Understanding the Foreign Exchange Market

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Contributor, Benzinga
February 14, 2023

The foreign exchange market, also known as the FX/forex/currency market, can seem like a complex beast. 

In this enormous and liquid market, trillions of dollars change hands every day. Unlike the New York Stock Exchange or Nasdaq exchange, the forex market has no centralized location, but it determines the exchange rate for currencies around the world. 

But what is the FX market, and how does this complex giant work?

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What is the Foreign Exchange Market?

The foreign exchange market is a global, decentralized, over-the-counter market where people and institutions trade currencies electronically through computer networks. This market sets the exchange rates of every currency pair. It covers all facets of purchasing, selling and exchanging currencies at established or current rates.

Banks, commercial businesses, central banks, forex dealers,  hedge funds, investment management companies, retail forex dealers and investors make up the foreign exchange markets.

How Does the Foreign Exchange Market Work?

The foreign exchange market has been in existence since countries traded with each other. However, modern foreign exchange trading began in the 1970s, when countries began to abandon the fixed Bretton Woods system for floating exchange rates. 

The foreign exchange market is the largest financial market in the world by trading volume and is open globally 24 hours a day.

The FX market provides a way to buy, sell, exchange and speculate on currencies while allowing currency conversion for international trade settlements and investments. Establishing the price of one currency compared to another is the primary function of the forex market.

Currencies are traded in pairs — for example, the EUR/USD — and the market determines the exchange rate for the currencies. 

Size of the Foreign Exchange Market

According to the Bank for International Settlements in its preliminary 2022 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets global results, trading in foreign exchange markets averaged $7.5 trillion per day in April 2022. The forex market continues to be the largest financial market in the world — larger than the stock market — with the most recent data trumping the 2019 results of $6.6 trillion.

3 Types of Foreign Exchange Markets

While the foreign exchange market is enormous, it can be broken down into three markets — the spot market, futures market and forwards market. 

Spot Forex Market

In the spot market, currencies are exchanged at the going rate. This significant element of the overall forex market includes buyers and sellers from across the financial industry as well as people who are exchanging currencies.

Futures Forex Market

The forex futures market is comparable to the forward market, with trades taking place at an agreed price at an agreed date. The futures market takes place on exchanges regulated by the Commodity Futures Trading Commission (CFTC), a distinction from the forward market. For example, the Chicago Mercantile Exchange offers currency futures and options on currency futures products.

Forward Forex Market

In the forward forex market, similarly to the futures market, the buyer and seller agree to exchange currencies at a predetermined price and time in the future. These transactions are privately negotiated and take place without an exchange. Only the value is changed; no actual currencies are traded. Like the futures market, traders frequently use hedging strategies in the forward market.

The CME Group provides this chart that shows the difference between the futures and forward markets.

Advantages of the Foreign Exchange Market

One of the forex market's primary advantages is that it is open 24 hours a day, allowing investors and traders to participate in the market at any time. The majority of investors and traders don’t pay traditional fees or commissions that can be charged in other markets. Forex has no central regulatory body that oversees the market. The foreign exchange market (especially the major and minor currency pairs) is liquid. When trading currencies, forex traders are able to gain access to significant leverage, allowing them to use margin to magnify gains (or losses).

Disadvantages of the Foreign Exchange Market

While having no central body to oversee the market can be an advantage, it is also a disadvantage, heightening the potential risk. 

While investing in other markets, such as stocks or bonds, can provide a potential return via dividends or interest payments, profiting via the forex market relies on the price moving in the investor’s favor. 

Using leverage in the forex market can help boost profits, but it can lead to significant losses that may threaten an investor’s account.

Should You Trade the Forex Market?

Trading the currency market is easy to do, with the majority of people able to access a brokerage account from their laptops and cell phones. However, it is not easy to do it well. To be a successful forex trader, you need a considerable amount of knowledge and experience to succeed. It's important to understand the forex market and the potential pitfalls before jumping in. 

Frequently Asked Questions

Q

What is the purpose of the foreign exchange market?

A

The currency market facilitates cross-border trade, as well as investment and financial transactions, allowing businesses that make transactions and deals in foreign currencies to convert the currencies they need.

Q

What are the three types of foreign exchange markets?

A

The three types of foreign exchange markets are the spot market, futures market and forward market.

Q

What is an example of a foreign exchange market?

A

An example of a foreign exchange pair is the EUR/USD, which is the exchange rate for the euro vs. the U.S. dollar.

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About Sam Boughedda, Stock Market Analyst

He is an expert in the following spaces: stock market news writing, analysis, and research.