Foreign Exchange | B2B Finance Glossary

Aug 31, 2023 by Zazil Martinez

What is Foreign Exchange?

Foreign exchange is the process of converting currency from one country into another country's currency. The foreign exchange rate is the specific conversion rate in which this process occurs, which always changes due to supply and demand. For example, if a tourist from one country goes to visit another country, that tourist must exchange his or her native currency for the currency of the country that is being visited. This type of currency exchange contributes to the demand for a specific currency tied to a specific country.

Foreign exchange is handled globally among different banks, and all transactions are handled by the Bank for International Settlements (BIS).


What Are the Factors that Impact Foreign Exchange Rates?

Many factors can impact foreign exchange rates, including tourism, investment, geopolitical risk, and government economic policies, including inflation, economic growth outlook, and trade balances. On top of this, other economic, political, and psychological conditions can greatly impact foreign exchange rates.

Things like political instability and political conflicts can negatively impact a currency at any given time.


How Does Inflation Impact Foreign Exchange Rates?

Inflation is just one of the many factors that determine foreign exchange rates. Still, it has the ability to have a very negative impact on a currency’s value and foreign exchange rate. While a low inflation rate does not necessarily translate to a good exchange rate, a very high inflation rate usually has a negative impact on the foreign exchange rate. This is because inflation is so closely related to interest rates which have the ability to impact exchange rates.

Low-interest rates don’t normally attract foreign investment, but higher interest rates do, and this leads to an increase in demand for the corresponding country’s currency.


What is the Foreign Exchange Market?

The foreign exchange market (also known as forex or FX) is the world's largest and most liquid financial market. This market was one of the original markets created to offer a structure for the growing global economy.

The foreign exchange market is made up of a global network of financial centers that transact 24 hours each day; however, this market is closed on the weekends. To keep the markets going during the week, one major forex hub will open in one part of the world as soon as another hub closes in another part of the world. The foreign exchange market’s major trading centers are located in major global financial hubs, such as New York, London, Tokyo, Sydney, Hong Kong, and London.

It’s important to note that the foreign exchange market is an over-the-counter (OTC) marketplace. It does not rely on a single centralized exchange but operates through a decentralized broker-dealer network. Participants in the foreign exchange market can buy, sell, exchange, and speculate on the relative exchange rates of many different currency pairs.

Currencies are always quoted in relation to another currency, so a currency pair is the price quote between two different currencies in the foreign exchange market; in other words, the value of one currency in a pair is relative to the value of the other currency in that pair. The first listed currency of the currency pair is the base currency, while the second is the quote currency.

The main function of the foreign exchange market is to establish the price for the global markets through pairs. Since the value of one currency in a pair is relative to the value of the other, this determines how much of one country’s currency another country can buy. This also helps enhance liquidity and stability in all other financial markets.

Additionally, currencies are either free float or fixed float. Fixed float currencies include the Saudi Riyal. In this instance, a country’s governing body sets its currency’s relative value to other currencies, usually by pegging it to a particular standard. Free float currencies include the US dollar and the British pound, and their relative value is determined by free-market forces like supply and demand.


What Are the Pros and Cons of the Foreign Exchange Market?

Here are the pros:

  • The foreign exchange market is open 24 hours a day during the week, meaning traders can trade any time on weekdays.
  • The foreign exchange market is decentralized, so no clearing house or central body facilitates trade.
  • Investors in the foreign exchange market aren’t held to the same strict standards and regulations tied to other markets.

Here are the cons:

  • There is a lack of transparency in the foreign exchange market which can hurt traders since they do not have full control over how their trades are filled.
  • The foreign exchange market is unregulated, which can bring risks to traders.
  • There are no set limits on leverage in the foreign exchange market, which means investors can potentially lose a lot of money.