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What is Foreign Exchange (FX or Forex)?

Foreign Exchange (FOREX) is the simultaneous buying and selling of a nation's currency for another. The foreign exchange market is the most liquid and largest financial market in the world, with the equivalent of over $1.5 trillion changing hands daily; more than all the major equity markets combined. Unlike other financial markets, the Forex market has no physical location or central exchange, but rather operates via an interbank market 24 hours a day through a global electronic network of banks, corporations, and individuals, spanning from one time zone to another in all the major financial centers, starting with Sydney and ending in New York. Approximately 80% of transactions take place between the US dollar, euro, Japanese yen, British pound, Swiss franc, and Australian and Canadian dollar.

The foreign exchange market was traditionally the domain of the major banks and international corporations. With the growth of online trading platforms and new regulations and policies, the Forex market is finally open to retail investors and smaller financial institutions.

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The Role of Forex in the Global Economy

Since most, if not all, of the transactions in the world involve currencies, the foreign exchange market has an incredible reach of influence into every financial facet such as the equities and bond markets, private property, and manufacturing assets. The currency rates determined by this market play a vital role in the financing of government deficits, as well as equity ownerships in real estate holdings and in other companies. The influence of the Forex market affects your purchasing power, hence your every day consumption decisions.

History of the Forex Market

In an effort to keep cash from draining out of war-ravaged Europe and provide international monetary stability, the Bretton Woods Agreement was initiated in 1944. This agreement pegged the U.S. dollar to the price of gold, and other currency values to the U.S. dollar. Then in 1971, the disintegration of the Bretton Woods Agreement led to the emergence of the modern era of the foreign exchange market. The U.S. dollar was no longer convertible into gold, signaling an increase in currency market volatility and trading opportunities.

Following the collapse in 1973 of the subsequent Smithsonian and European Joint Float Agreements, we saw the true beginning of the free-floating currency exchange system among the major industrialized nations, which meant that the Forex market would now be driven by the forces of supply and demand.

The rapid growth of the euro-dollar market –the market for US dollar deposits in banks outside the US- was a major catalyst in the development of foreign exchange trading. It was the precursor to the broader Euromarkets; those in which assets are deposited outside the currency of origin. The Eurodollar market was born in the 1950s when Russia's oil revenue - all in dollars -- was deposited outside the US in fear of it being frozen by US regulators.

The U.S. government responded to the growth in the pool of offshore dollars with laws restricting lending of that currency to foreigners. U.S. companies found the euro market attractive for its higher yields, as well as a favorable center for holding excess liquidity, providing short-term loans and financing imports and exports. Thus, London became the preeminent offshore market and the leader in global finance for its convenient location and its ability to link Asian and American markets.

In the 1980s, the advent of computers and technology brought about the acceleration of cross-border capital movements, extending the market continuum through Asian, European and American time zones. Transactions in foreign exchange rocketed from about $70 billion a day in the 1980s, to more than $1.5 trillion a day two decades later. Additionally, the popularity and increasing reliability of online currency trading offered to private investors and financial institutions has led to the democratizing of the foreign exchange market and the widening of the retail market.

Market Players

In the last few years, the foreign exchange market has evolved into one not only transacted by banks but also by many other kinds of financial institutions such as brokers and market-makers, non-financial corporations, investment firms, hedge funds, and day traders.

Foreign exchange is an 'over the counter' (OTC) market, meaning there is no central exchange. The foreign exchange market moves through the trading ‘centers’ (in order of importance): London, New York, Tokyo, Singapore, Frankfurt, Geneva & Zurich, Paris, and Hong Kong. In the retail market, customers demand a written, legally accepted contract between themselves and their broker in exchange of a deposit of funds on which basis the customer may trade.

Market participants have various reasons for involvement in foreign exchange. Asset managers, sophisticated investors, and major corporations such as importers and exporters utilize the Forex market to diversify their portfolio holdings, hedge against their foreign or domestic currency denominated assets, and/or profit from price fluctuations. Whatever their motive may be, they all play a role in the demand and supply for currencies.

Understanding Forex Quotes

The first step in trading is to understand currency quotes. Since foreign exchange is the simultaneous purchase and sale of two currencies, the quote will always be given in pairs. Each pair has a base currency, which is the first listed currency (e.g. USD/CHF). When the quote rises, it means that the base rate has strengthened in value, since $1 could buy more francs, and vice versa. The base rate, which is normally the U.S. dollar, is set to a value of $1. There are a few major pairs in which the dollar is not the base currency, such as the British pound (GBP/USD), the euro (EUR/USD), and the Australian and New Zealand dollars (AUD/USD, NZD/USD). If the GBP/USD rises in price, then the British pound is rising in purchasing power versus the US dollar.

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