A:

Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation.

The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with a company in a specific country. Usually, the foreign company will have to pay the local company in their local currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and are the reasons why foreign exchange markets are so large.

Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank of International Settlements.

(For more on this topic, see our Forex Tutorial.)

RELATED FAQS
  1. How are international exchange rates set?

    International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency ... Read Answer >>
  2. What types of companies benefit from reporting results utilizing constant currencies ...

    Understand constant currency figures, and explore some of the reasons why a company is likely to benefit from reporting using ... Read Answer >>
  3. What are key economic factors that can cause currency depreciation in a country?

    Read about the causes of currency devaluation, and find out how to differentiate between relative and absolute currency devaluation. Read Answer >>
  4. Why do forex traders use a currency converter?

    All currencies are quoted in pairs - one country's currency against another country's currency. A currency converter is used ... Read Answer >>
  5. What is the difference between a nation's current account deficit and its currency ...

    Learn the respective meanings of the two terms, current account deficit and currency valuation, and understand the relationship ... Read Answer >>
Related Articles
  1. Investing

    Why Countries Keep Reserve Currency

    Central banks and financial institutions hold large amounts of foreign money as their reserve currency.
  2. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  3. Trading

    Currency Exchange: Floating Rate Vs. Fixed Rate

    Baffled by exchange rates? Wonder why some currencies fluctuate while others are pegged? This article has the answers.
  4. Trading

    Main Factors that Influence Exchange Rates

    The exchange rate is one of the most important determinants of a country's relative level of economic health and can impact your returns.
  5. Investing

    The Pros And Cons Of A Pegged Exchange Rate

    A pegged exchange rate occurs when one country fixes its currency’s value to the value of another country’s currency. But it has both pros and cons.
  6. Investing

    5 Ways To Invest In Currencies

    As the economies of some countries sputter and former third-world countries are beginning to emerge, currency investing is becoming more intriguing. Learn ways to make money on money with the ...
  7. Trading

    Understanding the Floating Exchange Rate

    Floating exchange rate is the exchange rate between two currencies at any given time.
  8. Trading

    Interest Rate and Currency Value And Exchange Rate

    In general, higher interest rates in one country tend to increase the value of its currency.
  9. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders.
RELATED TERMS
  1. International Currency Exchange Rate

    The rate at which two currencies in the market can be exchanged. ...
  2. Currency

    Currency is a generally accepted form of money, including coins ...
  3. Currency Pairs

    Two currencies with exchange rates that are traded in the retail ...
  4. Soft Currency

    A currency with a value that fluctuates as a result of the country's ...
  5. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  6. Key Currency

    The currency used as a reference in an international transaction ...
Hot Definitions
  1. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  2. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  3. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  4. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  5. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
  6. Wash-Sale Rule

    An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security ...
Trading Center