Foreign Exchange (Forex) Markets

The foreign exchange market is the largest financial market globally, with daily trading volumes exceeding $6 trillion. This decentralized, worldwide market enables the exchange of currencies, supporting international trade, investment, and monetary policy.

Market Structure: Unlike stocks or bonds, forex trading occurs through a global network of banks, dealers, and electronic platforms without a central exchange. The interbank market—where large institutions trade directly—forms the core, with retail participants accessing the market through brokers and platforms that connect to this liquidity pool.

Major Currency Pairs: Trading concentrates around several key relationships, particularly the 'majors' involving the US dollar: EUR/USD (Euro/Dollar), USD/JPY (Dollar/Yen), GBP/USD (Pound/Dollar), and USD/CHF (Dollar/Swiss Franc). These pairs account for the majority of trading volume, with EUR/USD alone representing approximately 30% of the market.

Practical Example: When a U.S. company purchases components from a German manufacturer, it typically needs to convert dollars to euros. Similarly, when Japanese investors purchase U.S. Treasury bonds, they must convert yen to dollars. These commercial and investment flows create legitimate demand for currency exchange beyond speculative trading.

Price Determination: Currency values reflect relative economic conditions between countries, including interest rate differentials, inflation expectations, political stability, current account balances, and central bank policies. For instance, if the European Central Bank maintains higher interest rates than the Federal Reserve, this typically supports the euro against the dollar (all else being equal).

Trading Mechanisms: Spot transactions involve immediate exchange at current rates, while forwards and futures allow locking in exchange rates for future transactions. Swaps combine spot and forward transactions, used primarily for managing cash flows and reducing transaction costs.

Market Participants: Beyond banks and financial institutions, central banks actively participate to implement monetary policy or stabilize their currencies. Multinational corporations engage to manage international operations and hedge currency risk. Retail traders and speculators seek profit from exchange rate movements, though they represent a small fraction of total volume.

Unique Characteristics: The forex market operates 24 hours during the business week, following the sun from Asia to Europe to North America. Major centers include London (the largest), New York, Tokyo, and Singapore, with peak liquidity occurring during overlapping operating hours between these regions.