What Is the Foreign Exchange (Forex) Market?
In the foreign exchange market, commonly referred to as “forex,” one currency can be traded for another currency. Just like with any market, trading can be volatile since many currencies are freely traded, and foreign exchange rates are influenced by supply and demand. But trading one currency must involve another, and currencies are always traded in pairs on the foreign exchange market.
Foreign exchange markets exist in major cities around the world, and as a whole, forex is by far the biggest market in the world on a daily trading basis, exceeding turnover of the bond and stock markets. Daily turnover on foreign exchange markets exceeded $6 trillion in 2019, the latest year in which data was compiled by the Bank for International Settlements—a financial institution that is controlled by central banks worldwide and serves as their bank. The U.S. dollar is the most dominant in currency transactions, accounting for almost 90 percent of all trades in 2019.
Why Is the Foreign Exchange Market Important?
Foreign exchange is an integral part of global business, and reportedly about 40 percent of the earnings of companies that make up the S&P 500 Index come from overseas. That means that large companies must repatriate money earned in euros, yen, pounds sterling, Swiss francs, Brazilian reais, Canadian dollars, Indian rupees, and other currencies back into U.S. dollars through these foreign exchange markets. Depreciating or appreciating currencies can therefore have a large impact on a company’s bottom line.
The most traded currencies in the global forex market are the U.S. dollar, the British pound, the Canadian dollar, the euro, and the Japanese yen. Multinational corporations, hedge funds, government institutions, mutual funds, and insurance firms are among the largest forex traders. Their transactions range from loans and investments to the purchase and sale of imported and exported goods.
Central banks also participate in the foreign exchange market to protect their nation’s currencies in what’s known in the trade as intervention. For example, the Federal Reserve says the U.S. has only intervened on three occasions since 1996: buying yen in 1998, purchasing euros in 2000, and selling yen in 2011.
Fluctuations in exchange rates on forex markets are often caused by changes in supply and demand for currencies, typically by companies repatriating their earnings, investors exchanging a particular currency, or a central bank’s actions—such as intervening to stabilize its nation’s currency.
What Are the Major Centers of Foreign Exchange Trading?
Trading on foreign exchange markets is done around the clock, 24/7, and around the world. The traditional major centers for trading are in London, New York, and Tokyo, representing the regions of the most traded currencies in the world: the euro, U.S. dollar, and yen.
Other important cities with high turnover in the foreign exchange markets include Hong Kong, Singapore, Shanghai, Sydney, and Dubai.
What Instruments Are Traded on a Foreign Exchange Market?
Foreign exchange swaps, or FX swaps, are the most traded instrument on the foreign exchange market. Under an FX swap, a trader borrows one currency and loans another currency at an initial date at the same time, and then exchanges the amounts when they are due.
Spot trading, which is trading of currencies at their most recent rates, is the second most active instrument on the foreign exchange market. Other types of instruments include options, outright forwards (which are contracts between two parties on the future delivery of currencies), and currency swaps (which are contracts tied to the payment of different currencies).