The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. Put simply, it’s the global market that allows one to trade two currencies against each other.
This market determines foreign exchange rates for every currency. An exchange rate is the relative price of two currencies from two different countries. The forex market includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, with turnover of $6.6 trillion per day (2019), followed by the credit market. The U.S. stock market trades around $257 billion a day; quite a large sum, but only a fraction of what forex trades.
The $6.6 trillion forex market turnover break-down is as follows:
$2 trillion in spot transactions
$1 trillion in outright forwards
$3.2 trillion in foreign exchange swaps
$108 billion currency swaps
$294 billion in options and other products
The main participants in this market are the larger international banks. Supply of a currency is controlled by central banks, who can announce measures that will have a significant effect on their currency’s price. Quantitative easing, for instance, involves injecting more money into an economy, and can cause its currency’s price to drop.
The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.
The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, which set out the rules for commercial and financial relations among the world's major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:
its huge trading volume, representing the largest asset class in the world leading to high liquidity;
its geographical dispersion;
its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
the variety of factors that affect exchange rates;
the low margins of relative profit compared with other markets of fixed income; and
the use of leverage to enhance profit and loss margins and with respect to account size.
A currency pair is the quotation of two different currencies, with the value of one currency being quoted against the other. The first listed currency of a currency pair is called the base currency, and the second currency is called the quote currency. Currency pairs are expressed by three-letter symbols.
Pairs are generally divided in the following categories:
Major pairs. Seven currencies that make up 80% of global forex trading. Includes EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD and AUD/USD
Minor pairs. Less frequently traded, these often feature major currencies against each other instead of the US dollar. Includes: EUR/GBP, EUR/CHF, GBP/JPY
Exotics. A major currency against one from a small or emerging economy. Includes: USD/PLN (US dollar vs Polish zloty) , GBP/MXN (Sterling vs Mexican peso), EUR/CZK
Regional pairs. Pairs classified by region – such as Scandinavia or Australasia. Includes: EUR/NOK (Euro vs Norwegian krona), AUD/NZD (Australian dollar vs New Zealand dollar), AUD/SGD
In the next article you’ll learn what moves forex prices.