What is Forex Trading and How Does it Work?

Forex trading is a critical part of every international business relationship, allowing businesses in every corner of the globe to send and receive payments for goods and services. In order to best take advantage of forex trading, it is important to understand what is is: from the basics of understanding currency markets, to the forex trading tools available, and how to use the markets and tools in order to execute effective transactions.

Forex Trading: How It Works

Arguably the largest and most important market in the world is the global currency market. If, hypothetically, all trading in equities, fixed income, derivatives and commodities were to suddenly cease, currency trading would still continue, as businesses in different countries would still have to pay each other for goods and services. Forex trading is the “other side of the coin” of all global trade; no goods or services move from one country to another without a corresponding foreign currency transaction.

The modern fluctuating exchange rate system emerged in the early 1970s, when the majority of countries ceased linking their currencies to the value of gold.¹ Once this international standard was removed, each currency’s value was able to shift or “float” relative to the currencies of other countries. Following the move away from gold as a pricing standard, the forex trading market blossomed. With the exponential growth in forex trading volume came a corresponding increase in liquidity and volatility, as well as a dramatic increase in trading and pricing speed. Making the forex trading market even more complex is the fact that, unlike other securities markets, it is truly a 24-hour market. Timely and accurate pricing quotes are paramount in executing profitable forex trades. When there are discrepancies in pricing, the opportunity for triangular arbitrage arises; for traders who can execute forex trades in milliseconds there are profits to be made.

Forex Trading Tools

There are some basic forex trading tools everyone should be familiar with when executing currency trades: spot contracts, forward contracts and futures contracts. Most forex trading is based on the spot rate, which is the current exchange rate between two currencies, such as pounds sterling and Australian dollars. A spot contract is a contract for an immediate forex trade at the spot rate; however, the delivery of the purchased currencies to the buyer and seller can take up to two days.²

A forward contract is an agreement that locks in a rate for the exchange of two currencies at a specific time in the future. Forward contracts are often used to hedge a company’s currency position; they can help to insulate the company from the effect of fluctuations in exchange rates. By knowing precisely how much foreign currency it will receive (or have to pay out) in the future, a company can focus on its core business instead of fretting over cash management. Forward contracts can be executed with foreign exchange providers, who can ensure swift and seamless transfers on the settlement date. Future contracts are similar to forward contracts in that they are contracts to buy or sell currency at a predetermined price on a set date in the future. However, they differ from forward contracts in that they are financial instruments that are bought and sold on derivatives exchanges. They can be used to mitigate exchange-rate risks or to speculate on exchange-rate fluctuations.

The Takeaway:

Forex trading is an enormous, complex and volatile market in which even a small difference in pricing can have a significant effect on a business’s profits. Therefore, it is paramount to engage with a trusted, robust, and transparent currency exchange provider that furnishes accurate, up-date information.

Sources

1. “The Bretton Woods System: How It Changed The World”, Investopedia; http://www.investopedia.com/articles/forex/122215/bretton-woods-system-how-it-changed-world.asp .
2. “Spot Trade”, Investopedia; http://www.investopedia.com/terms/s/spottrade.asp.
3. “Forward Exchange Contract”, Investopedia; http://www.investopedia.com/terms/f/forward-exchange-contract.aspbr/> 4. “Forex Futures”; Investopedia; http://www.investopedia.com/terms/f/forexfutures.asp