Transactions in financial markets are a way to allocate capital and scarce resources to their most productive uses. Financial markets can do this by facilitating exchanges between capitalists and entrepreneurs. Resources, such as commodities or monies, or financial vehicles, such as stocks or bonds, can be exchanged on financial markets. A resource or institution’s productivity is measured in monetary terms by the returns, or lack thereof, on the capital exchanged. There are many different types of financial markets, one of them being the foreign exchange (forex) market.
The foreign exchange market, or forex as it is often referred to, is a term for exchanging currencies. It includes the transfer of bills and coins and exchanges of debt instruments and futures contracts denominated in foreign currencies; this can be done through various financial intermediaries, such as banks or brokers.
Foreign currency exchanges can be as simple as visiting a kiosk while on vacation, or as complicated as predicting future interest rates, foreign policy, and exchange rates. However, the basic mechanics of currency exchanges are the same. This article will explain how forex works, its history, its effects, and how you can start trading.
The History of Foreign Exchange
Societies have used money as a medium of exchange since before written history; but, while certain money is useful within a society for trade, it might not be accepted by another one.
This is where foreign exchange comes in because the traders and merchants must be able to exchange their monies before they can buy each other’s goods.
The first instance of a transaction between currencies is not recorded. Still, based on Aristotle’s writings on money and interest in The Nicomachean Ethics, it can be inferred that foreign exchange had been happening before 350 BC.
After the fall of the Roman Empire, foreign exchange became more relevant, as the territory was broken into different countries and societies, each adopting their own form of currency.
NOTE: Forex is less relevant when the money used is a commodity (such as gold or silver), as there is usually an established exchange rate for an ounce of precious metal. However, when currencies are fiat, or when there is an additional value placed on a specific country’s coin, then forex becomes more relevant.
Foreign exchange practices, contracts, and occurrences became more formalized and common in the Middle Ages in Europe. Inter-temporal transactions, such as bills of exchange, futures contracts, and lending, also developed. The way currency futures contracts are organized today stems directly from the practices established during the Middle Ages.
The Italian merchants of Genoa, Florence, and Venice were particularly influential in creating forex systems. They built clearing houses to settle accounts between merchants and even governments. Foreign exchange clearinghouses limited the necessity for merchants and representatives to carry currency when traveling in dangerous lands.
Later, the British, specifically those in London, took over as the world specialists in forex. Even today, London remains the hub of foreign exchange transactions, with about 25% of all foreign exchange transactions occurring in the London Commodities Exchange.
How Forex Works
The best way to think of forex is to understand that money is a good; just as goods can be exchanged, money can be exchanged. In a supermarket, groceries can be purchased. In a financial market, securities can be bought. In the forex market, currency can be purchased.
NOTE: Money is simply society’s medium of exchange. While currency is a nationalized money, often taking the form of coins or bills, these terms can be interchangeable.
Foreign exchange works by using one currency to buy another currency, and the most common currency bought and sold around the world is the US Dollar (USD). In simpler terms, think of going to the “Currency Store” and using your USD to buy other currencies, like Euros, Yen, Pounds, and Francs.
Here’s an example of a forex trade to see how it works in practice:
- Start by investing $1,000 in your trading account.
- Enter a trade by buying $1,000 (USD) worth of Euros (€).
- Receive, based on the exchange rate of the day, roughly €850 into the account.
- Sell the €850 for USD if the EUR/USD exchange rate decreases.
- The result is then more than $1,000 back in your account, with the exact profits dependent on the change in the exchange rate (more on this later).
Where Do Trades Take Place?
- Electronic Markets, including Brokerage Accounts
- Interbank Markets
While it is possible to participate in forex on an interpersonal level, or through unconventional means, it always requires more fees or commission and is typically less efficient. For small amounts, such as vacation money, it does not make much of a difference how one exchanges currencies, but, for investments, it is only prudent to do so through a broker, bank, or other retail investing firm.
Also, most retail investors can avoid high currency exchange fees by trading electronically. However, they then would not have access to physical bills or coins.
Types of Forex
The simplest and most common way to trade currencies is at the spot price (more on this later). This can be done through almost any financial intermediary, brokerage account, bank, kiosk, or even at some ATMs.
However, there are other, inter-temporal ways to exchange currency.
