What is Forex?
One of the oldest functions of money, was to use it as a physical medium of exchange. The owner of a cow needed wood to build a house, but didn’t own a forest. The owner of a forest needed milk or meat to feed the family. How do you exchange one cow for wood? How much wood should the cow owner get for his animal (commodity)? This problem was solved by creating an intermediary exchange mechanism: money. It is much easier to assign a value to goods, if there is a medium that makes the comparison more feasible. Since this became the most practical way of conducting business and facilitating transactions between different parties, this idea spread like wildfire. Many money forms where introduced and every country and kingdom introduced their own exchange mechanism. Sometimes based on another commodity (like Gold and Silver) and other times based on assets of value to the local community. One example are shells, which the Chinese society found so interesting and valuable (probably because there is no easy access to the sea in the interior parts of China). Up to this day Chinese characters related to money, include a symbol for the word “shell”.
This brings us to the next question or problem and to the topic of our article. How would you exchange a gold coin for a shell? As soon as communities and civilizations started to do cross-border transactions, this problem would arise. What is extremely valuable for some people is worthless to others. Nations that are close to the sea, don’t value shell money as much as folks that live up in the mountains. This is where a new market was born: the foreign exchange market. This marketplace is decentralized and developed a “life of its own”, so to speak. This is the market, where money can buy money or money is priced against another form of money. Basically the value of one currency (money form) is compared to another currency (money form of another country/nation). The price difference between two currencies is called spread.
One currency owner is asking for a certain amount of another currencies value and the owner of the second currency is willing to give up a certain amount of his currency for a specific price – called bidding. Therefore there you will often hear the terms “ask price” and “bid price”. The difference between the two is the spread. The value – or price – of currencies is expressed as percentage in point. This is a technical financial term, to measure the smallest price change that an exchange rate can make. The short term or acronym for this price change is called: a Pip. Most currencies are priced to four numbers after the point. This means that 1 Pip is the equivalent of a price move of 0.0001. This sounds very technical (and partially it is), but is very easy to understand, once you start trading with foreign exchange currencies. It is actually quite easy to understand. The spread is expressed in a Pip value. If a broker indicates that their spread for the Euro-Dollar currency pair is one Pip, than that means you will pay the equivalent in terms of money value to the dealing part (in this case the broker).
The foreign exchange market (in short: Forex) is the largest market in the world. The volume of trading is huge. According to the Bank for International Settlements, the daily trading volume is around 5.3 trillion US-Dollars. There is simply no other market that can compete with this amount of volume. The reasons are manifold. The market participants are governments, central banks, international banks, big corporations and investment funds. One important size of this volume, comes from commercial companies, which operate on an international level and need to buy goods and services from other countries or pay their employees, suppliers and partners across many borders. Another important aspect are commercial banks and so called top-tier banks that need foreign currencies to do business or to facilitate transactions. Over 39% of the daily trading volume comes from banks at this level.
There are many more market participants in foreign exchange markets, even a tourist, that needs to travel to another country and exchanges his currency for the currency of his travel destination, is – so to say – a foreign exchange trader or a market participant. His reasons for the exchange are different, than the reasons for a big corporation (need to buy goods) or an investment fund (need to profit by speculation), but nonetheless he becomes another Forex trader!
The exchange happens at various levels. There are for instance interbank transactions, with very tight spreads (because of the colossal trading volume) and there are transactions at lower levels (one example is our tourist that goes into a bank or exchange office to buy foreign money). In between these levels, many more possibilities exist to trade currencies against each other. One of the big advantages of Forex is the decentralized manner at which business is conducted. The only exception being Central Banks, which more often intervene, in an effort to control or manipulate the value of one currency against another currency.
The daily volume is moved by financial institutions. Banks are not the only players. There are dealers of currencies, also called Brokers. This is the access point of retail Forex traders or speculators to the market. Some of these brokers are closer to the upper levels (and therefore are able to offer better conditions) and some are small and further apart from the “real action” at the top. The closer a trader gets to the top-tier, the cheaper his transactions become, but also the more he is to buy in order to be noticed. The trading volume at this level is called the line. Some participants have a daily trading line that goes beyond several millions and in certain cases even into billions.
Characteristics of the Foreign Exchange Market
The Forex market is a over-the-counter market. This means, that the transactions happen between the market participants. There is not a central authority, which is determining the value of currencies. If you go to the supermarket to buy butter, the price of a certain butter brand is determined by the producer. In the case of currencies, central banks are the “producers” of the currency, but they cannot determine what other market participants are willing or not willing to pay for the currency. This is determined by demand and supply. That is why the Forex market has often being considered as the “almost perfect” market. This is only partially true, since in the past 10 years we have seen lots of intervention and manipulation by big market participants (like Central Banks). It is still a more “independent” market and offers traders, speculators and investors a good opportunity to participate in a market that has high liquidity (available funds being used for transactions) and basically never sleeps. The Forex market operates 24 hours by 365 days in a year. There is always some country, which is not asleep and needs money to keep the economy moving and afloat.
Currencies are traded against each other in pairs. Each pair constitutes one financial instrument. One example is the Euro-Dollar-Pair. This particular “package” is expressed as: EUR/USD or EURUSD (the nomenclature is defined by international ISO-norms). The first currency in the pair is called the base currency. This means: whatever price you will see for this “currency package” is the price of the first currency against the second (called: counter currency or quote currency). In this case, if you see a quote of that looks like this: EURUSD 1,1700, this means that 1,17 Dollars will give you 1,00 Euros. The quotation always gives you the price of one unit of the base currency.
Most currency pairs are valued against the US-Dollar or the Euro. Matter of fact, the most traded currencies – by value – are: the US-Dollar (87% of the daily trading volume), the Euro (33% of the daily trading volume), the Japanese yen (23% of the daily trading volume) and the Pound Sterling (12% of the daily trading volume). One note. Maybe you noticed that the percentage values are in sum more than 100%, this is due to the fact, that you always trade a pair. Which means, that the sum of all currency pairs will always be 200%.
There are many more specific aspects to discuss about the Foreign Exchange Market (Forex), which you can read in other articles on this site. The Forex market represents an interesting and fascinating way to trade and to profit from fluctuations in currency prices. Banks and corporations are making profits with the exchange of one currency against another. You have this possibility too. Please have a look at some of our broker reviews, to see if there is one broker that suits you to give access to the biggest market in the world. Not every broker will give you all the advantages that you need, but there are many good brokers out there, that can give you all the tools to understand and trade in the Forex market.