What Is The Foreign Exchange Market? How It Works & Examples

Tourists, business people and investors all need to consider the fluctuations in the foreign exchange markets.

In this article, we'll give you an overview of the foreign exchange and currency markets, briefly covering their history, how they work and how people and businesses use them.

We'll also cover in short what the relevant regulations are in the United States and the European Union.

What is a Foreign Exchange Market

Foreign exchange markets can be briefly defined as those financial markets on which any financial instrument related to one or more currencies (and subsequent exchange rates between foreign currencies) is exchanged.

Spread across multiple financial centers, these markets settled daily in 2022 transactions for about $7.5 trillion. The major currencies, based on trading volume, were the USD ($6.6 trillion), EUR ($2.4 trillion), JPY ($1.2 trillion), GBP ($968 billion), and CNY ($526 billion).

🔎 Note: CNY and CNH are not the same. The first is used for onshore payments in China, the second is instead employed for offshore payments.

The currency conversion rate is slightly different between them. Generally, CNH trades at a lower foreign exchange rate than the CNY against other currencies. This is due to tighter controls by the PBOC (People's Bank of China) on the latter.

But why are these financial markets so liquid? There are two main reasons for that, and they are to manage foreign currency exchange risk related to international trade and obtain speculative gains through arbitrage.

History of the Foreign Exchange Market

Foreign exchange has existed for as long as the act of trading between people from different parts of the world.

Initially, it might have revolved around "commodity money", i.e. gold and silver, that held different values depending on the local supply and demand.

Then, for a while, it was based on "token currency", like bank acceptances or bills of exchange, used by European merchants to allow for safer and easier trade between regions like Italy and the Flanders.

Today, foreign exchange markets trade fiat currencies.

How Modern Currency Market Works

In general, most financial transactions involving the foreign exchange market are completed, i.e., cleared, authorized, and then settled, through bilateral contracts agreed upon by phone.

This makes the foreign exchange market the world's largest financial market which can be considered mostly an over-the-counter market. One of the many reasons the Forex market is also referred to as a "behind-the-scenes market".

It must be noted that this is progressively changing, at least in the European Union, when in 2013 came into effect a new regulation now mandates all trades involving derivatives to be registered in designated trade repositories.

The regulation is currently being enforced by the ESMA (European Securities & Markets Authority).

In the United States, the competent authority for these matters is the CFTC (Commodity Futures Trade Commission), established in 1974.

How to Use the Foreign Exchange Markets

There are many ways retail traders and businesses use foreign currency trading and exchange markets. In this example, we will explain how companies use foreign exchange markets.

Company A - An international business based in the US, exporting electrical machinery to Europe.

Company B - A manufacturing company in Germany importing machines for the factory.

Company B is scheduled to transfer EUR 1,000 to Company A to make a payment for their order on 15th March 2023. However, Company A believes that the EUR/USD exchange rate will decrease by the time they make the transfer, which means Company A will be receiving less USD than originally planned.

What can Company A do in this situation?

It can contact its dealer of choice and sign with her or him a contract that guarantees the dealer will buy its EUR for the amount of USD at the current forward market rate, minus a certain markup applied for the service offered by the dealer.

💡 Note: When a dealer provides you with a quote for any rate, be it EURUSD or GBPUSD you have to remember a few things.

For a start, that in most cases the first currency is the one of which you take one unit.

Second, you should either look at the Bid or Ask side depending on if you need to buy or sell the second currency for the first.

The Ask rate will be by definition higher than the Bid one.

This is what usually happens in the forward market.

Obviously, the dealer is willing to sign such a contract because she or he has different expectations about the future of the EURUSD exchange rate, i.e., she expects EUR to appreciate. From her perspective that would mean getting less EUR for her USD.

What we just described is known as a forward contract. There are two counterparties involved, and the contractual terms are highly personalized.

While the contract is potentially transferable, it wouldn't make sense economically for any of the sides involved to do so. The transaction costs would be so high as to offset any potential gain from such a choice.

In other words, what does a third person know about you? How can he be sure you will have the amount of EUR by the settlement time of the contract from the other business, more than anything, what are the guarantees the investor would be able to get even partially such an amount in this event?

These are respectively called liquidity and credit risk.

Another Use of The FX Markets: Speculation

Certain types of investors, mainly hedge funds and more broadly the foreign exchange trading desks of investment management firms all over the world, act in the foreign exchange market with the idea of taking advantage of any arbitrage opportunity.

💡 Note: the term arbitrage refers to a situation in which you are able to make a profit without taking any additional risk in doing so.

In the FX Markets, this happens when the exchange rate between two currencies is higher or lower than the difference between the interest rates charged by the respective central banks if we are to believe.

These professional intermediaries apply in-house financial models to information collected from both foreign exchange dealers in the spot market and forward market to try and predict the exchange rate fluctuations in the short and medium term.

Given the quite high upside (and potential downside) one could obtain from such actions, the amount of research done on trying to understand what the relevant explanatory variables are is pretty meaningful, but unfortunately, only a small hand of them yield any result.

Now, to show you how someone would go on to make a profit from speculating in the FX market we'll use a typical carry trade performed on the JPYUSD exchange rate.

Suppose you're the manager of Company A, which has taken out a Japanese yen (JPY) loan to invest the sum into a profitable project in the US (which will generate cash inflows in USD).

In this case Company A will need to pay passive interest on its loan in JPY and might decide to subscribe to a contract with Company B that allows it to pay instead interest charges for a USD loan in exchange for someone else paying hers in JPY.

Why? Let's say that the loan our manager took out was provided with a variable interest rate. She speculates that expectations on inflation are such that in the near future the Japanese central bank will probably have to further increase the lending rate it applies to its loans.

Outflows associated with the loan will therefore increase. However, thanks to the contract signed by our manager, this increase will be borne by someone else, and not the company. On the contrary, given the now stronger JPY, the company has made a profit thanks to a greater purchasing power associated with any JPY held.

These types of contracts are called foreign exchange swaps and are just but a piece of the very broad swap market.

💡 Note: Finding a willing-to-trade counterpart is not something you should worry about. That function is today performed by financial intermediaries.

Company A - Real Estate Investment Trust focused on the US market, by taking out a loan in JPY because of the lower interest charged

Company B - International grocery store that has debt in the US, and thinks that the interest rate charged by FED will increase

Conclusion

In conclusion, the foreign exchange market is a dynamic and essential component of the global financial system. It serves as a platform for the exchange of currencies between countries, facilitating international trade and investment. Understanding how the foreign exchange market works is crucial for businesses, investors, and individuals alike, as it impacts exchange rates and can influence economic conditions.