Understanding the FX Market

November 1, 2022 | 5-min. read

Understanding the FX Market

The foreign exchange market (also known as the “FX” or “Forex” market) is a global network of currency traders. It’s one of the world’s largest and most liquid markets, with an average daily trading volume of $7 trillion. If you’re paying for a child’s tuition abroad, receiving remittances from a relative overseas, or importing goods, you will be impacted by exchange rates. Understanding the mechanics of how rates are set and what makes them move can give you a competitive edge.

If the global economy used a single currency, there wouldn’t be an FX market. Since no such thing exists, when goods and services are bought and sold across borders, their prices need to be converted. This is because imports from a foreign country are most often paid for in its local currency.

What’s important to know is exchange rates aren’t static. The market operates 24/7 (with the exception of weekends) and is extremely responsive, with price quotes fluctuating throughout the day. When traders buy a currency it pushes up the price and causes the currency to appreciate against other currencies. Selling a currency causes the reverse.

Altogether, there are more than 170 currencies in the world, with each having a three-digit code to identify it. For example, “XAF” is the code for Cameroon’s currency, the Central African Franc. Currencies are traded over the counter (between two counterparties) rather than on centralized exchanges, with the price depending on the source of the quote. Different counterparties quote different prices, which reflect their inventory and risk appetites.

Currencies trade against each other in pairs, with the market setting the value of one against another. The difference in price between buying a currency (the “ask”) and selling another currency (the “bid”) is called the “spread.” For example, if you purchased 1 USD on October 20, 2022, you would pay XAF 666.63. But if you were to buy 1 USD instead, you would pay XAF 668.19, implying a spread of 1.562 XAF (or 0.23%).

Governments are directly involved in the FX market through their central banks, which manage massive foreign currency reserves. While governments intervene to influence policy, private participants like large international banks are the biggest players. For them, a minimum trade size is typically one million of a given currency, but is often in the 10 to 100 million range. “Interbank” deals account for slightly more than half of all exchanges.

For this reason, banks are the biggest influencers in determining currency prices. They benefit from small differences between the bid and ask prices. Other participants include institutional investors, hedge funds, and currency speculators who actively trade for investment and risk management purposes. The lack of a centralized exchange results in this opaque and lightly regulated market, with no visible common price. What price you get depends on who you trade with.

Because developed markets hold most of the world’s reserve currencies, emerging markets are more prone to currency crises. At the first sign of trouble, investors flee to safety, dumping emerging market currencies and buying up safer assets in mature markets.

This phenomenon has led to currency crises in countries like Argentina, Thailand, and Zimbabwe. The flight to safety that triggers a devaluation can also be caused by mismanagement and bad domestic policy like chronic foreign debt, nationalizations of foreign companies, and sanctions.

To avoid vulnerability, some emerging markets choose to peg their currencies to reserve currencies. For instance, the CEMAC zone pegs the XAF to the Euro. Even mature markets like China don’t allow the value of its currency (the Renminbi) to deviate too far from that of the USD, using their huge foreign reserves to prop it up. Other countries go further by adopting another country’s currency. Zimbabwe, the Democratic Republic of the Congo, and Timor-Leste have adopted full or partial use of the USD.

These are the forces that shape the FX market and invariably impact your business, whether or not you engage in cross-border trade. Understanding how the FX market works can enable you to plan better, especially when a weakening global economy has direct impacts. Due to US monetary policy tightening, the XAF has depreciated by about 20% against the USD since a year ago, driving up the price of imports and leading to inflation (for more about this phenomenon, see The Challenges of a Strong Dollar).

Kappa wants to empower you with the knowledge you need to make financial decisions for your business with confidence and certainty. This includes understanding why your rate may rise and fall over time when making transactions on Kappa.

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