The foreign exchange (forex) market is where banks and individuals buy, sell, or exchange currencies. It's the largest financial market in the world, according to the latest reliable data from 2022, when global daily trading was $7.5 trillion. Made up of banks, commercial companies, central banks, investment management firms, hedge funds, retail forex brokers, and investors, the forex trade is in the mid-2020s more than seven times the daily currency value traded at the beginning of the millennium.
Key Takeaways
- The forex market allows participants, including banks, funds, and individuals to buy, sell or exchange currencies for both hedging and speculative purposes.
- The forex market operates 24 hours, five days a week, and handles trillions of dollars in daily trading.
- The forex market is an over-the-counter (OTC) market.
- Many forex accounts can be opened with as little as $100.
Understanding the Forex Market
The forex marketis not dominated by a single market exchange but involves a global network of computers and brokers from worldwide. Forex brokers act as market makersas well and may post bids and ask prices for a currency pair that differs from the most competitive bid in the market.
The forex market is an over-the-counter (OTC) market. This means trading happens without a single centralized exchange. Currencies move between those who are trading, although with the support of brokers who provide the means to do so. There exists a substantial amount of interbank forex trading, which helps determine swings in exchange rates. Large banks trade currencies to hedge, adjust balance sheets, and to trade on behalf of clients.
$1.021 billion
The average daily volume in total North American OTC foreign exchange in October 2023, according to the 39th Survey of North American Foreign Exchange Volume.
From Monday morning in Asia to Friday afternoon in New York, the forex market is a 24-hour market. The forex market opens from Sunday at 5 p.m. ET until Friday at 5 p.m. ET.
This differs from markets such as equities, bonds, and commodities, which all close, generally in the late afternoon EST. However, as with most things, there are exceptions. Some emerging market currencies close for a break time during the trading day.
History of the Forex Market
Until World War I, currencies were pegged to precious metals such as gold and silver. During the Great Depression and World War II, the system collapsed and was replaced by the Bretton Woods Agreement. The latter created two international organizations related to global economic activity: the International Monetary Fund and the International Bank for Reconstruction and Development, commonly known as the World Bank. The Bretton Woods meeting also produced the General Agreement on Tariffs and Trade.
The new system also replaced gold with the U.S. dollar as a peg for international currencies. In turn, the U.S. government promised to back up its dollar with equivalent gold reserves. However, the Bretton Woods currency system was discontinued in 1971 when U.S. President Richard Nixon suspended the dollar’s convertibility into gold.
Since then, the forex market has undergone significant changes driven by technological advancements, regulatory developments, and economic events. Currencies have free-floating exchange rates determined by supply and demand in international markets. Despite the many changes since 1971, the U.S. remains the world's dominant reserve currency.
Forex Currency Pairs
In the global foreign exchange (forex) market, currencies are traded in pairs, each consisting of two different currencies. In the above chart, you can see the most traded currencies worldwide. A currency pair is the exchange rate between two currencies, indicating how much of the quote currency is needed to buy one unit of the base currency.
For example, in the EUR/USD pair, the euro is the base currency, and the U.S. dollar is the quote currency. If the EUR/USD exchange rate is 1.20, it means that one euro can be exchanged for 1.20 U.S. dollars. Below is an example of how the EUR/USD pair has traded since the introduction of the euro in 1999:
Recent Developments in Forex
The introduction of electronic trading platforms in the 1990s vastly changed the forex market, making it more accessible, efficient, and liquid. Regulatory milestones, such as the European Monetary Union's creation and the euro launch in 1999, reshaped the currency landscape. Economic crises, like the 2008 global financial crisis, the 2010 European debt crisis, and the early 2020s pandemic, also profoundly impacted currency pairs, leading to increased volatility and shifts in the market.
The most widely traded currency pairs are the "majors," which include EUR/USD, USD/JPY, GBP/USD, and USD/CAD. These pairs account for a significant part of global forex transactions because of their currencies' economic and political importance. In recent years, emerging market currencies, such as the Chinese yuan (CNY) and the Indian rupee (INR), have gained more prominence as their economies have grown. Nevertheless, they haven't yet broken high onto the list of most traded currencies.JPMorgan Chase & Co (JPM), UBS Group AG (UBS), and Deutsche Bank (DB) are some of the biggest banks involved in global FX transactions.
In addition, the rise of cryptocurrencies has introduced a new dimension to the forex market, with some investors viewing them as alternatives to traditional fiat currencies. That said, cryptocurrencies are a drop in currency flows compared with the tidal waves traded daily in fiat currencies. The crypto news site, the Block, puts daily crypto trading between the extremes of $30 billion and almost $100 billion in the mid-2020s. Even on its most traded days, the value of all crypto traded is less than 1% of daily forex and far less on most others.
Types of Forex Markets
Three are three key types of forex markets: spot, forward, and futures.
1) Spot Forex Market
The spot market is the exchange of currency between buyers and sellers at the current exchange rate. This makes up much of daily currency trading.
