Foreign Exchange Market: An Introduction

The foreign exchange market is the biggest market in the world, where daily turnover in spot trading exceeds 4 trillion US dollars. While the US dollar is the most widely traded currency the biggest foreign exchange market is London. 

Trading in foreign exchange refers to currency trading. While the basic principles are the same, trading in currencies is a little different from other markets. While in other markets you trade a specific share, commodity or index, in currency market you trade currency pairs.

Trading involves buying or selling but how does one buy a currency? There has to be a different currency in which one can pay for the currency one buys. It is because of this that currencies are traded in pairs. It is also the reason why the currency market is known as foreign exchange market; the rates reflected are exchange rates. An exchange rate is the rate at which one currency can be exchanged for another. 

In the foreign exchange market, the big banks are the ultimate market makers. In fact, not very long ago, currency trading was only in the domain of large banks that bought and sold currencies for themselves and for their clients. The bid and ask prices of currency pairs are also set by banks after considering the demand and supply situation. However, brokers in the retail market have varying rates as there is no centralised exchange. 

The difference between bid and ask prices is known as a spread, which represents the profit of the broker. Historically, the narrowest spread is reserved for participants in the interbank foreign exchange market. In the retail market, brokers do not charge a commission on trades but derive their profit from the spread.