Forex as a Hedge
Commercial enterprises doing business in foreign countries are at risk due to fluctuation in the currency value when they have to buy goods or services from or sell goods or services to another country. Hence, the foreign exchange markets provide a way to hedge the risk by fixing a rate at which the transaction will be concluded at some time in the future. To accomplish this, a trader can buy or sell currencies in the forward or swap markets, at which time the bank will lock in a rate so that the trader knows exactly what the exchange rate will be and thus mitigate his or her company's risk. To some extent, the futures market can also offer a means to hedge currency risk, depending on the size of the trade and the actual currency involved. The futures market is conducted in a centralized exchange and is less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world. (For a new way to hedge your currency, read Hedge Against Exchange Rate Risk With Currency ETFs.)
Forex as a Speculation
Since there is constant fluctuation between the currency values of the various countries due to varying supply and demand factors, such as interest rates, trade flows, tourism, economic strength, geopolitical risk and so on, an opportunity exists to bet against these changing values by buying or selling one currency against another in the hopes that the currency you buy will gain in strength or that the currency you sell will weaken against its counterpart. (For addition reading, see Top 7 Questions About Currency Trading Answered.)
Currency as an Asset Class
There are two distinct features to this class:
You can earn the interest rate differential between two currencies.
You can gain value in the exchange rate.
Why We Can Trade Currencies
Until the advent of the internet, currency trading was really limited to interbank activity on behalf of their clients. Gradually, the banks themselves set up proprietary desks to trade for their own accounts, and this was followed by large multinational corporations, hedge funds and high net worth individuals.
With the proliferation of the internet, a retail market aimed at individual traders has sprung up that provides easy access to the foreign exchange markets, either through the banks themselves or brokers making a secondary market. (For more on the basics of forex, check out 8 Basic Forex Market Concepts.)
Forex Risk
Confusion exists about the risks involved in trading currencies. Much has been said about the interbank market being unregulated and therefore very risky due to a lack of oversight. This perception is not entirely true, though. A better approach to the discussion of risk would be to understand the differences between a decentralized market versus a centralized market and then determine where regulation would be appropriate.
The interbank market is made up of many banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and for this they have many internal auditing processes to keep them as safe as possible. The regulations are industry imposed for the sake and protection of each participating bank.
Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is arrived at through supply and demand. Due to the huge flows within the system, it is almost impossible for any one rogue trader to influence the price of a currency. Indeed, in today's high-volume market, with between $2 trillion and $3 trillion being traded per day, even the central banks cannot move the market for any length of time without the full coordination and cooperation of other central banks. (For more on the interbank system, read The Foreign Exchange Interbank Market.)
Read more: Forex Trading: A Beginner's Guide http://www.investopedia.com/articles/forex/11/why-trade-forex.asp#ixzz4rq2f3NJR
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