Unlike stocks or commodities, forex is not traded on exchanges, but rather directly between two parties in the over-the-counter (OTC) market. The forex market is managed through a global network of banks distributed across four major forex trading centers in different time zones: London, New York, Sydney, and Tokyo. Because there is no central location, forex trading is available 24 hours a day.
There are two different types of forex markets:
The spot forex market: This is the physical exchange of a currency pair, which takes place at the point specified for settlement of the trade, either immediately or within a short period of time.
Forex futures market: In this market, an agreement is made to buy or sell a certain amount of currency at a specific price, to be settled on a specific date in the future within a range of future dates.
What is a base currency?
The base currency is the first currency in a forex pair, while the second currency is called the quote currency. Therefore, forex trading is always about selling one currency to buy another. The price of a forex pair is the value of one unit of the base currency in the quote currency.
Each currency in the pair is displayed as a three-letter symbol, the first two letters usually representing the country or region, and the third the currency itself.
For example, EUR/USD is a currency pair that involves buying euros in exchange for US dollars - i.e., selling US dollars.
Therefore, you will find currencies divided into several categories according to their importance:
Major currency pairs: These consist of 7 major currencies and are divided into two categories based on their correlation with the dollar - direct and indirect.
Currency | Country |
EUR/USD | Euro region/ United States of America |
GBP/USD | Great Britain/United States of America |
AUD/USD | Australia/United States of America |
NZD/USD | New Zealand/ United States of America |
USD/CHF | United States of America/Switzerland |
USD/JPY | United States of America/Japan |
USD/CAD | United States of America/Canada |
Cross-currency pairs or minor currency pairs: Currency pairs that do not include the US dollar are known as cross currency pairs. These are pairs where major currencies are traded against each other wihtout the US dollar being present.
Examples include: GBP/JPY, EUR/NZD, EUR/CHF, CAD/JPY, CHF/JPY, and so on.
Non-Major of Limited-Demand Pairs: These are rare currency pairs consisting of a major currency paired with the currency of an emerging or strong but smaller economy from a global perspective, such as Hong Kong, Singapore, or European countries outside the Eurozone. These pairs are not traded as frequently as major or minor pairs, so the cost of trading them is often higher due to the lower liquidity in these markets.
Examples include: EUR/TRY, USD/SEK, USD/NOK, USD/DKK, USD/ZAR, USD/HKD, and USD/SGD.
How do we read currency prices?
When a currency is priced, it is paired with another currency. Therefore, the value of one is reflected in the value of the other. The base currency is on the left of the pair, and the quote currency is on the right.
See example below:
GBP/USD : 1.3450
In this case, the British Pound is the base currency and the US dollar is the quote currency. Therefore: 1 British Pound = 1.345 US dollars.
However, when we trade in financial instruments such as currencies, we offer two slightly different prices.
We have the selling price (also known as the bid price) and the buying price (also known as the ask price).
The bid price is the best price we can sell at in the market.
The ask price is the best available price we can buy at from the market.
The difference between both prices is called "Spread".
In this case, we can see that the bid price for the EURUSD pair is 1.12643 and the ask price is 1.12646. The difference between the two is 0.00003, or what we call three-tenths of a point.
What drives the forex markets?
The forex market consists of currencies from all over the world, making it difficult to predict exchange rates due to the numerous factors that can influence price movements. However, like most financial markets, forex is primarily driven by supply and demand, and understanding the factors that cause price volatility is crucial.
Central banks
The supply of money is controlled by central banks, which can announce measures that will significantly affect the price of their currency. For example, raising or lowering interest rates can cause the currency to appreciate or depreciate.
News release
Commercial banks and investors tend to allocate their capital to economies with strong prospects. Therefore, if positive news emerges in the markets regarding a particular currency of a country, it will encourage investment and increase demand for that currency.
Similarly, negative news can cause a decrease in investment and a decline in the value of a currency. This is why currencies tend to reflect perceptions of the economic health of the region they represent.
Supply and demand
This determines market sentiment, which can play a key role in currency price increases. If traders believe a currency is heading in a certain direction, they will trade accordingly, leading to either increased or decreased demand.