What is the Foreign Currency Exchange Market?

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi riyals, even though the United States is not involved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying and selling of different currencies takes place. The price of one currency in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens—there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day.

The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1,210 billion was traded each day—roughly equivalent to every person in the world trading $195 each day.

Foreign Exchange Market Participants

There are four types of market participants—banks, brokers, customers, and central banks.

-Banks and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other.

-Brokers act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange.

-Customers, mainly large companies, require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.

-Central banks, which act on behalf of their governments, sometimes participate in the FX market to influence the value of their currencies. With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.

With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

-To earn short-term profits from fluctuations in exchange rates, -To protect themselves from loss due to changes in exchange rates, and -To acquire the foreign currency necessary to buy goods and services from other countries.