The trading of foreign currency is the exchange of money issued in one country for money issued in another. Foreign currency trading takes place in the highly-solvent foreign exchange market. Currencies are traded for one another at exchange rates, which are relative prices determined by market supply and demand. The reasons for currency trading are twofold: practicality and speculation. The latter of these, speculation, occupies the majority orders placed in the foreign exchange market. At a practical level, currency trading benefits countries that wish to engage in cross-border commerce or trade.
The Foreign Exchange Market
Generally regarded as the most solvent of the world's financial markets, the foreign exchange market meets the needs of those who wish to obtain a specific currency in return for one they already hold. In this regard, the foreign exchange market plays a crucial role as the world's economies become increasingly interconnected. It consists of a network of numerous currency brokers located all over the world, both on the Internet and in physical locations such as banks and airports. Currency brokers offer to buy and sell the world's currencies at the market exchange rate appropriate to the currency deal.
Exchange Rates
Foreign exchange rates are simply the price of money. A given exchange rate reflects the relative market value between exactly two currencies. The rate is always expressed as the cost, in one currency, of one unit of the other currency. For instance, if the cost of one UK pound sterling, GBP, is 1.600 U.S. dollars, USD, then the USD-GBP exchange rate would be expressed as 1.600 USD/GBP, or 1.600 dollars for every one pound sterling. Furthermore, the reciprocal of an exchange rate (one divided by the exchange rate) expresses the cost of the other currency, or 0.625 GBP/USD using the first example.
Bid and Ask Prices
Traders in the foreign exchange market seldom, if ever, receive their desired currency at the exact market exchange rate. The reason is because currency brokers, as service providers, adjust the exchange rate they offer by between roughly 1 and 4 percent in order to obtain compensation. The price at which brokers sell one currency for another is called the "ask" price and comprises an upward adjustment. By contrast, the price at which brokers buy a currency is called the "bid" price and reflects a downward adjustment.
Trading Currency for Practical Reasons
At a fundamental level, a currency trader places a foreign exchange trade in order to obtain an amount of a specific currency with the intention of using it as a medium of exchange. In such trades, an individual or entity solicits a currency broker for either the equivalent in a foreign currency of an amount of money he already has, or a specific amount of a foreign currency that he wishes to obtain. This may include "changing" money at an airport prior to international travel, or placing a trade in order to cover an invoice on imported goods and services.
Trading Currency for Speculative Purposes
A trader places a speculative currency trade if she wishes to buy or sell a specific currency at a given exchange rate level in order to make a profit from a movement in that exchange rate at a later time. For this reason, a speculative currency trader has no intrinsic interest in a currency apart from her perception thereof as an appreciable market asset. Speculation is the most common reason for trading currency, and speculative trades are placed no differently than those described earlier. Speculative trades differ in that traders must place at least two trades: a buy and, later, a sell. Since it is not possible to predict with certainty the future movements of a specific exchange rate, speculative currency trading carries a tremendous risk of loss.