Forward Market for Currencies
These contracts lock in an exchange at the current spot price, to be executed on a date sometime in the future, usually not more than one year from the current date. Forward contracts are not facilitated through financial intermediaries. There are fewer rules and regulations for forward contracts than for futures contracts, and thus non-traditional or interpersonal trades may occur.
Futures Market for Currencies
These contracts arrange a specific time and exchange rate in the future at which to trade goods. In forex, futures contracts specify the amount of currency to be exchanged (the amount always being measured in lots), and the date upon which the transaction will occur. These types of forex must take place in a commodities market. (Remember, money is just another commodity.)
Because these two methods mentioned above deal with inter-temporal pricing, in this way, forex markets can help with price arbitrage across time.
By agreeing upon future exchange rates, it means that the investors have researched and predicted that the trade will be profitable in the future (notwithstanding the poorly planned transactions).
Setting a future exchange rate influences the market because money then has a known future value. Thus, a benefit of forex is that foreign exchange markets can limit unpredicted drastic changes in a commodity’s value by anticipating, speculating, and contractually confirming future exchange rates.
This type of stability is only possible in countries that allow private investors and firms to participate in financial markets. If only inter- and intra-governmental trading were allowed, forex would not have the same effect of price arbitrage across time.
Understanding Forex Units
Trading in foreign currencies is not as regulated as equity, bond, or other asset trading, but financial intermediaries and traders use some established methods and measurements.
Forex trades done on an electronic forex market or through established intermediaries are measured in “lots,” which are specific amounts of currency to be traded. The trader either buys or sells a particular quantity of one currency (that is, his “base currency” denominated in lots), in exchange for the other currency’s resulting amount, dependent on the exchange rate. (More on exchange rates below.)
Lots come in three sizes:
- Micro Lots: 1,000 units of a currency
- Mini Lots: 10,000 units of a currency
- Standard Lots: 100,000 units of a currency
When engaging in foreign exchange interpersonally, or small scale through a bank, lots are not necessary. In these cases, the units required for a trade to occur is determined between the involved parties, based on their needs.
One makes a profit in forex based on relative value changes in currencies or purchasing specific coins to get a better price on another asset.
A percentage in point, abbreviated as “pip,” is the smallest possible change in the exchange rate. In other words, it is a way of measuring the difference in the value of a specific currency.
Pips are typically equal to 1/100 of a percent in change. This is because currencies are often traded, extending to four decimal places.
Example: A EUR/USD exchange rate is written with four decimal places like so: X.XXXX. So, for this particular rate, one pip would be 0.0001.
Once a pip’s value is determined, typically being 0.0001, pips are used to describe the difference in bid and ask prices of trading currency pairs.
Pips were invented because they are easier to calculate using computer trading systems than actual exchange rates. This is because not every exchange rate is as neat as the EUR/USD; some rates are hundreds, or even millions, to one.
To measure profits when trading currencies, subtract the entry exchange rate from the exit exchange rate to find the number of pips gained (or lost) per unit traded. It is then stated that one earns XX pips on the trade (even though they really earned those pips times the number of base units traded).
NOTE: Just like a penny is .01 of a dollar, a pip is also a unit of measurement, just with more decimal places. Most assets are traded at two decimal places, allowing profits to be expressed in US Dollars and Cents; but the currency is often traded using four decimal points, so the exchange rate cannot always be stated in terms of USD cents. This is where the pip comes in.
Pips are small—not even a penny in US Dollars—but as forex trades are at least 1,000 base units in size, they really do add up! But, for the person exchanging currencies on a smaller level, not on an official market or through a broker, pips are irrelevant.
Foreign Exchange Rates
Exchange rates can be thought of as the current currency price, with respect to another currency. These are called pairs, and all forex is done in pairs.
The term exchange rateis used only in currency trading. The term exchange ratiocan be used anytime one is expressing a relationship between two goods or in the context of equity divisions and allocations.
In forex, although ratio sounds similar and means roughly the same thing, the term rate should be used when describing the price of a currency denominated by another currency.
NOTE: A foreign exchange ratio is used to estimate income changes based on exchange rates and interest rate changes. American companies calculate this when trading in currencies other than the USD. It is used to determine hedging and corporate investment strategies.
