Importance of the Foreign Exchange Market

The $1.5 trillion-per-day foreign exchange (FX) market surpasses stocks and bonds as the largest market in the world. Foreign exchange markets are critical for setting exchange rates between countries.

Liquidity

In terms of international trade, liquidity is the ease in which foreign currency is converted into domestic currency. FX markets, such as the New York Mercantile Exchange, match buyers and sellers to bring about speedy, orderly transactions.

Rates

Buyers and sellers set prices using the auction method in the FX market. Sellers try to earn the highest "ask" price possible, and buyers try to purchase currency at the lowest "bid." Buyers and sellers meet at the "spot" price, the current value and exchange rate for a particular currency against others.

Reserves

International governments enter the FX market to build and manage foreign exchange reserves. They build the reserves to make official payments and influence domestic currency values.

International Trade

Businesses rely on FX markets to buy currency that is spent to obtain overseas goods. Corporations will also look to FX markets to convert international earnings back into the domestic currency.

Hedging

Traders use foreign exchange derivatives, which "derive" their valuations and costs from the spot market. Options and futures contracts effectively lock in exchange rates for a set period, to hedge against the risks of currency fluctuations.

References

• Trading Foreign Exchange
• Foreign Currency Exchange
• FX Market Microstructure