Introduction to & Explanation of Foreign Currency Trading

Dollars, euro, yen or your currency of choice

Foreign currency trading, also known as the foreign exchange or "FX" market, involves the buying and selling of currency from different countries. Trading occurs via worldwide communication systems such as telephones and the Internet. More than 80 percent of foreign currency trading includes the U.S. dollar, the Japanese yen, the euro and the British pound--known as hard currencies and always in demand--according to the Federal Reserve Bank of New York. Soft currencies refer to the sometimes difficult-to-convert money of less developed countries.

Market Participants

Banks, brokers, customers and central banks make up the market participants. Financial institutions corner the biggest share of the market, while brokers act as the middlemen between different banks, providing anonymity during transactions, which they profit on by charging a fee. Customers, usually large companies, often need foreign funds for business dealings. Some individuals travel abroad and need funds or may be planning to make a foreign purchase. The government can use central banks to act on its behalf and to influence the exchange rate or value of its money.

Fixed Exchange Rates

An exchange rate is the value of one country's currency when compared or traded with another country's currency. The New York Fed reports that before 1971, the United States based all foreign exchange rates on the value of gold. As individuals and countries began exchanging currency for gold in greater quantities, U.S. gold reserves declined, leading President Richard Nixon to abandon that system.

Floating Exchange Rates

By 1973, the abolishment of the gold exchange rate led to our current system of floating exchange rates. The role of the foreign exchange market has moved from a place of relative unimportance to a critical part of financial transactions. Currency values now fluctuate in accordance with supply and demand.

Transaction Types

Foreign currency trading uses several types of transactions. Spot transactions involve two parties who trade currency at an agreed exchange rate over one or two days. Forward transactions take place at a future date, ranging from days, months to years. Futures are forward transactions set up in a separate market exchange. Options are forward transactions, but instead of a fixed future date, the option may be sold any time up to a final date. A swap is an exchange of currency now, with an agreement to trade it back in the future.

Rate Determination

Many factors influence the determination of foreign exchange rates, points out the New York Fed, including wars, new economic developments, tax laws, bank takeovers or sales, the housing market, political influences, inflation or deflation, international investment or spending patterns and stock market information. The same principles regarding supply and demand also impact currency. If the demand exceeds supply, the price of the currency will rise. If the supply is higher than the demand, the price will drop.

References

• Federal Reserve Bank of New York: The Basics of Foreign Trade and Exchange