What is Foreign Currency Exchange?

FOREX or Foreign Currency Exchange is the global financial marketplace where people are able to trade one currency against the other. The foreign exchange market works like any other market in the world but the main difference is that in an ordinary marketplace people buy things in exchange for money but here in FOREX, people buy money (one particular currency) in exchange for money (another currency). Besides, this marketplace has no specific location; rather it is operated and participated virtually is open throughout the day and closes only on weekends.

Understanding Foreign Currency Exchange

One currency is traded against another based on the exchange rate that it has. Here an exchange rate is the relative price of two currencies from two different sovereign nations. For example, if someone from the United States exchanges one dollar for the Japanese yen then he or she will get 100 yen. If this is the case then that person can claim to have participated in the foreign exchange.

Let us give you another example to make things a bit more clear. If that person visits Japan and at the end of his visit tries to convert the remaining yen that he has to the US dollar and if he finds out that the exchange rate has changed a bit then these fluctuations allow the traders to make a profit from this marketplace.

Exchange rates change by a fraction of a moment making this market very fluid. The participants can be categorized into five different categories i.e. government, organizations, traders, ordinary people, and speculators. The government participates in this market for taking or paying back loans or grants. Organizations like multinational corporations or NGOs participate to carry out their business. Traders participate to do import-export, ordinary people participate in this market to access foreign currency to pay for travel, education, or healthcare expenses in a foreign country.

These are the real participants of the market. Real in the sense that they participate to cater to a genuine need of theirs. Besides them another group of people that take part in this market are speculators. They participate to earn a profit based on the fluctuations of the exchange rates. Hence, most of the currency transactions that take place in the FOREX or Foreign Exchange Currency market are bought (and sold) for speculative reasons.

Instruments that are Traded in Foreign Exchange Currency Market

As the name suggests, currencies of different kinds are traded or transacted in the foreign exchange market. Here currencies can be divided into two broad categories like major currencies and minor currencies. Major currencies are the US Dollar, Great Britain Pound, Canadian Dollar, Euro, Swiss Franc, Japanese Yen, Australian Dollar, and New Zealand Dollar. The rest of the currencies can be defined as minor currencies. Major currencies are so-called because these currencies are more heavily traded than others. Correspondingly they represent the major economies of the globe. Purchasing one of the major currencies is like investing in that country’s economy as the value of that particular currency summarily represents the economic condition of that nation.

Foreign Exchange Currency Market Size and Liquidity

In terms of size, the FOREX or foreign exchange market is the largest marketplace than any other market on earth. It is a virtual market that neither has a physical location nor it has a central exchange. For this reason, this market is sometimes called the over-the-counter (OTC) market, and the bulk of transactions are conducted on what is called the “interbank market“.

The U.S. dollar is the most traded currency, making up 84.9% of all transactions in this market whereas, with a volume of 39.1%, Euro comes second, while the Japanese Yen comes in the third position with 19.0% market share. The US Dollar is one-half of every major currency pair that are traded in this market, and the majors comprise 75% of all transactions, so it’s a must to pay close attention to the U.S. dollar. In fact, as per International Monetary Fund (IMF), the US Dollar consists 62% of the globe’s official foreign exchange reserve.

A Bit About United States Dollar

The United States of America is the lone superpower of the world boasting the largest economy on earth. Which makes its national currency US Dollar the de facto reserve currency of the global financial system. The financial marketplace that the US has is the world’s largest and the most fluid. Besides, the US has the most stable political system anywhere in the world. All these factors have contributed to making the United States Dollar or USD the most preferred currency to trade-in. 

Speculative Nature of the Foreign Exchange Currency Market

The most important thing to consider about the Forex market is that though the transaction done by the participants having a genuine need to participate in the market becomes part of the trading volume, the major part of the trading or market movement takes place based on speculative transactions. Let us put it differently, most of the trading volume comes from market participants that buy and sell based on the short-term price movements of currency pairs.

According to some experts, the trading volume brought about by speculative activity may comprise around 90% of the total trade volume. Thus making this marketplace very fluid, meaning it becomes very easy to either buy or sell any currency pair during any given point of time in the trading session, while the effect on the price of the currency remains minimal. It must be noted that, though the Forex market is very fluid and liquid. The depth of the marking changes depending on the pair of currency and the time of the trading session (day).

Multiple Ways of Foreign Exchange Currency Trading

Apart from being decentralized and fluid, the Forex market is very flexible as well. It provides different ways to do the transaction and those are retail forex, spot FX, currency futures, currency options, currency exchange-traded funds (or ETFs), forex CFDs, and forex spread betting. Other financial instruments like FX swaps and forwards are reserved for institutional investors. Let us discuss these ones by one.

• • Retail Forex

    Retail Forex provides the investor to participate in trading on an individual basis. There exists a secondary over-the-counter (OTC) market that allows an individual investor to participate in the foreign exchange. Access to this market is provided by “forex trading providers”. Forex trading providers trade in the primary OTC market on the client’s behalf. They trace the best available prices and then add a ‘markup’ before posting those prices in their respective forex trading apps.

  • Spot FX

    Spot FX is also an over-the-counter (OTC) market like retail forex but the difference is that the spot transaction is a bilateral agreement between two parties to physically exchange one currency against another. This agreement is a binding obligation to buy or sell a certain amount of foreign currency at a price that is the “spot exchange rate” or the current exchange rate.

  • Currency Futures

     Futures is a legally binding agreement to buy or sell a certain currency at a specific price on a specific date. Currency futures were invented in 1972 by Chicago Mercantile Exchange (CME). The market for the future is centralized and well regulated and transparent. 

  • Currency Options

    Options are a kind of financial instrument that provides the buyer the ‘option’ but not the ‘obligation’ to buy or sell a particular currency at a specific price on the option’s date of expiry. Like futures, the options are also traded in centralized exchanges like Chicago Mercantile Exchange (CME), International Securities Exchange (ISE), or the Philadelphia Stock Exchange (PHLX).

  • Currency ETFs

    ETFs are very much like mutual funds, meaning it does not place the burden of trading on an individual investor. ETFs are used mostly for minimizing risks by diversifying the investment portfolio. ETFs are managed by financial institutions. Those institutions buy and hold the desired currencies in a fund. They then offer shares of the fund to ordinary investors.

  • Forex CFD

    Forex CFD is a contract for difference. This is a financial derivative. As the name goes, this kind of financial instrument traces the price of an underlying asset so that traders can speculate on whether the price of that particular asset will rise or fall. Here the asset would be the currencies.