How Do Currency Markets Work?

Fiat Currency

Currency markets 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, in actual practice, 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.

Currency Markets

The basic principle of trading on a currency market is really very simple, and operates like any other commodity: Buy for a little, sell for a lot. In this case, the commodity is money, so when you make a trade on the currency market, you are betting either that the currency you are selling will decrease in value, the currency you are buying will increase, or both, and thus enable you to turn a profit on the difference. Like other commodity markets, futures contracts are also available for currency speculation. The big players in this market are typically private banks, including all of the top five world foreign exchange traders.

How Market Activity Affects Value

Just as in a stock exchange, when a trader bets against a given currency, they are selling it and trying to transfer their capital into currencies that they think will have stable or appreciating value. The result of many traders doing this at the same time dumps massive amounts of the currency on the market, driving the value down relative to other currencies. When they bet for a given currency, they are buying it up. When a lot of traders do that, the increased demand on a fixed supply raises the price, thus increasing the value of that currency against others.