As the largest market in the world, Forex attracts all kinds of investors. Each has a different reason for being in the market, and each uses a different technique and mechanism to achieve his or her investing goals. Although you might not be interested in using these techniques or strategies yourself, it's a good idea to learn about them anyway. They will move the markets and affect your returns.
Most traders in the Forex market today have one ambition—to make money fast. Of the market's average daily turnover—$1.2 trillion—more than 90 percent of the trades are speculative. That means that the person or institution investing that money has no other objective than to turn a profit. This is supported by other
Forex statistics. More than 40 percent of Forex trades last less than two days, and 80 percent last less than two weeks (source: BIS Triennial Survey, 2001).
Other participants in the market, however, are concerned less with making money than with protecting it. They want to hedge against currency swings or manage cash flow across international borders. They include giant banks, insurance companies, and multinational corporations such as BMW, Sony, and Wal-Mart, which must report profits from countries all over the world.
These players can select from several different kinds of trading vehicles to best realize their trading strategy and achieve their investing objective.
The most widely used vehicle is the spot market, also called cash or simply Forex. Spot trading represents the most basic transaction in Forex. A buyer and seller agree on a price and exchange money within two days. Deal done. Spot, however, is not the only trading tool available to investors. As in other markets, alternative investing vehicles were developed to satisfy each participant's unique needs.
These trading tools—called derivatives—are forwards, futures, and options and swaps. The last two are derivatives that have become critical players in the foreign exchange market. Of the Forex market's daily turnover in 2001, about $650 million was swaps, almost $400 million was spot transactions, and more than $100 million was forwards.
Each Forex participant can select the vehicle that best suits his or her purpose. For example, Ford Motor Company uses a forward to stabilize its cash flow in foreign revenues. Citibank might prefer a swap to lower its exposure to a specific currency. A hedge fund might select options to take advantage of currency moves.
A good way to understand the concept of choosing an investment instrument is to compare trading to a journey. Anyone planning to travel from, say, Boston to Mexico City can choose from a variety of transportation methods. You can fly, drive, take a train, or even walk. No method is necessarily wrong, but perhaps some ways are better than others. It all depends on what you want out of the trip.
When developing a trading strategy, you should see foreign exchange not as a single trading vehicle but as one with many choices. Once you have determined a strategy, it's critical that you choose a trading vehicle that will get you to your destination most effectively. Forex is just one way to trade foreign exchange.
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