What Is the Foreign Exchange (FX) Market?

Every time you travel abroad, order something from another country, or buy a foreign stock, you are already participating in the foreign exchange (FX or forex) market — the place where currencies are bought and sold against each other. It is the largest financial market in the world, with over $7 trillion traded daily (BIS 2022), more than all stock markets combined.

There is one way this market differs from stocks at the root, and once you grasp it, every detail that follows falls into place: currencies have no absolute price. “This stock is worth $100” is a meaningful sentence. “What is the dollar worth?” has no answer until you add “measured in what?” Currencies only have relative prices, so everything in FX — the quotes, the trades, the profits, even the forces that move the market — is a difference between two things.

An Exchange Rate: One Currency Priced in Another

An exchange rate is the price of one currency in terms of another. EUR/USD = 1.08 means 1 euro buys 1.08 US dollars; equivalently, 1 dollar buys 0.926 euros. Same fact, two readings — relative pricing made visible.

Quotes follow fixed conventions: EUR/USD reads “how many USD per EUR,” USD/JPY reads “how many JPY per USD,” GBP/USD reads “how many USD per GBP.” The currency before the slash is the base currency — the thing you actually buy or sell. The one after is the quote currency — the units the price is stated in. The conventions are historical accidents; just learn the reading.

You Always Do Two Things at Once

Since only relative prices exist, every FX trade is a pair trade: buying one currency means simultaneously selling another. Buying EUR/USD means buying euros and selling dollars; if the euro then strengthens against the dollar (EUR/USD rises), you profit. There is no such thing as being “long euros” in isolation — you are long euros against some counterpart currency.

This is the single most counterintuitive point for newcomers, and it gives FX its symmetry: every position is a bull bet on one currency and a bear bet on another, inseparably.

Who Trades, and Why

Most of the flow in this market is not speculation at all. A US company buying European goods has to sell dollars for euros. A traveler headed to Japan converts dollars to yen. Buying foreign stocks or real estate starts with a currency conversion. Companies with foreign-currency revenues or costs lock in exchange rates to protect their income statements — that’s hedging. Speculators betting on rate moves are just one participant among several.

Ranked roughly by size: commercial banks are the largest FX traders, executing for clients (importers, exporters, investors) and trading their own books. Multinational corporations — the Apples and Toyotas — hedge the currency exposure their international operations create. Hedge funds and proprietary traders take directional bets. Retail investors and tourists convert money for travel or hold small speculative positions. And then there is one special class of player: central banks. The Fed, the ECB, the Bank of Japan mostly stay out — but when one steps in to stabilize its currency, the impact is enormous. Rare, which is exactly why every intervention makes headlines.

A Market That Doesn’t Sleep

Unlike a stock exchange with opening and closing bells, the FX market runs 24 hours a day, 5 days a week, because trading follows the sun. The rough session map (in US Eastern time; exact hours shift with daylight saving):

As Tokyo winds down, London opens; as London closes, New York is already running. For a trader this cuts both ways: no routine overnight gaps to suffer through, but also no closing bell granting permission to stop watching.

Pips and Spreads: The Market’s Units of Measure

FX prices are quoted to the fourth decimal place for most pairs, and the smallest price increment is called a pip:

EUR/USD moving from 1.0800 to 1.0805 has moved 5 pips. JPY pairs are the exception: for USD/JPY the pip lives at the second decimal (0.01).

The pip is the market’s universal yardstick because spreads and profits are both quoted in it. Like stocks, FX has a bid-ask spread: the bid is the price at which the market buys from you, the ask is the price at which it sells to you, and the gap is the market maker’s profit. Spread width is a direct readout of liquidity. On a major pair like EUR/USD, spreads run as low as 0.1–0.5 pips, and 2 pips already counts as wide; on exotic pairs like USD/TRY or USD/ZAR, 20–100+ pips is business as usual. The same “10-pip spread” is a disaster on EUR/USD and perfectly normal on USD/ZAR — spread numbers mean nothing without the pair attached.

Carry: Positions That Pay (or Charge) You Daily

FX has a feature stocks don’t: every open position accrues interest based on the interest rate differential between its two currencies. Hold the higher-rate currency and owe the lower-rate one, and you collect the difference daily; do it the other way around and you pay it.

Buy AUD/JPY (own AUD, owe JPY) and you earn Australia’s higher rate while paying Japan’s lower one — positive carry. Buy JPY/CHF (own JPY, owe CHF) and you earn Japan’s low rate while paying Switzerland’s higher one — negative carry, bleeding the differential every day. To get positive carry on those same two currencies, flip the direction: buy CHF/JPY instead.

The strategy of earning the differential itself is the carry trade: own the high-rate currency, owe the low-rate one, and as long as the exchange rate holds still, the differential is your return. It is popular in low-volatility periods — but notice the load-bearing clause, “as long as the exchange rate holds still.” One sharp adverse move can hand back a year of accumulated carry in days. A negative-carry position, meanwhile, only makes sense when you expect the currency you own to appreciate by more than the differential you pay.

What Actually Moves Exchange Rates

Back to the opening point: currencies only have relative prices. So what drives an exchange rate is never one country’s condition in isolation — it is always the difference between two countries.

The interest rate differential is the first driver: higher rates attract foreign capital and push the currency up — the same soil the carry trade grows in. Growth and inflation differentials come second: GDP, employment, and inflation prints stronger than the counterpart country’s strengthen the currency. Central bank policy rewrites the expected rate differential directly — hikes, QE, forward guidance, each one is an FX event. Political risk works one-sided: elections gone chaotic, instability, war all depreciate the home currency. Current account imbalances are the slow variable: a country running large trade deficits must keep selling its own currency for others, a persistent source of depreciation pressure.

The last driver belongs to no single country: risk sentiment. When markets panic, money floods into the “safe-haven” currencies (USD, JPY, CHF) and they strengthen; when markets get greedy, it chases the higher-yielding ones (AUD, NZD). The same pair, with nothing changed in the fundamentals, can move hard purely because global mood flipped — a reality every FX trader has to make peace with.

For a systematic treatment, Harris’s Trading and Exchanges covers FX market structure in Ch. 18, Sarno and Taylor’s The Economics of Exchange Rates covers the theory and evidence on exchange rate economics, and Lyons’s The Microstructure Approach to Exchange Rates explains, from a microstructure angle, why order flow has explanatory power for exchange rates.

References

• Harris, Trading and Exchanges, Ch. 18. Oxford University Press, 2003. ISBN: 978-0-19-514470-3.
• Sarno, Taylor, The Economics of Exchange Rates. Cambridge, 2012. ISBN: 978-0-521-48447-6.
• Lyons, The Microstructure Approach to Exchange Rates. MIT Press, 2001. ISBN: 978-0-262-12228-0.