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The purpose of the foreign exchange market is to facilitate the trading of various currencies around the world.  Although many different types of currency are exchanged, the majority of trades involve only a small number of them, including the U.S. Dollar, Yen, Euro, Swiss Franc, Pound Sterling, Australian Dollar, and Canadian Dollar.  The U.S. Dollar is involved in over 90% of all exchanges on the forex markets.  Contrary to popular belief, there is no one centralized market in which all currency trading occurs; rather, the foreign exchange is a loose conglomerate of several different markets, each of which has its own rules and regulations.  Major markets are located in the U.S., London, and Tokyo, and each is open during different hours according to their time zones.  Naturally, trading is heaviest when the market hours overlap, and almost two thirds of the trading activity at the New York market takes place during the morning while the European markets are still open.

Because there is no centralized market, a single exchange rate for a given currency does not exist.  Because of the over-the-counter (OTC) nature of the markets, the bid and ask rates for a currency can vary among different geographic markets and market makers, although they are usually fairly close to each other.  Since the price of a currency must be given in relation to another currency, it is expressed in the form XXX/YYY, where each trio of letters represents the international currency code.  For example, the price of Euros in U.S. Dollars is written as EUR/USD.  Traditionally, the first currency in the pair, called the base currency, is always the one that was strongest when the pair was created, and the other currency is known as the counter currency.  The actual prices themselves are in decimal form, typically rounded to the nearest ten-thousandth of a unit.

The forex markets make up the largest marketplace in the world, with the equivalent of £1.9 trillion changing hands every 24 hours.  It is largely a short term, speculative market, with more than 40% of positions closed out before two days, and nearly 4 out of 5 lasting less than a week.  It is an extremely liquid market, much more so than equities, due to the many participants throughout the world and the very high daily turnover.  The top ten most active traders, however, account for nearly 73% of total trading volume.  Made up of international banks, these huge players provide the market with bid and ask prices that are far tighter than retail customers can expect, and trading activity that occurs between them is known as the “interbank market”.

Introduced in 1972 at the Chicago Mercantile Exchange, forex futures contracts are derivative instruments that are actively traded as well, as they account for around seven percent of total foreign exchange volume.  In addition, foreign exchange options have taken hold as a popular hedging strategy.  They represent contracts to buy currency at a certain price on a set day in the future, and investors often purchase these derivatives to offset any potential losses they may suffer due to the decline in price of a currency.  Another way traders are able to mitigate risk is through a swap, in which both parties agree to exchange one currency for another for a set period of time, and will then reverse the transaction after the period expires.

The foreign exchange market is a fast-paced, international currency exchange that is without rival among financial markets.  Its immense popularity among large banks, financial institutions, international companies, and even retail investors ensures that its growth will continue into the future.