Exchange rates are determined on forex markets, and are, in a word, the “spot price” of a currency represented in another currency (usually USD). The spot price in forex is used the same way as the term “spot price” is used in commodities trading.
The spot price is the most competitive price on the market, and the price is traded in the fastest-paced markets. However, because there is no central “foreign exchange market,” the exchange rate can be set by each broker and can differ from the spot price. That is why if one searches EUR spot or EUR/USD, the spot price might be lower than the asking price of a currency exchanger.
If one is thinking in terms of the US Dollar, think of the exchange rate as how many dollars it will cost to buy another type of currency.
Exchange rates are written out as a number following a fraction, using abbreviations of currency names.
Common currency abbreviations include:
- USD = United States Dollar
- EUR = Euro
- CHF = Swiss Franc
- GBP = British Pound
- JPY = Japanese Yen
- CNY = Chinese Yuan
- TRY = Turkish Lira
- ASD = Australian Dollar
The number, or exchange rate, is the amount of currency in the denominator position required for 1 of the currency in the numerator position.
Example: EUR/USD 1.1741 = This is simply saying that it would take about 1.17 United States Dollars to buy one Euro. In other words, the Euro is more valuable in relation to the US Dollar.
Exchange Rate Changes
The exchange rate between currencies is always fluctuating—usually not by much, but it is changing (which is one way investors can make profits).
Because currency prices, as with all other goods, are dependent on supply and demand of the currency, one must look at the variables influencing the supply and demand to predict its future value and possible changes in the exchange rate.
Some very general reasons for changes in a money’s supply or demand are:
- Monetary policy changes
- Future tax rates
- Interest rates
- Trade deals
- The country’s reputation
- Consumer preferences
All these factors, and infinitely more, can influence exchange rates. Forex is especially tricky because investors must compare all variables in two countries before making an informed trade (not just of one asset).
Why Should You Engage in Forex?
Besides the personal benefit, foreign exchange is done when traders anticipate a change in value or wish to purchase assets denominated in foreign currencies.
NOTE: Of course, if one is planning a vacation, it does not matter what the anticipated value of the currency is, so long as they can spend it while in another country for a short period.
Traders engage in foreign exchange because they are investing in a currency. They buy when they expect that the value of the currency will rise in relation to other currencies and sell if they forecast decreasing relative amounts.
Today, many foreign investors engage in forex to acquire USD and then use USD to buy securities on the New York Stock Exchange (NYSE). Without foreign exchange, it would otherwise be impossible for them to buy US securities because they would not have the currency the securities are sold in (namely, the USD).
Other benefits of forex include:
- More hours of operation
- Fewer commission fees
- Possibility for making leveraged trades at levels much higher than allowed for other assets
- Equal opportunity for bulls and bears
The Positive Impact of a Foreign Exchange Market
Like other financial markets, capitalists trading on the foreign exchange market seek positive returns on investment. By investing in currencies, and by extension, countries that yield the highest returns, they ensure that their capital is put to the most productive uses.
By allowing people, companies, and countries to engage in currency trading on a large scale, these markets encourage nations to maintain strong currencies and discourage the devaluation of currencies (at risk of sell-offs of their currency in foreign exchanges).
In other words, countries with a strong currency will be rewarded in the forex market because investors will demand their currency.
NOTE: For more information on the flow of relative high-value and low-value currencies, see David Hume’s Price-Specie flow mechanism.
Who Should Engage in Forex?
Anyone can trade currencies; in fact, most people probably already have!
As described above, anyone who goes to the bank and trades currencies engages in forex. In fact, even if one simply holds cash in his or her own currency, he or she influences the foreign exchange market by (even if it is only slightly) changing the money supply, also known as the amount of money available on the market.
As an example: Imagine if every US resident suddenly took all the money out of their bank accounts and held it in cash under their mattress, not spending it. This would change the amount of USD available to banks, brokers, and traders. This change in USD’s supply would make the USD a lot harder to attain and, all else held constant, more valuable.
Instead of simply going through a financial intermediary, someone looking to buy USD would have to directly ask the people holding it in their homes for purchase.
This is, of course, a silly example. But on a much smaller scale, people can influence the exchange rates of foreign currencies by holding, spending, or investing their monies. In other words, practically anyone can exchange currencies and actually impact forex through everyday saving and spending habits.
