Understanding Foreign Exchange Trading

Modern times has brought small scale, online FOREX trading into being and been punctuated by wild swings in foreign currency values. This makes having an understanding of what foreign currency trading is, why the value of currency fluctuates, and at the bottom of it all what the money we use everyday really is ever more important.

Identification

The foreign exchange rate is the amount of money required in one currency to purchase another. Foreign Exchange Trading (or FOREX) is the market for world currencies as commodities.

Considerations

FOREX can only exist because of the prevalence of fiat currency. Unlike money that is made out of or backed by precious metals, fiat currency only has value because the issuing government says that it does. However, there are some examples where the exchange rate is set by government order, and the currency is not allowed to "float" on the open market. China, for example, has a "managed" floating exchange rate, where supply and demand in FOREX influence, but do not determine, the currency's exchange rate.

Function

As a practical matter, a currency's value is never derived solely on the basis of what a government says it should be. Instead, it is a mixture of what a government says it should be, what that government's fiscal policies are, the health of the country's economy and what people think the value of the currency should be. The latter gives rise to the practice of trading currency as if it were a commodity, and thus the foreign exchange or currency market.
So, for example, if a government is running a high, systemic deficit; has a weak economy; and is suffering a string of financial scandals, it will fall in value toward what the actors on the market perceive its real value to be. State banks, private banks, and corporations will start selling that currency for more valuable or stable currencies, and speculators will begin betting against it. The result is a dumping of the undesired currency, and a scramble to buy other forms of money. This is exactly what happened when the US dollar went into a record, downward spiral against the Euro, Pound Sterling, and Yen in 2007 and 2008.

Significance

FOREX works like any other commodities market does. The objective is to buy for a little and sell for a lot. The only real difference is that the commodity traded is not coffee, oil,or securities. At FOREX, it is the money issued by sovereign governments. The result is that while the value of a currency is usually roughly what it should be given rational considerations, FOREX is vulnerable to wild swings driven by speculation and irrational decision making.

Expert Insight

Daily movements in FOREX are typically much smaller than is the case for securities or commodities. Therefore, the main players in FOREX are banks that deal in very large quantities. While there are FOREX trading services now available to private investors, FOREX investment does not work in the same way that other online investments do. There are really only two avenues open to a small investor in FOREX: betting that a country's currency is going to steadily improve in the long term (i.e. buying a block of cash from the next "Asian Tiger"---a future Korea or Taiwan), or identifying an irrational trend in the market and betting against it.

Considerations

The most heavily traded of the world's currencies are the U.S. dollar, the Euro, the British pound sterling, the Japanese yen and the Swiss franc. This makes them the currencies most liable to substantial short-term changes.