foreign exchange

The foreign-exchange market, usually shortened to Forex or FX, is the market in which one country’s currency is exchanged for another’s. Trading happens in pairs: buying one currency means selling another, and the exchange rate between the two is the price. Unlike a stock exchange, the Forex market has no single central marketplace; trading takes place over the counter through networks of banks, brokers, and electronic platforms.

Many kinds of participants use this market for different reasons. Businesses exchange currencies to pay for goods and services across borders and to manage the currency risk in their contracts. Banks trade for their clients and for themselves. Governments and central banks participate in connection with their monetary and reserve policies. Investors and speculators trade in an attempt to profit from changes in exchange rates. This article is educational only; it is not investment advice, and nothing here is a recommendation to trade.

The modern market is best understood through its history. For much of the early twentieth century, major currencies were linked to gold, and the United States dollar was convertible to gold at a fixed rate, backed by official gold reserves. After the Second World War, the Bretton Woods framework tied participating currencies to the dollar and established the two Bretton Woods institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). The General Agreement on Tariffs and Trade (GATT), signed in 1947, was not a Bretton Woods institution, but it was envisaged as the trade leg of the same postwar economic architecture. In 1971, the United States suspended the dollar’s convertibility into gold, which effectively marked the end of the fixed-rate framework; a brief attempt to restore fixed parities followed before major currencies moved to floating rates. This is why 1971 is often treated as the beginning of the modern Forex era.

Since then, most major currencies have floated: their values move with supply and demand in international markets rather than by a fixed peg. This is a general description, not a universal rule; some countries continue to peg or manage their currencies, and exchange-rate policy differs by country. Exchange rates respond to many influences, including interest rates, inflation, trade flows, and economic and geopolitical events, and these relationships are neither simple nor stable.

Whether any of this matters for a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

To go deeper, the related articles on this site cover correlation, the Sharpe ratio, managed accounts and hedge funds, and how to think about a manager’s track record.