FOREX DEFINED

FOREX is the acronym for the foreign exchange market, where one coun-try’s currency is exchanged for that of another through a floating-exchange-rate system. It is the world’s largest financial market, with an estimated daily average turnover of upwards of $2.5 trillion.

FOREX trading is not bound to any one trading floor and is not a mar-ket in the traditional sense because there is no central exchange. Instead, the entire market is run electronically, within a network of banks, continu-ously over a 24-hour period. The market opens Sunday at 5 P.M. (EST) and goes thru Friday afternoon at 4:30 P.M. (EST).

Banks have a natural flow of foreign exchange business from their customers, who buy and sell currency according to their individual needs. The banks must manage their own currency deposits in the changing light of their customers’ transactions. To hedge or not to hedge? This is a way to basically minimize their potential for loss, often referred to as a hedge.
Investment managers also now deal globally, and they also must take positions in the different currencies, as well as in more traditional instru-ments, such as bonds and equities. For example, if a mutual fund is invested in U.S. bonds, the manager must decide if the fund should be invested in U.S. dollars or in a different currency. Again it is a question of hedging, another layer of risk to manage.
Conversely, because currencies have become an asset class, managers also must decide if the creation of a foreign currency exposure is desirable for speculative purposes. For example, it is possible to be long (to have bought) on the Nikkei Dow and short of (to have sold) the Japanese yen. In this case, the manager is using his or her knowledge of currency fluctua-tions to hedge in equity index position.
Companies and institutions of all kinds that have foreign customers or suppliers must decide if they should hedge the foreign exchange exposure that this creates. Exporters have the risk of a rise in the value of their local currency, and importers have the risk of a fall in theirs. If there is a change in currency value before the goods are exchanged, one of the parties could lose all their expected profits. This uncertainty in expected profits can be eliminated by offsetting the risk in the currency exchange.
As a result of these types of transactions, noninterbank turnover in the FOREX now accounts for about 25 percent of all transactions (21 percent in 1992).