But who shouldinvest in or with foreign currencies?
Investing in any asset requires patience, skill, knowledge, and practice. It is important to recognize also that trading currencies is conceptually a little more complicated because they are denominated in rates and not in simple prices like equities are.
With that said, the ideal forex trader should be:
- Patient: Signals may take a while to appear, or policies may take time to come into action.
- Risk-averse: Forex is risky, primarily due to the required capital commitment per trade.
- Knowledgeable: Not only about the technical aspects of trading and investing, but also about world events, government policies, and other fundamentals.
How to Trade Foreign Currencies
If you’ve reached this point in the article and feel like forex is worth investing in, there are a few steps you should take first.
To get started in forex trading, open a brokerage account that allows foreign exchange trading. (This is very easy in the 21st century, but it wasn’t always this way! Personal computers have made retail investing in forex more possible.)
A couple of examples of popular brokerages that include forex are:
NOTE: Charles Schwab used to, but no longer offers forex trading. Also, most digital trading applications (such as Robinhood and eTrade) do not offer forex trading.
When trading forex, investors can use technical analysis and fundamental analysis to influence their trades:
- Technical Analysis: Best used for short term trades. This analyzes the direction and volume of trades and can give investors key entry and exit prices, along with specific prices for stops. It is based on charts, which in the digital age are updated, often, in real-time. Because this is done in the short term, and drastic exchange rate changes take time, this is often the best method for beginning or low-capital investors.
- Fundamental Analysis: This is best for long term trades, or when you trade to purchase other assets with the newly acquired currency. This type of analysis looks to geopolitical events, trade, government policy, and social demands for insight into possible currency value changes.
How to Make a Profit in Forex
As with all investing, buying low and selling high is the tried and true way to profit. But that, of course, is easier said than done.
Similar goods are often traded at different rates in different countries, allowing for a margin of profit combined with a strong purchasing currency.
For example, a McDonald’s Value Menu hamburger is one dollar in the United States. In Germany, McDonald’s also sells value hamburgers, but for one Euro. Because the dollar is (generally) weaker than the Euro, it costs more in USD to buy a hamburger in Germany than in the United States.
This hamburger example is relevant for travelers, but what about for traders?
Think about it in the same way, but on a larger scale. Investors looking to buy commodities will look at the value of the commodity in dollars and the relevant currencies it might be sold in (besides USD). They might engage in a forex transaction to acquire another currency first, before purchasing the said commodity.
In short, make a profit by buying currencies of relatively lower value for currencies expected to increase in value. And sell, or short-sell, coins that are expected to decrease in value. Exchange with a stable currency or exchange currencies that are changing in value inversely to one another.
Additionally, look for profits outside of the forex market via purchasing other assets. It is possible to still make a profit through access to assets one otherwise could not buy, even if one “overpays” in the forex market.
Final Forex Facts
- The forex market is the most liquid financial market compared to other financial markets such as the stock market or the bond market. This means that there is easier entry and exit in this market, as there are always willing buyers and sellers.
- There is no central location, no clearinghouses, and no central oversight of the foreign exchange market. Because of the lack of central management, there are fewer rules and regulations around forex than other financial markets.
- There are trillions of dollars exchanged every day between individuals, companies, and countries.
- In forex, if a trade does not contain a USD, it is called a “cross.”
- The US Dollar is, in fact, the most traded currency. This is because many countries still use the dollar as their reserve currency. Furthermore, since the Bretton Woods Agreement in 1944, the USD has been known as the “World’s Reserve Currency,” because many countries back their fiat currencies with dollars (USD backing is not required, but it is often the case).
For centuries, foreign exchange has been used to facilitate transactions, settle debts, and build wealth around the world. Today, forex trading can be an excellent and profitable investment for many people.
It is more complicated than trading securities, but it is, in some ways, easier due to the hours of trading and the liquidity of the market. Forex also has other stabilizing effects and price evening effects globally.
In short, foreign exchange is good for individuals, firms, and governments. However, it is essential to remember that forex is only accessible to firms and individuals in a capitalist economy.
De Cecco Marcello. 2008. “Foreign Exchange Markets, History of.” In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London.
De Roover, Raymond. 1954. “New interpretations of the history of banking.” Journal of World History 4: 38–76.