What is the Foreign Exchange Market?

Updated: Jan 26




The foreign exchange market, also known as the forex or FX market for short, is the global market for trading in the world’s currencies. Rather than being a market with a central exchange, the foreign exchange market is an informal over-the-counter marketplace. Over-the-counter exchanges are exchanges made between two parties without any form of supervision.


The foreign exchange market is a completely open market. In fact, any activity related to the buying, selling, or exchanging of currencies can be said to be taking place on the foreign exchange market.


The foreign exchange market is by far the biggest marketplace on the planet, with average daily turnovers for some periods in 2019 (which was a very active year) approaching highs of over 6 trillion US dollars.


Who Trades on the Foreign Exchange Market?

The participants who are engaged in the trading of currencies on the foreign exchange market can be thought of as existing on different levels.


With so many participants and so many levels of selling in the foreign exchange market, it is easier to look at it as a series of interconnected marketplaces than as a single entity.


The Interbank Market

The top-level is known as the interbank market and is a behind-the-scenes market, which only a small number of people can access. At this level of the market, the main participants are the banks, although a small number of insurance companies and other financial organisations also take part. At this level, very large amounts of currency are traded between these participants with a very low spread. The spread is a cost built into an exchange of currencies.


The rate set in the interbank market is known as the interbank rate and this rate underpins the rates of exchange that are offered between participants at other levels of the market.


Other Levels

At the other levels, there are a number of other participants, such as international businesses, hedge funds, investment management firms, currency brokers, or various other participants who all trade on the foreign exchange market for various reasons.


Generally speaking, the specific levels that participants sit on can be seen as different bands according to the amounts of money which are exchanged. However, there is a huge spread in participants at other levels with levels of interconnectedness as well.


Exchange Rates

One important outcome of the foreign exchange market is that the values of the world’s currencies are decided by the level of demand for them on the currency market.

This is particularly true for free-floating currencies. These are currencies for which the value is entirely set by the foreign exchange market. However, currencies that peg the value of their currency either to the value of another currency or an alternative reference point (such as the value of gold) also have their values decided to vary degrees by the activities of the currency market.


As the value of a country’s currency shifts, so does its position within the system of global trade.


As a country’s currency strengthens against others, its buying power increases while its export price competitiveness decreases. As a country’s currency weakens against others, its buying power decreases but its competitiveness as an exporter increases.


As such, the value of a currency on the foreign exchange market has a large knock-on effect.


Exchange Rates are Variable and Unpredictable

While this is true, the value of currencies on the currency market is highly variable and also highly unpredictable. Markets can make large and sudden shifts, for example as happened during the 2008 financial crisis, and it is very hard indeed to predict how currency values will vary in the future.


The high unpredictability in currency value is understandable, however, as no other market is influenced by such a vast array of factors. A huge amount of what happens in the world at any given time is in some way connected to the foreign exchange market.


What Function Does the Foreign Exchange Market Serve?

The primary functions that the foreign exchange market serves are to provide access to foreign currencies and to allow for speculation on the value of currencies.


Speculation

Forex traders can speculate on the value of currencies in various ways. Speculation refers to the buying and selling of currencies for the purpose of profiting from changes to exchange rates. The popularity of this activity has increased enormously recently as the internet has allowed access to a wider range of people to speculate on currencies.


The largest known currency trade in the world happened in 1992 when George Soros made, probably, over $1 billion dollars by betting that the pound sterling would fall in value. He was right and his speculation earned him a huge amount of money.


Trade, Investment, and Hedging

Another function of the foreign exchange market is that it provides access to foreign currencies, whether this be to businesses, individuals, governments, or other groups. Having access to foreign currencies is particularly useful in business as it allows international trade to take place.


Having readily available access to foreign currencies allows businesses to import and export goods and materials, and to carry out overseas operations. On top of this, businesses and other groups are able to make investments in foreign countries as well.


FX Hedging

One area which is less well known outside of international business is the area of foreign exchange (FX) hedging. FX hedging refers to measurements which businesses that trade in foreign currencies take to protect themselves from fluctuations in the exchange rate.


Businesses can be affected to varying degrees and in varying ways by changes to the exchange rate. The risk that is posed to businesses by exchange rate fluctuations is known as currency risk. Those businesses which are most affected by it are those which hold assets that are denominated in foreign currencies and those which carry out transactions in foreign currencies.


Businesses that are exposed to currency risk can protect themselves against it in various ways. Often this involves making an arrangement through the foreign exchange market which either offsets the risk that a company is exposed to or avoids it by fixing an exchange rate for a future date. By fixing an exchange rate, any changes which take place in the time before the currency is exchanged are negated.


What Factors Influence Exchange Rates?

As we said earlier, the exchange rates which come about as a result of activity on the foreign exchange market are often highly variable and highly unpredictable. While various attempts have been made to understand the movement of exchange rates, there is little success to report. Some predictability can be seen in short-term fluctuations. However, longer-term variations are still very hard to predict.


That said, the three major influencers on exchange rates are well known to be political events, economic factors, and the trading behaviour of the foreign exchange market itself.


Politics

National, regional and global politics can have a significant effect on the value of a currency. In general terms, instability tends to weaken the value of a currency, whereas stability tends to strengthen it. However, the extent to which weakening or strengthening of a currency happens is hard to predict and political events are often highly unpredictable as well.


The Brexit vote of 2016 is a good example of how politics can influence the value of a currency. After the vote was announced, the pound suffered one of its biggest falls in value for a single day on record. This can largely be attributed to the unexpected nature of the vote and the lack of preparation for it. As ever, uncertainty implies instability and the pound fell in value as a result.


It should also be pointed out that the value of the pound has still not recovered and that there has been a high level of variability in exchange rates for the British pound ever since the Brexit vote was announced.


Economic Factors

This refers to the economic policy and trade rules under which a currency operates and also the economic conditions of the country(s) in which it exists.


There are a number of things to consider when assessing the economy which underpins a currency. These include government fiscal and monetary policy, government budgets and deficits, trends in economic performance, productivity trends, and the level of inflation.


The Foreign Exchange Market

Another key factor is the influence that the foreign exchange market has on itself. This is largely down to the psychology of the various participants in it and is a highly reactive factor.

One major trend is that there tends to be rushed away from certain currencies (like the British pound after Brexit) and towards safer currencies when they are seen as unstable. While this is true, the extent to which this happens is highly variable and where this trend exists it can also present an opportunity as the price of a currency drops.


As well as this, the market often overreacts in advance to expected events and then acts in the opposite direction after an event has passed. This influences the timing of market movements and demonstrates how markets can be entirely moved by the expectations of participants rather than by actual events.


As the participants in the foreign exchange market are the key driving force behind the trades which take place on it, it is natural that their predictions and fears will have a huge influence. This is in light of the fact that events in foreign exchange are so unpredictable.





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