Introducing the financial markets

Lesson 7 of 10

What is forex?

If you've ever gone on holiday and exchanged say, dollars for euros, then you've participated in the forex market. Simply put:

Forex is how individuals and businesses convert one currency to another.

Forex, also known as foreign exchange, FX or the currency market, is the largest financial market in the world. On average over $5 trillion worth of transactions take place every day. That's around 100 times more than the New York Stock Exchange (NYSE) - the world's biggest stock exchange.

As well as being traded by individuals and businesses, forex is also important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.

Who trades forex?

There are a huge number of market participants looking to trade forex at any particular time, from individual speculators wanting to turn a quick profit, to central banks trying to control the amount of currency in circulation.

However, by far the most significant players in the forex market are the major international banks. Between them, Citigroup, Deutsche Bank, Barclays, JPMorgan and UBS account for around 50% of global forex trade.

Why do people trade forex?

Individuals and businesses participate in the forex market for two main reasons:

Speculation

The vast majority of forex transactions are made simply to make money. This means the person or institution making the trade has no plans to take delivery of the currency, they are just looking to turn a profit on movements in the market.

With major financial institutions always looking to profit from small changes in forex prices, many large trades can occur throughout the day. This activity means currency rates are some of the most consistently volatile financial markets in the world - which in turn provides more opportunity for speculators to make money.

Purchasing goods or services in another currency

Every time a transaction is made between two entities in different regions, a foreign exchange transaction needs to take place to pay for the goods or services exchanged. Transactions such as this happen globally, every second of every day.

Despite the number of transactions, the amount of currency traded is often very small compared to trades made by large speculators. Therefore commercial trading tends not to have such a big effect on short-term market rates.

How do you trade forex?

Unlike equity trading, forex is an over-the-counter (OTC) market. This means that currencies are exchanged directly between two parties rather than through an exchange.

The forex market is run electronically via a global network of banks - it has no central location, and trades can take place anywhere via a forex broker of your choice. This also means that you can trade forex at any time, so long as it's during trading hours in any one of the four major forex trading centres (New York, Sydney, Tokyo and London).

Forex trading hours: April-October (Eastern Time)

The market is open 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST on Friday.

How does a forex trade work?

Forex prices are always quoted in pairs such as EUR/USD, which stands for the US dollar versus the euro. This is because if you want to purchase US dollars you need to buy them with another currency, like euros.

When trading forex you are simultaneously BUYING one currency while SELLING another.

Each currency in a pair is known by a three letter currency code. In general the first two letters stand for the country/region, and the last letter represents the currency. So taking USD/JPY as an example:

USD stands for the US dollar, while JPY represents the Japanese yen.

Question

Select right country for the following currency code:

AUD?
  • a Switzerland
  • b Japan
  • c South Africa
  • d Australia

Correct

Incorrect

AUD = Australian dollar → Australia.
Reveal answer

Question

Select right country for the following currency code:

CHF?
  • a Switzerland
  • b Japan
  • c South Africa
  • d Australia

Correct

Incorrect

CHF = Swiss franc → Switzerland.
Reveal answer

Question

Select right country for the following currency code:

JPY?
  • a Switzerland
  • b Japan
  • c South Africa
  • d Australia

Correct

Incorrect

JPY = Japanese yen → Japan.
Reveal answer

Question

Select right country for the following currency code:

ZAR?
  • a Switzerland
  • b Japan
  • c South Africa
  • d Australia

Correct

Incorrect

ZAR = South African rand → South Africa.
Reveal answer

The first currency in every forex pair is called the base or primary currency. The second currency is known as the quote or counter currency. A forex price indicates how much one unit of the base currency will buy of the quote currency. So, if you see the following quote:

EUR/USD = 1.20164

This means one euro is worth 1.20164 dollars.

You would buy this pair if you think the base currency, the euro, will strengthen against the quote currency, the dollar. This is known as going long. Or, you could sell the pair if you believe the euro will weaken - this is going short.

In the next lesson, we'll take a closer look at the terminology involved in forex trading.

Question

Let's say a news story has led you to believe that sterling will rise against the Australian dollar. You decide to buy £1000 of GBP/AUD at 1.97700, which costs you A$1977.00. A few weeks later you decide to sell at 1.99800. Which one of the following statements is true (not taking into account commission or any other charges)?
  • a You made A$200 profit
  • b You made A$11 loss
  • c You made A$21 profit
  • d You made A$370 profit

Correct

Incorrect

You sold at 1.99800 which meant you would have received A$1998.00 so making A$21 profit (A$1998 – A$1977).
Reveal answer

Lesson summary

  • Forex is how individuals and businesses convert one currency to another
  • The main players in the market are major international banks
  • Speculation accounts for the vast majority of transactions
  • It's an over-the-counter (OTC) market, where trades take place directly between two parties rather than through an exchange
  • Forex is traded in pairs - you are simultaneously buying one currency while selling another
  • The first currency in every pair is the base or primary currency. The second is the quote or counter currency
Lesson complete