Forex stands for Foreign Exchange and is essentially a market where the currency of one country is traded for the currency of the other. Presently the foreign exchange market is by far the largest financial market in the world where transactions of the order of $1.9 trillion are carried out on a daily basis. This is equivalent to three times the amount of transactions being carried out in the US Equity and Treasury markets combined.
The significance of this foreign exchange market is that unlike other traditional financial markets they do not have any one central exchange and no physical location. The Forex market operates only through a network of individuals, corporations and banks all trading one foreign currency for another and is spread throughout the world. Not only does this give the market a global reach but the absence of a central physical location also means it can operate continuously throughout the day, spanning all time zones and all major financial centers.
Earlier, if retail investors desired to trade on the foreign exchange market, they could do so only through banks which typically carried out transactions for large sums of foreign currency, meant either for commercial or investment purpose. However, in 1971, exchange rates were permitted to float freely. This led to a dramatic increase in the trading volumes. However, today there are many individuals like importers and exporters or multinational corporations who pay for goods and services as well as disburse wages in foreign currencies.
You also have international portfolio managers along with speculators, long-term holders and day traders who carry out transactions in various financial assets using the Forex market. You can also find hedge funds that try to hedge their exposure in various other markets so that the risk of currency movements that is inevitable in a Forex market can be reduced.
Another important point to be noted is that in the foreign currency market, there is hardly any possibility of getting any inside information. All the currency exchange rate fluctuations are caused by the amount of money that actually flows through the market as also any ups or downs in expectations about the global macroeconomic conditions. If there is release of any news or information that is expected to have a significant effect on the market everyone in the world comes to receive the news at almost the same time.
Typically in a foreign exchange market, foreign currencies are traded against one another. A pair of foreign currencies is treated as a single product and denoted as AAA/BBB, where AAA is the internationally recognized, ISO 4217 standard, three-letter code for a particular foreign currency.
Similarly, BBB is the code for another foreign currency and AAA/BBB denotes the price of AAA in terms of BBB. For example, EUR/USD denotes the price of the Euro expressed in terms of the US dollar. So, EUR/USD is 1.2733 or 1 Euro is 1.2733 US dollars.
The foreign exchange market is different from the stocks and futures exchange market in more than one way. The Forex market is in fact an interbank and an over-the-counter market. This implies that any particular foreign currency pair does not have a fixed universal exchange rate.
This stems from the fact that the foreign currency market operates twenty fours a day, seven days a week with individuals transacting in foreign currency with foreign exchange brokers, these brokers interacting with banks, banks transacting with other banks, all over the world. This also means that even if one trading session ends somewhere, a new one is starting elsewhere.
For example, when the Asian trading session ends, the European session starts and when the European session ends, the US session will be in full swing. This is very significant since it means that all world currencies are in play at all times. It also means that traders anywhere in the world do not necessarily have to wait for local markets to open for them to carry out any transaction – they can react to any significant news that will have a bearing on the foreign exchange market as quickly as they can.