The foreign exchange market refers to the trading place where foreign exchange is traded, or the place where different currencies exchange with each other. The Forex market exists because:
- Trade and investment
Importers and exporters pay one currency when they import goods and charge another when they export goods. This means that they pay different currencies when they close their accounts. Therefore, they need to convert some of the currency they receive into currencies that can be used to purchase goods. Similarly, a company that buys foreign assets must pay in the currency of the state concerned, and therefore it needs to convert its own currency into the currency of the state concerned.
Exchange rates between two currencies vary with supply and demand between the two currencies. A trader can make a profit by buying a currency at one exchange rate and selling it at another, more favorable exchange rate. Speculation accounts for about the vast majority of foreign exchange market trading.
Because of fluctuations in exchange rates between the two related currencies, companies that own foreign assets, such as factories, may be exposed to some risk when converting those assets into the national currency of the cost country. When the value of a foreign asset denominated in foreign currency remains the same for a period of time, a gain or loss is generated when the exchange rate changes and the value of the asset is converted into domestic currency. Companies can eliminate this potential gain or loss by hedging. This is the execution of a foreign exchange transaction, the result of which is just to offset the gains and losses of foreign currency assets arising from exchange rate movements.