Foreign Currency Market

The foreign exchange market (currency, forex, or FX) is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another

TRADING CHARACTERISTICS:

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously.

Fluctuations secondary to the supply and demand for a given currency in exchange  rates are usually caused by the following :

A. Economic

• Expectations of economic growth and health are reflected by the reports on gross domestic product (GDP) growth, employment levels, retail sales, and capacity utilization.  Generally, the more healthy and robust a country’s economy is, the better its currency will perform, and the more demand for it there will be.
• Inflation (purchasing power parity theory) typically puts pressure on a currency. It loses value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
• Interest rates which is derived from the government’s central bank monetary policy can affect the currency pricing. When interest rates of a currency increases, then its demand increases too.
• Budget and trade deficits or surpluses reflects the actual monetary flow and  competetiveness of a country. The trade surpluses can positively impact the nation’s currency. The  trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country’s currency to conduct trade. 
• Macroeconomic conditions affecting the increasing productivity in an economy should positively influence the value of its currency. The effect is more prominent if the increase is in the traded sector.

B. Political

• All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation’s economy. For example, destabilization of coalition governments in India, Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

C. Market Psychology

• Flights to quality. There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts which may be beset by political upheavals, and economic downturns.
• Long-term trends. The business cycles analysis looks at the longer-term price trends that may rise from the the political and economic trends.  
• "Buy the rumor, sell the fact" It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction.
• Economic numbers Often there will be significant price reaction to financial data, information or news. Unexpected news or information that is perceived as positive for the economy or for a particular market sector or company will of course increase stock prices, and vice versa.