Reviewed by Gordon Scott
Foreign exchange is the conversion of one currency into another. The foreign exchange market, or “the forex” as it is often called, is the global marketplace for converting currencies at their current values, which rise and fall according to changes in supply and demand.
Not all currencies trade on the foreign exchange market. A nation may choose to peg its currency value to that of another currency, such as the U.S. dollar. It may also choose to freeze its currency value.
However, many countries float their currencies freely against those of other countries. This keeps the value of each currency in constant fluctuation against the values of other currencies.
Key Takeaways
- The value of a currency is determined by market forces related to trade, investment, tourism, and geopolitical risk.
- Trading in currencies is conducted by companies and banking institutions that do business globally and by traders seeking to profit from the constant fluctuations in values.
- Foreign exchange is handled globally between banks, with all transactions falling under the auspices of the Bank for International Settlements (BIS).
Understanding Currency Value
The value of a currency at any given time is determined by market forces responding to developments in foreign trade, investment, tourism, and geopolitical risk.
Every time a tourist visits a country, for example, they must pay for goods and services using the currency of the host country. Currency exchange of this kind is one of the demand factors for a particular currency.
Another demand factor occurs when a foreign company seeks to do business with another in a specific country. Usually, the foreign company has to pay in the local company’s currency.
Yet another demand factor arises from investors who want to put their money into a foreign country, requiring them to raise cash in the foreign currency.
All of these requirements produce a need for foreign exchange and contribute to the vast size of foreign exchange markets.
Foreign exchange is handled globally between banks and all transactions fall under the auspices of the Bank for International Settlements (BIS).
How Inflation Affects Foreign Exchange Rates
Inflation can have a major effect on the value of a country’s currency and its foreign exchange rates against other currencies.
While it is just one factor among many, inflation is more likely to have a significant negative effect on a currency’s value. A low rate of inflation does not guarantee a favorable exchange rate, but an extremely high inflation rate is very likely to have a negative impact.
Inflation is also closely related to interest rates, which can influence exchange rates. The interrelationship between interest rates and inflation is complex and often difficult for countries to manage.
Low interest rates spur consumer spending and economic growth, creating generally positive influences on currency value. If consumer spending increases and demand grows to exceed supply, inflation may ensue, which is not necessarily a bad outcome.
However, low interest rates don’t usually attract foreign investment the way higher interest rates can. Higher interest rates attract foreign investment, which is likely to increase demand for a country’s currency.
Can Anyone Trade on the Forex?
The forex is dominated by institutional traders exchanging huge amounts of money at split-second speeds. That said, anyone can trade on the forex. Many internet-based trading platforms give investors access.
Understand going in that forex trading is risky business.
Who Owns the Forex?
Nobody owns the forex. It has no management, no headquarters, and no physical existence. Trading is entirely electronic and global, and it occurs 24 hours a day to accommodate the world’s time zones. The modern forex market began to emerge after the U.S. dropped the gold standard in 1971 and fully developed with the introduction of electronic trading.
Are All Currencies Traded on the Forex?
Only free-floating currencies are traded on the forex. More importantly, a few currency pairs dominate trading. Those pairs consist of two of the following: the U.S. dollar, the euro, the Canadian dollar, the British pound, the Australian dollar, the Chinese yuan, and the Swiss franc.
The Bottom Line
For many people, exchanging currency is a necessary bit of business. Travelers abroad need local currency to spend. Companies doing business abroad need to obtain foreign currencies to complete their transactions.
To others, exchanging currency is a way to make money by exploiting the constant fluctuations in the value of major currencies compared to the values of other major currencies.