WHAT IS FOREX (FX) TRADING?

What is Forex (also commonly known as FX)?  

The word ‘Forex’ is actually a portmanteau, (a fancy word created by the mash-up of two words), created from the words ‘Foreign’ and ‘Exchange’. So, the real question should be ‘what is Foreign Exchange’?

Foreign Exchange, is the exchange of one currency for another or the conversion of one currency into another currency.

The example below will show you what Foreign Exchange looks like, and why it is relevant to the exciting world that is Forex trading.

EXAMPLE 1

A British company approaches a Japanese rice supplier for 500 tons of rice, for which the Japanese rice supplier quotes 500,000 Japanese Yen (¥).

Therefore every 1 ton of rice is traded at an ‘exchange rate’ of 1000 Japanese Yen (¥).
This could be written as 1 ton of rice : 1000 Japanese Yen (¥).

In order to make this possible, the British company must convert their Pounds sterling (£) for Japanese yen (¥).

The British company approaches a bank who quotes an exchange rate of 1:143 (Pound Sterling:Japanese yen), this means that for every £1 they will in exchange receive ¥143.

This means that the British company must pay approximately £3,500 (500,000 ÷ 143) for 500 tons of rice.

Voila, here we have an example of a Foreign Exchange transaction!

What is an Exchange Rate?

An exchange rate tells us how much we will get from one currency relative to another. They are constantly fluctuating due to the market forces of ‘supply and demand’.

Imagine what would happen to the exchange rate if 20 million British companies all wanted to exchange their Pounds sterling (£) for Japanese Yen (¥) at the same time…

The Japanese Yen (¥) would greatly increase in value, due to the huge demand, yet no real increase in its supply. 

This means that exchange rates are constantly changing due to the fact that supply and demand levels are never equally balanced. It is this constant fluctuation that creates the basis of Forex trading. 

What is Forex (FX) Trading?

Forex trading is the buying and/or selling of one currency against another – with traders making a profit on the fluctuation/volatility of the exchange rates from one currency relative to another.

A Forex traders aim is to buy a currency when it has a lower exchange rate and sell it when it has a higher exchange rate (and vice versa) in order to make a profit.

BONUS:

We now know that exchange rates fluctuate due to the market forces of ‘supply and demand’.

But what affects the supply and demand of a currency?

A notable factor is the macroeconomic part an economy plays on the currency. Examples of the most significant macroeconomic factors that affect an exchange rate include;

• Central Banks monetary policy
• Interest Rate Differential
• Inflation
• Current-Account Deficits
• Public Debt
• Political Stability and Geopolitical Stability