What is the Forex Market?

The Forex Market is the world’s currency market. Forex stands for Foreign Exchange. Out of every market in the world, more money flows through the Forex market on a daily basis than any other. Since 2010, the Bank for International Settlements records that the Forex market rose 20%. Each day, the market had a $4 trillion turnover.

What Is the Purpose of Forex?

If an American company wants to ship cars over from Japan, they will have to pay the Japanese company. To convert their dollars to yen, they would go to the Foreign Exchange market. After the conversion is complete, they can pay for their import and receive the shipment.

International trade is the primary reason why Forex exists, but over time investors have gradually begun to take advantage of it. By placing bets on the future value of the currency, an investor can potentially reap a profit. This bet-making is called speculation. Hedge funds, banks and individual investors all try to guess how the currency will perform. If they are correct, they could make a substantial sum of money. If not, they could lose their investment.

The History of the Forex

Until 1946, the global markets pegged each currency to gold. If an investor wanted to, they could actually go in to trade their currency for its tangible, golden form. In 1946, the world switched to the Bretton Woods system. Each currency was pegged to the United States dollar. In turn, the United States dollar was pegged (or fixed) to the price of gold. This system worked fairly well. Each piece of paper money could potentially be exchanged for gold and had a tangible value.

Without consulting the international community, President Richard Nixon decided the United States would leave the gold standard behind completely. On August 15, 1971, the world switched to a floating exchange rate. The impact of this event has been called the “Nixon shock”. Each currency was then valued according to the fluctuation of the markets. From that date onward, paper money had no tangible value—it’s worth came only from what the market dictated it could trade for.

How the Forex Market Works

Over the course of even a day, the value of a currency can fluctuate drastically. Investors and banks may choose to speculate on the currency or hedge against currency risk. Some companies who are involved in international trade place a “forward contract” with their bank. This forward contract states that the company can trade currency at a certain price in the future. Although this protects the company if the currency they are trading for is currently undervalued, if the fluctuations go the other way the company will potentially lose a significant amount of money.

Other than international trade deals, currency trades are done as a manner of speculation. Investors, hedge funds and banks try to guess if the price will improve or go down. Depending on if they were correct or not, they will either make a profit or take a loss.

Bid-Offer Spreads

Technically, there are no commissions charged for trades on the Forex market. In reality, the broker is still making some money off of the trade. The broker collects money from sellers and charges a higher price to bidders. The difference between the two trades is known as the “bid-offer spread” Although the spreads are not significant—often a few hundredths of a percentage point—over several trades, the broker can accumulate a decent profit.

Leverage

Normally, currency does not rapidly increase or decrease in value. Due to this trait, many brokers will allow an investor to use a deposit as collateral and borrow extra money on the margin. This system of buying currency is known as “leverage”. For example, if someone has an investment leveraged 5-to-1 they would be effectively borrowing $5,000 for a $1,000 deposit with the broker. If the currency the investor bought improves ten percent, then the investor will make $500. Unfortunately, the currency could also depreciate the same amount and the investor could lose $500 of their investment.

Basic Trades on the Forex Market

The most simple of trades on the Forex market is just exchanging currency. Next up the list, is an exchange known as a “swap”. This trade is an exchange of currency, in addition to an agreement to reverse the exchange in the future. Investors could also do a “forward” transaction. To do this, they would make an agreement with another investor to trade currencies in the future. Much like the stock market, the currency market also offers investors the choice of buying and selling options.

How Do Banks Affect the Market?

Many of the most powerful banks in the world do try to affect the currency market. These banks will lends money to the government and set the country’s interest rate. With their massive stores of wealth, the world’s most powerful banks can cause their currency to become stronger or weaker by choosing to sell or buy other currencies in the Forex market. When the economy of the country is taking a hit, these banks will buy or sell currency as an intervention in the market.