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. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  2. How do I close a long position in forex?

    Closing a long position in forex trading depends on whether you are using a broker operating under U.S. trading regulations. In ... Read Full Answer >>
  3. Where did the term 'pip' in currency exchange come from?

    The term pip is an acronym for percentage in point or price interest point. It measures a unit of change within a pair of ... Read Full Answer >>
  4. How do changes in national interest rates affect a currency's value and exchange ...

    All other factors being equal, higher interest rates in a country increase the value of that country's currency relative ... Read Full Answer >>
  5. What is the difference between pips, points, and ticks?

    Point, tick and pip are terms used to describe price changes in the stock market and other markets. While traders and analysts ... Read Full Answer >>
  6. What is the difference between extensive margin and intensive margin in economics?

    Trading on margin is not commonly done in stock trading except by professional investors and institutional traders. However, ... Read Full Answer >>
Related Articles
  1. Economics

    Understanding the History of Money

    Money has been a part of human history for at least 3,000 years, evolving from bartering to banknotes.
  2. Forex Fundamentals

    How To Calculate An Exchange Rate

    An exchange rate is how much it costs to exchange one currency for another.
  3. Forex Education

    Four Currencies Under the Spotlight in 2016

    With currencies having become the “tail that wags the dog,” in terms of their impact on the global economy, these four currencies will be under the spotlight in 2016.
  4. Forex

    How 2016 Could Be A Disaster for These Currencies

    Tanking oil prices, slowing BRIC growth, and general instability do not bode well for these currencies.
  5. Forex Strategies

    How To Build A Forex Trading Model

    The forex market is volatile, but a forex trading model with clear, step-by-step rules based on a sound strategy can help decrease losing trades.
  6. Forex Fundamentals

    Explaining Slippage

    Slippage occurs when a trade is executed at a different price than what was expected.
  7. Forex Education

    About the EGP, or Egyptian Pound

    The EGP, or the Egyptian pound, is the currency of Egypt.
  8. Forex Education

    The History Of Money: From Barter To Banknotes

    Money has been a part of human history for at least 3,000 years. Learn how it evolved.
  9. Forex Education

    Top 7 Questions About Currency Trading Answered

    Whether you're puzzled by pips or curious about carry trades, your queries are answered here.
  10. Forex Education

    Bretton Woods: How It Changed the World

    While the Bretton Woods system is no longer in place, it fundamentally changed the international monetary order.
RELATED TERMS
  1. Purchasing Power Parity - PPP

    An economic theory that estimates the amount of adjustment needed ...
  2. Currency

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

    The risk that a local currency cannot be converted into the currency ...
  4. ICE LIBOR

    See LIBOR
  5. WM/Reuters Benchmark Rates

    Spot and forward foreign exchange rates that are used as standard ...
  6. Exchange Rate

    The price of a nation’s currency in terms of another currency. ...
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center