What is the 'Foreign Exchange'

Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency.

Foreign exchange also refers to the global market where currencies are traded virtually around the clock. The largest trading centers are London, New York, Singapore and Tokyo. The term foreign exchange is usually abbreviated as "forex" and occasionally as "FX."

BREAKING DOWN 'Foreign Exchange'

Foreign exchange transactions encompass everything from the conversion of currencies by a traveler at an airport kiosk to billion-dollar payments made by corporations, financial institutions and governments. Transactions range from imports and exports to speculative positions with no underlying goods or services. Increasing globalization has led to a massive increase in the number of foreign exchange transactions in recent decades.

The global foreign exchange market is the largest financial market in the world, with average daily volumes in the trillions of dollars. Foreign exchange transactions can be done for spot or forward delivery. There is no centralized market for forex transactions, which are executed over the counter and around the clock.

Spot Market

Spot for most currencies is two business days; the major exception is the U.S. dollar versus the Canadian dollar, which settles on the next business day. Other pairs settle in two business days. During periods that have multiple holidays, such as Easter or Christmas, spot transactions can take as long as six days to settle. The price is established on the trade date but money is exchanged on the value date.

The U.S. dollar is the most actively traded currency. The most common pairs are the dollar versus the euro, Japanese yen, British pound and Swiss franc. Trading pairs that do not include the dollar are referred to as crosses. The most common crosses are the euro versus the pound and yen.

The spot market can be very volatile. Movement in the short term is dominated by technical trading, which focuses on direction and speed of movement. People who focus on technicals are often referred to as chartists. Long-term currency moves are driven by fundamental factors such as relative interest rates and economic growth.

Forward Market

A forward trade is any trade that settles further in the future than spot. The forward price is a combination of the spot rate plus or minus forward points that represent the interest rate differential between the two currencies. Most have a maturity less than a year in the future but longer is possible. Like with a spot, the price is set on the transaction date but money is exchanged on the maturity date.

A forward contract is tailor-made to the requirements of the counterparties. They can be for any amount and settle on any date that is not a weekend or a holiday in one of the countries.

Futures Market

A futures transaction is similar to a forward in that it settles later than a spot deal, but it is for a standard size and settlement date and is traded on a commodities market. The exchange acts as the counterparty.

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