, the rapid growth of the world economy was faster than the supply of new gold, and a long term shortage of gold became a constraint to maintain the peg.

The abandonment of the convertibility to gold was the start of the Forex market. The US Dollar, already under serious pressure due to the US trade deficit, was allowed to float and all currencies were set adrift to find their place in the global economy. From there on many speculative opportunities started to afloat.

Since the early 70's the major world currencies started to float freely, mainly controlled by offer and demand on the exchange market, and has kept floating for almost 4 decades now. Among these currencies, there were the Deutsche Mark, the British Pound and the Yen, and their prices were calculated on a daily basis. The volumes, velocity and volatility started to increase and new financial instruments were created. Since then, exchange rate instability among major currencies has been the norm

Transformation Of Currency Exchange In The '70s

The following decades saw the FOREX being transformed by far in the largest and less regulated financial market in the world thus abolishing restrictions on capital flows in almost all countries, and allowing market forces to move exchange rates.

But the idea to fix exchange rates did not disappear. Some major economies attempted to move back to a peg or valuate currencies relatively to something: it happened during the 70's and 80's when Asian communities tried to group together as the west Europeans did. During these years currencies exhibited short-term volatility, medium-term misalignment and long-term drift. While after the breakdown of Bretton Woods the majority of policy makers thought the free floating system had an automatic adjusting mechanism, the fact was that exchange rate instability itself became a serious threat to the world economy.

In December 1971, there was an international effort to re-establish the fixed exchange rate system at adjusted levels: the monetary authorities of major countries gathered in Washington, DC to set their mutual exchange rates at new levels and the Smithsonian Agreement is signed, similar to the previous Bretton Woods, but allowing higher foreign exchange fluctuations.

In 1972, the European Community, in an attempt to gain independence from the influence of the Dollar, created the European Joint Float formed by the German Federal Republic, France, Italy, Holland, Belgium and Luxembourg. This was another initiative to revise and redesign the international monetary system. However the agreement is abolished a year later and a shift to a floating rate system occurred by default, since there was no alternative agreement at the time. As a result, new markets emerged along with new financial instruments, market deregulation, market systems and trade liberalization.

Governments could thereafter set semi-pegged or leave their currencies fluctuate freely. In fact, in 1978, the free floating system is installed between the main industrialized countries, which meant, once again, that the relative value of currencies would be determined by the forces of supply and demand.

One of the major catalysts for the acceleration of currency exchange was the rapid increase in US Dollar deposits in banks outside the control of US authorities. Revenues from Russian oil sales, for example, were deposited in Dollars, but out off of the United States, due to the fear of being frozen by the regulatory authorities of the United States.

The US government imposed laws to restrict Dollar lending to foreigners. Euromarkets were particularly attractive because they had far fewer regulations and offered higher yields. The US government restricted lending Dollars to foreigners in response to the explosive growth in the number and size of deposits abroad.

This was a precursor of the Eurodollar market (a market where assets are deposited in a currency different from the currency of origin). Later in 1978 Europe created the European Monetary System, based on the Eurodollar market which first emerged in the 50's.

Within this context, and because of its convenient location - which permits to operate simultaneously with the Asian and American markets - and its ability to connect these two markets, London became, and still remains, the world capital of the foreign exchange market.
In the 80's it became the key center of the Eurodollar market when British banks began lending Dollars as an alternative to Pounds in order to maintain its leadership position in global finance.

Until 1985, the Dollar gradually appreciated damaging the international competitiveness of US firms. In September 1985, the Plaza Agreement was signed between the G5 countries (US, Japan, Germany, France, UK) to lower the US Dollar which was clearly overvalued.

The joint intervention of the G5 was very effective, however, the US Dollar continued to lose ground beyond acceptable levels for Japan and Germany. In February 1987, the economic leaders of the G7 countries (G5 plus Italy and Canada) met in Paris to stop the further fall of the Dollar, known as the "Louvre Accord". This cooperation era was about managing free floating exchange rates through coordinated interventions.
From the late 80's onwards US companies began to borrow foreign currencies, finding in the Euromarkets an attractive investment opportunity where to channel their excess of liquidity, and a source of short-term financing for foreign trade.

