1.1 – What is Foreign Exchange?

Description: This forex course basics section covers what the forex market is, what a forex trade involves, and why participants trade forex.

 

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The principles of foreign exchange have been in practice since the beginnings of commercial activity between people of different nations.

 

Furthermore, since the exchange rates of the major currencies of the world began to float in the early 1970’s, the foreign exchange or forex market has become the largest financial market in the world.

 

What a Forex Trade Involves

 

In essence, a foreign exchange transaction involves the simultaneous buying and selling of a pair of currencies from different countries at an agreed upon rate of exchange.

 

The primary types of foreign exchange transactions in common usage today are spot, forward, swap, currency future and currency option trades. Each of these will each be covered in greater detail later in this course.

 

Why Use the Foreign Exchange Market?

 

Depending on the participant, trading in the forex market can be driven by several different purposes that vary according to their needs. Some of the primary uses of the foreign exchange market include:

 

  • Making Direct Foreign Investments – An investor or company may see an opportunity in purchasing physical assets in a foreign country. This can require the sale of their home currency and the purchase of the foreign currency to complete the asset’s purchase.

 

  • Purchasing Foreign Financial Instruments – Investors interested in buying foreign securities usually need to purchase the securities in the currency in which they are denominated. For example, European Union bonds need to be bought with Euros, so a U.S. based investor would need to sell dollars and buy Euros to purchase them.

 

  • Speculation on Short-Term Currency Fluctuations – One of the most popular reasons to trade in the forex market involves short term speculation on future exchange rate movements, and this makes up the majority of retail forex trading activity.

 

  • Hedging the Currency Risk of Importers and Exporters – If a company conducts business abroad, they may receive or need to pay foreign currency which they will often need to respectively sell for or buy with their home currency. Such companies can use the forex market to protect or hedge against future currency exchange rate fluctuations.

 

How the Foreign Exchange Market Works

 

Many people that travel have a rudimentary knowledge of foreign exchange. For example, a traveler performs foreign exchange transactions whenever they have to change their U.S. Dollars or Euros for Yen or Sterling.

 

Of course, the currencies involved in their forex transactions will differ depending on where their travels take them and what type of currency they happen to be carrying.

 

This type of retail currency transaction represents the most basic type of foreign exchange, where an individual purchases an equivalent amount of currency in a foreign denomination in order to be able to spend their money in the foreign country they are visiting.

 

Furthermore, the traveler has conducted a foreign exchange cash transaction for delivery the same day. Nevertheless, most forex trades settle for value spot.

 

Executing a forex trade for “value spot” means that delivery of the pair of currencies involved takes place among the counterparties in two business days for most currency pairs. The exception is USD/CAD which usually settles in one business day.

 

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