The foreign exchange market and who trades in it
The foreign exchange (FX) market, the world's largest, swaps one currency for another so trade and cross-border investment can happen. Big dealing banks form the sell side; the buy side includes corporations, real money funds, leveraged traders, retail traders, governments, central banks and sovereign wealth funds. Most volume is FX swaps driven by financial institutions, not trade.
Before this: Monetary Policy
On the exam
- Describe the foreign exchange market, including its functions and participants, distinguish between nominal and real exchange rates, and calculate and interpret the percentage change in a currency relative to another currency
Describe the FX market, its functions and its participants. Expect "which of these is a sell-side participant?", "which participant uses little leverage?" and "which instrument has the largest turnover?".
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What does the foreign exchange market do?
The foreign exchange market is where one currency is exchanged for another. It is the largest financial market in the world, and it exists so that trade and cross-border investment can happen: an importer must pay in the exporter’s currency, and a fund buying foreign bonds must first buy the currency they are priced in. It also lets anyone hedge or speculate on currencies.
- Open around the clock. Trading follows the sun across time zones through the business week, and is busiest while London and New York are both open.
- A currency is not an exchange rate. You hold a currency (EUR 1 million on deposit). An exchange rate is a price involving two currencies.
- Most volume is financial. Investment, hedging and speculation drive far more turnover than paying for goods.
What products are traded?
Memorize
Four products matter. A spot transaction settles in about two business days at today’s rate. An outright forward settles on a future date at a rate fixed today. An FX swap is a spot trade combined with an offsetting forward trade in the opposite direction, and it is the biggest product by turnover. FX options give the right, not the obligation, to exchange at a set rate, and are the smallest of the four.
- FX swaps Memorize spot plus an offsetting forward; the largest share
- Spot transactions Use it settle in about two business days
- Outright forwards Use it settle on a future date at a rate fixed today
- FX options right, not obligation; the smallest share
Exam tip The exam trap is spot. It feels like the main product but FX swaps are larger.
Who trades?
Memorize
Participants fall into two groups. The sell side is the large dealing banks that make markets, quoting prices to clients and earning the bid-offer spread. The buy side is everyone who uses those prices.
- Sell side Memorize dealers who make markets and earn the bid-offer spread
- First-tier banks large global dealers
- Second- and third-tier banks regional; rely on the big dealers
-
- Buy side Memorize clients who use the market
- Corporations trade payments, mergers and acquisitions (M&A), foreign borrowing
- Real money accounts Memorize pension, mutual and insurance funds, endowments, exchange-traded funds; little leverage
- Leveraged accounts Memorize hedge funds, proprietary and algorithmic traders; speculate
- Retail accounts travelers and online speculators
- Governments official payments, foreign-currency borrowing
- Central banks intervene to steer the currency; manage reserves
- Sovereign wealth funds Use it invest national surpluses like large real money funds
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| Side | Participant | Typical motive |
|---|---|---|
| Sell side | large dealing banks (first tier); regional banks (second and third tier) that rely on them | make markets, earn the bid-offer spread |
| Buy side | corporations | pay and receive for trade, mergers and acquisitions (M&A), foreign borrowing |
| real money accounts (pension, mutual and insurance funds, endowments, exchange-traded funds) | invest abroad with little leverage | |
| leveraged accounts (hedge funds, proprietary and algorithmic traders) | speculate; a large and growing share of volume | |
| retail accounts | travel money, online speculation | |
| governments | official payments, foreign-currency borrowing | |
| central banks | intervene to steer the currency, manage FX reserves | |
| sovereign wealth funds | invest national surpluses; behave like large real money funds |
Most participants mix hedging and speculation, and public bodies may add policy aims. Three facts about market structure are enough for the exam: FX swaps are the largest product; financial clients now trade more than banks trade among themselves, while non-financial clients are a small slice; and each of the five most traded currency pairs includes the US dollar.
Go deeper Why a few first-tier banks dominate dealing
Know the idea
Technology and a global client base let the biggest banks match many client orders against each other internally, so they can quote tighter prices than smaller banks. Regional banks therefore rely on them for liquidity. A voluntary global code of conduct covers ethics, execution and settlement practices for FX dealers and their clients.