This movement of capital across borders skyrocketed foreign exchange transactions to about US$ 70 million a day in the early 80's with the development of computational tools. These tools accelerated the international flow of capital, bringing the market spread throughout Asia, Europe and America. These same tools allowed the participation of private investors in a market that was traditionally the exclusive domain of banks and large institutions.

In 1991 the Maastricht treaty was signed. It was meant to converge the exchange rates, inflation and fiscal balance between several European currencies. However, the unification of West and East Germany conducted at a 1 to 1 exchange rate, put an upward pressure on the Deutsche Mark which was the anchor currency for the future Euro. This put a downward pressure on other currencies, the British Pound started to fall and England abandoned the group, unwilling to import high interest rates from Germany. In 1992-93 the European monetary system almost collapsed when economic pressures were threatening with a weaker currency devaluation.
But the pursuit of monetary stability in Europe, which started in Europe in the 1970s, continued with a renewed attempt not only to fix the European currencies, but also to replace them with a single currency. Finally, in 2001, the project to establish a regionally common currency completed and the Euro surged stronger against the US Dollar. page 1,2, 3, 4,

Oversupply of Dollars

The expansion of international trade and the massive capital movements led to a Dollar shortage.
Later, during the 50's, the Bretton Woods system was under enormous pressure and needed help to function properly when the major economies started to evolve in different directions. While the classical gold standard collapsed because of external forces (the outbreak of WWI), the Bretton Woods regime failed due to internal inconsistency. US monetary policy was the system's anchor and the growing inflation in the US destabilized the system until it started to disintegrate.
After WWII, Europe and Japan needed to import from US all kinds of manufactured goods and machinery for its own reconstruction while US wanted to favor Western European countries in front of the menace of Eastern European countries and the USSR. But there were not enough Dollars in circulation. So in 1948 the US decided to give west Europe an economic aid, under the name of the Marshal Plan, officially called the European Recovery Program.

In the 60's the situation started to revert and an oversupply of Dollars in circulation gradually appears. The Vietnam war, welfare expenditure and the space race with the USSR were the major reasons for the increased US government spending. When US inflation began to accelerate, other countries refused to import it into their economies. This whole situation destabilized the exchange rates agreed upon in Bretton Woods.

Shortage in international currencies and abundance of US Dollars rise some doubts about its convertibility to gold. The already high trade deficit of the US led to speculative pressures awaiting a strong devaluation of the US Dollar versus gold. A series of readjustments held the system for a while but finally, on August 15, 1971, everything changed. US President Nixon suspended the gold convertibility standard and in 1973 the US formally announced the permanent floating of the US Dollar, thereby officially ending the fixed exchange rate regime and the Bretton Woods system.
The system became an open US-Dollar-based world payments arrangement.
Let's define some of the concepts that we have learned so far:
For instance, if you are a European wanting to travel to the US and the exchange rate for EUR 1.00 is USD 1.50 this means that for every Euro, you can buy one and a half US Dollar.

You have also seen that there are different ways the price of a currency can be determined against another:
Through a fixed, or pegged, rate which is a rate the central bank sets and maintains as the official exchange rate. In this case a set price will be determined against a major world currency (usually the US Dollar, but also other major currencies such as the Euro, the Yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return of the currency to which it is pegged. To do this, the central bank must keep enough foreign reserves to release or absorb into or out of the market.

Some governments may also choose to have a semi-peg whereby the government periodically reassesses the value of the peg and then changes the peg rate accordingly. Usually the change is devaluation but one that is controlled so that market panic is avoided. This method is often used in the transition from a peg to a floating regime.

Although the peg has worked in creating global trade and monetary stability, it was only used at a time when all the major economies were a part of it.
And while a floating regime has its flaws, it has proven to be an efficient means of determining the long term value of a currency and creating equilibrium in the international market.

You may now ask: "Why the need to fix a currency?" It has to do with the aim to create a stable atmosphere for foreign investment, specially among developing nations. If the currency is pegged, the investor will always know what its value is and will not fear hyperinflation. However the peril exists that such countries experience financial crisis as well, like Mexico in 1995 and Russia in 1997.

