Most countries have their own currency, but many businesses and individuals need to swap one type of money for another. It’s called foreign exchange, or forex. The process takes place in a global marketplace where financial institutions, investment firms and speculators trade currencies around the clock.
The market determines the relative value of a currency pair by setting how much of country A’s currency is worth in country B. It also establishes a relationship (price) for all other markets that deal in the buying, selling or exchanging of currencies. This helps make the world economy more stable.
A traveler going from the United States to Europe needs to exchange their U.S. dollars for euros when they arrive in Germany. In this instance, they participate in the spot market of the foreign exchange market. This is the largest and most liquid market segment.
Investors and companies trade currencies to hedge against the risk of future changes in exchange rates. This reduces their exposure to foreign-exchange-related financial and operating risks. Traders speculate on the direction of exchange rates by buying currencies that they expect to rise in value and selling those that they believe will decline in value.
The vast majority of people and firms that need to exchange currency go to their bank, which is a major participant in the foreign-exchange market. The market works through these banks and a smaller number of financial firms known as dealers. The large dealers keep a close eye on each other’s trading activities and price quotations to avoid making inaccurate market-making assumptions about the relative values of different currencies.