What is Foreign Exchange (Forex)?
Foreign Exchange (FOREX) is the arena where a nation's currency is exchanged for that of another. The foreign exchange market is the largest financial market in the world, with the equivalent of over $1.9 to $2.5 trillion changing hands daily; more than three times the aggregate amount of the US Equity and Treasury markets combined. Unlikeother financial markets, the Forex market has no physical location and no central exchange. It operates through a global network of banks, corporations and individuals trading one currency for another. The lack of a physical exchange enables the Forex market to operate on a 24-hour basis, spanning from one zone to another in all the major financial centers.
Traditionally,
retail investors' only means of gaining access to the foreign exchange
market was through banks that transacted large amounts of currencies for
commercial and investment purposes. Trading volume has increased rapidly
over time, especially after exchange rates were allowed to float freely
in 1971. Today, importers and exporters, international portfolio managers,
multinational corporations, speculators, day traders, long-term holders
and hedge funds all use the FOREX market to pay for goods and services,
transact in financial assets or to reduce the risk of currency movements
by hedging their exposure in other markets.
For active traders and investors, foreign exchange should be no different than other investment products such as equities, commodities, bonds, notes, bills, etc.. In fact because of the globalization of the economic world and the consolidation of whole economic regions (i.e., the European Union), having currencies as part of a diversified portfolio simply makes sound portfolio sense.
Just
like these other investment alternatives, foreign exchange offers traders/investors
a market (it is an over-the counter market) where they can buy and/or
sell an investment product. In this case it is a specific
Currency Pair. The currency pair may be the Euro versus the US Dollar,
the US Dollar versus the Japanese Yen, the British Pound versus the US
Dollar , the Euro versus British Pound, or a number of other currency
combinations.
The different currency combinations represent nothing more than the value of one currency versus the value of another. That relationship is represented by a single price. In foreign exchange, the price of a currency pair is the markets expectations (at that time) of the value of that currency vis-à-vis another currency given the current and expected economic and political situation of the two countries. In equity terms, it is the price of the stock.
If, for example, a country's inflation/interest rates are low and stable. If it's economy is strong. If it's politics are stable and expectations are for more of the same, then one can expect (in general) for that country's currency to remain strong versus a less fundamentally favorable currency.
Contrasting
that with an equity, if the domestic and global economy is strong.
If inflation is not running away. If competition is not taking away
market share or eating into margins. If product demand and growth
are strong. If the companies internal "politics" are such
that the workers are happy and productive, and expectations are for more
of the same, then you can expect that companies stock to remain strong
versus a company with less favorable fundamentals.
Like equities there are other factors that determine the short term value of a product including technical analysis, short term supply and demand, seasonal capital flow patterns, the current price of the instrument, etc. It is these universal dynamics that will move a currency up or down. By analyzing the pricing dynamics and combining that with sound money management discipline like stop loss orders, the investor can insure greater success in his foreign exchange trading.
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