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Currencies are traded against
one another. Each pair of currencies thus constitutes an individual
product and is traditionally noted XXX/YYY, where YYY is the ISO 4217
international three-letter code of the currency into which the price of
one unit of XXX currency is expressed. For instance, EUR/USD is the price
of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.
On the spot market, according to the BIS study, the most heavily traded
products were:
EUR/USD - 28 %
USD/JPY - 18 %
GBP/USD (also called cable) - 14 %
and the US currency was involved in 89% of transactions, followed by the
euro (37%), the yen (20%) and sterling (17%). (Note that volume
percentages should add up to 200% - 100% for all the sellers, and 100% for
all the buyers).
Although trading in the euro has grown considerably since the currency's
creation in January 1999, the foreign exchange market is thus still
largely dollar-centered. For instance, trading the euro versus a
non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ.
The only exception to this is EUR/JPY, which is an established traded
currency pair in the interbank spot market.
National central banks play an important role in the foreign exchange
markets. They try to control the money supply, inflation, and/or interest
rates and often have official or unofficial target rates for their
currencies. They can use their often substantial foreign exchange
reserves, to stabilize the market. Milton Friedman argued that the best
stabilization strategy would be for central banks to buy when the exchange
rate is too low, and to sell when the rate is too high - that is, to trade
for a profit. Nevertheless, central banks do not go bankrupt if they make
large losses, like other traders would, and there is no convincing
evidence that they do make a profit trading.
The mere expectation or rumor of central bank intervention might be
enough to stabilize a currency, but aggressive intervention might be used
several times each year in countries with a dirty float currency regime.
Central banks do not always achieve their objectives, however. The
combined resources of the market can easily overwhelm any central bank.
Several scenarios of this nature were seen in the 1992-93 ERM collapse,
and in more recent times in South East Asia.
The rules of the game in trading FX are highly disadvantageous for retail
speculators. Most retail speculators in FX lack trading experience and
capital (account minimums at some firms are as low as 250-500 USD). Large
minimum position sizes, which on most retail platforms ranges from $10,000
to $100,000, force small traders to take imprudently large positions using
extremely high leverage. Professional forex traders rarely use more than
10:1 leverage, yet many retail forex firms allow client leverage of 100:1
or even 200:1, without disclosing that this is highly unusual for currency
traders. This drastically increases the risk of a margin call (which, if
the speculator's trade is not offset, is pure profit for the market
maker).
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