What is the Foreign Exchange Market?

The foreign exchange market (also known as forex, FX or the currency market) is an over-the-counter (OTC) global marketplace that determines the exchange rate for currencies around the world. Participants are able to buy, sell, exchange and speculate on currencies. Foreign exchange markets are made up of banks, forex dealers, commercial companies, central banks, investment management firms, hedge funds, retail forex dealers and investors.

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Forex Market Basics

Understanding the Foreign Exchange Market

The foreign exchange market – also called forex, FX, or currency market – was one of the original financial markets formed to bring structure to the burgeoning global economy. In terms of trading volume it is, by far, the largest financial market in the world. Aside from providing a venue for the buying, selling, exchanging and speculation of currencies, the forex market also enables currency conversion for international trade settlements and investments. According to the Bank for International Settlements (BIS), which is owned by central banks, trading in foreign exchange markets averaged $5.1 trillion per day in April 2016.

Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative to the value of the other. This determines how much of country A's currency country B can buy, and vice versa. Establishing this relationship (price) for the global markets is the main function of the foreign exchange market. This also greatly enhances liquidity in all other financial markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float". Free floating currencies are those whose relative value is determined by free market forces, such as supply / demand relationships. A fixed float is where a country's governing body sets its currency's relative value to other currencies, often by pegging it to some standard. Free floating currencies include the U.S. Dollar, Japanese Yen and British Pound, while examples of fixed floating currencies include the Chinese Yuan and the Indian Rupee.

One of the most unique features of the forex market is that it is comprised of a global network of financial centers that transact 24 hours a day, closing only on the weekends. As one major forex hub closes, another hub in a different part of the world remains open for business. This increases the liquidity available in currency markets, which adds to its appeal as the largest asset class available to investors.

The most liquid trading pairs are, in descending order of liquidity:

  1. EUR/USD
  2. USD/JPY
  3. GBP/USD

Key Takeaways

  • The foreign exchange market is an over-the-counter (OTC) marketplace that determines the exchange rate for global currencies.
  • It is, by far, the largest financial market in the world and is comprised of a global network of financial centers that transact 24 hours a day, closing only on the weekends.
  • Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative to the value of the other.

Forex Leverage

The leverage available in FX markets is one of the highest that traders and investors can find anywhere. Leverage is a loan given to an investor by their broker. With this loan, investors are able to increase their trade size, which could translate to greater profitability. A word of caution, though: losses are also amplified.

For example, investors who have a $1,000 forex market account can trade $100,000 worth of currency with a margin of 1 percent. This is referred to as having a 100:1 leverage. Their profit or loss will be based on the $100,000 notional amount.

Benefits of Using the Forex Market

  • There are fewer rules, which means investors aren't held to the strict standards or regulations found in other markets.
  • There are no clearing houses and no central bodies that oversee the forex market.
  • Most investors won't have to pay the traditional fees or commissions that you would on another market.
  • Because the market is open 24 hours a day, you can trade at any time of day, which means there's no cut-off time to be able to participate in the market.
  • Finally, if you're worried about risk and reward, you can get in and out whenever you want and you can buy as much currency as you can afford.