The Forex Market Basics

Introduction to the Forex Market

The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of US$1.9 trillion — 30 times larger than the combined volume of all U.S. equity markets.

"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

There are two reasons to buy and sell currencies. About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency. The other 95% is traded because of cross-border investment activity (i.e. global equity and fixed income investing) and speculation.

For speculators, the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

The foreign exchange market is the only true 24-hour market. The trading day begins at 5pm New York time – which is the beginning of a typical trading day for dealers in Sydney, Australia. As the dealers in each financial center around the world begin their trading day, the market’s center of activity shifts from city to city – first to Tokyo and Hong Kong, then on to Europe and London and, finally, New York. The trading day ends at 5pm New York time – simultaneous with the beginning of the next trading day.

Consequently, and unlike any other financial market, investors can respond to currency fluctuations caused by economic, social and political events at the time they occur - day or night.

The FX market is considered an Over-The-Counter (OTC) due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network. Its depth and liquidity is derived from the 'inter-bank' market. The inter-bank market consists of all transactions executed by the market’s liquidity providers (dealers) offsetting position risk among themselves. Trading is not conducted on a regulated exchange and, as a result, there are additional risks associated with forex trading than if this were the case. See Risk Disclosures.

More information
For more background about the Foreign Exchange market, review the Federal Reserve Bank’s special report "All About the Foreign Exchange Markets in the United States".

Understanding Forex Quotes

Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things:

1. The currency listed first is the Base currency and the currency listed second is the Counter currency
2. The rate of exchange is the quantity of the Counter currency it takes to buy one unit of the Base currency.

The US dollar is the centerpiece of the Forex market and is normally considered the base currency for quotes. Of the ‘major’ currency pairs, this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as the number of units of the Counter currency per 1 USD. For example, a quote of USD/JPY 115.01 means that 1 U.S. dollar is equal to 115.01 Japanese yen.

When the U.S. dollar is the base unit and a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 119.01, the dollar is stronger because it will now buy more yen than before.

The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.8367, meaning that one British pound equals 1.8367 U.S. dollars.

In these three currency pairs, where the U.S. dollar is not the base currency, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.

Remember this: if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.

Currency pairs that do not involve the U.S. dollar are called cross-currencies and the premise is the same. For example, a quote of EUR/JPY 137.95 signifies that one Euro is equal to 137.95 Japanese yen.

When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'ask':

The 'bid' is the price at which you can sell the base currency to the dealer making the quote (at the same time buying the counter currency).
The 'ask' is the price at which you can buy the base currency from the dealer (at the same time selling the counter currency).

What is a Pip?

Pip stands for "percentage in points" and is the smallest unit of change in a currency pair as it is typically quoted in the Forex market. Forex prices are quoted according to dealer ‘conventions’ that evolved over the many years currencies have been exchanged between the financial institutions of different countries.

For many currencies (most of the majors), a pip is the fourth decimal point. A change in price of 1 pip is equal to 1/100th of 1% of one unit of the counter currency.

For example, in EUR/USD, a 3-pip spread would be quoted as follows:

Among the major currencies, the only exception to that rule is the Japanese yen. In USD/JPY, the quotation is only taken out to two decimal points. Therefore, a change in price of 1 pip in USD/JPY is equal to 1% of one yen.

Therefore, in USD/JPY, a 4 pip spread is quoted as follows: