There are differences between the equity and forex markets. In the equity marketplace, investors typically only do their trades with other individuals, or institutions, like mutual funds. In the forex marketplace, additional players are on the field, and they have agendas unlike those found in the equity marketplace. So, it’s critical to learn and comprehend the roles and agendas of the primary players within the forex marketplace.
Central Banks and Governments
Without a doubt, federal governments and central banks are among the most powerful players in the currency exchange marketplace. In many nations, the central banking institution is just a long arm of the federal government and accords its policies hand in hand with leading government officials. On the other hand, other governments prefer a central banking institution that has a degree of autonomy from the government leadership, as they feel it is better in terms of minimizing inflation and interest rates, all of which are conducive to growth of the national economy. Whether or not a central bank is part of a government or an independent institution, most nations have regular conversations between central banks and government leaders about the national monetary policy. So, central banking institutions and the national government leaders typically are in agreement about monetary policy.
Central banking institutions usually manage volumes of currency reserves, and they manipulate them in accordance with the agreed upon economic agendas. For instance, since China locked the value of its yuan currency to the American dollar, Beijing has been purchasing multiple millions of dollars in American treasury bills so that China can keep its currency at an ideal rate of exchange. Many central banking institutions take advantage of the forex marketplace to manipulate their own volumes of currency reserve. If their holdings are significant enough, they can hold tremendous sway over the forex marketplace.
Other Banks and Financial Institutions
On top of governments themselves, and central banking institutions, independent or nonaligned banks are among the biggest entities that involve themselves with the forex marketplace. Most individual people that require smaller scale volumes of another nation’s currency just get it at their community bank. On the other hand, the amount of monies exchanged locally by individuals pales in comparison to the sheer masses of currency exchanged between banks on the global scale.
This is done through the interbank market, which is where big financial institutions, mostly banks, trade with one another and figure out the specific currency values that personal traders are given through their trading interfaces. Global banks interact with one another through electronic brokering interchanges which use credit as a foundation for business. Transactions only occur between institutions that have credit relationships with one another. The larger a bank is, the more total credit relationships it can have, as well as the better prices it can negotiate for its clients. Smaller banks have fewer numbers of credit relationships and a lower place on the pricing totem poll.
It’s easy to consider banks as dealers in this marketplace given that they both buy and sell currency at bidding and asking prices. One method that banks use to profit off of forex is by paying a good price for currency and then selling it at a premium rate. The forex marketplace is not a centralized thing, so it’s not rare to see various banks with different exchange rates for identical currencies.
Businesses with routine international transactions are among the largest customers of banks dealing in forex. When any business sells to overseas clients or buys from outside its native borders, it has to have a way to manage the constant volatility of currencies whose values are always in flux.
If shareholders and company leadership were to choose one thing that they absolutely loathe, it is anything uncertain. Multinationals usually face forex risk as among their largest issues. For instance, assume that a French business orders electronics from Japan which will get paid for in ten months in yen. The exchange rates between euros and yen can swing drastically over those ten months, so the French business has absolutely no clue what the cost will be at the end of the wait.
One possible option is that the French business could cut down on the volatility and risk by going through the spot market to do an immediate purchase for whatever foreign currency they might later need.
Regrettably, many businesses simply do not have enough liquid assets to do spot transaction, and they might also be averse to the idea of personally holding large volumes of a specific foreign currency for multiple months. So, instead, businesses usually make use of hedging strategies so they can lock down a distinct rate of exchange for future business, or possibly remove any sources of rate of exchange risk for a particular transaction.
For instance, if a Brazilian company wants to import nickel from the United States, it has to pay in American dollars. If the price of the Brazilian currency falls compared to the dollar, the Brazilian firm will suffer financial losses. Instead, it would rather enter the contract with a locked rate of exchange based on current prices so that there is no risk of doing business in American greenbacks. Such contracts might be futures contracts or forwards.
Speculators are another type of player in the forex marketplace. Speculators do not hedge against movements within exchange rates or currency exchanges used to finance international business. Instead, speculators try to profit by playing the actual fluctuations in levels of rates of exchange.
George Soros might be the most famous of all currency speculators. He speculated a decline in Britain’s pound once, and the moves he made netted him over a billion American dollars in profit in just under a month, for which he became famous. At the opposite end of the spectrum is Nick Leeson, who worked for England’s Barings Bank as a derivatives trader. He undertook speculation on yen futures contracts that triggered losses of nearly a billion and a half, which doomed the company.
Hedge funds are among the biggest speculators in forex, and they are quite controversial, since they are unregulated in many cases and use untraditional tactics in pursuit of large profits. They are like mutual funds who have gotten too powerful for their own good. Many central banks enjoy criticizing hedge funds. Given the ability of hedge funds to make massive waves, they do have significant impact on currencies and economies. A few notable critics cite hedge funds as the cause behind Asian currency crises in the 90s, but others claim that central bank incompetence was really at fault.