Let's gain a little more insight into which type of transactions dominate the FX Market all data. We will see here has been taken from the triennial Central Bank survey of Foreign Exchange in OTC derivatives markets in 2016. First. Let's have a look at where trading actually takes place as we can see on the pie chart. The UK IE London is the location with the highest share in the FX Market by far with almost 40% of all transactions Happening Here on average the US IE New York is the second largest Center. The remaining share is split across the range of other countries, which all play significantly smaller roles. The reason why London dominates the FX Market reflects that it's time zone overlaps with Asia and us which makes it well positioned for a global trading hub.
When we break down The Daily transactions into currency pairs, we see that as expected. The US dollar is clearly the dominating currency according to the bis. The US dollar was on the side of 88% of all FX transactions that took place over the 2016 survey period the single most actively traded currency pair was euro versus US dollar followed by US dollar versus Japanese Yen and US dollar versus the pound.
Let's change gears for a second and talk about what a derivative is as they play a big role in the FX Market a derivative is a financial security or product which gives you similar exposure to an underlying asset without necessarily having to buy or sell that asset in many cases derivatives are more cost effective than buying the underlying asset. You can outlay less capital in order to get the same asset exposure. There are numerous types of derivatives. Some only expose you to buying or selling or some just to part of The Upside or downside.
The last breakdown we want to have a look at is the breakdown of FX by instrument class. In other words, which instruments are mainly traded in the FX Market as for any other asset class. There are multiple instruments available that refer to Foreign Exchange in general. We can distinguish the so-called spot instruments from derivatives in a spot trade. The agreement is made to exchange the two currency amounts involved immediately which in financial markets usually means two business days after the trade has been agreed in the case of derivatives. There is usually a longer gap between the trade date and the actual settlement in case of FX forwards. For example, the price of an fx transaction is agreed today, but the exchange of the two currency amounts is agreed to take place, for example, 12 months from now other derivatives only give the buyer of a currency the right to buy this currency at the agreed upon price in the future but not an obligation to do so, these instruments are known as FX.
Options as we can see the share of derivatives transactions in the FX Market significantly exceeds the share of spot transactions.
All prices quoted in professional trading have a bid side and an Ask side in FX rates are no exception the bid side of the quote 1.1325 in this case is the price at which the market taker can sell the base currency, which is Euros in the Euro US dollar pair the ask side, which is quoted at one point one. Three two, six is the price at which the market taker can buy the base currency. So if a client sells zeros the bid price applies if a client buy zeros the ask price applies.
As currencies are priced in relation to another currency. They are always quoted in pairs. This also means that if you are buying the base currency, you are selling the quoted currency and vice versa. This leads to a very simple rule for trading Foreign Exchange in the spot Market. If you expect the base currency to appreciate in other words to gain value versus the quoted currency, you buy the base currency and sell the quoted currency. If you expect the base currency to depreciate so to lose value versus the quoted currency, you sell the base currency and by the quoted currency So as an example if the euro to US dollar trades at the bid ask of 1.132526 and you expect one Euro to appreciate value to around $1.18. You would buy the Euro cheap now at 1.1326.
On the other hand if you were to US dollar trades at the bid ask of 1.132526 and you expect the euro to depreciate value to around $1.6 for each Euro. You would sell the Euro for 1.1325 now.
So let's have a look at some of the drivers behind foreign exchange spot prices it all of course comes down to supply and demand at least in the case of flexible exchange rates when the demand for a certain currency relative to another currency increases the value of this currency will increase relative to the other as well. But what drives such a change in demand and supply numerous Studies have been done to explain the behavior of FX rates in many factors have been found to have an impact simultaneously which is what makes forecasting of the future FX rates. Very challenging in practice. Here are just a couple of points that an fx forecasts would have to consider the interest rate in inflation differentials are significant short-term effects drivers higher real interest rates offered by a currency a track capital inflows and should lead to currency appreciation. Also as market prices are driven by expectations. Not only the current real interest rates are important but also the expectation of how those will develop in the future which will depend on future economic developments and monetary policy in the two countries political stability is of course, another factor and is a long-term Factor. The purchasing power of parity principle is often mentioned behind this principle stands the idea that similar Goods should have similar effects adjusted prices in all countries.