The major participants in the spot market include commercial, investment, and central banks, as well as dealers, brokers, and speculators. Large commercial and investment banks make up a major part of spot trades, trading not only for themselves but also for their customers.
Here are some features of the spot forex market:
- Accessibility:Often the starting point for beginners in forex trading because of its relative simplicity.
- Decentralized:Trades are conducted directly between parties without a central exchange.
- Immediate settlement:Transactions are settled within one business day (abbreviated as "T+1").
- Real-time rates:Reflects current supply and demand dynamics.
2) Forward Forex Market
In forward markets, two parties agree to trade a currency for a set price and quantity at some future date. The two parties can be companies, individuals, governments, or other entities. They are not traded on exchanges.
Here are some features of the forward forex market:
- Hedging:Forwards are used to manage currency risk by locking in exchange rates for future transactions.
- Customization:Contracts can be tailored to specific needs regarding the amount, delivery date, and other terms. This makes these contracts illiquid.
- Private transactions:Conducted OTC, offering privacy and confidentiality.
- Counterparty risk:Participants must assess counterparty reliability to mitigate credit/counterparty risk.
3) Futures Forex Market
Future markets are like forward markets in their function. However, the big difference is that future markets use centralized exchanges, which guarantee traders against counterparty risk. This helps ensure future markets are highly liquid, especially compared with forward markets.
Here are some features of the forex futures market:
- Exchange-traded:Traded on organized exchanges like the Chicago Mercantile Exchange.
- Margin requirements:Participants must maintain margin accounts to cover potential losses.
- Transparency:Prices and trading volumes are publicly available, reducing counterparty risk.
Options Market
The options market allows traders to buy or sell currency options, which give the holder the right, but not the obligation, to exchange currency at a specific rate before a certain date.
Here are some features of the forex options market:
- Hedging and speculation:Used for both hedging against adverse currency movements and for speculative purposes to profit from price moves.
- Premium costs:Buyers pay a premium for the option, which can be a cost consideration.
Swap Market
The currency swap market involves the exchange of two streams of cash flows in different currencies. Swaps are often used by banks and financial institutions to manage currency exposure and liquidity.
- Double transactions:Involves a spot transaction followed by a forward trade.
- Liquidity management:Helps institutions manage their currency positions and liquidity.
- Customizable:Terms can be tailored to the needs of the parties involved.
Forex Market Examples
Spot Market Example
Let's say the EUR/USD exchange rate is 1.08, meaning it takes 1.08 U.S. dollars to buy one euro. Now, suppose you think the dollar will depreciate against the euro, and exchange $1,000 for euros at this rate, receiving about €925.93 (€1,000 / $1.08 per €).
Later, the exchange rate changes to 1.10, meaning it now takes 1.10 U.S. dollars to buy one euro. Your prediction confirmed, you decide to convert your euros back into dollars. You receive about $1,018.52 (€925.93 × $1.10 per €). This means you've made a profit of $18.52.
But suppose you were wrong, and the exchange rate decreases to 1.06 (meaning it takes 1.06 U.S. dollars to buy one euro). You would then receive $986.73 (€925.93 × $1.06 per €), resulting in a loss of $13.27.
Swap Forex Example
Suppose we have two banks, Bank USA and Bank EU, in different countries with different currencies. Bank USA, based in the U.S., has a surplus of U.S. dollars, while Bank EU, based in Europe, needs euros to fund loans to its American clients.
They enter into a currency swap instead of going to the foreign exchange market to buy the currencies directly.
Under the swap agreement, Bank USA agrees to give Bank EU a certain amount of U.S. dollars, and in return, Bank EU agrees to give Bank USA their present worth in euros. They set a date when they will swap the currencies back. Here's what they agree on:
- Notional principal: Both banks agree to exchange a principal amount of €100 million and its equivalent in USD at the present rate of 1.10 EUR/USD. This means Bank EU receives $110 million from Bank USA, and Bank USA receives €100 million from Bank EU.
- Interest: They agree to exchange interest payments on the notional amounts. Bank EU will pay Bank USA a fixed interest rate of 3% annually on the USD notional amount ($110 million). Meanwhile, Bank EU will pay Bank USA a floating interest rate of EURIBOR + 1% on the EUR notional amount (€100 million).
- Maturity: The swap will have a maturity of five years. At that point, the banks will exchange the original principal amounts (€100 million and $110 million), having already paid interest during the swap to each other.
The swap agreement helps the banks manage their currency exposure and ensures they have the funds in the right currency for their operations. It also allows them to hedge against currency fluctuations, as the exchange rate for the swap is determined upfront.
| Types of Forex Trading | ||
|---|---|---|
| Reason for Trading Forex | Description | Traders |
| Hedging | Reducing or eliminating exposure to adverse currency changes. Most global companies use the forex market for this purpose. | Corporations, financial institutions |
| Speculation | Taking on risk in anticipation of future price moves. Speculators try to predict market trends and profit from short-term fluctuations in exchange rates. | Individual traders, hedge funds |
| Arbitrage | Exploiting often incremental price differences in different markets to make a profit. Traders buy a currency in one market and simultaneously sell it in another where it's priced higher. | Banks, financial institutions, high-frequency traders |
| Interest rate differences | Taking advantage of interest rate differences between countries. Traders may borrow in a low-interest-rate currency and invest in a higher-interest-rate currency. | Carry traders |
| Diversification | Spreading risk by investing in different asset classes. Forex can diversify a portfolio, as currency moves are often uncorrelated with stocks and bonds. It can also geographically diversify a portfolio. | Institutional investors, portfolio managers |
Advantages and Disadvantages of Forex Trading
Forex markets have key advantages and disadvantages.