An attempt to maintain a high value of the local currency to the peg can result in the currencies eventually becoming overvalued. This means that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors would start to convert their currency into foreign currency before the local currency is devalued against the peg, depleting the central bank's foreign reserves.

There is also a floating condition, which allows the Forex market to function as we know it nowadays with most of the major currencies. A floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market.
A floating exchange rate is constantly changing as a decrease in demand for a currency will lower its value in the market. This in turn will make imported goods more expensive and stimulate demand for local goods and services. As a consequence, more jobs are created, and hence an auto-correction occurs in the market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, compared with a fixed system, it is less frequent that the central bank of a floating regime interferes.

A country can also opt to implement a dual or multiple foreign exchange rate system, where both modalities run in parallel. Unlike a pegged or floating system, the dual and multiple systems consist of different rates, fixed and floating, running at the same time. The fixed rate is usually a preferential rate and the floating a more discouraging one.
While the fixed rate is only applied to certain segments of the market, like the import/export of essential goods, the floating rate is set by the forces of supply and demand in the market and is applied to non-essential goods like luxury imports.

This system is also usual in transitional periods as a means by which governments can quickly implement control over foreign currency transactions. In those cases, instead of depleting its foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market.
As with the other solutions, a multiple exchange rates system is not free from negative consequences: creating artificial conditions for certain market segments is one of them. But it could also be used as an effective means to address the problem in the balance of payments developed under the conditions of a completely free floating system.

Note that none of these systems are perfect, but that all are thought as mechanisms to deal with those underlying problems in economic crisis and inflation periods. Their aim is to eventually keep the equilibrium in the monetary system.

Just to summarize, these are the four exchange rate systems, or regimes:

* Pegged exchange rate system: the value of the currency is tied to another currency, to a basket of currencies or to the price of gold. The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.
* Semi-pegged exchange rate system: the central bank periodically readjusts the fixed (pegged) value of its currency.
* Floating exchange rate system: the value of a currency changes freely and is determined by supply and demand in the Forex market.
* Multiple exchange rate system: both systems are simultaneously used in different segments of the economy.
Previous,3, 4,

ABSOLUTE & ESSENTIALS of Forex

Topics 1 : History, Monetary, structure, Advantages and disadvantages
* Historical background which gave birth to the Forex market is made by the same milestones which compose the history of a broader international regime.
* Floating exchange rates are not the only possible monetary system. Over time, international monetary systems exhibit oscillation between fixed and free floating regimes. We may think that the prevailing system is a normal condition and is here to stay, but whether it is permanent or not is an interesting and open question which can affect your trading carrer.
* The global market structure and the main financial centers
* Other instruments besides the spot Forex
* Advantages and disadvantages of the Forex market.
What is an exchange rate? An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of one country's currency compared to that of another. When traveling abroad you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency.
Foreign exchange market

You don't have to be a trader to participate in the foreign exchange market: every time you travel and need to exchange your currency into a foreign currency, you are participating in it.

It also happens when companies from different countries buy and sell goods and services across national borders which require payments in non-domestic currencies. Either way, importing or exporting, there is going to be a transaction which takes one currency being swapped for another.

Nevertheless, in order to trade actively in this market, you should know how it came to be. The current market's shape and conditions are relatively new in the large history of money and that is what you are going to learn in this first chapter.
Despite your curiosity to jump directly into the more practical knowledge, you should know that an understanding of the historical circumstances from which this market emerged will gear you up with more insight when it comes to plan your future business in FX trading.

What about a little historical background about the largest financial market in the world?

1. The Origins
The FOREX (FOReign EXchange) Market is a cash-bank market established in 1971 when the US went off the gold standard adopted in the 1930's. At that time the US had to drop the gold standard after the 1929 crash and the British Pound became the currency of choice and the world's currency.

