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Foreign exchange (FX) is basically the process of trading one country’s currency for that of another. In a global market with hundreds of currencies in use, this is a necessary process if international trade is going to occur. The international exchange rate is what determines the value of a country’s currency compared to that of another. The open trading of currencies in the forex market creates the fluctuations in the market values of the currencies.

The concept of foreign exchange has been around as long as trade between countries with different currencies has been transpiring. Foreign exchange has been documented as far back as biblical times, but Julian Walmsley, author of The Foreign Exchange and Money Markets Guide, claims that the foreign exchange as we know it today did not actually develop until the 1800’s when cable transfers took place between the cities of London and New York City.

From a historical standpoint, in order to improve a country’s trade position, governments attempted to establish exchange rates individually. When a country set its exchange rates lower than the rates of other countries, it was doing this in order to improve its trade position. It would make its exports more affordable, while at the same time making its imports from other countries less affordable. Trade wars were oftentimes the result of this practice as it caused other countries to struggle for a better trade position.

Most major countries have been allowed to “float” their currencies — a technique that allows a country’s exchange rates to be determined by economic supply and demand factors within the different currency markets. Floating currencies has been allowed since the early 1970’s, so this is not a recent concept in the forex market. The purchasing and selling of foreign exchange reserves enables countries to fine tune their exchange rates by keeping reserves of foreign currencies or gold in the central banks.

Market Composition

There are thousands of businesses and governments worldwide that purchase, sell, and trade different currencies. However, the foreign exchange markets are decentralized. Since rapidly falling or unstable prices can create economic destruction and even the death of a country’s economy, most governments have a keen interest in what rates are doing in the forex market. When a government is involved in the purchase, sale, or trade of foreign currencies, it is basically trying to influence the exchange rate of its own currency. It also provides the country an opportunity to intervene in the foreign market via open market activities.

Other common participants in the forex market are commercial banks, foreign currency brokers, and portfolio managers. Currencies are seen as an investment instrument to these financial entities. Sometimes, rather than selling to a foreign concern, they will sell to their own customers such as exporters, importers, or multinational companies that require the conversion of currencies to operate their businesses. Commercial banks are normally the larger users of the forex market, often serving as the intermediary between the purchaser and seller of a foreign currency.

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