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

Although we don’t see it in our daily lives, the value of our currency is always fluctuating, and it impacts all of us. Whether you are a tourist visiting another country or a business owner importing or exporting goods, the foreign currency market will influence how much you pay and how much you earn.

In this article, we will discuss what the foreign exchange market is, and how it works and provide you with examples that can give you a better understanding of this important topic. 

The foreign exchange market, or forex market for short, is where currencies are traded.

Spread across multiple financial centers, these markets settled daily in 2022 transactions for about USD 7.5 trillion. The major currencies, based on trading volume, were:

• USD (USD 6.6 trillion)
• EUR (USD 2.3 trillion)
• JPY (USD 1.25 trillion)
• GBP (USD 969 billion), and
• CNY (USD 526 billion).

The foreign exchange market has a long history, dating back to the earliest forms of international trade.

Initially, people used "commodity money," such as gold and silver, to exchange goods and services. These precious metals held intrinsic value due to their rarity and universal recognition.

Then, for a while, European merchants adopted “token currencies” like bills of exchange for safer and easier trade between regions, for example, Italy and the Flanders. These instruments functioned as a form of credit, allowing traders to purchase goods without immediate payment.

Today, foreign exchange markets trade fiat currencies, which are issued by governments and are not backed by any physical commodity

But how exactly does the foreign exchange market work, and why is it important for businesses? Let's take a look.

The forex market operates primarily as an over-the-counter (OTC) market, meaning transactions happen electronically through networks of banks, financial institutions, and forex brokers.

While some trades may still be conducted over the phone, the majority of forex transactions are executed electronically on trading platforms.

The dominance of OTC trading and the global reach of the forex market contribute to its reputation as a "behind-the-scenes" market.

However, regulations are evolving to ensure transparency and stability. Financial authorities like the European Securities and Markets Authority (ESMA) and the Commodity Futures Trading Commission (CFTC) in the US play a role in overseeing forex activities, particularly derivatives trading.

With a vast network of participants operating 24/5 across the globe, the currency market is the world's largest financial market in terms of daily trading volume.

When you’re trading currencies, you will come across 2 terms: bid and ask prices.

• Bid Price: This is the rate at which a dealer is willing to buy your currency from you. Think of it as their "offer" for your euros (or any other currency you're selling).
• Ask Price: This is the rate at which a dealer will sell you currency. In essence, it is the "price tag" for buying euros (or any other currency you want).

The asking price will always be slightly higher than the bid price. This difference represents the dealer's profit margin, also known as spread.

Below are the main types of forex markets.

1. Spot Market: This is the largest and most liquid segment of the forex market. Here, currencies are exchanged immediately at the current exchange rate (or spot rate). For instance, you're traveling abroad and need to convert your local cash to the currency of the destination country. You’d be participating in the spot market.
2. Forward Market:  Businesses and institutions often use the forward market to lock in an exchange rate for a future date. This helps them manage currency risk and avoid potential losses due to fluctuations. Forward contracts are agreements between two parties to exchange currencies at a predetermined rate on a specific future date.
3. Futures Market:  Similar to the forward market, the futures market allows participants to secure exchange rates for future delivery. However, futures contracts are standardized and traded on exchanges, meaning they follow specific size and maturity date rules set by the exchange itself. This adds a layer of transparency and standardization compared to over-the-counter (OTC) forward contracts.
4. Swap Market: A swap is a two-way exchange that occurs simultaneously for a set period. Corporations and financial institutions often use swap transactions to manage their exposure to multiple currencies or interest rates.
5. Options Market:  This type offers more flexibility. It allows participants to buy or sell the right, not the obligation, to exchange currencies at a specific price by a certain date. This opens doors for strategies like hedging (protecting against risk) or even speculation on future currency movements.

Here, we illustrate how businesses can effectively use foreign exchange markets.

Case Study: Managing Foreign Exchange Risk Through Forward Contracts

• Company A - An international business based in the US that exports electrical machinery to Europe.
• Company B - A manufacturing company in Germany importing machines for the factory. 

Scenario: Company B is scheduled to pay EUR 1,000 to Company A on 30 September 2024 for machinery. However, Company A is concerned that the EUR/USD exchange rate might decline by the payment date, potentially reducing the value of the payment received in USD.

The exchange rate risk is unavoidable for businesses of all sizes dealing internationally. Fluctuations in exchange rates can significantly impact profits if left unaddressed.

The foreign exchange market isn't just for businesses managing everyday transactions. Some investors, such as hedge funds and investment firms, use it for speculative trading, aiming to profit from short-term fluctuations in exchange rates.

Professional traders employ various strategies to exploit market inefficiencies and potential opportunities. Here are 2 common approaches.

1. Arbitrage: Traders look for price discrepancies between different markets and earn a quick profit. For example, a currency might be slightly overpriced in one market compared to another. By buying in the cheaper market and selling in the more expensive one, a trader can capture this price difference.
2. Carry Trade: This strategy capitalizes on the difference in interest rates between two currencies. It involves:
3. Borrowing Low: A trader borrows money in a low-interest-rate currency (like the Japanese Yen - JPY).
4. Investing High: They then invest that money in a higher-interest-rate currency (like the US Dollar - USD).
5. The goal is to pocket the difference in interest rates, known as the "carry." Ideally, the trader also benefits if the borrowed currency weakens against the investment currency. This generates additional profit when converting the investment back to the original currency to repay the loan.

Suppose you're a manager at a US real estate investment company. You need money to fund a project, so you take out a loan in Japanese yen (JPY) because Japanese interest rates are lower.

However, you are worried that Japanese interest rates might rise soon, making your loan more expensive. To hedge this risk, you enter a swap contract with another company.

• You agree to pay them interest on a USD loan.
• In exchange, they agree to pay your JPY interest.

Why it might be profitable?

• You hope the USD strengthens against the JPY. This means you will need fewer JPY to pay back your USD loan (thanks to the swap).
• Even if the JPY interest rate rises, you will not be affected because the other company covers it (thanks to the swap).

While the potential rewards are high, so are the risks. Finding reliable patterns in currency movement is difficult. Many factors influence exchange rates, and only a few can be accurately predicted. Traders can suffer significant losses if their predictions are wrong and currency movements go against their positions.

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.