Foreign Exchange Market Overview Bookmark and Share

The Foreign Exchange Market (FX or FOREX Market for short) refers to where currency trading takes place. It is the largest and most liquid market in the world hosting a variety of market participants. The major centers for trading are New York, London, and Tokyo which allow for trading to occur 24 hours a day (except weekends). Due to relatively small daily fluctuations in currency values and large trading volumes, the currency market makes use of extensive use of leverage. For example, one may only put $10,000 of capital to control the equivalent of $1,000,000 of currency. The overwhelming majority of all currency trades are purely speculative. The FX market is divided into levels of access with only the largest banking firms having access to razor sharp bid-ask spreads. Each bank may trade billions of dollars a day and prices are normally unavailable to those outside the inner circle. Other participants in the FX market include: commercial companies, central banks, hedge funds, investment management firms, and retail brokers.

Currencies are traded against one another. They are quoted in terms of pairs, which compares one currency's value versus another. The usual syntax for the currency pair is: XXX/YYY, where XXX represents the base currency and YYY represents the quote currency. For example the quote GBP/USD = 1.5 would indicate that 1 British Pound (GBP) is equal to 1.5 U.S Dollars (USD). The major currency pairs account for over 90% of FX trading and are the following:

  • EUR/USD (Euro vs. US Dollar)
  • GBP/USD (British Pound vs. US Dollar)
  • USD/JPY (US Dollar vs. Japanese Yen)
  • USD/CHF (US Dollar vs. Swiss Franc)
  • AUD/USD (Australian Dollar vs. US Dollar)
  • USD/CAD (US Dollar vs. Canadian Dollar)

When a currency pair does not contain the U.S. Dollar, it is referred to as a currency cross, such as EUR/GBP.

When you try to exchange one currency for another, let's say at an airport, you are usually quoted two rates -- one labeled "we buy" and one labeled "we sell". These represent the bid price (buy) and the ask price (sell) at which the merchant is willing to transact on the first (base) currency of the pair. For example, lets say you are quoted the following market when trying to exchange your Euros for US Dollars:

EUR/USD
We Buy (Bid): 1.2500
We Sell (Ask): 1.2503

If you wanted to get rid of your euros and receive dollars, you would receive a rate of 1.25. If you wanted to exchange your dollars and receive euros, you would be doing so at a slightly higher rate of 1.2503. Actually, this exchange rate would be 1/1.2503 = .7998. The difference between the bid and ask prices of 0.0003 represents the spread. In this case the spread is referred to as 3 pips (percentage in point= 0.0001). Only the largest banks in the world would usually be able to quote a market 3 pips wide.

There are different types of transactions involving currencies. Up until this point we have been discussing spot transactions, which is a direct exchange of currency for cash. Currencies can also be transacted on a forward basis where two parties transact on an agreed upon exchange rate for a particular date in the future. For example, I might agree to sell you $1mm euro at 1.25 one year from now. Depending on the actual exchange rate 1 year from now, I may make or lose money on this transaction. These forward transactions can also be traded on exchanges and when they are, they are referred to as futures. The exchange provides standardized contract sizes and maturity dates and requires participants to post margin that reflects the current value of their futures contract (this protects against one party defaulting on its obligation).
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