Pros
Lots of flexibility, trading 24 hours a day, five days a week
High liquidity
Low transaction costs
Leverage from margin trading can lead to outsized gains
Cons
Less regulation and the decentralized nature of forex markets increases counterparty risk
Leverage from margin trading can lead to outsized losses
Credit/counterparty risk
Risk of fraud
Advantages of Forex Trading
Let's put together the benefits traders find in this area of finance:
- 24-hour market: Unlike other markets that operate during set hours, the forex market is open 24 hours a day, five days a week. This allows traders to take advantage of market prospects anytime, providing greater flexibility for those with busy schedules or those in different time zones.
- Accessibility: Retail traders can start trading with relatively small amounts of capital, and trading platforms provide tools and resources to help beginners learn and participate in the market.
- High liquidity: The forex market is the most liquid financial market in the world. This high liquidity means that transactions can be executed quickly and with minimal price changes, which reduces the risk of price manipulation and enhances price stability.
- Leverage: Forex brokers often offer significant leverage, allowing traders to control large positions with relatively little capital. While this can amplify profits, managing risk to avoid substantial losses is essential.
- Low transaction costs: Forex trading typically incurs low transaction costs, primarily in the form of spreads. This makes it cost-effective for traders, especially compared to other markets like equities or commodities.
Disadvantages of Forex Trading
- Complexity: Forex trading requires a solid understanding of economic indicators, the effects of geopolitical events, and market psychology. The learning curve can be steep, and you'll need to invest time and practice to develop effective trading strategies and risk management practices.
- Counterparty risk: When there's no central exchange guaranteeing your trade, there's always a risk of default by the other party, especially in fast-moving markets.
- High volatility: The forex market is known for its quick swings that can take traders out of the game. While this volatility can create prospects for profit, it also increases the risk of substantial losses, especially if you're inexperienced.
- Leverage Risks: Although leverage can magnify profits, it can also amplify losses.
- Limited Regulation: The forex market is decentralized and less regulated than other financial markets. While this can give you greater flexibility, it also increases the risk of fraud. Traders must exercise due diligence when choosing a reputable broker. In the U.S., that means using only one of six registered and regulated FX exchanges:
- Charles Schwab Futures and Forex LLC
- Gain Capital Group LLC (Forex.com)
- IG US LLC
- Interactive Brokers LLC
- Oanda Corporation (Oanda, FXTrade.com)
- Trading.com Markets Inc. (Trading.com)
- Market manipulation: Despite its liquidity, the forex market is not immune to the machinations of large financial institutions and central banks. These entities can and have influenced exchange rates through significant trades or monetary policy decisions.
- Need for trading discipline: The fast-paced nature of forex trading can lead to emotional stress and impulsive decisions that can amp up losses.
Although the fact that it operates almost 24 hours a day can be a positive for some, it also means that some traders will have to use algorithms or trading programs to protect their investments while they are away. This adds to operational risks and can increase costs. To minimize these risks and costs, many recommend not holding positions into the next trading day.
Can You Get Rich by Trading Forex?
Forex trading can make you rich, but it'll likely require deep pockets to do so. That is, hedge funds often have the skills and available funds to make forex trading highly profitable. However, for individual and retail investors, forex trading can be profitable, but it's also very risky.
How Do I Start Trading Forex?
To get started in forex trading, the first step is to learn about forex trading. This includes developing knowledge of the currency markets and specifics of forex trading. It also takes a brokerage account set up for forex trading. One of the more important things from there is setting up a trading strategy, which includes the amount of money you’re willing to risk.
How Much Do You Need to Start Trading Forex?
In most cases, you can open and trade via forex account for as little as $100. Of course, the higher the amount you can invest the greater the potential upside (and downside). Many recommend investing at least $1,000 and even $5,000 to properly implement a strategy since otherwise fees and such will cut away any potential profits.
The Bottom Line
Forex trading offers several advantages over other markets, such as flexibility with types of contracts and 24-hour-a-day trading for five days a week. It also allows investors to leverage their trades by 20 to 30 times, which can magnify gains.
However, it also comes with substantial risks like high volatility, the potential for leverage-related losses, and the need for a deep understanding of market mechanics. Forex trading requires a disciplined approach, robust risk management strategies, and continuous education. Forex trading can be rewarding for those willing to invest the time and effort to navigate its complexities. That said, it's vital to approach it with caution and a well-informed strategy to mitigate the inherent risks.
