Foreign exchange, or forex as it is more commonly known, is the trading of one currency against another in other words it is currency exchange.

In fact we are all involved in currency exchange in particularly, when we travel to other countries. We visit the bank or exchange bureau and convert our home currency into the currency of the country we are visiting. You will notice that there is a difference between the rate at which you buy and the rate at which you sell. Equally when you make overseas purchases online you will also be involved with currency exchange and it is the strength of your home currency which determines the true price of the purchased goods, e.g. a short while ago the British pound was worth nearly two dollars but today it is approximately 25% less, therefore trading against the dollar and buying goods in dollars is more expensive.

It is the volume of these transactions which is significant because while each one is small the total volume is large.

When a business trades overseas it will pay in the currency of the exporter and it will undoubtedly experience a difference in the rate at the conception of the purchase and the actual rate when the bill is paid. This is why businesses which trade abroad have an exchange rate loss/profit account set up in their accounts.

Large companies exchange huge amounts of currency each year. The timing of the exchange can have a significant affect on their profits and balance sheet. As an example at the time of 9/11 I was engaged in a financial role in the textile industry exporting to the US. The change in exchange rate and an over night lack of confidence drove that textile company into liquidation.

Investors and speculators require currency exchange whenever they trade in any foreign investment, which generally includes equities, bonds, bank deposits, and commodities.

Commercial and investment banks are the usual source for companies for the provision of currency exchange.

Governments and central banks are heavily involved with currency exchange not in a speculative way but in an attempt to correct any imbalances. In fact it was through this activity that led to the Great Depression of 1929 otherwise known as the Wall Street Crash.

Currency exchange rates are determined by the currency exchange market and strongly influenced by a number of factors namely wars, acts of terrorism, Government announcements e.g. interest rates, unemployment and inflation data.

A currency exchange rate is typically given as a pair consisting of a bid price and an ask price. The ask price applies when buying a currency pair and represents what has to be paid in the quote currency to obtain one unit of the base currency. The bid price applies when selling and represents what will be obtained in the quote currency when selling one unit of the base currency. The bid price is always lower than the ask price.

acquiring the currency pair implies buying the first, base currency and selling (short) an equivalent amount of the second, quote currency (to pay for the base currency). (It is not necessary for the trader to own the quote currency prior to selling, as it is sold short.)

On the basis that a speculator believes that the base currency will rise or exchange rate will rise, they will buy a currency pair. A speculator selling a currency pair in effect sells the first, base currency short and buys the second, quote currency.

Conversely if the spectator believes that the base currency exchange rate will drop against the quote currency or that the quote currency will rise against the base currency the speculator will sell and be in an open position in the currency pair.

Immediately after such a trade, the net effect will be nil. This is due to the fact that the value of the base currency will be or less equal to the value of the equivalent amount of the quote currency. In fact, the value will be slightly negative, because of the spread involved.