What Is The Forex Market?: Key Takeaways

KEY TAKEAWAYS
 The foreign exchange (also known as FX or forex) market is a global

marketplace for exchanging national currencies.
 Because of the worldwide reach of trade, commerce, and finance, forex
markets tend to be the largest and most liquid asset markets in the world.
 Currencies trade against each other as exchange rate pairs. For example,
EUR/USD is a currency pair for trading euro against the US dollar.
 Forex markets exist as spot (cash) markets as well as derivatives markets
offering forwards, futures, options, and currency swaps.
 Market participants use forex to hedge against international currency and
interest rate risk, to speculate on geopolitical events, and to diversify
portfolios, among several other reasons.
What Is the Forex Market?
The foreign exchange market is where currencies are traded. Currencies are
important because they enable purchase of goods and services locally and
across borders. International currencies need to be exchanged in order to
conduct foreign trade and business.
If you are living in the U.S. and want to buy cheese from France, either you or the
company that you buy the cheese from has to pay the French for the cheese in
euros (EUR). This means that the U.S. importer would have to exchange the
equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A
French tourist in Egypt can't pay in euros to see the pyramids because it's not the
locally accepted currency. As such, the tourist has to exchange the euros for the
local currency, in this case the Egyptian pound, at the current exchange rate.
One unique aspect of this international market is that there is no central

marketplace for foreign exchange. Rather, currency trading is conducted
electronically over-the-counter (OTC), which means that all transactions occur
via computer networks between traders around the world, rather than on one
centralized exchange. The market is open 24 hours a day, five and a half days a
week, and currencies are traded worldwide in the major financial centers of
London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and
Sydney—across almost every time zone. This means that when the trading day
in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As
such, the forex market can be extremely active any time of the day, with price
quotes changing constantly.
A Brief History of Forex

In its most basic sense, the forex market has been around for centuries. People
have always exchanged or bartered goods and currencies to purchase goods
and services. However, the forex market, as we understand it today, is a
relatively modern invention.
After the accord at Bretton Woods in 1971, more currencies were allowed to float
freely against one another. The values of individual currencies vary based on
demand and circulation and they are monitored by foreign exchange trading
services.
Commercial and investment banks conduct most of the trading in forex markets

on behalf of their clients, but there are also speculative opportunities for trading
one currency against another for professional and individual investors.
There are two distinct features to currencies as an asset class:
 You can earn the interest rate differential between two currencies.

 You can profit from changes in the exchange rate.
An investor can profit from the difference between two interest rates in two
different economies by buying the currency with the higher interest rate and
shorting the currency with the lower interest rate. Prior to the 2008 financial
crisis, it was very common to short the Japanese yen (JPY) and buy British
pounds (GBP) because the interest rate differential was very large. This strategy
is sometimes referred to as a "carry trade."
Why We Can Trade Currencies

Currency trading was very difficult for individual investors prior to the internet.
Most currency traders were large multinational corporations, hedge funds or high
net worth individuals because forex trading required a lot of capital. With help
from the internet, a retail market aimed at individual traders has emerged,
providing easy access to the foreign exchange markets, either through the banks
themselves or brokers making a secondary market. Most online brokers or
dealers offer very high leverage to individual traders who can control a large
trade with a small account balance.
An Overview of Forex Markets

The FX market is where currencies are traded. It is the only truly continuous and
nonstop trading market in the world. In the past, the forex market was dominated
by institutional firms and large banks, who acted on behalf of clients. But it has
become more retail-oriented in recent years and traders and investors of many
holding sizes have begun participating in it.
An interesting aspect of world forex markets is that there are no physical

buildings that function as trading venues for the markets. Instead, it is a series of
connections made through trading terminals and computer networks. Participants
in this market are institutions, investment banks, commercial banks, and retail
investors.
The foreign exchange market is considered more opaque as compared to other

financial markets. Currencies are traded in OTC markets, where disclosures are
not mandatory. Large liquidity pools from institutional firms are a prevalent
feature of the market. One would presume that a country’s economic parameters
should be the most important criterion to determine its price. But that’s not the
case. A 2019 survey found that the motives of large financial institutions played
the most important role in determining currency prices.
There are three ways to trade Forex. They are as follows:
Spot market
Forex trading in the spot market has always been the largest because it trades in
the biggest “underlying” real asset for the forwards and futures market.
Previously, volumes in the futures and forwards markets surpassed those of the
spot market. However, the trading volumes for forex spot markets received a
boost with the advent of electronic trading and proliferation of forex brokers.
When people refer to the forex market, they usually are referring to the spot
market. The forwards and futures markets tend to be more popular with
companies that need to hedge their foreign exchange risks out to a specific date
in the future.
How Does the Spot Market Work?

