by Andrew Horowitz
What is a foreign exchange market, or Forex market? Are Forex markets really as risky and dangerous as you've been told? If you've ever had basic questions as to what the foreign exchange markets are, then this episode is for you. I’ll give you the basic information you need to understand the basics of the world's most liquid market.
What is the Forex?
Let's get started with a basic definition. Forex refers to "foreign exchange, or currencies" and it is the method by which currencies are converted across the globe. This market helps set the exchange rates you'll pay when you exchange your dollars for Euros when you go to visit Europe or into Yen when you travel for business or a vacation in Japan. It might be easier to visit other countries if there were a single global currency, but that's not the way the world works; each country has its own currency, which can make traveling overseas difficult. As such, the Forex market exists to facilitate simple currency conversions between foreign governments, banks, and individual citizens from across the world.
What is the Forex Market?
The Forex market is mainly an electronic exchange of currencies. It does not have a central location like the U.S. stock market, which has its headquarters on Wall Street in New York City.
The simple-to-explain purpose of the foreign exchange market is to help international trade and investment.
There are financial centers around the world including Tokyo, London, and New York, but none of them claim the "global capital" of the foreign exchange markets. London has the largest daily volume, at roughly $1.3 trillion dollars, which is just over 35% of the total global volume, so it's the largest hub for foreign exchange. The simple-to-explain purpose of the foreign exchange market is to help international trade and investment. The Forex market helps businesses convert one currency to another.
Who Uses the Forex Market?
For example, it permits a U.S. business to import European goods and pay in Euros, even though the business's income is in U.S. Dollars. Also, McDonald’s restaurants that operate in Europe take in Euros from their European customers, and these Euros must be converted into U.S. dollars for McDonald’s, as a U.S.-based company, to use the profits from its overseas stores. Any U.S. company that does business overseas will convert currencies back and forth through the Forex market.
It's estimated that the global turnover or total transactions that take place on a daily basis in the broad Forex market is just shy of $4 trillion dollars. Four trillion per day! According to the NYSE website, the average turnover on the NYSE/US Stock Market is just over $150 billion per day. That's a huge difference in daily turnover!
What is the Currency Cross Rate?
Currency quotes are always quoted in pairs, or how one currency compares to the other. That's an important distinction to make--currency does not have value by itself. We need to know how one currency compares to another, which is called the currency cross rate.
For example, the most popular or largest traded currency quote is between the euro and the U.S. dollar--also called the euro / U.S. dollar cross which is under the symbol EURUSD.
Think of currencies as a ratio, with the first currency called the base. In this example, the euro would be the base in the EURUSD pair. The base is always 1 (one) in the ratio, and we want to know how many of the second pair will buy one of the base pair.
Toward the end of 2009, the exchange rate of the EURUSD pair is just above 1.50, which means we can buy 1 Euro with 1.50 US Dollars. Or, to make a better example, it would take $150 US Dollars to get 100 Euros. That's no fun for Americans! We have to pay 50% more to get one Euro! That works well for European visitors to the U.S., who will get $150 U.S. dollars with 100 euros because the exchange rate is in their favor.
How to Understand the Currency Cross Rate
If the exchange rate was 1.0, it would mean that 1 U.S. dollar would buy 1 euro; the term we use for that is parity. We would say the "euro is at parity with the U.S. dollar" which would mean they would be equal.
If the ratio is above 1, then it means that the euro is stronger than the dollar because it takes more than 1 dollar to buy 1 euro.
When the ratio is rising, it means that it will take more dollars to buy one euro, and thus the euro is getting stronger than the U.S. dollar in the ratio pair.
And of course, if the ratio is less than 1, we would say that the euro is weaker than the dollar, because it would take less than 1 dollar to get 1 euro.
Think of it like a fraction. The euro is on top of the fraction and the U.S. dollar is on the bottom of the fraction. If the number on top gets larger, then the fraction gets bigger.
This takes some getting used to when looking at Forex/Currency quotes, but it gets easier to understand with time.
Just remember that the first currency in the pair is the base, and if that number is going up, then that currency is getting stronger, and if the number goes down, then that base currency is getting weaker.
Stay tuned as we discuss more about the Forex market and what it means to you as an individual investor.
Keep with us as we discuss even more ways to become a winning investor in our next article! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show.
And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market wishing you all the best on your quest to investment success.