Go deeper Why FX matters even if you only buy domestic equities
Know the idea
A domestic company can earn much of its revenue abroad, compete with foreign rivals and have foreign owners. Currency moves therefore reach its earnings and share price even if you never buy a foreign asset.
Memorize this
MemorizeSell side and buy side
| Side | Who | Why they trade |
|---|---|---|
| Sell side | large dealing banks (first tier), regional banks | make markets, earn the spread |
| Buy side | corporations | trade payments, M&A, foreign borrowing |
| Buy side | real money accounts | invest abroad, little leverage |
| Buy side | leveraged accounts | speculate, growing share |
| Buy side | retail, governments, central banks, SWFs | travel money, official payments, intervention, national surpluses |
Memory hook Sell side SELLS a service (prices). Everyone who BUYS that service is buy side.
Know it cold A corporation that borrows abroad is a client, so it is buy side.
MemorizeProduct ranking
| Rank | Product |
|---|---|
| 1 | FX swaps |
| 2 | Spot |
| 3 | Outright forwards |
| 4 | Options (smallest) |
Memory hook Swaps, Spot, Forwards, Options: S, S, F, O.
Know it cold Financial institutions, not trade settlement, generate most volume.
- Sell side Memorize dealers who make markets and earn the bid-offer spread
- First-tier banks large global dealers
- Second- and third-tier banks regional; rely on the big dealers
-
- Buy side Memorize clients who use the market
- Corporations trade payments, mergers and acquisitions (M&A), foreign borrowing
- Real money accounts Memorize pension, mutual and insurance funds, endowments, exchange-traded funds; little leverage
- Leveraged accounts Memorize hedge funds, proprietary and algorithmic traders; speculate
- Retail accounts travelers and online speculators
- Governments official payments, foreign-currency borrowing
- Central banks intervene to steer the currency; manage reserves
- Sovereign wealth funds Use it invest national surpluses like large real money funds
-
- FX swaps Memorize spot plus an offsetting forward; the largest share
- Spot transactions Use it settle in about two business days
- Outright forwards Use it settle on a future date at a rate fixed today
- FX options right, not obligation; the smallest share
How it is asked
-
Which side?
Which participant makes markets and earns the bid-offer spread?
A large dealing bank (sell side). Pension and hedge funds are buy side.
-
Largest product
The FX product with the largest daily turnover is most likely:
FX swaps. Spot is the trap because it gets the headlines.
-
Little leverage
Pension funds and mutual funds that use little leverage are called:
Real money accounts, as opposed to leveraged accounts such as hedge funds.
Exam traps
- Assuming spot is the largest product. FX swaps are.
- Assuming trade-related corporate flows dominate volume. Investment and speculative flows do.
- Calling a corporation that borrows abroad sell side. Corporations are clients, so buy side.
Checkpoint
4 exam-style questions. About 90 seconds each.
1Which participant makes markets in currencies and earns the bid-offer spread?
2The FX product with the largest share of daily turnover is most likely:
3Pension funds and mutual funds that use little leverage are referred to as:
4A manufacturer borrows in a foreign currency to fund a new plant and must convert the proceeds. In the FX market it is best classified as:
Key takeaways
- The FX market enables trade, investment, hedging and speculation.
- Sell side = dealing banks. Buy side = corporations, funds, traders, official sector and retail.
- FX swaps and financial institutions dominate volume.
All Economics formulas, every lesson
Practice exam-style questions on Capital Flows and the FX Market
Questions about this lesson?
Where this comes back
- Exchange rate quotes and percentage change in a currency Capital Flows and the FX Market
Questions candidates ask
Who are the participants in the foreign exchange market?
The sell side is the large dealing banks that quote prices. The buy side is everyone who uses those quotes: corporations, real money funds, leveraged accounts such as hedge funds, retail traders, governments, central banks and sovereign wealth funds.
What is the difference between real money and leveraged accounts?
Real money accounts, such as pension funds, mutual funds and endowments, invest with little or no leverage and few derivatives. Leveraged accounts, such as hedge funds and proprietary traders, borrow to speculate, and their share of volume has grown.
What is an FX swap?
An FX swap combines a spot trade with an offsetting forward trade in the opposite direction. It lets a party borrow one currency against another for a period, and it is the largest product by turnover.
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