How Does Forex Markets Work?

What is Forex? 

Forex or FX trading is the trading of one currency with the other. Buyers and sellers, be it individuals, companies and even central banks exchange currencies at an agreed price. According to reports, Forex is one of the most actively traded markets globally, with a daily trading volume of $5 trillion. 

If you are living in the U.S and want to buy a commodity from the U.K; either you or the company that you purchase the commodity from has to pay the U.K company in Pound Sterling (GBP). This means that the U.S importer would have to exchange the equivalent value of U.S. dollars (USD) into Pound Sterling (GBP). Similarly, A U.S tourist in the U.K cannot pay in U.S. dollars (USD) because it’s not the locally accepted currency. As such, the tourist has to exchange U.S. dollars (USD) for the local currency, in this case, Pound Sterling (GBP), at the current exchange rate. 

How do forex markets work? 

Forex or currency trading is conducted electronically over-the-counter (OTC) between the two parties. All transactions take place via computer networks between traders around the world. The forex market is operated by a global network of banks, financial institutions and brokers in different time zones: London, New York, Sydney and Tokyo since, there is no central location, you can trade forex 24 hours a day. 

Types of forex market: 

1. Forex spot market: In Spot forex, the price of the currencies are quoted on a real-time basis. Trades that happen in the spot market occur at the prevalent rates on that day and time. 

2. Forward forex market: Forward forex involves a contract that locks the exchange rate for the purchase or sale of a currency on a future date. Forward contracts are customized contracts between the two parties. 

3. Future forex market: Future markets are also called centralized markets and are offered by exchanges which have set contracts for various currency pairs which expire on a specified date and wherein new contracts for future expiry dates are introduced. A futures contract is legally binding, unlike forwards which need not be binding. 

What is Base Currency in forex? 

The base currency in forex is the first currency in a forex pair, while the second currency is the quote currency. Fx trading involves selling one currency to buy another, and this is why it is quoted in pairs. The price of an fx pair is determined by how much one unit of the base currency is worth in the quote currency. Each currency in the pair is listed as a three-letter code. For example, if someone is buying 1 lot of EURUSD, it means that they are buying 1 lot of EUR against USD 

Most provider’s split the pairs into the following categories: 

Major Pairs:  Currencies that make up 80% of global forex trading is USD/JPY, GBP/USD, EUR/USD and USD/CHF. 

Minor Pairs:  Intermittently traded, these often feature major currencies against each other instead of the US dollar is GBP/JPY, EUR/GBP, EUR/CHF. 

Exotics:  Are a major currency against one from a small or emerging economy are USDTRY, EUR/CZK, USD/PLN, GBP/MXN. 

Regional Pairs: Pairs which are classified by regions – such as Scandinavia or Australasia. Includes: EUR/NOK, AUD/NZD, AUD/SGD 

What affects the forex market? 

The forex market comprises of global currencies, which can make exchange rate predictions tough since there are multiple factors that could add to the price movements. 

Forex, like most financial markets, is mainly driven by supply and demand, and it is essential to have an understanding of the influences that drive price fluctuations. 

 1. News Reports: 

Commercial banks and global investors tend to put their investments in economies that have a strong outlook. So, if positive news hits the markets about a certain country or a region, it will encourage investments and increase the demand for those countries or the region’s currency. But if there is a parallel increase in supply for that currency, the price to increase due to the disparity between supply and demand. 

 Similarly, negative news can cause investments to decrease and lower a currency’s price, and this is the reason why currencies tend to reflect the reported economic health of the region they represent. 

2. Central Banks: 

Central banks control the supply and announce measures that have a significant impact on their currencies price. Based on how the economy is doing with respect to imports/ exports, inflation etc. they may increase/decrease interest rates, put fiscal measures in place which would cause volatility in the currency trading as investors/speculators rely on such announcements for their trading decisions. 

3. Market Sentiment: 

Market sentiment often in reaction to the news, can also play a major role in driving currency prices. If traders believe that a currency is headed in a certain direction, they will trade accordingly and may convince others to follow suit, increasing or decreasing demand. 

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