How to Understand the Forex Market

Have you heard about the forex market, but don’t really understand what it is? The forex market, or foreign exchange market, is the largest marketplace on Earth, allowing investors, governments, banks, corporations and even speculative traders to exchange various currencies as the prices fluctuate.

You might understand that forex has something to do with money, but many people also assume that it’s related to the stock market in some way. This simply isn’t true. The forex market is the money market on which the currencies of various countries are bought, sold or otherwise exchanged.

While speculative traders exchange various forex currencies in an effort to make profits and generate income, there is also scope for various exporting and importing corporations to solidify their own profit margins by using the forex market to their own advantage. To highlight how the forex market works between countries, here’s a simplified example.

Imagine a large US car manufacturer wants to sell $1 million dollars worth of cars to another country. That manufacturer wants to be sure they’re going to get $1 million in US dollars to cover their costs and maintain their profit margin. Let’s assume the buyer is in the UK and will be paying for the shipment of cars with UK pounds. This is a basic forex transaction.

The buyer works out that it should only cost them £606,449 based on the forex quoted rates on the day they receive their quote. They put aside this amount of money and they promise to pay it when the shipment arrives.

Now let’s assume the value of those UK pounds changes between the time of the quote and the time of the payment being due. Changes in foreign currency exchange prices are common on the forex market. Remember, the buyer over in the UK has put aside £606,449 to pay for a shipment of cars. The US car manufacturer needs to receive $1 million US dollars in order to pay staff wages, pay for the cost of making those cars and make a bit of profit to keep the company running.

By the time the shipment of cars is sent over, the value of the currency prices has changed. Neither of the participants in this transaction has altered the amount of money they think they’re sending or receiving, yet the forex market pricing has changed. The UK buyers send the same amount of money they put aside for the transaction, but instead of receiving $1,000,000, the US car manufacturer received $1,052,632 because the value of the forex currencies altered sufficiently to make a higher profit than they expected. The same thing could also happen in reverse so that the manufacturer could potentially receive a much lower amount of money than they expected. There are ways to protect against this happening.

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