Mechanics of Forex Trading

Forex trading is an important aspect of forex management. It is basically concerned with various forex operations including purchase and sale of currencies of different countries in order to meet payments and receipts requirements as a result of foreign trade. Forex trading is done either in retail market or in whole sale market (also called inter bank market). Under retail market, the traveler and tourists exchange one currency for another in form of currency notes or traveller cheques. Here, the total turnover and average transaction size are very small. The spread between buying and selling price is large. Whereas wholesale market of inter bank market is a market with huge turnover. The major market participants of this market include commercial banks, corporation and central banks.

In the inter bank market deals are done on the telephone or on electronic media. Suppose bank A wishes to buy the British Pound sterling against the US dollar. A trader in bank A might call his counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details the amount bought/sold, the price, the identity of the counter party etc. - in their respective banks' computerized records systems and go on to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do the deals very rapidly. At the international level inter-bank settlement is effected through the Clearing House Inter bank Payment System (CHIPS), located at New york.

When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader gives a "two-way quote" i.e. he quotes two prices: a price at which he will buy a sterling in exchange for dollars and a price at which he will sell a sterling for dollars. The enquirer does not have to specify whether the wants to sell or buy pounds against dollars; as mentioned above, the marker is ready to take either side of the transactions. Thus his quotation can be represented as (the numbers are hypothetical);

$/£: 1.7554-1.7560 or 1:7554/1.7560

The number on the left of the hyphen or the slash is the amount of dollars the trader will pay to buy a pound. This is the trader's bid rate for a pound sterling (against dollar). The number on the right is the amount of dollars the trader will require to sell a pound. This is the trader's ask rate (also called the offer rate). For a quote given above the Bid-ask spread is 0.0006 dollar or 0.06 cent per pound. This margin is the market maker's compensation for the costs incurred and normal profit on capital invested in the dealing function.

In a normal two-way market, a trader expects "to be hit" on both sides of his quote in roughly equal amounts. That is, in the pound-dollar case above, on a normal business day the trader expects to buy and sell roughly equal amount of pounds (and of course dollars). The Bank's margin would then be the bid-ask spread.

But suppose during the course of trading a trader finds that he is "being hit" on one side of his quote much more often than the other side. In our pound-dollar example this means that he is either buying many more pounds than he is selling or vice versa. This leads to the trader building up "a position". If he has sold (bought) more pounds than he had bought (sold) he is said to have net short position (long position) in pounds. Given the volatility of the exchange rates, maintaining a short or long position for too long can be a risky proportion. For instance, suppose that a trader has build up a net short position in pounds of 1,00,000. The pound suddenly appreciates from say $1.7500 to $1.7520, this implies that the bank's liability increases by $2000 ($0.0020 per pound for 1 million pounds). Of course, a pound depreciation would have resulted in a gain. Similarly, a net long position leads to a loss if it has to be covered at a lower price and gain if at a higher price. (By "covering a position" we mean undertaking transactions what will reduce the net position to zero. A trader net long in pounds must sell pounds to cover; a net short must buy pounds).

The potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for long durations would be equivalent to speculation and bank exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight.

In an ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itself is the transaction cost. Also, unlike the money or capital markets, where different rates of interest are charged to different borrowers depending on their creditworthiness, in the wholesale foreign exchange market no much distinction is made. Default risk - the possibility that the counter party in a transaction may not deliver in its side of the deal is handled by prescribing limits on the size of positions a trader can take with different corporate customers.

Communications pertaining to international financial transactions are handled mainly by a large network called Society for Worldwide Inter Bank Financial Telecommunication (SWIFT). This is a non-profit Belgian cooperative with main and on the location, a bank can access a regional processor or a main center which then transmits the information to the appropriate location.