Foreign Exchange (Forex) Definition
In this video, you’ll learn about foreign exchange. Also known as forex or FX, foreign exchange is the trading of one national currency for another. The forex market is the largest, most liquid market in the world, with trillions of dollars being traded every day. The foreign exchange market determines the value, also known as an exchange rate, of the majority of currencies. The forex market has no centralized location, but is made up of a electronic network of banks, brokers, and institutions. Watch this video for more more information on FX and trading in the foreign exchange market.
Reviewed by Gordon ScottFact checked by Katrina MunichielloReviewed by Gordon ScottFact checked by Katrina Munichiello
The foreign exchange, also known as FX or the forex market, is the largest financial market in the world with a daily volume of $6.6 trillion. Forex is the digital site where one currency is exchanged for another.
The forex market has a lot of unique attributes that may come as a surprise for new traders. Consider teaming up with a good forex broker if you’re new to the game and want to engage in some currency trades.
Key Takeaways
- The foreign exchange, also known as FX or the forex market, is a global marketplace for exchanging national currencies against each other.
- Market participants use forex to hedge against international currency and interest rate risk, to speculate on geopolitical events, and to diversify portfolios.
- Major players in this market tend to be financial institutions like commercial banks, central banks, money managers, and hedge funds.
- Global corporations use forex markets to hedge currency risk from foreign transactions.
- Individual traders are a very small relative portion of forex volume and mainly use the market to speculate and day trade.
What Is Forex?
An exchange rate is a price paid for one currency in exchange for another. This is the type of exchange that drives the forex market.
There are 161 official currencies in the world. Most international forex trades and payments are made using the U.S. dollar, British pound, Japanese yen, and the euro, however. Other popular currency trading instruments include the Australian dollar, Swiss franc, Canadian dollar, and New Zealand dollar.
Currency can be traded through spot transactions, forwards, swaps, and option contracts where the underlying instrument is a currency. Currency trading occurs continuously around the world, 24 hours a day, five days a week.
Who Trades Forex?
The forex market not only has many players but many types of players as well.
Commercial and Investment Banks
The greatest volume of currency is traded in the interbank market where banks of all sizes trade currency with each other and through electronic networks. Big banks account for a large percentage of total currency volume trades. Banks facilitate forex transactions for clients and conduct speculative trades from their own trading desks.
The bid-ask spread represents the bank’s profits when banks act as dealers for clients. Speculative currency trades are executed to profit from currency fluctuations. Currencies can also provide diversification to a portfolio mix.
Central Banks
Central banks represent their nations’ governments. They’re extremely important players in the forex market. Open market operations and interest rate policies of central banks influence currency rates to a very large extent.
A central bank is responsible for fixing the price of its native currency on forex. This is the exchange rate regime by which its currency will trade in the open market. Exchange rate regimes are divided into floating, fixed, and pegged types.
Any action taken by a central bank in the forex market is done to stabilize or increase the competitiveness of that nation’s economy. Central banks as well as speculators may engage in currency interventions to make their currencies appreciate or depreciate.
A central bank may weaken its own currency by creating additional supply during periods of long deflationary trends. This is then used to purchase foreign currency. It effectively weakens the domestic currency, making exports more competitive in the global market.
Important
Central banks use these strategies to calm inflation. Doing so serves as a long-term indicator for forex traders.
Investment Managers and Hedge Funds
Portfolio managers, pooled funds, and hedge funds make up the second-largest collection of players in the forex market. Investment managers trade currencies for large accounts such as pension funds, foundations, and endowments.
An investment manager with an international portfolio will purchase and sell currencies to trade foreign securities. Investment managers may also make speculative forex trades. Some hedge funds execute speculative currency trades as part of their investment strategies.
Multinational Corporations
Firms engaged in importing and exporting use forex transactions to pay for goods and services. Consider the example of a German solar panel producer that imports American components and sells its finished products in China. The Chinese yuan the producer received must be converted back to euros after the final sale is made. The German firm must then exchange euros for dollars to purchase more American components.
Companies trade forex to hedge the risk associated with foreign currency translations. The same German firm might purchase American dollars in the spot market or enter into a currency swap agreement to obtain dollars in advance of purchasing components from the American company to reduce foreign currency exposure risk.
Note
Hedging against currency risk can also add a level of safety to offshore investments.
Individual Investors
The volume of forex trades made by retail investors is extremely low compared to financial institutions and companies but it’s growing rapidly in popularity. Investors base currency trades on a combination of fundamentals such as interest rate parity, inflation rates, monetary policy expectations, and technical factors including support, resistance, and price patterns.
How Forex Trading Shapes Business
The resulting collaboration of the types of forex traders is a highly liquid, global market that impacts businesses around the world. Exchange rate movements are a factor in inflation, global corporate earnings, and the balance of payments account for each country.
The popular currency carry trade strategy highlights how market participants influence exchange rates that spill over to the global economy. It’s executed by banks, hedge funds, investment managers, and individual investors. It’s designed to capture differences in yields across currencies by borrowing low-yielding currencies and selling them to purchase high-yielding currencies. Market participants would sell the Japanese yen and buy a higher-yield currency if the yen has a low yield.
The carry trade unwinds and investors sell their higher-yielding investments when interest rates in higher-yielding countries begin to fall back toward lower-yielding countries. An unwinding of the yen carry trade may cause large Japanese financial institutions and investors with sizable foreign holdings to move money back into Japan as the spread between foreign yields and domestic yields narrows. This strategy may result in a broad decrease in global equity prices.
What Is a Currency Forward?
A currency forward is a binding, customized, written contract between two parties who agree to trade at a specified exchange rate on a future, predetermined date. Currency forwards are traded over the counter.
What Is a Spot Market?
A spot market is largely about timing. Commodities are traded for instant delivery but “instant” doesn’t necessarily translate to immediate delivery. It can take a day or two.
What Is a Currency Carry Trade?
A currency carry trade involves borrowing money in a currency with a low interest rate and then investing it in one with a high interest rate. The goal is to make money on the differential.
The Bottom Line
Forex is the largest market in the world because it empowers everyone from central banks to retail investors to potentially see profits from currency fluctuations related to the global economy. Various strategies can be used to trade and hedge currencies such as the carry trade which highlights how forex players impact the global economy.
The reasons for forex trading are varied. Speculative trades executed by banks, financial institutions, hedge funds, and individual investors are profit-motivated. Central banks move forex markets dramatically through monetary policy, exchange regime setting, and currency intervention in rare cases. Corporations trade currency for global business operations and to hedge risk. Investors can benefit from knowing who trades forex and why they do so.
Read the original article on Investopedia.