There have been other times before in Western History when paper money could be exchanged for gold. Throughout most of the 19th century and up to the outbreak of WW1, the world was on so-called "Classical Gold Standard" with all major countries participating in it. A gold standard meant that the value of a local currency was fixed at a set exchange rate to gold ounces. This allowed unrestricted capital mobility as well as global stability in currencies and trade

The participating countries were required to observe some rules: for example, it was particularly important that no country would impose restrictions on the importation or exportation of gold as a commodity nor a payment method. This was a guarantee for a free capital mobility based on supply and demand conditions.

Under this model, in which most central banks backed their paper money with gold, the currencies were supposed to enter in a new phase of stability, without the danger of an arbitrary manipulation of its value to increase inflation.
During the interwar period the world powers tried to return to the gold standard at the exchange rates previous to 1914, which seemed to offer prosperity and stability, but the attempt did not succeed and exchange rates ended mostly floating. The classical gold standard was shattered by the outbreak end of WWI and collapsed under its violence. Private trade and financial transactions were suspended, gold exports were banned, and each country started to print money to finance the war effort. The 1920s-30s were characterized by recessions and the Great Depression. There was a hegemonic power shift from the UK to the US.

After WWII the system became a US-centered fixed rates under a new international gold standard and the world economy experienced high growth, price stability and movement toward freer trade. Unlike the classical gold standard days, however, there were severe restrictions on private capital mobility.

The gold standard had its inefficiencies the way it was handled: the combination of a greater supply of paper money without the gold to back it led to devastating inflation and resulted in political instability.

The problem with gold is that its quantity is too constraining: the world supply of gold was insufficient to make the Bretton Woods system workable -particularly as the use of the Dollar as a reserve currency was essential to create the required international liquidity to sustain world trade and growth. As economies grew stronger and needed more money to pay imported goods, there was no sufficient gold reserves to pay for it. As a result the monetary mass decreased, the interest rates increased and the economic activity slowed down and the economy entered in a recession.
In such cases, the low prices of manufactured goods were then attractive for other nations. These started to import massively and by doing so they contributed to the increase of the monetary mass in the exporting country. This, in turn, allowed to ease the interest rates and subsequently the economy to grow. It was evident that the mechanism linking inflation/deflation with gold flows was not able to adjust macroeconomic imbalances. It was thought that under a gold standard, a country with a current account deficit would imply an outflow of gold. The loss of gold means less money supply, so the country would experience a price deflation. This would make its goods become cheaper in the global markets, making imports rise and exports fall, improving the current account again.

These peak-bottom periods alternated until the WWI interrupted the commercial flow and the gold exchange. Until WWII, currency speculation was almost inexistent and even not very much favored by institutions. The Great Depression and the abolition of the gold standard in 1931 led to a pause in the exchange activity. But later, after the transition period of 1971-73, the market suffered a series of changes which shaped the actual global monetary system: the major currencies started to float.

The Bretton Woods Era

After WWII the world needed a stable currency and a monetary agreement was reached by July 1944: seven hundred and thirty delegates from forty-four allied nations came together in Bretton Woods, NH, US The reason for the gathering was the United Nations Monetary and Financial Conference. For the first time in history monetary relations amongst the world's major industrial states were governed; it was the first time a system was implemented, in which the rules for commercial and financial relations were negotiated and agreed upon.
conference

It is said that many political reasons ended up resulting in the Bretton Woods agreement. Just to name a few: the two world wars and the interwar years, which was followed by the need to rebuild international economy; the Great Depression; the strong and shared belief in capitalism; USA.'s status of dominant power; the need for an economic system that would act as security.
Pegged, Semi-Pegged And Floating Condition

Considering the outcome of floating rates in the 1930's, which had negative worldwide consequences, the participants of the conference were eager to adopt basic rules with which to regulate the international monetary system as well as to create a policy in which the exchange rate of each currency would have a fixed value.

And indeed such measures were implemented: new international institutions were established to promote foreign trade and to maintain the monetary stability of the global economy.

The Bretton Woods system was an effective system that controlled conflict for many years. It could achieve the common goals that were set, however, its lifespan was finally short as by 1971 it collapsed.

