The foreign exchange market, also known as FEM by abbreviationfinder, is part of the financial market and, with an estimated daily turnover of 5 trillion US dollars, the largest market in the world. The foreign exchange market trades in book money, i.e. in the form of cashless payment instruments that are bought, sold or exchanged in foreign currency. Risks and benefits in forex trading arise from fluctuating exchange rates.
- Cashless purchases, sales and exchanges of domestic and foreign currencies take place on the foreign exchange market.
- Trading on the foreign exchange market is primarily carried out in interbank trading and a distinction is made between cash and futures markets.
- Central banks intervene in the foreign exchange market to regulate exchange rate fluctuations or to actively influence exchange rates.
- The most traded and stable currencies and currency pairs are the US dollar, the euro, the Japanese yen and the British pound.
Forex trading and market participants
Foreign exchange refers to a cashless balance of foreign currency that can be bought, sold or exchanged on the foreign exchange market. The trading of currency supply and demand takes place directly on a decentralized, so-called over-the-counter (OTC) market. This is where market participants do business without an exchange as an interface and use a network of dealers made up of market makers who essentially determine the supply and demand rates for currency transactions. Market participants are primarily commercial, private and central banks, which is why the term interbank trading is also used. Recently, however, trading on the foreign exchange market has also been open to private entrepreneurs and is brokered through forex brokers.
It is important to know that private entrepreneurs also have to pay tax on profits from foreign exchange trading. This is where the so-called final withholding tax comes into play , which has taxed all forms of investment income since 2009.
The cash and futures market
The economic location of foreign exchange trading is divided into cash and futures markets according to the time required to fulfill transactions.
- In the cash market, investors primarily trade in foreign exchange and securities ( stocks or bonds ). Contracts that have been concluded must be complied with within two trading days.
- Every fulfillment obligation that goes beyond two trading days is negotiated on the futures market. The trading objects here are primarily derivatives (futures, options and other contracts shifted into the future).
Exchange rate fluctuations
Exchange rates show the value of a domestic currency in foreign currencies. This value arises from the relationship between supply and demand that forms the foreign exchange market. The key interest rate determines the supply of a currency. The key interest rate determined by central banks such as the European Central Bank or the Federal Reserve indicates the amount of domestic money available and increases or decreases the value of a currency. The less money there is in circulation, the higher its value in the foreign exchange market; the more money there is in circulation, the greater the loss in value.
Forex market intervention
Upper and lower intervention points usually regulate fluctuations in exchange rates. If the exchange rate of a currency falls below or exceeds the exchange rate range set by a central bank, mechanisms are activated that regulate the currency again within the range. Central banks use these mechanisms to control inflation, to maintain the competitiveness of their own currency or to guarantee its general stability.
On the foreign exchange market, such interventions appear through the purchase or sale of foreign currencies in order to appreciate or depreciate one’s own currency. Such foreign exchange market interventions are primarily used by central banks in developing and emerging countries. In extreme cases, they can serve as an “economic weapon” in a currency war.
Frequently traded currencies
Three quarters of the total trading volume on the foreign exchange market is determined by the following five currencies:
- US dollar (USD)
- Euro (EUR)
- Japanese yen (JPY)
- British pound (GBP)
- Swiss Francs (CHF)
The most commonly traded currency pairs are:
- US dollars and euros
- US dollars and Japanese yen
These currency pairs are particularly attractive for newcomers to forex trading, as they promise stable exchange rates, a constant supply-demand ratio and high liquidity.