The Hard Working Dollar

What Is Foreign Currency Trading?

Posted by A.L.K. On July - 28 - 2009

What Is Foreign Currency Trading?

As a side effect of the growth of the Internet and the democratization of information, the once obscure field of foreign currency trading has become available to individuals with little or no previous exposure to capital markets. However, before pursing this field, one needs to first define foreign currency trading.

Google defines currency trading as follows:

“The act of exchanging the legal tender of one country for another.“

In simpler terms, currency trading is the exchanging of the paper or metal mediums of payment of one country or economic region for the mediums of payment of another country or economic region. In most situations, currencies are traded between countries and/or economic regions because individual governments aren’t required to accept another country’s currency and often have multiple trading partners outside of their own borders. Therefore, the need to trade currencies comes out of the desire to trade goods and services with other countries, while maintaining economic independence via your own country’s currency. Additionally, there are several other reasons for trading currencies which will be discussed below.

Now that we have discussed why countries and economic regions participate in foreign currency trading, we have to discuss where, when, how, who and why of foreign currency trading.

Where Do Foreign Currency Trades Occur?
All foreign currency trades take place on an exchange just like stocks and other capital market assets. This exchange is called the “foreign exchange” and is the place where currencies are bought and sold for immediate or future delivery. The foreign exchange is also known as the Forex market (FOReign EXchange = FOREX) and is the largest exchange in the world. According to the Bank of International Settlements the foreign exchange has an estimated average daily turnover of $3.98 Trillion (and that estimate was as off 2007).

Although most currency trades occur in electronic currency markets, trading currencies also occurs in physical markets. A great example of physical currency trading is when an individual exchanges their country’s currency for another country’s currency when traveling.

When Does Currency Trading Take Place?
Currency trading takes place at all times. Unlike stock exchanges, the foreign exchange is open 24 hours a day starting at around 5pm EST Sunday and ending at 5pm EST Friday. The forex market is also open Saturdays, but prices don’t move much because of the decreased number of market participants. This 24 hour market cycle is due to the fact that the world, as a whole, is never asleep all at once and therefore one country’s good or service is always being exchanged for another country’s good or service.

How Do You Trade Currencies?
Currencies are traded in pairs. This is because when a currency trade is made, two transactions actually take place. One currency is being bought and another currency is being sold. For example if you were an American traveling to Europe, you would exchange your US Dollars for European Euros, which is the same as selling your US Dollars and buying European Euros.

Who Trades Currencies?
The foreign exchange market is made up of numerous market participants. The primary categories for market participants are governments, central banks (which are usually extensions of the government), large banks, corporations, currency speculators and other financial institutions.

Why Trade Currencies?
There are two main reasons to trade currencies, 1) to profit from the increase or decrease in value of one currency when compared to another currency or 2) to protect asset holdings in one currency from losing value against another currency.

As a whole, currency trading is a vital cog in the wheels that drive a global economy. It is especially important considering that our world is heavily dependent on trade between numerous countries and economic regions. So the next time you read a product label that says “Made in China” or drink a cup of Colombian coffee, consider the fact that a currency trade had to take place in order for you to enjoy that product.