A:

Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a country's currency is valued according to the laws 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 may also be set 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, they 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 another in a specific country. Usually, the foreign company will have to pay in the local company's 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 contribute to the vast size of foreign exchange markets.

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

For further reading on this topic, see our Forex Tutorial.

RELATED FAQS
  1. How does inflation affect the exchange rate between two nations?

    Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and can influence ... Read Answer >>
  2. 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 >>
  3. How often do exchange rates fluctuate?

    Learn how exchange rates fluctuate. Exchange rates float freely against one another, which means they are in constant fluctuation. ... Read Answer >>
  4. Can I trade a currency when its main market is closed?

    In the forex market, currencies from all over the world can be traded at all times of the day. The forex market is very liquid, ... Read Answer >>
  5. How does the foreign exchange market trade 24 hours a day?

    Because foreign currencies are in high demand, the forex market is open 24 hours a day, and trading is not done at one central ... Read Answer >>
Related Articles
  1. Trading

    6 factors that influence exchange rates

    Aside from interest rates and inflation, the exchange rate is one of the most important determinants of a country's level of economic health.
  2. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments. Find out more about currency risk analysis in global investing.
  3. Trading

    Dollarization Explained

    Find out how fledgling economies can find some stability in their currency and attract foreign investment.
  4. Trading

    Currency exchange: Floating rate versus fixed rate

    Baffled by exchange rates? Wonder why some currencies fluctuate while others are pegged? This article has the answers regarding the difference between floating and fixed exchange rates.
  5. 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 ...
  6. 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.
  7. 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.
  8. Trading

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
RELATED TERMS
  1. International Currency Exchange Rate

    An international currency exchange rate is the rate at which ...
  2. Key Currency

    A key currency used is money issued by stable, developed country ...
  3. International Currency Converter

    An international currency converter converts the value of one ...
  4. Accounting Currency

    Accounting currency is the monetary unit used when recording ...
  5. Managed Currency

    A managed currency is one whose monetary exchange rate is affected ...
  6. International Currency Markets

    The International Currency Market is a market in which participants ...
Hot Definitions
  1. Monero

    Monero is a digital currency that offers a high level of anonymity for users and their online transactions.
  2. Risk Tolerance

    Risk tolerance is the degree of variability in investment returns that an individual is willing to withstand.
  3. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  4. Initial Coin Offering (ICO)

    An Initial Coin Offering (ICO) is an unregulated means by which funds are raised for a new cryptocurrency venture.
  5. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  6. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
Trading Center