The forex market is the largest financial market in the world, with a daily volume of transactions of more than $6.5 trillion. Why does investing in currencies attract so much attention of investors and how to start your adventure on the forex market? Learn more about forex by reading this article.
Explore forex
Forex (Foreign Exchange) is the world’s largest financial market, with a daily volume of $6.5 trillion and an estimated value of more than $2.4 trillion. By comparison, the market capitalization of all publicly traded companies is estimated at around $90 trillion, roughly half of which is held by companies listed on US stock exchanges. The currency market is characterized by lower volatility than the stock market, the commodity market or especially cryptocurrencies. Still, investing in currencies attracts the attention of millions of retail investors around the world. Why?
By using most commonly Contracts for Difference (CFDs), traders can speculate on changes in exchange rates, using the mechanism of financial leverage. However, anyone who thinks that forex is a market full of speculators is wrong. Although forex attracts short-term investors for whom profit is the most important, the currency market is also a place where entrepreneurs, international corporations and other entities that need currency meet. Financial institutions and banks make thousands of transactions a day, trading hundreds of billions of dollars to meet the demand for currencies. The forex market – except for weekends and rare holidays – never sleeps, and the Asian, European and American sessions allow you to invest in currencies practically around the clock. The forex market can be both intriguing and incomprehensible – especially for beginners. In this article, we explain the basics of forex and show you how to invest in currencies while maintaining an acceptable level of risk.
Forex Fundamentals
Exchange rates compare the strength of individual economies, aggregating all available information about them, valuing individual risks and prospects. The exchange rate refers to a currency pair such as EURUSD. This most popular currency pair compares the Eurozone economy to the United States economy, and the EURUSD exchange rate will reflect everything that affects both of these economies. Exchange rates very often react to the most important economic data from each country, and one of the key price-setting factors is the cyclical publication of economic data. These include, among others:
- Central bank monetary policy (e.g. Federal Reserve, European Central Bank or Bank of England)
- Decisions on interest rates, money supply, etc.
- Geopolitical and internal issues
- Inflation forecasts
- Gross domestic product growth
- Economic activity
- Labour market data (e.g. unemployment rate)
What you should know about the forex market
A currency pair reflects the relationship of two currencies. The first currency in the pair is called the base (or fixed) currency, while the second currency in the pair is called the quote (or variable) currency. The exchange rate of a currency pair is the resultant of all factors affecting the value of both currencies in the pair. Intuition tells us that an increase in the EURUSD exchange rate will mean an increase in the value of the base currency (in this case, EUR) to the value of the quote currency (USD). However, this relationship can be reversed and the increase in the EURUSD exchange rate may be the result of a decrease in the value of the USD against the EUR.
The forex market is the largest and most liquid financial market in the world, with a daily trading volume of up to $2.6 trillion. Forex is also an OTC (Over The Counter) market, which means that there is no “forex exchange” that has a headquarters or location. The forex market is a decentralized market, created by a huge number of transactions concluded between many entities. Forex is also an interbank market, which is why its most important participants are banks and other large financial institutions. Due to the technological progress that has taken place in recent decades, investing in currencies is no longer the domain of the largest banks and corporations, and thanks to instruments such as CFDs, the forex market is also available to individual investors.
Factors affecting exchange rates
Exchange rates are constantly changing, which makes investing in currencies an extremely attractive option for many. At the same time, the number of factors that affect exchange rates is enormous, and keeping track of them all at once is an extremely difficult task. The most important factors affecting exchange rates include:
Interest rates – central bank decisions regarding the level of interest rates in the economy are crucial for the valuation of the currency. Official interest rates determine the “cost of money” in the economy – higher levels will make the currency more attractive to foreign investors. Conversely, a decrease in interest rates reduces the demand for a currency, which means that its valuation against other currencies usually falls.
Inflation level – inflation, i.e. a decrease in the purchasing value of money (which results in an increase in prices in the economy) is of key importance for the monetary policy of the central bank, as well as for the level of interest rates. Currently, many central banks list the protection of the purchasing value of money as one of their most important tasks, which in short means the fight against inflation. A higher level of inflation increases the chances of an increase in interest rates, which in turn should translate into an increase in demand for the currency. Conversely, lower inflation prompts the central bank to loosen monetary conditions in the economy by lowering interest rates
Macroeconomic data – the publication of macroeconomic reports can have a clear impact on the valuation of a given currency. Information on the dynamics of economic growth, business activity and retail sales is closely watched by investors, who try to determine its potential impact on the future monetary decisions of the central bank on the occasion of each publication.
Political events and investor sentiment – geopolitical issues can have a significant impact on exchange rates, as exemplified by Russia’s invasion of Ukraine in 2022 and the marked weakening of the region’s currencies (including the Polish zloty) in response to this event. Investor sentiment is another factor affecting exchange rates.
The US dollar and high inflation
Periods of higher and volatile inflation can cause volatility in the forex market to skyrocket and the value of many currencies to fall. In moments of economic uncertainty, investors tend to gravitate towards currencies perceived as “safe”, mainly the US dollar.
For example, when inflation in the US rises above the Federal Reserve’s inflation target, then the US central bank raises the level of interest rates, changing its policy to a more hawkish one. Higher interest rates attract foreign investors, which leads to an increase in the value of the US dollar.
The US dollar, due to its crucial role in global markets, is seen as the “safe haven” of the forex market. In times of market uncertainty and increased risk aversion, investors from all over the world prefer to hold US dollars – also due to the fact that the US is the largest economy in the world.
The US dollar index measures the strength of the US dollar against a basket of six other major currencies: the euro, the British pound, the Japanese yen, the Swiss franc, the Canadian dollar and the Swedish krona. The index has quite a long history and was created in 1973. An increase in the index means an increase in the value of the US dollar.