What is the Foreign Exchange Market (FX/Forex)?
Forex (FX) is a foreign exchange marketplace where currencies from all over the world are bought and sold in exchange for one another. This global marketplace doesn't require a lot of capital to partake in transactions. Because of the ease and accessibility, trade volume in forex is high. Activity in forex is made up of financial and global business transactions, as well as anyone traveling to another to a foreign country to purchase goods. Expenses for travelers include a souvenir, dinner at a restaurant, or a bus ticket. The forex caters to everyday activities as well as business affairs.
FX rate is the rate at which one currency will be exchanged for another. It is usually expressed in dollars, and it can either be fixed or floating, depending on the country. This official rate is only a benchmark: it shows the tendency of the markets and it considers the curve of supply and demand. The real FX rate in a currency transaction will be defined by the market player you are trading with. Spread, on the other hand, is the difference between rates. In the FX market, it represents the difference between the "official" FX rate expressed by the market and the price you will pay for the currency.
How Forex Markets Work
When partaking in FX, an individual or entity exchanges one currency for another. Each country (and the EU) has a denoted symbol. So, to transfer money from Mexico to England, the Mexican peso (MXN) is in exchange for a British pound (GBP), for example.
Currencies' values fluctuate based on demand and the economy. In our example, the price of the MXN will differ from the cost of the GBP. When currencies differ in values, as the MXN and GBP typically do, the exchange will result in a lower value for one currency. Today, for example, the GBP is valued higher than the MXN, so the GBP – it's more expensive. However, in return, the exchange will net a higher worth in the MXN.
Another way to look at this concept is to figure how many pesos does it take to buy one British pound? If the British pound is worth more than the peso, it will take several pesos to buy one pound. But, if the British pound has a lower value, then one peso will buy many British pounds.
The Importance of Currency Rates
The currency value is notated to the fifth decimal point to accommodate the constant flux. This nomenclature indicates a more precise amount than the average purchase price in a country, which typically assigns two decimal points. Because values always change, it's possible to make a profit through exchange activity. In a scenario in which money is exchanged, and then eventually returned to the original currency (typical in travel), if the value becomes lower over time, a profit will incur. The more that money is available to buy back, the better the profit.
While in leisure travel, this is not a significant profit, for investors or businesses, currency exchange can both be an income strategy, as well as a consideration in doing transactions around the world.
What does influence the FX rate?
The FX market operates based on macroeconomic indicators from the countries: economic forecasts and results, changes in national interest rates, unemployment rate, retail sales, a global outbreak, political turmoils in key markets, a polemic statement from a world leader... everything may lead to change or instability in a currency rate. Flotation is based on the news published about those factors.
This type of news and its developments influence demand and supply for foreign currencies. For any investor, there is nothing worse than instability -- this is why, depending on the news, there is a capital flight from one or another country, which leads to a change in the FX rate. The bigger/stronger one country's economy is, the more influence it has on the exchange rate for other countries and currencies.
It is worth highlighting that one country may adopt floating or fixed exchange rates: in the first case, the FX rate will fluctuate according to the market and economic indicators, and in the latter, the Central Bank will use its foreign currency reserves to maintain the FX rate in a specific currency band.
How Does Forex Trading Work?
The forex is the only market that has 24/7 trading. It's most beneficial to trade during high activity periods, which can be challenging to determine since the entire globe is working in the market.
Trading can be strategized with the currency pairs a trader is dealing with, using those active time zones to trade.
Commissions do not exist in forex. However, spread costs will incur based on pip or currency pair trading. All a trader needs is software and a reliable internet connection.
What Are the Most Traded Currency Pairs?
The markets are incredibly volatile now, so keeping on top of the foreign currency trades is a risky business. However, some touchstone data for a leveling off might indicate the popularity of currencies from the end of 2019. The most traded currency pairs were:
EUR – USD (Euro-US Dollar)
USD – JPY (US Dollar-Japanese Yen)
GBP-USD (British Pound-US Dollar)
AUD-USD (Australian Dollar-US Dollar)
USD-CHF (US Dollar-Swiss Franc).
While the economy is undergoing massive economic fluctuations, these exchange pairs tend to be regular leaders and have a lower foreign exchange risk. Companies look to these currency matches when strategizing income and overall foreign business practices. Countries aim to drop their currencies to attract traders, for example, which shows the importance of currency pairs and international forex trading.
What is a pip? How is pip Affiliated With Currency Pair Trading?
A pip (percentage in point) is the market value of a currency pair. As values move throughout the day, the combinations of currencies, and how they might benefit an investor also change. In currency pairs, the value of the pip is equal to 1/100 of a percentage point.
Due to the fluid nature of the forex, pip trades are determined by the bid price (the selling price point) and the asking price (the buyer's payment for the pip) of the currency, the difference of which is called a spread. A broker takes a fee in the form of a spread. As far as FX international payments fees, this broker expense is the only additional cost.
For investors in the foreign market, having a good knowledge of currency pairs and their correlating pip is the basis for making a profit. As it applies to business, pip pricing can alter the profit of goods and services sold and bought in the foreign market.
How Does FX Affect the Economy?
Because currency rates are dependent on their use and earnings power, the forex has a significant effect on the global economy. Exchanges in the forex have a direct influence on the currencies traded, which means that their value is greatly influenced by forex activity. While the travel industry is vital to the global economy, the rise in businesses working on a global level due to increasing technology, commerce exchange is a significant force in the world's economic workings.
Profits are made through small investments with forex, which again, drums up economic power.