The spot market is where currencies are bought and sold based on their trading
price. That price is determined by supply and demand and is calculated based on
several factors including current interest rates, economic performance, sentiment
towards ongoing political situations (both locally and internationally) as well as
the perception of the future performance of one currency against another.
A finalized deal is known as a "spot deal." It is a bilateral transaction in which one

party delivers an agreed-upon currency amount to the counter party and receives
a specified amount of another currency at the agreed-upon exchange rate value.
After a position is closed, the settlement is in cash. Although the spot market is
commonly known as one that deals with transactions in the present (rather than
the future), these trades actually take two days for settlement.
Forwards and Futures Markets

A forward contract is a private agreement between two parties to buy a currency
at a future date and at a pre-determined price in the OTC markets. A futures
contract is a standardized agreement between two parties to take delivery of a
currency at a future date and at a predetermined price.
Unlike the spot market, the forwards and futures markets do not trade actual
currencies. Instead they deal in contracts that represent claims to a certain
currency type, a specific price per unit and a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties,
who determine the terms of the agreement between themselves. In the futures
market, futures contracts are bought and sold based upon a standard size and
settlement date on public commodities markets, such as the Chicago Mercantile
Exchange.
In the U.S., the National Futures Association regulates the futures market.
Futures contracts have specific details, including the number of units being
traded, delivery and settlement dates, and minimum price increments that cannot
be customized. The exchange acts as a counterparty to the trader, providing
clearance and settlement services.
Both types of contracts are binding and are typically settled for cash at the
exchange in question upon expiry, although contracts can also be bought and
sold before they expire. The currency forwards and futures markets can offer
protection against risk when trading currencies. Usually, big international
corporations use these markets in order to hedge against future exchange rate
fluctuations, but speculators take part in these markets as well.
Note that you'll often see the terms: FX, forex, foreign-exchange market, and
currency market. These terms are synonymous and all refer to the forex market.
Forex for Hedging

Companies doing business in foreign countries are at risk due to fluctuations in
currency values when they buy or sell goods and services outside of their
domestic market. Foreign exchange markets provide a way to hedge currency
risk by fixing a rate at which the transaction will be completed.
To accomplish this, a trader can buy or sell currencies in the forward or swap

markets in advance, which locks in an exchange rate. For example, imagine that
a company plans to sell U.S.-made blenders in Europe when the exchange rate
between the euro and the dollar (EUR/USD) is €1 to $1 at parity.
The blender costs $100 to manufacture, and the U.S. firm plans to sell it for €150
—which is competitive with other blenders that were made in Europe. If this plan
is successful, the company will make $50 in profit because the EUR/USD
exchange rate is even. Unfortunately, the USD begins to rise in value versus the
euro until the EUR/USD exchange rate is 0.80, which means it now costs $0.80
to buy €1.00.
The problem the company faces is that while it still costs $100 to make the
blender, the company can only sell the product at the competitive price of €150,
which when translated back into dollars is only $120 (€150 X 0.80 = $120). A
stronger dollar resulted in a much smaller profit than expected.
The blender company could have reduced this risk by shorting the euro and
buying the USD when they were at parity. That way, if the dollar rose in value,
the profits from the trade would offset the reduced profit from the sale of
blenders. If the USD fell in value, the more favorable exchange rate will increase
the profit from the sale of blenders, which offsets the losses in the trade.
Hedging of this kind can be done in the currency futures market. The advantage
for the trader is that futures contracts are standardized and cleared by a central
authority. However, currency futures may be less liquid than the forward markets,
which are decentralized and exist within the interbank system throughout the
world.
Forex for Speculation

Factors like interest rates, trade flows, tourism, economic
strength, and geopolitical risk affect supply and demand for currencies, which
creates daily volatility in the forex markets. An opportunity exists to profit from
changes that may increase or reduce one currency's value compared to another.
A forecast that one currency will weaken is essentially the same as assuming
that the other currency in the pair will strengthen because currencies are traded
as pairs.
Imagine a trader who expects interest rates to rise in the U.S. compared to
Australia while the exchange rate between the two currencies (AUD/USD) is 0.71
(it takes $0.71 USD to buy $1.00 AUD). The trader believes higher interest rates
in the U.S. will increase demand for USD, and therefore the AUD/USD exchange
rate will fall because it will require fewer, stronger USD to buy an AUD.
Assume that the trader is correct and interest rates rise, which decreases the
AUD/USD exchange rate to 0.50. This means that it requires $0.50 USD to buy
$1.00 AUD. If the investor had shorted the AUD and went long the USD, they
would have profited from the change in value.
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KEY TAKEAWAYS

 The foreign exchange (also known as FX or forex) market is a global

One unique aspect of this international market is that there is no central

A Brief History of Forex

Commercial and investment banks conduct most of the trading in forex markets

There are two distinct features to currencies as an asset class:

 You can earn the interest rate differential between two currencies.

Why We Can Trade Currencies

An Overview of Forex Markets

An interesting aspect of world forex markets is that there are no physical

The foreign exchange market is considered more opaque as compared to other

There are three ways to trade Forex. They are as follows:

How Does the Spot Market Work?

A finalized deal is known as a "spot deal." It is a bilateral transaction in which one

Forwards and Futures Markets

Forex for Hedging

To accomplish this, a trader can buy or sell currencies in the forward or swap

Forex for Speculation

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