It was also agreed that currencies would once again be fixed, or pegged, but this time to the US Dollar, which in turn was pegged to gold at 35 USD per fine ounces of gold. This meant that the value of a currency was directly linked to the value of the US Dollar. At that time if you needed to buy British Pounds, the value of the Pound would be expressed in US Dollars, whose value in turn was determined by the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to change the pegged value of its currency.
washington_hotel

Mount Washington Hotel, in Bretton Woods, New Hampshire, where in 1944, the United Nations Monetary and Financial Conference was celebrated, gathering representatives of 44 countries.

The peg was maintained until 1971 when the US Dollar could no longer hold the value of the pegged rate. From then on major governments adopted a floating system and all attempts from major economies to move back to a peg were eventually abandoned.

The Bretton Woods agreement was also meant to accomplish several other purposes: to avoid the capital evasion between nations, to restrict speculation with currencies, and to prevent each country from pursuing selfish policies, such as competitive devaluation, protectionism and forming trade blocks More generally speaking, to create a new world economic order. In fact, this new model brought two main advantages to the US: in on hand the revenues from the money creation itself calledseigniorage and on the other hand the possibility to hold a trade deficit for a very long time.

John Maynard Keynes, chairman of the Bank Commission at the Bretton Woods conference, and one of its intellectual founding fathers, envisaged an international monetary clearing union that in reality would have been a world central bank creating and using a world currency he called 'bancor'.

The problem, as Keynes well understood, was that an international trade and payments system - that relied on flexible exchange rates system with multiple currencies - would be inherently unstable. Keynes' proposal for a clearing union would penalize both deficit and surplus countries. Each country would have an official account in this mechanism, and all balance of payments surpluses and deficits would be recorded and settled through these accounts. There would be an incentive for both types of economies to run balanced trading systems as each country would bear the responsibility for correcting its imbalance.

This truly visionary proposal to create a mighty settlement union for all countries was seen as negative from US point of view.
Keynes' plan was not fully adopted but, in recognition of the pragmatic validity of his proposed solution, the exchange rates were fixed relative to the US Dollar and the Dollar backed by gold reserves. All other currencies could not deviate more than 10% to both sides of the fixed rate.

The US proposal, which was finally adopted, meant that each country would contribute to a common fund and member countries with surplus or deficit imbalances would have to purchase hard currencies from this fund. At the time, the UK was a deficit country and the US a surplus country, and only deficit countries would bear the responsibility for correcting the imbalance.

In case of such a fundamental imbalance, the central bank responsible of the currency had to ask authorization to the International Monetary Fund (IMF) to bring the value of its currency back to accepted levels. The IMF and what has evolved to be today the World Bank, the International Bank for Reconstruction and Development, emerged at that time to administer the new system.

At this point let's summarize the main features of the Bretton Woods system:

* It's a Dollar-based world payments arrangement: officially, the Bretton Woods system was a gold-based system which worked symmetrically for all countries. But in reality, it was a US-dominated system, which means the US provided domestic price stability (or instability) that other countries could (or should) "import". As the US did not itself engage in exchange rates intervention, which would have been desirable, all other countries had the obligation to intervene themselves in the currency market to fix their exchange rates against the US Dollar.
* It was a semi-pegged exchange rate system: this means that exchange rates were normally fixed but permitted to be infrequently adjusted under certain conditions. Members were obligated to declare a par value (a 'peg') for their national currency and to intervene in currency markets to limit exchange rate fluctuations within maximum 'band' of one per cent above or below parity. At the same time, members also retained the right, whenever necessary and in accordance with agreed procedures, to alter their peg to correct a 'fundamental disequilibrium' in their balance of payments. This arrangement was thought to combine exchange rate stability and flexibility, while avoiding mutually destructive devaluation.
* Tight capital mobility: by contrast to the classical gold standard of 1879-1914, when there was free capital mobility, member countries could impose capital-account regulations and severe exchange controls.
* Macroeconomic growth reached historically unprecedented highs: this was achieved through global price stability and trade liberalization from the mid 1950s to the late 1960s. page : 2, 3, 4, Market Structure, trade instrument , Advantages and Disadvantages,

Source: http://en.wikipedia.org,fxstreet.com