Foreign Exchange (Forex): How the Market Works

Key takeaways

• Forex (FX) is the global, decentralized marketplace for exchanging one national currency for another.
• It is the largest and most liquid financial market, with trading volumes of several trillion dollars each day.
• Currencies trade in pairs (e.g., EUR/USD); transactions occur in the spot, forward, and futures markets.
• Forex trading is electronic, operates 24 hours a day on weekdays, and is accessible to individuals through brokers.

What is the forex market?

The foreign exchange market (forex or FX) is where currencies are bought and sold. Rather than a single physical exchange, forex is a global electronic network that connects banks, brokerages, institutional investors, corporations, and individual traders. Exchange rates set in this market determine how much of one currency is required to buy another and influence international trade, travel, and corporate cash management.

How forex trading works

Every forex trade involves two currencies: one is bought (the base currency) and the other is sold (the quote currency). Prices are quoted as pairs, for example:
* EUR/USD = 1.20 means 1 euro costs 1.20 U.S. dollars.

Traders take positions based on expectations of currency movements:
* Going long: buying a currency expecting it will appreciate.
* Going short: selling a currency expecting it will depreciate.

Trades are typically executed electronically through brokers. There is no physical exchange of banknotes; traders gain or lose value based on changes in exchange rates.

Market structure and participants

• Decentralized: no single exchange or central clearing house.
• Open 24 hours a day on weekdays: trading follows overlapping sessions across time zones (major centers include London, New York, Tokyo, Singapore, and Hong Kong).
• Participants: central banks, commercial banks, corporations, hedge funds, investment managers, and retail traders.

Types of forex transactions

• Spot market: immediate exchange at the current spot rate. Settlement commonly occurs within two business days.
• Forward market: customized contracts to exchange currencies at a specified future date and rate, reflecting interest rate differentials.
• Futures market: standardized contracts traded on exchanges (e.g., futures exchanges) specifying a future exchange at a set price and date.

Role of the U.S. dollar and currency crosses

The U.S. dollar is the most actively traded currency and appears in the majority of currency pairs. Pairs that do not include the dollar are called cross-currency pairs (crosses), such as EUR/GBP or EUR/JPY.

Trading units and liquidity

Currencies are traded in lots:
* Micro lot = 1,000 units
* Mini lot = 10,000 units
* Standard lot = 100,000 units

High liquidity means traders can usually enter and exit positions quickly and at tight bid-ask spreads.

Example trade (simple)

A trader believes the euro will weaken versus the dollar. They sell (short) €100,000 at an exchange rate of 1.15 (receiving $115,000). If the euro falls to 1.10 and the trader buys back €100,000, they pay $110,000, realizing a $5,000 profit (ignoring transaction costs and leverage effects). If the euro had strengthened instead, the position would incur a loss.

Pros and cons of forex trading

Pros
* Liquidity: large market depth enables easier entry and exit.
* Continuous trading hours on weekdays: accommodates different time zones.
* Low apparent transaction costs: many brokers earn via spreads rather than high commissions.
* Broad access: wide variety of currency pairs for diversification and hedging.

Cons
* Leverage risk: widespread use of leverage can amplify losses and lead to losses greater than the initial investment.
* Complexity: currency values are influenced by macroeconomic factors, interest rates, and geopolitics, requiring substantial study.
* Volatility and speculation: short-term trading and news-driven moves can cause rapid price swings.
* Dominance by large institutions: professional players and deep-pocketed participants often set market dynamics.

Common forex terms

• Bid: the price at which the market (or broker) will buy the base currency.
• Ask: the price at which the market (or broker) will sell the base currency.
• Spread: the difference between the ask and bid prices.
• Pip: the smallest standard price movement for a currency pair (commonly the fourth decimal place).
• Leverage: borrowed capital used to increase exposure in a trade.
• Swap/rollover: interest paid or earned for holding a position overnight, based on interest-rate differentials.

Major currency pairs

The most frequently traded pairs include:
* EUR/USD (euro / U.S. dollar)
* USD/JPY (U.S. dollar / Japanese yen)
* GBP/USD (British pound / U.S. dollar)
* AUD/USD (Australian dollar / U.S. dollar)
* USD/CAD (U.S. dollar / Canadian dollar)
* USD/CHF (U.S. dollar / Swiss franc)
* NZD/USD (New Zealand dollar / U.S. dollar)

Market size and significance

Daily trading in the forex market is measured in the trillions of dollars, making it larger than most other financial markets. Exchange-rate movements affect global trade costs, corporate earnings on cross-border transactions, consumer prices for imports, and central-bank policy decisions.

Conclusion

Forex is the central mechanism by which currencies are priced and exchanged worldwide. Its decentralized, highly liquid, and 24-hour nature makes it attractive for hedging, corporate treasury management, and speculative trading. However, the market’s complexity, leverage-related risks, and fast-moving volatility require disciplined risk management and a solid understanding of macroeconomic drivers for anyone participating in currency markets.